On Friday, August 6, 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.) As anticipated, a court challenge to these rules didn’t take long to materialize. On Monday, August 9, the Alliance for Fair Board Recruitment filed a slim petition under Section 25(a) of the Exchange Act in 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.) That petition was soon followed by a new petition challenging the rules filed by the National Center for Public Policy Research and subsequently transferred to the Fifth Circuit where the earlier filed petition was pending. (See this PubCo post.) Yesterday, a three-judge panel of the Fifth Circuit—by repute, the Circuit of choice for advocates of conservative causes—denied those petitions, in effect upholding Nasdaq’s board diversity listing rules. According to the unanimous decision,  “AFBR and NCPPR have given us no reason to conclude that the SEC’s Approval Order violates the Exchange Act or the APA.” The case is Alliance for Fair Board Recruitment, National Center for Public Policy Research v. SEC.  

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+.  A person is “diverse” under the rule who “self-identifies in one or more of the following categories: (i) Female, (ii) Underrepresented Minority or (iii) LGBTQ+.”  These terms are all defined—and sub-defined—in the rules. For example, an “underrepresented minority” is defined as someone who is “Black or African American, Hispanic or Latinx, Asian, Native American or Alaska Native, Native Hawaiian or Pacific Islander, or Two or More Races or Ethnicities”; all of those terms are also defined. Separately, Nasdaq also provides 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. 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.”


In their briefs, petitioners argued, among other things, that the Nasdaq listing rules imposed a quota that violates the constitutional right to equal protection by encouraging discrimination against potential board members and compels disclosure of controversial information in violation of the First Amendment. The rule “issued by Nasdaq and approved by SEC constitute[s] state action that is subject to constitutional restraints.” In addition, they contended that the “SEC lacked statutory authority to issue the order, which seeks to regulate demographics through the guise of ‘financial disclosures.’” Further, they maintained that the SEC’s order violates the “Vesting Clause in Article I of the Constitution because it is an exercise of sweeping legislative power to regulate demographics that Congress could not have delegated” and also violates the Administrative Procedure Act.

In their briefs, the SEC and intervenor Nasdaq argued that Exchanges are “for-profit enterprises subject to Commission oversight both in their quasi-governmental role as regulators of their members and in their private, voluntary association with listed companies.” They have long had listing standards addressing disclosures and corporate governance, and the SEC’s role in reviewing proposed rules is “limited to determining whether the rule is consistent with requirements specified in the Act. If the rule clears the statutory floor, the Commission must approve it regardless of the Commission’s own policy views.”  Nasdaq’s rules were proposed “in response to significant and growing market demand for enhanced disclosures regarding diversity on public company boards,” and the SEC “reasonably concluded that Nasdaq’s rules meet that standard because they will facilitate more consistent and comparable disclosure of information important to investors’ investment and voting decisions.” The rules don’t mandate particular board composition, but rather require that companies that do not meet the diversity goals “provide their shareholders an explanation—in their own words, in as much or as little detail as they choose.”  Delegation of authority to address board diversity, they maintained, is not really an issue here because Nasdaq is not a state actor nor are exchange listing standards subject to constitutional scrutiny; Nasdaq is a private company that establishes listing rules, and companies “enter into private, voluntary contractual relationships with Nasdaq to list their securities.”  In addition, under relevant precedent, the SEC’s “mere approval of an exchange rule and regulation of exchanges does not convert their private conduct into state action.”  Rather, they contended, the question is whether the SEC “reasonably concluded, based on substantial evidence, that Nasdaq’s rules are consistent with the Act.”  In addition, they argued that the petitioners’ “policy disagreement about the merits of boardroom diversity isn’t sufficient to show that the Securities and Exchange Commission’s findings lacked substantial evidence or that its conclusion that Nasdaq’s rules are consistent with the Securities Exchange Act was arbitrary and capricious.”

Court’s opinion

That approach to framing the proposals seems to have been persuasive—right out of the gate the Court describes 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.”

Constitutional Claims

In its lengthy, detailed opinion, the Court first turned to the petitioners’ Constitutional claims, which the Court reviewed de novo. First, given that the constitution applies only to state action, the petitioners had to show that Nasdaq, a private entity, is really a state actor. They argued first, that Nasdaq is itself a government entity bound by the Constitution, based on “Nasdaq’s characteristics and its relationship to the SEC”; and “second, that Nasdaq’s Rules in this case are attributable to the government such that constitutional restraints apply.” The Court held that neither theory prevailed.

While the Court acknowledged that “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,” a conclusion that has been followed by other courts. The Court distinguished this case from two Amtrak cases, reasoning that, while “Nasdaq and other SROs must register with the SEC, they were not created by the government….Nor does Nasdaq operate under the direction or control of the SEC in the manner described in [the Amtrak cases.] Its board members are not appointed or confirmed by government officials, nor are they removable by the government.” The Court concluded that Nasdaq was not a state actor.

Nor did “the SEC’s involvement with and approval of Nasdaq’s Rules render the Rules subject to constitutional scrutiny.” According to the Court, this standard requires that there be “a sufficiently close nexus between the State and the challenged action of the regulated entity,… for example,  “(i) when the private entity performs a traditional, exclusive public function; (ii) when the government compels the private entity to take a particular action; or (iii) when the government acts jointly with the private entity.” According to the Court, none of those conditions was met in this case. As one example, the petitioners tried to argue that the SEC “compelled Nasdaq to draft these Rules by pointing to the comments of two individual commissioners, Allison Herren Lee and Caroline Crenshaw, who had previously spoken in favor of diversity disclosure policies in the context of an SEC rule.” The Court bought none of it. “Far from it,” the Court said, “Nasdaq came up with and proposed the Rules on its own.” Nor was the government “pervasively entwined” with Nasdaq.  Rather “Nasdaq generated the Rules itself, and then submitted them to the SEC for approval, as required by statute. The SEC engaged in its statutory review and issued the Approval Order.” The Court observed that SCOTUS recently cautioned against “[e]xpanding the state-action doctrine beyond its traditional boundaries,” and the Court determined to “heed this warning in holding that the Rules drafted and proposed by Nasdaq, a private self-regulatory organization, are not attributable to the government and are therefore not subject to constitutional scrutiny.”

SEC Authority

Petitioners also argued that the SEC’s Order approving the rule “exceeds the agency’s authority under the Exchange Act and is arbitrary and capricious.” Petitioners made four arguments: (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. 

Subjective evidence. First, the Court determined that the “Exchange Act does not limit the SEC to considering ‘objective evidence’ in deciding whether to approve a proposed rule. Instead, ‘the findings of the [SEC] as to the facts, if supported by substantial evidence, are conclusive.’” While the SEC must  “independently analyze investor comments submitted during the administrative process,” nevertheless, the “subjective opinions of those investors may be relevant evidence and sufficient to meet the substantial evidence standard, as they are here.”

Materiality. The Court was likewise not convinced by the materiality argument—an argument that arises frequently in other contexts. A disclosure rule, the Court reasoned, “can be ‘related to the purposes of [the Exchange Act],’… even if the SEC does not find that the disclosure rule is limited to information that would be ‘material’ in the securities fraud context. The ‘fundamental purpose’ of the Exchange Act is ‘implementing a philosophy of full disclosure,’…not just the disclosure of information sufficient to state a securities fraud claim. Indeed, the Exchange Act gives the SEC ‘very broad discretion to promulgate rules governing corporate disclosure.’”  In fact, the Court concluded, a “materiality standard” for exchange disclosure rules would be “unworkable.”  And, “even if the petitioners’ theory were right, substantial evidence supports the SEC’s finding that Nasdaq’s rule would provide ‘information that would contribute to investors’ investment and voting decisions,’” citing industry demand in various letters from institutional investors.  What’s more, the SEC could find that disclosure of board diversity information would be viewed as material by a reasonable investor “even without conclusive empirical evidence that board diversity helps or hurts corporate performance.”

State sovereignty.  The next argument was that the SEC’s Approval Order “regulates corporate governance, an issue reserved for the states.” However, the Court maintained, the SEC “conclusively determined, based on substantial evidence,” that the Nasdaq rule proposal was “a disclosure rule, not a mandatory quota; that Nasdaq’s disclosure-based framework does not alter the state-federal balance; and that the Exchange Act unambiguously authorizes the SEC to approve disclosure rules.” Both Nasdaq and the SEC made clear that, if a company does not meet diversity objectives, the company may simply explain why not, and Nasdaq “would not assess the substance of the company’s explanation.” Nasdaq offered much flexibility for listed companies in crafting the explanation. While there are some mandatory components of the Rule, and the Rule might have the effect of encouraging diversity, that is not the same as a diversity mandate. In the end, the Court found that the SEC made a “reasonable finding,” and the Court decided to adhere to it.

Nor did the Court agree that the SEC construed the Exchange Act to permit federal encroachment upon a traditional state power: “Nasdaq’s disclosure-based framework does not alter the state-federal balance. It is well-established that disclosure rules do not interfere with the role of ‘state corporate law.’”  Moreover, the SEC is required by the Exchange Act to approve Nasdaq’s disclosure-based framework “if it is ‘consistent with the requirements of [the Exchange Act].’”

Major questions doctrine. The Court also rejected the application of the “major questions” doctrine in this case.  Citing West Virginia v. EPA (see this PubCo post), the Court explained that “the ‘major questions doctrine’ 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.’” This was not one of those cases.  Rather, in this instance, “the SEC’s asserted authority is an ordinary exercise of its power to approve exchange listing rules”—“business as usual for the SEC.”  Nor was the “SEC’s approval of a rule requiring disclosures of board diversity information…economically and politically significant enough to trigger the major questions doctrine.” Moreover, the delegation of authority to approve the Nasdaq rule is not ambiguous; the “authorization is plain on the face of the Exchange Act.” The Court held “that the SEC’s Approval Order fell within its statutory authority under the Exchange Act.”

Arbitrary and capricious

Finally, the Court concluded that the SEC’s Approval Order was not arbitrary and capricious under the APA. That standard requires that the SEC “examine the relevant data and articulate a satisfactory explanation for its action including a rational connection between the facts found and the choice made.” Petitioners contended that “the SEC: (1) improperly decided that the Disclosure Rule is designed to accomplish at least one objective listed in [the rules applicable to national exchanges]; (2) improperly decided that the Disclosure Rule is not designed to permit unfair discrimination among issuers; (3) improperly assessed the costs of the Disclosure Rule; (4) failed to conduct an independent review of the record; and (5) failed to adequately analyze the content of the Recruiting Rule.” The Court found no merit in any  of those contentions.

The Court concluded that the SEC’s finding that the Rule would “contribute to the maintenance of fair and orderly markets” was “supported by substantial evidence,” including numerous comments from market participants. The Court found that the record was “full of evidence that the status quo deprives market participants of fair access to information about board composition, impeding efficiency.”

In addition, the Court rejected Petitioners’ argument that “because the Disclosure Rule imposes different disclosure requirements on domestic and foreign issuers, the SEC erred in concluding that the rule is not designed to permit unfair discrimination among issuers.” Although the Rule provides different definitions of diversity for foreign issuers than for other Nasdaq-listed companies, Nasdaq crafted its definition of underrepresented individuals applicable to foreign issuers by borrowing from a United Nations Declaration; the SEC concluded that the differences were reasonable and not “unfairly discriminatory” because the meaning of diversity varies globally, and it “is fair and desirable to let foreign issuers report diversity information according to nationally appropriate standards.” The Court also concluded that the SEC “rationally found that the disclosure-based framework would provide investors with information that would influence investment and voting decisions and would mitigate market inefficiencies, regardless of variations in the standards for those disclosures.”

Petitioners also contended that the SEC failed to show “that the asserted benefits of the diversity rule outweigh the costs.” In that analysis, the SEC  “must analyze burdens on competition, and then decide whether those burdens are ‘necessary or appropriate’ to further the purposes of the Exchange Act. The Court concluded that the SEC “adequately considered potential burdens on competition,” and also “reasonably weighed” those burdens “against the ‘difficult-to-quantify, intangible benefits’ of the Disclosure Rule in furthering the purposes of the Exchange Act.”  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.”

The Court also disagreed that the SEC had not independently reviewed the record, as required by statute, or that it had failed to consider a number of questions Petitioners posed related to the board recruiting service. Nor was it apparent to the Court why the SEC needed to know all of those answers.

In the end, the Court found “no reason to conclude that the SEC’s Approval Order violates the Exchange Act or the APA” and denied the petitions. It’s worth noting, however, that, according to a new article from the WSJ, the three-judge panel were all appointed by Democratic presidents, which might lead the Petitioners to seek a rehearing en banc by the entire Fifth Circuit, which is “dominated by Republican-appointed judges.” Of course, the Petitioners could also appeal to SCOTUS. 

Posted by Cydney Posner