How to Contract for ESG: Sustainability-Linked Bonds and a New Investor Paradigm 

By | July 14, 2022

Companies today are facing unprecedented pressure to make progress on environmental, social, and governance (ESG) issues. The demand for companies to address these issues is not new, but a relatively recent development is that this demand now comes from investors, rather than activists or other stakeholders. The pressure from investors has caused many companies to take steps in response, such as commitments to reduce their carbon emissions or increase diversity among their employees. But other companies are struggling to keep up with the demand, or to get started in the first place. 

At the same time, the managers and directors of Delaware corporations—representing the majority of companies in the S&P 500—owe fiduciary duties to their shareholders, which are often described as a requirement to maximize financial returns to shareholders instead of pursuing environmentally or socially sustainable goals.   

This post describes one set of ESG investments that companies and investors have already started developing—sustainability-linked bonds (SLBs)—that may present a solution to some of these challenges. Issuers of SLBs typically make a contractual commitment to achieve certain specified ESG goals in exchange for a more favorable interest rate from participating creditors. SLBs thus potentially allow companies to meet investor demand for ESG goals without sacrificing financial return and allow investors to “pay” for only the ESG products that suit their preferences. 

A Shift in Investor Focus 

Under the traditional paradigm, the only thing that matters to investors is making as much money as possible. This was perhaps most famously expressed by Milton Friedman’s essay, the title of which says it all: The Social Responsibility of Business Is to Increase Its Profits. When corporate managers and directors deviate from the singular goal of profit generation—say, in an effort to reduce carbon emissions—according to Friedman they are simply “spending someone else’s money for a general social interest.” Shareholders who fit this paradigm would thus evaluate ESG activity the same way they evaluate any other corporate action: supporting everything that is reasonably expected to increase a company’s overall financial return and opposing anything that would cost the company money. But a shift has been occurring, and the traditional paradigm does not dominate the markets like it used to. 

Today, investors of all types are starting to take account of ESG factors in their investment decisions. This may be most visible in the large institutional investors—including those long described as “passive” investors due to their deference toward corporate management—that have started to push companies for progress on ESG issues. For example, Climate Action 100+, a group of more than 500 institutional investors that collectively manage more than $50 trillion in assets, has launched a years-long campaign seeking voluntary commitments to net-zero greenhouse gas emissions from major oil and gas producers—and has already seen notable successes. In 2017, to give another example, two of the world’s biggest institutional investors announced that they would vote against the nominating committees of companies that did not have a minimum number of women on the board or show efforts to improve board diversity. While many investors maintain that their focus on ESG is fundamentally tied to long-term profit, even these few examples serve illustrate the major shift in focus that has occurred in the market. 

Of course, ESG remains controversial, and many investors have rejected it altogether out of a preference for the traditional paradigm. While prior debates about corporate purpose saw some agreement among particular market groups (e.g., shareholders aligned against management), the ESG debate has unfolded rather visibly along the pre-existing lines of political parties, where broadly held cultural and ethical convictions seem to carry the most weight. In other words, it is safe to say that those who view issues like global warming, income inequality, and racial injustice as existential threats to modern life are more likely to view the rise of ESG as a positive development overall, whereas those who remain unpersuaded that such threats are looming (or will materialize in the future) are more likely to approach ESG with skepticism if not criticism. The result is that investors can now be expected to have views about ESG issues that are just as disparate—and irreconcilable—as those of the public at large. 

The choice that corporate managers and directors are left with, then, is hardly a choice at all: Any action they take (or fail to take) stakes a new position in the ESG debate, one that is bound to be scrutinized by shareholders that stand on opposite sides of it. These challenges can exist in any corporation, regardless of the corporate law that governs the conduct of managers and directors. But for businesses incorporated in Delaware these difficulties are compounded by the fiduciary duties that managers and directors owe to shareholders. 

Fiduciary Duty to “Maximize Shareholder Wealth” 

Under Delaware corporate law, corporate managers and directors owe shareholders a fiduciary duty, which scholars of the law and economics persuasion often characterize as a duty to “maximize shareholder wealth.” In theory, this duty prohibits corporate managers and directors from pursuing the sustainable or socially responsible goals that characterize ESG, unless they reasonably believe the achievement of such goals would ultimately result in maximized shareholder profits. While Delaware courts have never held that directors would violate their fiduciary duties by serving the non-economic interests of shareholders, recent Delaware decisions have made the connection between directors’ fiduciary duties and maximized economic value explicit.1 Corporate actions designed to increase the welfare of non-shareholders—like employees, customers, or the environment—at the expense of financial return to shareholders therefore have the potential to expose managers and directors to fiduciary liability. Two disparate outcomes are likely to result. 

On the one hand, the risk of shareholder suits for fiduciary duty violations incentivizes managers and directors to forego ESG actions altogether, even in instances where shareholders would ultimately prefer, they be carried out. If a company’s board concludes that achieving net-zero greenhouse gas emissions would, all things considered, reduce the company’s ultimate financial return to shareholders, a strict reading of Delaware jurisprudence would hold that doing so would violate the board’s fiduciary duties. Thus, many shareholders who seek to make investments that align with their ethical convictions may well be thwarted by the confines of Delaware law. 

On the other hand, there are certain practical limits to shareholders’ ability to enforce managers’ and directors’ fiduciary duties, and these limits can function to insulate directors from fiduciary liability in certain ways. The business judgment rule offers a fair amount of protection, especially when it comes ESG actions for which it is difficult to determine the ultimate financial impact on shareholders, and when Delaware courts have not expressly held that serving the non-economic interests of shareholders is a violation of fiduciary duty. As such, managers and directors who would prefer to take ESG actions may well find the legal flexibility to do so—but their incentives are still a cause for concern. The risk of fiduciary liability actually incentivizes managers and directors to frame ESG actions as if they are expected to increase shareholder profit in the long run, even when they are not. This creates a separate problem: traditional shareholders that do not want to sacrifice financial return for the specified ESG goal may nonetheless do so unwillingly, unless they are able to monitor corporate activity better than corporate insiders are, which is unlikely. If traditional shareholders cannot identify unprofitable ESG actions and voice their dissent to them (say, by voting or by selling their shares) in a cost-effective way, they will be “taxed” in the amount of the costs that any such ESG actions incur. 

To summarize, Delaware fiduciary duties are likely to produce disparate outcomes, some of which are suboptimal for ESG investors and some of which are suboptimal for traditional shareholders. One possible solution to this, of course, is a modification to Delaware law that would authorize (or permit shareholders to vote to authorize) directors to maximize shareholder welfare more broadly, instead of aiming narrowly to maximize shareholder wealth. Given the controversy that currently surrounds ESG, though, it may be foolish to expect that a modification to Delaware fiduciary duties is forthcoming any time soon. Fortunately, a contractual solution may have already emerged. 

Sustainability-Linked Bonds: A Contractual Solution 

Investors and companies have recently developed a type of ESG investment product, SLBs, which potentially present an interim solution to the obstacles described above. Companies looking to meet investor demand for progress on ESG issues should give serious consideration to an SLB issuance and the solutions it may offer. 

An SLB is a traditional bond plus a quantifiable ESG commitment by the issuing company. In short, “the idea is that socially responsible investors provide cheaper capital to companies in exchange for those companies promising to do socially responsible things.” 

An issuer of an SLB typically accepts a loan of money on traditional terms (like a conventional bond issuance), but also adopts an additional contractual commitment to achieve certain specified ESG goals (e.g., decrease carbon emissions or increase employee diversity) in exchange for a more favorable interest rate from participating creditors. Among the many contractual terms of these bonds, the issuer agrees to pay a higher interest rate to bondholders—called the interest rate “step-up”—if the target is not met by a certain cut-off date. Whatever target is chosen, the issuer’s performance with respect to it must be measurable and externally verifiable to determine whether it has been met by the pre-determined, contractual deadline. 

Typically, the issuer will provide reports to investors at least annually to track its performance and engages an auditor or environmental consultant to perform independent evaluations of such performance and provide opinions to support the issuer’s reports. If the issuer does not meet the target by the set cut-off date, the interest rate step-up will typically apply for the remaining life of the bond. 

The features of SLBs allow corporate managers and directors to respond to the ESG demands of their investors without running afoul of their fiduciary duties or imposing a “tax” on unwilling shareholders: 

  • Maximized Shareholder Wealth. The most obvious advantage of SLBs is that they provide companies the opportunity to pursue ESG goals without reducing shareholder wealth. Because there is currently a higher demand for investment products with ESG features or performance targets, companies that issue SLBs may be able to obtain more favorable terms than would be available with conventional debt products, most commonly in the form of a lower interest rate. 
  • Ex-Ante Enumeration of ESG Terms. With SLBs, the issuer’s commitments are specifically enumerated in the offering documentation that is shown to prospective investors. This avoids the guesswork that would otherwise be inherent to any corporate decision to implement ESG actions, where directors would be required to decipher the various competing preferences of shareholders. Many investors today remain entirely unwilling to pay for ESG actions, while other investors are demanding them. SLBs allow investors to see the full terms of the contract before entering into it, and thus to sacrifice financial return only when they truly want to do so. 
  • Specified Pricing. One of the most important contractual terms of SLBs that is known to investors in advance is price: exactly how much profit they must give up to see the company achieve a particular ESG goal. As both the ESG target and its price are set forth in concrete terms before sales of the bonds are affected, prospective investors therefore know exactly which ESG actions they are agreeing to pay for, and exactly how much it will cost them: the margin of reduced return on the SLB compared to the return they could expect with a traditional bond. 

In other words, for investors that want to see more ESG activity, there is now a way for them to pay for it. And for investors that don’t—with SLBs, they won’t have to. While there may or may not be a change to Delaware’s fiduciary duties in the near future, SLBs already offer companies and investors the opportunity to avoid the problems they may create. 

Jonathan R. Povilonis is an associate at Cleary Gottlieb Steen & Hamilton LLP.  

This post is adapted from the author’s paper, “Contracting for ESG: Sustainability-Linked Bonds and a New Investor Paradigm,” available on SSRN and published in The Business Lawyer as part of a larger symposium.   

The views expressed in this post are those of the author and do not represent the views of the author’s firm, the Global Financial Markets Center or Duke Law. 

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