Fiduciary Duties of Public Pension Systems and Registered Investment Advisors With Respect to Funds, Including Index Funds, Owned By ESG-Promoting Asset Management Firms

So-called Environmental, Social, and Governance (“ESG”) investment practices have come under increasing legal scrutiny.  Areas of legal concerns include potential breaches of fiduciary duty, conflicts of interest, violations of antitrust law, and violations of federal securities law. 

This white paper addresses three questions:

1. Does state law prohibit public pension trustees from choosing investments, adopting investment strategies, or exercising appurtenant voting rights based on ESG considerations?

2. Does state law prohibit public pension trustees from allocating capital to funds, including index funds, owned by asset management firms that engage with portfolio companies, and/or exercise appurtenant voting rights, to promote ESG objectives?

3. Does state or federal law prohibit a registered investment advisor (“RIA”) from investing client capital, or advising a client to invest capital, in funds, including index funds, owned by asset management firms that engage with portfolio companies and/or exercise appurtenant voting rights to promote ESG objectives, without expressly informing the client of these ESG-promoting practices and obtaining the client’s express advance consent?

BRIEF ANSWERS

In our opinion, the answer to all three questions is yes. 

Under well-established law, public pension trustees and RIAs are fiduciaries, charged with the highest legal duties of loyalty and prudence, and specifically with the duty to act solely and exclusively in the interests of their beneficiaries/clients.  In the case of state pension trustees, these fiduciary duties require that state assets be invested solely to maximize financial return.  By contrast, registered investment advisors (RIAs) are permitted to invest client capital in the service of non-pecuniary objectives, but only if the client gives his express, informed, advance consent thereto. 

In our opinion, courts are likely to conclude that ESG investment practices are motivated, either primarily or at least in part, by social and political objectives, not solely by considerations of maximizing financial return.  Thus state pension trustees may neither engage in ESG investment practices nor allocate capital to asset management firms who engage in such practices.  RIAs, however, may invest client capital with an asset management firm that engages in ESG-promotion, but only if they have first obtained informed, express client consent thereto.  

BACKGROUND

What is ESG?   

ESG refers to a set of loosely-defined but highly influential non-pecuniary criteria that purport to assess the extent to which companies are achieving certain social and political objectives with which many citizens disagree. 

Prominent among these ESG objectives are what ESG proponents call: (1) “DEI,” an acronym for Diversity, Equity, and Inclusion; and (2) “Sustainability.”  DEI is a euphemism for measures such as affirmative action, “racial audits,” and mandatory “anti-racism” sessions, said to be necessary to fight “structural racism,” “systemic gender bias,” or “white supremacy.”  Sustainability refers to goals pursued by the environmentalist movement, such as “net-zero” and the lowering or outright banning of fossil fuel production/consumption. 

The ESG movement grew out of the Socially Responsible Investing (SRI) movement of the 1970s and 1980s and has been called by respected commentators a “rebranded” version thereof.[1]  The goal of SRI was to encourage institutional investors to promote through their investment decisions global outcomes considered socially responsible.  The movement was propelled into worldwide prominence by a United Nations initiative launched in 1999 by then-Secretary-General Kofi Annan at the World Economic Forum in Davos, calling on private firms to accept a “Global Compact” “to embrace, support and enact a set of core values in the areas of human rights, labour standards, and environmental practices.”[2] 

An important and current statement of ESG principles can be found in the “United Nations Principles of Responsible Investing,” which has been signed by over 3,000 asset managers pledging to further “environmental, social, and corporate governance (ESG)” goals in order to “better align investors with broader objectives of society.”[3]  

ESG is also very closely aligned with the “Stakeholder Capitalism” movement, which holds that companies should look beyond “profits and a high share price,”[4] instead “meeting the needs of all [their] stakeholders: customers, employees, partners, the community, and society as a whole.”[5]  According to BlackRock CEO Larry Fink, a leading proponent of both the Stakeholder Capitalism and ESG movements, Stakeholder Capitalism is a “driving force behind ESG.”[6] 

ESG investing is frequently claimed by its proponents to increase long-term value and profitability.  Financially demonstrable proof of this claim, however, is at present entirely lacking.  Instead, as discussed below, recent evidence suggests that ESG investing in fact produces inferior financial outcomes.[7]  At a minimum, ESG investment practices appear plainly to be motivated, either primarily or at least in part, by social and political objectives rather than the sole objective of maximizing financial return.

ESG Promotion by Asset Managers

In recent years the ESG movement has catapulted into a dominant position throughout the asset management industry.  Globally, ESG-themed investments totaled an estimated $37.8 trillion in assets under management for year-end 2021.[8]  As stated above, the UN PRI principles have garnered thousands of asset manager signatories.  Signatories to the “Climate Action 100+,” an “investor-led initiative to ensure the world’s largest corporate greenhouse gas emitters take necessary action on climate change,” include hundreds of asset managers “responsible for more than $68 trillion in assets under management across 33 markets,” including the so-called Big Three (BlackRock, Vanguard Asset Management, and State Street Global Advisors).[9] 

The Big Three, which collectively control roughly $20 trillion in assets, rivaling the entire U.S. GDP, are also members of the “Net Zero Asset Managers Initiative,” a partnership dedicated to transforming the global economy to reach net-zero carbon emissions. Before joining the initiative, each member must commit to implementing a “stewardship and engagement policy”—i.e., a policy of proxy share voting and engaging with corporate executives—consistent with “achieving global net zero emissions by 2050.”  The Net Zero Asset Managers Initiative requires its members to prescribe specific emissions targets for industry sectors.  One internationally prominent net-zero emissions target calls for eliminating fossil fuels from electricity generation by 2050, which would require every American utility and most major American energy companies to radically alter their business operations and policies.[10]  

The Big Three asset managers have not only publicly committed themselves to promoting the ESG agenda, but have also made “firmwide commitments” to do so.  See, e.g., BlackRock 2020 Sustainability Disclosure, at 6, https://perma.cc/4HE5-6DXH (disclosing BlackRock’s “firmwide commitment to integrate ESG information into investment processes across . . . all of [its] investment divisions and investments teams”).  Significantly, such “firmwide” ESG commitments extend not merely to offering ESG-themed products to interested investors, but also to advancing the ESG agenda throughout all investment platforms and portfolios, including their so-called “passive” index funds. 

In the case of index funds, asset management firms like the Big Three pursue ESG-promotion through two primary mechanisms: (1) shareholder proxy voting and (2) corporate “engagement,” defined by Vanguard as “[d]irect contact with companies to discourage undesirable corporate behavior.”[11] These “direct contacts”—for example, high-level in-person conversations or phone calls with corporate officers—often take place behind closed doors, and the specifics of these communications are typically undisclosed to outsiders.  Corporate engagement is less visible and to many less well-known than proxy voting, but is known to be highly influential because of the tens of trillions of dollars in potential investment capital wielded by firms like BlackRock, Vanguard, and State Street. 

Through both mechanisms, ESG-promoting asset managers use their power as “shareholders in an attempt to . . . promote what they consider to be the right public policy. This takes place through dialogue with officers and proxy voting.”[12]  Again, asset managers who engage in these ESG-promoting practices—including BlackRock, Vanguard, and State Street—admit that they do so throughout all their investment portfolios, including their nominally “passive” index funds.[13]  SEC Commissioner Mark Uyeda recently described how the major American asset management firms use both shareholder voting and corporate “engagement” to push the ESG agenda on corporate America:

In reviewing any large asset manager’s stewardship website, mentions of ESG seem ubiquitous, from voting guidelines to engagements statistics. The information on these websites often document how an asset manager (1) establishes its expectations for ESG matters, (2) engages with companies that aren’t meeting its expectations, and (3) may vote against one or more incumbent directors if those companies do not continue to meet expectations. For example, an asset manager publicly disclosed a case study where, following multi-year engagements, it voted against a director of a public company, who also chaired the board committee overseeing ESG matters, because the company had failed to disclose its forward-looking GHG reduction targets. This is one of many instances in which an asset manager did not support the election of a director on the basis of climate-related issues.[14]

With their $20 trillion in assets under management, the Big Three control a staggering sum of investment capital—the “equivalent of more than half of the combined value of all shares for companies in the S&P 500.”[15]  They are also, collectively, the owners of some 20-25% of the voting shares of most major U.S. companies and thus able in many cases to control the election of directors.  Due to this extraordinary economic and shareholding power, ESG-promotion by firms like BlackRock, Vanguard, and State Street can and does have a profound impact on company management and policy all across America, often at odds with the best financial interests of the company and its shareholders.

For example, in 2021, an environmental activist group holding a minuscule number of shares of Exxon nominated at that company’s annual shareholder meeting a slate of new directors committed to reducing oil production.  Whether one agrees or disagrees with this initiative as a matter of social policy, it is hard to see how reducing oil production is in the best financial interests of an oil company.  Nevertheless, the Big Three asset management firms voted their proxies in favor of the activist slate of directors, and as a result the activist directors won, causing Exxon subsequently to cut oil production, thereby reducing the company’s revenues and contributing to a nationwide increase in gas prices. 

This result is disturbing not only because it is a prime example of ESG-promotion by BlackRock and other major asset management serving to further social or political goals at the expense of investors.  It is also concerning because oil projects abandoned by Exxon can be picked up by rival companies like PetroChina, the Chinese national energy company—one of whose largest private shareholders happens to be BlackRock.[16]  There is no record evidence that BlackRock notified any of its investor-clients of this serious potential conflict of interest—i.e., that Exxon’s loss could be BlackRock’s gain. 

In other examples of ESG initiatives seemingly at odds with the best interests of shareholders and other investors, the Big Three voted their proxies in 2021 to cause Chevron to adopt Scope 3 emissions cuts and in 2022 to cause Apple to engage in a company-wide “racial equity audit.”  However strongly some may support such measures, they are not primarily motivated by the interests of shareholders, but rather, as their proponents freely acknowledge, by a putative desire to advance the interests of certain social groups, society at large, or a company’s other “stakeholders.”  For example, the proponents of Apple’s racial equity audit shareholder proposal claimed that such an audit was required to determine “how [Apple] contributes to social and economic inequality” and to force Apple to “identify, remedy, and avoid adverse impacts on its stakeholders.” Color of Change—one of the activist groups pushing for a racial equity audit at Apple—explains that its mission is “to hold companies accountable for the ways they perpetuate white supremacy.”  Some may view “hold[ing] companies accountable” for “white supremacy” as a noble goal, but it is a goal quite different from maximizing return to those companies’ shareholders.

Growing Concern Over the Legality of ESG Investment Practices

In recent months, there has been growing, serious concern over the legality of ESG investment practices, particularly in connection with state public pension systems.  Of particular relevance are the following actions taken by state Attorneys General:

  • On May 26, 2022, the Attorney General of Kentucky concluded in a formal legal opinion that under the law of Kentucky, “‘environmental, social, and governance’ investment practices that introduce mixed motivations to investment decisions” violate the “fiduciary duties owed by investment management firms to [state] public pension plans.
  • On August 4, 2022, nineteen state Attorneys General wrote a letter to BlackRock CEO Laurence D. Fink, expressing concern that BlackRock’s ESG promotion “may violate multiple state laws . . . requiring a sole focus on financial return.
  • On August 30, 2022, the Attorney General of Louisiana issued a formal legal guidance letter warning of a “trend among some investment management firms, such as BlackRock, to use money from public and state employee pension plans to push their own political agendas and force social change through use of ESG criteria.”  The guidance went on to state: “The Big Three have all violated their fiduciary duty by, among other things, pledging together as part of Climate Action 100+, and, thus, have placed their interest in the ESG agenda above the interest of their investor-clients. In dereliction of their fiduciary duties, they have supplanted their client’s best monetary interest with their own agenda on climate change, politics, and other self-interests. They appear to have weaponized their client’s money to force changes in corporate structures and hierarchy, to change corporate policies, and to force companies to follow the ESG agenda all without their client’s best monetary interest at the forefront.
  • On September 1, 2022, the Attorney General of Indiana issued a formal legal opinion concluding that public pension fund fiduciaries act unlawfully if they allocate capital to asset management firms that “engage with portfolio companies, or exercise voting rights appurtenant to investments based on ESG considerations.”

LAW AND ANALYSIS

The Sole Interest Rule

Throughout the United States, pension plan managers and investment staff are trustees as well as fiduciaries, required to comply with “the sole interest rule,” according to which “a plan fiduciary “shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and . . . for the exclusive purpose of providing benefits to participants and their beneficiaries.”   Cent. States, Southeast & Southwest Areas Pension Fund v. Cent. Transp., Inc., 472 U.S. 559, 570-71 (1985) (emphasis added) (citation omitted). 

Across America, the sole interest rule is codified in state constitutions, state statutory law, and case law.  “All fifty states authorize the assets of public retirement systems to be held in trust. . . . The obligations imposed on the board and third party managers include duties of undivided loyalty and reasonable care that are at the core of fiduciary law.”  T. Leigh Anenson, Public Pensions and Fiduciary Law: A View From Equity, 50 Mich. J.L. Ref. 251, 258 (2016); see, e.g., 3 Restatement (Third) Of Trusts § 78(1) (trustees must act solely in the interest of beneficiaries); Uniform Prudent Investor Act § 5 (1994).  As the United States Court of Appeals for the Second Circuit has stated, the “fiduciary obligations of the trustees to the participants and beneficiaries of [a pension] plan are those of trustees of an express trust—the highest known to the law.”[17] 

Non-Pecuniary Considerations Prohibited; Mixed-Motive Investing Prohibited

Under the sole interest rule, as applied to pension funds, trustees are not permitted to make investments to advance non-pecuniary interests; rather, they must act solely and exclusively to maximize retirees’ “financial benefits.”  Fifth Third Bancorp v. Dudenhoeffer, 573 U.S. 409, 421 (2014) (emphasis added).  Pension fiduciaries must not be influenced by any motives—whether personal, altruistic, or political—other than maximizing the financial benefits of retirees.  See, e.g., 3 Restatement (Third) of Trusts § 78(1) cmt. f. (“the trustee has a duty to the beneficiaries not to be influenced by the interest of any third person or by motives other than the accomplishment of the purposes of the trust”).[18]

 Because fiduciaries must be solely motivated by considerations of financial return, “mixed-motive” investing is unlawful.  Opinion of the Attorney General of Kentucky, OAG 22-05 at 5 (May 26, 2022) (“mixed-motive” investing violates pension trustees’ fiduciary duty); Opinion of the Attorney General of Indiana, No. 2022-3, at 11 (Ind. Sept. 1, 2022) (“A fiduciary breaches this duty merely by having a mixed motive.”); see, e.g., Donovan v. Bierwirth, 680 F.2d 263, 271 (2nd Cir. 1982) (pension fund fiduciary must “act for the exclusive purpose” of providing financial benefits to plan beneficiaries) (emphasis added); Schanzenbach & Sitkoff, supra, at 401 (“Acting with mixed motives triggers ‘an irrebuttable presumption of wrongdoing,’ full stop.”) (emphasis added). 

Social Investing Prohibited

For the same reasons, “social investing”—i.e., the investing of plan assets motivated by social or political considerations rather than solely motivated by considerations of financial return—is prohibited in state pension systems.  As stated in the comments to the Uniform Prudent Investor Act:

No form of so-called “social investing” is consistent with the duty of loyalty if the investment activity entails sacrificing the interests of trust beneficiaries … in favor of the interests of the persons supposedly benefitted by pursuing the particular social cause.

Uniform Prudent Investor Act, § 5, cmt. (1994) (emphasis added).

Registered Investment Advisors

Investment advisers are fiduciaries under both state and federal law.  See, e.g., Securities & Exch. Comm’n v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (1963) (advisors are fiduciaries under federal and common law); SEC Guidance, Commission Interpretation Regarding Standard of Conduct for Investment Advisers,” https://www.sec.gov/rules/interp/‌2019/‌ia-5248.pdf (“Under federal law, an investment adviser is a fiduciary.”).  As the SEC has stated, investment advisors must make a reasonable inquiry into their clients’ objectives and must “adopt the [client’s] goals, objectives, or ends.”  Id.

Accordingly, in contrast to pension fund fiduciaries, investment advisors may lawfully invest client capital to pursue non-pecuniary objectives, including social investing.  Individual investors are free to use their investment capital however they wish, including to pursue social or political objectives, rather than solely to maximize financial return.  And investment advisors are legally bound to “adopt” and execute such objectives, if the client has chosen them.

The corollary, however, is that investment advisors may not place client capital in investments promoting social, political, or other non-pecuniary objectives unless the client is aware this is being done and has consented to it.  Under well-established law, investment advisers have a fiduciary duty to disclose to clients all material information.  “As a general matter, an investment adviser, as a fiduciary, has a duty to disclose to clients all material facts . . . Information is ‘material if there is a substantial likelihood that a reasonable [client] would consider it important.’  This duty is enforceable under Section 206 of the Advisers Act.”[19]  The fact that an investor’s money and shares will be used to promote a non-pecuniary social or political agenda would seem plainly material; some investors may welcome it, but others could reasonably choose to avoid placing their money with an asset manager who intends to vote their shares (or pursue “corporate engagement”) to advance an agenda with which the investor does not agree.  Thus, before placing client capital in an investment promoting non-pecuniary objectives, investment advisors must disclose that information to their clients and secure their advance consent.

ESG Investing Barred in Public Pension Systems

Under the foregoing principles, it is clear that public pension trustees may not engage in ESG investing.   

ESG calls for investment decisions to be made to advance certain social and/or political objectives, such as “diversity, equity and inclusion” or “sustainability.”  ESG is therefore a form of “social investing” or, at an absolute minimum, an example of “mixed-motive investing.”  It is not motivated solely and exclusively to maximize financial return, as the law requires of pension fiduciaries.  Citizens may agree or disagree with the ESG agenda, but under well-established law, state pension trustees are not permitted to use employees’ retirement assets to advance it. 

ESG advocates sometimes claim that ESG investing is not intended to advance social or political objectives, but rather is solely motivated by financial considerations.  Such claims have become more common in recent months as legal scrutiny of ESG has intensified.  These claims, however, are not credible, and in our opinion courts are likely to reject them.

ESG is a rebranded version of the earlier Socially Responsible Investing movement.  Its proponents believe that corporations and investors should not consider only their own profits, but should rather, as the UN “Global Compact” and “Principles for Responsible Investing” declare, “embrace, support and enact a set of core values in the areas of human rights, labour standards, and environmental practices”[20] in order to “better align investors with broader objectives of society.”[21] 

Candid descriptions of ESG acknowledge that its goal is to advance “socially responsible,” “socially conscious,” or “social impact” outcomes, even at the expense of “profit margin.”  The following represent just a few examples:

  • “The goal of the [ESG] movement is to ensure that companies take into account not only their profit margin but also the impact they have on society and the world.”[22]
  • “Environmental, social, and governance (ESG) criteria are a set of standards for a company’s behavior used by socially conscious investors to screen potential investments . . . to encourage companies to act responsibly” and to allow investors to “put[] their money where their values are.”[23]
  • “The corporate social responsibility (CSR) movement wants companies to consider the societal impact of their operations. A recent outgrowth of CSR has been to speak in terms of environmental, social, and governance (ESG) impact of a company’s operations. . . . ESG reflects a way to measure the societal impact by providing metrics [to] investors and investment analysts.”[24] 
  • “The PRI defines responsible investment as a strategy and practice to incorporate environmental, social and governance (ESG) factors in investment decisions and active ownership.”[25]

Indeed, BlackRock itself used to candidly acknowledge that ESG investing was a form of “social impact” investing, notwithstanding recent name or wording changes in its public statements apparently adopted to obfuscate this fact.  For example, as late as 2021, BlackRock described its “ESG US Equity Fund” as “invest[ing] in a portfolio of equity securities of companies with positive aggregate societal impact outcomes.”  In 2022, however, BlackRock changed this fund’s name to “BlackRock Sustainable Advantage Large Cap Core Fund,” telling investors that the fund picks companies positioned to capture “climate opportunities.”[26]  Such post-hoc rebranding confirms that ESG is in reality a form of “social impact” investing and undermines recent attempts to redescribe ESG in terms of capitalizing on market “opportunities.”

As to the claim that ESG actually increases investment returns, courts cannot and will not simply defer on this issue to the say-so of ESG-promoting asset management firms or other ESG proponents.  Rather, the burden of proof falls on those investment fiduciaries who seek to engage in ESG investment practices.  “[U]nder the common law, a fiduciary who allegedly breached his or her fiduciary duty must justify his or her conduct.  See, e.g.Geddes v. Anaconda Copper Mining Co., 254 U.S. 590, 599 (1921).”  Green v. Fund Asset Mgmt., L.P., 245 F.3d 214, 227 n.14 (3d Cir. 2001).  Where “it is possible to question fiduciaries’ loyalty,” “intensive and scrupulous” inquiry is appropriate, and substantial, objective and “independent” evidence must support the fiduciaries’ claims.  Howard v. Shay, 100 F.3d 1484, 1488-89 (9th Cir. 1996) (quoting Leigh v. Engle, 727 F.2d 113, 125-26 (7th Cir. 1984)).  

At present, proof that ESG increases investor return is wholly lacking.  On the contrary, significant evidence suggests that ESG investing in fact produces inferior financial returns.  As stated in a March 2022 report issued by the Harvard Business Review:

ESG funds certainly perform poorly in financial terms. In a recent Journal of Finance paper, University of Chicago researchers analyzed the Morningstar sustainability ratings of more than 20,000 mutual funds representing over $8 trillion of investor savings. Although the highest rated funds in terms of sustainability certainly attracted more capital than the lowest rated funds, none of the high sustainability funds outperformed any of the lowest rated funds.[27]

Industry studies purporting to show an ESG “alpha”—a higher rate of return—have been called into question by academic research.  See, e.g., Financial Times, ESG outperformance narrative ‘is flawed’, new research shows, May 3, 2021, https://www.ft.com/content/be140b1b-2249-4dd9-859c-3f8f12ce6036. “‘There is no ESG alpha,’ said Felix Goltz, research director at Scientific Beta . . . . ‘The claims of positive alpha in popular industry publications are not valid because the analysis underlying these claims is flawed,’ with analytical errors ‘enabling the documenting of outperformance where in reality there is none.’”  Id

According to data from Morningstar, out of 170 U.S.-centered funds with ESG mandates, only 49 (less than a third) outperformed the S&P 500 index in 2021, and as of mid-February, fewer than a quarter of those funds had done so in 2022.[28] A recent study of a “comprehensive sample of self-labeled ESG mutual funds” found that “ESG funds appear to underperform financially relative to other funds within the same asset manager and year.”[29] A leading rating agency’s study of data from 2010 through 2017 in a large U.S. equities index concluded that ESG-based “[s]tock selection (asset selection) accounted for an annual drag on returns of -1.45 percentage points. . . . [S]electing companies with high ESG ratings led to under-performance.”[30] Many industry observers now agree that earlier assertions of an ESG alpha were based on faulty correlations and, in addition, predict that recent global economic shocks will produce an “extended period” of continued “underperformance” for ESG investments going forward.[31]

The absence of demonstrable, empirical proof of the financial superiority of ESG investing—together with significant evidence of underperformance—fatally undermines claims by ESG-promoting firms such as BlackRock that their ESG policies are motivated solely and exclusively to increase financial returns.  Rather, the empirical evidence confirms that ESG is motivated, either primarily or at least in part, to advance social and political objectives.

Accordingly, public pension system fiduciaries are prohibited from choosing investments, adopting investment strategies, or exercising appurtenant voting rights based on ESG considerations.  A public pension trustee must not invest pension assets for any purpose other than paying benefits to plan participants.  ESG investment practices are not consistent with this obligation.

Similarly, pension plan fiduciaries are prohibited from allocating capital to investment funds, including index funds, owned or controlled by asset management firms that engage with portfolio companies, or exercise appurtenant voting rights, to promote ESG objectives.  Again, this would permit the use of public pension assets for purposes other than paying benefits to plan participants.  The corporate engagement and proxy voting practices engaged in by BlackRock and other ESG-promoting firms are not motivated solely to maximize financial return.  They are motivated at least in part to achieve “social impact” objectives—objectives with which many disagree.  Such practices are highly influential, imposing costs and policies on American companies that ESG proponents may favor but that are not provably in the best interests of those companies, shareholders or investors. 

ESG Investment Permitted for RIAs, but Only with Client Consent

With respect to RIAs, the foregoing analysis shows that RIAs, unlike pension plan trustees, may base their investment advice on ESG considerations and may place client capital in ESG-promoting investments, including index funds owned or controlled by asset management firms that engage with portfolio companies, or exercise appurtenant voting rights, to promote ESG objectives.  However, they may do so if and only if they have first informed their clients of these facts and obtained advance client consent thereto.

As stated earlier, “an investment adviser, as a fiduciary, has a duty to disclose to clients all material facts,” and information is “material if there is a substantial likelihood that a reasonable [client] would consider it important.” [32]   An investment adviser’s “[f]ailure to disclose material facts must be deemed fraud,” the Supreme Court has held, and this is so regardless of the presence or absence of any intent to deceive.  Capital Gains Research Bur.,375 U.S. at 200; Chiarella v. United States, 445 U.S. 222, 228 (1980); SEC v. Wash. Investment Network, 475 F.3d 392, 404 (D.C. Cir. 2007).

 How a client’s shares will be voted is undoubtedly material information that investors have a right to know.  Specifically, the fact that a client’s shares will be voted to advance the ESG agenda is information that many investors will reasonably view as important, especially investors who may not support that agenda.  The fact that a client’s investment capital will be used by an asset manager for “corporate engagement” with company executives to promote the ESG agenda—rather than solely to produce maximal financial return—is also significant, material information that investors have a right to know. 

At present, it appears that RIAs frequently place client capital in funds owned by ESG-promoting asset management firms—or even in ESG investment vehicles—without so informing their clients.  A year-end 2021 report by Bloomberg is illustrative:

Almost two years have passed since Larry Fink, the chief executive officer of BlackRock Inc., declared that a fundamental reshaping of global capitalism was underway and that his firm would help lead it by making it easier to invest in companies with favorable environmental and social practices. Lately, he’s been taking a victory lap.

“Our flows continue to grow and dominate,” Fink said Oct. 13 of so-called ESG, or environmental, social and governance funds, and similar investments. On the same conference call with analysts, he added: “BlackRock is a leader in this, and we are seeing the flows, and I continue to see this big shift in investor portfolios.”

What Fink did not say is that BlackRock drove a significant part of that shift by inserting its primary ESG fund into popular and influential model portfolios offered to investment advisers, who use them with clients across North America. The huge flows from such models mean many investors got into an ESG vehicle without necessarily choosing one as a specific investment strategy, or even knowing that their money has gone into one.[33]

Under well-established law, placing client capital into an “ESG vehicle,” or even in a passive index fund owned by an asset manager that uses proxy voting and/or corporate engagement to promote ESG objectives, is an act of fraud on the part of an investment adviser if the adviser has not informed the client of this information.  Therefore RIAs must make such disclosure to their clients, and obtain advance consent, before placing client capital in ESG-themed investments or with ESG-promoting asset management firms.

Conclusion

For the foregoing reasons, it is our opinion that state pension trustees may neither engage in ESG investment practices nor allocate capital to asset management firms that engage in such practices, and that RIAs may invest client capital (or recommend the investment of a client’s capital) with an asset management firm that engages in ESG-promotion only if they have first obtained informed, express client consent thereto


[1] See Schanzenbach & Sitkoff, supra note 1, at 388 (“[i]n the late 1990s and early 2000s, . . .  proponents of SRI rebranded the concept as ESG”).

[2] United Nations Secretary-General, Secretary-General Proposes Global Compact on Human Rights, Labour, Environment, in Address to the World Economic Forum in Davos (Feb. 1., 1999),

https://www.un.org/press/en/1999/19990201.sgsm6881.html.; see Elizabeth Pollman, The Origins and Consequences of the ESG Moniker, U. Penn. L. Research Paper No. 22-23, https://ecgi.global/sites/‌default/files/Paper%3A%20Elizabeth%20Pollman.pdf.

[3] U.N. PRI, https://www.unpri.org/about-us/what-are-the-principles-for-responsible-investment.

[4] McKinsey & Co., Putting stakeholder capitalism into practice, Jan. 2, 2022, https://www.‌mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/putting-stakeholder-capitalism-into-practice.

[5] Steve Denning, Why Stakeholder Capitalism Will Fail, Forbes, Jan. 5, 2020, https://www.forbes.com/‌sites/stevedenning/2020/01/05/why-stakeholder-capitalism-will-fail/?sh=74017d25785a.

[6] ConService ESG, Stakeholder capitalism is a driving force behind ESG, says Larry Fink, Jan. 20, 2022, https://www.gobyinc.com/larry-fink-stakeholder-capitalism-driving-force-behind-esg.

[7] See infra pp. 10-11.

[8] Bloomberg Intelligence, ESG assets may hit $53 trillion by 2025, a third of global AUM, Feb. 23, 2021, https://www.bloomberg.com/professional/blog/esg-assets-may-hit-53-trillion-by-2025-a-third-of-global-aum.

[9] Climate Action 100+, https://www.climateaction100.org and https://www.climateaction100.org/whos-involved/investors.

[10] See Will Hild, End Vanguard’s ESG Meddling With Utilities, Wall St. J., Dec. 1, 2022, https://www.‌wsj.‌com/articles/end-vanguards-esg-meddling-with-utilities-11669938471?mod=opinion_lead_pos8.

[11] Vanguard, ESG, SRI, and Impact Investing: A Primer for Decision-Making, Aug. 2018, at 4, https://perma.cc/42T2-K35T.

[12] Javier Al-Hage, Fixing ESG: Are Mandatory ESG Disclosures The Solution To Misleading ESG Ratings?, 26 Fordham J. Corp. & Fin. L. 359, 366 (2021).

[13] See, e.g.,BlackRock, BlackRock ESG Integration Statement, May 19, 2022, at 2, https://www.‌blackrock.com/corporate/literature/publication/blk-esg-investment-statement-web.pdf (“In index portfolios where the objective is to replicate a predetermined market benchmark, we engage with investee companies on ESG issues”).

[14] U.S. Securities & Exchange Comm., Nov. 17, 2022, https://www.sec.gov/news/speech/uyeda-remarks-cato-summit-financial-regulation-111722 (remarks of Comm. Uyeda at Cato Summit on Financial Regulation).

[15] Farhad Manjoo, What BlackRock, Vanguard and State Street Are Doing to the Economy, New York Times (May 12, 2022), https://www.nytimes.com/2022/05/12/opinion/vanguard-power-blackrock-state-street.html.

[16] See Fintel, BlackRock Inc. ownership in PTR / PetroChina Co., Ltd., Feb. 3, 2022 (reporting that BlackRock owns over 1 trillion shares—or 5.7%—of PetroChina).

[17] Donovan v. Bierwirth, 680 F.2d 263, 272 n.8 (2d Cir. 1982) (citing Restatement (Second) of Trusts § 2, comment b (1959) (emphasis added)).

[18] New administrative rules recently adopted by the Biden Administration’s Department of Labor (DOL) governing ERISA pension plans reaffirm that the “focus of . . . plan fiduciaries on . . . financial returns and risk to beneficiaries must be paramount” and that plan fiduciaries “may not sacrifice investment returns or assume greater investment risks as a means of promoting collateral social policy goals,” but nevertheless permit ERISA pension fund managers to promote the ESG agenda as a “tie-breaker” when competing investments “equally serve” the plan’s financial interests.  DOL, Employee Benefits Sec. Admin., Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights, 87 Fed. Reg. 73822, 73823, 73835 (published Dec. 1, 2022).  Whether courts will uphold the new DOL rules, given ERISA’s statutory mandate that plan fiduciaries must act solely to maximize “financial benefits,” Dudenhoeffer, 573 U.S. at 421, remains to be seen.  We note here only that ERISA does not apply to state public pension plans, which are governed instead by state law, and a “tie-breaker” policy like the DOL’s would appear to be illegal in states with express prohibitions forbidding public pension plan assets from being used to further any purpose other than providing financial benefits to plan participants.  See, e.g., South Carolina Const., Art. X, sec. 16 (“[a]ssets and funds established, created and accruing for the purpose of paying obligations to members of the several retirement systems of the State and political subdivisions shall not be diverted or used for any other purpose”) (emphasis added).

[19] 1 Investment Advisers: Law & Compliance § 8.02 (2022) (emphasis added) (citing TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976), Basic, Inc. v. Levinson, 485 U.S. 224 (1988), and SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963)).

[20] United Nations Secretary-General, Secretary-General Proposes Global Compact on Human Rights, Labour, Environment, in Address to the World Economic Forum in Davos (Feb. 1., 1999),

https://www.un.org/press/en/1999/19990201.sgsm6881.html.; see Elizabeth Pollman, The Origins and Consequences of the ESG Moniker, U. Penn. L. Research Paper No. 22-23, https://ecgi.global/sites/‌default/files/Paper%3A%20Elizabeth%20Pollman.pdf.

[21] U.N. PRI, https://www.unpri.org/about-us/what-are-the-principles-for-responsible-investment.

[22] ESG-The Report, What Is ESG and Why Is It Important, Nov. 25, 2021, https://www.esgthereport.‌com/what-is-esg-and-why-is-it-important.

[23] Investopedia, Environmental, Social, and Governance (ESG) Criteria, May 28, 2022, https://www.‌investopedia.com/terms/e/environmental-social-and-governance-esg-criteria.asp;

[24] Thomas Lee Hazen, Corporate and Securities Law Impact on Social Responsibility and Corporate Purpose, 62 B.C.L. Rev. 851, 852 (2021).

[25] United Nations, What is responsible investment?, https://www.unpri.org/an-introduction-to-responsible-investment/what-is-responsible-investment/4780.article.

[26] See Bloomberg Law, One Fund, Three Names and Lots of Questions for ‘ESG’, Aug. 25, 2022, https://news.bloomberglaw.com/esg/one-fund-three-names-and-lots-of-questions-for-esg. 

[27] Harvard Business Review, An Inconvenient Truth About ESG Investing, Mar. 31, 2022, https://‌hbr.org/‌2022/03/an-inconvenient-truth-about-esg-investing.

[28] Barron’s, Sustainable Funds Are Off to a Rough Start to the Year, Feb. 14, 2022, https://www.‌barrons.com/articles/esg-sustainable-funds-performance-51644844397.

[29] Aneesh Raghunandan & Shiva Rajgopal, Do ESG funds make stakeholder-friendly investments?, Rev. of Acct. Stud., June 2022, at 1, https://link.springer.com/article/10.1007/s11142-022-09693-1.

[30] MSCI, Performance and Risk Analysis of Index-Based ESG Portfolios, J. Index Investing, Spring 2019, https://www.msci.com/documents/10199/b07d04e1-2cce-9f35-5400-0e5cf4a0c76a (emphasis added).

[31] See, e.g., Trustnet, ESG investors face extended period of underperformance, Mar. 24, 2022,

[32] 1 Investment Advisers: Law & Compliance § 8.02 (2022).

[33] Bloomberg, How BlackRock Made ESG the Hottest Ticket on Wall Street: Stampede into sustainable funds got push from model portfolios; Main result is ‘giving them more fees,’ says former executive, Dec. 31, 2021, https://www.bloomberg.com/news/articles/2021-12-31/how-blackrock-s-invisible-hand-helped-make-esg-a-hot-ticket.