SEC Approves Nasdaq “Comply-or-Explain” Proposal for Board Diversity

Cydney S. Posner is special counsel at Cooley LLP. This post is based on her Cooley memorandum. 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).

You probably remember that, late last year, Nasdaq filed with the SEC a 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 would adopt a “comply or explain” mandate for board diversity for most listed companies and require companies listed on Nasdaq’s U.S. exchange to publicly disclose “consistent, transparent diversity statistics” regarding the composition of their boards. In March, after Nasdaq amended its proposal, and in June, the Division of Trading and Markets, pursuant to delegated authority, took actions that had the effect of postponing a decision on the proposal—until now. On Friday afternoon, the SEC approved the two proposals.

To refute potential criticism of the board diversity proposal as a quota in disguise, Nasdaq took great pains to frame its proposal as principally “a disclosure-based framework and not a mandate,” a presentation that the SEC’s Order has clearly embraced. 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. The proposal would also require 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+.

Separately, Nasdaq also proposed to provide 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.) In March, in response to public comments, Nasdaq amended its proposal to make compliance a bit easier for smaller companies, providing, among other things, that companies with five or fewer directors may satisfy the recommended objective with one director from a diverse background rather than two and providing a one-year grace period in the event a vacancy on the board brings a company under the recommended diversity objective. (See this PubCo post.)

In approving the proposals, the SEC made clear that it had no discretion to modify the proposal and, if it found the rule 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

That the approval of the proposals was by the SEC and not by the Division of Trading and Markets under delegated authority has some real significance. You might recall that in August 2020, the SEC’s Division of Trading and Markets took action, pursuant to delegated authority, to approve a proposed NYSE rule change that would allow companies going public to raise capital through a primary direct listing. (See this PubCo post.) Five days later, that rule change hit a “snag,” as the WSJ put it—the SEC notified the NYSE that the approval order had been stayed because the SEC had received a notice of intention to petition for review of the approval order. The petition, submitted by the Council of Institutional Investors, was granted in September. It wasn’t until December 2020 that the SEC approved, by a vote of three to two, the NYSE’s proposed rule change, as amended. (See this PubCo post.) By approving the proposals directly, the SEC may have eliminated that particular hiccup.

According to the WSJ, critics of the Nasdaq proposal “have warned that it could be challenged in court. Some conservative groups have argued that the exchange’s diversity rule, if implemented, would violate the U.S. Constitution and civil rights laws.” Of course California’s board diversity laws are facing a number of legal challenges contending that the diversity laws are unconstitutional under the equal protection provisions of the 14th Amendment. (See this PubCo post, this PubCo post, this PubCo post and this PubCo post.) Nasdaq has rejected that claim, arguing that the rule would not be a quota, since a written explanation would suffice if a company failed to satisfy the rule. (Update: the Alliance for Fair Board Recruitment has filed a petition in the Fifth Circuit Court of Appeals for review of the SEC’s final order approving the Nasdaq rule.)

Why this proposal? Although institutional investors and others have been pressuring companies for a number of years to add more diverse board members (see, e.g., this PubCo post, this PubCo post and this PubCo post), the WSJ cited a June analysis from board and executive recruiting firm Spencer Stuart showing that, while there has been a shift, it has not made much of a dent: “big U.S. companies significantly boosted the share of new directors who are Black or Latino this year, and have added more women to their boards in recent years. Nearly 75% of new independent directors at companies in the S&P 500 are women or belong to a racial or ethnic minority, up from about 60% last year and 31% a decade ago…. Still, the shift left around 80% of board seats occupied by white directors and about 70% by men. About 11% of S&P 500 board members are Black, 4% are Latino and 6% are Asian, Spencer Stuart found.”

SideBar

Now that the Nasdaq board diversity rule has been approved, should we expect the NYSE to follow suit? Unlikely. In an interview with Bloomberg, Stacey Cunningham, president of NYSE Group, said that, while she supports Nasdaq’s goal, “she doesn’t think it’s the role of exchanges to try to change society. ‘The data is very, very clear that businesses perform better when there’s more diversity on their board,’ Cunningham [said in late 2020] in a Bloomberg TV interview. However, she added, ‘When we use exchange listing standards to require things like diversity profiles or others, we’re defining the investable universe.’”

The Board Diversity Proposal

Comply or explain. As described by the SEC in the Order, the Board Diversity Proposal establishes a “disclosure-based framework” under Rules 5605(f) and 5606. New Rule 5605(f)(2) will require each Nasdaq-listed company (with specified exceptions) to have, or explain why it does not have, at least two diverse board members, including at least one who self-identifies as female and at least one who self-identifies as an underrepresented minority or LGBTQ+. Under Rule 5605(f)(2)(D), each company with a board of directors of five or fewer members (referred to as a “company with a smaller board”) would need to have, or explain why it does not have, at least one board member who is diverse.

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.

If a company elects disclosure in lieu of compliance with the diversity objectives, the company would be required to identify the applicable requirements and explain the reasons why it did not satisfy them. Nasdaq “would not evaluate the substance or merits of a company’s explanation.” The disclosure must be provided in advance of the company’s next annual meeting of shareholders (1) in a proxy or information statement (or, if a company does not file a proxy, in its Form 10-K or 20-F), or (2) on the company’s website. If the company provides the disclosure on its website, it must submit the disclosure concurrently with its proxy statement and submit a URL link to the disclosure through the Nasdaq Listing Center, within one business day after posting.

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.” He then offered examples of acceptable types of disclosure:

“the company could disclose that ‘The Company does not meet the diversity objectives of Rule 5605(f)(2)(C) because it does not believe Nasdaq’s listing rule is appropriate,’ or ‘because it does not believe achieving Nasdaq’s diversity objectives are feasible given the company’s current circumstances.’ A company who chooses to describe a different approach could explain that, for example, ‘The Company does not meet the diversity objectives of Rule 5605(f)(2)(A) because the Nominations Committee considers a variety of professional, industry, and personal backgrounds and skill sets to provide the Board with the appropriate talent, skills, and expertise to oversee the Company’s business’ or ‘is committed to ensuring that the Board’s composition appropriately reflects the current and anticipated needs of the Board and the company.’”

If the company failed to comply, it would be notified by the Listing Qualifications Department that it had until the later of its next annual shareholders meeting or 180 days from the event that caused the deficiency to cure the deficiency. If a company did not regain compliance within the applicable cure period, the company would receive a Staff Delisting Determination Letter.

Exceptions. Slightly different requirements apply to certain types of companies:

  • Company with a smaller board: Rule 5605(f)(2)(D) would require each company with a board of directors of five or fewer members to have, or explain why it does not have, at least one member of its board of directors who is diverse. If the company had five board members before becoming subject to the rule, it could still add a sixth director to satisfy the diversity objective without becoming subject to the broader objectives. However, subsequent expansions of the board would subject the company to the more extensive diversity objectives.
  • Foreign issuer: Rule 5605(f)(2)(B) would require each foreign issuer (other than a company with a smaller board) to have, or explain why it does not have, at least two diverse members of its board, including at least one diverse director who self-identifies as female. The second diverse director may include an individual who self-identifies as one or more of the following: female, LGBTQ+ or an underrepresented individual. A “foreign issuer” includes a “foreign private issuer” or a “foreign issuer” (Rule 3b-4(b) that has its principal executive offices located outside of the United States. Some of the definitions are slightly different for foreign issuers. For example, “diverse” includes an “underrepresented individual,” which is based on “national, racial, ethnic, indigenous, cultural, religious, or linguistic identity” in the country where the company’s principal executive offices are located.
  • Smaller reporting company: Rule 5605(f)(2)(C) would require each smaller reporting company (as defined in Rule 12b-2, other than a company with a smaller board) to have, or explain why it does not have, at least two diverse members of its board, including at least one diverse director who self-identifies as female. The second diverse director may include an individual who self-identifies as one or more of the following: female, LGBTQ+ or an underrepresented minority.

Diversity matrix. Rule 5606(a) requires each Nasdaq-listed company to disclose, to the extent permitted by applicable law, its board-level diversity data annually in a “Board Diversity Matrix,” or a substantially similar format, that indicates the total number of directors and “(1) the number of directors based on gender identity (female, male, or non-binary) and the number of directors who did not disclose gender; (2) the number of directors based on race and ethnicity (African American or Black, Alaskan Native or Native American, Asian, Hispanic or Latinx, Native Hawaiian or Pacific Islander, White, or Two or More Races or Ethnicities), disaggregated by gender identity (or did not disclose gender); (3) the number of directors who self-identify as LGBTQ+; and (4) the number of directors who did not disclose a demographic background under item (2) or (3) above.” The instructions require companies to publish the Matrix information in a searchable format. Companies are permitted to supplement the disclosure by providing additional information related to its directors. Foreign issuers may elect to use an alternative Board Diversity Matrix format.

Companies will be required to provide the Board Diversity Matrix information at least once a year. The Matrix may be published in advance of the company’s next annual meeting of shareholders in any proxy statement or any information statement (or, if the company does not file a proxy, in its Form 10-K or 20-F) or on the company’s website. If the company provides the disclosure on its website, it must submit the disclosure concurrently with its proxy statement and submit a URL link to the disclosure through the Nasdaq Listing Center, within one business day after posting. The Matrix must be provided in the same manner as, and concurrently with, the company’s explanation for not satisfying the Nasdaq diversity objectives.

After the first year of disclosure, companies will be required to disclose the matrix for the current year and immediately prior year and provide the required disclosures in a proxy statement or information statement (or if a company does not file a proxy, in its Form 10-K or 20-F) in advance of the company’s annual shareholders meeting or provide the required disclosures on the company’s website concurrently with the filing of the company’s proxy statement.

A company that fails to comply would have 45 calendar days after notification to submit a plan to regain compliance. Nasdaq could provide up to 180 days to permit the company to regain compliance. If the company does not submit a plan or regain compliance within the applicable time periods, it would be issued a Staff Delisting Determination, which the company could appeal to a Hearings Panel.

Transition periods. As stated in the Order, the transition periods set forth in Rule 5605(f)(7) for implementation of the diversity rule “recognize the differences (e.g., in demographics or resources) among different types of companies and would not unfairly discriminate among companies.” Under the rule, each company will be required to comply, or explain why it does not comply, as follows:

  • All Nasdaq companies (including companies with smaller boards) will have two years to have at least one diverse director—by the later of August 7, 2023 (that is, the first Monday, two calendar years after the approval date of the proposal), or the date the company files its proxy statement for its annual shareholders meeting during 2023. (Rule 5605(f)(7)(A))
  • Nasdaq Global Select Market (“NGS”) or Nasdaq Global Market (“NGM”) companies will have four years to have at least two diverse directors—by the later of August 6, 2025 (four calendar years after the approval date of the proposal), or the date the company files its proxy statement for its annual shareholders meeting during 2025 (Rule 5605(f)(7)(B))
  • Nasdaq Capital Market (“NCM”) companies will have five years to have at least two diverse directors—by the later of August 6, 2026 (five calendar years after the approval date of the proposal), or the date the company files its proxy statement for its annual shareholders meeting during 2026. (Rule 5605(f)(7)(C))

Under Rule 5605(f)(6)(B), a company that has satisfied the diversity objectives within the applicable timeframes, but later ceases to satisfy them because of a board vacancy would have a grace period until the later of one year from the date of vacancy or the date the company files its proxy statement in the calendar year following the year of the date of vacancy to satisfy Rule 5605(f)(2) or (3). For its explanation, the company may publicly disclose that it is relying on the grace period provided by Rule 5605(f)(6)(B). This disclosure must be provided in advance of the company’s next annual meeting in its proxy statement or, as described above, on the company’s website.

Rule 5606 (the diversity matrix) will become operative one year after SEC approval. A company will be required to be in compliance with Rule 5606 by the later of August 8, 2022 (that is, the first Monday, one calendar year from the approval date) or the date the company files its proxy statement for its annual meeting of shareholders during 2022.

All references to “proxy statements” include information statements, or if the company does not file a proxy statement, its Form 10-K or 20-F.

Phase-in periods. Rule 5605(f)(5) provides for various phase-in periods, depending on the particular Nasdaq market, for any company newly listing on Nasdaq (that was not previously subject to a substantially similar requirement of another exchange), such as through an IPO, direct listing, spin-off, transfer from another exchange or de-SPAC merger, and for any company that ceases to be a foreign Issuer, a smaller reporting company or an exempt company. “Exempt companies” include companies such as acquisition companies (SPACs), asset-backed issuers and cooperatives. Under the rule, each company would need to comply, or explain why it does not comply, as follows:

  • NGS or NGM company will have (i) one year to have at least one diverse director—by the later of one year from the date of listing, or the date the company files its proxy statement for its first annual meeting of shareholders subsequent to listing; and (ii) two years to have at least two diverse directors—by the later of two years from the date of listing, or the date the company files its proxy statement for its second annual meeting subsequent to listing. (Rule 5605(f)(5)(A))
  • NCM company will have two years to have at least two diverse directors—by the later of two years from the date of listing, or the date the company files its proxy for its second annual meeting of shareholders subsequent to listing. (Rule 5605(f)(5)(B))
  • Company with a smaller board will have two years to have at least one diverse director—by the later of two years from the date of listing, or the date the company files its proxy statement for its second annual meeting of shareholders subsequent to its listing. (Rule 5605(f)(5)(D))
  • Company that ceases to be a foreign issuer, smaller reporting company or exempt company will have one year to satisfy the applicable requirements—by the later of one year from the date that the company no longer qualifies as a foreign issuer, smaller reporting company or exempt company, or the date the company files its proxy statement for the company’s first annual meeting of shareholders subsequent to such event. (Rule 5605(f)(5)(C)) Note that acquisition companies, i.e., SPACs, are included among the exempt companies, but under Rule 5605(f), upon completion of a business combination with an operating company, the post-business combination entity would be provided the same phase-in period as other newly listed companies to satisfy the requirements of proposed Rule 5605(f).

All references to “proxy statements” include information statements, or, if the company does not file a proxy statement, its Form 10-K or 20-F.

Board Recruiting Service Proposal

In a separate proposal, Nasdaq would offer “eligible companies” one year of complimentary access for two users to a board recruiting service, “which would provide access to a network of board-ready diverse candidates for companies to identify and evaluate.” This proposal was designed to assist listed companies to increase the diversity of their boards, which Nasdaq “believes could result in improved corporate governance, strengthening of market integrity, and improved investor confidence.” While the service is optional, it could help companies to achieve compliance with the board diversity proposal.

An “eligible company” is a listed company that represents to Nasdaq that it does not have: (i) at least one director who self-identifies as female; and (ii) at least one director who self-identifies as an underrepresented minority or LGBTQ+. Different definitions would apply to foreign issuers and smaller reporting companies. A company that is not eligible may still receive complimentary 90-day access. Nasdaq believes that “eligible companies” have the greatest need for assistance.

Nasdaq rationale

Nasdaq indicated that, among its reasons for the proposal, “while some companies have made progress in diversifying their boardrooms, the national market system and the public interest would be well-served by a ‘disclosure-based, business driven’ framework for companies to embrace meaningful and multi-dimensional diversification of their boards.” While some commenters viewed the rule as imposing a de facto quota, Nasdaq rejected that characterization, insisting that “the Board Diversity Proposal would establish a disclosure-based framework and not a mandate or quota.” According to Nasdaq, proposed Rule 5605(f) would set forth only “‘aspirational diversity objectives’ and not quotas, mandates, or set-asides, and companies that do not meet the objectives need only explain why they do not.” Moreover, Nasdaq asserted, the proposal “would not require any particular board composition or require a company to select directors based on any criteria other than an individual’s qualifications for the position. The Exchange believes that its proposal would balance the calls of investors for companies to increase diverse representation on their boards with the need for companies to maintain flexibility and decision-making authority over their board composition.” For companies that “prefer not to explain their approach to board diversity for various reasons, such as concerns regarding perceived reputational, legal, or other harm[,] the proposal could mitigate potential concerns by giving companies substantial flexibility in crafting the required explanation—including how much detail to provide—and the Exchange would not evaluate the substance of the explanation.”

In addition, Nasdaq indicated that “it has reviewed dozens of empirical studies and found that an extensive body of empirical research demonstrates that diverse boards are positively associated with improved corporate governance and company performance.” According to Nasdaq, there is also “substantial evidence that board diversity promotes investor protection, including by enhancing the quality of a company’s financial reporting, internal controls, public disclosures, and management oversight,” such as by “reducing ‘groupthink’ and improving decision-making.”

Although some commenters contended that “the perceived investor demand for diverse boards and diversity information is overstated,” in its discussions with market participants and stakeholders, Nasdaq found “strong support for disclosure requirements that would standardize the reporting of board diversity statistics,” particularly as current reporting of board diversity data is not consistent or comparable. In addition, the current “lack of transparency creates barriers to investment analysis, due diligence, and academic study, and affects investors who are increasingly basing public advocacy, proxy voting, and direct shareholder-company engagement decisions on board diversity considerations.” While the disclosure framework “may influence corporate conduct,” and increase opportunities for diverse candidates, a company that chooses to disclose and not comply would “provide analysts and investors with a better understanding about a company’s reasons for not doing so.”

With regard to the board recruiting service, some commenters expressed concern that the service could create potential conflicts of interest between establishing a regulatory standard and concurrently promoting a revenue-generating compliance solution, Nasdaq responded that “it is not generating any revenue” from the service, companies are not required to use it, and “whether a listed company takes advantage of the complimentary board recruiting service has no relationship to how, or whether, the Exchange would enforce proposed Rule 5605(f), and there are no circumstances under which the Exchange would penalize a company solely for its decision to not take advantage of a complimentary board recruiting service.”

SEC findings and responses

The Order made a number of findings to demonstrate that, in the view of the SEC, both of the proposals were consistent with the requirements of the Exchange Act. According to the Order, the board diversity proposal would “establish a disclosure-based framework that would make consistent and comparable statistics widely available to investors regarding the number of Diverse directors serving on a Nasdaq-listed company’s board.” The SEC found that these statistics are “currently not widely available on a consistent and comparable basis,” although many commenters representing a broad array of investors argued that it was important information for investors. The Proposal would also increase transparency and require an explanation regarding why a company does not meet the Nasdaq objectives if it chooses not to do so. This explanation would augment existing SEC requirements to disclose whether, and how, boards consider diversity in nominating new directors and contribute to investors’ investment and voting decisions, regardless of whether the investor believes that board diversity affects company performance and governance. As a result, the proposal would contribute to the “maintenance of fair and orderly markets, which has previously been found by the Commission to support a finding that an exchange listing standard satisfied the requirements of Section 6(b)(5).”

Some commenters argued that Nasdaq had not adequately demonstrated causation, as opposed to correlation, between board diversity and various benefits attributed to it in the proposal. They also asserted that many of the studies regarding the benefits of board diversity were inconclusive. The SEC observed that the studies were distinguishable because they related to diversity mandates, as opposed to comply-or-explain frameworks. In addition, the SEC contended that the proposal “would mitigate concerns regarding unequal access to information“ among investors and might benefit companies that chose to comply with the diversity objectives. In light of these disclosure benefits, and “given that the studies of the effects of board diversity are generally inconclusive and the costs of the proposal are likely to be comparatively limited,” the SEC found that the proposal was consistent with the requirements of the Act.

In response to comments that the proposal “unfairly discriminates among issuers” by, for example, giving foreign issuers flexibility that is not available to domestic issuers, the SEC found that the proposal was “not designed to permit unfair discrimination between issuers and would not impose a burden on competition between issuers that is not necessary or appropriate in furtherance of the purposes of the Act. As an initial matter, even though the Board Diversity Proposal would establish different diversity objectives and disclosures for different types of Nasdaq-listed companies, it would not mandate any particular board composition for Nasdaq-listed companies, companies that do not meet the applicable diversity objectives would only need to explain their reason(s) for not meeting the objectives and would have substantial flexibility in crafting such an explanation, and directors would not be required to self-identify their Diverse characteristics for purposes of the Board Diversity Matrix.” In addition, the SEC concluded, it was “not unreasonable” for Nasdaq to “take into account the differing demographic compositions of foreign countries and to provide Foreign Issuers flexibility in recognition of the different circumstances associated with Foreign Issuers hiring Diverse directors…. Accordingly, it is not unfairly discriminatory, and does not impose an unnecessary or inappropriate burden on competition, for the Exchange to provide this flexibility to Foreign Issuers.” Similarly, it was “not unreasonable for the Exchange to recognize the unique challenges (including potential resource constraints) faced by Smaller Reporting Companies and Companies with a Smaller Board in meeting the proposed diversity objectives and to provide more flexibility to these companies to the extent they choose to meet the diversity objectives.” Those more flexible diversity objectives were likewise “not unfairly discriminatory,” nor did they “impose an unnecessary or inappropriate burden on competition.”

Some commenters contended that the board diversity proposal was impermissible because it was “designed to address political and social issues and would redefine the purpose of businesses in a way that is unrelated to traditional business purposes (e.g., profitability, obligation to shareholders, satisfying customers, and treating workers and suppliers fairly),” or because the proposal “does not relate to any traditional corporate governance matter,” or generally exceeds Nasdaq’s authority. Nasdaq had responded that it was “performing its duties as an exchange to fashion listing rules that promote good corporate governance,” and that “companies voluntarily list on the Exchange, as a private entity, and choose to submit to the Exchange’s listing rules.”

Sidebar

For example, Republican Senators on the Senate Committee on Banking, Housing, and Urban Affairs, however, submitted a letter asking the SEC to reject the Nasdaq board diversity proposal. While the Senators applauded board diversity as a concept, they believed that Nasdaq was, among other things, acting outside its proper scope as an SRO:

“it is not the role of NASDAQ, as a self-regulatory organization, to act as an arbitrator of social policy or force a prescriptive one-size-fits-all solution upon markets and investors. NASDAQ’s narrow concept of mandated diversity, one that prioritizes race, gender, and sexual orientation, and pressured board diversity, misses the mark. It interferes with a board’s duty to follow its legal obligations to govern in the best interest of the corporation and its shareholders. It violates central principles of materiality that govern securities disclosures, and finally, it harms economic growth by imposing costs on public corporations and discouraging private corporations from going public.”

The Senators also argued that the Nasdaq proposal would interfere with a board’s fiduciary responsibility to govern in the best interests of shareholders, that there was no evidence that diversity caused improved corporate performance, that Nasdaq’s definition of diversity was too narrow and that the proposal was unnecessary because corporations were already seeking to diversify. See this PubCo post.)

The SEC disagreed that the proposal improperly addressed social and political concerns, contending that, instead, the proposal “would make consistent and comparable information relating to the corporate governance of Nasdaq-listed companies (i.e., information regarding board diversity) widely available on the same basis to investors, which would increase efficiency for investors that gather and use this information. In addition, the proposal would not redefine the purpose of Nasdaq-listed companies’ businesses in a way that is unrelated to traditional business purposes, as claimed by certain commenters. Rather, it could enhance investors’ investment and voting decisions and, as discussed throughout this order, is consistent with Section 6 of the Act, which requires that the rules of an exchange be designed to, among other things, 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.” Moreover, the SEC observed that exchanges have “historically adopted listing rules that require disclosures in addition to those required by Commission rules.” These listing rules may supplement or overlap with SEC disclosure requirements, providing investors with “information that facilitates informed investment and voting decisions contribute to the maintenance of fair and orderly markets.” The SEC concluded that the proposal would not cause Nasdaq “to regulate, by virtue of any authority conferred by the Act, matters not related to the purposes of the Act or the administration of the Exchange.”

Some commenters contended that the proposal was discriminatory and unconstitutional under various constitutional amendments and, therefore, that the proposal would fail under a strict scrutiny test. Nasdaq responded that it was “not a state actor, and the proposal does not constitute state action subject to constitutional scrutiny,” and, even if it were, the proposal just established “aspirational diversity objectives,” and did “not mandate any particular number of Diverse directors and would therefore survive scrutiny.” And even if strict scrutiny were to apply, the proposal “would survive strict scrutiny because it is necessary to achieve a compelling state interest and is narrowly tailored to achieve that interest.” Similarly, with respect to the argument that the proposal violated the First Amendment because it would require companies to engage in compelled speech, Nasdaq again argued that it was not a state actor. Moreover, Nasdaq said, disclosures about board composition are the kinds of disclosures that are routinely permitted, and the explanation that could be required did not compel any specific message.

With regard to allegations of unconstitutionality, the SEC agreed with Nasdaq that it was not a state actor: “[n]umerous courts (and the Commission) have repeatedly held that SROs generally are not state actors, and commenters identify no persuasive basis for reaching a different conclusion with respect to the Exchange’s Board Diversity Proposal. The Commission’s ‘[m]ere approval’ of the proposal as consistent with the requirements of the Act is ‘not sufficient’ to convert it into state action. Similarly, the fact that the Exchange is subject to ‘extensive and detailed’ regulation by the Commission—including, for example, the Commission’s role in reviewing the Exchange’s enforcement of its listing standards—’does not convert [its] actions into those of the [Commission].’ In any event, the proposal would survive constitutional scrutiny because the objectives set forth in the proposal are not mandates, and the disclosures that the proposal requires are factual in nature and advance important interests as described throughout this order.”

Some commenters expressed concern about the economic impact of compliance. The SEC concluded otherwise, finding that the proposal “would not have a material impact on efficiency, that it is reasonably designed not to unduly burden Nasdaq-listed companies, and that it would not unduly deter capital formation (e.g., by affecting companies’ decisions to go public and list on the Exchange).” Under the proposal, companies can choose not to meet the diversity objectives. A company that would prefer not to comply or explain “may transfer its listing to a competing listing exchange.” Directors are not required to self-identify. In addition, the proposal provides directors with the option to not self-identify. The proposal is also flexible and the offer to make available the recruiting service would help to mitigate burdens associated with compliance as well as any related impact on capital formation.

The SEC also found that the Board Recruiting Service Proposal “would provide Eligible Companies, which by definition do not have a specified number of Diverse directors, with access to a network of board-ready diverse candidates, allowing these companies to identify and evaluate such candidates if they choose to use the service to increase diverse representation on their boards.” The proposal would also help Nasdaq compete to attract and retain listings. Accordingly, the SEC found “that the Board Recruiting Service Proposal is designed to provide for the equitable allocation of reasonable dues, fees, and other charges among issuers, is not designed to permit unfair discrimination between issuers, and does not impose any burden on competition not necessary or appropriate in furtherance of the purposes of the Act. The Commission further believes that the Board Recruiting Service Proposal would provide for the equitable allocation of complimentary services and reflects the current competitive environment for listings among national securities exchanges.”

Commissioner Statements

Although there was no open meeting to consider the proposal, the Commissioners all issued statements following the approval. SEC Chair Gary Gensler said that the “rules will allow investors to gain a better understanding of Nasdaq-listed companies’ approach to board diversity, while ensuring that those companies have the flexibility to make decisions that best serve their shareholders. As the order discusses, the rules are consistent with the requirements of the Exchange Act. These rules reflect calls from investors for greater transparency about the people who lead public companies, and a broad cross-section of commenters supported the proposed board diversity disclosure rule. Investors are looking for consistent and comparable data when making decisions about their investments. I believe that our markets work best when investors have access to such information.”

Similarly, Commissioners Allison Herren Lee and Caroline Crenshaw, who also supported the proposal, issued a joint statement. They viewed the proposal as “a step forward for investors on board diversity,” but noted that it certainly wasn’t the end of the story: “there is more work to be done in improving both diversity and transparency at public companies and in our capital markets more broadly. For example, disability may be a relevant characteristic, as well as diversity among senior management and the workforce more broadly. There is a continued, harmful disparity in the representation of a wide range of communities in our capital markets. Because enhanced diversity is critically important for investors, the markets, and our economy, we hope this is a starting point for initiatives related to diversity, not the finish line.”

Although he viewed Nasdaq’s commitment to diversity and inclusion to be “commendable,” and voted in support of the proposal to make recruitment services available, Commissioner Elad Roisman did not support the board diversity proposal. He said that he “struggled” with the decision because he supports the “goal of having more diverse and inclusive boards of directors,” recognizing that “[p]ublic company boards of directors should not be private clubs with membership limited to narrow social circles.” However, he did not believe that the SEC had “fulfilled its obligations to find that this Proposal, which has delisting implications for companies, meets the legal standards” required for evaluating proposed SRO rules. In his view, the Order was largely premised on the idea that investors were “demanding the type of categorical diversity information the Proposal aims to elicit from Nasdaq’s listed companies. Based largely on this demand, the Commission appears to conclude that the Proposal would ‘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.’” While he saw the connection with regard to improving investor protection, he found the analysis to be conclusory and wanting with respect as to the Act’s other criteria. He argued that the SEC “mostly reiterates the Exchange’s assertions and then in places summarily finds that the Proposal is consistent with the Exchange Act. Almost four years ago, Judge Merrick Garland of the D.C. Circuit Court of Appeals wrote an opinion holding that the Commission had not fulfilled its obligations under the Act when approving another SRO rule proposal because the Commission did not undertake its own ‘reasoned analysis’ to evaluate the merits of the proposal at issue. I believe the Approval Order today suffers from the same failing and could set a troubling precedent for SRO oversight.”

With regard to the contention that the proposal might be unconstitutional, he likewise found inadequate the SEC’s analysis of whether the Proposal could be considered state action subject to strict scrutiny. The SEC, he said, just referred to past precedents indicating that “SROs generally are not state actors [emphasis added],” but he was not convinced that “this Proposal fits into the general archetype of SRO actions, and it could raise novel issues for the Commission. A serious concern is that the SEC—without any doubt, a state actor—may need to take future action in which the agency must consider disclosure of the racial, ethnic, gender, or LGTBQ+ status of individual directors. After all, the Commission is the adjudicating body for exchange delisting decisions.” He believed that “the Approval Order should have included more analysis of whether the Proposal could implicate state action through the Commission’s downstream enforcement responsibilities, or why the Commission believes this is unlikely. Instead, the Approval Order gives short shrift to this point, quickly concluding that even if the Proposal were to amount to state action, it ‘would survive constitutional scrutiny because the objectives set forth in the Proposal are not mandates, and the disclosures that the Proposal requires are factual in nature and advance important interests as described throughout this order.”

In a very, very long statement, Commissioner Hester Peirce said that, although she shared the goal of the diversity proposal to expand opportunity, she believes that the proposal “improperly leverages authority that Congress has entrusted to it under the Exchange Act. Because the Exchange cannot show that its Proposal is consistent with the Exchange Act, and because the Proposal is in fact outside the scope of the Act and contrary to fundamental Constitutional principles,” she could not support it. Peirce began by asserting that Nasdaq failed to provide sufficient evidence to show that the proposal was satisfied any of the criteria of Section 6(b)(5) of the Exchange Act; rather, Nasdaq simply referred to studies that “appear to show (or suggest, or perhaps to hint at) a correlation between (primarily) gender diversity and (to a lesser extent) racial diversity on the one hand and, on the other, certain desirable effects on corporate performance, and asserts that the proposal would be beneficial.” Nasdaq failed, she argued, to examine the quality of the studies or to demonstrate that they establish causation. While these deficiencies should have “doomed” the proposal, Nasdaq argued that, “even if the empirical evidence is equivocal,… investors desire consistent and comparable information relating to diversity in making their investment decisions.” However, Peirce contended, “this type of anecdotal support for the rule is insufficient to meet the Exchange’s burden to show that its Proposal is consistent with the Act.” In addition, she maintained, the SEC’s Order “politely declines to wade into the messy job of assessing the Exchange’s empirical claims on their merits and instead finds that investors would be served by this diversity information because ‘commenters representing a broad array of investors’ so clearly want it.” In her view, however, that argument fails under past precedent and is contrary to the Exchange Act.

She also contended that the proposal would not provide consistent and comparable information for investors because the diversity categories are arbitrary, the proposal relies on self-identification and permits foreign companies to apply different categories. In addition, she argued that the “mandated diversity matrix will encourage investors to overlook important differences in director perspectives by shifting their focus to demographic characteristics of the board as a whole rather than to the individual experiences and skill sets that each director brings to the board room.” She also argued that the proposal will harm the market by allowing Nasdaq “to micromanage the delicate process of composing a board, a process that does not lend itself well to standardization,” will lead by example to similarly poor reasoning in future rule proposals, incentivize misleading disclosure, diminish the effectiveness of board oversight by investors and asset managers, and create an unfair advantage for foreign issuers.

Further, she asserted, the proposal would harm the public interest by lending “a government imprimatur to the race- and sex-based board-selection objectives that are contrary to the public interest. The disclosure categories and the Exchange’s numerical ‘diversity objectives’ rely on inappropriate stereotyping, are poorly tailored to the Exchange’s justifications for selecting them, and—intending to remedy societal discrimination—actually place a disproportionate burden on women, underrepresented minorities, and LBGTQ+ individuals.” She also contended that the proposal addresses issues outside the scope of the Exchange Act because it reflected Nasdaq’s attempt to “address matters of grave social concern by using its authority as a listing exchange to create incentives for issuers to make changes that the Exchange believes will bring about socially desirable results.” Finally, she contended that the proposal conflicts with Constitutional principles by encouraging discrimination and compelling speech by both individuals and companies “in a way that offends protected Constitutional interests.” Both Nasdaq and the SEC Order, she argued, dismiss out of hand the question of whether Nasdaq is a “state actor” and also fail to give “due consideration to a more important question, namely the Commission’s own role in this rule, which extends beyond approving the rule, as the Commission is doing here, to a significant role in its administration and enforcement by the Exchange.”

Peirce concluded by arguing that the proposal will “not help to achieve greater opportunity for all members of society to exercise their talents. Nor will it advance the Exchange’s stated objectives of more accurate and comparable board diversity data and less ‘groupthink.’ It is more likely to do the opposite because it relies on crude categorizations of people into racial, gender, ethnic, and LGBTQ+ status boxes that deprive the people being categorized of their individuality and their professional, educational, experiential, and personal complexity.” Although the proposal argues that companies have a choice, she contends, “there is no real choice here. The Exchange’s focus on the disclosure option as a key element that prevents the rule from being a mandate disregards the current political context: No issuer will consider disclosure (rather than compliance) a realistic option in the current environment. No director who qualifies as ‘diverse’ will consider non-disclosure a realistic option.”

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