The interplay between profitability and environmental and social governance ("ESG") issues is a topic firmly fixed on the corporate agenda. Corporations are under increasing pressure from regulators and stakeholders alike to carefully consider more than just their bottom line in decision making.
Since the inception of the Companies Act 2006 ("the Act"), directors have been under a broad obligation to consider the impact of a company's operations on the wider community and the environment (s. 172(1)(d)). Now, activist shareholders are increasingly seeking to utilise this provision to target directors for perceived ESG failings.
In this article, we explore what the s. 172(1)(d) obligation means for directors against the backdrop of a rapidly evolving ESG landscape, looking at: (i) the scope of the duty; (ii) the potential risks and consequences of non-compliance; and (iii) best practice for directors to mitigate their vulnerability.
1. Scope of the duty
Section 172(1) states: "A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to:
- the likely consequences of any decision in the long term,
- the interests of the company's employees,
- the need to foster the company's business relationships with suppliers, customers and others,
- the impact of the company's operations on the community and the environment,
- the desirability of the company maintaining a reputation for high standards of business conduct, and
- the need to act fairly as between members of the company."
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The s. 172(1) factors
A director's primary duty is to promote the success of the company for its shareholders as a whole. However, "success" is not specifically defined. For most commercial companies, success means long term value creation. However, in fulfilling that obligation, directors must "have regard to" the non-exhaustive list of factors listed at s.172(1)(a) – (f) of the Act.
The guidance notes to the Act stress that consideration of these factors is not a tick-box exercise, stating: "It will not be sufficient to pay lip service to the factors, and, in many cases, the directors will need to take action to comply with this aspect of the duty". Importantly, assessment of the s. 172 factors is necessarily contextual - the factors themselves are not given any particular weight within the Act, and in certain instances, it may be that factors conflict and point to different outcomes.
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What is the standard?
In determining whether a director has failed to meet its obligations under s. 172, the key question is whether the director honestly believed that their act or omission was in the interests of the company. It is a subjective test: the court will look at whether the director has fallen short, based on their own abilities, of the care, skill and diligence that would be exercised by a reasonably diligent person with the general knowledge, skill and experience that the director has.
A director may be liable even if they have not been consciously dishonest. The court will not look back, with the benefit of hindsight, on a director's decision. However, decisions which have disastrous consequences are more likely to lead to questions as to whether or not the directors were acting in the company's best interests.
2. The potential risks and consequences of non-compliance
The first claims testing a shareholder's power to bring a derivative claim against one of the company's directors in respect of alleged breaches of s. 172(1)(d), have arisen in the environmental context:
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Dr Ewan McGaughey and Dr Neil Davies were two members of a pension scheme for university staff. In October 2021, they commenced proceedings against the corporate trustee, alleging that the failure of current and former directors (including a shadow director) to create a credible plan for divestment from fossil fuel investments prejudiced, and will continue to prejudice, the success of the company. On the fossil fuels issue, Leech J decided that the claimants had not established a prima facie case that the company had suffered any immediate financial loss as a consequence of the directors' failure. However, even if they had been able to establish such a loss, the claimants did not suggest it was reflective of financial losses they had suffered themselves, and so they lacked sufficient interest or standing to bring the claim. Permission to continue the claim was therefore refused.
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ClientEarth v Shell
In March 2022, ClientEarth sent a pre-action letter to Shell's Board, alleging "mismanagement of climate risk". The complaint has been widely reported. ClientEarth argues, in broad terms, that Shell's Board has failed to adopt and implement a climate strategy that aligns with the Paris Agreement. In 2021, Shell published an "Energy Transition Strategy" setting out how it would seek to achieve its target of becoming "a net-zero emissions energy business by 2050", yet ClientEarth alleges that those plans are significantly deficient.
ClientEarth has indicated that, subject to Shell's response, it will issue proceedings and seek permission to bring a derivative action on behalf of the company. That is a significant hurdle to surmount. However, the facts differ from McGaughey in that ClientEarth is a direct shareholder in the respondent company.
Whilst it remains to be seen whether permission to bring such a derivative claim will be granted in this, or any future case, it is clear that: (i) ESG regulation, particularly in the climate sector, is advancing at pace; and (ii) the risks (both reputational and financial) of responding to even pre-action activity by activist shareholders are not insignificant.
3. Best practice to mitigate the risks
Standard procedures should be put in place to ensure directors are complying with their duties under s. 172, for example, ensuring that directors are fully briefed on all duties on appointment, circulating a copy of s. 172 with a board pack and ensuring that board minutes state that s. 172(1) factors have been taken into account and any discussions are fully recorded. In addition, directors may benefit from attending specific external training on their responsibilities, liabilities and best practice in the board room.
In relation to s. 172(1)(d) specifically, directors should ensure environmental consequences of the company’s operations are appropriately considered at board meetings, for example by:
- Routinely addressing climate change considerations in agendas to prompt consideration of net zero targets, carbon footprint and climate change risks as a part of overall decision-making; and
- Robustly considering material climate impacts and risks in relation to significant contracts and transactions, and if required seeking out expert advice on the matter.
It may be possible to seek ratification of a directors' failure to comply with their s. 172 duties by shareholders, and such ratification will be a complete bar to a derivative claim. However, directors should note that ratification may not absolve a company of broader liability under environmental or social legislative frameworks. Equally, such a path may be ill advised in a world where increasingly, maximising profit and making social and environmental choices are not mutually exclusive. As noted by Lord Sales in his address to the Anglo-Australian Law Society on directors' duties and climate change in 2019, there is: "Growing recognition of the fact that good environmental practices will often be financially prudent, at least in the long term, on top of being laudable from a corporate social responsibility or ethical perspective".
For further information on directors' duties and ESG issues, please see our previous articles on the changing nature of corporate purpose, the Better Business Act, stakeholder pressure and director's duties in the context of the COVID-19 pandemic, as well as the Mishcon Purpose Framework, a global "standard" for ESG considerations, and Mishcon Purpose Toolkit, which integrates key legal and ESG advisory services.
For more information on how we can advise on disputes relating to directors' duties or ESG issues, please contact one of our team.