New Information Filing Requirements for Public Companies Incorporated or Qualified To Do Business in California

California corporations and corporations qualified to do business in California whose shares are publicly traded will be subject to additional information filing requirements under new California legislation signed by Governor Davis on September 28, 2002 and becoming effective January 1, 2003. The new legislation, the California Corporate Disclosure Act (Assembly Bill 55) (the "Corporate Disclosure Act"), makes significant additions to the information previously required to be filed with the California Secretary of State under Sections 1502 and 2117 of the California Corporations Code and increases the frequency of the filings from every two years to every year. A copy of the Corporate Disclosure Act is attached (PDF).

The legislation was introduced on August 22, 2002 as an amendment to an existing bill on an entirely different subject, and it became law within 37 days after its introduction. As a result, the legislation was not subjected to the same degree of scrutiny from outside the California Legislature that proposed legislation of this kind ordinarily would receive, and its passage came as a surprise to many corporations and members of the corporate bar.

Although the subject matter of the new disclosures is similar to what is already required to be filed with the Securities and Exchange Commission by companies reporting under the Securities Exchange Act of 1934, apparently little attempt was made to coordinate the two disclosure requirements, and compliance with the California requirements will require more than just a "cut and paste" from information required to be prepared for filing or already filed with the SEC. Also, because of the differences in the disclosure requirements, officers' and directors' questionnaires that are typically relied upon in preparing '34 Act filings will have to be revised if they are to be relied upon for the California filing.

The information is to be filed on a form prescribed by the California Secretary of State. The Corporate Disclosure Act does not mandate a time in which the form must be produced or whether the form will address any of the open questions described below. The Secretary of State is required to make the disclosed information "available and open" to the public and, by December 31, 2004, to provide access to the information by means of an online database.

The additional information that public companies must file under the Corporate Disclosure Law is as follows:

• Auditor and Non-Audit Services. The name of the independent auditor used by the corporation and a description of any "other services" (presumably non-audit services) performed for the corporation during the previous 24 months by the independent auditor or certain of its affiliates and the date of the "last report" prepared by the auditor (presumably the last audit report). A copy of the report is required to be attached to the statement of information filed with the Secretary of State.
  Directors' and Executive Officers' Compensation. The annual compensation paid to each member of the board of directors and each executive officer. The compensation disclosed is required to include the number of shares or options to purchase shares "that were not available to other employees . . . ." The meaning of "not available to other employees" is not clear, although the intention could have been to exclude broad-based stock purchase plans where directors and executive officers are treated on an equal basis with employees. There is also no definition of "compensation," something that took the SEC thousands of words to define in Item 402 of Regulation S-K. There is no prescribed format for presentation of the information, although the form to be produced by the Secretary of State may address this. In addition, the period for which the information is to be reported is not clearly indicated. The requirement appears to refer to the current rate of compensation at the time the information statement is filed, which could be different from that which is disclosed in the corporation's proxy statement prepared in accordance with the '34 Act. The reference to options presumably is to options outstanding at the time of filing, but the reference to shares is difficult to interpret because the period during which the shares to be disclosed were issued is not designated. Issues with respect to the definition of "executive officer" are discussed below.
• Loans to Directors. A description of any loans made to a director "at a preferential rate" during the preceding 24 months, including the amounts and terms of the loans. Interestingly, loans to executive officers are not covered. As there appears to be no legislative history to interpret the phrase "preferential rate," that could prove to be a significant loophole. However, the intention could have been to exclude only those loans made by corporations that lend money in the ordinary course of their business if the loans to directors were made at the rate made available to others. That treatment would be similar to the federal Sarbanes-Oxley Act, which was adopted shortly before this legislation was introduced. The Sarbanes-Oxley Act totally prohibits personal loans to directors and executive officers, but contains an exclusion for certain kinds of issuers who extend credit in the ordinary course of their business provided the credit is extended on market terms or on terms no more favorable than those offered to the general public. It is also interesting to note that, in the Corporate Disclosure Act, "preferential" relates only to the rate and not to the other terms or the amounts of the loans.
• Bankruptcy. A statement indicating whether any bankruptcy was filed by the corporation, its executive officers or members of the board of directors within the preceding ten years. Read literally, the disclosure requirement does not include cases of involuntary bankruptcy.
• Fraud Convictions. A statement indicating whether any member of the board of directors or any executive officer of the corporation was "convicted of fraud" during the previous ten years. Again, read literally, the language does not include judgments in civil actions or orders or decrees in regulatory proceedings.
• Securities Laws Violations. A statement indicating whether the corporation violated any federal securities laws or any security or banking provision of California law in the previous ten years for which the corporation was found liable in any action before a court, regulatory agency or self-regulatory organization in which a judgment over $10,000 was entered. The statute would require disclosure of such a judgment even if it was vacated or reversed on appeal.

The information filed under the Corporate Disclosure Act by a California corporation must be certified by the corporation as being true and correct. Interestingly, there is no corresponding certification provision for filings by non-California corporations qualified to do business in California.

"Executive officer" is defined in the Corporate Disclosure Act as each of the five most highly compensated officers, "excluding any officer who is also a member of the board of directors." This definition differs from that set forth in the SEC's Rule 405 under the Securities Act of 1933 and the comparable Rule 3b-7 under the '34 Act, where the term refers to the president, any vice-president in charge of a principal business unit, division or function, any officer who performs a policy making function, or any other person who performs similar policy-making functions. The federal definition expressly includes executive officers of subsidiaries who perform policy-making functions for the parent.

In the typical situation where the chief executive officer is also a director, it is unclear under the Corporate Disclosure Act whether the number of other officers included in the definition is reduced to four or whether another officer's compensation must be added. The language could bear either meaning. In the absence of authoritative clarification on the issue, it would probably be prudent to interpret "executive officer" as including each of the five most highly compensated officers who is not a director.

The information required by the Corporate Disclosure Act must be filed each year by a California corporation during the calendar month in which its original articles were filed or in any of the preceding five calendar months. The filing period is the same for a non-California corporation qualified to do business in California, except that the period is measured from the month in which the corporation filed the forms prescribed by the Secretary of State to qualify to do business in California. This means that the corporation has some control over the timing of the filing and therefore what information will be disclosed. For example, for a company that has a fiscal year ending December 31 and that was incorporated in April 1995 and files on April 1, 2003, the information filed would relate to the audit report for 2002 (under normal circumstances), compensation of directors and executive officers for 2003 and loans made to directors during the 24-month period from April 1, 2001 to March 31, 2003. However, if the corporation chose to file its information statement on December 1, 2002, it would be providing information about the audit report for 2001, compensation for 2002 and loans made during the period from December 1, 2000 to November 30, 2002.

The preceding example assumes that the reference to loans made "during the previous 24 months" refers to calendar months preceding the calendar month of filing, although that is not clear from the legislation. The other possible meaning would be the 24 months preceding the date of filing. For example, for a filing at the close of business on April 5, 2003, the 24-month period might be from April 5, 2001 to April 5, 2003. In the absence of any authoritative clarification, it would be prudent to be over-inclusive and use the 24 calendar months preceding the calendar month of filing plus any intervening subsequent days in the month of filing, although that would require disclosure current as of the date of filing. A similar problem exists in determining the ten-year periods for which bankruptcies, fraud convictions and judgments under securities and banking laws must be disclosed.

Another problem with the reporting period under the Corporate Disclosure Act is that a corporation might be required to disclose information that otherwise would become publicly available through filings under the '34 Act. Absent unusual circumstances, this will almost always be true for disclosure of compensation given that the SEC's proxy rules require disclosure of compensation for the last completed fiscal year, while the Corporate Disclosure Act appears to require disclosure for the current year at the time of filing. Under circumstances where material information is first being disclosed in the California filing, the corporation would have to consider filing a current report on Form 8-K with the SEC in order to be sure that there is widespread public disclosure.

If any of the disclosed information changes, the corporation is permitted, but not required, to file a current statement containing all of the required information. While it is arguable that corporations should make current filings in order to prevent the information previously filed from being inaccurate or misleading, presumably the statement speaks only as of the date it is filed, and the statute appears to expressly preclude any requirement of updating (with an exception described below). Also, current information that is material may be publicly available through press releases and filings under the '34 Act. If the name or address of the designated agent for service of process changes, a current statement is required as to all of the information referred to above, not just the information regarding the agent. Therefore, a new filing could be triggered by events outside of the corporation's control.

The Corporate Disclosure Act applies to each "publicly traded company" that is either a California corporation or qualified to do business in California. "Publicly traded company" is defined by the Corporate Disclosure Act as a company whose securities are listed or admitted to trading on a national or foreign securities exchange or are the subject of two-way quotations, such as bid and ask prices, that are regularly published by one or more broker-dealers in the National Daily Quotation Service (i.e. the pink sheets) or a similar service. Parent corporations not incorporated or qualified to do business in California but do business in California through subsidiaries apparently are not required to make the filings under the Corporate Disclosure Act. Their subsidiaries also are not required to make the filings if their securities are not publicly traded.

The Corporate Disclosure Act imposes a new filing fee of $5.00 (in addition to the current filing fee of $20) and provides that one-half of the $5 will be deposited into the new Victims of Corporate Fraud Compensation Fund to be administered by the California Secretary of State and to be used to provide restitution to victims of corporate fraud according to regulations to be adopted by the Secretary of State. "Corporate fraud" is not defined. The other one-half of the $5 is to be used to further the disclosure provisions of the Corporate Disclosure Act, including the development and maintenance of the online database to be established by the Secretary of State.

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