Fifth Circuit strikes Nasdaq board diversity rules

On December 11, 2024, the United States Court of Appeals for the Fifth Circuit granted the consolidated petitions for review and vacated the order by the Securities and Exchange Commission (SEC) that approved Nasdaq’s rules designed to disclose and improve board diversity.

The court’s decision in Alliance for Fair Board Recruitment v. SEC concluded that Nasdaq’s board diversity rules were inconsistent with the purposes of the Securities Exchange Act of 1934, as amended (the Exchange Act). The SEC’s approval of those rules as consistent with the Exchange Act was, therefore, “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.”

Background

In December 2020, Nasdaq proposed three rules, each seeking to increase board diversity among the exchange’s listed companies. The rules included the Disclosure Rule (requiring disclosure of directors’ diversity characteristics), the Diversity Rule (requiring at least two diverse directors or an explanation for noncompliance), and the Recruiting Rule (offering a board recruiting service to help companies meet diversity objectives). The SEC approved the rules on August 6, 2021, finding them consistent with the requirements of the Exchange Act as discussed in our prior alert.

The rules became effective on August 8, 2022, and Nasdaq listed companies began making the required disclosures beginning with the 2023 proxy season.

The decision

The court examined whether the rules were related to the purposes of the Exchange Act, which the court described as primarily focused on investor protection and protection of the macroeconomy from speculative, manipulative, and fraudulent practices, as well as on promoting competition in the securities market.

The court concluded that the SEC did not adequately explain how the Disclosure Rule and the Diversity Rule were related to these purposes, and it found that the SEC’s justification – that the rules would provide information important to some investors – was insufficient.

The court also evaluated the diversity rules under the major questions doctrine, which requires clear congressional authorization for agencies to make decisions of vast economic and political significance. The court found that the SEC’s approval of Nasdaq’s board diversity rules represented a significant and novel exercise of power that lacked clear congressional authorization, and that “no part of the Exchange Act even hints at the SEC’s purported power to remake corporate boards using diversity factors.” The court emphasized that the SEC’s action intruded into areas traditionally regulated by state law and other federal agencies. Furthermore, the court concluded that a disclosure rule is valid only if it is related to the primary purposes of the Exchange Act, which are to eliminate fraud, speculation, or some other Exchange Act-related harm.

Dissenting opinion

The dissent emphasized the limited role of the SEC in overseeing private ordering through rules proposed by self-regulatory organizations (SROs) and argued that the majority’s decision improperly expanded the SEC’s role. The dissent also highlighted SEC findings that investors sought the information required by the Disclosure Rule in an environment where such information was otherwise inaccurate, inefficient, and asymmetrical. As a result, investor interest in that information satisfied the requirement that the Disclosure Rule be related to the purposes of the Exchange Act. The dissent did not articulate a similar rationale in support of the Diversity Rule.

Key takeaways

It is doubtful that the SEC will challenge the court’s determination, considering the incoming presidential administration’s agenda and Nasdaq’s statements that it will not appeal the court’s decision. Notwithstanding, Nasdaq-listed companies are advised to give thoughtful consideration before removing board diversity disclosures from their upcoming SEC filings (eg, proxy statement or Form 20-F) or their websites.

Accordingly, prior to making any disclosure decisions, companies should consider weighing a number of factors, such as:

• Prior public disclosures surrounding diversity goals and strategies already in their SEC filings, environmental, social, and governance (ESG) reports, or other public disclosures
• Board member perspectives on voluntary disclosure
• Investors’ requests or expectations for board diversity disclosures, and
• Voting guidelines of proxy advisory firms and large institutional investors, requiring gender and/or racial ethnic board diversity, in particular, Glass Lewis’ policy for Russell 3000 companies whose boards are not at least 30-percent diverse. Noncompliance with these voting guidelines may result in votes against or withholding of votes for the election of directors at companies lacking such diversity.

While it will likely take time to assess how market trends on diversity disclosure may evolve, companies are encouraged to arrive at their disclosure determination based on the analysis of their specific facts and circumstances. Companies may decide to continue including board diversity disclosures in their SEC filings, and with the rule vacated, they may provide such information in the format and with the level of detail that best suits their needs, rather than through the Nasdaq-mandated tabular disclosure. Therefore, rushing to make any significant changes to director and officer (D&O) questionnaires regarding the solicitation of board diversity information and consents for the disclosure of such information by directors, may not be the best course of action.

Additionally, while providing reasons for noncompliance with Nasdaq’s specific board diversity requirements is no longer required, for the reasons noted above, companies may consider whether to disclose any plans to increase diversity on their boards consistent with their prior public disclosures surrounding diversity goals and strategies.

Regardless of a company’s decision on what and how much information to provide, the court’s decision signifies increased flexibility for companies in determining which disclosures best suit their own facts and circumstances.

If you have any questions related to this topic, please reach out to any one of DLA Piper’s Public Company and Governance lawyers.