Contracting for ESG: Sustainability-Linked Bonds and a New Investor Paradigm

Abstract

Demand for investments that account for environmental, social, and governance (ESG) factors has recently surged to unprecedented highs. Many corporations have begun taking ESG actions to meet this investor demand—from carbon neutrality to increased diversity to sustainability reporting—some of which are reasonably expected to increase overall financial return. On the other hand, some investors have even started to show an interest in ESG actions that are expected to reduce financial return—but companies face certain obstacles to implementing them. First, under current Delaware law, officers and directors have a fiduciary duty to maximize shareholder wealth, which in theory prohibits them from pursuing ESG goals unless they reasonably believe their achievement will ultimately result in increased shareholder profit. Second, since directors that do take ESG actions are highly incentivized under currently law to frame them as wealth-maximizing, the shareholders who do not share such ESG preferences are effectively “taxed” by these actions if their returns are thereby reduced.

This paper provides an economic analysis of investors who are willing to “pay” for ESG actions in the form of reduced financial returns, filling a gap in legal scholarship that has otherwise presumed investors exclusively seek profit. Then it examines one set of ESG investments that companies and investors have already started developing—sustainability-linked bonds (SLBs)—and argues that they present an interim solution to the obstacles described above. Issuers of SLBs typically make a contractual commitment to achieve certain specified ESG goals (e.g., decrease carbon emissions, increase diversity) in exchange for a more favorable interest rate from participating creditors. This arrangement potentially allows companies to meet investor demand for ESG goals while nonetheless increasing shareholder wealth in the form of cheaper capital. Further, the terms of the ESG commitments in SLBs are specified in advance by contract, allowing prospective investors the ability to “pay” for only those products that suit their preferences. While there may or may not be a change to Delaware’s fiduciary duties in the near future, SLBs already offer impact ESG investors and traditional investors the opportunity to avoid the problems they may create.

Keywords: ESG, Sustainability-Linked Bonds, Green Bonds, Corporate Social Responsibility, Fiduciary Duties, Corporate Law, Delaware