Diversity, Equity, and Inclusion (DEI) initiatives are under fire, being materially scaled back or jettisoned entirely by both the federal government and private employers.

With the future scope or, indeed, continued existence of DEI initiatives subject to considerable uncertainty, it is worth reexamining the legality of provisions advancing such initiatives that may have made their way into credit agreements, including a brief look at the origin of DEI provisions in financing arrangements.

Examples of DEI Initiatives in Credit Agreements

At first blush, it may seem unlikely that finance would be an area impacted by the controversy engulfing DEI, but provisions intended to support DEI initiatives have been incorporated into numerous credit agreements.

Some credit agreements, for example, provide for interest rate and commitment fee incentives and disincentives based on the company’s/borrower’s compliance with specified DEI targets (including but not limited to internal hiring practices, business dealings, and permitted investment targets).

In one such example, an agreement rewarded the company/borrower with interest and commitment fee savings on a sliding scale based on the number of minorities promoted to the title of vice president (or a more important or senior title). Another example is a credit agreement term contemplating interest rate and commitment fee reductions tied to achieving targets for the provision of certain services by the company and its affiliates to women and girls.

Other credit agreements have tied interest rates and fees to specified performance metrics that link to DEI targets such as:

• percentage increase in minority employees;

• percentage increase in female executives; and

• percentage increase in diversity in the board of directors.

Why Did Borrowers Implement DEI Metrics in Credit Agreements?

Such DEI-linked provisions have often appeared – among other metrics – in the ESG (Environmental, Social, and Governance) pricing supplements to credit agreements, as DEI metrics fit naturally into this preexisting framework for “encouraged company action.”

While such ESG pricing supplements were traditionally more commonly focused on workplace safety measures and reduction of greenhouse gases, they expanded in recent years to also sometimes include DEI metrics, particularly as ESG evolved to explicitly include DEI as part of the “S” (social) component of ESG.

With this ESG backdrop, borrowers implemented DEI metrics in their credit agreements for a variety of reasons.

First, as discussed above, there was a strong economic incentive for the company/borrower to agree to meeting DEI targets, realized through the reduction of interest rates and fees on the borrower’s loans. Achieving a DEI target in a billion-dollar credit facility, for instance, would decrease interest rates by 0.05%, saving millions in borrowing costs over the life of the debt.

Second, including DEI metrics could have enhanced a borrower’s access to capital by making the borrower a more attractive partner to lenders and even broadening the borrower’s pool of potential lenders. Banks that participated in large credit facilities increasingly prioritized ESG-linked lending to meet their own regulatory pressures and attract institutional investors. Accordingly, including DEI metric triggers within the ESG criteria could have made borrowers more attractive to these lenders, potentially allowing borrowers to obtain larger credit lines, achieve better loan terms, and expand their universe of potential lending partners.

Third, companies faced expectations from their stakeholders – including shareholders, employees, and customers – to demonstrate social responsibility. Publicly committing to DEI initiatives in a credit agreement showcased a company’s commitment to diversity, aligned with stakeholder values, afforded a measure of accountability (by penalizing missed targets with higher interest rates and fees), and ensured the embedding of diversity into corporate strategy.

Proxy advisors also considered DEI metrics when evaluating a board’s nominees.

Thus, including DEI metrics in credit agreements could have been viewed favorably by proxy advisors benefiting the company in that respect as well.

What is the Legal Concern with These Initiatives?

From the perspective of the lender, the Equal Credit Opportunity Act and its implementing regulation (Regulation B) provide that:

[i]t shall be unlawful for any creditor to discriminate against any applicant with respect to any aspect of a credit transaction – (1) on the basis of race, color, religion, national origin, sex or marital status, or age (provided the applicant has the ability to contract). …

Further, Regulation B provides that a “creditor shall not consider race, color, national origin, or sex … in any aspect of a credit transaction.”

This prohibition covers every aspect of an applicant’s dealings with a creditor, including the specific terms of a loan (such as the interest rate and fees). Moreover, and importantly, it applies not only to discrimination against women and racial and ethnic minority groups but also to any consideration of sex, race, or ethnicity in any aspect of a credit transaction. As such, it prohibits discrimination going in the opposite direction (colloquially referred to as “reverse discrimination”), regardless of how well-intentioned it may be.

Although the June 2023 U.S. Supreme Court decision in Students for Fair Admissions, Inc. v. President and Fellows of Harvard College^[1] ​is specific to higher education and not directly applicable to private sector practices, it has reshaped the legal landscape far beyond educational institutions. That decision held that race-conscious admissions programs at Harvard College and the University of North Carolina violated the Equal Protection Clause of the 14th Amendment because they lacked sufficiently measurable objectives and clear durational endpoints making them fail the “strict scrutiny” standard.

While the ruling does not directly impact practices in credit agreements, initiatives based on or expressly taking account of protected characteristics, such as sex and race, are facing increased scrutiny. Existing precedent applicable to employers under Title VII of the Civil Rights Act of 1964 (the Students for Fair Admissions case was based on Title VI of that Act) and to private contracts generally under Section 1981 of the Civil Rights Act are being examined and informed by the Students for Fair Admissions ruling. Ensuring that DEI efforts do not “unnecessarily trammel” (United Steelworkers of America v. Weber​^​​[2]) the Section 1981 rights of nonbeneficiaries is critical.

The concepts in some of the credit agreements noted above could be problematic both for the lenders and for the company/borrower to the extent they conflict with Regulation B, and existing state and Federal laws prohibiting discrimination.

Incentivizing the promotion within an organization of a particular race or gender and rewarding the provision of services to a particular gender arguably are considering sex and race in a credit transaction in violation of Regulation B insofar as the lender is concerned and in violation of Title VII with respect to the borrower (and potentially the lender on an aiding and abetting theory), perhaps even if no interest rate or fee benefits actually result.

With respect to the borrower, those incentives discriminate based on race and gender and may be inconsistent with existing Section 1981 precedent, failing the “strict scrutiny” standard. Regulation B does allow for “special purpose credit programs” permitting creditors to offer credit or favorable credit terms to specific groups to address economic or social disadvantages without violating Regulation B, but those programs must comply with strict regulatory requirements. Programs must include a written plan outlining its purpose and eligibility criteria, the lender must show that the program addresses specific economic or social disadvantages (often supported by data or studies) and, importantly, the program cannot unlawfully discriminate against non-targeted groups.

We would expect that special purpose credit programs offered voluntarily by lenders could be subject to closer examination, particularly if the lender receives any government funding or grants.

What Now?

Lenders and borrowers should carefully review their credit agreements to ensure that they do not conflict with federal and state laws prohibiting discrimination, including reverse discrimination – especially given that DEI initiatives are subject to heighted scrutiny in the current political and legal environment and could attract regulatory action and legal challenges.

Endnotes

[1] Students for Fair Admissions Inc. v. President & Fellows of Harvard Coll., 261 F. Supp. 3d 99 (D. Mass. 2017), aff’d, 980 F.3d 157 (1st Cir. 2020). ↩

[2] Steelworkers v. Weber 443 U.S. 193 (1979). ↩