In the wake of Black Lives Matter protests over racial inequality, a number of companies including Oracle, Facebook, Qualcomm, Norton LifeLock and The Gap have been hit with lawsuits related to board diversity.
The complaints in each of these lawsuits are very similar: Shareholders, acting derivatively on behalf of the subject company, allege that the board of directors violated their fiduciary duties with their inaction on diversity issues. These lawsuits also accuse the companies of violating Section 14(a) of the Securities Exchange Act of 1934, which outlines requirements for company disclosures during proxy contests when various parties might solicit an investor’s vote on a corporate action or for the election of board members. The complaints allege that the companies misrepresented their commitment to diversity in proxy statements.
While organizations typically focus DEI initiatives at the management level to avoid strategic risks, they must not lose sight of the importance of diversity, equity and inclusion among workers at the operational level. Read more in the article“Diversity on the Front Line.”
Some of the complaints seek various actions by the respective defendant companies by way of relief. These vary broadly but are related to the return of board members’ remuneration, nomination of new Black board directors, creation of a company fund to hire Black and other minority candidates, or the implementation of policies tying executive compensation to diversity-related goals.
While it might be too early to label this as a D&O liability trend, the frequency of diversity-related lawsuits brought since the beginning of July 2020 should raise concerns that any company lacking racial, gender and age diversity on its board of directors might face similar lawsuits.
Awareness of how a lack of diversity impacts the company’s image and reputation is increasing substantially. More public attention to the topic of diversity is influencing companies’ internal managerial practices, and recent D&O lawsuits should intensify this momentum.
The Effect of Diversity Neglect on D&O
While the ultimate financial impact of these diversity-related D&O lawsuits remains to be seen, there will be substantial legal defense costs involved in settling them. This growing D&O liability threat may further drive the increasing frequency and severity of U.S. securities class actions seen in recent years. This risk is heightened by the U.S. Securities and Exchange Commission (SEC) disclosure requirements obligating companies to be more transparent regarding diversity.
Another anticipated impact on the D&O insurance market is in the type of information underwriters will seek and questions that can be expected at meetings between customers and carriers. D&O underwriters will increasingly seek to understand how important diversity, equity and inclusion are to the management team and how this is reflected in certain key performance indicators.
Underwriters will want to know whether the organization has a chief diversity officer (CDO) or diversity council and, if so, the scope of their authority and responsibility. They will also want to know how diversity, equity and inclusion are demonstrated across the company and reflected in key processes such as training and recruiting.
D&O litigation risk will also increase due to potential changes in regulation and legislation on diversity. For example, in the United States, California recently passed a bill that will require any publicly traded company in the state to have at least one director from “an underrepresented community” by the end of 2021, and other states such as Illinois or New York may adopt similar board diversity legislation. Meanwhile, the European Commission is proposing a gender diversity requirement for corporate governance codes in each EU member country.
Board Diversity Benefits
Diversity should be at the top of the agenda of all organizations, both for ethical reasons and financial benefits. Companies putting emphasis on diversity are more likely to outperform their peers in terms of profitability, are more attractive to skilled talent, and can improve customer orientation. Investors, activists and shareholders negatively perceive a lack of diversity, and it is highly relevant to D&O litigation.
Some of the specific ways board diversity benefits companies include:
Financial performance: Diversity is directly correlated with better financial performance. A 2019 study by McKinsey & Company confirmed that companies in the top quartile for gender, ethnic and cultural diversity on their executive team are 25% more likely to have above-average profitability and outperform on the earnings before interest and taxes (EBIT) margin compared to companies in the fourth quartile. In fact, the greater the representation, the higher the likelihood of outperformance. An update to the study also analyzed how companies navigated the COVID-19 pandemic, concluding that diverse and inclusive companies were better positioned to create more adaptive, effective teams and recover more quickly.
Talent management: Diversity in leadership can help a company tap into more sources of talent and gain the upper hand in competitive recruitment, improving its global relevance. It is widely recognized that the pool of skilled experts and leaders has not kept pace with demand in many industries, making it difficult—and critical—to secure top talent in emerging markets and many of the most competitive fields. Diversity management means addressing talent shortages to give organizations an advantage in competing for the best people. As reflected in their underrepresented status, these groups present an untapped well of valuable talent.
Customer orientation: Corporations with diverse leaders that hold a customer-centric perspective can adapt to changing market developments and customer needs more creatively and effectively. When considering choices for leadership roles, many industries are now taking the perspective that boardrooms and C-suites should reflect the people they serve.
By committing to diversity within management and the board, companies can align their own organizations more closely with a wider customer base. In other words, diversity allows for improved customer orientation. This enables companies to form a tighter bond with customers of different backgrounds and better relate to them by defining a clearer customer perspective and reaching key purchasing decision-makers.
Diverse management boards whose composition more closely mirrors the demographics of the general population can also more effectively reach key decision-makers among their clients and customers. For example, in the United Kingdom, 80% of purchasing decisions are made by women. By 2025, McKinsey estimates that women will own 60% of all personal wealth and control £400 million ($546 million) more per week in expenditures than their male counterparts.
Decision-making and innovation: Managers working on tough problems often assemble a diverse team to challenge one another and improve the quality of their deliverables. With a diverse range of opinions, multiple objections and alternatives can be explored to solve problems more efficiently and with greater confidence. Research has shown that the presence of women and minority members on a leadership team enhances its problem-solving capability as they each contribute perspectives from their different backgrounds and experiences. Ethnic- and gender-diverse leaders provide companies with a different set of problem-solving tools, thinking and solutions.
Prioritizing Diversity, Equity & Inclusion
Improving racial, age and gender diversity should be a priority for all organizations, not only to take advantage of the beneficial impacts, but to avoid the risks from how investors, activists and shareholders perceive the lack of diversity, the threat of D&O litigation, and changes in diversity legislation. Combined, these factors put additional pressure on companies to address the composition of their board and management team as soon as possible.