Although the concept of ESG has replaced what was formerly termed Corporate Social Responsibility (CSR), there is a key difference between the two.
ESG is deliberately quantifiable and criteria led, enabling businesses to measure their practices and efforts across three broad categories: Environmental, Social and Governance. As ESG regulation, legislation and stakeholder expectation continues to grow, businesses are under the spotlight more than ever, but it is the directors running businesses that face the responsibilities, and potential liabilities, arising in relation to ESG practices and efforts.
Boards of directors should be assessing their ESG vulnerability in certain key areas and taking practical steps now to abide by good ESG metrics to manage their current and future risks. This article focuses on three of those areas: directors duties; disclosure and greenwashing; and human rights.
It is widely accepted that directors have a legal obligation under the Companies Act 2006 to consider ESG factors, but how might failure to do so constitute a breach of duty and lead to claims against a director?
Directors must take into account a non-exhaustive list of factors when making decisions to promote the success of the company, including the 'interests of the company's employees' and 'the impact of the company's operations on the community and environment.' It is not sufficient for directors to justify their decision-making on economic considerations alone; regulatory risks or changes in the business environment relating to ESG that could threaten, or improve, the company’s future financial success must also be considered. The scope for error here is potentially huge, not least because directors must also consider ’externalities’ (factors that do not currently impact the business). For example, directors of a business reliant on unsustainable farming or coal extraction practices must not only consider ESG factors that affect their business today, but also the likelihood of such practices being outlawed, or causing reputational damage, in the future. Where insufficient consideration of an ESG factor leads to a poor decision resulting in damage to the company, directors leave themselves exposed to directors duties’ claims.
Practical steps can help guard against these risks and ensure directors are discharging their duties. Boards should consider, at a minimum, taking the following steps:
- Evaluate which ESG considerations are most relevant to the company, its operations and long-term success.
- Incorporate compliance-management and other processes to ensure ESG risks and opportunities factor into corporate decision-making.
- Perform an ESG skills audit and appoint directors with deep knowledge and experience of the sector, the company’s business plan and operations. Where expert advice is needed, follow proper processes to delegate authority to non-executive directors and independent advisors.
The ESG and climate-related reporting landscape has evolved rapidly in recent years and continues to grow at pace.
Since the Financial Stability Board established the global Task Force on Climate-related Financial Disclosures (TCFD) in 2017, the UK has strongly endorsed the recommendations and announced its intention to make TCFD-aligned disclosures mandatory across the UK economy by 2025. Boards should review the UK Taskforce’s Interim Report and consider, now, how its accompanying roadmap published in November 2020 will impact their business. The UK Corporate Governance Code sets out best practice for boards of directors in protecting shareholder investments and ensuring effective corporate governance. It is widely expected that environmental best practice may be incorporated into the Code in the coming years. The Financial Conduct Authority has also stated that it is actively considering including ESG factors in reporting obligations for issuers, as well as how best to address 'greenwashing', where companies give misleading statements about the environmental credentials of their products.
Directors need to be mindful not only of current mandatory disclosure obligations, but also how the trend in favour of more ESG transparency and accountability might affect them and the businesses they run over the short and long term. When reporting on ESG, directors should also be mindful of their potential liability. For example, directors with knowledge that statements made in (or excluded from) directors reports, strategic reports and corporate governance statements are untrue or misleading will be liable to compensate the company for loss suffered as a result.
To address the risks of reputational damage and potential litigation arising from voluntary and mandatory ESG reporting, directors should:
- Proactively assess their ESG reporting practices and requirements on an ongoing basis.
- Where not already implemented, consider implementing well-recognised standard frameworks.
- Ensure ESG statements are accurate, adopting cautionary language where appropriate.
Public awareness of and regulatory focus on corporate violations of human rights, in both general corporate conduct and supply chain management, has rightly brought modern slavery and human rights issues to the top of the corporate agenda. A director’s duty under the Companies Act to consider the impact of a company’s operations on the community and environment already incorporates human rights issues, but directors should also be aware of other legislation dealing with related social issues such as the Bribery Act 2010, the Modern Slavery Act 2015, the Equality Act 2010 and the Corporate Manslaughter and Corporate Homicide Act 2007.
For example, under the Modern Slavery Act, companies with a presence in the UK and a global annual turnover in excess of £36 million must publish an annual statement setting out the steps they have taken to manage their supply chain risk in relation to human trafficking or modern slavery. Directors should be aware that these statements must be updated annually; published on the company’s website; and approved by the board of directors. The consequences of failing to produce accurate statements may be severe. The UK government has stated it will introduce legislation to strengthen this requirement under the Act, suggesting that breaches should be grounds for director disqualification. The EU is looking to adopt an even more robust approach, recommending the introduction of mandatory corporate due diligence to better identify, prevent and mitigate human rights violations in business’ supply chains.
To help manage these risks, boards should:
- Properly assess and consider human rights risk across their business operations including supply chains.
- Ensure corporate strategy takes into account and addresses these risks.
- Implement effective procedures and policies for whistleblowing and complaints.
- Be mindful of human rights related mandatory and voluntary reporting, ensuring all reporting is accurate and meets the required standards under local and applicable foreign laws.
- Closely follow recommendations put forward by the UK, EU and other countries to introduce mandatory corporate due diligence and impose stricter or new regulatory requirements on corporates.
Failure by directors to take these steps may lead to disqualification and personal liability and is likely to have a serious impact on corporate value, particularly where such matters become public.
A top-down approach to ESG has never been more important. Failure to properly consider the risks posed by ESG exposes directors to serious potential liabilities that go well beyond those relating to directors duties, reporting and human rights covered in this article. Directors have no choice but to contend with a complex and ever-expanding body of global legislation, soft law codes and frameworks, and to take practical steps to manage and minimise the risks they pose to themselves as well as the companies they run.