ESG Risks: Litigation Scenarios in Corporate Investments

Do company directors have a legal duty to divest from fossil fuel investments?

By Alex Lerner, Senior Associate, Commercial Litigation, Fraud and Tax Litigation and Resolution

Environmental, social and governance (ESG) issues have quickly risen to become a top priority at almost every large business, fund and organisation in each sector of the economy, not least because failing to address ESG concerns is now an active litigation risk.

The Companies Act 2006 (CA2006) provides, among other things, that directors must act:

in accordance with a company’s constitution and only exercise powers for the purposes for which they are conferred (section 171), and
in the way that they consider, in good faith, would be most likely to promote the success of a company for the benefit of its members as a whole (section 172).

This article considers one scenario that could (and has) led to litigation: corporate trustee company directors that continued fossil fuel investments without an immediate plan for divestment, alleged to be acting contrary to the company’s long-term interests.

What could a divestment claim look like?

The case of McGaughey v Universities Superannuation Scheme Ltd [2022] EWHC 1233 (Ch) provides an example of the kinds of claims that can arise based on ESG issues, specifically around companies continuing to make fossil fuel investments while also pledging commitment to net zero emissions.

The Universities Superannuation Scheme is a defined benefits and a defined contribution scheme established for the purpose of providing superannuation benefits for academic and comparable staff in universities and other higher education institutions in the United Kingdom (the scheme). The Universities Superannuation Scheme Ltd was the corporate trustee of the scheme (the company).

Two members of the scheme, Dr Ewan McGaughey and Dr Neil Davies, claimed as part of broader legal proceedings that the company’s directors were in breach of sections 171 and 172 of CA2006 because they had continued to invest directly and indirectly in fossil fuel investments without an immediate plan for divestment, despite having announced on 4 May 2021 that the company’s ambition was to be carbon neutral by 2050. The claimants argued that this was contrary to the company’s long-term interests, that this prejudiced the company’s success and that the company suffered loss in consequence.

Notably, there were two arguments that the claimants did not make. First, they did not allege that the company had a duty to divest from fossil fuel investments for ethical reasons, likely because of the decision in Cowan v Scargill [1985] Ch 270. Cowan held that when the purpose of a trust is to provide financial benefits for the beneficiaries, as is usually the case, the best interests of the beneficiaries are normally their best financial interests. Although it did not go so far as finding that financial benefit was the inevitable or sole means of assessing benefit to beneficiaries, in practice Cowan left only limited scope for arguing in favour of divestment from fossil fuel investments for ethical reasons.

Second, the claimants do not appear to have specifically relied on section 172(1)(d) CA2006, which obliges directors to have regard to environmental matters. The reasons for this are less clear.

What did the judge rule?

The judge noted that although the claimants may have disagreed with the directors’ approach to investments in fossil fuel companies on ethical grounds and, in particular, with their view that divestment is not the appropriate way to reach net zero, they did not put their case on the basis of those objections. Instead, it was put on the grounds that the company had suffered financially as a result of the decision not to divest. However, the claimants failed to persuade the judge that the company had suffered immediate financial loss due to the directors’ failure to adopt an adequate plan for long-term divestment.

The judge identified that the claimants:

had not provided particulars of the alleged losses,
did not specify which particular investments the company should have sold or when, or what the consequences would have been if it had done so, and
did not specify why the company would have avoided consequences if it had adopted an immediate plan for divestment, or the plan the company should have adopted instead.

For example, Dr McGaughey and Dr Davies did not allege that the company should have sold its investments in fossil fuel companies overnight. Neither did they propose that if it had adopted a long-term divestment plan, it would have avoided any immediate losses as a result of its holdings in fossil fuel companies.

By contrast, the defendants successfully evidenced that the directors had exercised their powers of investment in a manner consistent with their duties: they had taken legal advice; conducted a survey of members; adopted an ambition of net zero by 2050; and introduced policies for working with the companies in which it had investments to transition towards carbon neutrality in the meantime.

What are the key lessons?

McGaughey provides several key lessons for cases concerning divestment from fossil fuel investments. First, as noted above, it provides helpful guidance for companies and directors on steps they can take to protect their position against prospective claims.

Second, for claimants, arguments in favour of divesting from fossil fuel investments founded on avoidance of financial losses are likely to have better prospects than arguments founded purely on ethical considerations, at least for now.

But, third, claimants proceeding on that basis must plead out a cogent and sufficiently detailed claim in relation to causation and loss, as well as providing sufficient details of any counter-factual scenario relied on (to show how alleged damage could have been avoided). To achieve this, practitioners are likely to require expert input and evidence from an early stage.

In McGaughey, the principal evidential support for the claimants’ case was in Dr McGaughey’s witness statement, which asserted that investment in fossil fuels “has caused significant financial detriment to the interests of beneficiaries in recent years”. He did not claim to have any expertise in expressing this view and his evidence was based on a selection of Financial Times articles. Further, Dr Davies had expressed the view that the company’s decision to sell Russian fossil fuel companies had come too late to avoid losses arising from sanctions. The judge commented that the supporting evidence was so weak that it rendered the claim liable to being struck out. Clearly, the judge thought such evidence was insufficient.

Fourth, the judge held that even if he had been persuaded by the evidence in support of the claimants’ case, he would not have exercised his discretion to allow the claimants to continue their claim (that the directors had continued their fossil fuel investments without an immediate plan for divestment). The judge said the better approach would have been a direct claim against the company for breach of trust, notwithstanding the difficulties inherent to such a claim.

The number of claims linked to ESG concerns around investments is only likely to increase, and fossil fuel investments are a clear target for claimants. Companies and directors must be aware of potential grounds for a claim; would-be claimants must be clear about the appropriate procedures for bringing such claims, and how best to argue and substantiate them.