Draft GCGC 2022 has a strong focus on sustainability

On 21 January 2022, the Government Commission German Corporate Governance Code adopted the draft German Corporate Governance Code 2022 (GCGC 2022-E). The deadline for comments expires on 11 March 2022.

The new principles and recommendations proposed in the GCGC 2022-E relate on the one hand to adjustments to the legal situation made through the German Financial Market Integrity Strengthening Act (FISG) and the German Second Executive Position Act (FüPoG II) and, on the other hand, take into consideration environmental and social sustainability in the management and supervision of listed enterprises. With the introduction of these sustainability-related code recommendations, the pressure on enterprises for sustainability transformation is likely to increase further.

Amendments to the Code in light of sustainability

The main focus of the amendments to the Code is to implement sustainability aspects into corporate governance.

Preamble on corporate responsibility

According to the Government Commission's Explanatory Memorandum, the preamble of the German Corporate Governance Code, as amended on 16 December 2019 (GCGC 2020), published in the German Federal Gazette on 20 March 2020, already needs to be readjusted because the expectations relating to the consideration of sustainability factors in corporate governance have become much more specific. Furthermore, the draft proposed by the EU Commission on sustainability reporting (Corporate Sustainability Reporting Directive – "CSRD") contains the clear requirement for enterprises to not only include the influence of social and environmental factors on the enterprise's success (the "outside-in" perspective), but also the effects of the enterprise on people and the environment (the "inside-out" perspective) ("double relevance").

The proposed amendments to the preamble, therefore, stipulate that in future the Management Board and Supervisory Board take both perspectives into account when managing and monitoring the enterprise.

Sustainability-related recommendations for the Management Board

The Management Board should consider environmental and social sustainability aspects in the management of the enterprise. According to the Government Commission, it should also balance economic, environmental and social concerns.

Recommendation A.1 GCGC 2022-E for the Management Board: identify risks and opportunities, corporate strategy and corporate planning

"The Management Board shall systematically identify and assess the risks and opportunities associated with social and environmental factors, as well as the environmental and social impacts of the enterprise’s activities. The strategy of the company shall provide information on how the economic, environmental and social objectives can be achieved in a well-balanced manner. Corporate planning shall comprise financial and sustainability-related objectives."

This Recommendation which is addressed to the Management Board relates first of all to the recording of risks and opportunities for the enterprise associated with the social and environmental factors with the methods of risk management, and in this respect should rather be understood as a clarification; as Comprehensive Risk Management should record all risks and opportunities that are relevant for the enterprise.

A new requirement on the other hand, is the systematic identification and assessment of the environmental and social impacts of the enterprise's activities and, therefore, the adoption of the "inside-out" perspective, which as a reflex at best leads back to opportunities and risks for the enterprise. It can be assumed that both perspectives are intended to serve the pursuit of an (overall) corporate strategy that encompasses both financial and sustainability-related aspects, with correspondingly aligned corporate planning.

According to the Explanatory Memorandum to the draft, the corporate strategy shall

• represent the balance between economy, environmental and social issues,
• and be an expression of a corporate management committed to the interests of the company, which
• balances the interests of shareholders and other stakeholders, including the environmental and social concerns of the company.

The Government Commission understands this Recommendation as putting the "stakeholder approach" in more concrete terms with regard to determining the enterprise's interests. This is, however, not regulated by law, but rather highly disputed:

The central but undefined term "corporate interest" is today predominantly understood to mean that the administration must in principle take into account all the interests of the various interest groups (shareholders, lenders, employees, customers, suppliers and the general public or public welfare) that come together in the enterprise (interest plural concept). It is, therefore, not – as the GCGC 2022-E suggests – about the balancing of interests, but rather the consideration of interests. It is also disputed whether, and to what extent, there is a (slight) advantage in favour of the shareholders' interests – to be determined in an abstractly typified manner – over the interests of other stakeholders. In practice, the controversy is partly put into perspective by the fact that even according to an approach that places the (long-term) shareholder interests and, therefore, the securing of permanent (sustainable) profitability and earning power in the foreground, the consideration of other stakeholder interests is always indirectly included (within the meaning of Corporate Reputation Management, for example the well-understood shareholder interest, i.e., that increases the value of the enterprise). However, many follow-up questions, e.g., with regard to whether, and to what extent, it must be proven that certain measures, also financially, serve shareholder interests in the long term, remain unanswered and disputed.

With Recommendation A.1 GCGC 2022-E, the Government Commission ultimately anticipates a regulation of "Sustainable Corporate Governance" as considered by the EU Commission. This is surprising, especially as the Government Commission had taken a very critical stance on such a regulatory project in a letter addressed to the EU Commissioner for Justice on 5 January 2021.

Recommendation A.3 GCGC 2022-E for the Management Board: internal control and risk management system

"The internal control and risk management system shall be geared towards financial and sustainability-related matters. This shall include processes and systems for collecting and processing sustainability-related data."

The announced CSRD, which is to apply to financial years beginning from 1 January 2024 or, in the case of publicly traded small and medium-sized enterprises (SMEs) (excluding micro enterprises) from 1 January 2026, requires that sustainability aspects, which are reportable at a high level of detail, be comprehensively integrated into governance systems. As it is only when these aspects are adequately identified and evaluated, the appropriate measures are derived from them and the processes are implemented and controlled, that such reporting will be possible in the required form.

In addition, sustainability reporting – which has been massively expanded compared to the CSR Directive (see sections 289b ff., 315b f. German Commercial Code (HGB)) – will in future be treated the same as financial reporting (amongst other things, mandatory part of the [group] management report, audit by audit committee and auditor or other auditing firm and – according to the idea of the EU Parliament Committee on Legal Affairs – alternatively also audit by so-called independent providers of assurance services). Sustainability risks should, therefore, logically be included in the internal control and risk management system (ICS and RMS).

In this context, the draft Code also states that the Internal Control and Risk Management System should also comprise a Compliance Management System (CMS) which is aligned with the enterprise's risk situation (see Principle 4 sentence 2 GCGC 2022-E). In addition, internal auditing will also have to be expanded to include sustainability aspects in the future. The Government Commission correctly points out in the Explanatory Memorandum to the draft that the collection and processing of sustainability-related data within the governance systems is a mandatory prerequisite for the effective implementation of the (overall) corporate strategy.

Sustainability-related recommendations for the Supervisory Board

The Supervisory Board shall monitor how the Management Board deals with sustainability issues. In order for them to be able to carry out their function, Supervisory Board members need the appropriate sustainability expertise.

Recommendation A.6 GCGC 2022-E for the Supervisory Board: supervising the sustainability-related tasks of the Management Board

"In particular, the Supervisory Board shall monitor:

• how ecological and social sustainability is considered in the corporate strategy and its implementation;

• that strategic and operational plans compromise financial as well as sustainability-related objectives;

• that the internal control and risk management system is also geared towards sustainability-related matters."

This recommendation transfers the Recommendations A.1 and A.3 GCGC 2022-E concerning the Management Board to the Supervisory Board, which in this respect has a corresponding sustainability-related supervisory function.

Recommendation C.1 GCGC 2022-E for the Supervisory Board: corporate sustainability expertise

"The Supervisory Board’s skills and expertise profile shall also comprise expertise regarding sustainability issues relevant for the enterprise."

This Recommendation is intended to ensure the relevant corporate sustainability expertise within the Supervisory Board so the Supervisory Board is able to fulfil its sustainability-related supervisory function. It is explicitly stated that the expertise on sustainability issues that are of importance to the enterprise should be independent of the expertise for sustainability reporting and its audit (see below Recommendation D.4 GCGC 2022-E). It is, therefore, necessary to differentiate between the more substantive expertise on relevant sustainability issues and the expertise on reporting in this regard within the framework of accounting.

We will discuss in a separate article why this draft Recommendation C.1 sentence 3 GCGC 2022-E is likely to be of considerable practical relevance for proposals relating to supervisory board elections in the 2022 general meeting season that has already begun.

Recommendation D.4 GCGC 2022-E for the Supervisory Board: skills and expertise profile for the Audit Committee

"The Chair of the Audit Committee shall have specific knowledge and experience in applying accounting principles, in sustainability reporting and internal control and risk management systems, or in audits of financial statements, including the assurance of sustainability reporting. At least one additional member shall be knowledgeable in the complementary areas. The Supervisory Board shall include the details on the specific knowledge and experience of the Audit Committee members concerned in the areas mentioned in the Corporate Governance Statement. […]."

With this Recommendation, the requirement is abandoned for dual (financial) expertise of the Audit Committee Chair, who according to the previous regulation should have special knowledge and experience in the application of accounting principles and internal control procedures as well as be familiar with the auditing of financial statements (D.4 sentence 1 GCGC 2020). In future, it will be sufficient if the Audit Committee Chair's professional qualification relates to either accounting or auditing and at least one additional Committee Member has the complementary skills and expertise.

With regard to the audits of financial statements, the qualification requirement has also been tightened to the effect that in future special knowledge and experience will also be required here instead of (mere) familiarity with the subject area. In addition, the skills and expertise profile for the accounting or auditing expert will be expanded in each case with regard to sustainability reporting or its audit. Also new is the Recommendation that the Supervisory Board should provide more detailed information on the special knowledge and experience of the relevant experts on the Audit Committee in the Corporate Governance Statement, although this should already be common practice for the most part.

Amendments to the Code in light of the German Financial Market Integrity Strengthening Act (FISG)

The new regulations brought by the German Financial Market Integrity Strengthening Act (FISG) have – as a legislative reaction to the Wirecard case – in parts codified the already existing Best Practice on the Audit Committee and on governance systems in stock corporation law and have now made the Recommendation D.3 GCGC 2020 (establishment and tasks of the Audit Committee) obsolete.

Furthermore, the establishment of a Compliance Management System (CMS) will no longer be worded as a Recommendation (see A.2 sentence 1 GCGC 2020) but as a Principle (see Principle 4 GCGC 2022-E). This must be viewed against the background that with listed companies, due to their risk exposure, an obligation to set up a CMS can generally be derived from the duty of legality and general duty of care (including organisational duties) under sections 93 (1) sentence 1, 76 (1) German Stock Corporation Act (AktG) (see also the grounds for the draft bill p. 116 Begr. RefE FISG (only available in German); the clarification can no longer be found in the grounds for draft bill on p. 114 f. Regr. RegE FISG (only available in German)).

However, even after the introduction of section 91 (3) German Stock Corporation Act (AktG) through the German Financial Market Integrity Strengthening Act (FISG), it is still disputed in stock corporation law whether the Management Board is per se (mandatorily) obliged to set up such a comprehensive institutionalised compliance organisation, or whether the respective obligation depends on the situation – taking into account, in particular, the size of the enterprise and the risk situation (e.g. regulations to be observed, industry, geographical presence) – if otherwise the assurance of legality in the company cannot be guaranteed. The latter view corresponds to the previous differentiation in Principle 5 and Recommendation A.2 GCGC 2020, which will now to be abandoned according to the Government Commission’s proposal. At least for smaller listed companies with low-risk exposure (e.g., holding companies), for which this dispute is also relevant (in terms of liability), this will be seen as an aggravation.

Other amendments to the Code

Finally, the other new Recommendations of the draft Code concern the description of the essential features of the Internal Control and Risk Management System (ICS and RMS), as well as the statement on the adequacy and effectiveness of these systems in the Management Report (Recommendation A.5 GCGC 2022-E), the functioning of the Audit Committee (Recommendations D.3 and D.11 GCGC 2022-E) and the arrangement of external audits of the governance systems by the Audit Committee (Recommendation D.3 last half-sentence GCGC 2022-E).

On the way to increasing Sustainable Board Governance

Sustainability aspects already form an integral part of the corporate strategy, management and planning at many listed enterprises and are accordingly included as (ESG) risks in the Governance Systems (ICS, RMS, CMS, internal audit). Therefore, for these enterprises, the proposed amendments to the Code result in only a minor need for adjustment at best.

However, it remains to be seen what (sustainability-related) amendments the Code will ultimately undergo in the course of the consultation process. The Government Commission's reluctance to include further recommendations on the composition and internal organisation of the management board and supervisory board is welcomed, therefore leaving other details of the (self-)organisation of the bodies up to the specific characteristics of the enterprise. This applies, for example, to the (special) sustainability expertise within the management board, as such expertise can also be provided comprehensively at downstream management levels – for example, in the form of sustainability committees, which are entrusted to the management board with the steering of the sustainability strategy, the definition of certain sustainability KPIs and the (internal and external) sustainability reporting.

In any case, due to their (increasing) strategic relevance, sustainability and ESG aspects will become an integral part of management and supervisory board activities and, as a cross-functional issue, will keep the overall executive bodies even busier than before.