Environmental, Social and Governance in Latin America – How Will the M&A Market React?
The incorporation of environmental, social and governance (ESG) practices in guiding corporate decision-making in Latin America is following a growing global trend of focus on sustainability, ESG and impact investing by shareholders, customers and employees. Attorneys practising in the region should be prepared to address ESG matters in transactional preparation, due diligence investigations, acquisition documentation and post-closing operations as ESG practices are adopted by financial institutions, strategic investors and regulatory authorities throughout Latin America. However, even ahead of regulation, in most cases ESG is considered both a driver of value in M&A and a means of reducing risks associated with operations post-acquisition.
ESG criteria are standards that seek to integrate environmental, social and governance data related to company performance into the decision-making and risk management process for investors, financial institutions and regulators, among others. Environmental criteria are used to consider how a company performs to reduce its impact on the natural environment (e.g., climate, energy, water). Social criteria examine how companies manage their relationships with all stakeholders (e.g., employees, suppliers, customers and the communities where they operate) rather than just shareholders. Governance risks concern how a company is run and are often tied to areas such as company leadership, anti-corruption, executive pay, auditing, internal controls, transparency in disclosure and shareholder rights.
Background on ESG
ESG investing can potentially increase value and mitigate governance and social risks, such as loss of assets due to lawsuits, social discord, political intervention, environmental harm or regulatory fines and penalties. The market seems to agree, with ESG funds receiving US$51.1 billion of net new capital from investors in 2020 in the US alone, more than double the prior year. On a global scale, assets under management in ESG funds grew by 29 per cent to US$1.7 trillion in the fourth quarter of 2021. Such growth is linked to an accelerating push from governments globally to encourage climate-friendly investments, many of which are held by ESG funds, by transitioning to low-carbon energy economies and updating their market rules and tax regimes. In Latin America and the Caribbean, FDI investment grew by 13.2 per cent in 2018 – a growth that has stalled mainly due to the global pandemic – in large part due to a paradigm shift by multinational companies operating in the region to push a sustainable development agenda. BlackRock, State Street, T. Rowe Price, Vanguard and other large fund managers have stated that ESG-focused companies create long-term value for stockholders. Some credit rating agencies have begun assessing ESG risk with the same rigour as traditional metrics like credit and liquidity risk. Meanwhile, law firms worldwide have started tailoring their services to provide clients with a comprehensive examination of their targets from an ESG perspective.
Tracking and analysing ESG information remains a work in progress, as no uniform reporting standard has been universally adopted. To further complicate matters, ESG considerations differ depending on the sector and region in which a company operates. Although there is currently no one globally accepted ESG measurement standard, currently the leading ESG standard organisations are:
- the Global Reporting Initiative;
- the Sustainability Accounting Standards Board (SASB);
- the Carbon Disclosure Project;
- the Carbon Disclosure Standards Board (CDSB); and
- the International Integrated Reporting Council (IIRC).
These leading organisations are aware of the need to set one standardised measuring system for ESG and, in 2020, published a prototype climate-related financial disclosure standard and a joint statement of intention to work with each other and other key institutions, including the International Organization of Securities, the International Financial Reporting Standards, the European Commission and the World Economic Forum’s International Business Council, to develop global standards.
ESG framework providers attempt to provide guidance as to which factors and indicators should be prioritised in different sectors. The SASB, for example, has worked to implement a uniform ESG reporting standard to aid investors in identifying the minimum set of sustainability issues likely to be material for companies within a given industry. The SASB’s ‘Materiality Map’ highlights the types of risks prevalent across a multitude of sectors. The risk types span five major categories:
- social capital;
- human capital;
- business model and innovation; and
- leadership and governance.
For example, the map identifies the following high-risk areas for a company that operates in the metals and mining sector: GHG emissions, air quality, energy management, waste and water management, waste and hazardous materials management, ecological impacts, labour practices, employee health and safety and business ethics. A team working on an M&A deal can use this tool to identify the baseline risks in the target company’s sector. Nonetheless, although ESG framework and standard setting institutions provide guidance as to the factors to analyse in each industry, and the SABS tries to focus on those sustainability factors that are likely to have material financial impact, there is still difficulty quantifying the financial impact or materiality of ESG data as ESG frameworks relate mostly to non-financial disclosures.
ESG standards may be broken down further into three separate classes:
- ESG issues material to a company’s operations; and
- additional ESG policies that surpass those that are required by law or by regulatory authorities.
Compliance is an area where legal departments are heavily involved, and covers risks such as human rights, trafficking, slavery, conflict minerals, anticorruption compliance, privacy and cybersecurity. ESG standards that are ‘material to operations’ flag and track those ESG standards imposed by regulations (e.g., SEC guidelines and SASB compliance), which carry reporting requirements and potential penalties for non-compliance. Finally, certain companies incorporate ESG policies that surpass those that are required by law or by regulatory authorities, such as having a corporate social responsibility policy and other philanthropic initiatives (e.g., carbon reduction, responsible sourcing, responsible artificial AI development and inclusive economic opportunity commitments) that the company may, but is not legally required to, have.
State of ESG in Latin America
Although Latin America lags behind other regions in adopting ESG practices, Latin American companies are increasingly working to improve ESG standards following criteria established by growing international investor focus on ESG, and credit rating agencies that focus on ESG when evaluating a company’s creditworthiness. The shift of Latin American companies towards a more ESG-driven approach is reflected in the IndexAmericas created by the Inter-American Development Bank, which highlights the top 100 sustainable firms operating in Latin America and the Caribbean, measured against environmental, social and corporate governance criteria. The IndexAmericas, which initially comprised mostly multinationals operating in the region, has seen an increase in recent years in the number of Latin American companies on the index of more than 30 per cent.
In Latin America, the financial industry and government regulators are driving ESG efforts, as evidenced by economic trends. Foreign direct investment (FDI) in Latin America experienced a steep decline in 2020, primarily as a result of the covid-19 pandemic, with the region receiving its lowest amount of FDI since 2010. Latin American governments are increasingly using ESG as an instrument to address social and environmental matters and the consequences of the covid-19 pandemic. Countries in the region are promoting ESG policies to drive investment and address social unrest prevalent in the region. There is enhanced clarity that Latin America would benefit from low carbon energy solutions to address the growing threat of climate disasters, as well as stricter criminal laws, enforcement mechanisms and tools to address social inequality (such as exploitation, gender violence and poverty), environmental degradation and political corruption in the region. Commitments from local officials and governments to implement ESG policies attract investors focused on ESG to the region. Notable advancements by Latin American regulators in the ESG arena include the following.
As reported by the UN, Mexico experienced an increase in FDI in 2020, which the United Nations attributes to the country’s issuance of the world’s first sustainable sovereign bond (SDG).
Demand for the Mexican SDG bond totalled US$5.696 billion, equivalent to 6.4 times the allotted amount, [with] a total of 267 global investment firms participat[ing] in the auction.
Approximately 73 per cent of the Mexican SDG issuance went to ‘sustainable investors’, which incorporate ESG criteria into their investment decision-making process. Mexico has earmarked the proceeds from the bond issuance to finance ESG-related projects across 1,345 cities grappling with low literacy and school attendance rates, poor health services, lack of toilets, sewage and potable drinking water in homes and lack of access to electricity.
Mexico’s pension fund regulator (CONSAR) has published rules regarding investment strategies that include an obligation to analyse companies’ social responsibility credentials, effective January 2022. When the rule becomes effective, retirement funds will be required to incorporate sustainability criteria in their methodologies and prioritise ESG investments in their portfolios, as well as advocate within the public companies in which they are represented for compliance with sustainable principles.
Mexico was home to Latin America’s second ESG index. Additionally, the Mexican stock exchange (BMV) has created Exchange Traded Funds that replicate the performance of their ESG indices and as many as 21 sustainable (green, social and sustainable) bonds. Lastly, in connection with the Climate Bonds Initiative, the BMV founded the Green Finance Advisory Council with the aim of promoting sustainable finance and public policy changes driven by ESG.
A resolution passed by the Brazilian National Monetary Council in 2018 requires pension fund asset managers to consider ESG risks as part of their investment decision-making process. This development is a significant advancement from prior resolutions, as it increases the obligation from mere disclosure of ESG considerations to a mandate to integrate ESG issues whenever possible. Additionally, in 2021 the Brazilian Central Bank implemented regulatory initiatives to increase banks’ ESG disclosures. Finally, in 2021 the S&P Dow Jones Indices (S&P DJI) and the Brazilian stock exchange (Brasil Bolsa Balcão [B3]) developed the S&P/B3 Brazil ESG Index to highlight strong ESG companies traded on the Brazilian stock exchange.
Effective since May 2021, Chile’s retirement plans, known as AFPs, are required by the Superintendency of Pensions to report how they incorporate ESG risks into their investment processes. Additionally, AFP plan executives must include metrics to measure the impact of climate change on their portfolios. Chile also has a proposal pending before its Financial Market Commission that would mandate ESG factors in annual company reports for all publicly traded companies.
In 2020, Chile’s Ministry of Finance published its inaugural Sustainable Bond Framework, laying the groundwork for the issuance of Chile’s Social, Green and Sustainable bonds, aimed at diversifying the investor base for government debt by appealing to foreign investors focused on ESG measures. In doing so, the Chilean government is promoting the funding of concrete initiatives that favour sustainable development, support vulnerable populations and protect the environment. The bond features attractive yields and has generated approximately US$1.5 billion in proceeds. Chile also raised approximately €1.65 billion in the European markets to fund green and social projects. According to a report by Bloomberg, both the dollar and euro offerings were oversubscribed by investors with dedicated ESG mandates – further illustrating domestic and foreign investors’ interest in and commitment to ESG-focused investments.
The Colombian National Council on Economic and Social Policy (CONPES) enacted laws and policies such as the Green Growth Policy (CONPES 3934) and the Strategy for the Implementation of Sustainable Development Objectives in Colombia (CONPES 3918), which exemplify a commitment to exploring new sources of sustainable economic growth. These policies incorporate ESG into Colombia’s strategic initiatives to maintain sustained development. The CONPES policies prioritise the diversification of Colombia’s economy based on commitments to sustainable use of the country’s natural resources, strengthening the nation’s human capital, and transparent incorporation of ESG metrics in evaluating future projects and investments.
Colombia has also made concrete strides to solidify ESG initiatives in its financial infrastructure. In April 2021, Colombia’s Financial Superintendency adopted Circular 007, which requires that all Colombian institutional investors, as part of their mandated disclosures, discuss the ways in which ESG factors were evaluated when making investment decisions. Colombia has enacted other laws, through different ministries and departments, which increase the disclosure requirements by domestic companies of their adoption and compliance with ESG policies. Lastly, Colombia’s Financial Superintendency has also promulgated laws such as Circular 028, which outlines the best practices for the issuance of green bonds by Colombian issuers.
ESG in Latin American M&A
Large international investors, companies and regulators stressing the importance of ESG are driving exponential growth in ESG diligence and disclosures during M&A transactions. As investors incorporate ESG performance metrics into a target’s valuation and risk assessment, ESG key performance metrics are being gathered and measured during the diligence process and throughout the negotiation of acquisition contracts. ESG is being woven into M&A in the following areas: the diligence process, negotiation of contractual protections and post-closing integration of ESG policies and procedures.
ESG due diligence
ESG is not a one-size-fits-all proposition for every company. While there are measurements used across industries that are of particular importance for most companies (Foreign Corrupt Practices Act and antibribery; privacy and cybersecurity; climate (risk and emission); diversity, equity and inclusion (DEI); and human rights and labour practices), other ESG indicators measured by investors vary based on a company’s industry or region. Sell-side advisers should guide a target company to focus on ESG by identifying:
- applicable regulatory and compliance regimes;
- areas of ESG focus particular to a region; and
- ESG initiatives that can enhance value in the target’s particular industry or sector as well as ESG policies that, when implemented, can reduce potential risk or legal liability.
While some ESG diligence may relate to topics traditionally covered in the ordinary due diligence process, ESG due diligence typically goes further, focusing on the target’s values, culture and social responsibility. For instance, traditional due diligence typically addresses the target’s compliance with labour and employment laws; however, ESG due diligence may address workplace diversity, gender inequity, sexual harassment and workplace misconduct.
ESG due diligence is still evolving and there is no defined process to properly measure ESG risks associated with a target; however, sell-side advisers should prepare their clients in advance to be evaluated and rated by potential acquirers in accordance with at least one of the commonly used ESG measurement standards previously discussed.
In connection with the ESG diligence process, target companies should be prepared to provide key ESG data tailored for their particular industry based on the measurement standards by one of the above-listed ESG standard organisations, including, among other things, relevant information regarding the following:
- corporate social responsibility;
- compliance with international conventions and agreements regarding hazardous chemicals or banned substances;
- environmental performance;
- labour practices, including working conditions;
- DEI (equal opportunities, board diversity, gender pay gap, etc.);
- land use practices involving indigenous peoples or cultural heritage sites;
- health and safety practices;
- community health impact; and
- compliance with permits and licensing requirements.
As further discussed below, sell-side advisers can also assist target companies in establishing and implementing corporate governance initiatives where practicable in advance of a diligence process, including policies regarding political contributions and government relations; appointment of independent directors and audit committees; conflicts of interests; related party transaction reporting and approval; anti-corruption policies and procedures; whistle-blower protection; and the establishment of a code of ethics and code of conduct. Target companies preparing for the M&A process should also develop their own system of record-keeping and evaluation of its compliance with any mandated reporting regime and compliance with the self-imposed policies described above.
Representations and warranties regarding compliance with anti-money laundering laws, data privacy laws, anti-corruption laws and trade laws are customary in M&A transactions in the region, together with representations regarding compliance regimes, monitoring and compliance testing. However, Latin America may slowly start to see more specific ESG-focused provisions such as the ‘Weinstein clauses’ (where a target represents and warrants that its officers or executives have been the subject of allegations of sexual harassment or misconduct). Additionally, other ESG-focused representations will include those regarding the target’s compliance with applicable ESG policies (assuming the target has committed to comply with such standards) or representations particular to the target’s industry and region regarding social, labour, health and safety, security or environmental incidents.
Notwithstanding, the ESG focus in M&A contracts is likely to also focus largely on ESG post-closing covenants regarding ESG policies and procedures, especially in the event of a partial or staggered sale or a contingent value right pricing element, such as earn-outs. To ensure a robust data gathering and reporting process in an M&A deal, the transaction should include, as a preliminary matter, a covenant to implement any of the more widely accepted ESG reporting standards (e.g., SASB, CDSB or IIRC) if the target has not already done so. The covenant can be robust and include establishing key performance indicators upon which to measure ESG performance and setting a timeline for implementing the ESG reporting standards along with the frequency that such data is reported and measured. Other covenants can address ESG risks pertinent to the target. For instance, acquirers might use a covenant to implement cybersecurity and data privacy initiatives, sustainably source raw materials, commit to reducing carbon emissions by a specific date, diversify the workforce, and more. The key is to ensure that the covenant emphasises the reporting and data collection efforts required to achieve these ESG goals.
Given the evidence that positive ESG results can drive long-term shareholder value, experts believe that executive incentive plans designs would be better served by including ‘quantifiable’ ESG measures. As such, M&A transactions may also include covenants in executive compensation packages that provide incentives to drive ESG goals. However, covenant drafters should pay special attention to addressing the reliability of the ESG metrics used to quantify such outcomes. A way to avoid questionable reporting practices by executives is to peg non-executive employee compensation and promotions to ESG reporting goals (as opposed to ESG outcome). According to experts, when companies decide to incorporate ESG measures into annual incentive plans for executives, they can measure progress between three to five years, or toward longer-term objectives when ESG goals cannot be measured over a 12-month period, such as climate-related issues that warrant a much lengthier view (10 years and longer). Such covenants must be structured in a way that will provide flexibility for uncertainties such as evolving market trends and ESG standards, and be limited to a focus on up to three ESG measures to guarantee focus, efficacy and compliance.
Buyers can also use pre-closing covenants and closing conditions to address ESG issues identified during the due diligence phase of the M&A transaction. For example, buyers can cause the target company to adopt any of the internationally recognised ESG reporting frameworks and provide a deliverable by the closing date that shows it adopted such framework while disclosing all actual and anticipated ESG risks. In addition, buyers can request a special indemnification agreement to address all known ESG issues and risks, to be reassured and to mitigate risk pre-closing. The use of such pre-closing covenants and closing conditions is particularly useful in transactions with longer wait times between signing and closing, such as those requiring regulatory approvals (e.g., CNBV approvals in Mexico or CADE approvals in Brazil). In deals with shorter pre-closing periods, the target company can covenant to implement an ESG compliance programme within a specified period post-closing. Notwithstanding the pre-closing period's length, incorporating pre-closing covenants and closing conditions in the M&A agreement will ensure a smooth transition during the post-closing integration of the contemplated ESG programmes.
After completion of diligence and the closing of an acquisition, acquirers will likely implement programmes to address and monitor any ESG risks or shortfalls discovered during the diligence process (in addition to integration, compliance and monitoring of any ESG programmes already in place pre-acquisition).
Acquirers will generally want to align a target’s overall ESG philosophy and culture to its own by monitoring implementation and compliance of any ESG policies. ESG compliance is bespoke to each company while being guided largely by the global ESG measurement standards issued by the institutions discussed above. However, there are certain strategies and initiatives to consider when completing a successful post-closing implementation of ESG metrics into a target operation:
- ensure that the acquired company’s organisational documents and shareholder agreements contain provisions that mandate a board seat be allocated to an independent director;
- create positions for a chief sustainability officer, chief compliance officer, or both;
- empower the chief compliance officer or chief sustainability officer to coordinate ESG efforts with the organisation and oversee ESG employees;
- undertake a formal risk assessment, including contracting with third-party consultants and auditors covering the complete supply chain, and including an evaluation of resource accessibility, usage and sustainability; talent recruitment, engagement and retention; financial performance and risk; and reputational impacts;
- implement ESG data reporting and measurement systems by working with third-party consultants and auditors that have developed systems to ‘quantify’ ESG results, and adjust accordingly as the ESG data collection process evolves;
- draft policies and procedures in compliance with local environmental, safety and health laws and regulatory frameworks; rectify any wrongdoing and assist the company in completing any regulatory filings to comply with local laws, issuing disclosure statements (internal or external) if required and coordinating any employee terminations, as applicable;
- establish a code of conduct and code of ethics;
- implement training and communication of the new policies and procedures; and
- remain current with the legal and regulatory changes pertaining to ESG in the target’s industry, and make timely updates to the policies and procedures to reflect such changes.
Additionally, while the above examples lend some insight into ESG post-closing integration, attorneys in Latin America should tailor their ESG approach to meet more specific regional needs and the regulatory environment in each jurisdiction. Ideally, where possible, ESG initiatives identified above can be part of a pre-transaction planning to emphasise a commitment to ESG prior to a sale process to uncover and remediate any systemic risks in advance of a change of control transaction or outside investment.
As ESG continues to evolve in Latin America, attorneys should expect to play a larger role in the analysis of more detailed, ESG-driven information and the exploration of uniquely Latin American environmental, social and governance issues. With these regimes continuing to grow and develop, ESG matters will increase in importance in transaction planning, negotiation and post-closing integration. Accordingly, attorneys in the region must work to familiarise themselves with the types of issues capable of halting a deal in its tracks and remain abreast of decisions by local regulators, relevant government priorities and global trends that may be adopted in the region.
 Randy Bullard and Alexandra Aguirre are partners and Fernando Guardazzi and Giselle C Sardiñas are associates at Morrison & Foerster.
 Greg Iacurci, ‘Money Invested in ESG funds more than doubles in a year’, CNBC, 11 February 2021, https://www.cnbc.com/2021/02/11/sustainable-investment-funds-more-than-doubled-in-2020-.html.
 Elizabeth Howcroft, ‘Sustainable Fund Assets Hit Record $1.7 Trln in 2020: Morningstar’, Reuters, January 2021, https://www.reuters.com/article/us-global-funds-sustainable-idUSKBN29X2NM.
 Economic Commission for Latin America and the Caribbean, ‘Foreign Direct Investment in Latin America and the Caribbean Increased by 13.2% in 2018, Ending a Five-Year Downward Trend’, 5 August 2019, https://www.cepal.org/en/pressreleases/foreign-direct-investment-latin-america-and-caribbean-increased-132-2018-ending-five.
 Impact Management Project, World Economic Forum and Deloitte, ‘Statement of Intent to Work Together Towards Comprehensive Corporate Reporting’, September 2020, https://29kjwb3armds2g3gi4lq2sx1-wpengine.netdna-ssl.com/wp-content/
 S&P Global Ratings, ‘How ESG Factors Can Affect Credit Ratings’, https://www.spglobal.com/ratings/en/products-benefits/products/esg-in-credit-ratings#overview.
 See Chapter 1 of this guide, 'Roundtable: The Impact of Political Instability and Social Unrest on Dealmaking in Latin America'.
 Economic Commission for Latin America and the Caribbean, ‘Amid the COVID-19 Crisis, Latin America and the Caribbean Received in 2020 the Lowest Amount of Foreign Direct Investment in a Decade’, 5 August 2021, https://www.cepal.org/en/pressreleases/amid-covid-19-crisis-latin-america-and-caribbean-received-2020-lowest-amount-foreign.
 United Nations Development Programme, ‘Historic $890 million Sustainable Development Goals Bond issued by Mexico’, 14 September 2020, https://www.undp.org/press-releases/historic-890-million-sustainable-development-goals-bond-issued-mexico.
 Nasdaq, ‘Leading in an Era of Impact: Inside Bolsa Mexicana de Valores’ Decade-long Journey to Build Sustainable Finance in Mexico’, 30 July 2021, https://www.nasdaq.com/articles/leading-in-an-era-of-impact%3A-inside-bolsa-mexicana-de-valores-decade-long-journey-to-build.
 United Nations Environment Program Finance Initiative,’ Brazilian Monetary Authority Approves New ESG Requirements in the Investment Rules of Occupational Pension Funds’, 10 July 2018, https://www.unepfi.org/news/industries/investment/brazilian-monetary-authority-approves-new-esg-requirements/.
 Central Bank of Brazil, ‘BCB Public Consultation No. 86/2021 – Regulation on the disclosure of social, environmental, and climate-related risks by financial institutions’, 30 April 2021.
 S&P Dow Jones Indices, ‘S&P/B3 Brazil ESG Index’, https://www.spglobal.com/spdji/en/indices/esg/sp-b3-brazil-esg-index/#overview.
 Sophie Baker, ‘Chile’s retirement plans told to report on ESG risks’, Pensions & Investments, 27 November 2020, https://www.pionline.com/esg/chiles-retirement-plans-told-report-esg-risks.
 Chilean Financial Market Commission, ‘CMF publishes for consultation a regulation incorporating sustainability and corporate governance issues in Annual Reports’, 22 March 2021.
 David Caleb Mutua, ‘Chile Sells Biggest Latin American Sovereign Sustainability Bond’, Bloomberg Green, 20 January 2021, https://www.bloomberg.com/news/articles/2021-01-20/chile-sells-biggest-latin-american-sovereign-sustainability-bond.
 CONPES, ‘Estrategia para la Implementación de los Objetivos de Desarrollo Sostenible (ODS) en Colombia’, 15 March 2018, https://colaboracion.dnp.gov.co/CDT/Conpes/Econ%C3%B3micos/3918.pdf.
 Brigard Urrutia, ‘CONPES for sustainable economic recovery’, 26 February 2021, https://bu.com.co/en/noticias/conpes-sustainable-economic-recovery.
 Jose V. Zapata, Daniel Fajardo Villada and Camila Del Villar, ‘Superfinanciera expide reglamento sobre emisión de Bonos Verdes en Colombia’, Holland & Knight, 10 September 2020, https://www.hklaw.com/en/insights/publications/2020/09/superfinanciera-expide-reglamento-sobre-emision-de-bonos-verdes.
 R. Boffo and R. Patalano, ‘ESG Investing: Practices, Progress and Challenges’, OECD Paris, 2020, https://www.oecd.org/finance/ESG-Investing-Practices-Progress-Challenges.pdf.
 Kristen Sullivan and Maureen Bujno, Deloitte LLP, ‘Incorporating ESG Measures Into Executive Compensation Plans’, Harvard Law School Forum on Corporate Governance, 24 May 2021, https://corpgov.law.harvard.edu/2021/05/24/incorporating-esg-measures-into-executive-compensation-plans/.
 John A. Terry, et al., ‘Canada: The Growing Importance of ESG in M&A Transactions’, Mondaq, January 2021, https://www.mondaq.com/canada/corporate-and-company-law/1025746/the-growing-importance-of-esg-in-ma-transactions.