ESG Risks: Navigating Them Through Insolvency and Restructuring
By Polina Lyadnova, Thomas Kessler, Deandra Fike and James Armshaw, Cleary Gottlieb Steen & Hamilton LLP , Guest Contributors
As Environmental, Social and Governance or “ESG” risks become more entrenched in the financial markets generally, they can present themselves in the restructuring world in a number of ways. For example, ESG concerns can be the primary reason for restructuring where they mean that a business is no longer viable due to lack of investor interest, declining revenues or legal challenges; or drive a company’s emergence from restructuring as investors increasingly look for ESG-focused investments.
In the future, ESG trends are expected to play a growing role in restructuring, especially considering the increase in market litigation related to sustainability. Lawsuits concerning ESG issues have grown by more than 25% over the last three decades, according to analysis published in 2023 by the World Business Council for Sustainable Development(1). Additionally, there has been an increase in companies including ESG angles in debt issuances to take advantage of market interest. The recent COP 28 conference in November/December 2023 highlighted that ESG-focused financings are only set to increase to fund the global clean energy transition.
Increased ESG Financing on the Global Stage
Companies from Brazil to Ukraine have commenced restructurings at least in part due to environmental-related incidents or growing concerns. On the investment front, financial instruments are increasingly incorporating social and environmental targets, and the COP 28 conference has signaled a growing global consensus to transition from “dirtier” sectors, like fossil fuels, to greener technologies. Further, environmentally motivated litigation and regulation is on the rise both in the US and on the other side of the Atlantic, with parent corporations domiciled in the UK facing the added risk of being held liable for actions of subsidiaries located far afield in emerging markets. In this article we explore some of these recent ESG trends and their implications in an insolvency and restructuring context.
Overview of ESG Considerations in Restructurings
ESG considerations increasingly affect the availability of funding for businesses both in the context of restructurings and more generally, as investors are more and more keen to embrace nature-linked causes as part of bond issuances or debt exchanges.(2) But while the primary market initially focused on ‘green’ and ‘blue’ bonds and financings – where proceeds of the issuances are used for a specific project or purpose – for the past few years the number of sustainability-linked financings not tied to a specific project has grown exponentially.
In these instances, the issuer agrees to adhere to certain targets related to a broader array of causes, including social targets such as gender and minority representation in management.(3) Further ESG themes around which targets can be structured include greenhouse gas emissions, energy efficiency, data protection and product governance. Financing pricing is linked to the extent to which a company meets these specific targets.
Nevertheless, there are still a number of issues with these instruments including, in particular, the reporting and auditing of the extent to which companies are meeting such targets. We expect this will continue to be a hot topic, especially considering that investor caution is growing around potential “greenwashing” by companies: a prevalent risk due to the breadth of what may constitute a green or sustainable bond or target and a lack of formal issuance guidelines in certain markets.(4) Although auditors are assessing companies’ work in achieving their ESG targets, such auditing is developing in real time with no single global, mandatory standard having yet been developed.(5)
We also expect to see the inclusion of more sophisticated terms in these financings in the near future. One idea often toyed with is a requirement for a debtor to invest the benefits that it receives, as financing costs, from these financings in specific ESG projects.
As financial instruments with ESG features become more common, so too does it become more likely that a failure to meet ESG targets will serve as an early warning sign to creditors that a business’ financial condition has deteriorated; a business that fails to meet ESG targets may do so because it cannot afford to meet them. This could prove significant where traditional financial and information covenants in financial instruments are light. An effective early warning sign, however, requires there to be both sufficient clarity as to the ESG targets included within the relevant financial instrument with which a company is required to comply, and consistent ESG reporting and auditing so that third parties can properly evaluate compliance.
With investor appetite gravitating further towards financings linked to ESG themes and regulation increases, it is increasingly common for ESG considerations to be one of the factors that precipitates the need for a business to restructure. Companies with ESG issues increasingly need to restructure to seek to put themselves on a financial footing that will allow them to make the operational changes necessary to ensure their business remains viable in the long term. For example, Ukrainian energy group DTEK cited the material adverse impact of the global shift from fossil fuels to renewable energy sources on traditional forms of power generation as a reason for the financial difficulties that led to its 2021 restructuring.
In addition to precipitating the need for a company to restructure, ESG considerations can shape the restructuring terms negotiated between a company and its stakeholders. As part of a restructuring, a company may seek to divest parts of its business with ESG issues (see ‘Specific Sectors’ section below) and businesses with significant ESG concerns may need to engage with environmental authorities, regulators and action groups. For example, a key issue in the December 2023 restructuring of Samarco Mineração S.A. was the preservation of Samarco’s environmental remediation and reparation obligations to Brazilian public authorities following the collapse of its dam near Mariana, Brazil in 2015.
ESG considerations can also come into play where valuation is a key issue in the restructuring process. In a court-sanctioned restructuring, such as Chapter 11 bankruptcies in the US and schemes of arrangement and restructuring plans in the UK, or a consensual restructuring where additional leverage is needed, the company proposing the restructuring will often need to put forward valuation evidence to prove that the proposed deal provides a better return for stakeholders than would otherwise be the case if there were no restructuring. For many businesses, ESG factors, including the long-term sustainability of the business may significantly impact the going concern valuation and, consequently, the court’s willingness to sanction or creditors’ willingness to approve the terms of a restructuring.
Specific Sectors
Key industries where ESG trends are clearly having an impact in the restructuring space include metals and mining and oil and gas. The options for the companies in these sectors are diminishing as they hold onto assets or production methods that are not clean or sustainable.
Many companies that have coal assets, for example, are looking to sell to monetize non-core assets to help weather a restructuring or refinancing storm. At the beginning of 2023, one of the suggestions for dealing with the Adani Group’s debt was to monetize its coal assets, but this plan gained little traction as there were few investors willing to enter this space.(6) ESG trends can have an impact on the appetite of investors to provide funding, particularly in the case of large conglomerates with investments diversified across sectors (some of which are not considered to be clean assets). This can significantly limit the options for those businesses when they require liquidity.
Impact
The impacts on these industries will likely become more acute as the push towards phasing out fossil fuels gains global momentum. The COP 28 conference culminated in a “global stocktake” agreement, which calls on parties to contribute to global efforts aimed at “accelerating efforts towards the phase-down of unabated coal power, phasing out inefficient fossil fuel subsidies, and other measures that drive the transition away from fossil fuels in energy systems.”(7) Although the agreement faced criticism due to its use of softer, suggestive language rather than any firm demands to phase-out fossil fuels, the agreement still marks a significant step on the global stage given that it is the first in the history of COP decisions to directly address fossil fuels.(8) At the very least, the language signals a trend towards a global consensus that restrictions in these “dirtier” industries are necessary, and shows the prioritization given to the development of greener technologies. The effects of this cleaner energy transition will not be even across different jurisdictions and sectors. It will require significant private investment, alongside public capital, particularly from public and private investors in developed countries into emerging market jurisdictions which are likely to be hardest hit by the transition.
Litigation or Regulation
Historically, the US has been big on talk and small on action in implementing large-scale governmental regulation of environmental liability for global operations, particularly at the federal level.(9) However, the US court system is relatively easy to access and has fewer cost implications for the individuals, environmentalists or shareholders who may bring suit in the US than for their counterparts in European courts, which are more likely to require unsuccessful litigants to pay their opponents’ legal fees. The biggest impacts on businesses in the US will therefore likely stem from private and/or state litigation.
Indeed, the total number of cases related to climate change filed in the US has steadily increased over the past decade, with claims levied against private as well as public actors. Although climate change litigation has traditionally been aimed at high-emitting (i.e. oil and gas) companies, recent trends have broadened the pool of potential private defendants. Environmental-based suits have now expanded to include cases seeking to establish corporate liability for deception or disinformation regarding climate change, including insufficient disclosure of climate-related information to shareholders and intentional deception in advertising (i.e. “greenwashing”), as well as claims based on financial risks, fiduciary duties, and corporate due diligence.(10) Beyond climate change, lawsuits concerning environmental justice are likely to increase on a global scale. (11) For example, in the UK in February 2023 action group ClientEarth filed a case against the UK board of directors of an oil and gas company, Shell, alleging mismanagement of climate risk because the board had failed to adopt and implement a climate strategy that aligned with the Paris Agreement adopted at COP 21 (although ClientEarth’s case was subsequently dismissed).
On the other side of the Atlantic, the UK and EU are likely to lead efforts to increase regulation of environmental liability at a global level (12). But we are also seeing increasing numbers of UK-headquartered parent companies be held liable for corporate torts of subsidiary companies located in emerging markets. Specifically, in 2021, the UK Supreme Court held that a UK-based parent company could be held liable for actions of a subsidiary domiciled elsewhere, turning the traditional strict approach to corporate separation on its head and signaling that the corporate veil may not be sufficient to protect a company from these types of suits. (13) Environmental regulations or legislation in different jurisdictions can, thus, sometimes be effectively “overridden” by the transnational aspect of lawsuits and the sophistication of the legal system in which the lawsuit is filed.
Litigation Focus: Environmental Tort Case Examples
A general trend towards an increase in environmental-related litigation, typically with severe consequences for defendants, can be seen in toxic tort class actions. Recent examples include class action suits filed against AT&T in connection with the company’s use of lead-sheathed cables, alleging that the cables posed a hazard to utility workers and that AT&T did not adequately notify shareholders as to the risks the cables posed. In August 2023, legal actions were also filed against a number of entities in Hawaii in the aftermath of devastating state wildfires. Suits were filed against the State of Hawaii, the County of Maui, and several utility companies on a variety of bases, such as nuisance and trespass. These suits included one against Hawaiian Electric Industries that alleged the company negligently caused the fires with its equipment, while the county is also accused of negligence in fire prevention and response efforts. A question for the defendants of such suits is whether the Hawaiian courts will follow California’s example and analogize the fire damage to a governmental taking of private property, creating an easier path to liability.(14) While California has applied this theory of “inverse condemnation” in numerous wildfire-related cases, this would be an issue of first impression for the Hawaiian courts.
Similarly, a number of companies faced lawsuits based on their contribution to the proliferation of PFAS (per- and polyfluoroalkyl substances), which are linked to various health-related issues. One such company, Kidde-Fenwal, Inc., was forced into bankruptcy in May 2023 as a result of over 4,400 suits that it faced for its PFAS-laden fire suppressant foam. Another, 3M Co., was ordered to pay a multibillion-dollar settlement that could ultimately bankrupt the company by the end of the payout period.(15)
Long-Term Outlook
In the longer term, we expect to see an increase in lawsuits from all corners - environmental groups, investors, and ordinary citizens - against governments and private enterprises for environmental liabilities. Litigation in this sphere could focus on failure either to comply with environmental guidelines or to provide sufficient transparency on environmental risks. Businesses that are not well-adapted to the current environmental trends are likely to face more distress and insolvency risk. Mass tort cases springing from disasters, such as those referenced above, almost always lead to some form of insolvency proceeding, and previous insolvencies provide clues as to how current or future restructurings could play out.
PG&E filed for bankruptcy in 2019 after its faulty equipment sparked several fires in California, including the 2018 Camp Fire that killed 84 people. The company ended up reaching a $13.5bn settlement with the victims of that wildfire and several others in 2015, 2016 and 2017. The restructuring played out amid a confluence of climate regulation and private markets. Because of the earlier referenced “inverse condemnation” state law, PG&E essentially had uncapped liability for any wildfires caused by the company’s equipment, which put the entity under a significant amount of pressure, even if there were other alleged causes of the fires.(16)
Bankruptcy As a Tool
In response to the threat of mass tort litigation, bankruptcy has also been used as a tool to stem the onslaught of lawsuits brought against a company and amalgamate them into a single proceeding. For example, Purdue Pharma, the Oxycontin manufacturer, filed for bankruptcy in an effort to stymie the thousands of lawsuits being brought against them for their role in the opioid epidemic.(17) Similarly, Johnson & Johnson (“J&J”) brought public scrutiny to a corporate law maneuver known as the “Texas Two-Step”, wherein a company creates a new legal entity to which it transfers all of its tort liabilities along with a relatively small portion of the main company’s assets.(18) That new entity then files for bankruptcy, ultimately protecting the main company from the cost of tort liabilities, as the large majority of their assets are no longer at play.(19) In J&J’s case, over 38,000 litigants have alleged personal injury due to asbestos contamination in the company’s well-known baby powder product. In October 2021, J&J responded by incorporating a new entity in Texas, and transferred all of the liability related to the asbestos claims to the new shell company, keeping the majority of their assets separate.(20) The new entity then promptly filed for bankruptcy.(21) Per typical bankruptcy procedure, all related litigation, including the thousands of asbestos personal injury lawsuits, were automatically stayed pending the bankruptcy case’s resolution.(22)
The Texas Two-Step is still unreliable as a defense to mass tort cases, as the Third Circuit on appeal overturned the bankruptcy court’s decision upholding strategy, instead finding that a filing for bankruptcy must be made in good faith, which requires the company to be in financial distress; as in J&J’s example, the Third Circuit determined it did not meet those standards.(23) In June 2023, the Bankruptcy Court for the Southern District of Indiana similarly dismissed the bankruptcy of 3M, a subsidiary of Aearo Technologies, which faced over 200,000 lawsuits alleging military earplugs caused hearing loss for veterans and US service members, finding that, as a result of a funding agreement with 3M, it was not in financial distress.(24) Yet, despite this trend, in late December 2023, the Bankruptcy Court for the Western District of North Carolina declined to dismiss a similar bankruptcy filing by two Trane Technologies subsidiaries facing asbestos-related tort exposure.(25) If the Trane decision is appealed and upheld by the Fourth Circuit, the split between the Fourth and Third Circuit approaches could lead to the Supreme Court weighing in on the maneuver. The Texas Two-Step has also received attention from federal representatives, which could indicate future action on the legislative front in this area.(26)
We continue to track legislation that relates to corporate accountability and climate, as companies will need to respond to this and mitigate the consequent risk of loss. In California, for example, the state legislature recently passed two climate-related legislative measures to standardize climate disclosures, align public investments with climate objectives and raise the criteria for companies to promote climate action.(27) This is especially important because there is a strong correlation between increases in environmental liabilities and increases in litigation and insolvency. As demonstrated through the above examples, environmental liabilities often lead to more instances of not only litigation, but also high-impact mass tort claims, where all too often insolvency looms as a likely consequence.
Looking Ahead
Going forward, companies will increasingly have to grapple with ESG concerns, whether in the context of litigation, funding or regulation. Companies and their stakeholders should pay close attention to ESG-related developments and their implications in the restructuring, insolvency and wider finance landscape.
See e.g. BlackRock’s financing deal linking a $4.4bn dollar credit facility to its efforts to meet targets for women in senior leadership roles and increase the representation of Black and Latino employees in its workforce. https://www.bloomberg.com/news/newsletters/2021-04-07/money-stuff-blackrock-borrows-against-diversity. The fact that this deal was struck with a group of large banks indicates the prevalence of ESG-minded investment, as such institutional lenders are not typically thought to be at the forefront of advancing social goals.
https://www.pimco.com/gbl/en/resources/education/understanding-green-social-and-sustainability-bonds.
https://www.reuters.com/markets/funds/corporate-sustainability-push-35-trillion-dollar-conundrum-auditors-2022-02-22/. The International Auditing and Assurance Standards Board (IAASB) in January of this year published a public consultation for its 2024-27 proposed strategy and work plan to develop a standard for assurance on sustainability reporting; https://www.iaasb.org/news-events/2023-01/iaasb-begins-work-global-standards-esg-assurance; https://www.icmagroup.org/sustainable-finance/the-principles-guidelines-and-handbooks/sustainability-linked-bond-principles-slbp/.
https://www.bloomberg.com/news/articles/2023-01-30/activists-ask-bondholders-to-stop-funding-adani-s-coal-empire?embedded-checkout=true.
Kiara Worth, United Nations Climate Change, COP28 Agreement Signals “Beginning of the End” of the Fossil Fuel Era, Dec. 13, 2023, https://unfccc.int/news/cop28-agreement-signals-beginning-of-the-end-of-the-fossil-fuel-era.
https://www.theguardian.com/environment/2023/dec/11/cop28-draft-agreement-calls-for-fossil-fuel-cuts-but-avoids-phase-out; https://www.amnesty.org/en/latest/news/2023/12/global-cop28-agreement-to-move-away-from-fossil-fuels-sets-precedent-but-falls-short-of-safeguarding-human-rights/.
Note, however, that in 2021 the Biden Administration committed to reducing national emissions by 50-52% from 2005 levels by 2030, and achieve net zero emissions by 2050. See https://www.whitehouse.gov/briefing-room/statements-releases/2021/04/22/fact-sheet-president-biden-sets-2030-greenhouse-gas-pollution-reduction-target-aimed-at-creating-good-paying-union-jobs-and-securing-u-s-leadership-on-clean-energy-technologies/. Development on this front will likely depend on the political party in power, as historically Democrats have placed more emphasis on regulation of climate-change-contributing emitters, while Republican administrations have not made that a priority.
For further information on this topic, see https://content.clearygottlieb.com/corporate/emerging-markets-restructuring-journal-winter-2022/impact-investing-expanding-the-focus-from-climate-to-nature/index.html.
See, for example, the EU’s “Biodiversity Strategy for 2030” laying out a comprehensive long-term plan to protect nature and reverse the degradation of ecosystems with the focus on improving financial supervisors and business’ awareness of the nature-related impacts of their supply chains. https://content.clearygottlieb.com/corporate/emerging-markets-restructuring-journal-winter-2022/impact-investing-expanding-the-focus-from-climate-to-nature/index.html. See also France’s “Duty of Vigilance” law enacted in 2017, which requires large French companies to publish “vigilance plans” each year which lay out measures for companies to identify risks and prevent severe impacts on human rights and the environment, not just as a result of their own operations, but those of their subsidiaries, subcontractors and suppliers. https://www.business-humanrights.org/en/big-issues/corporate-legal-accountability/frances-duty-of-vigilance-law/.
Okpabi and others v Royal Dutch Shell plc and another [2021] UKSC 3.
https://news.bloomberglaw.com/bankruptcy-law/trillions-in-pfas-liabilities-threaten-corporate-bankruptcy-wave; https://news.bloomberglaw.com/environment-and-energy/3ms-revised-pfas-settlement-includes-atypical-liability-terms.
https://journals.library.columbia.edu/index.php/CBLR/announcement/view/432.
This is permitted under Texas’ divisive merger statute. Note that though the maneuver is named for Texas’ business-friendly corporate law, the same actions are also permitted under Delaware’s Limited Liability Company Act (“DLLCA”). DLLCA § 18-217.
Third-Party Releases in Bankruptcy Plans, Practical Law Practice Note 3-570-7925; https://journals.library.columbia.edu/index.php/CBLR/announcement/view/432.
11 U.S.C. Section 362 (“…a petition filed…operates as a stay, applicable to all entities, of…the commencement or continuation…of a judicial, administrative, or other action or proceeding against the debtor that was or could have been commenced before the commencement of the case under this title, or to recover a claim against the debtor that arose before the commencement of the case under this title….”).
https://news.law.fordham.edu/jcfl/2023/09/24/the-texas-two-step-and-big-pharma/.