Board Diversity in the Balance: Federal Court Holds that California’s Board of Directors Diversity Requirement Violates Equal Protection

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Public Company Advisory Client Alert:

On May 15, 2023, the U.S. District Court for the Eastern District of California granted summary judgment for the Alliance for Fair Board Recruitment, finding that California Assembly Bill (AB) 979 violates federal law.^[1] AB 979, in relevant part, required publicly held companies headquartered in California to have a minimum number of directors from designated underrepresented racial, ethnic, and LGBTQ backgrounds. The court concluded that the racial and ethnic classifications created impermissible quotas and that the unconstitutional aspects of the bill could not be severed.

AB 979 Created Impermissible Race-Based Quotas

On September 30, 2020, California passed AB 979, adding California Corporations Code Sections 301.4 and 2115.6. The bill required California-headquartered public companies to appoint to their boards a minimum number of individuals from underrepresented groups. The legislation defined underrepresented groups to include individuals of “Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, or Alaska Native . . . gay, lesbian, bisexual or transgender” communities. The minimum number of directors from these groups depended on the size of the corporation, with such number ranging from one to three persons. Noncompliance could result in a $100,000 fine for an initial violation and a $300,000 fine for subsequent violations.

The Alliance for Fair Board Recruitment, a Texas non-profit with members who are seeking employment as corporate directors and do not identify as members of an underrepresented group, as well as shareholders of publicly traded companies headquartered in California, filed a lawsuit in the U.S. District Court for the Eastern District of California challenging the legislation under the Equal Protection Clause of the Fourteenth Amendment to the U.S. Constitution. The Alliance for Fair Board Recruitment also contended in the suit that the statute violated the prohibition in 42 U.S.C. §1981 against discrimination on the basis of race in the making and enforcing of contracts by hindering those who do not identify as members of the favored class from securing contracts for board positions at California-headquartered corporations. Relying on the United States Supreme Court’s affirmative action jurisprudence, the federal district court found AB 979 facially unconstitutional. The court reasoned that the legislation created a racial quota because it mandated that a board’s composition consist of a fixed number of “Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, or Alaska Native” individuals. Despite the bill’s aim at remedying past discrimination, the court emphasized that prior cases such as Grutter v. Bollinger, 539 U.S. 306 (2003) prohibit states from establishing racial quotas. The court also granted summary judgment for the Alliance for Fair Board Recruitment with respect to its claim that the statute violated the prohibition in 42 U.S.C. §1981. Therefore, the court determined that California could not force companies to reserve board seats for certain minority groups.

The Court’s Treatment of LGBTQ Groups

Since the court had only found the racial and ethnic classifications in AB 979 to be unconstitutional, it went on to address whether AB 979 could require corporations to have a board member from an LGBTQ background. To determine if AB 979’s unconstitutional provisions (i.e., the racial and ethnic classifications) could be severed, the court turned to California state law. California law allows severability when (1) it would not affect the remaining statute’s wording or coherence, (2) the remainder of the statute is complete in and of itself, and (3) there is an indication that the legislature still would have adopted the bill without the unconstitutional portions.^[2] In this case, the court could not extricate the legislation’s references to LGBTQ groups because AB 979’s language was “almost exclusively cast in racial and ethnic terms.”

The court noted two additional points contributing to AB 979’s lack of severability. First, California’s Secretary of State stated that the main purpose of AB 979 was to remedy racial and ethnic discrimination. Second, AB 979 did not have a severability clause indicating that the legislature would have adopted the remainder of the statute if the racial and ethnic classifications were deemed invalid. Thus, the court struck down AB 979 in its entirety.

Looking Ahead

This decision follows closely on the heels of last year’s ruling from the Los Angeles Superior Court regarding California’s Senate Bill (SB) 826, which is currently on appeal.^[3] In that case, the California state court held that SB 826, which required gender diversity for public companies headquartered in California, was unconstitutional. These two decisions are particularly pertinent to the pending Fifth Circuit decision in the petitions by the Alliance for Fair Board Recruitment and the National Center for Public Policy Research under Section 25(a) of the Securities Exchange Act of 1934 (the Act) for review of the final order by the Securities and Exchange Commission (SEC) approving Nasdaq’s board diversity rules. In 2021, the SEC approved Nasdaq’s proposed board diversity rules, which establish a “disclosure-based framework” under Nasdaq listing rules 5605(f) and 5606. Rule 5605(f)(2) requires each Nasdaq-listed company (with specified exceptions) to have, or explain why it does not have, at least two diverse board members, including at least one who self-identifies as female and at least one who self-identifies as an underrepresented minority or LGBTQ+. Under Rule 5605(f)(2)(D), each company with a board of directors of five or fewer members (referred to as a “company with a smaller board”) would need to have, or explain why it does not have, at least one board member who is diverse. If a Nasdaq-listed company elects disclosure in lieu of compliance with the diversity objectives, the company would be required to identify the applicable requirements and explain the reasons why it did not satisfy them. The petitioners in Alliance for Fair Board Recruitment, National Center for Public Policy Research v. Securities and Exchange Commission have asserted that the listing rules issued by Nasdaq and approved by the SEC constitute state action that is subject to constitutional restraints.[4] Specifically, they contend that the SEC’s order approving Nasdaq’s proposed listing rules violates the constitutional right to equal protection because it “encourages discrimination against potential board members and also by current board members and shareholders; and it stigmatizes board members who identify as one of the preferred demographics.”^[5] They further assert that the order violates the First Amendment by demanding disclosure of controversial information, which the Supreme Court has prohibited absent compelling justifications and narrow tailoring.^[6] In addition, the petitioners contend that the SEC’s order violated the Administrative Procedure Act,^[7] that the “SEC lacked statutory authority to issue the order, which seeks to regulate demographics through the guise of ‘financial disclosures,’”^[8] and that the SEC's order violates the Vesting Clause in Article I of the Constitution “because it is an exercise of sweeping legislative power to regulate demographics that Congress could not have delegated.”^[9] Although the Nasdaq board diversity rules have been framed as a disclosure-based framework, rather than a mandate, and the SEC’s role in reviewing proposed rules is limited to determining whether the rule is consistent with requirements specified in the Act, Alliance for Fair Bd. Recruitment v. Weber may nonetheless foreshadow the outcome of the equal protection challenge to the SEC’s approval of Nasdaq’s board diversity rules.

For additional information about any of the above developments, or to discuss any questions that you may have, please contact a member of Maynard Nexsen’s Public Company Advisory Group.

_{[1] A copy of the court order can be found here: Alliance for Fair Board Recruitment v. Weber: Court Order.
[2] Cal. Redev. Ass’n v. Matosantos, 267 P.3d 580, 608 (Cal. 2011).
[3] Crest v. Padilla, Case No. 19STCV27561: Verdict
[4] See Brief for The Alliance for Fair Board Recruitment, All. for Fair Bd. Recruitment, Nat’l Ctr. for Pub. Policy Research v. SEC, No. 21-60626 (5th Cir filed August 9, 2021).
[5] Id at 1.
[6] Id at 42.
[7] Brief for The National Center for Public Policy Research, All. for Fair Bd. Recruitment, Nat’l Ctr. for Pub. Policy Research v. SEC, No. 21-60626 (5th Cir filed August 9, 2021).
[8] Brief for The Alliance for Fair Board Recruitment at 1.
[9] Brief for The National Center for Public Policy Research at 1.}

^{This Client Alert is for information purposes only and should not be construed as legal advice. The information in this Client Alert is not intended to create and does not create an attorney-client relationship.}