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SEC’s Board Diversity Drive Runs Risk of More Legal Challenges

Oct. 22, 2021, 10:00 AM

The SEC faces a legal fight over its efforts to encourage diversity on corporate boards, but an agency focus on disclosure over quotas would complicate conservative activists’ arguments.

The Securities and Exchange Commission already is facing two cases over its authorization of Nasdaq Inc. rules that require its listed companies to have diverse board members or explain why they don’t. More litigation could follow as the SEC is contemplating adopting, as early as next year, its own board diversity rules for a broader range of companies.

Legal challenges to the SEC’s anticipated rules could delay their implementation and interfere with Democratic Chair Gary Gensler’s ambitious environmental, social, and governance agenda, even if the agency ultimately prevails.

Board diversity regulation critics’ arguments are starting to shape in their lawsuits to challenge the Nasdaq’s rules. The stock exchange’s diversity rules violate federal securities laws and directors’ and companies’ First Amendment rights, according to the organizations that are challenging the changes—Alliance for Fair Board Recruitment and the New Civil Liberties Alliance. The organizations said they also are on the lookout for similar points of contention in the SEC’s rules.

“Our government must stop the sordid, unconstitutional business of dividing Americans into racial and other identity boxes,” said Edward Blum, president of the Alliance for Fair Board Recruitment.

Legal Problems

Legal action against the SEC’s rules would have at least some weaknesses, depending on how the regulations are crafted, lawyers told Bloomberg Law.

The SEC could mirror Nasdaq’s regulations, which mandate that listed companies have at least one female board member and at least one from an underrepresented minority or LGBTQ—or say why they don’t. The agency also could require disclosures without caveats about how diverse boards should be.

Rules that simply direct companies to report on the diversity of their boards have a better chance of surviving a legal challenge, said David Burton, a senior fellow in economic policy at right-leaning think tank Heritage Foundation.

Straight disclosure of boards’ diversity would also be more consistent with the SEC’s traditional regulatory approach, he said.

“If they do anything akin to the Nasdaq rule imposing quotas, they’ll be in deep trouble ethically and legally,” Burton said. “If they narrowly require disclosure of the composition of the board, that’s still problematic, but less so.”

In a recent interview, Gensler signaled that the SEC might shy away from the “comply-or-explain” approach featured in the Nasdaq rules.

“We’re really a disclosure-based regime,” Gensler said in an Oct. 19 interview conducted by former SEC Commissioner and current NYU Law professor Robert Jackson.

The main challenge to a disclosure rule would be whether it’s outside of the SEC’s rulemaking authority and requires information from companies that isn’t material to investors, said Howard Berkenblit, a Sullivan & Worcester LLP partner.

“These would seem to be more difficult claims to support than those currently being launched against the Nasdaq rule,” said Berkenblit, who leads his firm’s capital markets group.

But the SEC may not have to limit rulemaking to straight disclosures.

The agency would have the upper hand fending off litigation, even if it adopts the quotas in Nasdaq’s model, said Cynthia Krus, an Eversheds Sutherland (US) LLP partner.

Rules about corporate governance aren’t alien to the SEC’s mission, Krus said. Mutual funds, for example, must have boards in which a majority of their members are independent directors.

“There is a role for the SEC,” Krus said. “Honestly, the market is demanding this.”

SEC Powers

The Alliance for Fair Board Recruitment and the New Civil Liberties Alliance haven’t committed to taking the SEC to court over any board diversity rules it may issue.

The SEC could face litigation if it exceeds its powers under the 1934 Securities Exchange Act, said Peggy Little, senior litigation counsel for the New Civil Liberties Alliance, which describes itself as nonpartisan group that challenges government overreach. The NCLA is representing conservative think tank National Center for Public Policy Research in the Nasdaq rules litigation.

The statute created the SEC and helped define its mission to protect investors, maintain fair markets, and promote capital formation. These are duties, she said, the agency already shirked when it approved Nasdaq’s rules.

Constitutional concerns also could land the SEC in court, Little said.

Nasdaq’s rules violate the First Amendment by compelling speech, according to the Alliance for Fair Board Recruitment and the National Center for Public Policy Research.

The First Amendment prohibits the SEC from compelling companies to disclose “controversial” information, such as board diversity data, the Alliance for Fair Board Recruitment told the agency earlier this year. Only “noncontroversial” information, like disclosures about whether company has at least one financial expert on its audit committee, is permissible, the group said.

“All aspects of government have a duty to conform to both the constraints of their power and constitutional limitations on such power,” Little said.

An SEC representative declined to comment.

No Problem Here

Gensler disputed violations of the Exchange Act in August when the SEC approved Nasdaq’s board diversity rules. The regulations reflect demands from investors for greater transparency about company leaders, he said.

The rules don’t infringe on the First Amendment either because board composition disclosures are routinely made, according to Nasdaq.

A vast majority of the 100 biggest U.S companies, including Starbucks Corp., Verizon Communications Inc., and Target Corp., disclose the racial and ethnic makeup of the board directors or nominees, according to advocacy group JUST Capital.

Nasdaq also doesn’t require companies to convey any specific message about why they don’t have a diverse board if they don’t have one, the exchange said.

“I’m not convinced the suits challenging Nasdaq’s rules will prevail, but they certainly may delay implementation,” Berkenblit said.

The SEC has heard concerns about unconstitutional ESG disclosures before. Republicans and business groups previously warned the agency it could violate the First Amendment by compelling companies to make climate change disclosures that normal investors aren’t seeking.

“Public companies are having to deal with ESG,” Krus said. “To not have it also included in your public documents, it doesn’t seem like that’s where we’re going to end up.”

To contact the reporter on this story: Andrew Ramonas in Washington at aramonas@bloomberglaw.com

To contact the editors responsible for this story: Michael Ferullo at mferullo@bloomberglaw.com; Roger Yu at ryu@bloomberglaw.com

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