Nasdaq Board Diversity Regulations Face Skeptical Fifth Circuit

SEC-approved rules aimed at fostering diverse boards for companies listed on Nasdaq encountered pointed questions at the right-leaning Fifth Circuit on Tuesday, as the full court reviewed a three-judge panel’s decision backing the regulations.

Judges on the US Court of Appeals for the Fifth Circuit raised questions about the Securities and Exchange Commission’s authority to permit the 2021 Nasdaq rules under a law intended to help investors make informed decisions. Three Democratic-appointed judges previously upheld the regulations last year in the face of a conservative challenge.

The rules require thousands of Nasdaq-listed companies to report on their boards’ diversity and to include diverse directors or explain why they don’t have them. The SEC needed to sign off on the regulations for them to take effect and is now defending the rules alongside Nasdaq Inc.

Several judges pressed SEC and Nasdaq lawyers during oral arguments in New Orleans on whether the 1934 Securities Exchange Act limits the types of disclosure requirements the SEC can approve for a stock exchange. Could an exchange require reporting on corporate directors’ support of Israel or their position on a feud between rappers Drake and Kendrick Lamar, the judges asked.

“I’m trying to figure out where to draw the line,” Judge Kurt Engelhardt said. The Trump appointee was among 17 judges who heard en banc oral arguments in the case. All but six of the judges were picked by Republican presidents.

Exchange Act Authority

The hearing came almost two years after three of the court’s Democrat-appointed 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, which said the SEC overstepped its authority in approving the rules, faced sharped questioning in 2022 from Higginson, an Obama appointee.

He wrote an October 2023 opinion on behalf of the three-judge panel, backing the rules. The SEC acted appropriately when it concluded that “a ‘reasonable investor’ could find board diversity information ‘important,’” he wrote. The Exchange Act permits disclosures important to shareholders’ investment and voting decisions.

The regulations 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. The full Fifth Circuit agreed to rehear the case in February.

Investors with trillions of dollars held in companies listed on Nasdaq told the SEC and the exchange that they consider board diversity information important, making the rules permissible, SEC assistant general counsel Tracey Hardin said at the hearing. A difference of opinion over Nasdaq’s decision to require board diversity disclosures doesn’t make it illegal, she said.

“That disagreement doesn’t provide a legal basis to overturn Nasdaq’s business judgment,” or show the rules are inconsistent with the Exchange Act, Hardin said.

Lawyers for the National Center for Public Policy Research and Alliance for Fair Board Recruitment argued the SEC still overstepped its authority under the Exchange Act.

The statute does not give the agency power to approve rules concerning “socially controversial matters,” Peggy Little, a lawyer representing the National Center for Public Policy Research, said at the hearing. Diversity, equity, and inclusion is “one of the biggest controversies” in the US now, she said.

“The SEC should not be taking sides,” said Little, a senior litigation counsel at the New Civil Liberties Alliance, a right-leaning legal group.

“The SEC has blessed a proposal that facially discriminates based on race and sex,” added Boyden Gray PLLC managing partner Jonathan Berry, who represented the Alliance for Fair Board Recruitment at the hearing.

‘Free Market’

Nasdaq and the SEC have argued the rules require disclosures, but not diverse boards. Companies without diverse boards can “simply provide an explanation—in their own words, in as much or as little detail as they choose,” the SEC said in an April court filing.

They also can choose whether to list on Nasdaq, said Allyson Ho, a Gibson, Dunn & Crutcher LLP partner representing the exchange. She is married to Fifth Circuit Judge James Ho, who sat out during the oral arguments.

“Companies can and do vote with their feet and move to another exchange,” Ho said. “And as a result, the exchanges compete vigorously for companies’ listings. It’s a free market form of regulation that has served free enterprise well.”

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