SEC approves Nasdaq’s disclosure-based approach to improving diversity

On Aug. 6, the Securities and Exchange Commission approved Nasdaq Stock Market LLC’s proposed listing rule changes pertaining to board diversity, which require that companies “publicly disclose board-level diversity statistics using a standardized template” and “have or explain why they do not have at least two diverse directors” (consisting of at least one director who self-identifies as female and one who self-identifies as an underrepresented minority or LGBTQ+). Companies with boards that have five or fewer directors are required to have, or explain why they do not have, one diverse director by Aug. 7, 2023. Further, the SEC approved Nasdaq’s providing one year of complimentary access to a board recruiting service to certain companies. As noted in the SEC’s order approving the new rule, this service aims to “provide access to a network of board-ready diverse candidates, allowing companies to identify and evaluate such candidates.”

Nasdaq first proposed its board diversity rule last December, after California had enacted Senate Bill 826 and Assembly Bill 979, which mandate a minimum number of women directors and directors from underrepresented communities, respectively, on boards of publicly held companies headquartered in California. Both laws have been challenged in federal and state court on constitutional grounds, in lawsuits that are currently pending.

Nasdaq, however, specifically stated that this “rule is not a mandate and does not set a hard target that companies must adhere to regardless of their circumstances.” Instead, Nasdaq describes its board diversity rule as “a disclosure standard.”

In addition to “encourag[ing] a minimum board diversity objective for companies,” the rule “provide[s] stakeholders with consistent, comparable disclosures concerning a company’s current board composition.” As SEC Chairman Gary Gensler noted in his public statement on the rule’s approval, 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.” In other words, these rules reflect the demands of the investing public and are not top-down “social engineering,” as some critics have argued.

Moreover, because the primary goal of the Nasdaq board diversity rule is transparency, companies have flexibility as to the timetable for compliance. Nasdaq-listed companies will have a transition period to meet the diversity objectives or explain their reasons for not doing so (the timeframe is based on a company’s listing tier). For example, Nasdaq Global Select Market or Nasdaq Global Market companies are required to have, or explain why they do not have, one diverse director by Aug. 7, 2023, and two diverse directors by Aug. 6, 2025.

Further, a Nasdaq-listed company could choose not to meet the minimum diversity standard at all, provided it explains why it does not meet that standard in a proxy or information statement, annual report, or on its website. Thus, contrary to the arguments of some commenters, the rule is not a gender or racial quota subject to constitutional scrutiny (not to mention that the SEC noted in its approval order that Nasdaq is not a state actor). Indeed, with regard to the requirement for companies to “explain,” Nasdaq has stated that it will simply “verify that the company has provided an explanation, but will not assess the merits of the explanation,” and that “[t]here is no right or wrong reason that a company may give for not having at least two directors.”

Rather, consistent with the disclosure-based approach of the federal securities laws as a whole, each member of the investing public can make its own assessment of the explanation a company gives. Companies will have the incentive to put earnest thought into their approach to increasing their diversity, with the public acting as a check on the sincerity of the efforts. To the extent a company identifies real structural barriers preventing it from securing the desired number of diverse candidates, perhaps this exercise will shed light on the contours of this issue. If a company would rather not participate, it can always list with another exchange.

This of course generates the question as to whether other exchanges will follow suit. At least at present, this does not appear likely. Stacey Cunningham, president of the NYSE Group, which oversees the New York Stock Exchange, was quoted as saying that although the “data is very, very clear that businesses perform better when there’s more diversity on their board,” “when we use exchange listing standards to require things like diversity profiles or others, we’re defining the investable universe.”

However, the SEC itself may choose to implement its own board diversity disclosure requirements. In a public statement about the Nasdaq rule, SEC Commissioners Allison Herren Lee and Caroline A. Crenshaw noted, “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.”

It remains to be seen whether the Nasdaq board diversity rule will face legal challenges similar to those made against SB 826 and AB 979 and what the outcome of any challenges will be. Regardless, given studies that have identified positive relationships between board diversity and commonly used financial metrics, including higher returns on invested capital and returns on equity, the Nasdaq and the investors demanding board diversity information appear to be on solid ground in arguing that the information is both useful and consistent with the requirements and goals of the Securities and Exchange Act of 1934. 

The views expressed herein are the authors own and do not reflect the views of their law firm or its clients.