As discussed in this PubCo post from February, a California bill, SB 826, addressing the issue of board gender diversity, has been making its way through the California legislature. Today, Governor Jerry Brown signed that bill into law. Interestingly, one factor apparently influential in his decision to sign the bill was the recent hearing in Washington. As you may have heard, the legislation requires, as Brown phrases it, a “representative number” of women on boards of public companies, including foreign corporations with principal executive offices located in California. Will other states now follow suit? Will corporations incorporated in other states observe its provisions or challenge the application of this California law?
In signing the bill, Governor Brown issued a letter acknowledging that there
“have been numerous objections to this bill and serious legal concerns have been raised. I don’t minimize the potential flaws that indeed may prove fatal to its ultimate implementation. Nevertheless, recent events in Washington, D.C. — and beyond — make it crystal clear that many are not getting the message. As far back as 1886, and before women were even allowed to vote, corporations have been considered persons within the meaning of the Fourteenth Amendment….. Given all the special privileges that corporations have enjoyed for so long, it’s high time corporate boards include the people who constitute more than half the ‘persons’ in America.”
What the new law requires. Under the new law, public companies would be required to have a minimum of one woman on its board of directors by the close of 2019. That minimum would increase to two by December 31, 2021, if the corporation has five directors, and to three women directors if the corporation has six or more directors. The law expressly provides that a corporation may increase the number of directors on its board to comply (which may or may not be permitted under a company’s organizational documents without a shareholder vote). The law also requires reports to be published on the website of the California Secretary of State reflecting the level of compliance with these provisions, along with the number of corporations moving in or out of the state and the number going private. The legislation also authorizes the imposition of fines for violations of the new law in the amounts of $100,000 for the first violation, and $300,000 for each subsequent violation. Failure to timely file board member information with the Secretary of State is also subject to a fine of $100,000. Any publicly held corporation (defined as a corporation listed on a major US stock exchange) with principal executive offices, as reported on the corporation’s 10-K, located in California would be subject to the new law, whether incorporated in California or elsewhere.
Potential legal challenges. According to the SF Chronicle, over “two dozen organizations officially oppose the bill, stating in a coalition letter that it prioritizes a single element of diversity and violates the U.S. constitution.” The coalition includes every variety of Chamber of Commerce in California. So don’t be surprised to see a court challenge materialize.
One legal challenge may well come under new Section 2115.5. As a matter that smacks of internal corporate governance, the new legislation naturally raises the issue of whether it could legitimately be applied or enforced against companies incorporated outside of California. (According to a 2016 column in the NYT, in the period 2000 to 2013, 19.46 percent of public companies were headquartered in California, while reportedly only 7 percent of corporations headquartered in California are also incorporated in California.) You may recall that, generally, the “internal affairs doctrine” provides that the law of the state of incorporation governs those matters that pertain to the relationships among or between the corporation and its officers, directors and shareholders. In case you were wondering how California could profess to control the internal corporate affairs of a foreign corporation, you may not be familiar with the long arm of California’s Section 2115, which purports to apply to foreign corporations that satisfy certain tests related to presence in California (minimum contacts), referred to as “pseudo-foreign corporations.” Section 2115 used to cause severe heartburn—more like acid reflux disease—for opinion committees everywhere until the provision was amended to exclude from its application companies listed on the NYSE or Nasdaq. (Of course, the provision continues to apply to companies that are not listed.)
This law, however, adds new Section 2115.5, which purports to make the new mandate expressly applicable to foreign corporations with outstanding shares listed on a major U.S. stock exchange—to the exclusion of the law of the jurisdiction in which the foreign corporation is incorporated. While there is not so much as a tip of the hat to the types of minimum contacts (e.g., sales, payroll, property) identified in Section 2115, presumably the need for “contacts” was intended to be addressed by the condition that the company’s principal executive offices be located in California. (A company’s principal executive offices cannot be located in more than one state, so, under the provision, no other state can claim the same nexus in that regard. In addition, presumably, the headquarters is where many board meetings are held and board-level matters are discussed.) While Delaware courts have refused to apply Section 2115 (including the Delaware Supreme Court in 2005 in VantagePoint Venture Partners 1996 v. Examen Inc., which questioned the constitutionality of Section 2115), California courts have not taken that view (except a lower court in dicta). Whether courts will view the location of a company’s principal executive office as sufficient to confirm California’s interest in the composition of a pseudo-foreign corporation’s board, or otherwise to establish the nexus necessary to overcome the internal affairs doctrine in this regard, remains to be seen. But, from a practical perspective, will concerns about potential adverse public reaction overwhelm the desire to contest application of the new law in this case? Or will the fear of what legislation comes next mandate that public companies contest any infringement of the internal affairs doctrine?
There’s not a smidgen of equivocation about the constitutionality of SB 826 in this article from Stanford’s Rock Center for Corporate Governance. In the article, Professor Joseph Grundfest argues that
“[w]hile well intentioned, this legislation will not achieve its intended effect because it is unconstitutional as applied to the vast majority, if not all, of publicly held corporations headquartered in California. The internal affairs doctrine will limit the law’s application to only 72 corporations headquartered and chartered in California, or 1.59 percent of all publicly traded corporations. The bill will increase the number of board seats occupied by women by trivial amounts, if at all. These trivial changes will, however, come at great risk to the evolution of affirmative action jurisprudence. California’s own legislative analysis concludes that ‘the use of a quota-like system, as proposed by this bill … may be difficult to defend.’ A successful equal rights challenge means that SB 826 will have no effect at all. The legislation thus offers a poor bargain for diversity advocates: gain a trivial number of board seats, if any, but increase the risk of judicial rulings inimical to broader affirmative action initiatives.”
Instead, the professor advocates shareholder activism as a more effective, less perilous route to achieving board gender diversity.
Potential impact on corporations. A study from consultant Equilar looked at the potential impact on public companies headquartered in California—without regard to where they were incorporated—with annual revenues of $5 million or more—a total of 211 companies with an aggregate of 349 women and 1,466 men board members. In general, the study concluded that “California is slightly below other states and the national average in terms of average women on a board. California, on average, has 1.65 female members per board, whereas other states and the United States as a whole average 1.76 and 1.75 female members, respectively.” The study concluded that, by 2019, most companies in California would pass muster and not incur any financial penalties under the new law: currently, 82% of public companies in the study “will meet the initial criteria, whereas 18% will not. Consequently, 37 public companies would be faced with a fine….” Drilling down by sector, the study found that, by 2019, “the basic materials and utilities sectors in California would both have a 100% success rate. Thus, every company within these two sectors has at least one female director present on their board. The next sector with the highest rate of success is services, with 92% having at least one female member. Both the healthcare and technology sectors are tied for lowest compliance at 83% pass.”
But, the study showed, meeting the second target in 2021 presents quite another story. Applying those criteria to boards as currently constituted, the study concluded that 79% of public companies would fail, while only 21% would pass. Drilling down again, the basic materials sector—which scored a 100% success rate under the 2019 criteria—was projected, based on current facts, to fall to a 50% pass rate. The highest success rate was projected in the utilities sector at 75%, while the technology and industrial goods sectors had the lowest projected success rate at 14%. The healthcare sector was projected to come in at a 72% failure rate.
Reasons for the legislation. Why was this bill considered necessary? The Legislature found that “[m]ore women directors serving on boards of directors of publicly held corporations will boost the California economy, improve opportunities for women in the workplace, and protect California taxpayers, shareholders, and retirees, including retired California state employees and teachers whose pensions are managed by CalPERS and CalSTRS.” However, board gender parity has been slow in coming. The bill cited studies predicting that “it will take 40 or 50 years to achieve gender parity, if something is not done proactively.”
The issue is even more acute for smaller companies: among the 50 California-based companies with the lowest revenues, averaging $13 million in 2015, “only 8.4 percent of the director seats are held by women, and nearly half, or 48 percent, of these companies have NO women directors.” By comparison, among the 50 largest California companies, with average revenues in 2015 of nearly $30 billion, “23.5 percent of the director seats are held by women. All of the 50 have at least one woman director.” And a quarter of “California’s public companies in the Russell 3000 index have NO women on their boards of directors; and for the rest of the companies, women hold only 15.5 percent of the board seats.” What’s more, companies going public are not changing the dynamic: “Nearly one-half of the 75 largest IPOs from 2014 to 2016 went public with NO women on their boards. Many technology companies in California have gone public with no women on their boards, according to a 2017 national study by 2020 Women on Boards.”
What accounts for this continuing failure to increase board gender diversity? Low priority might be one reason. As discussed in this PubCo post, the 2015 PwC annual survey of almost 800 public company directors revealed that only 39% of directors surveyed viewed board gender diversity as “very important.” Some have argued that the problem is the absence of qualified candidates: in the 2016 Global Board of Directors Survey of more than 4,000 directors of both public and large, privately held companies from 60 countries conducted by Spencer Stuart, the WomenCorporateDirectors (WCD) Foundation and several academics (see this PubCo post), 39% of male directors in the 55-to-60 age group said the “lack of qualified female candidates” was the primary reason for the low numbers of female directors. However, 69% of female directors in that same age cohort attributed the low numbers to the failure to rank diversity as a top priority in board recruiting.
Nevertheless, pressure from institutional investors has recently served to elevate the importance of the issue. (See this PubCo post for data from Equilar for Q2 of 2018.) (Some even argue that the legislation is unnecessary because, among other reasons, the marketplace is working.) For example, the voting guidelines regarding board composition issued this year by BlackRock (reportedly the largest asset management firm) made clear that BlackRock expected “boards to be comprised of a diverse selection of individuals who bring their personal and professional experiences to bear in order to create a constructive debate of competing views and opinions in the boardroom. In addition to other elements of diversity, we would normally expect to see at least two women directors on every board.” (See this PubCo post.)
Blackrock is certainly not the only asset manager to try to tackle this issue. This article in the WSJ reports that, in 2017, asset manager State Street “voted against the reelection of directors at 400 companies…on grounds they failed to take steps to add women to their boards.” (See this PubCo post.) More generally, in its survey of over 60 institutional investors with an aggregate of $32 trillion under management, the EY Center for Board Matters reported that, among investors’ top priorities for companies in 2018, board composition, particularly gender diversity, was a top priority for 82%. About half of respondents reported that they consider board diversity in voting, while a quarter do so in the context of proxy contests and shareholder proposals. The driver appears to be the “interest in effective board composition, given the wide range of studies demonstrating the benefits of diversity, including how diverse perspectives enhance issue identification and problem-solving ability and impede ‘group think.’” (See this PubCo post.)
Board gender diversity quotas in other countries. Mandating board quotas for gender diversity is an approach that has been adopted in a number of other countries. According to the bill, “Germany is the largest economy to mandate a quota requiring that 30 percent of public company board seats be held by women; in 2003, Norway was the first country to legislate a mandatory 40 percent quota for female representation on corporate boards. Since then, other European nations that have legislated similar quotas include France, Spain, Iceland, and the Netherlands.” And the quotas appear to have been effective in increasing the proportion of women directors. The WSJ reports that “the number of women on big-company boards in Italy, Germany and several other European nations has tripled and, in some cases, quadrupled in recent years as mandates have forced corporations to boost the share of female directors to as much as 40%.”
Views on the use of board diversity quotas. Nevertheless, opinions on gender quotas cut both ways. This article from the San Jose Mercury News suggests that one question some Bay Area women were asking was whether the bill presents “an insult or an opportunity.” That is, the article continues, while there “is little dispute that inherent and systematic bias against experienced, qualified women is unfairly hampering their rise in the workforce[,] will mandating that public companies in California put women on their boards help solve the problem or create ‘token’ positions that end up hurting women’s advancement in the workforce?” However, as reported in the Mercury News, one of the bill’s co-authors believed the bill was “necessary because she wasn’t seeing any progress. An ‘aspirational’ resolution that she wrote in 2013 urging corporate boards to voluntarily add women ‘fell on deaf ears,’ with the percentage of women on corporate boards barely inching up from 15.5 percent in 2013 to 16 percent five years later.”
According to the 2016 Global Board of Directors Survey referred to above, 73% of directors in the survey opposed boardroom diversity quotas; about 49% of female directors supported them (almost half of whom were age 55 and younger), but only 9% of male directors did. However, among women, age made a significant difference: 67% of the youngest generation of women directors (age 55 and younger) supported the concept of boardroom diversity quotas, compared with 36% of female directors over 55. But even in the youngest age group, only 11% of men supported quotas and the percentages went down for older male directors. One of the authors of the study commented that “‘[a]lthough we are hearing more talk about the importance of diversity from boards, it’s not necessarily translating into numbers. Unfortunately, we haven’t seen as much progress as we were hoping for compared to our past survey on the diversity of boards.’” However, it’s an open question as to whether the data would be the same now. (See this PubCo post.)
As discussed in this recent article in The Economist, opponents of quotas cautioned that boards would be “stuffed with inexperienced, token women. Another concern is that a small number of highly qualified women, known as ‘golden skirts,’ would be stretched thinly across too many boards.” However, the article continues, in Europe, where quotas have been in effect for a number of years,
“such fears have not been realised. In large listed European companies ‘golden trousers’ are almost as common: 15% of male directors sit on three or more boards; 19% of female directors do. Worries that quotas would lead to the appointment of under-qualified female directors also appear misplaced. A study of Italy’s 33% quota found that female directors at the biggest firms were more likely than their pre-quota predecessors to have professional degrees and qualifications. Norway’s quota led to a similar outcome. Elsewhere the picture has been more mixed, though, with female directors appointed after quotas likely to be younger, less experienced and, in some countries, foreign.”
According to this article in the Washington Post, research has shown that, to reach a “critical mass,” there should be at least three women on the board—that’s the point at which women’s “contributions make the most impact. Having three or more female board members has been linked to more innovation and limits the chances that women’s views will be sidelined. It also increases the chance of culture change on a board,…making it one that listens more to management, leading executives to be more apt to share bad news.” In the absence of a critical mass, it can be hard for women to be heard.
Even some of those initially opposed to European board gender quotas have come around. As reported in The New Republic, Christine Lagarde, managing director of the International Monetary Fund, commenting on gender quotas at the 2014 World Economic Forum, “admitted that while she had objections to gender quotas initially, she is now an advocate of them: ‘I soon realize that unless we had targets, if not quotas, there was no way we were going to make the right step.’”
In light of the new California directive, what are some approaches to recruiting new women directors? One factor is key: companies will need to make clear that the female candidate was chosen on merit to add value, not just to fill a slot. And, as discussed in this article in the WSJ, companies may need to “revamp the way they recruit female directors.” According to the chair of the NACD, the “‘system produces white male candidates unless board leaders deliberately do something different’ [but] ‘people are beginning to figure out how recruiting more women to boards is done….’” One approach used by a recruiter who specializes in seeking qualified female directors is to present women-only slates for consideration. The recruiter, who has successfully recruited a number of women for board positions, “thinks boards will gain more gender diversity if they ‘interview all women slates before interviewing men.’’’ According to one company commentator, the “common requirement” that board candidates have previously served on a public company board “is one reason that boards have appointed so few female directors.” However, the article observes, “companies don’t always demand the same qualification for male directors. ‘Boards dominated by men have grown used to the male standard of congeniality and so accept a man who’s never been a director before,’ even though they usually reject women without such experience,” according to a governance consultant cited in the article. The article also provides a number of illustrations of successful recruiting of female directors using a version of the “Rooney Rule, which requires that at least one woman or underrepresented minority be interviewed for positions. The National Football League created the rule to ensure that teams interviewed minority candidates for head-coaching and general-manager jobs.” (See this PubCo post.)
Reasons for board gender diversity. Board gender diversity is not just a social goal; according to the bill’s findings,
“numerous independent studies have concluded that publicly held companies perform better when women serve on their boards of directors, including:
(1) A 2017 study by MSCI found that United States’ companies that began the five-year period from 2011 to 2016 with three or more female directors reported earnings per share that were 45 percent higher than those companies with no female directors at the beginning of the period.
(2) In 2014, Credit Suisse found that companies with at least one woman on the board had an average return on equity (ROE) of 12.2 percent, compared to 10.1 percent for companies with no female directors. Additionally, the price-to-book value of these firms was greater for those with women on their boards: 2.4 times the value in comparison to 1.8 times the value for zero-women boards.
(3) A 2012 University of California, Berkeley study called “Women Create a Sustainable Future” found that companies with more women on their boards are more likely to “create a sustainable future” by, among other things, instituting strong governance structures with a high level of transparency.
(4) Credit Suisse conducted a six-year global research study from 2006 to 2012, with more than 2,000 companies worldwide, showing that women on boards improve business performance for key metrics, including stock performance. For companies with a market capitalization of more than $10 billion, those with women directors on boards outperformed shares of comparable businesses with all-male boards by 26 percent.
(5) The Credit Suisse report included the following findings:
(A) There has been a greater correlation between stock performance and the presence of women on a board since the financial crisis in 2008.
(B) Companies with women on their boards of directors significantly outperformed others when the recession occurred.
(C) Companies with women on their boards tend to be somewhat risk averse and carry less debt, on average.
(D) Net income growth for companies with women on their boards averaged 14 percent over a six-year period, compared with 10 percent for companies with no women directors.”
The Economist tempers that enthusiam, all the data above notwithstanding, suggesting that it’s too soon to tell whether an increased proportion of women on boards will have a positive effect on businesses:
“Some ‘snapshot’ studies show that companies with more women on their boards have better returns and are less likely to be beset by fraud or shareholder battles. But causation is hard to prove. Studies comparing firms’ performance before and after quotas were introduced have been inconclusive. Some have found positive effects on firms’ results; others the opposite. One Italian study found an initial increase in stock price when female directors were elected to firms affected by the quota. But it found no effect on any of seven measures of firms’ performance, including profit, output, debt and return on assets. A French study offers one clue for why the addition of more women has not made a consistent difference. It concluded that the country’s new quota system led to changes in the way the boards made decisions. But there was no change in the substance of the decisions. It also found that the process did not change because the new members were women. It was because they were likely to be outsiders. Perhaps it is too early to judge the effect of quotas on companies’ performance. But if Europe’s experience offers any guidance, expectations that California’s new law could dramatically boost or hurt corporate performance are exaggerated.