CGj reviews the Institute’s latest research paper, published in collaboration with Ben McQuhae & Co, highlighting directors’ duties to take into account environmental, social and governance (ESG) developments for sustainable business operations.
Integrating ESG into business strategy is increasingly recognised as a core part of good governance and effective risk management. Directors therefore have every incentive to give ESG appropriate consideration, but a new research paper published by the Institute in November 2022 highlights an additional, and perhaps even more persuasive, incentive for directors to adequately address ESG matters – namely, that directors who fail to do so can be deemed to be negligent in the performance of their directors’ duties.
The research paper, Legal Developments in Directors’ Duties and ESG – What Every Hong Kong Company Director Should Know (the Paper), serves as a wake-up call to any directors under the illusion that ESG falls outside the remit of their fiduciary duties, or their duties to exercise care, skill and diligence. It clarifies the standards expected of directors for properly discharging their duties in respect of ESG considerations with reference to existing legal and regulatory requirements.
It also makes the point that directors need to stay informed, not only of changes to the local regulatory regime, but also of the broader, global developments that are informing the trajectory of those regulations, as well as stakeholder expectations. Governance professionals can play a crucial role here and the Paper emphasises their role in ensuring that material ESG issues get the attention they deserve at the board level.
ESG is a board responsibility
1. The statutory obligations
One of the reasons that directors are not always aware of the personal liability they potentially face if they fail to effectively oversee the ESG function is that there is currently no express common law authority or statutory provision under Hong Kong law obliging directors, in the discharge of their duties (fiduciary or otherwise), to consider ESG considerations.
The Paper points out, however, that directors should not assume that they are not under any legal obligation to have regard to ESG considerations under Hong Kong law. On the contrary, because directors are legally obliged to act in the best interests of the company, and to exercise reasonable care, skill and diligence in the performance of their functions, they are obliged to consider any ESG issues that affect the company’s interests.
The ESG issues with material significance for companies will of course depend on the specific industry and circumstances of each company, but there are few companies unaffected by core ESG issues such as climate change, for example, and a failure by the board to consider such issues would be likely to have an adverse impact on the business and operations of the company.
Moreover, the Paper points out that directors are increasingly subject to legal requirements relating to the disclosure of their ESG strategies and performance. Schedule 5 of the Companies Ordinance specifies that the business review that companies have to include in their annual reports must include a discussion of the company’s environmental policies and performance, and a discussion of the company’s compliance with relevant laws and regulations.
2. The regulatory requirements
Directors of listed or regulated entities also have to take note of relevant non-statutory requirements – notably the Listing Rules or ESG-related regulations introduced by their regulator. Indeed, the Listing Rules play an arguably more critical role in the regulation of companies in Hong Kong since they apply to all companies listed on The Stock Exchange of Hong Kong, irrespective of their jurisdiction of incorporation.
The Paper points out that Hong Kong Exchanges and Clearing Ltd (HKEX) has been progressively tightening the Listing Rule requirements relating to listed companies’ management of ESG issues. Companies are required, for example, under the Environmental, Social and Governance Reporting Guide (Appendix 27 of the Main Board Listing Rules), to report on the board’s overall responsibility for the company’s ESG strategy and reporting. The Corporate Governance Code (Appendix 14 of the Main Board Listing Rules) also includes an explicit link between ESG and corporate governance – requiring directors, as part of their annual review of their risk management and internal controls systems, to consider the effectiveness of their ESG governance structure.
Since a primary duty of directors is to ensure compliance with regulations, a breach of the Listing Rules is likely to be deemed a breach of a director’s duty to exercise reasonable care, skill and diligence. Moreover, the Listing Rules are not the only rules of relevance to directors’ ESG obligations. ESG regulations have been introduced by the Securities and Futures Commission (SFC) and the Hong Kong Monetary Authority (HKMA). Directors working for financial institutions in Hong Kong will therefore need to consider the SFC or the HKMA’s requirements. These include requirements relating to incorporating climate considerations into the company’s governance, strategy, risk management, and disclosure policies and procedures.
The importance of effective board oversight of ESG issues has been a key theme of Hong Kong’s major regulators and of the emerging international consensus on ESG and sustainability best practice. Indeed, the Paper warns that international trends will continue to raise the bar for directors in Hong Kong.
‘Directors should be mindful that the range and breadth of ESG-related obligations will certainly expand as the ESG policy and regulatory landscape evolves, including through the adoption in Hong Kong of sustainability reporting standards developed by the International Sustainability Standards Board (ISSB),’ the Paper states.
In particular, directors of listed companies in Hong Kong should be preparing now for a new requirement to report on their Scope 3 greenhouse gas (GHG) emissions. Scope 3 emissions include all indirect emissions that occur in the value chain of companies, both upstream and downstream. Regulators in Hong Kong have committed to aligning Hong Kong’s ESG regime with the finalised sustainability standards about to be launched by the ISSB – standards that will certainly require Scope 3 reporting.
The purpose of the Institute’s latest research paper is not only to make directors more aware of the personal liability they potentially face for ESG breaches, it also makes suggestions on how they can avoid such breaches. First and foremost, it urges directors to stay adequately informed of ESG developments.
‘They need at least to have access to information via internal or external sources about ESG considerations affecting, or potentially affecting, the company, the likely consequences for the company, and how the company is currently monitoring and managing such considerations,’ the Paper states.
Directors should proactively make inquiries to obtain the necessary information, or to seek appropriately qualified and independent expert advice where necessary, but governance professionals also have a part to play in this.
‘As advisers to boards on governance-related matters, governance professionals need to be well-equipped to ensure regular board consideration of ESG risks and their implications for the company’s business. Directors might find it helpful to seek advice from governance professionals, including company secretaries, to ensure that consideration of ESG risks and implications is a regular agenda item. Boards and governance professionals are reminded to seek duly qualified assistance regarding ESG matters where necessary,’ thePaper states.
Determining the level of detail required by directors will be a difficult judgement for governance professionals and will depend on the specific circumstances of each company. Nevertheless, the Paper points out that the information should go beyond changes to the local regulatory regime.
‘The global ESG regulatory landscape continues to evolve and expand across jurisdictions. To enable directors to properly and continually discharge their ESG-related obligations in Hong Kong, directors would be well advised to keep ahead by staying informed of the direction of travel, such as via public statements by Hong Kong’s regulators and policymakers, and developments in other key jurisdictions,’ the Paper states.
Developments in other jurisdictions, the Paper points out, may be an indication of how Hong Kong’s own regime will evolve in the years ahead. Many jurisdictions have express statutory provisions that either permit or obligate directors to consider ESG matters and stakeholder interests in discharging their fiduciary duties to the company.
The Canada Business Corporations Act, for example, permits directors to have regard for the environment and stakeholders, such as employees and consumers, in their pursuit of the company’s best interests. The UK Companies Act imposes a clear affirmative duty on directors to consider a number of factors when discharging the duty to act in utmost good faith to promote the company’s success. These factors include the interests of employees, the impact of company operations on the community and environment, the need to foster the company’s business relationships with suppliers, customers and others, and the importance of maintaining a reputation for high standards of business conduct.
The EU’s proposed Corporate Sustainability Due Diligence Directive, currently under debate in the European Parliament, would impose a duty of care on directors, when fulfilling their duty to act in the best interest of the company, to ‘take into account the consequences of their decisions for sustainability matters, including, where applicable, human rights, climate change and environmental consequences, including in the short, medium and long term’.
The Directive would also impose an obligation on directors to put in place and oversee processes and policies for conducting human rights and environmental due diligence of company operations, and to give due consideration to relevant input from stakeholders and civil society organisations. A reporting mechanism is to be implemented at the board level. Directors would have to adapt the company’s corporate strategy to consider the actual and potential adverse impacts identified under the due diligence exercises, and the remedial measures taken.
The Institute’s latest research paper also highlights the fact that claims relating to an alleged breach of directors’ duties are not hypothetical. Royal Dutch Shell PLC is currently facing a breach of directors’ duties claims specifically related to alleged ESG failures. In March 2022, ClientEarth, a non-governmental organisation and shareholder in the company, launched a derivative claim against Shell’s board members. The claim seeks to secure:
- a declaration that the directors are in breach of their duties under the UK Companies Act 2006 to promote the success of the company (section 172) and to exercise reasonable care, skill and diligence in carrying out their roles as directors (section 174), and
- an order that the directors should adopt an energy strategy that includes GHG reduction targets that are aligned to the goals of the UN Paris Agreement (which seeks to limit the global temperature increase in this century to 1.5°C above pre-industrial levels).
The claim is still in its early stages, but, whatever the outcome of the case, the Paper emphasises the need for directors to ensure their and their company’s compliance with the ESG obligations under existing legal and regulatory requirements.
‘We are of the view that directors of listed companies are obligated, both under existing legal principles in relation to directors’ duties and the Listing Rules, to pay due regard to ESG considerations in managing the company’s affairs,’ it states.
The operating environment for companies in Hong Kong will continue to evolve, but the Institute’s latest research paper makes it very clear that directors cannot afford to neglect their ESG obligations.
‘The ESG obligations imposed on directors under relevant ESG regulations will likely influence and shape the scope of directors’ duties in respect of ESG considerations. In light of the current and anticipated future regulatory environment, it will become increasingly complex, if at all possible, for a director of a regulated entity to act reasonably if they fail to reasonably consider and/or manage relevant and material ESG risks affecting the company,’ the Paper states.
Legal Developments in Directors’ Duties and ESG – What Every Hong Kong Company Director Should Know can be accessed via the Thought Leadership/Research Papers sections of the Institute’s website: www.hkcgi.org.hk.
The Institute is grateful for the contributions of Ben McQuhae and his team to the Paper, with input from Ernest Lee FCG HKFCG(PE), Institute President; Gillian Meller FCG HKFCG(PE), Institute Past President; April Chan FCG HKFCG, Institute Past President and Chairman, Technical Consultation Panel; and Mohan Datwani FCG HKFCG(PE), Institute Deputy Chief Executive.