The Fifth Circuit has rejected the challenge to Nasdaq’s “show and tell” diversity rule that requires Nasdaq companies to publicly disclose the makeup of their boards. In Alliance for Fair Board Recruitment, National Center for Public Policy Research v. SEC (“Alliance for Fair Board Recruitment”), the Court denied petitions two conservative groups had filed challenging the SEC’s authority to issue the rule.
Edward Blum, the founder of Alliance for Fair Board Recruitment—one of the groups challenging the SEC’s approval—has already expressed his group’s plan to appeal the decision, which could either be a request for en banc review by the Fifth Circuit (i.e., a rehearing/review of the decision by all active judges on the Fifth Circuit), or an appeal to the Supreme Court. Given Blum’s recent success before the Supreme Court in Students for Fair Admissions v. President and Fellows of Harvard College (“Students for Fair Admissions”), the current Supreme Court might be receptive to such a challenge. We discuss Nasdaq’s rule, the decision, and implications for corporations, corporate boards, and business leaders, below.
The Nasdaq’s “Show and Tell” Rules & The SEC’s Approval
On August 4, 2020, Nasdaq filed with the SEC a proposed rule requiring Nasdaq-listed companies to “have, or explain why it does not have,” at least two diverse directors on its board. Nasdaq has clarified that the rule is not a mandate, but rather reflects diversity objectives that Nasdaq-listed companies should strive to achieve. If a company does not meet the diversity objectives for its board, it must explain why it failed to satisfy these objectives in its proxy statement, an information statement, or on the company’s website. Nasdaq has indicated that it will not assess the substance or merits of a company’s explanation. In addition, the rule also requires Nasdaq-listed companies to annually publish, using a standardized “matrix,” statistical information regarding the diversity composition of its board of directors, including directors’ self-identified gender, race, and LGBTQ+ status.
The SEC’s Approval & Subsequent Challenges
The SEC approved Nasdaq’s proposed rule on August 6, 2021. In its Approval Order, the SEC explained that the rule “would establish a disclosure-based framework for Nasdaq-listed companies that would contribute to investors’ investment and voting decisions,” and “[w]hile the proposal may have the effect of encouraging some Nasdaq-listed companies to increase diversity on their boards, the proposed rules do not mandate any particular board composition.” The SEC also emphasized that companies that do not achieve the diversity objectives are afforded “substantial flexibility in crafting the required explanation,” and importantly Nasdaq “would not evaluate the substance of the explanation.” The SEC also cited extensive interest in board diversity information from “institutional investors, investment managers, listed companies, and individual investors,” among other stakeholders, all of whom “expressed interest in board diversity information,” and explained that Nasdaq’s rule “would make such information widely available on the same basis to all investors,” and thus was calculated 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.” In short, the SEC made clear that Nasdaq’s rule was not a mandate, but rather, the rule was calibrated to remove informational asymmetries that existed around board diversity which might have the effect of creating a more efficient market.
Shortly after the SEC approved Nasdaq’s rule, the National Center for Public Policy Research (“NCPPR”) and the Alliance for Fair Board Recruitment (“AFBR”) (collectively the “Petitioners”) petitioned for review, arguing that the SEC’s approval order violated the Constitution and exceeded its authority under the Securities Exchange Act and the Administrative Procedures Act. Specifically, the Petitioners argued that Nasdaq’s rule amounted, in effect, to a diversity “quota” in violation of the Equal Protection Clause of the Fourteenth Amendment, and otherwise violated a company’s First Amendment right against compelled speech.
The Fifth Circuit’s Decision
The Fifth Circuit first disposed of Petitioners’ Constitutional arguments. Contrary to Petitioners’ claim that the Nasdaq “is itself a government entity bound by the Constitution,” the Fifth Circuit emphasized that Nasdaq is private entity—not a state actor. And, while Nasdaq “must register with and is heavily regulated by the SEC, the Supreme Court has made clear that a private entity does not become a state actor merely by virtue of being regulated.” Nor does the SEC’s “involvement with and approval of Nasdaq’s Rules render the Rules subject to Constitutional scrutiny.” The Fifth Circuit cited three separate grounds in rejecting this alternative argument: (1) the Nasdaq is not performing a “traditional, exclusive public function”; (2) the SEC did not “compel” Nasdaq to promulgate the rule; and (3) the SEC and Nasdaq did not act jointly in a manner such that Nasdaq’s “conduct could be attributed to the government.” Emphasizing the Supreme Court’s cautioning against expanding “the state-action doctrine beyond its traditional boundaries,” the Fifth Circuit “heed[ed] this warning in holding that the Rules drafted and proposed by Nasdaq, a private self-regulatory organization, are not attributable to the government and therefore not subject to constitutional scrutiny.”
The Fifth Circuit next disposed of Petitioners’ contention that the SEC’s Approval Order exceeded its statutory authority and was arbitrary and capricious. Petitioners advanced four distinct arguments here, and the Fifth Circuit addressed and rejected each in turn.
- First, the Fifth Circuit explained that the SEC did not improperly consider the “subjective belief and desire of a subset of investors,” noting that the “Exchange Act does not limit the SEC to considering ‘objective evidence’ in deciding whether to approve a proposed rule,” as Petitioners attempted to argue.
- Second, the Fifth Circuit rejected Petitioners’ “materiality” argument—which essentially contended that because the disclosure requirement did not pertain to “material” information, the SEC acted outside its authority in approving the rule. The Fifth Circuit rejected this “unworkable” materiality standard, explaining that the Exchange Act confers upon the SEC broad discretion to regulate rules, beyond those involving exclusively “material” information, and that the SEC’s Approval Order was otherwise supported by substantial evidence that the disclosure requirement would inform and influence investors’ investment and voting decisions. The Court referenced statements cited by the SEC from Vanguard, State Street Global Advisors, and BlackRock—three of the largest institutional investors in the world—each of whom called for companies to disclose board diversity information.
- Third, the Court rejected the contention that the Approval Order infringed on state sovereignty by regulating corporate governance—an issue reserved for the states. The Court explicitly noted that the SEC “conclusively determined, based on substantial evidence” that the Nasdaq rule was a “disclosure rule, not a mandatory quota,” and Petitioners failed to explain how it regulated the “internal affairs” of a corporation, or otherwise upset the state-federal balance.
- Fourth, the Court found that the SEC’s Approval Order did not violate the “major questions” doctrine—which applies in “‘extraordinary cases’ where the ‘history and the breadth of the authority that the agency has asserted, and the economic and political significance of that assertion, provide a reason to hesitate before concluding that Congress meant to confer such authority.’” The Fifth Circuit rejected the notion that this was one of those cases. Rather, the SEC had clear authority under the Exchange Act to regulate the Nasdaq’s rule.
Finally, the Fifth Circuit found that the SEC’s Approval Order was not arbitrary and capricious in violation of the Administrative Procedures Act The Court reasoned that the SEC’s Approval Order was supported by a significant body of evidence, and furthered at least one legitimate objective under the Exchange Act, most notably finding that Nasdaq’s rule would mitigate “unequal access to information that may currently exist between (likely large and more resourceful) investors who could obtain the information and other (likely smaller) investors who may not be able to do so.” The Court also highlighted the SEC’s careful consideration of the benefits (i.e., mitigation of the information asymmetries in the market) with the burdens (i.e., increased risk of activist divestment campaigns or shareholder lawsuits) in approving Nasdaq’s rule.
In short, the Fifth Circuit analyzed the approval process in which the SEC engaged, ultimately concluding that “AFBR and NCPPR have given [the Fifth Circuit] no reason to conclude that the SEC’s Approval Order violates the Exchange Act or the APA.”
Broader Implications and Takeaways
The Fifth Circuit’s decision leaves Nasdaq’s rule in full effect. In practice, this triggers several obligations for Nasdaq-listed companies, including disclosure requirements with a December 31, 2023 deadline. Nasdaq has released a summary document outlining what companies should know, which is helpful in setting forth, at a high level, the rule’s obligations.
Nasdaq-listed companies that lack board diversity will need to consider framing the explanation for not achieving these metrics. While Nasdaq has expressed that it will not consider the substance of company’s explanation, the general public—including investors and stakeholders—may draw their own conclusions. Thus, while Nasdaq’s rule does not impose penalties on companies that fail to meet diversity objectives, it does not prevent or limit the repercussions that Nasdaq-listed companies could face in the marketplace for either failing to increase board diversity, or for releasing an inadequate or insufficiently thoughtful explanation for the lack of board diversity. How investors and stakeholders approach the implementation of the rule will be important, as they may demand substantive explanations that go beyond generic statements relating to the failure to achieve board diversity. It is also possible that the SEC’s endorsement of the Nasdaq “show and tell” approach may portend future regulatory rules addressing these issues.
The firm’s ESG Practice Group is available to answer any question corporate leaders have about the new disclosure rule and any other ESG-related matter.