Before environmental, social, and governance (ESG) matters became cultural and business movements, the lack of diversity and inclusion within corporate governance structures was noted but not scrutinized. Now, there at least ten pending shareholder derivative lawsuits alleging that a lack of board and management diversity constitutes a breach of fiduciary duty. Organizations that lack diversity in their corporate leadership are also subject to increased regulation and directives in state laws, investment bank requirements, and potential industry edicts. Despite substantial research establishing the social and economic benefits of diverse boards, changing the face of corporate governance remains difficult. This article will:
- examine the issues presented by the suits, regulations, and mandates; and
- provide simple (but not easy) steps companies can take to begin the diversification of corporate governance.
Board Diversity Lawsuits
The pending shareholder actions, most filed by the same group of firms and targeted at many companies identified in a recent Newsweek article that listed companies without a black director, generally assert that the defendants:
- breached their fiduciary duties; and
- violated Section 14(a) of the Securities Exchange Act;
by making false or misleading public statements regarding the company’s commitment to diversity even though their boards and management did not include racially diverse – specifically black – directors. To underscore this point, most of the complaints contain photographs of racially homogeneous current board members.
Though the well-established “Caremark” duties – outlined in In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996) – are not expressly referenced in the complaints, they certainly influence the plaintiffs’ arguments that the boards breached their fiduciary duties when they:
- failed to prevent violations of law by allowing discriminatory practices concerning governance;
- did not make diverse board appointments; and
- authorized false statements about diversity priorities to be made in proxy documents despite a lack of governance diversity.
To address these breaches, the aggrieved shareholders’ suits demand:
- quantifiable plans to achieve board diversity and inclusion;
- annual diversity reports on hiring, advancement, promotion and pay;
- annual diversity and inclusion training;
- funds (measured in the hundreds of millions) to hire and promote diversity throughout the corporation;
- creation of open seats for new, and appropriately compensated, diverse directors; and
- attorneys’ fees.
While the purpose of these suits is laudable, significant threshold legal questions exist. First, the suits typically allege “demand futility” to explain why underlying diversity concerns were not taken to the board as opposed to directly filing suit. Considering the focus on diversity issues in the new ESG environment, and the lack of any detail regarding board processes and deliberation, whether such requests were futile is a crucial issue to be resolved by the courts. Next, statements regarding legal or ESG compliance are not typically actionable. Finally, causation and damages will be high hurdles, since a direct relationship between board diversity/ESG failures and actual shareholder harm must be established. Plaintiffs currently allege that greater board diversity leads to greater profits, relying upon, among other things, a 2018 McKinsey & Company report noting that companies with more diverse boards were more likely to have higher profits. However, correlation is not legal causation, and it will be difficult to convince courts that studies like this justify ignoring the protection of the Business Judgment Rule.
Recognizing many of these defenses, the U.S. District Court for the Northern District of California dismissed a board diversity lawsuit against Facebook in a March 19, 2021 order. The Court found that plaintiffs in Ocegueda v. Zuckerberg, N.D. Cal., No. 3:20-cv-04444, did not plausibly plead demand futility or “a materially false statement” under Section 14(a).
That said, a legal victory may not be the goal. Faced with similar allegations from some of the same lawyers in the board diversity suits, Google's parent recently settled its #MeToo derivative litigation by, among other things, creating a $310 million diversity, equity, and inclusion fund (operating over the next 10 years) to support global diversity and inclusion initiatives within Google, and supporting various ESG programs outside Google focused on the digital and technology industries. Ergo, the ultimate goal of the board diversity suits may be similar settlements and capitulations.
Regulatory, Industry, and Shareholder Engagement Efforts
While the lawsuits are the most recent effort to spur board diversity, they were preceded by federal and state regulatory efforts. The Securities and Exchange Commission (SEC) has issued compliance interpretations advising companies on how to disclose diversity characteristics they rely on when nominating board members. And in November 2019, the House of Representatives considered a bill requiring issuers of securities to disclose, among other things:
- the racial, ethnic, and gender composition of their boards of directors and executive officers; and
- any plans to promote such diversity.
California was the first state to require that public companies headquartered there have a minimum number of female directors in 2019 or face sanctions, with the minimum to be increased in 2021. In June 2020, New York began requiring companies to report how many of their directors are women. More recently, California has mandated that public companies headquartered in the state elect at least one director from an underrepresented community by December 2021, or face up to $300,000 in fines. For boards with between four and nine directors, two such directors must be in place by December 2022 and companies with more than nine directors must have three. Considering these regulations, it is no coincidence that the vast majority of board diversity suits were filed in California.
At the industry level, the NASDAQ exchange (on which many of the board diversity defendants are listed) filed a proposal with the SEC to adopt regulations that would require most listed companies to elect at least one female director and one director from an underrepresented minority or who identifies as LGBTQ+. If adopted, the tiered requirements would force noncompliant companies to disclose the reasons for any failure to meet this diversity mandate in the company’s annual meeting proxy statement or on its website. The SEC has solicited public comment on this proposal.
In the private sector, institutional investors such as BlackRock and Vanguard have encouraged companies to pursue ESG goals and disclose the racial diversity of their boards, using proxy votes to advance such efforts. Separately, Institutional Shareholder Services, many private and public companies, and some non-profit organizations have either encouraged companies to disclose their diversity efforts or have signed onto private challenges and pledges to increase the diversity on their boards.
Concrete Plans Can Decrease Director Risk
The business and social benefits of diversity are well established; and successful companies know that an organization’s diversity commitment cannot be rhetorical and may be measured by the number of their diverse board and management leaders.
As pending lawsuits and legislation use diversity statements to form the basis of liability and/or regulatory culpability, companies should ensure that their diversity proclamations are fully supported by their actions. Among other things, boards should:
- Take the lead from public and private efforts and review – and (if necessary) reform – board composition to open or create seats for diverse directors.
- When recruiting new board members, identify and prioritize salient diversity characteristics; if necessary, utilize a diversity-focused search consultant to ensure a diverse pool of candidates.
- Develop a quantifiable plan on diversity issues by reviewing and augmenting governance guidelines, board committee efforts, and executive compensation criteria.
- Create and promote diversity and inclusion goals and incorporate training at the board and management levels.
- Require quarterly board reporting on diversity and inclusion programs to reveal trends and progress towards stated goals.
As companies express their commitment to board and C-Level diversity and other ESG efforts through public statements, investor engagement and shareholder proposals, recent litigation and regulatory trends should encourage companies to move beyond platitudes and, instead:
- create and follow concrete plans with defined goals; and
- meticulously measure their progress.
Want more? Participate in a live CLE webinar on this topic at the upcoming Business Law Virtual Spring Meeting! The program, "Diversifying Corporate Governance Institutions: Who Should Be At the Table?," will be presented on April 23, 2021, at 12:15pm CT. Registration is completely free for Business Law Section members—sign up now!