The legal duties imposed on UK company directors require them, when exercising their powers, to understand and anticipate relevant risks to, and opportunities for, the company, including those related to environmental, social and governance (ESG) factors. Directors should ensure that their company has processes to identify, manage and mitigate or exploit those risks and opportunities.
The PRI has commissioned a legal memorandum from law firm Debevoise & Plimpton on the duties of directors who sit on private equity-backed portfolio company boards to consider the ESG risks and opportunities those companies face. A more comprehensive analysis of UK directors’ duties in the specific context of climate risk has been produced by the Commonwealth Climate and Law Initiative and is available on their website.
The memorandum is specifically focused on the duties of UK company directors. The PRI has commissioned a follow-up note on the duties of US company directors.
The memorandum concludes that, when they are exercising power in relation to the company, directors have a clear, affirmative duty to consider all relevant factors that are material to the business, including any relevant and material ESG factors, through the principle of enlightened shareholder value adopted by the Companies Act 2006. Directors’ duties require them to “have regard to” a number of considerations, including, among other things, the interests of employees, the impact of company operations on the community and environment, and the importance of maintaining a reputation for high standards of business conduct. The memorandum recommends that boards conduct a thorough analysis of all risks and opportunities faced by the company – and establish robust processes to ensure that relevant material risks and opportunities are adequately taken into account in decision-making and are reviewed, managed and mitigated.
Investors’ fiduciary duty to consider relevant ESG factors
Fiduciary duties exist to ensure that those who manage other people’s money act in their beneficiaries’ interests rather than serving their own interests. The manner in which fiduciary duty is defined has profound implications for investment management.
Decisions made by fiduciaries cascade down the investment chain affecting decision-making processes, ownership practices and ultimately the way in which companies are managed. Fiduciary duties of investors are important for companies to understand: if companies seek to attract capital from investors bound by duties to take account of ESG factors, that will affect their own approach to long term strategy.
There has, in recent years, been a long-running debate as to whether fiduciary duty poses a legitimate barrier to the integration of ESG issues in investment practice and decision-making. Fiduciary Duty in the 21st Century, a collaboration between the PRI, UNEP FI and The Generation Foundation, has assembled an extensive evidence base to end this debate.
The project finds that failing to integrate ESG factors in investment decision-making is a failure of fiduciary duty, and, in consequence, fiduciaries should:
- incorporate ESG factors consistent with the timeframe of the obligation;
- understand and incorporate the sustainability preferences of beneficiaries; and
- disclose the process followed.
The project has also produced country roadmaps, including for the UK, which set out recommendations to fully embed the consideration of ESG factors in the fiduciary duties of investors across capital markets. In many countries, policy makers are responding with clarifications to existing regulations.
Implications for private equity
Private equity fund sponsors (general partners, or GPs) typically appoint investment professionals to act as directors of portfolio companies, particularly if their investment strategy is to take controlling positions in investee companies. This aspect of private equity investing means that GPs are well positioned to ensure that company boards can be a key driver of ESG integration in investments. Moreover, the GP may be the majority shareholder, or one of a small number of significant shareholders, with considerable influence over the company’s objectives and strategy.
By ensuring that the portfolio company board takes appropriate responsibility for, and actively oversees the management of, relevant ESG factors, the GP is able to:
- implement a robust responsible investment policy that commits to ESG integration throughout the investment process (often part of a specific commitment to investors);
- uphold its commitment to the six Principles for Responsible Investment as a PRI signatory (in particular, Principle 2 which is concerned with ownership practices) and to the PRI Reporting Framework (GPs are asked to report on board level oversight and competence); and
- systematise its governance processes to better manage current and emerging regulatory risks.
The governance structures of private equity-backed companies tend to have several characteristics that amplify both the ability of and the incentives for the directors to act on ESG risks and opportunities.
For example, private equity-appointed directors may be industry and/or sector experts, capable of identifying risks and opportunities that may have an impact on long-term shareholder value – and, as discussed in the legal memorandum, directors are required by the law to bring their expertise to bear in the decision-making process.
Private equity-backed company boards are likely to be closely involved in operational and strategic decision-making and tend to meet regularly, allowing for in-depth discussion and monitoring. They also usually have existing robust governance processes and structures that could be leveraged to incorporate ESG considerations, where appropriate.
In addition, the private equity business model typically involves working towards exit from the outset of an investment, meaning that it is generally in the GP’s interests to ensure that portfolio companies adhere to high standards of business conduct, manage longer-term risks, and follow a long-term sustainable approach to maximise their value to potential buyers. It is likely that whoever buys the company will conduct extensive due diligence and will themselves be highly sophisticated.
Moreover, private equity sponsors have an interest in protecting their own reputation for integrity, risk management and sound decision-making in order to raise and deploy capital from investors in the future. Sponsors are closely associated with portfolio companies and any failings at the company level could tarnish their own reputations – especially if the failings can be attributed to shortcomings in governance practices.
Principle 2: We will be active owners and incorporate ESG issues into our ownership policies
The PRI encourages GPs to use the legal memorandum to brief portfolio company boards on their obligations to consider relevant ESG factors, and to make that consideration a formal part of board procedure.
Consistent with existing good practice, the PRI encourages GPs to seek to ensure that portfolio company boards take responsibility and accountability for ESG matters, and that they have the necessary expertise on ESG matters, or have access to the necessary expertise, to deliver on their individual duties as directors.
Specifically, the PRI recommends that GPs promote (via their board appointees and/or shareholder or investor rights) the following possible actions to portfolio company boards:
- Initiate an (annual) affirmation process on ESG compliance, including confirmations to ensure that company directors are aware of their duties with regard to potentially relevant ESG factors and that they are exercising them accordingly;
- As part of more general risk assessment, incorporate a regular and strategic analysis of material ESG factors (and processes for mitigation, oversight and resourcing) into existing board processes or committees, or set up a dedicated board committee to conduct assessments. They might make use of due diligence materials and the 100-day plan to kick-start this ongoing analysis;
- Proactively seek appropriate advice on ESG risks and opportunities, including regulatory risks and likely changes to the business environment; board members should be prepared to interrogate any advice received and evaluate its implications for the business;
- Evaluate whether management of ESG risks and opportunities is adequately delegated to company management, is properly resourced and appropriately monitored by the board;
- Evaluate the company’s purpose and identify any relevant ESG factors which may contribute to its long term success; consider how this will be communicated to potential buyers/shareholders, employees and relevant stakeholders; and
- Perform an ESG skills audit of the board and provide relevant training for directors to ensure that they have the knowledge they need to perform their duties.
GPs should also note that the shareholders of a UK company have the ability to define a company’s “purpose”, and thereby modify the focus of the directors’ duties, and they may consider building specific provisions into the company’s constitution to make clear their commitment to a sustainable business model. See Additional Resources for guidance.
When evaluating a GP’s approach to ESG integration, private equity limited partners (LPs) should seek to understand how the GP leverages the critical role played by the portfolio company board to deliver on ESG objectives. LPs could ask their GPs to share this legal memorandum and seek its adoption by the underlying portfolio company boards, as part of their strategy for the due consideration of ESG risks and opportunities to the company.
Relevant developments in UK policy and regulation
Company directors would be well-advised to seek appropriate advice on emerging regulation and changes to the business environment. Examples of recent developments that may impact UK businesses are set out below. Although most of the initiatives only apply to listed companies and large private companies, they are a clear indicator of the growing emphasis being placed on ESG considerations.
The Financial Reporting Council issued guidance in July 2018 on how all UK companies can ensure their Strategic Reports and Directors’ Reports comply with the Companies Act and the Non-Financial Reporting Directive. Large companies are required to report on a range of ESG issues, including carbon emissions, human rights policies and their approach to stakeholder engagement.
New corporate governance reporting requirements will apply to very large UK-incorporated companies in respect of financial years starting on or after 1 January 2019. Private companies (whether or not legally required to make such reports) can adopt the Wates Corporate Governance Principles for Large Private Companies (published in December 2018) as a framework for disclosure. The “apply and explain approach” of the Wates Principles encourages boards to consider each principle individually within the context of the company’s specific circumstances, and to explain in their own words how they have addressed them in their governance practices.
The UK government has published a Green Finance Strategy which takes steps towards establishing the recommendations of the Task Force on Climate-related Financial Disclosures as a mandatory disclosure requirement for listed UK corporates and large asset owners by 2022.
In June 2019, the UK government committed to net-zero carbon emissions by 2050. The Treasury Select Committee (a parliamentary committee responsible for scrutinising the Treasury) held a hearing the following month on decarbonising the UK economy and green finance.
The UK government began a consultation in July 2019 on revising the Modern Slavery Act 2015 to require improved reporting by corporates on modern slavery risks in their supply chains. A government review has recommended that directors at companies which fail to comply with the Act’s mandatory reporting requirements should face disqualification. The Modern Slavery Act mandates reporting by any commercial organisation that carries on business in the UK and has an annual turnover of at least £36 million.
- For evidence of the materiality of ESG factors to company performance, see widely cited 2016 academic study by Khan, Serafeim and Yoon: “Corporate Sustainability: First Evidence on Materiality”.
- For an understanding of financially material issues that can affect company performance according to industry and sector, see the SASB Materiality Map. It can be used to guide corporates to focus their sustainability strategies on the most important issues (and understand the metrics that underpin each disclosure topic).
- For guidance on how to implement a board oversight framework for E&S and business integrity issues, see the CDC ESG Toolkit for Fund Managers and the note on “Board oversight of ESG”. The ESG Toolkit is also a rich source of information on the relevance of specific E&S issues to businesses, and has a section on sector profiles for an understanding of typical ESG risks and opportunities across a range of industries.
- See BVCA Technical Briefing on “Narrative reporting developments for portfolio companies” (November 2018) for a summary of which narrative reporting requirements large UK private companies must comply with and start preparing for.
- For guidance on how to customise the Articles of Association to embed company purpose, see website getpurpose.ly (the final customised articles have been drafted by law firm Bates Wells Braithwaite).
- See B Corporation website to understand how businesses can achieve certification for the highest standards of verified social and environmental performance, public transparency, and legal accountability to balance profit and purpose. B Corps directors are legally required to consider the impact of their decisions on all their stakeholders, and B Corps are required to adopt particular language (known as the “legal test”) into their articles of association as part of becoming a B Corp. One of the key features of this language is that B Corp Directors are not required to privilege any particular group of stakeholders (such as shareholders) above another when making decisions about the company.
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The US and the UK markets were selected as the initial focus for this work as they represent two of the largest PRI signatory groups of private equity managers. They are also two markets with significant numbers of private equity-backed companies: see bvca.co.uk and investmentcouncil.org.
Research suggests that boards of most UK private equity-backed companies meet at least 10 times each year – see The corporate governance of private equity-backed companies, page 106, 2017, Simon Witney, PhD thesis, The London School of Economics and Political Science (available at http://etheses.lse.ac.uk/3557/).
The Invest Europe Handbook of Professional Standards (2018) states that “All members of the board are ultimately responsible for, and should actively participate in, risk and opportunity identification, assessment and management across all business areas, including the review of financial and non-financial (e.g. ESG) factors. This includes ensuring that the management of the portfolio company establishes effective policies and procedures that adequately address the identification and control of risk, including legal risks. Members of the board should actively and regularly seek assurance that risk management procedures are in place and are operating effectively.” See also the section on “Board membership” for an overview on what the role entails and what skills are needed. (pages 37-38)
Large companies are defined as those that cannot satisfy two of the three following tests: turnover of less than £36 million; balance sheet total of less than £18 million; fewer than 250 employees.
See Guidance on the Strategic Report, Financial Reporting Council, July 2018
Very large companies are defined as those that have either: (i) more than 2,000 employees globally, or (ii) a turnover of over £200 million globally, and a balance sheet total over £2 billion globally.
See Independent review of the Modern Slavery Act, UK Home Office on gov.uk, last updated 9 July 2019