Fifth Circuit Strikes Down Nasdaq Diversity Disclosure Rule

On December 11, 2024, in Alliance for Fair Board Recruitment v. SEC,¹ the United States Court of Appeals for the Fifth Circuit struck down a rule proposed by Nasdaq and approved by the U.S. Securities and Exchange Commission (the "SEC") that would have required most Nasdaq-listed companies to disclose statistical information relating to board diversity and to have, or explain why they do not have, at least two diverse directors.² By a 9-8 vote, the majority of the Circuit court held that the disclosure requirements were not related to the goals of protecting investors from speculative, manipulative and fraudulent practices and promoting competition in the market for securities transactions-which the majority considered the primary purposes of the Securities and Exchange Act of 1934 (the "Exchange Act")-and that the SEC's determination that the proposed rule was consistent with the requirements of the Exchange Act was "arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law."³

Background

The Nasdaq Stock Market LLC first submitted to the SEC in December 2020⁴ a proposal for promoting transparency into the board diversity of Nasdaq-listed companies. Nasdaq amended its proposal in February 2021 after the SEC received over 200 comment letters from issuers, investors, asset managers and other stakeholders. The rule as amended required each Nasdaq-listed company (subject to certain exceptions) to (i) have at least two "Diverse" directors or explain why it does not and (ii) disclose, in aggregated form, information on the voluntary self-identified gender, racial characteristics, and LGBTQ+ status of the company's board. On August 6, 2021, the SEC approved the proposed rule, determining that the disclosure would contribute to the maintenance of fair and orderly markets and "promote just and equitable principles of trade, remove impediments to and perfect the mechanism of a free and open market and a national system, and protect investors and the public interest" in accordance with Section 6(b)(5) of the Exchange Act.⁵

The Alliance for Fair Board Recruitment and the National Center for Public Policy Research filed suit challenging the rule, claiming that it violated the First and Fourteenth Amendments to the U.S. Constitution and that the rule exceeded the SEC's authority under the Exchange Act and the Administrative Procedure Act (the "APA").

On October 18, 2023, a three-judge panel of the Fifth Circuit dismissed the challenge.⁶ The panel held that the SEC's approval of the rule complied with the Exchange Act and the APA, and that the Alliance for Fair Board Recruitment and the National Center for Public Policy Research argument that disclosure requirements had to be related to material information within the scope of the Exchange Act did not apply. The panel rejected the constitutional claims because Nasdaq is a private entity, not a government institution or state actor. The Alliance for Fair Board Recruitment and the National Center for Public Policy Research petitioned the Fifth Circuit court to review the case en banc, which the court granted on February 19, 2024.

The Majority Decision

The Fifth Circuit majority held that the SEC's approval of the Nasdaq disclosure rule was "arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law" as the rule was not related to Nasdaq's role as established by the Exchange Act.⁷

The Primary Purpose of the Exchange Act Is to Prevent Fraudulent Practices

The majority holding relies in large part on a view that the Exchange Act's primary goals are those stated in the statute's preamble and legislative-purpose section: to "prevent inequitable and unfair practices on [securities] exchanges and markets" and "to stamp out 'excessive speculation,' which causes 'unreasonable fluctuations' in 'the volume of credit available for trade, transportation, and industry in interstate commerce' and 'hinder[s] the proper appraisal of the value of securities.'"⁸ The majority reaches this view after tracing the history of stock exchanges in America, noting that the Exchange Act and SEC's regulatory regime primarily developed to address the issue of rampant fraud in the 1920s.

The decision also emphasizes the amendments to the Exchange Act passed in 1975, which narrowed self-regulatory organizations' ("SRO") authority to regulate matters "not inconsistent with" the Exchange Act to matters "related to the purpose" of the Exchange Act.⁹ The court focuses on Section 6(b)(5) of the Exchange Act, which states that a stock exchange can only be registered as a national securities exchange if the SEC determines that:

"The rules of the exchange are designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information with respect to, and facilitating transactions in securities, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest; and are not designed to permit unfair discrimination between customers, issuers, brokers, or dealers, or to regulate by virtue of any authority conferred by this chapter matters not related to the purposes of this chapter or the administration of the exchange."¹⁰

As such, in the opinion of the majority, SROs can only adopt rules, and the SEC is only authorized to approve SRO rules, that are related to the purpose of preventing fraudulent and manipulative acts and practices or to one of the other delineated purposes as read in the context of the provision as a whole.

The Disclosure Rule Does Not Relate to the Purpose of the Exchange Act

The SEC argued that the disclosure rule is in fact related to the purposes listed in Section 6(b)(5) of the Exchange Act in that it is designed to:

• promote "just and equitable principles of trade";
• "remove impediments to and perfect the mechanism of a free and open market and a national market system"; and
• "protect investors and the public interest" by making desired information available to investors.

The court, however, considered these asserted connections to be no more than "passing citations" to the statute.¹¹

The majority held that the disclosure rule is "far removed" from the application of securities exchange rules that do promote "just and equitable principles of trade."¹² In the court's view, the purpose of the "just and equitable" provision as applied in practice is to enforce rules that discipline exchange members for securities law violations, charging unreasonable rates, withholding customer money, and so on. By contrast, "[i]t is not unethical for a company to decline to disclose information about the racial, gender, and LGTBQ+ characteristics of its directors."¹³

The majority also rejected the SEC's argument that the diversity rule would "remove impediments to and perfect the mechanism of a free and open market and a national market system." The court held that this provision is aimed at reducing transaction costs associated with executing securities trades; although providing investors with information to make sound investment decisions "might be a good idea,"¹⁴ it is not related to the free-market prong of Section 6(b)(5).

The majority also took issue with the SEC's reading of the "protect investors and the public interest" prong. The court held as a matter of statutory interpretation that this general phrasing could only be understood in light of the harms that the Exchange Act explicitly lists as its targets: speculation, manipulation, fraud and anticompetitive exchange behavior.¹⁵ The court highlighted Nasdaq's majority-independent board requirement as an example of a rule that addresses those concerns, as that rule seeks to ensure accurate and reliable disclosures and financial reporting. By contrast, the court asked rhetorically what public interest is served by the Nasdaq disclosure rule, questioning whether there is any empirical "or even logical link between the racial, gender, and sexual composition of a company's board and the quality of its governance."¹⁶

The "Major Questions" Doctrine Supports the Majority's Interpretation of the Exchange Act

The Fifth Circuit majority held that the major-questions doctrine confirms the court's interpretation of the Exchange Act's ordinary meaning. The doctrine provides that with respect to issues of major national significance-in this case, the new disclosure mandate-a regulatory agency must have clear statutory authorization to take action and cannot rely on its general agency authority. The court held that the question holds economic significance owing to Nasdaq's status as the second-largest stock exchange in the world, and that the political significance of the issue is "likewise staggering."¹⁷ The SEC, meanwhile, would be stepping outside the "ordinary regulatory domain of market manipulation and proxy voting" and into the domain of corporate law-a body of law governed by the states-by effectively forcing boards of directors across the country to reconfigure in response to the rule.¹⁸

The SEC and Nasdaq offered several arguments in response, principally that the rule is a mere disclosure requirement and does not encroach on corporate law, and that enabling full disclosure is in fact a core purpose of the Exchange Act under Supreme Court precedent that the SEC is therefore authorized to regulate.

The court rejected these arguments. To the claim that the rule is merely interested in disclosure, the court noted the language in the adopting release stating that the rule sets forth "aspirational diversity objectives" (even if not explicit mandates). The court also described the rule's requirement to explain why a company has not satisfied the diversity standard as not a disclosure requirement but a "public-shaming penalty."¹⁹

The court also took issue with the SEC and Nasdaq's interpretation of Supreme Court precedent. In the court's reading, the Supreme Court has not said that full disclosure is a core requirement of the Exchange Act, but that the Exchange Act "substitute[s] a philosophy of full disclosure for the philosophy of caveat emptor" for the sake of "achiev[ing] a high standard of business ethics in the securities industry."²⁰ As such, disclosure is not a self-justifying end, but a means toward promoting ethical behavior.

The Dissent

The dissenting opinion comes at the issue from an entirely different perspective. The dissent notes that Nasdaq is a private company, not a government actor, entering into voluntary contractual agreements with companies wishing to list on the exchange. Under Section 6(b) of the Exchange Act, the SEC "shall" approve a rule proposed by an exchange "if it finds" that the rule is "consistent with the requirements" of the Exchange Act.²¹ Interpreting the word "shall" as a term of obligation, the dissent reads the statute as obligating the SEC to approve an SRO's proposed rule if it is consistent with the Exchange Act and not substitute its own policy instead.

The dissent addresses the majority's view that only preventing market abuses and eliminating fraudulent behavior are the concerns of SROs per the Exchange Act. The dissent highlights well-established case law stating that the elimination of information asymmetries regarding corporate board leadership is also a core concern of the Exchange Act.

The dissent also picks up on the majority's apparent disinterest in the stated desires of major institutional investors to obtain consistently presented board-composition information. The dissent notes that a wide range of investors seek this information and that Nasdaq "cannot be characterized as responding only to the whims of a few activist institutional investors."²²

Takeaways

As a direct result of the decision in Alliance for Fair Board Recruitment, Nasdaq-listed companies will not be required to make the board-diversity disclosures that would have been mandated by the Nasdaq rule, pending the outcome of any appeal. Nasdaq has indicated that it does not intend to take further action in the litigation, although the SEC has been less committal and could appeal to the Supreme Court.

Although the standardized disclosures of the Nasdaq rule may never become obligatory, public companies in recent years have faced other sources of pressure to provide board-diversity disclosure. Some institutional shareholders, customers and end users have encouraged similar disclosures in some cases, while the major proxy advisory firms have adopted policies to make negative recommendations in specific instances of failure to diversify the board. Perhaps that pressure may persist. Or perhaps this case coincides with a more general shift in attitudes towards such disclosure.

Beyond the immediate effect on the Nasdaq disclosure rule, the Fifth Circuit court has signaled to the market that it stands ready to strike any SEC rulemaking not clearly related to the purpose of preventing fraudulent practices. The majority decision engages in a kind of strict-constructionist analysis of the statute, placing emphasis on the wording that suggests that all SEC and SRO rulemaking must fundamentally be concerned with prevention of fraud. In so doing, it rejects the view that rulemaking may be justified on the grounds that it provides the information necessary for price discovery, or that the SEC and stock exchanges should be responsive to the stated desires of investors who seek a certain type of information on a consistent basis.

The court's meditation on the major-questions doctrine also suggests skepticism on its part toward any rule or regulation that ventures beyond the express core purposes of a statute. For example, consider the SEC's proposed rules for climate-related disclosures-already stayed by a panel of the Fifth Circuit court.²³ Those rules would apparently be the type of rulemaking that falls under a broader conception of the SEC's regulatory authority, as they mandate information that is sought by major market participants and they enable accurate price discovery in an environment of increasing climate change. But under the Fifth Circuit's narrower reading of the SEC's authority under the Exchange Act, it becomes much harder to find a purpose of the climate rules having to do with prevention of fraud. At the same time, if board-diversity disclosures could be considered economically and politically significant enough to implicate a "major question," the proposed climate-related disclosures would easily qualify as well.

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