En Banc Fifth Circuit Court of Appeals Rejects Nasdaq’s Board-Diversity Rules

The U.S. Court of Appeals for the Fifth Circuit, sitting en banc, vacated the Securities and Exchange Commission’s approval of proposed rules promulgated by the Nasdaq Stock Market concerning the diversity of directors on Nasdaq-listed companies’ boards.  Those rules require listed companies to disclose director-diversity information and either to have a certain number of diverse directors or to explain why not.  The sharply divided 9-to-8 decision in Alliance for Fair Board Recruitment v. SEC (5th Cir. Dec. 11, 2024) held that the rules “cannot be squared with the Securities Exchange Act of 1934” and that the SEC therefore had acted arbitrarily and capriciously and had abused its discretion in approving them.

The majority’s decision would appear to prevent securities exchanges from adopting, and the SEC from approving, board-diversity rules such as Nasdaq’s.  Whether the court's ruling will dampen corporations’ own efforts to diversify their boards remains to be seen.

Background

In August 2021, the SEC approved Nasdaq’s proposal to adopt a listing standard designed to promote greater diversity on boards of Nasdaq-listed companies and to require uniform presentation of diversity-related information for those companies.

• Proposed Rule 5606 (the Disclosure Rule) required companies “to provide statistical information in a proposed uniform format on the company’s board of directors related to a director’s self-identified gender, [self-identified] race, and self-identification as LGBTQ+.”
• Proposed Rule 5605(f) (the Diversity Rule) imposed a comply-or-explain requirement:  it required listed companies to have at least one self-identifying female director and at least one self-identifying director within other specified racial or ethnic categories – or “to explain why the company does not have at least two directors on its board who self-identify in the categories listed above.”

Nasdaq emphasized that the Diversity Rule set forth “aspirational diversity objectives – not quotas, mandates, or set asides.  Companies that do not meet the diversity objectives need only explain why they do not.”  Nasdaq listed various permissible explanations for any lack of diversity, such as “[t]he Company does not meet the diversity objectives . . . because it does not believe Nasdaq’s listing rule is appropriate,” “because it does not believe achieving Nasdaq’s diversity objectives [is] feasible given the company’s current circumstances,” “because the Nominating Committee considers a variety of [factors]” for director positions, or “because the Nominating Committee is committed to ensuring that the Board’s composition appropriately reflects the current and anticipated needs of the Board and the company.” 

The Alliance for Fair Board Recruitment (a nonprofit organization that has challenged other board-diversity requirements) and the National Center for Public Policy Research petitioned for review of the SEC’s approval of Nasdaq’s proposed rules, arguing that the rules are unconstitutional under the First and Fourteenth Amendments and that the SEC’s approval violated the agency’s statutory obligations under the Securities Exchange Act and the Administrative Procedure Act.

A unanimous panel of the Fifth Circuit, composed entirely of Democratic appointees (who are a relatively small minority on the current Fifth Circuit), denied the petition for review and upheld the SEC’s approval of Nasdaq’s rules.

• The panel rejected the petitioners’ constitutional claims because “the Constitution only applies to state action.”  Nasdaq is a private self-regulatory organization, and its adoption of the rules did not constitute state action.
• The panel held that the SEC had not violated its duties under the Exchange Act.  The SEC had “substantial evidence” that a significant number of investors wanted board-diversity information – and wanted it to be presented in a consistent, coherent manner. 
• The panel held that the SEC had not acted arbitrarily or capriciously, in violation of the Administrative Procedure Act, in approving the rules because substantial evidence supported the SEC’s findings that “[b]oard-level diversity statistics are currently not widely available on a consistent and comparable basis, even though [Nasdaq] and many commenters argue that this type of information is important to investors.”

In February 2024, the Fifth Circuit granted a petition for rehearing en banc and vacated the panel’s ruling.  And on December 11, 2024, the en banc court vacated the SEC’s approval of Nasdaq’s rules.  Without reaching the petitioners’ constitutional claims, the majority decided the case solely on statutory grounds and held that the SEC had “failed to justify its determination that Nasdaq’s Board Diversity Proposal is consistent with the requirements of the Exchange Act.”

The En Banc Court’s Decision

The majority (consisting entirely of Republican appointees) held that the SEC could not approve a rule proposed by an exchange unless the rule was related to the purposes of the Exchange Act.  Those purposes are “primarily about limiting speculation, manipulation, and fraud, and removing barriers to exchange competition.”  But “disclosure of any and all information is not among them.”  So, unless a disclosure rule is “related to the purposes of the Act [by having] some connection to the ails Congress designed the Act to eradicate,” the SEC could not conclude that “a proposed exchange rule is related to the purposes of the Act simply because it would compel disclosure of information about exchange-listed companies.”

The majority concluded that Nasdaq’s diversity rules did not relate to the Exchange Act’s purposes.

• The rules were not “‘designed to . . . promote just and equitable principles of trade,’” one of the specific statutory purposes.  “It is not unethical for a company to decline to disclose information about the racial, gender, and LGBTQ+ characteristics of its directors.”
• The rules also were not designed “‘to remove impediments to and perfect the mechanism of a free and open market and a national market system,’” another purpose specified in the Exchange Act.
• Nor could the SEC rely on the statutory purpose requiring that exchange rules be “‘designed . . . in general, to protect investors and the public interest.’”  According to the majority, this “catch-all” provision must be tied to the other, more-specific purposes detailed in the Exchange Act:  “in determining whether Nasdaq’s Proposal is designed to protect investors and the public interest, the question is whether it protects investors or the public from the kinds of harms that the Exchange Act explicitly lists as its targets – that is, speculation, manipulation, fraud, anticompetitive behavior, &c.”  The majority found that Nasdaq had offered “little support for its assertion that there is an empirically established – or even logical – link between the racial, gender, and sexual composition of a company’s board and the quality of its governance.”  And the SEC’s determination that “some important investors” wanted diversity information did not fit within “the more specific purposes Congress listed prior to the general catch-all purpose.”

In addition, the majority held that the SEC’s approval of the rules was inconsistent with the “major questions” doctrine, which requires that, “when an agency asserts the power to substantially restructure [a market], it must point to clear congressional authorization for the power it claims.”  “No part of the Exchange Act even hints at SEC’s purported power to remake corporate boards using diversity factors.”

The eight dissenters (six Democratic appointees and two appointed by former President George W. Bush) opined that the SEC had simply approved a disclosure rule proposed by Nasdaq and that the SEC should not second-guess Nasdaq’s judgment on the need for such disclosure.  A “wide range of investors and listed companies” had “told Nasdaq that information about board composition wasn’t standardized or efficient to procure, but that investors were seeking it, nonetheless.”  In approving the proposed rule, the SEC “relied on its finding that substantial evidence supported the conclusion that investors sought this information in the face of inaccuracies, inefficiencies, and asymmetries.”  “The SEC approved the Rule because the reviewing scheme that Congress created doesn’t permit the SEC to displace Nasdaq’s private business judgment – informed by investor behavior – with agency policy priorities.”

Implications

The Fifth Circuit’s decision invalidates the SEC’s approval of Nasdaq’s board-diversity rules.  The ruling was based on the terms of the Exchange Act, so Congress theoretically could amend the statute to expand its stated purposes.  In the current political climate, however, such action does not appear likely.  Exchanges therefore will probably not be able to impose similar disclosure requirements at least in the near future.

The ruling does not prevent companies themselves from disclosing diversity-related data or from taking steps to diversify their boards.  But such efforts generally might need to avoid quotas or set-asides – issues that have arisen in other lawsuits, including challenges to California’s board-diversity laws.

Efforts to increase board diversity and to respond to what the Fifth Circuit called “the social justice movement” are “politically divisive issues in the Nation” these days, and the Fifth Circuit’s ruling could provide ammunition to opponents of voluntary, non-quota-based diversity measures.  The majority opinion observed that, in the context of corporate governance and investor protection, “Nasdaq offered little support for its assertion that there is an empirically established – or even logical – link between the racial, gender, and sexual composition of a company’s board and the quality of its governance.”  The majority noted that Nasdaq had “proffered some studies that suggest ‘a positive association between gender diversity and important investor protections,’ . . . but the SEC canvassed all the evidence Nasdaq submitted and concluded it was ‘mixed.’”  “And even supposing that Nasdaq’s gender-diversity evidence was sufficient, Nasdaq offered only the barest speculation to support the proposition that there is any link between investor protection and racial and sexual diversity.”  These comments could lead to more studies about the effects of board diversity on board and corporate performance.  A number of such studies already exist, but their findings are not necessarily definitive.

Corporations and their directors ultimately will need to exercise their business judgment (within existing legal constraints relating to quotas) about whether board diversification promotes shareholders’ interests – a consideration that generally can also take into account other stakeholders’ interests to the extent they enhance corporate value.  Moreover, board diversity need not be limited to categories such as race, gender, and sexual orientation; it also can include diversity of experience, skills, economic background, and other potentially less controversial classifications.  Reducing the risk of “group think” at the board level would seem to be a worthy goal in most cases, and more-diverse boards might help promote that goal.