Recent developments in the Court of Chancery concerning a corporate board’s duty to monitor and provide oversight over a corporation’s operations, so-called Caremark claims, are likely to intersect with the Securities and Exchange Commission’s (“SEC”) proposed new ESG disclosure obligations to create a new category of corporate risk.  In this article, we discuss the recent trends in Delaware law that have led to a revitalization of Caremark and the SEC’s current proposals for enhanced ESG disclosure, the intersection of which can be expected to result in litigation and other corporate risk, and some commonsense steps corporations can take to mitigate this potential new category of risk.

The “Caremark” Doctrine

One of the more notable developments in Delaware case law in recent years has been the revitalization of “Caremark duty” claims.  Caremark actions traditionally were notoriously difficult to plead—in explaining the doctrine, the Chancery Court famously called it “the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.”  In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959, 967 (Del. Ch. 1996). In recent years, however, the Delaware courts have breathed new life into the Caremark doctrine by allowing these types of claims to proceed to discovery.

Specifically, the Caremark doctrine was returned to potency in 2019 following the Delaware Supreme Court’s decision in Marchand v. Barnhill, 212 A.3d 805 (Del. 2019).  Although Marchand did not change the Caremark standard, it demonstrated the Delaware courts’ greater willingness to permit Caremark claims to pass the motion to dismiss phase if they could be plausibly pled.  Marchand ultimately laid the groundwork for a number of subsequent rulings demonstrating the renewed vitality of Caremark claims—not only have at least four Caremark suits survived a motion to dismiss since Marchand, but there are also several ongoing Caremark suits in Delaware.

Under Caremark, there are two distinct types of claims.  The first type concern a board’s failure to implement a system of controls to prevent some unlawful misconduct that occurred.  The second type of claims concern a failure to monitor by the directors.  It is imperative, therefore, that boards focus on:  (1) establishing adequate information and reporting systems to monitor “mission critical” aspects of their company’s business; and (2) monitoring those systems once in place.

The SEC’s Proposed New Climate-Related Disclosures

On March 21, 2022, the SEC proposed new rules requiring companies to report extensive line-item disclosures on climate-related ESG issues, entitled: “The Enhancement and Standardization of Climate-Related Disclosures for Investors.”  If implemented as written, the proposed rules would require registrants to make significant additional disclosures regarding the impact of climate-related risks on their business.

Among other things, under the proposed rules, registrants would be required to disclose:

1. Greenhouse gas (“GHG”) emissions, regardless as to whether those emissions are deemed material by the company.  Emissions would now be reported by “scope” or type.

2. “Climate-related risks” that are “reasonably likely to have a material impact,” including climate-related conditions and events that impact financial statements, business operations, or value chains.

3. Governance disclosures related to climate risk, including how the board and management assess and manage these climate-related risks.

4. Any targets or goals related to the reduction of GHG emissions.

These proposed new rules are part of the Biden Administration’s efforts to “advance consistent, clear, intelligible, comparable, and accurate disclosure of climate-related financial risk.”  Yet the sheer breadth, specificity, and complexity of the proposed rules would result in one of the most profound changes to public companies’ disclosure obligations in the history of the SEC.

Additional Caremark Exposure

The SEC’s climate-related disclosure rules will likely fuel ESG-related Caremark claims.  In particular, heightened disclosure requirements will provide ammunition for derivative or class action lawsuits and may expose companies to specific indirect risks, including heightened exposure to pre-suit discovery and proxy contests.

Direct Litigation Risk

The SEC’s new reporting requirements are likely to create new grounds for investors to assert liability claims against corporations and their boards of directors and management. Shareholders can be expected to leverage the new disclosures to seek to hold companies accountable for failing to properly oversee, mitigate or eliminate climate-related risk.  The revitalized Caremark doctrine is likely to be employed to allege boards and managers failed to oversee so-called “mission-critical” aspects of their business that generate climate-related risk.

In this vein, plaintiffs may choose to use disclosures required by the SEC’s proposed rules as the basis for a breach of duty to monitor or Caremark claim through either a derivative suit, brought on behalf of the company against its directors and officers, or a class action suit, brought on behalf of a class of injured shareholders or investors.  Caremark claims will likely arise if and when a board fails to exercise proper oversight with respect to climate-related risks or to consider proper mitigating steps. This new threat will be amplified for companies that (i) have yet to fully examine how ESG issues factor into their mission-critical operations or (ii) have yet to devote resources and personnel to measuring (using consistent, comparable and reliable data) and analyzing their own ESG-related risks. Companies need to be able to ascertain and address their most pressing ESG-related risks to avoid future Caremark liability.

Indirect Risks

Indirect risks from the proposed new disclosure regime may manifest in a variety of ways..  They can result in the disclosure of embarrassing or harmful information about a company, its board, or managers, and lead to the replacement of key company executives or directors by aggrieved shareholders.  Moreover, they give rise to issues that are expensive and resource-intensive to address.  While these risks are indirect to companies, they pose a direct threat to board members and managers.

Pre-Suit Discovery.  Boards can expect new disclosure requirements to enable shareholders to gain greater access to pre-suit discovery.  Section 220 of Delaware’s General Corporate Law provides shareholders with a qualified right to inspect a company’s books and records for suspected corporate wrongdoing or mismanagement, and need only demonstrate a “credible basis” to proceed.  The new ESG reporting requirements will likely provide shareholders with even more information as ammunition to fuel Section 220 demands.  Opening a company’s books to pre-suit discovery could expose boards, management, or companies to serious reputational harm, as well as provide fodder for future lawsuits against the current board.

Proxy Contests.  New ESG-related disclosures are also likely to generate greater turmoil in the form of proxy battles at the board level.  Historically, shareholder activists have been focused on addressing short-term profit, stock price and total shareholder return.  Yet activist campaigns containing an environmental or social objective have doubled as a proportion of campaigns overall during the five years between 2016 and 2021, including a successful campaign against Exxon to place directors on its board.  The proliferation of new ESG reporting requirements is expected to further fuel these contests, particularly with respect to companies that are perceived to be lagging on ESG commitments or expectations.

Avoiding Environmental-Caremark Claims

Companies should take several steps in preparation for the increased pressure expected to arise from the need to address ESG issues.

First, companies should be aware of the obligations and risks they face with regard to ESG issues.  That means determining what ESG-related risks could detrimentally impact a “mission-critical” aspect of a company’s business.  What is determined to be “mission-critical” will necessarily vary by company.

Second, once companies are cognizant of the ESG-related risks they face, they will need to start implementing appropriate governance structures so that they are aware of, and can take steps to address, ESG risks.  Directors should establish responsible committees and internal information and reporting procedures to ensure board members have proper oversight of these efforts.  This will allow boards to demonstrate their engagement in response to potential Caremark claims, as well as to respond to any ESG risks arising in the company’s operations.

Third, with these governance structures in place, companies must focus on generating, collecting, and analyzing consistent and comparable data on the ESG-related risks they face.  These data should be actively monitored by managers and board members so they can identify and address ESG risks before they result in catastrophic situations and resulting litigation.  And, if Caremark claims ensue, boards will be able to use these governance structures and reporting regimes to demonstrate that they have satisfied their oversight obligations.

Finally, once these systems are in place, companies should take steps to prepare for the adoption of the SEC’s new climate-related disclosure requirements.  The development of governance and reporting structures will undoubtedly aid in the collection of information for these purposes.  While taking these steps, it is advisable that corporate executives and boards seek input from subject matter experts and experienced legal counsel to help design and implement robust compliance and monitoring regimes that can help to discourage or forestall future litigation in the form of Caremark or other claims related to ESG issues.

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Yesterday, the Department of Labor “released a final rule under the Employee Retirement Income Security Act (ERISA) . . . [that] clarif[ied] that fiduciaries may consider climate change and other environmental, social, and governance (ESG) factors when they make investment decisions and when they exercise shareholder rights, including voting on shareholder resolutions and board nominations.”  This rule effectively overturned two rules published in the last months of the Trump Administration, which essentially prohibited the consideration of ESG factors when ERISA fiduciaries made investments or exercised their rights.  In short, the Biden Administration has now enabled investment managers of ERISA funds to consider “factors [that] may include the economic effects of climate change and other ESG consideration on the particular investment or investment course of action.”

This action by the Department of Labor is one of several steps undertaken by the Biden Administration to enable (and promote) consideration of ESG factors, particularly climate-related risks, in the context of financial decision-making.  (The most prominent of these initiatives is the pending SEC proposed rule which would require climate-related disclosures by public companies, and so promote consideration of climate factors by investors due to the availability of this type of information.)  Indeed, as part of the Biden Administration’s broader climate agenda, it has consistently focused on financial decisions as a means to combat climate change, and this latest development fits neatly within that broader framework.

It should also be noted that the timing of this action suggests that the Biden Administration has been emboldened by the results of the 2022 midterm elections to proceed with its climate agenda.  As a parallel point, shortly after the elections, the Biden Administration issued a rule that will compel federal contractors to disclose GHG emissions–this action by the Department of Labor is encompassed within the same overall architecture of initiatives designed to encourage the incorporation of ESG factors into financial decision-making.

With respect to the Department of Labor rule itself, the key point is that ESG factors may now be considered when making an investment decision, without fear of enforcement action (as suggested by the Trump-era guidance). Specifically, the “regulatory text clarif[ies] that a fiduciary’s duty of prudence must be based on factors that the fiduciary reasonably determine are relevant to a risk and return analysis and that such factors may include the economic effects of climate change and other ESG considerations on the particular investment or investment course of action.” (emphasis added)  In other words, the regulation embraced by the Department of Labor expressly contemplates that ESG considerations can be incorporated into financial decision-making because such factors are deemed to have an economic impact.

Notably, the federal government’s embrace of the consideration of ESG factors as part of prudent financial decision-making in the context of investing for retirement, as reflected in this Department of Labor rule concerning ERISA, conflicts directly with initiatives embraced by certain conservative-leaning states, such as Florida, which have prohibited the consideration of ESG factors (albeit with exceptions) in the investment decisions by state pension funds. This move by the Biden Administration reflects and amplifies the partisan divide over ESG, particularly climate risks, that is resulting in conflicting directives to companies across America.

The Department of Labor (Department) is adopting amendments to the Investment Duties regulation under Title I of the Employee Retirement Income Security Act of 1974, as amended (ERISA). The amendments clarify the application of ERISA’s fiduciary duties of prudence and loyalty to selecting investments and investment courses of action, including selecting qualified default investment alternatives, exercising shareholder rights, such as proxy voting, and the use of written proxy voting policies and guidelines. The amendments reverse and modify certain amendments to the Investment Duties regulation adopted in 2020.

 https://www.dol.gov/sites/dolgov/files/ebsa/temporary-postings/prudence-and-loyalty-in-selecting-plan-investments-and-exercising-shareholder-rights-final-rule.pdf

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