California court strikes down board diversity law as unconstitutional

Notepad on table in empty conference room

Employment Alert

Corporate Governance Alert

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On April 1, 2022, Los Angeles Superior Court Judge Terry Green ruled in Robin Crest, et al v Alex Padilla that Assembly Bill 979 (California Corporations Code § 301.4), or AB 979, mandating that publicly traded companies include a specific number of people from underrepresented communities on their boards, violates the California Constitution’s Equal Protection Clause.

California AB 979

Passed in 2020, AB 979 required foreign and domestic companies with their principal executive offices in California to name at least one board member by the close of 2021 from an underrepresented community, meaning that the director self-identifies as Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian or Alaska Native, or who self-identifies as LGBTQ+. It also required, by the close of 2022, for companies with more than four but fewer than nine directors to have a minimum of two directors from underrepresented communities, and companies with nine or more directors to have a minimum of three directors from underrepresented communities.

The law authorizes the California Secretary of State (the Secretary) to impose fines of $100,000 for the first violation and $300,000 for subsequent violations.  While no fines have been issued to date, the Secretary issued its first compliance report on March 1, 2022.

AB 979 violates the Equal Protection Clause

In Crest, three California taxpayers represented by Judicial Watch sought to enjoin the State of California from spending taxpayer funds or taxpayer-financed resources to enforce AB 979 and to declare the statute unconstitutional. In a ruling granting summary judgment to plaintiffs, the court held:

Because Section 301.4 treats similarly-situated individuals differently based on race, sexual orientation, and gender identity, because that use of suspect categories is not justified by any compelling interest, and because the statute is not narrowly tailored to serve the interests offered, Section 301.4 violates the Equal Protection Clause of the California Constitution.

 

In striking down AB 979, the court reasoned that “a legislative classification satisfies equal protection of law so long as persons similarly situated with respect to the legitimate purpose of the law receive like treatment.” According to the court, while legislative classifications generally are entitled to judicial deference, judicial deference does not extend to laws that employ suspect classifications, such as race: “Because suspect classifications are pernicious and are so rarely relevant to a legitimate governmental purpose, they are subjected to strict judicial scrutiny; i.e., they may be upheld only if they are shown to be necessary for furtherance of a compelling state interest and they address that interest through the least restrictive means available.”

The court concluded that AB 979 “clearly applies suspect categories: it imposes a duty on corporations to use such categories in the selection of their board members. It requires corporations to have a specific number of directors who are members of certain listed races, or else have certain listed sexual orientations or gender identities.” In doing so, it rejected the Secretary’s arguments that a company could use an anonymized selection process to produce a compliant board or expand the size of the board to avoid firing any current board members. According to the court, these solutions do not “cure the problem,” and plaintiffs properly brought a facial challenge to the law.

The court also rejected the Secretary’s argument that the classification in the law is justified because the listed groups are underrepresented and have been subjected to discrimination and, thus, are not “similarly situated” to anyone else. On this point, the court concluded that the relevant set of individuals is those qualified to sit on corporate boards and, thus, individual members of both the listed and unlisted groups are similarly situated.

The court next addressed the compelling interests asserted by the Secretary of remedying discrimination and obtaining benefits that come from more diverse boards, including more profitable corporations which lead to more tax revenue, improved corporate integrity and more inclusive workplaces. While acknowledging that remediating discrimination may be a compelling interest, in this case, the court concluded that the state failed to identify a specific arena in which discrimination has occurred. According to the court, the arena of “corporate board selection” is “neither confined nor specific” insofar as it covers the entire nation and all industries. Even if the state could meet the specificity requirement, the court held that the Secretary failed to produce “convincing evidence” that remedial action is necessary.

With respect to the public benefits of diverse boards, the court held that “the state’s generic interest in healthy businesses is not sufficiently specific or immediate to permit the use of suspect classification.”

Finally, the court considered whether, even if the Secretary had shown a compelling interest, the remedy chosen is narrowly tailed to suit that interest. According to the court, this is where the law “rests on the thinnest ice” as there is “little indication that the Legislature seriously considered or attempted other intermediate and race-neutral measures.”

What happens next?

It is expected that the State of California will appeal the court’s ruling. In the meantime, the order means that enforcement of AB 979 is stayed.

Other lawsuits could offer guidance on whether corporate board diversity provisions can withstand constitutional challenges. Judicial Watch’s separate lawsuit challenging the constitutionality of Senate Bill 826, mandating gender balance on the boards of directors of publicly held corporations headquartered in California, remains pending.

In addition, a lawsuit filed against the US Securities and Exchange Commission, Alliance for Fair Board Recruitment v SEC, alleges that the SEC exceeded its authority by approving Nasdaq’s board diversity rule in August 2021. At least 17 states are backing the challenge.  This Nasdaq rule would generally require listed companies to disclose a “matrix” of diversity data for directors in proxy statements filed after August 8, 2022 and to have (or explain why the company does not have) diverse directors in filings on August 7, 2023, assuming the rule survives litigation. 

Meanwhile, what should public companies do?

Despite the legal challenges to state and federal diversity mandates, many expect the SEC to adopt additional requirements relating to diversity.  For example, in approving Nasdaq’s diversity rules, SEC Chair Gary Gensler stated they “reflect calls from investors for greater transparency about the people who lead public companies,” and two additional SEC commissioners expressed their hope that Nasdaq’s diversity rules are “a starting point for initiatives related to diversity, not the finish line.”  In addition, the major proxy advisory firms and a growing number of institutional shareholders have voting policies that require board diversity and related diversity disclosures, and shareholder proposals regarding board and management diversity have been notable this proxy season.  These dynamics, as well as individual companies’ assessments of the value of a diverse board, may lead companies to seek greater board diversity regardless of the outcome of court cases examining the legality of government mandates.

Companies seeking increased diversity for their boards are encouraged to obtain legal counsel in structuring board searches in ways that will avoid running afoul of state or federal anti-discrimination laws, while also showing good-faith compliance with state and federal diversity mandates that may be in effect.  Similar concerns may arise for companies considering whether and how to embody diversity goals in their director recruitment and refreshment policies and procedures, corporate governance guidelines, governance disclosure, shareholder engagement practices and other aspects of their public-company existence.

We will continue to monitor Crest, Alliance for Fair Board Recruitment and other challenges to state and federal board diversity requirements, as well as developments in the area of board diversity more broadly.  Please contact the authors or your DLA Piper relationship attorney if you have questions regarding any of these topics.