The Intersection of Risk and Responsibility: Role of Corporate Governance in Mitigation of the Risk of ESG Litigation

 “Corporate Governance” means the process and structure used to direct and manage business affairs of the corporate body towards enhancing prosperity and corporate accounting with the ultimate objective of realizing shareholders’ long-term value while taking into account the interests of other stakeholders. “Good corporate governance seeks to attract capital, to ensure proper company management and administration (mainly for those that issue securities on stock exchanges), to protect investors and other interest groups’ rights, to build confidence in financial markets, and to promote competitiveness.”^[1]

In recent times, investors, regulators, and other stakeholders have increased their focus on Environmental,Social, and Governance (ESG) Factors of the firm while assessing the long-term sustainability of the firm. These ESG Factors include a range of issues from ethical governance practices, corporate social responsibility, environment-friendly abilities of the firm, and sustainability. However, these factors are increasing various issues that could potentially tarnish the image of the firm such as labor rights violations, corporate governance scandals, lack of sustainability, environmental degradation, etc.^[2]

Recently, there has been an extreme rise in ESG litigation across the globe. The report of the United Nations Environmental Program (UNEP) 2023 has demonstrated the figures of environmental litigation. Various firms or companies are being targeted over their part in climate change and their contribution to the degeneration of the environment.[3] There is a basic duty to care that any organization owes to the public in general. However, the breach of this duty has led to an increase in ESG litigation. Even if there hasn’t been as much (corporate) governance litigation up to this point, ESG-fit corporate governance is and will continue to be crucial since new laws may increase liability and lawsuit risks.

ANALYSIS:

India is the most populous country in the world. Due to this India not only attracts a momentous foreign investment but several Indian companies compete in the global market in terms of products and services and capital markets. India has received much global attention due to its experiments in the corporate sector on the stakeholders.

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What are ESG Risks?

The origin point of an environmental risk can be internal or external. Therefore, while such risks are being pinpointed, the company needs to check if these risks are being posed by its operations, and supply chains, that is if they are endogenous or exogenous. Social risks are not only limited to the stakeholders of the company but also extend to human rights violations resulting from situations in local communities impacted by the business and its suppliers as well as worldwide supply networks. A change in the company’s organizational structure or contractual agreements can impact the social risks posed to the organization. The strength and ingenuity of the company’s processes for adhering to the framework of pertinent rules and regulations, within which the firm works, are linked to governance risks.[4]

 Mitigation of ESG Litigation:

1. Responsibility of the Board and Transparency:

Various factors influence and elevate the ESG Board agenda. The Companies Act, 2013 provides for the composition of a Board of Directors.^[5] The Board of Directors of a firm is responsible for the implementation of ethical and environmentally friendly practices that align with the shareholders, and other stakeholders and also do not violate legal constraints. Section 166(2) of the Companies Act mandates the directors of the company to act in good faith and take actions that are beneficial for the company’s members, employees, shareholders, environment, and the community at large.[6] Clause (3) of the same section provides that the directors should exercise their duties with skill, and due diligence, and they should use their best judgment.[7] Several issues, including investor demands, the relationship between ESG and cost of capital and firm value, the influence of "E" and "S" factors on business models, regulatory pressure to disclose ESG information, and legal concerns, are pushing ESG further into the mainstream agenda.

The policies of the board play a pivotal role in setting the tone and also in altering the approach of the organization towards ESG issues. To effectively utilize the funds of the corporation and to navigate through the dynamic surrounding ESG, the management may adopt a triple-bottom-line approach that takes the company, community, and environment into consideration.

A director of a company works like the delegate of the members of that company and thus is expected to act in consistent with the principle of delegatus non potest delegare. With various industries in the picture, there is no size fits all mechanism for ESG issues. These models include complete board oversight with the ability to bring in necessary knowledge and skills requiring an existing committee to support the board, creating a dedicated board committee for ESG, creating external advisor councils to provide recommendations on ESG to the board, creating stakeholder councils with representation from a variety of stakeholders to gain their perspectives, or a combination of all these methods.[8]

In India, certain organizations need to inculcate mandatory committees of the board members and these committees can specialize in the issues of ESG. They may oversee risk management, and CSR activities, NRC, auditing, etc. An interplay among such committees is essential.

 Legal Compliance

In comparison to environmental and social issues, companies received greater scores for policy disclosures and governance factors. This pattern is explained by the fact that throughout the previous 20 years, governance improvements have been turned into laws, with regulatory bodies requiring the creation of many policies.[9]

Recently the regulatory factors in India have started focusing on ESG in the corporates. No place has given ESG a more prescribed status than India, where the Companies Act 2013, the fundamental corporate statute, goes into great detail regarding firms’ duties to act in a way that helps the public good in addition to their shareholders. The CSR activities in India are legally mandated to the companies Indian companies are legally mandated to comply with the CSR requirements by contributing a certain amount towards social activities, thereby conflating corporate philanthropy with CSR.

3. Stakeholder Engagement

Due diligence procedures, ESG risk management, and the disclosure policies that accompany them don’t develop in a vacuum. Certain stakeholders and investors may disagree and insist that a particular risk be addressed or acknowledged, even when the company’s board of directors and auditors, acting in good faith and under their fiduciary obligations, deem it inconsequential. From the perspective of their portfolio, an investor’s interests in other firms that are influenced by the operations of the first company may increase the risk associated with the first company. Then, the issue of whether the corporation or the investor should pay for mitigating the portfolio risk of a particular investment emerges. This exemplifies how diverse the investor community is in terms of investing strategy, risk tolerance, and credentials. An effective corporate governance framework offers effective rules-based mechanisms to arbitrate any discrepancies in investor preferences, including exit opportunities for shareholders who dissent.

 Recently, a startup named “Breathe ESG” raised a funding of 2.6 crores. Breathe ESG offers SaaS i.e. Software as a service for sustainable management and reporting of the company.

In 2009, a global IT Company named Satyam Computers based in India, reported the biggest scam of financial activities. The CEO, Ramlingam Raju took responsibility for the inconsistencies in the accounting which claimed that the company possessed profits and revenue and cash reserves amounting to 1.04 billion dollars but it did not exist in real life. This case highlights the practical importance of corporate governance. Satyam Computers was awarded the Golden Peacock Award for Corporate Governance by the World Council for Corporate Governance in 2008. The responsibility for this fraud could be attached to one or two individuals who did not realize back then that small discrepancies they would create would lead to a gigantic problem later.^[10]

The global economy is impacted by such kinds of activities that they have an impact on all of us. The capitalist system itself is in danger if there is insufficient trust in the idea that businesses would behave in good faith

CONCLUSION:

When Corporate Governance is considered from the perspective of ESG factors then it implies effective management techniques that promote environmental sustainability, governance transparency, accountability, and efficiency in the organization and the business environment. When Corporate Governance establishes strong mechanisms that take responsibility for the actions of the firm, and take into account the interest of the shareholder and also the employees, customers, environment, and all other stakeholders. The governing body and its composition, control systems, decision-making, structure of the management, and ethics are all included in the formation of these strong mechanisms.

Similar to other risks, the risk of ESG differs across companies and industries. Identifying the mechanisms that a company can put into place to mitigate the risk of ESG is a complex task. Pragmatically, companies should consider such characteristics while deciding the ESG policy of the organization

Author: Siddhi Jakatdar

REFERENCES

Good corporate governance: Does it pay in Peru? Journal of Business Research

Does effective corporate governance mitigate the negative effect of ESG controversies on firm value? Economic Analysis and Policy.

·         United Nations Environmental Program (UNEP), Global Climate Litigation Report 2023 Status Review.

·         What Matters in Corporate Governance? 22 (2) REV. FIN. STUD., 783 (2009)

·         Mainstreaming ESG and Role of the Board, Journal on Governance (2022).

·         Implications of Corporate Governance on Financial Performance: An Analytical review of Governance and Social Reporting Reforms in India, Asian Journal of Sustainability and Social Responsibility (2018).

·         ‘The Satyam Scandal’ (Forbes, 7^th January 2009) www.forbes.com/2009/01/07/satyam-raju-governance-oped cx_sb_0107balachandran.html?sh=7399deaf3044

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^[1] Fuenzalida, D., Mongrut, S., Arteaga, J. R., & Erausquin, A. (2013), Good corporate governance: Does it pay in Peru? Journal of Business Research, 66(10), pg. 1759–1770

^[2] Zihao Wu, Siliang Lin, Tianhao Chen, Chunyang Luo, Hui Xu, Does effective corporate governance mitigate the negative effect of ESG controversies on firm value? Economic Analysis and Policy, Volume 80,2023, Pages 1772-1793

[3]United Nations Environmental Program (UNEP), Global Climate Litigation Report 2023 Status Review,  <www.unep.org/resources/report/global-climate-litigation-report-2023-status-review>(Last accessed  24.05.2024)

[4] Lucian A. Bebchuk et al., What Matters in Corporate Governance? 22 (2) REV. FIN. STUD., 783 (2009), <https://ssrn.com/abstract=593423>

^[5] Section 149(1), Companies Act, 2013

[6] Section 166(2), Companies Act, 2013.

[7] Section 166(3), Companies Act, 2013.

[8] Dr. Niraj Gupta and Amar Chanchal, Mainstreaming ESG and Role of the Board, Journal on Governance (2022), Volume 05 (01).

[9] Puneeta Goel, Implications of Corporate Governance on Financial Performance: An Analytical review of Governance and Social Reporting Reforms in India, Asian Journal of Sustainability and Social Responsibility (2018), Volume 04. <//https://doi.org/10.1186/s41180-018-0020-4> (Last accessed  24.05.2024)

^[10] Forbes, ‘The Satyam Scandal’ (Forbes, 7^th January 2009) www.forbes.com/2009/01/07/satyam-raju-governance-oped cx_sb_0107balachandran.html?sh=7399deaf3044 (Last accessed  24.05.2024)