Corporate strategy on climate risk in the courtroom: Not worth powder in shot

Abstract

In ClientEarth v Shell Plc, ClientEarth brought ‘ground-breaking’ derivative litigation against the board of directors of Royal Dutch Shell Plc by alleging their corporate strategy on climate risk was determined in breaches of duties under the Companies Act 2006, ss. 172 and 174. This analysis of ClientEarth demonstrates the importance of the decision for climate litigation. First, it confirms that corporate strategy on climate risk is a matter for the directors and is not actionable because there is no accepted methodology on managing climate risk that can evidence the strategy is unreasonable. Second, it confirms that even if corporate strategy on climate risk is determined in breach of duty, it is still not worth powder in shot to pursue derivatively. The decision means climate risk is left to the private ordering of the company. That should send a message to Parliament because the directors’ determination of what is best for the company is not frictionless with environmental law goals. Without effective public ordering, the friction risks the UK failing to meet its international climate obligations.

Introduction

In ClientEarth v Shell Plc, ¹ ClientEarth brought what it called a ‘ground-breaking’ derivative claim against the directors of Royal Dutch Shell Plc (hereafter ‘Shell’). ² As a shareholder in Shell, ClientEarth alleged that the board of directors’ corporate strategy on climate risk was unreasonable, amounting to breaches of duties owed to the company under the Companies Act (CA) 2006. If the claim had been successful it would have reposed in activist shareholders a useful weapon to challenge corporate strategies on climate risk. However, the High Court refused to grant permission to ClientEarth to bring an action derivatively, holding that a difference of opinion on corporate strategy is not prima facie actionable because it is a matter for the directors to determine. The confirmation of this in ClientEarth is trite law but the decision also confirmed that derivative litigation on challenging corporate strategies determined in breach of duty under ss. 172 and 174 is not worth powder in shot. These confirmations should send an important message to Parliament. The board's strategy was not actionable as there is no accepted methodology on how to manage climate risk. It could not, therefore, be evidenced that the strategy was determined in breach of duty. However, directors are incentivised to do what they think is best for the company, which is not frictionless with environmental goals. ClientEarth shows this friction risks the subordination of the latter to the former and without effective public ordering, it means the UK may not meet its international climate obligations. ³

Challenging derivatively the lawfulness corporate strategy

The derivative litigation brought by ClientEarth alleged that the corporate strategy was determined in breaches of duties under the CA 2006, ss. 172 and 174. ⁴ These duties require the directors to act in a way they consider, in good faith, to be in the best interests of the company, and to discharge their role with due care, skill and diligence.

As a shareholder, ClientEarth did not have a right of standing to enforce those duties. Duties of a director are owed to the company and the cause of action for any breach of those duties is vested in the company as a legal person. ⁵ However, an exception to the rule is recognised in circumstances where those who control the company are the ones who have committed a wrong against it. Without this exception, there would be a wrong without redress. ⁶ The exception allows a shareholder of the company to pursue the cause of action vested in the company in the company's name. However, a shareholder does not automatically have standing. To do so would collapse the rule into an exception. A shareholder must first claim permission from the court to derive the right of action vested in the company to enforce its rights against the wrongdoers. This is the derivative claim.

The derivative claim is now enshrined in the CA 2006 as a two-part procedure. ⁷ First, ClientEarth faced an evidentiary burden to disclose a prima facie case that the claim falls within the proper boundaries of the statutory exception to the rule. ⁸ The formal boundaries of the procedure include the cause of action arising from an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of the company. ⁹ To discharge the burden, the shareholder must evidence that the company would be entitled to judgement in the absence of an answer from the defendant. ¹⁰ If they do this, the court has discretion on whether to grant permission at the second stage, subject to three mandatory bars. ¹¹

Legal standards for establishing a prima facie case

The specifics of the allegations are set out in detail in the case, ¹² but in general, ClientEarth had alleged that the strategy ‘fell outside the range of reasonable responses to climate change risk and will cause harm to Shell's members’ which put them in breach of the duties mentioned. ¹³ It was alleged that there was: a failure to set appropriate emission targets; no reasonable basis for achieving its net zero target; and a failure to comply with a Dutch Order. ¹⁴ The evidence for these allegations was from two witness statements from ClientEarth's own lawyers. ¹⁵

Starting with section 172, what is best for the company is for a good faith, subjective determination by the directors. ¹⁶ In discharging, this duty they must have regard to stakeholder interests, including the environment. ¹⁷ Therefore, a director is required by law to act in a way they think will promote the best ‘interests of the company as a whole’. ¹⁸ Provided the director does so in good faith, the ‘cornerstone’ for liability, ¹⁹ the court will not, and by extension will not allow the shareholders to, question the decisions of directors ‘honestly arrived at’. ²⁰ It is not subject to a qualification of reasonableness. ²¹ However, a director may be in breach if the conduct is not in the interests of the company. The court described this as requiring evidence that ‘there is no basis on which a director could reasonably have come to the conclusion that the actions that have taken have been in the interests of Shell’. ²² For example, a director who arranged a company pension for his wife had no basis for concluding it was in the interests of the company ²³ but a director who grants a week's wages as gratuities for the company's employees would have. ²⁴ Finally, a director who does not consider the interests of the company may also be in breach of duty. ²⁵

As for section 174, the standard of liability is objective. ²⁶ The decision taken must not fall outside the range of reasonable options available. ²⁷ However, there is no standard to objectively hold the directors’ substantive business judgements to say it fell outside that range. ²⁸ Therefore, like what is best for the company, whether the strategy is a reasonable one, it is an autonomous decision for them to take. ²⁹

No accepted methodology on climate risk

ClientEarth's evidence failed to establish a prima facie breach of either duty. ³⁰ The law makes clear that corporate strategy is a matter for the board of directors unless it can be shown to be unreasonable, either because it was devised without care under section 174 or there was no basis for it being in the interests of the company under section 172. ³¹ This exposition of the duties’ standards of liability highlights the fundamental problem with ClientEarth's allegations. The witness statements submitted as evidence may have alleged that the strategy was unreasonable but these expressed differences of opinion as to whether the strategy would meet the targets and not fact. ³² ClientEarth had not evidenced prima facie that the strategy was unreasonable in fact because there is no accepted methodology on how to manage climate risk to show it fell outside the range of reasonable options available or had no basis for its pursuit. ³³ The absence of a methodology on managing climate risk made it ‘very difficult’ to treat Shell's strategy as unreasonable. ³⁴ The witness statements, while expressing genuinely held views, ³⁵ were mere differences of opinion that the court could not ‘properly rely’ because neither were from experts and were ‘plainly insufficient’. ³⁶

That was not all. It may well be that the strategy exposes Shell to climate risk and the targets may not be met, as ClientEarth alleged. ³⁷ However, those risks, even if evidence as fact, do not make the strategy unreasonable under either duty because directors have ‘competing considerations’ to balance when determining the corporate strategy to pursue. ³⁸ Failing to prioritise climate risk is not unreasonable. ³⁹ Climate risk does not have an ‘overriding status’ ⁴⁰ on other considerations and the judge is not well placed to question that balancing act except in a ‘clear case’. ⁴¹ Likewise, the strategy was not evidenced to be prima facie in breach of section 172 as one that did not consider the interests of the environment because, by ClientEarth's own admission, there was a corporate strategy on climate risk. ⁴²

These legal standards will stymie most, if not all, derivative litigation challenging corporate strategy on climate risk because the evidence required to disclose prima facie an actionable breach of duty is unlikely to exist. If there is no accepted methodology on how to manage climate risk, and corporate strategy is determined autonomously by the directors balancing a range of considerations, ⁴³ any expert evidence produced is likely to express only disagreement about its reasonableness. The evidentiary burden is not lightened merely because it is difficult to obtain expert evidence. ⁴⁴ The court rejected ClientEarth's suggestion that their evidence should be taken ‘at its highest’, and thus accept the allegations without critical evaluation. The evidentiary burden is on the claimant who must satisfy the court that the company is prima facie entitled to the relief sought. ⁴⁵ To take ClientEarth's evidence at its highest would be to shift the evidentiary burden onto the directors without ClientEarth having first evidenced a prima facie breach of duty.

Therefore, the evidence did not disclose that the strategy devised was one that ‘no reasonable director could properly have adopted’ to breach either duty. ⁴⁶ Differences of opinion do not create prima facie actionable breaches of duties because strategy is a matter for the board of directors. ⁴⁷ Without evidence of bad faith, the court concluded that while there were ‘fundamental disagreements’ on what is best for the company, the court ‘respects the autonomy’ of the directors. ⁴⁸

Prima facie actionable breaches are not worth powder in shot

If we suppose that ClientEarth's evidence was sufficient to disclose prima facie actionable breaches of duties under ss. 172 and 174, the court's obiter remarks confirm that derivative litigation challenging strategy on climate risk may still not be worth powder in shot. This is because permission is a discretion resting with the court exercised on established principles. ⁴⁹ Since the origins of the procedure are equitable, ⁵⁰ permission is a ‘matter of grace’. ⁵¹ If a principle is established, then permission will not be granted to the shareholder as the ‘proper person’ to enforce the breaches in the name of the company. ⁵² Deference to discretionary principles shows that shareholders should still be wary of pursuing derivative litigation on challenging the lawfulness of the corporate strategy on climate risk under ss. 172 and 174, even if they can evidence prima facie breaches of duties. Directors have the assets of the company at their disposal and it is unlikely that they will be unable to come up with at least one principled reason for the court to exercise their discretion to refuse permission for such allegations. ⁵³ This will then leave the claimant shareholder liable for costs, as they are allocated on English-rule loser pays, ⁵⁴ and thus the claim is not worth powder in shot.

ClientEarth follows the judicial deference to discretionary principles that show most, if not all, derivative litigation on prima facie breaches of ss. 172 and 174 is likely to be refused, including those seeking to challenge the reasonableness of corporate strategy on climate risk. ⁵⁵ In ClientEarth, there was not one but four discretionary reasons for refusing permission. These were ClientEarth acting for an ulterior purpose; ⁵⁶ they had adequate alternative remedies; ⁵⁷ they lacked the support of independent shareholders; ⁵⁸ and a director acting in accordance with section 172 would not continue the claim, or would attach little weight to it. ⁵⁹ It is the court's treatment of the latter two principles that offer the strongest evidence of why most derivative litigation challenging corporate strategy on ss. 172 and 174 would be denied permission. ⁶⁰

Consider first the principle that if a director acting in accordance with section 172 would not continue the claim, ⁶¹ or attach little weight to it, ⁶² permission will not be granted. To satisfy either requirement, the court approaches the question according to the strength of the claim's legal merits because it is not well placed to consider commercial considerations except in a ‘clear case’. ⁶³ The legal merits must then be in a state that meets the court's somewhat nebulous threshold that they disclose an ‘obvious breach of duty’, ⁶⁴ a ‘strong case’ ⁶⁵ or the like. ⁶⁶

Prima facie breaches of ss. 172 and 174 are likely to be challenged by directors with evidence to the contrary that would prevent the claim from meeting the relevant threshold. Indeed, ClientEarth was able to do this for Shell. The court noted that it was ‘part of ClientEarth's own case that the directors do have policies and targets to achieve [net zero] by 2050’ and is ‘inconsistent with any suggestion that the directors have not in fact considered what is in the best interests of Shell … when addressing the most appropriate manner in which to deal with climate risk’. ⁶⁷ Likewise, the absence of a methodology on managing climate risk and the range of considerations a director must balance in discharge of their duties evidenced an autonomous decision had been exercised that the court could not interfere with unless it was unreasonable. ⁶⁸ Therefore, the fact directors have devised a strategy would in most, if not all, litigation cast significant doubt over any prima facie breach of duty to prevent them from meeting the relevant threshold for permission.

The legal merits of prima facie breaches of ss. 172 and 174 are also unlikely to sufficiently strong to have weight attached to it at the court's discretion because of the remedial relief required to enforce them. In ClientEarth, a mandatory injunction was ‘too imprecise to be suitable for enforcement’ and it was ‘likely that any such order would have a disruptive impact on Shell's business’ because the ‘court would be required to adjudicate on disputes over whether or not a business is being run in accordance with its terms’. ⁶⁹

Therefore, ClientEarth shows that claims challenging corporate strategy on climate risk under ss. 172 or 174 are likely to be of doubtful legal merit to satisfy this principle at the court's discretion. In ClientEarth, the court concluded the claims were such that no director would continue them and would, therefore, be barred under section 263(2)(a), ⁷⁰ let alone being ‘an obvious breach of duty’ that a director would attach weight to them. ⁷¹

Now consider the principles concerning the views of shareholders independent of the claim. ⁷² A court will consider whether the conduct is likely to be authorised or ratified ⁷³ and particular regard must be given to the views of those members with no personal interest in the matter. ⁷⁴ If they do not support litigation then it is another discretionary reason for refusal. ⁷⁵ In litigation on ss. 172 and 174, the majority of independent views are likely to support the directors, even if there is a breach of duty, due to a range of factors. ⁷⁶ Therefore, all the directors need to do to have permission refused is to have independent support put in confirmatory terms because, provided it is not illegitimately obtained, ⁷⁷ the court will not review how that decision was reached. ⁷⁸ As the court expressed in Kleanthous, the disinterested majority are in a better position than the court to decide whether the litigation is in the interest of the company. ⁷⁹

This general approach has translated into the decision in ClientEarth. ⁸⁰ Despite inaccurate media fanfare that their litigation ‘has already received support from institutional investors who together hold over 12 million shares in the company’, ⁸¹ support for the litigation was actually uncertain and ‘very small’. ⁸² Its disapproval of the strategy garnered greater support but still only represented a minority interest. ⁸³ The majority of shareholders did not favour the litigation, which the court accepted as another principled reason to dismiss the claim. ⁸⁴ As such, even if there is a breach of duty in determining a company's strategy on climate risk, the majority of views independent of the claim are unlikely to support it, resulting in permission being refused with costs. ⁸⁵

ClientEarth's appeal

ClientEarth is appealing the decision. They may quibble about part of the reasoning that there was no prima facie case, but there is little prospect that permission will be allowed on appeal to encourage shareholders to challenge corporate strategy derivatively.

The inaccuracy in the reasoning was that the court incorrectly, and without authority, considered discretionary factors of the second stage ‘must be taken into account’ in its determination about the first stage. ⁸⁶ The mistake made by the court was not distinguishing the company's cause of action from the shareholder's claim to enforce it. If a shareholder seeks to derive a right of action from the company contrary to principle, that principle prevents them from doing so. For example, equity requires the claimant to come with clean hands, so a shareholder who seeks permission in bad faith will be denied permission to stand. ⁸⁷ That is distinct from the company enforcing its rights. It may still be in the interests of the company to enforce the duty it is owed by the director, even though a shareholder seeks to do so in bad faith. It does not excuse the prima facie breach of duty owed to the company. The company, as a legal person, has not acted in bad faith.

The error is unlikely to result in the appeal being allowed because the discretionary factors merely confirmed that ClientEarth has failed to evidence that their claim disclosed a prima facie case. It is still the case that their evidence hinged on witness statements differing in opinion on the reasonableness of the corporate strategy, which were not actionable breaches of duties. Unless new evidence is produced, there is no reason to believe the court will allow the appeal.

Even if this is wrong and there is a prima facie case, the consideration of the discretionary factors only evidence that ClientEarth would not be given permission. When a court applies a discretion it is a general principle that in the exercise of judicial discretion, while there may be room for ‘legitimate difference of judicial opinion’ it will only be overturned if it ‘proceeded upon some erroneous principle or was plainly and obviously wrong’. ⁸⁸

A message for parliament

ClientEarth echoes the existing message of the court that corporate strategy is for the company itself to decide and the court will not ‘pioneer’ new methods to regulate it. ⁸⁹ If there are disagreements about corporate strategy on climate risk, the proper forum for such disputes is the company's own internal mechanisms. ⁹⁰ Parliament should hear that message because it risks the UK not meeting its international obligations on climate change. ⁹¹

If corporate strategy on climate risk is left to the private ordering of the company's own internal mechanisms, without effective public ordering the tension between corporate law's purpose and environmental law goals risks the subordination of the latter to the former because the corporate contract allocates almost complete discretion to the directors who are incentivised to do what is best for the company as a whole, not the environment. ⁹²

The problem this friction creates for environmental law goals can be explained briefly through a couple of examples. First, the purpose of corporate law is to maximise the wealth of the company and it is achieved by approximating the efficient contract between directors and shareholders to maximise their aggregate welfare. ⁹³ It is approximated, in part, by allocating decision-making to the directors who are legally required and incentivised to do what is best for the company as a whole. ⁹⁴ If corporate law was instead structured to do what is best for stakeholders, such as the environment, it may fail to meet corporate law's purpose. If directors were legally required to act in a way that is best for the environment, the company's wealth will be subordinated to environmental law goals, thus failing to approximate the efficient contract. ⁹⁵ Shareholders, for example, may pay less for the company's shares due to the increased risk exposure from the subordination of their interests. ⁹⁶

Now consider this friction with the way directors are remunerated. Directors’ remuneration incentivises them to achieve the corporate purpose, assessed through metrics such as total shareholder return and earnings per share. ⁹⁷ The directors’ remuneration predominately vests over three years, but net zero targets are set between 2030 and 2050. The long-term consequences for the company of any decisions made by current directors will be borne by future incumbents. As such, directors of today will not be primarily concerned with the future consequences of climate risk when their rewards are based on more immediate pressures, such as their own remuneration or re-election. ⁹⁸ The incentive structure for directors to maximise the value of the company is then inherently in tension with what is best for the environment. ⁹⁹

ClientEarth shows that with private ordering alone some boards will not lightly act in the interest of the environment if it affects the interests of the company, with Shell's strategy committing to new investments in fossil fuels projects. ¹⁰⁰ To address this friction, it is argued that better public ordering of corporate strategy is needed if the UK is to fully decarbonise its power supply by 2035. ¹⁰¹ Regulation needs to require companies to move to cleaner energy rather than leaving it to the board to decide whether it is in the interests of the company or not.

Banning certain activities, such as drilling for oil and gas, may well be treated with hostility as a matter of principle, but should not be ruled out. ¹⁰² Perhaps a more palatable option is to regulate how corporate strategy on climate risk should be managed. A one-size-fits-all model is unlikely to be appropriate ¹⁰³ and it may be difficult to agree on accepted methodology on reducing emissions, as ClientEarth evidenced. Instead, the UK could learn from private efforts to reduce emissions in specific sectors, such as shipping, ¹⁰⁴ and mandate that they are reduced in accordance with the Paris Agreement, leaving the flexibility to individual companies to determine how to meet that target. An alternative is to learn from other jurisdictions, such as Fiji or the European Union, which places specific obligations on directors in the discharge of their duty of care, ¹⁰⁵ something not present under the UK's statutory duty. ¹⁰⁶ A failure to exercise that care may then become an actionable breach of duty that shareholders could enforce derivatively. ¹⁰⁷ While rules on directors’ remuneration could be amended to require incentives to meet environmental goals, it should be part of a wider effort to ensure companies reduce their emissions. Such incentives in isolation are unlikely to have a meaningful impact on director behaviour to prefer environmental goals over corporate purpose. ¹⁰⁸

Conclusion

ClientEarth confirms that corporate strategy on climate risk is an autonomous decision for the directors and is not prima facie actionable under ss. 172 and 174 when shareholders disagree on whether it is a reasonable strategy. It also confirms prima facie breaches are not worth powder in shot to pursue such breaches derivatively because of the court's deference to discretionary principles and English rule on costs. ClientEarth's appeal is unlikely to change that.

The legal duties described above do not prevent a director from aligning corporate purpose with environmental goals. Many companies do so. Nonetheless, by leaving the decision of corporate strategy to the board of directors, the friction between corporate purpose and environmental law goals presents a distinct problem to the UK meeting its international climate obligations. Left to the status quo, directors are incentivised to prefer the interests of the company. Public ordering must be considered to address this friction so that companies adopt strategies that meet environmental law goals. The status quo, however, remains for now because, for ‘ground-breaking’ derivative litigation, ClientEarth did not break soil.