Ethical Investments

In recent years, significant developments have occurred in the market for socially responsible investing, also known as ESG (environmental, social, and governance) investments. However, despite its rapid growth, the market has lately faced setbacks, including various regulatory initiatives, such as those in Florida, aimed at blocking the consideration of ESG factors in investment decisions. These trends could be expected to also reach the courts, as demonstrated by a decision last March in Texas, where an ESG backlash lawsuit survived a dismissal motion.

While there is no shortage of writing that deals with the subject of ESG investments, a crucial legal question that stands at the heart of these debates still lacks a satisfying answer: Does the law allow institutional investors to consider ESG factors when making investment decisions? With trillions of dollars in global corporate equity, institutional investors potentially wield significant influence. However, these institutions are subject to a strict set of legal rules, bound by fiduciary duties that govern their investment decision-making.

A recent and highly influential scholarly account of the issue, endorsed by many fund managers, claims that the answer to this legal question is decisively no. According to this view, fiduciary law, as expressed in ERISA regulation, obligates institutional investors to act solely in the direct financial interest of the investors. Since ESG considerations may encompass ethical elements, and the effect of ESG factors on the value of investments is far from certain, this position significantly limits the potential scope of ESG, which, in turn, could have devastating consequences for the promotion of a sustainable future.

In a new working paper, I argue that this restrictive interpretation of fiduciary law is fundamentally flawed. Drawing on a systematic analysis of dozens of cases and through a discussion of private law theories, I propose a new approach to determine the accurate legal position. Contrary to what appears to be a widespread assumption, I demonstrate that fiduciary law does not inherently prohibit ethical investments.

The paper begins by offering, in Part I, a brief overview of the essential context concerning institutional investors and their role within the market. This section further outlines ERISA, the pertinent legal framework that regulates these institutions. It also discusses the rapid growth of ESG investing and the attempts to define the scope of ESG and offers a taxonomy that distinguishes between ‘financial ESG considerations’ and ‘ethical ESG considerations.’ Part I concludes by presenting the perspective that argues against the compliance of ethical investments with fiduciary law. On this view, the duty of loyalty compels institutional investors to prioritize the beneficiaries’ direct financial interests. Therefore, if the motivation behind ESG investing is ethical rather than a well-defined and substantiated pecuniary one, it would be deemed a breach of fiduciary law.

Part II aims to correct this prominent misinterpretation of ERISA. Initially, this section seeks to dispel common misconception surrounding the Supreme Court’s ruling in Fifth Third Bancorp, which was cited as a basis for the mistaken interpretive conclusion. Part II asserts that since the court explicitly stated, “we limit our review to the duty-of-prudence claims,” drawing extensive conclusions regarding the concept of loyalty from the case’s reasoning would be a legal error. Moreover, the paper elucidates that the court’s remarks concerning trustees’ obligation to prioritize financial considerations were confined to a specific context: debating when ESOP (Employee Stock Ownership Plan) fiduciaries should be presumed to have acted prudently. Consequently, this ruling cannot be extrapolated to interpret ERISA’s stance on ethical investments.

Subsequently, the paper scrutinizes dozens of Supreme Court and Courts of Appeals cases, demonstrating that none substantiates the notion that ERISA’s duty of loyalty exclusively pertains to the ‘financial benefits’ of the beneficiaries. On the contrary, many of these cases could provide alternative grounds to support an opposing conclusion. Furthermore, the article points out that since the Supreme Court clarified in different contexts that ERISA preempts state law, the final word in this debate is reserved for Congress, not for individual states.  This section then evaluates the new DOL rule and elucidates why it does not alter the findings derived from the case law research.

Part III then focuses on possible normative objections to the legal stance which allows for ethical investments, arguing that there are no compelling justifications to accept them. It first addresses the flexible nature of the term ESG and explains why the assertion that ethical considerations impose values on beneficiaries is erroneous. It also rejects the claim that prioritizing financial considerations is justified by the allegedly paternalistic purpose of the relevant legislation. Furthermore, it sheds light on the adverse consequences of opposing institutional investors’ activism and emphasizes the importance of relying on ESG indicators, despite their inherent limitations, particularly in the context of the climate crisis. Additionally, it addresses concerns regarding the potential misuse of ethical ESG by managers to advance personal goals and confronts arguments pertaining to subjectivity and greenwashing, illustrating why they are unfounded.

Finally, Part IV articulates some potential implications of the findings. The importance of providing more legal clarity cannot be overstated. Apart from the challenges arising from insufficient incentives or structural constraints, the presence of legal obstacles poses another significant limitation on the capacity and motivation of institutional investors to foster ESG investments, especially those aimed at addressing the climate crisis. In fact, research has already demonstrated that legal uncertainty is a primary factor limiting American institutional investors in adhering to their responsible investment declarations. This should not come as a surprise, given that the concerns from such legal ramifications are not unfounded; the aforementioned court decision from Texas has incorrectly relied on Fifth Third Bancorp while arguing that as part of the duty of loyalty, ERISA plan fiduciaries must discharge their duties solely for the purpose of providing financial benefits to the participants. Hopefully, this paper can clarify this uncertainty and offer an extremely important practical contribution to an urgent need of our time: funding corporations that increase social welfare.

The complete paper is available here.