Environment, social, and governance (ESG) are factors directors, investors, industries, and governments increasingly focus on when making commercial decisions. This is particularly so given increasing public awareness of such issues following recurrent environmental disasters and international summits such as COP26. Tim Symes and Ryan Hooton review the current regulatory environment in the UK, how it might bite on a company’s insolvency and when directors may find themselves personally liable for their actions.

The growing awareness of ESG correlates with a shift among shareholders and investors to ensure their businesses and investments align with ‘green’ values.

Law and regulation

To date, most ESG law and regulation in the UK has proven underused or unused. Take s172(1)(d) of the Companies Act 2006, for example, which places liability on a director whose commercial decisions have potential negative impacts on the environment. We are aware of only one concluded case that has considered this duty. Campaigners brought a claim against the UK Treasury, citing a lack of adequate environmental and human rights considerations when investing in the Royal Bank of Scotland (RBS). RBS had allegedly financed several controversial companies and projects, undermining the UK’s commitment to halt climate change. The court refused to permit a judicial review of the decision, siding with the directors whose actions were of benefit to the shareholders in general, even at potential environmental cost.

However, ClientEarth, a non-governmental organisation (NGO) and shareholder in Royal Dutch Shell PLC, has recently announced a prospective derivative claim against Shell’s board members. ClientEarth claims that Shell’s directors have failed to meet their duties under s172(1)(d) as concerns the 1.5°C temperature goal of the Paris Agreement and Shell’s own net zero emission ambitions. The case, should it proceed, will again test s172(1)(d) and may well produce a different result.

Some ESG laws have produced little to no enforcement action. There has been no material enforcement under the Modern Slavery Act 2015, and enforcement under the Corporate Manslaughter and Corporate Homicide Act 2007 is relatively rare.

However, environmental regulators are levying increasing fines against companies that fail to meet expected standards. A record fine of more than £90m was issued against Southern Water in 2021 for widespread pollution involving 6,971 unpermitted sewage discharges. In 2020, Flybe was fined £51.9m for an emissions breach. Monarch and Thomas Cook, who breached the same legislation, received fines of £48.1m and £32.1m, respectively. All three airlines have since entered a formal insolvency process.

Potential ramifications for directors of insolvent companies

Several circumstances, including Covid-19, led to these three airlines becoming insolvent. However, it is likely an insolvency officeholder will investigate the decisions of directors that led to a company attracting millions of pounds in environmental fines, particularly if they significantly impacted on the company’s solvency. Taking the above examples, the question the insolvency officeholder will be asking is, was it in the creditors’ best interests to make decisions that led to polluting the environment or breaching emissions limits that negatively impacted the financial state of the company?

An administrator or liquidator could argue that directors are guilty of breaching their Companies Act duties for allowing or causing those acts or omissions to occur. This is particularly the case where such acts attract regulatory sanctions and associated negative publicity that impacts upon the company’s reputation and cash flow and perhaps results in its failure.

Further, where a company holds itself to a certain ‘green’ standard (i.e. a commitment is made to source parts sustainably or ensure its carbon footprint is offset), directors should be wary of an investigation by officeholders where the company has fallen below that standard. If that standard is one of the company’s main USPs and a key draw for investment, failure to meet those standards could lead to a loss of company reputation, shareholder investment and liquidity issues. It follows that any director who conducts business with flagrant disregard for stated ESG commitments to maximise financial returns could be considered as acting with the intent to deceive and defraud creditors and customers. A potential insolvency officeholder may consider whether fraudulent trading has occurred.

Future ESG regulation

The UK recently introduced mandatory climate-related financial disclosures in accordance with the recommendations of the Taskforce on Climate-related Financial Disclosures (TCFD). The disclosure recommendations require companies to disclose the risks and opportunities that arise from climate change. The TCFD guidelines focus on four main pillars: governance, strategy, risk management, and metrics and targets.

The aim of such disclosures is to allow the measure of carbon; it can be used to assess where carbon is emitted and allocate capital accordingly. Asset managers and owners must report on TCFD by 2022. By the end of 2023, mandatory climate-related disclosures will apply to most UK registered companies and banks. All companies will be required to make these disclosures by 2025.

The UK has also announced its plans for Sustainability Disclosure Requirements (SDR), which effectively broadens the scope of TCFD as it includes reporting sustainability factors. The EU has a similar regulation already in place (Sustainable Finance Disclosure Regulation (SFDR)), which will partially come into force in June and applies to UK financial institutions that operate either in the EU or manage EU-based clients. The UK will implement its own taxonomy (adopting one similar to the EU’s taxonomy) around 2023.

There is no doubt that ESG law and regulation is on the increase. Consequently, directors will be increasingly scrutinised in an ESG context. A director owes duties to its shareholders at first. But if a company becomes insolvent or potentially insolvent, that duty is then owed to creditors. It follows that wherever a company enters formal insolvency, if officeholders find breaches of ESG (which are expected to become more prevalent) that have caused the company loss, they may seek to recoup losses from the directors who caused those breaches.

As ESG law and regulation emerges as a key consideration for both consumers and legislators, directors are encouraged to give due consideration to their ESG responsibilities. Understanding current and upcoming requirements properly will place directors ahead of what is expected to be significant public and legal scrutiny. To avoid any potential claims against directors in an insolvency context, it is advisable that they ensure the companies they are in charge of meet their responsibilities now rather than become personally responsible for failing to meet them later.

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This communication has been authorised by Arthur J Gallagher Insurance Brokers Limited for the purpose of s21 of the Financial Services and Markets Act 2000