5th Circuit Again Adopts Restrictive View of Exchange Act Purposes and SEC Regulatory Power

On December 11, 2024, the 5th Circuit issued another important opinion (for the third time this year) requiring that an administrative agency's rules fit squarely within the statutory scheme that empowers the agency to act. Agencies often take expansive views of their powers, sometimes taking the initiative to fill a perceived gap or advance a worthy and commendable public policy, even if it is unclear that Congress authorized them to do so. Former CFPB director Richard Cordray famously referred to this as "pushing the envelope." Below we explore how in Alliance for Fair Board Recruitment v. SEC, No. 21-60626 (5th Cir., Dec. 11, 2024) (hereinafter "Alliance") the court rejected the agency's expansive view of the purposes of the Securities Exchange Act of 1934 (the "Exchange Act") and instead held that "an exchange rule is not related to the purposes of the Exchange Act simply because it is a disclosure rule." We also examine whether past statements of the presumptive incoming chair and two of the incumbent commissioners indicate how the SEC might view its rulemaking authority under new leadership.

The Proposed Nasdaq Rules

In 2020, Nasdaq issued a series of rules intended to promote diverse board membership among its listed companies. According to Nasdaq, the three-part proposal was "designed to promote just and equitable principles of trade, remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, protect investors and the public interest." The first of the three-part series was a disclosure rule (Rule 5606) which "would require Nasdaq listed companies ... to provide statistical information – in a proposed uniform format – on the company's board of directors. This information related to a director's self-identified gender, [self-identified] race, and self-identification as LGBTQ+." The second part (Rule 5605(f)) would generally require Nasdaq-related companies to have at least one director who identifies as a female, one director who identifies as a listed ethnic minority or LGBTQ+, or explain why the board did not have at least two such directors among its members. The third part (Rule IM-5900-9) would enable Nasdaq to offer companies who did not meet the "aspirational diversity objectives" complimentary access to a board recruiting solution which might allow companies to evaluate diverse board candidates and board support for benchmarking. An amended version of those proposed rules was approved by the SEC on August 6, 2021.

Because Nasdaq is a self-regulatory organization ("SRO"), under § 78s(b) of the Exchange Act, the SEC must approve changes to its proposed regulations. Further, under 15 U.S.C. § 78f(b) the SEC must find that any proposed SRO rule change is related to the purposes of the Exchange Act. When the proposed rules were challenged, that section of the Exchange Act became the center of the 5th Circuit's judicial analysis and decision.

The Challenge

The proposed rules were controversial from the beginning and elicited substantial comment, support, and criticism. Several days after SEC approval, the Alliance for Fair Board Representation ("AFBP") filed a petition in the 5th Circuit challenging the rule on constitutional grounds and as being inconsistent with the requirements of the Exchange Act because it regulated matters not related to the purposes of the Exchange Act. In October of 2023, the 5th Circuit upheld the SEC's approval of the Nasdaq rules. However, in February of 2024 it granted a petition for rehearing en banc.

The Court's en banc Analysis and Decision

In its decision, a closely divided (9-8) en banc panel vacated the SEC's approval of the three Nasdaq rules. The court held that the rules could not be squared with the statutory purpose established by the Exchange Act (establishing the original disclosure-based and anti-fraud framework) and the 1975 Amendments to that Act (establishing the National Market System, or "NMS"). Notably, this was the third time in 2024 that either the 5th Circuit or a district court within the 5th Circuit reversed a significant SEC rule for failure to establish that the rule was within its statutory authorization. The other two cases were National Association of Private Fund Managers v. SEC, No. 23-6047 (5th Cir., June 5, 2024) regarding the regulation of private fund advisors (the "private fund rule"), and National Association of Fund Managers v. SEC, No. 4:2024-cv-00250 (N.D. Tex., Nov. 21, 2024), regarding the SEC's so-called "dealer rule" (intended to give the SEC greater insight into high-frequency traders ("HFTs"), usually proprietary traders).[1]

As noted above, in order to approve the proposed rules, the SEC was required to find that the proposed rules were related to the purposes of the Exchange Act. This, according to the 5th Circuit, was where the proposed rules fell short. The court first noted the criticisms when the rules were initially approved by Commissioners Elad Roisman and Hester Peirce. Commissioner Roisman faulted the SEC for failing to undertake its own reasoned analysis to evaluate the proposals. According to Commissioner Peirce, the purposes of the Exchange Act "boiled down to regulating securities transactions with an eye toward protecting interstate commerce and the financial system, and ensuring the maintenance of fair and honest markets, in securities transactions." In her view, "the board diversity proposal did not advance any of these purposes."[2]

The SEC defended its position on the basis that these rules would improve overall disclosures regarding publicly listed companies. The court, however, was not persuaded, noting:

The [Exchange] Act exists primarily to protect investors in the macro economy 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 to those purposes, but not otherwise. [But] the SEC did not explain how the board diversity proposal has any connection with those purposes.

Notably, the court did not accept the SEC's argument that the proposal was designed to advance the purposes contained in the Exchange Act, stating that the Exchange Act's purposes "bore no relationship to the disclosure of information about the racial, gender, and sexual characteristics of the directors of public companies." It simply was not enough, in the court's view, for the SEC to contend that any disclosure-based rule is related to the purposes of the Exchange Act. The court determined that disclosure of "any and all information" is simply not among the purposes of the Exchange Act and that a mandated disclosure would be related to the purpose of the Exchange Act "if and only if it has some connection to the ills Congress designed the Act to eradicate."

The court engaged in a detailed historical evaluation of both the Exchange Act and its 1975 Amendments which established the NMS. It noted in particular that the NMS established a system of execution intended to lower transaction costs and promote a free and open market for securities transactions. According to the court, however, the board diversity proposal did not do anything to advance those goals. While the proposal might be a good idea and make available information which could contribute to some investor's investment and voting decisions, "it has nothing to do with the execution of security transactions."

In support of the rules, Nasdaq asserted that there was an established link between the racial, gender, and sexual identities of a company's board members and "the quality of a company's financial reporting, internal controls, public disclosures, and management oversight." The court disagreed, noting that "Nasdaq offered only the barest speculation to support the proposition that there is any link between investor protection and racial and sexual diversity." It went on to state that the SEC "could not 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." From the court's perspective, Nasdaq failed to establish that there was any difference in corporate governance practices between (a) boards which are non-diverse and have no explanation for their non-diversity, and (b) non-diverse boards that have good reasons for non-diversity.[3]

The court also supported its decision with an analysis of the Major Questions Doctrine ("MQD"). The court explained that the MQD has been in existence as long as the administrative state and that by the early 20th century it was firmly ensconced in treatises discussing administrative law, citing Frank J. Goodnow, "The Principles of the Administrative Law of the United States" 326-27 (1905) ("the general rule in this country is that the administrative authorities … may issue ordinances only when the power to issue such ordinances has been expressly given to them by the legislature"). Relying in part on the import of the Supreme Court's recent decision in Loper Bright v. Raimondo, the court held that in its modern formulation, the MQD rests on the principle that "administrative agencies have no independent constitutional provenance" and are without any inherent or implied authority. Thus, an agency's power to make major decisions "must come only from unequivocal statutory text." (emphasis added.) The court noted that the statutory provisions at issue were "long extant," and in that period of time the SEC had never claimed "the authority to impose diversity requirements, or anything resembling them, on corporate boards." Finally, the court also took into account that the proposed rules upset the relationship between the corporations and their historic primary regulator, the states.[4]

What Comes Next: How Are Those Interested in These Rules And Related Policies Likely To Respond?

The last question is what happens next. Nasdaq has indicated that it does not intend to seek Supreme Court review, and the SEC has commented that it is still reviewing the decision. However, assuming that Chairman-designate Atkins is confirmed, and assuming further that the SEC will have to husband its resources in the new era of (the proposed) DOGE, it does not seem likely that they will seek further review. Indeed, it is possible that litigation that is extant may be resolved by the SEC "confessing error" and proceeding to a settlement order.

What is perhaps more interesting is how those interested in the broader policy will respond. Many publicly listed companies have already adopted board diversity standards and seem unlikely to cast them aside. Major institutional investors and prominent shareholder advisory firms continue to express a genuine interest in diversity policies and in diverse corporate boards. Furthermore, the states, many of which are home to a large number of publicly held companies, also are interested in the advancement of diverse boards and are likely to continue to weigh in. Indeed, companies committed to diversity could continue to use Nasdaq's board diversity matrix voluntarily. Going forward, it is highly unlikely that board diversity will be abandoned or ignored.

From a broader regulatory policy perspective, the 5th Circuit's rulings on the diversity rules, the private fund advisor rule, and the dealer rule may be a precursor to the SEC retreating from a more expansive interpretation and adopting a more restrictive one, perhaps even a textualist view of its powers. Indeed, the prior writings and public statements of the presumptive incoming SEC chairman indicates that he may share such a limited view. While testifying before Congress, Mr. Atkins commented that the SEC needed to take into account more strongly the views of economists over lawyers, particularly in the rulemaking process. (Statement of Paul S. Atkins United States House of Representatives Committee on Financial Services, September 15, 2011). He further has noted that it is important that information to be disclosed be material and related to:

The SEC's statutory mission [] to maintain fair, orderly, and efficient markets, facilitate capital formation, and to protect investors. It carries out that last part by ensuring market participants have accurate material information about the securities in which they invest.

Testimony of Paul S. Atkins, Hearing Before United States House of Representatives Subcommittee on Investor Protection, Committee on Financial Services (July 10, 2019).

In the same testimony, in connection with the discussion of several proposed bills before Congress, Mr. Atkins also stated:

[T]he SEC should focus on its mission of regulating capital markets and protecting investors, rather than being tasked with lofty goals it is not equipped to handle, such as 'supporting the public interest in ensuring publicly traded companies do not cause or contribute to adverse human rights impacts.'

A Broader View

In short, the three cases noted above and the impending change in SEC leadership likely means that the days of the SEC using expansive interpretations of statutory terms to achieve policy goals not tightly bound to the language of its enabling legislation have come to an end—at least for the next four years. Moreover, given the tightening of regulatory policy both at OMB and at the proposed DOGE, unless an agency proposes a rule that falls within the "chalk lines" of the statute from which it derives power, is supported by substantial public record and comment, and is underpinned by a solid economic cost-benefit analysis, it is unlikely to advance very far under a second Trump Administration.

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If you have any questions related to this topic, please contact any one of the authors or any DWT financial services lawyer. DWT can assist with evaluating SEC and DEI policies and initiatives, assess legal risk, and provide recommendations and best practices. DWT will continue to monitor these and other issues related to corporate governance and disclosure requirements for future developments.