What actions can corporate boards take to mitigate the risk of legal problems around what the company reports and says about its ESG initiatives and practices?
The interest of investors, consumers, and the public that is expanding beyond environmental issues to include diversity and inclusion, social justice, and governance — and the corresponding heightened attention by regulators across the world — has brought new scrutiny to corporations that are reporting and statements about these environmental, social and governance (ESG) issues.
This close examination and increased focus by a growing number of stakeholder groups over the last 18 months have forced company boardrooms to pay more attention to how their corporations are reporting information and conveying messages in the media about corporate actions.
Indeed, the new and proposed regulations around what public companies are required to disclose in the ESG space and what they say regarding ESG issues have increased the risk to companies’ financial performances and stock prices. “There’s definitely pressure on directors to ensure that they’re thinking through ESG risks and examining the systems in place to implement appropriate oversight in those areas,” says Colleen Smith, partner and Global Vice Chair of the Securities Litigation & Professional Liability Practice at Latham & Watkins.
Legal claims against company board members increase
Corporate directors are increasingly becoming the targets of litigation, according to Smith and her colleague Sarah Fortt, partner and Global Co-Chair of the ESG practice at Latham & Watkins. Some of the driving forces in this growth in the number of court cases against board members include:
- plaintiffs bringing legal action for a perceived breach of fiduciary duty based on a lack of oversight;
- corporate directors being accused of failing to comply with their fiduciary duties based on underlying ESG claims; and
- shareholders attempting to use the courts to force corporate board diversity, although these efforts have not yet been successful.
New & emerging ways to reduce risks
To reduce to the risk of legal action, members of company boards need to ensure that mechanisms are in place to provide sufficient oversight. Before this can be done, however, many companies need to commit to treating ESG risks in the same way as they do any other corporate reporting and compliance requirement. And that means it will be necessary for corporations to increase the rigor of their enterprise data collection, management, and controls around ESG topics. Fortt and Smith recommend these key actions:
Improve cross-functional data collection, management & controls — Perhaps the biggest challenge in mitigating legal exposure to board members is ESG data itself. Sources of ESG information cut across many corporate functions and sit in siloed systems without the technical capability to easily collate it from multiple databases.
Investing in a technology solution may be the first necessary step in cutting the risk of legal action simply because it ideally enables potential improvements in data transparency and information integrity. Currently, an inordinate amount of time is spent on manually modifying the data to put it in a format where reporting becomes possible by the various corporate functions which own an ESG data set. This manual process increases the potential for data mishaps, which could cause adverse impacts throughout the corporation and hinder the board’s ability to provide oversight — or in a worst case scenario, lead to potentially actionable public misstatements concerning ESG topics.
Ensure there is healthy debate around how to navigate the murky political risk environment — Corporate board directors are increasingly concerned about the political risks around a company’s ESG agenda, says Fortt. Interestingly, a key risk mitigant to ensure the board’s collective ability to effectively provide oversight to the political risk exposure, she adds, is the degree of healthy collaboration and debate on the board itself.
One of the biggest indicators of board ineffectiveness is that it becomes an echo chamber, with little or no healthy debate, Fortt explains, adding that the diversity of thought and of differing perspectives that “maps appropriately to your key stakeholders is one of the best indicators of effectiveness.”
Enhance documentation of board members’ expertise around ESG issues — Because ESG represents many of the major issues that humanity currently faces, Fortt and Smith both agree that one or more of the individuals already on the board is likely tuned into each major issue and has some expertise to offer. It just might not be obvious from their board member bio.
“When a company is defending a claim regarding the organization’s adequate response to an oversight of issues pertaining to ESG matters, it is helpful to be able to point to well-documented processes, including board and committee meeting minutes and other materials reflecting directors’ expertise and backgrounds,” Smith says. It is also important to make sure that those deliberations and directors’ expertise in particular areas are not underrepresented.
Likewise, carefully documenting the ways in which the board and the management team are thinking about risks is also critical as a way to mitigate any potential litigation brought because of the lack of board oversight.
One of the mechanisms that Fortt says she finds most effective in risk mitigation is to ensure ESG topics are analyzed from multiple angles. Because the level of risk and what it involves can evolve quickly in the ESG space, it is important for ESG issues to be raised through multiple conversations and with a wide range of perspectives being represented.
More specifically, as corporate boards seek to stay abreast of the magnitude of their companies’ ESG risks and exposure, they are seeking an ever-expanding perspective on how ESG currently is and could potentially be impacting operations and strategies.
To that end, boards should intentionally seek perspectives from the management team, the ESG team, the legal team, and others to assess companies’ evolving risk appetites. They also should understand how their enterprise risk management systems consider the material ESG risks through their own operations and that of the supply chain. These practices, taken in concert with one another, are the best tactics for corporate boards to mitigate current and emerging risk exposure in the ESG space.