Medical Device Link.

Originally Published MX March/April 2003

GOVERNMENTAL & LEGAL AFFAIRS

California's recently implemented legislation on corporate disclosures may be the harbinger of more state legislation to come.

Ian D. Smith

In the wake of the U.S. government's enactment of the Sarbanes-Oxley Act of 2002, the State of California has followed with its own legislation regarding corporate disclosures (see sidebar).¹ Last September, Governor Gray Davis signed into law the California Corporate Disclosure Act, which imposes new disclosure requirements on publicly traded corporations incorporated or qualified to do business in California.²

Under the act, publicly traded corporations will be required to disclose specified information about their auditors, their directors and officers, and certain historical events. Such disclosures are in addition to the information that companies are already required to file with the California secretary of state. The act also requires that the California secretary of state make all filed information publicly available through an on-line database. The act became effective January 1, 2003.

Rapid Enactment

The California Corporate Disclosure Act represents the latest of several federal and state legislative acts to reform the regulation of corporate governance and increase the transparency of corporate actions. The act was originally introduced in the California state assembly on August 22, 2002, by then-Assemblyman (now Secretary of State) Kevin Shelley, who substantially amended a previously introduced voting rights bill (AB 55) to create the provisions that ultimately became the California Corporate Disclosure Act.

The amended bill was approved almost immediately by various assembly and senate committees, was passed by both houses by August 31, was sent to Governor Davis on September 5, and was signed into law on September 28. Moving from initial conception to enactment in just over one month, the bill attracted little attention from the business community, which remained largely unaware of the act's potential significance.

All Companies, Public Companies

Under previous law, all companies incorporated or qualified to do business in California were required to file a brief information statement with the California secretary of state every two years.³ Under the new act, all companies will now be required to file such information statements annually.

Publicly traded companies incorporated or qualified to do business in California will now also be required to provide significantly more information in their filings with the secretary of state. The act defines publicly traded companies as those with securities that are 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 similar services. The definition includes companies listed on the New York and American Stock Exchanges and the Nasdaq Stock Market as well as foreign companies and companies whose shares are traded on the OTB Bulletin Board or in the "pink sheets." The act does not apply to limited liability companies, limited partnerships, or general partnerships.

Disclosure Requirements

A public company subject to the provisions of the act will be required to disclose on an annual basis the following information. In many instances, such required disclosures differ from similar disclosures required under federal securities laws.

Auditor Information. Companies must disclose the name of their independent auditor and a description of any other services performed for the company during the previous 24 months by the independent auditor or its affiliates. A copy of the most recent report prepared for the company by the independent auditor must be attached to the filing.

Compensation of Directors and Executive Officers. Companies must disclose the annual compensation paid to each director and the five most highly compensated executive officers, including any stock or stock options "that were not available to other employees" of the company.

Federal laws require that companies disclose compensation paid to certain "named executive officers," including the company's chief executive officer and its other four most highly compensated officers serving at the end of the company's last completed fiscal year.⁴ This requirement is subject to limited variation under certain circumstances.

Because of the different ways that the two laws define the affected group of company executives, the requirement for compensation disclosure may pertain to different individuals under California and federal securities law.

Loans to Directors. The company must describe any loan made to a director at a "preferential" loan rate during the previous 24 months, including the amount and terms of the loans. The act does not define the term preferential.

Federal law requires a description of any transaction since the beginning of the company's previous fiscal year, to which the company or any of its subsidiaries was or is to be a party with a director or executive officer, in which the amount involved exceeds $60,000, and in which the director or executive director has a direct or indirect material interest.⁵ Federal law also explicitly prohibits most loans to executives, whether preferential or not.

Bankruptcies. The company must disclose whether any bankruptcy filing has been made by the company or any of its directors or executive officers within the previous 10 years.

Federal laws require the disclosure of any bankruptcy filed by a director or executive officer within the past five years if such disclosure is material to an evaluation of the ability or integrity of that individual.⁶ Although federal law does not specifically require disclosure of the historic bankruptcy proceedings of a public company, such disclosure can be expected for at least the three years corresponding to the three-year period covered in a company's annual report.

Fraud Convictions. The company must disclose whether any director or executive officer of the company has been convicted of fraud during the previous 10 years.

Federal law requires similar disclosures—but only if they are material to an evaluation of the ability or integrity of the individual.⁶ Specific items that must be disclosed include the following.

• Any conviction of any director or executive officer in a criminal proceeding.
• Whether any such individual was the named subject of a pending criminal proceeding within the past five years.
• Whether any such individual was the subject of any order, judgment, or decree not subsequently removed, suspended, or vacated permanently or temporarily, enjoining them from or otherwise limiting certain securities-related activities.
• Whether any such individual was found by a court or regulatory authority in a civil proceeding or enforcement action to have violated the federal or state securities or commodities laws.

Securities Laws Violations. The company must report whether it violated any federal securities laws or any securities or banking provisions of California law during the previous 10 years for which the company was found liable or fined more than $10,000.

Federal law requires only the disclosure of any material pending legal proceedings—other than ordinary routine litigation incidental to the corporation's business—to which the corporation or any of its subsidiaries is a party or of which any of their property is the subject.⁷ Although some historic disclosure can be expected in public company filings, it is unlikely that such disclosures would extend beyond the three years included in annual reports. As noted above, historic disclosure about violations of federal and state securities laws by officers and directors is required at the federal level.

As set forth above, it is clear that the California act has a number of material differences from comparable provisions in federal securities laws applicable to publicly traded companies. Additionally, it is worth noting that the filing period for a corporation's annual statement under the act will likely differ from the corporation's periodic filings under the Securities Exchange Act.⁸

Accordingly, publicly traded corporations incorporated or qualified to do business in California should be mindful of the different information requirements under the act and the federal securities laws. Similarly, they should remember that common information required by both the act and federal securities laws may need to be updated before incorporating it into any filing intended to meet California or federal disclosure requirements.

Filing

The new act amends the previously existing requirement for a biennial statement to require that all domestic and foreign corporations file annual statements with the secretary of state. The required information statement must be filed during a six-month period ending with the calendar month in which the corporation's original articles of incorporation or qualification to do business in California were filed.

In the event that a corporation changes its agent for service of process between the filing of its annual statements, the corporation will be required to file a current statement containing all the information required by the California Corporations Code, sec. 1502 or 2117, as applicable.

Each domestic corporation is required to certify that the information provided in its statement is true and correct. However, the act does not impose a similar certification requirement on foreign corporations.

Regulations and Forms

Corporations have traditionally filed the information statement required by the California Corporations Code on a single one-page form. The California secretary of state has created new forms that corporations will use for the act's expanded annual filing. The new forms and brief instructions for their use are available via the secretary of state's Web site (http://www.ss.ca.gov). Additionally, the secretary of state may promulgate regulations interpreting ambiguous provisions of the act.

Although the secretary of state is required to send each corporation a statement to be completed three months prior to its due date, failure to receive such a statement will not excuse a corporation's noncompliance with the California Corporations Code, sec. 1502 or 2117, as applicable.

Fraud Compensation Fund

On top of previous fees for each filing of a corporation's information statement, the act imposes a new $5 fee for each annual filing of the information statement. Half of the fee will be used to create a new compensation fund for victims of corporate fraud established by the act. The fund will be administered by the California secretary of state and will be used solely to provide "restitution to the victims of a corporate fraud." At this time, it is unclear how and to whom such funds will be distributed.

The other half of the new filing fee will be used to fund the secretary of state's implementation of the act, including development of the on-line database discussed above.

Conclusion

The unique requirements of California's new disclosure act impose additional administrative duties on publicly traded companies incorporated or qualified to do business in California. Until such time as the California secretary of state promulgates regulations regarding the forms and filing procedures relating to the act, the extent of those additional duties will remain unclear.

So far, no other state has passed legislation resembling California's disclosure act. However, it is possible that other states' failure to address the issue results less from a determination that federal disclosure requirements are adequate than from the limited legislative schedules available during last year's election season. In 2003, it seems likely that additional state legislatures will address the issues raised in California's disclosure act.

References

1. Sarbanes-Oxley Act of 2002, P.L. 107-204.

2. California Corporate Disclosure Act.

3. California Corporations Code, sec. 1502 and 2117.

4. "Regulation S-K: Standard Instructions for Filing Forms under the Securities Act of 1933, Securities Exchange Act of 1934, and Energy Policy and Conservation Act of 1975" [Regulation S-K], item 402; Code of Federal Regulations, 17 CFR 229.

5. Regulation S-K, item 404.

6. Regulation S-K, item 401(f).

7. Regulation S-K, item 103.

8. Securities Exchange Act of 1934, as amended; 15 USC 78a–78mm.

Ian D. Smith is an attorney in the corporate and securities practice group of Sheppard, Mullin, Richter & Hampton LLP (Santa Barbara, CA).

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