Experienced counsel have for some time advised companies to consider ESG factors in their mergers and acquisitions. While environmental, social, and governance (ESG) or “sustainability” factors are not included on financial statements, increasing pressure for sustainability, data collection, and transparency on climate risk, social justice, and corporate governance now make ESG risk due diligence a must. This note explains some recent legal changes that make these matters even more pressing in M&A deals and gives information on an upcoming CLE program that will discuss these development in the U.S. and Europe.
When acquirers consider a target, or sellers prepare to go market, all ESG matters associated with historic and projected operations should be evaluated with the goal of identifying and, if necessary, mitigating all financial, reputational, environmental, and human rights risks. The process for deep environmental and employee inquiry to inform target representations and warranties is well developed, but due diligence to identify human rights violations, the target’s ESG ratings, and the use of ESG standards has just begun in earnest. Unlike traditional due diligence, which addresses how the entity responds to incidents, human rights due diligence (HRDD, or HREDD when including environmental factors) focuses on both past incidents and ongoing possibilities of adverse human rights impacts.
In the context of the “S” in ESG, particularly with respect to human rights impacts, customary representations and warranties cannot meaningfully mitigate the financial, reputational, or evolving regulatory risks without documenting adoption and ongoing compliance with human rights codes of conduct or guidelines. Qualifiers in merger agreements, including clauses on knowledge, materiality, or “no material adverse change,” will not be effective alone. Investors and consumers, and soon national and global regulators, now want to see proof of an ESG culture of concern and compliance. Assurances and documentation of historic investigation (with a negotiated lookback period of three to five years) and of robust, ongoing training and enforcement of corporate codes and guidelines are necessary to reflect such an ESG culture. Where problems are found, remediation should be documented, too. Current expectations often require “mapping and tracking,” and good HREDD needs to evaluate the severity of risks based on specific industry or product details.
Consider the significant financial and reputational damage resulting from adverse human rights impacts when Customs and Border Protection (CBP) discovers, post closing, seller’s imported goods tainted by forced or child labor. Imports of such goods have been prohibited for decades, but until recently, the “consumer demand exception” protected many imports in spite of the prohibition. This exception, which had largely swallowed the rule, was repealed by the 2016 amendments to the 1930 Tariff Act. Since the effective date of the amendments and the creation of the Forced Labor Division in 2018 within the CBP’s Office of Trade—the arm of the Department of Homeland Security (DHS) charged with enforcing amended Section 307 of the Tariff Act—CBP investigations into forced or child labor, product Withhold Release Orders (WRO), and adverse Findings have increased dramatically. There are fifty-five current WROs in place and nine Findings. Once a WRO is issued, shipments subject to the WRO are held indefinitely at the port of entry.
Perhaps most pressingly, trade lawyers are advising their clients that the Uyghur Forced Labor Prevention Act (UFLPA, effective June 2022) is a game changer. The UFLPA shifts the burden of proof away from CBP and onto the companies importing, in whole or in part, from China’s Xinjiang Uyghur Autonomous Region (XUAR, or Xinjiang). The law bans all imports from Xinjiang unless the importer can prove the products are not connected to forced labor or child labor. To be in compliance with UFLPA, companies must provide a comprehensive supply chain mapping, a complete list of all workers at an entity subject to the “rebuttable presumption” that there is a connection to forced labor, and proof that workers were not subject to conditions typical of forced labor practices.
Product importers out of the Xinjiang regions and companies seeking an M&A transaction with them should not be the only ones worried about the surge in CBP activity. On July 29, DHS announced a strategic partnership between the DHS’s Center for Countering Human Trafficking (CCHR) and Liberty Shared, an international NGO, to enhance DHS’s ability to investigate forced labor in supply chains and combat human trafficking. In its announcement CBP stated its commitment to stopping forced labor, estimated to be the predominant form of human trafficking, with victims of forced labor making up an estimated 80% of the twenty-five million people around the world affected. Increased partnerships between DHS and NGOs signals the likelihood of further surges in enforcement activity.
The ESG legal regimes in Europe are even more far-reaching, especially in relation to supply chains. Several nations already require HREDD to prevent, identify, and remedy or mitigate adverse impacts. Under proposed legislation, HREDD will be an obligation of many companies in or doing business in the EU. See European Commission Proposal for a Directive on Corporate Sustainability Due Diligence (Proposed Directive), 2019/1937, COM (2022) 71. Concurrently with the publication on Febrary 23, 2022, of the Proposed Directive, the EU Commission published a Communication on Decent Work Worldwide, COM (2022) 66, outlining plans to ban products made with forced or child labor from the EU market.
The Proposed Directive applies to companies established ouside the EU with either (i) a net turnover in the EU of more than EUR 150 million or (ii) a net worldwide turnover of more than EUR 40 million but a net turnover in the EU of less than EUR 150 million, if at least 50% of the net worldwide turnover was generated in high-risk sectors like textiles, leather, garments, and footwear; agriculture, forestry, fisheries, husbandry, food and beverages; and the extraction and manufacture of mineral and metal products, regardless of where extracted, including crude petroleum, gas, coal, and metal ores. Upon adoption by the European Parliament and the Member States, the EU Directive will work in tandem with the Sustainabile Finance Disclosure, Regulation (SFDR), Regulation (EU) 2019/2088, and the Taxonomy Regulation, Regulation (EU) 2020/852.
M&A lawyers should not miss the upcoming Business Law Essentials program at the Business Law Section Hybrid Annual Meeting in Washington, D.C., and online on Thursday, September 15, 10:00–11:30 AM ET. This program will provide a unique opportunity to hear from top government officials on developing trends shaping U.S. and global sustainability and legal requirements to collect data, disclose, and remediate ESG risks. In addition to covering proposed rules from the SEC and CBP enforcement of the UFLPA, there will be updates on the EU Proposed Directive that will affect most, if not all, international business operations. Speakers include: Erik Gerding, Deputy Director, SEC (Division of Corporate Finance—Legal & Regulatory Policy); Salla Saastamoinen, acting Director-General for Justice and Consumers, European Commission; Eric Choy, Executive Director, U.S. Customs and Border Protection (Trade Remedy Law Enforcement); Professor Claire Bright (Nova University, Lisbon, Portugal); and Professor David Snyder (American University, D.C.).
Susan Maslow, Vice Chair of the Working Group to Draft Model Contract Clauses to Protect Human Rights in International Supply Chains and Chair of the CSR Law Committee.