DEI Under Scrutiny, Part XI: Fifth Circuit Reconsiders Nasdaq’s Board Diversity Rule

Quick Hits

• The full Fifth Circuit could soon rule on the SEC’s decision to approve Nasdaq’s requirement that companies on the stock exchange have diversity on their board of directors or explain why they do not.
• The pending decision comes after the circuit court agreed to reconsider a panel decision that had sided with the SEC and the Nasdaq rule.
• If upheld, the rule will take full effect in December 2026.

The full Fifth Circuit is reconsidering the SEC’s decision to approve Nasdaq’s requirement that companies on the stock exchange have diversity on their board of directors or explain why they do not have directors who self-identify as members of underrepresented groups. The Fifth Circuit heard oral arguments en banc on May 14, 2024, and a decision is expected soon.

The ruling could impact how corporations recruit and select their board members. The case comes at a time when corporate diversity, equity, and inclusion (DEI) programs have faced various legal challenges, after the Supreme Court of the United States ruled against affirmative action in college admissions in 2023.

Nasdaq Board Diversity Rule

In 2021, Nasdaq established a rule that requires companies listed on its stock exchange to disclose demographic information about their board members. The rule requires companies with more than five board members to have two members who are from an underrepresented group, including one female and one person who self-identifies as Black, Hispanic, Asian, Native American, Alaskan Native, Native Hawaiian, Pacific Islander, biracial, or LGBTQ+. If the company does not meet that requirement, it must explain why. If not, it could risk being delisted from the exchange.

After the SEC approved this rule in August 2021, the Alliance for Fair Board Recruitment and the National Center for Public Policy Research filed suit challenging the rule, claiming that the rule violated the First and Fourteenth Amendments to the U.S. Constitution and that the rule exceeded the SEC’s authority under the Securities Exchange Act of 1934 (Exchange Act) and the Administrative Procedure Act (APA).

They alleged the rule discriminated on the basis of sex and race. The SEC rule “fails every aspect of heightened review under equal protection principles,” and “compels controversial disclosures the D.C. Circuit has called ‘obviously repugnant to the First Amendment,’” the plaintiffs stated.

They also argued that any disclosure requirement must be limited to material information, meaning a reasonable investor would consider the information important in making a purchase decision. The groups further alleged that the required information regarding board members’ race, gender, and sexuality is not material. In response, the SEC argued that there is substantial evidence of broad demand for board diversity information among investors who already use that information to make investments. “Some of the largest and most sophisticated asset managers, who operate in competitive markets and are subject to a fiduciary duty to their clients, have concluded that board diversity benefits companies and make decisions based on it,” the SEC stated in its approval decision.

On October 18, 2023, the Fifth Circuit ruled in favor of the SEC. It found the SEC’s approval of the rule complied with the Exchange Act and the APA, and the materiality standard did not apply. “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,” the court noted. (Emphasis in the original.) The court rejected the constitutional claims because Nasdaq is a private entity, not a government institution or state actor. “This is not a case where the ‘government compel[led] the private entity to take a particular action,’” the court stated. “There is no evidence that the SEC as an entity weighed in on the merits of diversity disclosure rules, much less that Nasdaq was ‘compelled’ or even ‘significant[ly] encourage[d]’ by the SEC to take this particular action.”

The challengers then requested the Fifth Circuit to review the case en banc, which the appellate court granted on February 19, 2024.

Next Steps

The Fifth Circuit’s en banc consideration of the SEC’s approval of the Nasdaq rule comes at a time when initiatives to promote diversity at all levels of companies have come under increasing scrutiny. The ruling will likely have some impact on how publicly held companies formulate, describe, and implement their recruitment strategies for board members and describe their board composition. Regardless of the outcome, members of boards of directors of publicly traded companies may wish to evaluate the nature and extent of current and future DEI and environmental, social, and governance (ESG) initiatives, as corporate DEI-related ESG commitments may expose companies to increased scrutiny from public interest groups, civil rights lawsuits, shareholder-derivative litigation, and inquiries from internal and external stakeholders. As such, careful design of these initiatives in accordance with the organization’s risk tolerance and business goals may represent an important component of the strategy to mitigate risk.

For more information on DEI policies, initiatives, and strategies, including increased demands for inclusivity and belonging in the United States and globally, as well as challenges and litigation threats following the Supreme Court’s decision that race-conscious affirmative action admission policies violate the Equal Protection Clause and the Fourteenth Amendment, please see Ogletree Deakins’ “DEI Under Scrutiny” series, which examines the evolving DEI legal landscape since the Supreme Court’s decision and assists employers in balancing these concerns while moving forward with legally defensible programming and initiatives.

To assist employers with navigating these new challenges, Ogletree Deakins’ DEI Task Force—a multidisciplinary team of lawyers from our Diversity, Equity and Inclusion, Environmental, Social, and Governance (ESG), Litigation, OFCCP Compliance, Government Contracting, and Reporting, and Pay Equity practice groups—has developed a toolkit to assist with evaluating DEI initiatives, assessing legal risk, and providing recommendations and best practices. For more information, please contact the Ogletree attorney with whom you work or email clientservices@ogletree.com.

Ogletree Deakins will continue to monitor developments and will provide updates on the Diversity, Equity and Inclusion blog as additional information becomes available.

Simone R. D. Francis is a shareholder in Ogletree Deakins’ St. Thomas and New York offices.

This article was co-authored by Leah J. Shepherd, who is a writer in Ogletree Deakins’ Washington, D.C., office.

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