The California Legislature has approved and sent to the Governor for signature a bill ("SB 826") requiring companies incorporated in California and foreign corporations (such as Delaware corporations) headquartered in California, in each case which are listed on major U.S. stock exchanges, to have a specified number of women on their boards of directors. Failure to comply with the new law would expose such corporations to substantial fines imposed by the California Secretary of State.
If SB 826 is signed by the Governor and becomes law, California would be the first state in the U.S. to mandate female directors on public company boards.
According to the author of SB 826, this bill is intended to improve diversity on public company boards. The author's view is that "gender diversity on corporate boards is associated with increased profitability, performance, governance, innovation, and opportunity."
The findings and declarations to SB 826 set forth a variety of statistics indicating the absence of women directors serving on public company boards. For example, SB 826 states that "26% of the Russell 3000 companies based in California have NO women directors serving on their boards." Further, "[n]early one-half of the 75 largest IPOs from 2014 to 2016 went public with NO women on boards."
What You Need to Know About SB 826
The new legislation would require publicly held corporations incorporated in California or headquartered in California (even though they are not California corporations) to take steps to ensure that by (a) the end of calendar year 2019, such corporations have at least one female director and (b) December 31, 2021, such corporations have one, two or three female directors depending upon the size of the board of directors. SB 826 expressly authorizes such corporations to increase their board sizes to allow for compliance with the bill's requirements.
SB 826 also requires the California Secretary of State to impose the following penalties for violations of the new law: (1) a $100,000 fine for a first-time violation; and (2) a $300,000 fine for a second and each subsequent violation. The California Secretary of State also would be empowered to adopt regulations to implement the new law.
SB 826 defines a publicly traded corporation as a corporation whose outstanding shares are listed on "a major United States stock exchange." Although this definition does not further describe what constitutes a "major" stock exchange, it should be expected that the New York Stock Exchange, NASDAQ Global Select, NASDAQ Capital Market and NYSE/AMEX all will fall within this definition. According to a California State Senate Rules Committee analysis, "[t]here are currently 761 publicly traded companies headquartered in California, including 510 traded on NASDAQ, 216 traded on the NYSE, and 35 on AMEX."
Whether a corporation has its principal executive offices (i.e., is headquartered) in California would be determined with reference to disclosure of such location in the corporation's annual Form 10-K filing with the U.S. Securities and Exchange Commission.
Finally, SB 826 defines female as "an individual who self-identifies her gender as a woman, without regard to the individual's designated sex at birth."
Important Business and Legal Considerations
Assuming SB 826 becomes law:
- Complexity of Implementation. SB 826 authorizes a corporation to increase the number of directors so that the corporation can comply with the new legislation by appointing female directors without removing male directors. SB 826 also provides that if a female director holds a position for only a portion of a year, this partial service will not constitute a violation of the new legislation.
- Nevertheless, compliance with SB 826 is not as easy as simply appointing one or more new directors. Corporations still must abide by, or where necessary take steps to change (including possible seeking stockholder approval for amendments to), charter and bylaw requirements dictating the maximum board size. Further, since director candidates nominated by boards – whether or not previously appointed – must be approved by stockholders, corporations need to anticipate instances where one or more female nominees are not elected, must resign for failure to receive a majority vote or are removed by stockholders. Ultimately, directors must be acceptable to stockholders and resort to repeated appointments to comply with the new law despite the wishes of the stockholders likely will be detrimental to the governance of the corporation.
- Public Companies and the 2019 Deadline. According to a study by Equilar, an executive compensation and corporate governance data firm (www.equilar.com), "82% of public companies in California [i.e. stock exchange traded and headquartered in California] who have annual revenues of over $5 million will meet the initial criteria, whereas 18% will not." For those public companies who fall in the 18% camp, time will be of the essence if SB 826 becomes law. The search process for identifying qualified director candidates, the vetting process and the work needed to prepare appropriate proxy statement disclosure about the qualifications of new director nominees will take considerable time. With the 2019 proxy season just a few short months away, qualifying public companies currently lacking any female directors will need to move quickly to avoid being non-compliant by the end of next year.
- IPO Companies. SB 826 does not contain any transition period for IPO companies. Therefore, California headquartered companies that intend to go public and seek a listing on a major U.S. stock exchange need to anticipate compliance with SB 826.
- Controlled Companies. Unlike NYSE and NASDAQ listing requirements, which exempt listed companies from many important corporate governance requirements, SB 826 makes no exception for companies with controlling stockholders.
- Significance of the 2021 Deadline. By December 31, 2021, qualifying public companies with six or more directors must have a minimum of three female directors, companies with five directors must have a minimum of two female directors and companies with four or fewer directors must have at least one director. According to the study by Equilar, if these requirements were in effect today, "79% of [stock exchange traded and headquartered in California] public companies would fail, while only 21% would pass." Accordingly, qualifying companies have a long way to go to avoid penalties due to SB 826. Although year end 2021 might seem distant from today, planning for compliance with SB 826 should begin now so that a properly constituted board of directors is in place by the end of the 2021 proxy season.
- Activism. For companies not yet compliant with SB 826, failure to move quickly toward compliance could become a weakness that activists will seek to exploit. One of the most important activist tactics is to gain entry to the boardroom. And, running a director slate that includes one or more female director candidates whose election would bring a target company into compliance with SB 826 might be a winning strategy for advancing an activist's agenda. Accordingly, vulnerable public companies need to anticipate such an effort and consider speeding up their compliance with SB 826.
Will SB 826 Survive Legal Challenge?
- Constitutionality. The Assembly Judiciary Committee Analysis points out that SB 826 could be vulnerable to legal challenge on equal protection grounds due to the creation of an express gender classification. Indeed, many commentators in recent months have described SB 826 as a likely unconstitutional gender quota requirement. As the Assembly Floor Analysis states, "[t]he use of a quota-like system, as proposed by this bill, to remedy past discrimination and differences in opportunity may be difficult to defend."
- Nevertheless, it is instructive to keep in mind that in 1977, when the modern California Corporations Code (the "Code") was enacted, many commentators warned that Section 2115 of the Code, which imposes certain Code provisions on foreign corporations with specified substantial contacts with California (other than those listed on a securities exchange), also was vulnerable to constitutional challenge. Yet, over 40 years later, this statute remains on the books as good California law, not yet addressed by the U.S. Supreme Court and, therefore, must be seriously considered when evaluating the proper, legally compliant governance of such foreign corporations.
- Internal Affairs Doctrine. SB 826 includes a provision stating that the new law would apply to qualifying public companies incorporated outside of California notwithstanding the laws of their state of incorporation. Whether this provision and SB 826 as a whole will be respected by California courts or courts in other states is uncertain. More than a decade ago, the Delaware Supreme Court ruled that Delaware courts need not enforce Code Section 2115 on the basis of the Delaware internal affairs doctrine.[1] Yet, as noted in the Assembly Floor Analysis for SB 826, the Witkin treatise, a respected authority on California law, "notes that the internal affairs doctrine is sometimes ignored where . . . a business' books, records and principal operations are located in California."[2]
- Notably, a number of provisions of the California Corporations Code regulate foreign corporations headquartered in California and these statutes have not been challenged in court and are frequently complied with by foreign corporations.[3]
Final Word
Although SB 826 has been characterized by its proponents as a call for action for improving gender diversity on public company boards, the legislation also has drawn strong objections from those asserting that employing quotas to achieve this objective is poor public policy or unlawful. Whether or not this new legislation will be challenged in court and, if so, will survive such a challenge remains to be seen. In the meantime, however, California headquartered public companies should move expeditiously to comply with SB 826 to avoid the risk of penalties and undue pressure from major institutional investors who support greater gender diversity in the boardroom and from activists who might view a failure to quickly comply with SB 826 as a weakness worth exploiting.
[1] See Vantage Point Venture Partners v. Examen, Inc., 871 A.2d. 1108 (Del. 2005).
[2] 9 Witkin, Summary of Cal. Law, Corporations § 239, p. 1006 (10th Ed. 2005); quoted in Vaughn v. LJ Int'l., Inc., 174 Cal.App.4th 213, 223 (2009).
[3] See, e.g., Code Section 2117 requiring the filing with the California Secretary of State of information statements by foreign corporations; Code Section 2117.1 requiring filing with the California Secretary of State of disclosures concerning, among other things, the auditors, and compensation paid to directors and executive officers, of publicly traded foreign corporations; Code Section 1501 requiring the delivery of annual reports by foreign corporations headquartered in California; and Code Section 1600 regarding stockholder inspection rights afforded to stockholders of foreign corporations headquartered in California.