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Jun 22, 2023

How legal pushbacks are targeting ESG investing in 2023

Elizabeth Goldberg, Erin Martin and Pamela Wu look at developments across the ESG space this year, notably the variety of legal and political efforts to curb related investing

Many companies have found themselves between a rock and a hard place this year with respect to ESG amid competing forces of restrictive legislation, antitrust inquiries and class-action lawsuits. As we approach the year’s midway point, here are five trends in ESG that have dominated the space so far in 2023.

  1. Proxy season: More shareholder proposals but support falls

As the 2023 proxy season approaches its conclusion, a significant increase in the number of shareholder proposals continues to be a dominant trend. According to a recent report published by the Harvard Law School Forum on Corporate Governance, shareholders have filed 803 proposals at Russell 3000 companies, compared with 801 in the first half of 2022. By comparison, 798 proposals were filed in all of 2021.

But support for shareholder proposals has declined in every category: corporate governance, executive compensation, environmental, social and human capital management. Although the report notes that environmental proposals have seen the steepest decline in average levels of support – 21 percent in the first half of 2023, down from 34 percent in the first half of 2022 – climate-related proposals remain the most popular subcategory.

A relatively minor but growing percentage of shareholder proposals – 88 in total as of early June – seek to limit how ESG is addressed by companies. Although anti-ESG proposals continue to challenge companies on their diversity, equity & inclusion (DE&I) policies and governance, their focus has expanded in 2023 to include 19 proposals on human rights, compared with three in 2022, while moving away from topics such as charitable giving (12 in 2022 versus one in 2023) and political spending (four versus one, respectively), according to the report published by Harvard Law.

Despite their growth in numbers, ISS Corporate Solutions reports that anti-ESG proposals receive relatively low levels of support and underperform their pro-ESG counterparts. Based on data through May 16, 2023, 23 anti-ESG proposals had been voted on, 31 were pending and none had passed.

In recent years, shareholders have requested independent audits of companies’ practices related to racial equity and/or civil rights. Investors and proxy advisers view these audits as a way to measure the success of a company’s DE&I practices as well as an independent assessment of the internal and external impacts of an organization’s policies, practices, products and services to determine whether any practices inadvertently result in discriminatory impacts.

With respect to the ability of companies to exclude shareholder proposals from their proxy statements through no-action requests submitted under Rule 14a-8 of the Securities Exchange Act of 1934, the SEC appears to continue to favor shareholder proponents.

Although the presumption in Rule 14a-8 is for inclusion, some outcomes have been magnified in the last couple of years and are further underscored by recent staff guidance and proposed rulemaking that would reduce the likelihood of companies receiving no-action relief to exclude shareholder proposals.

  1. Fiduciary duty: A balancing act

The US Department of Labor (DoL) has been engaged in political regulatory back and forth on ESG (previously referred to as corporate social responsibility) investing for the past two decades. It came back into the spotlight with a new 2022 rule that allows Employee Retirement Income Security Act (Erisa) fiduciaries to consider ESG factors in making their investments.

In a sign of legislative efforts to limit ESG investing, both the US House of Representatives and the US Senate earlier this year voted to overturn the rule, although President Joe Biden issued the first veto of his presidency to uphold the DoL regulation.

Eighteen US states have introduced laws or regulations that would limit ESG-based investing of state assets, namely state retirement assets, with 74 anti-ESG bills pending in state legislatures around the country. By contrast, 25 pro-ESG bills are pending in US state legislatures. Forty of the 50 states have either enacted or have a pending state-specific ESG investing rule.

Although these bills do not outright ban the consideration of ESG factors, they mandate that fiduciaries or companies consider only those factors that are relevant for financial – rather than social or ethical – reasons. Erisa, which regulates private-employee benefit plans and assets and subjects relevant decision-makers to fiduciary duties of prudence and loyalty, pre-empts these state laws from applying to private employer-sponsored retirement plans. But state regulations serve as a harbinger of future federal ESG regulation if there were a shift in control of the Senate and the White House.

Interest from investment managers and investors in ESG retirement plan investments may need to be considered in the context of both federal and state fiduciary standards, along with the duty of plan sponsor fiduciaries, investment consultants, asset managers, Erisa-regulated funds and some broker-dealers.

A first-of-its-kind class-action lawsuit was recently filed alleging that the use of ESG in a 401(k) plan was a breach of Erisa’s fiduciary duty. Whether this will lead to a wave of litigation making similar allegations about ESG investing with Erisa-regulated assets remains to be seen.

  1. Political and cultural debate around ESG investing heats up

In late May 2022, the SEC took a significant first step toward standardizing ESG disclosure practices for funds and investment advisers by proposing rule changes that are expected to be finalized in the fall of 2023. The proposed amendments helped set off a domino effect that has embroiled ESG-focused funds in cultural wars and political debates.

Some state governments are trying to protect state industries, including energy and timber, through so-called ‘boycott bills’ and by discouraging ESG investing at the state level, while others are looking to regulate state funds and financial services companies more broadly.

The debate over ESG investing at the state and federal levels is rooted in the same underlying issue: are fiduciaries considering ESG factors because they prudently believe those factors are appropriate financial considerations? Or are they considering ESG factors because of certain ethical or moral beliefs about certain industries and political attitudes?

      4. Challenges to the 'S' in ESG

Although affirmative-action programs and DE&I strategies have been a major focus of higher education and employers for years, there is a marked pushback to those efforts, with challenges to DE&I programs and policies through litigation, complaints to federal and state agencies and shareholder proxy proposals. But even if the number of these legal actions increases, pressure on higher-education institutions, employers and investors to take meaningful action to advance ESG and DE&I will likely continue.

Many observers are watching pending US Supreme Court decisions on the legality of race-conscious admissions programs used by Harvard University and the University of North Carolina. These decisions could have broad consequences for DE&I practices in a range of sectors, including employers’ DE&I programs, suppliers’ diversity programs, corporate and non-profit foundation philanthropy and emerging manager programs.

With the decisions anticipated before the court’s term ends in July, employers and non-profits should evaluate their existing DE&I hiring, recruitment and advancement programs as well as any race-conscious investments and charitable initiatives to identify areas of potential risk, assess their level of risk tolerance and develop communications strategies.

Employers should avoid sharing any competitively sensitive, non-public information with their competitors or peer institutions regarding their strategies, as doing so may expose them to risk, including under antitrust laws.

  1. Carbon offsets: Growing regulatory enforcement and litigation risks

Many companies use carbon offsets to help achieve their emission-reduction goals. Carbon offsets, which represent the permanent reduction or removal of emissions of carbon dioxide or other greenhouse gases (GHGs), are often used to cover the last increment of reduction that companies cannot otherwise achieve through operational changes. With more than 5,000 companies having set net-zero or science-based targets to reduce carbon emissions, carbon-offset projects (such as forest management and conservation, carbon-removal projects and renewable energy development) have risen in popularity.

This is an emerging area; no universal standard applies to quantify the emissions avoided or reduced of all carbon offsets, and there is no universal registry that tracks all carbon offsets. This creates exposure for holders of carbon offsets relating to their quality, validity, verification and use. Companies transacting carbon offsets need to ensure their carbon offsets are valid, verifiable and unclaimed, and that the projects that generated the carbon offsets permanently removed emissions from the atmosphere.

No federal agency has exercised regulatory oversight over the voluntary carbon markets, but these issues are attracting the attention of regulators. Within the past year, Commodity Futures Trading Commission (CFTC) commissioners have indicated that their agency intends to exercise its anti-fraud and anti-manipulation authority over the voluntary carbon markets.

They have concerns about fraudulent sales of carbon offsets that do not exist or do not belong to the seller and misleading communications about the material terms of carbon offsets. The CFTC’s whistleblower office this week issued an alert that individuals may be eligible for monetary awards and certain protections by identifying potential fraud and manipulation in the carbon markets.

Class-action lawsuits have begun to question the validity of carbon offsets in claims of carbon-neutrality.

Striking a balance

Amid economic headwinds and rising geopolitical tensions, many companies are looking to strike a balance between mitigation of short-term risks and long-term sustainability goals. Pending decisions and rules from lawmakers and regulators may provide some vital clarity about the broad scope and evolution of ESG but could also create further regulatory uncertainty due to the likely legal challenges regarding their legitimacy.

Elizabeth Goldberg, Erin Martin and Pamela Wu are partners with Morgan Lewis