Public companies having their principal place of business in California (as stated in the company's most recent Form 10-K filed with the U.S. Securities and Exchange Commission (the “SEC”), and which are listed on major U.S. stock exchanges), will soon be required to appoint women to their boards of directors. On September 30, 2018, California Governor Jerry Brown signed State Bill-826 (“SB-826”) into to law that makes California the first state in the United States to require companies that are incorporated or based in California, and are listed on major U.S. stock exchanges, to have at least one woman on their boards of directors by the end of 2019, and a representative number of women on their boards of directors by the end of 2021.

Summary of the New Law

Applicability

• The law applies to publicly held domestic or foreign (non-California incorporated) corporations whose principal executive offices are located in California, as reported on the company's most recently filed Form 10-K filed with the SEC.
• A female is an individual who self-identifies her gender as a woman, without regard to the individual's designated sex at birth.
• A publicly held corporation is a corporation with outstanding shares on a major United States stock exchange. A “major United States stock exchange” is not defined under the law, but an analysis by the California State Senate Rules Committee noted that the vast majority of the approximately 761 public companies traded on NASDAQ, NYSE and NYSE American would be subject to the law.
• There are no exceptions for “controlled companies” or investment companies under the law, nor does it include phase-in rules for new or small public companies.

Compliance

• By the end of 2019, each publicly traded corporation must have at least one female director.
• By the end of 2021, each publicly traded corporation must comply with the following:

• 3 female directors if the total number of directors is 6 or more;

• 2 female directors if the total number of directors is 5; or

• 1 female director if the total number of directors is 4 or fewer.

• The bill provides that publicly traded corporations may increase the number of directors on its board via amending organizational documents, consent or otherwise to add seats for female directors to avoid displacing any current directors.
• The California Secretary of State is required to publish various reports regarding publicly traded corporations that (i) comply with the statute, (ii) moved their headquarters into or out of California in the preceding year, and (iii) were previously subject to the statute and are no longer publicly traded. The Secretary of State may also adopt regulations to implement this new law.

Noncompliance and penalties

• A publicly traded corporation violates the law if a director seat that is required to be held by a female is not held by a female during at least a portion of the applicable calendar year.
• The bill provides the California Secretary of State with authority and discretion to impose the following penalties:

• First violation: $100,000

• Subsequent violations: $300,000

First state to mandate female directors

Although California and other states, including Illinois, Massachusetts, Pennsylvania, Ohio, and Colorado, have issued nonbinding resolutions encouraging gender diversity on corporate boards, until now, there has been no mandate for female representation on a state or federal level. California is the first state in the United States to mandate gender diversity on corporate boards, following several countries with similar legal mandates for female representation on boards, including, among others, Germany, Norway, and France.

Push towards gender diversity in the boardroom

Corporations have also faced shareholder pressure to increase female representation on their boards. Institutional investors have recently made gender diversity on boards a high priority.

In February 2018, BlackRock, Inc. included in its proxy voting guidelines that it wants its portfolio companies to have diverse boards and noted that “we would normally expect to see at least two women directors on every board.” Further, BlackRock also wrote to about 300 companies in the Russell 1000 that have fewer than two women on the board to ask them to disclose their approach to boardroom and employee diversity.

State Street Global Advisors, another index-fund giant, also pressed companies in which its money management unit invests to improve boardroom diversity in 2017. It did not set a quota but asked companies to prove that attempts were made to improve their lack of diversity. State Street also voted against the re-election of directors charged with nominating new board members at about 400 companies that it said failed to address gender diversity in a meaningful way.

As a result, there has been a positive trend towards increased female representation on public company boards. In the first half of 2018, females were elected to more than one-third of the new directorships, according to the Q2 2018 Equilar Gender Diversity Index (GDI). Moreover, the percentage of women on Russell 3000 companies' boards increased from 16.9% to 17.7% in the second quarter of 2018, according to the same study.

Board diversity linked to better financial performance

SB-826 cited several studies that have concluded that publicly held companies perform better when women serve on the boards of directors, are more profitable and productive and outperform companies with all-male directors, including significant outperformance during economic recessions.

Policy Debate and Commentary

The new law is widely expected to face legal challenges, something even Governor Jerry Brown acknowledged when signing it. In his statement on signing the bill into law, the California governor pointedly carbon copied the U.S. Senate Judiciary Committee and wrote: “I don't minimize the potential flaws that indeed may prove fatal to [the law's] implementation. Nevertheless, recent events in Washington D.C.—and beyond—make it crystal clear that many are not getting the message.”

Commentators argue that the law may violate the equal protection clauses of the United States Constitution and the California Constitution due to the creation of an express gender classification and California's Unruh Civil Rights Act by discriminating based on gender.

Implementation

2019 Deadline

Many companies, especially large market cap companies, already may 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.” Time will be of the essence for the 18% of companies who do not meet the initial criteria. The director search and vetting process and the work required to prepare the annual proxy statement disclosure about the qualifications of any new director nominees are time consuming processes and the 2019 proxy season is just a few short months away. Thus, any public companies currently lacking female directors will need to move quickly to avoid becoming noncompliant.

2021 Deadline

As mentioned above, 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 female director by the end of 2021. According to an Equilar study, if the future criteria were to be applied today “79% of [stock exchange traded and headquartered in California] public companies would fail, while only 21% would pass.” Planning for the 2021 requirements should begin now to ensure compliance by the end of the 2021 proxy season.

Implementation Challenges

Compliance with the new law is not as simple as appointing one or more new directors. Corporations must still abide by, and where necessary amend, including potentially seeking stockholder approval for amendments to, charters and bylaws, which may dictate maximum board size. Further, director candidates nominated by boards must be approved by stockholders, and, as a result, corporations must ensure any new director nominee will be acceptable to stockholders. In addition, companies that fail to comply with the law will face financial penalties, as mentioned above, but any noncompliance could also be used by activists as a tactic to gain entry into the boardroom.

IPO Companies

Additionally, the law doesn't provide any transition periods for IPO companies. Any California companies seeking to go public by listing on a major U.S. stock exchange will need to anticipate compliance with the new law immediately.

Public companies should move quickly to comply with the new law to avoid the risk of penalties and any potential tension with major institutional investors or activists. Furthermore, if the law were to survive any likely legal challenge, other states can be expected to follow suit.

 JR Lanis is a partner in Drinker Biddle & Reath's Los Angeles and San Francisco offices. His practice focuses on corporations and securities law and financial services. He advises publicly traded and privately held companies, funds and investors in a variety of industries, with an emphasis in technology, financial services, hospitality, life sciences and energy.