DEI: When regulators come knocking, will you be ready?

Introduction

In April 2022, the UK Financial Conduct Authority ("FCA") finalized new rules to encourage the disclosure of diversity data by listed companies, whether based in the UK or abroad.  Across the pond, the U.S. Securities and Exchange Commission ("SEC") has implemented similar rules, which will come into force in August 2022, targeted at Nasdaq listed companies.

These changes form part of a wider trend towards an increased focus on Diversity, Equity, and Inclusion ("DEI") issues by UK and U.S. financial regulators. The FCA has stated that it sees DEI as a regulatory issue,¹ and similarly the SEC, as part of its five overarching goals in support of diversity and inclusion, aims to "advance diversity and inclusion in the SEC supplier base and with entities regulated by the SEC."² Environmental, Social and Governance ("ESG") reporting standards are changing the way companies measure performance and, with DEI now seen as a critical part of the "S" in ESG,³ there has been a drive from investors for increased accountability and transparency on the approach companies are taking to tackling diversity issues.  Accordingly, firms will need to ensure that they are attuned to the changing nature of DEI regulation to avoid criticism from shareholders and, importantly, potential regulatory action.

UK: The FCA steps up its game

The FCA’s Policy Statement (PS22/3) (published in April 2022) contains new rules designed to improve transparency in relation to the diversity of company boards and their executive management.  The FCA’s goal is for these transparency measures to encourage companies, through investor pressure, to achieve greater diversity in practice.

• New rules: New FCA Listing Rules⁴ require, as an ongoing listing obligation, in-scope companies to include a statement in their annual report setting out whether they have met specific board diversity targets on a 'comply or explain' basis.  If they have not met the targets, they must explain why. The targets are for at least:
  • 40% of the board to be women; 
  • one of the senior board positions (Chair, CEO, CFO or Senior Independent Director) to be a woman; and 
  • one member of the board to be from a minority ethnic background.
• Additional Listing Rules⁵ will also require in-scope companies to publish numerical data on the sex or gender identity and ethnic diversity of their board, senior board positions and executive management, as well as to explain their approach to data collection.⁶

• To whom do the new measures apply: The new Listing Rules apply to UK and overseas companies with equity shares⁷ admitted to premium or standard listings on the UK Official List. This includes closed-ended investment funds and sovereign controlled companies, but excludes open-ended investment companies and shell companies. The rules do not apply to issuers of listed debt and debt-like securities, securitized derivatives or miscellaneous securities.

• When are the measures effective: In-scope companies are required to make the required disclosures in their annual report for financial years starting on or after 1 April 2022, but the FCA encourages voluntary early adoption by those whose financial years began before then.

The new measures set out above fall within the FCA’s broader focus on diversity, equity and inclusion in the financial sector, as set out in Discussion Paper 21/2 (published in July 2021), which opened a discussion on driving change in DEI across the UK financial services industry (see last year’s OnPoint here).  The FCA has described this Discussion Paper as a "first step in setting out a new regulatory framework on diversity and inclusion" and the new Listing Rules are evidence of this "new regulatory framework" becoming more formalized.⁸  The FCA plans to publish a Consultation Paper this year proposing new requirements in response to the Discussion Paper, with the proposals expected to apply broadly across the financial sector, including non-listed companies.  Firms will need to carefully scrutinize any proposals for change and we anticipate that broader DEI regulation is likely to be accompanied by enforcement for non-compliance.  Georgina Philippou, a Senior Adviser to the FCA, set out in a speech last year that the FCA "want to mainstream diversity and inclusion into all of [its] regulatory processes – from the gateway, in policy making, through to Supervision and Enforcement and everything else [the FCA] does".⁹

US: SEC approves Nasdaq rules as a first step

On August 6, 2021, the SEC approved new Nasdaq listing rules¹⁰ aimed at advancing diversity and promoting inclusive markets. We anticipate other U.S. regulatory and legislative bodies will follow suit.

• New rules: New Nasdaq listing rules require most Nasdaq-listed companies, including foreign companies, to:
  • provide statistical information regarding the company’s board of directors related to a director’s self-identified gender, race, and self-identification as LGBTQ+ in (i) their annual meeting proxy statements or information statements; or (ii) on their websites, in a “board diversity matrix” or a substantially similar format;
  • have, or explain why it does not have, at least two members of its board of directors who are diverse, including (i) at least one diverse director who self-identifies as female; and (ii) at least one diverse director who self-identifies as an underrepresented minority or LGBTQ+.

• To whom do the new requirements apply: The Nasdaq listing rules broadly apply to U.S. and foreign issuers¹¹ with the exception of a small category of exempted companies.¹²

• When are the measures effective: All Nasdaq-listed companies will be required to make the public disclosures by August 8, 2022 or the date the company files its 2022 proxy or information statement, whichever is later.  Newly listed companies on Nasdaq must satisfy the disclosure requirements within one year of listing.

DEI measures by legislators and shareholders

There has also been increased Congressional scrutiny of diversity data from the financial industry among others, including a call for records relating to capital allocation to Black and minority investment managers.¹³

• The House Financial Services Subcommittee on Diversity and Inclusion is currently reviewing legislation, the Diversity and Inclusion Data Accountability and Transparency Act, that would require banks to conduct Racial Equity Audits every two years in an effort to promote diversity and equity.¹⁴
  • Initial debates on the draft legislation considered penalties for non-compliance, including fines of up to $20,000 a day for failure to engage in such audits.¹⁵

• Further, heightened pressure through shareholder demands on DEI disclosures and Racial Equity Audits may prompt more engagement on DEI:
  • A civil rights audit shareholder proposal at Apple received support from 54% of the shareholders in the early March 2022 proxy season.¹⁶
  • Shareholder proposals calling for Racial Equity Audits at Johnson & Johnson and Citigroup Inc. received backing from more than a third of shareholders at annual meetings in April 2022.¹⁷
  • Shareholders are increasingly bringing derivative suits against corporations for failing to uphold diversity and inclusion policies.¹⁸

In the U.S., in light of this increased focus on DEI by stakeholders and regulators, we anticipate increased shareholder litigation and potential regulatory and legislative enforcement to address DEI issues.

The benefits of DEI

Notwithstanding the increased scrutiny from UK and U.S. regulators, there are of course several benefits to firms in focusing on DEI and ensuring that there is diversity within the workplace.

• DEI initiatives improve companies’ overall bottom line. Increased efforts on DEI not only mitigate legal and regulatory risks but also correlate to improved financial results. Organizations with greater diversity in the workforce and leadership teams are more innovative, productive, and better able to thrive during economic downturns.¹⁹ According to the Wall Street Journal, the 20 most diverse S&P 500 companies performed better financially over five and ten-year periods than non-diverse firms.²⁰  According to studies which cover the UK and US, companies in the top quartile of gender diversity on executive teams were 25 percent more likely to experience above-average profitability than peer companies in the fourth quartile.²¹ Further, companies with the highest degrees of ethnic/cultural diversity were 33% more likely to outperform their less diverse peers and companies with the most ethnically/culturally diverse boards of directors are 43% more likely to experience higher profits than their less diverse peers.²²

• DEI helps bolster public perception. 77% of Americans believe companies must respond to racial injustice if they want to “earn or keep [public] trust.”²³ Further, almost three quarters of Britons think that social diversity is part of the UK’s culture.²⁴ As such, increased efforts by companies on DEI measures can have positive reputational impacts for companies.  For example, Starbucks' public announcement of its Racial Equity Audit aided in rehabilitating its public image and the company subsequently became the "most popular restaurant stock on the S&P 500 with actively managed funds that are dedicated to ESG investing."²⁵

• DEI can aid in recruiting and retaining top talent. Nearly 80% of workers want to work for a company that values DEI.²⁶  Companies with inclusive cultures have 22% lower employee turnover rates.²⁷

Conclusion

DEI was already high on the agenda of financial services firms. The attention paid to it should be further enhanced now that regulators in the UK and U.S. are looking more seriously at requiring diversity disclosures and other steps to boost DEI in the financial services industry. Dechert can provide expert legal advice on compliance with new DEI regulations, as well as conducting a wider assessment of the effectiveness of DEI measures. For example, we have a depth and breadth of experience in conducting DEI audits tailored to an organization’s business model. DEI initiatives such as this can provide assurance that a company is in compliance with increasing disclosure and diversity requirements in order to mitigate the risk of an enforcement action in the future, as well as to enable the company to reap the benefits of improved DEI in the workplace.

While there are variations in laws and regulations across the UK and U.S. markets, DEI is a universal concept, and there is increased cooperation and information sharing between the different regulatory agencies in the two markets.  As such, we expect there to be further alignment from the regulators on issues of DEI in the UK and U.S.  Given similar developments in these jurisdictions, including the FCA and Nasdaq Listing Rules on DEI, it would be prudent for companies with business operations in either or both of these jurisdictions to be proactive in their DEI efforts.

Endnotes:

1) Speech by Nikhil Rathi, FCA CEO, titled "Why diversity and inclusion are regulatory issues," delivered 17 March 2021, available here.

2) See here.

3) For example, the FCA’s Business Plan for 2022/2023 makes clear that the FCA will take DEI into account when considering ESG issues for the purposes of authorising firms and individuals.

4) LR 9.8.6R(9) and LR 14.3.33R(1)

5) LR 9.8.6R(10) and LR 14.3.33R(2)

6) Several other changes are also being introduced, including changing DTR 7.2.8AR (which requires in-scope companies to disclose certain information regarding their diversity policies) to expand the reporting requirements to cover the diversity policies of key board committees, and to set out that reporting on board and board committee diversity policies should consider wider diversity characteristics.

7) Or equity shares represented by certificates.

8) Policy Statement PS22/3, p. 10.

9) Speech by Georgina Philippou, Senior Adviser to the FCA on the Public Sector Equality Duty, titled ‘Why does the FCA care about diversity and inclusion?’ delivered on 21 January 2021, available here.

10) Nasdaq Listing Rules 5605(f) and 560.

11)  For foreign issuers, Nasdaq recognized that U.S. categories of race and ethnicity may not extend to other countries, and thus allow foreign companies the flexibility to comply with the diversity objectives by having: (i) two directors who voluntarily self-identify as female; or (ii) one director who voluntarily self-identifies as female and one director who voluntarily self-identifies as an underrepresented individual based on national, racial, ethnic, indigenous, cultural, religious, or linguistic identity in the country of the company’s principal executive offices.

12) Companies exempt from Nasdaq Rule 5605(f) include acquisition companies, asset-backed issuers and other passive issuers, cooperatives, limited partnerships, management investment companies, and issuers of solely non-voting preferred securities, debt securities and derivative securities.

13) U.S. House Committee on Financial Services Report titled "Diversity and inclusion: holding America’s large banks accountable," (Feb. 2020), available here.

14) The Hill article titled "Lawmakers debate bill mandating racial equity audits at firms," (30 June 2021), available here.

15) H.R.2123 bill proposed by Rep. Beatty, "Diversity and inclusion data accountability and transparency act of 2021," latest action: placed on the Union Calendar, Calendar No. 264 on 7 June, 2022, available here.

16) CNBC article titled "Shareholders vote for Apple to conduct a civil rights audit, bucking company’s recommendation," dated 4 March 2022, available here.

17) Bloomberg article titled "Goldman, Citi stave off investor calls for racial audits," dated 4 May 2021, available here.

18) Bloomberg Law article titled "Cisco beats board diversity shareholder derivative suits, for now," dated 2 March 2022, available here.

19) BCG article titled "The business imperative of diversity," dated 20 June 2019, available here.

20) HR Dive article titled "WSJ analysts: diversity boosts business performance," dated 29 October 2019, available here.

21) McKinsey & Company article titled "Diversity wins: how inclusion matters," dated May 2020, available here.

22) McKinsey & Company article titled "Delivering through diversity," dated 18 January 2018, available here.

23) Deloitte article titled "The equity imperative: The need for business to take bold action now," dated February 2021, available here.

24) Times article titled "Diversity? It’s what makes us British, says poll," dated 19 May 2022, available here.

25) CNBC article titled "Starbucks pledges $100 million to help small businesses and black communities," dated 12 January 2021, available here.

26) CNBC article titled "Majority of employees want to work for a company that values diversity, equity and inclusion, survey shows," dated 30 April 2021, available here.

27) Deloitte article titled "Inclusive mobility: how mobilizing a diverse workforce can drive business performance" (2018), available here.