California Mandates Board Diversity for Many Public Companies

By Jarrod Melson Monday, January 25, 2021
board of directors diversity requirementsIn September 2018 and September 2020, the State of California adopted laws imposing board diversity mandates on Subject Companies (as defined below), including public companies formed in Delaware but have their “principal executive office” in California. These laws require that women and members of “underrepresented communities” constitute a certain percentage of a Subject Company’s boards of directors, depending upon the size of the Subject Company’s board. 
 
The gender-based requirement (the “Gender Requirement”) is in the process of being phased in, with full gender-compliance mandated by December 31, 2021; all Subject Companies should, by now, have at least one woman on their respective board of directors as discussed below.  The underrepresented community requirement (the “Representation Requirement”), which is also being phased-in over approximately two years, requires all Subject Companies have at least one board member qualifying under the law by December 31, 2021, and full compliance, discussed below, must be achieved by December 31, 2022.
 
In this article, we seek to describe the key aspects of the laws, including:
  • Features and criteria defining a Subject Company,
  • Subject Companies’ required board composition under the Gender Requirement and Representation Requirement,
  • Reporting and other requirements under the laws, and
  • A brief summary of legal challenges to the laws, especially Delaware’s likely assertion of the “internal-affairs doctrine.”  

Subject Companies to which the laws apply

In order to qualify as a “Subject Company,” a corporation:
  • must have a class of stock trading on a “major U.S. stock exchange” (a term used but not defined in the Gender Requirement or Representation Requirement),1 and
  • must:
    • have been formed under the corporation law of California, or
    • maintain its “principal executive office” in California (as evidenced by the corporation’s address listed on the cover page of its annual Form 10-K2 filed with the Securities and Exchange Commission (the “SEC”)), regardless of the corporation’s state of incorporation.  
The California Partners Project, a nonprofit which champions the greater representation of women on corporate boards (among other things), determined in its 2020 progress report on the Gender Requirement (the “CPP Progress Report”) that 650 companies qualified as Subject Companies at the time the Gender Requirement became law.3 The same criteria apply with respect to Subject Companies under the Representation Requirement, giving a scope of affected entities for both laws.

Mandated Categories of Directors under the Gender and Representation Requirements

Women Directors

A Subject Company’s required number of female directors depends on the number of total seats on its board.  As noted above, all Subject Companies were required to have at least one female member on their respective Boards by December 31, 2019.  By December 31, 2021, a Subject Company with a board composed of (a) six or more directors – must have at least three female directors, (b) five directors – must have at least two female directors, and (c) four or fewer directors – must have at least one female director. 
 
This chart illustrates the required number of female directors required, depending on the size of the board as a whole, as the Gender Requirement is phased-in:
 
California Requirement for Women Directors
Board Size

Women Required for Board
(Dec. 31, 2019)

Women Required for Board
(Dec. 31, 2021)

4 or fewer 1 1
5 1 2
6+ 1 3

 

The Gender Requirement, which passed and began to phase-in sooner than the Representation Requirement, has already had an effect.  From the law’s passage in 2018 to present, Subject Companies have increased the number of women on their boards by 66.5%.4  This increase still represents a modest portion of the total board seats of Subject Companies, with only 24% of such seats held by women.5  In 2018, however, 30% of Subject Company boards were all male, now fewer than 3% lack female representation.6

Underrepresented Community Member Directors

As with the Gender Requirement, the number of required directors from underrepresented communities under the Representation Requirement depends upon the size of the relevant Subject Company’s board.  A Subject Company’s board is permitted to increase the number of director seats to accommodate the new members, but, in at least some cases, this increase could in turn increase the number of persons required on the board by law by increasing its total size. 
 
A Subject Company must have, by December 31, 2021, at least one director who self-identifies as a member of an underrepresented community.  By December 31, 2022, a Subject Company with a Board composed of (a) four or fewer directors – must have at least one underrepresented community member on its board, (b) five to eight directors – must have at least two underrepresented community members on its board, and (c) nine or more directors- must have at least three underrepresented community members on its board.  This chart illustrates the required number of underrepresented community members required of a Subject Company, depending on the size of the board as a whole:
 
California Requirement for Underrepresented Community Directors
Board Size

Underrepresented Community Board Members
(Dec. 31, 2021)

Underrepresented Community Board Members
(Dec. 31, 2022)

4 or fewer 1 1
5 to 8 1 2
9+ 1 3
 
Under the Representation Requirement, a member of an “underrepresented community” means “those who self-identify as Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, or Alaska Native, or . . . as gay, lesbian, bisexual, or transgender.” 
 
There will undoubtedly prove to be issues with this definition, as it will be deemed too restrictive and rigid by some, while others will call its basis in self-identification and a general lack of objective criteria too loose and capable of manipulation.  However, California’s regulator in this area likely would be loath to challenge a director’s self-identification in connection with his or her sexual orientation, gender identification, racial background, religious or other spiritual beliefs, or other extremely personal topics.
 
Additional open interpretative questions remain as well, which may need to be fleshed out through rulemaking and guidance releases.  For example, it is unclear whether a single director can count both as a female and a member of an underrepresented community, assuming she qualifies under both the Gender Requirement and the Representation Requirement.7 This kind of double-counting could be viewed as a way of “gaming” the system and circumventing the full, but, on the other hand, if the director’s characteristics meet the required categories, it is unclear why a Subject Company could not take the whole person into consideration, with all facets of her background, identifications, and other characteristics given appropriate weight in satisfying the letter of the two requirements.

Reporting Obligations under the Requirements

Subject Companies, as well as any corporation that has its principal executive office in California, but which is traded on an exchange other than a “major U.S. stock exchange,” must file an annual Publicly-Traded Corporate Disclosure Statement reporting its board composition with the California Secretary of State. These reports are and will be used by the California Secretary of State to compile reports on the progress of and compliance with the requirements, as well as the effect of the laws on the number of companies formed in California and whether companies with offices in the State are fleeing as a result of the mandates.

Challenges to the Laws – The Internal Affairs Doctrine

Subject Companies and trade and advocacy groups have and will continue to challenge the laws on Constitutional grounds. The laws will also be challenged to the extent they purport to apply to corporations formed under Delaware law.  
 
Under the well-settled “internal affairs doctrine,” a state may not supplant or otherwise modify the corporate law of another state (the “Formation State”) with respect to the internal, fundamentally corporate aspects of a business entity formed in the Formation State, regardless of where the business maintains its offices.8
 
In the future, we will present a follow-up piece specifically on the internal affairs doctrine, but the composition of the board of a corporation is undoubtedly fundamental to its corporate structure, and is given over to the discretion and will of the corporation’s shareholders.  By disenfranchising shareholders in mandating a smaller pool of director candidates and expressly stating that the requirements supersede any relevant provision of the Formation State, California likely will quickly find the mandates challenged under the doctrine in Delaware Courts.
 
We will keep you informed regarding developments relating to the Gender or Representation Requirement, as well as challenges to the laws by Delaware corporations.

References:

1. Many legal practitioners and policy experts have concluded “major U.S. stock exchange” would include, potentially among others, the New York Stock Exchange (NYSE), the NASDAQ Global Market and Nasdaq Capital Market, and the NYSE American (formerly the American Stock Exchange, or AMEX).

2. The SEC has not defined “principal executive office” for purposes of the Form 10-K, and commenters postulate that otherwise-Subject Companies may seek to manipulate the lack of clarity to claim a different location for its principal executive office, removing them from the scope of the new laws. Moon, William, Delaware’s New Competition, Northwest University Law Review, Volume 114, No. 6 (2020) (“[T]he SEC has not defined the
‘principal place of business,’ and it is common for firms to abuse this shortcoming.”).

3. See Claim Your Seat: A Progress Report on Women’s Representation on California Corporate Boards, California Partners Project (2020), available at https://www.calpartnersproject.org/claimyourseat (last visited December 12, 2020).  Note that the CPP Progress Report states that it considered only public companies trading on the NYSE and NASDAQ in its pool of potential Subject Companies, taking a more narrow interpretation of the term “major US stock exchange” than described in footnote 1

4. Id.

5. Id.

6. Id.

7. Goodwin Proctor, a highly-respected law firm, concludes that the legislative intent and purpose of the two requirements argues strongly in favor of the possibility of dual counting of a single qualifying director.  The firm cites the legislature’s use and citation of statistics in passing and justifying the need for the laws; these statistics pointed out not only the dramatic underrepresentation of women on Subject Company boards, but also, among women, the lack of women of underrepresented communities.  This would counsel that the legislature intended a female director with the requisite membership in an underrepresented community to be considered for both purposes.  See, New California Law will require Increased Diversity in Public Boards, Goodwin Proctor Alert (Oct. 14, 2020) available at https://www.goodwinlaw.com/publications/2020/10/10_14-new-california-law-will-require (last visited December 16, 2020).
 
8. As recently as August of this year, the Delaware Chancery Court struck down a California law that applied to Delaware companies on the same basis as the Gender and Representation Requirement – by virtue of an office in California or a registration to business in the State.  In that case, California sought to supplant Delaware’s provision relating to shareholder inspection of records (§220 of the Delaware General Corporations Law).  The Chancery Court found that shareholder inspection rights “are a core matter of internal corporate affairs.”  If such rights are central to corporate law governing Delaware corporations, the qualifications for service as a director of a corporation are, a fortiori, central to corporate internal affairs.  Juul Labs, Inc. v. Grove, C.A. No. 2020-0005-JTL (Del. Ch. Aug. 13, 2020).

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