The EU Sustainable Corporate Governance Initiative: Where are We and Where are We Headed?

Wolf-Georg Ringe is Director of the Institute of Law & Economics at the University of Hamburg and Visiting Professor at the University of Oxford Faculty of Law; Alperen A. Gözlügöl is Assistant Professor at the Law & Finance cluster of the Leibniz Institute for Financial Research SAFE.

The European Union, frequently seen as the international pace-setter in ESG regulation, is currently making some decisive changes to its regulatory framework. As readers of this Forum will know, the EU had started a sustainable corporate governance initiative back in 2020. This initiative was backed by an Ernst & Young report, called a “study on directors’ duties and sustainable corporate governance”. The initiative and especially the EY study drew fierce criticism, also from many U.S. scholars, indicating some misleading and erroneous elements (such as Roe et al (2020); Coffee, Jr. (2020)).

The Initiative gained global attention partly because of taking stock with the “corporate purpose” debate. It indicated that an EU level initiative to empower corporate directors to integrate wider interests into corporate decisions was in sight. Specifically, a reform option was to require (or allow) “company directors to take into account all stakeholders’ interests which are relevant for the long-term sustainability of the firm or which belong to those affected by it (employees, environment, other stakeholders affected by the business, etc.), as part of their duty of care to promote the interests of the company and pursue its objectives…”.

Just now, the European Commission (‘Commission’) has followed up with a long-awaited Proposal for a Directive on corporate sustainability due diligence (‘CSDD’). The delay in the adoption of the Proposal including the trouble with the Regulatory Scrutiny Board (a quality control and support body for Commission impact assessments and evaluations at early stages of the legislative process) that unusually issued two negative opinions in itself indicates controversies surrounding the initiative.

It appears that the proposed CSDD has taken a step back in terms of reforming directors’ duties. The relevant provision (art. 25) is less revolutionary than expected and only states that when fulfilling their duty to act in the best interest of the company, directors must take into account the consequences of their decisions for sustainability matters, including, where applicable, human rights, climate change and environment, in the short, medium and long term.

From a broader perspective, the issue relates to the well-known debate on what corporate purpose should be and what directors’ duties should accordingly require: shareholder vs. stakeholder value. On both sides of the Atlantic, the debate has been breathed new life with the Commission’s above-mentioned initiative and the 2019 Business Roundtable Statement in the U.S. In addition, in the U.S., there is a push towards making company directors legally accountable for the promotion of sustainability goals through relying on the Caremark duty for failing to exercise proper risk oversight (see Barker et al (2021)).

The Commission’s intentions are well-received. Given the increasingly visible sustainability challenges of our world, especially climate change, corporations come to the fore as obvious candidates to streamline their operations in line with the sustainability aims. There are in fact many Member States in the E.U. that have long followed a stakeholder approach, which partly results from path dependency (such as Germany). We however think that a stakeholderist orientation of directors’ duties is no panacea for achieving more sustainable companies, especially for reducing their environmental externalities. It is also not without undesirable consequences.

As we elaborated elsewhere, our main objection stems from the general (legal and non-legal) framework in which such a scheme would operate in the E.U. Directors’ duties, which are notoriously vague, are rarely enforced in Europe given the low levels of litigation due to the absence of class actions and the prohibition on contingency fees in most Member States. Furthermore, concentrated ownership is the norm in Europe. How directors of a company would perform is particularly affected by the existence of controlling shareholders who have the power to nominate, appoint and remove them. Combined with little enforcement and liability risk, company directors will generally follow controlling shareholders’ interests and demands which may not be aligned with environmental (or stakeholder) interests, whatever their duty actually requires.

Other potential weaknesses are also well-noted. Take, for example, the difficulty in balancing different interests when directors need to pursue a stakeholderist approach. The Volkswagen diesel scandal is a case in point, demonstrating that worker-oriented governance may not always produce best results for the environment (see Gelter (2016)). Furthermore, wide discretion under the stakeholder value approach for company directors can be used to increase insulation and reduce accountability to institutional investors as shareholders (see Bebchuk & Tallarita (2020)). This may also adversely affect the net-zero transition as investor-led sustainability is increasingly becoming visible.

Turning back to the evaluation of the proposed CSDD in light of the above explanations, it should be first noted that the relevant provision on the general duty of care does not go as far as the options first signaled back in 2020. In fact, as stated in the CSDD Proposal, it only amounts to a “clarification” and does not require changing existing national corporate structures (recital 63). Indeed, whatever the exact contours and content of the duty of care are in a Member State, we discern that there would be no company director that would not reasonably take into account the consequences of his or her decision for human rights or environmental concerns. “Take into account” is quite broad and weak, which does not require certain actions or prioritization of certain interests.

It is ironic that after all the heated discussion and efforts, the Proposal arrives at rather an anticlimactic point and aims to provide only a “clarification”, which can even be deemed as a waste of legislative sources. Ultimately, however, in our opinion, it is to be welcomed that it remains each Member States’ choice to shape directors’ duties (and broader corporate governance) standards as they see fit. Directors’ duties do not operate in a vacuum and will have complementarities with certain legal and non-legal institutional arrangements in the relevant Member State. They should ultimately determine the optimum choice.

It should also be noted that as the name implies, the proposed CSDD brings a corporate sustainability due diligence system and establishes a corporate due diligence duty (arts. 5-11). This duty involves identifying, ending, preventing, mitigating, and accounting for negative human rights and environmental impacts in the company’s own operations, their subsidiaries, and their value chains. Directors also have a duty of setting up and overseeing the implementation of the due diligence processes and integrating due diligence into the corporate strategy. Corporate due diligence duty applies to certain large EU and non-EU (but active in the EU) companies (art. 2). In addition, a certain group of these companies are required, under some conditions, to have a plan to ensure that their business strategy is compatible with limiting global warming to 1.5°C in line with the Paris Agreement (in other words, to have net-zero transition plans and targets) (art. 15), supplementing the forthcoming disclosure requirements under the Corporate Sustainability Reporting Directive. The Commission’s proposal also includes certain enforcement mechanisms (through administrative sanctions and civil liability).

The requirement to adopt net-zero transition plans and targets is certainly a big step. But many companies already adopt and disclose such plans and targets voluntarily. A more important issue that remains to be addressed is to what extent such statements serve greenwashing and constitute a credible commitment.

With regard to the corporate due diligence duty, it is not totally new in the EU. France had pioneered such a mechanism (called the duty of due vigilance) in 2017. Germany had similarly adopted a Supply Chain Due Diligence Act in 2021. The EU initiative aims to provide a harmonized legal framework in the EU, creating legal certainty and level playing field. The French experience has produced mixed results so far, having in fact led to two high-profile (pending) cases against the carbon major TotalEnergies.

A long and contentious legislative process certainly awaits the proposed CSDD. Depending on the final legal product, it remains to be seen whether the due diligence duty will lead to desirable substantive outcomes, or prove too costly, or will be just another tick-the-box exercise. What is certainly commendable is that it drops the usual public/private (company) divide and uses ‘size-related’ indicators to determine the scope of addressee companies, which is crucial as we explain in a forthcoming paper.

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