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 has just been granted by the Fifth Circuit—on Presidents’ Day—and the opinion of the lower court was vacated.
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. 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.”
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.” In November, an amicus brief in support of the petition for rehearing was submitted by the attorneys general of 19 states.
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.
According to CNBC, the president of the Alliance for Fair Board Recruitment said that his group “is grateful that the entire Fifth Circuit Court of Appeals will reconsider the lower court’s opinion….NASDAQ’s rule promotes racial discrimination and polarizing personal disclosures and it is to be hoped that this rule is struck down.” Senior litigation counsel for Petitioner NCPPR said in a press release that they “are rejoicing over the Court’s vote to rehear the panel decision, as the Constitution, state and federal laws, and Supreme Court precedents all forbid such invidious discrimination. The Rules shock the conscience in even being proposed, much less in being approved as law. NCLA looks forward to ending this arrogation of unlawful power over internal corporate governance.” A spokesperson for the SEC told Bloomberg that “the agency will keep defending its endorsement of Nasdaq’s rules in court, adding that ‘we believe the panel decision was correct.’”
Oral argument in the case has been tentatively calendared for the week of May 13, 2024, with briefing due in March and April.
