Debate over the precise implications of UK law on directors’ duties was given fresh legs this week with publication of a legal memorandum warning that failure to consider environmental, social and governance (ESG) factors could constitute a breach of duty of care resulting in legal claims against a director.

The warning comes in a document produced by a company law expert at law firm Debevoise & Plimpton and commissioned by the not-for-profit Principles for Responsible Investment (PRI).

According to Fiona Reynolds, chief executive of PRI, the memorandum—aimed specifically at private equity houses appointing non-executives to the boards of investee companies—offers a timely reminder of a directors’ legal obligations.

“A company’s board of directors is a crucial lever for transformation and adaptation. As our private equity signatories look to integrate ESG considerations into all aspects of the investment process, they utilise their engagement with company boards to drive effective oversight of ESG risks and strategic planning for ESG opportunities,” she said.

“This guidance proposes a way to systematise that governance mechanism to ensure that our private equity signatories and their underlying investee boards are aware of their legal duties to have regard to ESG factors.”

The memorandum concentrates on the much-debated section 172 of the UK’s Companies Act 2006. Many observers argue that the provisions impose a responsibility on directors for ESG issues, though to date many boards and their directors may have interpreted the law differently. Many believe the section favours the interests of “shareholders” over “stakeholders”.

The memo, drafted by lawyer Simon Witney and released to coincide with this week’s PRI conference in Paris, considers two duties in the Act: the “fiduciary duty” to promote a company’s success, and the duty to “exercise reasonable care, skill and diligence” in acting as a director.

It argues that the law does not permit a director to take action that would “damage the financial success of the company”.

“That means that ESG factors should be used to justify a decision or the use of company resources only if such factors are relevant to long-term shareholder value (including because they pose a material risk to long-term value or, at best, if taking them into account is neutral as regards shareholder value.”

It adds that directors need not be convinced that ESG will affect a company’s risk, only that the risk is material and should be avoided.

Duty of care

When the memo tackles the issue of directors’ competencies it concludes that courts expect them to maintain the right knowledge base to fulfil their duties. “For a company affected by an ESG issue, this would suggest that the directors ought to have—or, at least, have access to–information about that issue and its likely consequences for the company,” the memorandum says.

It goes on to conclude that a “duty of care” requires directors to follow a process that ensures all “relevant factors”, including ESG considerations, are included in their decision-making.

The memo acknowledges that bringing a claim against a director for breaching their duty of care is difficult for a number of reasons.

“However, in extreme cases, failure to ask the right questions or to consider a factor which clearly could have an adverse impact on value for a particular company, such as (if relevant and material) climate risk or the risk of corruption or forced labour in the supply chain, could form the basis of a claim for breach of duty.”

The document also warns that recent legal changes have placed a spotlight on section 172, including requirements for a company’s strategic report to include a commentary on how directors have complied with their duties.

Not everyone is convinced section 172 can deliver focused attention for ESG issues, and believe “soft law”, such as governance codes, might be a better way forward.

Two years ago Dr Georgina Tsagas, a lecturer in law at the University of Bristol, blogged that continuing with section 172 as a “safeguard for stakeholder interests” is “futile”. She argued for significant changes to the UK governance code instead.
Last year’s new code included reference to stakeholders and a provision that directors report on how their interest have been “considered in board discussion” in the light of section 172 provisions.

As discussion over the role of business in tackling the climate crisis intensifies, directors’ duties in this area are set to come under ever closer scrutiny. The latest commentary will likely make a useful addition to the debate.

Read the full memorandum here.