Double Trouble: California Set to Challenge Two Decisions Rejecting Diversification of Corporate Boards

Last week, the California Secretary of State appealed a decision by the Los Angeles County Superior Court striking down the second of California’s two board diversity laws, which required all publicly traded companies headquartered in California to include a minimum number of female directors. The appeal will challenge the court’s finding that the board diversity legislation violates the Equal Protection Clause of the California Constitution because its classification of director candidates based on gender does not further a compelling government interest.

In addition, the same court—acting through a different judge—has also overturned California’s other board diversity statute, which required boards of publicly traded companies headquartered in California to include at least one director from an “underrepresented community” on their board. This decision was appealed in June.

The rulings, if not overturned on appeal, spell an end to California’s board diversity requirements as currently framed. Both courts rejected arguments by the state that remediating discrimination against women and members of underrepresented communities, and enhancing corporate performance through board diversity, constitute compelling state interests justifying the statutes’ diversity requirements. These rulings come even as institutional investors and activist shareholders apply mounting pressure to diversify corporate boards.¹

Below, we provide additional background on the two trial court rulings and a summary of what will likely happen next in the two cases.

Background

In 2018 and 2020, California enacted two statutes mandating diversification of boards of publicly traded companies with “principal executive offices” in California. These statutes authorized the state to track the composition of those boards and to issue fines for non-compliance. Senate Bill 826 (SB 826), enacted in 2018 and codified as Corporations Code section 301.3, required publicly traded companies headquartered in California to appoint a minimum number of female directors. Two years later, Assembly Bill 979 (AB 979), codified as Corporations Code Section 301.4, imposed a similar regime for directors from “underrepresented communities,” defined in the statute to include members of racial minorities and the LGBTQ+ community.

Champions of both initiatives emphasized that legislative action was necessary to correct discrepancies in the composition of boards, which were disproportionately white, cisgender, and male. Supporters emphasized that diversification of boards would not only address and remedy discrimination but also improve corporate performance, thereby enriching California and benefiting the public.

Legal challenges were swift. Opponents of the statutes filed suits both in state and federal courts asserting that the statutes employed unconstitutional classifications of board candidates, based on gender and race, that did not serve a compelling government interest. And, as noted above, in two state cases the California courts agreed. The federal case is pending and being held in abeyance until any appeal of either state court decision becomes final.²

On April 1, 2022, in Crest v. Padilla (Crest - AB 979), Judge Green—of the Los Angeles Superior Court—held that Section 301.4, which mandated appointment of directors from underrepresented communities, violated the California Constitution’s Equal Protection Clause.³ The court concluded that the law resulted in disparate treatment of similarly situated qualified candidates for corporate boards on the basis of their race, sexual orientation, or gender identity,⁴ triggering strict scrutiny.⁵ The court concluded there was no compelling government interest to treat candidates from underrepresented communities differently from others, in part, because it found no “convincing evidence” of discrimination against those candidates.⁶ 

To support the statute, the state put forward statistical evidence of underrepresentation of diverse candidates on boards compared to their presence in the general population.⁷ However, the state did not submit evidence of such a statistical discrepancy between directors and qualified candidates.⁸ To the contrary, the state explained that the pipeline of candidates were C-suite executives who, like the directors themselves, were largely white, cisgender males.⁹ In rejecting the state’s purported compelling interest in remediating this discrepancy at the corporate board level, the court distinguished between evidence suggesting discrimination in the formation of the candidate pool and discrimination in the choice of candidates from that pool for director seats.¹⁰ It observed that while the statistics might constitute “evidence of discrimination in selection of C-suite executives,” that issue was not before the court.¹¹ 

The court was unwilling to assume that this discrepancy in the pipeline was the result of past, overt discrimination. Instead, in a footnote, it postulated that “any robust notion of cultural pluralism requires a factfinder to at least consider the possibility that the presence or absence of a given group in a given industry is the product of benign cultural preferences.”¹² The court also rejected arguments by the state that the statute furthered a compelling government interest because diverse boards employ more inclusive workplace standards and strengthen corporate performance.¹³ While the court did not question these benefits, it held that a “state’s generic interest in healthy businesses is not sufficiently specific or immediate to permit the use of suspect classifications.”¹⁴ 

On May 13, 2022, Judge Duffy-Lewis—also of the Los Angeles Superior Court—reached a similar conclusion in a second action also titled Crest v. Padilla (Crest - SB 826). The court abrogated Section 301.3, which mandated the appointment of a minimum number of females to boards, concluding that the statute violated the Equal Protection Clause of the California Constitution. Judge Duffy-Lewis reasoned that, because the statute afforded disparate treatment to qualified candidates for corporate board positions on the basis of gender, without furthering a compelling government interest, it violated equal protection.¹⁵ Echoing Crest - AB 979, the court reasoned that while discrepancies may exist in how individuals come under consideration as board candidates, the board selection process did not differentiate between men and women.¹⁶ The Crest - SB 826 court also ruled that the state failed to put forward “strong” evidence to show that including women on boards served a compelling state interest.¹⁷ Like the Crest - AB 979 court, the Crest - SB 826 court was not persuaded by claims concerning the economic benefits of diversification and found that adding women to boards was not necessary to “boost California’s economy.”¹⁸

The Crest - SB 826 court concluded that the state’s empirical evidence of the economic benefits associated with corporations having more female board members was unpersuasive, stating “the studies [the state] cited failed to sufficiently show a causal connection between women on corporate boards and [improved] corporate governance and did not otherwise provide reliable conclusions.”¹⁹ The court further opined that the state’s purported interest in “gender-balancing” did not further a state interest in “remedying discrimination.”²⁰ Implicit in this conclusion is the idea that the disparity between men and women on boards may be attributable to some factor other than discrimination, perhaps the same “benign cultural differences” cited, but not explained, by Judge Green in Crest - AB 979.²¹

Future Outlook

It remains to be seen how the statutes will fare in the appellate courts. Appeals in both Crest - AB 979 and Crest - SB 82 are pending.

On appeal, the state can be expected to raise again a variety of points made in the trial court actions, including the following: (i) Contrary to the challengers’ arguments, these statutes do not impose a “quota” that excludes some candidates but instead requires only that each board have a critical mass of diverse board members; (ii) A company can choose to increase the total number of board seats such that the diverse board members are merely additive; and (iii) A critical mass of diverse board members furthers the state’s interest in allowing diverse members true participation on a board, given that a lone diverse member, for instance, is not as likely to be truly heard and bring the full benefits of diverse perspectives into the boardroom.

In addition, the state will likely argue again that the nature of board recruitment and appointments make it impossible to prove individualized discrimination, as both Crest - AB 979 and Crest - SB 826 concluded was necessary, because pursuing remedies for generalized discrimination is not a sufficiently compelling interest. Board appointments are not made through a public or even systematized process; one does not apply to be a board member. Rather, board members and sometimes recruiters identify candidates who are then approached, but the pool of candidates is mostly drawn from the board members’ or recruiters’ informal networks. That system tends to replicate existing demographics of board members. It is impossible, given this network-driven system, to prove that any particular woman or member of an underrepresented community has been discriminated against.

The appeals will most likely, at the earliest, be decided next year.

© Arnold & Porter Kaye Scholer LLP 2022 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.