Environmental, social and governance (ESG) factors are used to evaluate a company’s risk management and overall sustainability outlook, particularly in relation to its operations and engagement with its community, employees, customers, and suppliers.
A company’s commitment to evolving and developing its ESG investments is becoming increasingly important globally, and local legal due diligence processes should evolve alongside it, especially when it comes to matching companies in potential mergers & acquisitions (M&As). In SA, M&A activities are certainly due for a legal and ESG rethink and upgrade.
ESG considerations are increasingly evolving in SA, with the government and the private sector developing frameworks and standards within which companies are encouraged or mandated to operate. The government’s National Development Plan 2030 (NDP), the JSE and FTSE Russell’s responsible investment index series, regulation 28 of the Pension Fund Act, regulation 43 of the Companies Act, and the 2016 King IV Report on Corporate Governance for SA are all cases in point.
NDP goals
The NDP outlines the country’s 2030 ESG “goals”, which are geared towards creating a country that is environmentally sustainable and climate change resilient, with a low-carbon economy and a just society. To achieve this vision, the private sector and civil society will need to adhere to the policy frameworks and economic signals that the government creates and promotes, which encourages a change in overall behaviour and practices.
The responsible investment index series measures the performance of companies that have an ESG score above a specific threshold. The series focuses on a company’s exposure to, and management of, ESG issues, aiding investors in identifying target companies for sustainable investing.
Regulation 28 provides that a pension fund organisation must “before making an investment in and while invested in an asset, consider any factor which may materially affect the sustainable long-term performance of the asset including, but not limited to, those of an ESG character”.
Similarly, regulation 43 provides that every state-owned company, listed public company and any other company that has a prescribed “public interest score” above 500 points must appoint a social and ethics committee that must monitor the company’s activities in respect of its commitment to social and economic development, good corporate citizenship and the environment, health and public safety. The committee is required to report to its shareholders at the company’s AGM on ESG-related matters within its mandate.
The King report, although subscribed to voluntarily, recommends ESG practices and considerations in its code of corporate governance. Principle 3 provides that a governing body should ensure that the company is a responsible corporate citizen that oversees and monitors its activities in the workplace, economy, society and environment. The JSE listing requirements incorporate and make mandatory certain corporate governance practices from the code of corporate governance while others are to be adopted on an “apply and explain” basis.
Path ahead
SA is moving towards an ESG-centric landscape. Existing mandatory obligations and regulations will become more far-reaching and apply to companies not already captured by the mandatory regimes. There will be a gradual transition from voluntary or recommended reporting obligations to more obligatory ESG-compliance frameworks. All types of companies will be mandated to take proactive steps in ensuring that their business practices, at all levels, consider ESG.
Impact funds or ESG funds consider ESG requirements when deciding where to invest, seeking to put their money where it will have a broad positive effect while making a financial return. Companies that do not align themselves with ESG standards and metrics run the risk of losing their attractiveness.
Reinforced and regulated ESG frameworks and standards are reshaping transactions within corporate M&A and the role of legal advisers in undertaking legal due diligences.
Legal advisers acting for acquirers will have to, alongside their clients, consider whether the target company has established processes and functions to oversee their compliance with ESG frameworks and mitigation of any ESG-related risks. Acquirers should consider whether the target company has adopted regular ESG disclosure and reporting obligations and whether the company has a board-appointed committee with oversight responsibility on ESG matters and which drives ESG initiatives and opportunities.
If these processes and functions do not exist or are inadequate, the legal due diligence report should flag this as a risk to the acquirer. Transaction agreements should include undertakings by target companies to, within the period between signing and closing of the transaction, establish ESG-compliant processes and functions. If that time is too short, the acquirer could consider establishing its own frameworks to ensure that the target company adheres to ESG principles after closure of the transaction. If the target company has ESG processes and functions in place, the legal due diligence process must ensure that these are adequate and satisfactory.
Greenwashing
Legal advisers should also suggest that the transaction agreements include an undertaking from the target company that, during the interim period, it will maintain all of its ESG processes, functions and initiatives and refrain from taking any action that will be detrimental or contrary to the target company’s adopted ESG framework.
The legal due diligence process should involve an in-depth analysis of the target company’s business practices, and whether these practices foreground ESG compliance, for instance in respect of their climate change and environmental sustainability statements and processes, to guard against greenwashing.
On the social aspect, the main suppliers of the target company should be identified, to avoid acquiring a supply chain that is involved in practices of child labour and forced labour or environmental crimes. On the governance aspect, the target company’s existing governance frameworks should be scrutinised. Decision-making mechanics, board independence, shareholder powers, transparency, and risk and crisis management processes are all important to look at. Systemic issues of gender and race representation in decision-making are also important to consider and can be remedied through the transaction documents.
In SA, corporate stakeholders are becoming increasingly ESG-focused and driving companies to adopt sustainable practices in their interactions with their communities, employees, customers and suppliers. Legal due diligence processes need to reflect this. In M&A processes, legal advisers should emphasise the efforts made by a target company to adopt and subscribe to robust ESG frameworks, and how they will fix it where they have fallen short.
Law firms can prepare their client companies for acquisition or disposal by ensuring that they are compliant with ESG frameworks and obligations. They must uncover any risks and gaps that may put the parties to a transaction at risk. ESG risk mitigation measures should always form the backbone of any legal M&A process.
• Eleftheriadis is associate and Marule a candidate attorney at law firm Allen & Overy SA.
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