Understanding ESG’s Attempt to Undermine Fiduciary Duty

Environmental, social, and governance criteria, and euphemisms such as conscientious capitalism, stakeholder capitalism, and social responsibility all undermine the same legal principle that is vital to a functioning free market economy—fiduciary duty. Many U.S. corporations are legally obligated to maximize stockholder value when they are incorporated in the state of Delaware.

Stockholders are not just insiders. U.S. households have retirement assets that hold shares of mutual funds and exchange-traded funds that own large swaths of corporate America. The total U.S. retirement market amounts to over $33 trillion.

Manifestations of ESG have forced companies to subordinate stockholder interests in favor of stakeholders such as the environment, activists, and unions. This has resulted in investment products that are not providing adequate returns. According to one paper, of the 20,000 mutual funds analyzed, “none of the high sustainability funds outperformed any of the lowest rated funds.” Research from Boston College compared the returns on ESG mutual funds to “unrestricted Vanguard funds over 1-year, 5-year, and 10-year periods.” The paper found that “Vanguard funds generally outperform their ESG counterparts, often by a considerable margin. Part of the reason is that the fees in the ESG funds are roughly 80 basis points higher than their Vanguard counterparts.”

One article published in The University of Chicago Business Law Review pointed out that investment managers could also be in breach of their fiduciary duty under the Employee Retirement Income Security Act of 1974 “as defined in” Tibble v. Edison Int’l if they “leave underperforming ESG investments in their portfolio, or add new underperforming ESG investments.”

ESG funds are run by corporations and their subsidiaries incorporated as limited liability companies and limited partnerships. Many of these business entities are incorporated in Delaware. In fact, nearly 2 million business entities are incorporated in Delaware, including over 68 percent of all Fortune 500 companies. In 2022, Delaware registered 79 percent of all U.S. initial public offerings.

While some states have loosened their statutory requirements to allow directors to put stakeholders above stockholders, Delaware is not one of them. In fact, Delaware law “is intensely focused on stockholders.”

Corporate directors do not have freedom under Delaware law to subordinate stockholders’ interests to that of stakeholders. If Delaware courts shifted gears and provided directors the flexibility to subordinate stockholder interests that “would involve them making a policy determination jarringly inconsistent with the structure” of Delaware law. Even public benefit corporations, which are allowed to consider certain non-stockholder interests, are still required to balance “the pecuniary interests of the stockholders” and “the best interests of those materially affected by the corporation’s conduct.”

According to the Delaware Supreme Court, a corporate board is allowed to consider “constituencies” other than stockholders under Unocal v. Mesa Petroleum Co. Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. affirms this “provided there are rationally related benefits accruing to stockholders.” Revlon also made it clear “that directors of a for-profit corporation must at all times pursue the best interests of the corporation’s stockholders.” Stakeholders may be considered, but only if the consideration benefits stockholders.

Dodge v. Ford Motor Co. and eBay Domestic Holdings, Inc. v. Newmark also find that for-profit corporations exist to maximize financial returns to stockholders. Specifically, Dodge found that a “business corporation is organized and carried on primarily for the profit of the stockholders.” Dodge is a seminal case that held the importance of shareholder profit maximization. According to Leo Strine, former Chief Justice of the Delaware Supreme Court, these cases prove that if any consideration other than stockholder wealth is an “end in itself” then it is a breach of fiduciary duty. Strine goes on to talk about how subordinating stockholder interests is “injurious to social welfare.” At the end of the day “directors must make stockholder welfare their sole end, and that other interests may be taken into consideration only as a means of promoting stockholder welfare.”

According to Strine, there are some states that have amended their statutes to allow corporate directors “to promote interests other than stockholder interests,” but they “have done little, if anything, to make corporations more socially responsible or more respectful of their workers’ or communities’ interests.”

Milton Friedman aptly pointed out in his 1970 essay in The New York Times that social responsibility hews closely with maximizing shareholder value. He quotes his own book, stating that the only social responsibility a business has is “‘to use its resources and engage in activities designed to increase its profits.’” This ensures directors are held accountable for their actions and do not take actions that are self-serving.

In Delaware, LLCs and LPs are governed differently compared to corporations. Many investment adviser subsidiaries are set up as LLCs. Admittedly, Delaware law largely gives LLCs and LPs the authority to write up contracts that can eliminate fiduciary duty. The caveat is that LLC agreements “may not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing.” Moreover, if LLCs, LPs, or their directors or managers are grossly negligent, under Smith v. Van Gorkom and Aronson v. Lewis, corporate directors and officers are liable for breaching their fiduciary duty of care. USACafes held that directors of LLCs and LPs owe fiduciary duties to investors. According to one paper, for LLCs and LPs, “Fiduciary duties emerged as a non-waivable common law overlay in the corporate area.”

Delaware statute could be amended to better conform with existing fiduciary duties under common law and the law for corporations. Specifically, aligning the law for LLCs and LPs so they must consider pecuniary interests is vital to maximizing financial value, avoiding conflicts of interest, and holding directors and managers accountable.