New Law Requires Racial, Ethnic or LGBT Diversity on Boards of California-Based Public Companies

In a move that continues California’s push for increased diversity on corporate boards, Governor Gavin Newsom on September 30, 2020 signed into law a bill that requires publicly held companies headquartered in the state to include board members from underrepresented communities. The action follows passage of a similar law in 2018 mandating that public companies headquartered in the state have at least one woman on their boards of directors by the end of 2019 (SB 826), with further future increases required depending on board size.

The law significantly expands on the diversity categories included in the legislation as originally proposed (see our prior coverage of the draft legislation here).

Companies that do not comply with the new law, AB 979, will face similar penalties as those noncompliant with SB 826, the gender diversity law: fines in the six figures, in addition to ramifications to their brand and reputation. As with SB 826, the new law contains some open questions and ambiguities that may affect implementation.

Requirements of AB 979

AB 979 requires that by the end of 2021 California-headquartered public companies have at least one director on their boards who is from an underrepresented community, defined as “an individual who self‑identifies as Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, or Alaska Native, or who self‑identifies as gay, lesbian, bisexual, or transgender.”

In addition to that initial 2021 requirement, the law mandates that the number of directors from underrepresented communities be increased by the end of calendar year 2022, depending on the size of the board, as follows:

A company can comply with the law by adding one or more board seats, rather than removing directors. However, the step-up feature of the requirement, where an increased number of directors from underrepresented communities is required as board size expands, could make that challenging for some smaller boards.

For example, an eight-member all-white board without LGBT representation could satisfy the 2021 requirement by adding a new member who meets the diversity requirements (simultaneously increasing the board size). But that company will find it needs to add two more members who meet the diversity requirements by 2022. That’s because, unless it removes members who don’t meet the requirements, the company would then step up to a board composed of nine or more members, triggering the requirement that it have three members from underrepresented communities. A similar result would hold for a similarly comprised board starting with four members.

Of course, adding a woman who meets the diversity requirements in 2021 could allow a company to tick two boxes at once: gender diversity, as required by SB 826 (which applies starting in 2019 and includes a step up in 2021) and, potentially, if the woman is also LGBT, racially or ethnically diverse, the diversity requirement under AB 979 (which applies starting in 2021 and steps up in 2022). This means that, for example, a four-person board with one woman in 2020 that adds an Asian woman in 2021 could meet the requirements of both laws for that year: two women and one-person meeting diversity requirements.

AB 979 defines a “publicly held corporation” as a corporation with outstanding shares listed on a major U.S. stock exchange. While a major U.S. stock exchange is not defined by the law, it is expected that exchanges such as the New York Stock Exchange, NYSE American, Nasdaq Global Market and Nasdaq Capital Market would qualify (as has been the general understanding under SB 826). A corporation would be deemed to be headquartered in California based on whether its principal executive offices, according to the corporation’s Annual Report on Form 10-K, are located in California.

Failure to Comply

Companies that fail to comply will be fined $100,000 for the first violation and $300,000 for each additional violation. Each required director seat not held by a member who meets the diversity requirements will count as a separate violation, but a seat held by a diverse director for at least a portion of the year will be deemed to satisfy the requirement. While the fines are not particularly consequential, they may add up, and the cost of public criticism and embarrassment should not be underestimated (for example, the impact on brand and reputation, recruitment and retention, and investor relations should be considered).

Legal Challenges

Some legislators and commentators have noted that the bill has potentially fatal issues. We expect AB 979 to be challenged on various constitutional and other grounds.

In addition to Equal Protection Clause- and Civil Rights Act-based arguments, it is possible that the bill will be challenged under the “internal affairs doctrine” (a longstanding doctrine under the Commerce and Full Faith and Credit Clauses and conflict of laws principles) which provides that the internal affairs (such as corporate governance) of a corporation should be governed by the state law in which it is incorporated.

So far, SB 826 has been challenged on equal-protection grounds in several lawsuits. The results have been mixed, as described below:

• In Meland v. Padilla, a conservative legal organization claimed on behalf of a public company shareholder that, in requiring a female board member, the law prevented that shareholder from voting as he desired. The U.S. District Court for the Eastern District of California ruled against the plaintiff.
• In Crest v. Padilla, the plaintiff sought to block Secretary of State Alex Padilla from spending taxpayer money to enforce the law on the grounds that it violated the California constitution by imposing an unconstitutional gender-based quota. In June, a state Superior Court judge overruled Padilla’s argument that the plaintiffs lacked standing. The Secretary of State’s office will eventually be required to answer the complaint, giving observers a view into the state’s stance on challenges to this law.

No company or potential board member has been willing to serve as a plaintiff to challenge SB 826, and we expect that will also be the case for AB 979.

Regardless of the potential legal challenges, publicly held corporations headquartered in California should make preparations for compliance.

Open Questions and Ambiguities

The law contains a number of open questions, gaps and ambiguities. These include:

• Are directors of Middle Eastern descent included in the meaning of “director from an underrepresented community”?
  • The statute is silent on the subject, but it appears that they could be included if they choose to self‑identify as Asian or African‑American.
• How will the California Secretary of State determine violations?
  • There is currently no requirement that public companies disclose the race, ethnicity or LGBT self-identification of their board members, and the law is silent as to what new reporting requirements will be implemented as a result of this law. There is also no ready way to determine this information based on other required public disclosures.
• How does it apply to newly public companies that become public through an IPO or direct listing late in a year (for example, December 2020)?
  • On the face of the statute, there is no transition provision.
• The law says there is no violation if a person from an underrepresented community held a seat for at least a portion of the year, but how small is a portion?
  • Literally read, a company could wait until the very end of the year to make an appointment.
• What if there is a proxy contest or majority voting requirement for director election, and the director from an underrepresented community nominated by the company loses?
  • To penalize a company in such circumstances may be unfair and undercut shareholder democracy, but the statute appears to make no exception. In such a situation, to avoid violation of the statute the board could choose to expand the board and/or add or reappoint a director from an underrepresented community, or in the case of failure to receive a majority, appoint a new director from an underrepresented community to replace a director that did not receive a majority. Alternatively, it may provide circumstances in which a company is willing to challenge the validity of the statute (e.g., on “internal affairs doctrine” grounds).
• Would a company satisfy the requirement if a company with five directors had two different directors from underrepresented communities on the board for a portion of 2021?
  • As with SB 826, the law does not state whether directors from underrepresented communities that serve for only a portion of the year need to overlap, whether they need to hold different seats, how vacancies would be counted, how the requirement is treated if the board size was adjusted during the year, or when the number of seats would be counted.
• How are biracial or multi‑ethnic directors counted?
  • The statute does not specifically address biracial or multi‑ethnic directors. However, if a director self‑identifies as one of the groups included in the definition of a “director from an underrepresented community,” we believe that they qualify under the statute, even if they also self‑identify with a racial or ethnic group not included in the definition.
• How will directors be counted to meet the combined gender diversity and racial/ethnic/LGBT requirements under SB 826 and AB 979?
  • On their face, the statutory requirements are separately counted, and one person could satisfy a requirement under each statute simultaneously. By way of example, we would expect that:
    • A gay Latino would count as one director from an underrepresented community under AB 979 (but not as gender diverse under SB 826).
    • A Caucasian lesbian would count as one director from an underrepresented community under AB 979 and one woman under SB 826.
    • A transgender black woman would count as one director from an underrepresented community under AB 979 and as one woman under SB 826. Under the revised text of the combined statute, AB 979 has added the concept of “self‑identified” to the gender diversity provisions of SB 826. While some women’s groups oppose counting transgender women for these sorts of purposes (under the belief that such women have not suffered the same disadvantages that gender diversity requirements are meant to address), we expect California courts to count such individuals under SB 826.

Subject companies should also monitor any implementing regulations that the California Secretary of State may adopt and/or consult with legal advisors.

Practical Advice to Companies

Despite the expected legal challenges to AB 979 and the open questions and ambiguities related to its implementation, the topic of board diversity remains an important issue for important stakeholders: customers, employees, investors and many of the communities in which companies operate.

Board diversity shareholder proposals are on the rise and several institutional investors, such as Blackrock and State Street Global Advisors, have announced plans to proactively campaign for increased diversity on public company boards. Shareholders have also begun to bring suits against boards based on their lack of diversity.

We advise that companies and their boards take the following steps to address board diversity and AB 979.

• Confer with counsel to develop a process for gathering and disclosing relevant self‑identification information from board members.
  • Many directors may consider this information to be deeply personal and may find public identification by such categories as distasteful or demeaning (disliking any suggestion that this is the reason for their board membership). Companies will have to approach solicition of such information with sensitivity, including explaining the form in which such information will be disclosed.
  • To limit the potential that the solicitation of such information required by AB 979 will later be used as a basis for a discrimination claim, consider limiting the collection and review of individualized information to the chairman of the board’s nominating committee and/or the committee itself. Those involved should work along with the company’s human resources function to ensure appropriate handling of any sensitive information.
  • In the context of public securities filings, aggregated information is likely to be common, rather than individualized disclosure. We are hopeful that whatever reporting mechanism and format is developed by the California Secretary of State will accommodate such aggregated disclosure (perhaps as simply as asking a company whether it was in compliance during the prior calendar year).
  • To the extent that the information will be included in public securities filings, companies should also have appropriate disclosure controls and procedures in connection with the recording, aggregation and disclosure of such information.
• Have a plan to consciously consider traditional diversity factors, such as gender, race, ethnicity and LGBT status, as a plus when recruiting new board members.
  • Consider adopting an adapted version of the “Rooney Rule” for board recruiting (for example, interview at least one woman and at least one member of an underrepresented community as potential final candidates for each open board seat).
  • Use reputable and/or diversity-focused recruiters and specify that the candidate pool must include women, LGBT and minority candidates.
• Be prepared to discuss the gender, LGBT, racial and ethnic makeup of the board as well as these diversity plans and efforts, either in a public forum or in discussions with individual investors.
  • The company’s PR and investor relations teams should have a prepared response on this subject as part of its broader communication strategy addressing the current social justice environment.
  • The company should also be prepared to discuss these subjects as part of its stockholder engagement discussions.
• Do not state a specific intent to comply with AB 979, and do not cite the statute as a reason for selecting one board candidate over another (and do not let your recruiter do so).
  • Given the expected legal challenges to AB 979, stating specific compliance with the law could put the company at risk for getting involved in a public controversy and in potentially expensive litigation.
  • Instead, consider a general statement to the effect that the company is complying with all legal requirements and that the company seeks the best qualified candidate to suit the needs of the company, the board and its stockholders, and takes into consideration many factors, including diversity.