By Robin Hamaker-Taylor, Richard Bater, and Nadine Coudel
Climate risk disclosures are now a crucial part of the voluntary disclosure activities of many corporates and financial institutions. As these disclosures grow, questions around the extent to which they may leave disclosers exposed to litigation linger. Recent analysis from the accounting literature indicates that voluntary disclosures can actually lead to reduced litigation risk however. This article looks to these recent studies in other areas of voluntary disclosure to explore this question, and reviews changes underfoot that could increase litigation risk in the medium-term.
As capital markets began to grow and open up in the last century, it soon became clear that traditional financial reporting frameworks were not able to fill the information gaps between shareholders (investors) and corporate management according to researchers Schuster and O’Connell. Voluntary disclosure grew out of the need to fill the gap between the management’s view of the company’s value and what the market or investors saw as the view of the company’s value.
Corporates’ key performance data, for example, was not fully captured in conventional financial reports. As such, a number of frameworks for value-based reporting emerged in the 1990’s, which call for a range of voluntary disclosures such as forecasts of threats and opportunities, information on tangible and intangible assets, and management, among others. Coupled with the advent of technological advancements such as the internet, which for the first time allowed for rapid information dissemination via corporate websites, voluntary disclosures among corporates took off and are now part and parcel of firms’ external communications.
As public interest in the transparency around the procedures, policies, governance structures, and risk management strategies of corporates and financial institutions continues to grow, an important debate has unfolded around the relationship between voluntary disclosures and litigation risk. Litigation risk is, simply put, the potential that legal action could be taken because of a corporation’s products, actions, inaction, etc. The current debate centres around whether or not voluntary disclosure reduces or increases litigation risk, and following that, if litigation risk increases voluntary disclosures.
Researchers Dong and Zhang find evidence – in the US context – that litigation risk increases voluntary disclosure. The authors hypothesise that this may be the case either because disclosures could work to invalidate claims the firm is withholding information from investors, or because disclosures can help prevent one trigger of investor lawsuits – namely stock price crashes. Further analysis also indicates in the US, in instances of lower litigation risk, the likelihood and frequency of disclosures (e.g. earnings forecasts) are reduced, in particular for companies conveying negative news. This is a much-studied question in the accounting literature, however, and empirical evidence suggests litigation risk may deter disclosures. This may be the case because lawsuits could emerge after forward-looking disclosures are proven untrue after the fact.
Climate risk disclosures are now firmly part of the voluntary disclosure landscape, in part due to voluntary carbon disclosure frameworks such as the CDP and the more recent Task Force on Climate-related Financial Disclosures (TCFD) recommendations. The Financial Stability Board (FSB) established the TCFD in 2015, who published its final voluntary recommendations for climate risk and opportunity assessment and disclosure in 2017. The FSB was concerned that because of the information asymmetry between financial markets and those they are lending to, investing in, and insuring, climate risks are a threat to the stability of the wider financial system.
The TCFD recommendations have been taken up with gusto among corporates and financial institutions, with over 500 official supporters as of early 2019. Recent analysis shows that two out of three companies assessed have started to disclose climate change-related risks, though importantly, the quality of disclosures is still low, and disclosures have varied greatly across markets in the first few years of reporting, according an annual climate risk disclosure study. Given the growing number of finance and corporate actors starting to voluntarily disclose climate risks and opportunities, and the varying scope and quality of disclosures, the debate about the influence of voluntary disclosures on litigation risks is reawakened.
There is, however, a general anxiety among corporates and financial institutions that they could be held liable for their climate risks disclosures, concerns which have been used as reasoning for lack of action in this space. Others argue that companies and their directors are actually more likely to face litigation if they fail to assess and disclose climate-related financial risks. Evidence is emerging to that effect: in 2017, shareholders of the Australian Commonwealth Bank sued, alleging the Bank violated the Corporations Act of 2001 by failing to disclose climate-change risks in its 2016 annual report. Though the case was settled, it may be a sign of what is to come.
The Hutley opinion, a 2016 landmark legal opinion set out the ways that company directors who do not properly manage climate risk could be held liable for breaching their legal duty of due care and diligence. The 2019 supplementary opinion, provided again by Noel Hutley SC and Sebastian Hartford Davison on instruction from Sarah Barker, reinforces and strengthens the original opinion by highlighting the financial and economic significance of climate change and the resulting risks, which should be considered at board-level. As the 2016 opinion explains: “It is likely to be only a matter of time before we see litigation against a director who has failed to perceive, disclose or take steps in relation to a foreseeable climate-related risk that can be demonstrated to have caused harm to a company”.
There has been a marked increase in climate disclosure litigation since 2017, underpinned by innovations of legal argument, increasing awareness, and progress in scientific evidence. This can give rise to considerable legal and reputational costs regardless of outcome, especially where liabilities are not covered by liability insurance. The disclosure trajectory is clear, therefore firms that get ahead of the game stand to benefit from unearthing opportunities, win the confidence of investors and consumers, and minimise liability risk. To be clear, firms should follow best practice in order to reduce concerns around liability associated with TCFD-style scenario-analysis and disclosures. Further recommendations on this are available here.
The legal and physical environment in which organisations (e.g. firms, municipalities, and financial institutions) are operating is in a period of rapid flux. Past knowledge and assumptions about the resilience of assets, investments and supply chains to climate risk may no longer be valid, potentially giving rise material financial risks that investors have a right to be informed about. Several changes are afoot that could increase litigation risk in the medium-term. In April 2019, the Bank of England’s Prudential Regulation Authority released a Supervisory Statement (SS) concerning banks’ and insurers’ management of climate risks. The SS sets out clear expectations regarding the strategic approach that banks and insurers will be expected to take, including appropriate disclosure of climate-related financial risks, with mandatory requirements not an impossibility in the medium term.
The obligations that Directors, boards, financial intermediaries are under are also in flux. New and existing reporting frameworks increasingly require reporting and / or disclosure of climate-related risks, whilst the attitude of investors, consumers, and regulators is hardening. All of this is serving to steadily evolve standards of professional practice and reasonable expectations of fiduciaries and officersunder existing law.
Following the release of the recommendations of the High-Level Expert Group on Sustainable Finance, in March 2019 the EU published is Action Plan on Sustainable Finance. With its declared ambitions to become a global leader in this area, the European Commission has announced that it will review reporting frameworks on non-financial information in line with TCFD and update accounting standards. The Commission is steadily laying the groundwork for sustainable finance regulation based on the Action Plan, whilst the European Parliament is also considering amendments to the IORP II Directive, that could require investment firms to consider and disclose ESG risks associated with occupational pensions. In the United States, there are legislative proposals to strengthen disclosure of climate risks to the SEC. From 2020, signatories to the widely-adopted Principles for Responsible Investment Reporting Framework will be required to report (not disclose) climate-related risks consistent with the TCFD.
A rapidly evolving legal and climatic context is shifting the context in which firms are operating. As firms and legal systems adjust to this new regime, litigation can be expected to hold firms accountable, test expectations, and clarify the law. Failing to keep pace with demands to manage and disclose climate risk in a dynamic climatic setting is likely to increase litigation risk, such as for breaches of duty, false or misleading disclosure, or non-disclosure. Organisations will need to ensure that disclosures are based on rigorous assessment and are accurately communicated to minimise litigation risk.
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