Doug Bryden and John Buttanshaw, Travers Smith LLP (UK)
Responsible investment, under its various guises, is nothing new. Certain elements have been scrutinised by the investor community and its advisers for some time. However, over recent years, the range of issues within the scope of responsible investment has grown exponentially. In addition to environmental and climate change risks, concerns relating to social impact, human rights, gender inequality and financial crime are now commonly considered. It is fair to say that the legal profession has at times seemed unsure of how, and even whether, to properly engage with this expanding area (or simply remain “deep” specialists in given constituent parts).
Some are perhaps put off by the mere task of navigating the various different labels for, or sub-categories of, responsible investment. Depending on the context, one can be discussing environmental, social and governance (ESG) matters, sustainable investment, socially responsible investment, or the more assertive-sounding mission-related investment or social impact investment, among many other terms. None of these terms fall neatly into the tightly defined specialist categories through which lawyers traditionally approach the world – environment, safety, financial regulation, corporate crime, employment, and so on. Some lawyers also see responsible investment as just one among many factors that inform the commercial decision-making and fundraising activities of their investor clients, and outside the strict legal purviews of liability identification and management or transaction documentation. The frequent focus (particularly among consultants) on “value creation” and “opportunity” in the context of responsible investment may often entrench this view. However, this should not distract from the very real legal issues at stake within these areas and the need for robust legal input.
As the “responsible investment” (or however it is termed) expectations of investors, lenders, customers, NGOs and society more generally continue to move apace, it is critical that lawyers confront and understand the broader implications of these developments. These extend to a range of legal matters of profound complexity and importance – including not only immediate legal compliance matters (eg, ensuring a company is complying with increasingly complex ESG reporting requirements) but also sensitive judgements on risk management (eg, considering what liabilities the company, or its parent, is exposed to once that information is in the public domain). This article considers some of these, and the tensions and challenges that will result for legal practitioners.
Responsible investment is fundamentally about measuring the ethical impact, sustainability and non-financial performance of businesses and incorporating this into investment decision-making. Logically, this process must begin with information on ESG matters, which must in turn be made available. This need for readily available information presents a challenge in a traditional deal context as, by the time specific disclosures are made or secure data rooms are set up, it may be too late to influence the “investment decision” with regard to these issues. Accordingly, a significant amount of the regulation and voluntary frameworks in this area focus on increased reporting and transparency of both public and private companies. In parallel, many investors are subject to (generally, at present, voluntarily assumed) frameworks designed to report on their own approach to assimilating and acting on this information.
The examples of this are manifold. The United Nations Principles for Responsible Investment (the leading proponent of responsible investment on behalf of investors) found in its 2016 study that the vast majority of countries it reviewed (38 of the top 50 world economies) had, or were developing, some kind of government-led disclosure guidelines for corporations covering ESG issues. These can range from specific legislation (eg, the EU’s Non-Financial Reporting Directive), guidelines issued by regulators (eg, pensions regulators) or other quasi-governmental authorities (such as the London Stock Exchange’s comprehensive guide on ESG reporting by listed companies and others). Many of these are voluntary or “comply or explain” in nature, or target only a limited number of listed or very large organisations, but they still play a key role in raising awareness and offering a framework for disclosure. In addition to government-led initiatives, there are also purely voluntary disclosure guidelines and frameworks, such as the Global Reporting Initiative (GRI) Sustainability Reporting Standards, CDP (formerly the Carbon Disclosure Project), the Integrated Reporting Framework and the UN Global Compact.
This has all contributed to a rapid but fragmented approach to the reporting of ESG matters. Attempts to develop a more harmonised approach to reporting on ESG matters – akin to that seen with financial reporting – have yet to come to fruition. Helping clients navigate this landscape remains complex.
That said, the EU is now turning its full attention to this area, and a more harmonised approach (within the EU at least) may begin to emerge. Following a report by its High-Level Expert Group in early 2018, the EU has prepared an action plan aimed at stimulating sustainable financing. Recent proposals include standardising terminology in the area; a requirement for institutional investors to disclose how they integrate ESG factors into their risk processes; and amendments to financial and insurance regulatory frameworks to include ESG considerations in the advice that investment firms and insurance distributors offer to individual clients. These proposals are at the early stages of the legislative process and it will likely take a few years for the proposals to make it through the European Parliament and Council, and to take effect.
More information in the public domain is one thing. Acting on that information and incorporating it into investment decision-making is quite another. There is a self-evident commercial incentive to do so: a business that is sustainable in terms of environment, climate change and social responsibility is more likely to be sustainable from a commercial perspective. However, for institutional investors at least, there may also be a legal imperative to make use of that information. If an institutional investor fails to take into account long-term value drivers – which must surely include ESG issues – it may be failing to discharge its fiduciary duties. Stakeholder litigation and/or regulatory sanctions could follow. For example, in the US a number of Exxon Mobil employees recently brought a claim against their pension fund alleging that it had mismanaged its assets by over-investing in Exxon Mobil itself, despite its exposure and vulnerability to climate change. Exxon Mobil argued, among other things, that climate science was “uncertain” until recently, and so its fiduciaries had no reason to avoid Exxon Mobil stock. The case never got beyond preliminary hearings. However, as climate science and awareness of the impact of climate change continues to grow, so too may the expectations on fiduciaries to respond accordingly, and the willingness of courts to hold them responsible for failing to do so.
Naturally these reporting and transparency regimes also pose a number of risks to the disclosing organisations. Again, many of these risks are commercial and/or reputational in nature. The business may find it harder to attract investment where it is reporting poor performance on ESG metrics. It may also find it harder to win business or retain customers – for example, more organisations are including ESG parameters in their procurement process, as are consumers in their own purchasing decisions.
A business reporting poor ESG performance may come under additional scrutiny from NGOs and in turn regulators, who may suspect related breaches of law. An investee could also be liable to its own shareholders, investors or other stakeholders acting in reliance on that information. The Massey Mining case in the US is an instructive case study here. In April 2010, 29 miners tragically died in an explosion at the Upper Big Branch coal mine in West Virginia, operated by the listed Massey Energy Company. This was caused in part by serious safety failings and Massey was fined $10 million. The incident led to a reduction of over $3 billion in market capitalisation of Massey. Its shareholders brought a claim against Massey, adducing a series of public statements and reports it had made about its strong safety record and proactive management, which they alleged were now shown to have been false and as having artificially inflated the share price. The action was eventually settled for $265 million. The risk is clear. As ESG reporting continues to grow, and investors place ever more weight on that information, the duty of care of companies to ensure they are reporting accurately becomes
Additionally, there is a risk that a parent reporting on, and controlling, ESG matters at a consolidated group level may be argued to have assumed responsibility for compliance by its subsidiaries. In a recent case in the English courts, brought by various members of a Nigerian community against Royal Dutch Shell plc for alleged environmental harm caused by its Nigerian subsidiaries, the claimants relied on Shell’s “sustainability report” and its descriptions of the environmental standards Shell applied to its group around the world. This, the claimants said, demonstrated that a duty of care had been assumed by the Shell parent company to implement those standards. The Court of Appeal considered this (and other evidence) insufficient on the facts, and that an additional level of control was required for a duty to arise. This is not in itself surprising. The courts are wary of creating a chilling effect on group-wide reporting and policies, given these will often be in the interests of improved ESG management. However, organisations need to be careful here (particularly pending further certainty from the courts – this and another similar case are expected to proceed to the Supreme Court), as the margins between oversight, reporting and control can be fine.
It is interesting that, in addition to environmental and social matters, the third limb of ESG is governance. This is significant as it relates to the wider culture, ethics and management of an organisation. This is entirely in line with the approach we have recently seen from legislators, regulators and courts in the UK – where the focus is shifting from a particular act or wrongdoer to the broader culture and approach of the wider organisation. Legislation such as the Bribery Act 2010 and the Criminal Finances Act 2015 are drawing corporate groups together in how they should address corruption and tax evasion respectively (both at home and abroad). Parent companies can in certain circumstances be responsible for the acts of their subsidiaries, agents and other associated persons and are encouraged to institute “adequate procedures” to prevent breaches, and improve the culture of both organisations and their business partners.
Furthermore, when it comes to sentencing, courts are increasingly looking towards wider organisations. The recent UK health and safety and environmental offences sentencing guidelines set the levels of fines based on an organisation’s turnover, and state that the resources of “linked organisations” may be taken into account in determining this. The UK courts have also been clear that their intent when setting fines for serious incidents is to ensure that they are sufficiently high that the wider group/shareholders feel their effect and so are incentivised to drive cultural change from above. The UK Court of Appeal recently noted that this approach could lead to fines in excess of £100 million.
Although the ESG community is keen to promote the “carrot” in the form of opportunities associated with good ESG management, legislators, regulators and the courts have not forgotten the more traditional means of effecting change: namely, the “stick” of regulation, as well as making organisations responsible for their associated entities. We would suggest the lawyer’s role is more important than ever in helping clients navigate this multifaceted risk-and-reward landscape.
The above hopefully demonstrates the array of legal considerations that responsible investment gives rise to. There are challenges here: complying with corporate reporting obligations, tackling new “long-arm” style legislation, discharging fiduciary duties and safeguarding against the potential erosion of the corporate veil. Lawyers must tread a delicate line in helping clients balance legal and reputational risk against the need to meet ever-increasing ESG and responsible investment demands.
While much of this may feel far removed from the more traditional practices of the environmental lawyer, the fundamental skillset is the same: an ability to digest and apply a fast-moving and highly politicised/globalised regulatory framework, and to help clients comply while managing reputational and legal risk. Those possessing these skills and a willingness to embrace this new direction of travel may find their practices more relevant than ever. This will, however, require us to expand our knowledge horizons as well as collaborate better with other specialists (legal or otherwise).