By Richard Vernon Smith
California has enacted a new law mandating that companies incorporated in California as well as foreign corporations (such as Delaware corporations) headquartered in California, and which are listed on major U.S. stock exchanges, have at the close of calendar 2019:
- At least 1 female director
At the close of calendar 2021:
- At least 3 female directors if the board of directors’ size then is 6 or more members
- At least 2 female directors if the board of directors’ size then is 5 members
- At least 1 female director if the board of directors’ size then is 4 or fewer members
The following penalties would be imposed by the California Secretary of State 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 new law will not be violated where a female director holds her directorship for less than a full year.
What You Need to Know About California Requiring Female Representation on Public Company Boards
California is the first state in the country to mandate female directors on public company boards.
According to the principal author of the new law, California State Senator Hannah-Beth Jackson, this law is intended to improve diversity on public company boards. Senator Jackson’s view is that “gender diversity on corporate boards is associated with increased profitability, performance, governance, innovation, and opportunity.”
The legislative findings and declarations to the new law set forth a variety of statistics indicating the absence of gender diversity on California public company boards. For example, the legislation 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.”
A publicly traded corporation is defined in the new law as a corporation whose outstanding shares are listed on “a major United States stock exchange.” The New York Stock Exchange, NASDAQ Global Select, NASDAQ Capital Market, and NYSE/AMEX all likely will fall within this broad definition. Accordingly, as noted in a California Senate report, “[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 will be determined with reference to the office location disclosed in the corporation’s annual Form 10-K filing with the U.S. Securities and Exchange Commission.
The new law defines female as “an individual who self-identifies her gender as a woman, without regard to the individual’s designated sex at birth.”
Companies whose fiscal year does not end on December 31st must comply with the 2019 and 2021 deadlines by the close of those calendar years and not by the end of their 2019 or 2021 fiscal years.
The California Secretary of State also would be empowered to adopt regulations to implement the new law.
Important Business and Legal Considerations About California’s New Board Gender Diversity Law
Complexity of implementation
A qualifying company will be allowed under the new law to increase the number of directors so that the company can comply with the new legislation by appointing female directors without removing male directors. The new law 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 statute.
Nevertheless, compliance with the new law will not be as easy as simply appointing one or more new directors. Companies still must abide by charter and bylaw requirements dictating maximum board size, or where necessary take steps to change those requirements—including possibly seeking stockholder approval for amendments to them.
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Further, since director candidates nominated by corporate boards—whether or not previously appointed—must be approved by shareholders, companies 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 shareholders. Ultimately, directors must be acceptable to shareholders, and resorting to repeated appointments to comply with the new law despite the wishes of the shareholders will likely be detrimental to the governance of the company.
Public companies and the 2019 deadline
Many companies, especially large market cap companies, already have at least one female director on their boards. According to a study by Equilar, an executive compensation and corporate governance data firm, “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, however, time will be of the essence under the new 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
The new law does not contain any transition period for IPO companies. California headquartered companies that intend to go public and seek a listing on a major U.S. stock exchange need to anticipate compliance and, if necessary, adjust their time table for going public accordingly.
Controlled companies
Unlike NYSE and NASDAQ listing requirements, which exempt listed companies from many important corporate governance requirements, the new law makes no exception for companies with controlling shareholders.
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. The challenge for qualifying public companies is not only meeting this deadline but also developing a plan for full compliance going forward in light of normal director turnover and unexpected developments that affect corporate board composition.
According to the Equilar study, 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, the vast majority of qualifying companies have a long way to go to avoid penalties. Although year end 2021 might seem distant from today, planning for ongoing compliance with the new law should begin now so that a properly constituted board of directors is in place at least by the end of the 2021 proxy season and the company is able to maintain compliance over the long term.
New Tool for Activists?
For companies not compliant with the new law, 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 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 efforts for meeting the new law’s female corporate board member requirements.
Will the California Gender Diversity Mandate Survive Legal Challenge?
Constitutionality
According to a California Assembly report, the new law 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 the legislation as a likely unconstitutional gender quota requirement. As the report 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.”
Proponents of the new law disagree and believe a mandatory female director requirement for corporate boards is essential to increasing gender diversity on corporate boards much sooner than current trends for the sake of benefiting California’s economy, and to more quickly promote women’s advancement in corporate leadership and senior management.
In his letter explaining his decision to sign the bill enacting the new law, Governor Edmund G. Brown, Jr., stated that “I don’t minimize the potential flaws [in the new law] that indeed may prove fatal to its ultimate implementation.” Nevertheless, Governor Brown offered his view that despite the objections to the new law, “It’s high time corporate boards include the people who constitute more than half the ‘persons’ in America.”
Internal affairs doctrine
The new law includes a provision overriding a basic principle of corporate law, long known as the internal affairs doctrine, providing that relations between directors and shareholders should be determined only by the laws of a company’s state of incorporation. If this override is not respected by California courts or courts in other states—which is uncertain—the new law’s mandates will not apply to non-California corporations even though they are headquartered in California.
Advocates point out that California already lawfully regulates some internal affairs of non-California corporations and that these companies routinely abide by those laws. On the other hand, more than a decade ago the highly respected Delaware Supreme Court ruled that Delaware courts need not follow a key California law attempting to regulate shareholder voting rights in Delaware corporations on the basis of the Delaware internal affairs doctrine.
Final Word
Although the new law 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 both poor public policy and 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 publicly traded companies should move expeditiously to comply with the new statute 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 implement the new law as a weakness worth exploiting.
Richard Vernon Smith is a partner in the Silicon Valley and San Francisco offices of Orrick, Herrington & Sutcliffe LLP, and a member of its Global Mergers & Acquisitions and Private Equity Group. He specializes in the areas of mergers and acquisitions, corporate governance, and activist defense. Richard has advised on more than 400 M&A transactions and has represented clients in all aspects of mergers and acquisitions transactions involving public and private companies, corporate governance, and activist defense. He is a co-author of the recently published 1,500-page book by Bloomberg: Mergers and Acquisitions of Privately Held Companies: Analysis, Forms and Agreements.