Litigation and Enforcement Risks for Corporates arising from Enhanced ESG Obligations and Stakeholder Pressure

Key takeaways

• New and prospective environmental, social and governance (ESG) reporting and supply chain due diligence requirements in the European Union (EU), together with enhanced global regulatory scrutiny of ESG issues, mean that corporates who operate in the EU or have supply chains within the EU will need to ensure that their ESG performance can withstand public scrutiny in the evolving legal, regulatory and stakeholder environment.

• Boards and management should take action now to get ahead and ensure compliance and best practices at an early stage, by implementing ESG reporting and human rights due diligence into the company’s holistic compliance framework in accordance with global ESG benchmarks and principles.

• This will include corporates conducting comprehensive and regular reviews and audits of their supply chains for potential adverse human rights and environmental impacts, and assessing their capability to provide the ESG data disclosure indicators required by existing and prospective ESG reporting requirements.

• These new and prospective ESG legal obligations, combined with activist stakeholders increasingly holding companies with EU and global operations to account and intensifying public scrutiny of ESG issues, could lead to increased litigation and enforcement risks for businesses. This OnPoint is the first in Dechert’s “ESG Compliance Series” and provides an overview of some of the ESG litigation and enforcement risks faced by corporates.

• Dechert’s leading global investigations, compliance and litigation lawyers help companies minimize their exposure to ESG-related litigation and enforcement risks by conducting ESG and human rights supply chain audits, enhancing compliance programs to manage ESG risks and advising on ESG reporting requirements and standards.
  

Introduction 

The COVID-19 pandemic, worsening climate risks and the profound social inequalities existing in today’s society have led to a renewed focus on demands for a fairer society and climate change, reinforced by the recent publication of the United Nations (UN) Intergovernmental Panel on Climate Change (IPCC) report on climate change and the upcoming UN Climate Change Conference (COP 26) in November 2021.¹ These concerns have contributed to the growing momentum of the ESG movement. Corporates are now expected to do their part by accurately reporting the impact their operations have on society and the environment, and to conduct human rights due diligence on their supply chains, so that stakeholders can make informed decisions about the businesses they choose to invest in and support.  

International policymakers and regulators are also focused on sustainability risks and are pushing for more consistent ESG reporting and supply chain due diligence. A suite of new and pending ESG laws in the EU and enhanced global regulatory focus on ESG reporting mean that businesses who have exposure to EU and global markets will need to take steps to identify their ESG risks and opportunities, and review and assess their ESG disclosure obligations and supply chain due diligence risks from a human rights perspective. 

In addition to legal and regulatory obligations, corporates are facing increased pressure and accountability from stakeholders for disclosure of ESG issues. ESG activist shareholders are increasingly calling on companies to disclose more information on their ESG risks and opportunities, and are holding companies to account by seeking election to companies’ boards, as seen recently in the case of ExxonMobil.  

There has also been a rise in corporate ESG performance benchmarks aimed at creating more consistency in ESG disclosures (such as the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD)) and holding companies to account for achieving ESG goals, such as the UN World Benchmark Alliance, who are developing a series of publicly available benchmarks assessing 2,000 of the world’s most influential companies, ranking and measuring them on their contributions to the UN Sustainable Development Goals (SDGs).²    

These new and prospective ESG legal obligations, combined with activist stakeholders increasingly holding companies to account and intensifying public scrutiny of ESG issues, could lead to increased litigation and enforcement risks for businesses. This OnPoint is the first in Dechert’s “ESG Compliance Series” and provides an overview of some of the ESG litigation and enforcement risks faced by corporates.  

Our series will examine in greater detail the ESG compliance factors corporates need to manage to mitigate their exposure to ESG litigation and enforcement risks, with a particular focus on: (i) ESG reporting requirements, (ii) human rights supply chain due diligence obligations, (iii) ESG compliance risks in the context of M&A activity and (iv) the impact of ESG legislation on US and non-EU/UK corporates. 

ESG reporting requirements for asset managers and corporates 

Socially responsible and environmentally conscious investors are increasingly using ESG criteria to screen potential investments in funds and corporates. Corporates operating in the EU and elsewhere face legal and stakeholder pressure to accurately disclose the ESG impact of their business. Stakeholders and activist non-governmental organisations are also willing to bring litigation to hold corporates to account for ESG failings, and regulators will take action against issuers that make misleading ESG statements to the market.   

The EU, through new and proposed legislation, is currently leading the way on ESG reporting standards and harmonisation. However, these EU laws will have a knock-on effect on corporates around the world as foreign regulators protect ESG investors from misleading statements and competitors standardise their global operations to meet the required higher standards. 

Legislation either having recently entered into effect or on the horizon, with significant implications for both corporates and asset managers within the EU (and those outside the EU who operate or provide services in the EU), includes the following: 

• EU legislation imposed on financial advisers and other financial market participants to accurately disclose how ESG factors are handled at both entity and financial product level, in accordance with prescriptive ESG reporting criteria.³
• Prospective EU legislation requiring firms to provide the types of specified information financial markets participants require to meet their own reporting obligations.⁴  
• The U.S. Securities and Exchange Commission (SEC) is currently developing a mandatory ESG disclosure framework for public company filings, and has created a “Climate and ESG Task Force” as part of its Division of Enforcement.⁵ The Climate and ESG Task Force will develop initiatives to proactively identify ESG-related misconduct (together with evaluating and pursuing tips, referrals and whistleblower complaints on ESG-related issues) and analyse disclosure and compliance issues relating to investment advisers’ and funds’ ESG strategies. However, its initial focus will be on identifying any material gaps or misstatements in issuers’ disclosure of climate risks under existing rules. As a sign of future regulatory scrutiny and potential enforcement action over misleading ESG disclosures, press reports state that the SEC and the U.S. Justice Department have opened an investigation into  the asset management arm of a global bank, in relation to allegations that the asset manager over-stated its use of sustainable investing criteria to manage its assets.    
• In June 2021, the U.S. House of Representatives voted to pass the ESG Disclosure Simplification Act of 2021 (H. R. 1187) (ESG Bill). If ultimately passed by the U.S. Senate and signed into law, the ESG Bill would direct the SEC to define “ESG metrics” within the federal securities laws to guide SEC registrants in relation to required corporate ESG disclosures. The ESG Bill would also establish a “Sustainable Finance Advisory Committee” to advise the SEC on the ESG metrics issuers should be required to disclose in their public filings, and would require public companies to disclose ESG metrics in their audited financial statements. The prospect that the ESG Bill becomes law remains unclear at this time, as positions on ESG legislation in Congress are divided on a partisan basis and Senate Republicans have staunchly opposed ESG reporting requirements.
• The UK Financial Conduct Authority (FCA) now requires companies with a UK premium listing to disclose, on a “comply or explain” basis, in line with the recommendations of the TCFD. The FCA is also consulting on proposals to extend the application of its climate-related disclosure requirements to issuers of standard listed equity shares, and to introduce disclosure requirements aligned with the TCFD recommendations for asset managers, life insurers and FCA-regulated pension providers, with both consultation periods due to end in September 2021. The FCA expects to finalise its policy position by the end of 2021.

Businesses should act now to ensure they are ready for the new and impending legislation. While many of these new requirements will apply to EU entities and those outside the EU who operate or provide services in the EU, the world has shifted towards enhanced ESG reporting standards, with investor / capital provider confidence expected to diminish in non-compliant companies, potentially creating barriers of entry for non-compliant companies who wish to trade in and secure capital from western markets.  

Human rights supply chain due diligence obligations

ESG reporting and due diligence relating to corporates’ supply chains are also coming into focus in the EU, with proposed laws that could lead to certain EU companies, as well as non-EU companies that provide goods and services in the EU, facing penalties if they fail to take “all due care” to detect and prevent adverse human rights and ESG impacts across their entire value chain. In March 2021, the EU Parliament adopted an outline proposal for a draft directive on Corporate Due Diligence and Corporate Accountability (Draft CDD Directive).⁶ The European Commission is drafting a formal legislative proposal relating to the Draft CDD Directive, which is expected to be presented to the European Parliament in the autumn of 2021, with the Draft CDD Directive not expected to come into force until late 2022 / early 2023.

The UK government has also demonstrated its growing commitment to increasing transparency and ensuring responsible practices in supply chains, by committing in September 2020 to strengthening the reporting requirements in the Modern Slavery Act 2015 via the introduction of mandatory specific reporting criteria for companies’ annual slavery and human trafficking (SHT) statements and requiring companies to file their SHT statement with the government’s “Modern Slavery Statement Registry” in the future (this is currently done on a voluntary basis).⁷ Additionally, the Modern Slavery (Amendments) Bill introduced to the House of Lords in June 2021 proposes two new offences for: (i) persons responsible for SHT statements, where information in the SHT is false or incomplete in a material particular, and the person either knows it is or is reckless as to whether it is; and (ii) for companies to continue to source from suppliers or sub-suppliers which fail to demonstrate minimum transparency standards following receipt of a formal warning from the Independent Anti-slavery Commissioner. 

ESG compliance risks in M&A transactions

Disclosures and data related to ESG performance are increasingly being factored into company valuations and risk assessments as part of M&A transactions, and influencing how corporates select potential business partners and acquisition targets. This includes assessing potential business opportunities arising from partnering with companies with an established ESG profile and undertaking transactional due diligence on potential ESG risks.   

ESG transactional due diligence is likely to consider key ESG factors, such as a target’s environmental practices, policies related to climate change and greenhouse gas reductions, absence of abusive labor practices, human rights record and policies aimed at preventing financial crime. The risk assessment process is also likely to consider the target’s ability to meet ESG goals and strategies set by the buyer’s management and any potential impact on the cost of and access to capital due to weak ESG performance.  In evaluating or approving a transaction, boards will need to ensure that any material risks identified are appropriately mitigated via contractual protections (for example, via ESG-specific representations, warranties and indemnity arrangements) and are subject to ongoing monitoring. 

The buyer’s shareholders and investors will expect ESG risks to be effectively analysed and dealt with as part of M&A decisions, and to be reflected in any post-integration plan. The acquirer’s board / management should be prepared to engage with stakeholders on such issues.  

The impact of ESG legal and regulatory obligations on non-EU / UK corporates

While many of the new and prospective ESG reporting and supply chain due diligence requirements emanate from the EU, non-EU corporates will also be caught by many of the obligations if they provide goods and services in the EU, have transferable securities listed on an EU-regulated market or have EU subsidiaries. Additionally, EU corporates will require detailed ESG data from non-EU supply chain corporates in order to comply with their obligations, and failure to provide this could lead to termination of contracts. 

As mentioned above, failure to conform to similar or equivalent ESG standards may subject non-EU corporates to the risk of losing access to EU capital markets and EU-based lenders. Similarly, increased ESG standards in the EU are likely to have a ripple effect on other countries who may adopt similar legislation (as demonstrated by the UK and U.S. focus on ESG issues), coupled with competitor and stakeholder pressure to conform to strong ESG principles and standards, meaning that companies who demonstrate strong ESG disclosure and due diligence practices are likely to maintain a competitive edge and retain investor confidence.

Enforcement and litigation risks 

In addition to the enhanced legal and regulatory obligations set forth above, activists are targeting management and boards of certain companies that fail to take a proactive stance on ESG issues, and social and mainstream media are quick to expose companies’ failings in ESG areas, often causing reputational and investment damage.

These obligations, together with growth in stakeholder accountability and public scrutiny fed by a desire for change, will result in an increase in enforcement and litigation risks for corporates. These risks include:

• Misleading and inaccurate ESG disclosures or “greenwashing” by issuers may result in liability in relation to investors who have suffered loss as a result of any untrue or misleading statements, or omissions. For example, in 2018 a pension fund member filed a claim in Australia’s Federal Court alleging that the pension fund had failed to provide adequate information related to climate change business risks and actions taken in response to such risks. The parties ultimately reached a settlement on the matter at the end of 2020, which included the pension fund’s agreement to engage with its investee companies and industry associations to promote the climate goals of the 2015 Paris Agreement on climate change.⁸ Companies may also face regulatory action for failures in this area.  
• The potential for sanctions for breaches of prospective supply chain due diligence requirements under the Draft CDD Directive, such as debarment from public procurement, loss of export credit and fines. Companies also face significant reputational and financial damage from governance and oversight failures of supply chain risks where there are allegations over poor labor practices, human rights abuses and slavery.  
• Claims by asset managers for indemnity and contributions to meet regulatory penalties or damages arising from misleading ESG disclosures provided by companies.
• Employees feel more emboldened to call out their employers for non-compliance with their published ESG standards. 
• Workforce claims for exploitation, health and safety, and environmental damage.
• Climate-related legal action brought by environmental groups continues to rise, with The Hague District Court recently ordering Royal Dutch Shell to reduce its carbon emissions by 45% (compared to 2019 levels) by 2030. In July 2021, Royal Dutch Shell confirmed its intention to appeal the court ruling.⁹ During the same week, investors in energy company Chevron, voted to cut emissions generated by the use of the company’s products. These developments are likely to lead to further transformations with the energy sector (including in relation to transport and mining), with companies increasingly likely to face similar lawsuits from environmental groups, together with pressure from investors to reduce their contributions to climate change. 
• The English courts appear willing to hold UK-domiciled parent companies liable to claimants outside the UK for the acts / omissions of their foreign subsidiaries where the harm caused is as a result of deficiencies in group-wide policies and procedures (in this case the English courts were being asked to consider deficiencies in Shell’s environmental policies). For more information on the Supreme Court’s recent judgment in Okpabi v Shell¹⁰, see here for our Dechert OnPoint on the case. 
  

As part of Dechert’s upcoming “ESG Compliance Series”, we will examine in further detail some of the specific ESG compliance factors corporates need to manage to mitigate their exposure to ESG litigation and enforcement risks.

Footnotes

1) IPCC’s Sixth Assessment Report (AR6) on the physical science basis of climate change (August 2021): https://www.ipcc.ch/report/ar6/wg1/#FullReport 

2) The 17 SDGs are: (1) no poverty, (2) zero hunger, (3) good health and well-being, (4) quality education, (5) gender equality, (6) clean water and sanitation, (7) affordable and clean energy, (8) decent work and economic growth, (9) industry, innovation and infrastructure, (10) reduced inequalities, (11) sustainable cities and communities, (12) responsible consumption and production, (13) climate action, (14) life below water, (15) life on land, (16) peace, justice and strong institutions and (17) partnerships for the goals.  All UN Member States adopted the SDGs in 2015 as part of the UN’s 2030 Agenda for Sustainable Development, which set out a 15 year plan to achieve the SDGs. 

3) Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial services sector (SFDR)

4) In April 2021, the European Commission adopted a proposal for a Corporate Sustainability Reporting Directive (CSRD), which would extend sustainability reporting to additional companies and amend existing reporting requirements under the Non-Financial Reporting Directive (NFRD) (Directive 2014/95/EU)

5) https://www.sec.gov/news/press-release/2021-42 

6) https://www.europarl.europa.eu/doceo/document/TA-9-2021-0073_EN.pdf 

7) This commitment forms part of the UK government’s response to its 2019 consultation on ‘Transparency in supply chains’: 
https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/919937/Government_response_to_transparency_in_supply_chains_consultation_21_09_20.pdf, https://www.gov.uk/government/news/new-tough-measures-to-tackle-modern-slavery-in-supply-chains; and https://www.gov.uk/guidance/publish-an-annual-modern-slavery-statement 

8) McVeigh v Retail Employees Superannuation Trust (REST) [2019] FCA 14. REST’s press statement, “Rest reaches settlement with Mark McVeigh” (2 November 2020): https://rest.com.au/why-rest/about-rest/news/rest-reaches-settlement-with-mark-mcveigh 

9) https://www.shell.com/media/news-and-media-releases/2021/shell-confirms-decision-to-appeal-court-ruling-in-netherlands-climate-case.html

10) Okpabi and others v Royal Dutch Shell plc and another [2021] UKSC 3.