California Court Finds California Board Diversity Law Unconstitutional

David A. Bell, Dean Kristy, and Dawn Belt are partners at Fenwick & West LLP. This post is based on a Fenwick memorandum by Mr. Bell, Mr. Kristy, Ms. Belt, Jennifer J. Hitchcock, and Ron C. Llewellyn. Related research from the Program on Corporate Governance includes Politics and Gender in the Executive Suite by Alma Cohen, Moshe Hazan, and David Weiss (discussed on the Forum here); Will Nasdaq’s Diversity Rules Harm Investors? by Jesse M. Fried (discussed on the Forum here); and Duty and Diversity by Chris Brummer and Leo E. Strine, Jr. (discussed on the Forum here).

On April 1, 2022, the Superior Court of California, County of Los Angeles granted the plaintiffs’ motion for summary judgment in a case challenging the legality of AB 979 under the California Constitution. AB 979 required California-headquartered companies to have a specified minimum number of ethnically and racially diverse or LGBT members on their boards of directors. The court’s decision effectively strikes down AB 979, a law that had been championed as an effective means for remedying the lack of diversity on the boards of directors of California-based companies.

AB 979

As described in our previous post, AB 979, which was signed into law on September 30, 2020, by Governor Gavin Newsom, required California-headquartered public companies to 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” by the end of 2021. The required number of directors from underrepresented communities would increase by the end of 2022 to two directors for boards with more than four but fewer than nine directors and to three directors for boards with at least nine directors. Under AB 979, the California Secretary of State must report annually on companies’ compliance with the law and may impose fines of $100,000 for an initial violation and $300,000 for each subsequent violation.

Crest v. Padilla II

In October 2020, shortly after AB 979 was signed into law, three California plaintiffs, represented by Judicial Watch, challenged the legality of the statute in California state court in Robin Crest, et al. v. Alex Padilla (No.20ST-CV-37513) (Crest v. Padilla II). The plaintiffs’ complaint asserted that expenditure of taxpayer funds or taxpayer-financed resources on AB 979 was illegal because it forced companies to appoint a specific number of directors based upon race, ethnicity, sexual preference and transgender status and could not demonstrate a compelling governmental interest required for the use of such classifications under the California Constitution. The plaintiffs sought a judgment that expenditures related to the implementation and enforcement of AB 979 were illegal and an injunction prohibiting the California Secretary of State from using taxpayer funds for implementing and enforcing AB 979. The defendant, the California Secretary of State in his official capacity, also sought summary judgment, which the court denied. The State of California and California’s Secretary of State have not yet announced whether they intend to appeal the trial court’s decision in Crest v. Padilla II, though we consider such an appeal highly likely.

The plaintiffs also filed a similar complaint in August 2019 in California state court, (see Crest v. Padilla I), arguing that SB 826 (see our previous post discussing that statute), which requires California-headquartered companies to have a minimum number of women directors, violated the California Constitution on similar grounds. That case is still pending, and a decision could be announced at any time. While it is unclear whether the court will similarly rule in the plaintiffs’ favor and strike down SB 826, we expect that both statutes will ultimately survive or fall together.

Practical Considerations for California Public Companies

Institutional shareholders, regulators, employees, customers and other stakeholders have shown strong support for board diversity and related initiatives. As discussed in our prior alert, in August 2021, the U.S. Securities and Exchange Commission (SEC) approved rules that would require most Nasdaq companies to have at least two diverse directors (at least one member who self-identifies as a woman and one who self-identifies as either an underrepresented minority or LGBTQ+) or publicly disclose the reason for their failure to meet that minimum target. The rules would also require companies to publicly disclose their board diversity statistics in a prescribed format. SEC Chairman Gensler has also suggested that board diversity may be a subject for SEC-rulemaking later this year.

Institutional Shareholder Services (ISS), one of the leading proxy advisory firms, will generally recommend that shareholders of companies in the Russell 3000 or S&P 1500 indices vote against the election of the chair of a company’s nominating committee (and potentially other directors) if it lacks gender or racial/ethnic diversity. Similarly, many large institutional investors, such as BlackRock and State Street, expect their portfolio companies to have boards that are gender- and ethnic/racially-diverse and have adopted proxy voting guidelines that may result in votes against board members where there is a lack of diversity.

Irrespective of the ultimate outcome in the cases challenging the California statutes, Nasdaq-listed companies are still subject to their board diversity rules. Failure to comply with the rules’ requirements could subject a company to delisting from the Nasdaq. More generally, it is possible that the SEC will adopt regulations requiring board diversity disclosure in the near future. A company’s failure to show sufficient diversity or progress in achieving diversity may invite additional scrutiny and negative attention from shareholders and other stakeholders, including its employees and customers. In some cases, lack of board diversity may result in negative votes for nominating committee chairs and members and even the entire board. Institutional investors have also indicated that board diversity is a topic that they prioritize when engaging with companies, so companies should understand the board diversity policies of their key investors and be prepared to discuss any deficiencies in board diversity, regardless of the court’s recent decision.

Accordingly, despite the court’s decision in Crest v. Padilla II, California-headquartered companies should consider continuing with efforts to diversify their boards as necessary. Even if an appeal of the decision is unsuccessful or the State of California decides not to appeal the decision, given the strong interest in and preference for board diversity, companies should consider the negative consequences of failing to have a diverse board. We expect that the benchmarks established in AB 979 and SB 826 will continue to be influential in the expectations of stakeholders, even if they are ultimately struck down after any final appeals. Further, as many California-based companies already have come into compliance—or are nearing full compliance—with one or both of the statutes and many larger companies have achieved similar levels of diversity, we expect that peer comparisons will add additional ongoing pressure in this regard.

The desire for board diversity remains strong. Companies should consider the stated preferences and voting policies of their key stakeholders and other regulatory requirements in determining how to address board diversity.

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