How a Three-Dimensional Approach to Governance Can Help Boards Avoid ESG Lapses

Aarthi Natarajan

Attracting scrutiny over climate action is nothing new for oil and gas companies. Legal action against their boards is, however. In March 2022, ClientEarth took the first step of holding Shell’s board of directors liable in this area, alleging a breach of duties under sections 182 and 194 of the UK Companies Act.

“Shell is seriously exposed to the risks of climate change, yet its climate plan is fundamentally flawed,” wrote Paul Benson, a lawyer for climate accountability. “Shell’s board is increasing the company’s vulnerability to climate risk, putting the long-term value of the company in jeopardy.”

For the first time ever, a company’s board has been challenged on its failure to properly prepare for the net zero transition. Furthermore, at the risk of using a carbon-based metaphor, boards can consider the Shell lawsuit their “canary in the coal mine,” and they should expect even more demand for accountability on ESG compliance and performance in the year ahead.

In April 2022, Bloomberg reported a record of more than 200-plus environmental and social resolutions submitted to corporations across the United States. “With asset managers looking to bolster their ESG credibility, everyone feels empowered these days to flex their voting muscles,” Bloomberg Intelligence senior ESG analyst Rob Du Boff warned.

Read on for more cases of companies and boards that failed to meet expectations, how the legal stakes are even higher thanks to a new Delaware court ruling, and why a three-dimensional approach to governance — one that enables effective insight, oversight and foresight — is more important for boards than ever.

Escalating Expectations, from Divestments to Deforestation to Diversity

Oil and gas companies aren’t the only ones in the crosshairs of escalating investor and regulatory scrutiny, as the following examples demonstrate.

Climate activists have cast a stern eye on the financial sector — and with good reason. Since 2015, when the Paris climate agreement was announced, the financial industry has arranged roughly $4.2 trillion of bonds and loans for oil and gas companies. Earlier this year, the Sierra Club Foundation and other investor members of the Interfaith Center on Corporate Responsibility filed first-of-their-kind resolutions to “simply ask the banks to align their practices with their public commitments to climate action.

Across many industries, companies and their boards are finding all aspects of sustainability under scrutiny. Last May at home improvement retailer Home Depot, shareholders voted on a proposal by Green Century Funds requiring the company to study the certification standards of its wood suppliers and asking how the company could increase the “scale, pace, and rigor of its efforts to eliminate deforestation and the degradation of primary forests in its supply chains.” 

In May, activist group As You Sow gave McDonalds a “D-” grade on its Plastics Pollution Scorecard and filed a resolution requesting that the McDonald’s board file a report describing how the company will reduce its plastic use.

As companies face such escalating demands around ESG’s “E”, attention is growing on the “S” as well. In 2021, third-party “civil rights audits” become a popular way for tech companies and banks to respond to accusations of bias and discrimination. Increasingly, shareholders across industries have been requesting them as well. At the 2022 annual shareholder meeting of Chipotle Mexican Grill, two proposals came up for a vote: one calling for a third-party racial equity audit and another for the company to publish qualitative data on workforce composition, retention and promotion rates of employees by gender, race and ethnicity. 

Heightened Legal Implications for Boards

The 1996 Caremark case requires directors to implement and monitor risk oversight processes as part of their duty of loyalty. Directors breach this duty when they have either “utterly failed to implement any reporting or information system or controls” or “having implemented such a system or controls, … consciously failed to monitor or oversee its operations, thus disabling themselves from being informed of risks or problems requiring their attention.”

While “no Caremark claim has ever even gone to trial,” the Harvard Law School Forum on Corporate Governance notes, “in recent years stockholders have utilized their rights to inspect corporate books and records more frequently, and in a growing number of Caremark cases, they have drawn on that internal information to allege bad faith with enough detail to survive a motion to dismiss.”

What this means for corporate directors: Delaware courts have become more willing to let stockholders pursue claims where they perceive insufficient board oversight of risk management and compliance.

Given this trend, a number of gaps in oversight can make a board vulnerable, including:

  • A lack of established oversight processes for monitoring risk, particularly in “mission critical” aspects of the business
  • Missed “red flags” of looming problems
  • Insufficient time and attention spent on risks and compliance
  • Inadequate documentation of oversight efforts

How Governance Technology Can Help

Amid these escalating consequences for lax oversight, a three-dimensional approach to governance can help directors understand, fulfill and document their evolving duties — and reduce their vulnerability to investor, shareholder and legal action.

What do we mean by a three-dimensional approach? Loosely, it can be defined as real-time visibility into internal and external factors for critical decisions — for compliance, risk management, audit and especially ESG. This approach, and the technology that empowers it, leverages data from across the organization and combines it with proprietary intelligence to give directors, committees and leadership teams a comprehensive view of the internal and external landscape. And it gives boards assurance and confidence by equipping them with the data necessary for three key aspects of effective governance: insight, oversight and foresight.

Given today’s rapidly evolving ESG landscape, there’s not a moment to waste to strengthen visibility and shore up defenses against vulnerabilities. This might involve:

  • Identifying what issues spur an ESG red flag
  • Determining who on the board should receive regular reports
  • Setting up systems for monitoring compliance and taking action when these systems identify issues
  • Documenting board efforts in sufficient detail
  • Anticipating emerging risks and taking preventative action to mitigate them

Request a demo to learn how Diligent can help strengthen your board’s ESG oversight with a three-dimensional approach to governance.

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