SEC, Nasdaq Square Off Against Challengers to Nasdaq's Board Diversity Rule

The SEC was once again before the U.S. Court of Appeals for the Fifth Circuit¹ on Aug. 29, 2022, this time in connection with the agency's approval of the Nasdaq Stock Market LLC's (Nasdaq) Board Diversity Rule (Rule). The Rule generally requires each of the more than 3,500 companies listed on the Nasdaq exchange to have at least two diverse members on the board of directors or annually disclose why it does not. This week, a three-judge panel of the Fifth Circuit heard oral arguments from the SEC and some of the Rule's challengers in Alliance for Fair Board Recruitment v. SEC. In this post, we summarize the Rule, the arguments advanced for and against it, how the parties advocated those positions before the Fifth Circuit earlier this week, and when to expect a decision.

Summary of Nasdaq's Board Diversity Rule

When the SEC approved the Board Diversity Rule in August 2021, it became part of Nasdaq's corporate governance requirements as Rules 5605(f) and 5606.² Subject to certain exceptions, the Rule requires each Nasdaq-listed company to 1) publicly disclose diversity statistics regarding its board of directors, and 2) have, or explain why it does not have, at least two diverse directors, including at least one who self-identifies as female³ and one individual who self-identifies as an underrepresented minority⁴ or LGBTQ+⁵.

The portion of the Board Diversity Rule relating to public disclosure of diversity statistics is required annually for most companies, beginning on the later of Aug. 8, 2022, or the date the company files its proxy statement or its information statement for its 2022 annual shareholders meeting (or, if the company does not file a proxy or information statement, the date it files its Form 10-K or 20-F).⁶ Companies are required to disclose diversity statistics utilizing the Board Diversity Matrix format prescribed by Nasdaq.

With regard to board membership, the Rule requires each company to have at least one diverse director (or explain why it does not) by the later of Aug. 7, 2023, or when it files either its proxy statement or its information statement the 2023 annual shareholder meeting. And each company is required to have at least two diverse directors (or explain why it does not) by the later of:

• Aug. 6, 2025, or the date the company files its proxy statement or its information statement for its annual meeting of shareholders during 2025 (for companies listed on the Nasdaq Global Select Market or the Nasdaq Global Market); or
• Aug. 6, 2026, or the date the company files its proxy statement or its information statement for its annual meeting of shareholders during 2026 (for companies listed on the Nasdaq Capital Market)

Companies with five or fewer directors are required only to have at least one diverse director. The requirements and phase-in periods vary for newly listed issuers, foreign issuers and issuers that qualify as "smaller reporting companies" (as defined in Rule 12b-2 under the Securities Exchange Act of 1934).⁷

Why Opponents Sued the SEC over the Board Diversity Rule, and the Arguments For and Against the Rule

As a national stock exchange and self-regulatory organization, Nasdaq is subject to SEC oversight, including review and approval of its proposed rulemaking.⁸ In December 2020, Nasdaq filed a proposal with the SEC asking to implement the Board Diversity Rule. On Aug. 6, 2021, the SEC issued an order finding that the Board Diversity Rule complied with the requirements of the Securities Exchange Act of 1934 (Exchange Act) and approving the proposed rule (as amended) in a 3-2 vote along party lines.⁹ In announcing the agency's approval, SEC Chair Gary Gensler stated that the Board Diversity Rule reflects "calls from investors for greater transparency about the people who lead public companies, and a broad cross-section of commenters supported the proposed board diversity disclosure rule." In their own joint statement, SEC Commissioners Allison Lee and Caroline Crenshaw anticipated that the Rule will "improve the quality of information available to investors for making investment and voting decisions by providing consistent and comparable diversity metrics."

The same month the SEC approved the Rule, the Alliance for Fair Board Recruitment (AFBR) filed a legal challenge against the Rule¹⁰ in the Fifth Circuit.¹¹ AFBR and other opponents such as the National Center for Public Policy Research and nearly 20 state attorneys general argue that the SEC lacks (or exceeded) authority in approving the Rule, which they claim lacks sufficient evidence of Exchange Act compliance, establishes quota requirements, inappropriately veers into states' interests in addressing matters of corporate governance and constitutes state action warranting constitutional scrutiny under which the Rule fails because – they argue – it violates the First and Fifth Amendment's free speech and equal-protection principles.

For its part, the SEC rejects outright the notion that the Rule is unconstitutional and argues that, because Nasdaq is a private actor, the SEC's review and approval of the Rule does not constitute a state action that would subject the Rule to constitutional scrutiny.¹² The agency also argues that review and approval of Nasdaq's rule proposals is a normal-course practice that demonstrably complies with the Exchange Act.¹³ As with the Rule's opponents, the SEC is also supported by significant amici, including a number of academic experts in the fields of business, management and economics who argue that substantial evidence in the record underscores the connection between diversity and board performance, corporate financial performance and non-financial outcomes alike.

Oral Argument to the Fifth Circuit

A three-judge panel of the Fifth Circuit heard argument in the case on Aug. 29, 2022. The panel – made up of Judges Carl Stewart,¹⁴ James Dennis¹⁵ and Stephen Higginson¹⁶ – represents something of a rarity on the Fifth Circuit, both because all three judges on the panel are from Louisiana,¹⁷ and because all three judges were appointed by presidents from the Democratic Party.¹⁸ Petitioners AFBR and National Center for Public Policy Research (NCPPR) shared time presenting arguments challenging the Rule, and the SEC (as Respondent) and Nasdaq (as Intervenor) each argued in support of the Rule.

The parties faced a "hot panel," in that the Judges' questions began early and continued throughout the arguments – so much so that both sides were afforded additional argument time to fully answer questions.¹⁹ Judge Higginson asked the most questions, several of which were directed at linking the parties' arguments to specific statements in the SEC's approval order or elsewhere in the record.

Key issues raised during the arguments included:

• the effect of the Fifth Circuit's 1971 opinion in Intercontinental Industries, Inc. v. American Stock Exchange²⁰
• The petitioners' constitutional challenges to the Rule are predicated on the existence of state action – as opposed to purely private action. The SEC and Nasdaq argue that Nasdaq is a private actor, not a governmental entity. The petitioners argue that there is state action when Nasdaq acts in conjunction with the SEC and that Nasdaq did so here. In support, they rely on Intercontinental, in which the Fifth Circuit rejected an argument that constitutional due process did not apply to an SEC order authorizing the American Stock Exchange to delist the petitioner (an SRO) because the American Stock Exchange was not a governmental entity. The Fifth Circuit stated that the American Stock Exchange's "intimate involvement" with the SEC "brings it within the purview of the Fifth Amendment controls over governmental due process." At oral argument, the parties disputed whether the relevant language in Intercontinental was dicta and whether it was consistent with post-1971 U.S. Supreme Court authority. The SEC and Nasdaq also argued that finding state action in this case would create a circuit split, most notably with the Second Circuit.
• AFBR also relied heavily on Moose Lodge No. 107 v. Irvis,²¹ in which the Supreme Court stated that the "impetus for the forbidden discrimination need not originate with the State if it is State action that enforces privately originated discrimination."
• whether the Rule was investor-driven or prompted by the statements made by Lee and Crenshaw
• This issue is relevant to the question of whether the Rule, and subsequent SEC approval, constitutes state action.
• Higginson asked the AFBR whether petitioners need to show coercion or at least encouragement by the regulators – i.e., "entwinement" – to establish state action. In response, AFBR invoked Moose Lodge and argued that state action is present in this case, independent of entwinement, because Nasdaq and the SEC have an enforcement duty under federal law.
• investor demand for the information required to be disclosed by the Rule may also have bearing on whether the Rule complies with the Exchange Act
• The petitioners argue that the Rule is not consistent with the Exchange Act because it is not designed to achieve one of the Act's four permitted goals: 1) to prevent fraudulent and manipulative acts and practices; 2) to promote just and equitable principles of trade; 3) to remove impediments to and perfect the mechanism of a free and open market and a national market system; or 4) to protect investors and the public interest.²²
• Similarly, petitioners argue that the Rule violates the Exchange Act's prohibitions against a Rule that would: 1) permit unfair discrimination between customers, issuers, brokers or dealers; 2) regulate matters not related to the purposes of the Exchange Act or the administration of the exchange; or 3) impose any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Exchange Act.²³
• Higginson asked NCPPR whether the Rule satisfied the "just and equitable principles of trade" if it was designed to provide information that investors wanted.
• Later, Higginson asked a similar question about whether the Rule is permissible if it assists the market in finding talent that has been overlooked in the past (as a result of lesser opportunity and greater impediments to success). In response, AFBR indicated that rectifying past discrimination might be a constitutionally permissible goal, but the record does not support that in this case.
• Stewart also asked at least one question along these lines.
• whether the Rule is supported by substantial evidence
• Petitioners argue that the Rule is not supported by "substantial evidence," as required by the Exchange Act. This issue implicates the discussion above about whether the information to be disclosed under the Rule is information that will be helpful to investors.
• During the rulemaking process, Nasdaq relied on studies that support a causal link between greater board diversity and improved company performance. In approving the rule, the SEC stated that the data on that issue was inconclusive. But the SEC determined that there was a "reasonable debate" as to the benefits of the information and that many investors wanted the information.
• whether the non-delegation doctrine is at play
• In response to the NCPPR's non-delegation argument, the SEC stated that because Nasdaq is a private entity, it does not need a delegation of authority from Congress to act; it merely needs to refrain from those actions barred by law. The SEC further argued that its own authority to act comes the Exchange Act, which its approval order satisfied.
• whether the issue is properly before the Court in this case or should await determination in a (possible) future enforcement action
• The SEC indicated at oral argument that the Moose Lodge issue is not before the Court in this matter, because the petitioners challenged the Rule itself, not subsequent enforcement actions. In response to follow-up questions, the SEC and Nasdaq seemed to imply that the issue would be before the Court if the Nasdaq failed to enforce its Rule and the SEC brought an action to compel Nasdaq to enforce the Rule.
• In response to these arguments, AFBR asserted that the SEC and Nasdaq cannot persuasively argue that the Rule is constitutionally sound when enforcement of the Rule would be unconstitutional. According to AFBR, the ongoing duty under the Exchange Act to enforce the rule is sufficient.

Issues that received little (if any) direct discussion at oral argument included whether strict scrutiny applies in this matter and, if so, whether the compelling-interest and narrowly tailored tests (or the parallel criteria under lower scrutiny standards) are satisfied.

The SECond Opinions Blog will continue to monitor this case and provide further updates when a decision is handed down and for any further appeal thereafter. If you need any additional information on this topic – or anything related to SEC enforcement – please contact the authors or another member of Holland & Knight's Securities Enforcement Defense Team.

Notes

¹ A previous Holland & Knight alert, "SEC in Constitutional Danger Zone Following Several Recent Decisions," June 3, 2022, covered the Fifth Circuit's decision holding that the SEC's administrative law judges are unconstitutionally insulated from removal in Jarkesy v. SEC. In addition, Ms. Magee previously shared her insights regarding one justice's concurring opinion questioning the agency's long-standing use of no-admit, no-deny settlement provisions in Novinger v. SEC.

² See Self-Regulatory Organizations; The Nasdaq Stock Market LLC; Order Approving Proposed Rule Changes, as Modified by Amendment No. 1, to Adopt Listing Rules Related to Board Diversity and to Offer Certain Listed Companies Access to a Complimentary Board Recruiting Service, 86 Fed. Reg. 44,424 (Aug. 12, 2021).

³ Rule 5605(f) defines "female" as an individual who self-identifies her gender as a woman, without regard to the individual's designated sex at birth.

⁴ Rule 5605(f) defines "underrepresented minority" 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.

⁵ Rule 5605(f) defines "LGBTQ+" as an individual who self-identifies as any of the following: lesbian, gay, bisexual, transgender or as a member of the queer community.

⁶ For companies listed after Aug. 8, 2021, the Rule provides for an extended transition period.

⁷ Additionally, the following companies are exempt from the Board Diversity Rule: acquisition companies listed under IM-5101-2; asset-backed issuers and other passive issuers (as set forth in Rule 5615(a)(1)); cooperatives (as set forth in Rule 5615(a)(2)); limited partnerships (as set forth in Rule 5615(a)(4)); management investment companies (as set forth in Rule 5615(a)(5)); issuers of non-voting preferred securities, debt securities and Derivative Securities (as set forth in Rule 5615(a)(6)) that do not have equity securities listed on Nasdaq; and issuers of securities listed under the Rule 5700 Series.

⁸ Nasdaq is registered as a national securities exchange with the SEC and is therefore classified as a "self-regulatory organization." See 15 U.S.C. §§ 78c(a)(26), 78q-1(b). "A self-regulatory organization, or "SRO," may propose a change in its rules or propose a new rule by filing the proposal with the [SEC] pursuant to Section 19(b)(1) of the [Exchange Act.]" SeeOrder, infra, at N.2. The SEC "shall approve" a self-regulatory organization's proposed rule change only "if it finds that such proposed rule change is consistent with" provisions of the Exchange Act. Id. § 78s(b)(2)(C)(i); see id at (b)(2)(C)(ii). See Susquehanna International Group, LLP, et al. v. SEC, 866 F.3d 442(DC Cir.) (Aug. 8, 2017).

⁹ Commissioners Peirce and Roisman issued dissenting statements similarly opposing approval of the Rule on the grounds that it exceeded the SEC's authority and raises constitutional concerns. AFBR and other challengers no doubt agree with their views and echo and advance them in their Fifth Circuit challenge.

¹⁰ Later in 2021, the National Center for Public Policy Research also challenged the Rule on similar grounds.

¹¹ In July 2021, AFBR challenged California laws addressing board diversity. See Alliance for Fair Board Recruitment v. Weber, Case No. 2:21-cv-01951-JAM-AC (E.D. Cal. 2021). The California laws differ notably from Nasdaq's disclosure-oriented rule. The case is currently stayed pending appeal of the successful challenge to the California law in Crest v. Padilla, No. 20STCV37513 (Cal. Super. Ct. 2020).

¹² Nasdaq intervened in the action to assert the same no-state-action argument.

¹³ The SEC argues, at pp. 2-3 of its brief, that "Congress has tasked the Commission with reviewing and approving each exchange's rules, including its listing standards. That review is limited to determining whether the rule is consistent with requirements specified in the Act. If the rule clears the statutory floor, the Commission must approve it regardless of the Commission's own policy views. The Commission reasonably concluded that Nasdaq's rules meet that standard because they will facilitate more consistent and comparable disclosure of information important to investors' investment and voting decisions. In challenging that conclusion, petitioners…distort the rules and the Commission's statutory role in reviewing them."

¹⁴ Judge Stewart was the Chief Judge of the Fifth Circuit from 2012 to 2019.

¹⁵ Judge Dennis announced earlier this year that he would be taking senior status, and President Biden as nominated U.S. Magistrate Judge (E.D. La.) Dana Douglas to fill the seat. Judge Dennis's senior status will become effective upon the confirmation of his successor.

¹⁶ Judge Higginson also sits as a judge on the United States Foreign Intelligence Surveillance Court of Review.

¹⁷ Judges Stewart and Dennis were appointed by former President Clinton, and Judge Higginson was appointed by former President Obama. Of the 17 active judges on the Fifth Circuit Court of Appeals, nine are from Texas, five are from Louisiana and three are from Mississippi.

¹⁸ Five of the active judges on the Fifth Circuit were appointed by Democratic Presidents, and the remaining 12 were appointed by Republican Presidents.

¹⁹ In fact, at the end of argument, Judge Stewart indicated that he believed the case would have qualified for expanded oral argument time, had the parties requested it.

²⁰ 452 F.2d 935 (5th Cir. 1971).

²¹ 407 U.S. 163 (1972).

²² 15 U.S.C. § 78f(b)(5), (b)(8).

²³ Id.