Sustainability – comprising environmental, social and governance (ESG) factors – has risen fast to the top of the board agenda and become central to corporate competitiveness and businesses’ continued ability to operate.
As the UK focuses on trying to meet its net zero commitments, businesses can expect further rules and regulations which are designed to change corporate behaviour. These will pose an additional burden for directors who are responsible for ensuring compliance.
This article looks at the changing nature of directors’ responsibilities and forms part of a series which considers how the fast-evolving ESG landscape affects small and medium-sized enterprises (SMEs). To read more about why SMEs should pay attention to ESG issues, see our article here.
Recent expansion of directors’ duties
Along with directors’ general statutory duties under the Companies Act 2006, there are various other laws and regulations affecting businesses and their directors which relate to ESG considerations such as obligations under health and safety and anti-bribery legislation.
To read more about directors’ statutory duties, potential liabilities and mitigating actions, see our article here.
Wider stakeholder engagement has been a key driver in ongoing corporate governance discussions, bolstering a range of areas such as environmental reporting, modern slavery and data protection, along with recent guidelines on remuneration, board composition and diversity (to name a few).
Currently, disclosure and reporting obligations for directors depend on the size and nature of the company. Some examples of the key obligations already in place are outlined below.
- Large companies (including large private companies) are required to include a 'section 172 statement' in their strategic report describing how the directors have had regard to the matters in section 172 of the Companies Act 2006 (ie to promote the success of the company). The directors’ report must also include a statement explaining how the directors have had regard to the need to foster the company's business relationships with suppliers, customers and others, and the impact of that on the business.
- Large and medium-sized companies (including private companies) with more than 250 UK employees are required to include a statement in their directors' report explaining how the directors have engaged with employees, how they have had regard to employee interests and the effect of that on the business. Such companies must also publish specific information about their gender pay gap.
- Companies that have a turnover exceeding £36 million must publish a modern slavery statement that describes the actions they have taken to deal with slavery and human trafficking risks in their supply chain as well as in their own activities.
- Large companies and limited liability partnerships (LLPs) have also been required since 2019 to report annually on emissions, energy consumption and efficiency action.
More recently, the Companies (Strategic Report) (Climate-related Financial Disclosure) Regulations 2022 and the Limited Liability Partnerships (Climate-related Financial Disclosure) Regulations 2022, in force from 6 April 2022, made changes to the reporting obligations for certain large companies and LLPs, requiring them to produce additional disclosures in line with the Taskforce on Climate-related Financial Disclosures (TCFD) recommendations. These disclosure obligations mirror the FCA Listing Rules which already required premium listed issuers in the UK to make disclosures in accordance with the TCFD recommendations on a ‘comply or explain basis’.
Further anticipated developments include for example:
- The government’s plans to introduce Sustainability Disclosure Requirements and a green taxonomy for large businesses and financial services firms, aimed at cracking down on greenwashing and providing transparency to investors on sustainability credentials.
The EU already has similar regulations in place which affect certain UK entities and there are proposals to bolster corporate sustainability non-financial reporting along with establishing a corporate sustainability due diligence duty, requiring large companies operating in the EU to undertake DD checks of their supply chain to identify actual and potential adverse impacts of their activities – it remains to be seen if the UK follows suit.
- More regulation resulting from the Taskforce on Nature-related Financial Disclosures, an international initiative which is developing a new framework and builds on the TCFD model.
How are SMEs affected?
Although SMEs have seemingly remained unscathed by legal developments, recent and proposed regulations will have an impact on investors and private equity houses which regularly invest in SMEs (and, likewise, large companies that deal with SMEs in their supply chains).
An increase in ESG-related disclosure requirements is therefore expected for businesses looking to transact with third parties or receive investment, alongside potentially greater pressure from existing investors and contracting parties for businesses to increase their sustainability credentials.
Notably, as part of the government’s net zero transition plans, the intention is that, by the end of 2023, mandatory climate-related financial disclosures will apply to most UK companies and financial institutions with a view to all businesses being required to make these disclosures by 2025.
While regulators have yet to amend directors’ statutory duties, there are growing calls to make the board more accountable. For example, the UK’s Institute of Directors has called on the government to develop a code of conduct for directors to 'incorporate modern thinking relating to issues such as climate change, diversity and business purposes…' However, time will tell if the government takes this suggestion forward and if, in fact, such a voluntary code would suffice in the wake of recent corporate scandals.
Moreover, we also expect increased lobbying. For example, the Better Business Coalition, supported by over 1,000 businesses across the UK, is campaigning for a Better Business Act (BBA), to change the focus of a director's statutory duty under section 172 of the Companies Act 2006 from being a duty 'to promote the success of the company' to a duty 'to advance the purpose of the company'.
The BBA recognises that, although the overriding section 172 duty requires directors to ‘have regard’ to various stakeholder factors, directors have largely been driven by the need to maximise profits and shareholder value. Consequently, the Coalition’s FAQs note that 'in situations where a director has to choose between the company's intention to create positive social or environmental impacts and the interests of shareholders, the directors would no longer be compelled to default to prioritising shareholders'.
This would result in directors being legally required to take a broader view of stakeholder issues such as the company’s impact on the environment, their employees and the wider community, alongside their commercial objectives and profits.
Investor pressure, internal governance and workplace issues, along with the proliferation of various reporting frameworks and standards in relation to sustainability makes this a complex area for boards to manage, with companies of all sizes increasingly aware that a failure to address these matters can be detrimental to their businesses, both financially and through reputational damage.
Indeed, we are already seeing a rise in ‘green’ litigation claims, with boards of directors facing mounting pressure and accountability over their commercial practices. For example, in March 2022 ClientEarth started legal action against Shell’s directors for breach of directors’ duties, alleging a failure to prepare adequately for a net-zero transition, so in breach of directors' duties under the Companies Act 2006 (in particular, to promote the success of the company and to exercise reasonable care, skill and diligence).
It remains to be seen how this first-ever attempt at holding directors personally liable for mismanagement of climate risk will unfold but it is clear that the trend for increased shareholder activism will continue across sectors.
Businesses are also exposed to greater financial and reputational damage - such as P&O’s decision to lay-off a large number of employees - and are increasingly dealing with the consequences of greenwashing claims, such as Tesco’s ‘misleading’ ad over its vegan burgers. Again, boards may find themselves subject to regulatory investigations if any statements were made without reasonable grounds. Litigation by investors may also follow if the value of an asset falls due to an asset being greenwashed.
The way in which businesses govern themselves, manage risk and engage with their stakeholders is under unprecedented scrutiny. Amid the introduction of numerous legislative requirements by regulators, investor pressure, workplace issues and increasing accountability to those outside the organisation, directors are faced with a matrix of growing challenges.
We advise a range of clients across the full spectrum of governance-related risks and compliance matters and are well-equipped to help businesses and directors proactively manage these issues. Please contact us to discuss further.