SEC Approves Nasdaq Board Diversity Rule

On August 6, 2021, the SEC approved Nasdaq’s board diversity listing standards proposal.  Not surprisingly, the approval vote was divided with Commissioner Hester Peirce dissenting and Commissioner Elad Roisman dissenting in part.  On the same day as the approval, Chair Gary Gensler and Commissioners Peirce, Roisman and Allison Herren Lee and Caroline Crenshaw issued statements on the new Rules.

As more fully explained below, new Nasdaq Rule 5605(f) requires Nasdaq listed companies, subject to certain exceptions, to: (i) to have at least one director who self identifies as a female, and (ii) have at least one director who self-identifies as Black or African American, Hispanic or Latino, Asian, Native American or Alaska Native, Native Hawaiian or Pacific Islander, two or more races or ethnicities, or as LGBTQ+, or (iii) explain why the company does not have at least two directors on its board who self-identify in the categories listed above.  The rule changes also made headlines in most major publications.  One of the most common themes in the press was the lack of inclusion of people with disabilities in the definition of an “underrepresented minority” for purposes of complying with the new Rules.

Clearly anticipating backlash and recognizing the controversy surrounding the Rules, in its approving release, the SEC made sure to point out that it is required to approve a proposal if it meets the requirements of the Exchange Act and the Rules and regulations applicable to SROs.  The SEC states that it does not have the authority to make any changes to the rule proposal as submitted, or to disapprove the rule proposal on the ground that the SEC would prefer some alternative rule on the same topic.

Nasdaq Final Board Diversity Rule

Nasdaq has added Rule 5606(a) to the corporate governance requirements for listing and continued listing which requires Nasdaq listed companies, to publicly disclose, in an aggregated form, to the extent permitted by law (for example, some foreign countries may prohibit such disclosure), information on the voluntary self-identified gender and racial characteristics and LGBTQ+ status of the company’s board of directors.  Each company will need to provide an annual Board Diversity Matrix disclosure including: (i)  the total number of directors; (ii) the number of directors based on gender identity (female, male or non-binary); (iii) the number of directors that did not disclose gender; (iv) the number of directors based on race and ethnicity; (v) the number of directors who self-identify as LGBTQ+; and (vi) the number of directors who did not disclose a demographic background.

Foreign issuers may elect to use an Alternative Board Diversity Matrix format.  Foreign issuers using the Alternative Matrix are required to disclose: (i) the total number of directors; (ii) its country of principal executive offices; (iii) whether it qualifies as a Foreign Private Issuer; (iv) whether disclosure is prohibited under its home country law; (v) the number of directors based on gender identity and the number of directors who did not disclose gender; (vi) the number of directors who self-identify as underrepresented individuals in its home country; (vii) the number of directors who self-identify as LGBTQ+; and the number of directors who did not disclose a demographic background.

The Board Diversity Matrix is required to be included in an annual report or proxy statement, or on the company’s website beginning in 2022.  If a company files its 2022 proxy before August 8, 2022, and does not include the Matrix, it will need to either amend or post the Matrix by August 8, 2022.  If a company files its 2022 proxy after August 8, 2022, it must either include the Matrix or the Matrix must be posted on its website within one day of filing the proxy.

Although not required, the rule encourages disclosure of other diverse attributes such as nationality, disability or veteran status.  Failure to provide the disclosure will result in a listing deficiency with the ability to submit a plan within 45 days that would provide for cure within 180 days.  Ultimate non-compliance could result in delisting.  I’ve included both the Board Diversity Matrix and Alternative Board Diversity Matrix at the end of this blog.

Nasdaq has also added Rule 5605(f), pursuant to which, subject to certain exceptions, each listed company will be required to: (i) have at least one director who self identifies as a female, and (ii) have at least one director who self-identifies as Black or African American, Hispanic or Latinx, Asian, Native American or Alaska Native, Native Hawaiian or Pacific Islander, two or more races or ethnicities, or as LGBTQ+, or (iii) explain why the company does not have at least two directors on its board who self-identify in the categories listed above.

Foreign issuers are required to have at least two diverse directors including at least one female.  Both foreign issuers and smaller reporting companies may satisfy the two diverse director requirements by having two female directors.

Nasdaq stresses that it is not establishing quotas or mandating diversity as companies that do not meet the objectives need only explain why they do not.  The Exchange has provided examples of what might be contained in an explanation.  It could be that a company’s reasoning for not having board members that specifically fit the diverse attributes in the Rule, is that it has otherwise a diverse board composition based on other considerations.  However, as noted in my introduction, disability advocacy groups are very disappointed that those with disabilities are not included in the definition of diverse attributes under the Rule.

Under the Rule, Nasdaq will not assess the substance of an explanation but will just verify that the company has provided one.  In fact, the final rule release reiterated many times that Nasdaq will not evaluate the substance of the explanation and that a company has full flexibility and discretion in drafting such explanation, including how much detail to provide.

Nasdaq has also added to its list of services for listed companies, a complimentary board recruiting solution to help advance diversity on company boards.  The service provides companies that have not yet achieved a certain level of diversity with one-year complimentary access for two users to a board recruiting solution, which will provide access to a network of board-ready diverse candidates.  The service is intended to allow companies to identify and evaluate diverse board candidates, and act as a tool to support board benchmarking.  To access the service, a listed company must make a request on or before December 1, 2022.

The following types of companies are exempt from the requirements: (i) SPACs; (ii) asset backed issuers; (iii) cooperatives; (iv) limited partnerships; (v) management investment companies; (vi) issuers of non-voting preferred securities, debt securities or derivative securities; and (vii) ETFs and similar funds.

The Rule provides each company with one year from its adoption to comply with the Rule’s requirement to provide statistical information disclosures.   A company that goes public via a business combination with a SPAC, an IPO, a direct listing, a transfer from another exchange or an uplisting from the OTC Markets has one year to comply with the disclosure requirements.

A Nasdaq Global Select Market and Nasdaq Global Market listed company, other than a smaller reporting company, SPAC or other exempt company, must have at least one diverse director by August 7, 2023 and two diverse directors by August 6, 2025, or explain the reasoning as to why not.  A Nasdaq Capital Market listed company must have at least one diverse director by August 7, 2023, and two diverse directors by August 6, 2026, or explain the reasoning as to why not.  Companies with boards of five or fewer directors, regardless of listing tier, are required to have, or explain why they do not have, one diverse director by August 7, 2023.

Purpose of the Rule

Simply put, Nasdaq is of the view that diversity in the board room equates to good corporate governance.  They believe that increased diversity brings fresh perspectives, improved decision making and oversight and strengthened internal controls.  Further, Nasdaq asserts that the increased focus on diversity by companies, investors, legislators and corporate governance organizations provides evidence that investor confidence is enhanced by greater board diversity.  In conducting an internal study on diversity amongst listed companies, Nasdaq found they fell short and that a regulatory impetus would help.

Nasdaq indicates it conducted extensive research including reviewing a substantial body of third-party research and conducting interviews.  Among the questions it sought to answer were (i) whether there is empirical evidence to support the proposition that board diversity increases shareholder value, investor protections and board decision-making; (ii) investors interest in board diversity information; (iii) the current state of board diversity and disclosure; (iv) causes of underrepresentation; (v) various approaches to encourage board diversity; and (vi) the success of approaches taken by other groups, both domestic and foreign.

Clearly, Nasdaq is confident that the answers to these questions support not only the value of board diversity and related disclosure, but the value of regulations requiring same.  In addition to the results of its studies, Nasdaq cites the increasing call for diversity by large institutional investors such as Vanguard and BlackRock in their corporate engagement and proxy guidelines.  Nasdaq also believes that the SEC disclosure regime supports disclosure requirements in this context.

Both the 127-page Nasdaq proposed rule release and 82-page approval of the Rules contain an in-depth discussion of Nasdaq’s research, findings, and conclusions.  Nasdaq also presents counter-information.  There is a lack of studies or information of the association between LGBTQ+ diversity and board representation, stock or other financial performance.  Many studies support a correlation between women on the board and increased earnings and other financial metric performance, but some also show a lack of correlation between the two.  Studies which include other factors, such as strong shareholder rights, show a decreasing impact of diversity to performance.

Interestingly, I believe it is the non-financial aspects, including investor protections (through increased internal controls, public disclosure, and management oversight) and confidence, that compelled Nasdaq adopt the rule.  As it states in its release, “[A]t a minimum, Nasdaq believes that the academic studies support the conclusion that board diversity does not have adverse effects on company financial performance.”   Moreover, as most directors are chosen from the current directors and C-Suite executive’s social and business network, without a compelling reason to search elsewhere, such as regulatory compliance, a natural impediment to increased diversity will remain.

Commissioner Public Statements

On the same day as the approval, Chair Gary Gensler and Commissioners Peirce, Roisman and Allison Herren Lee and Caroline Crenshaw issued statements on the new Rules.  Whereas Chair Gary Gensler issued a very brief statement confirming that the new Rules are consistent with the requirements of the Exchange Act and will provide investors with additional information that they have been seeking, Commissioners Peirce and Roisman were not convinced.  Following Gary Gensler’s format, Commissioners Allison Herren Lee and Caroline Crenshaw issued a brief joint statement showing their support for the rule as a first step, but noting that other diverse categories, such as those with disabilities or seniors should be considered as well.

Commissioner Roisman took a somewhat middle of the road approach, commending Nasdaq’s commitment to diversity but dissenting to the Rule itself.  Like Commissioner Peirce, Roisman does not believe the Rule meets the required legal preconditions for adoptions. Roisman, however, did vote in favor of the recruitment service offered by Nasdaq.

Strongly dissenting across the board, Commissioner Peirce issued a lengthy statement, reading like a judiciary ruling, citing the numerous legal deficiencies with the Rules, including Constitutional issues.  First, the Exchange Act requires national exchange rules to be:

“designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade… to remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest; and not designed to permit unfair discrimination between customers, issuers, brokers, or dealers, or to regulate by virtue of any authority conferred by this chapter matters not related to the purposes of this chapter or the administration of the exchange.”

Although the rule release cites the Exchange Act standards, Commissioner Peirce does not believe it provides any valid argument that the new Rules meet the listed criteria.  Peirce questioned the empirical weakness with the data and studies propounded by Nasdaq in support of its position.  She notes that “commenters and studies persuasively demonstrate that the studies used by the Exchange are generally of low quality; that several do not make public the underlying data and the others that make the underlying data available show, at best, correlation; and that the Exchange has disregarded several high-quality studies that contradict the studies upon which the Exchange relies.”

Further, the studies cited only focus on gender and, to a lesser extent, racial diversity.  The Exchange makes no effort to explain why studies examining the effects of gender and, to a lesser extent, racial diversity support its decision to include in its rule other types of diversity for which there is no evidence linking board membership to corporate performance.  She believes the Exchange sidestepped these issues by arguing that various stakeholders desire consistent and comparable information relating to diversity in making their investment decisions.  However, this type of anecdotal support for the rule is insufficient to meet the Exchange’s burden to show that its proposal is consistent with the Exchange Act.  Commissioner Peirce is clearly concerned with regulating disclosures at the whim of current societal sentiment.  Likewise, she believes the SEC itself failed in its obligation to take a deeper dive and not unquestioningly rely on the Exchange’s analysis.  The SEC itself bended to a small group of investor pressure.

Continuing her dissent, Commissioner Peirce posits that the new Rules do not protect investors.  The Exchange’s designation of relevant demographic categories is arbitrary, as it has not shown that they are tailored to provide the “consistent” and “comparable” diversity-related information the Exchange believes investors are demanding.  Of the many issues raised, she notes that relying on self-identification cannot result in comparable information.  Even worse, she is concerned that shifting focus away from the actual business experience and qualifications of individual board members to demographic characteristics of the board as a whole will not benefit investors.  Companies may also be encouraged to recruit board members that check the boxes without even considering other meritorious candidates with unique, hard-won expertise and knowledge that would add meaningful value to the company.

Commissioner Peirce argues that the new Rules harm market integrity.  By micro-managing the delicate process of board selection, the Exchange is encouraging companies to forgo individual qualification that may be necessary for its success, in favor of meeting demographic standards.  The requirement to explain why a board is not diverse is likely to lead to poorly reasoned and poorly substantiated rationales.  Further, the new Rules could lead to less effective investor oversight of the board as investment managers will be less concerned with individual qualifications, skills and experience.  Commissioner Peirce also questions the unfair advantage foreign issuers have under the Rules, not only through more flexible disclosures but also as a result of an inability to police compliance.

Worse, the new Rules will incentivize misleading disclosures.  By setting diversity objectives, requiring companies that fail to reach those targets to explain publicly why they have failed to do so, and relying on director self-identification, the Rules invite disclosure that pushes the envelope of plausibility. To avoid having to admit noncompliance with the Exchange’s “diversity objectives,” a confession that likely will draw negative attention, including perhaps shareholder litigation, customer boycotts, and higher capital costs, companies will be under tremendous pressure to fit their directors into one of the favored categories.

Hitting every important category, Commissioner Peirce continues that the new Rules are contrary to public interest.  Commissioner Peirce believes the Rules promote stereotyping, pushing the view that all women are interchangeable providing a “womanly perspective.”  Likewise, with those in the LBGTQ+ category.   Moreover, since a person must self-identify in a particular category, those that do not wish to label themselves but are otherwise qualified may be overlooked for valuable board positions, leading further to conformists who are unwilling to push back against management. Also, Nasdaq offers no explanation for its arbitrary inclusion of some diverse categories and exclusions of others.

Commissioner Peirce also believes the new Rules are unconstitutional, encouraging discrimination and compelling speech by both individuals and companies in a way that offends protected constitutional interests. Both the Exchange and the SEC dismissed these concerns on the basis that an Exchange is not a “state actor.”  Peirce isn’t buying it and citing the role of the SEC in the rule making – and the SEC is certainly a “state actor.”

Board Diversity – Beyond Nasdaq

Putting aside Nasdaq’s rule, a lot of groups and thought leaders have been tackling the question of whether board diversity is a benefit or detriment to corporations, with thorough arguments to support both sides of the fence.  Board composition is consistently one of the most important topics on the agenda for shareholder engagement, and voting.

Harvard Law Professor Jesse Fried has publicly questioned the empirical value of Nasdaq’s board diversity data.  Also, University of MN Law Professor and former chief White House ethics lawyer Richard Painter wrote a thorough rebuttal to Nasdaq’s findings.  That rebuttal was met with its own rebuttal’s pointing out the lack of, and age, of the data presented.  It seems one of the best sources of information is California, which imposed a board diversity obligation on corporations domiciled in the state two years ago.  Since the enactment of the statute, there has been a significant increase of women on the boards of California entities, though other minorities, including women of color, continue to lag.

Getting ahead of this year’s proxy season, Glass Lewis published an in-depth report on Board Gender Diversity with an overview of where things stand in the U.S. and internationally, investor and state efforts to promote balance in the boardroom, and academic research on the benefits of diversity. Glass Lewis recognizes the complexity of the issue and the recruiting involved to find uniquely qualified directors who bring a breadth of experience and insight to the board table.  Simply adding women to the board for diversity’s sake and without careful consideration of qualifications and experience is unlikely to automatically effect any positive corporate change.  With that said, the report also concludes that bringing women and diverse board members will add to the overall viewpoints and knowledge base of a board, thereby improving corporate performance.

Many companies are not waiting for a rule to increase diversity disclosure.  To help stakeholders compare disclosure practices, KPMG recently launched a free new web-based tool that tracks disclosure about board diversity.  The software compares disclosure practices by sector, index (Russell 3000 and S&P 500) and company size.  There are several comparative publications as well with one by Deloitte and the Alliance for Board Diversity including information through 2020.

The voluntary increase in disclosure comes, at least partially, from pressure by institutional investors which have been vocal on the subject.  In 2020 many of those entities promised to put their views to action by increasing diversity in their own house.  The data is not in yet as to whether specific vocal proponents of diversity have made significant internal changes, but some are putting on a better show than others.  The Carlyle Group announced a new policy calling for at least one candidate who is Black, Latino, Pacific Islander or Native American to be interviewed for every new position and that at least 30% of its portfolio companies will have ethnic diversity on the board of directors.

Besides investor financial incentives, D&O insurers have started to include diversity practices among the many considerations in granting and pricing liability policies.

On a positive note, the new Rules are adding pressure to states and other organizations to expand anti-discrimination laws and employment protections to those in the LGBTQ+ community.

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