October 15, 2020
Two years after passing legislation requiring California-based companies to include women on their boards of directors, the state has enacted a bill to expand that mandate to members of a broad range of underrepresented communities. At the signing ceremony on September 30, 2020, the bill’s co-author urged other states to follow California’s lead. That same day, a lawsuit was brought seeking to overturn the new legislation as unconstitutional. How should pension trustees incorporate this information into their own deliberations about diversity issues? The answer, as always, starts with adherence to fundamental fiduciary principles.
Background on Diversity Requirement
Under the law, California companies must appoint at least one board member from underrepresented communities by 2021 and, depending on the size of the board, two or three such directors by 2022. The law defines a member of an underrepresented community as someone who self-identifies as “Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, or Alaska Native” or as gay, lesbian, bisexual, or transgender.
The law permits the California Secretary of State to impose fines for violations of the law. Lawmakers cited data from a 2018 study from Deloitte and the Alliance for Board Diversity that found 84% of Fortune 500 company board seats were held by individuals who identified as white, a number that they noted is significantly higher than that group’s share of the general population.
This legislation follows another first-in-the-nation California law enacted in 2018 that mandated that the boards of publicly traded companies headquartered in the state include female directors. That law required corporations to include at least one female director by 2019 and, depending on the size of the board, two or three female directors by the end of 2021. When that law was passed, 29% of California-headquartered companies had all-male boards and, by 2019, the percentage had dropped to 4% according to a study by the KPMG Board Leadership Center.
The new law has already been challenged in state court by the same groups that sued to contest the 2018 law. The same day the new law was signed, three California taxpayers, backed by a conservative national nonprofit, filed a complaint in California Superior Court alleging that the new law violates the state constitution.
Other constitutional law experts do not share that view. For example, Dean Erwin Chemerinsky of the UC Berkeley School of Law has said he believes there is a strong argument that the laws are constitutional, since there is a compelling need to enhance diversity on corporate boards.
It will remain for the courts to decide whether these laws are sufficiently narrowly tailored to meet the compelling need. Institutional investors increasingly have focused on board diversity and have been evaluating companies that lack sufficient board diversity. Just a week before the California law was enacted, Connecticut State Treasurer Shawn T. Wooden announced that his office was partnering with the Ford Foundation to assemble a coalition of CEOs to confront longstanding racial economic disparities and their impact on the nation’s economy, including increasing diversity on their boards.
Contrast with Recent DOL Proposals
The California Law stands in sharp contrast to recent action of the U.S. Department of Labor (DOL) in proposing regulations under the Employee Retirement Income Security Act (ERISA) in two areas: consideration of environment, social, and governance (ESG) factors when making investment decisions, and shareholder rights including proxy voting.
In June 2020, in proposing regulations in the area of ESG the DOL stated that “ESG investing raises heightened concerns under ERISA.” According to the DOL, the growing emphasis on ESG investing may be prompting fiduciaries to make investment decisions for purposes other than the only permissible reasons—to provide benefits to participants and beneficiaries and defray reasonable expenses of administering the plan.
The proposed regulations are intended to confirm that ERISA requires plan fiduciaries to select investments based solely on financial considerations that are relevant to the risk-adjusted economic value of a particular investment. They also make clear that fiduciaries may not invest in ESG vehicles when they understand an underlying investment strategy of the vehicle is to subordinate return or increase risk for the purpose of what DOL refers to as non-pecuniary objectives.
While the DOL acknowledges that ESG factors may qualify as economic considerations, they caution that this is true “only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories.”
In August, the DOL released a proposal to amend its regulations to address the application of ERISA’s fiduciary duties of prudence and loyalty to the exercise of shareholder rights in the area of proxy voting. The DOL reiterated that fiduciaries may not subordinate the interests of plan participants and beneficiaries in their retirement income to any non-pecuniary objective. Stating that there appears to be a view among some that plan fiduciaries are required to vote all proxies, the proposed rule would instead provide that proxies may be voted only when the fiduciary prudently determines that the matter being voted upon would have an economic impact on the plan. The proposal contains a new provision under which plan fiduciaries must require that investment managers and proxy voting or advisory firms sufficiently document the rationale for proxy voting decisions or recommendations in order to demonstrate that the rationale was based upon the expected economic benefit to the plan.
DOL’s proposals have significance even for public pension plans because although ERISA is not binding on public pension plans, it does establish principles that set standards of conduct that inform the nature of fiduciary duty even for public plans.
It is clear that consideration of diversity is a topic of importance today to institutional investors including public pension plans and will likely remain so in the future. In light of increasing attention and assessment of advantages from corporate board diversity and engaged corporate governance on such social issues through proxy voting, fiduciaries will undoubtedly remain cognizant of these issues. What, then, is the role of a prudent fiduciary when addressing such issues? Fiduciaries may consider such issues provided they do so in a manner that reflects proper attention to their fiduciary duties.
Focus should be on the fundamental aspects of fiduciary duty. First, the underlying fiduciary principles—i.e., the exclusive benefit rule and the duties of loyalty, prudence, and care—must remain paramount. In addition, it is important to note that fiduciaries are judged by the process undertaken to reach decisions so that establishment of a reasonable decision-making process and adherence to that process help to demonstrate prudence. Finally, documentation of the process is key to demonstrating prudence. Fiduciaries would be well served by documenting the important effect of diversity from the perspective of material economic considerations, whether they are looking at corporate board performance or at investment risk, return and performance. The prudent fiduciary will be well served by a focus on these fundamentals.