On Friday, August 6, 2021, the SEC approved a Nasdaq proposal for new listing rules regarding board diversity and disclosure, accompanied by a proposal to provide free access to a board recruiting service. The new listing rules adopted a "comply or explain" mandate for board diversity for most listed companies and required companies listed on Nasdaq's U.S. exchange to publicly disclose "consistent, transparent diversity statistics" regarding the composition of their boards. (See this PubCo post.) As anticipated, a court challenge to these rules didn't take long to materialize. On Monday, August 9, the Alliance for Fair Board Recruitment filed a slim petition under Section 25(a) of the Exchange Act in the Fifth Circuit Court of Appeals—the Alliance has its principal place of business in Texas—for review of the SEC's final order approving the Nasdaq rule. (See this PubCo post.) That petition was soon followed by a new petition challenging the rules filed by the National Center for Public Policy Research and subsequently transferred to the Fifth Circuit where the earlier filed petition was pending. (See this PubCo post.) Last week, a three-judge panel of the Fifth Circuit heard oral argument in the case, Alliance for Fair Board Recruitment, National Center for Public Policy Research v. SEC. Did it signal a result?

The Nasdaq board diversity rule sets a "recommended objective" for most Nasdaq-listed companies to have at least two diverse directors on their boards; if they do not meet that objective, they would need to explain their rationales for not doing so. Companies with five or fewer directors may satisfy the recommended objective with one director from a diverse background rather than two. The rule also requires listed companies to provide annually, in a board diversity matrix format, statistical information regarding the company's board of directors related to the directors' self-identified gender, race and self-identification as LGBTQ+. A person is "diverse" under the rule who "self-identifies in one or more of the following categories: (i) Female, (ii) Underrepresented Minority or (iii) LGBTQ+." These terms are all defined—and sub-defined—in the rules. For example, an "underrepresented minority" is defined as someone who is "Black or African American, Hispanic or Latinx, Asian, Native American or Alaska Native, Native Hawaiian or Pacific Islander, or Two or More Races or Ethnicities"; all of those terms are also defined. Separately, Nasdaq also provides Nasdaq-listed companies with one-year of complimentary access to a board recruiting solution to help identify board-ready diverse candidates. (See this PubCo post.)

If a company elects disclosure in lieu of compliance with the diversity objectives, the company is required to identify the applicable requirements and explain the reasons why it did not satisfy them. Nasdaq said that it "would not evaluate the substance or merits of a company's explanation." According to correspondence from Nasdaq's Chief Legal and Regulatory Officer, the company "can choose to disclose as much, or as little, insight into the company's circumstances or diversity philosophy as the company determines, and shareholders may request additional information directly from the company if they need additional information to make an informed voting or investment decision."

To refute potential criticism of the board diversity proposal as a quota in disguise, Nasdaq took great pains to frame its proposals as principally "a disclosure-based framework and not a mandate," a presentation that the SEC embraced. In approving the proposals, the SEC made clear that it had no discretion to modify the proposals and, if it found the rules to be consistent with the Exchange Act, no real choice but to approve the proposals: under the Act, the SEC "'shall approve' a proposal if it finds that the rule is consistent with the requirements of the Act and the rules and regulations applicable to the SRO—including requirements in Section 6(b). The statute does not give the Commission the ability to make any changes to the rule proposal as submitted, or to disapprove the rule proposal on the ground that the Commission would prefer some alternative rule on the same topic." Because the SEC found both proposals to be consistent with the requirements of the Act and the rules and regulations applicable to Nasdaq, the SEC stated in the Order, "[t]he proposed rule changes therefore are required to be and are approved."

SideBar

You probably recall that two Los Angeles Superior Courts have recently struck down as unconstitutional California's legislation mandating that boards of public companies achieve specified levels of board diversity. The first Crest v. Padilla was filed in 2019 by three California taxpayers seeking to prevent implementation and enforcement of SB 826, the board gender diversity law. Framed as a "taxpayer suit," the litigation sought a judgment declaring the expenditure of taxpayer funds to enforce or implement SB 826 to be illegal and an injunction preventing the California Secretary of State from expending taxpayer funds for those purposes, alleging that the law's mandate was an unconstitutional gender-based quota and violated the Equal Protection Provisions of the California Constitution. After a bench trial, the court agreed with the plaintiffs and enjoined implementation and enforcement of the statute. (See this PubCo post.) That verdict followed summary judgment in favor of the same plaintiffs in the second Crest v. Padilla challenging AB 979, California's board diversity statute regarding "underrepresented communities," which was patterned after the board gender diversity statute. The court in that case concluded that the statute violated the equal protection clause of the California Constitution on its face because, in the court's view, it treated similarly situated individuals differently based on suspect racial and other categories that were not justified by a compelling interest, nor was the statute narrowly tailored to address the interests identified. (See this PubCo post.)

It's worth noting that the cases are being appealed, and the California Secretary of State has filed for a writ of supersedeas. In connection with the board gender diversity case (SB 826), the appeals court set dates for briefing on the writ and, in the meantime, temporarily lifted the permanent injunction imposed by the lower court, which had prevented the Secretary from expending taxpayer funds to implement the statute, pending further order of the appeals court.

According to a press release from the New Civil Liberties Alliance, which is representing the NCPPR in this case, the NCPPR "owns shares in many Nasdaq companies," and "argues that SEC has no power to regulate in this field because the rules have nothing to do with fraud or honest markets. The diversity rules fall outside of SEC's regulatory authority under the [Securities Exchange Act], which empowered SEC to regulate securities to ensure honest markets and enforce federal laws that punish fraud. These longstanding laws are being misinterpreted today by SEC to allow the agency, working with Nasdaq, to impose a 'meet quota, explain why, or get delisted' regime." Further, the NCLA contended, "Congress has not and cannot divest its lawmaking power to an administrative agency working with a quasi-public exchange to govern how boards of directors are constituted. These rules plainly violate the due process and equal protection rights of Americans. The rules further compel speech, in violation of the First Amendment, give SEC suspending and dispensing powers, and constitute prerogative warrants and orders in violation of the U.S. Constitution. Additionally, SEC should not be given Chevron or any other kind of deference in interpreting its own regulatory authority."

In their briefs, petitioners argued, among other things, that the Nasdaq listing rules imposed a quota that violates the constitutional right to equal protection by encouraging discrimination against potential board members and compels disclosure of controversial information in violation of the First Amendment. The rule "issued by Nasdaq and approved by SEC constitute[s] state action that is subject to constitutional restraints." In addition, they contended that the "SEC lacked statutory authority to issue the order, which seeks to regulate demographics through the guise of 'financial disclosures.'" Further, they maintained that the SEC's order violates the "Vesting Clause in Article I of the Constitution because it is an exercise of sweeping legislative power to regulate demographics that Congress could not have delegated" and also violates the Administrative Procedure Act.

In their briefs, the SEC and intervenor Nasdaq argued that Exchanges are "for-profit enterprises subject to Commission oversight both in their quasi-governmental role as regulators of their members and in their private, voluntary association with listed companies." They have long had listing standards addressing disclosures and corporate governance, and the SEC's role in reviewing proposed rules is "limited to determining whether the rule is consistent with requirements specified in the Act. If the rule clears the statutory floor, the Commission must approve it regardless of the Commission's own policy views." Nasdaq's rules were proposed "in response to significant and growing market demand for enhanced disclosures regarding diversity on public company boards," and the SEC "reasonably concluded that Nasdaq's rules meet that standard because they will facilitate more consistent and comparable disclosure of information important to investors' investment and voting decisions." The rules don't mandate particular board composition, but rather require that companies that do not meet the diversity goals "provide their shareholders an explanation—in their own words, in as much or as little detail as they choose." Delegation of authority to address board diversity, they maintained, is not really an issue here because Nasdaq is not a state actor nor are exchange listing standards subject to constitutional scrutiny; Nasdaq is a private company that establishes listing rules, and companies "enter into private, voluntary contractual relationships with Nasdaq to list their securities." In addition, under relevant precedent, the SEC's "mere approval of an exchange rule and regulation of exchanges does not convert their private conduct into state action." Rather, they contended, the question is whether the SEC "reasonably concluded, based on substantial evidence, that Nasdaq's rules are consistent with the Act." In addition, they argued that the petitioners' "policy disagreement about the merits of boardroom diversity isn't sufficient to show that the Securities and Exchange Commission's findings lacked substantial evidence or that its conclusion that Nasdaq's rules are consistent with the Securities Exchange Act was arbitrary and capricious."

[Below is based on my notes, so standard caveats apply.]

At the hearing, the arguments came down principally to a couple of key issues highlighted above: whether the adoption of the Nasdaq rule involved state action and whether the SEC exceeded its authority in approving the rule. Attorneys for each of the petitioners argued that the Nasdaq rule, with the imprimatur of the SEC, was facially discriminatory; a rule can't be unconstitutional and consistent with the Exchange Act, they maintained. The Nasdaq rule imposes unprecedented demographic "quota" and disclosure requirements—compelled disclosure that violates the First Amendment; if companies don't provide the disclosure, they can be delisted or face sanctions. In that context, petitioners said, Nasdaq is regulating Americans' speech. But, Judge Stephen Higginson, who was especially active throughout the hearing, interjected: the issues of equal protection and compelled disclosure raise the question of whether Nasdaq is a "state actor." Pointing to precedent from the 70s, petitioners contended that SROs are state actors because their rules are encouraged by or entwined with state action and the action by Nasdaq is fairly attributable to the government because of the SEC's role in enforcement of the Nasdaq rule. (Perhaps the matter was not yet ripe, Higginson suggested, and should wait for enforcement, under a case cited by petitioners.) The SEC appears neutral in its approval of the Nasdaq rule, Higginson noted, but counsel responded that it's not necessary for the government to cause Nasdaq's action. In this case, the SEC encouraged the rulemaking through speeches made by Commissioners Allison Herren Lee and Caroline Crenshaw. Judge Carl Stewart asked whether there was any evidence that Nasdaq was responsive to these speeches? In addition, petitioner contended, even if Nasdaq is considered a private actor, the rule on its face encourages discrimination on the basis of race and sex, in the absence of a record of past discrimination that it is trying to remedy.

Counsel for the SEC argued that most circuits have found that SROs are not state actors. The modern test for state action, she said, has moved away from a doctrine of joint participation to one that looks at the precise action alleged to be unconstitutional and whether there is sufficient government involvement in that action to fairly attribute it to the government. This action, however, was taken by a private company owned by a publicly held company; the government's decision here was simply to determine that the Nasdaq rule was permissible under the statute. In addition, the speeches identified did not represent the SEC in official action. Rather, they were made as criticism of omissions from an SEC rule and did not suggest that the Exchanges should take up the mantle. Are you sure they weren't just made with a wink and a nod indicating the need for a "woke" social justice mission, Higginson asked? No, government officials, she said, make policy statements all the time; they are not evidence of policy positions of the agency and shouldn't be viewed to result in state action. Was the SEC a catalyst, as petitioners argue, Stewart asked? Counsel responded that there was no evidence that the rule was the result of an SEC initiative; rather it was a private initiative by Nasdaq to which the SEC acquiesced. Where does the record show that the SEC was neutral on the matter, Higginson asked. Counsel said that there was an absence of a social justice mission expressed; instead, the statute requires the SEC to approve the rule if consistent with the Act. Here the SEC found that there were demands for the information from a broad swath of investors. The SEC simply acquiesced. Counsel for Nasdaq contended that the Constitution was not an obstacle here but instead protects private contractual relationships between Nasdaq as a private actor and companies choosing to list. Under current precedent, state action would require a level of "pervasive entwinement" not present here. The fact that the petitioners have to rely on two statements from commissioners, she argued, just underscores that petitioners can't meet that test. The rule was a Nasdaq rule and SEC approval does not suffice to convert the adoption into state action.

Petitioners also argued that the SEC's action in approving the Nasdaq rule was beyond its authority; the Exchange Act "can't bear the weight that the SEC and Nasdaq are putting on it." The Act provides that the SEC should approve Exchange rules, but, they maintained, only if they are within certain constraints established by Congress, such as preventing fraud or market manipulation and protecting investors. The Act prohibits the SEC from approving rules that are not within those constraints, but these rules were outside of the SEC's remit. Investor interest is not sufficient, petitioners contended; there must be substantial evidence that the proposal is consistent with the Act, and that would require actual association between the information and the purposes of the Act. Higginson asked whether providing information about the board that investors want and that helps identify new board members might not enhance economic performance? Counsel responded that even the SEC said that the evidence that board diversity benefits economic performance was inconclusive. Higginson asked whether the rules might fit within the concept of promoting "just and equitable principles of trade"? Isn't that determined in the eyes of investors, he asked? Shouldn't investors be able to decide the basis on which they will invest their money? Counsel responded that investors care about getting the best rate of return on their investments—"they don't invest to have their political decisions made for them." Higginson responded that "it sounds like what you're saying is the opposite—you're deciding what the information will be that they receive." The rules say comply or explain: how is that a quota, Higginson asked? The company tells investors about the board and investors decide how to vote and invest.

Counsel for the SEC observed that, under the Act, the SEC "shall approve" the proposed rules if consistent with the Act. The SEC approved the rule in light of the demand for diversity information from a broad swath of investors—not just from a narrow social justice segment. But how is that consistent with the Act, Higginson asked, is there an issue under the APA? Counsel responded that, although the SEC did determine that the evidence of benefit was inconclusive, weighing the benefit—which was a matter of debate—against the absence of any evidence of harm, the SEC acquiesced in approving the proposed rule. By contrast, if, hypothetically, this rule had instead asked for more inflammatory information—such as the hypothetical example Higginson posed that would require information about religious affiliation and practices—there would likely not be a broad record of demand nor the absence of a record of harm to investors and the market, which would militate against approval. Higginson asked whether the issue of delegation in the Fifth Circuit's Jarkesy decision was an issue here (see this PubCo post)? Counsel responded that no, the action by Nasdaq was not the same as government action and here the SEC's decision was guided by clearly delineated principles. Counsel for Nasdaq contended that the SEC's approval was within its authority under the statute because it was designed to further "just and equitable principles of trade" and "to remove impediments to and perfect the mechanism of a free and open market." The SEC, she said, reasonably concluded that the Nasdaq disclosure requirement leveled the playing field for smaller investors that do not have the staff to conduct this type of research into board diversity, thereby addressing information asymmetry in the market. In addition, she noted, this rule touches on matters of corporate governance—a topic that is well within the mainstream of Nasdaq-required disclosure.

In this article, MarketWatch concluded that the appeals court judges "sounded skeptical that the court should overturn the policy." In an interview with MarketWatch after the hearing, an attorney for the NCLA said that "'Nasdaq exercises quasi-governmental powers....Nasdaq gets protected as a government actor when they're being sued in other contexts,'" adding that "he thought the judges 'asked hard and fair questions to both sides.'" Senior counsel for a nonprofit that filed "an amicus brief supporting the SEC and Nasdaq on behalf of academics and experts who have studied board diversity" observed to MarketWatch that "the petitioners have tried to 'present this rule as untethered from empirical research' into the links between board diversity, corporate decision-making and positive company performance. But he said that 'the reality is, effects are very heavily studied... The Nasdaq rule did not come out of nowhere, nor are the calls from investors coming out of nowhere.'" In his view, "the judges' questions showed doubts about the constitutional argument. 'The time and tenor of questioning sounded skeptical of the petitioners' argument that the rule can be challenged on a constitutional argument,'" he said.

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