It's Time for a Fresh Look at DEI Metrics in Executive Compensation
The Background: It is estimated that over 84 percent of companies in the S&P 1500 use some form of "social" metric when determining their executives' incentive compensation. Many of these social metrics set forth diversity, equity and inclusion ("DEI") goals—some quantitative, others qualitative—usually summarized to some degree in a company's publicly filed proxy statement. For calendar year-end companies, decisions regarding the metrics of incentive compensation programs are typically made in the first quarter of each year.
The Situation: Last summer, the U.S. Supreme Court held in two companion cases that race-conscious admissions programs at Harvard and the University of North Carolina violated the Equal Protection clause. These decisions focused attention on the risks of DEI programs outside the college admissions context and emboldened critics of DEI programs. Some companies with well-publicized DEI goals received letters from anti-DEI activists questioning the legality of their DEI initiatives. Others have been sued under civil rights or securities laws, or received threats of such litigation.
Looking Ahead: As companies—public companies, in particular—consider the design of their 2024 incentive compensation programs, they should review their existing social metrics and assess how to best balance their well-founded goals for workforce diversity and inclusion against possible litigation and other risks of pursuing such goals.
Environmental, Social, and Governance/Diversity, Equity, and Inclusion, or ESG/DEI, will continue to be a leading theme in the upcoming proxy season as workforce diversity and inclusion remains front of mind for boards and investors alike. The benefits of diversity and inclusion within public companies have been well-documented over the past decade. A McKinsey study of more than 1,000 companies across 12 countries found companies in the top quartile for ethnic and cultural diversity were 33 percent more likely to outperform companies in the bottom quartile; and companies in the top quartile for gender diversity were 21 percent more profitable than companies in the bottom quartile. Research by Deloitte found that companies with inclusive cultures were twice as likely to meet or exceed financial targets and were more innovative and agile. Over the past several years, the boards of many public companies have, to varying degrees, tied discrete elements of executive incentive compensation to achievement of social metrics focused on workforce diversity and inclusion. In some cases, those social metrics have been published in proxy statements, sustainability reports, and websites, among other places.
However, the U.S. Supreme Court last term decided the companion cases Students for Fair Admissions v. President and Fellows of Harvard College and Students for Fair Admissions v. University of North Carolina, in which the Court held that both institutions' admissions programs violated the Equal Protection Clause of the 14th Amendment and Title VI of the Civil Rights Act of 1964, which prohibits discrimination in federally funded programs. The Court reasoned that, with limited exception, the Equal Protection Clause does not permit an admissions practice that treats applicants worse because of their race, regardless of whether the motivation behind it is commendable or detestable. Meanwhile, Title VII of the Civil Rights Act and other antidiscrimination statutes have always prohibited employers from making employment decisions based on race and other protected categories, even when decisions favor historically underrepresented groups. While employers in limited circumstances may implement voluntary affirmative action plans to remedy past discrimination or eliminate a manifest imbalance in a traditionally segregated job category, such affirmative action plans must be limited in time and scope, cannot involve mandatory quotas, and must meet certain other requirements. If not, they may violate the law.
DEI and Executive Compensation
In recent years, as public companies have increased diversity on their boards, they also have launched or enhanced workforce DEI initiatives, with goals related to such initiatives in some cases being tied to executive compensation. The approaches have been varied:
- Some companies have, to date, not treated workforce DEI as a factor in executive compensation. Within this group, however, many have felt differing degrees of outside pressure to include it.
- Other companies have chosen to reference DEI more generally, using aspirational language and assessing achievement using qualitative rather than quantitative metrics.
- A third group of companies has been more aggressive with DEI goals, using a quantitative approach and specifically identifying protected groups, segments of the workforce and geographic areas that should be the focus of DEI efforts, in some cases with specific numeric goals on which compensation decisions will be based (at least in part).
There is little dispute that DEI programs can add value, and that lawful DEI-based social initiatives can be pursued with careful drafting and attention to prohibitions under Title VII of the Civil Rights Act and case-law developments. However, tying executive compensation to diversity metrics creates litigation risk because it provides evidence for individuals who have been laid off or bypassed for promotion to argue that senior leaders of a company—whose compensation is influenced at least in part by achievement of diversity metrics—were incentivized to favor employees in underrepresented groups. Under Title VII of the Civil Rights Act, DEI initiatives that involve quotas or encourage employment decisions that favor any particular protected category create legal risk because such initiatives may be characterized by a litigation adversary as direct evidence of discrimination.
As an example, in late 2021, which was before the Supreme Court's college admissions decisions, a federal court jury seated in Charlotte, North Carolina, handed up a $10 million award in favor of a white former senior vice president of a hospital network who accused his employer of firing him and seven other white male executives as part of a diversity push. The employer defended the allegations by arguing, among other things, that its DEI program was a comprehensive initiative beneficial to the hospital network. The employer's DEI plan included the use of a diversity "lens" in its decision-making, and the implementation of a long-term incentive ("LTI") compensation award for senior leadership who demonstrated they improved DEI in various areas from 2017 through 2019. Fifty percent of the LTI plan was specifically dependent on senior leaders' ability to meet minority hiring targets. At trial, the federal district court instructed the jury that the former executive needed only to prove that his race and/or sex played a motivating role in the employment decision, even though other factors also may have motivated the employer. The jury found that the executive satisfied this causation standard.
In the following year, 2022, a federal district court in Houston, Texas, denied an employer's summary judgment motion in a reverse discrimination case brought by a high-performing male whose position was eliminated during a restructuring and who failed in his efforts to secure four other open company positions, all of which the company filled with females. The court cited evidence that the employer publicly pursued DEI initiatives that included a goal of achieving a gender-balanced workforce by 2025 and financially rewarded senior company leaders, in furtherance of that goal, if female representation in the company increased by three percent annually. In denying summary judgment, the court described the program as a veiled affirmative action plan that constituted direct evidence of bias against males. That case settled before trial.
More recently, roughly two months after the Supreme Court's college admissions decisions, a federal district court refused to dismiss disparate treatment and hostile work environment claims asserted by a City of Seattle employee who alleged that the city's Race and Social Justice Initiative caused him to receive "less favorable treatment in work/project assignments, hours, and promotions" and be subject to scorn and ridicule due to his perceived status as a "straight, white male."
Outside of the employment litigation context, public companies are seeing an uptick in securities litigation. Some that have struggled with financial performance have been accused of over-prioritizing DEI initiatives, to the detriment of company financial performance and, ultimately, shareholders.
Assessing and Addressing the Risk
Risk in the wake of last summer's Supreme Court decisions should not cause companies to scrap DEI initiatives entirely. Ultimately, the benefits to the company of pursuing DEI initiatives may, in the view of its board and senior leadership, outweigh any risk. For some employers, such as those that are aggressive in constantly reshaping the composition and skills of the workforce, or those with restructuring and layoffs on the near-term horizon, that risk may be significant.
Ultimately, companies that tie executive compensation to social metrics with DEI goals should assess where they sit on the risk spectrum and, if appropriate, revise how achievement is measured. Quantitative goals, in most cases numeric—and either achieved or not based on discoverable data—can be spun as direct evidence of bias by litigation adversaries. Qualitative goals tend to be more aspirational in tone and more general in nature, with achievement not based on hard data, lessening its probative value to a litigation adversary. Companies whose past-year goals have been quantitative in nature should work with their legal counsel to be mindful of what is considered and how achievement is documented as they assess achievement against already existing quantitative performance metrics.
Three Key Takeaways
- Recent Supreme Court decisions notwithstanding, DEI-based social initiatives may still be pursued by companies with careful design and drafting, with attention to prohibitions under Title VII of the Civil Rights Act and case-law developments.
- Companies that compensate their executives, at least in part, based on achievement of DEI-based social goals should assess their risk profile and balance the risk against the good that may be derived from such goals, including carefully considering the weight of such metrics in the context of the overall program (i.e., not placing undue weight on such metrics in the incentive programs).
- Compensation metrics based on quantitative goals should be closely scrutinized as part of this risk analysis and, if appropriate, modified to be more qualitative and focused on overall workforce diversity rather than specific protected groups.