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  • Klaus Ilmonen

ESG and Corporate Governance – What to Expect?

EU Initiatives for Corporate Regulation

Companies have increasingly been implementing ESG-related factors into their business operations and governance. Sustainability has changed from being a compliance or communications issue to serving as a competitive differentiator and a point of strategy. Companies in the Nordics have been better than many in leading the way in this regard. Sustainability has also emerged as a key policy for corporate law. The EU, in particular, has introduced a number of regulatory initiatives related to sustainable corporate governance, for example.

The European Commission has recently published its proposal on a Directive on Corporate Sustainability Due Diligence[1]. The Commission wants to introduce new due diligence requirements for corporations to ensure that relevant human rights and environmental standards are complied with through the value chain beyond the immediate domain of the corporation. Large corporations[2] would be obligated to draw up (i) due diligence policies and (ii) prevention action plans to ensure that their established business partners apply appropriate standards in this respect. Due diligence policies would include a code of conduct for employees and subsidiaries as well as measures for implementing and verifying due diligence. Measures to be taken would include contractual assurances from business partners as well as investing in compliance processes and in supporting business partners in their compliance endeavours. Corporations subject to the regulation would, for example, need to contractually require direct and indirect suppliers to comply with applicable social and environmental standards in their production or, ultimately, place the supply-relationships on hold. The requirements would place material new compliance burdens on larger corporations – but as the compliance requirements would apply through the value chain, many smaller companies would be affected as well.

The initiative has been controversial[3] and has been criticized for delegating duties to corporations that they may not be equipped to manage. Corporations may well lack effective means for monitoring compliance in complex and globalized supply chains. Moreover, the proposals are lacking in detail and appear to leave the corporate sector to its own devices to manage a highly challenging compliance framework. In this respect, the proposal can easily be argued not to provide a sufficiently robust framework for corporations to be able to apply the new rules. In fact, even internal bodies responsible for reviewing the quality of regulation in the EU have been critical of the proposed regulation.

On the other hand, it is clear that corporations have a tremendous impact on society today; corporate action has a significant impact with respect to environmental sustainability and the application of human rights and there is significant political pressure on the Commission to take meaningful regulatory action as regards promoting sustainable business and finance in the EU and beyond. In this respect, corporations operating globally in an international business environment provide an effective avenue for pursuing policy beyond the immediate jurisdiction of the legislator. The proposal is subject to further comments and debate and may yet be modified before it is adopted. However, considering the political stakes at play, the Commission is generally expected to continue to pursue the initiative and some level of due diligence requirements can be expected for companies based in the EU as regards social and environmental standards applied through the supply chain.

A revised proposal for a Directive on sustainability reporting requirements[4] is also expected during 2022 with the aim of expanding and revising current requirements on non-financial reporting. The requirements are expected to be applied not only to large listed or regulated companies, as before, but also to larger private corporations (i.e. companies that fulfil two of the following criteria – their annual turnover is no less than 40 million euro, their balance sheet is at least 20 million euro and they employ at least 250 persons on average). The reporting requirements are expected to be more detailed and based on standards to be set by the EU Commission; reporting will need to be monitored by the corporate audit committee, included in the company’s management reports and verified through external assurance. Detailed reporting standards are expected to be issued in the fall of 2022 and the new reporting standards are expected to be applied from the financial year 2023 or later.

Further related initiatives at the EU level include the EU Taxonomy Regulation (EU/2020/852)[5] that requires companies subject to non-financial reporting obligations to disclose their activities that qualify as environmentally sustainable. Reporting obligations apply for qualifying non-financial entities starting for the year 2022. The EU has issued detailed criteria for how such activities are assessed. In a controversial turn, the Commission has proposed including nuclear energy and natural gas as transitional activities subject to the taxonomy – emphasizing the challenges related to sustainability in energy production.

Expected Developments in Corporate Regulation

Similar initiatives are being considered in a number of countries in Europe and around the world. In Finland, an investigation is currently pending on the premises for introducing a national act on sustainable corporate governance.[6] The investigation may serve as a means to facilitate the implementation of the directive on sustainable corporate governance even if the act would not ultimately be passed as such. Overall, there is a clear demand for increased corporate action in relation to the sustainability ion the economy and for increased accountability for the effects of corporate action. There is a continued demand for increased regulation of business enterprise with respect to controlling perceived corporate externalities. Regardless of how the current EU initiatives progress, these trends already have clear new legal implications with respect to corporate governance, including increasing reporting requirements, risk of litigation, more detailed corporate regulation and the emergence of new corporate interest groups.

Increased Reporting Requirements

Reporting requirements for corporations have already increased significantly. So far, most new reporting requirements apply to listed or large corporations but reporting requirements will likely be increasingly expanded to apply to private companies as well.

Disclosure obligations may also increasingly apply to shareholders and/or their representatives. Certain institutional investors already have to disclose how their engagement in governance matters relates to their investment strategy (pursuant to SHRD II)[7]. Alternative investment funds are also obligated to disclose their plans for developing private companies where they have acquired control (AIFMD)[8].

Increased reporting will increase transparency on the effects of business enterprise; and as a result of increased reporting, corporate accountability will increase overall. To some extent corporate value statements have been soft rhetoric backed up with less substantive measures. However, investors are demanding more accountability – and there will be more requirements on measurable metrics that are reported and publicly disclosed. Such matters may include how incentive schemes take business principles or environmental goals into consideration, levels of investment in developing environmentally sustainable business or metrics for decreasing the carbon footprint of the corporation.

This will allow for more monitoring of corporations by different stakeholders, who may also, of course, use these disclosures to take action to influence corporate decision making or to seek remedies for any externalities caused by the corporation. New disclosure requirements will also increase compliance costs and may bring potential liabilities if disclosures are deemed insufficient or inaccurate.

Risk of Increased Corporate Litigation

A significant ruling[9] was passed in the Netherlands in May 2021 with respect to climate litigation. A Dutch court ruled based on local tort law that Shell had not made sufficient efforts to reduce carbon-dioxide emissions by the Shell-group globally to mitigate its impact on climate change. The court ordered Shell to reduce emissions by 45 percent from 2019 levels by 2030.

It is not unlikely that more such claims will be introduced in European courts – including in the Nordics. The tobacco-litigation in 1990’s may serve as a precedent for how the courts may be used to introduce policy changes. Court proceedings can also have significant reputational effects on the business premises of corporations. In general, it will be important for corporations to demonstrate that they are independently taking measures to pursue sustainable business models as regards environmental emissions.

Piercing the Corporate Veil in Corporate Groups

It is worth noting that, the Dutch ruling, Shell was deemed responsible for the actions of its subsidiaries on a global basis. In another ruling by a Dutch court[10] in January 2021, the parent company of the Shell-Group was found liable for environmental pollutions caused by its subsidiary in Nigeria. A ruling in the UK[11] with the same facts confirmed the liability of the parent entity for the actions of its subsidiaries.

In corporate law, it is not usual for parent entities to be deemed liable for the obligations of their subsidiaries or affiliates, except in cases of clear abuse of the corporate form. There are likely to be increasing efforts to make corporations liable for actions that are taken in their interest. In competition law, fines for anti-trust breaches are already determined at the group-level. It cannot be ruled out that, in the future, intra-group liability could be expanded through legal precedents or even through changes in regulation in environmental cases, for example. For groups, it may not be viable in the future to isolate potential liabilities to subsidiaries where the subsidiary’s operations benefit the whole group. Legal scholars have argued[12] that, as regards tort and other non-contractual liability, there may well be sufficient basis to pierce the corporate veil in the context of corporate groups.

Role of Corporate Stakeholders in Governance

New stakeholders have emerged in corporate governance. In addition to shareholders and employees, community representatives and special-interest groups are making increasingly relevant claims on the corporation. In addition to publicity campaigns, interest groups can use corporate governance as an avenue to pursue policy changes. Environmental groups have already used their rights as shareholders to make proposals at shareholders’ meetings. The World Wildlife Fund, acting in its capacity as a shareholder, introduced a proposal to amend the articles of association of Fortum Corporation in 2020[13]. At the same time, traditional key shareholder groups, such as pension institutions and institutional investors, are closely following the ESG performance of companies they invest in. Interest groups may look to work together with these institutions to reinforce their demands.

New stakeholders expect to be able to engage with corporations to call for increased accountability – if not otherwise than by acquiring shares and using their shareholder rights. If these stakeholders have strong and valid concerns to share at the general meeting, and if they work together with other concerned shareholder groups, their message is increasingly relevant. Dialogue and debate at general meetings of shareholders may well increase further in the future. However, it may be that other forums emerge for engagement with broader stakeholder groups. Corporations may increasingly look to establish avenues for communicating with interest groups and other stakeholders so that they can effectively and proactively address relevant concerns.

Increased Corporate Regulation

A less positive development is the likely further increase of corporate regulation. Political interest in corporate regulation can be expected to continue. As government policy is difficult to establish, corporate regulation may be increasingly used as a policy tool and for purely political purposes with little connection to corporate affairs. As the corporate environment has been relatively resilient to recent developments, political decision makers can sense that more of the costs of society can be allocated to corporations. Listed companies have traditionally been subject to more stringent regulation. In can be tempting for regulators to use existing regulatory framework for listed companies to pursue new regulatory policies. This has been apparent in connection with the introduction of recent EU corporate governance initiatives.

Regulators may expect to have more say on the corporate governance principles of corporations and, worryingly, may increasingly look to monitor and affect the substance of corporate affairs as well. Financial institutions, for example, are already subject to close scrutiny[14] as regards the form and substance of corporate decision making and these types of interventions could be introduced to large non-financial corporations as well – with respect to the management of ESG risks, for example.

The Politicization of the Corporation

Companies are increasingly required to take a stand with respect to political issues. International corporations have found themselves making public statements on civil rights and environmental matters. Recently, private corporations have reacted with unprecedented determination against Russia’s war against Ukraine by declining Russian business and withdrawing from the country altogether in many cases. What is driving the politicization of corporations?

One could suggest that maximizing shareholder value (in the long-term) may require ensuring the continued legitimacy of the corporation in times of political and economic turbulence. A focus on sustainability or corporate social responsibility could be seen as a strategic measure to increase competitiveness and thus to maximize shareholder value. However, corporate governance has also become an avenue for political action, and corporate stakeholders are looking to maximize their welfare by using the corporation as a tool for political action. One reason for this is that in many cases political institutions have not been able to satisfy the political needs of these stakeholders. Economic and political polarization and fragmentation has affected the ability of political institutions to form sustainable policies. In layman’s terms politics has increasingly become a part of the problem instead of the solution. Moreover, with the globalization of business, corporations often operate largely outside the reach of national regulation. This has resulted in a “regulatory gap”[15], where it is not necessarily clear what the “rules of the game” for international business enterprises are in each case. This has increased the political pressure to intervene in corporate affairs by other means. In this environment, stakeholders see the corporation as an alternative means to pursue social policy. In this environment, corporate governance has emerged as an important avenue for regulating the social aspects of business enterprise. A leading corporate law scholar Mariana Pargendler, for example, finds that “corporate governance has recently been enlisted as a solution to the greta social issues of our time, such as income inequality, gender imbalance, human rights, and environmental protection”[16] – rightly or wrongly. Importantly, such political action is also pursued by corporate stakeholders.

The political role of corporations is set to continue; political polarization seems to continue and there will be more room for private enterprise initiatives. Companies will continue to be required to take a stand. This dynamic may be demonstrated in a stronger emergence of responsible business conduct, where and with whom in business is conducted, social impact projects and investing in limiting environmental emissions.

Implications for Corporate Governance

The legal developments identified above will affect the relationships among key corporate constituencies and how we define the corporation itself.

The role of the board of directors will likely increase, as there is an increasing number of constituencies claiming rights with regard to the enterprise. The board remains accountable to shareholders, but it will also increasingly answer to other stakeholders and regulators. Board work is also likely to develop so that certain roles (chairperson) will be more time-consuming and include liaising with key stakeholder groups.

Corporate governance will develop to allow a voice for new stakeholders with an interest in the business enterprise. It can be contemplated that community representatives or interest group will have a voice at general meetings or that other forums for interaction with these constituencies will evolve. There will be more pressure on companies to respond and be accountable to these constituencies. Importantly, shareholder groups may join forces with these constituencies to increase pressure on accountability.

Shareholders will remain the ultimate beneficiaries of the enterprise – there do not seem to be trends where this would need to be challenged. However, there will be increasing demands on shareholders to carry more risk in the form of increased accountability for corporate externalities. Claims for damages, corporate fines, increased regulation of emission will all affect shareholder interests. At the same time, of course, demand on shareholder return will not diminish and corporate performance will be under close scrutiny. In many cases, it may make sense to try to turn the forces affecting the corporation into strategic advantages rather than to challenge them.

There has been much debate on the purpose of the corporation. It has been argued that corporations must serve a broader public interest beyond only maximizing shareholder value[17]. There is no doubt that corporations do serve the public interest by creating economic growth and new opportunities. Corporations must also provide an attractive competitive avenue for entrepreneurship and investment to mobilize economic potential. However, it is reasonable to expect that businesses are held accountable for the effects they have on social factors or the environment and that potential externalities are internalized by corporate stakeholders, including the ultimate beneficiaries of the enterprise. Corporate governance has, in fact, been defined as “the design of institutions that induce or force management to internalize the welfare of stakeholders”.[18] In fact, this metric can serve as a base for defining the corporation in the future.

Technological developments and the globalization of markets have provided opportunities for extremely scalable business models. Over the past years an increasing number of corporations have experienced extremely rapid and significant growth. There is nothing to suggest that the demands on sustainable corporate governance would prevent the development of corporate champions. However, there will be far greater scrutiny on the means for achieving growth and on the effects of businesses on their surrounding social and physical environment.

[1] Proposal for a Directive of the European Parliament and of the Council on Corporate Sustainability Due Diligence and amending Directive (EU) 2019/1937, COM(2022) 71 final; 2022/0051 (COD); [2] The requirements would initially apply to EU based companies with a turnover of over 150 million euros and over 500 employees; provided that companies with over 50% of their turnover deriving from sectors where sustainability issues are more prevalent (such as the textile industry, agriculture and the minerals industry), the thresholds would be EUR 40 million and 250 employees. Non-EU companies with significant operations in the EU would also be subject to the directive based on similar thresholds (Art 2.2). [3] Jesper Lau Hansen et al, Response to the Study on Directors’ Duties and Sustainable Corporate Governance by Nordic Company Law Scholars, University of Copenhagen Faculty of Law Legal Studies Research Paper Series, paper no. 2020-100. [4] Proposal for a Directive of the European Parliament and of the Council amending Directive 2013/34/EU, Directive 2004/109/EC, Directive 2006/43/EC and Regulation (EU) No 537/2014, as regards corporate sustainability reporting COM/2021/189 final; [5] Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088 (Text with EEA relevance); [6] Ministry of Economic Affairs and Employment, Memorandum on the due diligence obligation – Review of the national corporate responsibility act, Publication 2022:24, 2022. [7] Directive (EU) 2017/828 of the European Parliament and of the Council of 17 May 2017 amending Directive 2007/36/EC as regards the encouragement of long-term shareholder engagement (Text with EEA relevance); [8] Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010 Text with EEA relevance; [9] C/09/571932 / HA ZA 19-379; The Hague District Court has ordered Royal Dutch Shell (RDS) to reduce the CO2 emissions of the Shell group by net 45% in 2030, compared to 2019 levels, through the Shell group's corporate policy; [10] ECLI:NL:GHDHA:2021:1825; [11] Robert McCorquodale, Okpabi v Shell. The Supreme Court reverses the Court of Appeal and the High Court on jurisdictional hurdles in parent /subsidiaries cases, [12] Henry Hansmann & Reinier Kraakman, Toward Unlimited Shareholder Liability for Corporate Torts, 100 Yale L.J. 1879 (1991); Stefan H. C Lo., Piercing of the Corporate Veil for Evasion of Tort Obligations, 46 Common Law World Review 42 (2017), [13] [14] Klaus J. Hopt, Corporate Governance of Banks and Financial Institutions: Economic Theory, Supervisory Practice, Evidence and Policy, 22 European Business Organization Law Review 13 (2021). [15] See Jodi L. Short, Self-Regulation in the Regulatory Void: “Blue Moon” or “Bad Moon”? 649 Annals Am. Acad. Pol. & Soc. Sci. 22 (2013). [16] Mariana Pargendler, The Corporate Governance Obsession 42 J. of Corp. L. 359 at 389 (2016). [17] See Colin Mayer, Prosperity - Better Business Makes the Greater Good, Oxford Univ. Press, 2018. [18] See Jean Tirole, Corporate Governance 69 Econometrica 1 (2001).

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