The following article was written by Cahill Gordon & Reindel LLP partner Helene Banks and senior attorneys Peter Gioello and Lynn Schmidt.

Interest in environmental, social and governance, or ESG, matters has grown significantly in recent years and is expected to continue to grow as a focus for stakeholders across all sectors.

The interest has spilled over into corporate dealmaking and has led to an ESG focus in financing transactions, including loans, bonds and equity offerings.

Investment banks, lenders, funds and other financial institutions have established their own policies and net zero goals and are evaluating their portfolios and engagements to ensure that they align. Meanwhile, heightened focus on ESG has also led to an increase in so-called sustainable debt, or debt used for and tied to various ESG goals.

With ESG matters receiving ever-increasing levels of attention from investors, companies and governments, it is essential to assess ESG risks in all corporate transactions, including financings.

ESG risks can have a direct financial impact on a company, and investors are considering those effects in making credit and investment decisions. In addition, ESG disclosure requirements are rapidly evolving, adding a new dimension of review in financing transactions. As such, companies should be prepared for thorough ESG diligence as part of the legal and business review in their financing transactions.

ESG tracking and reporting has been largely discretionary to date, but the development of legal standards and benchmarks is anticipated in the near term.

Credit ratings agencies such as Moody’s Investors Service Inc., S&P Global Inc. and Fitch Ratings Inc. now employ ESG scores that can directly affect a company’s credit rating.

Industry groups, meanwhile, have created standardization initiatives to ensure the credibility of disclosures.

The International Financial Reporting Standards Foundation established the International Sustainability Standards Board, which will sit alongside the International Accounting Standards Board and oversee global sustainability reporting standards.

The ISSB will work with the International Organization of Securities Commissions and the Task Force on Climate-related Financial Disclosures to build a uniform set of ESG standards. Most recently, the Taskforce on Nature-related Financial Disclosures released the first beta version of its disclosure framework aimed at enabling and guiding organizations to report on evolving nature-related risks.

Governments, too, have begun to act.

In March 2021, the European Union’s Sustainable Finance Disclosure Regulation went into effect, which established standardized sustainability disclosure requirements for investment funds. Several other governments, including New Zealand and United Kingdom, have mandated TCFD-aligned disclosures for all or part of their respective economies.

U.S. regulators are also taking steps toward more stringent ESG legal requirements.

The SEC recently appointed a senior policy adviser for climate and ESG, and on March 21 the SEC announced proposed amendments to enhance and standardize climate related disclosures.

The agency has also created the Climate and ESG Task Force to “develop initiatives to proactively identify ESG-related misconduct.”[i] The Task Force will “identify any material gaps or misstatements in issuers’ disclosure of climate risks under existing rules” and will pursue ESG tips, referrals and whistleblower complaints.

The Federal Reserve’s Board of Governors, meanwhile, has noted the financial and financial stability risks of climate change[ii] and created two new committees with functions related to climate change. The Supervision Climate Committee will identify financial risks of climate change for individual institutions, while the Financial Stability Climate Committee is focused on systemic issues in the financial system related to climate change.[iii]

Treasury Secretary Janet Yellen has committed to leading a regulatory review of the effects of climate change on financial stability through the Financial Stability Oversight Council, which will work to improve climate-related financial disclosures. Yellen previously recommended central banks conduct regular climate stress tests[iv], and in September, researchers at the New York Federal Reserve Bank developed a climate stress test for banks focused on the risks of transition to a less carbon-intensive economy.[v]

At the state level, the New York Department of Financial Services issued final guidance for New York domestic insurers on managing the financial risks from climate change in November, the first state-level framework in the country.[vi] In the context of a secured financing, too, ESG factors can have an impact on the value of collateral and the cost or availability of insurance.

Given the evolving landscape of requirements, companies, financing sources and their counsel must ensure that a company’s ESG-related disclosures are compliant with all legal standards and do not expose the company or its financing sources to reputational risk from potential allegations of greenwashing where a company’s disclosures may be compliant but are perceived as overstating its progress on its ESG goals.

As standards for ESG continue to evolve, it is important for a company’s advisers to understand all facets of a company’s ESG profile, including its history, operations and the types and locations of its facilities.

Once a review of publicly available information is complete, the scope of further ESG due diligence can be determined depending on the type of transaction, relevant legal requirements, deal timeline and the extent to which financing sources consider ESG in risk analysis.

ESG screening tools — including the Loan Syndications and Trading Association’s ESG questionnaires — and third-party consultants can be helpful in the diligence process. In addition, both the European Leveraged Finance Association[vii] and the Sustainability Accounting Standards Board[viii] have industry guides to help identify key ESG risk areas for a particular industry.

The LSTA ESG questionnaires[ix] for borrowers and asset managers, for instance, offer guidance when reviewing transactions and focus on:

• ESG Governance — Whether there is a formal ESG policy and board oversight, a list of key individuals and their ESG credentials and the internal reporting and benchmarking process.
• ESG Frameworks — Has the borrower adopted any of the 14 listed  ESG frameworks.
• ESG Data and Reporting — How does the company gather and measure quantitative ESG data (e.g., climate change emissions) and the steps taken to address significant ESG risks, such as actions taken to manage water and energy consumption.
• Breakdown of Company Revenue — Disclosure on the percentage of revenue derived from a list of particularly sensitive activities or industries.

The Landmark Information’s RiskHorizon platform and solutions offered by S&P, Sustainalytics and Refinitiv can also help assess ESG risks, using a combination of industry and company-specific data. These reports typically provide an ESG score to facilitate comparison between companies. If a more in-depth review of specific ESG data is needed, a technical review by a third-party consultant such as Malk Partners, Ramboll or Bureau Veritas can help identify specific risks and liabilities.

During the in-depth review, counsel typically delivers a document request list to the company to obtain relevant nonpublic documents, which may include internal ESG policies and manuals, board minutes of any ESG committees, internal ESG presentations, written notices of claims, ESG communication with regulators or stakeholders, ESG metrics and data and any scientific or consultants’ reports that support the publicly disclosed information. Document review may reveal topics that require more explanation such as internal ESG management systems and policies, spending, company goals, anticipated ESG regulatory developments and any other unforeseen or unresolved ESG-related risks, liabilities or disputes.

The company, its financing sources and their counsels often participate in diligence calls where these more detailed questions about the company’s ESG program can be raised and discussed.

Once the information gathering is complete, results of diligence calls and document reviews are compared against public disclosures and offering documents for the transaction.

In the case of sustainable debt, an additional diligence step involves review of the company’s sustainability framework and the second-party opinion delivered to assess the framework. Any discrepancies between the information gathered and what has been disclosed will need to be reconciled, bearing in mind the overarching goal of avoiding any material omissions or misstatements.

[i] https://www.sec.gov/news/press-release/2021-42

[ii] https://www.federalreserve.gov/econres/notes/feds-notes/climate-change-and-financial-stability-20210319.htm

[iii] https://www.federalreserve.gov/newsevents/speech/brainard20210323a.htm

[iv] https://www.arnoldporter.com/en/perspectives/publications/2021/02/biden-harris-bank-shot-part-1

[v] https://www.newyorkfed.org/research/staff_reports/sr977

[vi] https://www.dfs.ny.gov/industry_guidance/climate_change

[vii] https://elfainvestors.com/publications/elfa-diligence/

[viii] https://www.sasb.org/standards/download/

[ix] https://www.lsta.org/content/esg-diligence-questionnaire-borrower/; https://www.lsta.org/content/esg-diligence-questionnaire-managers/

Editor’s Note: For more from Cahill Gordon & Reindel, be sure to read “OpEd: ESG in Due Diligence Not Just Another Box to Check.”