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Director Diversity and Derivative Lawsuits – Climate of Change

October 09, 2020

Diversity and inclusion in business has taken center stage in public discourse, and by-and-large, businesses have stated their commitment to diversity and inclusion, announcing various new initiatives to address racial inequality. Yet a wave of derivative and securities lawsuits, a recent California law signed by Governor Gavin Newsom (AB 979), and diversity legislation in other states have put a microscope on diversity at the board of director level. Corporations and their advisers should be prepared for litigation, state regulation, and increased scrutiny regarding the diversity of their board of directors.

Increased Securities and Shareholder Derivative Litigation – Lack of Action Backing Up Public Statements on Diversity

Over the last few months, several companies’ directors have been sued for breach of fiduciary duty and securities violations due to their lack of diversity on their board of directors. Directors of several prominent technology companies are among the persons sued recently.

While each suit has its nuances and the specific allegations in each complaint vary, at a high level, the underlying premise of these cases is that while companies have announced their commitment to diversity in proxy statements and other means to shareholders and the public, companies are falling short of their commitment – especially at the director and officer level. The lawsuits target individual directors, as well as executives. In each of the complaints, plaintiffs use photographs of individual board members, allege that these boards are all (or nearly all) composed of white persons, allege that the company’s leadership was aware that it had a diversity problem, and failed to effectively do anything about it – despite public statements to the contrary.

In addition to targeting the board level, the complaints also allege that the companies have diversity problems within the workforce including lack of executives from diverse backgrounds, the implementation of executive compensation plans were not meaningfully affected by the performance regarding diversity and inclusion, and pay inequities between white and nonwhite employees. Several of the complaints salaciously detail reported history of discrimination claims at the company and publicized lawsuits. Some also have made allegations of company boards’ failures to address reports of male-dominated cultures that created negative environments for female employees.

The legal basis for these claims is based in alleged violations of directors’ fiduciary duties to shareholders and violations of securities laws against misleading statements. As shareholder derivative actions, the claim is essentially that directors breached their fiduciary duties of loyalty by failing to live up to the company’s public statements on diversity and covering up alleged discrimination at the board and executive level, resulting in financial and reputational damage. From a securities law standpoint, plaintiffs allege that statements made regarding companies’ commitment to diversity in proxy statements were false in violation of Section 14(a) of the Securities Exchange Act of 1934. Additionally, the lawsuits include unjust enrichment claims – asserting that directors and executives have been wrongly enriched through bonuses and dividends that should have gone instead to addressing the corporation’s diversity initiatives and resolving pay inequities.

These lawsuits seek significant monetary damages including executive and director compensation, hundreds of millions of dollars in pledges to funds for economic and social justice programs, as well as wide-ranging institutional changes such as installing diverse board members, executives, and specific percentages of employees, instituting salary history bans, and the creation of public accountability measures such as public dashboards reporting the diversity metrics. 

AB 979: The Law – Minimum Requirements for Board Member Diversity from Underrepresented Communities

Amid this wave of lawsuits, California enacted a new law requiring California corporations to increase diversity at the board level. By the end of 2021, California-headquartered public corporations will need to have at least one board member from an underrepresented community. By the end of 2022, corporations with one to four board members must have at least one board member from an underrepresented community, five to eight board members must have at least two, and corporations with nine or more board members must have at least three. Under AB 979, a board member is from an underrepresented community if they identify as “Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, or Alaska Native, gay, lesbian, bisexual, or transgender.”

The law applies to all publicly-held corporations (foreign and domestic) whose principal executive offices identified in the company’s SEC 10-K form are located in California. Notably, the corporation’s state of incorporation is irrelevant; so a corporation incorporated in Delaware with its principal office in California would be subject to the law. Publicly held corporations include corporations with outstanding shares listed on a major United States stock exchange.

The California Secretary of State may adopt regulations in furtherance of the law, so further developments and regulations may be forthcoming. The Secretary of State may also levy $100,000 fines on California corporations for failing to timely report board member information, $100,000 fines for violation of the provision (i.e., each director seat that is not filled by a director from an underrepresented community that should be under the statutory framework), and $300,000 for each subsequent director seat violation. 

The law adds to an existing law, SB 826, which required California corporations to have a minimum number of female directors by 2020. SB 826 is currently being challenged in court. The California legislature cited a number of reasons for passing AB 979, including:

  • Despite considerable percentages of persons from diverse backgrounds participating in the workforce, of 662 publicly traded companies based in California that lack in diversity, only 13% have a Latino director, 16% have an African American director, and 42% have an Asian American director. In contrast, 100% of these boards have at least one White board member.
  • Various studies indicate that companies with diverse board members and executives have better outcomes than those who are not diverse.
  • Plans to increase the representation of women and minorities in historically unrepresented fields and occupations further the legislative goals of the Civil Rights Act of 1964.

AB 979 is currently in effect, and in order to be in compliance, California corporations must have had a more diverse board for at least part of the year by the end of 2021. However, within less than a week of being enacted into law, its constitutionality has been challenged in court. California’s gender board diversity law passed in 2018 faced similar challenges; none of those challenges has proven successful in defeating SB 826 thus far.

Beyond California - Board Diversity Legislation in Other States

California’s law is unique and no other state has enacted a similar legislation. However, other states will likely be watching to see how challenges to California’s law proceed and developing their own laws. Other states including Colorado, Illinois, Maryland, Massachusetts, Michigan, New Jersey, Ohio, Pennsylvania, and Washington have similarly introduced or passed legislation or resolutions related to board diversity.

For example, Illinois law requires corporations headquartered in the state to report to the Illinois Secretary of State and publish the gender and racial demographic information regarding board members, data regarding board member qualifications, information relating to the board member and executive nomination process, and the company’s policies regarding diversity and inclusion by January 2021. Similarly, Maryland and New York now require certain corporations headquartered in their states to report the numbers of directors on the corporation’s boards and how many of those directors are women to address gender inequities at the board level.

Final Thoughts and Recommendations

Board composition and diversity will be a focus of legislatures and the public, going forward. In light of these developments, here are several recommendations for board members and their advisors:

  • Assess whether your company is subject to AB 979 and, if so, take steps to comply by adding diverse board members.
  • Monitor state legislatures that may consider adopting California’s diversity requirement law or similar legislation and regulations that may impact your company.
  • Evaluate your board’s decisionmaking around nominating board members and ensure the process is in line with the company’s diversity and inclusion philosophy.
  • Ensure your company’s executive compensation plan adequately incentivizes performance in terms of achieving the company’s diversity and inclusion goals.
  • Review with counsel future public disclosures regarding diversity policies and practices carefully, including the new disclosure requirement on human capital resources in Form 10-K and annual proxy statements.
  • Identify strategies to avoid being next on the list of companies sued for a lack of director diversity and closely monitor developments in this quickly changing landscape.
  • Consider evaluating the diversity of your company’s board members and carefully engaging with institutional investors on this topic in consultation with outside counsel.
  • Consider adding a forum selection clause to your organizational documents.
  • Develop an appropriate process for collecting and maintaining the confidentiality of board member demographic information.

Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Washington, DC
Robin Nunn
Grace E. Speights

San Francisco
Susan D. Resley
Joseph E. Floren
Mark Feller