SEC authority hobbled again by federal appeals court, knocking down board diversity quota

As massive corporations roll back diversity, equity and inclusion efforts to avoid backlash by right-of-center customers, and major universities do the same in response to lawmakers, donors and irate faculty, a financial regulator's DEI enforcement is being taken out of its hands.

A 9-8 ruling Wednesday by the full 5th U.S. Circuit Court of Appeals, with Judge James Ho recused, overturned the Securities and Exchange Commission's approval of stock exchange Nasdaq's diversity board quotas for listed companies, finding them far outside its statutory authority.

It replaces a three-judge panel's ruling for the SEC that found "sufficient" evidence to support the agency's view that "disclosure of information about board diversity would inform how investors behave in the market." That panel was all Democratic nominees.

"We are not aware of any established rule or custom of the securities trade," and the SEC didn't cite any, "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 majority opinion by Judge Andrew Oldham said.

While the original 1934 Securities Exchange Act required disclosure of "basic corporate and financial information" to protect investors and prevent speculation, "nothing in the original Act required disclosure for disclosure’s sake," he wrote, distinguishing the quotas from statutory rules around "just and equitable principles of trade."

While the SEC claims the quotas "protect investors and the public interest," that would be like enacting a rule protecting them "from the perils of tobacco," the opinion says.

"Even SEC itself determined these demographic characteristics have no rational relationship to corporate performance and investor returns," the New Civil Liberties Alliance, which sued on behalf of the National Center for Public Policy Research, wrote in celebrating the ruling.

The other plaintiff was the Alliance for Fair Board Recruitment, created by the same conservative activist behind affirmative-action legal challenges, Edward Blum. 

The ACLU notably defended the SEC's authority to compel speech from private companies, both their boards' demographics and justification for not meeting Nasdaq's quotas.

It's the latest bad news for an agency already on the outs with the New Orleans-based appeals court for its climate disclosure rule and denial of jury trials for enforcement targets. The Supreme Court upheld the 5th Circuit's jury requirement for civil penalties this year.

President-elect Donald Trump's decisive Nov. 5 victory prompted Chairman Gary Gensler, a villain in Trump's orbit for long delaying the merger between Truth Social and Digital World Acquisition Corp. and Gensler's crypto crackdowns, to announce he would resign on Inauguration Day.

One bright spot for the SEC in recent years was SCOTUS denying a petition, backed by free-spoken billionaires Elon Musk and Mark Cuban, to review the constitutionality of the gag orders the agency routinely imposes as a condition of settlement. The SEC refused to stop its 52-year practice this year, prompting a lengthy dissent from Commissioner Hester Peirce.

Oldham's majority opinion emphasized the market cap of Nasdaq-listed companies "exceeds $25 trillion, greater than the real GDP of the United States," and this attempt to "transform the internal structure of many of the largest corporations in the world" comes close to regulating "the entire economy." (Most Fortune 500 companies still have DEI programs.)

"The political significance is likewise staggering" because the rules are based on social justice, the agency "has never claimed the authority to impose … anything resembling" diversity rules on corporate boards and it makes no sense that Congress would vest that authority in the SEC instead of Equal Employment Opportunity Commission or Justice Department, he wrote.

Such regulation is even more the province of the states, the opinion says, as is the landlord-tenant relationship despite the federal Fair Housing Act.

The agency is really asking the 5th Circuit to ignore congressional revisions to the law in 1975 that "limited the regulatory power of exchanges to matters that are related to the purposes of the Act …  just because exchanges once operated free from federal oversight," Oldham wrote.

He mocked the thin evidence SEC accepted from Nasdaq in support of the quotas, that there's a link between race, sex and sexual orientation representation and "the quality of a company’s financial reporting, internal controls, public disclosures, and management oversight."

The SEC itself acknowledged the evidence was "mixed," and "Nasdaq offered only the barest speculation to support the proposition that there is any link between investor protection and racial and sexual diversity," Oldham wrote.

Even if the link is real, that could only justify disclosure, not requiring "companies to explain why they failed to be as diverse as Nasdaq would prefer," the opinion says – unless Nasdaq could show "a corporate governance delta" between non-diverse boards with no explanation for that condition and those with purportedly good reasons for non-diversity.

The exchange's proposed three-part test for adopting disclosure rules is at odds with its claim that the Supreme Court has determined "full disclosure" is the core of the law, he said.

"Would not every disclosure rule be related to the purpose of full disclosure," such as requiring boards to disclose religious affiliation, for whom they voted, "or whether they recycle, drive electric vehicles, and take public transit," Oldham asked rhetorically.

He accused the SEC of gaslighting the judges by claiming the rule "does not actually remake the boardrooms of America’s corporations."

Nasdaq said its purpose was to impose "aspirational diversity objectives" and force companies that don't reach them to "explain they they failed," the opinion says. "That is a public-shaming penalty for a corporation’s failure to abide by the Government’s diversity requirements."

The dissent by Judge Stephen Higginson, who also wrote the vacated panel ruling, emphasized that "Nasdaq does not evaluate the substance of a company’s explanation of why it does not have two diverse board members," and a company could comply by saying it doesn't meet the quota because it "prioritizes diversity of thought or geography."

He portrayed the majority opinion as an expansion of government, creating "a new, mandatory and enlarged role for SEC intervention, ordering the SEC to displace largely private ordering with alternate policy priorities.

"Indeed, had the SEC disapproved of the Disclosure Rule, Nasdaq would have had a compelling case that the SEC had acted arbitrarily and capriciously, given both its limited supervisory role and also the precept of administrative law that like cases be treated alike," Higginson wrote in a footnote.