Fifth Circuit Invalidates Nasdaq Diversity Rules – What Public Companies Should Know
On December 11, 2024, in a 9-8 en banc decision in Alliance for Fair Board Recruitment v. SEC, 2024 WL 5078034 (5th Cir. 2024), the United States Circuit Court of Appeals for the Fifth Circuit vacated an SEC order approving Nasdaq’s board diversity rules, finding that the rules were not related to the purposes of the Securities Exchange Act of 1934 (the Exchange Act). Consequently, Nasdaq-listed companies no longer need to comply with the rules.
The legal analysis in the opinion provides a basis for future challenges to other efforts by the SEC and Nasdaq to advance social objectives through disclosure rulemaking.
Nasdaq Listing Standards on Diverse Board Representation
Nasdaq Listing Rule 5605(f) required Nasdaq-listed companies to achieve certain diversity representation objectives for the composition of their respective boards of directors. Under these standards (with certain exceptions), a company was required to have or explain in its proxy or information statement or website why it does not have at least two diverse directors, including one director who self-identifies as female and one director who self-identifies as an “underrepresented minority” or LGBTQ+.
In addition, Nasdaq Rule 5606 required that each Nasdaq-listed company annually disclose in its proxy or information statement or website and, to the extent permitted by applicable law, information on each director’s voluntary self-identified diversity characteristics in a “Board Diversity Matrix.” Separately, Nasdaq Rule IM-5900-9 offered access to a complimentary board recruiting service to help certain listed companies meet Nasdaq’s Board diversity rules. These and other board-related diversity standards have encountered legal challenges since their adoption, including the recent Fifth Circuit decision discussed below.
Alliance for Fair Board Recruitment v. SEC
Following the SEC’s approval of the Nasdaq board diversity and recruiting service rules in August 2021, the Alliance for Fair Board Recruitment (AFBR) filed a petition for review in the Fifth Circuit challenging the SEC’s approval of the rules. Nasdaq intervened to defend the rules. The National Center for Public Policy Research (NCPPR) also filed a petition for review in the United States Court of Appeals for the Third Circuit challenging the same rules, which was later consolidated with AFBR’s petition. In October 2023, a three-judge panel in the Fifth Circuit upheld the rules, rejecting AFBR and NCPPR’s constitutional challenges to the rules. The panel reasoned that Nasdaq is not a state actor and the SEC’s approval of the rules complied with both the Exchange Act and the Administrative Procedure Act. See Alliance for Fair Board Recruitment v. SEC, 2023 WL 6862856 (5th Cir. Oct. 18, 2023). Yet, the Fifth Circuit granted a petition for rehearing en banc and vacated the panel’s February 2024 decision.
In the en banc opinion delivered by Circuit Judge Andrew S. Oldham, the Fifth Circuit held that Nasdaq’s diversity rules “cannot be squared” with the Exchange Act, reasoning that the SEC’s approval of the rules was “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with the law” due to the SEC’s failure to justify its determination that the rules were consistent with the requirements of the Exchange Act. The Court first focused on the relevant statutory text, noting that the SEC must disapprove an exchange’s proposed rule change if it does not find that the proposal is “consistent with the requirements of” the Exchange Act. Under Section 78f(b) of the Exchange Act, exchanges may not regulate matters not related to the purposes of the Exchange Act.
The Court examined the SEC’s approval of Nasdaq Rule 5605(f) (the Diversity Rule) and Nasdaq Rule 5606 (the Disclosure Rule and together with the Diversity Rule the Board Diversity Proposal). The Court reasoned that an exchange rule is not related to the purposes of the Exchange Act simply because it is a disclosure rule. A disclosure rule must have some connection with those purposes, including protecting investors and the macroeconomy from speculative, manipulative, or fraudulent practices and the promotion of market competition for securities transactions. The Court noted that the SEC did not explain how Nasdaq’s Board Diversity Proposal had “any connection” with Exchange Act purposes.
Specifically, the Court examined the history of the Exchange Act and its amendments, stating that “history makes clear that the [Exchange Act] is primarily about limiting speculation, manipulation, and fraud, and removing barriers to exchange competition.” While other ancillary purposes to the law exist, “disclosure of any and all information is not among them.” Congress vested the SEC with “limited power to compel disclosure of basic corporate and financial information…to protect investors and prevent speculation.” In addition, Congress aimed to promote the development of a national market system and competition in the securities market through regulation of exchanges – most relevant here via procedures for SEC review and amendment of exchange rule changes.
Here, the Court noted that the SEC only made a few passing citations to the statutorily expressed purposes of the Exchange Act when approving the Board Diversity Proposal and did not demonstrate a direct relationship. For example, as to promoting “just and equitable principles of trade,” a purpose which exchanges have frequently used to police unethical conduct, the Court indicated that it is not unethical for a company to decline to disclose information about the diversity characteristics of its directors as it can always do so voluntarily. Similarly, the Board Diversity Proposal did not promote a free and open market and national market system because it had nothing to do with the execution of securities transactions. Likewise, the Board Diversity Proposal was not designed to protect investors and the public interest because it did not aim to prevent the kinds of harms specifically targeted by the Exchange Act. The Court observed that the Board Diversity Proposal “would serve the goal of investor protection only if there were some link between the reason for the lack of…diversity on a company’s board and the quality of its governance.”
In addition, the Court determined that “no part of the Exchange Act even hints at SEC’s purported power to remake corporate boards using diversity factors,” reasoning that the major questions doctrine confirms the Fifth Circuit’s interpretation of the “plain meaning” of the Exchange Act. Under the major questions doctrine, as expressed in West Virginia v. EPA, 597 U.S. 697 (2022), when an administrative agency asserts power, it must point to “clear congressional authorization for the power it claims.” An agency’s powers to make major decisions must come only from unequivocal statutory text. Here, the court reasoned that this was a major questions case because the SEC’s approval of the Board Diversity Proposal was of “economic and political significance” that was “staggering by any measure” due to the $25 trillion market cap of Nasdaq-traded companies and the politically divisive nature of social justice initiatives. The SEC was not acting within its “regulatory domain” by approving the rule, as the SEC has not been statutorily tasked with regulating corporate commitments to diversity and inclusion.
Providing a further rejection of the SEC’s and Nasdaq’s reasoning, the Court labeled their counterarguments “unavailing.” First, the Court rejected the SEC’s and Nasdaq’s contentions that exchanges are self-regulatory private institutions existing before the Exchange Act because the Court cannot ignore what Congress subsequently did to regulate exchanges. Second, the imposition of other substantive corporate governance rules by exchanges, like independence requirements, does not mean that exchanges can adopt rules that are not related to the purposes of the Exchange Act. Third, the SEC’s selective past ignorance of certain provisions of the Exchange Act to adopt similar rules does not automatically grant the SEC present authority under the Exchange Act to do the same. Fourth, the Board Diversity Proposal is not a mere disclosure requirement; rather, Nasdaq self-described the standards as “aspirational diversity objectives.” Corporations would face “a public-shaming penalty” for failure to abide by the requirements. Fifth, disclosure is “not an end in itself,” and a disclosure rule is related to the purposes of the Exchange Act only if it is related to Exchange Act-related harms.
Lastly, the en banc opinion held that the challenge to the SEC’s approval of Nasdaq Rule IM-5900-9 relating to recruiting services was “moot” because Nasdaq’s authority to offer benefits under this rule expired on December 1, 2023 and Nasdaq represented that no company was receiving service under this rule as of September 30, 2024.
Of further relevance is a footnote in the en banc opinion noting that the parties also challenged the Nasdaq rules on constitutional grounds. The court declined to discuss these arguments, instead resolving them on the above statutory reasoning. Constitutional grounds could prove relevant in future challenges of similar standards.
The Future of Standards for Diverse Board Representation
While the SEC has not announced whether it plans to appeal the decision, Nasdaq notified listed companies that they will no longer be required to follow the board diversity rules. Resurrection of the rules, while possible, is unlikely due to the upcoming transitions of presidential, congressional, and SEC leadership.
Notwithstanding the Fifth Circuit’s en banc decision, demographic and experiential diversity among public company directors is likely to remain of significant importance to stockholders, particularly institutional investors with an environmental, social, and governance (ESG) focus. Proxy advisory firms like ISS and Glass Lewis continue to maintain their own proxy voting guidelines with respect to board diversity, as do large institutional investors like BlackRock, State Street and Vanguard. A recent report from The Conference Board, Inc. found that gender and racial diversity on U.S. corporate boards in the Russell 3000 and S&P 500 reached record levels in 2024. However, the proportion of new directors who are women or from non-White backgrounds has declined from a high in 2022, suggesting a slowdown at least in part due to heightened political and social scrutiny of corporate diversity initiatives. Though, opportunity remains present, as 58 percent of S&P 500 boards implement a policy like the National Football League’s “Rooney Rule” to include individuals from diverse groups in the candidate pool. Moreover, it is becoming increasingly common for directors to have C-suite, international, technology, cybersecurity, or human capital management experience among the Russell 3000 and S&P 500.
Nevertheless, anti-ESG shareholder sentiment continues to grow, albeit with limited success. The 2024 proxy season was characterized by a repeated rise in stockholder proposals challenging company ESG efforts, including corporate political influence, diversity, equity, and inclusion programs, LGBTQ+ initiatives, and greenhouse gas reduction efforts. In 2024, 107 anti-ESG proposals were submitted by stockholders at Russell 3000 companies. Seventy-eight of these proposals were voted on but only received an average support of 2.4 percent. No anti-ESG stockholder proposal received more than 10 percent support.
As President-elect Donald J. Trump takes office for the second time in January 2025, the new Trump Administration begins to take shape with a new Chairman of the SEC, and a Republican-controlled Congress sets its legislative agenda, public companies should remain vigilant of and prepare for shifting policy priorities, including possible rollbacks of ESG initiatives, the SEC’s climate, human capital management, and diversity disclosure rules, potential changes to rules relating to executive compensation and proxy advisory firms under a new Chair, and further legal challenges to company diversity, equity, and inclusion programs.
Buchanan’s team of dedicated professionals in the Securities Practice Group is ready to assist registrants in evaluating their corporate governance standards and disclosures relating to director nominee identification and recruitment to assess compliance with SEC requirements and remaining Nasdaq listing standards. Director recruitment efforts will remain tailored to each company’s unique circumstances, strategy, culture, and operational needs while balancing appropriate concerns to reflect a multitude of representational interests, experiences, and skill sets that will align with the company’s long-term objectives, in addition to compliance concerns.