In August 2021, the SEC approved a Nasdaq proposal for new listing rules regarding board diversity and disclosure, accompanied by a proposal to provide free access to a board recruiting service. The new listing rules adopted a “comply or explain” mandate for board diversity for most listed companies and required companies listed on Nasdaq’s U.S. exchange to publicly disclose “consistent, transparent diversity statistics” regarding the composition of their boards. (See this PubCo post.) It didn’t take long for a court challenge to these rules to materialize: the Alliance for Fair Board Recruitment and, later, the National Center for Public Policy Research petitioned the Fifth Circuit Court of Appeals—the Alliance has its principal place of business in Texas—for review of the SEC’s final order approving the Nasdaq rule. (See this PubCo post and this PubCo post) In October 2023, a three-judge panel of the Fifth Circuit denied those petitions, in effect upholding Nasdaq’s board diversity listing rules. Given that, by repute, the Fifth Circuit is the circuit of choice for advocates of conservative causes, the decision to deny the petition may have taken some by surprise—unless, that is, they were aware, as discussed in the WSJ and Reuters, that the three judges on this panel happened to all be appointed by Democrats. Petitioners then filed a petition requesting a rehearing en banc by the Fifth Circuit, where Republican presidents have appointed 12 of the 16 active judges. (See this PubCo post.) Not that politics has anything to do with it, of course. That petition for rehearing en banc was granted, vacating the opinion of the lower court. Yesterday, oral argument was heard. Let’s just say that, while some points were made in support of the rule, the discussion seemed to be dominated by rule skeptics. But the feud between Drake and Kendrick Lamar did figure in the discussion. Some highlights below.
Nasdaq listing rule. The Nasdaq board diversity rule sets a “recommended objective” for most Nasdaq-listed companies to have at least two diverse directors on their boards; if they do not meet that objective, they would need to explain their rationales for not doing so. Companies with five or fewer directors may satisfy the recommended objective with one director from a diverse background rather than two. The rule also requires listed companies to provide annually, in a board diversity matrix format, statistical information regarding the company’s board of directors related to the directors’ self-identified gender, race and self-identification as LGBTQ+. Separately, Nasdaq also provided Nasdaq-listed companies with one-year of complimentary access to a board recruiting solution to help identify board-ready diverse candidates. (See this PubCo post.)
If a company elects disclosure in lieu of compliance with the diversity objectives, the company is required to identify the applicable requirements and explain the reasons why it did not satisfy them. Nasdaq said that it “would not evaluate the substance or merits of a company’s explanation.” According to correspondence from Nasdaq’s Chief Legal and Regulatory Officer, the company “can choose to disclose as much, or as little, insight into the company’s circumstances or diversity philosophy as the company determines, and shareholders may request additional information directly from the company if they need additional information to make an informed voting or investment decision.”
To refute potential criticism of the board diversity proposal as a quota in disguise, Nasdaq took great pains to frame its proposals as principally “a disclosure-based framework and not a mandate,” a presentation that the SEC embraced. The SEC observed that the proposal “would mitigate concerns regarding unequal access to information“ among investors and might benefit companies that chose to comply with the diversity objectives. In light of these disclosure benefits, and “given that the studies of the effects of board diversity are generally inconclusive and the costs of the proposal are likely to be comparatively limited,” the SEC found that the proposal was consistent with the requirements of the Act. In approving the proposals, the SEC made clear that it had no discretion to modify the proposals and, if it found the rules to be consistent with the Exchange Act, no real choice but to approve the proposals: under the Act, the SEC “‘shall approve’ a proposal if it finds that the rule is consistent with the requirements of the Act and the rules and regulations applicable to the SRO—including requirements in Section 6(b). The statute does not give the Commission the ability to make any changes to the rule proposal as submitted, or to disapprove the rule proposal on the ground that the Commission would prefer some alternative rule on the same topic.” Because the SEC found both proposals to be consistent with the requirements of the Act and the rules and regulations applicable to Nasdaq, the SEC stated in the Order, “[t]he proposed rule changes therefore are required to be and are approved.”
Three-judge panel opinion. That approach to framing the proposals seems to have been persuasive—right out of the gate, the three-judge panel described the Nasdaq listing rule as a “rule that would require companies listed on its stock exchange to disclose information about their board members, as well as a rule that would give certain companies access to a board recruiting service.”
Petitioners first made several Constitutional claims. The Court concluded that Nasdaq was not a state actor. Although Nasdaq “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 did “the SEC’s involvement with and approval of Nasdaq’s Rules render the Rules subject to constitutional scrutiny.” Petitioners also contended (i) that the SEC was prohibited “from considering investors’ subjective beliefs that disclosure would be valuable,” (ii) that the SEC was prohibited “from approving an exchange rule that requires disclosure of information that would not be ‘material’ for purposes of a securities fraud claim, (iii) that Congress did not explicitly authorize the SEC to approve a rule that infringes state sovereignty, and (iv) that Congress did not explicitly authorize the SEC to approve a rule that concerns ‘major policy questions of vast economic and political significance.’” But the Court rejected all of those arguments and concluded that, in approving the Nasdaq rules, the SEC acted within its statutory authority. Finally, the Court concluded that the SEC’s Approval Order was not arbitrary and capricious under the APA. Based on its analysis, “the SEC decided that the Disclosure Rule contributes to the maintenance of fair and orderly markets” and “reasonably concluded” that the Rule “would not impose a burden on competition between issuers that is not necessary or appropriate in furtherance of the purposes of the Act.” In the end, the panel unanimously decided that “AFBR and NCPPR have given us no reason to conclude that the SEC’s Approval Order violates the Exchange Act or the APA.” For a more detailed discussion of the now-vacated opinion of the three-judge panel, see this PubCo post.
Petition for rehearing. The petition for rehearing opened by observing, speaking of the Nasdaq board diversity listing rule, that “a rule that facially discriminates based on race and sex now has the imprimatur and backing of the federal government….That discrimination now has this Court’s seal of approval, too.” It’s worth noting here that there were a slew of amicus briefs submitted in this case, including FINRA, the State of Utah and 23 other states, the Buckeye Institute, the Manhattan Institute and 22 or so others, the Interfaith Center on Corporate Responsibility, Academic Experts in the Fields of Business, Management, and Economics and various other academics, Ariel Investments, L.L.C., the Council of Institutional Investors, Better Markets, Inc., the NAACP Legal Defense and Educational Fund, and an Ad Hoc Coalition of Nasdaq-Listed Companies.
The two questions identified in the petition for the Court’s en banc review were:
“(1) whether approval of the Rule and its compulsion of discrimination and controversial disclosure requirements are unconstitutional state action; and
(2) whether the Rule is justified under the Exchange Act on the sole basis that select financial activists want to encourage board selection based on race and sex.”
The petition contended that the listing rule violated the Equal Protection clause and, by compelling controversial disclosure, the First Amendment, citing the conflict minerals decision, Nat’l Ass’n of Mfrs. v. SEC. (See this PubCo post.) The petition also challenged the panel’s conclusion that no state action was involved, arguing that “requiring private parties to encourage discrimination that otherwise would not have occurred” is in effect, state action by the SEC. And the “unique relationship between the SEC and national stock exchanges like Nasdaq means exchange rules are subject to constitutional requirements, as well.”
The petition also requested that the Court grant the rehearing
“to remove this Court’s new stamp of approval on race and sex discrimination, to uphold the First Amendment, and to resolve the now-conflicting caselaw on state action. The Court should also grant rehearing to review the panel’s far-reaching determination that the Rule is consistent with the Exchange Act. Most notably, the panel held that even though the SEC found no link between a board’s race/sex breakdown and its corporate performance, the Rule was nonetheless justified because a few financial activists asked for it. Under that circular test, anything is ‘material’ and can be forcibly disclosed if someone wants it. The SEC could authorize compelled disclosures under the Exchange Act about how many firearms a company’s employees own, their political affiliations, what churches they attend, how many abortions they’ve had, etc. No court has ever adopted such an expansive definition of materiality, which will empower the SEC to act as a junior-varsity Congress unconstrained even by the Constitution.”
For more detailed discussion of the petition, see this PubCo post.
[Below based on my notes, so standard caveats apply.]
Oral Argument. Petitioners’ argument fairly tracked the paragraph of the petition quoted above: As a result of its order, the SEC gave its imprimatur to the Nasdaq rule, ultimately constituting state action; the rule imposed a quota, but even if the rule involved only disclosure, it was discriminatory on its face based on race and sex because it was designed to pressure companies to support DEI; and the rule compelled controversial speech about categories of race and sex in violation of the First Amendment.
But the discussion from the Court was largely focused on two issues: was the information required by the rule within the parameters of the Exchange Act provisions describing the purposes for which the SEC and Nasdaq may impose rules? And, in that light, were there any limits on what information the SEC could require companies to disclose?
Petitioners maintained that the purpose of the rule was not within the purposes cognizable under the Act—specifically Section 6(b)(5), 6(b)(8) and 19(b)—which generally include preventing fraudulent and manipulative acts and practices, promoting just and equitable principles of trade, removing impediments to and perfecting the mechanism of a free and open market and a national market system, and, in general, protecting investors and the public interest, along with approving proposed rule changes. Nor, petitioners maintained, does the rule promote efficiency, competition, capital formation or investor protection. The SEC may not approve rules that are out of bounds. Is it clear that board diversity is beneficial, they asked? Even the SEC, petitioners observed, in approving the Nasdaq rules, found that “the studies of the effects of board diversity are generally inconclusive.”
One judge asked if the purpose needs to profit-driven: aren’t there other values to protect? Petitioners contended that, unless the rules related to improving corporate performance and shareholder value, there was no basis for their approval. Investor requests for information, especially socially controversial information, outside the purposes of the Exchange Act do not justify the rules, they argued. But, the judge inquired, should the SEC have to interrogate investors like Goldman Sachs about their motivations? Shouldn’t the Court let the markets decide for themselves what information they need? Should the SEC be required to tell investors that they cannot have certain information because it’s controversial, the judge asked. Another judge, however, drew a distinction between a rule that requires companies to provide information and other processes, such as proxy advisor questions and shareholder proposals, to which companies can respond voluntarily. Later, petitioners said that the Court should look through the claims of investor interest to the real intent of the rules—to create a pressure campaign to allocate board seats based on race and sex. When asked how far the SEC needs to inquire into the motives of investors, counsel for petitioners argued that there was no need to look under the hood of the car—this rule was itself a hood ornament. The rule, they said, opens the door to disclosure of religion and political affiliation. Those demanding the information, they contended, are not really representative of the whole investor class, but rather of asset managers and proxy advisors and others with special interests who are not acting to maximize shareholder value, but rather to advance collateral social interests. In the hands of proxy advisors, they said, the information could even be harmful. They contrasted the 2009 SEC disclosure rule, which required information about how the nominating committee considers diversity in its director nominations, but did not define diversity. On this rule, they contended, Nasdaq was “out over its skis.”
But that issue quickly devolved into some amazing hypotheticals from the various judges as to what the rules could require if investors said they wanted to know: Could the rules require disclosure regarding the college degrees of board members? Could information be required about directors’ views on abortion, or attendance at religious services or religious affiliation as indicia of diversity? What about disclosure of directors’ views on Gaza? Whether they are on TikTok? Are they Swifties? In the interests of board integrity, could disclosure be required about spousal infidelity? If investors were interested, could the rules require disclosure of whether board members were “on Team Drake or Team Kendrick Lamar”? (Seriously.)
The SEC and Nasdaq contended that the Nasdaq rule does not involve state action: Nasdaq was a private exchange, and listing on Nasdaq involves a private agreement with each company. The ’34 Act did not federalize the exchanges and gave the SEC only limited oversight authority. To find state action here would upend a system that has been in place for years. In addition, they argued, companies can choose to list anywhere, and there is vigorous competition for listings. Each exchange adopts its own rules that govern the exchange’s relationships with its listed companies, they contended, and Nasdaq’s decision to differentiate itself with this rule was not a basis for the SEC to find the rule was inconsistent with the Act. The Long-Term Stock Exchange, they noted, has a different diversity rule that was also found to be consistent with the Act, a fact that led one judge to question how the Court could find the rule to be arbitrary and capricious here if the LTSE has a similar rule. The Court, they said, should reject the idea of turning private action by the exchange, which the Constitution protects, into public state action, which the Constitution constrains. This rule, they maintained, was consistent with the Act by promoting just and equitable trading by creating transparency and parity of information among large and small investors and protecting investors by providing information they want, and that is hard to collect, in a comparable format.
Several members of the en banc panel continued to pursue the issue of limitations. What is the line? If this rule is consistent with the Act, why doesn’t the NYSE adopt it? Why doesn’t the SEC? The SEC contended that, in this case, the record showed that investors wanted to use the information in decision-making, believing that diversity is a marker of good corporate governance and that it positively affects corporate performance. The SEC also pushed back on the argument that the SEC’s remit was limited to specific financial metrics.
Nasdaq took on the issue of limitations by explaining that it involves a three-legged stool: first, there should be investor demand for the information; second, a link to corporate governance, corporate performance or investor protection, which does not have to be conclusive; and third, an evidentiary record supporting the above. The hypotheticals that the Court raised would not, Nasdaq submitted, pass all of these tests—information about TikTok or abortion would not satisfy the second leg. One of the judges interjected that diversity of viewpoint—religion, politics—may well have a link. But, Nasdaq replied, the third leg requires an evidentiary record providing some evidence of that link; there is some evidence showing that women on boards have a positive impact on corporate governance, but there is no record regarding the Court’s hypotheticals. On rebuttal, petitioners said that the Nasdaq rule would fail that test because the SEC itself disclaimed a proven connection between diversity and shareholder value under the evidence.
Will the Nasdaq diversity rule survive en banc review? Let’s just say that, based on oral argument, it has a tough row to hoe.
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