Q&A: ESG and directors’ liability

March 2023  |  SPECIAL REPORT: MANAGING RISK

Financier Worldwide Magazine

March 2023 Issue

FW discusses ESG and directors’ liability with Simon Garrett at CMS Cameron McKenna Nabarro Olswang LLP and Mike Newham at RPC.

FW: How significant are environmental, social and governance (ESG) issues to companies today? How would you gauge the focus of boards on ESG?

Garrett: Environmental, social and governance (ESG) issues have moved from a niche concern to a boardroom issue for UK companies today. This change has been driven by a range of factors. For example, the work of international bodies such as the Task Force on Climate-related Disclosures has focused on improving the quality of climate-related reporting. That, in turn, has resulted in new regulations and laws, such as those introduced in the UK last year which will apply to public companies, large, limited liability partnerships (LLPs) and certain other companies, and will require, among other things, reporting of their governance arrangements in relation to assessing and managing climate-related risks and opportunities. Importantly, it also reflects the concerns of shareholders, employees, customers and trading partners.

Newham: ESG issues are of fundamental importance to companies operating today. The drivers for this are both commercial, relating to the growth, prosperity and reputation of the business, and legal, relating to regulatory compliance and potential civil or even criminal exposures for certain ESG failures. In exercising their duty to promote the success of the company – codified in section 172 of the Companies Act 2006 – directors must take account of a non-exhaustive list of factors, including the long-term consequences of their decisions, the interests of the company’s employees, and the impact of the company’s operations on the community and the environment. A short term – purely financial – focus by boards will not suffice.

FW: To what extent do ESG concerns present liability risks to a company’s directors & officers (D&Os)?

Newham: The liability risk to a company’s directors & officers (D&Os) posed by ESG concerns is varied and potentially substantial. This is even more so given that the range of issues encompassed within the umbrella term ESG is vast; there is no single accepted classification of what falls under the ‘E’, ‘S’ or ‘G’. The ‘universe’ of ESG issues is also constantly evolving, along with attendant law and regulations, including those which are ‘soft’ – such as guidelines and codes of conduct. All of this means that company D&Os are faced with an environment for making decisions and disclosures which are inherently complex and contain a plethora of possible bases upon which those decisions and disclosures may be scrutinised and criticised or challenged.

Garrett: While the primary target in many of the ESG-related actions we have seen to date has been the corporate body, there is a real risk of D&Os getting pulled into claims and regulatory investigations as well. An obvious way this can arise is through inaccurate disclosures in a company’s annual report which misrepresent the company’s actual approach to ESG-related issues. Claims against directors in respect of misrepresentations in an annual report are not new, but new ESG regulations are adding a significant new area of disclosures that need to be made, and in relation to which, accurate data is often hard to find. D&Os may also find themselves the target of activist investors, as is the case with the recently issued High Court derivative claim by ClientEarth against the directors of Shell, which alleges breaches of duties under the UK Companies Act. The relatively small number of claims against directors to date belies the extent of risk as new rules and regulations increase in scope and effect.

“The focus on ESG, and the evolution and growth of the law and issues constituting this area, are not a temporary phenomenon. The trend toward enforcement and increased avenues of exposure will continue.”
— Mike Newham

FW: How stringent is scrutiny of the ESG space? Beyond domestic laws and regulations, to what extent are D&Os also facing litigation risk from environmental groups and activist investors?

Garrett: Scrutiny of companies’ statements about ESG issues is ever increasing. For example, many companies are considering how they will reach ‘net zero’ and can expect activist groups to pore over such commitments, and expose any which are seen as being based on insufficiently rigorous plans. We see an increasing pattern of activist groups seeking to hold companies to account in respect of their position on ESG issues, and one way of doing this is to seek to apply pressure to companies’ D&Os. This can include utilising new laws and regulations, but could also involve relying on more longstanding causes of action, such as where misrepresentations arise. Action from activist groups can take many different forms; it could include litigation for breach of directors’ duties, such as in the ClientEarth claim against Shell’s directors, allegations of greenwashing, as seen in the Australasian Centre for Corporate Responsibility against Santos, or complaints to regulatory bodies seeking the commencement of regulatory investigations, such as the Mighty Earth complaint to the US Securities and Exchange Commission (SEC) regarding JBS.

Newham: There is substantial, and growing, scrutiny of the ESG space, including by governments, regulators, shareholders and consumers. Activist investors and environmental groups are playing a role here too – and finding creative ways to exert influence, including on D&Os, to bring about what they consider to be positive ‘E’, ‘S’ or ‘G’ change by large corporates. Last year, for example, an environmental organisation, ClientEarth, started legal action against the directors of Shell. Essentially, ClientEarth asserts, in its capacity as a minority shareholder of Shell and acting on behalf of the company, that Shell’s net-zero ambition is not matched by the company’s board and investment plans, which are not, therefore, in the long term best interests of Shell. This type of activism is expected to become more prevalent in the UK, encouraged by the growth and availability of group actions, litigation funding and after the event (ATE) insurance.

FW: What types of action against D&Os might arise from ESG-related issues?

Newham: Given the breadth and complexity of the ESG ‘universe’, the range of potential D&O exposures is equally difficult to specify with certainty. Mechanically, alleged ESG failures could result in derivative claims by shareholders against D&Os for breach of their duties to the company, such as the ClientEarth claim, direct claims from shareholders as a result of misleading or unsubstantiated ESG disclosures which cause those shareholders loss, also known as ‘greenwashing’, as well as regulatory investigations and fines. Even criminal prosecutions in certain cases are theoretically possible. It is worth noting that recent experiences, particularly in the US, have shown that it is not necessarily only companies that are ESG laggards that can face claims in respect of alleged ‘ESG failures’; such claims can just as easily – and sometimes more easily – be made against progressive boards ‘overreaching’ themselves in relation to ESG steps and disclosures.

FW: Could you outline the role of D&O liability insurance in mitigating ESG-related risks? What ESG considerations does such insurance typically cover?

Garrett: D&O liability insurance provides cover for D&Os when they face claims in relation to their management of the company and is a key way in which to mitigate litigation risk, including ESG-related claims. For example, D&O insurance may provide D&Os with cover for defence costs arising from regulatory investigations or from shareholder or activist litigation. It is important, however, to carefully consider the breadth of the policy wording, including not only the insuring clauses and any extensions of cover but also the definitions of ‘claim’ and ‘wrongful act’, as well as checking whether underwriters may have applied ESG exclusions. Some policies might limit cover to claims for damages rather than, for example, claims which seek a change in corporate strategy, which might nonetheless be expensive to defend. In this context, new products starting to become available may be of assistance, for example some insurers now provide Side D cover, an endorsement which provides corporate cover for costs arising from climate disclosure-related investigations.

Newham: D&O insurance typically provides cover to D&Os in respect of liability arising from actual or alleged wrongful acts, errors or omissions committed by D&Os in their capacity as such. This cover will extend to reasonable defence costs of claims, including in relation to criminal prosecutions, and usually also to the costs of dealing with regulatory investigations and enforcement procedures. It may also extend to cover fines, where allowed by law, and employment practices claims. In addition, cover may be provided for the company itself, most commonly in relation to securities claims. D&O insurance does not, therefore, generally seek to mitigate against exposure to specific or identified ESG issues, rather – and logically given the wide and growing ambit of the ESG ‘universe’ – D&O insurance operates by responding at a conceptual level, based on the type or nature of the claim or exposure in question.

“We see an increasing pattern of activist groups seeking to hold companies to account in respect of their position on ESG issues, and one way of doing this is to seek to apply pressure to companies’ D&Os.”
— Simon Garrett

FW: What essential advice would you offer D&Os on effectively managing the personal risks posed by ESG, including selecting appropriate insurance coverage?

Newham: The overwhelming message to D&Os must be to ensure that they continually implement, maintain and develop robust ESG governance frameworks, and oversee the same. Given the ever-changing ESG landscape this will likely mean the appointment of appropriate staff, such as sustainability and diversity and inclusion (D&I) officers, and policies, and ongoing investment and focus on all facets of ‘E’, ‘S’ and ‘G’ as a core operating philosophy; merely ‘talking a good game’ in this regard will not suffice. D&Os can expect insurers to look ever more closely at their performance in this area. Those that score well will likely find insurers more willing to offer capacity and on preferential terms.

Garrett: It is important to carefully consider the breadth of any D&O policy cover arranged by the company and whether additional cover may be required for ESG risks. Importantly, each individual D&O should be personally informed of ESG issues, as well as playing their role in developing the company’s risk management processes to address ESG risk and ensure ESG remains high up the boardroom agenda. D&Os should be fully aware of their statutory and fiduciary duties, and the structures in place within their company to manage and monitor ESG risk. D&Os should consider obtaining external legal advice or assurance services from professional advisers to verify and stress test any public statements that are being made about the company’s ESG policies and management of its ESG risk exposures.

FW: Looking ahead, how do you predict ESG-related liabilities for D&Os will unfold? How important is it for D&Os to continually address this issue and factor it into strategic decisions?

Garrett: Regulators and litigation funders will be looking closely at D&O compliance. As just one example, the UK government’s latest consultation paper on restoring trust in audit and corporate governance makes clear that the directors of public interest entities will be required to sign off on a triennial audit and assurance statement which sets out a company’s approach to assuring the quality of the information it reports to shareholders beyond that contained in the financial statements. As shareholder investment decisions become increasingly reliant on matters not covered by a statutory audit, including statements on ESG issues, how directors go about assuring themselves of these statements will become increasingly important. If these proposals are enacted into UK law, a failure by a director to accurately report on ESG issues could lead to the new regulator, the Audit Reporting and Governance Authority (ARGA), censuring and fining that director; and to companies and their shareholders pursing litigation against the director for losses as a result of relying on false or misleading statements in the company’s annual report.

Newham: The focus on ESG, and the evolution and growth of the law and issues constituting this area, are not a temporary phenomenon. The trend toward enforcement and increased avenues of exposure will continue. Historically, over the last 20 years or so, much D&O liability has been driven by governance issues; going forward, the expectation is that environmental claims – which are already being experienced, including on a group basis, and ‘S’ claims, covering such issues as human rights and modern slavery and supply chains, as well as D&I, will increase. This means that ESG management and governance needs to play a central role in board decision making and oversight on an ongoing basis, for the long-term benefit of both companies and their D&Os.

 

Simon Garrett is a partner in CMS’s insurance team. He has worked as a lawyer in the London insurance market since 2001. He acts for a variety of insurers, intermediaries and their insureds in defence of claims against them or advising on coverage issues. His practice focuses on claims against financial institutions, commercial D&O claims and complex professional indemnity disputes involving financial services companies and other professionals, particularly solicitors, IFAs, insurance brokers, accountants and other financial services professionals. He also represents clients facing investigations by regulatory bodies. He can be contacted on +44 (0)20 7367 2786 or by email: simon.garrett@cms-cmno.com.

Mike Newham’s practice focuses on advising London market non-marine insurers on complex coverage issues arising under a wide range of policies, including D&O, FI, crime and civil liability, investment management, trustee liability and PI. He also has significant experience of defending claims and regulatory investigations against professionals. He can be contacted on +44 (0)20 3060 6000 or by email: michael.newham@rpc.co.uk.

© Financier Worldwide

THE PANELLISTS

 

Simon Garrett

CMS Cameron McKenna Nabarro Olswang LLP

 

Mike Newham

RPC

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