Introduction
M&A, or mergers and acquisitions, is the process of combining the assets of two companies. That is, these are transactions in which the property of companies or their operating divisions is transferred or consolidated with another organization. From the point of view of strategic management, mergers and acquisitions allow enterprises to grow or optimize part of the business and change its nature and place in the market. A merger is understood as the process of combining two or more companies that form a new legal entity – all rights and obligations are transferred to it.
At the same time, companies’ independent activities can be terminated and preserved, and all assets are transferred to a new legal entity when liquidating independent activities. In this case, instead of the previous shares, all shareholders receive shares of the new combined company. Until a legal merger has taken place, the shares of the companies participating in the merger, as a rule, continue to be traded on the stock exchange. In the future, the shares of the newly merged company will be traded on the stock exchange, while the former shares of the liquidated companies will be delisted. If the independent activity of the companies does not stop, then only a part of the assets is transferred to the new legal entity. This paper attempts to answer the question of whether the legislative framework in this respect affects the formation of such a determinant as ESG, and how positively or negatively. An analysis of the laws in this area and a review of some recent examples are given, followed by a description of the conclusion.
Legislative Framework and Practice
The purchase of a private company in the UK is based on a contract of sale. Private businesses may also be acquired through a “contractual offer” under the CA Companies Act 2006 and under an agreement scheme1. The process of acquiring shares in a British private company depends on the complexity of the transaction, the number of participants, and whether bilateral negotiations are required. The CA 2006 sets out the legal framework for regulating mergers and acquisitions in the UK1. According to the Title Act 1994, the acquisition of the assets of an English company or its shares located in England and Wales is possible with a guarantee of full ownership or a guarantee of limited ownership of the so-called contractual obligations.
Subject to certain additional conditions that apply to real estate, a sale with a full guarantee of ownership means: that the seller has the right to sell the property; the seller, at his own expense, will make efforts to transfer the promised property to the buyer; the property is free from fees, encumbrances, and rights of third parties. Ownership of the shares of an English company incorporated under the provisions of CA 2006 may be obtained by updating the register of members to reflect the buyer as the registered shareholder upon receipt of the transfer deed.
Generally, the buyer prefers that all sellers sign the transaction documentation and agree to abide by it. However, minority shareholders may be required to sell their shares in accordance with the ‘pull’ provisions contained in the company’s Articles of Association or shareholder agreement1. In addition, if the acquisition of the assets of a UK private company is structured as a contractual offer under CA 2006, the acquirer may acquire minority interests that did not accept the offer after it has obtained at least 90% of the voting rights.
The sale of shares in a British company through M&A transactions allows shareholders to obtain a pre-emptive right and rights to holds. In the first case, a shareholder offers his shares for sale to other shareholders before they can be sold to a third party1. Attachment rights restrict a shareholder’s ability to transfer shares in a transaction that excludes other shareholders. The CMA may investigate transactions that meet jurisdictional thresholds: the share of supply test, which is performed when a transaction creates or increases a 25% share of the supply or purchases of any goods or services in the UK (or a significant part of it); and a turnover test, which is performed when the entity being acquired control generated a turnover in the UK in the previous financial year in excess of GBP 70 million.
As of June 11, 2018, lower thresholds apply to private M&A transactions in the United Kingdom for military, dual-use, computing, and quantum technology, where the turnover check threshold is GBP 1 million. The notification of a transaction in the CMA is voluntary1. However, in practice, notification is required to provide legal certainty, as the Regulator may initiate an investigation and subsequently submit a transaction for Phase 2 review in the event of a significant reduction in competition. Takeovers of UK companies by foreign providers may be subject to additional scrutiny under new legislation proposed by the UK government. The bill, which has been in the works since 2018, is widely seen as a response to growing concerns about foreign companies gaining access to sensitive technology and infrastructure.
Favorable Environment
When merging, the new legal entity already has specific rights and obligations that the company received from each participant in this procedure. Sometimes a merger acts as an alternative to liquidation. However, with proper management of the merger, this is an excellent tool for business development, as a result of which the assets of enterprises are combined, and the shares of their founders in the new company are distributed. The merger of firms gives the addition of existing assets of the merging companies, financial savings through cost reduction, and reduced competition in the market. In addition, it can be considered a bankruptcy alternative, especially during a crisis. As a result of the acquisition of a new company: market positions are growing due to entering new regions – in the event that it absorbs a legal entity from other regions, the range of services and the client base increase. In addition, there is a convergence of technologies, personnel, and resources, which positively affects the business. Finally, there is a need for stricter control over the actions of acquired companies.
The deal surge is symptomatic of a climate in which companies remain reluctant to invest capital and productivity. According to experts, companies pessimistic about the possibility of natural growth and development seek to accumulate profits by saving costs on mergers1. It is noteworthy that more than half of M&A transactions in the UK are concluded by non-EU companies, even though the resolution of conflicts related to M&A transactions in the UK is costly. An apparent reason for the popularity and choice of English law in such jurisdictions is the public status of companies, which implies compliance with the law in accordance with the listing on the exchange.
One of the tools or guarantees of English law used in mergers and acquisitions is the compilation of a list of key terms of the transaction – a term sheet at the initial stages of negotiations. This agreement is the primary term of commercial cooperation. One can also find other names for the list of key terms of the transaction, for example, memorandum of understanding or prior agreement. This list is believed to be an effective mechanism for reserving the main commercial aspects of the transaction. According to the rules of English law, the list of key terms of the transaction is not considered a binding document if the parties to the transaction have not specified the subject matter of the critical terms and mutual agreement1. A common mistake in concluding contracts under English law is the ill-conceived signing of the so-called memorandum of intent. Without it, in court, the disputants have a chance to prove that they did not have the will to conclude a contract.
In order to comply with the key terms of the M&A transaction, the parties may preliminarily agree on guarantee payments in the term sheet. English law provides these obligations as damages, a deposit, or a penalty for terminating the agreement. Indemnification is a requirement to pay a fixed amount for the breach of an enforceable obligation, which allows the aggrieved party to the transaction to recover a predetermined amount of damage. Thus, the number of damages must be justified and commensurate with the expected possible losses. A termination penalty is used when a party has the right to cancel an agreement that would otherwise become legally binding or when a party may fail to comply with a provisional agreement. Unlike a fine, a deposit is paid in advance to confirm the good faith and evidence of the seriousness of the party’s intentions and trust in the transaction.
ESG Context
A business that claims a good ESG score must meet development standards in social, managerial, and environmental categories. Environmental principles determine how much a company cares about the environment and how it tries to reduce the damage that is caused to the environment. For example, shoe brand Timberland has partnered with tire manufacturer Omni United to make shoe soles from recycled tires2. Social principles show the company’s attitude towards staff, suppliers, customers, partners, and consumers. To meet the standards, businesses must work on the quality of working conditions, monitor gender balance, or invest in social projects.
For example, the American outerwear brand Patagonia does not own the factories that make its products, so it cannot influence workers’ wages. To remedy this, as part of the Fairtrade program, the brand sends part of the proceeds from the sale of products to factories to raise employees’ salaries to the living wage3. Management principles affect the quality of company management: transparency of reporting, management salaries, a healthy environment in offices, relations with shareholders, and anti-corruption measures. Experts believe that for sustainable development, a company must balance all criteria. However, their significance may vary depending on the activities of different companies. For example, environmental criteria play a unique role for the energy sector, social criteria for the service sector, and managerial ones for finance.
The popularity of ESG investments is growing every year. Experts believe this is also due to the interests of millennials born in the 1980s and 1990s, who have become a solvent audience. The values ​​of this generation are different from the previous one: for them, business and investment are not only about income but also about caring for the environment and society. The increased demand for ESG is forcing companies to reckon with the principles of sustainable development. Now, due to pressure from investors and banks, it is not profitable for them to have a low ESG rating.
Several facts nevertheless reflect a harsher reality. Investors are less supportive of companies with low ESG ratings. In 2020, EY surveyed institutional investors – insurance and investment companies, pension, and charitable funds. As a result, 98% of those surveyed said they strictly monitor the company’s ESG rating3. There are several reasons: firstly, a positive relationship between responsible investment and the return on securities has been confirmed. Secondly, by focusing on the ESG rating, investors can avoid companies whose activities are associated with environmental risks and significant financial losses, for example, such as the oil spill due to the explosion of the Transocean platform in 20103. Finally, an essential factor is a fact that banks began to take into account the ESG rating when issuing loans.
ESG’s environmental, social, and governance priorities are at the top of the CEO’s agenda, with a greater focus on engaging employees in the hybrid world of work and acquiring, streamlining, or selling assets to improve their environmental impact. Themes such as decarbonization will drive deals by providing additional opportunities for new ventures linked to innovation in climate risk mitigation. Many companies will seek greater self-sufficiency in their products and services due to the enormous strain placed on global supply chains by the pandemic, social unrest, cyberattacks, and extreme weather events4. They will achieve this through reorganizations or mergers and acquisitions through vertical integration of upstream channels to improve supply reliability.
Accordingly, the market giants in a particular area of ​​business will often resort to takeovers and mergers instead of developing their departments of the enterprise and constantly resorting to outsourcing, often blocking the further development of the technology used by smaller businesses. Such “here and now” decisions are one of the reasons for the destructive policy of acquisitions concerning global ESG standards. Although, in fact, some local problem is being solved, and this solution generally contributes to sustainable development, there is no constant vector in these issues, which in turn require constant financial injections. If a smaller business could thus attract government subsidies and investors by centralizing this idea, then becoming part of a larger company are unlikely, especially if its reputation has already suffered in such sustainable development issues.
So far, the mainstream responsible investing discourse has centered on where general partners should invest in the future, but there is now more reason to think about the emissions-heavy assets already in the portfolio. Such assets are unlikely to have been comprehensively assessed for ESG when acquired but are likely to be subject to this procedure when sold, which may affect their value. Proactively addressing significant ESG issues will allow the private equity fund not only to meet stakeholder expectations but also to buy time to mitigate ESG risks or take advantage of opportunities to create value by improving the facility’s ESG performance. Such questions have begun to be asked only now, but the agenda has been standing for quite a long time.
Examples
Evaluating acquisitions in terms of ESG is sometimes quite tricky, especially for medical companies. Stryker received the necessary regulatory approvals on November 4, 2020, to acquire all of the outstanding common stock of Wright Medical Group N.V. through Stryker B.V., an indirect subsidiary. It is stated in the message Stryker. The sale and purchase agreement was signed on November 4, 2019, between Stryker, Stryker B.V., and Wright Medical5. In order to obtain the necessary regulatory approvals, Stryker has divested its STAR ankle replacement product assets. Stryker expected to close the deal on November 10, 2020. Stryker is one of the world’s leading medical technology companies. The company offers innovative products and services in the field of orthopedics, medicine, surgery, and neurotechnology for patient care5. It is worth noting that the direct and main activities of the companies meet the requirements of ESG in a global sense. If we regard the standard as an applied and additional practice aimed not only at the primary business vector, then filling the company’s asset portfolio and reputational risks associated with possible scandals of the organization in the past can play a role here.
As a rule, acquisition transactions are considered in detail for the threat of monopoly in a particular market. It includes the UK CMA and other bodies, including the European Commission and the US FTC/DOJ. However, even in such cases, one can sometimes see the direct impact of ESG standards on the conduct of the transaction. For example, at the end of 2020, S&P Global and IHS Markit announced that they had entered into a definitive merger agreement. S&P Global directly offers ESG solutions as part of its diversified credit rating line, while IHS focuses exclusively on analytics. ESG has been noted to provide an advantage to this deal, yet it is one of the many factors that contributed to the merger6. In this transaction, this factor is insignificant, but the practice of taking it into account is a growing trend in such transactions. However, at the moment, it is difficult to find an acquisition case where ESG could be a vital determinant of a large company’s decision.
Conclusion
The transformation of public companies into more attractive takeover targets for private capital is a consequence of both the legal framework and trends in attention to ESG, but a specific dependence is detrimental to sustainable development. First, in mergers and acquisitions, companies are still primarily interested in economic interest, potential competitiveness, profitability, and diversification of business areas more than ESG standards. Secondly, the legal framework, despite the high cost of such services in the UK, is the most favorable due to aspects of the public status of companies.
Finally, viable ESG projects require investment, but only large companies that can use this small or medium business for their purposes have such a level of capital. While these goals may meet ESG standards at a given moment in time, they lack consistency and a potential vector of development concerning any problem. As a result, a comprehensive approach is required to change the legal practice regarding ESG and acquisitions in order to, at a minimum, reduce the percentage of transactions that violate this policy in the long term.
References
Dorfleitner G, Kreuzer C, and Sparrer C, ‘ESG Controversies and Controversial ESG: About Silent Saints and Small Sinners’ (2020) 21 Journal of Asset Management
Feng X, ‘The Role of ESG in Acquirers’ Performance Change After M&A Deals’ (2021) 3 Green Finance
Maaloul A and others, ‘The Effect of Environmental, Social, and Governance (ESG) Performance and Disclosure on Cost of Debt: The Mediating Effect of Corporate Reputation’ [2021] Corporate Reputation Review
‘S&P Global Inc. / IHS Markit Ltd Merger Inquiry‘ (GOV.UK, 2022) Web.
‘Stryker / Wright Medical Merger Inquiry‘ (GOV.UK, 2022) Web.
Tawiah T, ‘Do We Need Public Enforcement for Breach of Duties of Company Directors Under the Companies Act 2006?’ (2021) 9 Journal of Law and Criminal Justice
Footnotes
- Theophilus Tawiah, ‘Do We Need Public Enforcement for Breach of Duties of Company Directors Under the Companies Act 2006?’ (2021) 9 Journal of Law and Criminal Justice.
- Anis Maaloul and others, ‘The Effect of Environmental, Social, And Governance (ESG) Performance and Disclosure on Cost Of Debt: The Mediating Effect of Corporate Reputation’ [2021] Corporate Reputation Review.
- Gregor Dorfleitner, Christian Kreuzer and Christian Sparrer, ‘ESG Controversies and Controversial ESG: About Silent Saints and Small Sinners’ (2020) 21 Journal of Asset Management.
- Xuan Feng, ‘The Role of ESG in Acquirers’ Performance Change After M&A Deals’ (2021) 3 Green Finance.
- ‘Stryker / Wright Medical Merger Inquiry’ (GOV.UK, 2022) Web.
- ‘S&P Global Inc. / IHS Markit Ltd Merger Inquiry’ (GOV.UK, 2022) Web.