Yup, two posts in one day – and early in the week for me – but this seems to be a day for an outpouring of corporate governance news. I reserve the right to take the week off at some future date.

Anyhoo, NASDAQ adopted a comply-or-explain rule for board diversity, which was approved by the SEC, and it was immediately challenged.  Unconstitutional, beyond SEC authority, major questions, etc etc. 

A rare Democratic Fifth Circuit panel upheld the rule, but then the case went en banc, and today, the full Court struck the rule in a 9-8 ruling.

The striking thing about the Fifth Circuit’s opinion is how narrowly it construes the purpose of the securities laws.  Sure, it unsurprisingly cast doubt on the evidence that NASDAQ offered regarding the benefits of diversified boards, but most of the opinion is devoted to a reinterpretation of the Exchange Act to focus nearly exclusively on the prevention of fraud and manipulation.

For example, some excerpts:

We (B) explain that an exchange rule is not related to the purposes of the Exchange Act simply because it is a disclosure rule. The Act exists primarily to protect investors and the macroeconomy 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 with those purposes, but not otherwise….

Congress enacted these disclosure provisions to protect investors and prevent speculation. … Second, it thought disclosure would facilitate “the evaluation of prices of securities” and therefore promote the efficient “direction of the flow of savings into industry.” .. Or put differently, disclosure would stabilize markets by curbing speculation.

See what they did in that latter paragraph? I deleted the citations but note how they acknowledged the price formation function of the securities laws but immediately reinterpreted it to be entirely about fraud prevention.  And then there’s:

That makes sense. If companies could hide their financial conditions, they could defraud investors or whip them into a speculative frenzy. Disclosure of basic corporate and financial information was a sound antidote. But it was not an end in itself; it served a purpose—essentially the same purpose served by restrictions on margin loans and short sales. That much is clear from the fact that Congress carefully limited SEC’s power to compel disclosure to the kinds of information that are most likely to eliminate fraudulent and speculative behavior.

By contrast, the original panel opinion (and the dissent here) read the purpose of the securities laws as to mandate disclosure.  Here are quotes from the original panel:

The “fundamental purpose” of the Securities Exchange Act of 1934 (Exchange Act), codified as amended at 15 U.S.C. § 78a et seq., is to enforce “a philosophy of full disclosure . . . in the securities industry.”…

The “fundamental purpose” of the Exchange Act is “implementing a philosophy of full disclosure,” …—not just the disclosure of information sufficient to state a securities fraud claim.  Indeed, the Exchange Act gives the SEC “very broad discretion to promulgate rules governing corporate disclosure.”  To give one example, for a security to be registered on an exchange, the SEC can require the issuer to disclose any information about “the organization, financial structure, and nature of the business” as is “necessary or appropriate in the public interest or for the protection of investors.”  15 U.S.C. § 78l(b)(1)(A).  Nothing in this provision or the provision governing exchange rules cabins disclosure rules to information that would meet the materiality element of a securities fraud claim.  And, as the SEC Approval Order explains, “[e]xchanges have historically adopted listing rules that require disclosures in addition to those required by [SEC] rules.”  …

That’s a crucial difference, because – while there surely are those who approach things differently – I’d argue the mainstream view today is that the meta purpose of the securities laws is to ensure that investors have sufficient information to accurately price securities (according to risk/return), with the broader goal of ensuring efficient capital allocation throughout the economy.  We want investors to give money to useful and productive businesses, and not to businesses that will set resources on fire, and the securities laws facilitate that.  (Here are two cites; there are countless more)

Fraud prevention suggests a much narrower scope for SEC disclosure regulation than does regulation for accuracy in pricing.

So, it’s not surprising that the Fifth Circuit went from there to hold that the diversity disclosure rule does not serve the narrow purpose of preventing fraud.  At one point, it went so far as to suggest the rule might be barred even if it provided financially useful information to investors:

Moreover, SEC may have asked the wrong question. SEC considered evidence respecting the effects of diversity on firm performance. See JA9. But it is not clear what firm performance has to do with the Exchange Act. Of course, investors generally like it when firms make more money, but Congress did not pass the Exchange Act for the purpose of maximizing shareholder wealth. It passed the Act to protect investors from fraud, manipulation, speculation, and anticompetitive exchange behavior. Firm performance has little to do with those objectives.

(As part of its logic, the Fifth Circuit also attacked the rule on MQD grounds by writing that “the SEC has never claimed the authority to impose diversity requirements, or anything resembling them, on corporate boards.” Item 407(c)(vi) would never)

So I am less concerned about the fate of this particular rule, than I am for the rhetoric here that suggests a dramatic curtailment of all securities disclosure requirements.

At which point I have to mention the climate change rules.

Those are currently being challenged in the Eighth Circuit.  With the election, who knows how that challenge will proceed; what’s certain is that the Trump Admin will end up unwinding the rules.

But in general, both the diversity rules, and the climate change disclosure rules, tend to be challenged with the same arguments.  Opponents accuse the SEC of stepping outside its lane to solve problems allocated to other agencies – to solve climate change, which is the EPA’s job, or to solve workplace discrimination, which is the EEOC’s.  When presented with evidence that major investors want these disclosure rules, there tend to be sideswipes to suggest these investors – BlackRock, for example – aren’t really seeking investment related information, but are instead trying to impose their own (Larry Fink’s) notion of the social good on corporate America.  The challengers also point out that the rules themselves are structured as disclosure rules, but function as governance rules – “disclose your process for evaluating climate risk,” for example, technically allows a company to say “we don’t evaluate that,” but no company wants to admit as much, so, in fact, the rule forces companies to start evaluating climate risk (or diversifying their board, or whatever), and that, opponents say, is bad. 

That’s definitely what the Fifth Circuit said in this case about the diversity rules (e.g., “If Congress had granted a diversity mandate to any agency … we would have expected Congress to give it to the Equal Employment Opportunity Commission or even the Department of Justice”; “corporations that do not meet those objectives must explain why they failed. That is not a disclosure requirement. That is a public-shaming penalty for a corporation’s failure to abide by the Government’s diversity requirements.”), and you see it in the briefing and general commentary on the climate change disclosure rules.

The challengers are half right.  Because, I tend to agree that diversity disclosure rule is not, in fact, intended to help investors price securities or even to adopt governance practices that contribute to wealth creation; it is more in the category of the kind of rule that serves a kind of signaling function, that the corporation is exercising its power responsibly and inclusively.  It’s a display of self-governance and discipline, in a manner that costs corporations very little but perhaps wins them legitimacy.  It benefits companies and investors, but not in the traditional manner by which the securities laws operate; it does so by contributing to their social license to operate. (Yeah, I talk about that in my paper, Of Chameleons and ESG).

But that’s not what the climate change rules do.  The climate change rules force companies to evaluate the actual financial impact of climate change on their business, and that is crucial information not to fight climate change (which the SEC is accused of trying to do), but to ensure that companies – and investors – accurately begin to weigh the financial costs of climate change.  And on a broader level, to encourage investors to seriously stop allocating capital to areas and industries that will simply not survive the transition.  Which is exactly what the function of the securities laws should be in our society.

That said, my fear with the challenges to the climate change rules was, the rules were so obviously financially-relevant that any decision by a court striking them down would necessarily have spillover effects to other, more traditional securities disclosure rules, which would damage the entire system.  How ironic that the Fifth Circuit did that anyway with the diversity rules – only it did so, as far as I can see, quite intentionally, in what looks like the first step in a project to pare back the securities laws across the board.

Anyhoo, in case you missed it, Mike Levin and I talked about the climate change disclosure rules on our podcast a few episodes ago – here on Apple, and here on Spotify.