The role of climate change in contentious M&A

Climate change and wider ESG elements are becoming increasingly common in international commercial disputes.

Since the beginning of the 21st century, the number of disputes involving a climate change element has snowballed. What began in the US as a few isolated cases is now a firm legal trend, numbering 2,000+ cases filed in more than 40 countries to date.

Pressure on companies and their boards to align business activities with the targets laid down in the 2016 Paris Agreement is increasing to the extent that climate change mitigation measures are becoming a legal obligation, rather than voluntary practice.

This was evidenced by the Milieudefensie et al. v Royal Dutch Shell plc case in the Netherlands, where in May 2021 the Hague District Court ruled that international energy giant Shell is obliged to reduce the CO2 emissions of its group activities by 45% by the end of 2030, relative to 2019, following a legal challenge by seven environmental groups and 17,000 Dutch citizens.

In March 2022, legal pressure group ClientEarth commenced legal action against Shell’s board over what it calls “mismanagement of climate risk” in a first of its kind case that seeks to hold directors personally liable for “net zero failures”.

Having purchased shares in Shell, ClientEarth alleges that Shell’s board is in breach of its duties under UK company law, pursuing near-term profit at the expense of enduring company viability.

While pressure groups taking shares in companies for the purpose of protesting against their activities is not a new tactic, direct litigation is a novel development that promises to have significant consequences for businesses.

Legislation is also starting to set clear rules on what companies are responsible for in the course of their business activities.

The EU, which is increasingly seen as the pacesetter in international ESG regulation, continues to take decisive steps to achieve its strategy of toughening up ESG rules for large businesses.

In February 2022, the European Commission published a long-awaited formal Proposal for a Directive on Corporate Sustainability Due Diligence.

Broadly, the proposal aims to ensure businesses conduct human rights and environmental due diligence of their operations and the operations of their subsidiaries and supply (or “value”) chains.

The proposal sets out a list of actions companies are expected to undertake to stay compliant. These include integrating detailed due diligence processes into their internal policies, identifying, preventing and mitigating any potential adverse impact of their operations, and establishing and maintaining a complaints procedure.

In addition, some companies are required, under certain conditions, to develop a plan to ensure their business strategy is compatible with limiting global warming to 1.5°C in line with the Paris Agreement.

While the proposal’s primary focus is on EU-incorporated companies, it also applies to non-EU companies that generate turnovers in the EU in excess of certain thresholds.

The proposal envisages that each Member State will designate a national supervisory authority to monitor compliance with the corporate due diligence duty and impose sanctions or liability for damages for non-compliance.

If the proposal is adopted, companies will face regulatory scrutiny of the accuracy of their statements and risk being accused of misleading customers or shareholders if they come up short, potentially exposing them to crippling liability for environmental and human rights breaches committed by their subsidiaries and supply chains.

The proposal provides for a combination of administrative sanctions (which, if pecuniary in nature, will be based on the company’s turnover) and civil liability according to rules set by each Member State.

In other words, the directive will introduce a direct cause of action allowing those affected by the adverse environmental and human rights impacts of a subsidiary’s operations to bring a claim for damages against the parent company.

In this context, regulatory authorities and shareholders could bring more actions regarding mitigation of climate risk or the veracity of corporate commitments, further encouraging investors to shift climate change considerations to the core of their choices between investment possibilities in different sectors, driving greater liability risk associated with corporate decisions.

Climate change in post-M&A disputes

Climate change-related disputes look set to fall into two broad categories: direct, where climate change is central to the issue in dispute, for example in transactions involving renewable energy projects or climate change mitigation technologies; and indirect, where other kinds of M&A transactions give rise to claims that, for example, a company has failed to observe its obligations regarding climate change, pursuant to its corporate policy or other substantive instruments of climate policy.

The majority of disputes are likely to fall into the indirect category.

Challenges to date have usually rested on allegations of insufficient communication, inaction or inadequate ambition by companies with respect to climate change. However, as the number of cases against private businesses increases, arguments and strategies to prove companies are failing to protect the climate are developing to demonstrate how corporate decisions are detrimental to claimants’ interests

The growth of climate change litigation is already having a direct effect on the M&A process. As well as affecting the choice and price of target, due diligence is beginning to probe what an organisation’s understanding of climate risk is in terms of physical, investment, market and litigation risk, as well as considering the climate change impact of the proposed transaction.

France’s “Devoir de vigilance” (Law n° 2017-399 of 27 March 2017), a national predecessor to the EU’s proposed directive on corporate sustainability due diligence, is now part of the French M&A process.

In the US, on 21 March 2022, the Securities and Exchange Commission (SEC) published proposed rule changes that would require US public companies to include certain climate-related disclosures in registration statements and periodic reports, including information about climate-related risks that are “reasonably likely” to have a material impact on their business.

This push for greater climate change-related disclosure will undoubtedly translate into representations and warranties, indemnities, force majeure clauses, change of law clauses and material adverse change clauses in M&A contracts.

Aspects of deals such as deferred payment terms are also becoming contingent on climate-related factors relevant to the performance of the target – such as rainfall for hydro-electric businesses.

To help businesses manage these anticipated changes, organisations such as the Chancery Lane Project are providing model climate clauses – standard climate-related definitions and tools for introducing climate clauses into contracts, including M&A documentation.

The increasing prevalence of climate-related terms at the contract drafting stage means there is inevitably scope for a greater number of climate change-related disputes.

The UK approach

UK companies with international operations look increasingly likely to be bound by ESG-related legislation in other jurisdictions, exposing them to more ESG risk than they have faced in the past.

At the time of writing, there is no existing or contemplated equivalent regime to the proposed EU directive on corporate sustainability due diligence in the UK.

While there are cases in which a parent company may ultimately be liable for actions of its subsidiaries under English law, the circumstances in which liability arises are narrow. UK parent companies can generally rely on the doctrine of limited liability to limit their exposure to risks associated with their subsidiaries’ operations and practices.

Some legislation, such as the Modern Slavery Act 2015, does extend to UK company supply chains. However, under the current regime, the Modern Slavery Act does not go beyond requiring UK companies to publish a slavery and human trafficking statement at the end of each financial year.

The statement should describe the steps the company has taken to ensure slavery and human trafficking is not taking place in its supply chains or in any part of its business. However, there is no duty on the parent company to take any specific steps nor any penalty for failing to take them.

If a person affected by the subsidiary’s unethical practices brings a claim, it will generally be the subsidiary (and not the parent company) that will be responsible for any harm.

The EU proposal goes much further in that it requires a UK parent company to identify and remove or reduce the risks of ‘adverse impacts’ arising out of breaches of the international standards. It also opens a path for any affected person or persons to bring a direct claim for damages (among other remedies) against the UK parent company.

The amount of damages sought may be substantial, depending on the extent and nature of the harm caused to individuals and communities. This is a stark contrast to the UK regime, where the parent company can generally expect its exposure to be limited to the amount of capital originally invested in the subsidiary.

Although a long and potentially complicated legislative process awaits the EU proposal before it becomes law, it is important that directors of UK companies with operations in the EU begin reviewing and assessing their networks and supply chains to determine whether any changes are required to ensure compliance with the EU’s ESG proposals.

Marily Paralika

Natalia Schuster

In the context of M&A transactions, prospective acquirers should carefully consider any potential risks as part of their pre-transaction due diligence. When diligencing a large international group of companies, it may be easy to overlook a relatively small and immaterial subsidiary incorporated in an area with a poor human rights record.

This article was authored by Marily Paralika, arbitration partner in Fieldfisher’s London office and Natalia Schuster, corporate partner in Fieldfisher’s London office.