Shareholder derivative suits focus on diversity at the top

Over the past few months, a spate of shareholder derivative actions and new California legislation have focused on diversity and inclusion at the executive and board level of public corporations.

Assembly Bill 979, signed into law by Gov. Gavin Newsom on Sept. 30, requires that no later than the close of the 2021 calendar year, publicly held domestic or foreign corporations whose principal executive offices are located in California must have a minimum of one director from an underrepresented community. AB 979 defines such a director 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. Further, by the close of 2022 such corporations with more than four but fewer than nine directors must have a minimum of two directors from underrepresented communities, and such corporations with nine or more directors must have a minimum of three directors from underrepresented communities.

AB 979 was patterned off of Senate Bill 826, enacted two years ago, requiring that the same category of corporations have a minimum of one female director at the close of 2019, and by close of 2021, have a minimum of two female directors on boards with five directors, and a minimum of three female directors on boards with six or more directors. Both laws authorize the secretary of state to impose fines for violations of these statutory requirements and would require the moneys from these fines to be available, upon appropriation, to offset the cost of administering the laws' requirements.

Shortly after AB 979 was introduced in the State Legislature on June 29, and a Newsweek article from June 16 was published naming the "The 20 Largest Public U.S. Companies Without a Black Person On Their Board," certain public companies, along with certain of their board members and executives, were named as defendants in shareholder derivative lawsuits for allegedly lacking Black board members. To date, eight lawsuits have been filed by two law firms against, among others, nominal defendants Facebook, Inc., Qualcomm Incorporated, The Gap, Inc., and Monster Beverage Corporation, some of which were named in the Newsweek article. At least three of the companies listed in the Newsweek article have added at least one Black board member since July.

Each of the lawsuits allege, among other causes of action, violations of Section 14(a) of the Securities Exchange Act of 1934 and SEC Rule 14a-9, promulgated thereunder, which prohibits false or misleading statements of material fact in proxy statements. The general theory underlying the claims is that these companies allegedly misled their investors by representing to them a commitment to and/or progress in increasing racial diversity while failing to have sufficient, and in some cases, any, Black board members. Further, certain of the lawsuits also point to research by a consulting firm who reported a statistically significant relationship between a more diverse leadership team across racial/ethnic lines and better financial performance. The plaintiffs then allege that the directors and executives breached their fiduciary duties because, by failing to racially diversify their boards and executive level positions, they failed to maximize corporate value. The plaintiffs generally seek money damages and an injunction requiring the companies to make various corporate governance changes.

To date, these derivative lawsuits specifically fault these corporations for alleged failures to appoint Black board members. Some of the complaints explicitly reference the Black Lives Matter movement, noting that "while many companies have only made public statements or pledged to donate money to anti-racist causes, other companies and corporate executives are looking inward and taking more meaningful measures to address racial discrimination in hiring and promotion." They then note that certain companies "have pledged to tie executive pay to diversity metrics," "PepsiCo announced a five-year, $400 million initiative that includes the goal of increasing Black managerial representation by 30% and more than doubling business with Black-owned suppliers," and that "Adidas committed to filling 30% of new positions with Black or Latino workers."

Both the lawsuits and AB 979 focus on diversity and inclusion at the very top leadership positions at these companies and cite to research tying increases in financial performance with increases in racial and ethnic diversity at these top positions. In the findings of AB 979, the Legislature pointed out that "[m]ore racially and gender diverse boards further the goals of the Sarbanes-Oxley Act of 2002, which pushed for more independent boards that decrease the likelihood of corporate fraud." The Legislature further found that "[d]irectors that hold numerous board seats exert considerable influence over United States corporations and broader society," and that "[a]s directors gain seats on more boards, they gain influence over the creation of policy in more companies and rise in corporate status amongst the corporate elite, which in turn enhances their influence on the creation of policy."

AB 979 has already been challenged by taxpayers who take issue with the costs the Secretary of State will incur to compile the report documenting compliance with the law. These plaintiffs contend that the "legislation's requirement that certain corporations appoint a specific number of directors based upon race, ethnicity, sexual preference and transgender status is immediately suspect and presumptively invalid and triggers strict scrutiny review." Plaintiffs then allege that AB 979 cannot be "justified by a compelling governmental interest" nor show that "its use of race and ethnicity" is "narrowly tailored to serve that compelling interest."

At this stage only Facebook, Inc. has responded to its respective complaint. In addition to arguing that the suit should be dismissed for failure to make a pre-suit demand and on forum non conveniens grounds based on a Delaware forum selection clause, Facebook also argues that the plaintiff failed to state a claim under section 14(a). Facebook argues, among other things, that (1) the alleged misstatements were not plead with requisite particularity, (2) the alleged failures to disclose allegedly deficient oversight of diversity and inclusion efforts are immaterial for section 14(a) purposes under 9th Circuit law, and (3) statements about a company's commitment to "a diverse workforce" and "an inclusive and positive working environment" are "precisely the type of 'puffery' that courts have consistently held to be inactionable."

The ultimate outcome of these shareholder derivative lawsuits -- which could face challenges of pleading and proof under existing laws -- and any constitutional challenges to AB979 remain open questions. The existence of these suits and legislation do add to the current conversation about how best to address issues of diversity and inclusion. 