As we have written about extensively, ESG factors are becoming a dominant force for companies to contend with and consider. While focus has largely been on environmental and climate issues and disclosures, recently, other social and governance factors have moved to the forefront. In early August, the SEC voted to approve Nasdaq’s proposed new guidelines regarding diversity of Nasdaq-listed companies’ boards. With limited exceptions, each company must now have at least two diverse board members and additionally disclose the gender, racial characteristics, and LGBTQ+ status of its board of directors. A legal challenge has quickly followed.
Regardless of its outcome, initiatives by investors and regulators around diversity are moving to the forefront and companies should ensure they are tracking and responding to these developments. We review the new Nasdaq rules, SEC commentary and potential legal battles below.
NEW NASDAQ RULES
On August 6, 2021, the SEC approved by a 3-2 vote Nasdaq’s proposal regarding diversity of board members. There are two new rules that Nasdaq-listed companies must comply with soon.
Two Diverse Directors
The first new Nasdaq rule requires each Nasdaq-listed company, subject to certain exceptions, to have at least two members of its board of directors who are “diverse,” defined in this context as at least one director who self-identifies as female and at least one director who self-identifies as an Underrepresented Minority or LGBTQ+(1), or otherwise explain why it does not have two such directors.(2)
There are limited exceptions to the requirement of two diverse directors. Smaller reporting companies and foreign issuers can satisfy the rule with two female directors. Companies with five or fewer directors can meet the diversity objective by having at least one diverse director.
Nasdaq-listed companies have a transition period to meet these requirements, or otherwise explain why they have not met the requirements. All companies must have one diverse director by August 7, 2023 — including boards with five or fewer directors. The second diverse director must be in place by either August 6, 2025 (Nasdaq Global Select Market or Nasdaq Global Market companies) or August 6, 2026 (Nasdaq Capital Market companies).
If a company elects to satisfy these requirements by explaining why it does not meet the applicable diversity objectives, the company will be required to both:
- Specify the requirements of the rule that are applicable
- Explain the reasons why it does not have two diverse directors
The Exchange will not evaluate the substance or merits of a company’s explanation. If a company fails to adhere to the rule entirely, the Exchange’s Listing Qualifications Department will promptly notify the company and inform it that it has 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 does not regain compliance within the applicable cure period, the Listings Qualifications Department would issue a Staff Delisting Determination Letter.
Board Diversity Disclosure
Additionally, the SEC voted to approve an additional new rule requiring each Nasdaq-listed company, to annually and publicly disclose in an aggregated form information on the voluntary self-identified gender and racial characteristics and LGBTQ+ status of the company’s board of directors, subject to certain exceptions.(3) Companies that fail to adhere to these new rules within the proscribed amount of time risk being delisted from Nasdaq.
Companies have until August 8, 2022, or until the company files its proxy or information statement for the company’s annual shareholder meeting during 2022 to disclose this information.
If a company fails to disclose its board-level diversity data, the Exchange will notify the company that it is not in compliance with a listing standard and allow the company forty-five calendar days to submit a plan to regain compliance and, upon review of such plan, the Exchange may provide the company with up to 180 days 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.
In order to support companies in implementing these new rules, Nasdaq will provide certain companies with one year of complimentary access to a board recruiting service, which provides access to a network of board-ready diverse candidates for companies to identify and evaluate.
SEC COMMENTARY AND DISSENT
The new Nasdaq rules were approved by the SEC in a split vote 3-2, along party lines. Reviewing the published order and comments by the SEC and its commissioners sheds light on the debate over these diversity measures and hints at the possible legal battle to come.
Support for Diversity Requirements
In its order approving these new Nasdaq rules, the SEC noted that board-level diversity statistics are currently not widely available on a consistent and comparable basis, “even though the Exchange and many commenters argue that this type of information is important to investors.” The Commission stated that the new Nasdaq requirements would also provide increased transparency and require an explanation regarding why a Nasdaq-listed company does or does not meet the proposed board diversity objectives. This would augment existing Commission requirements that companies disclose whether, and how, their boards or board nominating committees consider diversity in nominating new directors.
In proposing the new rules, Nasdaq stated that investors are increasingly interested in board diversity data, “as investors view board diversity as a key indicator of corporate governance.” The Exchange further stated that the wave of investors increasingly calling for companies to disclose diversity metrics and diversify their boards, and basing their voting decisions on whether companies do or do not, demonstrates that investors consider diversity disclosures material to their voting and investment decisions. The Exchange explained that its goal is to facilitate the collection, reliability and uniformity of board diversity data, while expanding access to the information.(4)
The Exchange also stated in support of its new disclosure requirements that its proposal would level the playing field for retail and institutional investors, and decrease the cost and time associated with data collection for all investors, by providing them with accessible, comparable and transparent information by which they could critically evaluate a company’s decisions with respect to how, whether or when to pursue board diversity.(5)
While noting that investors and companies have varying views regarding board diversity and whether or not board diversity affects company performance and governance, the SEC likewise stated that a better understanding of why a company does not meet the proposed objectives would contribute to investors’ investment and voting decisions.
Nasdaq stated that it believes that this disclosure would enable the investment community to conduct more informed analyses of, and have more informed conversations with, companies and “improve the quality of information available to investors who rely on this information to make informed investment and voting decisions.”(6) To that end, the SEC stated that it “finds that the Board Diversity Proposal is designed to 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.” (7)
In a statement by SEC Chairman Gary Gensler regarding the SEC’s approval of these new diversity disclosure rules, he stated that the rules “reflect calls from investors for greater transparency about the people who lead public companies.” Noting that a broad cross-section of commenters supported the proposed board diversity disclosure rule, Mr. Gensler stated that investors are looking for consistent and comparable data when making decisions about their investments and concluded “I believe that our markets work best when investors have access to such information.”
SEC Commissioners Allison Herren Lee and Caroline Crenshaw also issued a statement, which both supported the new Nasdaq rules and hinted at potential future diversity initiatives. Commissioners Lee and Crenshaw echoed prior comments by stating that “investors are increasingly demanding diverse boards and diversity-related information about public companies.” They stated their belief that Nasdaq’s proposal should improve the quality of information available to investors for making investment and voting decisions by providing consistent and comparable diversity metrics.(8)
The Commissioners then went further in stating that “there is more work to be done in improving both diversity and transparency at public companies and in our capital markets more broadly.” The Commissioners suggested that diversity among senior management and the workforce more broadly may be a relevant characteristic, as well as disability. They closed their statement by stating “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.”(9)
Opposition to Diversity Requirements
In contrast, the two Republican Commissioners issued separate statements voicing their opposition to the new Nasdaq rules. These statements hint at the possible legal battle to come over the Nasdaq or similar diversity measures.
In a lengthy dissent, Commissioner Hester Peirce voiced her opinion that the new Nasdaq rules improperly leverages authority that Congress has entrusted to the SEC under the Securities Exchange Act of 1934. Commissioner Pierce stated that because Nasdaq cannot show that its new rules are consistent with the Exchange Act, and because they are “in fact outside the scope of the Act and contrary to fundamental Constitutional principles, I cannot support its approval.”(10)
In a rebuke to those supporting the new Nasdaq rules based on investor concerns, Commissioner Peirce wrote:
That investors or the significantly more nebulous “stakeholder” community wants certain information does not itself determine whether an exchange rule mandating or incentivizing the disclosure of that information is consistent with the Exchange Act. The Act nowhere delegates authority to exchanges to impose on issuers disclosure mandates or “objectives” related to internal corporate affairs, much less those related to important societal problems, simply because current investor or “stakeholder” sentiment is said to favor such requirements.(11)
Commissioner Pierce hypothesized that:
[O]ne can easily imagine investors – and more importantly, as their views seem to have been given particular weight in this Proposal, “stakeholders” and other non-investor groups – asking for disclosure on any number of issues of public or social concern.
However, Commissioner Pierce stated that most of these issues fall outside the purposes of the Act, which Congress made quite narrow in scope.
In her dissent, Commissioner Pierce also critiqued the new Nasdaq rules as addressing issues outside the scope and purposes of the Exchange Act. She wrote that the United States faces myriad societal, economic and political challenges but the notion that Congress has not given exchanges and other SROs, or even the SEC, a mandate to address these challenges and remedy these injustices. She stated that any thought that Congress “expected them to attempt to do so merely because they have leverage over market participants through the authority granted them in the Exchange Act, is fanciful.”
Finally, Commissioner Pierce wrote that the new Nasdaq diversity disclosure rules conflict with core Constitutional principles in that they could require the SEC to make factual determinations that Commissioner Pierce believes the SEC as a government body should not be able to – and, under the Constitutional order, cannot – make. These determinations include questions about the validity of an individual’s self-identification or the adequacy of a firm’s philosophy regarding diversity.
In his own dissent, Commissioner Elad Roisman stated that while “diversity and inclusiveness is a worthy goal to have for businesses across our capital markets” and he supports the goal of having more diverse boards of directors, “a noble goal does not justify short-changing the agency’s legal obligations.”(12) Similar to Commissioner Pierce, Commissioner Roisman cited Susquehanna International Group, LLP, et al. v. SEC (DC Cir. Aug. 8, 2017), an opinion written by Judge Merrick Garland, which held that the Commission had not fulfilled its obligations under the Act when approving a different self-regulatory organization’s (“SRO”) rule proposal because the Commission did not undertake its own “reasoned analysis” to evaluate the merits of the proposal. Commissioner Roisman voiced this belief that the SEC’s approval of the Nasdaq rules “suffers from the same failing and could set a troubling precedent for SRO oversight.”
Commissioner Roisman further voiced his “serious concern” that the SEC, as adjudicating body for exchange delisting decisions, may need to take future action in which the agency must consider disclosure of the racial, ethnic, gender or LGTBQ+ status of individual directors. He stated that the SEC’s Approval Order should have included more analysis of whether the Nasdaq rules could implicate state action through the Commission’s downstream enforcement responsibilities, or otherwise why the Commission believes this is unlikely.
POTENTIAL LEGAL BATTLE
Just three days after the SEC approval of the new Nasdaq diversity disclosure rules, a nonprofit group filed a Petition for Review in the United States Court of Appeals for the Fifth Circuit to review the SEC order.
On August 9, 2021, the Alliance for Fair Board Recruitment filed a brief petition with the Fifth Circuit Court of Appeals. In a subsequent press release, the group voiced its disapproval of the new rules, stating its belief that “Nasdaq tries to shame companies into compliance” by requiring that those not meeting the rules “must publicly explain why.”(13) The group also took issue with Nasdaq and the SEC’s position that these disclosures will benefit investors, citing studies that have shown stock returns suffer when companies “are pressured to hire new directors for diversity reasons.”
The press release also states that “Nasdaq’s discriminate-or-explain rule also exceeds its role and the authority granted by federal securities law and also violates core Bill of Rights guarantees against compelled speech and discrimination based on sex and race by stereotyping all people of the same skin color or sex as being alike and interchangeable.” The press release closes with a quote from the president of AFFBR, stating that the new rules are unfair, illegal and “should be struck down by the courts without delay.”
While we wait to see whether the Fifth Circuit – or any other court – takes up a legal challenge to these new Nasdaq diversity rules, companies should plan for these diversity requirements as they become more important to both investors and regulators alike. From an insurance and risk management perspective, planning for compliance with these rules now can head off potential legal battles and corresponding costs down the road. These new diversity rules impact boards of directors directly and failure to comply with them could easily lead to shareholder suits, regulator actions and increases on D&O insurance. We will certainly report on any developments in this area as boards of directors and companies at large must pay ever-increasing attention to ESG factors.
(1) Per the Order, “Underrepresented Minority” would be defined to mean an individual who self-identifies as one or more of the following: 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; and “LGBTQ+” would be defined to mean an individual who self-identifies as any of the following: lesbian, gay, bisexual, transgender or as a member of the queer community.
(2) Order Approving Proposed Rule Changes, as Modified by Amendments No. 1, to Adopt Listing Rules Related to Board Diversity and to Offer Certain Listed Companies Access to a Complimentary Board Recruiting Service (sec.gov) at p. 3-4.
(3) Order Approving Proposed Rule Changes, as Modified by Amendments No. 1, to Adopt Listing Rules Related to Board Diversity and to Offer Certain Listed Companies Access to a Complimentary Board Recruiting Service (sec.gov) at p. 3-4.
(4) Id. at p. 24-25.
(6) Id. at 19-20.
(7) Id. at p. 7.
(8) SEC.gov | Statement on Nasdaq’s Diversity Proposals – A Positive First Step for Investors
(10) SEC.gov | Statement on the Commission’s Order Approving Proposed Rule Changes, as Modified by Amendments No. 1, to Adopt Listing Rules Related to Board Diversity submitted by the Nasdaq Stock Market LLC
(12) SEC.gov | Statement on the Commission’s Order Approving Exchange Rules Relating to Board Diversity
(13) Nasdaq Board Diversity Quotas Challenged in Federal Court by the Alliance for Fair Board Recruitment (prnewswire.com)