Is ESG now a crime in America?

In last week's Vibes Forecast, there were a number of predictions that did not ultimately make the cut, including one on how corporations would face increasing legal pressure for their sustainable activities. I should have left that one in because it was prescient: On January 10th, U.S. District Judge Reed O'Connor ruled in Spence v. American Airlines that American breached its fiduciary duty to 401k holders by (among other things) using BlackRock, an investment manager that considered environmental, social, and governance (ESG) factors in some of its investments. The case is an important win in what I expect to be a sustained legal effort by the Trump administration and conservative attorneys general to punish corporations for their ESG efforts, something that’s already been happening at a state level.

The decision is complex, but there’s a number of important points here for innovators, so I want to parse through the case and discuss a) why I think it’s poorly reasoned, b) what the implications are, and C) what (if anything) corporate innovators can do about it. Big picture: Using ESG factors as a justification for a business decision now presents a possible legal risk. If you are a corporate innovator or CTO, your CEO and CFO will now look with deep suspicion at your existing portfolio of sustainability-linked investments. You’ll need to pivot the branding of these projects with an eye to cost savings and resilience, but you will also need to come up with clear answers to tough questions on the value of ESG innovation to the bottom line: Mere alignment with corporate goals is no longer going to cut it. ?

First, a little context: O’Connor sits in the North District of Texas, a federal district court that has become well known for its slate of judges that are both highly conservative and very open to, let’s say, novel legal theories. It’s become a prime location for venue shopping (the practice of filing lawsuits in certain locations to get specific judges), and many controversial cases have come from the court, including the mifepristone ban. The plaintiffs certainly knew this when they filed the case, a class-action lawsuit that alleges American Airlines breached two elements of its fiduciary duty when administering its 401k plan: the duty of prudence, which requires fiduciaries to act in accordance with accepted best practices, and the duty of loyalty, which requires fiduciaries act solely in the best interest of their beneficiaries. It’s also worth noting that that the case deals with ESG investing, which is pretty different from, say, sustainability writ large. I’ll unpack that a little more at the end, but for now, keep in mind that we are talking about evaluating investments (mostly in large corporations) using ESG factors in addition to financial ones.

The ruling is 70 pages, mostly laying out what the court considers the facts of the case, and it’s in this finding of fact that the biggest issue in the ruling lies. O’Connor gives a broad definition of ESG investing and then states two things as a matter of fact: that ESG “is a strategy that considers or pursues a nonpecuniary interest as an end itself rather than as a means to some financial end,” and that that ESG investments underperform “traditional” investments by roughly 10%. He points to one year (2023) and cites no sources, before moving on throughout the rest of the case that ESG investing is definitionally incompatible with the pecuniary responsibility of fiduciary. I would call this sloppy, as O’Connor has failed to engage with any of the literature (here are multiple sources showing ESG funds outperforming traditional funds, even in 2023), but clearly O’Connor had already made up his mind on ESG as a matter of his politics. But what if the investor thinks an ESG strategy will produce better returns, as many clearly do? O’Connor quickly deals with this issue by stating that any consideration of nonfinancial benefits is disqualifying. From the ruling: “So even with mixed [ESG and financial] benefits, the presence of a nonpecuniary consideration reveals that the investment manager is not acting exclusively in an economic manner.” This may seem like a minor point, but it’s actually a huge deal: Under the law, fiduciaries have a duty of loyalty to “not subordinate the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to other objectives” ?but “are not prohibited from selecting the investment, or investment course of action, based on collateral benefits other than investment returns,” assuming risks and returns are expected to be the same or better. Any reasonable person would read this to mean ESG investing is perfectly compatible with fiduciary duties if you expect to make the same returns (which is not a crazy assumption). O’Connor, by simply declaring ESG investing to be definitionally worse than traditional investing, has essentially changed the law with regard to a specific, politically disfavored set of investments. It’s theoretically still possible to make ESG investments, but the defendant is now burdened with the responsibility of proving in a lawsuit that they operated under some sort of pure CEO mindset in which only financial benefits were considered — a high bar indeed. The fact that BlackRock, the investor largely at issue in this case, has clearly defined its ESG evaluation as being in service of “enhancing risk adjusted returns” doesn’t matter. The actual financial performance of the 401k, or the fact that apparently none of the 401k was invested in ESG funds, also doesn’t matter. ?The fact that BlackRock engages in ESG investing (and supports ESG-related activities at companies it holds) is enough to constitute a breach of loyalty. This is a bad decision, as ESG is now held to a standard that no other investment approach is: one of presumptive breach of fiduciary responsibility, a decision that was reached with spurious reasoning and essentially no evidence.

The case does not rest solely on this view of ESG — O’Connor finds American Airlines failed to adequately separate corporate and fiduciary duties when choosing BlackRock to administer its 401k as it was also a major shareholder and lender — but it rests primarily on this view. From the ruling: “Because of American’s corporate goals [on ESG] and as a complement to them, Defendants did not sufficiently monitor, evaluate, and address the potential impact of BlackRock’s nonpecuniary ESG investing. Together, the influences of these non-Plan interests constituted a breach of loyalty…” Despite O’Connor’s best efforts, he can’t find a way to also hold that American breached its duty of prudence when considering ESG factors and spends a good few pages seething about this failure. Still, he has likely done enough damage.

The implications are most obvious in the context of ESG investing: Major investors will find it riskier to operate ESG funds, and it will be somewhat more expensive for companies and ESG sectors like wind and solar to raise money. The real issue is whether this line of reasoning will be raised to other types of fiduciary duties (note that 401k managers have specific responsibilities, though the duty of loyalty extends to all fiduciaries in some form). Have CEOs and boards that invested in sustainable technologies breached their duty of loyalty to shareholders? What about companies that merely have ESG goals in their corporate reports? I expect future lawsuits on these very issues, and I don’t see O’Connor rethinking his anti-ESG views in the corporate context. For corporate innovators, there may not be much to do but try to slap a more financial (and risk-oriented) coat of paint on existing projects and wait for the next domino to fall.

What’s perhaps most frustrating about this case is how uncoupled from the real issues it is. O’Connor paints ESG investing as some sort of conspiracy to change society, but in practical terms, ESG investing is fake! ESG ratings are unregulated and vary wildly from provider to provider (unlike credit ratings), there’s no evidence ESG investing improves ESG outcomes, and investing (especially in public companies) is ultimately a very limited vehicle for impact. I am not a fan of ESG investing, but it now seems that this ruling on ESG will have a chilling effect on much more material development of sustainable technologies. If ESG becomes linked to “legal risk” in the mind of top executives, and ESG goals are scrubbed from corporate guidelines, it will become significantly harder to pitch innovation activities in cleantech. Innovation managers will need to focus on alternative branding — energy efficiency, supply chain resilience, and sales to discerning consumers — to continue developing very necessary technologies for the long-term health of their industries. If there’s a silver lining to the case (and the broader anti-ESG movement), it may force companies to get serious about justifying ESG. I mentioned above that the evidence against ESG is pretty thin, but the evidence for it is so far just as unconclusive. Institutional investors will need to get serious about establishing causal links between these nonpecuniary factors and the resilience and predictability of the bottom line if they want to keep the billions of dollars that have flowed into ESG funds.

What’s also frustrating is that, on some level, O’Connor is right: We will need to accept the consideration of nonfinancial factors to beat climate change, and there is a real conflict between that and the current structure of financial responsibility (though this conflict is not actually present in this case). We know that, for example, carbon emissions have a cost to society (somewhere between USD 100/tonne and USD 200/tonne, depending on what you include in “society”). Many businesses would cease to be profitable if they had to pay these costs, as Lux has shown in our carbon canvas. These businesses are essentially a net negative for society writ large. But the impacts of climate are both long term and most severely felt by poor persons in developing economies. A company acting to serve the interests of its shareholders (who definitionally have some wealth and are likely to live in the West) does not have an incentive to care about the harms it commits. It’s possible that consumer backlash could push companies to address these issues — using the court of public opinion to address what the courts of law won’t — but this is hard for corporate actors to predict. Until this tension between shareholder and societal interests is resolved (with a combination of new laws and new corporate structures), companies will not be able to consistently justify their sustainable activities, to the detriment of all.?

For more on #sustainable #innovation,?check out the Lux Research Blog and the Innovation Matters podcast. The opinions expressed in the Innovation Matters newsletter are my own and do not reflect the views of Lux Research.