Broadening corporate risk management in relation to director and officer liability for ESG – the future is now

April 2020  |  EXPERT BRIEFING  |  RISK MANAGEMENT

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It seems almost trite to say that shareholder primacy has long been the dominant consideration for corporations and that directors and officers (D&Os) should carefully consider the duties they owe to the corporations they work for. However, directors should not conceptualise these obligations as static. Shifts in the global social and legislative landscape have resulted in investors, shareholders and society pushing companies to consider more than just the traditional shareholder bottom line. As a result, environmental, social and corporate governance (ESG) considerations have emerged as a way to place greater emphasis on the impacts a corporation has on the people and the planet, in addition to the traditional financial impacts. This has led to debate surrounding the extent to which D&Os’ obligations will or should be impacted by the additional factors ESG encompasses.

What is ESG?

ESG factors are increasingly considered key to financial growth and long-term value creation for companies globally. Currently, concerns surrounding the impacts of climate change have become a hot button issue, dominating much of the ESG debate. While climate change issues fit squarely within the ‘E’ of ESG, the ‘S’ and ‘G’ components should not be forgotten. These segments of the ESG world encompass, among a multitude of other things, labour practices, management of supply chains, talent management, interaction with key stakeholders, product safety, data security, anti-corruption, privacy, board diversity, gender considerations, executive pay and business ethics.

Why should boards care?

In the traditional sense, because it is increasingly clear that ESG factors impact the financial performance of a corporation, failure to seriously consider ESG issues could result in directors misrepresenting the risks associated with ESG, or worse, failing to consider the material impacts of ESG altogether. The issues associated with ESG are rooted in global concerns, so directors should consider both domestic and international trends. Directors will then need to understand how these additional factors impact their responsibilities and develop strategies to help mitigate the associated risks. While certainly not exhaustive, there are three main areas of risk that should be front of mind for directors: (i) increasing shareholder activism related to ESG issues; (ii) the impact of ESG on investor decision making; and (iii) new avenues for litigation risks.

Shareholder activism. Shareholders are not sitting idle waiting for legislation to catch up to what they perceive as legitimate concerns about the way corporations are run. This is clear from the dramatic rise in shareholder proposals relating to environmental (particularly climate change) and social and governance issues (primarily gender and racial diversity on boards), proposals relating to adoption of environment or social policies and disclosure practices, over the past 10 years.

In Canada, there were nine proposals to adopt ESG metrics into compensation decisions in 2019, while in the US, 11 environment and social proposals received majority support. Initially, these types of proposals were excluded from proxies and garnered a very small share of the votes. Now, they appear on proxies in various jurisdictions with greater frequency and in some cases have received greater than 50 percent of the vote. They show a trend that shareholders and large institutional investors increasingly perceive ESG risks to be material to corporate performance. As regulators become more attuned to the requests by shareholders for ESG-related information, regulatory requirements are certain to catch up with shareholder demands.

Litigation risks. Directors have always faced litigation risks where they are shown to have failed to comply with their duties to the corporation. However, two recent decisions by the Delaware courts have provided further guidelines when considering the scope of a board’s responsibility as related to ESG-based corporate risk. The decisions in Marchand v. Barnhill and Clovis noted that it was not enough to merely show awareness of issues when they are ‘mission critical’ to the operation of the business.

In the context of ESG, the state of the law as it relates to director liability is in flux, especially in reference to climate change, and whether plaintiffs are ultimately successful in litigation may be beside the point, as the primary purpose of many of these lawsuits is to raise public awareness of ESG issues. In any case, the risks posed by these lawsuits are real. Litigation may impact a company’s reputation and requires significant resources to defend, even if the plaintiffs do not prevail in the end. As such, directors would be remiss to entirely dismiss the risk of liability.

Investor concerns. In the 2018 BlackRock letter to CEOs, Larry Fink indicated that for a company “[t]o prosper over time […] every company must not only deliver financial performance, but also show how it makes a positive contribution to society”. In the 2020 BlackRock letter to CEOs, Mr Fink carried this further stating that he believes “we are on the edge of a fundamental reshaping of finance”. This type of sentiment directly indicates the changes that are occurring to the traditional profit-only concerns. Not only is there growing evidence that companies are at greater financial risk if they are not actively managing their performance related to environmental, social and governance issues, but younger investors are demanding improved social performance.

A failure by directors to consider both the BlackRock’s of the world and the shifting mindsets of numerous other investors, globally, will likely have serious ramifications when raising capital in the future. This would almost certainly fall within the realm of issues that are “essential and mission critical” as was outlined in the Delaware decisions.

ESG strategies for board consideration

What are directors to do about the developing importance of ESG considerations? While by no means an exhaustive list, boards should be deliberate and strategic in evaluating the current state of the corporation with respect to ESG, the development of policies and strategies to address ESG matters, and conducting thorough and regular training for directors on ESG-related trends and issues.

Evaluate. Boards and management must seriously consider whether their existing strategies and governance practices are sufficient to ensure that ESG factors that are material, that may become material, or can be considered material in the context of their business and industry have been adequately addressed. This means looking to identify and understand key material ESG compliance risks. If corporations spend time understanding the risks associated with things like meaningful oversight and disclosure practices, they will likely be in a better position to future proof against regulatory changes that may already be in the works.

Develop. Opportunities exist for all companies to advance their internal practices to meet stakeholder scrutiny and demands and ensure they are better placed to adequately consider governance issues, including disclosure and other reporting, and consideration of appropriate lines of communication from management to the board regarding ESG initiatives. Guidance in the voluntary disclosure frameworks like SASB and TCFD can help to shape a corporation’s disclosure practices but are lengthy and require careful thought as to how they apply to a corporation’s circumstances.

The development of policies and procedures related to ESG issues should be carefully drafted and embedded throughout an organisation to meet ESG risks and take advantage of opportunities. In addition, the veracity of representations by the company will be critical, especially given the risk that they may later be subject to scrutiny.

Train. Changes to corporate strategy and internal control systems, which assist with the development of a risk-based approach to ESG should be rooted in corporate culture. Training to develop expertise within the corporation will help directors to more accurately identify red flags and act appropriately when necessary. In addition, training on ESG issues will assist with more robust discussion of the potential issues and opportunities for the corporation and will assist with the disclosure requirements that are being sought by shareholders and other institutional investors.

Determining material and non-material ESG risks and setting a path via robust internal education and engagement of experts sets up corporate purpose grounded in considerations outside of traditional profit motivations, and naturally leads to a culture that supports the company’s strategic direction.

A word of caution. While addressing these issues now gives boards time for careful consideration and refinement of ESG policies and may place them ahead of their competitors by providing fruitful opportunities for innovation and growth going forward, D&Os should be aware of the old adage that ‘no good deed goes unpunished’. Having a policy but failing to implement it can be detrimental. Directors should not put themselves in a position where a strategy only pays lip service to what they determine the market requires of them without having implemented such a plan.

Kellie L. Johnston is of counsel at Norton Rose Fulbright Canada LLP. She can be contacted on +1 (403) 267 8165 or by email: kellie.johnston@nortonrosefulbright.com. The author would like to thank Lauren Stelck, an associate at Norton Rose Fulbright, for her assistance in the preparation of this article.

BY

Kellie L. Johnston

Norton Rose Fulbright Canada LLP