Why Board Diversity and the Nasdaq Rule Requiring It Make Sense

In December 2020, Nasdaq asked the Securities and Exchange Commission (SEC) to approve a new boardroom diversity rule.[1] The aim is for most Nasdaq-listed companies to have at least one director self-identifying as a woman and another self-identifying as an underrepresented minority or LGBTQ+.  The rule is not a requirement that listed firms have such (minimally) diverse boards, but instead is a requirement that firms either comply with this expectation or explain in their securities disclosure filings why they have not complied. Foreign companies and smaller companies will be given flexibility in satisfying this requirement with two women directors.

In February 2021 Nasdaq amended the proposal to require boards with five or fewer members to have at least one diverse member or explain why they do not; to give recently-listed companies more time  to comply or explain their noncompliance; and to give companies that lose a diverse board member time to find another one or explain why they have not.[2]

Nasdaq also established different deadlines for meeting the minimum diversity expectations, depending on listing category.  All companies will be expected to have at least one diverse director within two years of the SEC’s approval of Nasdaq’s rule. Companies listed on the Nasdaq Global Select Market and Nasdaq Global Market will be expected to have two diverse directors within four years, and the deadline for companies listed on the Nasdaq Capital Market is five years. Companies that do not meet these expectations will not be delisted if they provide an explanation in their securities fillings.

Nasdaq is not alone in thinking diversity is important.  Eleven years ago, Congress in Section 342 of the Dodd-Frank Act of 2010 required federal financial-services regulators to establish their own offices of minority and women inclusion and to set standards for “assessing the diversity policies and practices of entities regulated by the agency.”[3]

Shortly after Nasdaq released its revised rule, Professor Jesse Fried of Harvard Law School posted an eight-page paper[4] strongly criticizing the rule and accusing Nasdaq of misrepresenting empirical studies of the impact of board diversity on firm value to support its proposed rule. Specifically Fried stated:

While Nasdaq claims these rules will benefit investors, the empirical evidence provides little support for the claim that gender or ethnic diversity in the boardroom increases shareholder value. In fact, rigorous scholarship – much of it by leading female economists – suggests that increasing board diversity can actually lead to lower share prices. Adoption of Nasdaq’s proposed rules would thus generate substantial risks for investors.

Fried warns in several parts of his paper that board diversity could harm shareholders. He argues that the Nasdaq proposal will “generate collateral damage” and that “a close look at these studies [cited by Nasdaq] as well as studies that Nasdaq fails to cite suggests that increasing board diversity may well reduce investors’ returns.”

In a new paper responding to Professor Fried,[5] I explain why the problem is clear. “Underrepresented ethnic and racial groups make up 40 percent of the U.S. population but just 12.5 percent of board directors”[6] of the 3000 largest publicly traded companies. Women make up approximately 21 percent of these corporate directors. The average board size is 9.2 members, according to the Corporate Library’s study.[7]  A company with nine directors that complies with the proposed Nasdaq rule would have one underrepresented minority and one female director, putting that company very close to the current average for underrepresented ethnic and racial groups on corporate boards but well below the average for the number of women directors – to meet the average, the company would need two female directors. The Nasdaq rule that Professor Fried criticizes thus is aimed at the laggards that bring the averages down.  It is these companies that are given a chance to increase minority and female representation up to today’s – not very impressive – averages or explain why not.

Nasdaq claims that increasing board diversity, among other benefits, will increase shareholder value.[8] Professor Fried argues that it will not.

Statistical studies probably do not prove impact of board diversity on stock price one way or the other.   This is not because diversity does not impact shareholder value, but because it is extraordinarily difficult for event studies to control for other factors that affect stock price.  Corporations that voluntarily add women and minorities to their boards of directors are disproportionately in some industries as opposed to others[9] and may be more likely to be headquartered in some regions of the country and not in others.  Some corporations may use diversity to compensate for other problems with corporate governance and management.  Some corporations may select diverse directors who are likely to support managers who are not effectively maximizing shareholder value.  Studies relying upon board diversity’s impact on stock price must control for all of these factors.  It is not surprising that an impact of board diversity on stock price is difficult to discern.

Fried cites only one study showing a slightly negative impact on stock price from gender diversity on corporate boards.[10] This study uses a data set two decades old that did not include the financial crisis of 2008.  The same study found that women board members are more effective in monitoring management.  The authors of the study attributed the slightly negative impact of board gender diversity on stock price to a number of factors, including most notably the fact that excessive monitoring of management by board members may decrease shareholder value. Had the data set included stock price performance in 2008 and 2009, the aftermath of the financial crisis, it might have shown different results given that insufficient monitoring for exposure to financial risk was at least partially responsible for destroying so much shareholder value during that period  It is also ironic that many academics have been pushing for more monitoring of management by corporate directors, including Harvard’s shareholder rights project which aggressively campaigned for annual election of directors,[11] only to see at least some of them get cold feet about the board monitoring function when directors happen to be women.

The other statistical studies cited by Professor Fried involve stock market price reaction to laws mandating gender diversity on corporate boards.  The first of these laws was enacted in Norway in 2003, the second in California in 2018 (California in 2020 enacted another law requiring representation of under-represented minorities on corporate boards).  As Professor Fried points out, stock market reaction in both instances was slightly negative. And this is understandable under the circumstances. Norway’s law required 40 percent female representation on corporate boards.  There may have been a supply and demand problem in Norway in 2003 for corporations all trying to find so many female directors at the same time. France enacted a similar law in 2011, and I am not aware of any studies showing a negative impact on stock price there.  The California law is more recent and is controversial not because of gender diversity but because it imposes this corporate governance norm on corporations headquartered in California even if they are incorporated in another state.  As professors Steven Davidoff Solomon and Jill Fisch point out in a separate paper,[12] California’s law is a departure from the internal affairs doctrine in the United States whereby the law of the state of incorporation governs matters such as election of directors and their fiduciary duties to shareholders. This trend, if continued by other states, or pursued into other areas of corporate governance, would move affected corporations toward the model of corporate governance in the European Union.  There, member states are required to recognize corporate charters from other member states but under the “seat theory” of corporate governance also reserve the right to regulate some internal affairs of corporations headquartered within their borders.  When viewed in this perspective, the adverse market reaction to the California law cited by Professor Fried is understandable. It very likely has nothing to do with women being on corporate boards but with the fundamental question of which jurisdictions should regulate corporate governance.

Most important, the Nasdaq rule is a “comply or explain” rule rather than a rigid requirement. Nasdaq chose the more flexible “comply or explain” option carefully, knowing that while studies on the impact of boardroom diversity on firm performance are not uniform in their conclusions, boardroom diversity is important to some investors, particularly institutional investors, and that disclosure of this information to investors is important.  Nasdaq, unlike the California legislature, is also very much focused on shareholder value.  Finally, the Nasdaq rule could discourage California and other states from moving further in the direction of intruding upon the internal affairs of corporations headquartered within their borders but incorporated elsewhere.

To support the proposed rules, Nasdaq cites numerous studies by both academics and institutional investors showing that boardroom diversity improves firm performance and the accuracy of a firm’s public securities disclosures. In my paper, I cite these and additional studies. For example, one study found that women directors were effective at reducing securities fraud.[13]  Another found, based on interviews with directors, that women directors sometimes widen a board’s perspective, help objectify discussion and act as mediators.[14] There is less empirical work on the impact of racial diversity on corporate boards or for diversity for sexual orientation and gender identity (LGBTQ+ directors). With boards just beginning to diversify, the sample size has probably been too small, although this may soon change.

The conceptual arguments in favor of board diversity, however, are powerful.  Groupthink is recognized in psychology and managerial economics as a serious impediment to quality decision making.[15] Even more pernicious is “affinity fraud,”[16] where some people, including corporate managers concealing fraud from their directors, successfully lie to those who want to believe people who are like themselves.  Diverse boards of directors also should help improve corporate relations with other constituents including regulators, employees, suppliers, customers, and the media.  This should translate into higher profits.  Furthermore, the Nasdaq rule is essentially a disclosure rule, requiring companies that do not have a diverse board of directors to explain why not.

There are broader issues at stake.  More institutional investors realize that the value of their entire portfolio depends on asset values in the economy, and solving environmental and social problems affect the value of the entire economy. Professor Madison Condon has explained that institutional investors’ support for addressing climate change is consistent with portfolio value maximization.[17] The same is likely true for resolving the present crisis in the United States over racial injustice and the importance of aligning the distribution of corporate wealth and power more closely with the demographics of our country.

Then there are the philosophical and political implications. Public perception associating corporate wealth with a legacy of racism and gender discrimination has negative long-term consequences.  A political backlash could result in more regulation and taxation.  In sum, shareholder wealth maximization alone in the long run requires that social problems be addressed.  Diversified boards of directors are not the entire solution to injustice and inequality but are a good way for corporations to do their part.

Thus, it is not surprising that a large number of asset managers support the proposed Nasdaq rule. These include not only public pension funds but also private asset managers such as Vanguard.  Fried dismisses this support for the rule as self-interested, saying that these asset managers engage in social justice activism in order to attract assets from socially conscious investors and earn fees. It is difficult, however, to see how this translates into asset managers supporting Nasdaq’s rule, which partially supplants asset manager activism.  If the rule is finalized, asset managers, in order to attract assets with their own activism on board diversity, will have to apply pressure for companies to have a greater number of diverse directors than the Nasdaq rule. This is hardly a reason for asset managers to support the rule simply in order to earn higher fees.

Diversification of corporate boardrooms very likely increases shareholder value, even more so for diversified investors having a stake in the entire economy.  Board room diversity does not decrease shareholder wealth. The Nasdaq’s comply-or-disclose rule is a sensible and flexible way to nudge listed companies in the right direction.  Finally, gender and racial balance on corporate boards is simply the right thing to do.


[1] Nasdaq Proposed Diversity Rule, 85 Fed. Reg. 80, 472 (December 4, 2020), Notice of Filing of Proposed Rule Change to Adopt Listing Rule IM-5900-9 to Offer Certain Listed Companies Access to a Complimentary Board Recruiting Solution to Help Advance Diversity on Company Boards, Exchange Act Release No. 34-90571 [hereinafter, “Nasdaq”].

[2] First Amendment to Nasdaq Proposed Diversity Rule (February 26, 2021).

[3] 12 U.S.C. § 5452.  https://www.law.cornell.edu/uscode/text/12/5452

[4] Fried, Jesse M., Will Nasdaq’s Diversity Rules Harm Investors? (March 31, 2021). Available at SSRN: https://ssrn.com/abstract=3812642 or http://dx.doi.org/10.2139/ssrn.3812642

[5] https://ssrn.com/abstract=3824245 or http://dx.doi.org/10.2139/ssrn.3824245

[6] https://www.nytimes.com/2020/09/15/business/economy/corporate-boards-black-hispanic-directors.html

[7] https://www.investopedia.com/articles/analyst/03/111903.asp

[8]  https://www.nasdaq.com/press-release/nasdaq-to-advance-diversity-through-new-proposed-listing-requirements-2020-12-01

[9] https://www.nytimes.com/2020/09/15/business/economy/corporate-boards-black-hispanic-directors.html

[9] https://www.investopedia.com/articles/analyst/03/111903.asp

[10] Adams, Renée B. and Ferreira, Daniel, Women in the Boardroom and Their Impact on Governance and Performance (October 22, 2008). European Corporate Governance Institute (ECGI) – Finance Working Paper No. 57/2004 , Available at SSRN: https://ssrn.com/abstract=1107721 or http://dx.doi.org/10.2139/ssrn.1107721

[11] http://www.srp.law.harvard.edu/companies-entering-into-agreements.shtml

[12] Fisch, Jill E. and Davidoff Solomon, Steven, Centros, California’s ‘Women on Boards’ Statute and the Scope of Regulatory Competition (2019). European Business Organization Law Review, Vol. 20, p. 493, 2019, U of Penn, Inst for Law & Econ Research Paper No. 19-23, European Corporate Governance Institute (ECGI) – Law Working Paper No. 454/2019, Available at SSRN: https://ssrn.com/abstract=3384768

[13] Cumming, Douglas J. and Leung, T.Y. and Rui, Oliver M., Gender Diversity and Securities Fraud (July 24, 2014). Available at SSRN: https://ssrn.com/abstract=2471081 or http://dx.doi.org/10.2139/ssrn.2471081 .  .

[14] Joecks, Jasmin and Pull, Kerstin and Scharfenkamp, Katrin, Women Directors’ Roles on Corporate Boards: Insights from a Qualitative Study (May 4, 2017). Available at SSRN: https://ssrn.com/abstract=2962947 or http://dx.doi.org/10.2139/ssrn.2962947. 

[15] I Janis, Groupthink: Psychological Studies of Policy Decisions and Fiascoes (1982).  https://books.google.com/books/about/Groupthink.html?id=ZB0bAAAAIAAJ

[16] See Fairfax, Lisa M., ‘With Friends Like These…’: Toward a More Efficacious Response to Affinity-Based Securities and Investment Fraud. Georgia Law Review, Vol. 36, p. 63, 2001, Available at SSRN: https://ssrn.com/abstract=921074

[17] Condon, Madison, Externalities and the Common Owner (April 26, 2019). 95 Washington Law Review 1 (2020) , NYU Law and Economics Research Paper No. 19-07, (Abstract) Available at SSRN: https://ssrn.com/abstract=3378783

This post comes to us from Richard W. Painter, the S. Walter Richey Professor of Corporate Law at the University of Minnesota Law School. It is based on his recent paper, “Board Diversity: A Response to Professor Fried,” available here.

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