The forthcoming Due Diligence Directive is likely to further increase opportunities for ESG-related litigation, says Alex Leitch, Head of London Complex Litigation Practice at Paul Hastings.
As companies adjust to the burdens, risks, opportunities and exigencies of ESG-related issues, so too are ‘plaintiff bar’ litigation lawyers sensing an opportunity to give powerful effect to shareholder and consumer activism, in the form of collective claims borne of alleged ESG violations.
The ‘new normal’?
Although litigation arising out of ESG-related issues is not a recent phenomenon, it is only relatively recently – and particularly since the onset of the Covid-19 pandemic – that these issues have moved to the forefront of strategic decisions considered by board directors, shareholders, investors, consumers, legislators and regulators. This rise of ESG-related issues from being lofty or worthwhile social aspirations, to hard-edged and legally enforceable principles, should, at least with the benefit of hindsight, come as no surprise.
But few might have expected that ESG principles would be reflected not simply in the development of the common law, but also in terms of legislative enactment, both in the UK and more broadly across the EU. During the last decade, there has been a significant global increase in ESG reporting frameworks and disclosure initiatives – from the Task Force on Climate-Related Financial Disclosures to the EU Taxonomy Regulation.
In March 2021, the European Parliament adopted a report calling for legislation that would require companies not only organised and headquartered in the EU, but also companies that provide services into the EU, to identify, assess, prevent, mitigate and remediate the potential and/or actual adverse ESG impacts, not only of their own operations, but also those of participants in their ‘value chains’ (the ‘Draft Due Diligence Directive’). It need hardly be said that the precise identity of participants in any ‘value chain’ will need to be worked out – but it is immediately apparent that it has the potential to capture both ‘upstream’ and ‘downstream’ participants.
A legislative proposal on the Draft Due Diligence Directive is expected to be submitted in late 2021 and will be debated in the EU Parliament and the Council of Members before it can be finalised and adopted – likely sometime in 2022 or 2023.
It is clear that the gathering momentum around ESG-related issues will not cease – these issues will only become more important to businesses, consumers and stakeholders. Certainly, the expectation is that plaintiff lawyers and litigation funders are likely to ensure, via claims, or the threat of potential claims, that ESG compliance remains high on the corporate agenda.
How can companies safely navigate the changing landscape?
Like so many legal principles, ESG principles are themselves easy to state, but altogether more complex to apply to specific business situations. Alongside any financial/economic ‘risk and reward’ analysis, a robust and well documented analysis of any associated ESG risk is likely to be a critical requirement – certainly if the company’s decisions are latterly called into question by, say, regulators, shareholders or consumers.
Unlike the securities class action suits which have featured in the US and Australia for many years, it is not only movements in share price that will provide the catalyst for claims, but also the company’s ESG compliance, and moreover within the EU, its dealings with and stance on other companies’ ESG compliance within its value chain. In the past, litigation has often followed the announcement of a regulatory investigation or decision, and this will only increase in the ESG ‘sphere’.
For companies doing business in Europe and their investors, this means that they are going to have to keep a close eye on the ESG compliance of any suppliers or consumers with whom they deal with in any significant way, and be willing to take a stance or position if they see obvious examples of ESG violations. Failing to do so is only likely to increase the risk of regulatory intervention and potential civil claims.
Traditions of English law
This notion of any element of responsibility or ‘vicarious liability’ for the ESG compliance of third parties is anathema to traditional principles of English law, which to this day, are underpinned by arm’s length and ‘adversarial’ contractual negotiation, and the historic principle of caveat emptor. This places the risk of a bad bargain at the foot of the buyer, who may choose to, but is also not obliged to, make enquiries of the vendor, much less as to whether the vendor’s own business practices are ESG compliant.
One might ask whether and how this English ‘legal orthodoxy’ can fit neatly into the world of EU ESG compliance – certainly once the Draft Due Diligence Directive has been enacted.
Concerns and questions
There are many questions that businesses, the directors and shareholders will need to address. For example, in this ‘new normal’, can purchasers turn a blind eye to a cheap manufacturer, if there is reason to believe that such prices are achieved through unacceptable labour conditions, environmental risk or even a poor track record on diversity and inclusion?
Is the purchasing company now bound to make such enquiries, and what happens if it does, and its concerns are either ignored, or turn out to be well-founded? Must it stop purchasing from this company, or insist upon some renegotiation/adjustment to address perceived ESG violations?
In addition to the likely rise in the cost of products to the purchaser, to reflect any costs incurred by the manufacturer itself to address the perceived (specific) deficiencies in its ESG compliance, it is also likely that the manufacturer might not appreciate any enquiry into its ESG compliance, much less to any attempt to renegotiate long-term supply contracts by reference to ESG compliance violations.
Plainly, the interpolation of ESG principles into ordinary commercial contracts has considerable potential to introduce tension and, in some cases, adversity and contention, where there previously have been none.
At both a domestic and EU legislative level, ESG disputes are not actually the ambition of the legislators – and ESG-related litigation largely remains a secondary concern for many companies, albeit a concern that is likely to achieve much greater prominence on the ‘internal radar’ screen of companies in the coming years.
Undoubtedly the hope is that such tension will be addressed and resolved before it arises, with commercial parties increasingly astute to ESG-related issues in their drafting of contracts and dealings.
The challenge of transition
How can companies address such risks, in respect of both existing relationships and contracts, and in respect of new contracts and relationships?
As a matter of legal analysis, new contracts are easier to ‘legislate’ for by the parties’ drafting because the parties can actively direct their minds to ESG compliance, and through the process of negotiation, find a mechanism to reflect any ESG obligations or aspirations. Such mechanisms are likely to give the non-breaching party a right to exit or terminate the contract in cases of serious ESG violation by its counterparty.
However, commercial parties will need to be astute to the risk that ESG clauses cannot thereafter be used unscrupulously by a counterparty. For instance, a basis for simply avoiding a bad bargain, or escaping an obligation of exclusivity – which may for independent commercial reasons, become financially or economically undesirable.
The more complex situation is likely to arise where existing commercial contracts include no reference to ESG compliance, and where any attempts to exit or renegotiate, even if undertaken sincerely on the basis of ESG compliance, are likely to be met with vigorously opposing views as to the question of how that party has in fact complied with ESG-related regulations, and an immediate threat of a substantial damages claim for unlawful repudiation.
Elements of these complex dynamics were seen a decade ago, with the introduction of the UK Bribery Act 2010 and in the US, much earlier with the Foreign Corrupt Practices Act of 1977 (FCPA). The compliance standards mandated by these statutes have over the years, created problems for international M&A lawyers when making acquisitions of foreign subsidiaries where the local business practices were – understandably, because the local business did not operate in the UK/US – not compliant.
Is ESG likely to be any different?
In summary, the answer is probably ‘yes’ – in that the translation of broad ESG-related principles into legal standards takes place at a time of convergence between greatly increased reputational and consumer risk due to ESG compliance/non-compliance, the growth of litigation funding, and the growth of collective legal redress in both the UK and the EU.
The traditional rules on cost shifting in the UK mean that plaintiff lawyers and litigation funders perceive an opportunity to advance ‘socially meritorious’ claims on behalf of stakeholders and consumers, and moreover, in the expectation that such claims succeed, to have big corporates pick up the tab for such claims.
As with all large changes, we will have to wait and respond to their impacts when they arrive, but it is important for businesses, directors, shareholders and the legal industry that we are prepared for the changes that are inevitably heading our way.
The notion of litigation lawyers undertaking, in addition to any industry regulators, the role of ‘police officer’ in relation to ESG compliance may seem strange, but there can be no doubt that these actors on the plaintiff side have the capital and collective ingenuity to monetise such opportunities, and the enshrining of ESG principles into law will provide a fertile environment for them in which to do so.
This article was co-written by Harry Denlegh-Maxwell, Associate at Paul Hastings.