The Crest Opinions: Impeding Legislative Efforts to Diversify Corporate Boards

I. INTRODUCTION

It’s no secret that most directors on corporate boards in the United States are white men—in 2021, approximately 60% of the board seats at S&P 500 companies were occupied by white men. Several states have tried to address this issue by enacting legislation aimed at increasing board diversity. California was the first state to impose gender diversity on boards when it passed Women on Boards (SB 826) in 2018, mandating corporations with executive offices in California to have at least one woman on their board by December 2019 and to add more women in subsequent years. In 2020, California expanded its efforts to increase board member diversity and passed AB 979, mandating those same corporations include at least one director from an underrepresented community by December 31, 2021.

In April 2022, Los Angeles County Superior Court Judge Terry Green ruled that AB 979 was unconstitutional when he granted the plaintiff’s summary judgment motion. The following month, Judge Maureen Duffy-Lewis of the same court determined that SB 826 was unconstitutional following a six-week trial. In addition to being a setback to the efforts in California, these rulings pose new obstacles to other existing and contemplated legislation designed to increase board diversity.

II. WHAT ARE BOARD DIVERSITY LAWS?

Board diversity laws aim to enhance gender and other types of diversity on corporate boards. California’s SB 826 applied to publicly traded corporations with their principal executive offices in the state. These covered corporations were required to have at least one female director by the end of 2019, either by filling an open seat or by adding a seat, and by the end of 2021, covered corporations were required to have certain minimum numbers of female directors based on the total size of the board. Covered corporations were required to make an annual filing with the Secretary of State stating the total number of directors and female directors. Failure to timely file this board member information or to meet the minimum requirements was punishable by fines ranging from $100,000 to $300,000.

Similar to SB 826, AB 979 applied to corporations with their principal executive offices in the state. The law required these covered corporations to include at least one director from an underrepresented community by December 31, 2021, and covered corporations were required to have certain minimum numbers of directors from underrepresented communities depending on the size of their board by December 31, 2022. The bill defined an individual from an underrepresented community 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” and imposed the same annual filing requirements, as well as fines for non-compliance, as SB 826.

Other states have passed their own versions of board diversity legislation or are considering doing so. Some states have focused solely on increasing the number of women on boards while others have passed legislation that also includes other underrepresented groups. In 2017, Colorado passed a legislative resolution calling for equitable and diverse gender representation on the boards of publicly held corporations headquartered there, but it has not passed any legislation requiring corporations to make changes. Some states, like Maryland and Illinois, have chosen to require corporations to disclose the total number of directors and total female directors, but do not impose a mandatory minimum number of female directors. (In addition to reporting on the gender of each board member, the Illinois law also requires disclosure of whether each member self-identifies as a racial minority and which race or ethnicity to which the person belongs.) Only one other state, Washington, has passed a law that mandates a minimum number of women on boards. Effective January 1, 2022, Washington’s law requires a public company to maintain a board of directors that is composed of individuals at least 25% of whom self-identify as women, or to provide its shareholders a discussion and analysis concerning its approach to board diversity in advance of its annual meetings. One key difference between Washington’s law and California’s legislation is that Washington’s law is “comply or explain,” meaning that it does not impose a monetary fine for failure to comply. Other states, like Pennsylvania and Michigan, have introduced legislation that would require a minimum number of female directors on a corporate board, but have not yet passed that legislation.

NASDAQ has also sought to encourage board diversity. In August 2021, the SEC approved the Board Diversity Proposal, which is another “comply or explain” rule that requires each NASDAQ-listed company to publicly disclose information on the voluntary self-identified gender and racial characteristics and LGBTQ+ status of board members. Each company would also be required to have, or explain why it does not have, at least two diverse board members, one of which must be female.

III. LEGAL CHALLENGES TO CALIFORNIA’S SB 826 AND AB 979

The lawsuits challenging both SB 826 and AB 979 were filed by California taxpayers against the California Secretary of State; both are styled Crest v. Padilla. The lawsuit challenging SB 826 is commonly referred to as Crest I and the lawsuit challenging AB 979 as Crest II.

Plaintiffs in both lawsuits challenged the legislation under the Equal Protection Clause of the California Constitution. Both courts noted that the first prerequisite to stating a claim under the Equal Protection Clause is showing that the State has adopted a classification that affects two or more “similarly situated” groups in an unequal manner. That showing was made in each case because the board selection process does not differentiate between people based on their race, gender, and/or LGBTQ+ status. Having reached that conclusion, both courts found that the challenged legislation was presumptively unconstitutional and the burden shifted to the Secretary of State to demonstrate (1) a compelling state interest, (2) that the legislation was necessary, and (3) that the legislation was narrowly tailored (in other words, that it survived strict scrutiny).

Both courts found the legislation lacked a compelling state interest. Remedying discrimination is only a compelling state interest if the government can identify a specific arena in which discrimination has occurred and is able to connect any proposed remedial measures to that arena. The Crest I court emphasized that “[g]eneralized assertions of discrimination in a particular region or industry are insufficient to give rise to a compelling government interest.” (Crest v. Padilla, LASC No. 19STCV27561.) In both cases, the Secretary argued that the compelling state interests were remedying discrimination in the board selection process and the various public benefits that would result from having more profitable corporations in the State. Specifically, the Crest II court summarized the Secretary’s argument on the increased public benefits as more diverse boards would lead to more profitable corporations and more profitable corporations, in turn, would result in better investment returns for public pension plans, more tax revenue for the state, better corporate integrity and oversight, and other benefits. (Crest v. Padilla (LASC No. 20STCV37513) 2022 WL 1073294, *11.)

Both courts soundly rejected this position. With regards to the interest of remedying discrimination, corporate boards—the arena where the discrimination occurred—was not sufficiently specific. The Crest II emphasized that an arena that “cover[ed] the entire nation and all industries” could be “neither confined nor specific.” (Id. at *12.) Nor did the Secretary produce convincing evidence of discrimination in that arena. It offered no reliable studies demonstrating that discrimination occurred in the board selection process. With respect to public benefits, the Crest II court held that the State’s interest in boosting the economy was not sufficiently specific or immediate to permit the use of suspect classifications, observing that “the state’s generic interest in healthy businesses is not sufficiently specific or immediate to permit the use of suspect classifications.” (Id. at *16.) The Crest I court determined that, despite the fact that the Secretary argued that public benefits were one of the compelling state interests, none of the evidence actually suggested this was a purpose of the bill itself—the text of the bill and other evidence of the legislative process showed that the actual goal was to get more women on boards and increase gender equity on boards; the Secretary’s failure to offer evidence quantifying the expected boost to the California economy or the other expected public benefits undermined its argument that it actually considered those benefits to be a legitimate state interest.

With regard to the second factor, whether the legislation was necessary, the Crest I court found that the Secretary failed to show that the use of a gender-based classification was necessary to achieve the State’s goals because the studies the Secretary relied on to show necessity “failed to sufficiently show a causal connection between women on corporate boards and corporate governance and did not otherwise provide reliable conclusions.” The Crest II court did not separately address this factor.

Finally, neither court was persuaded that the legislation was narrowly tailored. Indeed, the Crest II court observed that this is where the law “rests on the thinnest ice.” (Crest II, 2022 WL 1073294, *17.) The Crest II court determined there were other means the State could have used to increase diversity, including “the simplest and most obvious ... a disclosure requirement.” (Id. at *18.) The Crest I court found that the State failed to show that the legislation was narrowly tailored because, among other things, the Legislature did not consider amending existing anti-discrimination laws or enacting new anti-discrimination laws focusing on the board selection process before enacting SB 826, nor did it prove that the use of a gender-based classification was actually remedial. Having determined that the respective legislation before them was unconstitutional, both judges enjoined the laws.

IV. THE FUTURE OF BOARD DIVERSITY LAWS

Do the Crest opinions spell doom for board diversity laws? It’s hard to tell. First, the decisions may not stand. The California Secretary of State has appealed the ruling in Crest I and that appeal of course has the potential to result in reversal. Nevertheless, those who oppose board diversity statutes will likely feel emboldened to challenge existing board gender legislation, especially any that has a mandatory minimum requirement, following the two Crest rulings. Other courts will likely look to the Crest opinions in ruling on future challenges. Those statutes that merely require disclosure, rather than imposing any mandatory minimum, may fare better since they do not actually require companies to change the composition of their boards. The Crest II court even suggested such requirements may be permissible.

NASDAQ’s Board Diversity Proposal will likely be the next test and has the potential to further shape the future of board gender diversity laws. That proposal is currently being challenged in the Fifth Circuit.

The Crest opinions at a minimum will ensure that the slow-moving nature of the efforts towards increasing diversity in this context will not speed up, or may even slow down further. Hopefully, corporations will continue learning the value of diversity on their own and taking steps to address the problem without waiting to be forced to do so.

Rachel Naor is counsel at London & Stout P.C., a litigation boutique in Oakland.