Recent events have brought renewed attention to the push for greater diversity in the boardroom. In this alert, we discuss several developments highlighting the need for public company directors to remain focused on diversity issues. These include (1) a spate of stockholder lawsuits alleging corporate breach and securities law violations tied to the alleged failure to fulfill companies’ diversity aspirations; (2) a new California statute mandating minimum numbers of directors from underrepresented communities on the boards of California-based public companies; and (3) increasing pressure from institutional investors and other key stakeholders to monitor corporate progress aimed at increasing diversity on boards and in executive management.
In recent months, a number of stockholder lawsuits have been filed in federal court, alleging breaches of fiduciary duty from failures on the part of directors and officers of major U.S. corporations to uphold their commitments to diversity. These actions, mostly filed by the same California-based plaintiff’s firm, allege that directors and officers breached their fiduciary duties by failing to monitor compliance with anti-discrimination laws and failing to nominate diverse individuals to their boards. They also allege misstatements and omissions in the companies’ public filings relating to efforts to increase diversity, in violation of the federal securities laws. The actions, thus, assert a combination of so-called Caremark claims — allegations under state corporate law that directors caused or permitted a corporation to break the law or failed to establish a monitoring system to ensure corporate compliance — and violations of Section 14(a) of the Securities Exchange Act of 1934.
While many of the claims are novel and potentially vulnerable to dismissal on multiple grounds, these cases seek very high damages and extraordinarily wide-ranging injunctive relief. For example, plaintiffs in certain of these cases ask the court to create a fund dedicated to minority promotion, ranging from $700 million to $1 billion. They may also have reputational consequences.
These actions tend to rely on a corporation's annual proxy statement expressing the corporation’s commitment to diversity and inclusion, and allege that — when compared to certain statistics or other evidence — these statements are materially false and misleading under the Securities Exchange Act. Issuers should assure that their disclosures remain accurate.
In that connection, Item 401(e) of Regulation S-K, for example, requires “a brief discussion of the specific experience, qualifications, attributes or skills that led to the conclusion that the person should serve as a director.” The SEC clarified in 2019 guidance that, if specific diversity characteristics were used in selecting a director, they should be disclosed. Item 407(c)(2)(vi) of Regulation S-K requires disclosure of how a company’s board or nominating committee implements its policies with respect to the consideration of diversity in identifying director nominees. The SEC has clarified that this item should include a discussion of how the issuer considers the self-identified diversity attributes of nominees as well as any other qualifications its diversity policy takes into account, such as diverse work experiences, military service, or socioeconomic or demographic characteristics.
In addition, corporations are also likely to face an increase in books and records requests related to diversity issues, potentially from shareholders considering filing this sort of action. Fiduciary litigation is frequently preceded by a books and records request for board minutes and related materials, often under Section 220 of the Delaware General Corporation Law. Because potential plaintiffs tend to scour these materials and may reference them in any complaint, it is important to keep in mind that this material may form part of the record on consideration of a motion to dismiss.
California’s AB 979 and Other Legislation
On Sept. 30, 2020, California Gov. Gavin Newsom signed into law AB 979, requiring boards of public corporations based in California to include a minimum number (depending on board size) of directors from underrepresented communities. The law defines underrepresented communities broadly to include both racial and gender and sexual orientation categories. It comes into effect in phases beginning at the end of 2021, and carries a fine of up to $100,000 for a first violation and up to $300,000 for a second or subsequent violation.
The law follows a 2018 California statute, SB 826, imposing similar minimums as to female directors. Lawsuits have been filed challenging both state statutes under the Equal Protection Clause of the 14th Amendment and under the California Constitution. A federal district court dismissed a stockholder action for lack of standing, and that case is on appeal to the Ninth Circuit. Other cases remain pending.
These California statutes are part of a growing legislative trend focused on corporate diversity.
In 2020, New York joined a number of states requiring organizations to disclose their board compositions. Also in 2020, Washington state added a requirement that public companies subject to its state corporate law either have a gender-diverse board by Jan. 1, 2022 (defined as at least 25% individuals who self-identify as women), or make a disclosure in the annual proxy statement and on the company’s website. In 2019, Illinois passed a law, P.A. 101-0589, requiring corporations to provide additional information in annual reports submitted to the secretary of state, including a litany of diversity-related disclosures.
U.S. federal legislation has also been proposed. In November of 2019, the U.S. House of Representatives passed the Improving Corporate Governance Through Diversity Act of 2019 (H.R. 5084), which would amend the Securities Exchange Act to require certain organizations to disclose the gender, race and ethnicity of their boards of directors and executive officers.
Canada also amended its corporate law in 2019, requiring corporations with publicly traded securities to provide shareholders with information about the corporation’s diversity practices, including the percentage of members of the board and senior management who are women, Aboriginal persons, members of visible minorities and persons with disabilities.
Institutional Investor Pressure
At the same time, institutional investors and other key stakeholders have been ramping up their efforts to engage with companies to increase board diversity. On Aug. 27, 2020, State Street Global Advisors published a form letter that it had sent to the board chairs of public companies in its portfolio. The letter states that State Street expects “specific communications” to shareholders on a series of diversity-related issues starting in 2021, and noted that it is prepared to use its proxy voting authority “to hold companies accountable.”
Institutional Shareholder Services (ISS) has also called for greater diversity disclosure. It recently released a report finding that while underrepresented ethnic and racial groups make up 40% of the U.S. population, they make up just 12.5% of board directors, up from 10% in 2015. ISS has also released its proposed voting policy updates. Beginning in 2021, ISS is proposing to identify in its research reports U.S. companies that “lack racial and ethnic diversity (or lack disclosure of such),” as ISS already does with respect to gender. Beginning in 2022, ISS is proposing to impose a new policy of generally voting against or withholding votes from the chair of the nominating committee (or other directors on a case-by-case basis) where the board has no apparent racially or ethnically diverse members, as it already does with respect to gender. ISS will announce its final voting policies in mid-November.
Likewise, the New York City comptroller has sent formal letters requesting that companies adopt a diversity search policy requiring that the initial list of candidates from which director nominees and chief executives are chosen include qualified female and racially diverse candidates (an arrangement sometimes referred to as the “Rooney Rule,” after the policy that the National Football League established in 2003).
Long a high-profile issue, diversity has taken center stage in recent months, and conversations that have been happening in homes, living rooms and schools appear headed to boardrooms as well. Understanding these developments will be priorities for directors, executive management and their advisors.