[L]ittle attempt was made to coordinate the [California and SEC] disclosure requirements. Corporations Subject to the Act

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1 Compliance with the New California Disclosures Act: Issues and Tips by Roy J. Schmidt, Jennifer W. Chaloemtiarana, Gregory J. Conklin, and Russell C. Hansen* The State of California has jumped on the corporate reform bandwagon and, effective January 1, 2003, will impose new disclosure requirements on publicly-traded California corporations and publicly-traded corporations qualified to do business in California. The California Corporate Disclosure Act (Assembly Bill 55) 1 adds significant additional disclosure requirements to the information previously called for on the statement filed with the California Secretary of State under Sections 1502 and 2117 of the California Corporations Code. The Corporate Disclosure Act also increases the frequency of filing from every two years to every year. This article describes the new legislation and offers suggestions about how to cope with the new disclosure requirements. [L]ittle attempt was made to coordinate the [California and SEC] disclosure requirements. The legislation came as a surprise to many corporations and members of the corporate bar because it was introduced very late in the legislative session and was passed and signed by the Governor a mere five weeks later. As a result of this expedited process, the legislation was not subjected to the same amount of outside scrutiny that a proposal of this kind ordinarily would receive. 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, little attempt was made to coordinate the two sets of disclosure requirements; compliance with the Corporate Disclosure Act will require more than just a cut and paste from information filed with the SEC. Also, because of the differences in the disclosure requirements, officers and directors questionnaires that are typically relied upon in preparing Exchange Act filings will have to be revised if they are to support the California filing. The information is to be filed on revised forms of the Statement by Domestic Stock Corporations and Statement by Foreign Corporations to be prescribed by the California Secretary of State. Although the new statute mandates that the forms be mailed to each company subject to the filing requirements three months prior to the end of its filing period, that requirement apparently will not be met for companies required to file early in 2003; the Secretary of State s office has indicated that the forms likely will not be available until year end. The Corporate Disclosure Act requires the Secretary of State 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. Corporations Subject to the Act The Corporate Disclosure Act applies to each publicly traded company that is either a California corporation or qualified to do business in California. Under the Act, a publicly traded company is one 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, * The authors are all with Gibson, Dunn & Crutcher LLP. Ms. Chaloemtiarana (JChaloemtiarana@gibsondunn.com) and Mr. Conklin (GConklin@gibsondunn.com) are in the San Francisco office, Mr. Hansen (RHansen@gibsondunn.com) is in the Palo Alto office, and Mr. Schmidt (rschmidt@gibsondunn.com) is in the Los Angeles office Glasser LegalWorks VOL. 6, NO. 6/ Wall Street Lawyer/ 11 RM

2 that are regularly published by one or more broker-dealers in the National Daily Quotation Service or a similar service. The National Daily Quotation Service no longer exists, having been replaced by an electronic service known as the Pink Sheets that collects and publishes market maker bid and ask prices for over-the-counter securities. The reference to the National Daily Quotation Service in the Corporate Disclosure Act was probably intended as a reference to the Pink Sheets. The Pink Sheets, the Nasdaq National Market, the Nasdaq SmallCap Market, and the OTC Bulletin Board are likely to be determined to be similar to the National Daily Quotation Service because they all publish bid and ask quotations for the over-the-counter market. Surprisingly, publicly-traded corporations that are not incorporated or qualified to do business in California but do business in California through subsidiaries are not required to make the new filings. Subsidiaries also are not required to meet the expanded filing requirements if their securities are not publicly traded. New Disclosure Requirements The additional information that public companies must file under the Corporate Disclosure Act is described below. When filed by a California corporation, this information must be certified as being true and correct. Interestingly, there is no corresponding certification provision for filings by non-california corporations. Auditor and non-audit services. The name of the company s independent auditor, a description of any other services (presumably non-audit services) performed for the company during the previous 24 months by the 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 must be attached to the statement 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. There is no definition of compensation, despite the complexity of that term (as illustrated by the length of Item 402 of Regulation S-K), and it is not clear whether the amount of compensation should be determined on a cash or accrual basis. There are also problems (discussed below) with the meaning of the term executive officer. There is no prescribed format for presentation of compensation information, nor is there a clear indication of the period for which the information is to be reported. The requirement could be the current rate of compensation at the time the disclosure statement is filed, but that might differ from the compensation disclosed in the corporation s proxy statement. On the other hand, the requirement could be compensation for the last complete fiscal year (which is the requirement for a proxy statement), since arguably it is not possible to know the amount of annual compensation paid until the annual period is completed. There is a serious question as to whether [the loan] disclosure requirement would have included any of the highly publicized, abusive loans that helped fuel the corporate reform movement. The compensation disclosed must include the number of shares or options to purchase shares that were not available to other employees of the corporation. 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. The reference to options and shares is also difficult to interpret because the period during which the options and shares were issued is not designated. 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. Moreover, the term preferential relates only to the rate and not to the other terms or the amount of a loan. The meaning of the phrase preferential rate is not provided. Does it refer to loans at a lower rate than loans made by the corporation to other directors, executive officers, or employees? Does it mean loans at less than a market rate for comparable loans made by others? What is the 12 / Wall Street Lawyer/NOVEMBER Glasser LegalWorks

3 effect of the passage of time between loans being compared and intervening changes in interest rates? If the only loans made are to directors and there is no difference in interest rates, is the rate preferential? There is a serious question as to whether this disclosure requirement would have included any of the highly publicized, abusive loans that helped fuel the corporate reform movement this year. The intention of the Act could have been to force disclosure of all loans except those made at market rates by corporations that lend money in the ordinary course of their business. That treatment of loans would roughly parallel Section 402 of the Sarbanes-Oxley Act, which prohibits personal loans to directors and executive officers of companies subject to that legislation. The literal wording of the California provision does not support that interpretation, however. 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. Moreover, unlike federal disclosure obligations, the Corporate Disclosure Act imposes no obligation to report the bankruptcy of another business entity of which an executive officer or director has served as an executive officer or, in the case of a partnership, as general partner. Fraud convictions. A statement indicating whether any member of the board of directors or any executive officer was convicted of fraud during the preceding ten years. Again, read literally, the language does not include judgments in civil actions or orders or decrees in regulatory proceedings. Securities and banking law 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 an amount exceeding $10,000. The statute, taken literally, would require disclosure of such a judgment even if it was vacated or reversed on appeal. Note also that securities law violations by executive officers or directors are not addressed. Definition of Executive Officer 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 is different from the one set forth in the SEC s Rule 405 under the Securities Act and the comparable Rule 3b-7 under the Exchange Act, which includes all officers who perform policy-making functions. 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 disclosed. The language could bear either meaning. In the absence of authoritative clarification, it would be prudent to interpret executive officer as including each of the five most highly compensated officers who is not a director. Reporting Period The required disclosure form must be filed each year during the calendar month in which the company first filed its articles of incorporation (in the case of a California corporation) or filed the requisite forms to qualify to do business in California (in the case of a non-california corporation), or in any of the preceding five months. This flexibility means a corporation having a filing deadline within five months after the end of its fiscal year has some control over what information will be disclosed. By adjusting the filing date from year to year, a corporation could effectively eliminate an entire disclosure period. Consider a company with a fiscal year ending December 31 that was incorporated in the month of April. If the company files its disclosure form on April 1, 2004, the form would cover the audit report for 2003 (under normal circumstances), compensation data for 2004, and information about loans to directors for the 24- month period from April 1, 2002, to March 31, However, if that same corporation chose to file its disclosure form on December 1, 2003, it would provide information about the audit report 2002 Glasser LegalWorks VOL. 6, NO. 6/ Wall Street Lawyer/ 13 RM

4 for 2002, compensation for 2003, and loans made during the period from December 1, 2001, to November 30, By adjusting the filing date from year to year, a corporation could effectively eliminate an entire disclosure period. 2 [W]here material information is first being disclosed in the California filing, the corporation should consider filing a current report on Form 8-K. One problem with the reporting period under the Corporate Disclosure Act is that a corporation might be required to disclose information that will be, but is not yet, publicly disclosed through filings under the Exchange Act. This will often be true for disclosure of compensation; 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 should consider filing a current report on Form 8-K with the SEC to ensure widespread public disclosure. Responsibility to Update Disclosure Generally, if any of the disclosed information changes, a corporation is permitted, but not required, to file an updated disclosure form. However, if the name or address of the designated agent for service of process changes, the company must file a completely revised and current disclosure form covering all of the required information not just the information regarding the agent. As a result, a new filing could be triggered by the relocation of the service company designated as the corporation s local agent an event entirely beyond the corporation s control. What to do Now Don t overreact There is considerable unhappiness among corporations and the corporate bar about the Corporate Disclosure Act, and with good reason. Compliance with the new requirements will take some thought and effort, but the problems are manageable. Companies considering transfers of the California portions of their businesses to wholly-owned subsidiaries, or taking other significant steps to avoid the filing requirement, should carefully consider whether such measures will be cost effective. Find out when your filing is due The deadline for the first filing for a California corporation is the end of the same month of 2003 in which it first filed its articles of incorporation. The deadline for a non-california corporation is the end of the same month in 2003 in which it filed to qualify to do business in the state. These dates can be obtained by looking at prior filings with the Secretary of State, or by conducting a search at the Secretary of State s web site at < choosing California Business Portal, then California Business Search. Monitor developments The Secretary of State reportedly expects to distribute the new disclosure form by year end. This form may clarify some of the disclosure requirements. The State Bar Corporations Committee has already begun work on a cleanup bill to clarify many of the disclosure issues, but any such legislation will not be helpful to corporations for their filings due in 2003 unless it is passed as urgent legislation with an effective date in Change your directors and officers questionnaire Most public companies circulate questionnaires to directors and officers to gather information for their proxy statements. Because of the differences in the disclosures required by the Corporate Disclosure Act and the federal proxy rules, companies should either modify their questionnaires or circulate a separate California questionnaire. We recommend using a single questionnaire unless the timing of the two filings is so out of sync that information gathered in time for one filing would be stale before the other was due. Here are some changes we think companies should make in a typical directors and officers questionnaire. In some cases, these changes will elicit more information than the Corporate Disclosure Act specifically requires. We explain 14 / Wall Street Lawyer/NOVEMBER Glasser LegalWorks

5 our reasons for an overbroad approach below in the section headed Dealing with the Disclosure Issues. Questions regarding compensation should be broad enough to cover the year in which the California filing will be made as well as the immediately preceding full fiscal year. The questionnaire should specifically inquire about the issuance of shares and options to purchase shares as compensation. These questions should not be limited to shares that were not made available to other employees because the meaning of that phrase is uncertain. Questions regarding loans made by the company to directors should cover the last two full fiscal years and any interim period through the date the questionnaire is completed. Questions about loans should include all loans, not just those at a preferential loan rate as provided in the Corporate Disclosure Act. Similarly, these questions should not limit the information to personal loans, and should include loans maintained by the company as well as those made by the company. In light of the vigorous debate about the meaning of extending, maintaining, or arranging for credit in the form of personal loans in the Sarbanes-Oxley Act, the questionnaire should specifically explain that advances in connection with the company s indemnification obligations, payment of the premiums on split-dollar life insurance, certain cashless exercises of stock options, advances of travel expenses in excess of normal amounts for company business or not settled within a reasonable time, and use of company credit cards or company cars or planes for personal purposes where reimbursement of the company is required may be deemed loans. Questions regarding bankruptcy proceedings should relate to the ten full years and any interim period prior to signing the questionnaire rather than the five-year period referred to in Item 401(f) of Regulation S-K. The questions should be as broad as is required to respond to Item 401 and should not be limited simply to voluntary bankruptcy. Questions regarding criminal proceedings should be expanded to cover the same tenyear and interim periods referred to above, rather than the past five years provided for in Item 401 of Regulation S-K. The phrase conviction of fraud should be expressly included in the question, and the question should cover both civil and criminal proceedings in the nature of fraud. Because of the uncertainty about the definition of executive officer under the Corporate Disclosure Act, questionnaires should be sent to the five most highly compensated officers who are not on the board of directors as well as to all members of the board. Don t attempt an early filing Theoretically, a company required to file an information statement before the end of April 2003 could file one that meets the requirements of the current law (which are rather minimal) five months before the filing deadline, and thus before the Corporate Disclosure Act becomes effective on January 1, Some have wondered whether such a filing would delay for a year the entire problem of the new disclosures. Unfortunately, it appears the answer is no. The problem is that on January 1, 2003, and thereafter, the corporation will not have filed a form meeting all of the requirements of the then effective law. Dealing with the Disclosure Issues Assuming that the requirements of the Corporate Disclosure Act are not clarified in time for the first filing, coping with the statute s uncertainties will present a range of options. One end of the spectrum would be to minimize disclosure by complying with the literal requirements of the Act, for example by disclosing voluntary bankruptcies but not involuntary bankruptcies. The other extreme would be complying with the spirit of the Act (however divined) and providing the information that a reasonably drawn statute would have elicited. The method each filing corporation chooses will be a function of how it approaches disclosure issues in general and the input of its legal 2002 Glasser LegalWorks VOL. 6, NO. 6/ Wall Street Lawyer/ 15 RM

6 advisers. The minimal disclosure approach may avoid negative disclosures that otherwise might not have come to light and may reduce legal exposure simply because there will be less disclosure that could later be determined to be false or misleading. In contrast, the more comprehensive spirit-of-the-act approach may reduce the risk of making disclosures that, while literally complying with the Act, could be challenged as misleading. Offering meaningful disclosure beyond the literal requirements also may help a corporation appear to be a good corporate citizen. In the wake of the Sarbanes- Oxley Act, with its emphasis on disclosure beyond the technical requirements of the law, the more comprehensive approach is certainly politically correct for these times. Financial statements The Corporate Disclosure Act requires corporations to file a copy of their last audit report, but does not call for copies of the financial statements. Filing the report without the financial statements seems nonsensical, but the literal wording of the Act permits that course of action and it would seem to be a reasonably safe choice for a filer taking the minimalist approach. This practice may also avoid the need in some cases to file the financial statements with the California Secretary of State before filing them with the SEC a situation that seemingly would demand the concurrent filing of the financial statements with the SEC on a Form 8-K. For the filer wishing to comply with the spirit of the Act, the risk of incremental liability (over and above the risk of filing the financial statements with the SEC) seems small. Compensation Pending clarification of the issue, we think companies should disclose compensation for the last full fiscal year ended before the California filing is made, as well as compensation for the current year. This obviously is over-compliance, but we recommend it because we do not know what the literal language of the Act means. We think practitioners should assume that compensation has the same broad meaning in the Corporate Disclosure Act as in Item 402 of Regulation S-K. In many cases, incorporating the text of the compensation section of the most recent proxy statement or attaching a copy (if the Secretary of State will permit that) will provide much of the disclosure required. In most cases this will have to be supplemented, though, because of differences in the persons whose compensation must be included and in the reporting periods. Filing the [audit] report without the financial statements seems nonsensical, but the literal wording of the Act permits that course of action. Depending on the timing, some of the required information may not be available. In that event, the available information should be disclosed, together (if possible and appropriate) with meaningful disclosure of expected ranges, historical patterns, or other information that gives the reader some idea of what can be expected. Equity compensation The Corporate Disclosure Act seems to require that grants of stock options and issuance of restricted stock be associated with a particular time period because it uses the words annual compensation... including the number of shares or options.... Tying these events to particular time periods is tricky because grants and issuances typically provide for exercise and/or vesting over a multi-year period. Grants of unexercisable options and issuances of unvested restricted stock may not constitute compensation only for the year of grant. One approach would be to disclose all outstanding options, all outstanding restricted shares, the number of shares subject to options that become exercisable in the annual period being reported upon, and the corresponding number of shares of restricted stock that vest in that period. Alternatively, a filer could follow the pattern of Item 401 of Regulation S-K and provide a breakdown between the number of shares as to which outstanding options have become exercisable and the number not exercisable. Corresponding information would be provided as to restricted stock. We also recommend disclosing the total number of shares subject to options granted during the reporting 16 / Wall Street Lawyer/NOVEMBER Glasser LegalWorks

7 period and the total number of shares issued as compensation during the period. Although phantom stock plans that do not provide for settlement in stock do not involve shares or options for shares, the amounts available to participants under the plans clearly constitute compensation. Phantom stock plans will typically involve the same problem of tying the compensation to the annual period being reported and could be handled in a manner similar to stock options. Loans The Corporate Disclosure Act clearly limits disclosure to loans to directors and does not include officers. While this distinction does not seem to make sense, a filer adopting the minimalist approach would appear to be safe providing the information only as to directors. This requirement may result in disclosure of loans that do not have to be disclosed in proxy statements because they are less than the SEC s $60,000 threshold. Moreover, unlike Section 402 of the Sarbanes-Oxley Act, the California requirement makes no distinction between personal loans and other loans. We would not exclude loans on the ground that they were not at a preferential loan rate unless the company is in the business of making loans and the loans made to the directors were on terms no more favorable than those offered to third parties generally. We also would recommend disclosing loans where no preferential rate is involved if the amount or the terms of the loans are more favorable to the director than those made available to others. Bankruptcy Whether or not to disclose involuntary bankruptcies would be a difficult issue for a filer adopting the minimalist approach. Ultimately, the issue is whether failing to disclose involuntary bankruptcies violates a requirement that refers to any bankruptcy filed by the corporation, its executive officers or... directors (emphasis added), and whether disclosing only voluntary filings, while perhaps complying with the statutory language, is misleading. For spiritof-the-act filers, the answer is obvious. Although less obvious, filers should also consider whether or not to extend the disclosure to other proceedings picked up in Item 401 of Regulation S-K, which includes state insolvency laws, receiverships, and other similar arrangements, and also extends to partnerships in which a director was a partner, and corporations of which a director was an executive officer, within two years of the time of filing. For purposes of the Corporate Disclosure Act, we would use ten years instead of two years in the partnership/ executive officer context. Conviction of fraud Although the language of the Corporate Disclosure Act requires disclosure if any director or executive officer was convicted of fraud, we would include convictions on grounds that are in the nature of fraud, including failing to disclose or providing erroneous or misleading information. The word conviction seems to apply only to criminal proceedings, and a filer adopting the minimalist approach would probably be in compliance limiting the disclosure in that way. A filer adopting the more comprehensive approach should consider disclosing civil judgments and orders in administrative proceedings involving cases in the nature of fraud. W Notes 1 The full text of the bill is available at < bill/asm/ab_ /ab_55_bill_ _chaptered.html>. 2 This example assumes that loans made during the previous 24 months refers to calendar months preceding the month of filing, although that is not clear from the legislation. The other possible meaning would be the 24 months preceding the precise date of filing. Determining the ten-year periods for which bankruptcies, fraud convictions, and judgments under securities and banking laws must be disclosed presents a similar problem. The example also assumes that the compensation disclosure relates to the current year of filing. As noted above, the Corporate Disclosure Act gives no guidance about this disclosure period Glasser LegalWorks VOL. 6, NO. 6/ Wall Street Lawyer/ RM 17