ESG: Dealing with sustainability risks in the company purchase agreement

Influence of ESG on company valuation

It is becoming increasingly important for companies to meet environmental, social and governance (ESG) sustainability and corporate responsibility targets, particularly when companies consider valuations, purchase prices and purchase agreements. In order to maintain their competitive edge, companies who want to improve their own ESG credentials from a strategic point of view must divest existing business lines and methods that are incompatible with their long-term ESG and sustainability goals. 

Buyers and sellers face uncertainty in ESG-motivated M&A transactions which can lead to significant liability risks resulting in litigation. Therefore, the consideration of and management of ESG risks in the contract is imperative.

Regulatory framework

Contracting parties are faced with the additional legal challenge of considering non-binding regulations and guidance in addition to extensive statutory regulations. The amount of binding EU and German ESG-regulations (so called “hard-law”) continues to expand in scope including through the recent implementation of the “European Green Deal”, the provisions of the EU Taxonomy Regulation, the provisions on management and sustainability reports (sections 289b-e, 315b-d of the German Commercial Code), the German Supply Chain Duty of Care Act and the German Whistleblower Protection Act. 

There is no legal definition of “ESG-risk”.  BaFin, the German financial supervisory authority, describes sustainability risks as "events or conditions from the environmental, social or corporate governance fields, the occurrence of which may have actual or potential negative effects on the net assets, financial position and results of operations as well as on the reputation of a supervised company" (Merkblatt zum Umgang mit Nachhaltigkeitsrisiken, 13 January 2020). However, the subsequent list of examples of sustainability goals does not provide a clear distinction, as to when a sustainability goal can be considered an ESG risk which is essential to understand when drafting contracts.

Furthermore, companies must take into account non-binding, transnational regulations (so-called "soft law") such as the Paris Agreement on Climate Change, the OECD Guidelines for Multinational Enterprises or the guidelines for the preparation of corporate sustainability reports provided by the Global Reporting Initiative. Companies may make commitments in the form of internal guidelines or programs which can become binding insofar as an expectation is created vis-à-vis investors and the market. A failure to meet such targets can, at the very least, lead to reputational damage.

Sustainability Due Diligence

Due diligence is particularly important in managing sustainability risks. Buyers should review the target company's material agreements, ESG strategies and initiatives, and compliance models to ensure that they are not exposed to additional reputational and liability risks. However, there are not any uniform standards outlining the type or scope of information a buyer should request. The draft EU Directive on Corporate Sustainability Due Diligence aims to avoid fragmentation of due diligence requirements across the EU and provide legal certainty for businesses and stakeholders, but until implementation, it is for companies to determine the level of due diligence required.

The assessment of ESG risks must be a tailor-made, risk-appropriate approach. Businesses should assess the industry, specific products and services, size of the target company, supply chain and customer group of the target company when identifying relevant sustainability metrics to consider. The assessment should also evaluate the impact of the takeover on the target company and identify whether measures are needed to improve corporate governance practices to ensure compliance with ESG targets. 

In Germany, contracting parties are legally obliged to disclose possible ESG risks. According to the case law of the German Federal Supreme Court (Bundesgerichtshof – BGH), increased duties of disclosure and due diligence must be observed in the context of corporate transactions and "each contracting party has the duty to inform the other party of circumstances that may frustrate the purpose of the contract and are therefore of material importance for the other party's decision, provided that the other party may reasonably expect such information in good faith, taking into account the view of the contract" (BGH, 1 February 2013 - V ZR 72/11). The existence and scope of the duties of disclosure depend to a large extent on the circumstances of the individual case. Sellers, in particular, must pay increased attention to ensure all relevant matters are disclosed.

From 2024 onwards, the European Sustainability Reporting Standards (ESRS) will be gradually implemented. Companies will be subject to detailed legal standards and reporting requirements s, which include reporting obligations on climate change (ESRS-E1), labour in the value chain (ESRS-S2) or corporate governance (ESRS-G1). Furthermore, companies are obliged to regularly conduct sustainability due diligence, which can serve as a basis for the assessment of ESG risks in an M&A context. Despite this additional guidance and extensive due diligence, there will continue to be some ESG risks that cannot be accurately predicted or quantified in the purchase price.

Regulation options

Present and potential ESG risks can be managed through liability-sharing provisions in the company purchase agreement, considering the relevant hard and soft law.

Earn-out clauses

Earn-out clauses can be used to tie earnout payments to the target’s ability to achieve specific ESG targets resulting in profit such as measuring the impact of ESG measures taken to increase profitability or considering how the achievement of climate certification positively affects that target’s earning.

The contracting parties agree that part of the purchase price is owed depending on the future economic success of the target company, for example if certain key performance indicators (KPIs) are achieved after a certain period. However, these clauses are often susceptible to dispute due to questions of interpretation. In practice, it may be difficult to prove that certain ESG measures are the cause of a certain financial success or to quantify the amount by which the value of the company increases as a result of reaching a milestone.

Warranties

A buyer may seek a warranty, as defined in section 311 (1) of the German Civil Code, to protect themselves against a risk that was not identified in due diligence. A warranty guaranteeing compliance with the law will likely mean laws binding on the target company. However, given the importance of soft-law standards, care should be taken to ensure that references to any standards and/or regulations identify the specific soft-law provisions the buyer would want to rely on to ensure they are considered binding on the target company.

According to prevailing legal opinion, self-commitments by the target company (for example, on the "protection of healthy ecosystems", "fair working conditions" or "disclosure of information”) do not establish any legal obligations of the company towards third parties. Sellers may not want to make a warranty in this respect in order to avoid an obligation to indemnify.

The case is different for guarantees on litigation. The clauses usually used in M&A contracts are likely to be formulated in such a general way that the risk of so-called "climate lawsuits" is also covered. If not, the provision could be amended to state that climate-related lawsuits are not threatened and are not otherwise to be expected.

Indemnities

If concrete ESG risks have become known during the due diligence and there is still uncertainty about their actual realisation or the amount of the resulting disadvantage, the buyer will usually demand an indemnity. To avoid disputes, any damage triggering the indemnity claim and the legal consequences triggered by it must therefore be described as precisely as possible.

Insurance clauses

Claims for damages due to non-compliance with ESG criteria by the target company can also be shifted by the transaction participants to third parties, i.e. transaction insurers, through Warranty & Indemnity insurance. The buyer usually purchases the policy which often requires a corresponding guarantee (see above) to have been agreed. The policy usually includes guarantees relating to compliance with codified ESG standards. 

Claims arising from the breach of non-codified sustainability requirements and pre-contractual disclosure obligations of the seller, on the other hand, are generally not covered by insurance. Likewise, identified/concrete ESG risks are not insured and are usually covered by a contigent liability insurance provided that the realisation of the risk, which is usually legal, is not probable and the potential loss for the insurer is large but calculable. Such special insurance is formulated on a case-by-case basis for the respective special risk. Due to the increasing codification of certain ESG standards, an increase in contingent liability policies can be expected. 

Alternatively, typical M&A clauses in the form of insurance clauses can fulfil the same economic function as insurance policies, e.g. deductibles or baskets, caps, co-insurance, claims periods and related procedural provisions.

Material Adverse Change (MAC) and Material Adverse Events (MAC) 

Vague and difficult-to-measure ESG criteria typically do not play a role in the context of MAC/MAE clauses. This is because these clauses are based on a significant deterioration in the economic situation of the target company, which can result from many changes and events. If, however, the occurrence of a certain sustainability-related event is made a condition of execution, such as a downgrade of the ESG rating or negative media coverage, this can lead to considerable uncertainties for the seller and an increased risk of a dispute. To address the risk of a dispute, the parties should agree on a supplementary dispute resolution mechanism (see below).

Dispute Resolution clauses

The parties should agree on a suitable dispute resolution mechanism. Procedures before specialised state courts or suitable procedural rules of an arbitration institution could be agreed upon, by means of which a quick and appropriate solution can be reached based on the facts of the case and taking into account the individual circumstances. Schematic solutions will not be appropriate. Rather, the risks and disagreements that may arise will have to be anticipated and then, if possible, addressed in terms of substantive law (e.g. through lump-sum compensation for damage to reputation) or through special dispute resolution mechanisms.

Conclusion

he realisation of sustainability risks in the context of company purchase agreements is likely to lead to more legal disputes in the future. The fragmented codification of ESG standards, difficulties in quantifying ESG factors and a rapidly and dynamically changing transnational regulatory landscape are proving to be problematic. To avoid disputes related to ESG risks, company purchase agreements need to be drafted taking into account the relevant ESG-related regulations. For the resolution of ESG-related disputes, attention should be paid to an appropriate dispute resolution mechanism in the contract drafting process. It will be important to observe which further legislative initiatives and standards relating to ESG risks will be launched in the future.