What Happened

On December 11, 2024, an en banc panel of the US Court of Appeals for the Fifth Circuit vacated the US Securities and Exchange Commission’s orders approving a series of Nasdaq rules regarding board diversity.[1] Beyond the immediate impact of the decision on board diversity efforts, the opinion will have far broader consequences for future rulemaking by self-regulatory organizations and the SEC itself. This alert considers the administrative law implications of the Fifth Circuit opinion on the SEC and the myriad of self-regulatory organizations it oversees.

The Bottom Line

Over the past 20 years, a series of appellate cases vacating SEC actions has placed a growing number of limitations on the agency’s ability to issue orders and engage in rulemaking. But the Fifth Circuit’s Nasdaq case stands out because it clarifies substantial limits around several commonly-accepted assumptions underlying SEC rulemaking that have to date largely gone unchallenged.

Since the case involves Section 19(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), which lays out the procedure by which the SEC approves rules of self-regulatory organizations, the decision applies to a wide variety of SEC registrants who make use of the Section 19(b) process to issue their own rules and regulations. These entities include stock exchanges, clearing agencies, the Municipal Securities Rulemaking Board (“MSRB”), the Financial Industry Regulatory Authority (“FINRA”) and the Public Company Accounting Oversight Board (“PCAOB”). Of course, the SEC itself is also bound by the holding.

The Fifth Circuit opinion includes an exhaustive analysis of the Exchange Act from an historical, academic and textual perspective. The decision aligns with recent Supreme Court and Fifth Circuit precedent that seeks to preserve federalism, limit overreach by administrative agencies and construe statutes narrowly according to their plain meaning. Since courts typically interpret each of the SEC’s other primary statutes in a manner consistent with interpretations under the Exchange Act, the Fifth Circuit’s decision should also apply to rulemakings under the Securities Act of 1933, the Investment Advisers Act of 1940 and the Investment Company Act of 1940. This is a landmark administrative law case impacting the SEC and the self-regulatory organizations it oversees, and the case’s impact on future SEC rulemaking is significant.

The Full Story

In 2021, Nasdaq sought SEC approval under Section 19(b) of the Exchange Act of three separate listing requirements regarding board diversity. In two separate orders, the SEC approved new Nasdaq listing rules requiring most Nasdaq-listed companies to (1) publicly disclose board diversity statistics using a uniform format on an annual basis (the “Disclosure Rule”) and (2) have, or publicly disclose why they do not have, at least one self-identified female director and at least one director who self-identifies as an underrepresented minority (the “Diversity Rule”). A third SEC order approved a Nasdaq rule providing complimentary access to a board recruiting tool intended to aid Nasdaq-listed companies in complying with the first two rules (the “Recruiting Rule”).

Two groups challenged the SEC’s approval orders in separate litigation, alleging various statutory and constitutional infirmities. The petitions for review were eventually consolidated before the Fifth Circuit. In 2023, a three-judge Fifth Circuit panel denied the petitioners’ petitions for review and upheld the SEC’s approval of the Nasdaq rules.[2] But the Fifth Circuit subsequently granted en banc review, and the en banc panel reversed the panel decision by a vote of 9-8 (with one recusal). The full court’s majority vacated the Disclosure Rule and the Diversity Rule, and dismissed as moot the challenge to the Recruiting Rule since no companies had sought to use the recruiting tool. Nasdaq has stated publicly that it will not appeal the decision further, and with the change in presidential administrations, the SEC is not likely to take further action either. A summary of key portions of the opinion and key takeaways follows.

1. Disclosure for disclosure’s sake is not authorized under the Exchange Act

In its opinion, the Fifth Circuit first focused on the SEC’s assertion that any disclosure-based rule is related to the purposes of the Exchange Act, and thus within the SEC’s authority to adopt.[3] In response, the court undertook a detailed historical analysis of the underpinnings of the Exchange Act as enacted in 1934, as well as key amendments to the statute adopted in 1975 relevant to Nasdaq.

First, the court concluded that the “text and history of the original Exchange Act indicate Congress enacted it to protect investors and tackle the manipulation and speculation that Congress thought fueled the Great Depression.”[4] The Exchange Act also placed limits on solicitation of proxies to ensure fair elections for corporate boards.[5] But, according to the court, “nothing in the original Act required disclosure for disclosure’s sake.”[6] Instead, the court reasoned, the Exchange Act “was uniformly directed at preventing market abuses.”[7]

Next, the court determined that while Congress passed the original Exchange Act in 1934 “to protect investors and the American economy from speculative, manipulative and fraudulent practices,” it amended the statute in 1975 “to further these goals and . . . to remove barriers to the development of a national market system.”[8] The court conceded there may also be “other purposes buried in the Exchange Act’s voluminous text,” but that its review of the statute’s history “makes clear that disclosure of any and all information about listed companies is not among them.”[9] Thus, the court concluded that before the 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 Exchange Act.[10] Instead, the SEC must establish that the rule has “some connection to an actual, enumerated purpose of the Act.”[11] Later in the opinion, the court revisited this theme to double-down on the notion that “full disclosure” by itself is not a “core purpose” of the Exchange Act.[12]

Key Takeaways: In recent years, the subject matter of SEC disclosure requirements for public companies has expanded markedly through rulemakings involving a range of topics including cybersecurity, executive compensation, greenhouse gas emissions, climate change, and human capital, to name just a few. Among the justifications for each of these rulemakings has been the notion that the Exchange Act is a disclosure statute, and while there is a theoretical limit to the outer reaches of disclosure, the SEC has yet to reach that frontier. This case will require a fundamental rethinking of this line of reasoning and a redrawing of that outer boundary. It will, therefore, limit future SEC disclosure rules.

2. The purposes of the Exchange Act are narrowly construed

To support the rules, the SEC contended that they were designed to “promote just and equitable principles of trade” and “remove impediments to and perfect the mechanisms of a free and open market and a national market system,” each as contemplated in Section 6(b)(5) in the Exchange Act. Analyzing academic literature, SEC releases, other caselaw and even Webster’s dictionary to place these phrases in context, the court concluded that the Disclosure Rule and Diversity Rule were “far removed” from just and equitable principles of trade, and “had nothing to do with the execution of securities transactions.”[13] Notably, the court cited the Supreme Court’s recent decision in Loper Bright Enterprises v. Raimondo, which eliminated so-called Chevron deference, for the proposition that statutes can only be “sensibly understood . . . by reviewing text in context.”[14]

Key Takeaways: The federal securities laws are replete with aspirational and mystical-sounding terminology such as “just and equitable principles of trade” and “to protect investors and the public interest.” While there have been some prior cases attempting to assign meaning to such wording, the SEC often deploys an “I know it when I see it” approach to interpreting these and similar phrases in its authorizing statutes, and over the years few of its orders doing so have been subject to judicial review. Here the court took the SEC to task and concluded that this kind of terminology indeed has a more precise meaning.

3. To “protect investors and the public interest” is not independent grounds to act

The SEC also pointed to its mandate under the Exchange Act to “protect investors and the public interest” to justify the rules. In perhaps the most important section of the opinion, the court determined that this phrase is a “catch all” phrase that must be interpreted by references to the canons of noscitur a sociis (“a phrase is given more precise content by the neighboring words with which it is associated”) and ejusdem generis (“a general or collective term at the end of a list of specific items is typically controlled and defined by reference to the specific items that precede it”).[15] When read in the context of the other language surrounding the public interest provision in the Exchange Act, the court concluded that the Disclosure Rule and Diversity Rule were not related to that purpose. The court was also skeptical of the SEC’s rationale that simply satisfying “the demand of some important investors” was stand-alone grounds to justify rulemaking, and it rejected that argument as well.[16]

Key Takeaways: The SEC has frequently justified past rulemakings on the grounds that an action was in the public interest. For example, the agency’s controversial rulemaking on climate and greenhouse gas emissions (subject to a pending Eighth Circuit challenge) cites this provision as authority for those rules. The Fifth Circuit’s opinion here suggests that this justification, without more, may be insufficient. Likewise, in recent rulemakings the SEC has also cited investor demand as compulsion for the SEC to act, and that too may not survive future judicial scrutiny.

4. The major questions doctrine applies to the SEC

The court’s opinion also considered the application of the major questions doctrine under the Supreme Court’s 2022 decision in West Virginia v. EPA and its rapidly-expanding progeny. In brief, this doctrine generally provides that absent an express grant of authority, Congress does not impliedly grant administrative agencies the power to make decisions regarding significant political or economic issues. Parties challenging SEC rulemaking have increasingly cited the doctrine since the West Virginia decision was announced, and in this decision the Fifth Circuit provided a robust analysis of the application of the doctrine to SEC rulemaking.

Here, the court considered the significant economic and political implications of the Nasdaq rules and quickly concluded “this is a major questions case.”[17] The court was particularly concerned that the SEC appeared to be “stepping outside its ordinary regulatory domain of market manipulation and proxy voting and intruding into the province of other agencies.” The court was also troubled that the SEC appeared to be intruding on the rights of states to regulate corporate governance.[18]

Key Takeaways: The major questions doctrine as applied to the SEC will without a doubt cabin the agency’s most ambitious plans for future rulemaking when planned actions lack explicit statutory authority. This outcome will be a welcome development for those who wish the SEC to return to its roots as a market-oriented regulator that focuses its disclosure agenda on material financial information. Those who wish to see the SEC continue to expand its oversight of corporate behavior may be disappointed.

The Fifth Circuit’s deference to the states’ role as the primary regulators of corporations is also notable. Since the enactment of the Sarbanes-Oxley Act in 2002, the SEC has increasingly asserted itself into core areas of corporate governance, such as through the constant expansion of the universe of permissible shareholder proposals under Rule 14a-8 and ever-increasing “comply or explain” disclosure requirements around board and management oversight of the business. As described below, the Fifth Circuit also addressed comply-or-explain rules in its opinion. In total, the ruling may serve as an opportunity for the SEC to reconsider existing mandates regarding corporate governance couched as disclosure requirements.

5. Two wrongs don’t make a right

In defense of the rules, the SEC and Nasdaq cited another stock exchange’s listing requirement regarding board diversity. The Fifth Circuit was not persuaded that the prior rule justified the one before the court. Instead, it noted that the “SEC cannot nullify the statutory criteria governing exchange rules by repeatedly ignoring them.”[19] Said differently, an agency “cannot acquire authority forbidden by law through a process akin to adverse possession.”[20]

Key Takeaways: Another common defense of recent SEC rulemakings has been that the SEC has passed similar rules in the past without challenge, hence it is free to do so again in the future. This line of reasoning is also suspect going forward. Instead, the SEC must find independent authority and justification for each future rule and order.

6. Public-shaming rules are suspect

The SEC and Nasdaq also defended the rules by arguing that they were mere disclosure rules that did not seek to “remake the boardrooms of America’s corporations.”[21] The court found that the administrative record did not support this assertion, and noted that corporations not meeting the diversity requirements were compelled to explain themselves under the Disclosure Rule. The court seemed most troubled by this latter point, ruling that this approach was not a disclosure requirement, but rather “a public-shaming penalty” for failing to abide by the government’s preferred policy outcomes.

Key Takeaways: For decades the SEC has adopted rules under the “comply or explain” model as a way of nudging registrants to engage in the SEC’s preferred behavior even when the agency may not be authorized to compel that conduct directly. The theory is that most companies would rather not disclose a lack of alignment with the SEC’s preferred practice on a given topic (even if compliance is not mandatory), thus they will change behavior so as to avoid a potentially embarrassing disclosure. This case calls into question the “comply or explain” approach, at least when there is a shaming element to it, and may serve to limit its use going forward.

[1] Alliance for Fair Board Recruitment v. SEC, Case No. 21-60626 (5th Cir. Dec. 11, 2024) (en banc decision).

[2] Alliance for Fair Board Recruitment v. SEC, 85 F. 4th 226 (5th Cir. 2024) (panel decision).

[3] Slip Op., supra note 1, at 11.

[4] Id. at 17.

[5] Id.

[6] Id.

[7] Id.

[8] Id. at 22.

[9] Id.

[10] Id.

[11] Id.

[12] Id. at 38

[13] Id. at 25-7.

[14] Id. at 26 (internal citations omitted).

[15] Id. at 28 (internal citations omitted).

[16] See id. at 31.

[17] Id. at 34.

[18] Id. at 35.

[19] Id. at 38.

[20] Id. (citations omitted).

[21] Id.