Corporate governance is fast emerging as a critical area of sustainability, yet out of all of the topics under the environmental, social, and governance (ESG) umbrella, it is often the area that gets the least amount of focus.
To put it simply, corporate governance is an essential element of ESG simply because of the expanding environment of litigation risk across the ESG issue.
Vincent Walden, CEO of Kona AI and FRAUD Magazine columnist, says the expanding ESG risk environment, including potential concerns of fraud, is very real. “When company executives act in a different way that is counter to the company’s code of conduct or social norms, it can cause significant financial harm to the company and thus significantly increase pressure to cover up or misstate certain facts,” Walden says, adding that while this may not be outright fraud, the critical role of governance comes into play.
“If an organization does not have proper risk assessment, training, reporting, monitoring, and investigation protocols in place, the company’s corporate culture could suffer, which could open it up to a variety of fraud schemes, including asset misappropriation, corruption, or financial misstatement,” he explains.
However, defining ESG fraud is not so straight forward. In fact, from a legal point of view, it involves allegations of fraud related to ESG matters around misconduct or misstatements, according to Colleen Smith, partner and Global Vice Chair of the Securities Litigation & Professional Liability Practice at Latham & Watkins.
Increasing litigation across ESG areas
The reality is that allegations and complaints regarding ESG topics are increasing, no matter how these issues are framed. The heightened attention by regulators across the world — driven by the collective interest of investors, consumers, and the public — has brought scrutiny to corporations’ reporting and statements about ESG issues. The fact that public companies’ financial performance and stock price can move based on what information they disclose about ESG topics is a relatively new development.
Sarah Fortt, partner and Global Co-Chair of the Latham & Watkins ESG Practice, notes that these aforementioned related events have resulted in increased legal action across ESG issues, and further, that the scope of who is bringing legal action against whom is broadening. More specifically, Fortt and Smith agree that private consumer and shareholder plaintiffs both are making claims across a number of areas to include allegations of greenwashing, perceived supply chain abuses, and alleged misstatements or omissions regarding sustainability statements. In addition, corporate directors are increasingly targets of litigation regarding their perceived breach of fiduciary duty based on claims of lack of oversight or on a failure to comply, based on underlying ESG claims, they say.
Fortt says she expects to see the growth in litigation matters related to ESG to increase. In fact, she sees the pursuit of the claims regarding inequality as an additional emerging area for legal action on the horizon. Many companies have added “sustainability-related metrics as a lever in executive compensation, and allegations regarding executive compensation tend to emerge to the forefront of corporate governance during expected periods of economic downturn, stagnation, or uncertainty,” says Fortt.
Guidance for in-house lawyers
To reduce these ESG-related risks, Fortt and Smith are advising their clients to treat ESG in the same as any corporate reporting and compliance requirement. Specifically, they shared several ways in which corporate legal functions can stay abreast of ESG concerns, including:
Understand the data issues — First, in-house lawyers need to understand the degree to which ESG data is a challenge. “Even if there is not finalized regulation with respect to some of these matters in your jurisdiction, a lot of ESG data comes down to the boring work of ensuring rigor and consistency when it comes to setting up internal controls, auditing your processes around the KPIs [key performance indicators] that you are using and reporting,” Fortt states. However, the internal controls and audits tend not to be the responsibility of the corporate legal function, and attorneys need to understand the state of any data issues or gaps to in order to determine any potential exposure.
Kona AI’s Walden agrees, adding that lawyers need to become more comfortable with the transactional or structured data, such as payments to third parties, operational data, and other forms of financial data. “We are seeing attorneys becoming more tech savvy with respect to dashboarding, payment analytics, and predictive modeling to statistically identify potentially improper or corrupt payments and/or detect areas of financial misrepresentation,” Walden says, adding that this is also where accountants and attorneys can work hand-in-hand, each bringing their own areas of expertise.
Invest in learning to understand the deeper issues — Training your lawyers to think through not just the surface of what they hear from other corporate functions, but also the deeper layers and the implications that they have for ongoing effective internal reporting is really paramount.
To do so effectively, in-house lawyers consistently need to invest their effort in educating themselves on what ESG issues are important for their organization from the perspective of all stakeholders, including shareholders, employees, and customers — as well as to identify areas where additional effective controls are needed to mitigate risk. “Lawyers should counsel their clients as to the key risk areas unique to the business and ensure both that robust oversight controls are in place and that they are being followed,” advises Smith.
Advocate for proactive and consistent assessment, measuring, & auditing of corporate culture — Finally, in-house lawyers and executives, more broadly, need to measure and audit their corporate culture more effectively. Indeed, when situations of executive-level misconduct — such as a failed safety issue or a mishap from an ethics perspective — arise, cultural issues around the prevention of the appropriate internal reporting or a compromise in the reporting process are a popular key finding in the investigation process.
Companies talk a fair amount of corporate culture but find it challenging to actually do the hard work, Smith suggests. “Very often human behavior is at the root cause of corporate scandal,” she states.
Fortt agrees. “When you have people who are afraid to report issues, there is a lot of our humanity that gets wrapped up in our jobs that doesn’t necessarily get fully recognized or appreciated in a manner that would actually help corporations protect themselves and their stakeholders,” she says.