5th Circuit Vacates SEC Approval of NASDAQ Board Diversity Rules

On December 11, 2024, a closely divided Court of Appeals for the Fifth Circuit in Alliance for Fair Board Recruitment v. SEC (5th Cir.; 12/24), in a 9 to 8 en banc decision, struck down NASDAQ’s board diversity rules. The 5th Circuit majority held that the SEC exceeded its authority when it approved such rules, stating that “ … the diversity rules cannot be squared with the Securities Exchange Act of 1934.” The Court found that the diversity rules were not a disclosure requirement, but “a public-shaming penalty for a corporation’s failure to abide by the Government’s diversity requirements.” According to a Bloomberg Article, NASDAQ does not intend to appeal the decision. It remains to be seen whether the SEC will appeal, but given the coming change in administration, it seems unlikely that any appeal (if initiated) would continue.

Standard for Analysis – Board Diversity Regulations Must be “Related to” Exchange Act’s Purposes

Under 15 U.S.C. §78s(b), the SEC can approve a self-regulatory organization rule change proposal only if it finds the proposal to be “consistent with the requirements of” the Exchange Act. In this case, the Court, citing the statutory mandate that exchange rules not be designed “to regulate … matters not related to the purposes of this chapter or the administration of the exchange,” interpreted that standard to mean the proposed regulations must be “related to” the purposes of the Exchange Act, which include preventing fraud, promoting just and equitable principles of trade, and generally protecting investors and the public interest.¹ The majority of the Court and the SEC differed on the relationship of NASDAQ’s board diversity rules to the Exchange Act’s purposes, with the majority concluding that the board diversity rules failed the “related to” test.

NASDAQ’s Board Diversity Rules

The Court divided NASDAQ’s board diversity rule proposals into three parts – the “Disclosure Rule,” the “Diversity Rule,” and the “Recruiting Rule.” The “Disclosure Rule” requires listed companies (subject to specified exceptions) to annually disclose board-level diversity data based on each director’s voluntary self-identified characteristics in accordance with a prescribed “matrix.” The “Diversity Rule” requires listed companies (subject to specified exceptions) to have, or explain why they do not have, at least two members of its board of directors who are Diverse,² including (i) at least one Diverse director who self-identifies as Female, and (ii) at least one Diverse director who self-identifies as an Underrepresented Minority or LGBTQ+. ³ The “Recruiting Rule” provides for one year of complimentary access to a network of board-ready diverse candidates.⁴ NASDAQ noted that these rules merely prescribe “aspirational diversity objectives” and that companies that don’t meet such objectives “need only explain why they do not.”

The Disclosure Rule and the Diversity Rule

In concluding that both the Disclosure Rule and the Diversity Rule were “related to” the purposes of the Exchange Act, the SEC noted that board-level diversity information was important to institutional investors and others, that the rules would establish a “disclosure-based framework” making board diversity information available on a “consistent and comparable” basis, and that an explanation of why a company had not met the diversity objectives of the rules would contribute to investors’ investment and voting decisions. Accordingly, the SEC found that consistent with 15 U.S.C. §78f(b)(5), the rules were “designed to promote just and equitable principles of trade, remove impediments to and perfect the mechanism of a free and open market and a national market system, and protect investors and the public interest.”

The Court, however, took a different view. In explaining that all disclosure rules are not de facto “related to” the purposes of the Exchange Act, the Court stated that: “The Act exists primarily to protect investors and the macroeconomy from speculative, manipulative, and fraudulent practices, and to promote competition in the market for securities transactions. A disclosure rule is related to the purposes of the Act if it has some connection with those purposes, but not otherwise.” The Court further noted that Congress carefully limited the SEC’s power to compel disclosure to the kinds of information that are most likely to eliminate fraudulent and speculative behavior, concluding that although the SEC stated that the rules were designed to advance certain of the purposes set forth in 15 U.S.C. §78f(b)(5), such purposes were not related to the disclosure of information about the racial, gender, and sexual characteristics of public company directors.

Specifically, in rejecting the SEC’s contention that the Disclosure Rule and the Diversity Rule are related to the requirement that exchanges adopt rules “designed to ... promote just and equitable principles of trade,” the Court found that it is “not unethical for a company to decline to disclose information about the racial, gender, and LGTBQ+ characteristics of its directors.” In rejecting the SEC’s contention that such rules are related to the requirement that exchanges have rules “designed ... to remove impediments to and perfect the mechanism of a free and open market and a national market system,” the Court opined that what Congress meant by a “free and open market” was a free and open market for securities transactions, noting that making information available that may contribute to investment and voting decisions “… might be a good idea, but it has nothing to do with the execution of securities transactions.” In response to the SEC’s argument that the rules are related to the requirement that exchanges adopt rules designed “in general, to protect investors and the public interest,” the Court stated that the analysis should be based on whether the rule “protects investors or the public from the kinds of harms that the Exchange Act explicitly lists as its targets – that is, speculation, manipulation, fraud, anticompetitive exchange behavior, etc.” The Court found that “NASDAQ offered only the barest speculation to support the proposition that there is any link between investor protection and racial and sexual diversity.”

Major Questions Doctrine

In the majority’s view, the “major questions doctrine” provided additional support for their interpretation of the Exchange Act. This doctrine is grounded in the premise that in cases involving “vast and comprehensive” impact, the authority of administrative agencies is limited to what Congress has expressly provided. The Court concluded that under Supreme Court precedent, the Disclosure Rule and the Diversity Rule came within the purview of this doctrine (due to their “economic and political significance”). Further, the Court found no express authorization for the board diversity rules, as “no part of the Exchange Act even hints at SEC’s purported power to remake corporate boards using diversity factors.” The Court also suggested that if any such mandate existed, it would be given to more suitable agencies (e.g. the Employment Opportunity Commission or the Department of Justice), or left to the States themselves, which govern the creation of corporations.

The Dissent

The eight dissenting judges had a different view of the SEC’s role in approving the NASDAQ board diversity rules. The dissent observed that the SEC has only limited discretion in approving rules promulgated by private self-regulatory organizations like NASDAQ, stating that the SEC is not permitted to “displace NASDAQ’s private business judgement - informed by investor behavior - with agency policy priorities” when considering whether to approve a proposed listing rule. They noted that the SEC is obligated to approve rules proposed by securities exchanges if the proposed rule is consistent with the Exchange Act’s purposes, which under “well-established caselaw”, include “a philosophy of full disclosure.” Quoting from Intercontinental Indus., Inc. v. Am. Stock Exch., 452 F.2d 935, 940 (5th Cir. 1971), among other examples, they emphasized that “The requirement of full disclosure of all corporate information which might influence investment decisions is the very heart of the federal securities regulations.” Consistent with this view, the dissenting judges observed that the board diversity rules eliminate information asymmetries with respect to board diversity data between large investors, who have the market power and ability to directly obtain desired information about (and even influence) the board members, and smaller investors, who without such ability or leverage, must “rely on incomplete public disclosures” with respect to the corporation and its leadership. The dissenting judges pointed to the fact that the market has patently expressed a desire for information about the diversity of corporate boards, and that the SEC should not question the market’s position about the type of information that it wants to have disclosed, with consistency that is designed to ensure all investors have access to the same information.

Analysis

Many commentators have cited this decision as another “nail in the coffin” of corporate Diversity, Equity, and Inclusion (DEI) programs. Without question, it is consistent with a current trend for courts to narrowly interpret agency authority, and a broader policy trend towards limiting the focus of companies on DEI as part of their missions. As a result, the longer-term effect of this decision is that decision-making around board diversity and related disclosure will revert to the hands of market participants with significant leverage, risking the informational asymmetries about which the dissent warned.

However, it is worth noting that this decision rests on the Court’s view of the scope of securities disclosure requirements and a specific grant of authority in the Exchange Act; its relevance to other regulatory schemes is not clear. It also does not address the SEC’s long-mandated disclosures about consideration of diversity in identifying board members and about board qualifications. Current proxy rules require disclosure as to whether, and if so how, the nominating committee (or the board) considers diversity in identifying director nominees, and if such a policy exists, how it is implemented and its effectiveness assessed. Companies must also explain the specific experience, qualifications, attributes, or skills of nominees that support the board’s nomination decisions. Accordingly, public companies will continue to be obligated to make certain disclosures relating to board diversity.

In addition, notwithstanding this decision, the same institutional investors who pressed for board diversity information in the first place will likely continue to keep this in their agendas, and to push for continued public disclosure of this information.

© Arnold & Porter Kaye Scholer LLP 2024 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.