26 April 2022

Fate of Board Diversity Requirements In Jeopardy

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Recent efforts by the California Legislature to increase corporate boardroom diversity hit a road bump due to the Los Angeles County Superior Court decision earlier this month in Crest v. Padilla, Case No. 20-STCV-37513, which held that California Corporations Code § 301.4 (“Section 301.4”) is unconstitutional. The statute, ruled the court, poses a “present total and fatal conflict” with the Equal Protection Clause of the California Constitution.

The Statute. Section 301.4 is the result of Assembly Bill (AB) No. 979, signed into law in late 2020.  In relevant part, the statute requires that publicly held corporations with principal executive offices in California have at least one director from an “underrepresented community” (defined 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”) on its board by end of 2021. By 2022, boards of five to eight directors are required to have at least two qualifying directors and boards of nine or more directors are required to have three qualifying directors. The statute gives the Secretary of State the ability to impose fines of $100,000 for initial non-compliance, and $300,000 for subsequent violations.

Section 301.4 is the second California statute to address diversity on boards in recent years:  in 2018, Corporations Code § 301.3 (“Section 301.3”) (previously Senate Bill (SB) No. 826), which mandates gender diversity on corporate boards with similar requirements, was enacted. Both statutes have been the subject of legal challenges since becoming law, but the Crest decision concerning Section 301.4 is the first to find either statute unconstitutional.

The Challenge. Crest v. Padilla was brought pursuant to California Code of Civil Procedure Section 526a, which allows a California taxpayer, even if not himself an injured or threatened party, to challenge the actions of a government official who is using taxpayer funds for an improper or illegal purpose.  Cal Code Civ. Proc. § 526a. In the instant case, Plaintiffs (who are California taxpayers associated with Judicial Watch) assert that Section 301.4 imposes an improper duty on corporations to have a certain number of directors from certain demographic groups and that the Secretary of State necessarily has misused taxpayer funds to gather information for the purpose of enforcing this law.

On cross-motions for summary judgment, Plaintiffs brought a facial challenge to Section 301.4 under California’s Equal Protection Clause, Article I, Section 7, arguing that the law uses suspect classifications for the determination of board seats where no compelling state interest has been shown nor where the State has established that it is the least restrictive means available to meet such an interest.

The Ruling. The court held for Plaintiffs, finding that Section 301.4 poses a “present total and fatal conflict” with the Equal Protection Clause by imposing a duty on corporations to use suspect demographic categories in the selection of board members, to the exclusion of people from other races, sexual orientations, or gender identities. In so holding, the court explained that the relevant set of “similarly situated” individuals to examine were those individuals qualified to sit on corporate boards. Because board qualified individuals are members of the demographic groups listed in the statute and members of the unlisted demographic groups, the court concluded that similarly situated individuals were being treated differently under the law. The court thus rejected the Secretary’s argument that the existence of discrimination and historical underrepresentation differentiated the listed from unlisted groups and further questioned the manner and basis for the identification of the listed groups.

Having found a facial violation of the Equal Protection Clause, the court proceeded to consider and reject the Secretary’s proffer of two compelling state interests to justify the statute. First, the Secretary argued that there is a compelling interest in remediating discrimination in corporate board member selection. But the court found this was too generalized to be sufficient:  the court opined that little evidence had been presented to support that discrimination had occurred within the “arena” of the corporations regulated by the statute. As the court commented, “[n]o one in the record appears to have made any effort to identify, define, or survey the qualified talent pool for director positions.” Second, the Secretary argued that California has a compelling interest in obtaining the public benefits of more diverse boards, such as more tax revenue from more profitable corporations, improved corporate integrity, and more inclusive workforces. Again, the court was not persuaded that the state’s “generic interest in healthy business can constitute a compelling state interest.”

Finally, the court observed that even if the Secretary had shown a specific, compelling interest, the statute was not narrowly tailored to serve that interest because other “obvious and neutral” measures were not attempted (and in one instance, rejected), including voluntary surveys, seminars, public disclosures of board composition, and tracking and collection of demographic leadership data. “Before the Legislature may require that members of one group be given certain board seats, it must first try to create neutral conditions under which qualified individuals from any groups may succeed….That attempt was not made in this case.”

Conclusion. The decision in Crest v. Padilla will have implications beyond the legality of Section 301.4.  As noted at the outset, Section 301.3 mandates gender diversity on corporate boards under a similar structure to Section 301.4. Judicial Watch, the plaintiffs in Crest, have another lawsuit regarding SB 826 also pending before the Los Angeles County Superior Court and now have a potential roadmap to a successful constitutional challenge there as well. See Crest v. Weber, Case No. 19-STCV-27561.

We expect the State of California will seek appellate review in Crest v. Padilla, although the Secretary has not yet announced whether the state intends to appeal the decision. If so, it will have 60 days following the rendition of judgment to file its notice of appeal.