By Anne Sherry, J.D.
The leader of a challenge to Nasdaq’s board-diversity rule is asking the full Fifth Circuit to rehear the case. Last week, a three-judge panel held that the SEC properly used its Exchange Act authority in approving the rule and that the matter was not subject to constitutional restriction. In its petition for rehearing en banc, the Alliance for Fair Board Recruitment argues that the SEC’s approval of what AFBR calls a discriminatory rule is unconstitutional and that the rule is not justified just because some industry participants want more information about board demographics (Alliance for Fair Board Recruitment v. SEC, October 25, 2023).
Background. The comply-or-explain rule directs listed companies to maintain at least two diverse directors or provide an explanation why not. In approving the Nasdaq rule in August 2021, the SEC observed that while the proposal may have the effect of increasing board diversity, it does not require any particular board composition. Companies that provide an explanation for not meeting the rule’s diversity objectives will be deemed in compliance, and Nasdaq will not assess the substance of or reasoning behind the explanation. Furthermore, “companies that object to providing any explanation can choose instead to list on a different exchange,” the SEC noted.
Alliance for Fair Board Recruitment (AFBR) and the National Center for Public Policy Research (NCPPR) challenged the rule as violating the First and Fourteenth Amendments, as well as the SEC’s statutory obligations under the Exchange Act and the Administrative Procedure Act. But a Fifth Circuit panel upheld the SEC’s approval, emphasizing that the fundamental purpose of the Exchange Act is to promote full disclosure. The panel first held that Nasdaq is a private actor not subject to constitutional restraint before determining that the SEC properly exercised its authority under the Exchange Act in approving the rule.
Petition for rehearing. In its petition for rehearing en banc, AFBR writes that the case raises two questions that warrant the full court’s attention. The first issue is whether approval of the rule is unconstitutional state action; the second is whether the rule is justified under the Exchange Act on the sole basis that some stakeholders asked for it.
AFBR cites the Supreme Court’s language in Moose Lodge No. 107 v. Irvis (U.S. 1972) that a “regulation [that] requires compliance by [a private party] with provisions of its bylaws containing racially discriminatory provisions” is unconstitutional state action. This test has never been overruled and exactly describes approval of the Nasdaq rule, AFBR submits, yet the Fifth Circuit panel distinguished Moose Lodge because the instant case does not involve a direct enforcement action against Nasdaq for failing to enforce the rule. AFBR says this is wrong because the Exchange Act requires enforcement now that the rule has been approved, and Moose Lodge never said that a challenge could be raised only in the context of an enforcement action.
The SEC’s approval of a discriminatory rule, in AFBR’s view, is in itself a violation of equal protection and thus state action. “By approving the Rule, which would otherwise be invalid, the SEC undoubtedly encouraged discrimination during board hiring that otherwise would not occur. That is the Rule’s entire purpose.” The panel never addressed this argument, AFBR writes. The panel also departed from binding circuit precedent by wrongly calling a discussion of constitutional standards dicta.
Furthermore, AFBR characterizes the panel’s Exchange Act holding as allowing the SEC to approve the rule on the theory that “a handful of financial activists wanted the information and wanted companies to choose their boards based on race and sex.” (The panel opinion notes: “substantial evidence supports the SEC’s finding that Nasdaq’s rule would provide information that would contribute to investors’ investment and voting decisions. … In support, the SEC cited statements from Vanguard, State Street Global Advisors, and BlackRock that call for companies to disclose board diversity information, petitions for [SEC] rulemaking from groups of institutional investors, and comments from Goldman Sachs, Microsoft, and Facebook, among other market participants.” (Internal quotations omitted)).
AFBR asserts that this is not a valid basis under the Exchange Act, which allows the SEC to mandate disclosures only of material information. But the SEC’s approval order found that the link between diversity and performance is inconclusive, making this demographic information immaterial and beyond the agency’s disclosure authority, AFBR writes. And the desire for information cannot explain imposing target quotas, the group concludes.
The case is No. 21-60626.