Nasdaq’s diversity inclusion rules: All bark and no bite?

Background

In August 2021, the SEC approved Nasdaq’s proposal on diversity inclusion premised on the self-accountability framework of comply or explain. This was coupled with approval of Nasdaq’s one-year complimentary board recruiting service, which can help further the diversity inclusion mandate for companies without access to candidates who can fulfill the requirement.

Diversity has been defined on grounds of gender, race or ethnicity and LGBTQ+ status. The diversity inclusion rule requires: (a) at least two members of the board to be diverse or the company to provide an explanation for non-compliance; and (b) an annual disclosure of the company’s board-level diversity data in a prescribed format.

Of the two diverse board members, one should self-identify as female, and the second should self-identify as an unrepresented minority or LGBTQ+. However, a company cannot double count the same director in more than one diverse category. The annual disclosure of the diversity data has to be made in a specified format and is aimed at providing investors a comparable basis to evaluate diversity inclusion on boards of Nasdaq-listed companies. The board recruiting service aims to provide a network of board-ready diverse candidates for companies to identify, evaluate and appoint, in turn allowing for an increase in diverse representation on their boards. The rule also provides for a transition period.

The mandate has been relaxed for foreign issuers and small reporting companies, allowing them to comply by appointing two female directors. Companies with a small board, i.e., boards of five or fewer members, are required to have at least one member of its board to be diverse or, if not, then explain their approach. Relaxation for companies with small boards is a recognition of the disproportionate impact that the requirement may have on companies with small boards either due to the increased costs in expanding the board or diversity becoming a disproportionate consideration by requiring 40% or more of the board to be diverse.

Rationale

In adopting the comply or explain approach, Nasdaq rationalizes that the disclosure would allow investors to better understand why a company does not meet the proposed objectives. This would facilitate the investors’ evaluation of companies in which they might invest and their voting decisions in existing investments. The rule is aimed to provide a disclosure-based framework and not a mandate. Nasdaq would not evaluate the substance or merits of a company’s explanation, giving companies substantial flexibility in crafting the required explanation (including how much detail to provide).

This approach appears to be in line with the pro-diversity approach of institutional investors. State Street, in its proxy voting guidelines, provides that it is likely to vote against the chair of the nominating committee of a S&P 500 company that does not disclose, at minimum, the gender, racial and ethnic composition of its board. Blackrock Investment Stewardship encourages companies to have at least two women directors on their board, and if within a reasonable timeframe a company has not adequately accounted for diversity in its board composition, it may vote against members of the nominating/governance committee for an apparent lack of commitment to board effectiveness.

Effect

The flexible approach based on “comply or explain” has received support (p. 7-8) from certain stakeholders as it does not impose a mandate or a quota. However, the specification by Nasdaq that it would not assess the substance of the explanation and only evaluate that an explanation has in fact been provided renders the requirement meaningless. While the approach assumes that the explanation for non-compliance would contribute to the investors’ investments and voting decisions, in the absence of a meaningful explanation, there is no certainty that the investors would be able to draw any inference. To illustrate, the following is a list of examples of the explanations provided by Nadsaq: (p.8)

• The Company does not believe Nasdaq’s listing rule is appropriate.

• The Company does not believe achieving Nasdaq’s diversity objectives are feasible given the company’s current circumstances.

• The Company does not meet the diversity objectives because the nominations committee considers a variety of professional, industry, and personal backgrounds and skill sets to provide the board with the appropriate talent, skills, and expertise to oversee the company’s business.

• The Company is committed to ensuring that the board’s composition appropriately reflects the current and anticipated needs of the board and the company.

These explanations are vague and could be adopted by any of the Nasdaq-listed companies without any consideration of its specific circumstances. These explanations shed little light on the company’s policy or philosophy on diversity to allow an investor to make an informed decision. In defense of the approach (pg. 8), Nasdaq impractically suggests that shareholders may request additional information directly from the company if they need additional information to make an informed voting or investment decision. Accordingly, the absence of any evaluation by Nasdaq of the explanations provided by the company does tilt the balance in favor of companies while giving the investors a perception of informed decision making. An investment manager claims that the rule establishes a bright line which creates a reasonable minimum standard to appropriately escalate market awareness of listed companies with limited diversity. While that may have been the aim, the rule fails to meet this benchmark by a margin.

Gargi Bohra serves as a graduate editor of the NYU Journal of Law & Business. She is an LL.M. candidate specializing in corporation law at New York University School of Law. Prior to attending NYU, Gargi practiced corporate law for five years with a focus on mergers and acquisitions at Khaitan & Co. and L&L Partners, two of India’s leading law firms.