CLS Blue Sky Blog

Racial Diversity and Corporate Governance: Assessing California’s New Board Diversity Mandate

Corporate governance is historically perceived as a specialized, idiosyncratic and somewhat arcane field. But increasingly, it has come to serve as a lightning rod for broader public debates. Perhaps no moment underscores this trend more sharply than the 2020 calendar year: Not only did the world face twin crises of unprecedented global pandemic and an invigorated public debate about racial equity and inclusion, but those events accelerated nothing short of a seismic shift in how we think about corporate governance.

And no one does seismic shifts like California: In September of this year, Gov. Gavin Newsom signed into law a new statute mandating that all publicly traded corporations headquartered in California must diversify their boards of directors with directors who come from “underrepresented communities” (a category that includes both racial and LGBTQ status). Assembly Bill 979 (“AB 979”) will require prescribed companies to have at least one qualifying board member by the end of next calendar year, ramping up to full compliance (a variable numerical minimum that scales with the size of the board) by the end of 2022.

As a component of the jointly-organized conference on Racial Equity in Corporate Governance (between Columbia/Penn/Stanford), this post explores some of the most salient legal and political economy dimensions of AB 979.

1. Background

Although AB 979 is in certain ways a first-of-its-kind initiative, diversity oriented board mandates are hardly new. For example, since mid-2019, Canada has required publicly traded corporations governed by the Canada Business Corporations Act to disclose their policies, targets, and practices for achieving diversity within the board and senior management. Additionally, a 2019 Illinois statute contained a disclosure mandate similar to the Canadian model, applying to all publicly traded companies headquartered in the state.  And, perhaps most pertinently, in 2018 California embraced a mandate nearly identical to AB 979’s for gender diversity on public boards (SB 826), similarly requiring graduated steps to full compliance by the end of 2021. [For interested readers, we have produced a concise table comparing AB 979 and SB 826 here]. At least five other states have since followed California’s lead on this score (with legislative proposals currently pending in several others). And, prior to any of these efforts, Norway famously imposed gender diversity board mandates of its own (which were similarly emulated by other European nations). Although some time remains before California’s gender diversity statute becomes fully operational, it appears already to have moved the needle considerably in increasing the fraction of female representation on the boards of prescribed companies.

2. Likely Legal Challenges

The prospect of a legal challenge to AB 979 is far more than hypothetical. Indeed, there have already been several actions filed challenging AB 979 and/or SB 826; and, while some have been dismissed on a variety of grounds (more on that below), others are likely to stay afloat well into discovery if not litigation. Perhaps the two most serious substantive challenges to the new law are rooted in the Internal Affairs and Equal Protection doctrines, and we consider each in turn below.

a. Internal Affairs Doctrine

A critical feature of AB 979 (as well as SB 826) is that it applies to all publicly traded companies headquartered in California, regardless of where the company is incorporated. According to recent Compustat data, this population appears to include hundreds of California-based businesses that are incorporated in Delaware alone (constituting around 85 percent of all public companies with California headquarters). For bona fide corporate law wonks, this observation immediately raises thorny questions about the “internal affairs doctrine” (IAD). Corporate law is – for the most part – the province of the states, permitting them to compete with one another using their own corporate statutes that apply (in theory) to all companies incorporating there. Consequently, the law of the state of incorporation is said to prevail over “internal” corporate matters. The IAD was famously described by the U.S. Supreme Court as follows:

The internal affairs doctrine is a conflict of laws principle which recognizes that only one State should have the authority to regulate a corporation’s internal affairs—matters peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders—because otherwise a corporation could be faced with conflicting demands.

By these lights, it seems as if the IAD would be a show stopper for AB 979, right? All told, California is imposing an inter se governance mandate on more than 1,000 public companies (by our count) that are headquartered in the Golden State but incorporated elsewhere (a population that itself represents nearly $7 trillion in market capitalization).  What, after all, could be more “internal” to a company’s governance structure than its board roster?

Not so fast. For those well-versed in the contours of corporate law, analyzing AB 979 (or SB 826) through an IAD lens quickly becomes a puddle of muddle, for at least two reasons:

Thus, there is in our view significant reason to question the oft-uttered assertion that that board diversity mandates are ineluctably verboten under the IAD.

b. Equal Protection Doctrine

A second set of constitutional challenges to board diversity mandates comes from equal protection doctrine. As of this writing, three notable legal actions have challenged the validity of AB 979 and SB 826 under the equal protection guarantees under the California and federal constitutions. In one, a shareholder of a California-based corporation incorporated in Delaware challenged SB 826’s gender quotas under the Equal Protection Clause (“EPC”) of the 14th Amendment. Two additional actions were stylized as state taxpayer suits, challenging SB 826 and AB 979, respectively, as impermissible gender-based and race-based quotas under the California Constitution. Although the claims are similar between AB 979 and SB 826 as well as between federal and state levels, there are a few crucial differences that may affect the likelihood of success for future challengers.

(i) Federal

Under the EPC, statutes and governmental regulations are subjected to a tiered system of judicial scrutiny, with classifications based on race receiving the most exacting level of “strict” scrutiny, while gender classifications are accorded a lower, “intermediate” level of scrutiny (at least as of now). This distinction clearly bears on the prospects for SB 826 and AB 979 to pass constitutional muster. For SB 826 to pass intermediate scrutiny as a gender-based classification, it must (in the words of the Supreme Court) be substantially related to an important government objective. The court has yet to rule on the constitutionality of gender-based quotas, but (as other scholars have noted) a truly remedial gender quota-based mandate may well fit within the court’s existing gender classification case law and could well withstand intermediate scrutiny under the EPC.

The race-based classification of AB 979, in contrast, likely faces a bumpier road. To survive strict scrutiny, racial classifications must serve a compelling governmental interest, and they must be narrowly tailored to further that interest. And here, the Supreme Court has frequently taken a dim view of racial quotas. The most developed area of constitutional jurisprudence related to quotas has been in the context of public education, where – since the famous Bakke decision in 1978 – the court has developed a complicated yet relatively settled thread of jurisprudence surrounding appropriate affirmative action in education. In short, the use of racial quotas in public education is unconstitutional. That said, the jurisprudential disapprobation of quotas is largely confined to the education context, and there are still open questions about how or whether it carries over to other settings. Most pertinently, just over 30 years ago the Supreme Court struck down a numerical, minority set-aside program designed to address racial disparities in public contracting. But it arguably did so in a narrow way, noting that the government had failed to make the case that the track record of past discrimination in the specific market was sufficient to create a compelling governmental interest. The decision thus leaves open whether claims based on “harder” evidence of historical racial inequities (such as in corporate boards) might suffice, and whether quotas can be sufficiently narrowly tailored to address the challenge.

One cannot ignore that overlaying all of these considerations is the current composition of the Supreme Court. The recent confirmation of Amy Coney Barrett to take the late Ruth Bader Ginsburg’s seat no doubt suggests that the court will move further right. But when the composition of the court changes dramatically, so too can the inter-personal dynamics within its ranks – sometimes in surprising ways. (The same might be said, by the way, for any multi-member group, such as a board of directors.) Here, then, much remains to be seen.

(ii) State

A second (and less well documented) strand of equal protection challenge comes from state law. California’s Constitution provides that “[a] person may not be deprived of life, liberty, or property without due process of law or denied equal protection of the laws.” For AB 979, the equal protection analysis bears facial resemblance to federal law: State action must be, at a minimum, rationally related to a legitimate state interest, and if a suspect classification is at play, the state must demonstrate a compelling interest necessary to fulfill its purpose. Race-based statutes are such a suspect classification, and their analysis largely mirrors federal law. By contrast, sex-based classifications are suspect under California law and subject to strict scrutiny, raising the bar for the state’s justification and posing a formidable challenge to SB 826. At the same time, such a holding would necessarily be confined to the California Constitution, and it thus would not automatically carry over to the many other states that have passed (or are promulgating) similar mandates.

3. Process and Political Economy Matters

Outside of the many merits considerations, the question of who can bring a claim further complicates AB 979 and SB 826 challenges. At least on the state level, California’s broad taxpayer standing case law almost ensures that those state-based constitutional challenges will go forward without issue. And indeed, one of them has already withstood a challenge on this basis and is set for trial in mid-2021.

At the federal level (as well as in many other states), however, shareholders may find it difficult to establish standing unless they bring the case as a derivative action. In April, a federal district court dismissed the other shareholder-based challenge to SB 826, ruling that a company’s shareholder lacked standing to lodge an individual challenge to the constitutionality of the statute. If any party was harmed, the court held, it was the corporation itself, and thus the shareholder would have to make use of the derivative litigation process if (s)he wanted to force the issue.

And this brings us full circle to the realm of corporate governance. For a shareholder-instigated derivative challenge to either AB 979 or SB 826 would almost certainly be deemed a “demand required” case, so that the shareholder-plaintiff would be required to demand that the board of the corporation file an action. If the board refuses to do so, the shareholder is allowed to push the matter forward only if (s)he can demonstrate that the board is incapable of deliberating the merits of filing a challenge in a disinterested and independent way. Here, unlike in many conventional derivative-action situations, there would seem to be little reason to doubt the business judgment of boards that choose to eschew filing lawsuit on behalf of the corporation.  And, at least thus far, corporate boards seem to be doing a lot of eschewing. Not only would a legal challenge entail a significant expense that competitor firms would not face, but it would shine a bright and unflattering light on the boards that choose to pursue such ends. In addition, there is at least some intriguing evidence that board diversity is, on average, associated with better financial performance. Finally, it turns out that state legislatures are not the only important players interested in board diversity: Particularly since the worldwide protests triggered by the killing of George Floyd this past May, a host of institutional investors, proxy advisers, investors, listed companies, and CEOs have aggressively moved to redouble their efforts in enhancing diversity from top to bottom. Challenging the statute in court suggests a form of duplicity that is hard to ignore. Moreover, even if a court were to invalidate AB 979 (or SB 826) on constitutional grounds, the constituencies listed above may well rally to replicate the same governance mandates at the company level (emulating a similar private ordering reaction that took hold with proxy access after the judicial invalidation of SEC’s short-lived Rule 14a-11). Either way, picking a fight with California may represent a costly and visible signal that public companies (and their soon-to-be-diversified boards) can ill afford to send.

This post comes to us from Courtney Murray, a 2020 graduate of Columbia Law School who is slated to become an associate at WilmerHale in 2021, and Eric Talley, the Sulzbacher Professor of Law at Columbia Law School, faculty co-director of the Millstein Center for Global Markets and Corporate Ownership, and host of the podcast, “Beyond Unprecedented: The Post-Pandemic Economy.”

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