ESG in M&A transactions in Germany – INSIGHTS in five minutes
The influence of ESG aspects is growing rapidly in many areas – including German M&A transactions. It would not be surprising if, as in the field of compliance, ESG sensitive business models, investments or business activities are “retroactively” assessed. As a result, the opportunities and risks presented by ESG should and will take on an important role of their own in transaction processes. Suitable target companies are being selected more and more frequently according to ESG criteria. During due diligence process, purchasers will have to look more closely at ESG factors when examining the business models of target companies, including their supply chains. In view of the large volume of changes currently taking place, it is important to carefully track future developments.
ESG (environmental, social, governance)
Alongside the digital transformation, the growing social awareness of sustainability in environmental, social and governance (ESG) topics will be one of the trends presenting the biggest opportunities and risks for business in the long term.
Urgent calls from society have initially led to the creation of a plethora of soft law, out of which more and more hard law is now being rapidly developed.
This hard law includes, for example,
- the EU Taxonomy Regulation (Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088),
- the CSR reporting duties in secs. 289b-e, 315b-d of the German Commercial Code (Handelsgesetzbuch – HGB) and recently above all
- the German Act on Corporate Due Diligence to Prevent Human Rights Violations in Supply Chains ("German Supply Chain Act" – Lieferkettengesetz) adopted by the Bundestag on 11 June 2021.
More “hard” legislation will follow.
The consequences of this development for companies are becoming increasingly difficult to predict. For example, the Gerechtshof Den Haag ruled on 26 May 2021 (C/09/571932/HA ZA 19-379, BeckRS 2021, 15559) that – at least under Dutch law – corporate due diligence obligations can also be derived from protection obligations under human rights law and from international environmental standards. In its decision, the Gerechtshof Den Haag obliged the defendant to reduce its emissions to a level compatible with the Paris Climate Agreement.
As with many aspects which, as "compliance" topics, have been reviewed subject to new stricter standards in recent decades, this development will lead to "retroactive" assessments of business models, investments and business activities as part of the pursuit of the imprecise goal of "sustainability". This is because, regardless of any legislation, companies that are exposed to ESG risks could suffer major reputational damage in view of society's rapidly growing awareness of sustainability.
What are ESG or sustainability risks?
Given the vague definition of sustainability, it is not always easy to determine what is specifically meant by sustainable environmental, social and governance practices. Legislation, too, is often imprecise when it comes to setting out the elements of a breach. Above all, however, the things that are perceived in society as ESG aspects and that must be expected to present both opportunities and risks are likely to undergo constant dynamic change. That is why it will be vital for management bodies in particular to closely follow developments in industrialized societies and to review their own business models, investments, shareholdings and business activities.
To obtain a more precise current definition of sustainability risks (which, if avoided, amount to opportunities and represent quality attributes), it is advisable for both regulated and unregulated companies to look at the Guidance Notice on Dealing with Sustainability Risks published by the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht – BaFin). BaFin defines sustainability risks as environmental, social and governance events or conditions which, if they occur, actually have or may potentially have negative impacts on an entity's assets, financial and earnings situation or reputation (BaFin, Guidance Notice on Dealing with Sustainability Risks, most recently accessed on 5 July 2010, p. 13). It lists the following examples (BaFin, Guidance Notice on Dealing with Sustainability Risks, most recently accessed on 5 July 2010, p. 13):
- Climate mitigation
- Adjustment to climate change
- Protection of biodiversity
- Sustainable use and protection of water and maritime resources
- Transition to a circular economy, avoidance of waste, and recycling
- Avoidance and reduction of environmental pollution
- Protection of healthy ecosystems
- Sustainable land use
- Compliance with recognised labour standards (no child labour, forced labour or discrimination)
- Compliance with employment safety and health protection
- Appropriate remuneration, fair working conditions, diversity, and training and development opportunities
- Trade union rights and freedom of assembly
- Guarantee of adequate product safety, including health protection
- Application of the same requirements to entities in the supply chain
- Inclusive projects and consideration of the interests of communities and social minorities
- Tax honesty
- Anti-corruption measures
- Sustainability management by the board
- Board remuneration based on sustainability criteria
- Facilitation of whistle blowing
- Employee rights guarantees
- Data protection guarantees
- Information disclosure
When considering these risks (and the opportunities that arise from avoiding them), companies must look beyond their own operations. Under the obligations imposed by the German Supply Chain Act, supply chains must also be examined for such shortcomings.
ESG and M&A
The fast-evolving area of ESG will also have a lasting effect on the M&A market, starting with the search for and selection of suitable target companies (such as those with a particularly strong ESG profile) and continuing with the ongoing critical review of the investor's own business model, and the business model of business areas and shareholdings. This will not only lead to new investments, but also to divestments of ESG-critical business areas and shareholdings. Especially when selling equity interests, it is important to choose the right time – one that is early enough to allow a new purchase to make long-term changes to the business model. Otherwise, doubts may arise as to whether a mere change of owner will effect any improvement in the target company's ESG record.
Reviewing sustainability opportunities and risks in the light of the above will become a more and more significant part of any due diligence. In many cases, it will be advisable to conduct dedicated "ESG due diligence" – in much the same way as an investor would carry out environmental and compliance due diligence. A very large proportion of ESG topics will be covered by legal due diligence, while others will be addressed in commercial or ESG due diligence. This requires a precise definition of those ESG aspects that are to be reviewed during legal due diligence and those designated for commercial, environmental or tax due diligence. An early decision should also be taken as to whether legal due diligence is to focus on breaches, or potential risks from breaches, of hard law applicable to the target company or whether it will additionally cover requirements under soft law and, unless already defined by statute, protection obligations under human rights law and international environmental standards.
The ESG topics that are tailor-made for legal due diligence include, for example:
- fulfilment of the obligations under the German Supply Chain Act; this review should not be limited to the target company, but should also include its supply chains, in particular those outside Europe. Therefore, even where target companies are based solely in Germany, it will become increasingly important to understand their networks, coupled with a growing need to carry out audits abroad, restricted not only to direct suppliers, also looking at the supply chain. Conflicts of objectives involving antitrust law can be resolved using tried-and-tested procedures (deployment of clean teams);
- in the case of target companies not covered by the German Supply Chain Act: fulfilment of recognised labour law standards, as laid down in the ILO Core Labour Standards or the "UN Guiding Principles on Business and Human Rights". They include in particular the prohibition of child and forced labour. In addition, national laws governing non-German target companies must be taken into account. For example, suppliers based in France must comply with the 2017 Due Diligence Act ("Loi de Vigilance");
- fulfilment of the due diligence standards under the EU Conflict Minerals Regulation that entered into force on 1 January 2021 (Regulation (EU) 2017/821 of the European Parliament and of the Council of 17 May 2017 laying down supply chain due diligence obligations for Union importers of tin, tantalum and tungsten, their ores, and gold originating from conflict-affected and high-risk areas);
- anti-corruption measures (which, however, had already been reviewed up to now as part of compliance due diligence);
- existence of public-law approvals and permits that are relevant to ESG;
- measures to ensure data protection (which, to an increased extent since the entry into force of the GDPR, have been reviewed up to now as part of legal due diligence);
- fulfilment of statutory disclosure obligations – in Germany pursuant to secs. 289b-e and 315b-d HGB (this may also be reviewed by auditors in individual cases as part of financial due diligence).
Other, less heavily legal ESG topics to be addressed in ESG due diligence are:
- sustainable procurement and use of resources,
- sustainable product design and longevity ("product stewardship"),
- sustainable waste disposal,
- inclusion of ESG aspects in corporate strategy,
- existence of a sustainability strategy,
- existence of an ESG Code of Conduct and
- existence of an ESG risk-based risk management System.
(Legal) due diligence request lists must be adapted and supplemented to reflect the above. New topics requiring data to be requested are, among others:
- information on the participants in the supply chains of the target company and on its production sites;
- information on the fulfilment of due diligence obligations under the German Supply Chain Act and similar international laws or standards;
- information on resources used and their consumption by the target company and the participants in its supply chains;
- information on product design and longevity;
- presentation of sustainability, environmental or CSR reports;
- presentation of incentive programs for the remuneration of managers in order to promote ESG
- disclosure of events that are relevant to ESG
- disclosure of all accusations of sexual misconduct by managers (as currently discussed in the USA, cf. Brownstein/Silk/Niles, The Coming Impact of ESG on M&A, Harvard Law School Forum on Corporate Governance, accessible at https://corpgov.law.harvard.edu/2020/02/20/the-coming-impact-of-esg-on-ma/ – most recently accessed on 6 July 2021).
Warranties and Indemnities
Good share/asset purchase agreements are likely to already cover some of the relevant ESG risks.
Certain ESG opportunities and risks are not suitable to be governed by share/asset purchase agreements because they constitute relatively soft goals for which there are not yet any verifiable statutory requirements or because the ESG criteria are difficult to measure. These opportunities and risks – if identified during due diligence – are more relevant to the question of whether the transaction will take place at all.
It will be interesting to see whether and how the market will react to specific, measurable and hard ESG risks, in particular by adjusting lists of warranties and indemnities. Depending on the target company and the negotiating position, amendments might be made in the following areas in share/asset purchase Agreements:
- Like the compliance warranty, a separate "ESG warranty" could be introduced. A very purchaser-friendly version of this might read as follows:
"The Seller has no positive knowledge of situations, events or conditions at the target company from the areas environmental, social or governance (ESG), which, within the past [•] years before the signing date, have existed or occurred at the target company in violation of laws, regulations or standards and whose existence or occurrence within a period of [•] months from the signing date is reasonably expected to have a material adverse effect on the target company's assets, financial and earnings situation or on the target Company’s reputation."
However, such a clause would be capable of undermining the usually balanced system of special warranties ("catch all"). Furthermore, when it comes to determining the elements of a breach, the clause would be so broad and unspecific that a seller would at least have to place importance on the qualification of "knowledge" and on very high thresholds Debates on the definition of such terms typically arise during negotiations on "compliance with law" warranties. While, in that area, it is only violations of applicable (hard) law that could trigger a breach of warranty, an ESG warranty that is worded like a catch-all clause could even lead to violations of soft law, standards and possibly also international environmental obligations or even society's expectations regarding a warranty case. Even with qualifications and high thresholds, the agreement of such catch-all clauses would appear relatively difficult in the German market. It remains to be seen how the German M&A market will develop in this respect.
- Therefore, the more obvious approach is to make specific, isolated additions to warranties that are typically already agreed. For example, labour law warranties could be supplemented by a warranty on compliance with certain recognised labour law standards. Environmental law warranties could be supplemented by statements on the protection of biodiversity, avoidance of waste, recycling or a circular economy at the target company. Compliance with data protection legislation should already be included in a typical list of warranties. As part of the warranty on material agreements, the purchaser could request a warranty that the target company has fulfilled statutory due diligence obligations with regard to its supply chains, e.g. the obligations laid down in the German Supply Chain Act, the "UN Guiding Principles on Business and Human Rights", EU regulations or specific relevant international standards.
- Biodiversity could also be included as a protected element in environmental indemnities (in practical terms, this would be done as part of the definition of "environmental matters"). However, sellers will have a difficult time with this topic because – like other ESG aspects as well – it would involve them having to bear a risk that is extremely unpredictable and may have been neglected in the past.
- In practice, other such isolated additions to the list of warranties could result from the fact that the due diligence including ESG aspects has not sufficiently satisfied the purchaser's need for information. In areas where the due diligence has required adequate indications of an ESG-related breach with a certain economic weight, a purchaser will push for specific indemnities.
The influence of ESG aspects is growing rapidly in many areas – including German M&A transactions. It would not be surprising if, as in the field of compliance, ESG sensitive business models, investments or business activities were to be “retroactively” assessed. As a result, the opportunities and risks presented by ESG should and will take on an important role of their own in transaction processes. Target companies are being selected more and more frequently with ESG criteria in mind. During due diligence, purchasers will have to look more closely at ESG factors when examining the business models of target companies, including their supply chains. As a great deal of change is currently taking place, it is important to carefully track future developments.
Authored by Christoph Louven and Thomas Dünchheim.