Above Board: California's Board Diversity Law

In this episode of the Above Board podcast, Dave Lynn, a Washington, D.C.-based partner at Morrison & Foerster, speaks with Jackie Liu and Alexa Belonick, partners based in the firm’s San Francisco office, about a law requiring companies headquartered in California to have a certain number of board members from underrepresented communities.

When determining whether a company must comply, does it matter where the company is incorporated?

How long do affected companies have to comply?

Does the size of the board matter?

What are the consequences of non-compliance?

Dave, Jackie, and Alexa will address these questions and more.

Transcript

Speaker: Welcome to MoFo Perspectives, a podcast by Morrison & Foerster, where we share the perspectives of our clients, colleagues, subject matter experts, and lawyers.

David Lynn: Hello, I'm Dave Lynn. I'm a partner at Morrison & Foerster based in Washington, D.C., and I'm pleased to be joined by my colleagues, Jackie Liu who's a partner in the San Francisco office of Morrison & Foerster, and Alexa Belonick who's a partner in the San Francisco office as well. Today, we're going to talk about the important topic of board diversity and in particular recent legislation in California that will require more diverse boards for public companies with their principal executive offices located in California. Jackie and Alexa, thank you very much for joining me today.

Jackie Liu: We're happy to be here, Dave.

Alexa Belonick: Yeah, thank you.

David Lynn: Jackie, what recent legislation has California enacted that will require board diversity?

Jackie Liu: Great question. Today, we will discuss on this podcast, the significant new California legislation assembly bill 979, which Governor Newsom signed into law on September 30th, 2020. I believe this law will have a profound impact on board composition of public companies headquartered in California.

David Lynn: Alexa, one of the things that this legislation talks about is the notion of underrepresented communities. What are the underrepresented communities that the law focuses on?

Alexa Belonick: So the law has a really specific definition here for the communities it's looking at. Uh, and particularly it defines the underrepresented communities as black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, Alaska native, or someone who self identifies as a gay lesbian, bisexual, or transgendered individual. And the interesting thing about the law is that the perspective is really on self-identification. So what it calls for is for directors from these communities who self-identify as a member, and one interesting thing that that kind of raises for companies from a sort of information gathering perspective is how to ask this question. It's obviously a sensitive topic, but one thing that we are talking with companies is finding a method to solicit that self-identification information from their board members.

David Lynn: And how do you determine if the law actually applies to your company?

Alexa Belonick: So the law applies to publicly held companies. So focusing on those who are registered on the SEC system, but it applies to companies whose principal executive offices are in California. So the important thing there is that it's broader than just the state of incorporation. It picks up not just companies that are incorporated in California, but reaches out to those incorporated in other jurisdictions.

David Lynn: And what is the timetable for complying with the requirements that are set forth in this new law?

Alexa Belonick: So the law does create a staggered timetable for compliance with this new requirement. And the first deadline is coming up in December 31st, of 2021. And so at that point, companies are to have one director from an underrepresented community. The next deadline comes up at December 31st, 2022. And at that point, the requirement scales based on the size of the board. So if the board has nine or more directors, the company would need three directors from an underrepresented community. If the board has more than four, but fewer than nine directors, there would need to be two directors from underrepresented communities. And if the board has four or fewer directors, then you stay at that same level of one director from an underrepresented community.

David Lynn: Jackie, what are the consequences of not complying with this law?

Jackie Liu: That’s a great question. And I think I will set out first what the consequences are under law, but more importantly, we should also talk about the practical consequences. So under the law, the Secretary of State may impose fine of a hundred thousand dollars for the first violation and $300,000 for any subsequent violations. And then additionally, the Secretary of State may fine companies a hundred thousand dollars for failure to file the board member information in a timely manner to show compliance with the bill. So those are the penalties set forth under the law, but frankly, I think the greater harm is not necessarily the penalties because from a certain perspective, the penalties may not be material for a lot of public companies. So I think the greater harm is really the public perception and potentially employee relations issues. So as you know, even now doing annual shareholder engagements, a number of institutional shareholders are already asking companies about their diversity policy and the steps that companies have taken or contemplate to take to promote diversity, including if you are subject to the gender diversity law that has already passed, what are companies doing about that?

Jackie Liu: I think companies who fail to follow this new law will come under very heavy scrutiny for reasons why they're failing. And right now, I think it's difficult for companies to justify their failure to comply with the law. And then separately, I think the employee base is much more active. Employee activism is on the rise. And when you look at the surveys from employees, diversity is a very important factor for them as they view their employer. And so public companies who fail to comply with the law may need to answer to their own employee base, why they're failing to comply. So I think in summary, there is what the law provides in terms of penalties, but I think the public perception is much greater harm.

David Lynn: Alexa, is there an expectation that this law will be challenged?

Alexa Belonick: So generally we do expect the law is going to be met with heavy scrutiny and listeners may remember a similar process has been underway with Senate bill 826, which is the law in California that created a requirement for female board representation. That also had critics challenge it. And we think a similar process is likely with this law. In this case, again, critics may challenge the law alleging that it's unconstitutional for creating a mandatory quota related to race and sexual orientation and the drafters anticipated this again, having seen what happened and has been happening with a female board representation law. So in the text of the new AB-979, they asserted that the new law really fits within the framework of the Civil Rights Act of 1964, which permits affirmative action plans to address past discrimination and patterns of discrimination.

Alexa Belonick: So the California drafters really pointed to AB-97, as being consistent with the legislative goals of the Civil Rights Act. And so, you know, too early to predict what will actually be made of those arguments on either side, but generally we've really been talking to companies and to boards about regardless of what happens in terms of those challenges to start addressing this topic, assess their board composition, monitor changes with the law, but begin to prepare for this topic, because as we suggest you kind of other parts of this podcast, even outside of the law's requirements, it's become a topic that's become very prominent with shareholders, investors, even employees. And so waiting for a challenge to the law is not necessarily the best approach. And we think being proactive is the right way to address this topic.

David Lynn: Jackie, Alexa mentioned the law that targeted towards gender diversity, where do things stand with that law and company's efforts to comply?

Jackie Liu: The law 826 is in effect. And so I will talk in a little bit about the challenges, but companies should recognize that the law is in effect. So therefore, by the close of last year, 2019, public companies that are subject to the law should have at least one female director on its board. And similar to the diversity bill that Alexa just spoke about, there's also staggered requirements depending on the size of the board for compliance by the end of 2021, such that if a board has six or more directors, such company will need three female directors. And if the board has five directors, you need two. And if the board has four or fewer, they will need one. So from a practical standpoint, until we know what the challenges mean for the law, and given the size of most public company boards are six or more by the end of 2021, companies will have to have to have three female directors on its board.

Jackie Liu: And so I think I mentioned there are challenges, and as far as we know right now, there are two lawsuits challenging the bill 826. And I think the challenges are very interesting, because it does set a roadmap for the potential challenges and the scrutiny that AB 979 may face. And so, as Alexa mentioned, both challenges on the bill 826 relates to constitutionality, that basically for the bottom line is the new law is a violation of the equal protection clause under the U.S. constitution. But I think in addition to the fact that the law is being challenged, the fact that public companies are nonetheless preparing and finding female board members to comply with the law is very instructive on how we think public companies will also think about and comply with 979. Because from a practical standpoint, for most public companies, it takes a minimum of three to six months, sometimes even longer to find a suitable board candidate.

Jackie Liu: So in ways, I don't think companies have the luxury of waiting to see whether or not the challenges to the law will come to fruition. And there are penalties under the bill, as well as I noted before, public perception issues. And so the companies are definitely taking steps to comply, and that's an instructive, because again, I think the same thing's going to happen with the diversity bill. And once in many ways, companies go through the boards, go through that process, even if the law later comes to the challenges are effective. If you have found suitable board candidate, the likelihood of the companies, then therefore, asking such suitable board candidates to resign seems a little unlikely. And so our assumption is there may be challenges to both sets of laws, but I think companies will comply. And once the implementation process is ongoing, in many ways, it really doesn't matter at the end of the day, whether or not the challenges constitutionality or otherwise wins the day. The company would've already started that process.

David Lynn: And what can boards do now in response to these legislative efforts toward promoting diversity?

Jackie Liu: Sure. That's a great question, Dave. I think that the boards first and foremost should not take an isolated approach to implementing the new law. Rather, I think the passage of this law should provide an additional impetus for boards of directors to consider the company's diversity and inclusion policies, as well as, frankly, board qualifications on a holistic level, right? The gender diversity law was a push in that direction. And I think this new law is a further push. So boards, I think, should think about the overall standards. You know, the board composition on an overall basis, whether or not the existing board members on the board fits the requirements of the company and what the company is doing now, as well as the future of the company, and understand what qualification gaps exist now on the board, and then intermix that with the gender and diversity requirements.

Jackie Liu: So in other words, if public company boards have not already implemented a board metrics analysis, they should do so now. So I think that's the first thing, is to look at board composition from a holistic level. Two, I think 2021, will come upon the boards very fast. You know, it doesn't sound like it's immediately effective, but a year is not frankly, not a long time when you think about board dynamics. So I think the board really needs to put in place a timetable for compliance. And so what that means is in many ways, unless the board trying to comply with the new standards are thinking about expanding their board size, in many ways, I think the new law, as well as the gender law, probably necessitates recomposition of the board. So more likely than not certain board members will be replaced by directors that comply with the law.

Jackie Liu: So it's really imperative for the 2021, process that companies usually go through for the board evaluation process that it be thoughtful, and that such evaluation process takes into consideration the board dynamics. What I mean by that is the board metrics, as well as, how the company will go about implementing the new law. And then third, as Alexa mentioned earlier, the law in terms of identifying the underrepresented communities very much focuses on self-identification. So therefore, the board in, should work with the legal department. And although this is a very sensitive topic, the board with the legal department should determine a method to solicit and gather information regarding the self-identification of its board members, so that the company can understand where are they with the current board composition and what they need to do to comply with the law. Fourth, once the timetable is determined, and the board has a better understanding of the gaps and what they need to do to comply with the new law, then board should relay to director search firms the characteristics of the potential candidates that they want, as well as the timetable.

Jackie Liu: And I think the process may not be as easy as it seems, because one significant consideration for boards would be over boarding, right? Given the law where it stands, our assumption is there's going to be a certain set of directors with the characteristics that comply with the law that will be very attractive. At least in the short run, until new candidates come into the Rolodex of these director search firms, a small subset will be very attractive and they will be very in high demand. And I think that's important for boards to consider that because you may have a perfect candidate that fits all your requirements, but that director may already be on four boards. And so you really should consider over boarding, given the time and commitment that you require of your directors, as well as the complexity of your business to determine whether or not, no matter how attractive a candidate is because it fits all the characteristics, whether or not he or she makes a good board member. And then in addition, I think that if you are a public company that works with the IR department or the legal department on an annual basis with a set timetable for institutional shareholder engagements, this is also the time that you should work on a script, because undoubtedly institutional shareholders will ask, what is the company doing? Like what steps you're taking, what's your timetable for complying with this new law? So I think that summarizes the very initial steps. I think the board in working with the legal departments should immediately start to consider.

David Lynn: Great. Thank you, Jackie and Alexa, for all of those insights on these important developments regarding board diversity.

Alexa Belonick: Great. Thank you Dave, for having us.

Jackie Liu: Thank you, Dave.

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