Last week, the U.S. Court of Appeals for the Fifth Circuit upheld Nasdaq's board diversity rule, which the SEC first approved in August 2021 and was then challenged as unconstitutionally discriminatory and an improper restraint on free speech and enacted in violation of the Administrative Procedures Act (APA) and the Securities Exchange Act of 1934 (Exchange Act).

As the SECond Opinions blog previously reported, the rule requires Nasdaq-listed companies to disclose information about board diversity statistics and either include women and minority directors on their boards or disclose why they do not. Specifically, the rule – an exchange "listing standard" – requires a company to disclose board diversity statistics each year and either have or explain why it lacks at least one director who identifies as female and one director who is a member of an underrepresented racial or ethnic minority or LGBTQ+.

In Alliance For Fair Board Recruitment v. SEC, opponents of the rule argued that constitutional prohibitions against discrimination and restraints on free speech that apply to the federal government extend to, in this case, Nasdaq, because the SEC has the authority to penalize the exchange if it fails to enforce the rule. But Nasdaq and the SEC argued that Nasdaq is a private entity not subject to restrictions imposed on the government and that the rule itself is focused on disclosure and ensuring investors receive standardized information on board diversity.

A three-judge panel of the Fifth Circuit agreed with Nasdaq and the SEC and stated that although Nasdaq is regulated by the SEC, it is not itself a state actor and, thus, the constitutional claims failed. In rejecting arguments that the SEC exceeded its authority under the APA and Exchange Act, the Court concluded that 1) the "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," 2) the SEC's approval of the rule did not violate the Major Questions Doctrine because the SEC is authorized to regulate securities disclosures and 3) the SEC's approval was not arbitrary and capricious.

This decision is notable for several reasons, including:

• This is a rare recent victory for the SEC in the Fifth Circuit, which has dealt a number of significant losses to the SEC, including last year's holding in Jarkesy v. SEC that the agency's administrative proceedings against an investment adviser accused of securities fraud were unconstitutional. The U.S. Supreme Court granted certiorari on June 30, 2023, and oral argument in the case is slated for late November 2023.
• Petitioners indicated they will challenge the decision; an en banc review by the full Fifth Circuit could produce a different result.
• One practical likely consequence of the rule, if it remains intact, is that it "may have the effect of encouraging … companies to increase diversity on their boards," as the SEC acknowledges.
• The SEC is facing a number of other court challenges – and expected challenges – to its rulemaking and regulatory powers and, although this case dealt with the agency's approval of an exchange rule proposal, proponents and opponents of recent and forthcoming SEC rulemakings will closely analyze the Court's reasoning here, including the Court's statements on whether mandated disclosures are "material," including:
  • "[A] disclosure rule can be "related to the purposes of [the Exchange Act]" even if the SEC does not find that the disclosure rule is limited to information that would be "material" in the securities fraud context. The "fundamental purpose" of the Exchange Act is "implementing a philosophy of full disclosure," [Basic Inc. v. Levinson, 485 U.S. 224, 230 (1988)] – not just the disclosure of information sufficient to state a securities fraud claim. Indeed, the Exchange Act gives the SEC "very broad discretion to promulgate rules governing corporate disclosure." (internal citations omitted)
  • "Determining the materiality of a given statement is a "fact-specific inquiry," SEC v. World Tree Fin., L.L.C., 43 F.4th 448, 465 (5th Cir. 2022) (quoting Levinson, 485 U.S. at 240), that "is peculiarly within the competence of the trier of fact," (citation omitted). Because materiality is context-dependent, it is unclear how the SEC could say, in a factual vacuum, that a particular category of information is or is not material to investors in all circumstances. To make such a finding, the SEC would be forced to speculate about, and rule out, any factual scenarios in which there might be "a substantial likelihood that a reasonable investor would consider" any information falling within the relevant category "important in making a decision to invest."