US Appeals Court Upholds Nasdaq Rule Requiring Companies to Have ‘Diverse’ Directors on Board

The Nasdaq logo is displayed at the Nasdaq Market site in Times Square in New York City on Dec. 3, 2021. (Reuters/Jeenah Moon

A panel of the New Orleans-based 5th U.S. Circuit Court of Appeals on Oct. 18 struck down lawsuits challenging a Nasdaq stock market rule requiring companies listed on the exchange to have “diverse” directors on their boards or explain why they don’t.

In a lengthy opinion, the appeals court rejected lawsuits seeking to block the rule by the National Center for Public Policy Research and the Alliance for Fair Board Recruitment, a group formed by conservative legal activist Edward Blum.

The rule at the center of the lawsuit was approved by the Securities and Exchange Commission (SEC) in August 2021.

It states that companies listed on the exchange “must have, or explain why it does not have, at least two members of its board of directors who are diverse, including (i) at least one diverse director who self-identifies as female; and (ii) at least one diverse director who self-identifies as an underrepresented minority or LGBTQ+.”

The term “diverse” is described in the rule as “an individual who self-identifies in one or more of the following categories: female, underrepresented minority, or LGBTQ+.”

According to the rule, companies must have, or explain why they don’t have, two “diverse” directors by Dec. 31, 2026.

Companies must also disclose on an annual basis how board members identify in those categories, although the individuals don’t need to answer that question should they choose not to.

The SEC and Nasdaq argue that the rule is a disclosure requirement that provides standardized information on board diversity.

Berkeley University student Calvin Yang (C), flanked by Edward Blum (L) and Adam Mortaraw (R), speaks during a news conference on Supreme Court affirmative action in college admissions decision at the Press Club in Washington on June 29, 2023. Jose Luis Magana/AP Photo

‘Diversity Quota’

However, in their lawsuit challenging the rule, the groups argued that it was instead an attempt to coerce companies into satisfying a “diversity quota.”

In addition, the groups contended that the rule was unconstitutional and violated the Exchange Act, the Administrative Procedure Act, and free speech.

“Nasdaq’s discriminate-or-explain command is unlawful because it fails to advance any legitimate exchange purpose. It is instead a prohibited regulation of ’matters not related to the purposes’ of the Exchange Act,” the plaintiffs wrote. “To be lawful, Nasdaq’s diversity rule must be ‘designed to’ achieve one or more of the purposes of an exchange, like preventing fraud or protecting investors, and it may not impose unnecessary burdens on competition.

“But Nasdaq’s rule is designed to promote board diversity, not to prevent fraud or further any other legitimate purpose under the Exchange Act.

“Second, even if Nasdaq’s diversity rule were legally permissible and supported by substantial evidence (and it is not), it is not permissible under the U.S. Constitution. The U.S. Constitution’s Fifth Amendment prohibits federal discrimination based on sex, race, or sexual orientation except in very narrow circumstances. To approve the proposed discrimination, the SEC would have to conclude that Nasdaq’s rule survives the exacting scrutiny needed to justify the discriminatory treatment of individuals based on their sex, race, or sexual orientation.”

Rule Does Not Violate Free Speech, Court Finds

“Nasdaq’s pretextual interest in improving securities markets does not remotely begin to justify discriminatory classifications based on sex, race, or sexual orientation. The diversity rule would also unconstitutionally compel speech, exceed federal authority, and raise serious separation of powers concerns,” the groups wrote in their lawsuit.

The SEC and Nasdaq, however, countered that argument in court filings by noting that the stock exchange is a private entity and thus not bound by restrictions on government. It further noted the difference between disclosure requirements and “outright prohibitions on speech.”

In their ruling on Oct. 18, the 5th Circuit panel of judges agreed with the SEC, finding that it acted within its authority in approving the rule and rejecting the plaintiff’s claims that it violated free speech.

“This evidence is sufficient to support the SEC’s determination that regardless of whether investors think that board diversity is good or bad for companies, disclosure of information about board diversity would inform how investors behave in the market,” the panel wrote.

Nasdaq welcomed the ruling in a statement to The Washington Post.

“We are pleased that the U.S. Court of Appeals for the Fifth Circuit has upheld the U.S. Securities and Exchange Commission’s (SEC) approval of Nasdaq’s rule to enhance board diversity disclosures through a market-led solution,” Nasdaq wrote. “We look forward to working with our companies in continuing to implement this listing standard for corporate governance.”

Mr. Blum, however, said his organization was disappointed by the court’s decision and vowed to continue to “fight to eliminate race discrimination in corporate America.”

“An appeal to a higher court will be filed shortly,” he said in a statement to The Washington Post.

Reuters contributed to this report.