Diversity in the Boardroom: A Litigation and Governance Update

As noted in previous client alerts (including here), boardroom diversity continues to be an increasing focus of stakeholders ranging from legislators to institutional investors to retail stockholders. In recent years, their efforts have yielded significant legal developments that impose pressure — and, in some cases, mandatory requirements — on corporations to include more directors from historically underrepresented groups on their boards. Against this backdrop, multiple stockholder lawsuits have challenged companies’ alleged failures to fulfill their corporate diversity aspirations, by bringing fiduciary duty and securities claims against directors and officers of these companies.

This client alert provides an update on the landscape in which U.S. corporations ramp up their boardroom diversity efforts. Topics include (1) the legal challenges directed against state and regulatory corporate diversity requirements; (2) the status of certain stockholder litigations; and (3) the updated board diversity policies of proxy advisory firms and large institutional investors.

Legal Challenges Directed Against State and Regulatory Corporate Diversity Requirements

California Statutes

California spurred the growing legislative movement focusing on corporate diversity. In 2018, the state signed into law SB 826, a statute requiring a minimum number of women to serve on the boards of public corporations with principal offices located there (even if those entities are not incorporated in California). AB 979 followed two years later and extended similar requirements to the number of directors from historically underrepresented communities. Both of these statutes — predictably — have been subject to legal challenge in state and federal courts.

A post-trial decision is pending in the first of the actions, Crest v. Padilla, filed in California state court to prevent the implementation and enforcement of SB 826. Asserting standing as taxpayers, three plaintiffs alleged that the statute’s mandate is unconstitutional in setting a gender-based quota and, therefore, sought to prevent the unlawful expenditure of taxpayer funds to enforce it. California argued that the statute did not set any quota because it simply required adding seats for women without eliminating seats for men, reflecting the state’s “compelling interest” in gender diversity.^[1] A companion suit filed by these plaintiffs challenges AB 979 on essentially the same grounds, with a trial scheduled to begin before another judge in California state court at the end of March. Together, these rulings could help clarify the constitutional parameters of state corporate diversity provisions.

Meanwhile, two ongoing federal lawsuits claim that these California statutes violate the Equal Protection Clause of the U.S. Constitution. In Meland v. Weber, a shareholder of a public company headquartered in California filed an action challenging SB 826. The district court dismissed for lack of standing, only to be reversed by a three-judge panel of the Ninth Circuit. The panel reasoned that “[a] person required by the government to discriminate by ethnicity or sex against others has standing to challenge the validity of the requirement, even though the government does not discriminate against him.”^[2] Back in the district court, the parties now await a ruling on a preliminary injunction motion, which the state opposed by reasserting a standing challenge on the grounds that the plaintiff purportedly did not own enough stock to affect the outcome of any director election and could not have been coerced to vote for a woman when he in fact had just voted against her. The same district court judge presides over Alliance for Fair Board Recruitment v. Weber, a lawsuit filed by a nonprofit organization whose members claim to be aspiring directors or shareholders of companies subject to both SB 826 and AB 979.

The extent to which corporate diversity provisions can withstand these equal protection claims remains an open question. Once the courts issue their rulings, these cases may provide guidance on how legislators in other states can draft their own versions of these provisions, as well as how corporations can meet the applicable legal standards.^[3]

SEC Order Approving Nasdaq’s Proposed Rule Changes

Signifying an increasing regulatory interest in board diversity, in August 2021, the U.S. Securities and Exchange Commission (SEC) issued an order approving the “comply or disclose” board diversity framework introduced by Nasdaq Inc. As discussed in a previous client alert (here), Nasdaq’s proposed rule changes require companies listed on its stock exchange to either (1) include on their boards at least one woman, as well as at least one individual who identifies as a racial minority or as LGBTQ+, or (2) file a written explanation for why they are not meeting Nasdaq’s diversity targets. In Alliance for Fair Board Recruitment v. SEC, the same nonprofit that challenged California’s corporate diversity statutes filed an action in the Fifth Circuit, arguing that the SEC’s order violated the Equal Protection Clause. The nonprofit also asserted that the SEC lacks statutory authority to regulate the demographic composition of corporate boards. While Section 25(a) of the Securities Exchange Act of 1934 permits any “person aggrieved by a final order” to seek review of the order, the filing of the petition does not operate as a stay of the rule.

Status of Certain Stockholder Litigations

We have previously noted the uptick in stockholder litigation claiming that large corporations and their directors committed fiduciary duty breaches and securities laws violations in connection with alleged diversity shortcomings (including here). This month, a California district court granted a motion to dismiss a shareholder derivative action against Cisco Systems Inc. where the plaintiff did not properly allege that the board wrongly refused its pre-suit demand, or that such demand would have been futile.^[4] To the contrary, the court pointed to the “extensive investigation and review” conducted by the company’s demand review committee over the course of several months, which involved 22 witnesses. On that basis, the committee found that the company had “accurately described its diversity initiatives . . . and that none of its public statements in the Proxy Statements, [in the Corporate Social Responsibility] Reports, or elsewhere were false or misleading,” thus recommending that the board not pursue the claims. This decision is consistent with Ocegueda v. Zuckerberg, in which the magistrate judge dismissed the complaint on similar grounds.^[5] 

Proxy Advisory Firms and Institutional Investors

As we previously discussed here, the two largest proxy advisory firms in the United States, Institutional Shareholder Services (ISS) and Glass Lewis, have released their U.S. voting policies for the 2022 proxy season, which include specific guidelines relating to board diversity.

Regarding gender diversity, ISS will recommend voting against the chair of the nominating committee for companies in the Russell 3000 or S&P 1500 indices if there is not at least one woman on the board. For companies not in the Russell 3000 or S&P 1500 indices, this policy will be effective for meetings on or after Feb. 1, 2023. Glass Lewis goes a step further, and will recommend voting against chairs of nominating committees of companies in the Russell 3000 Index if the board has fewer than two gender-diverse directors (identifying as female or outside of the gender binary), and against the entire nominating committee if the board has no gender-diverse directors. Starting Jan. 1, 2023, Glass Lewis will recommend voting against the nominating committee chair if the board is not at least 30% gender diverse. However, Glass Lewis’ current policy requiring a minimum of one gender-diverse director will continue to apply to companies not in the Russell 3000 Index or with boards of six or fewer directors.

With respect to racial and ethnic diversity, ISS will recommend voting against the chair of the nominating committee of any company in the Russell 3000 or S&P 1500 indices if the board does not have at least one apparent racially or ethnically diverse member. Starting in 2023, Glass Lewis will adopt a similar policy, recommending shareholders vote against the chair of the nominating and/or governance committee of companies in the S&P 500 index that do not disclose individual or aggregate racial or ethnic demographic information for the board.

Finally, ISS will approach shareholder proposals asking a company to conduct an independent racial equity and/or civil rights audit on a case-by-case basis, considering a number of factors, including the company’s established internal processes for addressing racial inequity/discrimination, the company’s engagement with impacted communities, whether the company has been the subject of recent controversy and whether the company’s actions are aligned with market norms.

Large institutional shareholders including BlackRock, Vanguard and State Street have also released updates to their 2022 proxy voting guidelines that address diversity concerns. For example, BlackRock has adopted a policy regarding board diversity that is similar to Glass Lewis’, and has stated that companies should aspire to reach 30% member diversity on their boards, with at least two directors who identify as female and at least one director who is a member of an underrepresented group. Unlike the policies proposed by the advisory firms, Vanguard has not adopted minimum diversity requirements, but stated it will vote against the chair of the nominating or governance committee of the company if it is making “insufficient progress” with regard to board diversity. And State Street, starting in 2022, expects each of its portfolio companies to have at least one woman on the board of directors, and in 2023 will increase this requirement to 30% women for companies in major indices. Additionally, State Street will vote against responsible directors if (1) companies in the S&P 500 and FTSE 100 do not have a person of color on their boards, (2) companies in the S&P 500 and FTSE 100 do not disclose the racial and ethnic diversity of their boards, and (3) companies in the S&P 500 do not disclose their EEO-1 reports.

Conclusion

As these recent developments demonstrate, boardroom diversity continues to be a hot-button issue. Directors and executive management, and their advisors, should be proactive in monitoring the constantly evolving legal, regulatory and private frameworks governing diversity objectives. 

^[1] _{See https://www.law360.com/articles/1444974/calif-ag-defends-corp-board-diversity-law-as-trial-opens.}

^[2] _{See https://cdn.ca9.uscourts.gov/datastore/opinions/2021/06/21/20-15762.pdf.}

^[3] _{A number of states have followed California’s lead in enacting (or considering enacting) some type of board diversity measure. For example, New York requires every public and private for-profit corporation authorized to do business in the state to report the number of directors on its board and how many of them are women, thus encouraging gender diversity through this disclosure-based legislative regime. Meanwhile, Washington mandates that the boards of public companies incorporated in the state either include at least 25 percent women or comply with disclosure requirements.}

^[4] _{See https://www.law360.com/dockets/download/621e91c5f53a6a032e2b86ae?doc_url=https%3A%2F%2Fecf.cand.uscourts.gov%2Fdoc1%2F035121661814&label=Case+Filing.}

^[5] _{See https://storage.courtlistener.com/recap/gov.uscourts.cand.361956/gov.uscourts.cand.361956.61.0.pdf.}