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.

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 goal like its peers BP and Shell, an ESG-activist hedge fund initiated a proxy contest against the company. After receiving institutional investor support, the successful proxy challenge 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.”

But shareholder activism is 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.

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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