Advice for navigating the complexities of environmental, social and governance (ESG)

Author: Natalie Douglass, Esq.


It is clear that environmental, social and governance (ESG) is the hottest topic in Directors & Officers (D&O) right now. It is also proving to be a complicated area for companies to navigate. Not only is the subject expansive, covering everything from carbon emissions and board diversity to employee safety and corporate citizenship, but there are also multiple sources of regulation, influence and interests to consider. This complexity is best illustrated with examples. First, we'll explore board diversity, an important social topic under the S in ESG. Then, we will discuss recent developments in environmental issues, the E in ESG.

Board diversity legislation and litigation

A few years ago, the plaintiffs' bar began filing either derivative demand letters, lawsuits, or books and records demands against publicly traded organizations that allegedly did not have a diverse board of directors. The industry began to see these claims with some frequency, although to date "not a single claim" has survived the motion to dismiss.1

During this time, California introduced new legislation on board diversity. Senate Bill 826 required female directors for publicly traded organizations headquartered in California.2 Later, Assembly Bill 979 was passed addressing board representation of underrepresented minorities.3 Both laws set forth criteria and deadlines for compliance, as well as penalties for noncompliance.

Interestingly, California claimed success, stating that female directors accounted for 30% of board seats for publicly traded California companies.4 That being said, both laws were challenged as unconstitutional and, in separate rulings, California courts struck down the laws, finding both violated the Equal Protection Clause. Specifically, the state had not met their burden to show that the laws were justified by a compelling interest, nor did they show that they were narrowly tailored.5 It is speculated that the state will appeal both of these decisions.

Other states have also passed board diversity statutes, namely Illinois, Washington and New York, among others.6 As the Mintz law firm points out, the legislation tends to either follow the California model or one that pushes transparency over compliance, the latter of which might withstand legal challenges.7

Navigating ESG is complicated; there are numerous voices, expansive topics and changing boundaries to consider.

While the future of board diversity legislation remains in question, it is important to recognize that there are many other voices on board diversity. Last year, the Security and Exchange Commission (SEC) adopted NASDAQ's proposed board diversity rules, which requires NASDAQ-listed companies to have two diverse board members (which shall include at least one woman and at least one underrepresented minority or LGBTQ+ individual) or explain their noncompliance.8 Although these rules are currently being challenged in court, the reporting requirements go into effect this August.

A number of investment firms have also made board diversity commitments. Goldman Sachs, for example, pledged that they will not accept initial public offering (IPO) clients that do not have a diverse board member and recently touted that they have placed at least 50 diverse directors on boards.9 In addition, the largest asset managers — such as BlackRock, Vanguard and State Street — have proxy voting guidelines with respect to ESG disclosures.10 Glass Lewis, a proxy advisory firm, released their proxy guidelines for 2022:

"Beginning in 2022, we will generally recommend voting against the chair of the nominating committee of a board with fewer than two gender diverse directors, or the entire nominating committee of a board with no gender diverse directors, at companies within the Russell 3000 index. For companies outside of the Russell 3000 index, and all boards with six or fewer total directors, our existing policy requiring a minimum of one gender diverse director will remain in place... Additionally, when making these voting recommendations, we will carefully review a company's disclosure of its diversity considerations and may refrain from recommending that shareholders vote against directors of companies when boards have provided a sufficient rationale or plan to address the lack of diversity on the board."11

While the board diversity landscape seems to change quickly, it is clear that regardless of the future of statutory regulation, competitive pressures and commercial influence may continue to steer the discussions about board diversity.

Enforcing climate change and carbon emissions rules

The E in ESG is just as complicated.

In March of last year, the SEC announced the creation of their ESG Task Force and recently launched its first enforcement action.12 The action was brought against an investment advisor that had touted their ESG vetting in conjunction with their fund research, but the SEC found this to be a misleading statement when it was discovered that sub-advisers could select alternative investments that weren't subject to ESG review.13 The matter settled for a $1.5 million penalty.

There are indications this could be a growing trend — and, as D&O Diary points out, it remains unclear whether the plaintiffs' bar will leverage the efforts of the ESG Task Force for purposes of shareholder litigation.14 Shareholder litigation arising from environmental concerns like climate change and carbon emissions is a current reality.15

Additionally, the SEC proposed new rules relating to climate risk requiring registrants to disclose "climate-related risks that are reasonably likely to have a material impact on their business, results of operations, or financial condition, and certain climate-related financial statement metrics in a note to their audited financial statements...[including] disclosure of a registrant's greenhouse gas emissions..."16

While these rules are still in the comment period and not yet in effect, some speculate that they will provide a new roadmap for the plaintiffs bar to bolster greenwashing litigation, such as claims alleging overpromising and under-delivering on sustainability pledges.17 In a recent Harris Poll survey of nearly 1,500 C-Suite, 35% agreed that their "company treats sustainability like a PR stunt."18

Beyond potential SEC rules, investors have also influenced corporate action on climate change. According to Reuters, shareholders initiated 529 ESG resolutions this year, up 22% from 2021.19 Shareholder activism on climate change and greenhouse gases has even resulted in contested board elections resulting in activist shareholders gaining board seats, especially in the oil and gas industry.

It is for these reasons that the D&O industry is especially concerned with an anticipated increase in climate and sustainability litigation.

It's clear that navigating ESG is complicated; there are numerous voices, expansive topics and changing boundaries to consider. Some key takeaways are:

  • Consult with outside counsel. With ever-changing legislations, rules and regulations on countless ESG topics, it is very important to understand what your specific exposure is in order to comply. Not to mention that the aforementioned topics have really only skimmed the surface of U.S.-based exposure, and there are many other countries with ESG regulations in place. Germany, for example, recently raided a large bank on suspicions of greenwashing.20 Having a clear understanding of what regulatory standards are required is key.
  • Don't forget the G in ESG. Governance is the oft-forgotten third pillar of ESG, but critical to all things ESG. How a board of directors informs themselves, makes decisions and monitors progress all play a role not only in the defensibility of claims, but also in shareholders' and the general public's perception of the organization and its reputation.
  • Make ESG a priority and take action. So much of the ESG litigation to date stems from alleged overpromising on ESG efforts or, as the aforementioned Harris Poll suggested, a "PR stunt." Being able to demonstrate action that backs public disclosures is critical.

Lastly, D&O underwriters are more closely reviewing insureds' ESG efforts, and those that are considered best-in-class risks have robust ESG programs in place with measurable goals, and systems to track and monitor progress.

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