Five myths about ESG in M&A transactions

Everyone is talking about the opportunities and risks associated with this acronym. Lawyers from a wide range of disciplines are occupied with dealing with the "next big thing". But what does ESG mean for transactions?

According to the guiding principles of the proposals for the "ESG" directive, it is the behaviour of companies in all sectors of the economy that will be crucial to the successful transition of the Union to a more sustainable economy. Reinforcing the goal of European legal development, Blackrock's home page states: "Sustainability is no longer something that can be addressed after strategic investment decisions have been made; it is indispensable to making investment decisions." It is no wonder then that according to the first M&A Panel survey conducted by CMS and FINANCE Magazine almost two-thirds of the senior executives from M&A departments of German companies, investment bankers and M&A advisors already carry out due diligence where ESG issues are queried in the target company.

Ecologically and socially unsustainable contractual partners in a company's supply chain, breaches of occupational health and safety and gender equality requirements, lack of anti-corruption measures and a company's own environmental and social due diligence policy can often lead to exclusion from public procurement procedures, heavy fines, reputational damage (accusations of green-, blue- and pink-washing) and additional operational and financial expenses. A lack of ESG compliance can, as a result, be a dealbreaker.

ESG has therefore arrived in the transaction business with all its phases. But what needs to be taken into consideration? We take a look at five misconceptions about ESG in M&A transactions.

1. ESG-related legal developments and laws that have not yet come into force, such as the German Supply Chain Due Diligence Act (LkSG) or the German Whistleblower Protection Act (HinSchG), do not currently have to be observed in transactions.

Wrong: It is true that the relevant legislative acts have not yet entered into force. But buyers and sellers should nevertheless already now be taking the foreseeable laws into consideration in their transactions.

It is correct that even though the transposition deadline at national level has expired there is still only a draft bill of the German Whistleblower Protection Act (HinSchG) available. This act is not expected to come into force until autumn 2022. However, German private companies above a certain size, for which the EU Directive has no direct effect, should already be prepared to be obliged to set up a reporting office and internal reporting channels at short notice. In addition, it can be assumed that public bodies and private companies held by the state are already obliged by the Whistleblowing Directive due to the exceptionally direct effect of some of the Directive's provisions.

The EU Commission's currently discussed proposals for directives on the Corporate Sustainability Reporting Directive (CSRD) and the Corporate Sustainability Due Diligence (CSDD) still have to be adopted and then transposed into national laws within the implementation period so that the binding European corporate due diligence requirements on sustainability and the European reporting standards apply to their target group. However, according to the current schedule, this should already be the case for the CSRD from 1 January 2025 for the 2024 financial year.

The German Supply Chain Act (LkSG), on the other hand, will definitely apply from 1 January 2023, initially to companies with at least 3,000 employees, and from 1 January 2024 also to companies with at least 1,000 employees in Germany.

Therefore, it is expected that the German Whistleblower Protection Act (HinSchG) will come into force this year, and that the German Supply Chain Due Diligence Act (LkSG) will come into force from 1 January 2023, and at the same time it could be the first reporting year under the CSRD. In six months at the latest, sellers and buyers will have to comply with the then applicable legal obligations in transactions. In order to be well positioned in the future, sellers and buyers should, therefore, already prepare for the legal changes and address their (preventive) implementation in transactions in a focused manner. Buyers who are looking to the future will already now enquire in a due diligence how the target company is positioned with regard to the aforementioned legal changes in order to not have to bear the associated costs of the operational conversion nor the risks of possible fines in half a year. Therefore, for a seller there is by contrast a danger that it will not be able to sell its company or will only be able to sell it for less than its value. To this end, sellers are also well advised to ensure compliance with the foreseeable legal changes ahead of time.

2. Seller: If a target company has a poor ESG score it cannot be improved in the short term.

Wrong: Sellers should proactively address ESG issues in the target company. This is the only way that they will have a chance of clearing up any ESG inconsistencies, at least in the short term.

Initial short-term ESG-related adjustments and long-term corporate structuring require stocktaking on the seller side. CMS has developed an AI product called Green Trail for this purpose. By answering the questions, companies can receive an automated "self-assessment" on the areas E (Environmental), S (Social) and G (Governance) free of charge. Individual recommendations for action are derived from the status report generated from the self-assessment (quick wins for improving the ESG ratings) and discussed with the company. The aim is to provide concrete, fast, uncomplicated and yet tailor-made remedies with corresponding recommendations for action.

Consequently, sellers should take action at short notice to improve their own ESG rating. Those who present a status report, an action plan and initial successes or measures initiated before the due diligence can improve their market value and therefore achieve a higher purchase price when selling the company.

3. Buyer: A target company's poor ESG score can only be ascertained after acquisition.

Wrong: Buyers can already specifically identify any ESG risks that the target company may have during the due diligence process.

Due diligence serves, among other things, to evaluate a target company by identifying potential (ESG) opportunities and risks and evaluate them economically. This opportunity and risk allocation is based on the investment objective, the investment period and any exclusion criteria defined by the buyer with regard to the target company.

ESG expands and modifies the scope and reporting of a due diligence. We are currently developing ESG questions for due diligence in (inter)national working groups. The main drivers for the ESG-related expansion of the catalogue of questions are the aforementioned legal changes, the contractual obligations for ESG compliance of customers and suppliers, requirements for financial institutions to conduct ESG due diligence, the buyer's own reputation and the target company's existing ESG policy, if any.

4. Buyer: There is no point in buying a company with a poor ESG score.

Wrong: Some buyers may have various reasons to acquire a company with a poor ESG score.

On the one hand, buyers may well be "persuaders". Some buyers see it as their corporate responsibility to upgrade the relevant target companies in terms of ESG (e.g. to combat climate change, for the environment, for employees or even for third parties not involved in the company) for the benefit of all concerned and to put them back on the market.

On the other hand – and probably more often – a poor ESG score can also be used to acquire a company at a low purchase price. This is particularly useful if the buyer's group of companies is already ecologically and socially sustainable in itself. In these cases, the buyer may be able to transfer its know-how, structures and strategy to the target company without any major additional effort. However, such an approach is only advisable if the buyer has already positioned itself with regard to ESG matters in such a way that the inclusion of the target company in its portfolio does not have a significant negative impact on its own good ESG score.

5. Buyer: It is not possible to contractually protect oneself adequately against ESG risks.

Wrong: A buyer can counteract any identified ESG risks by using the customary provisions to protect itself. However, there are currently no tried and tested standards in contractual drafting when it comes to the area of ESG. With "The Chancery Lane Project", we at CMS are currently working with 2,300 lawyers from all over the world to develop contractual regulations. In all other respects, the classic instruments of an M&A contract are available.

Identified ESG issues can be included in the purchase price or as a purchase price adjustment clause. A fixed fine as a measurable loss can, for example, be imposed and can already reduce the purchase price. Alternatively, a ESG risk can be given a price and initially deducted from the purchase price. At the same time, an earn-out mechanism should be provided for where part of the purchase price to be paid to the seller will be paid when certain conditions have occurred in the future. For example, a surcharge on the purchase price could be agreed if a certain carbon footprint or diversity targets are achieved.

ESG issues that are significant for the buyer can also be addressed as closing conditions or, in a softer form, as seller obligations as post-closing or post-merger integration (PMI) measures.

In addition, guarantees and indemnities can cover general ESG risks or with a view to increased risks of the respective business activity be adjusted accordingly.

Finally, there are already first signs that S&I insurers are also entering the "ESG market".

We would, therefore, already recommend the following procedure for your transaction:

1. Gain awareness of the status quo in ESG. ESG is already important and will become increasingly more important under the Green Deal up to 2050.
2. Extend your due diligence to include the relevant ESG areas.
3. Provide for contractual safeguards to protect against current as well as future ESG risks.
4. Plan the post-merger integration under the constant legal development at an early stage.

In our monthly series "Five Myths" on ESG, sustainability and CSR, we dispel untruths and clichés that you may encounter as a legal practitioner, for example in the field of labour law, compliance or corporate law. Comprehensive legal advice that looks to the future.