ESG - Don’t forget the S & G – key 2022 risk trends you can’t overlook

It’s impossible to read the press these days without seeing the letters ESG – but it’s the E that dominates.

The S&G don’t get nearly as much media airtime, but they are hot topics on the agenda for regulators, investors and consumers. Let’s explore the key risk trends you need to be planning for in the realm of Social and Governance.

But first, what is “ESG”?

ESG is a collective term for how a business runs and its impact on environment and society, as well as how robust and transparent its internal governance is.

Now that’s quite broad, so let’s look through some specifics.

The Social aspect describes how a firm impacts wider society and workplace culture. It recognises that businesses should positively contribute to fairness in society, promoting ethical practices and clamping down on abuses when they arise.

Governance refers to wider firm behaviour, particularly at the executive level. It’s linked to the environmental and social aspects in that it focuses on decision-making processes behind them.

Shining a light on non-financial misconduct

Non-financial misconduct is a rapidly developing exposure for firms and senior managers that goes to the heart of the S&G. According to the FCA, it goes back to the FCA’s Conduct Rules (part of the Senior Managers and Certification Regime), and the need for senior managers to be “fit and proper”.

While the test isn’t new, the FCA’s recent interpretation of it arguably is.

Take Mr Frensham, a financial adviser banned from carrying out any regulated activity for conduct not directly related to that activity. This followed his conviction and imprisonment for grooming offences, which caused him to fail the “fit and proper” test.

And it’s not just the FCA whose attention is fixed on unacceptable behaviour not directly related to regulated functions.

In 2022, Lloyd’s of London handed down its largest ever fine – and its first ever for non-financial misconduct. Atrium Underwriting was found to have tolerated bullying and sexism on an annual “Boys Night Out”, resulting in an enormous £1m fine (plus £500k in Lloyd’s costs). The penalty clearly signals that bad workplace culture can create severe financial exposures.

In the Lloyd’s action, particular attention was given to Atrium’s failure to properly investigate and discipline the main perpetrators. This demonstrates how the “governance” and “social” aspects are often closely linked.

Toxic workplace culture isn’t new, so why are watchdogs taking action now?

Well, following the financial crisis in 2008, regulators turned their attention to culture, which they regarded as key to encouraging behaviour that led to the crash.

Before that whether a person was “fit and proper” to perform their role was mainly about how that person did their job. Now, it’s clear that wider factors are also relevant to the FCA Conduct Rules.

Combine this with the sharpened focus of regulators following the MeToo and Black Lives Matter movements, and you see an environment where firms can’t afford to dismiss the S&G.

How should you respond? Tackling group think

After a scandal has been exposed, it’s easy to identify the contributing problems in a firm’s culture. This begs the question, why not take corrective action before this point?

Group think goes some way to explain this, and proactively countering it should assist. Group think describes the tendency of individuals to agree with each other, usually in order to conform and keep harmony. Countless examples can be plucked from history.[1]

Having more diverse people in senior roles reduces group think and therefore leads to improved overall decision-making. It allows companies to better represent diverse needs of clients or consumers which might otherwise be neglected by those who are simply unaware of them. Of course, it also has wider social benefits by encouraging fairness in society.

As a starting point to push for more action in this area, the FCA has introduced reporting rules requiring listed companies to ‘comply or explain’ with respect to diversity targets. In-scope companies will be required to make disclosures on the gender and ethnic make-up of boards, in relation to whether they are meeting prescribed targets. These include that at least 40% of the board are women and that at least one member is from a minority ethnic background.

In the US we have seen shareholder class actions commenced against companies and their boards alleging misrepresentations in respect of diversity. Although none of them have survived motion to dismiss stage it nevertheless highlights the focus of shareholders on this issue, and reflects the importance of having good a D&O policy that will provide entity cover (including for legal costs) for securities claims.

Community relations – something you can ignore (until you can’t)

Social media scrutiny can shine a fierce spotlight at unfortunate incidents, as one City law firm found following the ‘viral’ allegation that senior employees behaved atrociously towards a waiter – prompting an investigation by the firm. The accusation – posted to Twitter by the restaurant’s chef – attracted 134k ‘likes’ on the platform and was reported in national and industry press. It reflects the speed with which bad behaviour can become widely known, and shows that firms cannot ignore conduct just because it happens outside the workplace.

Perceived social justice failures can create significant reputational exposures, which can have financial or regulatory consequences. For example, climate action groups have been mustering support for a boycott against Barclays, with one campaigning group managing to round up 11 institutional investors to back a resolution calling on the bank to phase out the fossil fuel financing.

Indeed, social media anger has also been linked to reviews undertaken by HM Treasury and the FCA into buy-now-pay-later loans – showing that outrage can translate into action.

Ultimately, stakeholders expect companies to engage with social issues and to establish good relationships with and also improve communities. This is not just a nice to have but a must. This is fundamental to building brand trust and preserving the good reputation of firms.

Take for instance a recent PwC study, which found that 64% of those surveyed would purchase from or boycott a brand solely based on a social stance.

These incidents reflect widespread care and concern that businesses should uphold and support social causes. And, that just as banks hold capital in readiness for financial stress, firms should build and maintain positive reputations to shield them from damaging publicity.

Insurance can be a real asset when firms are embroiled in damaging scandals. Consider, for example, the treatment of the waitress mentioned above. The law firm is conducting an internal investigation, and should they find that any breach of the SRA’s Principles, they would be expected to self-report wrongdoing. A good PI policy could cover the costs of the investigations and of reporting the incident.

Insurance cover

Good PI and D&O policies should provide cover for companies and their directors’ and officers’ for claims, investigations and potentially PR crises involving Social and Governance issues. However the extent of cover will vary depending on each policy, and therefore firms cannot afford to be complacent around this turbulent risk area.

For more on the insurance angle, let’s look at how Professional Indemnity and Directors’ & Officers’ policies are likely to respond – and we’ll provide some tips on issues of concern.

Authors:

Carey Lynn, Executive Director, Legal, Technical & Claims, Financial Lines at Howden

Neil Warlow, Divisional Director, Legal, Technical & Claims, Financial Lines at Howden

Sam Vardy, Divisional Director, Legal, Technical & Claims, Financial Lines at Howden

James Wakefield, Claims Handler, Legal, Technical & Claims, Financial Lines at Howden