Nasdaq recently asked the Securities and Exchange Commission (SEC) to approve new diversity rules. To avoid forced delisting, a firm must “diversify or explain”: either have a certain number of “diverse” directors or say why it does not. In its proposal, Nasdaq tips its hat to the social justice movement. But investors should be nervous. Rigorous scholarship, much of it by leading female economists, suggests that increasing board diversity—which Nasdaq’s rules will likely pressure firms to do—can actually lead to lower share prices.
The rules aim at ensuring Nasdaq-listed firms with six or more directors have at least one self-identifying as female and another self-identifying as an underrepresented minority or LGBTQ+. Nasdaq CEO Adena Friedman says “there are many studies that indicate that having a more diverse board… improves the financial performance of a company.” But while Nasdaq’s 271-page proposal cites studies finding a positive link between board diversity and good corporate governance, it fails to cite a single well-respected academic study showing that board diversity of any kind leads to higher stock prices, the outcome investors actually care about.
Nasdaq’s lacking good sources
Nasdaq’s evidence consists almost entirely of studies by consulting and financial firms that show a correlation between the two. But correlation does not imply causation. Other factors, such as firm size or industry, could explain both higher returns and a more diverse board. To prove causation, one needs sophisticated statistical techniques to control for such omitted variables. The only causal “evidence” offered by Nasdaq, besides a cryptic claim made in an investment firm’s marketing materials, is a 2003 academic paper whose inadequate methodology was subsequently noted in a leading finance journal.
Nasdaq cannot cite any high-quality study showing that board diversity boosts returns, because there appears to be none. In fact, there are many serious academic papers reporting the opposite result: diversifying boards can harm financial performance. Troublingly, Nasdaq disregards this evidence.
The headquarters of the U.S. Securities and Exchange Commission on Jan. 28, 2021, in Washington, D.C. (Photo: Saul Loeb/AFP via Getty Images)
Consider a 2009 study of almost 2,000 U.S. firms by Renee Adams and Daniel Ferreira. Nasdaq repeatedly highlights its finding that boards with female directors have better attendance records and greater oversight over CEOs. But Nasdaq omits the paper’s bottom line: “the average effect of gender diversity on firm performance is negative.” Why? Greater gender diversity in boards may lead to over-monitoring of executives. The paper’s key finding is as troubling as Nasdaq skipping over evidence that fails to support the proposed changes.
Several high-quality studies, none of which is mentioned in Nasdaq’s proposal, demonstrate that stock returns suffer when firms are pressured to hire new directors for diversity reasons. A 2012 paper by Kenneth Ahern and Amy Dittmar focuses on Norway’s 2003 gender quota law. It shows that the law caused an immediate 3.5% decrease in the stock prices of firms without female directors, along with lower stock prices at these firms over the next few years. The reason: firms were forced to replace more experienced male directors with less experienced female ones.
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Turning back to America, a recent working paper examines California’s 2018 gender quota law. The law required U.S.-listed firms with California headquarters to have at least one female director by the end of 2019, and at least one other by the end of 2021. Firms can avoid complying by paying modest fines. But California publicizes noncompliance to name and shame firms into diversifying. The law’s announcement caused stock prices of affected firms to drop by a market-adjusted 2.6%. The authors partially attribute the decrease to the costs associated with changing boards. Other papers report similar findings.
True, these studies cannot conclusively prove that complying with Nasdaq’s proposed diversity target would harm investors. But they do raise a red flag.
Diversifying boards does not mean better financial performance
Of course, Nasdaq could argue that its proposed rules do not actually require any changes to boards. A firm always has the option of leaving the board unchanged and explaining why the board is insufficiently diverse. In an ideal world, Nasdaq’s rules would lead to changes in boards only when increasing diversity benefits investors. Otherwise, boards would remain unaffected.
But is this rosy scenario likely? California’s experience suggests not. Like California’s gender quota law, Nasdaq’s diversify-or-explain rule is designed to name and shame. As a result, firms may be pressured to comply even when it harms financial performance.
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What’s more, Nasdaq also wants firms to disclose every director’s self-identified race, gender, and LGBTQ+ status. This information will help activists identify firms they consider to be insufficiently diverse, even if they satisfy Nasdaq’s diversity target. Thus firms complying with Nasdaq’s diversity rule may be cajoled into making even more board changes, potentially to investors’ detriment.
Many wish to believe that diversifying boards improves financial performance. But wishing does not make it so. The best evidence, including a study Nasdaq itself cites, points in the opposite direction. If the SEC approves Nasdaq’s proposed rules, investors should be worried.
Jesse Fried is the Dane Professor of Law at Harvard Law School.
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