Incentivizing Corporate Diversity through Debt Finance

-- By BrandonHolt - 13 Mar 2022

Introduction

When the video of Derek Chauvin murdering George Floyd commanded the attention of the world in May 2020, many United States corporations released statements decrying anti-Black racism and their own systemic failure at employee diversity. Corporations disclosed their demographic data, exposing the lack of diversity attainment across Black, Latinx, queer, and women employee populations. The general sentiment of these disclosures was, “We need to and will do better.”

Now, two years later, there is still the same want of corporate diversity. While challenges to a corporation’s lack of diversity are more acceptable in corporate talk, actions that produce meaningful diversity attainment are sparse or do not produce expedient results. This introduces the question to be explored here: how can corporations be incentivized to expediently diversify their workforces?

Multiple industries at all levels of seniority remain inaccessible to diverse employees. Demands to diversify need to be attached to an incentive structure that compel corporate change. Morality––or the market shame that results from lack of adherence to a moral position––is an unmoving, or at best slow yielding, corporate incentive. Conversely, financial stipulations that impact a corporation’s bottom-line necessarily dictate a corporation's strategy.

Access to capital limits all corporations. Corporations routinely fund general corporate initiatives through debt finance, where they borrow money from a syndicate of banks. The credit agreements that set a borrower's and lender's obligations are based in private contract law, meaning the parties bargain for the terms by which they are bound. This includes important terms like at what interest rate a loan is repaid to lenders and what advisory fees a borrower owes to legal and financial advisors. Could corporate diversity materially and expediently improve if these rates and fees were attached to diversity attainment over the course of the loan?

ESG and Shareholder Activism

Through due diligence, acquirers evaluate the risk profile of a target and balance those risks against their own risk appetite. An increasingly popular risk analysis is in ESG, Environmental, Social, and Governance. Climate-conscious investing is on the rise and is one of the most popular operational impacts to scrutinize through ESG. For example, when ExxonMobil? did not commit to a net-zero status goal like its peers BP and Shell, an ESG-activist hedge fund initiated a proxy contest against the company, which received institutional investor support and ultimately led to a shake up on the board of directors. The board is now exploring avenues for climate-friendlier operations.

The rise in ESG based attacks of corporate strategy are expansive and not limited to climate issues or challenges by large investors. Carl Ichan, famous for his serial activism, recently launched a board challenge at McDonald? ’s over animal rights abuse even though his ownership interests are only worth around $50,000. As the Financial Times noted, given the rise in ESG, companies and boards must now be prepared for investors of varying shareholder interests attacking even “squishy matters where blunt profit maximi[z]ation is not the issue.”

While shareholder activism and ESG-based challenges are the more obvious avenues to pressure corporations to pursue genuine workforce diversity, these strategies require continuous engagement, proxy coordination, and motivated shareholders. Further, these strategies are generally limited to public companies and do not solve the important issues of time and expediency.

The Proposal: Bank Financing

In their paper “Corporate Carbon Reduction Pledges: Beyond Greenwashing,” co-authors John Armour, Luca Enriques, and Thom Wetzer present their “green pill” solution to pressure corporations into green compliance. The solution requires corporate borrowers to meet agreed environmental goals. The interest rate on their bank credit is indirectly tied to their environmental goal attainment: the greater the attainment, the lower the interest rate.

A similar idea has been applied in the racial justice context. Napoleon Wallace’s firm, Activest, rates municipalities’ credit worthiness by incorporating police brutality prevalence into traditional municipal credit ratings. When occurrence of police brutality is high and the frequency and amount of lawsuit settlements are also high, the riskier the rating Activest assigns.

This proposal leverages both of the aforementioned concepts to make diversity attainment a measure of access to financing. The lower a company’s employee diversity, the higher the interest rate assigned at the start of the bank credit arrangement. In this way, a company’s existing employee diversity is a metric of its creditworthiness. As an incentive to improve diversity over the course of its term loan, a company’s interest rate improves as the firm’s employee diversity improves in keeping with the Armour, Enriques, and Wetzer model.

In order to glamorize their diversity metrics, companies often overstate their gender diversity at the expense of racial diversity or obfuscate their racial diversity through people of color metrics while specific racial groups remain underrepresented. For this financing model, employee diversity should be defined with specificity (i.e. identifying goals for particular marginalized groups) and the rate-based goal tiers should be ambitious in order to encourage material diversity.

Attaching diversity metrics to financing in this way will importantly drive expediency. Interest rates, particularly in the context of an acquisition or joint venture play an important role in how a target company is valued. If a valuation can become more favorable to an acquirer and borrower over time, multiple corporate parties, from senior leadership to boards and shareholders are motivated to realize the best rate which would be a direct result of diverse hiring and retention practices.

An excellent start, We need to make room for some further analysis, so the first step is an edit to make that room. We need the words that aren't pulling weight to go. Sentences can be shortened and simplified, and a few can be removed altogether. We need about 250-300 words back, which is eminently feasible.

With that recovered space the next draft needs to explain why banks will agree to perform this regulatory function. What legal regime sets interest rates, and determines the structure of these investment transactions, or in some other fashion motivates parties to consider interests other than their own in making their investment and lending decisions? This is also an issue in the global heating context on which you draw, where current efforts to use private financial interests to decarbonize the global economy, relying primarily on moral suasion, show the nature of the problem.

Your idea is also a potent illustration of David Graeber's point in his history of debt, that at the peak of debt cycles the position of creditors eclipses that of the State. The ability of the State to deliver social objectives has declined to the point that those seeking progress in social policy on which the State is blocked attempt to use private financial power to achieve their aims instead. But if they need the power of the State to compel or encourage private financial power to perform as desired?

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