ESG Compliance (3): New German Corporate Governance Code goes green.

 2022 code reform emphasizes importance of transformation towards greater sustainability.

ESG Compliance (3): New German Corporate Governance Code goes green.

The new German Corporate Governance Code (DCGK) entered into force at the end of June and provides a guideline for management and supervisory board actions. It places a far greater emphasis on ecological and social issues. Those affected need to be proactive.

The new code attempts a balancing act: On the one hand, it aims to address the fact that ecological and social issues have become increasingly important and need to be considered accordingly. On the other hand, it also attempts to provide management with sufficient freedom in deciding how best to implement sustainability issues. The Government Commission has also addressed the criticism frequently voiced during the consultation process that ecological and social aspects have been given excessive and one-sided emphasis.

New focus on sustainability

The revision of the German Corporate Governance Code essentially places a greater emphasis on environment, social, and governance (ESG) criteria. Therefore, publicly traded companies also need to consider and monitor social and environmental sustainability as part of their corporate strategy and planning. The Code Explanatory Memorandum states that companies can orient their interpretation of the sustainability terms on the 17 sustainable development goals of the UN.

Further adaptations were necessary due to the Act on Strengthening Financial Market Integrity (FISG) and the Second Management Positions Act (FüPoG II).

The eleven most important new regulations at a glance

1. Social and environmental factors for corporate management
The Preamble describes the role of company in society and its social responsibility. Therefore, its focus is not restricted to the outside-in perspective, namely the influence of environmental and social factors on corporate success. Additionally, the impact of the company on people and the environment also has to be considered from the inside-out perspective. The board of management and supervisory board must integrate these perspectives into their management and monitoring activities in the interests of the company. The new Recommendation A.1 expresses this focus very clearly.

2. Supervisory board monitoring also includes sustainability
In Principle 6, the DCGK 2022 generally states that the supervisory board’s task of monitoring and advising the board of management also covers sustainability issues.

3. Competence profile and qualification matrix for the supervisory board
According to Recommendation C.1 sentence 5, the competence profile of the supervisory board has been expanded to include expertise regarding sustainability issues relevant to the company. The corporate governance explanatory memorandum clarifies that the implementation status should also be disclosed as a qualification matrix.

4. Internal control system and risk management system
In the Act on Strengthening Financial Market Integrity ( FISG), the legislator has already clearly stated that the risk assessment of the internal control and risk management system, which previously focused primarily on financial issues, now has to be expanded to include operational risks for the company. Principle 4 of the new code reiterates the issue, clearly stating that internal monitoring is essential to ensure the adequacy and effectiveness of the systems.

5. ICS and risk management must also monitor sustainability targets
Furthermore, Recommendation A.3 of the new code states that internal control and risk management systems will also need to monitor sustainability targets as well as the collection and processing of sustainability data in future.

6. Statement in the management report
According to Recommendation A.5, the ICS and the risk management system need to be described in the management report together with the appropriateness and effectiveness of the systems.

7. Suitable compliance management system
In Principle 5 of the code it states that implementing an internal control and risk management system must also include a compliance management system which is suitable for the company’s specific risk profile.

8. Minimum gender involvement
Principle 9 takes up the statutory requirements from the Second Management Positions Act FüPoG II governing minimum staffing levels on the Board of Management and the definition of targets.

9. Audit committee now mandatory
Principle 14 stipulates that an audit committee must be established. This is no longer merely a recommendation. This change has come in response to Section 107 (4) sentence 1 of the German Stock Corporation Act (AktG), which was added as a result of the FISG.

10. Qualifications of the financial experts on the audit committee
According to Principle 15, at least one member of the audit committee needs to possess accounting expertise and at least one other member needs to possess auditing expertise. Recommendation D.3 is a new addition. It stipulates that alongside knowledge of and experience with applying accounting principles, as well as internal control and risk management systems, together with knowledge of and experience with auditing financial statements, the knowledge of sustainability reporting and auditing these reports is also mandatory.

11. Report regarding the form of supervisory board meetings
According to Recommendation D.7, the supervisory board report need to state how many meetings of the supervisory board and committees were held in person or as video or telephone conferences.

Customers, employees, suppliers and investors paying increasing attention to ecological, social and transparent corporate governance. As previously reported, new legislation such as the German Supply Chain Due Diligence Act, the EU plans for the Corporate Sustainability Reporting Directive and the Corporate Sustainability Due Diligence Directive are also on the horizon. These will all give even greater weight to ESG issues. The new version of the Corporate Governance Code now addresses development and reinforces the responsibility of management boards and supervisory boards with regard to sustainability and social issues. In the future, the management board will need to make ESG aspects an integral part of the corporate strategy and planning. Accordingly, ESG criteria have now also become a part of the monitoring scope of the supervisory board. As a consequence, company management will have to strike a balance between profit and sustainability. The good news is that companies which act proactively now and analyze any need for action will be prepared for more than just the next declaration of conformity. Foresighted ground work to prepare for ESG regulation can also open up potential value-creation through cost savings arising from energy efficiency measures or by participating in the circular economy to reduce dependence on scarce resources, for example. Larger small and medium-sized enterprises have also long been aware of these issues. Actively addressing the ESG criteria has been proven to provide decisive image benefits and competitive advantages.