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Nasdaq Diversity Rule To Bring Change, Or Shame, To Cos.

Partner Shaun Mathew spoke with Law360 regarding the recent Nasdaq board diversity rule approved by the U.S. Securities and Exchange Commission.

The Nasdaq board diversity rule approved by the U.S. Securities and Exchange Commission last week represents the latest victory for a new generation of shareholders demanding more diversity in corporate America, one that will compel Nasdaq-listed companies to comply or risk falling behind their peers, attorneys told Law360.

Under the Nasdaq rule, approved Aug. 6 by the SEC, most Nasdaq-listed U.S. companies will eventually need to have at least two "diverse" members on their boards, including "one who self-identifies as female and one who self-identifies as either an underrepresented minority or LGBTQ+" — or explain in writing why they don't.

It's being described as a "comply or explain" rule, given that it requires disclosures but does not mandate actual hiring of the so-called diverse directors. Most companies will need to have two "diverse" board members, or explain why not, beginning in 2025. 

Nasdaq's history as a technological innovator and the "disruption mentality" of its listed tech giants like Amazon, Google and Microsoft positions it best to take the lead versus older exchanges, said Valerie Dahiya, a Perkins Coie LLP partner and former branch chief in the SEC's Office of Trading Practices.

"Some exchanges are better positioned and more nimble to meet that investor demand based on their fundamental core values and how they got started," Dahiya said.

Many of the larger tech companies listed on Nasdaq will likely be in compliance by the time the rules go into effect, attorneys said. Other companies, particularly the smaller and younger ones, simply need more resources to get it done, they said, something that a supplemental aspect of the Nasdaq rule addresses by offering free recruitment services for one year.

Any stragglers will ultimately comply, if not by choice then through "shame," attorneys said, as they're forced to disclose board demographic information to a new generation of shareholders who feel empowered by progressive movements like Black Lives Matter and will simply invest elsewhere if their demands aren't met.

"At the end of the day, if issuers want to attract younger investors, they'll have to meet the disclosure demands of that demographic or lose that investor base," Dahiya said. 

As part of the rule, a new so-called board diversity matrix will require that Nasdaq-listed companies disclose detailed information about their boards' demographics, including gender, ethnicity and sexual orientation, a significant lift from a compliance perspective, attorneys said.

"If a company doesn't meet the minimum diversity goals, it will have to explain why, the goal being to effectively shame companies into increasing their levels of diversity," said Shaun J. Mathew, a partner in Kirkland & Ellis LLP's shareholder activism and hostile takeover defense practice.

"By making them publicly disclose board-level diversity data in a uniform format, it gives investors ammunition to hold companies accountable on that front," he added. "That will be the first time you'll see a broad swath of U.S. public companies putting out board-level diversity data in an organized way."

Companies will be required to file the board diversity matrix either one calendar year from the rule's approval date, or when they next make certain proxy statement or company filings, whichever comes later. 

"That's one thing that companies need to think about in the near term as the first order of business," said Sean Donahue, the chair of Goodwin Procter LLP's public company advisory practice. "A lot of companies don't currently have that type of disclosure in their proxy statement."

Failure to comply with either the board diversity rule's requirements or the matrix disclosures could subject companies to delisting, according to the rule. 

While the rule's requirements and the added pressure of potential delisting will help move the needle on board diversity, attorneys noted that they are reflective of a much broader macro focus on diversity and inclusion issues, as investors demand more diversity and companies realize that it could impact investor demand and, ultimately, financial performance. 

"It's not as though the rule has occurred and companies are going to begin to focus on it; leading companies have already been focusing on this issue for some time," said Mellissa Duru, special counsel with Covington & Burling LLP, whose focus includes U.S. securities regulation and development of ESG-related advisory guidance for public companies.

"This rule will facilitate those that are the leaders in their class to showcase what they have been doing, and really encourage those who may not have yet put things quite in place to get started on doing so," Duru said.

The Nasdaq rule comes amid a broader governmental effort to prioritize so-called environmental, social and governance issues. President Joe Biden made a more progressive agenda a focal point of his presidency early on, while Gary Gensler, hand-picked by Biden to head up the SEC, is pushing forward with plans to ramp up ESG disclosure requirements.  

Meanwhile, the key drivers influencing companies' decisions to diversify their boards include actions from large shareholders like BlackRock, State Street and Vanguard, as well as proxy advisory firms ISS and Glass Lewis, all of which have recently adopted voting policies that punish directors for failing to meet their expectations on diversity, Mathew noted.

"Given the potential reputational damage to directors who are on the receiving end of such adverse votes, these new policies have already been effective in encouraging boards to increase the diversity in their ranks," he said.

Though the relationship between board diversity and business performance continues to be debated, Nasdaq argued in its original proposal that an "extensive" body of research demonstrates that "diverse boards are positively associated with improved corporate governance and financial performance."

In its final rule, the SEC notes that "investors and companies have different views regarding board diversity and whether board diversity affects company performance and governance." 

"Regardless of their views on those issues, the [proposal] would provide investors with information to facilitate their evaluation of companies in which they might invest," the SEC said. 

Diversity Statistics

In its December proposal, Nasdaq cited statistics showing that white individuals occupied a disproportionate number of board seats at Fortune 500 companies compared with their representation in the U.S. population.

In 2018, 83.9% of those seats were held by white individuals, while they represented about 60% of the U.S. population. On the other hand, 8.6% of seats were held by Black individuals, though they represented 13% of the U.S. population, while 3.8% were held by "Hispanic/Latino(a)" individuals, although they represented 19% of the population.

Nasdaq also noted that white men held 66% of the board seats at Fortune 500 companies, while women of color occupied just 4.6% of the seats.

Despite those stark contrasts, many Nasdaq-listed companies, especially larger ones, have already done much of the work to bolster their boards with more diversity, typically having made the greatest strides on the gender front, attorneys said.

And by the time the aspects of the Nasdaq rule calling for two "diverse" directors goes into effect, beginning in 2025, the "vast majority of companies will have complied," said Mathew of Kirkland & Ellis. 

Among other recent steps that could help fulfill the goals, Amazon, Microsoft, Starbucks and Zillow, all listed on the Nasdaq, recently signed on to the so-called Black Boardroom Initiative, a new program aimed at increasing the ratio of Black executives on corporate boards of S&P 500 companies.

While major Nasdaq companies appear to be pushing board diversity at the ground level, a Nasdaq spokesperson said it's not possible to give an "accurate and complete answer" regarding current compliance with the two "diverse" director rule due to a lack of current, standardized data.

"With that said, the board diversity data information expected from our listed companies is to be made publicly available and will help provide more clarity," the spokesperson said in an email. 

The 'Other' Exchanges

As the board diversity matrix data required by the rule becomes available, it will not only move more Nasdaq-listed companies to diversify, but it will also focus shareholder attention on other U.S. exchanges, ultimately pushing them to consider following suit with similar rules, some attorneys said.

Until now, other leading exchanges have only been willing to "pay lip service" to diversity, and they have pushed back on requiring disclosures similar to those in the Nasdaq rule, said Dahiya of Perkins Coie.

In fact, the head of the New York Stock Exchange, Stacey Cunningham, said during a televised appearance earlier this year that while diversity had been shown to stimulate business performance, it wasn't the role of exchanges to dictate diversity.

The NYSE declined to comment for this article.

Dahiya nonetheless remains confident that the Nasdaq measures, coupled with intensifying investor demand, will lead other U.S. exchanges to impose similar disclosure requirements.

"I don't think it's a question of whether they will, I think it's a question of when," she said. "Change is inevitable, and you have to be flexible and nimble to survive." 

Duru, of Covington, agreed. She noted that the U.K.'s Financial Conduct Authority has put forth its own comply-or-explain rulemaking proposal on the heels of Nasdaq's.

The U.K. watchdog's late July proposal calls for, among other things, at least 40% women on company boards, and at least one member with a nonwhite ethnic minority background. 

While it isn't clear if the U.K. proposal was a response to Nasdaq's, or if they were hashed out simultaneously, Duru said that it's "very likely" that the Nasdaq rule would have "some amount of influence with respect to other exchanges."

Even if the NYSE sticks to its guns and fails to follow Nasdaq's lead, it may be a moot point as the broader tide turns in favor of more diversity, added Donahue of Goodwin Procter.

"Regardless of what anybody else does … I think the trend towards more diverse corporate boards is going to continue no matter what," Donahue said.

SEC Commissioners Dissent

The SEC's broader ESG agenda has been met with skepticism from its Republican commissioners, Hester Peirce and Elad Roisman.

Roisman issued a statement following the approval of the Nasdaq rule, stating that he supported the rule change regarding the free board recruiting service, but had voted against the broader board diversity disclosure measures.

"I do not believe that the commission has fulfilled its obligations to find that this proposal, which has delisting implications for companies, meets the legal standards that we are required to apply in evaluating rules proposed by self-regulatory organizations," Roisman said at the time. 

Likewise, Peirce issued a statement noting that while she did not object to the approval of the board recruiting service proposal, she could not approve the diversity disclosure rule because it falls "outside the scope" of securities laws and "contrary to fundamental constitutional principles."

Dahiya called out the commissioners for spending a "substantial amount of time focusing on the importance of diversity" yet ultimately defending the status quo based on what she called "pretextual state actor and constitutional arguments."

"It's easy to complain about what is being done when you are doing nothing at all and certainly not offering solutions," she said.