Germany: The Future of Legal, Compliance and ESG Departments in Companies

In response to the increasing importance of sustainability and ESG (environmental, social, governance), many companies are currently dealing with the question of which of their departments should be given responsibility for these issues or indeed whether a new sustainability department should be created. The following article summarises various perspectives from different companies and sets out recommendations for action.

What has triggered the discussion?

ESG in companies is no longer a question of “when”, but “how”. In contrast to small and medium-sized enterprises, large companies are often already subject to specific legal obligations in the context of sustainability, e.g. from the CSR Directive Implementation Act, the EU Taxonomy Regulation or the Supply Chain Due Diligence Act. Small or medium-sized enterprises, on the other hand, are feeling rapidly changing market expectations from their business partners, suggesting that they should already be dealing with this topic over and above what is actually required. Consequently, many companies are currently facing the challenge of institutionalising their own sustainability activities for the first time or developing them further in their internal processes.

It can already be seen that the issue of sustainability will entail a significant amount of work for companies. Sustainability reporting will become a core topic of corporate communication and will be on a par with financial reporting. This is clearly illustrated by Volkswagen AG’s Sustainability Report 2021, which is 111 A4 pages long. It would therefore be insufficient if companies simply appointed an employee with an extra function as sustainability officer and otherwise assumed that the additional sustainability requirements would be absorbed by the existing internal organisation. Instead, in view of the scope of the tasks ahead, it appears that more and more companies are setting up independent internal organisational units for ESG. However, since sustainability is very much an interdisciplinary field, a new organisational unit for this area will always have content overlaps with other departments in the company. This applies not only to the legal entities in a company, but also to the operational units, e.g. the purchasing, legal or human resources (HR) departments. These need to support the ESG department on an ongoing basis and provide reports on their respective ESG-relevant activities so that the information can be consolidated and made public. It is not uncommon today for companies to already have a sustainability department. Traditionally, due to the professional group often employed in this department, it is a department that considers ESG and sustainability from an operational perspective, namely from the point of view of environmental protection in the company and the public image of the company with regard to sustainability issues.

In this respect, the focus is not yet on the legal requirements, which are now advancing and will demand closer cooperation with the legal department and the compliance department. In the interests of a lean and modern corporate structure, it should therefore always be questioned whether thematically related departments should be organised independently, or whether they should be merged for reasons of efficiency. Various structures are currently under discussion.

Independent departments for legal, compliance and ESG

The current uncertainties in the organisational handling of the issues of sustainability and ESG (together referred to as ESG below) recall the discussions that took place when the issue of compliance arose. At that time, the question also concerned which instruments belonged to a compliance management system and where should these tasks be located in the company. The experience gained in establishing a compliance function in the company can now be used to discuss how the ESG function should be organised in the company.

In its early days, the compliance function in many companies was considered a sub-area of the legal department and was therefore subordinate to it in organisational terms. In the last 15 years, however, it has become increasingly apparent that the requirements of compliance go far beyond traditional legal issues. Modern compliance deals intensively with internal company processes for which there are often no concrete legal requirements, but which should lead to compliance with all applicable laws as well as internal regulations. In addition, the compliance department is concerned with the clarification of possible undesirable developments in the company, in which even the legal department sometimes plays a part. As a result, it can be observed today, especially in larger companies, that the legal department and the compliance department stand alongside each other in organisational terms and each have their own teams and resources. A compliance department should not necessarily consist only of lawyers, because in addition to a broad legal understanding, a comprehensive economic and operational understanding of business operations as well as strength in project coordination is required. The compliance department often assumes the role of challenger for the correct legal implementation of operational issues.

Taking this model further, it would be logical to organise ESG as an independent department, which would stand as a third pillar alongside the legal department and the compliance department. The disadvantage of such a three-pillar model is that the completely new establishment of an independent ESG department would involve huge organisational and financial burden and a risk that synergies between the respective departments might not be utilised. In addition, a clear division of tasks between the departments must be ensured to avoid organisational culpability due to duplicate structures where a matter is not dealt with because none of the departments considers itself responsible. A clear advantage of a three-pillar model is that the issue of ESG is given significant attention and value within the company, which is an expression of a forward-looking corporate strategy. Furthermore, a clear division reduces the risk that the activity profiles of the legal and compliance departments will be diluted by additional ESG-related tasks.

Establishment of a jointly responsible department for compliance and ESG

Some measures that have proven successful in the past in a compliance context can also be adapted to ESG. Familiar instruments from a compliance management system, such as guidelines, compliance officers, internal complaints bodies or control systems, are in principle also important for an ESG management system. The question therefore arises as to what extent the compliance experience in the company and what has been learned can now be applied in the implementation of ESG structures; in other words: to what extent ESG can be seen as part of compliance or vice versa.

There is undoubtedly a close proximity between the compliance department, which has often already been successfully established in companies, and the new ESG function. Against this background, it can currently be observed that some companies are expanding their existing compliance department to include a new ESG function and, in this context, renaming the entire department the “responsibility department”. In this department, original compliance and ESG tasks with legal relevance are then grouped together. In addition, the legal department will remain in place, which will continue to be responsible for classical legal matters, e.g. corporate law issues, review of contracts or legal disputes. The former Chief Compliance Officer will become the Chief Responsibility Officer. As far as the team structure is concerned, a very diverse composition is to be expected, although the majority of employees will certainly be lawyers with a focus on compliance and/or ESG. The existing compliance tools will then be expanded in terms of content to include an ESG component, e.g. reports on ESG matters can then also be made via the whistleblowing system, while employees can draw on their existing organisational compliance expertise with regard to ESG risk analyses, business partner audits or training. In addition, the typical challenger role of compliance departments can be extended to ESG issues by controlling and monitoring the implementation of sustainability issues in the operational units.

The realisation of this approach can regularly be implemented in corporate practice with comparatively moderate effort and enables the rapid achievement of an operational ESG department within the organisation.

Compliance, ESG and legal as separate departments

As a third option for the structure of Compliance, ESG and legal in a company, the creation of a single central department comprising legal, compliance and ESG competences is under discussion.

In the best case scenario, different sub-teams or employees within this department will then handle the tasks from the areas of law, compliance and ESG. There is currently heated debate about the potential name of such a department. Suggestions range from “Legal” to “Legal, Compliance and ESG” to “Risk Management” with each having its own merits. But perhaps another three-letter abbreviation “LCE” is the innovative solution. In the end, however, the selected name will also depend on corporate strategy and what status the individual issues should have in the company.

This department is usually headed by the previous head of the legal department, generally a lawyer. The particular advantage of this approach is a lean staff structure, clear allocation of competences and the avoidance of inefficient duplicate structures that are unavoidable when several departments deal in parallel with matters that all have some legal connection. The disadvantage is that there is a risk that this department, especially with regard to ESG and compliance, will not be given the status that these two topics of the future deserve. It would be a mistake if only the legal components were taken into account, but not the organisational, economic, human and operational issues. In contrast to the legal department, which can work independently, the ESG and compliance department is dependent on other operational departments to fulfil its cross-sectional function. In our experience, this model is therefore recommended primarily for young, smaller companies where the legal department is also still being established and where the different topics have a similar priority in implementation.

Lessons learned

Many companies want to institutionalise or professionalise their ESG activities. In doing so, they are faced with the challenge of deciding where in their internal organisation the new ESG function should be located. Three models are discussed:

• An ESG department can be set up as a separate organisational unit alongside the legal and compliance departments. In this way, special importance is attached to the issue of ESG, which emphasises the forward-looking readiness of the company. However, this model is likely to entail the greatest organisational effort, and synergies between the individual departments, especially with the compliance department, may be lost.
• The existing compliance department in the company can be expanded to include the ESG function. This approach makes it possible to quickly achieve an operational ESG organisation. Under the new name of responsibility department, the considerable synergy effects between compliance and ESG can be used. We are of the opinion that this approach is currently favoured by many companies.
• The legal department can be merged with the compliance department and the new ESG function into a single department. This particularly lean organisational model is likely to be considered primarily for young companies in the start-up phase.