Considerations for D&O Insurance in light of the Changing Diversity, Equity, and Inclusion (DEI) Legal Landscape

By Christina Lincoln

After George Floyd’s death in May 2020, companies (including their directors and officers) are facing increasing liability exposure and scrutiny from both sides of the political aisle relating to diversity, equity, and inclusion (DEI) initiatives. While coverage under a directors and officers (D&O) liability policy will vary according to the individual terms and conditions, there are specific coverage considerations insurance companies should keep in mind relating to such exposures.

Following George Floyd’s death in May 2020, America’s courts have become inundated by lawsuits on both sides of the political aisle relating to diversity, equity, and inclusion (DEI) initiatives across various arenas, ranging from university admission policies to the makeup of board members for publicly traded companies. As such lawsuits are appealed to the nation’s highest courts (into 2024 and beyond), key decisions will continue to shape the face of the DEI landscape. As related to lawsuits against companies and their directors and officers (D&O), these decisions will likely have substantive coverage considerations for insurance companies providing D&O liability insurance policies.

Overview of DEI Landscape

As background, California enacted legislation in August 2020 (called AB 979) expanding on existing legislation (SB 826) requiring corporations doing business in California to diversity their board of directors by the end of 2022 with persons self-identifying as “underrepresented minorities.”¹ A year later in August 2021, Nasdaq passed a controversial rule (by a vote of 3-2) in favor of requiring all Nasdaq companies, with certain exceptions, to either have (or explain why it did not have) at least two “diverse” board members – including at least one self-identified female, and at least one self-identified underrepresented minority or LGTBQIA+.² While generally dismissed at the pleading phase, many shareholder derivative lawsuits also were filed against current and former members of non-diverse boards for alleged breach of fiduciary duty, such as those filed against Cisco, Qualcomm, and NortonLifeLock board members.³

Lawsuits challenging the validity of these initiatives began hitting the books in May 2023, when the California legislation was overturned by a federal judge in the Eastern District of California on the basis that a “racial quota” for a “certain fixed number of board positions to be reserved exclusively for certain minority groups” is, on its face, invalid and unconstitutional under the U.S. Constitution’s Equal Protection Clause and Section 1981 of the Civil Rights Act of 1866.⁴ This decision was appealed and is pending before the Ninth Circuit Court of Appeals.

One month later, the U.S. Supreme Court issued a similar ruling relating to affirmative action in admission policies at universities, such as Harvard and the University of North Carolina. There, the Court reversed the lower courts’ decisions allowing for such practices, and held that the universities’ “numerical commitment” to its admission policies for certain minority groups violates the Equal Protection Clause in the Fourteenth Amendment.⁵ In other words, such admission policies “lack[ed] sufficiently focused and measurable objectives warranting  the use of race, unavoidably employ[ed] race in a negative manner, involve[d] racial stereotyping, and lack[ed] meaningful end points.”⁶ The Court clarified that a strict “numerical commitment” is distinct from consideration of an applicant’s discussion of “how race affected his or her life, be it through discrimination, inspiration, or otherwise.”⁷

On the heels of the Supreme Court’s decision, Attorney Generals from 34 different states joined one of two conflicting letters to Chief Executive Officers (CEOs) of Fortune 100 companies regarding the future of corporate DEI policies and its legal implications on the workplace. While the initial letter signed by 13 Attorney Generals warned of “serious legal consequences” for using “racial quotas and preferences in hiring, recruiting, retention, promotion, … advancement,” contracting practices, and treatment of customers,⁸ the response letter signed by 21 other Attorney Generals and issued less than a week later urged businesses to “double-down on diversity-focused programs.”⁹

The Fifth Circuit recently added to the ongoing discussion by issuing a unanimous order on October 18, 2023, upholding the Nasdaq’s board diversity rule – holding that the Constitution, including the Equal Protection Clause, “only applies to state action.”¹⁰ The fact that Nasdaq is a regulated entity is insufficient.¹¹ Moreover, the Security and Exchange Commission’s (SEC) approval of the rule did not violate the SEC’s authority under the Securities and Exchange Act of 1934 or Administrative Procedure Act (APA).¹² While this decision has not yet been appealed to the U.S. Supreme Court, one is expected to be filed shortly.

D&O Liability Insurance Coverage Considerations

In light of the above framework, companies as well as their directors and officers are facing increasing liability exposure and scrutiny from both sides of the DEI debate. For example, employees could make a claim against an insured company for alleged “wrongful acts” associated with discriminatory hiring and/or contracting practices by setting a numerical goal and/or quota for individuals and/or companies constituting (or owned by) underrepresented minorities. Such allegations would typically be dealt with by employment practices liability insurance (EPLI) policies, which are outside of the scope of this article.

However, a lawsuit also could be filed by a company’s shareholders in a derivative action on behalf of the company against its directors and officers, seeking (1) declaratory relief (e.g., under the Civil Rights Act of 1866, Title VII, state civil rights laws); (2) breach of the fiduciary duties of loyalty, good faith, and due care; and/or (3) preliminary/permanent injunction (along with any related causes of action) for (a) allegedly adopting and/or implementing “explicit racial quotas and preferences in hiring, recruiting, retention, promotion, and advancement”; and (b) using “race-based contracting practices, such as racial preferences and quotas in selecting suppliers, providing overt preferential treatment to customers on the basis of race, and pressuring contractors to adopt the company’s racially discriminatory quotas and preference.”¹³

While coverage under a D&O policy for the above exposures will vary according to the individual terms and conditions of the policy, securities class actions and shareholder derivative claims asserting DEI-related claims against a company and/or its directors and officers – such as those summarized above – often fall within the scope of the insuring agreement under a D&O policy, which covers “wrongful acts” typically defined as actual or alleged acts, errors, omissions, misstatements, misleading statements, neglects or breaches of duty by an insured person while acting in their official capacity as officer or director of the company.

In assessing the potential for coverage, a careful review of several exclusions and other issues would be necessary. For instance, as is often the case with D&O claims, the language of the conduct exclusion (i.e., dishonest, fraudulent, malicious, and criminal acts) should be reviewed to determine whether its application requires a final adjudication exhausted by appeal or only “in fact” confirmation of such conduct. This exclusion is particularly of interest in the DEI space, given the changing legal landscape of what constitutes a permissible policy of DEI consideration for university admission, recruitment, or otherwise across industries. Similarly, claims also may implicate the insured vs. insured exclusion to the extent shareholder derivative lawsuits are not carved out. Furthermore, individual employment-related claims are typically excluded by D&O insurance, which, as mentioned above, are addressed by EPLI policies.

While EPLI is beyond the scope of this article, “other insurance” provisions or self-insured retentions may come into play to limit coverage, depending on the existence of potentially overlapping factual allegations set forth in a given claim.

Pre-claim investigative coverage and/or Side D coverage for internal investigations also may be triggered when a DEI lawsuit is threatened, or a complaint is lodged with the board of directors. However, such coverages are typically limited with low sublimits and/or annual aggregates.

Overall, because companies and their directors and officers are facing increasing liability exposure and scrutiny from both sides of the DEI debate, we hope that the above overview of the actively evolving legal landscape and discussion of initial coverage issues within the D&O space is helpful for consideration.