Laws requiring board diversity are becoming more common – here’s what business leaders need to know

meeting
Retaining diverse board members should be viewed not as a risk mitigation strategy but as an opportunity for growth.

  • Some states have started mandating gender, ethnic, and social diversity across company boards.
  • While certain regulations could include fines for companies that fail to comply, others are advisory.
  • For now, experts say the real pressure to increase board diversity is coming from company investors.
  • See more stories on Insider’s business page.

Companies have long been talking about how their boards need to be more diverse. But now the legal landscape is changing, with some states mandating that companies do more than talk.

In Illinois, for instance, boards of publicly owned companies are required to disclose female and minority board membership, as well as how they identify and appoint those members. California has gone even further, mandating that boards have at least one woman, as well as a certain number of directors from underrepresented racial, ethnic, or LGBTQ communities. Other states, including Washington, Colorado, and Pennsylvania, have also passed legislation to encourage diverse boards, and more are considering this step.

All of this means that, in addition to being an ethical and reputational imperative, boosting board diversity is quickly becoming a legal one as well. So what should companies keep in mind?

“Because there’s such a patchwork of inconsistent state statutes – and because many of these statutes are looking at different kinds of diversity – it’s very hard, from a compliance standpoint, to figure out a one-size-fits-all answer,” said Mark McCareins, codirector of Kellogg’s JDMBA program and a clinical professor of business law.

That said, there are certain things that companies should understand about this quickly evolving legal landscape.

Read more: We identified 10 corporate board candidates with deep experience in M&A, tech, marketing, and social impact to keep an eye on

At least for now, the real pressure is coming from investors

Not all of these new legal requirements come with teeth. While some of the new state regulations include fines for companies that fail to comply, others are merely advisory.

“Some of the new statutes say, ‘we want to know what you’re doing in this area, but we haven’t decided yet what we’re going to do if you don’t report or you report and the numbers aren’t to our liking,'” McCareins said.

There are also some inherent limits to just how strong their enforcement can be. For example, a company in one state can reincorporate in another if it feels overly burdened by the board regulations.

That’s why, at least for now, the larger incentive is reputational.

“The biggest hammer in all this is probably from a perception in the equity markets that you are not a company that plays by the rules,” McCareins said.

Investors are making their will known in other ways, too. Last year, the NASDAQ submitted a proposal to the SEC that called for instituting diversity requirements. And institutional investors such as BlackRock, Vanguard, and StateStreet have begun bringing shareholder lawsuits against firms over board composition.

“If I’m a public corporation, whether or not I’m currently under state or federal regulation, I’m probably going to be as concerned about what my investor base – and specifically my institutional investors – are thinking about this issue,” McCareins said.

As with other ESG issues such as climate change, McCareins predicts that scrutiny over board diversity from a range of stakeholders will only increase over time.

“Companies want to be ahead of the curve on this and other issues,” he said. “These statutes have brought it into the corporate mindset that there really hasn’t been sufficient progress to diversify corporate governance. So regulators and investors are going to start taking baby steps in the hopes of getting companies’ attention – and in the hopes that they end up doing the right thing.”

Consider your bylaws

All of this means that as companies anticipate new mandates, they must also consider whether their own bylaws could stand in their way.

“Let’s say our company has bylaws where a five-member board all have eight-year terms,” McCareins said. “They have just been appointed in the last year. The company would love to be more diverse, but now we’re stuck with this board for the next seven under our bylaws.”

This can put companies in a legal bind. A company that slow-rolls its compliance efforts may face legal action from shareholders. But if the company takes actions to comply with new state laws and runs afoul its own bylaws in the process, that may create other legal problems.

“You could see shareholder derivative suits against boards for not fulfilling their fiduciary duties,” McCareins said.

Ultimately the power to change the board’s bylaws resides in the hands of shareholders. After all, while boards typically make recommendations to reconfigure their own makeup, they cannot do so unilaterally.

“Let’s say shareholders vote and say, ‘no, we don’t want to change the bylaws,'” McCareins said. “That’s where the rubber hits the road and state regulatory policy runs head-on into the shareholders who own the company.”

McCareins recommends that the board’s governance committee start by gaining a comprehensive understanding of the applicable state DEI statutes.

“Where a change is – or will be – mandated, the governance committee then needs to formulate proposals to reflect these changes in board composition,” he said. “If the governance committee feels ill-equipped to evaluate DEI principles, an outside consultant in such matters can be brought in to assist.”

Embrace the opportunity

There is plenty of good advice out there on how to find and retain diverse board members – and set them up for success. (For instance, see here and here.)

McCareins advises companies to embrace the process – not just as a risk mitigation strategy, but as an opportunity for continued growth.

He recommends codifying the nomination criteria and diversity metrics that would comply with necessary requirements and would fit the company’s goals. In addition to boosting gender or racial diversity, this may also be an opportunity to diversify in terms of professional backgrounds or skills. Or perhaps it is an opportunity to recruit directors who can better represent the voices and experiences of diverse clients, customers, and other stakeholders.

“Every company is different and every company culture is different,” McCareins says. “It is up to the nominating committee to spend time early in the process to identify the metrics which make sense and are attainable for their business.”

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A Kellogg finance professor explains why companies are adding more women to their leader boards

STOCK of people at a boardroom desk
American companies only recently tripled the rate at which they added female directors to prominent boards.

  • Professor David Matsa believes “the Big Three” investment companies influenced the recent uptick in female directorships.
  • “The more of a firm’s stock the Big Three held, the more women directors appeared on that firm’s board.”
  • The Big Three’s campaign to get more women on boards shows there are qualified women ready to serve.
  • See more stories on Insider’s business page.

The dearth of female leaders in corporate America is well established. For example, at the end of 2020, fewer than 8% of companies in the S&P 500 were woman-led.

One way to address this gender imbalance would be to increase female representation on corporate boards. Not only are board members corporate leaders in their own right, but they also hire CEOs.

While countries such as Norway have used government mandates to force companies to include women on their boards, few such rules are on the books in the US. Nonetheless, American companies recently tripled the rate at which they added female directors.

Were US firms unusually enlightened? Or were they responding to pressure from another source?

Kellogg finance professor David Matsa suspected the latter. In recent research, he and coauthors noticed that the conspicuous uptick in female directorships coincided with a cascade of gender-diversity influence campaigns mounted by a trio of powerful institutional investors: Vanguard, BlackRock, and State Street. Known as “the Big Three,” these firms manage over $15 trillion, accounting for three-quarters of indexed mutual fund assets. That means that these companies hold shares in almost every large firm in the US – in fact, they’re the dominant shareholder in 88% of firms on the S&P 500.

Given this outsized influence, Matsa and his collaborators – Todd Gormley of Washington University in St. Louis, and Vishal Gupta, Sandra Mortal, and Lukai Yang of the University of Alabama – wanted to know if the Big Three really were moving the needle on boardroom-diversity efforts. And if they were, how did those efforts compare to government-enforced quotas in other countries?

The researchers found evidence that the Big Three were indeed driving boardroom gender diversity – and that these efforts led to women in more powerful board positions than those spurred by government quotas. Furthermore, by analyzing how firms responded to the Big Three’s demands, the researchers shed light on why companies may be slow to appoint female board members in the first place.

“The Big Three changed the conversation around gender in corporate boardrooms,” Matsa said. “When your largest shareholders create a ruckus, you listen. And in important ways, their advocacy can be more effective than legislative mandates.”

The Big Three’s campaign

State Street led the Big Three’s charge for gender diversity with its March 2017 “Fearless Girl” campaign, named for an eponymous statue the company placed in front of the “Charging Bull” sculpture on Wall Street. By early 2018, Vanguard and BlackRock had launched similar campaigns.

Each member of the Big Three also backed up its campaign with a threat: it would vote against directors at any firms who failed to appoint more women to their boards. Directors on a corporate board are elected by the firm’s shareholders. And since Big Three investors tend to be a firm’s dominant shareholders, their voting threats are not idle.

“Being a director is a highly sought-after job: it’s prestigious and well-compensated. Directors don’t want to lose it,” Matsa explained. “Even though these elections typically aren’t contested, it doesn’t look good to have a lot of votes against you.”

To determine whether companies were responding to the Big Three’s diversity demands in 2017 and 2018, the researchers gathered two types of information about companies in the investors’ portfolios. First, they measured how much of a stake each Big Three investor held in each of the firms, with the idea being that the bigger the stake, the bigger their campaign’s influence would likely be.

Second, the researchers gathered information about the composition of each firm’s board of directors – whether members were male or female, when they’d been hired, whether they’d previously served as board members at this or other firms, and which board committees they served on.

They then analyzed the data across two spans of time: Three years before the Big Three’s gender-diversity campaigns (2014-16) and three years after (2017-2019). Together, this provided a before-and-after picture of how firms under the Big Three’s influence behaved.

“The firms with a larger share of their stock held by State Street, BlackRock, and Vanguard – to what extent did they change their boards of directors relative to other firms during this period?” Matsa said. “That’s the variation that we studied.”

More stake, more women – with more power

The results were undeniable: the more of a firm’s stock the Big Three held, the more women directors appeared on that firm’s board after 2017.

Indeed, for every additional 8% owned by Vanguard, BlackRock, or State Street, the number of new female board members rose by 76%. Before 2017, only one in twelve firms added a woman to its board each year. By 2019, one in four did.

The Big Three’s campaigns each had a slightly different focus. For example, State Street targeted firms without any female directors. BlackRock, meanwhile, said it expected at least two women directors on every board. So the researchers were able to track whether firms responded differently depending on the relative ownership stake of each of the Big Three institutions.

Sure enough, the researchers found that companies with larger State Street ownership exhibited the largest increases in diversity among those firms with all-male boards. Similarly, firms held more by BlackRock – and with fewer than two female directors prior to 2018 – made larger board-diversity changes compared with firms where Blackrock was less invested.

“The way a company changed their board corresponds to who holds large ownership stakes in them, and what those specific asset managers were pushing for,” Matsa said. “This finding gives us more confidence that these changes in the board-member composition are indeed a reaction to the pressure from these institutions.”

But to Matsa, the most interesting finding was the quality of the Big Three’s effect on board diversity.

He explains that previous research has shown that government quota systems – like California’s 2019 requirement that every public company have at least one woman on its board – can result in tokenism as boards “check the box” of adding female directors. But, the previous research shows, the companies often fail to put these women on committees where power is actually exercised.

“A lot of a board’s work is done in these committees,” Matsa explained. “For example, the audit committee oversees the company’s financial reporting and disclosure.”

The companies that responded to the Big Three’s diversity demands, however, did appoint more women to influential audit- and nominating-committee positions than firms complying with a mandatory quota did. This implies that institutional investors may be more effective than lawmakers at creating what Matsa calls a “ripple effect” in female corporate leadership.

“When women are involved in the nominating committee, it might begin a cycle of the boards being more open to female membership in the future, even when they aren’t subject to the shareholder campaign,” Matsa said.

Why aren’t boards hiring women already?

For Matsa, these results beg a larger question: Why aren’t companies doing this on their own? “This paper is also about understanding what impediments keep firms from appointing more women, outside of these influence campaigns,” he said.

The most commonly cited reason for failing to recruit qualified female board members, Matsa said, is that there simply aren’t enough of them. But that reasoning depends on certain biases.

For one, board nominating committees often use previous CEO experience as a proxy for “qualified” – even though, in practice, boards often include other senior business leaders and nonexecutive experts like lawyers, bankers, scientists, or academics. Since most CEOs are still men, this bias curtails the number of female board candidates. Moreover, nominating committees often rely on personal connections to filter potential candidates – so when those committees are male-dominated, their networks tend to be, too.

To satisfy the Big Three’s diversity demands, Matsa found that firms simply did the obvious: they didn’t prioritize previous CEO experience, and they ventured beyond their personal networks.

But did this result in a flood of unqualified female board members? Hardly. The Big Three believed that there were plenty of qualified women out there ready to serve on boards if only existing board members broadened their searches. And, indeed, the women who were nominated were “overwhelmingly” voted for by shareholders, Matsa said – and not just by the Big Three, who may have had a motive to see their diversity campaigns succeed.

“That fact is not consistent with there being widespread opposition to adding these women,” he explained. In other words, it’s often the old boys’ network – not a lack of real qualification – that’s keeping women out of boardrooms.

To Matsa, these findings are less about assigning blame than about illuminating what works.

“My sense is that few board members believe that they were selecting a man because he was a man,” Matsa said. “They would think of it as looking for someone experienced, who they can trust. It’s difficult to move outside of that frame. It takes someone influential, like your largest shareholder, to tell you that you should approach this differently.”

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