The last decades of the twentieth century experienced a growing concern for environmental and social issues. This trend continues today, with reform efforts affecting a wide landscape of fields and industries. The corporate world is not an exception. Corporations are immersed in a revolution, and these business structures must evaluate their role in society.

Concepts such as Corporate Social Responsibility (CSR) and “Environmental, Social, and Governance factors” have become well-known standards for businesses, leaving behind an era of profit maximization in the shortest possible time.

Environmental, Social, and Governance factors (ESG) originated as the main topic in the United Nations Global Compact 2004 Report, Who Cares Wins. The report addressed financial institutions and called on them to resort to standards that would promote sustainability in three different but interrelated topics: environmental protection, social progress, and adequate corporate governance.

In the report, financial institutions assessed how considerations for these factors should become more present in the financial industry to continue—and build on—the sustainability trend that commenced in the last quarter of the twentieth century. Although ESG may have been introduced in the financial context, it soon expanded into all industries, and it is now a strategy to create value in society (Garrido, 2022, unpublished).

The ESG Report was only one among the international initiatives that targeted increased social responsibility through a holistic perspective. The trend is not only limited to environmental protection and the fight against climate change—although this is the ESG factor that has gained more momentum—but overall human rights protections have been targeted. Initiatives like the UN Guiding Principles on Business and Human Rights (UNGP), the OECD Guidelines for Multinational Enterprises on Responsible Business Conduct, the Sustainable Development Goals (SDGs), the Paris Agreement, and the Taskforce on Climate-related Financial Disclosures derived from COP21 are some examples.

This new reality has expanded into the legal arena. The ESG trend initially took the form of soft law instruments relying on voluntary action by States and civil society. However, enforceable legal mechanisms have now emerged to address the issue, imposing mandatory due diligence on companies. Some examples are Section 54 of the UK Modern Slavery Act 2015, the UK Gender Pay Gap Information Regulations, Germany Supply Chain Due Diligence Act, or the EU Directive on Corporate Sustainability Due Diligence (CSDD). One of the theories explaining this shift in the approach is judicial interventionism. Initially, court decisions addressed States and breaches of their international law obligations. For instance, in the 2015 Urgenda case, the Dutch courts ordered the Dutch government to reduce greenhouse gas emissions by 25%. The Netherlands appeal was dismissed by the Dutch Supreme Court in 2019. This trend has now expanded to address corporate behavior by private law companies, as evidenced by the Shell judgment.

Besides the public legal arena, ESG factors have also entered the field of international business transactions, having become an important topic in contractual negotiations and mergers and acquisitions (M&A) transactions. This piece will address the convergence of ESG factors into the corporate realm. It will first delve into the materialization of these abstract factors and ideas into corporate obligations for companies. Then, it will present the disputes and liability risks that arise, along with some suggestions to adapt the dispute resolution process to the M&A and ESG specificities that may arise from these transactions.

ESG in M&A Transactions

ESG factors have become relevant—and sometimes determinative—factors in corporate structures. For instance, deference to ESG is not reserved to directors and officers, but shareholders take an active role in the introduction of ESG proposals into corporations. These factors present a crescent role in M&A transactions: What was initially perceived as a “reputational” trend has become a substantive part of the decision to finalize an M&A transaction.

For the purposes of this article, M&A transaction will refer to any merger & acquisition transactions or contractual instruments, such as Share Purchase Agreements (SPA), Asset Purchase Agreements (APA), or Business Sale Agreements (BSA).

The importance of ESG factors is first appreciated in the initial evaluation of potential targets. Then, as the negotiations advance, it becomes an intrinsic part of the due diligence process. The parties may then agree to include representations—or other contractual clauses—referring to ESG on their agreement or influence their agreed premium according to the target’s ESG performance. ESG factors remain relevant even after the transaction has been completed. They have been analyzed as a tool for value creation, and they pose a risk to both buyer and seller, as post-transactional disputes may arise from misrepresentations regarding the ESG status of the acquired company.

Pre-Transaction Relevance of ESG Factors

ESG factors play a crucial role in the selection of companies that will be subject to initial evaluations by the acquirer. Evidence suggests that buyers with strong ESG performance are more likely to invest in and acquire companies with a “similar ESG performance.” This shows the commitment of these firms to aligning their shareholders’ preferences with the target’s stakeholders, which is likely to favor governance after the transaction. Companies with highly independent directors are also more likely to opt for targets with “CSR orientation.”

A different approach to ESG lies in the theoretical business framework adopted. Under the stakeholder theory, ESG efforts and investment are perceived as the means to increase the company’s value in the long run, maximizing shareholder value. Conversely, the neoclassical theory focuses solely on short-term profit maximization. Supporters of the latter are more likely to reject ESG considerations in their M&A decision-making. An example is that big, large companies tend to avoid targets with a clear ESG orientation.

A similar distinction is found in the different approaches taken by financial and institutional investors. While the former are perceived as focusing on short-term profit maximization, the latter are considered friendlier to ESG because of their long-term focus. This view has, however, been contested by some authors, who argue that financial shareholders increasingly feel the need to adapt to the interests of multiple stakeholders, which makes them friendlier to ESG investments. Similarly, not all institutional shareholders would benefit from ESG developments (i.e., family investors).

As the M&A process progresses and once the buyer has identified a specific target, ESG factors are present throughout different phases of the transaction, beginning with the due diligence phase.

The due diligence phase is the “process of investigation, review and verification” used by the parties—but mainly the buyer—to decide (i) whether to proceed with a transaction, (ii) the price they are willing to pay, (iii) how to structure the transaction, and (iv) to check and analyze the veracity of the information provided. The due diligence phase is regarded as a crucial part of any M&A deal, and it helps to establish the strategic purpose of the transaction (why is there interest in the target), what are the value drivers of the target, and identify the key risks from the transaction. Despite its newness, most acquirers conduct it to increase their information on the target.

In this process, the relevance of ESG becomes manifest. Potential buyers will take into consideration the ESG factors of the target company, analyzing the potential risks and opportunities that would derive from the transaction. Before, financial and economic indicators were the main aspects to analyze when deciding whether to proceed with a transaction. However, environmental, social, and governance factors now play a key role and may ‘tip the balance’ for or against the transaction. Due to this evolution, certain ESG due diligence is increasingly being conducted, not only because of expanding binding legal requirements but also in response to non-binding guidance and increased stakeholder engagement expectations. ESG due diligence is not a new concept, as traditional areas of due diligence like environmental liabilities and anti-bribery compliance have always shown an ESG aspect. However, its scope has broadened, merging with traditional legal due diligence due to the widespread legal implications of ESG issues.

ESG due diligence exercises are typically conducted by law firms, accounting firms, and other professional services providers with specialized ESG expertise. However, given the likely overlap between ESG and traditional due diligence, a sort of cooperation between firms—or employing only one firm for both—would be advisable.

The ESG factors to be analyzed in due diligence processes can be categorized as risks. Environmental risks include the existence of any regulatory violations (increasingly important as regulatory activity in the environmental arena intensifies), exposure to climate change-related incidents (i.e., sea level rise, droughts, etc.), or prior pollution incidents (which may cause reputational damage or litigation risk). Social risks may encompass human rights violations, opposition from the local community to the company’s operations (opposition from key stakeholders can diminish the value of the company), or poor labor practices (which may result in administrative sanctions by local governments). Governance risks refer to the governance of the target company itself and primarily involve the risk of minority shareholders’ actions arising from conflicts of interest, lack of transparency, etc.

However, ESG risks can broadly include regulatory compliance risks (i.e., failure to adhere to industry standards or reporting requirements), reputational incidents, and supply chain risks. The latter refers to risks that are not necessarily presented by the target company itself but stem from its dealings with other market actors. Broadly speaking, it may be affected by climate, economic, or geopolitical disruptions in the global supply chain or by smaller issues, such as reliance on suppliers with poor labor practices.

Undertaking ESG due diligence serves several critical purposes. First, it helps mitigate legal risks by identifying ESG-relevant regulatory obligations of the target and assessing its compliance level. The exercise may also indicate potential impacts on the acquirer’s legal obligations, such as emissions reporting, and help evaluate the governance systems in place at the target. This process can reveal where governance practices may need to be aligned with those of the acquirer and suggest enhancements to future-proof governance frameworks and controls.

Beyond legal considerations, ESG due diligence is crucial for evaluating financial risk. As argued, ESG compliance, or lack thereof, can impact the target’s valuation and financial performance projections. For example, sanctions imposed on any of the target’s suppliers could materially affect the target’s financial outlook. Furthermore, the acquisition of a company with adverse ESG practices could harm the acquirer’s reputation, undermining the value of the investment. For this reason, ESG due diligence typically involves conducting background checks on a target’s stakeholders, workplace culture, and policies. These could reveal issues like controversial client associations or misconduct records, which might have a reputational impact.

Another essential benefit of ESG due diligence is the identification of ESG opportunities. Due diligence does not only focus on risk mitigation, but it also aims to uncover opportunities to enhance the target’s ESG profile, which could contribute to its future value. A target with strong ESG credentials may find it easier to navigate a subsequent sale and could maintain a higher valuation future.

In sum, ESG due diligence is a vital part of contemporary M&A transactions, influenced by changing legal requirements, the necessity for financial risk management, reputational factors, and the goal of value improvement. While it runs alongside traditional due diligence, ESG due diligence provides distinct insights that can influence the direction of M&A transactions. After a successful due diligence phase (e.g., the buyer remains interested in the seller, or the seller chooses the bidder with a better offer), ESG issues often become an intrinsic part of the process, with impacts on the procedure and substance of the negotiations.

ESG differences between target and acquirer impact the length of the M&A process. On the one hand, acquirers with good ESG results are more likely to opt for a thorough ESG due diligence process, which will unavoidably impact the speed of the deal. On the other, once the due diligence is underway, significant differences between ESG results of the target and the acquirer also impact the process by raising contentious topics and negotiations between the parties. Despite the broad reference to ESG, not all factors have the same impact, with Social (S) and Governance (G) factors playing a bigger role than Environmental (E) factors in delaying transactions. This shows the relevance of firm culture and policies for M&A deals, a clear indicator of the chances of success of the newly integrated model after the transaction.

Furthermore, the information obtained during due diligence may affect the takeover premium. Issues detected during this phase help determine the price of the transaction, and ESG factors are no exception. Although some early studies yielded a negative result in the correlation between the takeover premium and ESG concerns and factors by target and acquirer, other studies have shown a positive correlation between both. Specifically, they show that, although slim, there is a correlation between higher premiums and ESG factors. This is particularly true for certain industries—Media and Entertainment, Financial industry, and Real Estate— and it is, again, more noticeable for Social and Governance factors. In addition to price adjustments, detected ESG issues can serve to bargain concessions on other aspects of the negotiation.

The extent to which ESG factors affect the transaction is broader than its effects on the final price. Contract negotiations may require that the contract reflect some aspects of the target’s ESG situation at the time of the acquisition through indemnities, representations and warranties, and covenants. These clauses can be the origin of post-M&A litigation.

Indemnities or indemnification clauses are included in M&A contracts to address issues detected in the due diligence phase that have not yet occurred or are not yet quantifiable. While these issues can affect price determination, the parties can also decide to delay dealing with the issue through an indemnity clause. Through these clauses, the seller will accept liability if the terms of the clause finally materialize or when it becomes possible to quantify the issue.

Although indemnification clauses can also be drafted in favor of the seller (i.e., if the transaction fails due to actions—or inactions—attributable to the buyer or by breach of its pre-closing covenants), ESG indemnities will typically benefit the buyer. For example, the seller could agree to assume liability in case of a past breach of the applicable environmental regulations results in an economic sanction after the transaction. This is often referred to as “making the buyer whole.”

However, the expansive concepts covered by the acronym “ESG” can work against broad indemnity clauses. Sellers are likely to fight against the inclusion of broad indemnities for ESG misrepresentations, while they are more likely to accept indemnities for specific situations carefully drafted and limited in the SPA (i.e., if there is ongoing litigation for environmental damages, the seller may agree to indemnify the buyer for the resulting damages after the litigation ends).

Representations and warranties—often referred to as “reps & warranties”—constitute a fundamental component of any SPA or of any similar document in the M&A context. These clauses serve distinct yet complementary purposes within the transaction framework. Representations allow the seller to provide explanations and characterizations of certain realities or critical aspects of the target company. In contrast, warranties function as assurances to the buyer that determined situations will occur, will not occur, or will remain unchanged as in the status quo. They can be a way to extract information and distribute risk between the buyer and seller.

The issue with ESG-related reps & warranties is that standard M&A representations or warranties can broadly cover many ESG factors. For instance, any standard representation by the seller that the company “complies with the applicable laws and regulations” can encompass certain ESG commitments or obligations. Similarly, representations addressing the company’s situation about proper governance or warranties ensuring adherence to anti-bribery regulations would also typically fall under standard M&A clauses.

On the other hand, ESG-specific representations and warranties can delve deeper into areas not addressed by the standard provisions. For example, they could broadly affirm the authenticity or adequacy of the ESG assets acquired in the transaction. They might also validate the accuracy of the ESG practices identified during the due diligence process. Additionally, ESG-specific warranties could establish detailed provisions regarding compliance obligations, the accuracy of crucial information (i.e., about the target’s supply chain details), or require adherence and compliance with specific international industry standards. Other highly sensitive ESG issues, such as workplace harassment, can be addressed through a Weinstein warranty, which requires disclosure of prior misconduct allegations against senior executives.

Through covenants, the parties agree on their behavior until the operation completely closes and the acquisition is finalized or, sometimes, on their immediate behavior post-acquisition. The seller is typically required to avoid any engagement in activities diverging from the company’s normal business activities or to avoid initiating or continuing conversations with third parties for the sale of the company or about the company’s assets.

In the field of ESG, covenants could require the seller to produce public ESG statements in coordination with the buyer, to implement certain ESG initiatives, or to obtain regulatory approvals before the closing of the acquisition. Although a broad covenant referring to the prohibition of any action outside the scope of the normal business activity could already cover some ESG factors, a more specific ESG-related covenant could serve to prevent the seller from engaging in any activity that would impact the company’s reputation, an essential element in M&A.

In sum, ESG indemnifications, reps & warranties, and covenants will be negotiated between the parties and introduced into the contract upon the study of the results of the due diligence phase. They should be carefully drafted, defining rigorously the scope of the parties’ obligations (i.e., temporal scope, any limit on monetary liability for damages) and the exact circumstances that would trigger a breach of the clauses. The greatest risk involves non-binding ESG standards, for which it may be difficult to argue and prove that the standard for breach agreed between the parties has been triggered. These disputes may extend beyond the parties, and involve questions of insurance coverage.

Although a standard clause in the contract could already cover many situations, introducing ESG clauses will help with addressing shareholders’ engagement with ESG and will provide a direct pathway to tackle specific ESG issues.

Post-Transaction Relevance of ESG Factors

ESG strategies can increase companies’ value, which becomes especially relevant after an M&A transaction. A report published by McKinsey Quarterly establishes that ESG has five links to value creation: (i) it produces top-line growth for the company (i.e., consumers willing to pay for sustainable practices, reduced opposition by affected stakeholders, etc.); (ii) it helps to reduce costs—even if a high initial investment is necessary; (iii) it leads to reduced regulatory and legal intervention, improving relationships with local governments; (iv) it uplifts employee productivity—which is associated with increased profits, and (v) it optimizes company assets and investments.

The ultimate beneficiaries of M&A value creation are the target shareholders, who receive a premium payment for their assets in the corporation. Conversely, the success of the operation for the acquirer is measured by determining whether the price paid for the stock was lower than the expected value it will add to the acquiring organization.

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