Key Highlights from California’s New Diversity Reporting Law

Overview:

On October 8, 2023, California Governor Gavin Newsom signed into law Senate Bill 54[1] (the “Diversity Reporting Law”). The Diversity Reporting Law is intentionally broad in its scope and is intended to help highlight and address the lack of funding for companies owned by diverse owners, in particular minorities and woman.

At a high level, commencing on March 1, 2025, the Diversity Reporting Law requires certain entities with a California nexus to file an annual report detailing certain demographic data about the founding team members of the businesses in which such entities made a venture capital investment in the prior calendar year as well as the total amount of money invested in such businesses and a break down between diverse and non-diverse businesses and founding teams.

The collected data will be publicly available on the California Civil Rights Department website. 

Who Must Comply:

The Diversity Reporting Law applies to “covered entities.” Use the following flow chart to help determine if a company is a covered entity:

Practical Implications

The Diversity Reporting Law is broad in scope and can capture entities that are not otherwise subject to California state law reporting as well as entities that would not generally be deemed to be “traditional” venture capital funds (e.g., such as one defined under the Advisers Act). As such, managers should diligently review each of their investment vehicles, including private equity funds, single investor co-investment vehicles, alternative investment vehicles, family offices and trusts, etc., to determine whether such vehicles are covered entities under the Diversity Reporting Law. 

What Needs to be Disclosed:

Portfolio Company Level

At an aggregated level, for the founding team members[2] of all the portfolio companies invested in by the covered entity in the prior calendar year, the covered entity should provide the following information to the extent this information is provided pursuant to the survey described below:

For each founding team member, such member’s:

1. gender identity (including nonbinary and gender-fluid identities);
2. race;
3. ethnicity;
4. disability status;

and whether any founding team member:

5. identifies as LGBTQ+;
6. is a veteran or a disabled veteran;
7. is a resident of California; and
8. declines to provide any of the information in (1) – (7) above.

Practical Implications

The language of the Diversity Reporting Law states that a covered entity is only required to provide each founding team member with an “opportunity to participate” in a survey for the purposes of collecting the above listed information. While it is not clear what exactly constitutes an appropriate “opportunity to participate,” it would be prudent for the covered entity to internally document the dates they provided the surveys to founding team members and the dates and format (e.g., phone call, email, etc.) of any follow-ups related thereto. 

Covered Entity Level

For the prior calendar year, the covered entity should provide the following information:

1. On an anonymous basis, the number of Venture Capital Investments made in the prior calendar year in companies primarily founded by diverse founding team members[3] as a percentage compared to the total number of Venture Capital Investments made by the covered entity, in the aggregate and broken down into categories described in Item 1 under “Portfolio Company Level” subheader above.
2. The dollar amount[4] of Venture Capital Investments made in the prior calendar year in companies primarily founded by diverse founding team members as a percentage compared to the total dollar amount of Venture Capital Investments made by the covered entity, in the aggregate and broken down into categories described in Item 1 under “Portfolio Company Level” subheader above.
3. The total dollar amount invested in each entity in which a Venture Capital Investment was made.
4. The principal place of business of each entity in which a Venture Capital Investment was made.

How the Information must be Collected

On an annual basis pursuant to the timelines discussed in “Compliance Dates & Penalties” below, the covered entity shall obtain the information required by the California Civil Rights Department (the “Department”) by providing each applicable founding team member of a covered portfolio company with a standardized survey (which shall be provided pursuant to a form specified by the Department[5] and must include a “decline to state” option for each question).

The covered entity must also provide written disclosure to each founding team member (simultaneous or prior to distribution of the survey) that states that (i) disclosure of demographic information is voluntary, (ii) no adverse action will be taken against the founding team member if they decline to participate in the survey and (iii) the aggregate data collected for each demographic category will be reported to the Department.

For the avoidance of doubt, the covered entity may not provide the survey to the applicable founding team members until after the covered entity has actually executed an investment agreement with such portfolio company and made the first transfer of funds.

Compliance Dates & Penalties

Commencing on March 1, 2025, if a covered entity fails to submit a report to the Department by March 1 of each year, the Department shall give the covered entity notice and a cure period of 60 days to submit the report. If the covered entity again fails to submit the report after the cure period is over, the Department may file a petition in superior court to require the covered entity to comply with the Diversity Reporting Law and to pay a penalty. The determination of the penalty will be a facts and circumstance determination by the courts, which shall take into consideration several factors, including, but not limited to: (i) the size of the covered entity, (ii) the covered entity’s assets under management, and (iii) the nature of the covered entity’s failure to comply. The court may also award reasonable attorneys fees and costs of the Department in pursuing the actions, and any other relief that the court deems appropriate.

Practical Implications

The Diversity Reporting Law may face both resource and legal challenges that could delay or prevent implementation of the law.

In his letter signing Senate Bill 54 into law, Governor Newsom acknowledged[6] that the Diversity Reporting Law contains “problematic provisions and unrealistic timelines that could present barriers to successful implementation and enforcement.” Furthermore, he noted that the Diversity Reporting Law would require the Department to “undertake significant and ongoing investigations just to determine whether any given entity meets the criteria set forth in the [Diversity Reporting Law] - and the Department is not situated to perform this work.” 

In terms of legal challenges, California has also seen push back on some of their recent diversity bills. For example, earlier this year, a California court held California AB 979 was unconstitutional because it imposed a race-based classification by requiring publicly held corporations based in California to include at least one director from an underrepresented community. In 2022, another California court enjoined California law SB 826 on similar grounds for requiring public companies based in California to have a certain number of female directors. Although the Diversity Reporting Law differs from those proposed bills in that it only requires reporting diversity data and does not mandate any specific diversity quotas or targets, it may be more prone to attack in light of the growing number of challenges to laws, regulations, and corporate programs promoting diversity, equity, and inclusion following the U.S. Supreme Court’s recent decision effectively ending affirmative action for college admissions.[7]

Privacy Matters

The information required to be gathered and stored by covered entities under the Diversity Reporting Law, which includes sensitive personal information, will be sure to implicate potentially onerous compliance obligations (including relating to the collection, processing, storing, use, and disclosure of such information) under the various federal, state and even global privacy laws to which the covered entity and its affiliates may be subject. Since founding team members of implicated portfolio companies, whose personal information is involved, could reside anywhere in the world, privacy laws anywhere in the world could possibly be implicated. As such, covered entities should consult with their legal counsel to update their privacy notices related to the collection, processing, storage, use and disclosure of this information, consider whether obtaining such founding team members’ consent would be a viable method of compliance under applicable privacy laws, and to ensure their privacy policies and practices are updated to be in compliance with both the Diversity Reporting Law as well as such other privacy laws to which they may be subject.

[1] See S.B. 54, Leg. Ch. 594 (Cal. 2023).

[2] A founding team member means either of the following : (a) a person who (i) owned initial shares or similar ownership of the business, (ii) contributed to the concept, research, development or work performed by the business prior to initial shares being issued and (iii) was not a passive investor in the business; or (b) a person designated as chief executive officer, president, chief financial officer or manager of the business, or designated a role with similar authority.

[3] A business is primarily founded by diverse team members if more than half of founders respond to the survey and at least half of such team’s members identify as woman, nonbinary, Black, African American, Hispanic, Latino-Latina, Asian, Pacific Islander, Native American, Native Hawaiian, Alaskan Native, disabled, veteran or disabled veteran, lesbian, gay, bisexual, transgender, or queer.

[4] The plain language of the Diversity Reporting Law does not make clear whether or not the reporting in item 2 under the “Covered Entity Level” subheader is with respect to “amount” of companies or “dollar amount” invested in such companies. We have interpreted this as a reporting based on dollar amount as, if otherwise, it would be duplicative of the requirement under the “Covered Entity Level” subheader. We anticipate this will be clarified when the reporting form is provided.

[5] As of the date of the publication of this client alert, the standardized form has not yet been provided.

[6] See A signing message of Governor Newsom: SB 54 by Senator Nancy Skinner (D-Berkeley) – Venture Capital Companies: Reporting, Office of Governor (Oct. 8, 2023).

[7] See Morrison Foerster, SCOTUS Effectively Ends Affirmative Action for College Admissions: What This Decision Might Mean for Workplace Diversity Programs (Jun. 30, 2023).