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The Business Lawyer

Summer 2022 | Volume 77, Issue 3

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

Jonathan Romas Povilonis


  • Officers and directors are often advised that their fiduciary duties compel them to maximize shareholder wealth, which in theory would prohibit them from pursuing ESG actions that are not reasonably expected to result in maximized shareholder profit—or at least incentivize them to frame ESG actions as wealth-maximizing (even if they are not). This article examines one set of ESG investments that companies and investors have already started developing—sustainability-linked bonds (SLBs)— and argues that they present a solution to the obstacles created by corporate fiduciary duties. 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. SLBs thus potentially allow companies to meet investor demand for ESG goals without sacrificing shareholder wealth and allow investors to “pay” for only the ESG products that suit their preferences.
Contracting for ESG: Sustainability-Linked Bonds and a New Investor Paradigm
iStock/Olena Vasylieva

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Investors just want to make money—or at least that’s what Delaware corporate law presumes about them. For decades this presumption was a good one, and there was no need to question it: people chose to invest their money, rather than spend or hoard it, because they hoped to reap a profit from doing so. But recently, investors’ concerns have been expanding.

Within the past couple decades, and particularly within the past five years, demand for investments that account for environmental, social, and governance (“ESG”) factors has surged to unprecedented highs. In contrast to traditional investments, ESG investments are typically designed to achieve a particular environmentally or socially sustainable goal, in addition to financial return. Many investors incorporate ESG factors into their investment strategies simply because they believe doing so will increase their financial returns in the long run (or at least that’s what they say publicly). By contrast, other ESG investors want their investments to make certain positive impacts in the company or in the world, even if it means they’ll ultimately make less money as a result. For ease of reference, I will use the term “impact ESG” to refer to any corporate action (or investment strategy) that, at the time the relevant decision is made, is expected to sacrifice some amount of financial return for some amount of non-financial impact. Because Delaware corporate law does not currently account for the preferences of impact ESG investors, as I explain below, Delaware corporations cannot pursue impact ESG goals without some difficulty.

Under Delaware corporate law, corporate directors owe fiduciary duties to shareholders, which scholars of the law and economics persuasion often characterize as a duty to “maximize shareholder wealth.” This duty prohibits corporate directors from pursuing sustainable or socially responsible goals—such as those designed to increase the welfare of other stakeholders like employees, customers, or the environment—unless they reasonably believe such goals will ultimately result in maximized shareholder profits. The risk of fiduciary liability under current Delaware jurisprudence, then, incentivizes directors to forego impact ESG actions altogether, even in instances where shareholders would ultimately prefer they be carried out. Shareholders who seek to make investments that align with their social and ethical convictions may well find them thwarted by Delaware law.

On the other hand, there are certain practical limits to shareholders’ ability to enforce directors’ fiduciary duties, and these limits can function to insulate directors from fiduciary liability in certain ways. As such, directors who would prefer to take impact ESG actions may well have the legal flexibility to do so—but their fiduciary duties incentivize them to frame any impact ESG actions as if they are expected to increase shareholder profit in the long run, even though (by definition) 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 unwillingly do so, unless they are able to monitor corporate activity better than corporate insiders are, which is unlikely. If traditional shareholders cannot identify impact ESG actions and voice their dissent to them (say, by voting or by selling their shares) in a cost-effective way, they will bear whatever costs such impact ESG actions incur.

In other words, Delaware fiduciary duties are likely to produce disparate outcomes, some of which are suboptimal for impact 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.

But ESG remains controversial. The rise of ESG has fueled an intense and prolonged debate in which everyone from corporate leaders and investors to scholars and commentators have had a say. While prior debates about corporate purpose saw some agreement along the boundary lines of particular market groups (e.g., shareholders aligned against management), the ESG debate has unfolded rather visibly along 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. And it is also safe to say that those skeptical of ESG corporate actions would generally be opposed to any modification of Delaware fiduciary duties intended to facilitate them. I raise this here not to engage in the debate about the merits of ESG but to suggest that a resolution to it does not appear to be immediately forthcoming, and that likewise it may be foolish to expect that a modification to Delaware fiduciary duties is forthcoming as well.

Accordingly, in this article I explain an alternative solution. A new investment product called sustainability-linked bonds (“SLBs”), I argue, has the potential to resolve some of the issues created by Delaware fiduciary duties and the ongoing debate on ESG. Given how polarizing this debate can be, it is likely that some readers will be more concerned about the unrealized preferences of impact ESG shareholders while others will find the costs imposed on traditional shareholders more problematic—regardless, I argue below that SLBs allow companies to avoid both of them.

An SLB is a traditional bond plus a quantifiable ESG commitment by the issuing company: A company 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. Put simply, if there are individuals who want a company to decrease its carbon emissions badly enough that they are willing to pay for it, there is now a type of investment security that allows them to do just that. SLBs give companies the opportunity to meet market demand for ESG goals while nonetheless maximizing shareholder wealth, since the holders of SLBs are typically willing to accept a lower return and the issuer thereby has a reduced cost of capital. Further, the terms of ESG commitments in SLBs are specified in advance by contract, allowing prospective investors to sort themselves according to their preferences and purchase only those products they wish to pay for. With SLBs, in sum, impact ESG investors can pay for the ESG goals they want and traditional shareholders can avoid paying for them.

First, I explain in Part I the recent trend among investors toward ESG investing and away from an exclusive focus on financial return. Next, I explain in Part II how Delaware fiduciary duties create an obstacle for impact ESG actions that works to the detriment of both impact ESG investors and traditional shareholders. Thus, I argue in Part III that SLBs present a solution for this problem in the interim by allowing investors to sort themselves based on their preferences. I close with a brief conclusion.

I. The Rise of Impact ESG Investing

A. Corporate Law as a Contract

This article takes as a starting point the predominant theoretical framework for corporate law, known as the “nexus of contracts” or “contractarian” theory. Contractarian theory is the standard law and economics account of corporate law, and it holds that corporations and other business organizations are fundamentally species of contract—legal devices intended to facilitate a set of mutually beneficial agreements between voluntary parties. Corporate law, then, as it exists in state corporation codes and judicial case law, is seen as a set of “off the shelf ” contractual terms that commercial parties can select for their arrangements so as to reduce their costs of contracting. For contractarians, there is not (or need not be) an overarching “purpose” or “goal” of any corporate legal entity apart from the desires and intentions of those who are party to it. As such, contractarians presumptively disfavor mandatory rules in corporate law (with a few exceptions), because such rules would serve only to inhibit the intentions of the parties and thereby reduce freedom of contract. Instead, according to contractarians, corporate law should consist almost entirely of default rules that can be modified by mutual agreement among the various stakeholders of the corporation.

The rationale behind this is simple: corporate participants know more about what they want than legislators or judges do. Not only do they have better knowledge about their goals, they’re also better positioned to understand their risks and how to protect themselves against them. Thus, from a contractarian perspective, the only reason to impose mandatory rules on corporate parties is to provide protection for non-participants, for those that are not parties to the corporate “contract” and thus who cannot protect themselves from its potentially negative externalities. And, it’s worth noting, that contractarian scholars typically consider mandatory rules to be limited in number and best implemented via regulation or legislation that is external to corporate law (e.g., labor or environmental law).

Under the contractarian view, then, corporate law functions properly when it enables corporate participants to contract for the legal arrangements that they prefer, which has the added benefit of allowing corporate law to adapt to changes in preferences over time. If the default rules of corporate law are properly calibrated to the preferences of most corporate participants, their transaction costs (including the cost of contracting) will be relatively low, because they can simply adopt such rules for their business with minimal modifications—and as market preferences change, these default rules can be modified as the parties see fit. Inversely, contractarians typically believe that when a mandatory rule of corporate law prevents mutually beneficial arrangements, including new arrangements that develop over time, in most cases the law ought to be revised. If corporate parties want to be governed by a specific contractual term, in the absence of negative externalities there is no reason to prevent them from doing so.

Naturally, then, scholars evaluating the provisions of corporate law require an accurate understanding of the preferences of rational and self-interested commercial parties—otherwise, the risk that participants will be prevented from entering mutually agreeable contracts emerges. Now that ESG investing has become mainstream, as I explain below, this risk has begun to materialize.

B. The Profit–Exclusivity Paradigm

The twentieth century witnessed a variety of extended debates on corporations and social purpose. But even as views among scholars shifted from the managerialism of the earlier half of the century to the shareholder-centrism of the latter half, one assumption remained constant: shareholders seek profit, and profit alone. To be sure, the assumption was not that the people who in fact hold shares of corporations care only about money. It was simply that despite whatever other views these people might hold about politics, ethics, or society, in their capacity as shareholders they were collected for the common purpose of making a profit. And because shareholders were rarely, if ever, sufficiently aligned on other issues, it makes perfect sense that, at the time, the law took account only of this preference for profit.

Perhaps the most famous expression of this profit exclusivity is Milton Friedman’s essay, The Social Responsibility of Business Is to Increase Its Profits. As the title suggests, Friedman’s focus was on business enterprises as a whole, but he had plenty to say about shareholders in particular. His argument, in short, was that because corporate managers are the agents of a corporation’s owners—the shareholders—they have a responsibility “to conduct the business in accordance with [shareholders’] desires, which generally will be to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom.” When corporate managers deviate from shareholders’ goal of profit generation, then, according to Friedman they are simply “spending someone else’s money for a general social interest.” And, importantly for this discussion, in Friedman’s view,

the same argument applies to the newer phenomenon of calling upon stockholders to require corporations to exercise social responsibility. . . . In most of these cases, what is in effect involved is some stockholders trying to get other stockholders (or customers or employe[e]s) to contribute against their will to “social” causes favored by the activists. Insofar as they succeed, they are again [in effect] imposing taxes and spending the proceeds.

It’s clear, then, that Friedman’s typical shareholders are not merely interested in profit generation (within the guardrails of law and custom); they are also fiercely opposed to the use of their investments toward any kind of social goals. Anyone who would use shareholders’ invested funds to pursue such goals, according to Friedman, is effectively imposing a type of “tax” on them.

This same view is pervasive in legal scholarship as well. When describing shareholders as a class, leading scholars of corporate law have proceeded on the seemingly uncontroversial premise that “each investor will prefer the set of rules that maximizes the total value (wealth) enjoyed by the investors.” As one scholar put it, “[i]n most theoretical discussions of corporate purpose, shareholder primacy has been equated with the notion that corporate directors have a fiduciary duty to maximize the long-term wealth of the stockholders, with little consideration paid to the possibility that shareholders themselves may prefer a different outcome.”

With this in mind, corporate actions aimed at goals like environmental sustainability have typically been considered to be a cost center from the perspective of investors—something to be avoided unless under the circumstances they were expected to save money down the line (e.g., by avoiding litigation costs or reputational harms). For decades, there was no reason to challenge this conception: Corporate investors were sufficiently aligned over their preference for profit and insufficiently aligned over their preferences for everything else. But recently, that’s been changing.

C. The ESG Paradigm

Investors of all types are now making investment decisions that take account of ESG factors. The term “ESG” was coined in a landmark report following the 2005 United Nations conference called “Who Cares Wins.” Since then, ESG investing has undergone a “remarkable rise” and “rapid growth into the mainstream”—by one estimate, assets in the United States with sustainable investment strategies totaled $17.1 trillion in 2020, an increase of 42 percent over the prior two years. The sheer volume of ESG investments has revealed certain coherent preferences among investors that, at the very least, give reason to doubt that profit remains their only discernable priority.

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 major successes with BP and Royal Dutch Shell. In 2017, two of the world’s biggest institutional investors, State Street and BlackRock, 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. This behavior alone marks a drastic change from institutional investors like index funds, that have long been described as “passive investors” that rarely challenge corporate directors and officers on anything.

Investors like BlackRock and State Street tend to claim that their focus on factors like a company’s sustainability profile, employee welfare, or diversity metrics is strictly oriented toward the long-term financial value of the company. Not surprisingly, a more cynical view has emerged that argues that the hype around ESG benefits nobody except institutional investors and fund managers, who have attracted additional clients with all the publicity, but done little to contribute to global or social change. In either case, the focus on ESG by these investors represents simply a change in means, not ends: not a deviation from yesterday’s paradigm of profit-exclusivity so much as a reframing of how best to achieve it.

On the less cynical side, though, “there is a rising demand by [certain] investor types to improve the alignment of their portfolios with societal values, such as related to slowing climate change, improving socially just practices, and ensuring high standards of corporate governance.” Further, some of these investors have even shown a demonstrated willingness to sacrifice financial return for the sake of advancing certain ESG goals. It is these investors that mark a meaningful change from yesterday’s profit-exclusivity paradigm, as they see objectives like environmental sustainability and improved diversity as ends in themselves, and not just as a means to increase long-term profits. I have been referring to them as “impact ESG” investors, because, as I explain in the next part, they are willing to sacrifice some amount of expected financial return for an expected positive impact on corporate behavior.

D. Economic Analysis of Impact ESG

To ensure corporate law facilitates corporate contracting, scholars must account for various corporate preferences—including those that develop in the market over time. I provide the following economic analysis of impact ESG investing to lay a foundation for evaluating the provisions of corporate law discussed in the following part.

Starting with the basics, rational investors part with their money because they want something in return, some large part of which is financial profit (otherwise they would save or spend it). To get that profit, a corporate investor can invest either in a company’s debt or equity. Debt investors exchange their money for an agreed upon fixed payment by the company in return, like a bond or a loan. On the other hand, equity shareholders contract for is what is known as the “residual” claim in the corporation, which represents the economic value of the corporation, if any, that is left after all of the corporation’s fixed claims have been paid. Equity shareholders thus tend to have the most at stake in the long-term prospects of a corporation, because they have the most to gain or lose based on how the corporation performs as a whole—which contractarians assume generally means economic profit. That’s why contractarians say that rational, self-interested shareholders would typically seek the right to elect directors and to be owed fiduciary duties by them. However, to the extent that shareholders and other corporate participants develop non-economic preferences, contractarians would say they have every right to obtain contractual rights for those as well.

To illustrate this, assume that a Delaware corporation called Blue Chip Inc. can be expected to produce a 5 percent annual return on investments in its publicly traded common stock. Assume also that to produce this annual return, the management of Blue Chip must do everything it can to optimize its performance, such that there are no further steps it could take to increase revenues or minimize expenses in a given year.

Now imagine Investor A, who has a portfolio of equity and debt investments that is optimally diversified, which includes an investment of $100 in Blue Chip’s common stock. Under the profit–exclusivity model described above, the assumption that Investor A is a rational, self-interested shareholder means that she prefers simply that Blue Chip maximize her annual return, which in this case is expected to be $5. Inversely, it means that any action that Blue Chip could take that would result in Investor A getting less than $5 of return in a given year would be contrary to her preferences.

Investor B, on the other hand, is an impact ESG investor. Her portfolio is identical to that of Investor A, but her goals are slightly different. She too expects an annual return of $5 on her $100 investment in Blue Chip, but she is more open as to how to achieve it. Because Investor B values environmental sustainability, she also values any significant reduction of Blue Chip’s total carbon emissions at a price of $2 per year. As such, she would be willing to accept a financial return as low as $3 per year in any year Blue Chip made a significant reduction of its carbon emissions.

It is important to note here that the reasons behind Investor B’s preferences are relatively unimportant for the purposes of economic or contractarian analysis. Maybe Investor B believes reducing carbon emissions is the “right thing to do” morally, or maybe she is more or less self-interested and thinks it will simply contribute to a better world for her and the people she cares about. Or maybe, more cynically, she doesn’t care about any of those things, and wants merely to attract clients or customers who do care about them for her own personal enrichment. Further, it is entirely possible that corporate ESG actions will utterly fail to achieve any of those goals—won’t contribute to saving the planet, won’t make anyone’s lives any better, and won’t ultimately increase personal profits.

Of course, one’s views on broader issues may carry the most weight here. If an investor believes we are just a few years away from a climate catastrophe, she may think it obvious that carbon neutrality would create net gains for shareholders in the long run, and thus think the universe of impact ESG actions (i.e., those that reduce long-term shareholder wealth) is vanishingly small. On the other hand, an investor who thinks all this global warming talk is just another weapon of the leftist woke mob might believe that nearly all ESG actions will constitute impact ESG and cost shareholders money. But, again, for the purposes of corporate law, the substantive debate is largely irrelevant: Given that a fundamental premise of contractarianism is that individuals know more about what is better for them than do scholars or lawmakers, contractarians can completely disagree with all the personal preferences of impact ESG investors and nonetheless argue that corporate law should not interfere with them. The bottom line is that, for a variety of reasons, investors like Investor B are willing to “pay” as much as $2 each year to reduce Blue Chip’s carbon emissions. And, as long as other corporate parties are willing to agree to such terms, corporate law has no interest in intervening.

Now imagine that, in response to pressure from activist shareholders, Blue Chip establishes a carbon emissions initiative pursuant to which it will both significantly reduce its total emissions over time and publicly report its progress toward this goal to investors. Imagine also that Blue Chip’s board of directors reasonably and sincerely believes that the initiative will cost 1 percent of Blue Chip’s annual return to implement and maintain on an ongoing basis, even after accounting for any reputational benefits and decreased litigation risk, and that they publicly disclose this conclusion to investors.

Obviously, Investor A and Investor B would be expected to have very different reactions to the announcement. Investor A derives no value from Blue Chip’s carbon emissions initiative and would view it solely as a cost, whereas Investor B would strongly prefer it because it would allow her to capture a $1 surplus in value each year. Of course, these prices are simplified and entirely hypothetical, and in practice ESG initiatives may indeed cost much more to implement than any investors are willing to pay—or, conversely, may create much more value for corporations and their shareholders that nearly all investors would agree to them.

In any case, the point is that the question of whether corporate law should intervene depends, at least for contractarians, on the assumptions made about shareholder preferences. If most shareholders are like Investor A and prefer that corporations focus exclusively on maximizing their wealth, corporate law should perhaps reflect this preference—for example, by enforcing a rule that prohibits Blue Chip’s directors from launching the initiative. On the other hand, if a significant number of shareholders have the impact ESG preferences embodied by Investor B and no other corporate parties object, corporate law should facilitate impact ESG actions rather than prevent them. But Delaware corporate law has not yet gone that route.

II. Impediments to Impact ESG

Despite the growing prominence of impact ESG investing, significant doubt exists as to whether corporate directors are permitted to take impact ESG actions under current Delaware law. This doubt can be expected to produce two opposite outcomes—and no matter where a given shareholder stands in the ESG debate, they will likely run into outcomes they find regrettable fairly frequently. On the one hand, some corporations can be expected to avoid impact ESG actions altogether, as their boards seek to avoid liability for violations of fiduciary duty—even when these actions are favored by impact ESG shareholders. On the other hand, boards that do wish to take impact ESG actions may well have the legal flexibility to do so, but are incentivized to present them as wealth-maximizing, which obfuscates the costs that such actions impose on traditional shareholders. SLBs present a solution to both problematic outcomes, as I explain in Part III.

A. Fiduciary Duty to Maximize Shareholder Wealth

Directors and officers of for-profit Delaware corporations owe fiduciary duties exclusively to their shareholders. Generally, this means that “directors must make stockholder welfare their sole end, and that other interests”—whether environmental protection, employee welfare and diversity, community engagement, etc.—“may be taken into consideration only as a means of promoting stockholder welfare.” In Delaware, to put it bluntly, directors are legally obligated to prioritize shareholders over all other corporate stakeholders. And even though impact ESG actions are often driven by shareholder activism, it’s not hard to see how authorizing these actions would expose directors to the claim that they have violated their fiduciary duties. After all, many impact ESG actions benefit other groups like employees or the environment quite visibly and directly, while benefitting shareholders only indirectly. So we can consider this the outer limit of impact ESG actions in Delaware corporations: if directors take any ESG actions at all, they must do so in service of shareholder interests above all others.

As for how shareholder interests must be served, the canonical law and economics account understands fiduciary duties quite narrowly, as an obligation to “maximize shareholder wealth” over the long term. In other words, while decisions about business strategy and execution may be very complex, law and economics scholars hold that directors must approach such decisions with one simple goal in mind: to generate as much economic return for shareholders as possible. While Delaware courts have never held that directors violate their fiduciary duties by serving the non-economic interests of shareholders (as discussed in the following part), recent Delaware decisions have made the connection between directors’ fiduciary duties and maximized economic value explicit:

Having chosen a for-profit corporate form . . . directors are bound by the fiduciary duties and standards that accompany that form. Those standards include acting to promote the value of the corporation for the benefit of its stockholders. The “Inc.” after the company name has to mean at least that. Thus, I cannot accept as valid for the purposes of implementing . . . a corporate policy that specifically, clearly, and admittedly seeks not to maximize the economic value of a for-profit Delaware corporation for the benefit of its stockholders—no matter whether those stockholders are individuals of modest means or a corporate titan of online commerce.

Even if the shareholder wealth maximization norm has not been expressly endorsed by the Delaware courts, then, the combination of current case law with the canonical law and economics account serve to strongly discourage boards from serving anything other than shareholders’ economic interests.

Further, scholars typically consider fiduciary duties to be mandatory in for-profit corporations. Despite the reputation of the Delaware General Corporation Law as “a broad enabling act which leaves latitude for substantial private ordering,” an important limitation on this private ordering is that “judicially imposed principles of fiduciary duty [must be] honored.” Given that directors’ fiduciary duties to shareholders are not statutory provisions but instead judge-made principles of equity, they cannot be modified or abrogated by charter amendments that are adopted by commercial parties. The result is that the parties of for-profit Delaware corporations do not have the freedom to opt out of the shareholder wealth maximization norm, unless they were to take the more drastic measure of changing their jurisdiction or organizational form.

To summarize the canonical law and economics account, then, current Delaware law imposes a mandatory duty on directors of for-profit corporations to maximize long-term economic value for the benefit of shareholders alone. As for actions that would be expected to reduce shareholder profits and simultaneously provide benefits to non-shareholders, such as Blue Chip’s carbon emissions initiative, the threat of fiduciary liability incentivizes corporate directors not to carry them out—even if investors would strongly prefer that they did. Under the prevailing view of Delaware corporate law, then, the vast majority of companies in the S&P 500 are not currently permitted to take impact ESG actions at all.

Given the harsh penalties associated with a potential violation of fiduciary duties under the predominant view of corporate law, one outcome we can expect is that many directors will avoid impact ESG actions whenever possible. Further, where director compensation is tied to stock price or financial performance, directors will be financially incentivized to avoid actions that are likely to reduce or limit overall economic return. Unless directors have personal or reputational reasons to pursue impact ESG actions or determine that their tenure in office may be at risk if they do not pursue them (as discussed below), we can expect that they will largely avoid impact ESG actions, even when preferred by shareholders.

The consequences of this are regrettable from the perspective of certain ESG investors, who are becoming increasingly common in today’s capital markets. Recall that some shareholders, like Investor B, value the benefits of the impact ESG actions more than an incremental increase in their financial return on investment. If Delaware directors decline to take such actions due to their fiduciary duties, they will be unable to capture the gains that would otherwise be available to impact ESG investors. In other words, the result under the canonical view of Delaware law is suboptimal because it is inefficient, or at least less efficient than it could be without the obstacle of directors’ fiduciary duties. The impact ESG investors are worse off with this outcome than they would be if the ESG actions were carried out: instead of receiving the benefit of the ESG actions that they prefer, they receive incremental increases to their financial return that they do not value as highly.

As explained below, this result could be avoided if Delaware courts clarified that fiduciary duties permit directors to serve shareholders’ non-financial interests as well—though, traditional shareholders might object. In the meantime, SLBs provide an interim solution to this problem and allow corporate directors to capture (more of ) the potential gains among their constituencies.

B. A “Tax” on Traditional Shareholders

On the other hand, there is another outcome that we should also expect to be fairly common: some Delaware directors will take impact ESG actions anyway. The practical difficulties of strictly enforcing the shareholder wealth maximization norm insulate Delaware directors from fiduciary liability, such that those who want to take impact ESG actions will in many cases be able to do so without adverse legal consequences.

For one thing, even under the canonical view of Delaware law, the legal analysis of whether any particular corporate action satisfies directors’ fiduciary duties is far from simple in practice, due to the difficulty of determining the economic impact of that action at the time the decision to take it is made. Some actions taken in the name of ESG may ultimately increase shareholder wealth, and others may decrease it—but in most cases, there’s at least a colorable argument ex ante that shareholder wealth will be increased over the long term. This is because “ESG investing . . . is so complex and multi-faceted that almost any action short of theft or outright destruction of corporate property can be defended on some ESG ground or the other.” Directors who believe that reducing a company’s carbon emissions will improve its resilience in the face of the more negative effects of climate change, for example, may well be inclined to expect that any such reduction will result in net economic gain for their shareholders in the long run.

In other words, the above discussion assumed that it was a simple task to identify an action as an impact ESG action—that is, to identify which ESG-driven actions will decrease financial return rather than increase it. In reality, directors are tasked with making judgments about which courses of action are reasonably likely to produce a certain outcome, rather than selecting options with predetermined values.

This goes hand in hand with the business judgment rule, which functions as a limit to shareholders’ ability to enforce a strict wealth maximization norm in practice. The “business judgment rule gives blanket protection to any decision that can be framed, in good faith, as linked to shareholder value.” Decisions of directors that turn out to be unsuccessful (i.e., that lose money for the corporation and its shareholders) are not automatically determined to be violations of directors’ fiduciary duties. What matters for the court’s analysis is not how a decision appears in hindsight but how it appeared to the directors at the time they made it: a Delaware court will not overturn a board decision that can be “attributed to any rational business purpose.” Because this rational basis test is a fairly low bar, it is only in rare cases that some rational explanation cannot be provided, which gives the business judgment rule’s protection a wide-reaching application. For impact ESG actions, then, this means directors are able to avoid liability for violations of fiduciary duty unless they are unable to sincerely and reasonably conclude that shareholders will ultimately benefit from them.

Another wrinkle in the canonical law and economics view is that the Delaware courts have not answered this precise question of law before. As certain scholars have recently pointed out, a duty to act for the sole benefit of shareholders is not necessarily equivalent to a duty to maximize shareholder wealth, given that today many “shareholders have sincere commitments to social values that may be in tension with profit maximization.” The case law summarized in the previous part is frequently cited to support the claim that the shareholder wealth maximization norm is the law in Delaware. But it is worth noting that this case law is not directly on point: cases like Revlon and eBay involved claims that directors subordinated shareholder interests to other non-shareholder interests, like those of bondholders, employees, and more abstract goals like a corporation’s “culture.” In fact, Delaware courts have never decided a case in which directors were alleged to have subordinated shareholder wealth to other values of the shareholders like environmental or social sustainability. Even when Delaware courts have approved contested charitable gifts made by corporations (which directly benefit non-shareholders), they have done so on the grounds that shareholders would ultimately receive an economic benefit from these gifts in the long run. In short, Delaware courts have not held that directors violate their fiduciary duties if they sacrifice shareholder wealth in service of broader shareholder values.

Collectively, these features of Delaware law provide a fair amount of flexibility for directors to carry out impact ESG actions. Directors who have independent reasons to embrace ESG are incentivized to present ESG actions as if they contribute to the financial benefit of shareholders, even if they are not likely to do so. Thanks to the business judgment rule, these directors can rest assured that Delaware courts will not overturn this exercise of their business judgment, even if in hindsight it turns out they were wrong. And because there is no Delaware case specifically requiring that directors consider only shareholder wealth, some directors may believe that they can fulfill their fiduciary obligations so long as they seek to benefit shareholders more generally.

And there are many reasons to think that some Delaware directors will take advantage of this flexibility. For example, if a corporation’s most prominent and vocal shareholders demand that the corporation take specific impact ESG actions, it falls squarely within the directors’ self-interest to carry them out—after all, shareholders retain the power to vote them out of office. It is also possible that directors would be motivated by moral or reputational considerations, and desire to carry out impact ESG actions on the belief that they are “the right thing to do” or that they will be seen that way by others.

The point is that even though current Delaware jurisprudence discourages impact ESG actions in a general way, there are nonetheless plenty of incentives for directors to carry them out anyway. And given that there is some flexibility under Delaware law, at least some directors are likely to do so. Any proposed ESG corporate action can likely survive judicial scrutiny if the directors have some rational basis for concluding that the action will ultimately result in shareholder benefit, especially if it would maximize shareholder value in the long run. In other words, directors who want to take impact ESG actions can do so, as long as they are careful in how they do so.

Corporate directors that do take impact ESG actions in response to shareholder demand are therefore incentivized to frame these actions as ultimately benefiting shareholders—and even as increasing shareholder wealth, despite the fact that (by definition) they do ultimately reduce it. While this approach is likely to protect directors from fiduciary liability, it is not without its negative consequences. In particular, the incentive for boards to downplay the cost and overestimate the financial benefit of impact ESG actions has the potential to obfuscate the negative impact of these actions on corporate profit. Shareholders like Investor A that are unwilling to give up any profit in exchange for ESG actions will be unwittingly forced to do so—in Friedman’s words, they are “taxed” by these actions.

The “tax” works in the following way. Certain prominent or vocal shareholders can be expected to press corporate directors for specific impact ESG actions that they are willing to “pay” for in exchange for reduced profits. However, because the corporation, its directors, and its impact ESG investors are incentivized to frame these actions as ultimately maximizing shareholder value (to obtain the support of shareholders and avoid fiduciary liability), the costs of these actions will likely not be disclosed to investors accurately. Without accurate disclosure, traditional shareholders—who exclusively seek profit and are thus unwilling to “pay” for impact ESG actions—will not be on notice that they are being forced to do so. Instead, unless they are highly vigilant and investigate each ESG action proposed by each company in their portfolio, they will effectively pay a “tax” on their shares to subsidize the social values of the impact ESG shareholders.

Without a legal change that allows corporations and investors to openly identify impact ESG actions, shareholders will be subject to this “tax” across their portfolio companies. For the time being, however, SLBs present an opportunity for corporations and shareholders to avoid this tax altogether.

C. The Ongoing Debate

As laid out above, Delaware fiduciary duties are likely to produce outcomes that are suboptimal either for impact ESG investors or for traditional shareholders. In corporations whose boards are convinced by (or advised according to) the canonical law and economics account of Delaware law, impact ESG shareholders will frequently miss out on the value that they most prefer to capture. On the other hand, traditional shareholders will frequently have to pay for impact ESG actions they have no interest in, as they will have difficulty identifying them and virtually no ability to prevent determined boards from carrying them out.

Of course, one possible solution to this is a modification to Delaware law. Delaware lawmakers could make clear that shareholders are permitted to modify directors’ fiduciary duties, and may hold a vote that would authorize directors to maximize broader shareholder welfare instead of aiming narrowly to maximize shareholder wealth. Contractarians would have little to criticize about this approach, since directors would not be permitted to take impact ESG actions unless a majority (or perhaps supermajority) of shareholders preferred them to do so. All that could be said of Delaware corporate law, then, is that it would be simply facilitating the voluntary arrangements of commercial parties.

But while traditional shareholders would have limited reason to complain about this solution on contractarian grounds, it is not hard to see why they would nonetheless oppose it. The upside of a shareholder welfare standard from the perspective of traditional shareholders is that directors would be less incentivized to downplay the costs of impact ESG actions, since they would not face fiduciary liability for them. Dissenting shareholders would thereby be better positioned to identify such actions and vote against them (or the directors who support them), or perhaps even to sell their shares, to avoid incurring the costs of impact ESG. The downside, of course, is that this authorization may well cause impact ESG actions to become more common in the market, and traditional shareholders may find it increasingly difficult to find investments that suit their preference of profit exclusivity.

In other words, a change to Delaware law may well be optimal for impact ESG investors (or at least those whose preferences are widely shared in the market), but less than optimal for traditional shareholders. Fortunately for the latter, SLBs provide a solution to the problems created by Delaware fiduciary duties that may even allow directors to continue to pursue maximized shareholder wealth as their exclusive aim.

III. Sustainability-Linked Bonds

A. General Terms

Just as investor demand for ESG has dominated the equity markets in the past few years, it has been prevalent in the credit markets as well. The basic idea is the same: some investors want to finance projects or practices that are environmentally or socially friendly. The only difference is that the financing comes in the form of a credit instrument—a definitive contract to repay money like a loan or a bond—rather than the more open-ended equity investment in the residual claim. Most ESG credit products initially took the form of bond issuances, but certain companies have recently entered equivalent products for their private credit facilities instead.

ESG bond issuances typically fall into one of two types: “use-of-proceeds” bonds and “sustainability-linked” bonds. The most common type of use-of-proceeds bonds are known as “green” bonds, due to their focus on environmental benefits, but there are “social” use-of-proceeds bonds as well. Unsurprisingly, what distinguishes use-of-proceeds bonds from other ESG bonds is that, by their terms, the proceeds received by the issuer must be earmarked and used for projects with positive environmental or social outcomes. The interest rate on use-of-proceeds bonds is typically lower than it would be for traditional bonds of the same issuer, and it typically remains fixed throughout the full life of the bonds. As use-of-proceeds bonds grew in popularity, these features were sometimes seen as a limitation—not every company has the need, capacity, or expertise to oversee specific projects with ESG goals. At the same time, investor demand for companies to make specified ESG-driven changes to their existing operations was only increasing. Hence, the SLB was born.

The first SLB was issued in 2019, by the Italian multi-national energy company, Enel, and since then dozens of other companies in Europe, Asia, and Latin America have followed suit. According to ICMA’s sustainable bond database, the first SLB issuance by a U.S.-based company occurred in December 2020, by the Delaware corporation NRG Energy.

Unlike use-of-proceeds bonds, SLBs do not involve the issuer’s agreement to set aside the proceeds for any specified project or purpose. Sometimes called “key performance indicator” or “KPI” bonds, SLBs involve a commitment by the issuer to achieve a particular environmental or social performance target. 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. The most common sustainability target among corporate issuances to date is the reduction of the company’s total carbon emissions, “but issuers have also targeted water use and treatment, recovery or reinsertion of endangered species in the areas in which they operate, the number of green constructions built, the percentage of a portfolio allocated towards green investments and the number of customers reached in underserved areas” as well as goals “related to diversity, inclusion and other social metrics within their organizations.”

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 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 company 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.

There is no formal statutory or regulatory framework that specifically governs the measurement of the sustainability aspects of these bonds, which means their terms are determined entirely by contract. In hopes of establishing some cross-industry standards, ICMA has published a set of voluntary “Sustainability-Linked Bond Principles,” which most issuers of SLBs have voluntarily adopted. Among other things, these principles encourage each issuer to select sustainability targets that are core to its overall business and represent a material improvement beyond a “business as usual” trajectory. In other words, these principles are intended to guide issuers to select an area where an improvement to its environmental or social practices will be most impactful, and a measure of improvement that will be somewhat ambitious to achieve.

To give an example, NRG Energy completed the sale of $900 million aggregate principal amount of 2.450 percent senior secured first lien notes due 2027 on December 2, 2020. Pursuant to its Sustainability-Linked Bond Framework, NRG Energy’s target is to reduce its absolute carbon emissions (i.e., scope 1, 2, and 3 emissions) by 50 percent (from a 2014 baseline) to 31.7 million of metric tons of carbon dioxide equivalent by December 31, 2025. If NRG Energy does not meet this target (and have it confirmed by the designated external verifier), it will be required to pay the interest rate step-up of 25 basis points from and including the interest period ending on June 2, 2026, for a total annual interest rate of 2.700 percent.

B. Advantages of SLBs

For both investors and corporations, SLBs offer several distinct advantages over traditional equity investments when it comes to carrying out impact ESG actions. In general, the features of SLBs described below allow corporate directors to respond to the ESG demands of their investors without running afoul of their fiduciary duties or imposing a “tax” on unwilling shareholders.

1. 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. 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.” And as long as the costs of achieving the applicable sustainability targets does not exceed the savings from this cheaper capital, SLBs essentially arrange for impact ESG investors to pay for them.

In this way, corporate directors can avoid the risk of violating their fiduciary duties that is otherwise present in the implementation of ESG actions. Imagine certain investors want their company to be more diverse. If the company issues an SLB with a diversity-related performance target, “investors who care about diversity will get what they want (diversity) at the cost of giving up some economic return; also, the issuer will be incentivized to do what those investors want (become more diverse) in order to save money.”

Directors would no longer have to frame each proposed action to improve diversity at the company as profit-increasing in itself to obtain the protection of the business judgment rule, even if there are costs associated with such actions that are ultimately passed to shareholders. Instead, the directors can authorize the issuance of an SLB, and expect to save money with a reduced interest expense. At the same time, directors can be responsive to the investors who value the particular impact ESG goal because they are committing to concrete steps to achieve it. And because it is not shareholders but SLB bondholders who end up financing the ESG goal, the maximization of shareholder wealth is otherwise not impeded.

2. Ex-Ante Enumeration of ESG Terms

Further, SLBs allow companies to avoid imposing a “tax” on shareholders who are unwilling to pay for certain ESG projects and initiatives. A corporation that commits to reducing its carbon emissions or increasing its diversity without the use of an SLB is incentivized under current law to frame that commitment as likely to maximize shareholder wealth in the long run—otherwise its directors and officers risk facing claims that they’ve violated their fiduciary duties to shareholders. In the event that the commitment ultimately creates more expenses than revenues for the corporation, the net expense incurred will (in one way or another) reduce the corporation’s bottom line, thereby reducing the overall value of the corporation’s common resources for the benefit of the corporation’s residual claimants, the common shareholders.

With SLBs, on the other hand, the issuer’s commitments are specifically enumerated in the offering documentation that is shown to prospective investors and in the indenture that governs the terms of the bonds. 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 shareholders entered into the “corporate contract” (i.e., bought their shares) on the belief that the directors owed them a fiduciary duty to maximize their wealth, and remain entirely unwilling to pay for ESG actions. 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.

3. Specified Pricing

Finally, and relatedly, one of the most important contractual terms 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. If a company targets a reduction in carbon emissions or an increase in diversity without the use of SLBs, it will be more difficult for investors to isolate the costs and benefits that are directly attributable to the achievement of the target and determine the net gain or loss it resulted in.

With SLBs, both the ESG target and its price are set forth in concrete terms before sales of the bonds are effected. The company agrees to a measurable, verifiable target, like reducing its scope 1, 2, and 3 carbon emissions by 50 percent by 2030. 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 conventional bond.


The fiduciary duties of Delaware directors create scenarios in which traditional investors and impact ESG investors are each likely to lose out. At the very least, these duties discourage transparency from corporations as they consider various ways of responding to the demand for ESG that has recently dominated the securities markets, leaving investors unsure of the costs that ESG might impose. SLBs provide a solution to these problems by allowing investors to pay a specified price for a specified ESG performance target, thereby eliminating much of the guesswork by directors and investors alike. Investors who want ESG actions badly enough to pay for them will be able to do so in the form of a reduced return on investment. And shareholders who prefer not to bear these costs will not have to, since the corporation typically pays a lower interest expense on an SLB than it would on a conventional bond. 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 create.

The views expressed herein are my own and do not reflect the views of my firm.