Why D&I matters to D&O: exposures from diversity-driven lawsuits

A combination of recent events has forced issues of diversity and inclusion (D&I) onto the boardroom agenda. As a result, company boards now face increased scrutiny from the public, regulators, legislators and shareholders alike. If well-established benefits of having a diverse workforce are not enough to make companies enact change, the increasing threat of expensive D&O litigation and new legislative initiatives could well be. Although currently focused in the US, it seems likely that, with the momentum of the Black Lives Matter (BLM) movement and other calls for racial justice and diversity, similar claims (and potentially, similar legislation and regulations) will emerge in other countries. D&Os and their insurers should adapt how they assess risk in order to guard against these exposures.

Shareholder derivative actions in the US

Over the last eight months, multiple shareholder derivative actions have been brought against the boards of US public companies (which include Facebook, Oracle, Gap and Cisco) in respect of diversity issues. While many of these lawsuits have focused on technology companies, other impacted industries include retail, food services and social media.

These actions have alleged that boards violated their fiduciary duties by failing to make material changes pertaining to the diversity of office holders and individuals in other senior positions, thereby contradicting public statements of the respective companies’ commitments to improve diversity. Other claims include unjust enrichment and allegations of proxy solicitation violations under Section 14(a) of the Securities Exchange Act of 1934.

Essentially, shareholders allege that their investment was made as a result of these public disclosures and that they were deceived as diversity issues were, in practice, ignored. The remedies sought include resignation of board members to make room for new diverse directors, the return of board compensation, diversity training for board members, the creation of initiatives for hiring diverse board members, publishing annual diversity reports and attorneys’ fees.

In November 2020, Pinterest was hit with a shareholder derivative lawsuit alleging certain D&Os had breached fiduciary duties by causing or allowing the company to engage in race and gender discrimination and retaliation, thus harming Pinterest’s reputation and workforce. The lawsuit cites claims brought by former officials, including two black women who say they were partially motivated to expose the company’s practices following company statements made in support of BLM.

Using shareholder derivative actions as a means to attempt to steer social change and corporate governance is not a new phenomenon in the US. Further, while at this time it is uncertain whether these claims will succeed and what financial impact they will have, shareholder derivative litigation can be difficult to maintain given the high pleading standards required in these types of cases. However, depending on the nature of the allegation being made, it is possible that significant defence costs will be incurred even if the claims are dismissed. In addition, with the rise of “cancel culture”, these types of cases also present possible damage to a company’s reputation and bottom line. If share prices drop as a result of such claims, companies could face further claims for causative loss, and possibly even claims alleging securities fraud.

Clearly, these actions present a risk to D&O insurers where cover is provided for defence costs, damages, settlement costs, fines and legal fees, subject to the precise terms of such cover. In addition, shareholder derivative claims present unique potential exposure to Side A D&O carriers where a company is not permitted by law to indemnify its D&Os for settlement amounts made in these types of cases. D&I related litigation may also lead to wrongful termination and/or discrimination claims, which could also potentially impact the employment practices liability insurance market.

These proceedings follow the trend seen in recent years of increasing numbers of lawsuits relating to environmental, social and governance (ESG) factors, which is a topic we have previously addressed. These have caught the attention of regulators, with litigation arising out of the #MeToo movement leading to state legislation mandating the inclusion of women on boards via the 2018 Senate Bill 826. Regulators have started taking a similar approach to encourage racial diversity at board level, putting further pressure on companies to take diversity seriously.

In 2018, the US Securities and Exchange Commission (SEC) issued disclosure requirements encouraging company transparency on diversity by requiring companies to disclose self-identified characteristics of board candidates. In December 2020, Nasdaq filed a proposal with the SEC to adopt new listing rules requiring Nasdaq-listed companies to have, or explain why they do not have, at least two diverse directors on their boards. With President Biden having emphasised racial equality as a priority for his administration, announcing that he will require public companies to disclose the racial and gender composition of their boards in his “Build Back Better” plan, and coupled with the appointment of Gary Gensler as new SEC chair, it seems fair to assume this issue will, or ought to be, on the agenda of many US boards.

In what could be a sign of things to come, the California legislature passed Assembly Bill 979 in September 2020, which requires publicly-traded corporations headquartered in California (which is estimated to be in the range of 625) to have at least one director from an “underrepresented community” by the end of 2021 and increasing proportionally in 2022 depending on the size of the board. Under the statute, the term “underrepresented community” means a director 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.” Further, the statute provides that the failure of the companies to file board information with California Secretary of State pursuant to this regulation would result in fines of US$100,000 for first violations and US$300,000 for subsequent violations.

D&I in the UK

Although quotas remain prohibited in the UK under the Equality Act 2010, targets and guidance have attempted to encourage board diversity. The 2018 UK Corporate Governance Code required companies’ annual reports to include descriptions of boards’ policies on diversity, including any measurable objectives set and commentary on progress with regard to such objectives.

The 2017 Parker Review of ethnic diversity on UK boards recommended each FTSE 100 board have at least one BAME director by 2021. The Parker Review Committee reported in February 2020 that with less than a year left 37% of FTSE 100 companies had still not met this target. We may therefore soon see claims like those brought in the US emerging in the UK.

Comment

Companies that have not already done so should act now to effect change by implementing policies encouraging diversity at senior levels and delivering on any publicly stated corporate objectives, promises or goals.

D&Os need to be particularly careful when drafting public statements regarding their diversity efforts, ensuring accuracy and demonstrable implementation.

D&O insurers of publicly-listed companies have generally had to respond to increasing ESG-related financial exposures by raising premiums, or otherwise widening exclusions in policies. In view of the US actions referred to above, it would be prudent for underwriters to closely examine companies’ board compositions, diversity policies, related performance indicators, training and recruiting methods, and public statements regarding these practices to effectively assess and guard against future D&O exposures. In addition, D&O insurers should also carefully consider communications that have been made by D&Os and corporations on social media pertaining to ESG-related practices, as these could also be a source of potential exposure. Based on the US experience alone, it is clear that such potential exposure could include civil litigation in the form of derivative and securities fraud, governmental litigation and regulatory investigations.

Read other items in London Market Brief - February 2021

Related item: Potential D&O risks arising from corporate social responsibility

This article was published in Insurance Day on 3 March 2021.