The US Securities and Exchange Commission (SEC) approved new disclosure rules on August 6 regarding board member diversity of Nasdaq-listed companies. Nasdaq’s new rules require most companies to tell shareholders how many of their board members are diverse in terms of race, gender, and LGBTQ+ status and, if they do not have at least two diverse directors, they must explain to shareholders why by August 2022. The SEC’s decision provides insight into the agency’s increased focus on transparency, responsiveness to shareholder concerns, flexibility in exchange rulemaking, and other key issues. Companies will need to develop strategies to comply with these new rules.
Nasdaq’s Diversity Disclosure Rules and Public Commentary
On December 1, 2020, Nasdaq proposed the new listing rules (5605(f) and 5606). In a previous article, we discussed Nasdaq’s Rules in detail but the key aspects of the Rules are as follows:
The Comply-or-Explain Rule (Rule 5605(f)) would require most Nasdaq-listed companies to have, or explain why they do not have, at least two “diverse” directors, including (a) at least one director who self‑identifies as female; and (b) at least one director who self-identifies as an underrepresented minority (Black, Latino, Asian, Native American, Alaska Native, Native Hawaiian, or multiple ethnicities), or as LGBTQ+. Certain companies are exempted from this requirement, and foreign issuers and smaller companies have greater flexibility in complying with the Rule. Companies would need to explain why they have not met Nasdaq’s diversity objectives to shareholders but would not be scrutinized by Nasdaq for the explanation. A failure to comply or explain could result in delisting.
The Diversity Disclosure Rule (Rule 5606(a)) requires most Nasdaq-listed companies to publicly disclose statistical information about the self‑identified gender, race, and self-identification as LGBTQ+ of the companies’ directors. This disclosure must be provided on the company’s website or in the company’s proxy statement, or similar disclosure.
As part of the proposal, Nasdaq has offered help to companies that do not currently meet the diversity guidelines. Nasdaq is offering one-year free access to a network of board-ready diverse candidates to eligible companies.
Nasdaq’s proposal generated significant commentary from numerous news organizations and the public. Some wrote articles praising the Rules as an important step in improving access to the boardroom for women and minority groups. Others panned the new rules, accusing Nasdaq of overstepping its role as an exchange. Members of the public (including advocacy groups, individuals, companies, law firms, and legislators) sent hundreds of letters to the SEC for, against, and in favor of modifications to the Rules. The SEC took the matter under advisement in April 2021 and issued its official decision on August 6, 2021, approving the Rules in full.
The SEC’s Decision and Commissioners’ Statements
As with all rules proposed by self-regulatory organizations (SROs) like Nasdaq, the SEC had to review and approve the rules before they go into effect. Based on an analysis of the Rules, the applicable legal authority, and comments from the public, the SEC found that the Rules were appropriately designed to prevent fraudulent practices, promote just and equitable principles of trade, remove impediments to free and open market system, and protect investors.
Despite the heated rhetoric by some commentors and journalists regarding the debate of diversity mandates, the SEC approved the Rules in light of shareholder interest in consistent director diversity information and the flexible compliance regime proposed by Nasdaq. The SEC found that board-level diversity statistics are not currently available on a consistent and comparable basis even though a broad array of investors have expressed interest in this information. And, while investors and commentors are divided on the importance of diversity at the board level and its effect on company performance, the disclosure of such information may facilitate investors’ evaluation of companies and impact investment (and shareholder voting) decisions. The commission also found that these Rules augmented existing commission rules that require companies disclose whether, and how, their boards or board nominating committees consider diversity in nominating new directors. Finally, the commission determined that Nasdaq’s free one-year service to help companies identify diverse candidates was appropriate.
All five SEC commissioners penned statements regarding the decision. Chairman Gary Gensler wrote a brief letter extolling the ruling because it would allow investors to have access to information about “who leads our public boards” and that “markets work best when investors have access to such information.” Commissioners Allison Herren Lee and Caroline Crenshaw wrote a joint letter calling it a step forward and expressing hope that it would be a “starting point for initiatives related to diversity, not the finish line.” Lee and Crenshaw indicated support for further rules including considering disability as a relevant characteristic in the definition of diverse, as well as rules involving diversity among “senior management and the workforce more broadly.”
Commissioner Elad Roisman issued a statement dissenting in part; while he supported Nasdaq’s service center, he opposed the new rules. He opined that the commission had not conducted enough analysis regarding whether the rules were consistent with the Securities and Exchange Act of 1934 (the Exchange Act or the Act) and whether the Rules could be considered “state action” resulting in potential stricter scrutiny considering the rule’s diversity focus. Commissioner Hester M. Pierce issued a strongly-worded, lengthy statement against the Rules finding they are inconsistent with the Exchange Act – arguing the rules did not protect investors and actually undermined market integrity – and “offensive to important Constitutional principles.”
Key Highlights From the SEC’s Decision
The entire decision is worth reading but a few key points are worth highlighting because it shines a light into the SEC’s thinking and what the new rules mean for companies, including:
- Diversity disclosure rules are consistent with the Exchange Act’s goals: The SEC’s decision primarily rests on the focus of investor protection and providing information for which investors have clamored. Additionally, the SEC reasoned that the standardized format for disclosure allows for consistent comparable information and mitigates information disadvantages for investors with less resources, thus contributing to the maintenance of fair and orderly markets. The SEC’s reasoning may be a roadmap for future exchange rule changes on other topics.
- Comply-or-explain model blessed by the SEC: The SEC emphasized that the Rules do not mandate any particular board composition. Rather, companies need only disclose director diversity on an aggregate basis and explain why they do not meet Nasdaq’s proposed two diverse director objective. The SEC further noted that directors are not required to self-identify and companies have substantial flexibility in crafting an explanation for not meeting Nasdaq’s objectives. Future exchange rules may follow this model given the SEC’s focus on flexibility.
- Competition among exchanges: Throughout the SEC’s decision, it repeatedly expressed that companies are not required to list on the Nasdaq exchange and if companies strongly oppose complying with the new Rules, they may list elsewhere. The SEC noted Nasdaq’s Rules and similar proposals may provide another way in which exchanges compete for listings.
- SEC finds that regardless of mixed empirical studies on the benefits of diverse boards, disclosure requirement is still appropriate: The SEC took neither side of the debate many commenters were having – does diversity impact company performance? – and found that the empirical data on the benefits of increasing diverse board membership was mixed. Nonetheless, the SEC noted that companies may analyze the research conducted so far and make their own conclusions in determining whether to strive to meet Nasdaq’s objectives and how to explain to shareholders why they do not.
- Definition of diverse to include EEO-1 form plus LGBTQ+ is permissible: The SEC found that the Nasdaq’s definitions were reasonable. In particular, the Rules’ definition of “underrepresented minority” was reasonable considering it is consistent with the EEO-1 form with which companies are already familiar, and the addition of LGBTQ+ was found to be reasonable as well. While the definition did not include people with disabilities or veterans as some commentors have requested, two commissioners voiced strong support for such definitional improvements and companies may use more expansive definitions as long as they are disclosed under Rule 5606(f).
- SROs are not state actors, so no constitutional concerns: The SEC dismissed concerns that by compelling companies to make these disclosures regarding race and gender it was compelling speech and could be considered as unconstitutional state action based on race. The SEC found that exchanges are not state actors in mandating such disclosures.
Unless Nasdaq-listed companies plan on leaving the Nasdaq exchange, they will need to comply with the new diversity disclosure and the comply-or-explain rules.
- Get help from knowledgeable counsel and Nasdaq’s network service. Complying with Nasdaq’s Rules will require careful planning and execution; develop a strategy for compliance with knowledgeable counsel. Additionally, if the company is concerned it may not meet the current diversity objectives, it may access Nasdaq’s free service that has a number of diverse potential board candidates.
- Understand which rules apply to your company. The Rules provide different phase-in periods for certain companies including those listed on the Nasdaq Global Select Market, Nasdaq Global Market, and Capital Market. Additionally, different definitions and director objective numbers may apply for foreign issuers. Carefully review the Rules and determine which diversity objectives, phase-in periods, and definitions that may apply to your company, if any.
- Explain the new rule to the board, management, and shareholders. Clear communication will be key in complying with Nasdaq’s Rules with the least amount of headaches. Directors, for example, may have misconceptions of the rule that cause them to be concerned about how to comply with the Rules or what that means for their role on the board. Develop an intentional communication strategy to allay these fears; prepare stakeholders for the coming disclosure and related actions.
- Plan a path forward consistent with company values. After understanding what rules apply and explaining it to stakeholders—the board in particular—there should be a discussion of how to comply. Not only should the matter be discussed, but there should be a specific action plan to prepare for the company’s first disclosure. This planning process should keep in mind the company’s values and policies regarding diversity and inclusion. As the SEC noted, companies are provided substantial freedom to craft an explanation if they do not have the requisite number of diverse directors. The explanation piece could be a key communication to inform shareholders about the company’s board and its philosophy for including different viewpoints.
- Gather information in a sensitive way. A key part of complying with these Rules will be timely obtaining self-identification information from directors. While the Rules and the SEC made clear that there is no requirement that directors provide self-identifying information, there should be an attempt to get the information. Develop a clear, nonintrusive plan to obtain information regarding directors’ gender, race, LGBTQ+ status, and any other information relevant to the company’s diversity and inclusion policies. This information gathering should be sensitive to directors’ legitimate privacy concerns and should supplement existing information gathering done already for director and officer questionnaires.
- Prepare the disclosure and related communications. After information has been gathered, the company will need to determine how to best communicate it to shareholders by August 2022 or other applicable deadline. The Rules provide options in allowing companies to include the information on proxy statements, information statements, 10-Ks, 20-Fs, or the company’s website. Additionally, companies should prepare to proactively communicate and respond to inquiries regarding questions that may arise as a result of the disclosures.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Michael D. Blanchard
Jason D. Frank
Jordan D. Hershman
Emily E. Renshaw
Bernard J. Garbutt III
Thomas P. Giblin, Jr.
Brian A. Herman
John T. Hood
Christopher T. Jensen
Howard A. Kenny
Finnbarr D. Murphy
David W. Pollak
Kimberly M. Reisler
Kenneth I. Schacter
Robert E. Gooding, Jr.
Justin W. Chairman
Michael L. Kichline
James W. McKenzie
Laura Hughes McNally
Joanne R. Soslow
Korey R. Inglin
David C. Schwartz
Joseph E. Floren
Susan D. Resley
Charlene S. Shimada
David A. Sirignano
Grace E. Speights
George G. Yearsich