ESG: What boards of directors should do now

ESG oversight – taking responsibility

Duties of directors

Duties of loyalty and care are codified in various corporate legislation. The duty of loyalty requires directors to act honestly and in good faith with a view to the corporation’s best interests. The duty of care requires them to exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances.¹ 

When discharging their duty of loyalty, directors must determine what is in the corporation’s best interest. To do so, they may (and should) consider various stakeholders. The Canada Business Corporations Act was amended in 2019 to include a non-limitative list of factors that may be considered: shareholders, employees, retirees and pensioners, creditors, consumers, governments, the environment and the long-term interests of the corporation. This amendment followed two Supreme Court of Canada decisions that emphasized directors and officers should strive to make the corporation a “better corporation” and when determining what’s in the corporation’s best interests, directors may look to the interests of, “inter alia, shareholders, employees, creditors, consumers, governments and the environment to inform their decisions.”²

Absent conflicts of interests and subject to following a reasonable process, directors will generally be protected by the business judgment rule when determining which of these factors should be prioritized to foster the best interest of the corporation.

Following a reasonable process will also protect directors against liability when discharging their duty of care. Canadian courts have yet to hear the equivalent of the Caremark case, a 1996 decision by the Delaware Chancery Court that established certain obligations by corporate boards to ensure internal reporting systems and controls exist to identify, deter and confront problematic issues in the corporations they direct.³ Since Caremark, the Delaware courts have repeatedly confirmed its principles, clarifying that, although “as with any other disinterested business judgment, directors have great discretion to design context and industry-specific approaches,” directors may face liability where they fail to “make a good faith effort to implement an oversight system and then monitor it.”⁴ 

Canadian director oversight roles may be informed by these principles. Though our courts have not yet specifically imposed Caremark legal principles, the decision was cited in applying the business judgment rule.⁵ Furthermore, as a best practice, National Policy 58-201 Corporate Governance Guidelines recommends the board of a public company adopt a written mandate explicitly recognizing its responsibility for the stewardship of the issuer, including the board’s responsibility to identify the principal risks of an issuer’s business and ensure appropriate systems to manage these risks are implemented.⁶ 

Determining the right oversight structure

Directors should consider implementing an ESG oversight structure that ensures their decision-making process is adequate and will withstand the parameters of the business judgment rule. Hence, some boards may consider creating a specific committee to which they delegate specific responsibilities in order to benefit from centralized and integrated recommendations respecting ESG. Other boards may choose to deal with such matters at the board level and ask that new matrices be included in the risk management dashboards presented to them. 

Many investors are making it clear the sustainable value creation and total shareholder return they are looking for require keen ESG oversight by boards of directors. Still, though investors certainly want the board at the helm, many have been vague when it comes to voicing their expectations regarding the best ESG oversight structure. Institutional Shareholder Services (ISS) is an outlier in its specific suggestion that ESG oversight should be assigned to a standalone committee.⁷ 

An analysis of TSX 60 corporations shows that 52 out of 60 (86.7%) provide that either their board and/or at least one of its committees is responsible for overseeing ESG-related matters. When it comes to committee oversight, the preference seems to be either governance committees (or equivalent) or “specialized” committees such as an ESG committee, an environmental, health, safety and sustainable development committee, or a safety, workplace and project risk committee. Of the 48 issuers that have disclosed overseeing ESG matters by committee, whether in addition to or instead of their board, 11 assign ESG oversight to multiple committees. 

Many investors and proxy advisors are taking a firm stance in keeping boards accountable. Some have voting practices and policies that favour voting against the chair or members of the board or its committees who fail in this respect.⁸ Glass Lewis has announced that, come 2022, it may vote against any governance chair that fails to disclose the board’s role in ESG oversight. Others have taken a more qualified approach, and will vote against a risk committee chair that has failed to provide adequate disclosure on climate change risks or racial and ethnic diversity, topics that have attracted increased attention in the past few years.⁹  

Considering board and committee composition 

ESG oversight should ideally be performed by directors from diverse backgrounds, with the right skill sets. Thus far, most institutional investors and proxy advisory firms are not prescriptive in this regard; they recognize that appropriate skills may change with industry and size. However, some expect boards to at least provide clear disclosure on the ESG skills reflected amongst their ranks.¹⁰ For its part, Glass Lewis explicitly includes environmental and social, as well as health and safety skills in its evaluation of boards. Among other material factors to the business, it looks at proven knowledge of global environmental management, experience in leadership with workforce engagement, and relevant degrees in an environmental or social field.¹¹ 

An analysis of TSX 60 corporations shows that although many investors may not yet be calling for specific ESG factors in the board skills matrix, a stunning 88% of issuers base director nomination or disclose board composition on a skills matrix that includes some combination of ESG factors. A majority, namely 37 of 60 (61.7%), include general ESG skills or specifically name skills that fit into environmental, social and governance categories. A further 26.7% specify only particular aspects of ESG factors, whether G&E (3.3%), G&S (15%), or G alone (8.3%).

What’s more, investors are increasingly demanding board diversity, including for gender, ethnicity, race and age. CSA and CBCA regulations also require issuers to disclose the diversity composition of their boards.¹² In response, an analysis of TSX 60 corporations shows 98% of issuers have adopted a diversity policy or explicitly include diversity considerations in director nomination and board composition. Moreover, as members of the 30% Club (a campaign group seeking to increase gender diversity on boards and senior management), many Canadian institutional investors may vote against the chair of the nominating/governance committee where the board lacks at least 30% female representation.¹³  

Where corporate directors feel they have insufficient expertise, experience or background to grasp ESG factors relevant to their business, they may want to consider continuing education and/or retaining advisors to inform them in this regard.

Using a protocol in ESG oversight

When satisfied they have the right oversight structure and composition, boards should consider setting up a protocol to assist directors in properly discharging their duties of loyalty and care, taking into account ESG factors. As mentioned above, having such a protocol in place may prove useful as directors will be judged by the process they follow. Such a protocol could include the following steps¹⁴:

• Mapping. Identifying and categorizing ESG factors is a key first step in helping directors discharge their duties. This enables directors to map out areas that need particular attention and decisions that might require further reflection. Many of these factors will have been flagged through issuers’ legal compliance or risk management systems.
• Weighing. Once various factors have been mapped, directors should do their best to weigh them carefully and determine their impact on the corporation in a given situation, taking into account various stakeholders.¹⁵ In some instances, the motivation to prioritize certain factors will be influenced by legal requirements or the management of specific risks. Conflicts are to be expected when weighing such factors. 
• Deciding. After weighing various ESG factors and their expected impact on the corporation, directors should determine which course of action is in the corporation’s best interest.  
• Documenting. As directors remain accountable for their decisions, and different stakeholders might have conflicting views on what’s in the corporation’s best interests in a given situation, directors should maintain accurate and adequate records of their decision-making process. 

Corporate purpose statements and benefit corporations

In the last few years, many academics, working groups, and organizations have discussed the importance of developing a corporate purpose statement. Some are collaborating on a campaign aiming, by 2025, to have the board of every listed company publish one.¹⁶ A corporate purpose statement can help focus on ESG matters. However, the practice of adopting such a statement is not yet dominant. In an analysis of TSX 60 corporations, we found only 18 issuers mentioned a corporate purpose on their websites or in their proxy circulars. 

Another interesting development motivated by ESG-related factors is the creation of benefit corporations. Certain legislatures, including British Columbia, Nova Scotia and more than 35 US states, have amended their corporate statutes to provide for benefit corporations (or an equivalent), which specifically include in their articles an affirmation and commitment to operating responsibly, sustainably, and in such a way as to promote a social interest or public benefit.¹⁷ The designation of benefit corporation often imposes specific duties on the board, such as presenting public benefit reports at each annual meeting. In May 2021, the Quebec National Assembly tabled a bill proposing to bring benefit corporations to Quebec.¹⁸ Still, the benefit corporation model has not yet been widely adopted in North America.

Recommendation: Boards should think about how they intend to oversee ESG matters and if they have the right composition to do so. Directors should also consider adopting a protocol to determine which factors are the most relevant to their corporations and how to take those factors into account in their decision processes.  

ESG compensation – influencing behaviours

Once boards have taken responsibility for overseeing ESG factors, they should seek to promote and incentivize desired behaviours. To this end, including ESG objectives in executive compensation can prove to be a useful lever and is certainly one gaining traction. Indeed, investors and other stakeholders are increasingly pushing to have ESG achievements acknowledged alongside traditional key performance indicators (KPIs) in executive compensation. With compensation principles increasingly being subjected to say-on-pay votes, investors are in a strong position of influence in that respect.¹⁹  

For many investors, linking ESG metrics to executive pay presents an opportunity to demonstrate a commitment to ESG priorities.²⁰ However, proxy advisors are taking a qualified approach in this regard: 

• ISS recommends voting case-by-case on proposals linking executive compensation to sustainability criteria, considering among other things whether the company has management systems and oversight mechanisms in place regarding social and environmental performance, as well as the degree to which industry peers have incorporated similar non-financial criteria in their executive compensation practices.²¹  
• Glass Lewis normally expects performance measures for short-term incentive plans to be based not only on company-wide or divisional financial measures, but also non-financial factors such as those related to employee turnover, safety and environmental issues. However, it notes that ESG metrics ultimately used by any given company to drive accountability will necessarily vary among industries and ought to be appropriately tied to a company’s business drivers.²²

Based on our recent review of the proxy circulars of TSX 60 corporations, 41 of 60 issuers (68.3%) consider ESG measures in executive compensation to a certain extent. The vast majority of these issuers define the specific ESG KPIs to which they look. The nature and the respective weight given to these KPIs vary greatly as companies operating in different sectors or markets highlight different assortments of metrics; in client-facing industries such as financial services, companies often prioritize client satisfaction and employee engagement, whereas in the mining and transportation industries, health and safety appears more often. Overall, the most common ESG KPIs appear to be related to environment, health and safety²³ and human capital, as seen in the following table: 

These KPIs can be integrated in compensation design in various ways. They can be taken into account in short-term (bonus) plans or long-term incentive plans and can be considered on a “stand-alone” basis, as part of a scorecard, as a performance modifier or as a prerequisite to pay certain amounts.²⁴ 

Looking ahead, we expect this approach to ESG performance to be increasingly reflected in executive compensation. We also anticipate the average weight given to ESG KPIs continuing to increase over time.²⁵  

Recommendation: Once a board of directors has selected relevant ESG factors, according to a protocol, KPIs should be identified and incorporated into compensation plans to incentivize desired behaviours.

ESG reporting – advancing with caution

The pressure for enhanced disclosure

When it comes to ESG, a common thread is getting public companies to disclose more ESG-related information, in a better, more efficient and comparable way. Disclosure plays a key role in allowing investors, and the public in general, to understand and assess the risks and returns of ESG factors and their potential impact on long-term value.

The pressing nature of this issue becomes apparent when one reviews the latest versions of the proxy voting guidelines and principles of proxy advisory firms and institutional investors across North America. Many explicitly urge companies to “integrate information on their environmental and social performance into their annual reports and financial filings and to use recognized reporting standards”²⁶ or “to report to shareholders on an annual basis regarding the [application of policies and measures related to ESG issues].”²⁷  Some have also voiced their intention to vote in favour of certain proposals in connection with enhanced ESG reporting.²⁸  

In terms of topics, the main focus of various institutional investors remains on climate-related disclosures. Many will thus support proposals seeking disclosure on material environmental information such as carbon emissions, energy and natural resource use and waste and pollution management.²⁹ 

Given the pressure towards and advantages of comparability, many regulators have decided to suggest or impose some form of universal ESG reporting requirements. For instance, financial institutions supervised by the United Kingdom’s Prudential Regulation Authority have until December 31, 2021, to provide fully embedded TCFD disclosure. Similar requirements will extend to other listed companies in 2022 and may eventually apply to large private companies.³⁰  

Closer to home, the U.S. Securities and Exchange Commission (SEC) is considering requiring some ESG disclosure. The SEC’s acting chair recently asked SEC staff to “evaluate [the SEC’s] disclosure rules with an eye toward facilitating the disclosure of consistent, comparable, and reliable information on climate change.”³¹ While the challenge is great and the hurdles are considerable – some believe this would be outside the current realm of the SEC’s mandate if it were to impose the disclosure of ESG information that is not otherwise material³² – the policy motives behind this initiative speak for themselves: change is on the way.

Main reporting standards now well integrated among major Canadian issuers

Investor demands regarding disclosure parallel a growing trend towards adopting certain standard frameworks, as previously reported in our legal update on the standardization of ESG reporting. Major US institutional investors are pushing for the alignment of sustainability reporting with two well-established standard frameworks, namely the recommendations of the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) and the accounting standards established by the Sustainability Accounting Standards Board (SASB). A similar pattern can be observed north of the border, with the main institutional investors supporting the same standards, including eight major Canadian pension funds explicitly urging their portfolio companies to use them.³³ 

Be mindful of potential liability

When overseeing reporting on ESG, boards of directors should be mindful of potential liability on issuers, officers and directors. In their periodic disclosure, Canadian issuers now commonly issue statements on ESG strategies, objectives and performance. A popular, self-explanatory illustration of this is the issuer stating it aims to reduce certain emissions by “x” percent before year “y.” Once it is set by a public company, such an objective is typically trumpeted on many platforms.

This type of statement, as well as a myriad of other, more subtle ones, is not dissimilar to statements relating to operations or financial matters, in that ESG disclosure can sometimes be viewed as constituting forward-looking statements for securities law purposes. Thus, without the right amount of caution and disclosure on assumptions and risk factors considered, ESG reporting could in some cases trigger secondary market liability.

Through management disclosure committees, reporting to boards or their committees responsible for ESG matters, issuers should ensure ESG claims are accurate and the appropriate cautionary language is present.

Recommendation: Issuers from all industries should be proactive in assessing their ESG reporting practices and, if not already done, consider implementing well-recognized standard frameworks. Be mindful of potential liability. Ensure ESG claims are accurate and integrate forward-looking cautionary language in ESG disclosure when appropriate.

Conclusion

In short, boards should consider taking responsibility for ESG and ensure they have the right people to do so. They should consider developing protocols to identify which factors are important and integrate them into their decision process and compensation plans. They should also make sure reporting is adequate and be mindful of potential liability.

The authors wish to thank Emily Poirier, student, for her help in preparing this legal update.