Each of the two most oft-propounded notions of ESG – environmental, social, and governance – carries some persuasive weight in the debate about ESG’s impact on corporate governance.  If ESG results in a sharper focus on risk management and better metrics for guiding long-term value creation, then there is little room to object.[1]  But if ESG causes managers to give politics priority over profits,[2] redistribute corporate surplus as rents to stakeholders,[3] or consume the social benefits of ESG pursuits as perquisites or resume-builders, then one could doubt whether ESG enhances long-term value creation or provides any net social benefit at all.

In a recent article, I explore these competing versions of ESG, parsing the question with special attention to (1) how ESG fits into the tacit bargain between managers and shareholders that is part of the larger nexus of contracts in the corporation, and (2) how ESG shifts corporate managers’ incentives to maximize their compensation from corporate employment.  I conclude that, if ESG truly prompted better risk management, it could, in theory, result in greater wealth or social value.  In practice, it has become a way for managers to arrogate a greater share of corporate surplus to themselves.

High-level managers pursue ESG as a perquisite, enhancing their social status or deflecting potential questions about poor financial performance.  Lower-level managers pursue ESG to enhance their personal reputations at the expense of the corporation, using it as an avenue for advancement within the corporation or by lateral moves to other employers.  Indeed, ESG is an excellent opportunity to consider an understudied aspect of corporate governance: How corporate actors at all levels respond to internal incentives to maximize their own share of the corporate pie.

The Corporate Contract: A Tacit Bargain

Legal commentators regularly describe the corporation as a nexus of contracts.[4]  This theory of the firm began with Ronald Coase in the 1930s and has grown into the leading theory of the corporation.[5] As an economic firm, every corporation is a bundle of voluntary trades organized to produce whatever it is the corporation produces.  The bargain between those who run the corporation (managers, including directors and officers) and the capital providers (shareholders) is tacit – i.e., understood but not directly bargained-for –  and is a promise from the managers to the shareholders that the managers will generally try to provide a return on investment.  In addition, this bargain is necessarily incomplete, because generating a return involves innumerable decisions over long stretches of time.[6]  This bargain, shareholder wealth maximization, is the core of corporate law and governance.  Emphasizing ESG to the point where corporate decisions are reoriented – around it would significantly change that core bargain, for better or worse.  The mechanisms for that shift would include how strongly individual managers pursue ESG goals and how much the law permits or fuels that reorientation.

Consuming ESG: The Perquisites of Status and Advancement

Like anyone else, corporate managers respond to individual incentives within corporations, not just on behalf of their corporations.  It is well understood that their individual incentives never quite line up with maximizing the wealth of the shareholders.  Corporate law and governance practice have evolved to fine-tune this relationship, i.e., to minimize agency costs. As Dean Henry Manne observed, there is always a point where the cost of mechanisms designed to align managers’ incentives exceeds the reduction in agency costs attributable to them.[7]  Dean Manne also observed that insider trading was a special case of corporate insiders generating returns for themselves from their internal entrepreneurship.[8]  The engine of his analysis, on both points, was that corporate managers will maximize their returns from corporate employment, along whatever dimensions they can.  They can divert corporate surplus to themselves until doing so exceeds the costs of stopping them.  Common examples of surplus diversion include consuming perquisites of corporate office, such as using the corporate jet, furnishing one’s office with expensive trappings, or simply enjoying a less rigorous work schedule.[9]

I propose that corporate managers can also consume perquisites by pursuing ESG.  For executives, consuming ESG can help blunt the personal cost of a bad earnings report,[10] or it can help them earn social status in their social groups, who may favor ESG or related political causes.  It might be more valuable, personally, for a corporate manager to satisfy an interest group that supplies ESG ratings or scores, even though it might be more valuable to the corporation to avoid underlying social or political conflicts.[11]  Given that a significant portion of the public, including many investors, support ESG or related politics, a corporate manager might be able to consume more ESG than private jet rides, since ESG-friendly investors will not be as bothered by increased commitment of resources to ESG.  Moreover, the incentive filters down in the corporate hierarchy.  If middle-managers’ opportunities for advancement within a corporation or to move to higher positions in other corporations depend on their commitment to ESG, they should be expected to pursue ESG.[12]

Can ESG Fit into the Bargain?

Returning to the original question, my article addresses the possibility that it would be best to adjust the bargain by weaving in the pursuit of ESG.  This approach might work  if ESG truly were just improved risk management. It is also possible that compensating managers with the perquisite of ESG-related social status is less expensive than compensating them with more money or other perquisites.  This only works, though, if ESG is actually aligned with shareholder wealth, an empirical question that defies simple testing.  I ultimately contend that it is doubtful that a bargain where managers allocate corporate resources to ESG will result in benefits to shareholders – or to any other intended beneficiaries of ESG for that matter – that exceed the resources devoted to it.

ENDNOTES

[1] Noah S. Sweat, Mississippi State Senator, Address (1952) (“If by Whiskey . . .” or “The Whiskey Speech”).

[2] Stefan J. Padfield, Crony Stakeholder Capitalism, 111 Ky. L.J. 441 (2022).

[3] Jeremy Kidd & George Mocsary, Theft, Path to Central Planning, or Both?, Heritage Report (May 12, 2023).

[4] Eric C. Chaffee, The Origins of Corporate Social Responsibility, 85  U. Cin. L. Rev. 347 (2017).

[5] R.H. Coase, The Nature of the Firm, 4 Economica 386 (1937).

[6] Elsewhere, I have described “shareholder wealth maximization” as a “Schelling Point,” named after economist Thomas Schelling, who theorized that many tacit (or even express) bargains can be made where there is a contextually-unique point on which to coordinate.  In the corporate contract, that point is to make money for investors. Martin Edwards, Shareholder Wealth Maximization: A Schelling Point, 94 St. John’s L. Rev. 671 (2021).

[7] Henry G. Manne, Mergers and the Market for Corporate Control, 73 J. Pol. Econ. 110, 117 (1965).

[8] Henry G. Manne, Insider Trading and the Stock Market (1966).

[9] Henry G. Manne & Henry C. Wallach, The Modern Corporation and Social Responsibility 20 (1972).

[10] Ryan Flugum & Matthew E. Souther, Stakeholder Value: A Convenient Excuse for Underperforming Managers? J. Fin. & Quantitative Analysis, First Look, 1 (October 31, 2023).

[11] The list of examples of this phenomenon continues to grow, from Anheuser-Busch-InBev to Target to Tractor Supply Company.

[12] Of course, as might have been the case in the Anheuser-Busch-InBev situation, middle managers may also pursue ESG to enhance their social capital within their social groups.  See Amanda Holpuch & Julie Creswell, “2 Executives Are on Leave After Bud Light Promotion With Transgender Influencer,” N.Y. Times, B6 (April 25, 2023).

This post comes to us from Professor Martin Edwards at the University of Mississippi School of Law. It is based on his recent article, “ESG: Moving the Equilibrium or Moving the Goalposts?” available here.