United States: California Adopts Corporate Disclosure Act Applicable to All Corporations Incorporated or Qualified to do Business in California

By James R. Walther, Kenneth E. Kohler and Stephen D. Blevit

The Governor of the State of California recently signed the California Corporate Disclosure Act (the "California Disclosure Act"), which will become effective on January 1, 2003. 1 The California Disclosure Act changes the substance and timing of the disclosure statements that are required to be filed with the California Secretary of State for all corporations that are incorporated in California and all foreign corporations that have qualified to do business in California.

Currently, the California General Corporation Law (the "Corporations Code") requires each corporation that is incorporated in California and each foreign corporation that has qualified to do business in California to file statements every two years with the California Secretary of State disclosing basic information concerning its board of directors, officers and operations. The California Disclosure Act will require that these statements be filed annually and will require extensive additional disclosures for publicly traded corporations. These disclosures differ in a number of respects from the disclosures required under the Securities and Exchange Commission's rules. The California Disclosure Act will make the information contained in the statements open to public inspection, including through an online database that is to be established prior to December 31, 2004.

The California Disclosure Act was moved quickly through the California Legislature at the end of its term as a response to the highly publicized recent business scandals and the public was afforded little opportunity for meaningful comment. As a result, the California Disclosure Act contains a number of flaws and ambiguities. Early indications have been that the California Secretary of State does not intend to issue interpretive regulations or to provide informal guidance to filing companies and their advisors. However, the recent election of California Assemblyman Kevin Shelley, the author of the California Disclosure Act, as the California Secretary of State may result in the adoption of regulations interpreting the California Disclosure Act. Furthermore, the Corporations Committee of the Business Law Section of the California State Bar, and probably other groups as well, intend to seek clarifying and technical amendments to the Act, although there is no assurance that any corrective legislation will be adopted.

The California Disclosure Act applies to all corporations that are incorporated in California and all foreign corporations that have qualified to do business in California.2 It should be noted that application of the California Disclosure Act is not limited to the so-called "pseudo-foreign corporations" (that is, corporations organized under another state's laws but which have substantial business and shareholder contacts with California) that are required by Corporations Code Section 2115 to comply with specified corporate governance and other provisions of the California Code. The California Disclosure Act applies to corporations that have little if any contact with California other than having qualified to do business in the state. On the other hand, while not entirely clear, it appears that the additional disclosures required for publicly traded companies by the California Disclosure Act will not apply to companies whose contact with California is limited to having a subsidiary corporation qualified to do business in California. Furthermore, the California Disclosure Act does not apply to non-corporate entities such as business trusts, limited liability companies, partnerships or associations.

Sections 1502(a) and 2117(a) of the Corporations Code currently require that each corporation incorporated in California, and each foreign corporation that is qualified to do business in California, respectively, file a statement every two years with the California Secretary of State containing the following information:

• The names and complete business or residence addresses of its chief executive officer, secretary and chief financial office.
• The street address of its principal executive office.
• If the address of its principal executive office is not in California, the street address of its principal business office in California, if any.
• A statement of the general type of business that constitutes the principal business activity of the corporation.

In the case of a domestic corporation, Corporations Code Section 1502(a) also requires that the notice include the names and complete business or residence addresses of the corporation's incumbent directors and the number of vacancies on the board of directors, if any.

The California Disclosure Act will now require that these statements be filed with the California Secretary of State annually. In addition, the California Disclosure Act will require that domestic corporations certify that the information provided is true and correct. The California Disclosure Act does not contain a similar requirement for foreign corporations.

In addition to the currently required basic information described above, the California Disclosure Act will now require that each publicly traded company that is incorporated in California or qualified to do business in California also certify the following information in the statement required by Corporations Code Sections 1502(a) or 2117(a):

• The name of the independent auditor used by the corporation and a description of any other services performed for the corporation during the previous 24 months by the independent auditor or by any parent corporation, subsidiary or corporate affiliate of the independent auditor or its parent corporation. Each publicly traded company qualified to do business in California must also provide a description of any services performed for the corporation during the previous 24 months by an agent or corporate partner of the independent auditor or its parent corporation.
• The date of the last report prepared for the corporation by the independent auditor. A copy of the report must be attached to the statement.
• The annual compensation paid to each member of the board of directors and to each executive officer, including the number of any shares or options for shares that were not available to other employees of the corporation.
• A description of any loans made to a member of the board of directors by the corporation at a preferential loan rate during the previous 24 months, including the amount and terms of such loans.
• A statement indicating whether any bankruptcy was filed by the corporation or any of its executive officers or members of its board of directors within the previous 10 years.
• A statement indicating whether any member of the board of directors or executive officer of the corporation was convicted of fraud during the preceding 10 years.
• A statement indicating whether the corporation violated any federal securities laws or any securities or banking provision of California law during the preceding 10 years for which the corporation was found liable in an action before a federal or state court or regulatory agency or a self-regulatory organization in which a judgment of over $10,000 was entered.

A "publicly traded company"³ is defined under the California Disclosure Act as a company whose securities are either listed or admitted to trading on a national or foreign exchange, or are the subject of two-way quotations, such as both bid and asked prices, that are regularly published by one or more broker-dealers in the National Daily Quotation Service or a similar service. This definition covers all issuers whose shares are listed on the New York Stock Exchange and the American Stock Exchange, as well as other domestic and foreign securities exchanges. Beyond that, it is not entirely clear what other companies the California Disclosure Act is referring to.

As noted above, the "publicly traded company" definition refers to the "National Daily Quotation Service or a similar service." The drafters probably meant to refer to the National Quotation Bureau, which was previously the publisher of the Pink Sheets. However, the Pink Sheets are today published by New York-based Pink Sheets, LLC. Curiously, the California Disclosure Act does not refer to the three primary domestic over-the counter markets, the Nasdaq National Market, the Nasdaq Smallcap Market and the OTC Bulletin Board, although we believe that the reference in the definition to "a similar service," and perhaps the reference to "a national securities exchange,"⁴ was intended to cover companies whose securities trade in these markets. It should also be noted that this definition is not limited to reporting companies under the Exchange Act of 1934 (the "Exchange Act"). For example, the California Disclosure Act would apply to a German corporate entity whose securities are traded on a German or other foreign securities exchange but not on a United States securities exchange, if the entity has qualified to do business in California.

Some of the additional information required to be provided under the California Disclosure Act is similar, but not identical, to disclosures required to be filed with the Securities and Exchange Commission (the "SEC") under the Exchange Act. For example, the persons covered by the compensation disclosures will not necessarily correspond to the persons specified in Item 402 of Regulation S-K or Item 402 of Regulation S-B of the SEC. "Executive officer" is defined under the California Disclosure Act as each of the five most highly compensated officers of the company, but excluding any officer who is also a member of the board of directors. If this definition means that a director is excluded from the term "executive officer" and no additional officer is to be added to the list of five contemplated by the definition, then the California Disclosure Act requirement would parallel that of the SEC. If, on the other hand, it means that additional officers are to be added in the event that any of the five most highly compensated officers is also a director, then the California Disclosure Act will require disclosure of the compensation of persons whose compensation is not otherwise made public.

In addition to the interpretive questions raised by the definitions used in the California Disclosure Act, additional issues are raised by some of the other, undefined, terminology used to describe the information to be disclosed by publicly traded companies. For example, the California Disclosure Act does not define "annual compensation" and it is therefore not clear whether that term refers, for example, to compensation for the current year (on some sort of projected basis), or to the company's most recently completed fiscal year (in accordance with the SEC's regulations, or to the prior calendar year). Furthermore, it is not clear what was intended by the phrase "shares or options for shares that were not available to other employees." It is also not clear what the Legislature intended by the term "preferential loan rate." The reference to "convictions" appears to limit the required disclosures to criminal fraud. However, it is not clear what will be considered "fraud" for the purposes of the California Disclosure Act. While the California Disclosure Act clearly requires disclosure of certain voluntary bankruptcy cases, it oddly appears not to require disclosure of involuntary bankruptcy cases (i.e., cased filed against the corporation, its executive officers or directors). Similarly, while the California Disclosure Act requires disclosure of the auditor's report, it does not refer to the financial statements that are the subject of the report. Consequently, it is unclear whether the financial statements must be filed with the auditor's report.

The information statement required to be filed by the California Disclosure Act must be filed by a California corporation during a six-month window that ends in the calendar month during which its original articles of incorporation were filed. For a foreign corporation, the six-month window ends in the calendar month during which the foreign corporation's certificate of qualification was filed. Newly formed California corporations are required to make their first filing within 90 days after incorporation. Because these filing periods have no relationship to the fiscal years of the corporations, it is possible for a corporation to file timely, but with nearly one-year old information.

The Secretary of State is required to mail a form for compliance with the California Disclosure Act. The form is to be mailed approximately three months prior to the close of the applicable filing period. However, the failure to receive the form is not an excuse for failure to comply. It is possible, but not certain, that the new form will contain instructions to assist corporations in completing the form. If the information required to be disclosed has changed, the corporation may file a current statement containing all of the information required. If there has been no change in the information last filed, the corporation may, in lieu of filing a statement, advise the Secretary of State of that fact on a form prescribed by the Secretary of State.

Failure to file the annual statement may result in the imposition of a $250 fine that will be assessed by the California Franchise Tax Board and may result in the suspension of the corporation's powers, rights and privileges in California if the statement is not filed for more than 24 months.⁵ In addition, failure to file the statement may subject the corporation to a maximum penalty of $15,000 per violation to be paid to the share-holder or shareholders requesting that the statement be filed.⁶ The filing of a false or fraudulent statement by the director, officer or agent of a corporation is punishable as a felony.⁷

The California Disclosure Act requires that statements filed pursuant to Corporations Code Sections 1502(a) and 2117(a) be made available for public inspection. The California Disclosure Act further requires that the Secretary of State establish an online database for this purpose prior to December 31, 2004.

The California Disclosure Act also requires a corporation to pay a $5 disclosure fee when filing the annual statement in addition to any other fees required. One-half of the fee revenue collected will be deposited into the Victims of Corporate Fraud Compensation Fund established by the California Disclosure Act, which was established for the sole purpose of providing restitution to the victims of corporate fraud.

Copyright © 2007, Mayer, Brown, Rowe & Maw LLP. and/or Mayer Brown International LLP. This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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