The importance of environmental, social, and corporate governance (ESG) is on the rise, with legislators, regulators, and non-governmental actors around the world creating laws and standards on ESG. Though most of the action has occurred in Europe, ESG is gaining significance in the United States as well. A heated debate about the SEC’s proposed climate-disclosure rules is running at full throttle, for example, and the battle over ERISA rules on pension plan fiduciaries’ duties has just begun.
In a forthcoming chapter, I argue that these wide-ranging developments have brought corporate governance to the threshold of a fundamental change, especially in the area of corporate fiduciary law. Traditionally, the implicit assumption underlying corporate law rests on three pillars: (1) Fiduciary duties are creatures of national or state law, (2) the inclusion of stakeholder interests leads to a many-masters problem of responsibility for board members’ actions, (3) and the result is loss of corporate law’s capacity to regulate behavior through the threat of liability for corporate mismanagement. This traditional narrative has come under serious doubt. It is true that the vast majority of new ESG standards attach to the corporation and do not subject individual directors to specific duties. Yet ESG encroaches on the fiduciary relationship of the directors and the corporation due to a corporate-law mechanism that translates the “exterior” duties of the corporation into “interior” duties of the directors:
Directors may not breach any positive law the corporation has to uphold, even if they believe that this action would maximize shareholder value. Causing the corporation to break the law amounts to a violation of the duty of loyalty. As a result, international and transnational ESG standards increasingly overlay or modify national and state fiduciary law. Inch by inch, an ever-higher number of legal norms engulf the relationship between a corporation and its directors. The consequences are significant because directors who consciously break the law cannot resort to the business judgment rule (BJR).
Contrary to what many believe, instead of strengthened, the BJR is weakened in correlation to the growth of ESG-related positive legal norms. Where the law determines managers’ decisions, directors must abstain from what otherwise might have been their course of action when considering the demands of business.
Compliance and oversight duties operate as amplifiers. The board has a duty to monitor “the corporation’s operational viability, legal compliance, and financial performance [].”[1] Thus, an increasing number of legal norms the corporation has to comply with implies expanding oversight duties. In combination with recent developments in how courts construe compliance duties, matters become even more complicated for directors. Compliance systems, properly designed, ensure that board members act in accordance with their duty of care to be informed of all material information reasonably available before making a business decision. A failure to make that effort, e.g., through failure to install a working oversight system which directors adequately monitor, is not protected by the BJR.
Accordingly, the expanding body of ESG norms has the effect of a two-pronged attack on the BJR. Under the duty of loyalty, directors must act within the law and install a compliance system that keeps pace with the accelerating growth of ESG requirements. If they fail, either through breach of positive law or failure to exercise due care in overseeing the corporation’s operations, the board members cannot avail themselves of the protection of the BJR. Heightened ESG standards correlate with a more demanding duty of loyalty, resulting in a proportional weakening of the BJR.
Many of these changes result from national or state corporate law, e.g., through the introduction of national supply-chain regulation. They do not stand alone, however. ESG is a movement based on international “soft law” and transnational processes of norms crossing borders through lawmaking and private ordering. Increasingly, national laws interlace with international frameworks, one example being sec. 2(1)-(3) of the recent German Act on Corporate Due Diligence Obligations in Supply Chains, which refers to a plethora of international agreements, protocols, and the like. Moreover, international norms and transnational legal ordering become relevant for oversight duties. Their reach and the level of detail of compliance systems depend in no small part on which ESG aims and international standards corporations subscribe to, even though the relevant norms may not have the quality of positive law. Committing to “soft law,” like the UN Guiding Principles on Business and Human Rights, in a contract can turn non-binding international norms into enforceable “hard law,” triggering the duty to monitor legal compliance. Though the duty itself may remain the same, it is charged with content wrought by international organizations and private actors.
The chapter offers a two-fold contribution to the literature: an account of the forces driving the internationalization and transnationalization of corporate fiduciary law and standards and a functional perspective on how these developments affect the BJR and managerial discretion in comparative perspective.
ENDNOTE
[1] Marchand v. Barnhill, 212 A.3d 805, 809 (Del. 2019). For Germany, e.g., §°93(3) Stock Corporation Act (Aktiengesetz).
This post comes to us from Thilo Kuntz, chair in private, commercial, and corporate law and managing director of the Institute for Corporate Law at Heinrich-Heine-University in Düsseldorf, Germany. It is based on his recent chapter, “ESG and the Weakening Business Judgment Rule,” forthcoming in Research Handbook on Environmental, Social, and Corporate Governance, and available here.