Directors and Officers Who Fail to Respond to Climate Change May Face Claims

In early March of this year, the Securities and Exchange Commission adopted rules targeted at enhancing and standardizing climate-related disclosures by public companies and in public offerings.

The new rules mandate the inclusion of climate risk disclosures in a company’s SEC filings, including annual reports and registration statements, to increase transparency for investors concerned about climate-related impacts.

The common practice of listing climate risks on the company’s website will no longer suffice. In pertinent part, the SEC rules require companies to disclose climate-related risks that have had or are reasonably likely to have a material impact on the company’s business strategy, operations, or financial condition; activities to mitigate or adapt to such risks; and management’s role in managing material climate-related risks.

Accordingly, directors and officers whose companies fail to comply with applicable environmental regulations or fail to consider climate risks may face personal liability for related financial losses.

In light of these increased disclosure obligations, directors and officers insurance may provide coverage for losses arising from climate-related claims, including defense costs and attorneys’ fees to respond to SEC investigations and civil cases. Whether the D&O insurer covers such a claim depends on the policy’s wording, the facts surrounding the climate risk disclosed, the underlying theory of recovery and applicable law.

ESG Investing, Climate Risks and the SEC’s Response

Environmental, social and governance, or ESG, are the three main factors used to holistically analyze an organization’s non-financial risks. While investment decisions have traditionally been based on a company’s financial metrics, there has been a rise in ESG-related investments, evidencing the importance of certain non-financial metrics to shareholders and as a driver for directors’ and officers’ business decisions.

In a 2023 Directors and Officers Liability Survey, 42% of respondents ranked climate change as the most significant environmental risk for their organization. This is consistent with the rise in government regulations aimed at promoting transparency with respect to climate and sustainability disclosures, including the SEC’s new disclosure rules.

In 2021, the SEC launched its Climate and ESG Task Force in the Division of Enforcement, with the goal of identifying “any material gaps or misstatements in issuers’ disclosure of climate risks under existing rules” as “[c]limate risks and sustainability are critical issues for the investing public and our capital markets.” As a result of the ESG Task Force’s efforts, the SEC targeted several companies and brought claims for potential misstatements regarding climate risks and failure to disclose. For example, in 2022 the SEC charged Vale S.A, a Brazilian mining company with making false and misleading claims about the safety of its dams. In 2019, Vale S.A.’s Brumadinho dam collapsed, killing 270 people, causing environmental harm and leading to a loss of more than $4 billion in Vale’s market capitalization.

In its complaint, the SEC alleged that since 2016, Vale S.A. manipulated multiple dam safety audits, and regularly misled its investors about the safety of the dam through its ESG disclosures. The complaint also alleged that Vale S.A. knew that the dam, which was built to contain potentially toxic byproducts, did not meet internationally recognized standards for dam safety, yet assured its investors that the company adhered to “the strictest international practices.”

Vale ultimately agreed to pay $55.9 million to settle the dispute in 2023. At the time, Mark Cave, associate director of the SEC’s Division Enforcement Unit, stated the settlement would “demonstrate that public companies can and should be held accountable for material misrepresentations in their ESG-related disclosures, just as they would for any other material misrepresentations.”

With the adoption of the new rules, SEC Chair Gary Gensler acknowledged that “[i]nvestors representing literally tens of trillions of dollars support climate-related disclosures because they recognize that climate risks can pose significant financial risks to companies, and investors need reliable information about climate risks to make informed investment decisions.”

Potential Liability for Directors and Officers

With the adoption of new climate-related disclosure regulations, there is a growing number of corporations becoming the subject of climate-related claims and litigations. Data from the Global Trends in Climate Change Litigation: 2023 Snapshot reports corporations now face a variety of claims alleging damages associated with climate change, including challenges to corporate climate commitments, the board’s failure to disclose climate risks, and shareholder lawsuits citing corporate mismanagement of climate change’s financial impact.

For example, shareholders commenced In Re Exxon Mobil Corp. Derivative Litigation against Exxon, certain board members and executives alleging breach of fiduciary duty, waste of corporate assets, unjust enrichment and violations of the Securities Exchange Act of 1934.

The plaintiffs allege that Exxon made public statements that understated certain climate risks to the business and overstated the quality and profitability of its assets. Specifically, the complaint alleges Exxon’s management misrepresented the “proxy costs” of carbon and greenhouse gases and failing to disclose the risk that climate change presented to its business. The case is ongoing.

Coverage considerations for Climate-related Claims under D&O Policies

With new regulations focused on climate change, companies should ensure that there are people and mechanisms in place for compliance with those regulations.

A company’s ESG disclosures are now under more stringent review, so policyholders must take steps to adequately consider and oversee ESG risks, as well as keep shareholders and investors apprised of those risks. Risk managers, insurance brokers and other insurance claims professionals should also pay attention to those ESG considerations as the effects from climate change intensify. Here, D&O insurance can serve as a backstop to director and officer liability for climate-related claims in several ways.

First, D&O policies typically require the insurer to advance defense costs incurred by directors and officers to respond to underlying securities class actions and shareholder derivative lawsuits.

This means the insurer must often pay attorneys’ fees on a contemporary basis as the underlying litigation proceeds. This is true whether the company purchasing insurance has agreed to indemnify the directors and officers for a climate-related securities claim or has refused to indemnify. A D&O policy should cover a director’s or officer’s non-indemnifiable losses (Side A coverage) and the company when it pays defense costs on behalf of directors and officers pursuant to an indemnity obligation (Side B coverage).

Second, many D&O policies might cover a director’s or officer’s legal expenses associated with an SEC investigation of the company into failure to disclose climate risks. Sometimes referred to as “interview” or “pre-claim inquiry” coverage, D&O insurance can pay attorneys to assist directors and officers responding to an SEC document subpoena or request to meet with the SEC to discuss the company’s business practices. Such coverage may be available whether a formal civil or regulatory proceeding has been commenced against the company claiming specific misconduct.

Third, while D&O policies generally protect directors and officers from potential claims that arise from the execution of their duties, there are exclusions which may limit this coverage. In the climate risk context, some standard exclusions which may apply include, but are not limited to, the “conduct” exclusion for fraud or criminal acts, property damage or pollution exclusions, and language barring coverage for fines and penalties. Nevertheless, many policies available to publicly traded companies feature exceptions to these exclusions for securities claims against directors and officers, or require a final, non-appealable adjudication before the D&O insurer can attempt to deny coverage or stop paying defense costs.

Finally, D&O insurance covers losses stemming from actual or alleged “Wrongful Acts,” usually defined to include any act, error, omission, misstatement, or breach of duty by a directors and officers in their roles for the company. A failure to disclose climate risks in compliance with the SEC’s new rules could support allegations in an underlying complaint that triggers coverage. D&O insurers might also extend coverage to particular types of securities claims with a connection to climate impacts or offer a sub-limit for climate-related damages. When claims arise, D&O policies should be closely reviewed to determine what coverages, exclusions and sub-limits exist with respect to climate-risk and the increased regulations requiring the disclosure of those risks.

Hirsch is a partner in Pasich LLP’s Los Angeles office. He represents companies, directors and officers in corporate insurance recovery matters and coverage disputes with insurance companies.

Wah is a managing associate in the New York office. He has litigated in New York and federal courts, representing clients in a wide range of complex coverage disputes.