ESG disputes – understanding the credit and indirect litigation risk to lenders

Arguably the most obvious targets of ESG litigation (claims relating to environmental, social and corporate governance issues) are companies operating in the fossil fuel industry and other major greenhouse gas emitters.

Such claims frequently deploy novel lines of argument and, while these have been of mixed success, there is an increasing line of case law from various jurisdictions illustrating the courts’ unwillingness to dispose of such claims on a summary basis. 

While litigation of that nature may initially seem remote to many UK-based lenders, in this article we look at why it (and other similar types of ESG dispute) may nonetheless present lenders with both litigation and credit risk, and how these risks may be managed. 

The ‘underlying’ ESG litigation

As a starting point, it is worth recapping some of the key cases from the UK and abroad which are shaping the law in this area.  Very broadly speaking, these fall into 2 groups:

• those focussing on mitigating future climate change; and
• those seeking to hold companies accountable for environmental or other social/corporate governance failings by their subsidiaries or third parties in their ‘value chain’.

Mitigating climate change

• Milieudefensie et al -v- Royal Dutch Shell plc (Netherlands) – the claimant NGOs alleged Shell owed a duty to Dutch citizens to protect them from adverse effects of climate change. In May 2021 the Dutch District Court of the Hague agreed Shell had breached an unwritten duty of care by failing to implement appropriate corporate policies. It ordered Shell to reach a target reduction in CO2 emissions of at least 45% by 2030.According to Shell’s website it filed an appeal in August 2021 which it expects will take 2-3 years to be dealt with.In the meantime Milieudefensie have also written to 29 other multinational companies including ExxonMobil[1] and Uniliever, setting out how it believes the Dutch judgment (as it stands) affects them.

   

• ClientEarth shareholder litigation against Shell (E&W, pre-action) - closer to home, and in the wake of Shell’s relocation of its global HQ to London, ClientEarth has recently sent a pre-action letter to Shell notifying the company of its claim against the board of directors on the basis (in short) that it has failed to adopt and implement a climate strategy which truly aligns with the Paris Agreement, which in turn constitutes a breach of the directors’ duties under s.172 of the Companies Act 2006.This is the first attempt to hold a company’s directors personally liable for allegedly failing to prepare properly for the net zero transition.Following the directors’ pre-action response, ClientEarth would then need to seek the Court’s permission to bring the claim.

   

• Smith -v- Fonterra Co-operative Group Ltd (New Zealand) – this claim against 7 companies contributing to greenhouse gas emissions raised 3 causes of action in tort; public nuisance, negligence and breach of an inchoate duty of care.In March 2020 the High Court in New Zealand struck out the first two, but was not prepared to do so in respect of the third novel duty of care, finding that this should be explored at trial.However, all three causes of action have since been struck out on appeal with the Court of Appeal stating that “the issue of climate change cannot be effectively addressed through tort law”. As a NZ decision, this case may prove more influential to the UK courts than the Dutch Milieudefensie case above.It has been reported that Mr Smith has sought leave to appeal to the Supreme Court in NZ.

• Sharma -v- Minister for the Environment (Australia) – on behalf of “all children who ordinarily reside in Australia”, the Claimant argued successfully, at first instance, that the Minister owed a duty of care to all such children to exercise her statutory powers with reasonable care not to cause the children harm as a result of emissions from a particular project she was being asked to approve.However, in March 2022, the Minister was successful in appealing this decision.

   

• In Germany, following four separate complaints filed by individuals and climate protection groups in relation to the country’s Climate Protection Act (in the form enacted at the end of 2019), the Constitutional Court held on 24 March 2021 that the Act was unconstitutional in parts.The relevant provisions set out the greenhouse gas emissions reduction target to be achieved by 2030, which the Court found “are unconstitutional insofar as they lack provisions that satisfy the requirements of fundamental rights on the updating of [emission] reduction targets from 2031 until the point when climate neutrality is reached as required by Article 20a [of the German constitution].Almost immediately following this decision, the government presented a draft amendment on 12 May 2021 which was passed by the German parliament on 24 June 2021.

Parent company/value chain liability

• Vedanta Resources -v- Lungowe[2] (E&W) - in this landmark decision the Supreme Court ruled (largely upholding the High Court and Court of Appeal decisions) that a claim by 1,826 residents of the Zambian city of Chingola against Vedanta, the UK parent of a Zambian subsidiary KCM, could proceed to trial.The claim subsequently settled without proceeding to trial but the claimants had alleged that waste discharged from a copper mine owned and operated by KCM had caused pollution, personal injury, damage to property and loss of income.In finding that there was a real triable issue against Vedanta, a key factor was the extent to which Vedanta had intervened in the management of the mine owned by KCM, and whether such intervention equated to an assumption of a duty of care, or established statutory liability under the relevant Zambian laws.

   

• Okpabi -v- Royal Dutch Shell[3] (E&W) - following much of the rationale adopted in Vedanta, the Supreme Court again found that this claim by over 42,000 residents of Rivers State, Nigeria could proceed to a full hearing.The claimants allege environmental damage has been caused by RDS’s Nigerian subsidiary SPDC, and that RDS owed them a duty of care which arose as a result of the significant control RDS was said to have exercised over SPDC’s operations.As to that control, it was found (based on internal RDS documents) that the Shell group’s vertical structure meant that while decisions relating to operational safety and environmental responsibility were taken at subsidiary level, they generally followed prior advice and consent from the vertical organisational authority.

   

• Begum -v- Maran[4] (E&W) - while noting it would face “formidable hurdles”, the Court of Appeal declined to strike out this claim, finding that the allegation the defendant owed a duty of care was more than fanciful.Maran, a UK shipping agent, had sold a defunct oil tanker on terms which required the buyer to dispose of it ‘in safe conditions’, but at a price which (on the claimant’s evidence) meant Maran must have known that it would actually be broken up in notoriously dangerous conditions in Bangladesh.The ship was indeed broken in such conditions and a shipbreaker, the claimant’s husband, lost his life in the process.The CoA found that the claimant advanced two viable propositions; (i) that Maran owed the deceased a general duty of care to avoid reasonably foreseeable acts or omissions which could cause harm, and (ii) that Maran owed a duty of care having negligently caused or permitted a source of danger to be created, and it being reasonably foreseeable that none of the other entities involved would interfere so as to break the chain of causation, thereby causing harm.The claim has nonetheless since been discontinued (with no order as to costs), perhaps in light of the difficulties the Claimant faced on limitation.

How does this affect UK lenders?

ESG-related litigation can have a huge impact on a company’s reputation, legal spend and even its overall commercial viability.  It is crucial for lenders to look ever more closely at how exposed their borrowers (and prospective borrowers) are to these sorts of claims and challenges, both as part of their assessment of lending propositions and general creditworthiness, but also with an eye on the potential for lenders themselves to become embroiled in litigation brought against their borrowers.

Deal viability

Notwithstanding the Minister’s recent successful appeal, the Sharma case provides a good example of the potential commercial risk to lenders involved in the funding of infrastructure projects anticipated to have a significant negative environmental impact.Such projects will typically be funded by a syndicate/club deal requiring a heavy time investment from members (particularly the agent) ‘up front’.If the project is the subject of a challenge (even if not directed at the borrowers, but the approving government minister/department) it could be stalled for a significant period of time, during which any number of variables going into pricing and other factors affecting members’ appetite for the deal may change. This could lead to the deal being rewritten and/or to disputes between members, or ultimately to the project/deal not proceeding at all.While neither Sharma nor the Packham challenge to HS2 succeeded, there is little doubt that challenges of this nature will continue to be brought and can still have a significant impact even if they do not succeed in the UK courts through the adverse publicity generated.

Credit risk

Lenders will no doubt already be very alive to the various pressures on borrowers whose activities significantly contribute to greenhouse gas emissions, and/or which operate in (for want of a better phrase) other high ESG risk sectors, which may translate into credit risk.In light of the Vedanta, Okpabi and Maran decisions, however, it is important for lenders to consider not just what activities their ‘direct’ borrowers are engaging in, but also to understand the activities of their subsidiaries and third parties in their value/supply chain (even if there is no direct relationship between these entities and the lender), and any ESG risks these may pose.Should any such risks eventuate, and subject obviously to corporate structures, levels of oversight and control and so on, there is encouraging authority for those affected to seek to hold the parent or instructing entity accountable, posing just the same credit risk to the parent’s lender as if its own borrower were (allegedly) responsible.

Litigation risk

The parent/value chain liability claims are already testing hitherto established principles and boundaries about the circumstances in which one party may owe a duty of care to another.On the face of it, extending such claims to lenders as well might seem ‘a step too far’ but should not be discounted - a key characteristic of ESG litigation is the advancement of novel arguments and there is great interest in such claims in the litigation funding market.Taking a Maran-type situation as an example, if the buyer of a ship sought bank funding to facilitate the purchase[5], the lender would wish to know how the buyer proposed to pay the loan back, including details of the anticipated income and expenditure (including ship-breaking costs).It is not an inconceivable argument to say that a prudent lender would want to know, or ascertain, what the projected ship-breaking costs meant for the conditions in which the ship would be broken, and that if it nonetheless proceeded with the loan, either or both of the claimant’s propositions in Maran should apply equally to the buyer’s lender as to the entity selling the ship.

Key takeaways

Increasing ESG litigation reflects the increasing global concern around climate change, and poor working conditions and ethical practices (and the profits that some companies make as a result).  While the technical legal success or otherwise of such claims will of course vary on their facts, the way in which they are pleaded, and the jurisdiction in which they are brought, doors have been opened in this regard and there will be many instances in which even an ‘unsuccessful’ action nonetheless succeeds in bringing about positive change by an organisation through the reputational and commercial pressure it leverages. 

Banks/lenders play an integral role in keeping almost any business running.  Lenders need to be working in step with their clients to understand where ESG risks arise as part of their clients’ own operations, or that of their subsidiaries and value/supply chains, and responding accordingly – for example by requiring minimum heath and safety standards to be implemented, incentivising certain improvements, etc – as part of funding arrangements.  This enhanced due diligence and constructive collaboration with clients will not only help reduce the risk of ESG-related adverse events occurring, and the litigation and credit risk that flows from those, but will also form a central part of banks’/lenders’ own ESG credentials where it is essential that their actions match up with their public commitments and disclosures.