Private equity sponsors have typically exited their investments through a sale or public offering. While sales to a strategic or another private equity sponsor predominate, public offerings still represent an attractive opportunity to exit over time, with an ability to increase proceeds as the newly-public portfolio company (hopefully) appreciates in value. A public offering is a complex undertaking. To prepare for a public offering, the portfolio company needs to review a host of operational and policy issues including internal controls, review of executive compensation practices, insider trading policies and disclosure controls and processes. Recently, another issue has loomed larger and larger for any company contemplating a public offering.
On March 17, 2017, asset-management firm State Street Global Advisors commissioned the now-famous “Fearless Girl” statue in front of the iconic “Charging Bull” in lower Manhattan in an effort to bring greater attention to the lack of gender diversity on boards of directors and in senior-management roles in corporate America. This action, symbolic though it was, appropriately coincided with institutional investors and proxy advisory firms placing greater emphasis on gender and other forms of diversity in the boardroom. Widespread efforts to increase board diversity, particularly gender diversity, were sustained in 2018 as institutional investors continued to raise pressure on boards to become more diverse, and California enacted a state law mandating increased gender diversity on boards of companies headquartered in California. Primarily in response to this heightened focus on corporate board diversity, the SEC Division of Corporation Finance staff issued guidance in February 2019 regarding the disclosure of board nominees and directors’ diversity traits and the role of diversity in the board-nominee selection process. Each of these approaches to creating more diverse boards differ in terms of their scope, mechanism for enforcement, and steps that companies will need to take to comply.
Institutional Investors and Proxy Advisory Firms
On August 31, 2017, Vanguard Group, Inc. (“Vanguard”) published an open letter1 to directors of public companies worldwide, describing the “four pillars” that it considers when evaluating corporate governance practices: (i) the board, (ii) governance structures, (iii) appropriate compensation and (iv) risk oversight. The letter emphasized the importance of gender diversity, noting that “there is compelling evidence that boards with a critical mass of women have outperformed boards that are less diverse.” Although the letter did not provide any specific guidance to companies regarding the level of gender diversity that Vanguard would expect, it noted that progress on this issue would “inform its engagement and voting going forward.”
In its 2018 Governance Principles Survey,2 Institutional Shareholder Services (“ISS”) also recognized that investors are paying more attention to gender diversity on boards. In particular, the percentage of investors surveyed saying that lack of gender diversity indicated a problem in the board-recruitment process increased from 69% in 2017 to 80% in 2018. Despite this increased focus on gender diversity, the most common investor response to a board without women representation was to engage with the board and/or management, as it had been in 2017. More drastic responses, however, were less favored by investors. For example, the possibility of voting against the chair of the nominating or governance committee due to a lack of female directors was only the third-ranking response, while considering voting against the entire board placed fourth. Similar to Vanguard’s open letter, the ISS survey focused exclusively on gender diversity and not on other types of diversity. Perhaps reflecting the somewhat tepid nature of the survey responses, 20% of firms in the Russell 3000 Index still have no female representatives on their boards and only 4.1 percent of Russell 3000 companies have a female board chair.3
Glass Lewis, on the other hand, has indicated a willingness to take more concrete action against incumbent boards of directors of companies that lack gender diversity. In its 2018 proxy paper guidelines (the “Glass Lewis Guidelines”),4 Glass Lewis announced that, starting in 2019, its policy will be to “generally” recommend voting against the nominating committee chair of a board of a company in the Russell 3000 Index that has no women directors. Furthermore, Glass Lewis advised that it may extend this recommendation to a vote against other members of the nominating committee depending on other factors, including a company’s size, its industry and its governance profile. However, Glass Lewis may refrain from making such recommendations when the company has disclosed a plan to address the lack of diversity on the board or provided a “sufficient rationale” for not having any women on its board. It is unclear what such a sufficient rationale would entail, and indeed, it is difficult to imagine any such rationale that would not be suspect at best or offensive at worst. In addition, the Glass Lewis Guidelines note that Glass Lewis would make these determinations based on a review of a company’s disclosure, which seems to imply that a company lacking in board gender diversity would need to make its plan to increase diversity or its rationale for a lack of diversity public through its SEC filings or otherwise, potentially drawing scrutiny from the SEC and other investors for the content of its response. Glass Lewis confirmed in its 2019 proxy paper guidelines that its new policy would take effect for meetings held after January 1, 2019.5
Although the Glass Lewis Guidelines only describe potential repercussions for boards that lack gender diversity, Glass Lewis does extol the importance of diversity more generally, specifically mentioning age, race, gender, ethnicity, geographic knowledge, industry experience, board tenure and culture. Whether this discussion of other forms of diversity will be used as a guidepost for boards that lack gender diversity to make the case that they are otherwise diverse, or whether this is a signal that Glass Lewis will in the future recommend that shareholders take punitive action against boards that are not diverse in other areas beyond gender diversity, remains to be seen.
BlackRock, Inc. and its subsidiaries’ (collectively, “BlackRock”) 2019 Proxy Voting Guidelines (the “BlackRock Guidelines”)6 similarly describe the importance of myriad forms of board diversity, including gender, ethnicity, age and professional characteristics, such as a director’s industry, area of expertise and geographic location. The BlackRock Guidelines also increase pressure on boards in several key ways. First, the BlackRock Guidelines encourage companies to have at least two women directors on the board. Second, the BlackRock Guidelines make it clear that BlackRock expects companies to consider other forms of diversity in addition to gender diversity, and not merely as alternative means to achieve a diverse board notwithstanding a lack of women directors. In terms of voting recommendation, the BlackRock Guidelines recommend more severe action be taken against boards that lack diversity, recommending against the election of the entire nominating/governance committee rather than just the committee chair. In terms of disclosure, the BlackRock Guidelines encourage all companies to disclose the consideration given to board diversity and do not limit this guidance to companies seeking to avoid an unfavorable recommendation by explaining a lack of diversity.
California and other State Responses
Against the backdrop of institutional investors threatening to use the ballot box to demand greater diversity, several states are considering legislative solutions to increase gender diversity. Leading these efforts is California, which will require boards to have at least one woman director no later than December 31, 2019. Perhaps inspired by legislation in a number of European countries that mandate a certain percentage of board seats be filled by women, on September 30, 2018, California became the first state to impose gender quotas on boards of public companies headquartered in the state with the passage of SB-826. SB-826 applies to all corporations with shares listed on a major U.S. stock exchange that list California as the state in which their principal executive offices are located on their Form 10-K, and not just corporations that are incorporated in California. Under SB-826, such corporations will be required to have at least one woman director on their board by the end of 2019. By the end of 2021, such corporations will be required to have (i) at least one female director if their board has four or fewer directors, (ii) at least two female directors if their board has five directors and (iii) at least three female director if their board has six or more directors. The penalties for noncompliance may result in a $100,000 fine for the first violation and a $300,000 fine for each subsequent violation. Companies to which SB-826 applies will also need to file reports with the California Secretary of State disclosing their board composition, and a failure to file such reports in a timely fashion could result in a $100,000 fine.
Most California companies would have a long way to go to achieve compliance with SB-826. According to an ISS Study,7 one-third of California companies have no women on their boards and will be required to appoint at least one female director by the end of this year. The same study shows only 11% of California-based companies meeting the 2021 requirements. Accordingly, SB-826 is poised to have a significant impact on board diversity and corporate governance in general in the coming years as it is implemented.
Nonetheless, despite investor concerns for greater board gender diversity, SB-826 has raised considerable controversy, its wisdom and enforceability both coming under question. On May 29, 2018, the California Chamber of Commerce, along with other local California chambers of commerce and other trade organizations, sent a letter8 to the state legislature detailing its opposition to the law. In particular, the letter criticizes SB-826 for focusing only on gender diversity in a matter that risks elevating gender diversity above all other forms of diversity. To the extent that compliance with SB-826 would require a board to remove a male director or choose a female director candidate over a male candidate solely based on gender, the letter cautioned, SB-826 could run afoul of state and federal civil rights laws, as well as the California and U.S. Constitutions. The letter also asserts that SB-826 violates the internal affairs doctrine by subjecting corporations that were incorporated outside of the State to California law related to internal corporate law.
Concerns about the internal affairs doctrine will be less important, however, if other states continue to follow California’s lead. So far, California clearly leads the pack. Several states, including Massachusetts, Pennsylvania and Illinois, have passed nonbinding resolutions encouraging greater gender diversity. The New Jersey legislature is considering a bill similar to SB-826 that would require women board representation for all corporations headquartered in the state. The Illinois legislature is also considering a bill that would go one step further by setting quotas for women, as well as black and Latino, directors of companies that are headquartered in the state. The New York State legislature is considering a bill that would require companies to disclose the number of women on corporate boards, but would not impose any quotas. Most importantly to large public companies, however, the Delaware legislature has not taken any steps to encourage or require board diversity with respect to Delaware corporations. Accordingly, if challenges to SB-826 based on the internal affairs doctrine are successful, many large U.S. corporations would not need to comply with any state law mandating board diversity.
The SEC Approach
On February 6, 2019, the SEC’s Division of Corporation Finance released two new Compliance and Disclosure Interpretations (“C&DIs”) that encourage public companies to disclose the role that diversity plays in director nominations. The two C&DIs, which are identical but for the fact that one is in response to Item 401(e) of Regulation S-K and the other is in response to Item 407 of Regulation S-K, address disclosure related to a reporting company’s identification of board diversity characteristics and how they are used with respect to the nomination of board candidates.
Item 401(e) requires a reporting company to disclosure the specific experience, qualifications, attributes or skills that led to the company’s nominating committee to conclude that such person should serve as a director. Similarly, Item 407(c)(2)(vi) requires a reporting company that has a policy for the nominating committee to consider diversity as part of the director-selection process to explain how the board enforces any such policies. These disclosures are required in proxy statements and certain types of registration statements.
Consistent with the disclosure-based approach of the Securities Act of 1933, the C&DIs do not impose any substantive requirement on reporting companies to achieve specified levels of diversity or to even consider diversity as a factor in selecting directors. Instead, to the extent that diversity is considered in selecting a board nominee, the SEC staff “would expect” the company to disclose those characteristics and how they were considered if the nominee has consented to such disclosure. Under the C&DIs, diversity is defined in broad terms to include, for example, race, gender, ethnicity, religion, nationality, disability, sexual orientation, cultural background, as well as other qualifications that a diversity policy may take into account, including diverse work experiences, military service, or socio-economic or demographic characteristics.
The SEC approach differs from the California and institutional-investor approaches in several important ways. First, it does not require a company to take any action with respect to diversity, it merely requires disclosure to the extent that diversity is taken into account. However, if such disclosures become more commonplace, the absence of such disclosure may be seen as a glaring omission in the eyes of investors. Second, the C&DIs define diversity broadly and does not place higher emphasis on gender diversity. Although this element of the SEC approach may be viewed as more progressive than the California and other state laws that focus solely on gender diversity, this introduces additional challenges and complexities. Because many of the SEC diversity categories are less apparent than gender, disclosure is only required to the extent that the director or nominee consents to such disclosure. This disclosure requirement could create pressure on nominees or directors to disclose potentially sensitive personal characteristics in order for the company to receive recognition for fostering diversity. It may even create a situation where nominees with diverse characteristics are required to consent to such disclosure as a condition to being nominated to the board, which may create potential issues under anti-discrimination laws. Some commentators have also expressed concern that, because the board would be required in some cases to rely on a nominee or director’s self-identification of a diversity trait, companies may open themselves up to potential securities law violations if such self-identification turns out to be false. However, this fear may be misplaced given that companies regularly rely on other self-reported information from nominees and directors.
Final Thoughts
It is no surprise that corporate board diversity continues to be a hot topic in 2019. However, unlike in prior years where investors merely expressed a desire for boards to become more diverse, 2018 and 2019 were marked by institutional investors, state governments and the staff of the SEC taking concrete steps to encourage, and in some cases mandate, diverse corporate boards. The challenge that companies have is that these approaches have taken different forms. Institutional investors and state governments have focused almost exclusively on gender diversity, while the SEC staff encourages heightened disclosure related to various forms of diversity. Institutional investors seek to encourage compliance by voting against the chair of the nominating committee, or in some cases the rest of committee or the entire board, of companies that do not achieve certain levels of gender diversity. California, in contrast, mandates diversity through significant fines, and the SEC guidance requires additional disclosure of diversity, presumably in the hopes that this disclosure would shame companies to improve their diversity or encourage investors to take action against boards that lack diversity.
Each regulatory solution requires companies to take different approaches and be aware of potentially competing concerns. Companies seeking to add women to their corporate boards to satisfy their investors and to comply with state law should be cautious that replacing male directors to make room for female directors could, in and of itself, violate gender discrimination laws, and the loss of current directors could reduce the level of experience on the board or eliminate male directors that have other diverse characteristics. Although this concern could be addressed by increasing the size of the board, larger boards tend to introduce greater expense and logistical challenges. With respect to the California law specifically and other state laws that impose gender quotas, companies that are subject to such laws will need to determine whether they will be required to comply with those laws. Reporting companies seeking to comply with SEC guidance will need to evaluate their board-nomination policies and goals to determine whether disclosure under the new rules is required or, should such companies elect to include diversity attributes in their nominating policies, to determine the appropriate level of disclosure of these policies going forward. Companies would also be wise to ensure that their policies respect a nominee’s choice to not publicize sensitive diversity characteristics even though investors may react favorably to such disclosure.
It is not clear what path investors and regulators will take to encourage diversity going forward or whether states and institutional investors will turn their attention to other forms of diversity as efforts to increase gender diversity prove successful.
It is also unclear whether the SEC’s disclosure-based approach will result in companies taking concrete steps to improve diversity or whether its sweeping definition of diversity and challenges related to nominees’ self-identification of potentially sensitive personal characteristics will instead result in broad, toothless disclosure with little real results.
The answers to these questions remain to be seen. However, one thing is abundantly clear: diversity will continue to remain of paramount importance to investors as well as state and federal regulators. In response to this reality, companies will be forced to look at corporate board diversity more proactively and should take this opportunity to review their nominating policies and SEC disclosures carefully against a landscape of strong investor sentiment and changing state and federal law requirements.
Footnotes
1) F. William McNabb III, Chairman and Chief Executive Officer of The Vanguard Group, Inc., An Open Letter to Directors of Public Companies (August 31, 2017).
2) Institutional Shareholder Services Inc., 2018 Governance Principles Survey: Summary of Results (September 18, 2018).
3) The Conference Board & ESGAUGE, Corporate Board Practices in the Russell 3000 and S&P 500: 2019 Edition (April 2019).
4) Glass, Lewis & Co., 2018 Proxy Paper Guidelines: An Overview of the Glass Lewis Approach to Proxy Advice (United States) (November 2017).
5) Glass, Lewis & Co., 2019 Proxy Paper Guidelines: An Overview of the Glass Lewis Approach to Proxy Advice (United States) (October 2018).
6) BlackRock, Inc. and its subsidiaries, Proxy Voting Guidelines for U.S. Securities (January 2019).
7) Mikayla Kuhns, Rudy Kwack, & Kosmas Papadopoulos, California Dreamin’: The Impact of the New Board Gender Diversity Law, ISS Analytics (December 12, 2018).
8) Letter from the California Chamber of Commerce, et. al. to the California State Senate (May 29, 2018).
