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May, 2022

California Lost Two Battles But May Have Won the War: Diversity Mandates Succeeded with Corporate Boards, Despite Recent Court Rulings Finding the Mandates Unconstitutional

By Tracey I. Levy

In broad brushstrokes, California legislators sought to achieve gender and racial diversity on the boards of publicly held corporations headquartered in California several years ago by first mandating that every such board include a minimum number of women directors (SB 826), and then separately mandating that every such board include a minimum number of directors from “underrepresented” communities (defined to include Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, Alaska Native, gay, lesbian, bisexual or transgender-identifying individuals) (AB 979).  The laws were surprising at the time in two respects – they were innovative, and their legality was questionable at best.  Time is proving both to be true.

Available data indicates that diversity on corporate boards, and especially representation of women, has leapfrogged in the three plus years since the passage of SB 826.  And two recent state court decisions have invalidated both laws, finding them to violate the equal protection clause of the California constitution.

Corporations Largely Complied with California’s Mandates

A team of researchers at Clemson University, analyzing the impact of SB 826, reported that 61% of covered companies had at least one female director on their board prior to passage of the legislative mandate in September 2018, and by the compliance date of December 2019 virtually every company had achieved compliance with at least one female director.  This resulted in the cumulative addition of 306 female directors.

By way of comparison, in 2017 Equilar had forecast that it would take 40 years for the corporate boards comprising the Russell 3000 (which measures the performance of the top 3,000 U.S. publicly traded companies) to achieve gender parity.  As of the third quarter 2018, 18 percent of the directors on Russell 3000 corporate boards were women and by December 31, 2019 this figure had increased to 21.5%.

The Russell diversity index measures proportionate representation of men and women directors on each board, while the Clemson University analysis measured whether boards had at least one woman director.  A more apples-to-apples comparison can be found in Equilar’s Q4 2019 report, which noted that California jumped from ranking 29th among all U.S. states with 17.4% gender parity at the time SB 826 first passed, to ranking 16th with 23.3% gender parity as of the compliance deadline just 15 months later.  Apparently the legislative mandate had a measurable impact.

Quotas are Strictly Scrutinized

But the legislated mandates adopted by California were a form of quotas.  Corporations were required to ensure that a defined proportion of their directors fell into certain gender or racial categories.  Quotas are problematic under our legal system, whether applied to benefit white men or to benefit women or underrepresented racial groups.

The courts have held that laws that treat similarly situated individuals differently based on gender, race or other protected categories can only be sustained if they:

  • serve a compelling government interest and
  • are narrowly tailored to address the interest(s) identified.

This “strict scrutiny” test was outlined by the Supreme Court in analyzing such laws under the protections of the United States Constitution, and it has similarly been applied by numerous state courts when presented with concerns of discriminatory government action under their own constitutions.  It was the legal standard applied by the California trial courts in reviewing the constitutionality of SB 826 and AB 979.

Societal Discrimination Cannot Be Remedied by Legislative Fiat

In each of the California cases, the trial court found that the law was less about remedying any specific examples of past discrimination and more about achieving gender parity and racial diversity.  Evidence was presented in each case regarding the harms presented by demographically homogenous boards, including:

  • vulnerability to stagnant thinking and common assumptions;
  • less flexibility in responding to challenges; and
  • resulting poor business practices, less innovation and less profit.

The court considering AB 979 recognized the reasonableness of the underlying premise that demographic diversity can serve as a proxy for differing perspectives and life experiences.  It did not consider evidence on that point, however, because it reasoned that the legislative mandate intruded on individual rights under the California Constitution.  As a result, the mandates could not be attempted without first trying “to create neutral conditions under which qualified individuals from any group may succeed.”  Crest et al. v. Padilla, No. 20STCV3513 (Cal. Super.  April 1, 2022).  Such an effort had not been undertaken by the California legislature.

In contrast, the second court conducted a full trial, and reviewed all the evidence submitted on the benefits of gender diversity to corporate performance and governance.  The court ultimately found insufficient proof that adding more women to corporate boards would make them run better.  The court acknowledged some studies showing a correlation between gender diversity and corporate board effectiveness but found none showed a causal relationship.

The court struck down the law, however, on grounds very similar to those that felled AB 979.  Fundamentally, the court held that SB 826 could not withstand scrutiny because there was no “effort to limit the remedial scheme to those who suffered” specific discrimination.  Crest et al. v. Padilla, No. 19STCV27561 (Ca. Super.  May 13, 2022).  In each case, the legislature’s broad brushstrokes jumped too quickly to quotas, without evidence of specific discriminatory actions to be remediated and without first entertaining alternative options to enhance board diversity.

Lessons from California

The general principles cited by the courts in invalidating the board diversity mandates may be equally applicable to other government-directed initiatives to achieve gender and racial equity in public and quasi-public institutions.  If these initiatives set specific targets for representation by women and underrepresented racial groups, they will likely be reviewed through the same “strict scrutiny” test.

Most immediately, organizations are awaiting the outcome of a lawsuit challenging a NASDAQ “Board Diversity Rule” that was approved by the Securities and Exchange Commission (SEC) on August 6, 2021.  That rule requires listed companies to publicly disclose board-level diversity statistics and to either have or explain their failure to have two diverse directors beginning August 2023.  Notwithstanding the optionality of the “have or explain” framework of the NASDAQ rule, it is being challenged along the same lines as the prior California board diversity mandates, but under the U.S. Constitution.

How a Cudgel May Be Deployed

Given the clearly-recognized question as to the legality of California’s diversity mandates even at the time it was first signed into law, one question is why so many corporations were quick to comply by recruiting women as directors to their boards.  The answers may be manifold, including the public attention that the mandate shined on the issue and the $100,000 fine that corporations faced for noncompliance.

Another explanation, at least for some organizations, may be found in the cloak of legality provided by the California law.  In the midst of the pandemic, as vaccine mandates were being deliberated among many organizations and at various government levels, I was fielding inquiries from clients who wanted to know if the newest vaccine mandates applied to them.  A subset of those clients were disappointed when I would advise that the law did not apply.  Those clients were looking for the cover of the government requirement to institute a workplace policy to which they knew they would encounter employee opposition.

Similarly, from a corporate employer’s perspective, one benefit of the California legislative mandates was that they gave employers legal cover to put in place board diversity initiatives that organizations might not otherwise have felt comfortable instituting.  The mandates may have obviated questions from shareholders or others regarding why particular director candidates were considered or selected, and they may have provided some insulation against lawsuits challenging individual board director selections as discriminatory.  Organizations make business decisions based on a wide range of competing considerations and balancing the wants and needs of varying constituencies.  Sometimes it is the cudgel of heavy fines or legal actions that brings about change, and sometimes that cudgel works more subtly, as a tipping point to persuade individual stakeholders who may be resistant to organizational change.

By Tracey I. Levy

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