Management decisions around ESG are on the rise as legislators, activists, proxy advisers, and other stakeholders increasingly aim to push boards to implement measures that go beyond financial interests. Debates around “corporate purpose” or a “raison d’être” – contentious as such concepts may be – further serve to fuel this trend. We increasingly are seeing corporates undergoing a transformation of their business to more sustainable models that has itself triggered financial and ESG battlegrounds. Examples include the comprehensive switch of main production, e.g., in the context of “green steel” or “electromobility”, the complete withdrawal from certain business models, such as fracking, and carve-outs (and sale) of ESG-risky business units as well as the termination of relationships with customers in ESG-adverse sectors. Furthermore, current geopolitical conflicts, such as the war between Russia and Ukraine or the US / China decoupling trend, are making decisions around ESG even more complex and attract strong public interest.
Under these scenarios, can board members continue to rely on the business judgement rule, traditionally understood to be a “safe harbour” from liability for business decisions? In this blog post, we argue that while a trend towards increased regulation narrows the conceptual applicability of the business judgement rule, growing attention by stakeholders on the “ESG footprint” of a company and the effects this can have on its economic prospects may provide greater latitude to boards when taking decisions for the long-term good of the company.
The "safe harbour" concept of the business judgement rule
The “safe harbour” concept of the business judgement rule originated in common law jurisdictions but has become a long-standing centrepiece for questions of board liability for many corporate-law systems worldwide, including Germany. It serves to protect commercial decisions taken by directors from “hindsight scrutiny” and thereby frees them to take reasonable economic risks for the good of the company – as long as the decision-making meets certain standards.
While eligibility requirements for entering the safe harbour differ between jurisdictions, there are generally some common denominators: The directors must be free from conflicts of interest, they must act on a well-informed basis, and they must reasonably believe in good faith that the business judgement taken by them (following careful consideration) is in the best interests of the company.
Whether legal obligations set the ultimate boundaries for this privilege or not is handled more strictly in some jurisdictions (e.g., Germany, where erroneous legal interpretations may at most exculpate a director) than others (e.g., US state law, which tends to be interpreted more broadly to include “legal judgements”). Actions that clearly violate statutory or regulatory standards, however, normally never enter the safe harbour, as the duty to act in compliance with applicable laws bar corresponding decisions from such approval in the first place (i.e., “law as limit”).
ESG regulation and the narrowed scope for “business” decisions
Increased attention of regulators on ESG has a palpable influence on this framework. Understood correctly, the acronym is not a self-standing concept but rather refers to three categories – environment, social, and governance – that companies should consider and that span a broad range of policies, interests and risks.
Due to high attention and vocal pressure from the public, regulation in these areas has picked up considerable speed. Regarding environmental and social matters, the supply chain is one of the most prominent examples. To name but one initiative, the proposed European Corporate Sustainability Due Diligence Directive (CSDDD) which has recently emerged on the legislative horizon (see our latest blog post here) aims to protect environmental standards and human rights in the supply chain and foresees direct corporate liability for shortcomings. Similarly, increased regulation of ESG reporting (e.g., the Corporate Sustainability Reporting Directive (CSRD, see our latest blog post here) or proposed SEC regulations) is often considered to not only concern backwards-facing reporting, but also affect forward-facing corporate strategy. Lastly, decisions on executive pay may also serve as an example within the “governance pillar”, with regulation on variable remuneration more often referring not only to long-term value creation but specifically also to sustainability goals.
Taking into account the “law-as-limit” principle described above, this growth in regulation in the ESG space indicates that directors’ decisions will increasingly be determined by set rules, adherence to or transgression of which does not fall within their discretion and therefore not under the protection of the business judgement rule. In this respect, regulation of ESG matters therefore narrows the entrance to the safe harbour for directors’ decision-making as it constitutes binding legal obligations for boards.
Balancing interests for the good of the company: the extended playing field
At the same time, the focus on ESG arguably provides increased room for manoeuvre once corporate decision-making has observed and passed through the boundary-setting gates of regulation. When balancing the interests at stake and taking a decision that it reasonably believes to be in the best interests of the company, the board can attribute weight more liberally to ESG considerations given their growth in materiality to their core business.
Arguably, this is not so much a question of belief in the long-running argument between shareholder value and stakeholder concepts as it is the plain realization that ESG topics, and the way they are implemented in corporate strategies, may not only influence the long-term success of the company but also influence short-term corporate value.
With this in mind, the consideration of ESG-related aspects and other stakeholder factors is indeed a prerequisite if the board is to act prudently and within the scope of the business judgement rule. Importantly, embracing ESG factors in the process of decision-making does not mean that such aspects must necessarily be given preference. Rather, the board must consider, weigh, and balance them with the other factors at stake in order to take a prudent decision and mitigate risks.
It should be kept in mind, however, that while the growing importance of ESG-related aspects may mean an increased room for manoeuvre for the management board in weighing the relevant factors at stake, investors will continue to have a strong say by replacing board members or just exiting the company.
Summary and outlook
As public attention to ESG and the drive towards increased regulation on these matters show no signs of decelerating, boards are well-advised to consistently stay on top of regulatory changes affecting their company’s business. While this is not a new concept, the pace at which the legal framework – especially as regards ESG regulations – for their decision-making is shifting has gained additional momentum. In this environment of complexity, the safe harbour of the business judgement rule is becoming increasingly important to protect board members from hindsight scrutiny and potential liability. The key to benefitting from the scope of this safe harbour not only lies in compliance with ESG regulation, but equally in carefully weighing and balancing ESG-related aspects for the board’s business decisions. Hence, implementing and regularly updating a robust ESG corporate strategy (in accordance with legal ESG developments) should be a key aspect of good board governance. Accordingly, seeking regular legal advice to assess the web of ESG regulations will be critical to assure that boards continue to benefit from the “safe harbour” protections under the business judgement rule.