Understanding the ethical and business case for diversity

A recent case in the US overturning Nasdaq rules on diversity focused attention on “if not, why not” recommendations on board composition.

Late in 2024, the Court of Appeal for the Fifth Circuit in the United States vacated the decision of the US Securities and Exchange Commission (SEC) to approve two Nasdaq stock market rules relating to board diversity. The decision, in Alliance for Fair Board Recruitment v SEC, 21-60626 (11 December 2024), turned on the question of the SEC’s powers to approve listing rules under the Securities Exchange Act of 1934.

The rules in question were Nasdaq Rule 5605(f) (Diversity Rule) and Nasdaq Rule 5606 (Disclosure Rule). Subject to some exceptions, the former required a Nasdaq-listed company to have, or explain why it did not have, “at least two members of its board of directors who are Diverse, including (i) at least one Diverse director who self-identifies as Female; and (ii) at least one Diverse director who self-identifies as an Underrepresented Minority or LGBTQ+”.

The latter required the company to disclose, to the extent permitted by law, information on each director’s voluntary self-identified racial, gender and sexual identity.

By a narrow majority, the Appeal Court vacated the SEC’s approval on two grounds specific to US administrative law. These were that the SEC had not demonstrated sufficient relationship between the rules and the purpose of the Exchange Act and that it had exceeded the authority given to it by the US Congress.

The decision in the US came during the ongoing consultations by ASX Corporate Governance Council on its “if not, why not” recommendations on board diversity. These are taking place as part of the broader project to revisit and refresh its Corporate Governance Principles and Recommendations (CGPR). While directed specifically at ASX-listed entities, the Council’s approach is likely to influence broader discussions about board diversity in other settings.

Building a board

In most companies, appointments to the board are ultimately a matter for members. ASX-listed companies must hold director elections at each annual general meeting, and their directors must face re-election every three years. These are legally binding requirements of the ASX Listing Rules. Directors of all public companies, whether listed or not, who are directly appointed by the board, must put themselves forward for election by members at the next AGM.

For unlisted companies, how directors are selected depends on the constitution and other binding arrangements such as shareholder agreements.

While members may have the final say, incumbent directors have an important role to play in identifying suitable candidates and — often — bringing on new directors under casual vacancy or direct appointment provisions in the company’s constitution.

Boards also make a voting recommendation to members in director elections. In making these decisions affecting board composition, the current directors must always act in the best interests of the company and for a proper purpose.

Corporate governance codes and guidelines recognise the importance of the role incumbent directors, particularly chairs, play in shaping the composition of boards.

In 2003, the first edition of what is now the CGPR included a recommendation that a listed company should establish a nomination committee of the board with responsibility for “assessment of the necessary and desirable competencies of board members, review of board succession plans, evaluation of the board’s performance, and recommendations for the appointment and removal of directors”.