Baker McKenzie’s Peter Tomczak last spoke with Ethisphere Magazine a year ago in “The Super ESG Issue.” Since then, a few things in the ESG landscape have shifted, and the same trends we discussed then have only been accelerated by this year’s upheavals. We returned for a follow-up conversation with Tomczak about ESG’s long-neglected social aspect, Covid, the false dichotomy between short- and long-termism, metrics, and more.

Peter Tomczak, Chair – North America Litigation & Government Enforcement Practice Group, Baker McKenzie

Tyler Lawrence: The last time we spoke, a little under a year ago, we lived in a slightly different world. How has the pandemic and recent social unrest trickled into ESG conversations?

Peter Tomczak: Well, I think both the pandemic and ongoing social unrest in the United States around the Black Lives Matter movement have impacted corporate governance in at least two ways. One, in the ESG discussion, it’s really highlighted the “S,” the social factor. Before, there was more attention paid to the other letters, in part because the social side is difficult to quantify. The impact of COVID and the social awakening in the United States has really focused the conversation at the board level to try to understand: how are we engaging with communities on these issues? How are our stakeholders, broadly defined, impacted, including shareholders? And how is the company’s business and business model functioning during this turbulent time?

For example, the California legislature recently passed Assembly Bill 979. That bill mandates that a certain percentage of directors come from an underrepresented community. That will impact any corporation that’s publicly held and has principal executive offices located in California. Also, in late October an initiative led by the Illinois State Treasurer and representing investors that collectively have more than $3 trillion in assets under management or advisement, urged companies to publicly report the racial, ethnic and gender composition of their boards of directors in those companies’ annual proxies for 2021.

I think another part of that conversation is greater attention to human capital management issues. Former Chief Justice Leo Strine, Jr. of the Delaware Supreme Court has noted that ESG should really be EESG—the additional E being for employees. However you want to refer to it, we see much more attention being paid to how COVID and social developments have impacted the workforce, both from a more traditional operational perspective as well as diversity.

Looking at disclosures of human capital management metrics as a measurement of the company’s commitment is one way to answer whether the company is, in fact, living up to what it says about how it treats its employees and its workforce. Another variable of note is the number of shareholder proposals in these areas that pass. Before this year it was relatively low: I think by one commentator’s count, from 2017 to 2019 only 22 percent of human capital management disclosure proposals passed. But for the 2020 proxy season, 59 percent passed. So there clearly is a substantial amount of interest from investors and the other stakeholders in reviewing disclosures relating to these issues.

TL: And what’s the nature of those sort of proposals? Can you give examples of what kinds of measures have been passed?

PT: Many focus on disclosure. Some have focused on disclosure of diversity and gender measurements, while others seek disclosure of specific operational metrics, such as wages. Another proposal that certainly has been discussed is looking at the composition of the workforce, such as measuring employee turnover. They are more often focused on disclosure of data, as opposed to a mandated result. Tell us how you’re doing.

TL: And like you said earlier, one of the reasons that the social side has gotten short shrift is that it’s historically been the hardest to quantify social issues, or the hardest to pick a metric that people agree to measure on.

PT: I think that’s correct, yes. Not that any of the factors are easy to quantify. I recall that the last time we spoke, there was much consternation from the institutional investors and others in the investor community about having some sort of baseline and similarity in the types of ESG disclosures. Social issues are particularly tricky, but if there’s some baseline, then investors may be able to compare different companies meaningfully. Even within a company, if a company is changing the basis for calculation of a particular metric year to year, how is that being consistent to allow investors to compare across years?

There was a recent report from the GAO focusing on some of the issues that are being voiced about how we compare metrics and measure companies. And again, without a clear bright line from the SEC, or rulemaking, or other sources of regulation and law, it’s really coming down to adherence to certain voluntary standards and standard-setting organizations. There’s still significant variability, and so there’s significant frustration among investors, who really are interested in this data for a variety of different reasons. They want to receive accurate data and be able to meaningfully compare that data across companies and time frames, and understand what it all means.

TL: Are investors starting to speak in a more united voice on this front, or is that still a bit of a free-for-all in terms of what individual investors are asking for regarding social metrics?

PT: Each investor is different and is going to be looking at a specific investment in a particular company, so I don’t think you’ll ever see a uniform answer in that sense. But I think this concept of getting meaningfully comparable metrics and data has been voiced with increasing frequency.

The metrics tracking the number of ESG professionals at various investors or funds show a large increase in the number of staff that these funds and investors have dedicated towards ESG and stewardship. That clearly tells me these investors are putting their money where their mouths are, if you will. They’re investing in this area, to make sure that they can keep track of those issues, and hiring talented people to make sure they’re able to carry out that mission.

TL: And do you think that expansion is being driven by expanded investments specifically in ESG funds, or expanded consideration and weighting of ESG factors across all investments?

PT: Well, I think it’s a combination of both. There’s increasing evidence that shows ESG funds have outperformed the market. Now, I say that broadly, as there’s much nuance in the data. But there is research, particularly from outside the United States, from Harvard Business School as well as a couple of professors at Northwestern University, that support a finding that ESG funds generally out-perform the market.

Also, investors are increasingly recognizing that there is a tie between long-term value to the company and its shareholders, and commitments to ESG principles. The paradigm does not need to be jettisoned to understand the decision-making. The existing framework of incentives and duties and obligations can explain how an investor would say that ESG is an important aspect of its mission over the long term to generate a return for its investors.

TL: Well, and to give one example of what you just talked about, there was a European investor, Nordea, that dropped the Brazilian meat company from all of its funds, not just from its ESG-oriented funds over concerns about their continuing failure to advance along sustainability metrics. Do you think that that was a one-off, or do you think we should expect to see more and more of that where investors are willing to make larger decisions based on ESG?

PT: It’s certainly not a one-off. Without getting into names or specific examples, there are other instances. I think as you see more money in ESG funds, there is going to obviously be a greater sensitivity to ESG failures at companies. But again, I think there’s also a greater attention being paid to maximizing long term value from non-ESG funds, who are questioning whether or not their money is in the best place. They are evaluating whether or not, over the long term, this investment is going to pay off, as opposed to another company in the same space that may have a more sustainable, long term horizon, as reflected in its ESG commitment and actions implementing those stated goals.

TL: Well, and we’ve mentioned several times, you have this link between ESG-oriented management and long-termism, and I know that that’s something you’ve been thinking a lot about and writing about. Tell me a little bit more about what you’re thinking there and what your argument is.

PT: What we’re thinking about is this question: what are the directors’ duties for sustainability in ESG? A lot of the discussion on the Business Roundtable’s statement of corporate purpose has been framed as either favoring stakeholders, or favoring shareholders, and I just don’t think that reflects the reality in practice or in the law. I think in Delaware and in states that follow its jurisprudence, directors have a broad mandate to use their business judgment and promote long-term value, that is a long-term perspective of value enhancement, for both the corporation and its stockholders.

There are some exceptions, but I think within that statement, there is much to suggest that what ESG is truly focused on is taking a longer-term view of the value of a corporation. Admittedly, the discussion is framed through the perspective of whom you are benefiting, this concept of stakeholder versus stockholder. But how would stockholders gain in the long term by not following a sustainable business model? Viewed from this perspective, much of the tension seems to be a false dichotomy.

Yet another way to approach director duties is as an extension or application of Caremark duties, or directors’ duties to monitor the company. Directors are required under those duties to implement appropriate information and reporting systems that provide directors and senior management with accurate and timely information, so they can make informed judgements about compliance risk and understand the company’s compliance with laws.

When you think about what that requires in practice, you can think about ESG as being relevant in two ways. The first is that as ESG principles become enshrined in laws, they will affect what the compliance obligations of the company are and, in turn, the contours of directors’ duties of oversight and monitoring under Caremark.

The second is that if you are fulfilling ESG standards, you are probably also meeting your obligations to comply with your fiduciary duties. You’re going above and beyond. That is where legal duties may end, and where market expectations continue. What are these institutional investors asking? They’re not simply asking if directors complied with the law. They’re asking more broadly about a larger set of principles and a larger set of practices, like human capital management, that would promote the long-term value of the company, which matches their investment horizon.

TL: It sounds like you think that the weight of legal obligation is, if anything, more on the side of people who are pushing for directors to take more aggressive action and oversight over ESG concerns, in the pursuit of more long-term thinking.

PT: I wouldn’t go that far. I think there’s an increased attention to it. It’s a larger part of the discussion between stockholders and directors. But you still have significant discretion under the business judgment rule. There’s a limit on it, and there are cases that hold directors cannot totally disregard stockholder interests and value. You couldn’t just simply say, “I want to do this only because I think it’s the right thing to do, according to my own personal moral code.” There is, however, a broad unity of interest if you’re looking at the corporation’s value and its stockholders’ value long term.

In addition to state law fiduciary duty claims litigating these issues. I do expect an increase in disclosure claims under federal securities laws, involving ESG principles. Currently, ESG metrics aren’t mandated by the SEC to be part of a publicly-traded company’s disclosures. Increasingly, however, securities holders are asking when ESG issues and facts have become “material,” such that they need to be disclosed, or if there’s going to be rule-making and other legal developments by and from the SEC, in particular, to mandate certain disclosures.

TL: In relation to the pandemic, many people were making decisions very quickly about how their companies needed to move forward. I’m curious if you think that there’ll be any sort of retrospective reckoning from an ESG perspective— people looking back and judging how companies responded, treated their workers and communities, and factoring that into ESG calculations.

PT: I think you are going to see that even within the same industry and confronting what are the same general risks, some companies fared better than others, through the talents and efforts of their boards and their senior management, down to their frontline workers. The data suggests that there was a little pause in activism, but as activists now re-enter conversations, they’ll be asking hard questions, including the question you asked—how well did you manage your way through this? If we look at your performance versus one of your competitors’ performance, or just in general, was it satisfactory in our minds? Did it match what you were saying? Did the company continue to adhere to the principles it espoused, did it comply with laws? These tough questions are going to be asked.

TL: Anything else that you would like to add before I let you go?

PT: One very interesting thing to keep in mind is the rise of what we in the US call benefit corporations, or B Corps. Delaware in particular has reduced the barriers to entry to changing into a B Corp. So for companies that really want to move towards that type of organization, it is now easier to do that. There are now even several public companies organized as benefit corporations.

But now as we start seeing more IPOs, et cetera, do we see more of these companies filing to be B Corps, and do we see more public companies changing into B Corp status, which they’re free to do if they obtain the requisite vote and satisfy the other requirements. While much of what we have been talking about is framed by how we think a traditional corporation should work, there’s an alternative in the market for corporate forms, to organize as a B Corp, that is increasingly a viable option for companies that wish to do so.

TL: It’ll be interesting to watch. Well, thank you so much, Pete, for taking the time to chat.

PT: Oh, my pleasure. Thanks for having me.

About the Expert:

Peter Tomczak serves as the Chair of Baker McKenzie’s North America Litigation and Government Enforcement Practice Group. He conducts internal investigations for clients, and counsels clients and their boards of directors on issues of corporate compliance and corporate governance, particularly on anti-corruption matters. In addition, he serves as a member of the Global Steering Committee of the Firm’s Industrials, Manufacturing and Transportation industry group. He joined Baker McKenzie in 2003, after having served as a law clerk for the Delaware Court of Chancery.