What Boards Need To Know About D&O Diversity Claims

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The pressure on boards to diversify will only rise. Following are the two most common legal risks to directors, and how to take proactive steps to mitigate.

As part of the increased focus on diversity, equity and inclusion, corporate boards of directors are receiving unprecedented levels of scrutiny. Below is a summary of ways boards have been scrutinized, and proactive steps to take in response to this trend.

1. Recent Legislation to Promote D&O Diversity

Both state and federal legislatures are enacting laws addressing corporate diversity. For example, California enacted AB 979 requiring California-headquartered public corporations to have at least one board member from an “underrepresented community” by the end of 2021. By the end of 2022, corporations with one to four board members must have at least one board member from an underrepresented community, five to eight board members must have at least two, and corporations with nine or more must have at least three. AB 979 defines underrepresented communities as “Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, or Alaska Native, gay, lesbian, bisexual or transgender.”

The law applies to all publicly-held corporations whose principal executive offices identified in the company’s 10-K form are located in California. Notably, the state of incorporation is irrelevant; so a corporation incorporated in Delaware with its principal office in California would be subject to the law. The law adds to an existing law, SB 826, which requires California corporations to have a minimum number of women on public company boards.

Additionally, in November 2019, the U.S. House of Representatives passed H.R. 5084, the “Improving Corporate Governance Through Diversity Act.” This bill would require issuers of securities to disclose the racial, ethnic and gender composition of their boards of directors and executive officers, as well as the status of any of those directors and officers as a veteran, and to disclose any plan to promote racial, ethnic and gender diversity among these groups. The Senate has not taken up the bill.

2. Complaints Against Corporations for Lack of Diversity

Over the last several months, an increasing number of derivative and shareholder lawsuits have been filed in federal court complaining of a lack of diversity among corporate boards and executive management. Typically filed without a pre-litigation demand, these lawsuits allege that board members and directors breached their fiduciary duties to shareholders by falling short of their commitment to diversity.

The complaints claim breach of fiduciary duty, unjust enrichment, and proxy solicitation violations. They quote statements by the company lauding its diversity efforts, then contrast that with any prior discrimination claims against the company, statistics regarding lack of diversity at senior levels, and a description (often with photographs) of the racial makeup of the board. They allege that statements regarding the company’s efforts to promote diversity (including statements in proxy materials) were false and intended to mislead shareholders and the market. Further, the complaints typically include statistics and quotes that can be plugged directly into social media or press coverage (such as saying a company should have a “blacks need not apply sign” at corporate headquarters).

As relief, plaintiffs seek disgorgement of any compensation and benefits paid to the named directors and officers; large donations to philanthropies that promote diversity; changes to company policies (e.g. arbitration provisions, confidentiality agreements); punitive damages; and attorneys’ fees.

The Lawsuits’ Likelihood of Success and Recommendations Moving Forward

Plaintiffs in these actions will likely face difficult challenges identifying and quantifying damages to the company resulting from the absence of diversity. Accordingly, it is unlikely that plaintiffs will prevail on the merits. However, if you define success as subjecting corporations to adverse publicity to effect change, the jury is still out.

To prevent these types of lawsuits, companies should evaluate statements in support of social justice and diversity and ensure that their actions align with those statements. We expect the pressure on boards to diversify (from litigants, legislatures, regulators, and investors) to continue. Savvy corporations will want to evaluate their vulnerability to these efforts (ideally with general or outside counsel to keep the evaluation privileged) and determine what, if any, actions are necessary. Companies should also evaluate the process for nominating board members to ensure the process is compliant with the company’s diversity and inclusion policies and statements.

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