New sustainable corporate governance requirements on the horizon

The importance of sustainable corporate governance has been a central theme of the EU’s sustainability policy approach since the launch of the Sustainable Finance Action Plan in 2018. Concerned that companies are focusing too much on short-term financial performance, the Commission has been investigating whether corporate governance needs to be realigned with the longer-term horizons and broader considerations needed to transition to a sustainable economy.

Following studies into the root causes of short-termism and into supply chain due diligence requirements, the European Commission launched a consultation on sustainable corporate governance on 26 October 2020. The consultation is a preliminary step towards a future policy intervention, seeking feedback on potential changes to a number of aspects of corporate governance, which we discuss below.

Clarifying directors’ duty of care

The Commission’s research into sustainable corporate governance¹ (the Corporate Governance Study) argued that one of the key drivers for short-termism is a tendency for directors’ duties and company’s interests to be interpreted narrowly, with a tendency to favour the short-term maximisation of shareholder value. 

In the consultation, the Commission is seeking feedback on whether directors’ duties of care should be more clearly defined in legislation. This could include embedding a duty for directors to consider a wider range of stakeholders and to balance the interests of all stakeholders, rather than giving primacy to shareholders.  This could extend to an obligation to identify the relevant stakeholders and to implement procedures to ensure that adverse environmental, human rights and social impacts on stakeholders are addressed.

Strengthening enforcement of directors’ duties

The Corporate Governance Study also found that limited enforcement of directors’ duties to act in the long-term interest of the company was driving a narrow understanding of their duty of care. The Commission is now examining whether it needs to strengthen enforcement mechanisms outside of internal board structures and general meetings of shareholders. This might include an enforcement role for civil society stakeholder groups, such as those representing employee or environmental concerns.

Remuneration of directors

The role of remuneration in incentivising behaviour consistent with sustainability objectives has received increasing attention within the EU. 

The Corporate Governance Study found that board remuneration structures incentivise the focus on short-term shareholder value rather than long-term value creation for the company. 

The Commission sought views on whether directors’ variable remuneration should be tied to non-financial performance in its consultation on the new iteration of the Sustainable Finance Action Plan for the Von der Leyen Commission, the Renewed Sustainable Finance Strategy. To supplement this, the current consultation seeks additional feedback on a number of different approaches to aligning directors’ remuneration with a long-term approach, including compulsory sustainability metrics for remuneration and requiring the inclusion of carbon emission reductions in the factors affecting variable remuneration.

This echoes draft guidance by the European Central Bank² on how firms should prudently manage climate-related and environmental risk, which includes expectations that firms ensure their remuneration policy and practices are consistent with their climate-related and environmental risk approach.

Mandatory due diligence in the supply chain

The potential need for requirements for companies to undertake appropriate due diligence throughout the supply chain was flagged in Action 10 of the Sustainable Finance Action Plan in the context of sustainable corporate governance. 

The Commission published a report on due diligence in the supply chain³ (the Due Diligence Study) in February 2020. The study concluded that current practices are not sufficiently widespread to incentivise good practice, and that overall stakeholders preferred a cross-sectoral approach.

The consultation on the Renewed Sustainable Finance Strategy explored views on whether an EU framework for supply chain due diligence related to human rights and environmental issues is needed, and whether that should apply to all companies, including small and medium sized enterprises (SMEs). The current consultation seeks more detailed feedback on potential interventions, including whether the new due diligence requirements should cover any or all of the following:

• human rights (including labour rights, occupational health and safety, decent wages and working hours)
• climate change mitigation
• natural capital (including biodiversity loss)
• land degradation
• ecosystems degradation
• pollution
• efficient use of resources and raw materials
• hazardous substances and waste

The Commission is also considering if a mandatory corporate due diligence duty should be accompanied by an enforcement mechanism. This could include civil liability or enforcement via supervision by national competent authorities.

Sustainability expertise of the board

The Corporate Governance Study identified lack of expertise in sustainability at board level as one of the key problem drivers. The Commission is considering how directors’ competence in this area could be enhanced, potentially including requirements for companies to have a certain proportion of board members with environmental, social and/or human rights expertise or regular assessments of board expertise in this area complemented with regular training. 

Next steps

The consultation closes on 8 February 2021. A formal proposal is expected to be published by the Commission in Q2 2021, but further detail on the direction of the new initiative may be included when the Commission publishes its Renewed Sustainable Finance Strategy (now expected to be in Q1 2021).

Whilst the Commission is considering a number of policy options, both legislative and non-legislative, it is clear from comments by the European Commissioner for Justice earlier this year that the mandatory due diligence requirements at least are likely to take the form of a directive or regulation.⁴ 

Usually, the formal responses of the co-legislators follow the Commission proposal. However, the European Parliament has been proactively focused on this topic, particularly with respect to mandatory due diligence. Last Autumn, it published a draft own report with recommendations to the Commission on corporate due diligence and corporate accountability⁵, including calls for a directive on corporate due diligence which would apply to all economic sectors, including the financial sector. It seems likely that the Commission will follow a similar broad scope: Didier Reynders stated⁶ yesterday that he wants obligations to apply to all different sectors and to create a level playing field across the Union.

The publication of this consultation marks an important step in the EU’s sustainability/ESG policy programme, demonstrating how wide its ambitions reach. For more information on sustainable corporate governance, human rights or sustainability/ESG more broadly, please contact the following or your usual Allen & Overy contacts.

Author: Kelly Sporn.

Matt Townsend (Partner)
Environmental and Climate Law 
Matthew.Townsend@allenovery.com 

Suzanne Spears (Partner)
Business and Human Rights Law
Suzanne.Spears@allenovery.com 

Jonathan Benson (Senior Associate)
Environmental and Climate Law
Jonathan.Benson@allenovery.com

Kelly Sporn (Senior Policy Advisor)
Environmental and Climate Law
Kelly.Sporn@allenovery.com

Footnotes

1. _{“Study on directors’ duties and sustainable corporate governance: final report”, published July 2020.}
2. _{“ECB Guide on climate-related and environmental risks”, draft published May 2020}
3. _{“Study on due diligence requirements through the supply chain”, published February 2020.}
4. _{In April 2020, European Commissioner for Justice, Didier Reynders, confirmed that the Commission would introduce legislation on mandatory corporate human rights and environmental due diligence in 2021.}
5. _{2020/2129(INL)}
6. _{In a seminar on “Corporate responsibility for supply chains: which framework for the EU” held on 27 October 2020.}