As discussed in this PubCo post, on October 18, a three-judge panel of the Fifth Circuit denied the petitions filed by the Alliance for Fair Board Recruitment and the National Center for Public Policy Research challenging the SEC’s final order approving the Nasdaq listing rules regarding board diversity and disclosure. 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.) 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. Yesterday, the Petitioners filed a petition requesting a rehearing en banc by the Fifth Circuit, where Republican presidents have appointed 12 of the 16 active judges. Not that politics has anything to do with it, of course.
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.”
New petition
As noted above, the three-judge panel found “no reason to conclude that the SEC’s Approval Order violates the Exchange Act or the APA” and denied the petitions. (For a discussion of the panel’s decision, see this PubCo post.) The new petition 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.”
The petition contends that the listing rule violates 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 challenges 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 itself offers a pretty good summary of Petitioner’s contentions: the petition requests 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.”
The two questions identified in the petition for the Court’s en banc review are:
“(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.”
First, Petitioners take up the issue of state action, invoking Moose Lodge No. 107 v. Irvis, a 1972 Supreme Court case, for the proposition that a “government ‘regulation [that] requires compliance by [a private party] with provisions of its …bylaws containing racially discriminatory provisions’ is unconstitutional state action.” In opposition to the panel’s holding that no state action was involved, petitioners contend that the “Exchange Act requires enforcement once the Rule was approved,” and that “Moose Lodge never said that a challenge could be raised only after the government has brought an enforcement action against a private entity for failing to abide its own discriminatory rule.” In addition, Petitioners argue that “the SEC’s mere ‘authoriz[ing] or encourag[ing]’ of racial discrimination is itself a complete violation of equal protection and thus a fortiori is state action.” Rehearing is warranted, they argue, because the rule would “undoubtedly fail constitutional scrutiny.”
Petitioners also contend the panel’s opinion “created a conflict with the law” of the Fifth Circuit, which “has a ‘strict and rigidly applied’ prior-panel rule” mandating that precedent be followed. In addition, they argue, if there was no state action, then that must mean that the rule violated the private nondelegation doctrine. In light of the panel’s opinion, Petitioners envision of a “new world of government-backed discrimination and compelled disclosures, allowing the government and private parties to achieve what neither could lawfully do on their own.”
Second, Petitioners raise the issue of “materiality.” Although the SEC did not demonstrate a “causal relationship between corporate performance and the demographic breakdown of a company’s board,” Petitioners observe, the panel still concluded that the SEC could approve the Nasdaq board diversity rule “on the theory that a handful of financial activists wanted the information and wanted companies to choose their boards based on race and sex.” But that is not a valid basis in their view; rather, they argue, the “SEC can mandate disclosures only of ‘material’ information, that is, information ‘viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available’ for an investment decision.” And, they maintain, that standard means that compelled disclosures are limited to “financially material” information. Because board diversity information has “no demonstrable tie to any metric of corporate performance,” it can’t be material or within the SEC’s “disclosure authority.” According to Petitioners, a “handful of ideologically motivated corporate elites asking for something immaterial cannot magically convert it into something objectively material.” And that’s another reason why, they profess, the Court should rehear this matter en banc: if “a few well-placed financial activists were enough to invoke the SEC’s disclosure power, even when there is an acknowledged lack of connection to corporate performance, then anything and everything is fair game for mandatory disclosures.”
