Fifth Circuit Upholds Nasdaq Board Diversity Rule

The rule requires companies listed on Nasdaq (subject to certain exceptions and phase-in periods) to (1) publicly disclose board-level diversity data in a matrix format on an annual basis¹ and (2) have, or explain why they do not have, a certain number of diverse directors on their boards.² Nasdaq defines “diverse” to mean “an individual who self-identifies in one or more of the following categories: Female, Underrepresented Minority, or LGBTQ+.”³ The rule was proposed by Nasdaq in August 2020 and approved by the SEC in August of 2021. As Nasdaq states in its compliance resources, the rule is not a mandate for a certain level of board diversity, but rather it is a disclosure regime — companies can satisfy the board diversity objective by explaining why they have not met the objective and Nasdaq will not assess the merits of such explanations.

In August of 2021, the Alliance for Fair Board Recruitment (“AFBR”) filed a petition in the Fifth Circuit for review of the SEC’s final order approving the Nasdaq diversity rule. The AFBR is a non-profit formed by Edward Blum, who also founded the Students for Fair Admissions group that recently secured a victory at the Supreme Court to strike down allegedly race-conscious admissions systems of two universities (Students for Fair Admissions, Inc. v. President and Fellows of Harvard College, the “SFFA decision”). The AFBR was soon joined in the lawsuit by the National Center for Public Policy Research (“NCPPR”), a think tank that has also been involved in other high-profile anti-ESG efforts aimed at corporations, including a challenge to a public company’s diversity, equity, and inclusion (DEI) policies.

The AFBR and NCPPR argued that the diversity rule violates the First and Fourteenth Amendments to the U.S. Constitution because, among other things, it compels corporations to disclose  “controversial” information and “encourages discrimination” based on protected characteristics. In addition, the AFBR and NCPPR argued that, in approving the rule, the SEC violated the Securities Exchange Act of 1934 (“Exchange Act”) and the Administrative Procedure Act (“APA”).⁴

In an opinion issued on October 18, 2023, a three-judge panel of the Fifth Circuit unanimously rejected these arguments. The panel held that (1) Nasdaq is a private actor not subject to constitutional constraints, (2) the SEC did not exceed its authority under the Exchange Act because, among other things, the diversity rule is a “disclosure rule” and not a “mandatory quota,” and (3) the SEC’s order approving the rule was not “arbitrary and capricious” under the APA. In so doing, the panel noted that the SEC did not overreach in considering what petitioners called “the subjective belief and desire of a subset of investors” in approving the rule, finding that the SEC had “substantial evidence” to support its determination. Furthermore, the panel concluded that “[t]he SEC did not need to find . . . an empirical or scientific basis about the effects of board diversity [on corporate performance] . . . to conclude that a ‘reasonable investor’ could find board diversity information ‘important.’”⁵ Instead, according to the panel, the SEC could reasonably conclude that “board diversity information contribute[s] to investors’ investment and voting decisions based on substantial evidence of industry demand for this information,” despite certain “findings” of the SEC, including “that ‘studies of the effects of board diversity are generally inconclusive.’”⁶

The SEC had determined that while the rule may “encourage[e] some Nasdaq-listed companies to increase diversity on their boards,” it “does not impose a diversity quota” given that the rule “does not require companies to have any number of diverse board members” but only to give “a de minimis explanation for having less than two diverse board members.”⁷ The Fifth Circuit found these determinations to be reasonable. And, according to the panel, “the requirement that a company give an explanation is not a sanction that mandates compliance with the two-diverse-board-members benchmark. The only sanction is for giving no explanation at all.”⁸

One week after the panel’s ruling, the AFBR filed a petition asking for a rehearing by all of the judges on the Fifth Circuit, or an en banc review. If the AFBR’s petition is granted, it is possible that an en banc review could lead to a different outcome. If the petition for a rehearing is denied (or the full panel of judges upholds the original decision), the AFBR may appeal to the Supreme Court.

This decision comes at a time when DEI issues have been top-of-mind for corporations. As discussed in this V&E Insight and our last quarterly Securities and ESG Update, corporations are currently contending with heightened threats of litigation regarding DEI initiatives. At the same time, institutional investors have advanced policies and made statements supporting DEI goals and initiatives, including regarding board diversity, and such investors have not publicly rescinded or walked back these policies.

We will continue to monitor this case. Please contact V&E to discuss these developments and their implications.

¹ Companies must make such disclosure in their proxy statements or information statements (or, if they do not file proxy statements, their Form 10-Ks or 20-Fs) or on their websites. Note that compliance is already required for this requirement.

² Most Nasdaq-listed companies must have or explain why they do not have, in their proxy statements or information statements (or, if they do not file proxy statements, their Form 10-Ks or 20-Fs) or on their websites, at least two board members who are diverse, including at least one director who identifies as Female and one director who identifies as an Underrepresented Minority or LGBTQ+. Companies listed on Nasdaq before August 6, 2021 must have one diverse director or provide an explanation by December 31, 2023, and must have two diverse directors or provide an explanation by December 31, 2025 (for Nasdaq Global Select or Global Market companies) or December 31, 2026 (for Nasdaq Capital Market companies). Companies listed on Nasdaq on or after August 6, 2021 have between one and two years to include one or two diverse directors on their boards or provide an explanation, depending on the type of company. Note that the rule provides additional flexibility for (1) Smaller Reporting Companies and Foreign Issuers, which can meet the diversity objective by including two Female directors, and (2) for all companies with five or fewer directors, which can meet the diversity objective by including one diverse director.

³ According to the rule, “Female” is defined as an individual who self-identifies her gender as a woman, without regard to the individual’s designated sex at birth, “Underrepresented Minority” is defined as an individual who self-identifies as one or more of the following: “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,” and “LGBTQ+” is defined as an individual who self-identifies as any of the following: lesbian, gay, bisexual, transgender, or as a member of the queer community.

⁴ Self-regulatory organizations such as Nasdaq may propose new rules or changes to their existing rules by filing a proposal with the SEC pursuant to Section 19(b)(1) of the Exchange Act. The SEC will only approve the proposed rules “if it finds that such proposed rule change is consistent with” the provisions of the Exchange Act. See Section 19(b) of the Exchange Act.

⁵ Alliance for Fair Bd. Recruitment v. SEC, No. 21-60626, 2023 WL 6862856, at *14 (5th Cir. Oct. 18, 2023).

⁶ Id.

⁷ Id., at *16.

⁸ Id., at *15.