Businesses are increasingly aware that less-than-robust ESG strategies and practices can lead to penalties and a negative view of the brand. But while the risk of regulatory sanctions is understood, there is a looming threat which businesses are less prepared for: ESG litigation.
This article is the first in a series looking at ESG through the lense of economics, valuations and disputes.
Why is ESG reporting growing in importance?
ESG captures a broad range of issues, such as climate change (environment), labour and human-capital management (social) and business ethics (governance). ESG information being reported by companies is increasingly being used for regulatory compliance purposes and in decision-making in a number of areas.
- Consumers: consumer preferences are shifting to more ethical and sustainable goods, which is being guided by ESG disclosures
- Businesses: strong ESG propositions can improve top-line growth, reduce energy costs, improve productivity, reduce regulatory sanctions and assist in corporate valuations
- Investors: ESG investments have gained popularity due to improving risk management (and potential returns), changing societal values and consumer preferences, and a shift towards long-term returns that account for ESG risk factors
- Regulators: the reporting framework of the Task Force on Climate Related Financial Disclosures (TCFD), the Sustainable Finance Disclosure Regulation (SFDR) and the FCA considering additional regulations to prevent greenwashing is transforming what has been a largely unregulated sector.
ESG litigation – where might it arise?
Increasing regulation and the use of ESG metrics in decision-making increases the likelihood of their being the basis for the dispute. This could take many forms, for example a securities litigation, class action, shareholder dispute or litigation.
Here are four areas of potential litigation for businesses to be aware of:
1 Reporting and disclosure
Public ESG reporting within businesses is becoming increasingly common. These public reports are a gold mine for litigation with claimants scouring reports for false, misleading or missing ESG information.
Businesses are stuck between a rock and a hard place. If they don't report on ESG-related matters, they may be at risk of litigation for failure to disclose information – particularly as more regimented regulation is enforced. If they do report on these matters, the data must be accurate and verifiable, or they risk of litigation through reporting false or misleading information.
2 Product misrepresentation
Consumers are becoming more conscientious, and preferences are shifting to sustainably and ethically sourced goods. Accurate product labelling allows them to identify these products. Product misrepresentation – whether inadvertent or otherwise – will open the gates for consumer class action lawsuits against businesses.
3 Controls and duty of care
In certain circumstances, companies may owe a duty of care in respect of misstatements or (in)actions of their subsidiaries or by companies in their supply chain. Claimants (and regulators) increasingly seek to hold companies to account for the social and environmental impacts of their broader operations. Whilst parent companies have no free-standing duty of care for the actions of their subsidiaries or supply chain companies, it is open to claimants to seek to establish such a duty of care on the basis of, for example, evidence that the parent company exercised a sufficient degree of control or supervision.
Parent companies therefore need to pay close attention to the controls they have in place not only for their own organisation but also for entities in respect of whose misstatements or (in)actions they may be found to owe a duty of care. In addition, directors of UK companies have a statutory duty to ensure that statements made in documents such as the directors’ report, the strategic report and any corporate governance statements are correct, and are liable to compensate the company for any loss it suffers as a result of any untrue or misleading statements or omissions in such documents and are at risk, amongst other things of legal liability for breaches of directors’ duties by way of derivative actions.
4 Corporate valuation
Valuation of businesses must now consider ESG factors. For example, discounted cashflows should take into account:
- the social risks of decrease in revenues as a result of social backlash
- additional tax payments due to fines imposed by authorities
- the impact on the business under the ‘2-degree scenario’ (where global temperatures rise by over two degrees).
If these factors are not considered then business valuations are likely to be inflated, which may lead to corporate arbitration proceedings.
How to mitigate the risks
We consider that the following, at a minimum, should be considered as the three principal pillars for ESG litigation mitigation.
Be aware of current ESG regulatory requirements, and also of the ESG regulatory landscape as it evolves. ESG legislation is set to change significantly in the UK over 2022. It is paramount that businesses are aware of these changes, and what they mean for their business.
Ensure robust ESG compliance controls are in place across the business – from subsidiaries to supply chain companies.
Use clear metrics and quality data. Public ESG disclosures should be treated with caution, as any misinformation will be used by potential claimants. To protect against this, any ESG claims need to be backed by ESG-related metrics, which should be achievable, measurable, and based on robust and reliable data. The data underpinning these ESG metrics needs to be accurate, verifiable and based on global ESG frameworks.
Dealing with a dispute
Making sure you remain compliant is the first step. Implementing robust reporting frameworks and compliance controls across all areas of ESG should be a priority. Our recent webinar, for example, showed how to do this using a real-life case study in developing an ESG data and analytics platform to improve their ESG profile and reporting.
If the worst does happen and a dispute arises, our team of experienced economists, accountants and lawyers can support on ESG investigations, remedies or litigation.
To discuss any of these issues further, get in touch with Schellion Horn, Steve Holt or Jake Foad.
