California Mandates Representation of Underrepresented Communities on Boards of Public Corporations

On September 30, 2020, California Governor Gavin Newsom signed California Assembly Bill No. 979 (the "new law"), which amends California's General Corporation Law. The new law became effective immediately upon signing and requires, among other things, that publicly held corporations (regardless of their places of incorporation) whose principal executive offices are, according to their most recently filed annual reports on Form 10-K, located in California must have a minimum of one director from an underrepresented community (a "diverse director") on their respective boards of directors no later than the end of calendar year 2021. Such corporations may need to add additional diverse directors to their boards (depending on the size of the board at that time) no later than the end of calendar year 2022. The new law also provides that the California Secretary of State may impose fines of up to $300,000 on corporations that do not comply with these requirements.

Summary of the New Law

The new law requires that, by the end of the 2021 calendar year, a publicly held domestic (incorporated in California) or foreign (not incorporated in California) corporation whose principal executive offices are, according to its most recently filed annual report on Form 10-K, located in California must have a minimum of one diverse director on its board of directors.

In addition, by the end of the 2022 calendar year, any such corporation must have:

• A minimum of one diverse director, if its number of directors is four or fewer;
• A minimum of two diverse directors, if its number of directors is more than four but fewer than nine; or
• A minimum of three diverse directors, if its number of directors is nine or more.

According to the new law: (i) a "publicly held corporation" means a corporation with outstanding shares listed on a major United States stock exchange; and (ii) a "director from an underrepresented community" means an individual who self-identifies as Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, Alaska Native, gay, lesbian, bisexual, or transgender.

The new law also requires the California Secretary of State to publish an initial report, by March 1, 2022 (and annually thereafter), documenting the number of publicly held corporations that (i) were in compliance with the requirements of the new law during at least one point during the preceding calendar year; (ii) moved their U.S. headquarters in or out of California in the preceding year; and (iii) were subject to the new law during the preceding year but are no longer publicly traded.

Companies may be subject to fines if they fail to timely file board member information with the Secretary of State that reflects the new requirements. The size of these fines may begin at $100,000 for a first violation and increase to $300,000 for a second or subsequent violation.

Although the new law does not, on its face, specify that a director may satisfy both the underrepresented community diversity requirement and the gender diversity requirement of the Gender Diversity Law (as defined below), neither does it specify the contrary, and the emerging consensus among practitioners is that a single director may satisfy both requirements.

Legal Challenges

Similar to Senate Bill No. 826, which was passed in California in October 2018 and mandated the appointment of women to public company boards in California (the "Gender Diversity Law"), the new law is likely to face legal challenges on constitutional grounds. Those legal challenges to the Gender Diversity Law are still pending. (See our previous Jones Day Commentary, "California Mandates Female Directors for Public Corporations.")

Points to Consider

The new law cited numerous statistics in support of its adoption, including a report from the United States Bureau of Labor Statistics stating that, in 2019, 90% of chief executives were White. It also cited data from the Latino Corporate Directors Association that 233 out of 662 publicly traded companies headquartered in California have all White boards of directors as of this year.

Governor Newsom, when signing the bill, noted that the new law is necessary to promote diversity on company boards as part of a wider initiative to improve racial equality throughout the country.

The new law follows a trend of encouraging, and in some cases mandating, diversity on boards of directors and senior management teams of companies in the United States and around the world, and has been an area of focus for the U.S. Securities and Exchange Commission for several years.

Companies will need to consider disclosure around how they are planning to comply with the new law and take other steps to promote diversity from the top down within their organizations. It follows upon a wave of environmental, social and governance (ESG)-related mandates and policies in various jurisdictions, including the Gender Diversity Law in 2018, and is an example of how California is on the forefront of U.S. states in this regard.

The Gender Diversity Law was challenged in federal court in Meland v. Padilla, in which it was claimed on behalf of a public company shareholder that the statute should be struck down as unconstitutional under the equal protection provisions of the 14^th Amendment. This case was dismissed for lack of standing, but has been appealed to the U.S. Court of Appeals for the Ninth Circuit. Another case, Crest v. Alex Padilla, also challenged the law based on equal protection grounds under California's state constitution to stop the expenditure of state funding to enforce the law.

While even more legal challenges were expected at the time the Gender Diversity Law was passed in October 2018, particularly as it covers companies not incorporated in California, social trends and ESG-related campaigns from large hedge fund investors such as BlackRock and State Street have served to tamp down some of the impetus to challenge that law, and it seems that companies have by and large accepted these gender diversity requirements. California public companies added 176 women to their boards in 2018, 346 in 2019, and 147 in the first six months of 2020, according to a recent report from the California Partners Project. Even before the adoption of the new law, most companies seem to have already recognized the value of diversity in the boardroom, and do not want to be seen as challenging this trend. Nevertheless, the new law similarly covers companies not incorporated in California, and is likely to face legal challenges from conservative groups on the same grounds as the Gender Diversity Law. 

Public companies with their principal executive offices in California should review their current board compositions to assess whether they meet the requirements under the new law and also examine their articles of incorporation and bylaws to ensure their authorized number of directors and the mechanisms governing the election and removal of directors are sufficient to accommodate the required number of diverse directors. In particular, companies with classified boards may need to plan ahead, as the new law makes no allowance for failure to comply as a result of the staggered elections of a classified board. Affected companies should also consider the impact of the new law in their proxy disclosures regarding how diversity is assessed in choosing their directors.

Although the new law does not apply to nonpublic companies in California, pre-IPO stage companies headquartered in California should be aware of this legislation and the broader focus on board diversity when considering the composition of their own boards.

Some groups in favor of diversity fear that the combination of the new law and the Gender Diversity Law could mean that companies seeking merely to satisfy the minimum requirements may seek board candidates who are both female and a member of a defined underrepresented community, thereby stifling opportunities for male candidates from those communities.

Note that membership in an underrepresented group is based on self-identification by the individuals, and such self-identification is unlikely to be challenged by the California Secretary of State or other governmental authority.

Conclusion

The new law has been enacted during a period in which the value of board diversity is becoming widely accepted. As such, the new law's mandates seem to be codifying trends that are already in process among public companies in the United States, and particularly in the diverse state of California. While there still may be legal challenges against the new law based on, among others, legal theories grounded in the equal protection provisions under the 14^th Amendment, the opposition is likely to be more muted than was expected two years ago when California's Gender Diversity Law was passed.

In any case, California has made another significant statement on the importance of diversity by enacting the new law.