Will Nasdaq’s Diversity Rules Harm Investors?

Jesse M. Fried is Dane Professor of Law at Harvard Law School. This post is based on his recent paper. Related research from the Program on Corporate Governance includes Politics and Gender in the Executive Suite by Alma Cohen, Moshe Hazan, and David Weiss (discussed on the Forum here).

In December 2020, Nasdaq asked the Securities and Exchange Commission (SEC) to approve new diversity rules. The aim is for Nasdaq-listed firms to have at least one director self-identifying as female and another self-identifying as an underrepresented minority or LGBTQ+. To avoid forced delisting, a firm must “diversify or explain”: either have two such diverse directors, or say why it does not. Nasdaq also wants firms to disclose every director’s self-identified race, gender, and LGBTQ+ status.

While tipping its hat to the social justice movement, Nasdaq justifies the proposed rules by claiming the rules will benefit investors. Nasdaq’s 271-page proposal to the SEC cites numerous studies in an attempt to support this claim.

In a paper recently posted on SSRN, Will Nasdaq’s Diversity Rules Harm Investors?, I explain that the empirical evidence provides little support for the notion that gender or ethnic diversity in the boardroom increases shareholder value. In fact, rigorous scholarship—much of it by leading female economists—suggests that increasing board diversity can actually lead to lower share prices. The adoption of Nasdaq’s proposed rules may well generate substantial risks for investors.

The paper begins by examining Nasdaq’s evidence of the purported link between diverse boards and stock returns. Nasdaq relies almost entirely on reports—prepared by consulting and financial firms for marketing purposes—that claim to find a correlation between the two. But these reports are not academic studies; rather, they are aimed at attracting clients. More importantly, correlation does not imply causation. Other factors, such as firm size or industry, could explain both higher returns and a more diverse board. To prove causation, sophisticated statistical techniques are needed to control for omitted variables of this kind.

On the link between diversity and shareholder value, Nasdaq cites only three studies that go beyond mere correlation. The first is a cryptic claim made by the Carlyle Group in marketing materials. The second is a 2003 academic paper whose failure to adequately control for omitted variables was subsequently noted in a leading finance journal. The third is a high-quality study that shows a positive effect of board diversity on shareholder value. But this high-quality study measures diversity as a single variable that blends together six components—gender, ethnicity, age, college attended, financial expertise, and other board experience. The results generally hold even when any one of the individual components is omitted. Thus, the paper cannot show that the gender or ethnic diversity of the board improves financial performance.

Nasdaq cannot cite any high-quality study showing that board gender or ethnic diversity boosts returns, because there has been none. In fact, there is a sizeable body of academic work reporting the opposite result: diversifying boards can harm financial performance. Troublingly, Nasdaq fails to engage with—or even report—this evidence.

Consider a 2009 study of almost 2,000 U.S. firms by Renee Adams and Daniel Ferreira. Nasdaq is obviously aware of the work: it repeatedly highlights the paper’s findings that boards with female directors have better attendance records and impose greater oversight over CEOs. But Nasdaq omits the paper’s bottom line: “the average effect of gender diversity on firm performance is negative.” Why? Apparently, greater gender diversity in boards leads to excessive monitoring of executives. The paper’s key finding is troubling; so is Nasdaq’s failure to acknowledge it.

Nasdaq also fails to note several studies demonstrating that stock returns suffer when firms are pressured to hire new directors for diversity reasons. A famous 2012 paper by Kenneth Ahern and Amy Dittmar, published in one of the world’s leading economic journals, focuses on Norway’s 2003 board gender law. The paper shows that passing the law caused an immediate 3.5% decrease in the stock prices of firms without female directors, along with lower stock prices at these firms over the next few years. The apparent reason: firms were forced to replace more experienced male directors with less experienced female ones.

Turning back to America, several recent papers examine California’s 2018 board gender law. The law required U.S.-listed firms with California headquarters to have at least one female director by the end of 2019, and at least two by the end of 2021. Firms can avoid complying by paying penalties that, for a public company, are relatively modest, between $100,000 and $900,000 per year. For many firms, this is less than the cost of adding an additional board member.

But California’s law, like Nasdaq’s proposal, publicizes noncompliance to name and shame firms into diversifying. The law’s announcement caused stock prices of affected firms to drop by a market-adjusted 2.6%, with a mean value loss of $328.31 million. This far exceeds the present value of potential noncompliance penalties. The paper partially attributes the decrease to the costs associated with changing boards. Other papers report similar findings.

Nasdaq could argue that its proposed rules, unlike California’s gender law, do not actually require a firm change its board or pay a penalty. A firm can always leave the board unchanged and explain why the board is insufficiently diverse. From investors’ perspective, Nasdaq’s rules ideally would lead to changes in boards only when increasing diversity improves—or at least does not harm—financial performance. Otherwise, boards would remain unaffected.

But can investors count on this rosy result? Not necessarily. The sharply negative stock-price reaction to California’s law cannot be explained by the modest penalties imposed on non-compliant firms. But it is consistent with an expectation that directors, fearing controversy, will be improperly pressured into making board changes that harm shareholders. Nasdaq’s rules—including its request for every director’s diversity status—are designed to have the same naming-and-shaming effect. Many boards will feel that explaining is not actually a feasible alternative to complying.

As pressuring firms to diversify boards appears to be value-destroying, SEC approval of Nasdaq’s diversity rules can be expected to cause market-adjusted declines in the share prices of affected firms. Should the SEC approve Nasdaq’s proposed rules, do not expect investors to cheer.

The full paper is available here.

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