The importance of legal entity management for ESG

Good governance is the foundation of effective boards, sound management, solid relationships with stakeholders and shareholders, and comprehensive management of all facets of the business. In other words, governance underpins environmental and social initiatives, and it should drive legal entity management as well. In our view, governance is 80% of the legal entity management equation.

Companies that have more robust ESG functions often have an ESG officer in place to manage ESG-related initiatives and reporting: However, many of these functions do not have a legal reporting structure in place. While the corporate secretary is sometimes also a company’s general counsel, organizations often view managing legal entities as primarily a compliance task. It may be worthwhile to consider legal entity management, along with the rest of governance, as a strategic opportunity for the organization to advance its ESG initiatives.

New research by Deloitte identified that legal teams can deliver substantial value from taking a strategic approach to entity management. This research suggests that, as the SEC rolls out its new rules around ESG reporting and the M&A market becomes more aware of these nuances, buyers may feel more comfortable making an investment. Buoyed by that confidence, when considering an acquisition, buyers are often willing to expedite both due diligence and the overall deal timeline, and may thus be more likely to offer a higher price for a deal.

Conversely, when acquirers have unanswered questions about their target’s subsidiary management, including around ESG, they’re likely to delay a deal in order to conduct additional due diligence. Along the way, they’re likely to hedge their bets, double down on other concerns, and lower their offer.

Organizations are beginning to incorporate ESG initiatives in their corporate disclosures. But as they do, they are realizing that ESG reporting differs markedly from traditional financial reporting, which focuses exclusively on the allocation and usage of the organization’s capital resources.

ESG reports, by contrast, address the company’s impact on the environment, labor factors including diversity and inclusion, and management issues such as CEO pay. They also include both quantitative and qualitative measurements that address ESG risks, opportunities, and related strategies. Organizations should consider putting a process in place for staying up to date on the constantly evolving ESG requirements and learn how to report effectively on both the qualitative and quantitative aspects of ESG at the parent level – and that those aspects roll down uniformly to their subsidiaries. At the same time, organizations need to also consider how ESG initiatives may materially affect their financial statements and tax filings.

To get a clear picture of an organization’s potential ESG impact, compliance and legal personnel must consider not only the parent company, but also subsidiaries and even suppliers. This will be especially important as new SEC reporting expectations are rolled out as a result of ongoing work being done to create new rules by an ESG taskforce at the SEC. Take, as an example, the impact of just one rule being proposed for investment funds that market themselves as ESG-friendly. It would require funds and advisers to provide more specific ESG-related disclosures in fund prospectuses, annual reports, and adviser brochures. This makes entity management critical for companies that hold subsidiaries and are included in these types of funds because, without adequate understanding and controls on the entity structure, it will be difficult to meet these new reporting expectations.

Identifying the potential risks can be especially challenging in subsidiaries, as they tend to operate in different locations and sometimes in different industries. Subsidiaries need to be in compliance with the parent company’s ESG practices and protocols. Subsidiaries failing to align put the reputation and validity of ESG practices at risk across the entire organization.

Often, organizations divest subsidiaries to mitigate their risk, thus removing problematic divisions, products, or services that risk hurting a company’s reputation and profitability. But divesting subsidiaries, which is a core element of entity management, may lead to additional problems.

If a business sets a goal of achieving net-zero emissions but one of its subsidiaries generates significant emissions, it may elect to divest that business rather than working to find ways to reduce the subsidiary’s emissions. However, the divested subsidiary would be unlikely to completely disassociate from the company entirely; instead, it may end up as a vendor in the parent company’s supply chain. A change in entity structure in this type of situation does nothing to help the company achieve its goals, as investors and regulators may, at some point, scrutinize its supply chain. And even if the subsidiary does disassociate completely, there may be no overall reduction in its emissions.

As noted above, the SEC recently increased its scrutiny of climate-related corporate disclosure practices. But in the US, clear and consistent disclosures remain largely voluntary. The current SEC guidance suggests that organizations must disclose information that is “material,” or substantially likely that “a reasonable investor would consider it important” in making an investment or voting decision, or if it would have “significantly altered the ‘total mix’ of information made available.” But this nebulous standard puts the determination about what is material in the hands of the organization and runs the risk that critical information will not be disclosed. Establishing clear ESG-related policies and reporting standards within one’s own organization may mitigate this regulatory risk. And propagating the policies through the company’s subsidiaries will help to ensure they are adhered to uniformly. The SEC also signaled that it will step up scrutiny of corporate cybersecurity, which it classifies as an ESG issue. The agency has proposed amending Form 8-K to require disclosure of material cybersecurity incidents. The proposed rule suggests that organizations should disclose whether they believe cybersecurity risks are part of their business operations. Organizations should also describe their policies and procedures for identifying and managing cybersecurity risks, which may be difficult for subsidiaries that may not work closely with a parent company’s centralized IT and security teams. Additionally, the proposal requires disclosure about management’s role in overseeing cybersecurity risk and implementing the company’s policies, procedures, and strategies.

Regulators are likely to continue examining ESG-related issues and increase the number of regulatory enforcement actions. Organizations that fail to monitor their ESG-related risks and ensure they are enacted uniformly at its subsidiaries may struggle to meet the SEC’s standards for material disclosure.

Organizations with international subsidiaries may be at even greater risk of falling short of the emerging standards in the EU and UK for disclosing ESG-related threats to their assets. The European Council of the European Union recently adopted a new corporate sustainability reporting directive that strengthens the requirement that companies follow a double materiality standard – where they report on both how sustainability affects their performance, position, and development as well as their own impact on the environment and society. The directive enhances detail and transparency requirements for the information that companies must publish and includes a certification requirement for sustainability reporting.

ESG-related issues at subsidiaries may also create or exacerbate litigation risk. Plaintiffs’ firms that are already focused on environmental and social issues may begin to pursue governance claims on the premise that organizations are not acting quickly enough on ESG issues, and they can be savvy enough to compare performance at parent companies to their subsidiaries. Class actions are also likely to follow the path of regulatory enforcement. Clear corporate standards that include legal entities can be critical to avoid exposing an organization to litigation risk due to subsidiaries’ lax ESG practices or reporting.