Recent years have seen great progress in the market for socially responsible investing, also known as ESG (environmental, social and governance) investing. However, despite rapid growth, this market has recently faced setbacks, including various regulatory actions, such as in Florida, aimed at discouraging the consideration of ESG factors in investment decisions. These trends are expected to extend to the courts, as illustrated by a decision handed down in Texas last March, in which an ESG backlash lawsuit survived a motion to dismiss.
There has been a great deal of literature on the topic of ESG investing, but a key legal question at the heart of this debate remains unsatisfactory: whether institutional investors are permitted by law to consider ESG factors when making investment decisions. Institutional investors hold trillions of dollars in corporate equity around the world, giving them potentially enormous influence. Yet these institutions are subject to strict legal rules bound by fiduciary duties that govern their investment decisions.
A recent and highly influential academic exposition on this issue, supported by many fund managers, argues that the answer to this legal question is a resounding no. According to this view, fiduciary law, as expressed in ERISA regulations, requires institutional investors to act solely in the direct economic interest of investors. Because ESG considerations may have ethical components and the impact of ESG factors on investment value is far from certain, this position severely limits the potential scope of ESG, which could have devastating consequences for promoting a sustainable future.
In a new working paper, we argue that this restrictive interpretation of trust law is fundamentally flawed. Based on a systematic analysis of dozens of cases and a discussion of private law theory, we propose a new approach to determining the precise legal position. We demonstrate that, contrary to what seems to be widespread belief, trust law does not inherently prohibit ethical investments.
The paper begins in Part 1 with a brief overview of important background on institutional investors and their role in the marketplace. This section further outlines the relevant body of law that regulates these institutions, ERISA. It also discusses the rapid growth of ESG investing and attempts to define the scope of ESG, and presents a taxonomy that distinguishes between “financial ESG considerations” and “ethical ESG considerations.” Part 1 concludes with a view that argues against ethical investing being governed by trust law, which holds that the duty of loyalty requires institutional investors to prioritize the direct interests of beneficiaries. Finance Therefore, the motivation for ESG investing is Ethical Well-defined and proven Financial One is that it would be considered a violation of trust law.
Part II aims to correct this notable misinterpretation of ERISA. First, this section seeks to dispel a common misconception about the Supreme Court’s Fifth Third Bancorp decision, which was cited as the basis for the erroneous interpretation conclusion. Part II argues that it is a legal error to draw broad conclusions about the concept of loyalty from the reasoning in this case because the Court specifically stated, “We limit our consideration to the claims of the duty of prudence.” Furthermore, the paper makes clear that the Court’s remarks about the fiduciary’s duty to prioritize financial considerations were limited to the specific context of discussing when ESOP (employee stock ownership plan) fiduciaries should be presumed to have acted prudently. Therefore, this decision cannot be inferred to interpret ERISA’s position on ethical investing.
The paper then reviews dozens of Supreme Court and appellate court cases and finds that there is no precedent to substantiate the notion that ERISA’s fiduciary duty pertains solely to the beneficiary’s “financial interest.” Instead, many of these cases may provide alternative grounds to support the opposite conclusion. Moreover, the paper notes that the Supreme Court has made clear that ERISA preempts state law in a variety of contexts, so the final say in this debate rests with Congress, not the states. This section then evaluates the new DOL rule and explains why it does not change the findings from the case study.
Part III focuses on normative objections to the legal status that recognizes ethical investment and argues that there is no compelling justification for embracing ethical investment. First, we address the flexible nature of the term ESG and explain why the claim that ethical considerations impose values ​​on beneficiaries is false. We also reject the claim that prioritizing financial considerations is justified by the so-called paternalistic objectives of the relevant law. Furthermore, we highlight the negative consequences of opposing the activities of institutional investors and highlight the importance of relying on ESG indicators, despite their inherent limitations, especially in the context of the climate crisis. Furthermore, we address concerns regarding the potential misuse of ethical ESG by managers to advance their personal goals and confront arguments about subjectivity and greenwashing, explaining why they are unfounded.
Finally, in Part IV, we discuss some potential implications of our findings. The importance of increasing legal clarity cannot be understated. Apart from challenges arising from insufficient incentives and structural constraints, the existence of legal impediments poses another major constraint on institutional investors’ ability and motivation to promote ESG investments, especially those aimed at addressing the climate crisis. Indeed, research has already demonstrated that legal uncertainty is a major limiting factor for US institutional investors to comply with responsible investment pledges. This is not surprising given that such concerns about legal implications are not unfounded. The aforementioned Texas court decision misquoted Fifth Third Bancorp while arguing that, as part of their duty of loyalty, ERISA plan fiduciaries must perform their duties only with the purpose of providing financial benefits to participants. Hopefully, this paper will shed light on this uncertainty and provide a crucial practical contribution to the urgent need of our time: financing companies that improve social welfare.
The full paper can be found here.
