Company directors increasingly have ever-growing tasks on their agendas, with responsibility for upholding the success of their companies and making critical strategic decisions. Now their burden is only set to grow against the backdrop of the latest key updates in the field of European Union (EU) corporate governance, heavily aimed at ensuring that companies are managed in a manner that promotes transparency, accountability and long-term value creation.
Over the previous five years, several new directives and proposed guidelines have focused on improving corporate governance across key areas: sustainability, due diligence, shareholder rights and engagement, board diversity and the evolving concept of directors' duties.
Recent cases of questionable board control in the news demonstrate the fallout from poor governance, reminding directors to actively pursue more transparency and stricter accountability for key stakeholders.
As boards come under higher and higher levels of scrutiny from investors, consumers and regulators, they must hone their skills at managing an organization's people, processes, performance and purpose by better understanding and navigating the ever-evolving complexities and regulatory landscape.
To improve board performance, directors should remind themselves of their duties to responsibly govern their organization, be aware of the pitfalls they and their peers face, understand the new pressure to improve corporate governance and create sustainable value for all stakeholders, including employees, customers and the communities in which their company operates.
HOW IS CORPORATE GOVERNANCE MANAGED TODAY?
In today's environment, corporate governance can make or break a company. In the past two decades, there has been increasing focus on corporate governance and, more recently, a growing recognition of the importance of environmental, social and governance issues (ESG) in corporate decision-making. There has been a push for greater board diversity to ensure that boards are more representative of the communities they serve and a trend toward the growing awareness of shareholder rights, linked to increased shareholder activism.1 The goal of corporate boards is starting to shift from maximizing shareholder profits to ensuring sustainability, corporate responsibility, and stakeholder engagement and welfare.2 Managed through a combination of laws, regulations and voluntary frameworks, the aim of corporate governance is to ensure that companies operate in a responsible, transparent and sustainable manner. While the specifics of corporate governance regulations can vary among countries and regions, there are key common denominators.
Many countries have laws and regulations that establish basic requirements for corporate governance, and companies listed on a stock exchange are typically required to comply with additional rules and regulations. In addition to legal requirements, there are voluntary codes of conduct and frameworks that directors and companies can adopt. Shareholders also play a role in regulating corporate governance, with their influence growing in recent years due to new technology and tools, such as virtual or hybrid meetings and instant access to information, and with their use of voting rights to influence the actions of the board and management.
By establishing clear rules and standards for responsible business practices, regulations help to promote transparency, accountability and long-term value creation for directors and their companies and stakeholders. With the shift in focus toward the environment, equity and technology, rules and regulations have followed suit and have continued evolving to encompass new and varied issues. This leaves boards responsible for a wider range of concerns to oversee in order to maintain compliance and ensure corporate governance success.
WHAT ARE THE IMPACTS OF RECENT GOVERNANCE FAILURES?
While adhering to corporate governance regulations can create value, failing to comply can have severe consequences. Not only will governance failures damage a company's reputation and erode the trust of its stakeholders, including investors and customers, but they will also lead to financial and human capital losses. Governance failures can also expose companies and their executives to legal liability, including civil and criminal penalties.
Recent governance failures have resulted in fines from regulatory organizations, lost profits for investors and creditors, and bankruptcy, but the repercussions these companies faced weren't just financial. They also experienced data breaches, legal action, increased government oversight and poor public perception from their failures to comply with governance regulations and best practices.
HOW HAS CORPORATE GOVERNANCE RECENTLY EVOLVED IN THE EU?
There have been several key updates to EU corporate governance since 2017 that directors need to be aware of to avoid governance failings. These updates encompass new rules for listed companies, an increased focus on sustainability, improved guidelines on shareholder rights and engagement, more regulations on board diversity and a heightened scrutiny of executive pay.
Updates are included in the following:
- Directive of the European Parliament and of the Council as regards Corporate Sustainability Reporting (CSRD),3 which amends the Non-Financial Reporting Directive, modernizes and strengthens the rules concerning the social and environmental information that companies have to report, also making it mandatory for companies to have an audit of the sustainability information that they report.
- Proposal for a Directive of the European Parliament and of the Council on Corporate Sustainability Due Diligence (CSDDD)4
- Communication from the Commission: Draft Guidelines on the standardized presentation of the remuneration report under Directive 2007/36/EC, as amended by Directive (EU) 2017/828, as regards the encouragement of long-term shareholder engagement5
- European Securities and Markets Authority's call for evidence on the implementation of the Shareholders Rights Directive 26
Other EU legislation, such as the Market Abuse Regulation (2014/596/EU),7 the Prospectus Regulation (2017/1129/EU)8 and EU Capital Requirements Directive (2013/36/EU),9 also contain provisions related to corporate governance, transparency and disclosure.
Below are some of the major impacts of these proposals and guidelines, with a particular focus on 2022's proposed CSDDD.
HOW DO CORPORATE GOVERNANCE AND SUSTAINABILITY INTERSECT?
With many initiatives aimed at promoting responsible business practices, there has been a growing recognition of the importance of sustainability within corporate governance. Since 2014, the Non-Financial Reporting Directive (NFRD)10 has required companies falling within the scope of its application to include a nonfinancial statement in their annual reports outlining their policies, risks and outcomes related to environmental, social and employee matters, as well as respect for human rights, anti-corruption and bribery issues.
More recently, the EU Taxonomy for Sustainable Activities — published in the Official Journal of the European Union and entered into force on 12 July 2020 — set out four overarching conditions that an economic activity has to meet in order to qualify as environmentally sustainable.11
In the EU's policy context, sustainable finance is the process of considering ESG criteria when making investment decisions in the financial sector. The outcome is that directors will give more consideration to sustainable economic activities and projects.12
Sustainable finance encompasses a range of considerations:
- Environmental considerations include climate change mitigation as well as a broader focus on the environment. They can cover biodiversity preservation, pollution prevention and circular economy creation, among other measures.
- Social considerations refer to issues of inequality, inclusiveness, labor relations and human rights. Investment in human capital and communities is also included.
- Governance considerations of public and private institutions — including management structures, employee relations and executive remuneration — play a fundamental role in the inclusion of social and environmental considerations in the decision-making process.
An important step toward harmonized sustainability transparency occurred through the detailed rules on the disclosure of sustainability-related information included in the Sustainable Finance Disclosure Regulation (SFDR) for financial market participants (such as banks, investment firms and pension funds) and financial advisers (investment and insurance advisers).13
Most recently, on 5 January 2023, the Corporate Sustainability Reporting Directive (CSRD) entered into force, replacing the EU's NFRD, modernizing and strengthening the rules concerning the social and environmental information that companies have to report. The scope of the regulation has been extended to a broader set of large companies, as well as listed SMEs14, now subject to EU sustainability reporting requirements. Also expanded is the "double materiality" principle, which considers both the impact of sustainability matters on the company value (the investor perspective) and the environment, people and economy (the society perspective).15 "Single materiality" takes an outside-in approach on reporting, as climate- and society-related changes can impact businesses and matter to investors. "Double materiality" goes further, incorporating an inside-out perspective as well. It not only considers environmental and social impacts on a company as necessary to disclose, but also the company's impacts on the environment and other sustainability issues.16 First introduced in the 2019 Guidelines on Non-Financial Reporting, the "double materiality" principle is a core element of the CSRD.17 Under the proposed regulations, large companies and listed SMEs will be required to publicly disclose environmental and social risks as well as how they will manage them.18
EMBEDDING DUE DILIGENCE IN CORPORATE GOVERNANCE
Driven by the increased focus on sustainability, the European Commission proposed the CSDDD. Its goal is to ensure companies active in the international market contribute to sustainable development and the sustainability transition through the identification, prevention, mitigation and abolishment of adverse human rights and environmental impacts connected with their operations, subsidiary operations and value chain operations carried out by entities with whom the company has established business relationships.
Directors and their companies need to take appropriate steps to set up and carry out due diligence measures19 to not only meet these goals, but also position themselves as corporate sustainability leaders. This encompasses the integration of due diligence into corporate policies,20 the identification of actual or potential adverse human rights and environmental impacts,21 the prevention and mitigation of such potential adverse impacts,22 the introduction and maintenance of a compliant procedure,23 the monitoring of the effectiveness of the due diligence policy and measures,24 as well as public communication on due diligence.25
While mandatory due diligence requirements included in the CSDDD revolve around human rights, climate and environmental sustainability, and do not extend to due diligence requirements in the context of bribery and corruption risks,26 companies and their directors should be aware of the dangers across the wider ESG risk spectrum and take measures to prevent them. This, in adherence to the minimum safeguards anchored in guidance provided by competent international bodies and EU regulation (CSRD and SFDR), serves to protect their approach to due diligence in preparation for upcoming legal requirements27 and growing expectations across global value chains.
REDEFINING DIRECTORS' DUTIES UNDER THE EU REGULATORY REGIME
As investors, consumers and regulators demand greater accountability and transparency on ESG and governance issues, directors are facing new challenges and responsibilities when managing risks and creating sustainable value for stakeholders.
Director duties are evolving to adopt a more holistic and sustainable approach to business. There is an increasing recognition that directors have a duty to have a framework in place to proactively identify, manage and disclose potential risks related to ESG issues.
This is further supported by the CSDDD, which includes provisions related to director duties. Under it, directors would be required to take a more active role in identifying and addressing sustainability risks and impacts throughout the company's operations.
Similarly, the Task Force on Climate-related Financial Disclosures (TCFD)28 has recommended that companies disclose information on their climate-related risks and opportunities, including their potential financial impacts. Aligned with CSRD regulations, this would require directors to assess and announce the company's exposure to climate risks and develop strategies to mitigate them.
A company's activities impact a wide range of stakeholders (including shareholders) and societal interests (such as the environment) that need to be considered by directors from the perspective of their company's interests and purpose. Directors have a role in creating sustainable value for all stakeholders, including employees, customers and the communities in which the company operates. This will require both a long-term perspective and a commitment to balancing the interests of different stakeholders. Directors can't focus solely on short-term financial returns if they want to succeed. Rather, they will need to reconsider their approaches to executive compensation, board diversity and other governance practices that may impact the company's long-term sustainability, profitability and reputation.
WHAT CAN DIRECTORS DO?
As investor and regulator focus shifts toward ESG concerns, and recent corporate governance failures have made headlines, directors need to focus their efforts on corporate sustainability now more than ever. Though the EU has been leading the way with laws and regulations, corporate sustainability and governance is a global issue that cannot be ignored. In keeping with new regulations, directors must take an active role in their organizations' governance and implement a long-term, ethically- and sustainability-focused mindset.
Footnotes
1. See "The future of corporate governance", World Economic Forum (weforum.org), https://corpgov.law.harvard.edu/2023/03/10/global-corporate-governance-trends-for-2023/#:~:text=Investors%20will%20be%20most%20focused,Climate%20Disclosure%20Rule%20in%202023. See also " Global Corporate Governance Trends for 2023", harvard.edu, and "Shifting Corporate Governance Standards: Staying Ahead Of The Curve" (forbes.com).
2. "How Corporate Governance Is Changing." Knowledge at Wharton, 23 Nov. 2021, https://knowledge.wharton.upenn.edu/article/corporate-governance-changing/.
3. Directive (EU) 2022/2464 of the European Parliament and of the Council of 14 December 2022 amending Regulation (EU) No 537/2014, Directive 2004/109/EC, Directive 2006/43/EC and Directive 2013/34/EU, as regards corporate sustainability reporting, https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32022L2464.
4. Proposal for a Directive of the European Parliament and of the Council on Corporate Sustainability Due Diligence and amending Directive (EU) 2019/1937, https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A52022PC0071.
5. Nonbinding guidelines aimed at helping companies disclose clear, understandable, comprehensive, consistent and comparable information on individual directors' remuneration, https://corporategovernancecommittee.be/assets/pagedoc/1278410846-1651580265_1651580265-standardised-representation-of-the-remuneration-report-draft-12072019-1.pdf.
6. Directive (EU) 2017/828 of the European Parliament and of the Council of 17 May 2017 amending Directive 2007/36/EC as regards the encouragement of long-term shareholder engagement.
7. Regulation (EU) No 596/2014 of the European Parliament and of the Council of 16 April 2014 on market abuse (market abuse regulation) and repealing Directive 2003/6/EC of the European Parliament and of the Council and Commission Directives 2003/124/EC, 2003/125/EC and 2004/72/EN, https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32014R0596&from=EN.
8. Regulation (EU) 2017/1129 of the European Parliament and of the Council of 14 June 2017 on the prospectus to be published when securities are offered to the public or admitted to trading on a regulated market, and repealing Directive 2003/71/EC, https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32017R1129&from=EN.
9. Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC, https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32013L0036&from=EN.
10. Directive 2014/95/EU of the European Parliament and of the Council of 22 October 2014 amending Directive 2013/34/EU as regards disclosure of nonfinancial and diversity information by certain large undertakings and groups Text with EEA relevance, https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A32014L0095.
11. See Article 3 of the Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088. https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32020R0852 (the Taxonomy Regulation). The Taxonomy Regulation is coming into effect in phases, with the first two environmental objectives having come into effect on January 1, 2022, and the other four environmental objectives coming into force gradually; see https://finance.ec.europa.eu/regulation-and-supervision/financial-services-legislation/implementing-and-delegated-acts/taxonomy-regulation_en.
12. For more information in this regard see https://finance.ec.europa.eu/sustainable-finance/overview-sustainable-finance_en.
13. The SFDR was introduced in 2019 and came into effect in March 2021. On 1 January 2023, the SFDR Delegated Regulation came into effect providing more detail on the form and substance of sustainability disclosures. For an analysis of the EU SFDR see the article from Danny Busch, EU Sustainable Finance Disclosure Regulation, Capital Markets Law Journal, 2023.
14. The new sustainability reporting requirements under Article 1 of the CSRD will apply progressively from 2024–2028 to four categories of company: large EU "public interest entities", large EU undertakings and EU parent undertakings of large groups, EU SMEs that are listed on EU regulated markets and non-EU parent companies with (i) an EU-established large subsidiary or a listed SME subsidiary or (ii) a large EU branch. See https://www.whitecase.com/insight-alert/corporate-sustainability-reporting-new-eu-rules-large-companies-and-listed-smes for a brief overview.
15. https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32022L2464.
18. EUROPEAN SDG ROUNDTABLE - The Role of Double Materiality in Sustainability Reporting — CSR Europe.
19. According to Article 4 of the Proposal for a Directive of the European Parliament and of the Council on Corporate Sustainability Due Diligence and amending Directive (EU) 2019/1937.
20. See Article 5 of the CSDDD.
21. See Article 6 of the CSDDD.
22. See Articles 7–8 of the CSDDD.
23. See Article 9 of the CSDDD.
24. See Article 10 of the CSDDD.
25. See Article 11 of the CSDDD.
26. Therefore criticized by some as narrowly scoped. See indicatively CSDD directive: Is the EU opening the door for corruption?, https://www.euractiv.com/section/energy-environment/opinion/csdd-directive-is-the-eu-opening-the-door-for-corruption/.
27. New and strengthened rules in the fight against corruption are anticipated at the EU level; for more information in this context see https://ec.europa.eu/commission/presscorner/detail/en/ip_23_2516.
28. The TCFD was created by the Financial Stability Board to develop recommendations on the types of information that companies should disclose to support investors, lenders and insurance underwriters in appropriately assessing and pricing a specific set of risks related to climate change.
Originally published 30 May 2023
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