ESG-Related Due Diligence Is Paramount for Financial Investors

As the environmental, social, and governance landscape shifts from a patchwork of voluntary frameworks to globally expanding regulatory requirements, dealmakers must be alert to ESG considerations, even in deals with non-obvious ESG issues.

The EU, the US, California, and other jurisdictions have adopted sweeping ESG regulations applicable to many public and private companies. These regulations require in-scope entities to monitor and disclose the ESG impacts of their own operations, together with those in their value chains—suppliers, customers, investors, investees, and other business partners.

When vetting targets for a potential acquisition or investment, sponsors need to consider the ESG regulations applicable to the target, the robustness of the target’s compliance and governance frameworks, and the ESG implications of the potential transaction for the sponsor.

Not only could these considerations impact a sponsor’s assessment of a target’s attractiveness, but they also may warrant the sponsor seeking contractual protections, including through representations, warranties, indemnities, and covenants. In this new ESG environment, sponsors should be prepared to address several factors.

Sustainability reporting requirements. Many companies—including certain sponsors and their potential acquisition targets—are or will soon be subject to sustainability reporting requirements.

In the EU, large EU and non-EU companies will need to report detailed sustainability information under the Corporate Sustainability Reporting Directive beginning as early as 2025. In the US, although the Securities and Exchange Commission’s climate rules for US and foreign registrants have been stayed pending judicial review, new laws in California will require comprehensive climate reporting starting as early as 2026 for larger companies (both public and private) that “do business” in the state.

The emergence of these requirements heightens the importance of a target’s ESG disclosure controls and procedures in three key ways.

First, if a target is or will be subject to these reporting regulations, the sponsor should understand whether the target has the internal framework to support compliance. If internal controls are weak and claims regarding significant ESG benefits are unsubstantiated, the target could draw “greenwashing” scrutiny from investors and regulators in addition to liability under the applicable regulation.

EU and US lawmakers have recently adopted laws that make it easier for public and private litigants to bring lawsuits challenging the accuracy of “green” claims. These include California’s Assembly Bill 1305, which allows any California state or local enforcement official to sue any company operating in California for failing to publicly substantiate claims that the company, or its products or affiliates, significantly reduce greenhouse gas emissions.

Second, if the sponsor itself is or will be subject to these regulations, it should evaluate the target’s potential impact as part of the sponsor’s value chain, as many key regulations cover Scope 3—that is, value chain—emissions and other value chain disclosure requirements.

Today, the analysis often focuses on whether the target’s emissions or other impacts would become a notable portion of its value chain impacts—either quantitatively or qualitatively. As sponsors enhance their own Scope 3 reporting and assurance processes to meet emerging requirements, it may make sense for some of them to develop due diligence protocols to assess whether a target has implemented data collection and verification processes that align with those used by the sponsor and expected by its assurance provider.

Third, the target is likely in the value chain of other entities, such as key customers. It will be helpful to understand what disclosures, representations, or other commitments the target has made to those entities—either voluntarily or because of regulatory requirements.

In addition to due diligence, it might be appropriate for a sponsor to seek contractual protection against third-party liability in some cases, given the active greenwashing litigation and enforcement landscape.

Rapid evolution of ESG requirements. The ESG regulatory landscape continues to develop. For example, the EU recently adopted the Corporate Sustainability Due Diligence Directive, which goes well beyond disclosure requirements to mandate that in-scope EU and non-EU companies identify, assess, prevent, and mitigate adverse human rights and environmental impacts in their operations and value chains.

Failure to comply could result in significant liability, including penalties up to 5% of the target’s net worldwide turnover. Given the broad and complex changes that are expected under the directive, as well as the current lack of regulatory guidance, sponsors should work closely with legal teams to monitor and assess the directive’s potential impacts on dealmaking—including efforts to introduce model contracting clauses.

“Anti-ESG” movement. In the US, sponsors must pay attention to “anti-ESG” laws and regulations emerging in many Republican-controlled states. A number of asset managers have faced scrutiny from state officials for how ESG factors are incorporated into investment and dealmaking decisions. Some stakeholders also have put pressure on companies to reverse their ESG commitments.

As ESG regulations evolve, sponsors will need to build ESG-related considerations into the dealmaking process to support overall regulatory compliance and reduce transaction risks. This will necessitate a closer cross-functional collaboration on ESG issues for many sponsors, including between the deal team and compliance team, as well as legal, accounting, and other advisers.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Rita-Anne O’Neill is partner at Sullivan & Cromwell and serves as co-head of the firm’s global private equity group.

June M. Hu is special counsel at Sullivan & Cromwell and coordinates the firm’s global ESG practice.

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