A Board’s Guide to Oversight of ESG

Katie LaVoy is Counsel at Sidley Austin LLP. This post is based on a Sidley memorandum by Ms. LaVoy and Ben Cross. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); For Whom Corporate Leaders Bargain (discussed on the Forum here) and Stakeholder Capitalism in the Time of COVID (discussed on the Forum here) both by Lucian Bebchuk, Kobi Kastiel, and Roberto Tallarita; and Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy – A Reply to Professor Rock (discussed on the Forum here) by Leo E. Strine, Jr.

The past few years have brought significant attention to environmental, social and governance (ESG) principles, whether related to climate change, sustainability, human capital management or diversity, equity and inclusion. As boards of directors consider their risk management and oversight responsibilities, what weight should they give ESG issues?

Caremark and subsequent cases establish that directors may be held liable under the duty of loyalty for a failure of oversight if (1) directors “failed to implement any reporting or information system or controls” or (2) despite such a system or controls, the directors “consciously failed to monitor or oversee its operations, thus disabling themselves from being informed of risks or problems requiring their attention.” [1] Thus, the board’s fiduciary duties require that it exercise oversight—within its informed, good faith discretion—of the company’s strategy and “mission-critical” risks in pursuit of long-term value, including by implementing and monitoring an effective compliance program and related system of controls. [2]

Are ESG Issues and Opportunities “Mission-Critical”?

Leo Strine, former Chief Justice of the Delaware Supreme Court, recently advocated for consideration of employee, environmental, social and governance factors as interconnected to the board’s duty to monitor ordinary compliance. [3] Certainly, a recitation of board duties and responsibilities typically includes topics such as corporate strategy, financial integrity, risk oversight and oversight of key executives. With the individual topics of E[nvironmental], S[ocial] and G[overnance] covering such a broad range of topics, it is difficult to disagree with the conclusion that every company will need to consider some elements of ESG to be mission-critical. For example, within these broad topic areas lie many board-level responsibilities that fit unequivocally under the ESG umbrella, such as CEO succession and compensation, talent development and compliance with environmental and safety laws and regulations. Ignoring elements of ESG risk or failing to implement information systems and controls that allow board consideration of these types of ESG topics may indeed be the kind of failure that would sustain a Caremark claim.

Based on the flurry of ESG-related pronouncements and proposed rule-making the Securities and Exchange Commission (SEC) has engaged in over the last several years, it would appear that the SEC agrees and considers elements of ESG to rise to the level of mission-critical risk. For example, the SEC’s proposed rule on climate related-disclosures would require that public companies describe the board’s oversight and governance of climate-related risks, including (1) identification of the committee or directors responsible for climate-related risk oversight and whether any director has climate-related risk expertise, the processes by which the board or committees discuss climate-related risks, including how the board is informed of climate-related risks and the frequency of such discussions, (3) whether and how the board or committee considers climate-related risks as part of business strategy, risk management and financial oversight and (4) whether and how the board or committee sets and oversees progress against climate-related targets or goals. [4] If the rules are enacted as proposed, boards will have to evaluate whether their current governance processes over climate-related risk are sufficiently robust or should be enhanced in anticipation of the required disclosures.

In addition, in March 2021, the SEC announced the formation of a Climate and ESG Task Force focused on identifying material omissions or misstatements in issuers’ ESG disclosures, and in April 2022, the SEC filed its first ESG-related enforcement action against Vale S.A., a publicly traded mining company based in Brazil. The charges relate to fraudulent statements made by Vale related to dam safety and stability leading up to the collapse of Vale’s Brumadinho dam, as discussed in the Sidley Update available here. While the Vale complaint appears to be the first SEC action based in part on disclosures made in publicly available ESG or sustainability reports, the complaint follows a fairly typical format of alleging that Vale made false or misleading disclosures about the safety of its products or facilities. Nonetheless, public company boards should expect that the SEC and its Climate and ESG Task Force will scrutinize a company’s ESG disclosures for misrepresentations or omissions after a product or facility has caused environmental or social harm. Moreover, as part of the Climate and ESG Task Force’s mission is to proactively seek out material misstatements and disclosure gaps, companies may be subject to inquiry by the Climate and ESG Task Force before any actual physical harm has occurred. Boards must therefore ensure that processes and controls exist to confirm the accuracy of disclosures, be on guard for material omissions and maintain sufficient documentation to validate representations related to environmental and other ESG-related issues, whether they are published in filed disclosure or publicly available reports to shareholders and stakeholders, such as ESG or sustainability reports.

The protection of the business judgment rule provides boards with flexibility, however, to consider which elements of ESG are relevant to company operations. The important point here is that boards must actually consider and decide which elements of ESG are mission-critical and tailor board processes to ensure that oversight of those particular elements is integrated into board operations, or else be subject to an inference that it deliberately shielded itself from its oversight responsibilities. Boards should take caution, however, not to consider the entirety of “E and S and G” as mission-critical, which would dilute the importance of truly high-priority and essential subject matters.

Are ESG Issues and Opportunities of Strategic Importance?

Setting aside momentarily the question of whether a board has a legal obligation to enable processes to monitor and govern elements of ESG risk, boards may have other reasons to elevate ESG risk. Boards should consider good ESG governance an element of strategic importance—to attract customers, investors and employees or as an opportunity for growth.

A powerful and growing group of investors believes ESG risk is strategically important. Investors incorporate ESG elements into investment decisions and stewardship, viewing ESG as a means of generating long-term value and focusing on disclosure and compliance with reporting standards such as the Sustainability Accounting Standards Board and the Task Force on Climate-Related Financial Disclosures. Larry Fink, Chairman and CEO of BlackRock, explains his attention to ESG disclosure, practices and policies as a critical element of strategy: “Stakeholder capitalism is all about delivering long-term, durable returns for shareholders. And transparency around your company’s planning for a

net-zero world is an important element of that … As stewards of our clients’ capital, we ask businesses to demonstrate how they’re going to deliver on their responsibility to shareholders, including through sound environmental, social, and governance practices and policies.” [5]

An examination of the top 10 institutional investors by assets under management reveals that these investors broadly acknowledge that ESG is important in maximizing long-term shareholder value and expect and encourage annual reporting on ESG matters, including sustainability policies and strategy. While some institutions are more prescriptive in expressing expectations regarding disclosure on ESG-related issues and may have particular metrics in mind, others look just to obtain an understanding of the impact of ESG risks on the public company’s business. Institutional investors also perceive ESG matters as not only potentially value-destructive (such as with risks) but value-enhancing as well (such as with opportunities for growth and differentiation). As a result of increased investor focus, boards of directors should consider good ESG governance, at a minimum, an element of investor relations best practices.

Key constituents other than investors, such as employees, also focus on elements of ESG and expect boards to have ESG competence. In this era of talent competition, potential employees may seek employers with superior talent management programs and social impact—both elements of a solid “S” strategy—as well as commitment to sustainability practices and other climate-related goals. Current employees are also demanding more from their employers in the form of better working conditions and more flexible working arrangements which, when combined with a tight labor market, have led to high-profile unionization efforts at Amazon and Starbucks. The practical implications of this organizing success further strengthen the need for board oversight of a holistic human capital management strategy.

Customers, another important stakeholder group, may focus on brands’ social impacts in purchasing decisions and further consider a company’s adoption of sustainability practices as a differentiating element. A company’s efforts to increase both workforce and supplier diversity may be a key decision-making point for both potential employees and customers.

Appropriate and accurate disclosure of these programs and initiatives (and the avoidance of misstatements, critical omissions and “greenwashing”) should be an area of active oversight by boards.

Integrating Oversight of ESG Risk Into Board Processes

Effective board oversight necessitates understanding how ESG factors into business decisions, including strategic decisions, risk assessments and enterprise risk management. The board should determine how to incorporate ESG into long-term strategy and risk management and who in management has responsibility for ESG decision-making. The business judgment rule affords boards significant discretion in tailoring oversight of ESG matters to their companies’ particular businesses, and boards may delegate oversight authority to one or more committees.

With these principles in mind, boards of directors should tackle oversight of ESG risks as they would any other risk. First, boards and management should identify which elements of ESG are relevant and could rise to a level of “mission-critical” risk to the company, whether now or in the foreseeable future. This exercise may be accomplished through the company’s regular enterprise risk management processes and should include development of a process for identifying and reporting on those risks to the board.

Second, given the breadth of topics covered by ESG, boards should divide the various elements of ESG risk among its various committees or create a standalone ESG committee. [6] Companies often delegate ESG oversight to the nominating and governance committee, although oversight involving disclosure metrics is often delegated to the audit committee and human capital matters may be delegated to the compensation committee. Even when delegated, however, at the board level, directors should regularly discuss ESG as a component of the company’s long-term strategy and risk management.

For example, consider a board that has three committees: Audit, Compensation and Nominating and Governance. After considering the various risks that are relevant and important to the company, the board may amend the charters of the various committees as follows:

  • Audit Committee: include responsibility for review of ESG impacts on overall risk management, responsibility for review of the quality of the company’s internal controls to ensure disclosures are accurate and oversight of assurance or attestation, if any
  • Compensation Committee: include oversight of human capital management, talent development and diversity, equity and inclusion initiatives and incorporation of ESG performance metrics into short- and long-term executive compensation incentives
  • Nominating and Governance Committee: include general oversight of “E” and “S” in addition to “G” and consideration of ESG or sustainability experience in director qualifications and board composition

A board might further consider whether to amend its corporate governance guidelines to require best practices benchmarking of ESG-focused practices, risk oversight and disclosure as compared against peer practices, institutional investor guidelines and rating agency criteria.

Finally, the board should ensure that division of responsibility for ESG matters and execution of those duties is documented appropriately through regular board agenda items and explicitly address ESG responsibilities in governance guidelines or committee charters. As a final step in discharging those duties, the board should ensure that minutes of meetings reflect both the report of information on ESG topics and directors’ consideration of current and future issues and risks. Minutes should further reflect when the board discusses or receives reports on the remediation of any previously identified ESG issues to show proper oversight of management.

If the “carrot” of good governance and responsiveness to stakeholders is not enough to galvanize boards to monitor ESG risk, boards should consider the proverbial “stick.” Boards that do not meet investor expectations regarding ESG disclosures, policies and practices may find themselves the subjects of “vote against” campaigns and may face increasing numbers of shareholder proposals on ESG issues. [7] Perhaps more critically, the U.S. Sentencing Guidelines reward companies with effective ethics and compliance programs with reduced consequences and explicitly require that the “governing members” of the organization (e.g., the board of directors) “exercise reasonable oversight with respect to the implementation and effectiveness” of compliance and ethics programs. [8] Integration of ESG risks and potential issues into the board’s oversight of risk and compliance programming thus benefits the company from the perspective of good governance as well as a potential reduction in liability should one of those risks become reality.

Endnotes

1In re Caremark Int’l Derivative Litig., 698 A.2d 959 (Del. Ch. 1996) and Stone v. Ritter, 911 A.3d 362 (Del. 2006).(go back)

2Marchand v. Barnhill, 212 A.3d 805 (Del. 2019.(go back)

3Leo E. Strine, Jr. et al., Caremark and ESG, Perfect Together: A Practical Approach to Implementing an Integrated, Efficient, and Effective Caremark and EESG Strategy, 106 Iowa L. Rev. 1885 (2021).(go back)

4The SEC’s proposed rule on The Enhancement and Standardization of Climate-Related Disclosures for Investors is available here and summarized in the Sidley Update available here.(go back)

5Larry Fink’s 2022 Letter to CEOs: The Power of Capitalism, available here.(go back)

6Indeed, some institutional investors have specifically requested that boards create standalone committees designed to address ESG or sustainability issues. See, e.g., JPMorgan Asset Management, Corporate Governance Principles and Proxy Voting Guidelines (p. 16); UBS Asset Management, Proxy Voting Summary Policy & Procedures (p. 10).(go back)

7See, e.g., BlackRock Investment Stewardship, Proxy voting guidelines for S. securities (pp. 17-18); State Street Global Advisors, Guidance on Climate-Related Disclosures (pg. 4).(go back)

8United States Sentencing Guidelines, 8B2.1.(go back)

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