‘A Public-Shaming Penalty’: Appeals Court Strikes Down NASDAQ Corporate Board Diversity Rules

A major court victory for keeping power constrained by law and woke capital focused on capital, not wokeness.

T hese are not the best of times for the woke fever that broke out across corporate America and the rest of our institutions over the past decade, reaching a crescendo in 2020. Nor have these been the best few years for the Securities Exchange Commission in the United States Court of Appeals for the Fifth Circuit. On Wednesday, woke capital lost another round in that court in its effort to use the combined power of government bureaucracy and corporate power to remake the demographic composition of corporate boards to meet the standards of the cultural elite.

In December 2020, NASDAQ issued a trio of rules that collectively pressured NASDAQ-listed companies to disclose the “diversity” of their boards on race, gender, and sexual orientation lines, and compelled companies that failed to employ at least two “diverse” directors to explain publicly why. NASDAQ needed SEC approval to go down this road. Under the federal securities laws, as modified by Congress in 1975, self-regulatory organizations (“SROs”) such as NASDAQ and the New York Stock Exchange must submit their rules for approval to the SEC. Once approved, they carry the force and effect of federal law, but that also means that they can be challenged in court as if they were the regulations of a federal administrative agency.

In August 2021, the SEC approved the rules, and they were promptly challenged in court. JD Vance proposed legislation to override the rules, which a National Review editorial endorsed. Republican state attorneys general pressured NASDAQ to drop the rules. Now, at the end of the Biden interregnum, the rules have been struck down — unless the Supreme Court revives them.

On Wednesday, a divided en banc panel of the 17 active judges of the Fifth Circuit, by a vote of 9–8, declared in Alliance for Fair Board Recruitment v. Securities Exchange Comm’n that the rules exceeded the statutory authority of the SEC to approve or NASDAQ to adopt. (The court thus did not address constitutional challenges to the rules.) The court’s opinion, by Judge Andrew Oldham, found that the board diversity rules were unconnected to any of the statutory purposes for which Congress had empowered the SEC to make or approve rules, and involved major questions of public policy that should not be presumed to be within agency power without an express grant of authority from Congress.

Power and Where It Comes From

So much of woke capital is the exercise of power that was never granted for the purpose it is used for, and for which there is no accountability to the power-granting authority, whether that means voters or shareholders. As the majority observed, the SRO power to make rules and the SEC power to approve them derive from the federal securities laws.

Corporations are created by state rather than federal law. The laws creating and empowering the SEC, including the Securities Act of 1933, the Securities Exchange Act of 1934, and other New Deal–era laws, exist to prevent fraud on investors by companies and other market actors, mainly by means of falsehoods about company financial condition and market manipulation. They aimed to cure the real and perceived problems of market swindles that were felt to be behind the 1929 market crash that presaged the Great Depression. Given that these were laws passed at the height of Jim Crow with heavy Southern Democratic support, it would be strange if they included a charter to enforce racial diversity in the boardroom, much less to enforce modern ideas of gender equity and gay rights. Of course, the text of the statutes includes no such thing.

In 1975, out of concern that the markets were uncompetitive — exemplified by fixed commissions uniform across the stock brokerage industry for trades — Congress amended the Exchange Act in various ways aimed to create a national market system and a national system for the clearance and settlement of trades in stocks, bonds, and other investment securities. Those reforms included requiring the heretofore private SROs to clear rules changes through the SEC. These changes followed extensively documented studies of the industry following the late 1960s “paperwork crisis” that overwhelmed Wall Street’s capacity to handle rising trading volume. Congress was not vague about what it was doing, or why.

The statutory text included explicit legislative findings of the purpose of these amendments, such as “economically efficient execution of securities transactions,” “fair competition among brokers and dealers” and “among exchange markets,” “the availability to brokers, dealers, and investors of information with respect to quotations for and transactions in securities,” “the practicability of brokers executing investors’ orders in the best market,” “an opportunity . . . for investors’ orders to be executed without the participation of a dealer,” and “the linking of all markets for qualified securities through communication and data processing facilities.” This was actually pretty visionary stuff for the mid 1970s, and it was laser-focused on the nuts-and-bolts practicalities of market structure that helped birth the Wall Street boom of the 1980s. Again, the amendments said nothing about social engineering in corporate governance or employment.

Moreover, Congress in 1975 was explicit, as the Fifth Circuit explained, in stating that it was not just handing over its democratically legitimate legislative power to privately owned stock exchanges, with or without administrative approval:

An exchange may not “regulate by virtue of any authority conferred by this chapter matters not related to the purposes of [the Exchange Act] or the administration of the exchange.” That means a proposed exchange rule is not “consistent with the requirements of” the Exchange Act, id. § 78s(b)(2)(C)(i), if it “regulate[s] . . . matters not related to the purposes of” the Exchange Act, id. § 78f(b)(5).

Only in the past few years have the people running this system decided to seize upon the breadth of statutory principles of disclosure and good business ethics, in spite of these explicit limitations on their power, and claim that Congress hid within these statutes a vast authority to remake the personnel and priorities of corporate America.

The Excuses

As Judge Oldham observed, the NASDAQ rules are framed in terms of disclosure, but they are designed to be coercive. They go beyond just demanding full disclosure of the racial, gender, and sexual-orientation composition of boards: “Corporations that do not meet those objectives must explain why they failed. That is not a disclosure requirement. That is a public-shaming penalty for a corporation’s failure to abide by the Government’s diversity requirements.”

This has nothing to do with the statutory purpose:

The [Exchange] Act exists primarily to protect investors and the macroeconomy from speculative, manipulative, and fraudulent practices, and to promote competition in the market for securities transactions. A disclosure rule is related to the purposes of the Act if it has some connection with those purposes, but not otherwise. [The statutory] purposes bear no relationship to the disclosure of information about the racial, gender, and sexual characteristics of the directors of public companies.

Pressed to justify using public authority over stock trading to demand these types of cultural representation amongst directors, the SEC and NASDAQ offered a flimsy set of excuses. First, because SEC regulations are often said to be based upon a philosophy of full disclosure, the “SEC found that any disclosure-based exchange rule is related to the purposes of the Exchange Act.” But the statutory “history makes clear the Act is primarily about limiting speculation, manipulation, and fraud, and removing barriers to exchange competition. There are other, ancillary purposes, but disclosure of any and all information is not among them. The obvious implication is that a disclosure rule is related to the purposes of the Act if and only if it has some connection to the ails Congress designed the Act to eradicate.”

“No doubt,” the court observed, “the Act has ancillary purposes — for example, protection of corporate suffrage. . . . There may be other purposes buried in the Exchange Act’s voluminous text, but our review of the Act’s history makes clear that disclosure of any and all information about listed companies is not among them.” As a result, “before SEC approves an SRO rule, it must do more than posit that the rule furthers some ‘core disclosure purpose’ that is found nowhere in the Act. SEC may not approve even a disclosure rule unless it can establish the rule has some connection to an actual, enumerated purpose of the Act.” Judge Oldham noted how unlimited the SEC and SRO powers of disclosure might otherwise be:

Would not every disclosure rule be related to the purpose of full disclosure? For example, a rule that compelled disclosure of the religious affiliations of companies’ directors. Or the presidential candidate they voted for in the most recent election. Or their position on the hottest political issue of the day. Or whether they recycle, drive electric vehicles, and take public transit. We see no basis to derive such an unlimited principle [from general language in previous cases].

That inevitably means that courts have to police the agency to ensure that it is doing things with at least some relation to statutory goals set out by Congress. But that’s not an unreasonable judicial role when Congress has been so explicit about its statutory purposes, and it’s one that would be unnecessary so long as the SEC is approving rules somewhere within the ballpark of topics like market efficiency and financial disclosure. For example, the court was willing to entertain any rule that “did anything that might plausibly reduce the transaction costs associated with executing a securities trade — e.g., by lowering broker commissions or bid-ask spreads.” This isn’t that, by a mile, and the SEC didn’t really even try to claim that it was.

Next, the SEC cited “just and equitable principles of trade,” an umbrella concept for business ethics in stock trading and other established market customs. The court was again unpersuaded: “We are not aware of any established rule or custom of the securities trade that saddles companies with an obligation to explain why their boards of directors do not have as much racial, gender, or sexual orientation diversity as Nasdaq would prefer.”

The SEC cited the public interest. But that could mean anything, unless courts read it to mean the public interest in the goals of the statute. “An exchange could not enact a rule designed to protect investors or the public from the perils of tobacco.”

NASDAQ claimed that it could show that more diverse boards meant less corporate fraud, “But Nasdaq offered little support for its assertion that there is an empirically established — or even logical — link between the racial, gender, and sexual composition of a company’s board and the quality of its governance,” and at most this would support a disclosure requirement — not the additional requirement that companies confess in public struggle sessions why they failed to be sufficiently diverse. Again, the court was cautious about wading into flyspecking the SEC’s justifications, but while “it may be true that an exchange need not produce conclusive empirical evidence to show that a proposed rule is related to the purpose of investor protection,” it remains the case that “SEC cannot approve a rule simply because an exchange declared the existence of some fact. If it could, the statutory limitations on exchange authority would be dead letters.”

Major Questions

The majority further cited the major questions doctrine, quoting D.C. Circuit judge David Sentelle: Courts should not assume that “Congress not only had hidden a rather large elephant in a rather obscure mousehole, but had buried [it] beneath an incredibly deep mound of specificity, none of which bears the footprints of the beast or any indication that Congress even suspected its presence.” Judge Oldham traced the origins of the major questions doctrine to the earliest cases in the late 1890s placing limits on federal regulatory agencies to exceed the powers granted them by Congress. He also noted the presumption against handing to such agencies powers (such as over corporate governance) traditionally exercised by the states. He warned against reading federal laws out of their context into “empty vessels for SEC to exercise nearly unlimited regulatory authority.” (Alterations omitted.)

The dissenters, in an opinion by Judge Stephen Higginson, leaned hard into the point that NASDAQ is a private company with competitors, and that the scope of the SEC’s review of its rules should be less than the scope of the SEC’s discretion in writing rules of its own. But Congress in 1975 subjected these rules to federal oversight precisely on the theory that competition alone was insufficient to satisfy the federal interest in promoting national market efficiency. Moreover, the dissent gave some of the game away as to the ideological additions by NASDAQ to the supposed market demand for this information: “Nasdaq took the categories of information that companies are already reporting and, after adding LGBTQ+ identity, asked that the same information be collected from directors, who aren’t considered employees.” (Emphasis added.) What exactly makes the board’s sexual preferences a matter of federal interest in efficient markets and good governance?

One hopes that we are finally turning the corner and returning to an age when federal regulators and other major social institutions focused on doing their own jobs well rather than trying to do every job except their own. Is it too much to ask that government power derive from the people, rather than from what bureaucracies can get away with? The Fifth Circuit thought not. Hopefully, under new management, the SEC won’t fight that just and obvious conclusion.