The legal duties imposed on directors of US companies incorporated in Delaware require them to take into account material ESG factors and permit them to take other ESG factors into account when rationally related to stockholder interests when discharging their duties.
The PRI commissioned a legal memorandum from law firm Debevoise & Plimpton to seek a better understanding of what the law says regarding the duties of US directors, as they pertain to ESG. This guidance aims to inform investment professionals, and others, who sit on the boards of private equity-backed portfolio companies incorporated in Delaware.
More publicly listed companies are incorporated in Delaware than in any other state, and it is where many portfolio companies of private equity sponsors are also incorporated. It should be noted that not all private equity portfolio companies are organised as corporations. Many are limited liability companies (“LLCs”) whose governance is defined by contract. Those LLCs often have governing agreements that allow them to define the terms of their ownership and responsibilities to investors in unique ways. Director’s of such alternative vehicles are therefore often free to consider ESG factors without regard to the traditional constructs of state corporate law.
Ascertaining the legal duties of corporate directors is of particular importance to the private equity asset class because, in many investments, GPs will typically have at least one board seat and often more. This board-level representation is not only the case in control investments but often also occurs in influential minority investments. A board seat is an essential mechanism through with the GP exerts its influence over the portfolio company.
This memorandum follows from a report in 2019 looking at UK directors’ duties, that the PRI also commissioned from Debevoise & Plimpton.
The PRI has undertaken much work in the area of fiduciary duty and its latest major work in this area, Fiduciary Duty in the 21st Century, written in conjunction with UNEP FI, can be found here.
I applaud PRI in providing market participants and the public with information about the extent to which corporations may take into account key Double ESG — with the extra E for employees. PRI makes clear that there is wide discretion for all Delaware corporations to consider the interests of their stakeholders so long as their action has a rational relationship to the best interests of stockholders. Not only that, PRI underscores the growing recognition by institutions representing long-term investors that they cannot be faithful fiduciaries unless they recognize that these investors need — as an economic matter —companies to focus on sustainable growth, pay quality wages, treat the environment and consumers with respect, and avoid shifting externalities to taxpayers and other companies. These universal investors are workers, taxpayers, consumers, and live in the environment. Importantly, PRI also highlights the viability and promise of a new form of corporation, the Public Benefit Corporation, that aligns the interests of all company stakeholders while still providing investors with the crucial protections of Delaware law that they have come to rely upon.
Leo E. Strine, Jr. Former Chief Justice and Chancellor of Delaware; Distinguished Senior Fellow, Penn and Columbia; Of Counsel, Wachtell, Lipton, Rosen & Katz
PRI and Private Equity
The PRI has a range of ESG and responsible investment guidance targeted at the private equity industry. Recent work includes:
Too often, GPs’ momentum on ESG factors stops at the boardroom door. This memorandum confirms that directors of US companies have a duty to consider material ESG factors in their decision making.
Michael Cappucci, Managing Director – Compliance and Sustainable Investing, Harvard Management Company
Summary of Legal Opinion
This accompanying narrative to the legal memorandum explains the PRIs interpretation of the current legal position as it stands in Delaware, and how the legal position affects the private equity industry’s ESG efforts.
The fiduciary duties of directors of US corporations require directors to take into account ESG factors, both when making decisions where those ESG factors involved are directly material to the corporation, or when those ESG factors bear on material legal and compliance issues. They also permit directors to take ESG factors into account as long as they are rationally related to stockholder interests.
The law, however, still places stockholders as the only constituency given any enforceable rights.
2. Legal Liability
Importantly, for responsible private equity investors with board seats at their portfolio companies, the law says that directors have broad latitude when deciding whether ESG factors are material.
In taking ESG factors into account, the law gives directors broad latitude to decide whether an ESG factor is indeed material.
3. Time Horizon
An ESG factor that might not be material to a company now, but could be in the future, such as climate change, is nonetheless judged to be material and should be taken into account, despite the risk being in the future.
4. Duty of Care
Directors should operate on an informed basis and consider all material information that is readily available. It is this duty of care that bestows an obligation on directors to take into account material ESG factors when making decisions.
5. Duty of Inquiry
Typically, a director will rely on the experience of management to identify material risks and opportunities. Directors can rely in good faith on the information presented to them by management if they believe they are competent and have been selected with reasonable care.
However, directors may not consciously disregard a known material risk if this has not been identified by management. If management fails to identify a material ESG risk, directors cannot intentionally ignore this.
6. Non-stockholder Interests
Are directors forbidden from considering the interests of non-stockholder interests, such as those of employees, or the environment? No, as long as two tests are first passed.
Firstly, those interests must be rationally related to the benefits of stockholders. Secondly, in the case of a sale of the company, directors are obligated to seek the best price reasonably available to stockholders.
Purpose of a Corporation
Discussion around the purpose of a corporation in the US has been the topic of long-running and passionate debate and is one that continues to evolve. Whilst shareholders are the only external stakeholders that have power under current law in many US jurisdictions, discussion shows signs of moving away from holding shareholder primacy as sacrosanct.
For example, Business Roundtable, an association of CEO’s from some of America’s leading companies, stated that it had redefined the purpose of a corporation to promote “An economy that serves all Americans”. Since 1978, Business Roundtable has periodically issued its Principles of Corporate Governance. Each version of the document issued since 1997 has endorsed the principle of shareholder primacy – that corporations exist principally to serve shareholders. In 2019 this changed to consider other stakeholders.
These principles included commitments to invest in employees, deal fairly and ethically with suppliers, support the communities in which corporations work, and protect the environment by embracing sustainable practices across their business.
Successful private equity is all about creating value for the stakeholders and having the right governance in place; considering ESG factors at board level is one way that GPs can do this. This memo provides comfort that investment team members taking board seats in Delaware are indeed required to factor material ESG issues into their decision making and strategy setting.
Ignacio Sarria, Managing Director, New Mountain Capital.
Implications and Actions
The conclusions of this legal memorandum are welcomed by the PRI and provide the private equity industry in the US with clear guidance. Directors generally have a desire to seek clarity in terms of what the law expects of them, and this memorandum makes it clear what the law obliges, and also permits them to do, in the context of ESG. We have often heard from market participants in the US that their fiduciary duty as a director was an obstacle to the incorporation of ESG factors in their strategic oversight of portfolio companies. The memorandum illustrates that this is not the case when those ESG factors are material.
Whilst this is true during the monitoring phase, GPs must exercise care at exit. The only factor to be taken into consideration at exit is the price. This means that a GP may not elect to sell a portfolio company, structured as a Delaware corporation, to a buyer it sees as a more responsible future owner, even if the difference in price is inconsequential to the overall returns of the fund.
It is not always highly experienced director’s that are appointed by private equity firms to take board seats. Investment team members taking a board seat for the first time are less experienced as directors. As junior investment team members progress in seniority and take on additional responsibility, including directorships, providing the appropriate training on all aspects of their duties as directors, including ESG, is critical.
The PRI would encourage all GPs investing in the US to share this memorandum with their investment teams.
The law in Delaware both requires and permits directors to go further than ensuring compliance, as long as the ESG factor in question is material.
How though do GPs and their investment team members serving on boards determine which ESG factors are material? Much work has been undertaken in recent years on materiality. GPs can look to utilise this research by integrating resources such as SASB’s materiality map into their investment process. SASB’s analysis examines which ESG factors are material on an industry by industry basis, and they also provide a more in-depth study in their industry standards. These standards can be found here.
Good ESG practice at board level must, at a minimum, mean regular discussion of material ESG risks and opportunities. Management should also seek to routinely include data on those material ESG factors in board packs.
Many commentators argue that while the law continues to give shareholders the only real power in a corporate structure, there are other aspects of the financial system that should be addressed to allow for a more sustainable economy. Several interesting proposals are contained within a recent working paper by Leo E. Strine, Jr., former Chief Justice and Chancellor of the State of Delaware.
The working paper makes many interesting proposals. Private equity is an innovative asset class in many areas, it continues to grow in size as companies prefer to stay private and allocations to private equity grow. The industry should continue to look for ways to be more sustainable as it rises in importance.
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Incorporated in Delaware