On April 1, the L.A. County Superior Court granted the plaintiffs’ motion for summary judgment in Crest v. Padilla, the taxpayer litigation challenging AB 979, California’s board diversity statute for “underrepresented communities.”  (See this PubCo post.)   Unfortunately, at the time, only a minute order was released, which did not offer any explanation of the Court’s reasoning.  Now, a new 24-page Court Order, which provides the Court’s reasoning, has been made available, and, in it, the Court concludes that the statute, Corporations Code § 301.4, violates the equal protection clause of the California Constitution on its face. Why? Because, in the Court’s view, § 301.4 treats similarly situated individuals differently based on suspect racial and other categories that are not justified by a compelling interest, nor is the statute narrowly tailored to address the interests identified. Will this case have a spillover effect on the decision currently pending of plaintiffs’ taxpayer challenge to California’s board gender diversity statute, SB 826? According to Reuters, the California State Senator who authored SB 826 said that “the case involved a ‘very different set of facts and distinctly different legal issues.’”

California Corporations Code § 301.4

Patterned after SB 826, AB 979 (which became § 301.4 of the Corporations Code) required that a “publicly held corporation” (that is, a corporation with outstanding shares listed on a major U.S. stock exchange) with principal executive offices (according to its Form 10-K) located in California, no matter where it is incorporated, have a minimum of one director from an underrepresented community by the end of 2021.  No later than the close of 2022, a corporation with more than four but fewer than nine directors was required to have a minimum of two directors from underrepresented communities, and a corporation with nine or more directors was required to have a minimum of three directors from underrepresented communities.  A director from an “underrepresented community” means a director who self-identifies as Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, Alaska Native, gay, lesbian, bisexual or transgender.  A corporation could increase the number of directors on its board to comply with the law. As with board gender diversity, the law was expected to lead companies to look outside their traditional channels to find new directors from these communities. (See this PubCo post.)

The law also required that, on or before specified dates, the Secretary of State publish various reports on its website documenting, among other things, the number of corporations in compliance with the bill’s provisions, the number that have moved their headquarters in or out of California and the number no longer publicly traded. The 2022 report, posted on March 1, showed that, out of 716 publicly held corporations listed on major exchanges that identified principal executive offices in California in their 2021 10-Ks, 301 companies reported being in compliance with the phase-one requirements of § 301.4.  (See this PubCo post.) The legislation also authorized the imposition of fines for violations in the amounts of $100,000 for the first violation, and $300,000 for each subsequent violation. Failure to timely file board member information with the Secretary of State was also subject to a fine of $100,000. (Note, however, that no fines were levied and no regulations were adopted to implement the fines authorized under this law or even under SB 826, which was signed into law in 2018.)

Background of the case

In the litigation, the plaintiff taxpayers sued to enjoin the Secretary from “spending public funds on California’s race, ethnicity, sexual preference, and transgender quotas for boards of directors of publicly-traded corporations with their headquarters in California.”  They also sought a judgment declaring the diversity mandate to be unlawful in violation of the California constitution. The plaintiffs claimed standing as “taxpayers,” under “California’s common law taxpayer standing doctrine and Code of Civil Procedure Section 526a, which grants California taxpayers the right to sue government officials to prevent unlawful expenditures of taxpayer funds and taxpayer-financed resources.” They contended that, in so-called “taxpayer suits,” merely expending the time of a paid, public official in “performing illegal or unauthorized acts constitutes an unlawful use of funds that may be enjoined, [and] it is immaterial that the amount of the expenditure is small or that enjoining the illegal expenditure will permit a savings of tax funds.” Further, they alleged that, “[a]ccording to the Assembly Appropriations Committee, AB 979 ‘will result in ongoing costs in the hundreds of thousands of dollars to gather demographic information and compile a report on this data on its internet website.’”

The plaintiffs contended that “any expenditure of taxpayer funds or taxpayer-financed resources on AB 979 is illegal under the California Constitution.” That is, they asserted that the law’s “requirement that certain corporations appoint a specific number of directors based upon race, ethnicity, sexual preference, and transgender status is immediately suspect and presumptively invalid” under the equal protection provisions of the California Constitution and subject to “strict scrutiny” in the California courts. In support, the complaint cited the Senate Floor Analysis, which identified “potential constitutional issues posed by” AB 979, specifically that, “under the California Constitution, ‘a statute that draws a distinction based upon race or ethnicity in this fashion—whether remedial or punitive in intent—is suspect and only passes constitutional muster if it can meet the strict scrutiny test: that the statute is narrowly drawn to meet a compelling government interest.’ The analysis also stated, ‘the existence of general societal discrimination will not ordinarily satisfy the courts.’” On that basis, the complaint alleged that, “[b]ecause it classifies directors by virtue of their race, ethnicity, sexual preference, or transgender status, AB 979 can only be justified by a compelling governmental interest, and its use of race and ethnicity must be narrowly tailored to serve that compelling interest.”  However, the plaintiffs asserted, the Secretary of State “cannot make these difficult showings”; therefore, plaintiffs alleged, “AB 979 is unconstitutional and any expenditure of taxpayer funds or taxpayer-financed resources in furtherance of, ensuring compliance with, or otherwise effectuating the racial, ethnicity, sexual preference, and transgender quotas required by AB 979 is illegal.”

The plaintiffs made similar arguments in support of their motion for summary judgment, contending that the law was presumptively unconstitutional and that the state bore the burden of satisfying “strict scrutiny”—showing not only that the state “has a compelling interest which justifies the law but that the distinctions drawn by the law are necessary to further its purpose.” Citing Connerly v. State Personnel Bd, plaintiffs argued that a “classification based on race, ethnicity, sexual preference, or transgender status is immediately suspect for equal protection purposes where the persons subject to the classification are similarly situated.” It was “indisputable” they maintained, that § 301.4 employed these suspect classifications “to differentiate between similarly situated persons—current and prospective members of a subject corporation’s board, all of whom are subject to the same process for selecting board members.”

The Court’s Order

The Court began its Order with a discussion about how tempting it is to address a problem with the “most obvious and direct solution….But sometimes there are constraints which call for additional care. This is one of those times.” Here, the Legislature identified a lack of diversity on corporate boards, and “concluded that this disparity was the result, conscious or unconscious, of a process that leads board members to select replacements who look and feel like them. This meant that qualified members of other groups were, intentionally or unintentionally, being excluded.” As a result, the Legislature concluded, companies were more vulnerable to “stagnant thinking” and “poorer business practices.” The Court did not take issue with these conclusions; rather, the Court maintained that the

“Legislature’s observations are intuitively sensical….The underlying premise here is that demographic diversity is a reasonable proxy for differing perspectives and life experiences. That premise is not seriously challenged by anyone involved in this case….But that doesn’t mean the Legislature can skip directly to mandating heterogenous boards. The difficulty is that the Legislature is thinking in group terms. But the California Constitution protects the right of individuals to equal treatment. Before the Legislature may require that members of one group be given certain board seats, it must first try to create neutral conditions under which qualified individuals from any group may succeed. That attempt was not made in this case.”

The Court first analyzed the “taxpayer” question, concluding that the Secretary had indeed spent taxpayer money to gather and disseminate information related to § 301.4 for the purpose of securing or measuring compliance. Accordingly, there could be a constitutional violation, even if there were no monetary penalty for failure to comply, so long as it ultimately turned out that the statute imposed an unconstitutional duty. The Court also quickly concluded that there were no material questions of fact to be determined.

The Court quickly disposed of plaintiffs’ contention that § 301.4 violated the discrimination in public contracting provisions of the California Constitution; however, the Court held, “Section 301.4 does violate Article 1, Section 7 of the California Constitution,” the equal protection provisions.  Here, the Court cited Connerly for basic principles:

“A legislative classification satisfies equal protection of law so long as persons similarly situated with respect to the legitimate purpose of the law receive like treatment….Legislative classifications generally are entitled to judicial deference….However, judicial deference does not extend to laws that employ suspect classifications, such as race. Because suspect classifications are pernicious and are so rarely relevant to a legitimate governmental purpose [citation], they are subjected to strict judicial scrutiny; i.e., they may be upheld only if they are shown to be necessary for furtherance of a compelling state interest and they address that interest through the least restrictive means available.” 

In this instance, the Court held, the statute violates the Constitution on its face: “To succeed on this type of challenge, Plaintiffs must show that Section 301.4 ‘inevitably pose[s] a present total and fatal conflict’ with Article 1, Section 7….’” And, the Court concluded, “that was exactly the sort of conflict present here. Section 301.4 clearly applies suspect categories: it imposes a duty on corporations to use such categories in the selection of their board members. It requires corporations to have a specific number of directors who are members of certain listed races, or else have certain listed sexual orientations or gender identities. People of other races, orientations, and identities are necessarily excluded from those board seats.” The state, the Court said, had searched in vain “for a situation where compliance with Section 301.4 would not conflict with Equal Protection.”  The ability to expand the board size did not address the problem: “each new board seat would necessarily belong only to one of the groups on the list and to no one else.”

The state contended that the listed groups and the unlisted groups were not “similarly situated” because the listed groups are “underrepresented” and have been subjected to discrimination. But the Court did not buy that argument: equal protection involves individual rights, not group rights, the Court said, and accepting the state’s contention would “short-circuit” the analysis. Rather, the Court concluded, the “relevant set of individuals here is those who are qualified to, sit on corporate boards.”

In this context, the Court highlighted “that the groups selected for preference by the statute are not inclusive of all numeric minorities,” and questioned the basis for inclusion of some of the selected groups. In response to the Court’s inquiry, the “Secretary stated that these were the groups that had statistical discrepancies and no other group asked to be included. In effect, the included groups were included simply because they asked to be. Excluded groups were excluded because they didn’t show up.” There are hazards, the Court observed, “of deciding to lump every preferred minority group (other than women) into a single, exclusive list,” one of them being the “practical fact that every group added to the list waters down the benefits for the other groups.”

The Court also concluded that the state failed to show a compelling interest “with some degree of specificity.”  The Court identified two possible compelling interests offered by the state:  first, the state’s compelling interest in “remedying discrimination in corporate board selection,” and second, its compelling interest “in obtaining various public benefits that would come from diverse boards: more profitable corporations that lead to better investment returns for public pension plans and more tax revenue for the state, better corporate integrity and oversight, more inclusive workplaces, and so forth.” However, the Court was not persuaded: “[t]he broader public benefits produced by well-run businesses do not fit that bill.” A “generic interest in healthy businesses,” the Court said, “is not sufficiently specific or immediate to permit the use of suspect classifications.”  While the Court recognized that “diverse boards may be ‘good for business,’” nevertheless, “if these downstream, indirect effects were to be compelling interests, there is no limit to what might be allowed, provided the economic data were properly massaged.”

Acknowledging that “remediation of discrimination can be a compelling interest,” the Court still rejected the state’s contention here because the state did not adequately define the specific arena in which the discrimination occurred: “corporate board selection…is neither confined nor specific.”  The Legislature considered evidence “across all sorts of categories” of companies—”not the sort of concrete area in which the state interest in fixing discrimination can become compelling.…[I]f the Legislature cannot define the pool of qualified candidates, how can it say that it has properly focused its efforts on a specific arena of discrimination?”

Nor was Court satisfied that the evidence presented was convincing; there must be detailed consideration of past practices, anecdotal and statistical. With regard to statistical evidence, the state had to show “a disparity between the demographic make-up of the qualified talent pool and those who hold positions in the targeted arena.”   But here, there was no record of an “effort to identify, define, or survey the qualified talent pool for director positions.” (Interestingly, the Court noted that data submitted related to the board gender diversity statute was not really relevant to the type of discrimination at issue here.) Nor could the state make its case based only on anecdotal evidence; it needed “the support of either (1) properly established statistical disparity or (2) a properly traced statistical history showing that, from a time of formal discrimination until now, the composition of boards has remained unchanged.”

But even if the state had demonstrated a compelling interest, it still would need to “establish that the remedy chosen is narrowly tailored to suit that interest.”  That would require the serious consideration of race-neutral alternatives “which are plainly available and not obviously impractical.” And that, the Court said, was “where Section 301.4 rests on the thinnest ice.” In this context, the Court found “precious little indication that the Legislature seriously considered or attempted other intermediate and race-neutral measures.” Although past voluntary efforts had been ineffective, in “escalating from somewhat blase and voluntary requests straight to a numeric mandate, [the Legislature] skipped over several possible intermediate and neutral steps,” most prominently, a “disclosure requirement that would compel corporations to reveal the demographic information of their board members.” Although the state attributed the lack of diversity to the secretive, insular board selection process, the Court pointed out, the Legislature did not attempt in its legislation to address the board selection process. Accordingly, the Court concluded, “even if the Secretary had established a specific, compelling interest, Corporations Code § 301.4 is not narrowly tailored to serve that interest. It is not the least restrictive means available for accomplishing the goals the Legislature had in mind.”

“Because Section 301.4 treats similarly-situated individuals differently based on race, sexual orientation, and gender identity,” the Court concluded, “because that use of suspect categories is not justified by any compelling interest, and because the statute is not narrowly tailored to serve the interests offered, Section 301.4 violates the Equal Protection Clause of the California Constitution. Plaintiffs are entitled to a judgment declaring as much and an injunction preventing the expenditure of taxpayer funds on implementation of the measure.”


Cydney Posner

Posted by Cooley