California Board Diversity Laws Make Waves

Board Diversity
Though experts insist that California-headquartered companies won’t have difficulty finding directors from underrepresented communities as a new statute requires, the measures still have their opponents.

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On Sept. 30, California Gov. Gavin Newsom signed into law a statute requiring California-headquartered public corporations to appoint directors from underrepresented communities to their boards.

The statute requires companies to install one director by the end of 2021 from underrepresented communities, including individuals who identify as Black, Hispanic, Latino, gay, lesbian, bisexual or transgender. By 2022, boards with four to nine members must have at least two members from these groups, while boards over that size must have three.

The legislation, the first of its kind requiring board changes involving racial makeup, follows legislation approved in 2018 mandating that California-headquartered companies have one women on their board by the end of 2019 and more by 2022.

Experts following the new statutes agree on two key points. First, California corporations have succeeded in finding women directors from diverse backgrounds in response to the 2018 statute, despite opponents’ assertions that boards would have difficulty identifying good nominees. As a result, they contend that boards won’t have trouble identifying other diverse candidates either.

And second, both statutes will face a range of lawsuits, one or more of which will end up before the Supreme Court.

Two lawsuits are targeting the 2018 California women diversity law. One launched by conservative legal group Judicial Watch in Los Angeles Superior Court alleges the law is illegal based on California’s constitution. The lawsuit seeks an order declaring it is illegal to spend state funds to ensure corporations comply with the law.

The second lawsuit, filed in federal court by libertarian outfit Pacific Legal Foundation on behalf of a California-headquartered public company shareholder, argues the statute is unconstitutional under the equal protection provisions of the U.S. constitution because it discriminates based on sex. A federal judge dismissed the complaint, and it is under appeal in the 9th Circuit Court of Appeals.

Columbia Law School professor John Coffee agreed the California board diversity laws will eventually be reviewed by the Supreme Court.

A key argument could involve concerns around California-headquartered companies incorporated in other states, such as Delaware.

Coffee noted a lawsuit could emerge focusing on the so-called internal affairs doctrine, which seeks to recognize that only one state has authority to prescribe rules governing the internal affairs of a corporation involving the relationships among managers, boards and shareholders.

A key theory behind the doctrine is if multiple states apply their laws to a corporation, it would be subject to inconsistent or contradictory rules. The lawsuit could target California-headquartered companies that are incorporated elsewhere.

“There is no question as to whether California can enforce its rule with respect to California-incorporated companies,” Coffee said. “But whether it can apply it to Delaware- or other state-incorporated companies even if they have significant presence in California is much more questionable.”

Coffee pointed to a 1982 Supreme Court decision in Edgar vs. Mite Corp. that argued the strong presumption of U.S. law is that internal affairs are governed by the state of incorporation. That goes against the California statute, which seeks to influence internal affairs of companies headquartered in the state but incorporated elsewhere, he said.

Other issues could attract the interest of the Supreme Court, such as provisions seeking to install directors from different racial groups.

“That always attracts heightened scrutiny,” Coffee said. “The Supreme Court is becoming more conservative, and the California statutes could be objectionable to at least some of its members.”

Alternatively, a counterargument is that there is a limit to the internal affairs doctrine — that it wouldn’t apply to “pseudo foreign corporations” that are incorporated elsewhere but have all of their contacts in a particular state.

Belinda Vega, a partner at Venable LLP in Los Angeles, agrees that either or both existing women board diversity lawsuits could make their way to the Supreme Court. She also said another suit focused on the internal affairs doctrine could emerge as well.

However, she said as challenges wind through the legal system, California-headquartered companies are making changes to comply with the women diversity statute.

According to relationship mapping service BoardEx, a sister company to The Deal, 663 public California-headquartered companies had one or more women on their boards as of Sept. 30. In addition, 28 still have no women on their boards and many of those, including Inc. (PRTS), Fat Brands Inc. (FAT) and HF Foods Group Inc. (HFFG), are incorporated in Delaware.

EventBrite Inc. (EB), Evofem Biosciences Inc. (EVFM), Geron Corp. (GERN), Stitch Fix Inc. (SFIX), e.l.f. Beauty Inc. (ELF), Exponent Inc. (EXPO) and Dare Bioscience Inc. (DARE) have the most women on their boards of all California-headquartered companies. Between 57% to 71% of their boards are made up of women, BoardEx reports.

In addition, a February KPMG study showed that 96% of public companies headquartered in the state met the 2018 statute’s requirement to have at least one female director at the end of 2019.

The KPMG study also determined that 62% of women who joined all-male California boards during 2019 were first-time directors. Vegan pointed to the determination, to refute critics who argue that only women with existing board experience can get directorships. She expects companies will succeed at installing racially diverse candidates as well.

“The whole idea that only a few women would be on lots of boards isn’t happening, and the statistics show that,” she said. “There was a whole discussion that there wouldn’t be enough qualified women to fill these roles. But they are being filled, and a lot have M.B.A.s and Ph.D.s, and many have engineering and technology backgrounds, in addition to those with C-suite experience.”

Vega said she suspects that in a few years another study will emerge about companies being able to find qualified racially diverse candidates.

Companies are permitted to expand their boards to meet new requirements. The statutes, however, appear to encourage turnover at many smaller companies with overtenured directors.

“This encourages turnover, which is very important,” she said. “You will see some entrenched directors who are being de-seated.”

In addition, companies can pay a fine if they don’t want to meet board diversity requirements. Companies must pay a $100,000 fine if they didn’t have one women director by the end of 2019 and a $350,000 fine if they don’t install the number of women directors prescribed by the statute by 2022. The new racially diverse board statute has similar fines.

Coffee argued a company with “intransigent conservatives” might decide to pay the fine, which could be a minuscule percentage of revenue. “The real deterrent is not the penalty,” he said. “No one wants to attract the publicity of being an all-male board.”

Lawrence Elbaum, a partner at Vinson & Elkins LLP, said he expects the new statutes to push companies into adding significant ethnic diversity to their boards.

“This statutory reform puts additional pressure on boardrooms to put diversity at the top of their agendas,” Elbaum said. “There is no shortage of ethnically diverse board candidates out there. This statute is certainly progress, but corporate America must do better. It is unfortunate that legislation is needed to expedite this.”

Statistics on racial diversity on boards aren’t readily available. According to BoardEx, there are 1,500 ethnic diversity and inclusion associations, and 3,500 unique individuals are linked to those in the BoardEx universe of directors and executives.

Vega, a commissioner for the Los Angeles Fire and Police Pension Board, noted investors are demanding more transparency on racial diversity and have begun to require that companies have diverse boards.

“Many companies are reporting on diversity because pension funds are demanding that reporting,” she said.

Follow Ronald Orol on Twitter and LinkedIn.

About the author

Ronald Orol
Senior Editor at | + posts

Ronald Orol leads coverage of activist hedge fund managers, a high-profile group of corporate investors who press for blockbuster deals and were the subject of his book “Extreme Value Hedging: How Activist Hedge Fund Managers Are Taking on the World.” Ron produces the Activist Daily and Activist Weekly briefings, which offer exclusives, trend pieces and breaking analysis about insurgent investors and their M&A efforts. Ron also authored “Corporate Governance in the Era of Activism,” a digital handbook for CNBC’s Jim Cramer. He previously worked as a financial regulation and activism reporter at MarketWatch and Dow Jones Newswires.

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