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Excerpted From: Chris Brummer and Leo E. Strine, Jr., Duty and Diversity, 75 Vanderbilt Law Review 1 (January, 2022) (354 Footnotes) (Full Document)


BrummerStrineFifty years ago, Milton Friedman famously told corporate fiduciaries that they should narrowly focus on generating profits for stockholders. Less focused upon, but explicit, was his view that corporations should not have a “social conscience” or take action to “eliminat[e] discrimination,” which he trivialized as a “catchword[ ] of the contemporary crop of reformers.” Since then, Friedman and his adherents have espoused this cramped vision of fiduciary duty within the debate over corporate purpose and, even worse, sought to erode the external laws promoting equality and inclusion.

Today, the problem Milton Friedman trivialized remains urgent. The inequality gap between Black and white Americans grew in the period in which Friedman's views became influential with directors and policymakers, while the COVID-19 pandemic's unequal impact on minorities has underscored the persistence of inequality. So have horrific instances of violence against Black people and other evidence of ongoing exclusion. Likewise, inequality in wages and opportunity continues to adversely affect women.

Demands are growing for corporate leaders to address these serious issues by promoting effective practices to treat their employees, communities of operation and service, and customers with respect--and to take affirmative steps to ensure equal opportunity, create an inclusive and tolerant workplace, and embrace the diversity of humanity. This commitment to Diversity, Equity, and Inclusion (“Diversity” or “DEI” for short) is not just one corporations are being asked to make internally, but is also one requiring companies to evaluate how they treat their consumers and the communities in which they have an impact.

Although the immediate aftermath of the Floyd killing has tended to mute those who view corporate action to address issues like Diversity as an improper and illegitimate diversion from the pursuit of shareholder profits, history shows that will not last for long. Those who share Friedman's worldview will argue that corporate fiduciaries are on unstable ground if they commit their companies to Diversity, Equity, and Inclusion policies that go beyond the legal minimum of nondiscrimination and will suggest they face possible legal risk for failing to focus solely on corporate profit. Indeed, even as issues of racial equality have been central and many leading members of the corporate community are recognizing their obligation to do better, some have openly taken Friedman's position and have directed their employees to stay focused on profits and to avoid discussions of race at all costs. We fear that as the current moment wanes, attempts to twist corporate law will reemerge and argue that corporate leaders may not take action to assure that their companies go beyond the bare legal minimum to promote these important values, because by doing so they would be improperly diverting their focus from profit maximization.

In this Article, we explain why arguments of that type have no grounding in a proper understanding of corporate law, and in particular the important principles of fiduciary duty that govern the equitable expectations of corporate directors and officers. We show that, even under the nation's most stockholder-focused corporate law, that of Delaware, Friedman's normative view is not one that American corporate law embraces, and that corporate law presents no barrier to voluntary corporate efforts to increase equality and diversity.

In fact, a proper understanding of corporate fiduciary duties supports the ability of corporations to put in place effective DEI policies. Indeed, fiduciary duty requires boards to attend to DEI by monitoring company policies and practices that assure the company's compliance with important laws that focus on the equal treatment of diverse applicants, employees, customers, communities, and business partners. Not only that, the fiduciary duty of loyalty requires affirmative efforts to promote the sustainable success of the corporation, and directors and managers must try to promote the best interests of the company. Substantial evidence exists that companies with good DEI practices will not only be less likely to face adverse legal, regulatory, worker, community, and consumer backlash from their conduct, but that their boards and workforces will be more effective and their reputation with an increasingly diverse customer base and public will grow, as will trust from institutional investors increasingly focused on sustainable profitability and the avoidance of harmful externalities costly to their clients, who have diversified portfolios tracking the entire economy.

As a matter of fiduciary duty, therefore, corporate leaders not only have broad authority to promote an inclusive and diverse corporate culture, their affirmative obligation to act in the best interests of the corporation can be understood to require it, given the important legal requirements for corporations to avoid invidious discrimination and growing societal and investor expectations that business contribute to reducing racial and gender inequality. Even more, foundational corporate law principles like the business judgment rule protect and support directors and managers who believe that committing their companies to help improve Diversity, Equity, and Inclusion is the right way to do business. And that fiduciary duty imposes minimal guardrails and even floors of basic activity that must be undertaken to ensure that corporations honor societal laws protecting against discrimination.

This legal reality is important to ensuring that the accountability debate proceeds with clarity over whether corporate leaders, and the institutional investors who control public companies, are doing what they should to promote these values. All too often, the issue of Diversity is viewed as a cost center or something external to the mission of the modern firm--driving criticisms of Diversity-oriented corporate reforms as “virtue signaling at the expense of someone else.” But this Article advances a different theory--that the pursuit of Diversity, Equity, and Inclusion is solidly authorized by the operation of traditional corporate law principles and can even be easily squared with the views of those who embrace what has come to be known as “shareholder primacy.” As such, our contribution does not debate what corporate law should be, but instead explores what corporate law already is. And it offers an old answer to the novel question of what tools and obligations managers and directors must contemplate when grappling with the challenge and opportunity of Diversity.

This Article proceeds as follows. In Part I, we document the demographic dilemma facing corporate boards and C-suites across the United States--namely, the striking gap between the demographics of the leadership of corporate America and the nation as a whole. We then explore the implications of the data in a post-George Floyd, post- pandemic environment, in which demands for better corporate behavior and greater racial economic opportunity have both swelled and intensified.

Part II addresses the nexus between DEI and firm value. It starts with a survey of the empirical research associating diversity with financial performance and finds a mixed picture, but one that nonetheless has practical and legal importance for corporate decisionmakers weighing whether and how to address DEI issues. We find that as in many complex areas relevant to running a business, information is incomplete, at times defective, and a work in progress; nevertheless, the evidence from academic studies, and the logical arguments advanced by leading business consultants and thinkers, provide a rational basis for corporate fiduciaries to conclude that effective DEI policies are in the best interests of the corporation. Continuing this theme, we then turn our analysis to the long-running literature in organizational psychology that identifies cognitive diversity (and Diversity more generally) as prophylactics for groupthink and other social pathologies that can impair good decisionmaking and thus, in this context, endanger firm value. We then close this Part with what is perhaps the most compelling business case for Diversity--that of corporate reputation and its relationship to firm credibility and success. The Part investigates how DEI relates in a broader way to corporate success and highlights why attention to DEI is necessary for businesses to avoid the severe reputational harm, legal risk, and other downside consequences of being perceived as not being a business committed to treating all Americans with respect. We then connect that risk to the demographic realities facing firms seeking to preserve and maximize their returns. Because the available workforce, customer base, and strategic partners are diversifying both domestically and internationally, DEI considerations bear importantly on firms' reputation with these key stakeholders, and thus on their cost of capital, talent, and customer acquisition and retention. For all these reasons, we conclude that the requisite foundation for corporate policies advancing DEI exists, making the adoption of these policies, as we later address in more detail, eligible for the protection of the business judgment rule.

Part III examines current legislative and market initiatives to improve DEI within the corporate sector. To provide context, we start with an analysis of key federal laws that advance racial and gender equality in the business sector. We then catalogue a growing number of initiatives: investment fund activities where employee, environmental, social, and governance factors (“EESG”) have been integrated into investment processes; California and New York state corporate law reforms aiming for greater board diversity; proposed new listing rules for Nasdaq requiring disclosure of corporate board metrics; and a pledge made by Goldman Sachs to only assist companies meeting minimum diversity metrics when going public. These initiatives, we find, hold the prospect of potentially important upgrades to corporate Diversity. We conclude, however, that many face substantial constitutional challenges. As important, virtually all are board-level initiatives and do not cover private companies, which comprise an increasingly large share of economic activity. Nor do they address Equity and Inclusion, and by extension issues such as how corporations use contracted workers and interact with customer communities. They are thus, by definition, limited in their reach and robustness. For these reasons, if serious improvement in corporate practices is desirable, supplemental actions by corporations will be essential.

In Part IV, we provide a foundational theory of how the corporate law of fiduciary duty applies to corporate DEI policies. First, we explain the general principles underlying the duties of loyalty and care, and how the corporation's obligation to comply with the law is fundamental to the operation of corporate law. We show that the fiduciary duty of loyalty requires not only a negative responsibility to avoid harm to the corporation, but that it also requires the duty to take affirmative steps to advance the best interests of the corporation. This includes, as reflected in Delaware's famous Caremark decision, an obligation for fiduciaries to undertake active efforts to promote compliance with laws and regulations critical to the operations of the company. Importantly, we show that the most central role of Caremark is in the normative obligation it imposes on directors to try to avoid the regulatory penalties, managerial turnover, stakeholder backlash, and overall reputational and financial harm that occurs when companies violate laws essential to society. As we show, the very fact that a Caremark case is brought is usually a sign that the company has already lost, even if the directors do not ultimately face liability under Caremark itself. We also highlight the considerable discretion that the affirmative component of fiduciary duty law gives business leaders to pursue policies they rationally believe to be in the best interests of the corporation in terms of its sustained profitability and reputational integrity with its stakeholders, society, and regulators.

Part V takes the crucial step of showing how these general principles apply specifically to DEI. As to managers and directors skeptical about DEI, or those who fear it might be beyond their remit of responsibility as fiduciaries, we explain why fiduciary duty requires them to focus on antidiscrimination practices to some meaningful extent, and why failing to do so is riskier than making sure the company has effective DEI practices. We show how the legal expectation of lawful conduct, reflected in Delaware's Caremark decision, charges fiduciaries with preventative monitoring for compliance with antidiscrimination laws and legislation as a core feature of their duty of loyalty. Should they fail to do so, companies not only risk corporate liability accompanying such violations; they--along with their directors and top managers--also face the possibility of large reputational costs, stakeholder backlash, internal turnover at the top of management and on the board itself, and fines and injunctions from regulators, even if the follow-on derivative lawsuits are ultimately dismissed. From this standpoint, corporate law's fiduciary duty of compliance is not only important as a matter of “hard” law enforced by the threat of corporate and personal liability. It also defines what fiduciaries are expected by corporate law to do as normative “soft” law. These expectations go beyond what fiduciaries can be held liable for in damages and require them to protect the corporation from the financial, management, and reputational consequences of failing to comply with critical laws. And these consequences have been supercharged in the wake of George Floyd and Breonna Taylor and the inequality-revealing and exacerbating pandemic.

We then close by identifying why corporate managers and directors who wish to fulfill their normative duty of loyalty by taking affirmative steps to improve sustainable corporate profitability can safely embrace a commitment to Diversity, Equity, and Inclusion--i.e., more ambitious DEI policies that go beyond their duty under Caremark to monitor core antidiscrimination compliance obligations. In doing so, we emphasize that corporate fiduciaries do not need definitive evidence of DEI's impact on value to act. Because there is a rational basis for concluding that the promotion of DEI will improve the ability of corporations to function profitably in an increasingly diverse domestic and international economy, fiduciary duty law, and in particular the business judgment rule, provides authorization for corporate DEI policies and therefore leaves business leaders no corporate law reason not to adopt them, and some strong reasons to do so.

In forwarding this framework, this Article offers a doctrinally sound yet novel approach that will not be without its ideological detractors. For all of the attention now directed at DEI in corporate America, it is not usually talked about as a matter of long-standing corporate law principles. Indeed, from Friedman's derision of reformist “catchwords” to a sensitivity even among some Black Lives Matter activists to belittling the significance of Diversity by reducing a moral call to action to one of business prerogatives, Diversity is most commonly understood as an external matter to the firm.

We believe, however, that the case for Diversity has both a strong moral and business rationale, making it relevant even as a matter of traditional corporate law principles. Moreover, the internal/external dichotomy of the Friedman view is highly misleading: the very DNA of corporate law's most foundational duty, that of loyalty, is as much outwardly facing as it is inwardly facing in that it creates obligations to comply with all laws-- including core civil rights legislation--that are of critical importance to the company, its stakeholders, and society. These clarifications enable important interventions for refining current reforms and enabling new ones within even our legacy corporate law framework. This important reality poses a substantial question to American business leaders and the institutional investors who wield power over them: If corporate law not only enables directors and the board to address important DEI issues, but also requires corporate attention to them, will they meet their duties head on, and even exceed them, or will they incur the high financial, reputational, and legal risks of ignoring them?

[. . .]

The clarification of corporate law that this Article offers will not, in itself, cure the lack of representativeness of American corporate boards and management teams. Nor does it provide a simple answer to the broader equity challenges that must be met if the corporate sector is to meet the growing expectation to treat all its stakeholders with equal respect. It is, however, a piece of a larger puzzle and a vital legal and policy tool to help our nation live up to its ideals in vital economic activities essential to human freedom and dignity. Internal corporate action can address critical issues that current external reforms either overlook or will be unable to solve without operating in concert with internal corporate action. We applaud in principle the emerging external law efforts to spur greater Diversity, Equity, and Inclusion in the behavior of American companies. But, as we have explained, these external efforts have important limitations in terms of their application only to public companies, their inability to address the full range of issues where sensitivity to DEI issues is important to corporate treatment of stakeholders, and the difficulty any external regulation has in embedding values and norms in a complex organization, unless the leaders of that organization support that themselves. The full promise of DEI in creating not only a fairer nation, but stronger, more resilient, and sustainably profitable American businesses can only be realized if corporations themselves embrace these values in all the important ways in which they affect their stakeholders and society. Our goal in this Article is therefore focused, but important. We hope to have shown that corporate law itself has a positive role to play in supporting corporations in taking ambitious actions to promote DEI and contributing to a more inclusive and fair economy and nation.

For too long, corporate law has been misunderstood when it comes to important social matters that happen to make business sense. Diversity is one area where a course correction is needed. In the current moment, that is being slowly recognized by businesses themselves. But history shows that our ability to stay focused on issues of inequality is erratic, and there remains substantial resistance to DEI in our society. What we demonstrate is this important reality: corporate law is no island to itself, and the corporate law of fiduciary duty does not constrain directors and managers from promoting DEI. If anything, fiduciary duty pushes corporate managers legally, financially, and reputationally to focus on these important issues as part of their duty to promote the best interests of the corporation, increase its sustainable profitability for the benefits of its stockholders, and ensure that the corporation honors the laws of the society that chartered it.

In sum, corporate law allows and in fact encourages corporate leaders to do the right thing. Whether they do it is up to them and the institutional investors to which they owe their positions--fiduciary duty law leaves them with no excuses for failing to do so. Thus, the ultimate question is not whether business leaders can implement effective Diversity, Equity, and Inclusion policies, but will they?

Chris Brummer is the Agnes N. Williams Professor; Faculty Director, Institute of International Law; Professor of Law, Georgetown University Law Center.

Leo E. Strine, Jr., is the former Chief Justice and Chancellor of the State of Delaware; Michael L. Wachter Distinguished Fellow in Law and Policy at the University of Pennsylvania Carey Law School; Senior Fellow, Harvard Program on Corporate Governance; Henry Crown Fellow, Aspen Institute; Of Counsel, Wachtell, Lipton, Rosen & Katz.

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