As discussed in this PubCo post, on October 18, a three-judge panel of the Fifth Circuit denied the petitions filed by the Alliance for Fair Board Recruitment and the National Center for Public Policy Research challenging the SEC's final order approving the Nasdaq listing rules regarding board diversity and disclosure. The new listing rules adopted a "comply or explain" mandate for board diversity for most listed companies and required companies listed on Nasdaq's U.S. exchange to publicly disclose "consistent, transparent diversity statistics" regarding the composition of their boards. (See this PubCo post.) Given that, by repute, the Fifth Circuit is the circuit of choice for advocates of conservative causes, the decision to deny the petition may have taken some by surprise—unless, that is, they were aware, as discussed in the WSJ and Reuters, that the three judges on this panel happened to all be appointed by Democrats. Yesterday, the Petitioners filed a petition requesting a rehearing en banc by the Fifth Circuit, where Republican presidents have appointed 12 of the 16 active judges. Not that politics has anything to do with it, of course.
Nasdaq listing rule
The Nasdaq board diversity rule sets a "recommended objective" for most Nasdaq-listed companies to have at least two diverse directors on their boards; if they do not meet that objective, they would need to explain their rationales for not doing so. Companies with five or fewer directors may satisfy the recommended objective with one director from a diverse background rather than two. The rule also requires listed companies to provide annually, in a board diversity matrix format, statistical information regarding the company's board of directors related to the directors' self-identified gender, race and self-identification as LGBTQ+. A person is "diverse" under the rule who "self-identifies in one or more of the following categories: (i) Female, (ii) Underrepresented Minority or (iii) LGBTQ+." These terms are all defined—and sub-defined—in the rules. For example, an "underrepresented minority" is defined as someone who is "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"; all of those terms are also defined. Separately, Nasdaq also provides Nasdaq-listed companies with one-year of complimentary access to a board recruiting solution to help identify board-ready diverse candidates. (See this PubCo post.)
If a company elects disclosure in lieu of compliance with the diversity objectives, the company is required to identify the applicable requirements and explain the reasons why it did not satisfy them. Nasdaq said that it "would not evaluate the substance or merits of a company's explanation." According to correspondence from Nasdaq's Chief Legal and Regulatory Officer, the company "can choose to disclose as much, or as little, insight into the company's circumstances or diversity philosophy as the company determines, and shareholders may request additional information directly from the company if they need additional information to make an informed voting or investment decision."
To refute potential criticism of the board diversity proposal as a quota in disguise, Nasdaq took great pains to frame its proposals as principally "a disclosure-based framework and not a mandate," a presentation that the SEC embraced. In approving the proposals, the SEC made clear that it had no discretion to modify the proposals and, if it found the rules to be consistent with the Exchange Act, no real choice but to approve the proposals: under the Act, the SEC "'shall approve' a proposal if it finds that the rule is consistent with the requirements of the Act and the rules and regulations applicable to the SRO—including requirements in Section 6(b). The statute does not give the Commission the ability to make any changes to the rule proposal as submitted, or to disapprove the rule proposal on the ground that the Commission would prefer some alternative rule on the same topic." Because the SEC found both proposals to be consistent with the requirements of the Act and the rules and regulations applicable to Nasdaq, the SEC stated in the Order, "[t]he proposed rule changes therefore are required to be and are approved."
New petition
As noted above, the three-judge panel found "no reason to conclude that the SEC's Approval Order violates the Exchange Act or the APA" and denied the petitions. (For a discussion of the panel's decision, see this PubCo post.) The new petition opened by observing, speaking of the Nasdaq board diversity listing rule, that "a rule that facially discriminates based on race and sex now has the imprimatur and backing of the federal government....That discrimination now has this Court's seal of approval, too."
The petition contends that the listing rule violates the Equal Protection clause and, by compelling controversial disclosure, the First Amendment, citing the conflict minerals decision, Nat'l Ass'n of Mfrs. v. SEC. (See this PubCo post.) The petition also challenges the panel's conclusion that no state action was involved, arguing that "requiring private parties to encourage discrimination that otherwise would not have occurred" is in effect, state action by the SEC. And the "unique relationship between the SEC and national stock exchanges like Nasdaq means exchange rules are subject to constitutional requirements, as well."
The petition itself offers a pretty good summary of Petitioner's contentions: the petition requests that the Court grant the rehearing
"to remove this Court's new stamp of approval on race and sex discrimination, to uphold the First Amendment, and to resolve the now-conflicting caselaw on state action. The Court should also grant rehearing to review the panel's far-reaching determination that the Rule is consistent with the Exchange Act. Most notably, the panel held that even though the SEC found no link between a board's race/sex breakdown and its corporate performance, the Rule was nonetheless justified because a few financial activists asked for it. Under that circular test, anything is 'material' and can be forcibly disclosed if someone wants it. The SEC could authorize compelled disclosures under the Exchange Act about how many firearms a company's employees own, their political affiliations, what churches they attend, how many abortions they've had, etc. No court has ever adopted such an expansive definition of materiality, which will empower the SEC to act as a junior-varsity Congress unconstrained even by the Constitution."
The two questions identified in the petition for the Court's en banc review are:
"(1) whether approval of the Rule and its compulsion of discrimination and controversial disclosure requirements are unconstitutional state action; and (2) whether the Rule is justified under the Exchange Act on the sole basis that select financial activists want to encourage board selection based on race and sex."
First, Petitioners take up the issue of state action, invoking Moose Lodge No. 107 v. Irvis, a 1972 Supreme Court case, for the proposition that a "government 'regulation [that] requires compliance by [a private party] with provisions of its ...bylaws containing racially discriminatory provisions' is unconstitutional state action." In opposition to the panel's holding that no state action was involved, petitioners contend that the "Exchange Act requires enforcement once the Rule was approved," and that "Moose Lodge never said that a challenge could be raised only after the government has brought an enforcement action against a private entity for failing to abide its own discriminatory rule." In addition, Petitioners argue that "the SEC's mere 'authoriz[ing] or encourag[ing]' of racial discrimination is itself a complete violation of equal protection and thus a fortiori is state action." Rehearing is warranted, they argue, because the rule would "undoubtedly fail constitutional scrutiny."
Petitioners also contend the panel's opinion "created a conflict with the law" of the Fifth Circuit, which "has a 'strict and rigidly applied' prior-panel rule" mandating that precedent be followed. In addition, they argue, if there was no state action, then that must mean that the rule violated the private nondelegation doctrine. In light of the panel's opinion, Petitioners envision of a "new world of government-backed discrimination and compelled disclosures, allowing the government and private parties to achieve what neither could lawfully do on their own."
Second, Petitioners raise the issue of "materiality." Although the SEC did not demonstrate a "causal relationship between corporate performance and the demographic breakdown of a company's board," Petitioners observe, the panel still concluded that the SEC could approve the Nasdaq board diversity rule "on the theory that a handful of financial activists wanted the information and wanted companies to choose their boards based on race and sex." But that is not a valid basis in their view; rather, they argue, the "SEC can mandate disclosures only of 'material' information, that is, information 'viewed by the reasonable investor as having significantly altered the 'total mix' of information made available' for an investment decision." And, they maintain, that standard means that compelled disclosures are limited to "financially material" information. Because board diversity information has "no demonstrable tie to any metric of corporate performance," it can't be material or within the SEC's "disclosure authority." According to Petitioners, a "handful of ideologically motivated corporate elites asking for something immaterial cannot magically convert it into something objectively material." And that's another reason why, they profess, the Court should rehear this matter en banc: if "a few well-placed financial activists were enough to invoke the SEC's disclosure power, even when there is an acknowledged lack of connection to corporate performance, then anything and everything is fair game for mandatory disclosures."
SideBar
The issue of materiality has certainly taken center stage in the last few years. In keynote remarks at a 2021 ESG Disclosure Priorities Event, then-SEC Commissioner Allison Herren Lee discussed "Myths and Misconceptions about 'Materiality.'" Her myth #3 was that "SEC disclosure requirements must be strictly limited to material information," a myth that Lee viewed as a "widely held assumption. However, this is affirmatively not what the law requires, and thus not how the SEC has in fact approached disclosure rulemaking." Rather, she said, the SEC has broad statutory rulemaking authority that is not qualified by "materiality." Where materiality does come up is in connection with the anti-fraud rules, "such as Rules 10b-5 and 14a-9, where it plays a role in limiting how much information must be provided. In other words, materiality places limits on anti-fraud liability; it is not a legal limitation on disclosure rulemaking by the SEC." Historically, she observed, Reg S-K has always required disclosure that is "important to investors but may or may not be material in every respect to every company making the disclosure. We have done this, for example, with respect to disclosures of related party transactions, environmental proceedings, share repurchases, and executive compensation." For example, the requirement to disclose environmental proceedings has a bright-line threshold of $1 million—and, until recently, it was $100,000—without regard to materiality. Similarly, the prescriptive requirements for executive comp, such as the comp tables, include a number of metrics that may not be material to all companies, but are still required to be disclosed. And without these types of broadly applicable requirements, "comparability would be sacrificed almost completely. Indeed such an approach would be at odds with modern capital markets which have become increasingly comparative in nature thus requiring at least some specific metrics in order to make appropriate comparisons. The idea that the SEC must establish the materiality of each specific piece of information required to be disclosed in our rules is legally incorrect, historically unsupported, and inconsistent with the needs of modern investors, especially when it comes to climate and ESG." (See this PubCo post.)
Similarly, in a 2021 webinar, then-Acting Corp Fin Director John Coates discussed anticipated rulemaking regarding ESG disclosure with former SEC Commissioner Robert Jackson. According to Bloomberg, Jackson and Coates, both academics, discussed the issue of materiality in the context of ESG, with Jackson reinforcing the importance of materiality being considered from the perspective of the investor, not the issuer or its counsel. Coates noted in addition that "investor-focused materiality" is subject to change based on events (sometimes referred to as "dynamic materiality"), citing as an example the transformed perception over time of the materiality of asbestos. Importantly, both Jackson and Coates contended that the SEC has never limited its disclosure requirements to only material data, citing as an example the low threshold for disclosure of perks in the executive comp rules. (See this PubCo post.)
The issue of materiality has also been a hot topic during Congressional hearings. During SEC Chair Gary Gensler's confirmation hearings, then-Senator Pat Toomey expressed concern that Gensler's view of materiality was divorced from Toomey's concept of "financial" materiality. For example, at the committee hearing for Gensler's nomination, Toomey asked, if a large public company reported revenues of hundreds of billions of dollars, and it spent a million dollars on political issue ads, should disclosure be required? Gensler responded that the question is what information reasonable investors are seeking to make voting or investment decisions, and last year, in their proxy votes on shareholder proposals, a large proportion of shareholders said that political spending information would be material. So, even though the amount of spending is completely insignificant, Toomey asked, did he think it could be appropriate to mandate that disclosure? Gensler replied that he would be grounded in economic analysis and the courts' views of materiality as the information reasonable investors want to see as part of the total mix of information. Why not leave it up to the companies to decide, Toomey asked? Gensler repeated that it's a really a question of investors making the choice about the information they want. He later reiterated that he considered the 80 shareholder proposals submitted last year on the topic and the 40% vote in favor as a strong indicator. In light of that level of investor interest, political spending disclosure was something he thought the SEC should consider. (See this PubCo post.) (Note that Section 633 of the Appropriations Act generally prohibits the SEC from using funds on political spending disclosure. See this PubCo post.) The issue of materiality has also been raised frequently in other Congressional hearings in connection with the SEC's climate disclosure proposal. (See, for example, this PubCo post and this PubCo post.)
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