The importance of legal entity management for ESG

How organizations can improve approach to ESG law

As the importance of environmental, social, and governance (ESG) initiatives grow, so do the risks—from tax to divestitures, to M&A activity, to regulatory inquiries, and litigation. Checking all ESG legal boxes depends on transparent, consistent controls and operations. Discover how you can develop them.

The growing importance of ESG

Environmental, social, and governance (ESG) issues are among the most relevant ones that organizations face today. During the 2022 proxy season, shareholders offered 924 ESG-related proposals at annual meetings of companies listed on the Russell 3000 index, compared with 837 proposals in 2021 and 754 in 2020.

In early 2021, the U.S. Securities and Exchange Commission (SEC) created a Climate and ESG Task Force, increasing its focus on climate change disclosures, and hiring its first senior policy adviser for climate and ESG. In March 2022, the agency proposed a rule entitled “The Enhancement and Standardization of Climate-Related Disclosures for Investors,” which “would require registrants to include certain climate-related disclosures in their registration statements and periodic reports.”

And the SEC is not alone in its increased scrutiny of corporate ESG initiatives. Both the New York Stock Exchange and the NASDAQ consider ESG reporting to be a best practice, and both Institutional Shareholder Services and Glass Lewis have propagated voting guidelines. Similarly, overseas, the International Sustainability Standards Board, Taskforce on Nature-Related Financial Disclosures, the European Union, and United Kingdom all have proposed new climate and sustainability reporting standards.

But what is the upshot of all this activity?

Many companies have focused on making broad commitments to ESG-related goals, and much of that activity has focused on sustainability and diversity. For example, Amazon has pledged to achieve net-zero carbon emissions by 2040 and has challenged other organizations to join them.

What should companies be concerned about?

Some of the areas of concern for regulators, investors, and other stakeholders include how a company performs as a steward of the environment; how it views its relationship with the community; and how it manages executive pay, diversity, and shareholder rights. Examples include a company’s management of water or carbon; its policies around diversity, wellbeing, and safety; and its political stances and lobbying.

Transparency around an organization’s tax position is one such area of concern. Tax transparency has become an element of the effect a business has on society and regulators, and investors are increasingly using it as a measure of sustainable governance. These are laudable goals but investing too little in governance initiatives to oversee these practices can leave companies vulnerable to risk.

Governance requires organizations to follow sound practices in their controls and operations, including ethics, risk management, tax, and compliance, and as these issues have affected parent companies in recent years, they may affect subsidiary level governance going forward. As such, ensuring that ESG practices and reporting remain uniform through a company’s legal entities is an emerging area that will likely see increased scrutiny over the next few years.

Potential risks for parent organizations to consider

Organizations – even those with mature ESG functions – still need to invest time and resources into shoring up their legal entity management to ensure ongoing uniformity between the parent and subsidiary. And even organizations with a robust entity management operation likely will need to address new challenges arising from a series of potential risks, including those in the following categories.

How organizations can improve ESG at their subsidiaries

Following these proactive steps can help organizations avoid ESG-related risk by actively engaging with their subsidiaries and streamlining their corporate structure where possible.

  1. Establish a clear governance structure: Parent organizations would be wise to define the division of responsibilities between themselves and their subsidiaries with respect to ESG policy. While they cannot disclaim all responsibility for the subsidiary’s actions, they can set standards that require the subsidiary to escalate important ESG-related matters to the parent, which may serve them well if the subsidiary runs afoul of ESG standards.

    The key is to ensure that companies and their subsidiaries have clear accountability mechanisms and controls. Where possible, companies may establish mechanisms to make certain that their leaders understand how they are following through on the commitments, assertions, and targets they set in their corporate disclosures.
  2. Ensure management holds itself accountable for their disclosures: Directors and officers can be held personally responsible for ESG disclosures in corporate filings. Investors and regulators want to see proof that organizations are offering more than minimal efforts around ESG. Directors and officers, including those who serve on subsidiary boards, should ensure that they are fulfilling their obligations as fiduciaries to oversee the business and keep their commitments. Otherwise, they could be as liable as if they had no structures or commitments in place.
  3. Practice tax transparency: Organizations should make sure to live up to their declarations about tax transparency. Disclosures related to tax contributions, including clarity around the corporate structure and the impact of subsidiaries on taxation, can be helpful for building trust among tax authorities, investors, and other interested stakeholders.
  4. Simplify the corporate structure: Paring down the corporate structure can help lower a company’s risk profile, reducing its potential for reputational damage and other harm. Keeping dormant subsidiaries could expose parent companies and their subsidiaries’ board members to additional risk, particularly if there are hidden problems in subsidiaries’ books or if they pose potential ESG risks. There should be a sound business reason for the continued existence of every legal entity. A leading practice is for organizations to prune their corporate structure, as appropriate, so that it is no more complex than necessary for ease of tracking and maintenance.

ESG issues are increasingly top of mind for investors, stakeholders, regulators, and even plaintiffs’ attorneys, and companies are being called upon to provide in-depth answers about their efforts in these areas to an unprecedented degree. As the profile of ESG grows in importance, so do the risks at the parent and subsidiary level: from tax to divestitures to M&A activity to regulatory inquiries and litigation, companies must ensure that they are following all the relevant rules and laws. The key to doing so lies within transparent, consistent controls and operations at both parent companies and each subsidiary. Sound governance processes and procedures are the foundation for ensuring success around ESG and other entity management considerations and reducing any potential issues.

That means that companies concerned about ESG – which is most companies, these days – should be careful to make sure that ESG policies extend well past the parent company through all its subsidiaries, both international and domestic. Furthermore, it is wise to take steps to make sure that subsidiaries implement and enforce policies, so that strong ESG takes place in practice and happens uniformly throughout the organization, as we expect increased scrutiny over the next few years.

Fullwidth SCC. Do not delete! This box/component contains JavaScript that is needed on this page. This message will not be visible when page is activated.

Did you find this useful?