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California Board Diversity Bill Enters Uncharted Legal Waters

Sept. 4, 2020, 10:31 AM

California’s unprecedented push to create racial diversity quotas for corporate boards would move the companies there into uncharted territory, raising a host of legal questions and further empowering change-driven shareholders.

Gov. Gavin Newsom (D) has until Sept. 30 to sign legislation passed this week requiring publicly traded corporation boards to include directors from underrepresented groups, including Blacks, Hispanics, and Asians, as well as lesbian, gay, bisexual, and transgender individuals.

If inked, the bill is likely to encounter court challenges akin to the lawsuits fighting California’s mandate that corporations add female board members. Companies would have to scramble—with the help of recruiting firms and diversity advocates—to compete for qualified candidates. The mandate would add to the already heightened pressure on California companies working to boost gender diversity on their boards.

The legislation arrives against the backdrop of the social justice movement that has been invigorated by reactions to recent police shootings. But California lawmakers’ efforts to pass the bill, which started before recent Black Lives Matter protests, exposed the lack of racial diversity on corporate boards in one of the most progressive U.S. states. If the state’s women-on-boards law is any indication, the bill could fuel changes that prompt other states to follow suit.

“There are legitimate constitutional challenges that can and will be brought because of this,” said Darren Rosenblum, a professor at Pace University Law School who researches board diversity and corporate governance. “But that doesn’t change the fact that laws like this put pressure on firms to increase their focus on diversity.”

People identified as African American or Black, Hispanic or Latino, and Asian or Pacific Islander filled 8.6%, 3.8%, and 3.7% of Fortune 500 company board seats, respectively, according to 2018 data from Deloitte and the Alliance for Board Diversity cited in the bill.

“This is an entirely novel requirement,” Rosenblum said.

Pressure to Act

Under the bill, corporations with principal executive offices in California would be required to have at least one director from an underrepresented community by the end of 2021.

By the end of 2022, boards with nine or more directors would need a minimum of three minority or LGBT members. Boards with five to eight members must have two, while those with four directors or fewer would need at least one.

The legislation “would create increasing pressure for companies to reconstitute their boards,” said Shelly Heyduk, a partner with O’Melveny & Myers LLP. “That is a lot of change for one board in such a short time.”

Regardless of legal proceedings, the looming deadlines could could spur companies to expand typical search criteria to broaden the pool of potential new directors. It might also slow down the search process, attorneys and advisers say.

“It just becomes a question of companies changing their recruitment strategy — broadening their horizons a bit,” said Renee Jones, a Boston College Law School professor who researches corporate governance and regulation.

Responsive companies have already been working with outside parties to find women board members, and those entities are expected to drive a big portion of the recruiting processes for minority board members.

“Companies always say, ‘We can’t find any.’ So, it’s up to the executive search firms and all of these associations that exist to say, ‘Here’s a whole pool. I’m not sure why they’re not on your board,’” said Stephanie Creary, a University of Pennsylvania professor who studies board diversity.

Some minority executives with board experience could see a spike in demand from other companies for their services. Companies seeking board diversity have shown a tendency to draw from a limited pool of executives with board service experience. The “recycle rate” of minority women—the average number of Fortune 500 board seats they held— rose to 1.35 seats in 2018 from 1.33 seats in 2016, according to a January 2019 study by Deloitte LLP and the Alliance for Board Diversity.

Public companies must already meet certain standards for their board membership—largely targeted at having independent boards—imposed by stock exchanges as well as the Securities and Exchange Commission.

“Doing that without regard to race or ethnicity is itself an arduous task,” said Keith Bishop, an Allen Matkins Leck Gamble Mallory & Natsis LLP partner, who has opposed the bill. “Then adding this requirement on top of that is going to make the task much more difficult and complicated.”

Litigation Exposure

California’s gender diversity quota drew multiple lawsuits questioning its legality, with a trial currently slated for next year. A federal district court tossed one case for lack of standing, and that decision has since been appealed.

The law’s challengers have questioned if it can be applied to companies that have principal offices in the state, but are incorporated in another U.S. or foreign jurisdiction.

Former Gov. Jerry Brown (D), who signed it in 2018, then acknowledged its uncertain legal standing, but left it for the courts to sort out. Newsom has not said whether he plans to sign the pending board diversity bill.

“I’ve already heard from folks who are interested in challenging this,” Bishop said. “And I have no doubt that this will ultimately be found unconstitutional.”

Companies also could face private lawsuits alleging discrimination over their selection, Creary said. Normally, minority status alone can’t be the deciding factor for companies, she said.

The bill isn’t clear on whether quotas for minority board members let companies turn down well-qualified White male candidates, presenting a legal question, Creary said.

“What if two people of a different race or of a different gender both meet the qualifications? How do you then choose?” she said. “I think that’s what companies will need directions around.”

Meaningful Changes

Companies would also calculate the cost of compliance versus penalty. The California secretary of state reported earlier this year that more than 40 companies weren’t in compliance with the gender quota, but the state has so far been lax on enforcement.

The women-on-boards law imposes a fine of $100,000 for the first offense, and $300,000 for the second. Identical penalties are included in the pending legislation.

The $100,000 fine isn’t much for most of the companies that would fall under the bill’s requirements, and because of the likelihood of court challenges, they could always argue that they don’t have to comply, JP Motley, also a partner at O’Melveny & Myers, said.

For some companies, a willingness to comply might boil down to pressure from stockholders, investors, and the general public, rather than the threat of a state-imposed penalty.

“I don’t think they’re as concerned about litigation and penalties as they are about shareholder action,” Motley said.

If history is any guide, the bill could have its desired impact regardless of the legal questions that surround it.

Boards quickly started adding women directors after the state’s gender diversity requirement kicked in. Women occupied about 45% of new board seats at Russell 3000 companies based in California, in contrast to about 31% nationwide, according to Bloomberg.

The bill is “putting firms on notice that the public is watching,” Rosenblum said.

—With assistance from Andrea Vittorio.

To contact the reporter on this story: Jacob Rund in Washington at jrund@bloomberglaw.com; Andrew Ramonas in Washington at aramonas@bloomberglaw.com

To contact the editors responsible for this story: Roger Yu at ryu@bloomberglaw.com; Keith Perine at kperine@bloomberglaw.com

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