ESG factors are a 'must have' for all M&A transactions

ENVIRONMENTAL, social, and governance (ESG) frameworks are no longer a "good to have" but a "must have" for every corporation, reflecting the realisation that businesses have a greater role to play beyond merely making profits. This evolution is especially pronounced within the sphere of mergers and acquisitions (M&A) wherein ESG considerations are now live issues that must be addressed consciously.

Poor ESG practices may result in reputational damage to parties in an M&A transaction, cause the breakdown of such a transaction, or may even expose parties to pre-, peri-, and post-transaction legal risks. Conversely, companies that take proactive measures to manage ESG risks and have robust ESG practices implemented internally reduce the likelihood of such damages and risks.

It is imperative that parties to an M&A transaction determine the extent to which they are each exposed to legal risks, and the onus is on the parties to assess, identify, and mitigate these risks across the three dimensions of ESG.

ESG OBLIGATIONS

Firstly, the environmental practices of a target company must be assessed by the acquirer: policies pertaining to greenhouse gas emissions, pollution control, and renewable energy. An assessment of such practices must extend beyond the target company to include its supply chain as well. Where the target company is a marquee client of a supply chain, the target company may have certain obligations to ensure that its supply chain follows sustainable practices. For instance, Starbucks has implemented ethical sourcing of coffee beans at the core of its business strategy through its Coffee and Farmer Equity (CAFE) Practices by ensuring that farming methods promote long-term productivity and keep the soil healthy.

Secondly, corporate obligations under the social dimension cover a broad range of issues, from labour law, diversity and inclusion in hiring, human rights, and consumer protection. Companies must ensure that they do not engage in exploitative practices in jurisdictions where there is an unequal bargaining power between companies and the societies that they operate in. Beyond the prevention of ethical and legal violations, having a good track record in developing local communities is another measure of the social dimension that bestows reputational benefits on such companies.

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In emerging markets and certain developed countries, the avenues available for assisting local communities is contingent on how well these communities are already provided for. Where communities are not furnished with adequate public goods, such as roads and hospitals, there could be scope for greater scrutiny of the target company as to whether it is providing any of these community services. Therefore, it is important to note that with respect to the social dimension, any assessment must take into consideration the country in which the target company operates its business. Any assessment otherwise would not be nuanced and accurate.

Nonetheless, Singapore-based companies have certain "social" obligations. For example, companies are subject to the Consumer Protection (Fair Trading) Act (Cap 52A) which protects consumers against unfair practices and bestows the right on consumers to seek relief against companies engaging in such practices. With respect to diversity and inclusion in hiring practices, the Tripartite Guidelines on Fair Employment Practices ensures fair and merit-based employment practices. All Singapore-based organisations are expected to adhere to the Tripartite Guidelines which stipulates that companies must recruit and select employees only on the basis of skills, experience, or ability to perform the job.

Finally, proper (corporate) governance is not new to Singapore's existing regulatory requirements. Transparency, controls, and oversight are all aspects provided for and stringently enforced by the relevant acts and the Code of Corporate Governance. In particular, the Code sets out the principles that govern how companies manage multiple stakeholder relationships which include board performance, remuneration policies and conflicts of interests.

Beyond this Code, we now see more corporate codes of conducts reflecting the principles of the United Nations Guiding Principles of Business and Human Rights. Among other things, these Guiding Principles allow for due diligence on human rights violations, preventative measures, and remedial action. Presently, the Guiding Principles are increasingly being referred to in jurisdictions outside of Singapore and this trend is likely to catch on in Singapore as well.

WEIGHING UP THE RISKS

The emphasis on ESG due diligence continues to grow in M&A transactions as critical ESG factors such as environmental practices and corruption are now part of M&A due diligence exercises. With due diligence having a wider ambit, this would naturally have an impact on the nature and extent of contractual protections that acquirers would seek from target companies and /or the selling shareholders of the same. While negotiating transaction agreements, acquirers must now consider whether the ESG legal risks identified during the due diligence process can be mitigated through contractual provisions by way of representations, warranties, and indemnities.

Crucially, representations and warranties relating to environmental, human rights and specific ESG risks experienced by the target may provide significant protection to the acquirer. On a related note, the inclusion of pre-closing covenants mandating the disclosure of any new ESG risks, and special indemnity arrangements for known ESG issues should be also considered in a bid to cap the downside for the acquirer and to accurately reflect the value of the target company as well.

The degree to which representations, warranties, and indemnities are requested and provided for in an M&A transaction is largely determined by the willingness of each party to accept certain liabilities. For instance, in respect of M&A transactions within the oil and gas industry, the purchaser would negotiate for an indemnity for antecedent breaches, damages, losses and /or claims arising from environmental damages, claims and/or regulatory action, whereas the vendor would be desirous to sell on an "as is where is" basis to cap the post-completion liability for itself. This is often a "hot-button" issue between parties as both the purchaser and vendor are essentially negotiating from positions antithetical to each other. To bridge this chasm, an extensive list of warranties and representations is often provided as a compromising gesture to minimise the risk for the purchaser. This would lead to less reliance on indemnities by the said purchaser as it reassesses its potential risks and would be more willing to purchase on an "as is where is" basis, subject to certain caveats.

From an economic standpoint, although ESG risks are externalities, the advent of ESG due diligence and contractual protections addressing these risks would internalise such externalities, by way of representations, warranties, and indemnities, into the value of the target company.

ESG FACTORS IN VALUATION

Generally, the Discounted Cash Flow (DCF) model forecasting the free cash flows of a company is one method used to value target companies. This model discounts such cash flows by a rate equivalent to the weighted cost of capital (WACC) (reflective of the risk related to these cash flows).

Determinants of cash flows were once derived only from financial or economic factors, such as industry growth and market share. However, in tandem with the recognition of ESG risks and opportunities, there has also been a trend towards incorporating ESG considerations into valuation models.

For instance, cashflow determinants may now include the impact on revenues and cost-related cash flows due to employee unrest (for example, poor labour conditions). Likewise, the WACC being reflective of cash flow related risks may now reflect the additional environmental risks associated with climate change. Naturally, these adjustments will impact the valuation of target companies.

However, caution must be exercised in doing so, as one must minimise the risk of double-counting of the risks (and opportunities) in the discount rate. For instance, if a target company belongs to an industry (for example, automotive industry) which in general is impacted by environmental risks, it could be argued that the industry beta (a measure of risk) partly includes such risks already.

Therefore, one would need to be careful when applying additional downward adjustments to the cash flows caused by negative environmental impacts as the impact could already be partially reflected in the industry beta. To mitigate such risks, it is suggested that additional premiums or discounts in the discount rate should be carefully considered in conjunction with industry- and company-specific characteristics and the ESG adjustments in the cash flow.

IT'S JUST THE BEGINNING

Post-completion of any M&A transaction, ESG considerations must remain a focus of the integration plan. The integration plan must address ESG risks of the target company, implement remedial efforts and develop compliance measures going forward. This would ensure that ESG risks that persist beyond completion do not snowball into live legal implications.

The increased adoption and growing importance of ESG due diligence and disclosures in M&A transactions cannot be overstated. We can be sure that ESG performance of companies will be incorporated into mainstream valuations and risk assessments, with parties being expected to factor in ESG risks when evaluating the impact of any potential transactions.

• Yang Eu Jin is partner and co-head of RHTLaw Asia's corporate and capital markets practice; Philip Lim is principal consultant at sustainability advisory and consulting firm RHT Green.

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