The words sound simple and uncontroversial: Environmental, Social and Governance, or ESG. Who doesn’t love the environment, and who doesn’t want companies to respect the communities they operate in? What’s wrong with proper corporate governance?
The problem is applying ESG to the legal duties of directors. Set aside the furious debate over what constitutes an ESG-compliant company—is there any way Tesla really ranks below Royal Dutch Shell?—and think about how to honor ESG principles at the board level. Should you vote in favor of wage increases for workers to honor the “social” part, or should you invest the money in scrubbers that go far beyond current environmental regulations to check the box on E? Most shareholders would consider it good governance to distribute a fatter dividend. How does that square with a reputation-harming lower ESG score?
“Trying to sort out what you do as a director to balance these competing interests is difficult,” says Stephen Bainbridge, a professor at the UCLA School of Law and vocal critic of efforts to import ESG considerations into corporate law.
The problem with ESG, as Bainbridge sees it, is its vagueness. Unlike laws and regulations, ESG goals range from the purely aspirational—a world where global temperatures rise less than 2 degrees centigrade and the Alaskan permafrost remains intact—to the highly specific, such as mandates to increase women and minority representation in the C-Suite.
For more than a century, courts in Delaware and elsewhere have struck a bargain with corporate officers and directors known as the business judgment rule. Put simply, it says courts won’t impose liability for bad decisions, no matter how dumb—think AOL/Time Warner merger—but they will sock it to directors if they violate their duty of loyalty and engage in transactions that only benefit themselves.
As every corporate director knows, starting in 1996 with the Caremark decision, Delaware courts have chipped away at the business judgment rule, imposing potential liability on directors for failing to make sure companies have in place systems to detect wrongdoing and report it to the board. Blue Bell Creameries got tagged for a listeria outbreak, Boeing directors for the 737 Max fiasco, and, most recently, McDonald’s officers were held potentially liable for workplace sexual harassment, including the CEO’s relationships with subordinates.
The Road Ahead
Up to now, these rulings have focused on corporate miscues with serious legal and regulatory impact on a company’s operations. But it isn’t hard to see how a court someday will add ESG compliance to the list. And because the Caremark doctrine is based on the idea that directors violated their duty of loyalty by failing to act in the company’s best interest, they can be personally liable for damages.
“Caremark keeps getting bigger and bigger,” says Bainbridge, who wrote a book about the threat ESG presents to corporate directors and managers. “What if courts start saying directors had no legal obligation to do some ESG activity, but their failure to do so hurt the company?”
If that becomes the case, directors may resort to the tried-and-true tactic that they’ve used for generations to insulate themselves from criticism over massive layoffs and executive pay: Hire consultants. By doing what everybody else does, no matter how much that saps the company of original thinking and strategy, they might be able to avoid falling into the looming ESG trap.