Companies can no longer afford to ignore environmental, social and corporate governance due diligence—the risks, rewards and ramifications have become too great.

From the emergence of ESG ratings to the creation of government initiatives, like the U.S. Securities and Exchange Commission’s Climate and ESG Task Force, risk models now incorporate environmental, social and governance impacts. Organizations with strong ESG performance have been rewarded with greater access to capital, preferable directors and officers, or D&O, insurance terms and even better financial performance.

On the other hand, when ESG is poorly managed, organizations have found unwanted attention from shareholders, litigants and regulators.

Cautionary tales abound. Deutsche Bank AG’s asset-management arm stumbled upon environmental ramifications this year when it faced regulatory probes and a sell-off following allegations of greenwashing. Repeated social scandals stemming from poor human capital management in major organizations, like CBS, have occupied the news.

Governance risks, particularly those involving corruption and bribery, are also at the forefront as evidenced by the U.S. Department of Justice’s renewed focus on corporate criminal enforcement, particularly in the area of Foreign Corrupt Practices Act violations.

Embracing ESG diligence in pre-deal merger and acquisition transactions, supply chain audits and periodic company audits will help mitigate the risks surrounding ESG impacts while also supporting improved ESG performance in the long run.

ESG’s Evolution
The ESG ecosystem has quickly evolved in the last few years. Echoing the 2006 Principles of Responsible Investment, ESG also incorporates many of the concepts expressed by the 17 U.N. Sustainable Development Goals adopted by the U.N. General Assembly in 2015.[1]

While regulators initially shied away from mandatory corporate disclosures surrounding ESG, nongovernmental organizations stepped in to fill the void. As a result, disclosure frameworks from five organizations dominated the disclosure landscape: the CDP Global, the Climate Disclosure Standards Board, the Global Reporting Initiative, the International Integrated Reporting Council, or IIRC, and the Sustainability Accounting Standards Board, or SASB.

In June of this year, in an effort to streamline frameworks, the IIRC merged with the SASB to form the Value Reporting Foundation, which adopted the SASB Standards—i.e., a set of 77 industry-specific sustainability accounting standards.

Around the same time, the EU’s Sustainable Finance Disclosure Regulation came into effect, mandating certain ESG-related disclosures for financial services institutions. By the end of the year, the SEC is expected to outline its own mandatory framework for climate-related disclosures.

Likewise, the International Financial Reporting Standards Foundation has announced the International Sustainability Standards Board, or ISSB, which will consider work from the above standard setters. On Nov. 3, 38 governments, including the U.S., expressed support for the ISSB standards at the U.N. Climate Change Conference, COP26, in Glasgow. 

All developments thus signal evolution toward a more consistent set of industry-specific metrics and clarification in sustainability reporting.

These ESG standards coupled with companies’ disclosures inform ESG ratings used by shareholders determining where to place their investments. While the ratings space has been crowded with smaller organizations, major credit rating agencies have also entered the space, including S&P Global Inc., which acquired Robeco Schweiz AG’s ESG ratings business.[2]

Other prominent sources of ESG ratings include Morgan Stanley Capital International Inc., Sustainalytics, State Street Global Advisors Inc. and Refinitiv. Together, these ESG ratings provide a measure for previously intangible factors that predict business success or failure.

Rewards for Strong ESG Performance
A strong sustainability record, often reflected in a high ESG rating, is increasingly providing companies with a competitive advantage over sustainability laggards. Strong ESG performance signals risk mitigation.

As such, higher ESG ratings have been correlated with a higher credit rating.[3] Similarly, strong sustainability performances improve a company’s access to the capital markets and increases preferential treatment from investors and banks alike.[4] Strong ESG performance can even translate to better terms for D&O liability insurance.[5]

Companies are being rewarded for sustainability performance because it creates short-term and long-term value. Study after study shows that sustainable companies often outperform companies with poorer ESG ratings.[6] Summarizing over 2,000 studies, McKinsey & Company found that companies focused on “environmental, social and governance concerns do not experience a drag on value creation—in fact, quite the opposite ... [a] strong ESG proposition correlates with higher equity returns.”[7]

With increased transparency related to sustainability impacts, facilitated by ESG ratings, there are corresponding risks for ESG holdouts refusing to move beyond aspirational statements toward improved ESG performance.

Risks for Ignoring ESG

“E” Risks
In terms of environmental risks—encompassing everything from greenhouse gas emissions and resource depletion to waste management—companies have expanding exposure in connection with their climate-related disclosures and disproportionate environmental impacts.

With respect to greenwashing, i.e., exaggerating the environmental credentials of a product, service or practice, regulators and shareholders alike have become vigilant. DWS Group, Deutsche Bank AG’s asset-management arm, experienced this vigilance in late August when it faced a drop in share prices amid regulatory probes from the SEC and Germany’s Federal Financial Supervisory Authority, after a former executive accused the firm of greenwashing investment products.

Shortly thereafter, in September, the SEC reportedly sent letters to various companies regarding climate change disclosures to address greenwashing concerns after posting a sample letter to its website.[8] In the letter, the SEC warned companies that they should also assess and disclose material litigation risks or anticipated reputational risks resulting from operations that affect climate change.

Some companies, like Exxon Mobil Corporation, have already experienced such litigation risks as plaintiffs begin making headway in climate related litigation keyed to erroneous disclosures.

While Exxon has generally been successful in dismissing such suits, in the 2018 case Ramirez v. ExxonMobil Corp. in the U.S. District Court for the Northern District of Texas, pension fund plaintiffs defeated Exxon’s motion to dismiss their securities fraud lawsuit alleging material misstatements regarding Exxon’s use of proxy costs of carbon. The case is currently ongoing.

In terms of reputational risks, companies have likewise seen reputational consequences and market capitalization declines following negative climate impacts, particularly where they raise environmental justice concerns. Just this past summer, the nonprofit As You Sow ranked Exxon last in its Racial Justice Scorecard for the S&P 500.[9]

Citing a history of releasing toxic chemicals into predominantly Black areas, Exxon’s ranking received negative media coverage followed by a concomitant drop in share price. Exxon’s ESG rating from Sustainalytics published days later was high risk.

“S” Risks
In terms of social risks, examples of poor human capital management have dominated the news cycle in recent memory as society grapples with issues of workplace harassment and bias.

From the blockbuster Fox sexual harassment scandal to the ongoing allegations in the news surrounding CBS’ work culture, social failures seem to be increasing.

In the case of CBS, 2018 allegations of sexual misconduct by CBS’ former CEO Les Moonves were followed by a 7% drop in share price,[10] a long internal investigation expanding into claims of a toxic atmosphere,[11] and a shareholder stock-drop lawsuit claiming that misrepresentation about CBS’ compliance with antiharassment policies led to stock decline.[12]

Such litigation has been ongoing, even as new allegations of workplace toxicity resurfaced at CBS in early 2021 along with new claims of discrimination.

More recently, popular video game publisher Activision Blizzard Inc. faced similar workplace allegations and ramifications.

As evidenced by these examples, social risks involving employee relations, if not immediately addressed and rectified, can quickly gain momentum and lead to loss in shareholder value.

Another social consideration that looms is supply chain sustainability, raising questions about human rights abuses, corruption and environmental damage associated with an organization’s suppliers. Recent studies have found that many suppliers for so-called sustainable multinational companies have failed to comply with basic ESG-relevant standards that the multinational companies expected them to follow.[13] Practices were particularly problematic among lower-tier suppliers.

Admittedly, supplier issues have long led to negative press, as was seen years ago when reports circulated about Apple Inc.’s and Dell Inc.’s alleged sourcing of materials from suppliers with hazardous working conditions. However, if such coverage were to surface today, the consequences would also impair a company’s overall ESG performance.

“G” Risks
Finally, prominent governance risks of late have concentrated on anti-bribery and corruption measures, data privacy and board diversity—especially following California’s A.B. 979 and Nasdaq Rules 5605(f), 5606 and 5900-9.

Anti-corruption in particular has consistently been a DOJ focus under President Joe Biden’s administration.[14] In fact, one of the first Foreign Corrupt Practices Act cases resolved under the Biden administration involved a company that purchased successor liability for the preacquisition FCPA violations of an acquired subsidiary: Amec Foster Wheeler Energy Ltd. [15]

In SFO v. Amec Foster Wheeler Energy Ltd., as part of a global settlement, the acquired subsidiary of a U.K.-based parent company agreed to pay approximately $22.7 million in disgorgement and prejudgment interest to the SEC along with an $18 million penalty to the DOJ and £103 million to the UK’s Serious Fraud Office as part of deferred prosecution agreements.

As part of the DOJ resolution, both the parent and subsidiary agreed to enhance compliance programs and report back to the government on the enhanced programs.

When Should ESG Investigations Be Considered?
In light of the risks and rewards surrounding sustainability performance, most C-suite leaders and investment professionals have indicated a willingness to pay about a 10% median premium to acquire a company with a positive record for ESG issues, according to McKinsey & Company.[16]

By the same token, acquiring a company with a poor ESG record should be appropriately discounted. Discovering the need for a discount, however, is the problem that ESG due diligence addresses. Beginning the due diligence process early can ensure a thorough diligence process under legal privilege.

So, when should a company consider ESG due diligence?

Pre-Deal M&A Due Diligence
As highlighted by the above, ESG due diligence can help assess whether a target’s ESG profile complements or conflicts with the profile of the acquiring company. Leveraging materiality assessments, counsel can construct a review that analyzes the risks most relevant to the target’s industry and locations of operation.

Some reviews may prioritize environmental impact while others prioritize social capital and human capital management along with inquiries into labor rights, workforce diversity and ethical sourcing. In nearly all instances, FCPA due diligence should be undertaken if there are any overseas operations. Likewise, disclosures made by the target should be carefully reviewed and evaluated for accuracy. ESG-relevant policies related to environmental impacts, suppliers’ code of conduct, cybersecurity, as well as diversity and inclusion should also be reviewed. 

If done correctly, the diligence should uncover any problems that merit repricing or reassessing the deal overall. In terms of anti-corruption, simply doing such pre-acquisition due diligence is viewed as a mitigating factor in any subsequent regulatory probes.

Supply Chain Due Diligence
Even outside an M&A context, an ethical sourcing health-check of a company’s supply chain is also advisable to reduce risks associated with negative publicity and inaccurate disclosures.

Increasingly complex supply chains of multiple tiers, involving outsourcing and offshoring, require that organizations include both first-tier and lower-tier suppliers in their reviews.

Depending on the context, such reviews will require periodic due diligence involving data collection/analytics, site visits and information requests, to ensure compliance with supplier codes of conduct.

ESG Audits
Whether as a preventative measure or in response to a crisis, ESG audits are something startups should consider in addition to larger companies attempting to prepare for impending mandatory ESG reporting rules.

While environment-related audits have previously been a focus, continued workforce and governance issues also deserve review. Some companies with social issues have turned to racial equity and antiharassment audits to address human capital management problems after they surface while others, like BlackRock[17] and Citi[18], have begun to prophylactically consider such audits, in light of increased attention to ESG considerations.

In sum, conducting ESG diligence can help generate value and mitigate risk in the M&A context and beyond. And even if an ESG issue develops after the diligence is completed, if a company can show that ESG diligence was attempted prior to a merger or significant disclosure, this will arguably be a factor in the company's favor down the road—particularly in any potential government investigations.


The author would like to thank senior law clerk Jordan Rhodes for her assistance with this article.


[1] https://sdgs.un.org/goals.
[2] https://www.spglobal.com/marketintelligence/en/media-center/press-release/sp-global-acquires-the-esg-ratings-business-of-robecosam.
[3] https://www.mckinsey.com/~/media/McKinsey/Business%20Functions/Strategy%20and%20Corporate%20Finance/Our%20Insights/Five%20ways%20that%20ESG%20creates%20value/Five-ways-that-ESG-creates-value.ashx (see FN4).
[4] Id.
[5] https://www.wsj.com/articles/esg-gains-could-buy-better-terms-in-insurance-program-11635073200.
[6] https://www.fidelityinternational.com/editorial/blog/chart-room-the-clear-link-between-esg-and-returns-bbf01a-en5/https://www.barrons.com/articles/the-100-most-sustainable-companies-51581095228.
[7] https://www.mckinsey.com/~/media/McKinsey/Business%20Functions/Strategy%20and%20Corporate%20Finance/Our%20Insights/Five%20ways%20that%20ESG%20creates%20value/Five-ways-that-ESG-creates-value.ashx.
[8] SEC, Sample Letter to Companies Regarding Climate Change Disclosure, https://www.sec.gov/corpfin/sample-letter-climate-change-disclosures.
[9] https://www.asyousow.org/press-releases/2021/8/11/environmental-racism-metrics-as-you-sow-racial-justice-scorecard.
[10] https://www.thewrap.com/cbs-stock-drops-sexual-misconduct-story-looms/.
[11] https://www.latimes.com/entertainment-arts/business/story/2021-01-24/cbs-television-stations-peter-dunn-racism-sexism.
[12] https://www.law360.com/articles/1077183/cbs-hit-with-stock-drop-suit-over-sexual-harassment-claims.
[13] "The Missing Link? The Strategic Role of Procurement in Building Sustainable Supply Networks," by Verónica H. Villena, Production and Operations Management (May 2019); "On the Riskiness of Lower-Tier Suppliers: Managing Sustainability in Supply Networks," by Verónica H. Villena and Dennis A. Gioia, Journal of Operations Management (December 2018).
[14] Top Enforcement Officials Eye Individual Prosecutions, Crypto, Law360, https://www.law360.com/whitecollar/articles/1435304?cn_pk=1d280246-88f6-4491-913f-d01ccd449a97&utm_source=newsletter&utm_medium=email&utm_campaign=custom.
[15] https://www.sec.gov/news/press-release/2021-112https://www.justice.gov/opa/pr/amec-foster-wheeler-energy-limited-agrees-pay-over-18-million-resolve-charges-related-bribery.
[16] https://www.mckinsey.com/business-functions/sustainability/our-insights/the-esg-premium-new-perspectives-on-value-and-performanceperformance.
[17] https://fortune.com/2021/04/06/blackrock-racial-audit-corporate-diversity-inclusion-race-at-work/.
[18] https://blog.citigroup.com/2021/10/citi-will-conduct-a-racial-equity-audit/.