State Anti-ESG Laws

A growing number of states are passing laws to restrict the use of ESG factors in making investment and business decisions. Proponents of these laws claim ESG threatens investment returns and uses economic power to implement business standards beyond those required by law.

Together, these new anti-ESG laws create an uneven regulatory landscape that has already resulted in the divestment of billions of dollars in state funds from investment managers. Investors and businesses face a difficult choice between complying with these state laws and achieving the ESG goals promised to investors and stakeholders.

This article highlights recent legislation that targets ESG practices and presents significant uncertainty for an increasing range of businesses.

Fiduciary Duties and Non-Pecuniary Factors

Federal regulators, such as the US Department of Labor (DOL), and conservative lawmakers in some states are taking opposing approaches to defining the duties of fiduciaries. This conflict reflects a philosophical disagreement about whether companies should work only to maximize returns or should take into consideration the interests of a wider range of stakeholders and outcomes beyond traditional fiduciary criteria.

For example, under the Employment Retirement Income Security Act of 1974 (ERISA), retirement plan fiduciaries have a duty to act solely in the interest of plan participants and beneficiaries. In November 2022, the DOL released a final rule addressing when fiduciaries may consider ESG factors in accordance with their fiduciary duties under ERISA. The new rule clarifies that fiduciaries may consider ESG factors, such as climate change, and may select from competing investments based on collateral economic or social benefits. By January 2023, 25 states had filed a lawsuit in federal court seeking an injunction against the new rule.

Even before the release of the DOL final rule, several states proposed laws prohibiting the use of “non-pecuniary factors” in making investment decisions for state pensions and other funds. In March 2022, the American Legislative Exchange Council introduced the State Government Employee Retirement Protection Act, model legislation that closely mirrors these proposed laws.

In March 2023, Kentucky Governor Andy Beshear signed House Bill 236 into law. The law prohibits the use of “environmental, social, political, or ideological interests” not connected to investment returns in determining whether a fiduciary or proxy of the state retirement system is acting solely in the interest of the members and beneficiaries. Five non-exclusive factors, including statements of principles and participation in initiatives, are listed as evidence that a fiduciary has considered or acted on a non-pecuniary interest.

In total, legislators in more than 20 states, including Ohio and Missouri, have introduced bills amending the fiduciary duty laws covering investing and proxy voting for state retirement systems. By contrast, state pension funds in several states, including New York and California, have taken the opposite approach, setting net zero carbon targets for their portfolios.

Anti-Boycott Legislation

Conservative politicians often claim ESG uses economic power to enact political agendas through alternative means. They argue, for example, that decarbonization goals amount to a boycott of fossil fuel companies and pose a threat to the economies of states dependent on the extractive industry. Several states have already started the process of divesting retirement system and other funds from financial companies that they claim boycott fossil fuel companies.

Some new state legislation expands on previous anti-boycott laws to include companies that support ESG goals. For example, a 2021 Texas law requires the state comptroller to publish a list of boycotting companies. The comptroller’s initial criteria for inclusion on this list included membership in Climate Action 100 and the Net Zero Banking Alliance/Net Zero Asset Managers Initiative, two major financial industry initiatives focused on climate change.

Utah Governor Spencer Cox recently signed a bill into law that goes a step further to prohibit companies from coordinating or conspiring with another company to eliminate viable options for another company to obtain a product or service “with the specific intent of destroying a boycotted company.” A boycotted company is defined by the law as one that engages in aspects of the firearms industry or does not meet certain ESG standards.

Social Credit Scores

To many of its opponents and skeptics, ESG is an unaccountable shadow regulatory system that takes specific aim at industries and policies supported by conservatives.

The belief that the stated goals of ESG mask other motives is at the source of bills introduced in several states to prohibit financial institutions from using a “social credit score” to make lending or other decisions. These bills claim that the use of a social credit score invokes the Social Credit System used in China to monitor and punish individuals and businesses for certain behaviors, which serves as a type of banned list.

Although some ESG frameworks produce numerical scores for various metrics, ESG experts reject the comparison to China’s Social Credit System. There is no substantive overlap between China’s surveillance apparatus and ESG in goals or application.

This distinction has not dissuaded lawmakers in Florida, who enacted legislation amending state banking law to make the use of social credit scores by lenders an unsafe and unsound practice in violation of state financial institutions codes and unfair trade practices laws, subject to sanctions and penalties. The law prohibits the use of a social credit score based on factors that include, for example, ESG standards on greenhouse gas emissions and corporate board diversity.

The Florida bill and others like it expand previous efforts by the state to divest state funds to restrict decisions on private lending, potentially involving many more financial institutions.

On the Horizon

The volume of anti-ESG bills introduced in state legislatures is growing as the topic gains political salience, particularly on the political right. As these laws pass, they serve as models for similar legislation in other states. However, the success of future legislation faces significant headwinds.

Anti-ESG laws have been passed predominantly in states where Republicans control the governorship and both houses of the legislature. So far, there is little indication many Democrats will support these anti-ESG laws. Indeed, the growing scope of anti-ESG laws creates another roadblock to their widespread adoption. Newer laws impose restrictions on a much broader range of companies, which only increases the complexity of enforcement and the risk of a legal challenge.

A lack of uniformity means businesses operating in more than one state may have to make difficult choices. The broader economic consequences of anti-ESG laws are still undetermined, but compliance with these new laws presents immediate challenges.

Charles Donefer joined Practical Law from Squishable.com, Inc., where he was general counsel focusing on transactional matters, licensing, and consumer product safety. Previously he was an associate at Kaye Scholer LLP.