Environmental, Social and Governance Diligence in Loan Markets

Environmental, social and governance (ESG) considerations are continuing to come under increased scrutiny in the loan markets.  Topics such as climate change, composition of corporate boards and treatment of employees by corporations are at the forefront of individual and corporate consciousness, particularly in view of the impacts of the COVID-19 pandemic on the global workforce.  Tailored financial products such as sustainability-linked loans, which reward favorable ESG behavior by corporates through step-up/step-down pricing mechanisms, have gained huge popularity since their inception, and the demand for ESG investment options is expected to increase through 2021.  However, fundamental hurdles remain to mainstreaming ESG in the loan markets due to a lack of standardization around ESG reporting, resulting in inadequate ESG disclosures.  This makes it difficult for prospective investors and lenders to fully evaluate a company’s overall risk profile and make informed investment decisions, particularly where a company is not publicly traded and little relevant information about that company is otherwise readily available.

The New York-based Loan Syndications and Trading Association (LSTA) convened a specific working group to discuss how to mitigate potential ESG risks, which resulted in, among other things, the design of an ESG Diligence Questionnaire (the “Questionnaire”) in February 2020.  The Questionnaire, which is intended to be completed by borrowers during the loan origination process (but may also be used for any capital transaction, including in the context of refinancings), was developed with the goal of soliciting reliable ESG information from borrowers.  It offers a set of questions that, once completed, will provide prospective lenders with an overview of that borrower’s ESG or sustainability “story”.  As stated in the preamble to the Questionnaire, it is intended that completed questionnaires are “posted to the relevant data room (the public side if one exists) and available for review by prospective lenders”.  The LSTA has also published a helpful FAQ document which provides additional information on the Questionnaire and what it seeks to achieve. (Both documents are available for download by LSTA members on the LSTA website)

The Questionnaire comprises eight questions within four general sections, which we summarize below.  The questions are necessarily broad to cater to companies in the early through advanced stages of ESG implementation, and to allow borrowers to identify certain ESG concepts and goals relevant to their business, with the understanding that ESG or sustainability will mean different things to different companies.  Companies with nascent policies or plans, and even those without a formal policy, with respect to ESG should not be discouraged from completing the Questionnaire, but should view it as an opportunity to develop an understanding of ESG as it pertains to their business.

1. ESG Governance.  This section is aimed at providing lenders with an understanding of how advanced a borrower is in its ESG journey.  Questions include whether the borrower currently has an ESG policy, and if so, any measures in place for tracking progress, and if not, any plans the borrower has in relation to ESG, and whether any ESG-related reporting is made available.  It also asks the borrower to identify the individual(s) responsible for monitoring ESG issues and their level of seniority, including whether ESG is considered in relation to management performance evaluation or compensation.

2. Relevant ESG Frameworks.  This section asks the borrower to identify any recognized ESG frameworks and standards to which it adheres.  A list is provided by the LSTA in the Questionnaire, and includes frameworks such as the UN Sustainable Development Goals (SDGs)…