Current State of Board Diversity Rules and Policies

This article is an extract from Lexology In-House View: Diversity and Inclusion 2023. Click here for the full guide.

Executive summary

State legislatures, as well as regulators, institutional investors and proxy advisory firms, have taken different paths to promote diversity on public company boards. This chapter reviews the different attempts these constituents have taken to influence board diversity, as well as particular challenges that legislatures and regulators have faced in their efforts to codify board diversity-based rules or legislation. In light of the challenges faced by legislatures and regulators, institutional investor and proxy advisory firms have sought to fill the void by developing and refining their own board diversity policies. This chapter further summarises those policies for ease of reference and comparison.

Quotas

Recognising that market forces alone may not compel board diversity, at least one state legislature has attempted to promote board diversity by adopting quotas.

California first initiated Senate Bill 826 (SB 826) in 2018, and required public companies headquartered in California to include a certain number of female directors on their boards, depending on the overall board size.² By 31 December 2019, all public corporations headquartered in California were required to have at least one female director on their board.³ On 31 December 2021, the required minimum number of female directors was increased to two if the corporation has five directors and three if the corporation has six or more directors.⁴

In 2020, in response to broader concerns about making boards more inclusive, the California legislature passed Assembly Bill 979 (AB 979),⁵ which required public companies headquartered in California to maintain a certain number of directors from an underrepresented community.⁶ By 31 December 2021, all public corporations headquartered in California were required to have a minimum of one director from an underrepresented community.⁷ On 31 December 2022, the law increased the required minimum number of underrepresented directors to two if the corporation has more than four but fewer than nine directors, and to three for a corporation with nine or more directors.⁸ AB 979 defined an individual from an underrepresented community as those who identify 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.⁹

Under both SB 826 and AB 979, the California Secretary of State had the ability to levy fines. A first violation would result in a US$100,000 fine, while a subsequent violation would result in a US$300,000 fine.¹⁰ Advocates of the laws emphasised that legislative action was necessary to correct discrepancies in the composition of boards, which data showed were disproportionately white and male.¹¹

California’s approach followed similar quota approaches taken outside the United States. For example, in 2003, Norway adopted a quota requiring at least 40 per cent female representation on boards.¹² Other nations such as Germany, France, Belgium, Iceland and Italy adopted mandatory quotas on female representation.¹³

Both SB 826 and AB 979 were ultimately challenged and struck down based on the conclusion that the laws violated the equal protection clause of the California constitution in 2022.¹⁴

First, in April 2022, the Los Angeles Superior Court in Crest v Padilla concluded that AB 979 resulted in different treatment of similarly situated qualified potential board candidates on the basis of their race, sexual orientation or gender identity, triggering the strict scrutiny standard of review required under an equal protection analysis. It also determined that the requirement that a certain specific number of board seats must be reserved for members of the underrepresented groups necessarily excluded other members of other groups from board service.¹⁵ Further, the Court found no ‘convincing evidence’ of discrimination against underrepresented candidates and, based in part on this conclusion, no compelling government interest to treat candidates from underrepresented communities differently. Finally, the Court concluded that the statute was not narrowly tailored to serve the interests proffered by the state.¹⁶

Then, in May 2022, the Los Angeles Superior Court, in a case also titled Crest v Padilla, reached a similar conclusion regarding SB 826.¹⁷ There, the Court held that the law created a ‘suspect’ gender classification, and like the earlier case, the state failed to meet its burden of showing that the law met strict scrutiny. Specifically, the Court determined that SB 826’s goal of achieving gender equity or parity did not constitute a compelling governmental interest. In addition, the Court determined that SB 826 was neither necessary to boost California’s economy, improve opportunities for women in the workplace or protect California taxpayers, public employees, pensions and retirees, nor was it narrowly tailored.

Based on the experience in California, diversity-specific quotas requiring boards to maintain a minimum number of diverse board members seem unlikely to sustain judicial scrutiny on equal protection grounds.¹⁸ Indeed, at the time that Governor Jerry Brown signed SB 826 into law in 2018, there were already questions about the law’s legality.¹⁹ Governor Brown is reported as saying at the time: ‘Serious legal concerns have been raised. I don’t minimise the potential flaws that indeed may prove fatal to its ultimate implementation.’²⁰

However, California Secretary of State Shirley N Weber has not yet given up on SB 826 and AB 979. According to court records, both cases are now on appeal.²¹

In addition, it appears that other state legislatures have also not given up entirely on mandatory measures. The Hawaii legislature is reportedly considering a new type of bill in requiring boards to include individuals of all genders, including men.²² The bill would mandate a gender balance on boards. If the bill is ultimately adopted by the Hawaii legislature, it remains to be seen whether such a measure would survive legal challenge on equal protection grounds.

Despite the demise of SB 826 and AB 979, there has been a change in the diversity profile of California public companies. Between the passage of SB 826 in 2018 and shortly before the law was struck down in 2022, the share of women on boards of California public companies increased from approximately 15 per cent to 29 per cent.²³ In addition, research from the Latino Corporate Directors Association showed that, as of 31 December 2021, the number of all-white boards of California public companies had been reduced by 20 per cent since the passage of AB 979 in 2020.²⁴

Disclosure-based policies

Nasdaq

Outside of state legislature efforts, the most notable development has come from Nasdaq listing standards. Rather than recommending or mandating quotas, Nasdaq has taken a more traditional ‘comply or disclose’ approach, familiar under securities laws, but even that is facing challenges.

Approved by the Securities and Exchange Commission (SEC) in August 2021, Nasdaq’s Rules 5605 and 5606 seek to address board diversity in two ways.²⁵ On an annual basis, companies are required to disclose a matrix of how their board members self-identify as relates to gender, certain race and ethnic categories and LGBTQ+ status, with more tailored meaning of these categories based on home countries for foreign private issuers.²⁶ The rules will eventually require companies to have at least two board members who self-identify as diverse, or to publicly explain the reasons why they do not satisfy that requirement (Nasdaq and the SEC will not assess the merits of that explanation).²⁷ Leaving aside certain exceptions for smaller reporting companies and foreign private issuers, a company will need to have at least two diverse directors, including one who self-identifies as female and one who self-identifies as LGBTQ+ or as an underrepresented minority (which for US companies is one or more of Black or African American, Hispanic or Latinx, Asian, Native American or Alaskan Native, Native Hawaiian or Pacific Islander) to avoid adverse disclosures.²⁸ The board composition disclosure rules are being phased in from the end of 2023 with one director, and two directors from the end of 2025 or 2026 depending on the Nasdaq market.²⁹

Nasdaq has insisted that these rules are not intended to impose quotas or minimum requirements, but rather that they are designed to give shareholders more information when making investment decisions, and it will ultimately be up to each Nasdaq-listed company to decide the nature of their disclosure about their circumstances and diversity policy (albeit it will not be enough to simply state that it does not comply).³⁰ Critics have asserted that Nasdaq is seeking to shame companies into ensuring the appropriate level of diversity.

The National Center for Public Policy Research and the Alliance for Fair Board Recruitment are currently seeking to invalidate Nasdaq’s approach on the basis that it violates the equal protection clause of the Fifth Amendment and the First Amendment’s protection of free speech.³¹ While the petitioners are advancing constitutional arguments to challenge the SEC’s approval of the rules, within those arguments the petitioners contend that the rules encourage discrimination against potential board members and by current board members and shareholders.³² They further argue that (1) these rules stigmatise board members who identify as one of the preferred demographics and that there is an implication that, without the SEC’s or Nasdaq’s help, certain races cannot meaningfully compete for board positions; and (2) by stating that they will not judge a company’s explanation for a failure to comply with the rules, the only reason to demand an explanation is to shame only those companies that do not agree with the government’s and Nasdaq’s views.³³

The SEC response challenges the basis for the petitioners’ claim on the fundamental grounds that the SEC’s mere approvals of an exchange rule and regulation of exchanges does not convert their private conduct into state action.³⁴ However, the SEC also challenges the broader policy arguments of the petitioners by stating that the rules simply do not mandate any particular board composition, and that ‘at most, they require companies that choose to list on Nasdaq and do not meet Nasdaq’s board diversity goals to provide their shareholders an explanation – in their own words, in as much or as little detail as they choose.’³⁵

While the outcome remains to be seen, the SEC does not see the Nasdaq rules as the end of the road, in their words, ‘because enhanced diversity is critically important for investors, the markets, and our economy, we hope this is a starting point for initiatives related to diversity, not the finish line.’

United Kingdom

The approach taken by Nasdaq is generally consistent with the approach taken in other jurisdictions that have adopted voluntary goals as opposed to mandatory requirements. For example, regulation of corporate governance of public companies in the United Kingdom has broadly followed a ‘comply or explain’ model for over 20 years, and has recently taken the same approach when it comes to boardroom diversity.³⁶ Against the backdrop of an increased focus on board diversity and multiple years of government-led reviews on female and ethics board diversity since the mid-to-late 2010s, the United Kingdom’s Financial Conduct Authority adopted new rules in April 2022 with the express aim of seeking to ‘improve transparency on the diversity of company boards and their executive management for investors and other market participants, increasing engagement on this area and informing investment decisions’.³⁷

The regime requires premium and standard listed companies to include disclosure in their annual report, on a comply or explain basis, against specific board diversity targets:

• at least 40 per cent of the individuals on the board must be women;
• at least one senior board position (ie, chair, CEO, senior independent director, or CFO) must be held by a woman; and
• at least one member of the company’s board must be from a minority ethnic background.³⁸

Companies are also required to disclose, in their annual report, numerical data on the sex, gender and ethnic diversity of the board, senior board positions and executive management.³⁹ Finally, companies are required to explain their approach to collecting numerical data underlying these disclosures and the Financial Conduct Authority expects the explanation to include the method of collection, source of data and, where the data has been collected on the basis of self-reporting, a description of the questions asked.⁴⁰

In addition to the comply or explain aspects of the UK rules, the new listing rules include guidance to companies that they may wish to consider, including brief summaries of policies and procedures and wider context that might contribute to improving diversity, mitigating factors making achieving diversity more challenging and risks it foresees in meeting diversity targets.⁴¹ Changes have also been made to rules governing corporate governance statements, which require companies to disclose a description of their diversity policy applied to remuneration, audit and nomination committees, and how their diversity policies address wider diversity characteristics.⁴²

Shareholder voting policies

While legislatures and regulators have been focusing on board diversity, institutional investors and proxy advisory firms are continuing to develop and refine their policies. In the absence of regulatory solutions, institutional investor and proxy advisory firm policies are taking on greater importance. Over the past few years, the approaches of these investors and firms have evolved, including by increasing the focus on racial and ethnic diversity rather than just on gender diversity. It may be that these policies will continue to evolve over time, consistent with developing societal views and expectations.

Institutional investors

Vanguard, BlackRock and State Street (sometimes known as the ‘Big Three’ due to their dominant holdings in US public companies) have a combined nearly US$11 trillion of assets under management and are collectively the largest shareholder in 40 per cent of all publicly listed companies in the United States.⁴³ Through their voting influence, they exert significant sway over public company practices. Each investor has developed voting policies on board diversity, summarised below.

Vanguard

Vanguard will generally vote against the nominating or governance committee chair (or another relevant board member if the nominating or governance committee chair is not up for re-election) if the company’s board is making insufficient progress in its diversity composition or in addressing its board diversity-related disclosures.⁴⁴ Progress and disclosure are also taken into account. Vanguard expects at least one female director and at least one racially or ethnically diverse director.⁴⁵ Vanguard further believes that diversity in the boardroom will ‘meaningfully contribute to the ability of boards to serve as effective, engaged stewards of shareholders’ interests’.⁴⁶ When conducting searches for potential director candidates, Vanguard expects companies to engage in broad searches to include diverse board candidates.⁴⁷

BlackRock

BlackRock will often vote against members of the nominating committee unless boards are 30 per cent diverse.⁴⁸ For BlackRock, diversity means a board with at least two women and a director who identifies as a member of an underrepresented group. Progress towards this goal will also be taken into account. BlackRock believes that diversity in the boardroom will lead to diversity of thought and better economic outcomes. To illustrate how companies are moving towards these outcomes, BlackRock expects companies to be able to respond to several questions covering the board’s diversity composition and the recruitment and selection processes of a director candidate, among other things. Furthermore, they cite an avoidance of groupthink as a compelling reason for diverse boards.

State Street

State Street’s shareholder voting policies concerning board diversity include several components: an expectation that the company will meet a diversity target, disclosure of the diversity composition of the board and, if the company fails to meet the target, disclosure of a plan as to how the company expects to meet the target. At the time of writing, the board diversity target and disclosure guidelines vary based on the stock market index.

State Street expects the boards of directors of all publicly listed companies to include at least one woman on their boards⁴⁹ and companies in the Russell 3000 Index should have at least 30 per cent female directors. If the company fails to meet State Street’s expectation or, if the company is in the S&P 500 and does not disclose the gender diversity of its board, State Street may vote against the board’s nominating committee. However, even if the company fails to meet the expectation, State Street may waive the voting guideline if the company engages with State Street and provides a specific plan for achieving gender diversity targets.

The guidance for underrepresented community diversity follows a similar structure. State Street expects boards of companies in the S&P 500 to have at least one director from an underrepresented community. Further, State Street expects S&P 500 companies to disclose the underrepresented community diversity composition of their boards. If the S&P 500 company does not meet this target or fails to disclose their board’s diversity composition, State Street may not support the chair of the nominating committee.

Proxy advisers

Institutional Shareholder Services (ISS) and Glass Lewis are the two most prominent proxy advisory firms, each of whom has published updates to its proxy voting guidelines focused on board diversity, as summarised below.

ISS

ISS will generally recommend against the nominating committee chair if the board does not have at least one female director.⁵⁰ ISS will make an exception from this policy if, at the preceding annual meeting, the company had at least one woman on the board of directors and the company commits to having gender diversity on their board within one year.

For Russell 3000 and S&P 1500 companies, ISS will generally recommend against the nominating committee chair if the board does not have at least one racially or ethnically diverse director (subject to the same exception described above).⁵¹ Similar to their gender diversity guidelines, ISS will make an exception to companies that, at the previous annual meeting, had at least one racially or ethnically diverse board member and that commit to having at least one racially or ethnically director on their board within one year.

Glass Lewis

In 2022, Glass Lewis transitioned ‘from a fixed numerical approach to a percentage-based approach for board gender diversity’.⁵² Currently, Glass Lewis will generally recommend against the nominating committee chair of Russell 3000 boards that are not at least 30 per cent gender diverse. The boards of companies outside the Russell 3000 are subject to a requirement that mandates the board of directors have at least one gender diverse director. Glass Lewis reviews the company’s diversity disclosure and may refrain from recommending voting against certain directors where boards provide a sufficient justification or strategy to address their board’s lack of diversity.

Concerning the inclusion of underrepresented communities on boards of directors, Glass Lewis expects companies within the Russell 1000 to have at least one director from an underrepresented community.⁵³ Generally, Glass Lewis will recommend voting against the chair of the nominating committee if the company fails to meet this expectation. Glass Lewis defines a member of an underrepresented community as an individual who self-identifies as Black, African American, North African, Middle Eastern, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian or Alaskan Native, or who self-identifies as gay, lesbian, bisexual or transgender.

When considering board diversity in relation to underrepresented communities, Glass Lewis’ engagement policy is akin to its gender diversity policy. Where companies provide a sufficient justification or strategy to address the board’s lack of diversity, Glass Lewis may refrain from issuing a recommendation that shareholders vote against the board.⁵⁴

Conclusion

As illustrated by the failure of California state laws, specific diversity quotas for boards are unlikely to survive legal challenge and serve as a basis to influence board diversity. Instead, the ‘comply or explain’ model, along the lines adopted by Nasdaq and in the United Kingdom, is likely to be attempted, though even that regime is not free of legal challenge in the United States. Besides regulatory actions, The Big Three and proxy advisory firms are continuing to use their platforms to promote board diversity and use their influence to promote outcomes.