Environmental, social and governance (ESG) issues have become increasingly pressing for private equity and venture capital firms, with responsible investors taking care to ensure that their portfolio companies comply with applicable legal rules and adopt relevant best practices. However, recent developments in UK domestic law have brought into focus the risks associated with greater involvement by parent companies – and, by extension, investors – in the policies and operations of their subsidiaries or underlying investee companies.

Although the parent-subsidiary relationship cannot in itself give rise to a duty of care for parent companies as a matter of UK law, several cases have explored the circumstances in which a parent company can nevertheless assume responsibility for the wrongdoing of subsidiaries. In this regard, a number of significant UK Court of Appeal cases in 2018 confirmed that parent companies could not assume responsibility merely through the imposition of mandatory group-wide policies. In those cases, the relevant test was said to be one of “control”: Did the parent company exercise a sufficient level of control over the business operations of the subsidiary? The Court of Appeal generally took the view that group-wide policies by themselves did not meet this criterion.

The test was revisited last year by the UK Supreme Court in a case that involved a claim brought by a large number of individuals in Zambia against a Zambian copper mining company and its UK-based parent company. The Supreme Court confirmed that the key question is the level of control or intervention exercised by the parent company in the management of the subsidiary’s operations. By way of illustration, the Supreme Court drew a distinction between passive investors and vertically integrated corporate groups whose business is carried on “as if they were a single commercial undertaking, with boundaries of legal personality and ownership within the group becoming irrelevant, until the onset of insolvency, as happened with the Lehman Brothers group.”

In this respect, the Supreme Court merely reiterated the test that had been applied by the Court of Appeal. The Supreme Court also suggested that group-wide policies may themselves give rise to a duty of care in certain situations. The Court gave several examples of situations where group-wide policies might result in liability for a parent company, including when the parent company holds itself out in published materials as exercising a degree of supervision and control over its subsidiaries, even if it does not in fact do so, or where the parent company takes active steps, such as training, supervision and enforcement, in order to ensure that group-wide policies are implemented by subsidiaries.

It is important to bear in mind that these comments were made in the context of the overriding test, which remains one of control or intervention. In other words, the examples set out above still relate to the degree of control exercised by a parent company over its subsidiaries. Moreover, the Supreme Court did not technically decide the duty of care question on the merits, and so the precise scope of parent company responsibility remains to be determined.

This state of affairs may be of little comfort to investors who want clarity on exactly where the “control threshold” lies, particularly because the Supreme Court made it clear that the level of intervention will have to be assessed on a case-by-case basis. However, while that clarity will have to wait for future cases, the key takeaway is that the criterion used in determining liability remains the parent’s degree of control over the subsidiary’s operations. Further, the Supreme Court took the view that “passive” investors in separate businesses are unlikely to cross the requisite control threshold. This category of investors would appear to include investment funds and even, perhaps, private equity portfolios – in other words, equity investors that do not form part of an overarching, vertically integrated corporate group.

It is clear, therefore, that private equity fund managers and the funds that they manage are not in exactly the same position as parent companies. Nevertheless, managers should exercise some degree of caution in relation to their public statements regarding the actual level of control they exercise over portfolio companies, since the underlying legal principles are the same as for parent companies — it will very much depend on the level of intervention exercised in each case.

There may be more clarity of these questions later this year. There are a number of cases on the horizon that should provide the UK Supreme Court and the lower courts with an opportunity to throw further light on the issue of parent company liability. In particular, the Supreme Court will hear the appeal from the Court of Appeal decision in the Okpabi case, involving Royal Dutch Shell and the Shell group of companies. This is an area for private funds to watch.

This edition of European Funds Comment is an edited version of a note that appeared in the Debevoise & Plimpton Private Equity Year End Review and Outlook, published at the end of last year. Debevoise & Plimpton represented Royal Dutch Shell in the case His Royal Highness Okpabi v Royal Dutch Shell Plc referred to above.