In August 2021, the SEC approved new board diversity rules requiring Nasdaq-listed companies (i) to include a board diversity matrix in their proxy statement or on their website and (ii) to disclose whether they have one diverse director on their boards by December 31, 2023 and two diverse directors on their boards by December 31, 2025, or explain why they do not, subject to limited exceptions and extended deadlines. Following the SEC’s approval, the Alliance for Fair Board Recruitment (AFBR) and the National Center for Public Policy research (NCPRR) filed a petition for review of the SEC’s approval, arguing that the board diversity rules violated the First and Fourteenth Amendments of the U.S. Constitution and the SEC’s statutory authority under the Exchange Act of the 1934 (Exchange Act). Initially, a three-judge panel ruled in favor of the SEC and Nasdaq. Following this decision, petitioners filed a petition requesting a rehearing en banc by the full Fifth Circuit, which was granted earlier this year.
On December 11, 2024, the U.S. Court of Appeals for the Fifth Circuit struck down the Nasdaq board diversity rules, holding that the SEC lacked the statutory authority under the Exchange Act to approve the Nasdaq board diversity rules. The en banc court decided the case with a 9-8 vote.
The Exchange Act requires the SEC to approve any proposed rule changes by SEC-registered stock exchanges, such as Nasdaq. The SEC may only approve proposed rule changes if “‘it finds [the proposal] is consistent with the requirements of’ the Exchange Act.” According to the court, a proposed exchange rule is not consistent with the requirements of the Exchange Act if it regulates matters not related to the purposes of the Act. The court concluded that the Nasdaq board diversity rules were “far removed” from the purpose of the Exchange Act “to protect investors and the macroeconomy from speculative, manipulative, and fraudulent practices, and to promote competition in the market for securities transactions.”
The court rejected the SEC’s argument that any disclosure-based exchange rule is related to the purposes of the Exchange Act because it would compel disclosure of information about exchange-listed companies. In his opinion for the majority, Judge Andrew Oldham wrote “disclosure is not an end in itself but rather serves other purposes, such as the purpose of prompting ethical behavior or ‘the purpose of avoiding frauds.’” He continues, “It is not unethical for a company to decline to disclose information about the racial, gender, and LGTBQ+ characteristics of its directors. We are not aware of any established rule or custom of the securities trade that saddles companies with an obligation to explain why their boards of directors do not have as much racial, gender, or sexual orientation diversity as Nasdaq would prefer.” Drawing a distinction from Nasdaq’s board independence requirement, the court criticized Nasdaq for failing to demonstrate any empirically established link between the racial, gender, and sexual composition of a company’s board and the quality of its governance, and any link between investor protection and racial, gender and sexual diversity.
Interestingly, the court suggested that the states may be better situated to impose board diversity regulations because corporations are a product of state law. In recent years, a number of states have attempted to enact board diversity regulations, including California and Washington. In April and May 2022, the Los Angeles Superior Court struck down California’s board diversity laws though. While the Secretary of State of the State of California is appealing these decisions, an injunction on implementation and enforcement of these laws is currently in effect pending disposition of the appeals. It remains to be seen whether state board diversity regulations can survive ongoing legal challenges.
The SEC is reviewing the decision and will likely wait to determine next steps until the new SEC chair joins next year. Nasdaq has stated that it will not appeal the Fifth Circuit’s decision.
As a result of the court’s decision, Nasdaq-listed companies are no longer required (i) to include a board diversity matrix in their proxy statement or on their website and (ii) to disclose whether they have specified diverse directors on their board or explain why they do not. However, many large institutional investors may continue to expect companies to disclose information about the self-identified gender, race, ethnicity or LGBTQ+ status of their directors. Companies should consider their engagement conversations on this topic with their significant investors as well as the diversity and voting policies of institutional investors and proxy advisory firms before removing any existing board diversity disclosure.