California Expands Diversity Requirements for Public Company Boards

California Governor Gavin Newsom on September 30 signed into law Assembly Bill No. 979, which requires publicly held companies headquartered in California to have a minimum number of directors from “underrepresented communities.”

In passing Assembly Bill No. 979 (AB 979), a first-of-its-kind legislation in the United States, the California legislature cited numerous studies showing the lack of minority members serving on public company boards. For example, out of 662 publicly traded companies headquartered in California, only 13% have at least one Latino board member, 16% have at least one African American board member, 42% have at least one Asian board member, and notably, only 6%  have at least one other minority board member. In contrast, 100% of these boards have at least one white board member, and 35% of these companies have all white board members.

AB 979 represents California’s continuing effort to expand diversity requirements of public company boards and enhance equality and opportunities for minority groups through the legislative process. In 2018, California enacted SB 826, which requires California publicly held companies to have a minimum number of female directors, including at least one female director, no later than the end of 2019. The structure and statutory provisions of AB 979 are modeled closely after SB 826. Accordingly, California publicly held companies now are required to comply with both the female and the minority director rules. 

The following summarizes specific requirements of AB 979 and certain practical considerations for California public companies in response to these new requirements.

Director Composition Requirements

SB 979 adds Sections 301.4 and 2115.6 to the California Corporations Code to require a publicly held domestic or foreign corporation whose principal executive offices are located in California, as set forth on the corporation’s annual report on Form 10-K filed with the US Securities and Exchange Commission (SEC), to have a minimum of one director from an “underrepresented community” no later than the close of calendar year 2021.

Additionally, such California publicly held companies must comply with the following director composition requirements no later than the close of calendar year 2022:

• If the number of directors is nine or more, the company must have a minimum of three directors from underrepresented communities.
• If the number of directors is more than four but fewer than nine, the company must have a minimum of two directors from underrepresented communities.
• If the number of directors is four or fewer, the company must have a minimum of one director from an underrepresented community.

An individual is from an “underrepresented community” if such individual “self-identifies as Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, or Alaska Native,” or “self-identifies as gay, lesbian, bisexual, or transgender.” In addition, a “publicly held corporation” means a corporation with outstanding shares listed on a major “United States stock exchange.” While the statute does not define “major United States stock exchange,” the California secretary of state has previously stated that a “publicly held corporation” means a corporation with shares listed on the New York Stock Exchange, Nasdaq, or American Stock Exchange, and excludes corporations with shares quoted or traded on over-the-counter markets.

We note that AB-979 applies to publicly held companies with principal executive offices in California (as disclosed in the Form 10-K) regardless of the state of incorporation. Accordingly, any publicly held company incorporated in another state, such as Delaware, or any other country, will be subject to the new requirement if its principal executive office is in California.

Under AB 929, a company is permitted to amend its bylaws or charter to increase the total number of directors to accommodate the required directors from underrepresented communities, so that no incumbent director needs to be replaced. In addition, a director from an underrepresented community is not required to hold office for the entire calendar year to satisfy the rules—it is sufficient that they hold a seat for only a portion of the calendar year applicable under the requirement.

Enforcement, Penalties, and Reports

The new rules authorize the California secretary of state to impose fines for violations as follows: (1) $100,000 for a first violation, and (2) $300,000 for a second or subsequent violation. The secretary of state is required, no later than March 1, 2022, to include in its report required by the female director rules under SB 826 certain information regarding compliance with AB 979, including the number of corporations subject to the rule that were in compliance with the requirements, and the number of publicly held corporations that moved their US headquarters to California from another state or out of California into another state.

Legal Challenges

Similar to SB 826, we expect AB 979 will face legal challenges based on a number of theories, including a violation of the equal protection clause of the US and California Constitutions. In fact, on the very day that Governor Newsom signed AB 979, the same taxpayer plaintiffs challenging SB 826 (represented by Judicial Watch, Inc.) filed a second lawsuit challenging AB 979. In Crest v. Padilla (Sup. Ct. No. 20STCV37513), the plaintiffs assert that AB 979 also violates the equal protection and antidiscrimination provisions of the California Constitution. The case is pending in the Superior Court for the County of Los Angeles.

Currently two separate litigations involving SB 826 are winding through the court systems. In Meland v. Padilla (E.D. Cal No. 2:19-cv-02288), an individual shareholder of a company subject to SB 826 (represented by the Pacific Legal Foundation) asserted that the law impaired his right to vote for the board member nominee of his choice, in violation of the Equal Protection Clause of the Fourteenth Amendment of the US Constitution. The US District Court for the Eastern District of California dismissed the action because the shareholder plaintiff lacked standing. The case is currently on appeal before the US Court of Appeals for the Ninth Circuit.

In Crest v. Padilla (Sup. Ct. No. 19STCV27561), individual taxpayers (the same plaintiffs referenced above) asserted that SB 826 requires a gender-based quota in violation of equal protection and antidiscrimination provisions of the California Constitution. In June 2020, the Superior Court for the County of Los Angeles overruled a demurrer and subsequently set the case for trial in mid-2021.

Given the uncertainty of legal claims and the timing of compliance requirements for both SB 826 and AB 979 for calendar year 2021, publicly held companies headquartered in California should be prepared to comply fully with both rules notwithstanding the pending court cases.

Analysis and Practical Considerations for California Public Companies

We believe that the boards of directors of California publicly held companies, particularly those that do not currently have any directors from underrepresented communities, should consult with counsel familiar with SB 826 and AB 979 to understand fully the implications of these new legal developments in California, and formulate a plan to comply with applicable requirements or seek alternative action. As was the case with SB 826, AB 979 raises several interpretative questions and uncertainties, including the following:

• AB 979 permits a director from an underrepresented community to serve only a “portion” of the calendar year, but it does not address whether multiple directors from an underrepresented community must serve simultaneously. For example, if a company is required to have two such directors in 2021, is it possible for one director to serve only for the first half of the year, while a second director serves the second half? The statute does not address the question of whether multiple directors from underrepresented communities must serve simultaneously.
• SB 826 and AB 979 do not explicitly address whether the same individual can satisfy both the female and the underrepresented community member director requirements, although it appears from a plain reading of the statutes that this is permitted. For example, a Latino woman or an LGBTQ director who is white and identifies as female in theory could be counted as one qualifying director under both statutes. Accordingly, companies may find it more efficient to recruit one director who would permit the company to satisfy both rules.
• As public companies currently are not required to disclose the racial, ethnic, or other personal characteristics of directors, it is unclear as to how the California secretary of state will obtain sufficient information to enforce AB 979. Solicitation of personally identifiable information can be a sensitive subject for directors. Attempts to seek and publicly disclose such information may result in other legal risks, including claims of privacy breaches and discrimination. While the secretary of state may modify the annual disclosure statement that currently is required to be filed by California public companies to include a question on compliance with AB 979 (the current form already addresses compliance with SB 826), some public companies either neglect to file the annual disclosure statement or are not aware of the filing requirement. Without further action from the secretary of state, it is unclear whether a company’s failure to file the annual disclosure statement will constitute a violation of AB 979.
• Certain public corporations are “foreign private issuers” under federal securities laws and do not file annual reports on Form 10-K. It is not clear whether a foreign private issuer based in California must comply with AB 979, although a plain reading of the statute would lead to a conclusion that it is not.
• The statute does not address compliance requirements for newly public companies, including companies that have just completed an initial public offering (IPO). For example, if a company closed an IPO on the very last day of a calendar year for which compliance is required, does it mean that such company must have a director from an underrepresented community during such calendar year? This question may impact California companies that are planning to go public.
• The statute does not address the treatment of multiracial or multiethnic individuals or provide guidance as to whether an individual is limited to self-identifying with one racial or ethnic community. For example, will a person who is of mixed race qualify as an individual from the underrepresented community? It is also unclear whether a director’s response to a self-identification will be disclosed to the public or second-guessed.

We recommend that boards and management of California public companies consider the following practical steps in response to the new rules:

• Discuss with legal counsel familiar with these statutes and the California Corporations Code to understand the new requirements and determine whether AB 979 is applicable. The board of directors or the nominating committee should examine the current board composition to determine whether any change is needed, and if so, review the organizational documents of the company with counsel to determine the appropriate process to appoint or change directors and/or expand the size of the board.
• Consult with legal counsel to develop a procedure for directors to “self-identify” their underrepresented status. This may be a sensitive topic for some directors who are being asked to provide this information for the first time, and this process may ask directors to disclose information that they have never disclosed or kept closely held. Developing a reasonable and appropriate procedure is important to mitigate the discussion of complicated and sensitive topics and the risk of such sensitive information being used for future legal claims based on discrimination or violation of privacy laws and policies.
• Ensure that an annual disclosure statement is prepared and filed with the California secretary of state on a timely basis, and monitor any modification to the annual disclosure statement as such filing may be used as a basis for the secretary of state to determine compliance.
• Review and, if necessary, modify internal corporate governance policies or committee charters to ensure that the director nomination process appropriately considers diversity as a factor.
• Review with legal counsel current and future public disclosures regarding diversity policies and practices, including the SEC’s new human capital disclosure requirement under Regulation S-K. This is important in light of the recent uptick of shareholder derivative lawsuits based on lack of board diversity, particularly against public technology companies in California.
• Consider the possibility of relocating the principal executive office to another state, on balance with shareholder and other stakeholder concerns.

Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Palo Alto
Albert Lung
Tom Kellerman
John Park

San Francisco
Joan Haratani
Scott Karchmer
Nancy Yamaguchi

Los Angeles
John Filippone

Orange County
Todd Hentges
Randall Wood

Boston
Laurie Cerveny
Michael Conza
Bryan Keighery
Julio Vega

New York
Thomas P. Giblin, Jr.
Howard A. Kenny
Christina Melendi
Kimberly M. Reisler

Philadelphia
Justin W. Chairman
James W. McKenzie
Joanne R. Soslow

Pittsburgh
Celia Soehner

Princeton
David Schwartz