California Law Requiring Female Directors on Public Company Boards Held Unconstitutional

Ruling Follows Similar Decision on Underrepresented Minority Directors in April 2022

A California court has held that California Senate Bill 826, which required that “publicly held” corporations that listed a California address for their principal executive offices on the cover page of their Form 10-K reports must have specified numbers of female directors by certain dates, violates the California constitution and has enjoined the use of California taxpayer funds to carry out the 2018 law. This ruling follows the decision of another California court in April 2022 holding that California Assembly Bill 979 violated the California constitution and the issuance of a similar injunction preventing California from using taxpayer funds to implement that law. Assembly Bill 979 was enacted in 2020 to add a requirement that publicly held corporations that were already subject to Senate Bill 826 also have specified numbers of directors from “underrepresented minorities,” as defined in the law, by certain dates. If the state does not appeal these decisions and California appellate courts do not overturn these decisions, it appears that both of these legislative initiatives to promote more diverse representation on public company boards will have come to an end.

The Status of Diversity in U.S. Public Company Boardrooms

California and Other State Legislative Initiatives. Together, the two California decisions represent a visible legal setback to efforts to make public company boards more diverse. The California laws applied to any exchange-listed public company with its headquarters in California, based on whether the company listed a California address for its principal executive offices on its Form 10-K report, regardless of where the company was organized or conducted its business. The reach of these California laws therefore extended well beyond the typical scope of state corporate laws. However, although very visible, the practical impact of these decisions may not be immediately significant.

There are legislative initiatives to expand the diversity of public company boards in other states. Because the California decisions depend on interpretation of California constitutional provisions and perceived shortcomings in the legislative process, these decisions may have limited impact on pending initiatives in other states.

Nasdaq Gender and Demographic Diversity Rules. The California rulings have no effect on rules adopted by the Nasdaq Stock Exchange and approved by the U.S. Securities and Exchange Commission in August 2021 that require Nasdaq-listed companies (1) to disclose information about the gender and demographic self-identification of their directors and (2) to have specified numbers of directors who self-identify as female or as demographically diverse under Nasdaq rules or disclose why they do not, as described in an earlier Goodwin alert. Nasdaq engaged in a lengthy and detailed process to support its rulemaking, described in its 354-page proposal submitted to the SEC for approval. However, the Nasdaq rules are subject to pending legal challenges and the results of this litigation are difficult to predict. The New York Stock Exchange apparently has no similar amendments under consideration, which may reflect a reluctance to undertake the lengthy and costly process of proposing similar amendments until the outcome of the litigation involving the Nasdaq amendments is clearer.

Board Diversity Beyond the Mandates

It would be disingenuous not to acknowledge that the social debate and controversy about the merits of the diversity of directors serving as members of U.S. public company boards and the means of achieving greater diversity is taking place in a larger social and legal environment. Between the domain of legal and quasi-legal mandates, on the one hand, and increasingly bitter and sometimes violent conflict about the shape of U.S. domestic social norms, there are other influences operating on public company corporate governance. Of these, institutional investors are by far the most potent influence.

Institutional investors today can exercise unprecedented influence over corporate governance matters, and have never been more disposed to exercise their influence. As of mid-February 2022, five firms — Black Rock, Vanguard, UBS, Fidelity, and State Street — had more than $30.5 trillion dollars of assets under management. Each has voting policies that include diverse board composition as a prominent element, as do many other institutional investors. Proxy advisory services have also become increasingly focused on board diversity, and although they have arguably become followers rather than leaders in this area, their policies are at least indicators of the trajectory of diversity as a key part of U.S. public company governance. Although there are voices that are critical of the power — and liberal political priorities — of large institutional investors and proxy advisory services, there is currently no serious challenge to their voting power and influence. It is therefore likely that board diversity will continue to advance, however unevenly, as a result of shareholder voting rather than external mandates.

It should be noted that other Western economies have recently announced initiatives intended to expand the diversity of public company boards. The U.K. Financial Conduct Authority published new listing rules in April 2022 that will require listed companies to include a statement in their annual financial report setting out whether the company has met specific board diversity targets and expand current reporting requirements to cover the diversity policies of key board committees. In March 2022, EU member states agreed on a general legislative approach that is expected to result in greater gender equality on listed company boards.

Next Steps

California has 60 days to appeal the decisions involving Assembly Bill 979 and Senate Bill 826, so companies that would be subject to these laws should continue to monitor legal developments in these cases at least until the appeal periods expire.

Nasdaq-listed companies should similarly monitor the status of the legal challenges to the Nasdaq rules. Because there is no indication at this time that judicial action will delay or invalidate the Nasdaq rules, Nasdaq-listed companies should continue to consider their compliance plans. The Nasdaq rules permit companies that were listed on Nasdaq prior to August 6, 2021, to defer disclosure of the required director diversity matrix until August 8, 2022, or the date the company files its 2022 proxy statement, whichever is later. Companies listed on Nasdaq on or after August 6, 2021, have one year from the date of listing to disclose their director diversity matrix. The Nasdaq rules also include requirements that Nasdaq-listed companies have specified numbers of diverse directors or disclose why they do not, subject to a phase-in schedule. Director recruiting and onboarding are likely to require more lead time than gathering information about director self-identification, so companies should also consider this part of the Nasdaq rules.

Finally, most public companies will want to consider shareholder engagement matters and how the company wants to handle discussions with significant investors about board composition and corporate governance matters. As noted above, even if both California laws and the Nasdaq rules are overturned, there will be significant reasons for many companies to continue to focus on board composition and diversity.

The Goodwin Public Company Advisory Practice and allied Goodwin practices will continue to monitor developments in this area. At this time, we expect to maintain the Goodwin Year-End Tool Kit Director and Executive Officer Questionnaire in its current form at least until the appeal periods for the two California decisions expire, but have added a note regarding the two decisions. We will monitor developments and make decisions about revisions when the status of Assembly Bill 979 and Senate Bill 826 changes or if there are other developments that would affect the diversity portions of the questionnaire.