Despite a lack of clear guidelines, Russell 3000 and S&P 1500 boards will need to demonstrate diversity or risk anti-management proxy votes.

In the wake of a turbulent year where racial inequalities in America rocked the nation with ripple effects from Main Street to Wall Street, ISS is making history by becoming the first ESG rating agency to take a hard stance to increase ethnic and racial diversity in publicly traded American companies.

The impact is clear: corporations can no longer merely talk the talk when it comes to diversity and inclusion. Indeed, they have a little more than a year to get their boards looking a lot more like the rest of the country. Or they could reap the repercussions of anti-management proxy votes in 2022.

The fact that ISS is traditionally seen as a middle of the road, usually-pro-management rating agency makes the new benchmark proxy voting policies it released on 12 November 2020 that much more notable. The policies, which will be applied for shareholder meetings taking place on or after 1 February 2021 specifically recommend voting against (or withholding votes from) directors for companies in the Russell 3000 or S&P 1500 “where the board has no apparent racial or ethnically diverse members, and no mitigating factors are identified”.

While ISS is putting more teeth behind its recommendations than usual, it’s not the first time an ESG ratings agency has played a role in influencing board makeup. Gender diversity has been steadily increasing over the past decade as rating firms advocated first for one woman on the board, and now require at least 33% of all board members to be female.

While reports are mixed as to whether or not board diversity improves market performance, gender-diverse boards have been found to consistently deliver other critical benefits, including supporting innovative activity and organisational change.

In most corporations, however, the women elected to the board are white women. Companies that are making progress in one area are further widening the ethnic/racial gap in corporate America at the same time.

Open-ended questions

While the case for ethnic and racial diversity at the board level is increasingly well understood—it’s the only way to ensure boards are representing the ideas and perspectives of the wide range of people their companies serve—the specifics on how to achieve diversity and how to disclose it are still somewhat fuzzy. Because ISS has not provided a framework for ethnic/racial board makeup disclosure, many open-ended questions remain on the table.

The US can look to its neighbours to the north for some insight. In Canada, public companies have been required to disclose the ethnic/racial makeup of its boards for several years. Canadian companies disclose this by designating board members as “visible minorities” and “aboriginal peoples”.

In America, however, things are a bit more complex. One of our greatest qualities as a nation is that we are a melting pot made up of people from all kinds of ethnic and racial backgrounds. Because that melting pot has been mixing for hundreds of years, it begs the question—is classifying someone as “white” or “non-white” really appropriate?

The whole idea of “white passing” complicates this even more. Passing happens when someone who is classified as a member of one racial group is accepted as a member of another based on appearance alone.

You can see the potential problems just waiting to boil over. If ISS will decide who is and who isn’t ethnically or racially diverse based on appearance, that implies that it will not consider “white passing” candidates as diverse, regardless of their background or heritage.

This, in turn, opens the door to tokenism, a problem that many female board directors can attest to personally. As boards have been required to appoint more women, females in these roles often report that other members do not take the time to review their experience or ask for their opinions on important business decisions. Behaviour like this uncovers troublesome assumptions among some who believe that women are only there to check a box, rather than because of their unique qualifications.

We could see this same problem manifest with diversity appointments. If companies must look for and choose clearly diverse candidates based primarily on appearance rather than consider any and every candidate who is qualified for the job, it undermines the very purpose and benefits of the diversity requirements in the first place.

Investors can help build diverse boards

As companies try to navigate the requirements and make changes that will allow them to reap the benefits of diversity at the governing level of their organisations, they are not alone. Investors often can be a source of support. Those with more significant ownership or long-term stakes may be able to recommend qualified candidates who can bring diverse thinking to the table.

Other less supportive activist investors attempting to nominate a winning opposition slate will also be under the same onus as the company to identify diverse candidates.

Traditionally, most activist slates have been very light on diversity, and very strong on alignment with the activist investor’s perspective. Now to win the support of shareholders (and ISS’s own positive recommendation), they will need to look further afield for strong and diverse candidates.

Companies can’t afford to wait

Yes, there are unanswered questions and the formula is far from perfect. But companies cannot afford to wait for more direction and clarify to take action on diverse boards.

ISS will provide a grace period for boards that do not currently have any ethnically/racially diverse members. But that grace period is compressed. Companies will need to disclose by 1 February 2022—about 14 months from now.

If they do not, or if they cannot demonstrate ethnic and racial diversity, the companies will most likely see an increase in “no” votes during proxy season against one or more directors.

It’s up to boards and their investors to work together over the next year to build out the standard that ISS has left open-ended and decide how they will thoughtfully and purposefully classify their board members as ethnically and racially diverse.

While there is room for interpretation, the end goal should be this: ensure diverse thinking at the highest level of your company by onboarding people with unique backgrounds and perspectives. Then, give equal weight to every voice at your table.

Elizabeth Saunders is a founding partner at financial communications strategy firm Clermont Partners.