AGs Pressure Advisory Firms to Ditch ESG, Alleging Wrongdoing

T wenty-one state attorneys general released a letter to proxy advisory firms today taking issue with their use of ESG criteria in advice to state investment vehicles. The letter was written by Utah attorney general Sean Reyes. It provides evidence of possible violations of fiduciary duty and says, “We seek written assurance that you will cease such violations and commit to following the law.”

Proxy advisory firms exist to tell investors how to vote their shares. They are especially important to large institutional investors, such as state pension funds, that own too many stocks to be able to keep track of every question presented to shareholders. Those large institutional investors also control enough shares to swing votes for publicly traded companies.

There’s nothing wrong with proxy advisory firms in principle: They represent a logical application of the division of labor. However, there are only two major proxy advisory firms, ISS and Glass Lewis, and almost every fund is advised by one of them, so groupthink can take hold easily. With the rise of mutual funds and index funds, in addition to existing large public funds, their power has grown significantly in the past few decades, and they don’t own any of the shares that they are indirectly voting.

The attorneys general allege in the letter that by advocating criteria related to climate change and diversity, equity, and inclusion when advising state investment vehicles, ISS and Glass Lewis could be in violation of their contracts with state governments and the law.

On climate issues, the attorneys general say, “Rather than being based on a rational analysis of the effects that expected changes to government policy would have on any given company, your actions appear more like those of an activist forcing companies to comply with rules that governments will not otherwise institute.” This expresses a common criticism of ESG, namely that it is a way to circumvent the democratic process, which has not resulted in the implementation of the sweeping climate policies that environmentalists want.

They also allege a possible conflict of interest, considering that ISS and Glass Lewis — in addition to the advice they offer state investment vehicles — also offer services related to ESG investing. “The value of these services would be undermined if you were to admit in your advisory services that ESG factors are not material to a firm’s financial performance,” the attorneys general wrote. Insofar as climate issues are a material risk to investors, and there are some cases in which they are, companies are already required to disclose them, and proxy advisory firms would already take them into account in the absence of ESG criteria.

On diversity, equity, and inclusion, the attorneys general allege that ISS and Glass Lewis may be in violation of state anti-discrimination laws. “You have pledged to recommend votes against certain directors on boards that you view as having insufficient racial, ethnic, or sex-based diversity under arbitrary quotas that you have announced,” they wrote. They argued that the firms have not adequately considered the legality of their actions and have not demonstrated why such criteria would be relevant to economic performance, which, under the contracts they have with state governments, is supposed to be their goal.

With Republicans out of power in Washington for the past two years, state officials have taken the lead in calling out problematic ESG practices. That Utah’s attorney general is leading this letter comes as no surprise, as Utah officials have been particularly active on this issue. Andrew Stuttaford wrote in April 2022 about Utah’s governor, federal lawmakers, and other state officials speaking out against S&P’s decision to start publishing ESG scores for U.S. states.

The issue is especially significant to Western states with significant energy-industry presence. Sixteen GOP governors, largely from the West, came out against the Securities and Exchange Commission’s proposed climate-disclosure rules in May 2022. Like ESG considerations, climate-disclosure requirements would have the effect of disadvantaging those states’ economies more than others’.

Insofar as ESG is policy-making by nongovernmental means, proponents should expect political pushback. There are at least two sides to political questions; the use of investment tools rather than the democratic process to achieve desired political results does not mean that the opposition disappears. State GOP officials have made that clear in recent years. This letter is only the latest example.