DEI is DOA at Nasdaq After Fifth Circuit Ruling

Fifth Circuit Vacates Nasdaq Board Diversity Rules
Nasdaq listed companies are no longer subject to Nasdaq board diversity rule requirements

Fort Lauderdale, Fla. (January 17, 2025) - On December 11, 2024, the Fifth Circuit Court of Appeals vacated the Securities Exchange Commission’s (“SEC”) approval of Nasdaq’s board diversity rules, finding the SEC lacked statutory authority to approve the rules.¹

Following the court’s decision, Nasdaq-listed companies are no longer required to comply with the Nasdaq board diversity requirements. An appeal by Nasdaq or the SEC is possible, but unlikely. Nonetheless, listed companies should review the decision (including the dissenting opinion) and take heed that although no longer required by Nasdaq rules, market participants (e.g., some institutional investors beholden to privately imposed investment mandates) may still require listed companies to achieve similar aspirational diversity objectives or face divestment. Additionally, the court’s well-written opinion lays out a solid explanation of the SEC rulemaking process and SEC’s statutory authority with respect to approving exchange rules, which may serve as a playbook for future challenges of controversial rules promulgated by the SEC and other regulatory agencies.   

The board diversity rules were proposed by Nasdaq in 2020, in response to the social justice movement inspired by the George Floyd protests. Nasdaq’s proposed rules were designed to advance board diversity among listed companies and were comprised of the Disclosure Rule ², Diversity Rule ³ and Recruiting Rule ⁴. All three rules were subsequently approved by the SEC. 

Beginning in 2022, under the Disclosure Rule - subject to certain exemptions - each Nasdaq-listed company was required to have, or explain why it did not have, at least one board member who is a woman and one board member who is an underrepresented racial minority or LGBTQ+.

The petitioners in the case, Alliance for Fair Board Recruitment and the National Center for Public Policy Research, each separately challenged the SEC’s approval of the rules on constitutional and statutory grounds. Both cases were consolidated before the Fifth Circuit, which last month resolved the case on statutory grounds (without needing to address the constitutional arguments). The court denied as moot the petition for review of the Recruiting Rule, as the benefits under the Recruiting Rule had expired on December 1, 2023 and there were no companies receiving services under the rule as of September 30, 2024.

SRO Rule Making Process and SEC Approval

Nasdaq, like other SEC-registered exchanges, is a self-regulatory organization (“SRO”) which under the Securities Exchange Act of 1934 (“Exchange Act”) gives it the power to set rules governing the conduct of its members and participants. SROs may not change their rules without SEC approval. Under Section 78s(b) of the Exchange Act, if an SRO wants to adopt or change any of its rules (i) the SRO must first file the proposed change with the SEC; (ii) the SEC then will publish the proposal for review and comment; (iii) after the notice-and-comment period and additional hearings if necessary, the SEC must approve the proposal only if it finds the proposal is consistent with the requirements of the Exchange Act. If the SEC does not make that finding it must disapprove the proposal. ⁵

In reaching its decision, the court explained that an exchange rule is not related to the purposes of the Exchange Act simply because it is a disclosure rule. The court argued that the Exchange Act exists primarily to protect investors and the macroeconomy from speculative, manipulative, and fraudulent practices, and to promote competition in the market for securities transactions. Further, the court reasoned that a disclosure rule is related to the purposes of the Exchange Act only if it has some connection with those purposes.

The court concluded that in adopting Nasdaq’s board diversity rule proposal, the SEC did not explain how the board diversity rules had any connection with the purposes of the Exchange Act. The SEC argued the board diversity proposal was designed to advance three of the purposes contained in Exchange Act § 78f(b)(5) ⁶. But the court found the purposes advanced by the SEC bore no relationship to the disclosure of information about the racial, gender, and sexual characteristics of the directors of public companies and further that “no part of the Exchange Act even hints at SEC’s purported power to remake corporate boards using diversity factors.” ⁷

Implications of the Court's Holding

The court’s holding vacates the SEC’s order approving Nasdaq’s board diversity proposal and denies as moot the petition for review of the Recruiting Rule. Accordingly, Nasdaq listed companies are no longer subject to the requirements of Nasdaq’s board diversity rules. According to FAQ guidance posted on the Nasdaq listing center website, Nasdaq does not presently intend to seek further review of the court’s decision ⁸. However, we note that the U.S. government has recently appealed other Fifth Circuit decisions to the U.S. Supreme Court, seeking to temper the Fifth Circuit’s authority to unilaterally vacate or stay agency action ⁹. Therefore, a Supreme Court challenge of the holding in this case is not out of the realm of possibility, albeit unlikely given the pending change in administration.

As mentioned, listed companies may still wish to adhere to the aspirational board diversity guidelines as some market participants including certain institutional investors subject to diversity mandates continue to desire and/or are required to factor diversity objectives into their investment allocations.

For more information about this decision, contact the author or editors of this alert. Visit Lewis Brisbois' Securities & Corporate Finance Practice page to learn more about our capabilities in this area.

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¹ Alliance for Fair Board Recruitment v. SEC, No. 21-60626 (5th Cir. 2024) (the “Opinion”).

² Requires Nasdaq-listed companies to disclose statistical information about their board of directors’ gender, race, and LGBTQ+ status in a uniform format.

³ Mandates that Nasdaq-listed companies (subject to certain exemptions) have, or explain why it does not have at least one female director and one director from an underrepresented racial minority or LGBTQ+ group.

⁴ Provides companies that do not meet the diversity objectives complimentary access to a board recruiting service to help them identify and evaluate diverse board candidates.

⁵ Exchange Act § 78s(b)(2)(C)(ii).
 
⁶ Per the court’s opinion at 22, the SEC argued the board diversity proposal was “designed to promote [1] just and equitable principles of trade, [2] remove impediments to and perfect the mechanism of a free and open market and a national market system, and [3] protect investors and the public interest” because it will make available information that some investors want.

⁷ Opinion at 31.

⁸ Reference Library Search - Nasdaq Listing Center ID # 1873 posted December 11, 2024.

⁹ See for example, Garland v. Texas Top Cop Shop, Inc. Et. Al. No. 24A654 (U.S. Supreme Court)