New Guidance on ESG Disclosure in Leveraged Finance Transactions: A Step Toward Improved Consistency?

On January 19, 2021, together with the Principles for Responsible Investment (PRI), the European Leveraged Finance Association (ELFA) and the London-based Loan Market Association (LMA) jointly published a Guide for Company Advisers on ESG Disclosure in Leveraged Finance Transactions (Guide).

As sustainable investing continues to gain traction, environmental, social and governance (ESG) considerations are being given increasing significance by borrowers, investors and lenders alike. However, there is a general lack of clarity and consistency with respect to ESG disclosure. Stakeholders agree that a standardized approach to ESG disclosure would greatly benefit the market. The Guide aims to serve as a practical tool for company advisors to use in navigating ESG disclosure in the context of leveraged finance transactions and in integrating ESG considerations into a company’s offering documentation or credit agreement and ongoing financial reports.

The publication of this Guide is one example amongst many of recent developments in the area of sustainable finance. In the lending context, this increased focus on sustainable investment is also reflected by the development of Green Loan Principles (GLP),  Sustainability Linked Loan Principles (SLLP) and Sustainability-Linked Bond Principles (SLBP).

For more insight on GLPs, SLLPs, SLBPs and sustainable lending, consult our following Blakes Bulletins:

• New Guidance Documents on the Application of the Green Loan Principles in Real Estate Finance (December 2020)

• New Voluntary Guidance: Sustainability-Linked Bond Principles (July 2020)

• New Guidance Documents on Green Loans and Sustainability Linked Loans (May 2020)

• Lending Market Sets Sights on Sustainability Linked Loans (April 2019)

• LMA and LSTA Announce Extended Green Loan Principles (January 2019)

STANDARDIZING ESG DISCLOSURE IN THE EUROPEAN AND U.S. LOAN MARKETS

The Guide builds on the ESG Disclosure Initiative which was launched by the ELFA and LMA, together with the PRI, in June 2019. The ESG Disclosure Initiative has the goal of increasing and harmonizing ESG disclosure by borrowers, thereby reducing the need for investors to rely on individual ESG questionnaires.

In addition to the publication of the Guide, the ESG Disclosure Initiative includes the publication of ESG Fact Sheets which are designed to support borrowers in preparing ESG disclosure. The ESG Fact Sheets also have the aim of aligning market expectations, streamlining the disclosure process, and facilitating engagement between lenders, investors and borrowers on important ESG topics. Thus far, nine ESG Fact Sheets have been published, including ESG Fact Sheets specific to eight different industries (e.g., industrials, retail, software, paper and packaging), in addition to a general ESG Fact Sheet.

In February 2020, The New York-based Loan Syndications and Trading Association (LSTA) published a template ESG Diligence Questionnaire, applicable to borrowers across all industries, to facilitate due diligence reviews of the ESG profile of borrowers.
 

THE GUIDE: CONTENT

The Guide begins by setting out why enhanced disclosure regarding ESG factors is necessary, following which it provides an overview of the regulatory framework applicable in Europe with respect to ESG disclosure. The Guide then provides practical guidance with respect to how borrowers should disclose ESG information in leveraged finance transactions, particularly by discussing materiality thresholds regarding ESG information, describing how the ESG Fact Sheets can be incorporated into due diligence and setting out a roadmap for integrating ESG disclosure in offering memoranda. Finally, the Guide examines the potential for incorporating ESG considerations into contractual provisions of credit agreements. Certain of the key points of the Guide are summarized below.

Need for Enhanced ESG Disclosure

According to the Guide, ESG integration is additive to the investment process and the systematic incorporation of material ESG-related considerations can lead to more informed investment decisions. The Guide also references empirical studies that have demonstrated a clear correlation between strong ESG disclosure and returns. Many sub-investment grade borrowers, credit analysts and credit rating agencies have also acknowledged the growing need for disclosure of ESG information in order to retain sufficient investor interest and participation.
There is increased scrutiny and demand with respect to ESG considerations from investors and society at large. This is illustrated by the fact that over 3000 organizations, representing over US$103-trillion, have signed up to the PRI, thereby committing to a voluntary set of aspirational investment principles for integrating ESG issues into investment and ownership decisions.

Enhanced ESG disclosure is also made necessary by regulatory requirements. While Europe is at the forefront of this movement, the increase in ESG-related regulatory requirements is a global phenomenon. The call for transparency and better data in ESG disclosure is paving the way for previously voluntary ESG reporting frameworks and standards to become mandatory.

ESG Fact Sheets and Due Diligence

As investors give more consideration to ESG risks and opportunities as key factors in their decision-making, ESG factors must be given appropriate consideration from the outset of leveraged finance transactions, particularly through the due diligence process.

The ESG Fact Sheets provide a general framework for the disclosure of ESG-related matters by setting out the ESG-related issues that should be considered and disclosed. The use of the ESG Fact Sheets can therefore be particularly useful in streamlining the ESG-related due diligence process and in harmonizing the ESG-diligence approach of investors.

The identification of material information constitutes one of the primary objectives of the due diligence process, particularly given that disclosure in offering materials for leveraged finance transactions relies significantly on the information obtained throughout the diligence process. The materiality of ESG information differs depending on the company and the industry in which it operates, and there is currently no uniform approach as to how to evaluate materiality of ESG disclosures.

Roadmap for ESG Disclosure in Offering Memoranda

The Guide also provides a roadmap for the incorporation of ESG disclosure in offering materials in the context of bond offerings. Since offering memoranda are designed to provide investors with the material information that a reasonable investor requires in making an informed investment decision, all material ESG issues should be incorporated into the offering memoranda, preferably in a manner consistent with the disclosure approach undertaken in respect of non-ESG disclosures regarding a company’s business.

The Guide recommends a holistic approach to addressing ESG factors in offering memoranda such that the ESG-related information should be consolidated within the offering memoranda, rather than constitute a completely separate disclosure document. The Guide also provides recommendations and examples of specific approaches to incorporating ESG disclosure in typical key sections of an offering memoranda, including the company’s business, risk factors, MD&A and financial statements sections. Ideally, disclosure of ESG information should also follow a standardized approach in order to allow potential investors to compare and contrast the ESG profile of different issuers.

Contractual Provisions and other Considerations

The Guide addresses considerations for including ESG-specific contractual provisions in documentation such as credit agreements. Those considerations include balancing what is achievable for a borrower but still meaningful for investors, and which do not unintentionally trigger a default. Potential features of ESG-specific contractual provisions could include quarterly and/or annual reporting, ESG-compliance certificates, third party verification (optional) and as ESG metrics become more prevalent, the Guide anticipates that covenant protections may be elaborated to refer to pre-determined performance thresholds or metrics (more akin to a financial covenant). While difficult to create standardised terms that can be used across the market at this stage, given factors such as absence of consistency in ESG reporting, measurement and diligence, the Guide notes that the use of ESG-specific contractual provisions is expected to evolve. 

CONCLUSION

In light of the ESG Disclosure Initiative in the European loan market, and the publication of the ESG Diligence Questionnaire in the U.S. loan market, we will continue to monitor the development of ESG disclosure in the Canadian leveraged finance market.

As new developments emerge internationally and nationally with respect to ESG-related disclosure and sustainable finance more generally, we will continue to follow the new developments and provide updates on their impact.

For further information, please contact:

Fabien Lanteri-Massa                  514-982-4034
Michael Hickey                             416-863-4318
Rebecca Dawe                              514-982-5047

or any other member of our  Financial Services or Capital Markets groups.