Nasdaq Board Diversity Rules Face Test Before Full Fifth Circuit

SEC-backed Nasdaq regulations intended to encourage racial and gender diversity on company boards will face their biggest hurdle to date, as the right-leaning Fifth Circuit reconsiders the rules’ legality.

The full US Court of Appeals for the Fifth Circuit is set to hear oral arguments Tuesday in a conservative challenge to the stock exchange’s rules, after a panel of three Democratic-appointed judges upheld them last year. The New Orleans-based court, where Republican-picked judges have the majority, agreed to review the decision at the challengers’ request.

The Nasdaq rules at issue require thousands of publicly listed companies to report on their boards’ diversity and to include diverse directors or explain why they don’t. They needed approval from the Securities and Exchange Commission to take effect. The agency signed off on them in 2021 and is now defending the rules alongside the stock exchange.

The Alliance for Fair Board Recruitment and National Center for Public Policy Research, the conservative groups that sued, accuse the SEC of overstepping its authority by permitting the regulations. That argument could gain traction among the appeals court’s majority, where there’s at least some skepticism of agency actions under Democratic Chair Gary Gensler.

The Fifth Circuit is increasingly hostile to agencies facing government overreach claims, said Tad Bartlett, a special counsel at Fishman Haygood LLP who closely follows the court and clerked there.

“It’s more likely than not that they go the other way from the panel” that upheld the Nasdaq rules, Bartlett said of the full court. “There’s just a lot of momentum behind that.”

Initial Review

The Tuesday hearing will come almost two years after judges James Dennis, Stephen Higginson, and Carl Stewart first heard oral arguments in the case.

The Alliance for Fair Board Recruitment and National Center for Public Policy Research were on the defense in 2022, as Higginson, an Obama appointee, questioned their claims that the SEC overstepped its powers by approving the rules. The SEC and Nasdaq said the regulations were an appropriate response to broad investor demand for more information on board diversity, as permitted under federal securities law.

The rules generally require Nasdaq-listed companies to have least one woman and at least one minority or LGBTQ member on their boards, unless they disclose why they can’t comply. Companies also must report the gender and racial makeup of their boards annually under the regulations. The board composition disclosure provisions started to take effect in 2022, followed by the comply-or-explain diverse director requirements last year, despite the litigation.

Higginson ultimately backed the SEC and Nasdaq in an October opinion he wrote on behalf of the panel that heard the case. The SEC acted appropriately in reaching the conclusion that reasonable investors may find board diversity information important, he wrote.

The Alliance for Fair Board Recruitment and National Center for Public Policy Research then asked the full Fifth Circuit to rehear the case. The Fifth Circuit in February decided it would meet that request, meaning a majority of the court’s nonrecused active judges voted in favor of the en banc rehearing. The court told lawyers in the case to prepare to discuss the Nasdaq rules in relation to the 1934 Securities Exchange Act.

The statute permits stock exchanges to require disclosures that a reasonable investor may find useful. The Nasdaq regulations should be prohibited under the law because they impose a diversity quota that goes beyond a disclosure requirement, said Peggy Little, a lawyer who will represent the National Center for Public Policy Research at the oral arguments.

“When it passed the Exchange Act, Congress was not in fact conferring power on the SEC, whether working together with an exchange or on its own, to make rules that pertain to who sits on the boards of companies that list on any exchange,” said Little, a senior litigation counsel at the New Civil Liberties Alliance, a right-leaning legal group.

SEC Defense

SEC and Nasdaq lawyers said in court filings in April that the rules were consistent with the Exchange Act’s requirements. The regulations require disclosures, not diverse boards, they said. Companies without diverse boards can “simply provide an explanation—in their own words, in as much or as little detail as they choose—and any company that would prefer not may list on another exchange or trade off-exchange,” the SEC’s lawyers said in their filing.

The SEC and Nasdaq lawyers included agency assistant general counsel Tracey Hardin and Gibson, Dunn & Crutcher LLP partner Allyson Ho, who is representing the stock exchange. Both will defend the rules at the oral arguments. Ho is married to Fifth Circuit Judge James Ho, who has sat out during the case’s proceedings so far.

Hardin helped the SEC win a case over its proxy vote reporting rules at the Fifth Circuit on May 10, according to court records. She’s also involved in a pending National Association of Manufacturers lawsuit and another National Center for Public Policy Research challenge, which the manufacturers’ group joined. Those two cases could prove more difficult to win, after the SEC faced tough questioning at oral arguments about its actions under Gensler.

The National Association of Manufacturers and National Center for Public Policy Research are challenging SEC rules and policies they say improperly shape shareholder votes at company annual meetings. The Fifth Circuit grilled SEC lawyers at oral arguments for the cases in August 2023 and in March. Between the hearings, the court in December tossed an SEC rule requiring companies to disclose more about the stocks they buy back. The US Chamber of Commerce brought that case.

Despite the SEC’s setbacks at the Fifth Circuit, the court has enough evidence to see Nasdaq’s rules are legal, said Aman George, senior counsel and legal policy director at Democracy Forward, a left-leaning advocacy group. He helped file an amicus brief on behalf of academics this month, telling the court that Nasdaq and the SEC considered significant evidence of a positive link between board diversity and corporate performance, advancing the Exchange Act’s goals to protect investors.

“The way that the petitioners presented the evidence is just really divorced from the records that the SEC and Nasdaq actually considered and ignores the legal standard that is supposed to uphold SEC rules,” George said in an interview.

SEC and Nasdaq representatives declined to comment for this story.

Harvard Decision

Although the Fifth Circuit is expected to focus on the Exchange Act during oral arguments, other issues likely will come up, too, lawyers told Bloomberg Law. The Supreme Court’s 2023 decision against Harvard University’s use of affirmative action in student admissions is one possibility, they said.

The Supreme Court reached its decision in Students for Fair Admissions v. President and Fellows of Harvard College in June 2023, between the Fifth Circuit’s first oral arguments in the Nasdaq case and its initial ruling on the matter.

Higginson didn’t mention the Harvard case by name in his opinion. But the Fifth Circuit’s October decision in the Nadsaq rules case provided an early test of whether the Harvard decision applied outside higher education to companies.

The Alliance for Fair Board Recruitment is led by conservative activist Edward Blum, who also heads the Students for Fair Admissions group that brought the Harvard case. Jonathan Berry, who will represent the Alliance for Fair Board Recruitment at the oral arguments, has pushed the court to consider the Harvard decision.

“It underscores the ongoing controversy over affirmative action,” said Berry, managing partner of Boyden Gray PLLC.

The case is Alliance for Fair Board Recruitment v. SEC, 5th Cir., No. 21-60626, en banc oral arguments scheduled 5/14/24.