UK distressed restructuring: why are ESG issues important?

Key points

• With environment, social and governance (ESG) issues demanding worldwide attention, and directors under increasing pressure from shareholders to ‘do the right thing’, lenders and investors are more likely to scrutinise a company’s ESG policy. 
• ESG can therefore affect companies seeking funding to restructure through debt or equity. 
• This article looks at the key concepts and discusses why companies should not overlook their ESG policies even in the context of a distressed restructuring.

Companies are under increasing pressure to examine their ESG policies, and the UK’s commitment to achieving net-zero emissions by 2050 has intensified the ESG focus. 

We are already seeing ESG initiatives being cited as a reason for a company’s downfall. Alpine Summit Energy Partners, a US energy developer and financial company that operates and develops oil and gas assets, filed for Chapter 11 bankruptcy protection partly because they were finding it increasingly difficult to find funding for projects in the sector. Whilst the oil and gas industry is a more obvious ESG casualty, we will likely see adverse effects across all markets if companies fail to fall in line with the new ESG standards. 

With ESG issues demanding worldwide attention, lenders and investors may be more likely to scrutinise a company’s ESG policy before deciding whether to lend or invest into that business. This article discusses why companies should address and improve their own ESG policies when they are entering into a distressed restructuring.

What is ESG?

ESG, or Environmental, Social and Governance, is a term used to describe a set of standards that measures a business’ environmental and social impact.

In implementing ESG standards, a company should consider the following:

• Environment: a strong environmental policy would focus on reducing carbon emissions, managing water use and ensuring that a company’s products and services can be sustainably maintained. 
• Social: companies should be mindful of social issues around diversity and inclusion, employee relationships, health and safety and social justice. 
• Governance: good governance comprises ethical business practices, including complying with regulations, sourcing, data privacy and honesty.

At the COP26 conference in 2021, the summit discussed, amongst other key concepts, responsible financing, given that one of COP26’s four aims is to facilitate the financing of public and private sector initiatives to accomplish global net-zero emissions. The International Financial Reporting Standards (IFRS) Foundation Trustees also announced at the conference the creation of the International Sustainability Standards Board (ISSB). The ISSB aims to develop – in the public interest – a set of standards that will result in the comprehensive global baseline of ESG disclosures, designed to meet the information needs of investors in assessing enterprise value. The ISSB is working closely with other international organisations and jurisdictions to support the inclusion of the global baseline into jurisdictional requirements. This is a welcome development, offering more certainty around what is expected from companies from an ESG perspective. It may also lead to increasing pressures from lenders and investors for companies seeking investment/lending to provide high-quality, globally comparable information on sustainability-related risks and opportunities.

Whilst ESG matters were traditionally considered to be outside the scope of directors’ fiduciary duties, there is now increased consumer, regulatory and capital markets scrutiny. The traditional approach is therefore no longer viable, with boards now risking reputational and brand damage in failing to regard ESG matters when making board-level decisions. As well as reputational hazards, there are likely to be increased legal risks involved, given the rise in regulatory scrutiny. Directors are also now more exposed to shareholders pressuring them to ‘do the right thing’.

As ESG becomes a key boardroom topic with a direct link to value, it is now more important than ever for companies to assess their own ESG initiatives.

Why is ESG important in a restructuring?

As investors and lenders alike become more discerning, ESG can affect companies that are seeking funding to restructure through debt or equity.

In recent months, there has been a prominent increase in ESG-linked loans. The aim of this kind of loan is to encourage a commitment to sustainability by the borrower, through the setting of certain performance targets relating to ESG. Whilst there is not yet a legal requirement for ESG compliance when it comes to lending money, many of the institutional banks are setting up special budgets for sustainable finance for the coming years. This is, presumably, because they anticipate that there will be a legal requirement for ESG related performance targets in the foreseeable future. 

Funds, asset managers, private equity companies and family businesses will also be more mindful of ESG strategies when considering whether to invest. In a recent EY report, three-quarters of institutional investors say they may divest from companies with poor environmental track records.

Why is ESG important in a distressing restructuring?

Negotiating a restructuring can be challenging even in ordinary circumstances. In a distressed restructuring, the looming threat of corporate distress can ramp up the challenges even more, with negotiations carried out at rapid speed. 

Additionally, whilst ESG issues will be important to address from the outset, they can often become less dominant as they compete with other pressing concerns such as cashflow and reputational damage as a result of insolvency threats. ESG may therefore not be in the forefront of stakeholders’ minds when dealing with a distressed scenario.

However, even in a distressed scenario it would be remiss not to consider the importance of incorporating ESG factors into negotiations. In fact, for the reasons set out in the rest of this article, it could represent an opportunity, as the restructuring could be used as a springboard to drive sustainability and inclusion and, with it, long-term value creation and durability of the business. This should be a core goal in any event in a distressed restructuring, as stakeholders will want to avoid a similar distressed scenario later down the line.

ESG opportunities in a distressing restructuring

There are many reasons why a distressed restructuring represents an opportunity for stakeholders to consider ESG factors, including: 

• Customer retention: in an increasingly more ‘conscious’ world, an ESG-focused business may attract a larger customer base.
  Value enhancement: as well as attracting customers, it can also lead to a reduction in energy and waste costs. 
• Directors’ duties: directors have an express obligation to consider the ‘impact of the company’s operations in the community and the environment’. They could be held personally liable if a company’s ESG agenda is not robust enough.
• Litigation risk: claims from ESG-related breaches are on the rise, with many large corporates being accused of ‘greenwashing’. An effective ESG policy will help mitigate these risks.
• Divestment opportunities: a restructuring may provide an opportunity to divest areas in the business with acute ESG problems.

Customer retention

As we live in an increasingly socially and environmentally conscious world, customers are far more likely to demonstrate loyalty to companies that align with their values, such as those promoting environmental conservation, social responsibility, and ethical governance practices. Companies with a more ethically conscious customer base should therefore aim to stay true to their ESG policies in order secure the resilience of their business (and not just pay lip service). Resilience is a key part in turning a corner in a distressed scenario. 

This sentiment is supported by a PwC report, How much does the public care about ESG? timed around the COP26 conference, which found that 83% of consumers ‘think companies should be actively shaping ESG best practices’ (the ‘PWC Report’). The EY Future Consumer Index found that consumers are displaying increased loyalty and affiliation to brands that demonstrate a clear commitment to their purpose and ESG principles. A majority of the consumers covered in that study stated that they consider ESG factors when making a purchasing decision. There is therefore clearly now a de minimis level of moral conscience that companies are expected to demonstrate, and to fall short of that could lead to a serious decline in customer retention. 

Value enhancement

As well as attracting customers, integrating ESG considerations as part of company decision-making often leads to operational and process efficiencies within the business, enhancing profitability. This can be achieved through better policies to reduce waste, sustainable supply chain management practices to reduce the environmental impact across the supply chain, and cultivation of an inclusive culture.

Another factor linking sustainability to value creation is the impact of corporate sustainability on a firm’s cost of capital. Companies that focus on corporate sustainability tend to be less vulnerable to risks. 

For example, governments are increasingly examining the environmental impact of business activity, and with that comes heightened regulations. If a company already has ESG initiatives in place that mitigate its impact on the environment, then it is braced for increased government scrutiny. It could also create certain tax credit opportunities for the company, as well as avoiding any penalties for non-compliance. When governments trust the actions of companies, they are more likely to award them the access, approvals, and licences that afford fresh opportunities for growth.

A company’s value is also enhanced by strong ESG initiatives as it can often lead to a ‘purpose-driven workplace’ which naturally leads to increased productivity. A motivated workforce is crucial to the resilience of a business. The PWC report found that 86% of employees prefer to support or work for companies that care about the same issues they do. 

Lastly, investment into green technology and green assets can lead to asset optimisation. The market for green assets has grown exponentially over the years, and this trend looks set to continue.

Directors' duties

ESG is also important in the context of considering directors’ duties. Section 172(1) of the Companies Act 2006 (CA 2006) requires directors to act in good faith to ‘promote the success of the company for the benefit of its members as a whole’. The decision as to what promotes the success of the company within s 172(1) is one for a director’s subjective judgment exercised in good faith. Directors are expressly required to have regard to ‘the impact of the company’s operations on the community and the environment’ (s 172(1)(d)), with the explanatory notes to s 172 stating that ‘it will not be sufficient to pay lip service to the factors, and, in many cases the directors will need to take action to comply with this aspect of the duty’. Accordingly, in all the circumstances it is clear that directors are required to take an active role to discharge this duty. Therefore, if a director does not engage ESG factors when deciding on matters that impact the success of the company, they will be held to have been in breach of their duties under s 172(1)(d) of the CA 2006. This could affect the overall resilience of the business and, as noted before, resilience is a key factor for distressed businesses to achieve a successful restructuring.

The rise of ESG has been complemented by an increase in claims brought by activists and shareholders who seek to ensure that companies (and the directors running those companies) meet their ESG commitments. If it can be shown that a failure to consider ESG factors has led to a decision which is detrimental to the company, there is the potential for litigation. 

For example, ClientEarth, a non-governmental organisation and shareholder in Royal Dutch Shell PLC (Shell), recently brought a claim against Shell’s board members. ClientEarth claimed that Shell’s directors failed to meet their duties under s 172(1)(d) regarding the goals of the Paris Agreement and Shell’s own net zero emission ambitions. 

The Paris Agreement was adopted by 196 parties at the UN Climate Change Conference (COP21) in Paris, France, on 12 December 2015. The overarching goal is to hold ‘the increase in the global average temperature to well below 2°C above pre-industrial levels’ and pursue efforts ‘to limit the temperature increase to 1.5°C above pre-industrial levels.’ It is worth noting that, Whilst the UK ratified the Paris Agreement, the treaty does not give rise to domestic legal obligations and so any questions concerning its interpretation are for the UK government to determine.

ClientEarth sought:

• a declaration that the directors had breached their duties
• a mandatory injunction requiring the directors to (a) adopt and implement a strategy to manage climate risk in compliance with their statutory duties; and (b) comply immediately with an order the Hague District Court made on 26 May 2021 (following a class action), which had directed Shell to reduce its emissions by at least net 45% by 2030 relative to 2019.

At this initial stage, ClientEarth needed to demonstrate that they had a prima facie case for obtaining permission. If they could not, the Court had to dismiss the application (s 261(2)(a) CA 2006). The judge provided helpful guidance on the nature of directors’ duties in the context of climate change, the willingness of the court to intervene in this context, and the relevance of the shareholder’s motivation and other shareholder views. In particular, the judge reinforced the high hurdle that shareholder claimants have to pass in order to bring a derivative claim against a company and its directors and confirmed that the courts will be slow to interfere with company management decisions. Whilst the High Court refused permission for ClientEarth’s claim to proceed, the case represents an increase in scrutiny of directors’ actions in implementing ESG factors.

Further, where a company holds itself to a certain ‘green’ standard (ie a commitment is made to source parts sustainably or ensure its carbon footprint is offset), directors should be mindful of their liability where the company has fallen below that standard. If that standard is one of the company’s main selling points for investment, failure to meet those standards could lead to a loss of company reputation, shareholder investment and liquidity issues. Such failures could give rise to a claim against the directors for a breach of their duties.