REVISING: Incentivizing Corporate Diversity through Debt Finance

-- By BrandonHolt - 13 Mar 2022

Introduction

When the video of Derek Chauvin murdering George Floyd commanded the the world's attention in May 2020, many US corporations released statements decrying anti-Black racism and their own systemic failure at employee diversity. Corporations also disclosed their demographic data, confirming 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?

Demands to diversify need to be attached to an incentive structure that compel corporate change. Morality, alone,––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.

Capital limits all corporations. Corporations routinely fund general corporate initiatives through equity and debt finance. In equity markets, corporations dilute their ownership with investors who can directly challenge a company’s strategic direction. Could corporate diversity attainment improve with the activism of prominent shareholders? In debt finance, the credit agreements that set a borrower's and lender's obligations are based in contract law, where 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

For public companies, the equity markets are a central funding source for corporate initiatives. But dispensing equity yields shareholders who also have a say in a company's priorities. This shareholder activism is an increasingly popular tactic to move corporations in a particular strategic direction. Activism that targets ESG--Environmental, Social, and Governance--concerns usually take this form. Climate-conscious operations are a highly visible, and growing, cause for shareholder activists. For example, when ExxonMobil? did not commit to a net-zero status like its peers, an ESG-activist hedge fund initiated a successful proxy contest that led to the removal and addition of hand-picked directors on Exxon's board. The new board is now exploring avenues for climate-friendlier operations.

Shareholder activism may seem like an obvious argument for corporate diversity given the home “diversity” seemingly has under "social" in ESG and the general corporate preference for market-dictated outcomes. Even the Financial Times noted companies and boards must be prepared for investors of varying shareholder interests attacking even “squishy matters where blunt profit maximi[z]ation is not the issue.”

While undeniably impactful, shareholder activism is also limited. Its strategies require motivated shareholders, continuous engagement, proxy coordination amongst investors, and significant advisory resources (e.g. legal, activist, and financial advisors). The strategies, like board overhauls, are also antagonistic to the business and can be met with resistance that further delays realized progress. And importantly, these strategies are generally limited to public companies, which only represent a minority of US firms.

Debt Financing

As bank loans are a contract, the repayment terms can include an adjustable interest rate. The bank lender would assign an initial rate (based on a market benchmark like LIBOR or another benchmark given LIBOR's phaseout) that may include a premium. The premium, reflecting the borrower's creditworthiness, is triggered if the company has "low" diversity at the consummation of the loan. The borrower and lender can further agree to increase or decrease the interest rate over time based on whether the borrower meets the agreed diversity targets. The borrower need not be the only entity subject to a diversity commitment. The borrower could further bargain for discounts on advising fees if their legal and financial advisors to these transactions similarly fail to meet agreed diversity targets.

There is a precedent for this proposal in the climate space with "sustainability-linked loans". Under this loan structure, a borrower's interest rate is adjusted based on to their attainment of agreed to sustainability targets. Specifically, the loan's interest rate is lowered if the target is attained and the interest rate is increased if the borrower fails to meet the agreed targets. A related 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.

The public commitments corporations made to improve diversity could motivate lenders and borrowers to initially consider this type of proposal, particularly if special interest groups connected the sustainability-linked loan precedents to diversity attainment commitments and demands. But the benefits of this proposal to the bottom-lines of both lenders and borrowers provide reasons for parties to actually adopt and agree to these terms. For borrowers, this scheme provides access to favorable rates on funds that can be used for general corporate purposes and demonstrates a commitment to diversity to its stakeholders (e.g. boards, shareholders, employees, and consumers). For lenders, this scheme could increase the lender's executed deals and client base, result in higher returns, and bolster a lender’s reputation as assisting borrowers in fulfilling their public commitments on diversity. In essence, the scheme allows for borrowers and lenders to speculate on the ability of the borrower to diversify within established time frames.

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