ESG and Board-Shareholder Engagement in M&A

Corporate governance debates have undergone a fundamental shift, with environmental, social and governance (‘ESG’) issues coming to the forefront of decision-making by boards, executives, and shareholders. Across a spectrum of shareholders, companies and their boards face pressure to incorporate ESG considerations into their business strategies, including strategies around merger and acquisition (‘M&A’) transactions. Other stakeholders, including employees and customers, are similarly demanding that companies factor ESG concerns in their decision-making. And across the globe, there is a rising tide of regulatory reform focused on board oversight and disclosure of ESG risks. This paper, which will be published as a chapter in the forthcoming Cambridge University Press book ‘Board-Shareholder Dialogue: Policy Debate, Legal Constraints and Best Practices’ (Luca Enriques & Giovanni Strampelli eds, 2023), analyzes the implications of this shifting landscape for M&A transactions.

For boards assessing M&A deals, ESG factors are emerging as critical to all aspects of dealmaking—affecting both the logic of a deal and the procedural aspects of dealmaking. Companies report that ESG-influenced dealmaking is on the rise. For example, throughout 2020 and 2021, sustainability and climate change concerns motivated many M&A deals, particularly among energy companies. The acquisition of a target company with strong ESG ratings and performance can enable a buyer to improve its own ESG credentials. Targets can also use M&A activity to cleanse themselves of ESG-related problems. ESG expertise and service itself also has been an impetus for M&A deals. In terms of the procedural aspects of dealmaking, advisors regularly recommend in-depth ESG due diligence for both buyers and sellers in M&A. As ESG expands due diligence, there may be more disclosure on disclosure schedules, and further calibration of representations and warranties. For example, M&A due diligence now regularly encompasses diligence on sexual harassment or misconduct issues. Furthermore, over the last few years, many buyers have come to insist on ‘Weinstein Clauses’ in acquisition agreements that require targets to disclose allegations of sexual harassment or misconduct by senior executives.

Boards are increasingly expected to consider ESG factors in their strategic advisory role in M&A. As companies expand their own ESG goals, policies and strategies, boards are advised to consider the ESG-logic of a deal and to evaluate how the deal fits within a company’s strategic plan. Deal advisors frequently recommend that boards of sellers should factor into their consideration of a deal a buyer’s ESG performance and vulnerabilities. Boards also need to consider whether and how ESG concerns may influence shareholder support for a transaction.

While ESG may prove useful to a board’s strategic decisions in M&A, the flexibility of ESG may also complicate the board’s work. In the absence of a clear definition of ESG, boards may overly focus on one set of factors for a deal—factors that may or may not be crucial for a successful M&A transaction—to the exclusion of other factors. The large breadth of topics encompassed by ESG may also be distracting in the deal context where speed, efficiency, and certainty regarding closing, are often paramount. Rather than helping a company make an informed business decision, a company’s board and management could get bogged down in the vast variety of ESG factors, without clear boundaries.

For many boards, their primary involvement in an M&A transaction is an oversight role that engages the board’s core risk management responsibilities. ESG as a risk management tool can be useful to board oversight of M&A dealmaking. For example, targeted ESG due diligence can help boards evaluate and plan for potential risks in the parties’ operations and industry. Boards can use ESG-related information to evaluate reputational risks connected to a deal or to question management on potential integration challenges.

Nevertheless, it can be difficult to assess and incorporate ESG risk analysis in M&A dealmaking. ESG itself does not have a common agreed-upon definition. A company may perform quite strongly on one aspect of ESG, but more poorly on another ESG factor. Given the lack of clear regulatory guidance on ESG, there may also be questions about the accuracy of a particular firm’s ESG disclosure. Moreover, many firms rely on ESG ratings to gain information about a target or bidder. Yet, measurement challenges abound with respect to ESG ratings. The divergence and measurement problems in ESG can make it tricky for a board—facing the pressures of time, speed and costs in dealmaking—to systematically use ESG information to assess deal risks.

While pressure to account for ESG issues in M&A is expected to grow, there is also concern that ESG can help mask interested decision-making by boards and managers. Such concerns are palpable in M&A where the potential for soft conflicts of interest is particularly acute. For today’s large public companies, senior executives—especially CEOs—dominate decision-making especially in M&A. Executives typically control the initial conversations about a potential deal, engage in much of the diligence, negotiation and drafting, and control much of the flow of information to the board. Yet research finds that executive decision-making in M&A can be tainted by self-interest and cognitive biases such as hubris or overconfidence. The malleability of ESG may allow too much discretion for managers who may pursue their own interests in M&A.

The ESG movement may also complicate shareholder voting and activism related to M&A. To date, in many M&A transactions, even when shareholders have voting rights, their voice is muted—shareholders largely vote with or side with management. ESG disclosure and engagement has the potential to make shareholder voting in and shareholder monitoring of M&A dealmaking more effective. ESG activism may also place a greater spotlight on how large institutional investors vote on M&A deals, revealing the tensions between their economic goals and their espoused ESG commitments. This in turn, may result in greater institutional shareholder pressure on boards in connection with M&A. Furthermore, ESG-related diligence and integration efforts in connection with an M&A deal could provide useful avenues for shareholders to attempt to challenge a board’s decision-making in court.

In an ideal world, ESG information can help enhance board and shareholder decision-making around M&A. Yet, whether ESG considerations are likely to do so remains uncertain.

This post is part of an OBLB series on Board-Shareholder Dialogue. The introductory post of the series is available here. Other posts in the series can be accessed from the OBLB series page.

Afra Afsharipour is a Senior Associate Dean for Academic Affairs and Martin Luther King Jr Professor of Law at UC Davis School of Law.