ESG in M&A: Focus on the “S”

The growing importance of social considerations (the “S” in ESG) has appeared in numerous headlines, as companies learn the hard way that cutting corners in areas like supply chain and human capital does not pay off in the long run. In the past two years, a number of Fortune 500 companies have had to pay out large sums to mitigate the consequences of their poor choices surrounding overseas production. In this article we focus on the “S” aspects of ESG with regards to conducting M&A due diligence, and what companies should evaluate prior to approving an M&A deal.

As discussed in our prior ESG in M&A article, a large number of investors believe that companies with strong ESG initiatives are more lucrative investments, pose less risk, and are better positioned for the long term. Moreover, because of the SEC's announced plan to create an ESG reporting framework that would complement the current financial reporting framework, targets with higher ESG scores are perceived, in many cases, as having higher market value. Environmental and governance aspects of ESG seem to be easier to measure, which may explain why companies find it easier to tackle those issues first. Acquirers often overlook the social aspects of ESG metrics, which can result in minimal evaluation of social issues during ESG due diligence.

The “S” part of ESG is a broad topic that covers a wide range of social issues; diversity and inclusion, fair pay, workplace safety and environment, employee turnover, company ethics, and reputation are among the factors that are evaluated when assessing a company’s “social” health in ESG metrics. Increasingly, we have seen companies reevaluating their production practices to address supply chain hiccups and questionable labor practices. Many companies have had significant problems resulting from cargo crime, the invasion of Ukraine, the growth of e-commerce, sudden shortages, centralized inventory, and a patchwork of logistics, all of which are significant supply chain problems that fall under the “S” in ESG. We will examine a few of these issues more closely.

1. Supply Chain Risks

Since the beginning of the COVID-19 pandemic, companies have been suffering frequent and major disruptions to global supply chains. Prominent examples include shortages of lumber to build houses and of semiconductor chips for vehicles and mobile phones. To address these issues, manufacturing companies often sought out alternative suppliers. The manufacturers often failed to conduct proper vetting of such alternative suppliers and in many cases wound up with less reputable vendors as a result. In some cases, improperly vetted alternative vendors may be less transparent with their “social” practices and also less ethical in general. Vendor practices are increasingly “broadcast” worldwide via online and social platforms such as TikTok and Instagram. The questionable practices of suppliers—after coming to light—are often viewed by third parties as a reflection of the manufacturer’s practices and ethics, with the publishers of ESG ratings, and sometimes even litigants, holding the manufacturer accountable for its vendors’ practices. Some of the examples of ethical issues in supply chains are:

• corruption and bribery;
• unsafe labor conditions;
• non-living wages or forced labor;
• child labor;
• cargo crime;
• environmental harm; and
• discriminatory work environment.

To combat these issues and demonstrate their commitment to social and environmental performance, more businesses are looking to third-party certification processes. For example, many companies dealing with these issues choose to become “B Corp” certified. B Corp certification of for-profit companies is offered by the B Labs Global. The designation confirms that a business is meeting high standards of verified performance, accountability, and transparency on factors from employee benefits and charitable giving to supply chain practices and input materials. As of September 2022, there were 5,697 certified B Corporations across 158 industries in 85 countries. Among some of the best known B Corp certified companies are Ben & Jerry’s, TOMS, and Patagonia. Many of these companies also donate their products to charity to match purchases by consumers. For example, for every pair of TOMS shoes purchased, a pair of new shoes is given to a child in need in partnership with humanitarian organizations.

According to Accenture Strategy’s Global Consumer Pulse Research, more than 60% of surveyed consumers closely consider a company’s ethical values and authenticity before a purchase. Moreover, the research showed that 42% of consumers “stopped doing business with a company because of its words or actions about a social issue.”

To illustrate this with a real-world example, a confectioner was struggling to ensure that harvesting the ingredients it used, like cocoa and soy, did not contribute to deforestation. Also, several confectioners were accused of child labor issues in recent years, and were named in a lawsuit over child labor in cocoa production countries. As a result, the company made changes, such as setting strict policies on deforestation and promising to train all of its buyers on human rights issues. Child labor, forced labor, deforestation, women’s rights, and living wages were among the most pressing human rights issues across the value chain for these companies. Another real-world case that attracted headlines was the investigation of fashion retailer Boohoo, which was accused of being aware of its suppliers underpaying their staff and exposing workers to life-threatening risks in their workplaces. As a result, multiple online retailers removed Boohoo’s products from their websites.

Some companies have chosen an alternative solution to supply chain social concerns: bringing manufacturing in house. However, the high costs, risks, and logistics associated with this option mean it is not always a feasible choice to address supplier concerns.

2. M&A Due Diligence and Supply Chain Risks

The great difficulty with addressing these social and ethical issues is that they are often not discussed or uncovered in the M&A process until the company becomes a defendant in a lawsuit, the subject of an investigation, or the object of press or social media attention. At that point, the company has already suffered severe damage to its reputation due to actions taken by another party, not to mention potential exposure to monetary damages resulting from pre-closing actions. It is hard to measure many of these practices when they are defined differently across industries and from country to country. It also requires significant corporate resources to monitor each vendor and each of their sites. Nevertheless, with the growing pressure from customers and investors, ethical production is a critical component to have a successful and sustainable business in the 21^st century.

So, how should a buyer assess a target company’s approach to social compliance in its supply chain? Buyers should confirm that the target company is communicating regularly and often with its vendors and conducting periodic site visits, if possible. It is a good idea for a company to include its ESG standards in its supplier contracts to ensure that the company’s ESG policies have been clearly communicated and vendors know its expectations in that regard. Another good practice is to ask whether the target uses supply chain mapping to maintain awareness of its production sites and those of its vendors. With effective supply chain mapping, a company divides its vendors into different categories, which can allow it to see weak points in its supply chain and avoid incurring costly issues.

What impact do social issues have for potential buyers and targets in M&A transactions? To start with, buyers need to be aware of the prevalence and impact of these issues and be proactive in identifying and evaluating them. According to a study conducted by Accenture during the early months of the COVID-19 pandemic, 94% of Fortune 1000 companies are seeing supply chain disruptions, 75% of companies have had “negative or strongly negative impacts” on their business, and 55% of companies plan to downgrade their growth outlook or have already done so. Based on a survey conducted by Datasite of 200 UK-based dealmakers, almost 20% stated that supply chain problems were the cause of at least one deal falling apart in 2021, and 22% identified supply chain issues as the number one cause that would trigger an M&A deal to fall through in 2022. Many companies that had order backlogs of one to two months prior to COVID-19 now have increased their estimate of the backlog by up to four times. For instance, a target that had backups for almost every component in their products but one key part with no alternate supplier had to be taken down from the market due to potential buyers’ concern. Such a potential outcome suggests that targets also would be well advised to conduct thorough internal due diligence on these topics prior to going to market.

3. Fair Labor Practices and Unionization

Fair labor practices are another important aspect of the social responsibility portion of ESG. More U.S. stakeholders are urging companies to improve labor practices and working environments. If a company's ESG policies assert that they ensure equitable labor practices, they may face scrutiny if they fail to actively address workplace issues with their suppliers. Moreover, the recent resurgence of unionization activities is evidence of its importance. Unionization offers additional protection and benefits for employees, but can also pose extra costs and burdens on employers; oftentimes a company’s response to these activities is perceived as an indicator of a company’s labor practices and hence a part of its ESG assessment. A Starbucks store in Buffalo, New York, became the first Starbucks location in the U.S. to unionize in 2021. Since then, over 270 Starbucks stores have unionized. Starbucks, like other food and beverage companies, is bracing for the impact of the threat of higher labor costs due to unionization, and has also faced national scrutiny for its response to workers’ attempts to unionize.

In addition to the growing unionization in the U.S., more and more companies are addressing safe labor practices in their non-U.S. factories. One example of such an effort was the result of the tragic accident in Rana Plaza, a factory in Bangladesh that collapsed in 2013 killing over 1,100 people. Workers had noticed cracks in the structure before the building collapsed and begged not to be sent inside, but they were rebuffed by their employers. The collapse of the eight-story building, which housed five garment factories supplying at least 29 global brands, remains one of the deadliest industrial accidents to date. Such a “mass industrial homicide,” as union leaders called it, drew the attention of global organizations that took action to create safer working standards. These standards now show up in retailers’ ESG reports.

However, despite the aforementioned efforts to improve the conditions of factories in Bangladesh and other countries with significant garment sectors, the working environment for many employees remains far from ideal. A 2020 U.S. Senate Report titled “Seven Years After Rana Plaza, Significant Challenges Remain” discusses the unsafe practices of these factories, especially during the COVID-19 pandemic. The report found that in factories that remained in operation during the pandemic, workers were forced to work without adequate precautions, leaving them and their families at great risk of COVID-19 infection.

More recently, a fire at the Nandan Denim factory in India killed seven people in 2020. According to the Nandan Denim website, it is the biggest denim producer in India. The manufacturer sells jeans to more than twenty countries for many high street brands, and import data showed shipments entering the United States from the factory just one month before the fire occurred. Unfortunately, the Nandan Denim fire is not a rarity, as fires in retail factories are not an uncommon occurrence. Such occurrences can lead to damaged reputations as well as an influx of civil lawsuits and a criminal investigation. Following the Nandan Denim incident, the production facility came to a halt, and the director, general manager, and fire safety officer of Nandan Denim were taken into police custody. Additionally, six individuals from the factory's parent group were charged with homicide and negligence.

In light of these frequent tragedies, more and more U.S. stakeholders are asking companies to improve their labor practices and working environments, with some even supporting union organization activity. Employers that don’t actively inquire into the workplace issues of their suppliers may find themselves under scrutiny if their ESG policies state that the company ensures fair labor practices outside of the United States. Further, where a company represents that it strives to ensure fair labor practices for its vendors, taking action to oppose union organization in the U.S. may be seen as inconsistent with such claimed commitment to fair labor practices.

4. ESG Due Diligence

It is advisable for buyers in M&A transactions to conduct due diligence investigations regarding ESG practices of the target not only to determine whether there are potential risks, but also to ensure that the target will integrate well into the buyer’s own ESG practices and policies. A buyer should request information on whether there have been recent changes in supply chain vendors and suppliers of the target company. Also, a buyer should gain an understanding of how the target company monitors its supply chain and review its applicable contracts. Specifically, a buyer should look into whether there are any contractual requirements outlining ESG expectations in a target’s agreements with vendors and suppliers. Furthermore, buyers should visit physical sites, review compliance certificates, and provide questionnaires in order to be better aware of a target’s supply chain practices. Some industries are likely to have more significant exposure to ESG issues in the supply chain than others, particularly businesses in the automotive, semiconductors, industrials, and retail industries. Lastly, even after conducting appropriate ESG due diligence, a buyer should consider including ESG-related provisions in the purchase agreement. These clauses can include ESG representation and warranties, closing conditions, and ESG-specific indemnities. Such provisions can go hand-in-hand with (and often enhance) a thorough diligence process to give the buyer the best chance of avoiding post-closing losses.