NASDAQ Board Diversity Rule Upheld by Fifth Circuit

The U.S. Court of Appeals for the Fifth Circuit recently upheld the NASDAQ Board Diversity Rule. This rule, aimed at public disclosure and transparency, stipulates that companies listed on the NASDAQ stock exchange should have a diverse board of directors or provide a compelling explanation for any deviations from that guideline.

Understanding the NASDAQ Diversity Rule

The National Association of Securities Dealers Automated Quotations Stock Market (NASDAQ) is a major American stock exchange that handles global securities trading. It is the highest volume stock trading exchange in the United States and is second only to the New York Stock Exchange (NYSE) in market capitalization. The exchange set precedent with its Board Diversity Rule.

In a prior judicial test of board diversity rules, two California state laws mandating board were overturned by the courts on constitutional grounds. The NASDAQ rule did not follow the mandate model; it established a disclosure and reporting—essentially, a comply or explain—model.

The rule expects that NASDAQ-listed companies should have two diverse board members in terms of gender and demographic background. The rule takes into account the public company board nominating and governance process and allows for a transition period. NASDAQ companies should have at least one director who identifies as female, an underrepresented race or ethnicity, or LGBTQ+ by the end of 2023. By the end of 2026, companies are generally expected to have two diverse directors to satisfy the rule, with flexibility provided for Smaller Reporting Companies and Foreign Issuers.

If a company fails to meet the diversity requirement, they are obliged to explain why. Furthermore, companies must annually disclose how their board members identify in terms of gender, race and sexual orientation utilizing the NASDAQ Board Diversity Matrix. 

The Legal Challenge to the Rule

The National Center for Public Policy Research and the Alliance for Fair Board Recruitment, headed by a conservative legal activist, sought to obstruct the diversity rule. They filed a lawsuit against the U.S. Securities and Exchange Commission (SEC), which had previously approved the NASDAQ rule, in August 2021.

The petitioners argued that the rule contravened the U.S. Constitution's prohibition of discriminatory laws and free speech restrictions. They contended that these government restrictions extended to NASDAQ, as the SEC could penalize the exchange for failing to enforce the rule. They also alleged violations of the Securities Exchange Act (Exchange Act) and the Administrative Procedure Act (APA).

The Fifth Circuit Court's Decision

Kristyn Noeth, Founder of Verde Impact and Verde Legal, spoke to Bloomberg Law reporter Andrew Ramonas ahead of the oral argument in the case and said: "The NASDAQ disclosure rule is likely the best model going forward" and "the social and corporate value of the rule certainly weight in its favor" (NASDAQ Diversity Rule Challenge article, Bloomberg Law).

The Fifth Circuit upheld the NASDAQ diversity rule and issued a sound panel opinion in October 2023. The court determined that the SEC acted within its statutory authority and was correct in considering the importance of diversity data to investors in making investment decisions.

The court further noted the rule's disclosure model and the role of standardized information on board diversity in the marketplace. The unanimous panel of three judges ruled that the constitutional challenges fell short as NASDAQ is regulated by the SEC but is not a state actor, and that the petitioners gave no reason to conclude that the SEC's approval of the rule violated the Exchange Act or the APA.

The Value of Diversity Information for Investors

In approving the rule, the SEC found substantial evidence to support the view that information on board diversity would inform market behavior. The SEC determined that the rule would provide "information that would contribute to investors' investment and voting decisions." The findings were based on industry demand and various letters from institutional investors.

The court underscored that investors deem board diversity information crucial to their investment decisions. The court also pointed out that the SEC could consider subjective opinions of investors as relevant evidence to meet the substantial evidence standard.

Key Takeaways from the Court's Decision

The validation of the NASDAQ Board Diversity Rule by the Fifth Circuit has several implications:

1. Reinforced Importance of Board Diversity

The court's decision underlines the significance of board diversity in the corporate world. It emphasizes that promoting inclusivity within corporate boards is not just an ideal, but a necessary criterion that public companies must strive to meet.

2. Emphasis on Transparency

The ruling underscores the need for transparency in disclosing board diversity statistics. The court supported the rule's provision requiring companies to disclose the demographic makeup of their boards annually.

3. Enhanced Accountability

The rule holds companies accountable for their board composition. Companies that fail to meet the diversity standards must provide an explanation to investors and other stakeholders, which could catalyze corporate action.

4. Affirmed Value of Diversity Data for Investors

The court's decision affirms the importance of diversity data for investors. It is a clear indication that investors value this information and that it impacts their investment and voting decisions.

The Fifth Circuit's decision upholding the NASDAQ Diversity Rule is a landmark moment in the push for increased diversity within corporate boards. It emphasizes the importance of such diversity, the need for transparency and the relevance of standardized information in the marketplace. The court’s validation of the rule has the potential to advance diversity and representation with positive implications for recruitment, training, retention and access to opportunity in the corporate sector and beyond.

©2023 Verde Impact LLC. For more information on board diversity and corporate governance, contact Verde Impact at info@verdeimpact.com.