While the impacts of 2020’s seismic social and political disruptions will reverberate for some time, in what may come as surprise to some, the corporate boardroom is proving to be fertile ground for incremental social change taking permanent root. As more companies echo a chorus of diversity and inclusion initiatives and attempt to make their workforces more closely reflect society as a whole, several regulators and investors are taking steps to force or encourage boards of directors — that veritable power center of corporate America — to do the same thing, and to do it sooner than later.
California, Other States Lead the Way
Bills across the country are heading toward governors’ desks to require boards of directors to include minimum representation by women or members of minority communities. California is often the tip of the spear when it comes to ESG regulation, and on Sept. 30, California Governor Gavin Newsom enacted AB 979, requiring minimum representation by minority individuals on corporate boards. The law requires a minimum of one minority director by the end of 2021, and larger boards shall have a minimum of 2 or 3 by the end of 2022.
The law applies to public companies headquartered in California, and follows on the heels of 2018’s SB 826, which required similar minimums of female representation on boards. Noncompliance with either law can result in significant fines.
Both laws are the first of their kind, but at least 12 other states have proposed or enacted legislation aiming to diversify boards, although most of these simply encourage it (or “urge,” as does Ohio).
In addition, a coalition of institutional investors and advisers, led by two state treasurers, is pushing U.S. public companies to disclose the racial makeup of their boards in a bid to increase the diversity of corporate directors.
Challenges and Successes
Both of California’s board diversity laws faced immediate legal challenges in state and federal courts. A 2018 lawsuit claiming SB 826 violates the 14th Amendment’s Equal Protection Clause received significant attention but was ultimately dismissed for lack of standing. (The case has been appealed to the Ninth Circuit.) And in a 2019 lawsuit filed by Judicial Watch in Los Angeles Superior Court, the conservative group sought to enjoin California Secretary of State Alex Padilla from expending taxpayer funds to enforce or carry out SB 826. The group filed a similar claim against AB 979 after its passage.
In the meantime, many corporations that do business in California are already falling in line with the laws and instituting changes to their boards. Bloomberg reported that after SB 826 went into effect, women filled 45% of new board seats among California-based Russell 3000 companies, and a recent progress report from the California Partners Project puts the proportion of California boards with all male members at less than 3%, down from 30% in 2018.
Current Federal Regulatory Requirements
Unlike the states, federal regulators have limited tools available for influencing corporate behavior. The SEC relies primarily on limited materiality-based disclosure requirements rather than any quotas or particular diversity provisions.
Regarding their directors and director candidates, public companies must at least “briefly discuss” their qualifications, under Item 401(e) of Regulation S-K. Companies must also reveal how the nominating committee or the board considers diversity when reviewing candidates for board membership under Item 407(c)(2)(vi). In addition, issuers must disclose how they implement any diversity policies they may have.
The SEC staff discussed these requirements in a 2019 Compliance and Disclosure Interpretation applicable to both Item 401 and Item 407. According to the staff, the company must disclose how the board considered any diversity characteristics that directors or nominees identified. The interpretation applies only to those circumstances in which the director both provides the information and consents to its release.
The company remains the arbiter of what information will be disclosed under a materiality standard. While much information on diversity is publicly available, investors have little insight into how companies consider those factors.
SEC Commissioner Allison Herren Lee rejected the notion that “corporate diversity is about equality for equality’s sake,” noting that board diversity often correlates with enhanced performance. The current materiality-based disclosure system produces “spotty” results, she said, that are “not standardized, not consistent period to period, not comparable across companies, and not necessarily reliable.”
Investors Want More Disclosures
Institutional investors are at the forefront of the demand for more diversity disclosures. BlackRock stated in January that boards should be comprised of “a diverse selection of individuals who bring their personal and professional experiences to bear.” Companies should take “the full breadth of diversity” into consideration, and provide process-based disclosure as well as diversity statistics, Blackrock said. Similarly, in August, State Street Global Advisors urged companies to identify the racial and ethnic makeup of their boards, and to “articulate goals and strategy related to racial and ethnic representation at the board level.”
Additionally, several companies, like California-based Qualcomm and Oracle, have been taken to court over their all-white boards of directors in shareholder derivative suits alleging violations of the federal securities laws.
The Road Ahead
Institutional investors will continue to be a driving force behind enhanced board diversity disclosures in 2021. A revamped SEC will likely supplement this push by amending Regulation S-K to require expanded board demographic data and will continue to evaluate how boards should disclose their nominating processes.
Ultimately, the signal being sent by stakeholders across the country is that it’s high time to act on board diversity. And it’s not just diversity for diversity’s sake: Stakeholders also consider diversity a means to a more prosperous end. For example, the opening recitals in Maryland’s board diversity bill reference several studies (including one from McKinsey) supporting gender diversity on boards for the sake of better performance and decreased governance risks. Similar recitals are found in other state laws as well.
California’s laws are a harbinger of what is to come. With a growing number of state laws compelling companies to act, mounting demands from the investment community for diversity and disclosure, and even the SEC’s gradual movement toward mandatory board diversity disclosure, it is likely in companies’ best interests to get on board with diverse boards.
Access additional analyses from our Bloomberg Law 2021 series here, including pieces covering trends in Litigation, Transactions & Markets, the Future of the Legal Industry, and ESG.
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