The impact of the European Union’s ESG law on the corporate governance of the companies

The impact of the European Union’s ESG law on the corporate governance of the companies

by Stefano Montalbetti – Member of the Berkeley Global Society

Introduction

The article briefly analyses the European Union rules on ESG matters and the liability of companies’ directors arising from such rules. In particular, the article shows the main European laws regarding the reporting obligations of non-financial information, the sustainable finance and the new concept of sustainability due diligence for large European companies. Then, the analysis focuses on the liability of directors in their conduct which have to take into account these new duties and seeks to answers the question of whether there is a real enforcement mechanism that third-party stakeholders may activate to take claims against directors for their behaviors not in line with ESG goals.

Reporting obligations of non-financial information

Under the European Green Deal, the goal of the European institutions is funding activities that support environmental, social and governance (ESG) purposes, addressing in particular the financial flows to sustainable investments. To do this, European Union and member states continue to increase the reporting obligations regarding the disclosure of non-financial information (i.e. information relating to the environment, social and employee-related matters, respect for human rights, and action to address corruption and bribery) of the companies and financial institutions.

In this regard, the adoption of Directive 2014/95/UE (known as “Non-financial Reporting Directive” – NFRD), as integration of the provisions under Directive 2013/34/EU, established a set of rules to raise the transparency of social and environment information improving the disclosure of non-financial information in the annual management report by large undertakings which meet certain requirements (1).

Most recently, Directive 2022/2464/EU (known as “Corporate Sustainability Reporting Directive” – CSRD), entered into force on January 5, 2023 replacing the NFRD, will ensure investors and other stakeholders to have access to the sustainability report of a larger set of companies (including large undertakings, regardless of they are public companies, and also small and medium-size enterprises which are public interest entities) (2). Some companies shall apply the new measures starting from the financial year 2024 and Member States shall implement the Directive by July 6, 2024. Furthermore, following the need to establish a uniform EU framework providing for the criteria of EU non-financial reporting standards, the CSRD has welcomed the Commission to provide for sustainability reporting standards showing information the undertakings shall report in their statements. At these purposes, the European Financial Reporting Advisory Group (EFRAG) will play a key role in providing technical advice to the Commission (3) .

In this context, the responsibility for the proper and timely fulfillment of the aforementioned information duties lies with the management body of the company. According to article 51 of Directive 2013/34/EU, Member States, in their implementation of the directive, had to envisage for sanctions to infringements and conducts not in compliance with law. In this regard, several Member States decided to apply administrative sanctions for the management body operating not in line with non-financial disclosure obligations it being understood that management body would be also generally subject to the national law relating to civil liability. In addition, the new Directive (CSRD) amended Directive 2006/43/EC (on statutory audits of annual accounts) providing that the systems of investigations and penalties as regards the statutory audit of financial statements shall apply also to the assurance of sustainability reporting and, as a consequence, Member States shall establish sanctions in respect of statutory auditors and auditing firms which do not carry out the assurance on sustainability reporting in compliance with the provisions adopted by the Member States.

Sustainable finance

In addition to the reporting obligations, the divergence of the rules the Member States adopted with reference to sustainable finance led to the adoption of Taxonomy Regulation (EU) 2020/852 in line with the action plan on financing sustainable growth (4). The Taxonomy Regulation has led to the creation of a list of environmentally sustainable economic activities, implementing the European Green Deal. The Taxonomy Regulation was enacted as an investment mean based on a common classification, aiming at helping sustainable investments by identifying and defining activities qualified as sustainable. In this way, it should create security for investors, protect private investors from greenwashing, help companies to become more climate-friendly, mitigate market fragmentation and help shift investments where they are most needed (5).

Corporate sustainability due diligence

On February 22, 2022 the European Commission has furthermore adopted a proposal for a Directive on corporate sustainability due diligence (6) under which large companies (small and medium-size enterprises are not directly in the scope of this proposal) would be required to have a plan identifying potential risks with the aim at mitigating impacts of their activities on human rights (for example child labor and exploitation of workers) and environment (such as pollution and biodiversity loss) (7) . Member States should ensure companies to adopt a due diligence on their activities having in place a due diligence policy to be updated annually. Such policy should envisage a description of the company’s approach to the due diligence and encompass a code of conduct the company’s employees, subsidiaries as well as third parties operating with the company shall follow.

In order to guarantee that due diligence becomes a key point of the companies’ activities, the directors shall supervise the adoption of the due diligence integrating it into corporate strategy. Moreover, among their duties to act in the best interest of the company they shall take into account the human rights, climate change and environmental results of their decisions. To do this, directors should thereby consider also the input of stakeholders and civil society organizations.

This proposal gives a combination of administrative enforcement and civil liability to monitor and ensure overall compliance. National administrative authorities will have the role to oversee the application of these new rules and may impose fines in case of non-compliance. In addition, victims can take legal action for damages arising from not appropriate due diligence measures (8).

Directors’ liability

Despite the foregoing and the European law already adopted, it is however difficult to say that these measures at this stage have a concrete impact on directors’ liability.

It is evident, in fact, how an effective enforcement would require precise regulatory measures, also to avoid that the conduct of management can easily fall under the concept of the so-called “business judgment rule”. In addition, this broadening of the interests at stake would require the introduction of protection mechanisms that third parties and all the stakeholders in general can activate, since they should be interested, like the shareholders, in the company’s decisions.

The EU provisions and some of Member States rules provide for a director’s “generic” duty to pursue sustainable growth in their management activities. However, in most Member States there is still no real enforcement mechanism and a system of control and monitoring of compliance between the rules imposed and their implementation by the various stakeholders holding relationships with the company. The interest of shareholders is generally to have the directors duly committed to increase the value of the company’s shares so that it could be difficult that shareholders make a claim against directors if their conducts did not jeopardize the shares’ value.

For instance, in Italy the set of rules governing the duties of directors and claims that shareholders or third parties (such as creditors) may take against directors’ misconducts is not suited to this new duty to take in consideration the sustainable success of a company. Whether the articles of association do not include the company’s sustainability growth within the corporate purpose it seems difficult to challenge liability for directors’ conducts (9) .

EU institutions are however increasing the introduction of rules that envisage liability measures in case of non-compliance with non-financial duties for the companies and their directors. The hope is that all Member States in implementing these directives will provide for ad hoc national measures to ensure the protection of these interests and an enforcement system that guarantees various stakeholders to monitor the fulfillment of these duties allowing them to make a claim against the directors in case of non-compliance with such duties.

[1] For more explanations regarding the Non-financial Reporting Directive and reasons why the European Commission then decided to review the NFRD, refer to: https://www.europarl.europa.eu/RegData/etudes/BRIE/2021/654213/EPRS_BRI(2021)654213_EN.pdf ).

[2] See the text of the Corporate Sustainability Reporting Directive (CSRD) at https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32022L2464&from=IT. For more information about the CSRD and the iter followed to adopt this Directive, refer to: https://finance.ec.europa.eu/capital-markets-union-and-financial-markets/company-reporting-and-auditing/company-reporting/corporate-sustainability-reporting_en; https://www.consilium.europa.eu/en/press/press-releases/2022/06/21/new-rules-on-sustainability-disclosure-provisional-agreement-between-council-and-european-parliament/.

[3] See the sustainability reporting standards roadmap at  https://www.efrag.org/Activities/2010051123028442/Sustainability-reporting-standards-roadmap?AspxAutoDetectCookieSupport=1#.

[4] See the text of the Taxonomy Regulation (EU) 2020/852 at https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32020R0852&from=IT.

[5] For more explanations regarding the Taxonomy Regulation, refer to: https://finance.ec.europa.eu/sustainable-finance/tools-and-standards/eu-taxonomy-sustainable-activities_en; https://www.eurosif.org/policies/eutaxonomy/.

[6] See the text of the Directive on corporate sustainability due diligence at  https://eur-lex.europa.eu/resource.html?uri=cellar:bc4dcea4-9584-11ec-b4e4-.01aa75ed71a1.0001.02/DOC_1&format=PDF.

[7] For more information, see https://ec.europa.eu/commission/presscorner/detail/en/ip_22_1145.

[8] For more information about the enforcement of the obligations of this Directive proposal, refer to https://www.stibbe.com/publications-and-insights/proposal-for-a-directive-on-corporate-sustainability-due-diligence#_ftn1.

[9] However, it should be noted that in 2016 Italy became the first European State to introduce the status of “Benefit Corporation”, that are companies which combine the goal of profit with the purpose of creating a positive impact for society and environment operating in a transparent, responsible, and sustainable way. Although the introduction of such new legal corporate status (that companies are not obliged to adopt), real enforcement mechanisms to protect third stakeholders interests seem to be still missing.