22 January 2021

California’s call to diversify boards of directors


Brooke Schneider
Senior associate | US

This article was originally published in Corporate Compliance Insights on December 3, 2020.

Hard on the heels of racial discord in the United States and the Black Lives Matter movement, the California legislature has taken another step toward its focus on diversity and equality. On September 30, it passed legislation which requires the appointment of underrepresented individuals on the board of directors of public companies headquartered in California.

California Passes AB 979

According to the Latino Corporate Directors Association as set forth in the bill (AB 979), in 2020 nearly 35% of boards of directors in California – 233 out of 662 – were “all white” boards. The newly-enacted law is therefore intended to ensure that the diversity of the state is similarly reflected in the leadership of the organizations who reside within its borders.

The new law applies only to public companies, domestic or foreign (private companies are excluded), whose principal executive office is located in California. It requires appointment to the boards of these companies’ individuals who are generally “underrepresented” including Blacks, African Americans, Hispanics, Latinos, Asians, Native Americans, and members of the LGBTQ community. The requirements will be phased in, initially requiring all boards to have one underrepresented member by the end of 2021. By the end of 2022 boards with nine or more members must have three underrepresented members and those with five to eight members must have two. Failure to implement the quotas will result in financial penalties ranging from $100,000 to $300,000.1

Potential Responses from the Business Community

While the intention behind the law is to increase diversity in corporate leadership, the expectation is that doing so ultimately improves business performance through increased innovation and competitiveness, as well as improving companies’ bottom lines. A 2018 McKinsey & Company study of more than 1,000 businesses in 12 countries found increased diversity (gender, ethnicity and cultural diversity) in executive teams was correlated with higher financial returns.2 Additionally, the move will ultimately cause cultural shifts in California-business leadership, which can reduce and remedy racism (whether conscious or unconscious) that many view as systemic and/or a result of historic realities in the United States.

Nonetheless, the directive is likely – at least initially – to cause a fair amount of fluster in the business community. Companies should be swift in reviewing their current board composition and determine who has the relevant skills to direct the company, imperative for the current economic environment, and be swift to make what other determination via objective analysis (such as length of service etc.) as to who should be let go or, more likely, whose board seat should not be renewed. The other possible consideration is whether to enlarge the board to meet the requirements, a process that should involve review of the company’s corporate documents and consultation with legal counsel. This analysis is, of course, with a mind towards keeping shareholders happy and confident in the future of the company.

Concurrently with this determination, companies will have to begin the process of actively and purposefully recruiting and enticing underrepresented individuals to their board. If the board members renew on an annual/yearly basis, this may be more easily facilitated. However, staggered boards may find the process of replacement to be a more significant and complicated exercise. Moreover, as companies generally seek to appoint board members with deep bench experience in their particular industry segment while also targeting and ensuring that certain business expertise for the board as a whole is satisfied, focusing a search at least in part, around those who have the particular experience but who also meet the diversity requirement could be feared further to limit what might be an already narrow pool of candidates upon which to draw, thus increasing competition for board members, especially in more nuanced or smaller industries. Ultimately, however, given the ultimate goal of diversity, it is an effort worth taking on.

Some commentators have suggested that, at least initially, some companies may choose to risk penalties rather than comply with the law due to the (perceived) cost of implementing the change and the potential for disruption during an already turbulent time for most businesses. Companies have to answer to shareholders, and given the publicity surrounding the law and the negative press that would inevitably ensue from non-compliance, ultimately, compliance should be a non-negotiable both from a legal and a practical standpoint when it comes to finding business success within California.

Looking Forward

Whether the law will discourage new businesses from setting up shop in California altogether remains to be seen. But given California’s overall propensity to be a compelling place of business for companies and talented individuals, this might be a case of a corporation cutting off its business nose to spite its face. After all, the pool of individuals for board seats though perhaps more narrowed as a result of this legislation should nonetheless remain qualified and compelling. Moreover, although California is generally viewed as a more progressive state when it comes to business and employment-related issues and laws, it is quite possible that other states will follow California as dominoes, following its lead to implement similar legislation seeking both to achieve the goal of better business practice, but also the corollary of increased profitability.

Notably, this law comes approximately two years after the similar first-in-the-nation California law, which requires female representation on boards.3 Although certainly novel for the United States, many countries, including Belgium, France, Germany, Iceland, India, Israel, Italy, Norway, Pakistan, and Spain, have also implemented gender quotas for boards. Some companies may seek to cover both the gender and underrepresented-individuals directives in one board seat, but doing so could partly undermine the spirit and intent of both laws.

Finally, it is worth noting that the gender-based law, and now the underrepresented-individuals law, have been met with legal opposition. The legal group Judicial Watch filed a lawsuit in October in the Los Angeles Superior Court seeking to halt AB 9794 (after having filed a similar lawsuit in 2019 regarding SB 826).5 The plaintiffs assert, generally, that these laws cause for illegal expenditure and violate the equal protection clause of the constitution. The lawsuit to overturn SB 826 is expected to be heard next year, but undoubtedly will have significant implications for AB 979 as well.

Footnotes

[1] See, CA AB 979

[3] CA SB 826

[4] Crest v. Padilla II, Cal. Super. Ct. Case No. 20STCV37513

[5] Crest v. Padilla, Cal. Super. Ct. Case No. 19STCV27561

Brooke Schneider Senior associate | New York

Category: Article