Securities,
Administrative/Regulatory
Dec. 23, 2024
5th Circuit vacates SEC approval of NASDAQ board diversity rules
The 5th Circuit found that the diversity rules were not a disclosure requirement but a public-shaming penalty, and concluded that the rules were unrelated to the purposes of the Exchange Act.





Teresa L. Johnson
Partner, Arnold & Porter Kaye Scholer LLP
Email: teresa.johnson@arnoldporter.com
Teresa is co-head of the firm's Capital Markets Transactions practice. Her practice includes advising corporations on corporate governance, securities and finance matters.

Sara Adler
Counsel, Arnold & Porter Kaye Scholer LLP

The Dec. 11, 5th
Circuit en banc decision striking down NASDAQ's board diversity rules likely signals the end of the road for NASDAQ's embattled "diversify or disclose" requirements. A closely divided Court
of Appeals for the 5th Circuit in Alliance for Fair
Board Recruitment v. SEC
(5th Cir.; 12/24), in a 9 to 8 decision, held that the SEC's approval of
the rules exceeded its authority, reversing a 2023 decision by a 5th Circuit
panel. The court found that the
diversity rules were not a disclosure requirement, but "a public-shaming
penalty" for failing to abide by the government's diversity requirements. Neither NASDAQ nor
the SEC is likely to appeal the decision. This decision will not end board
diversity disclosure, because the market players that pushed for it, as well as
existing SEC disclosure requirements, will continue, but it does eliminate rules
that ensured consistency in such disclosure for NASDAQ-listed companies.
Under 15 U.S.C.
§78s(b), the SEC can only approve a self-regulatory organization (SRO) rule that
is "consistent with the requirements of" the Exchange Act. The court interpreted
this to mean the rule must be "related to" the Exchange Act's purposes, including
preventing fraud, promoting just and equitable trade principles, and generally
protecting investors and the public interest. The majority concluded that the
board diversity rules flunked this test.
The court broke down NASDAQ's
rule proposals into components and focused on the "disclosure rule" and the "diversity
rule." The disclosure rule" requires listed companies 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 to have, or explain why they do not have, at least two diverse directors,
including at least one female director and at least one underrepresented
minority or LGBTQ+ director.
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
make available "consistent and comparable" board diversity information, and
that an explanation of why a company had not met the rule's diversity
objectives would contribute to investors' investment and voting decisions.
Accordingly, the SEC found that the rules were "designed to promote just and
equitable principles of trade, remove impediments to ... a free and open market ...,
and protect investors and the public interest."
The
court, however, did not agree that the market's stated interest in board diversity
information, even in relation to investment and voting decisions, empowered the
SEC to approve SRO rules requiring disclosure of such information. It found
that all disclosure rules are not de facto "related to" the purposes of
the Exchange Act, noting that the Exchange Act's purpose is to protect against fraudulent practices and to promote
competition. The court concluded that
the limited purposes set forth in 15 U.S.C. §78f(b)(5)
were not related to the disclosure of the racial, gender, and sexual
characteristics of public company directors.
In rejecting the SEC's
contention that the diversity rules are "designed to . . . promote just and
equitable principles of trade," the court took the position that it was "not
unethical for a company to decline to disclose information about the racial,
gender, and LGTBQ+ characteristics of its directors." The court opined 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 rejecting the SEC's argument that the rules are designed "in
general, to protect investors and the public interest," the court found NASDAQ
offered insufficient support for "any link between investor protection and
racial and sexual diversity." The court also found support under the "major
questions doctrine," which provides that in cases involving "vast and
comprehensive" impact, an administrative agency's authority is limited to what Congress
has expressly provided. The court concluded that the diversity rules raised
major questions, and that express authorization was lacking, stating that "no
part of the Exchange Act even hints at SEC's purported power to remake
corporate boards using diversity factors."
The 8 dissenting
judges had a different view of the SEC's role in approving the NASDAQ board
diversity rules. The dissent stated that the SEC is not permitted to "displace
NASDAQ's private business judgement" when evaluating a proposed listing rule.
They noted that the SEC is obligated to approve exchange rules that are
consistent with the Exchange Act's purposes, which under well-established
caselaw, include a "philosophy of full disclosure." The dissenters observed
that the diversity rules eliminate information asymmetries with respect to
board diversity data between large investors, who have the market power to directly
obtain the desired information, and smaller investors, who must "rely on
incomplete public disclosures." The
dissent noted that the SEC should not question the market's judgment in seeking
disclosure of board diversity information.
Many commentators
have cited this decision as another "nail in the coffin" of corporate DEI
programs. It follows a current trend for courts to narrowly interpret agency
authority, and a policy trend limiting companies' focus on DEI initiatives. Interestingly,
the fact that the NASDAQ board diversity rules did not mandate diversity, only
disclosure, did not save them from being overturned.
However, this does
not sound the closing bell for board diversity disclosure. Current SEC proxy rules
require disclosure as to whether and 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 is assessed. Companies must also explain the specific experience,
qualifications, attributes, or skills of nominees.
Moreover, the
institutional investors who initially pressed for board diversity information
will likely continue to push for disclosure of this information. Going forward,
decision-making around board diversity and related disclosure will revert to
market participants with significant leverage, risking the informational
asymmetries about which the dissent warned.
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