Diversity Driven Derivative Suits: Culture Wars Come to the Boardroom

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Traditionally deployed to protect a corporation from its board’s imprudent investment or financial decision-making, in recent years shareholders have taken to bringing derivative actions on a corporation’s behalf for its board’s alleged failure to pay more than lip service to the diversity, equity and inclusion (“DEI”) commitments the company publicly proclaims. Spurred in 2020 in the wake of the George Floyd shooting, DEI suits are a subspecies of environmental, social and governance (“ESG”) suits, falling under the “social” prong of ESG. They allege that while professing to value inclusivity, in reality, corporations have fallen short of boosting racial, gender and ethnic diversity at the board or executive level.[i]

According to the complaint in a derivative action against The Gap, Inc., “[d]espite its supposed ‘imperative’ to be inclusive, Gap has failed to create any meaningful diversity at the very top,” instead hiring African American and other minorities for “low‐level and low‐paying jobs in its distribution centers.”[ii] As a result, plaintiff claimed that “Gap’s Directors have deceived stockholders and the market by repeatedly making false assertions about the Company’s commitment to diversity.”[iii] A DEI suit against Facebook pled similar allegations (i.e. “Facebook’s approach to diversity has been characterized by tokenism: make a small gesture to satisfy appearances, but don’t make any underlying substantial change”), and also alleged that the company did nothing to curb discriminatory advertising or hate speech on its platform.[iv] On the basis of these facts, DEI suits assert causes of action for fiduciary breach and violation of securities laws prohibiting companies from making false or misleading statements.

Several DEI suits have been dismissed at the pleading stage on three separate grounds: (1) failure to make a pre-suit demand on the board or adequately allege demand futility, (2) failure to allege wrongdoing with particularity, and (3) improper forum. The dismissal in the Facebook case is illustrative. There the Northern District of California, relying upon a forum-selection clause in Facebook’s certificate of incorporation making the Delaware Court of Chancery the exclusive forum for derivative suits, dismissed plaintiff’s state law claims for forum non conveniens, without prejudice to reasserting the same claims in Delaware.[v] The court also held that plaintiff did not adequately plead demand futility, a further ground for dismissal of the state law claims.[vi]

However, it was with respect to the federal claims that the court’s dismissal cut closest to the merits. The court held that plaintiff did not plead a materially false statement under Section 14(a) of the Securities Exchange Act of 1934 because a company’s statements about commitments to a diverse workforce are “non-actionable puffery or aspirational (and hence immaterial)” for purposes of Section 14(a).[vii] Following the Facebook dismissal, other courts dismissing DEI derivative suits have relied on its holding that diversity commitments are unactionable puffery.[viii]

The court in the Facebook case further held that plaintiff had not identified an “essential link” between Facebook’s false commitments to diversity and a “loss-generating corporate action.”[ix] Future DEI plaintiffs may encounter a similar obstacle alleging with particularity that superficial commitments to diversity actually caused a loss to the corporation. However, a possible way around this was addressed tangentially in the Gap case. While dismissing the suit for forum non conveniens (Gap’s bylaws contained a Delaware forum clause, whereas plaintiff brought suit in California), the Ninth Circuit expressly held that the same claims could be brought as a direct suit as plaintiff’s complaint is based on the theory that Gap’s shareholders suffered injury in their individual capacity by virtue of being denied the right to a fully informed vote because of a proxy nondisclosure in violation of Section 14(a).[x] Bringing the claims as a direct suit avoids plaintiffs having to prove “a loss-generating corporate action.”

A recent exception to dismissal is the McDonald’s case. There the Delaware Court of Chancery upheld a stockholder derivative suit alleging that a McDonald’s executive officer breached his fiduciary duties of oversight under the Caremark standard by “consciously ignoring red flags” and “allowing a corporate culture to develop that condoned sexual harassment and misconduct.”[xi] However, the allegations in that case are somewhat different from the typical DEI suit, as the stockholders are arguably alleging a higher level of misconduct (i.e. failure to investigate sexual harassment complaints, employee fear of retaliation, and a generally “toxic culture that accommodates sexual harassment”[xii]) than not having diverse representation at a company’s upper echelons.

Books and Records Actions as Precursors to Derivative Suits

Unlike a derivative action, which must surmount the hurdles of adequately alleging demand futility and actionable wrongdoing, a shareholder books and records action is not as easily dismissed. To inspect a corporation’s book and records, a “stockholder need not demonstrate that the alleged mismanagement or wrongdoing is actionable.”[xiii] Rather, all a stockholder must do is establish “a credible basis from which the Court of Chancery can infer there is possible mismanagement or wrongdoing warranting further investigation.”[xiv]

Shareholders may capitalize on the books and records action as a hook to obtain detailed information on a corporation’s diversity initiatives. Depending on the shareholders’ findings, an examination of a company’s books and records on this issue may thus form the basis of a later DEI derivative suit.

Backlash: Anti-DEI Suits 

In a twist of irony, shareholders driven by opposite ends have started mimicking the strategy of DEI plaintiffs by commencing derivative actions against companies for the purported backlash caused by their DEI commitments. A suit against Starbucks by a conservative advocacy group alleged a hodge-podge of state, federal, and common law claims, stemming from Starbucks’ consideration of diversity in its employment decisions and in its contracting with vendors.[xv] The suit was dismissed because the court found that plaintiff did not “not fairly and adequately represent the interests of shareholders,” and because plaintiff did not rebut the business judgment rule in pleading that the board wrongfully refused plaintiff’s demand to bring suit.[xvi] The court was skeptical as to the legitimacy of plaintiff’s claims, stating “it is clear to the Court that Plaintiff did not file this action to enforce the interests of Starbucks, but to advance its own political and public policy agendas.” Id.

A similar suit against Target’s directors was filed on August 8, 2023, alleging that they made false and misleading representations concerning the “customer and investor backlash” associated with Target’s DEI efforts, in violation of Sections 14(a), 10(b), and 20(d) of the Securities Exchange Act of 1934.[xvii] Plaintiff claims that the directors misrepresented the backlash springing from Target’s commitment to advance, retain, and hire minorities, its adoption of supplier diversity targets, and its publication of a Pride Manifesto.[xviii] A response to the complaint has not yet been filed.

Notably, on the books and records front, the Delaware Chancery Court recently denied a demand for an inspection by a Disney shareholder who disagreed with Disney’s opposition to the Florida law limiting classroom instruction on sexual orientation or gender identity.[xix] The court held that plaintiff did not have a proper purpose for seeking Disney’s books and records.[xx] Per the court, plaintiff was critiquing a business decision by Disney, but “disagreement with [a] business judgment is not evidence of wrongdoing warranting a Section 220 inspection.”[xxi]

What’s a Board to Do?

Directors and officers walk a tightrope in upholding and maintaining their corporation’s DEI commitments. On the one hand, they face suit for merely superficial commitments to DEI, while on the other for paying insufficient attention to the backlash risks from customers and investors.

The reputational impact of a lawsuit describing a company’s DEI commitments as mere platitudes may be significant (not to mention the defense costs). To avoid this, companies should consider the following measures:

  • Monitoring racial and gender composition of directors and executives: As board seats and executive positions become open, companies should ensure that diverse candidates are considered to fill the vacancies.
  • Promptly investigating discrimination allegations by employees, customers, or other stakeholders: One of the bases for the claims in the Facebook case was that the board was aware of but did little to prevent advertisers from discriminating by race and gender. Also, in the McDonald’s lawsuit, the court upheld plaintiff’s claims that the human resources department ignored sexual harassment complaints. Companies would be wise to bolster their internal controls so that systems are in place to take prompt action whenever a complaint is registered.
  • Aligning aspirations with policies and practices: The crux of DEI suits is a mismatch between a company’s public statements and its actual practices. On a variety of levels companies should strive to align the two, including regular assessments of compliance with workplace DEI policies, diversity training for board members and employees, and board oversight of diversity hiring at all levels of the company, as well as documentation of the same.

As to backlash, thus far, anti-DEI suits have not received much credence from the courts. As Judge Stanley Bastien put it in dismissing the Starbucks suit, “[t]his Complaint has no business being before this Court and resembles nothing more than a political platform…[i]f Plaintiff remains so concerned with Starbucks’ DEI and ESG initiatives and programs, the American version of capitalism allows them to freely reallocate their capital elsewhere.”[xxii]

[i] Lee v. Fisher, Case 3:20-cv-06163-SK, Dkt.  No. 1, ¶¶ 1-4 (N.D. Cal. Sep. 1., 2020; Ocegueda v. Zuckerberg, Case No. 20-cv-04444-LB, Dkt.  No. 1, ¶¶ 1-7 (N.D.Cal. Jul. 20, 2020; In re Danaher Corp. S’holder Derivative Litig., Civil No. 1:20-cv-02445, Dkt. No. 1, ¶¶ 4, 7-9 (D.D.C. Sep. 1, 2020); City of Pontiac Police & Fire Ret. Sys. v. Jamison, Case No. 3:20-cv-00874, Dkt. No., ¶¶ 2-10 (M.D. Tenn. Oct. 9, 2020).

[ii] Lee v. Fisher, Case 3:20-cv-06163-SK, Dkt.  No. 1, ¶¶ 1,4 (N.D. Cal. Sep. 1., 2020).

[iii] Id. at ¶ 5.

[iv] Ocegueda v. Zuckerberg, Case No. 20-cv-04444-LB, Dkt.  No. 1, ¶¶ 1-7 (N.D.Cal. Jul. 20, 2020).

[v] Ocegueda, 526 F. Supp. 3d at 650. The GAP suit was also dismissed for improper forum because of a Delaware forum selection clause in GAP’s bylaws. Lee v. Fisher, 70 F.4th 1129 (9th Cir. 2023).

[vi] Id. at 646-648. Other DEI suits have been dismissed on this same ground. In re Danaher Corp. S’holder Derivative Litig., 549 F. Supp. 3d 59, 62 (D.D.C. 2021); City of Pontiac Police & Fire Ret. Sys. v. Jamison, 2022 WL 884618, at *4 (M.D. Tenn. Mar. 24, 2022) (same); Lee v. Frost, 2021 WL 3912651, at *14 (S.D. Fla. Sept. 1, 2021).

[vii] Ocegueda, 526 F. Supp. 3d at 651.

[viii] City of Pontiac Police & Fire Ret. Sys. v. Jamison, 2022 WL 884618, at *16 (M.D. Tenn. Mar. 24, 2022); Lee, 2021 WL 3912651, at *12; Falat v. Sacks, 2021 WL 1558940, at *6 (C.D. Cal. Apr. 8, 2021); Klein v. Ellison, 2021 WL 2075591, at *7 (N.D. Cal. May 24, 2021).

[ix] Ocegueda, 526 F. Supp. 3d at 651.

[x] Lee, 70 F.4th at 1139-40.

[xi] In re McDonald’s Corp. S’holder Derivative Litig., 289 A.3d 343, 349 (Del. Ch. 2023).

[xii] Id. at 377.

[xiii] AmerisourceBergen Corp. v. Lebanon Cnty. Employees’ Ret. Fund, 243 A.3d 417, 437 (Del. 2020. Under Delaware law, which governs the internal affairs of many of the companies subject to DEI suits, a books and records action may be brought pursuant to Section 220 of Delaware General Corporation Law

[xiv] Id. (citing Sec. First Corp. v. U.S. Die Casting & Dev. Co., 687 A.2d 563, 568 (Del. 1997)).

[xv] National Center For Public Policy Research v. Howard Schultz, Case 2:22-cv-00267-SAB ECF No. 1-2 (E.D. Wash. Nov. 7, 2023).

[xvi] National Center For Public Policy Research v. Howard Schultz, 2023 WL 5945958, at *4 (E.D. Wash. Sept. 11, 2023).

[xvii] Craig v. Target Corp., et. al. No. 2:23-cv-00599, Dkt. No. 1, ¶¶, 285-304 (M.D. Fla. Aug. 8, 2023). Although not framed as a derivative suit, plaintiff’s claims are clearly on behalf of the corporation.

[xviii] Id. at ¶¶ 7- 12.

[xix] Simeone v. Walt Disney Co., 2023 WL 4208481 (Del. Ch. June 27, 2023).

[xx] Id. at *9-13.

[xxi] Id. at *10, 13 (citing Seinfeld v. Verizon Commc’ns, Inc., 909 A.2d 117, 120 (Del. 2006)).

[xxii] Schultz, 2023 WL 5945958, at *5.