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D.C. District Court Upholds SEC's Conflict Minerals Rules, Government Accountability Office (GAO) Report Questions Effectiveness on Humanitarian Efforts

On July 23, 2013, the U.S. District Court for the District of Columbia entered summary judgment in favor of the U.S. Securities and Exchange Commission (SEC) in connection with a challenge by the National Association of Manufacturers, The Business Roundtable and the U.S. Chamber of Commerce (collectively, NAM) to the rules adopted in August 2012 by the SEC that implement the disclosure and reporting of the use of “conflict minerals.”  These rules were mandated under Section 1502 of the Dodd-Frank Act in the adoption of which Congress determined that annual disclosure obligations imposeed on SEC-reporting companies that manufacture products containing conflict minerals sourced from the Democratic Republic of Congo and adjoining countries (DRC) would help “to ensure activities involving such minerals did not finance or benefit armed groups” in the region.   The court’s decision is a significant win for the SEC, which on July 2, 2013, had its rules relating to resource extraction payments – also mandated by Dodd-Frank – struck down by the same district court, in part as arbitrary and capricious.  Many observers expected that the conflict minerals rules, which contain no de minimis exception (cited as a key flaw in the resource extraction rules), would be voided, at least in part, on similar grounds.  Meanwhile, in a July 2013 report, the U.S. Government Accountability Office (GAO) issued its evaluation on whether the rules will ultimately achieve the humanitarian goals desired by Congress.

The conflict minerals rules have been a topic of hot debate across industry groups due to the arduous and expensive diligence obligations imposed on SEC-reporting companies, as well as other companies along the supply chain (many of which are not themselves subject to Dodd-Frank or the SEC rules).  Industry groups have estimated the compliance costs to be upwards of $15 billion in the first year, compared to the SEC’s cost analysis of $4-6 billion.  As noted in the SEC’s adopting release, approximately 6,000 domestic and foreign SEC-reporting companies are expected to be affected by the rules along with more than 278,000 suppliers, most of which would not be directly subject to the  diligence and reporting requirements.

District Court Rejects NAM’s Arguments

The complaint filed by NAM presented a challenge under the Administrative Procedures Act, claiming that the conflict minerals rules were arbitrary and capricious in several respects (including as to the “reasonable country of origin inquiry,” coverage of issuers that “contract to manufacture” products, and phase-in periods and the adequacy of the cost/benefits analysis).  NAM also contended that the mandatory website disclosure under the rules compelled “burdensome and stigmatizing speech” in violation of the First Amendment.  In its 63-page opinion, the district court stated that there was “no statutory support for Plaintiff’s argument that the [SEC] was required to evaluate whether the Conflict Minerals Rule would actually achieve the social benefits Congress envisioned.” Consequently, the court held that the rulemaking was not arbitrary, capricious or contrary to law.   The court also noted that the SEC was under a Congressional directive to promulgate rules under Section 1502 of Dodd-Frank and was not in a position to “second-guess Congress’s judgment.”  According to the court, the SEC adequately discharged its statutory duty to promote efficiency, competition, and capital formation by explaining in the adopting release that the information would be taken into account by investors in pricing a company’s securities, thus leading to informational efficiency even though there may be a loss in the company’s operational efficiency due to compliance costs. 

The district court also rejected NAM’s argument that the rules should be remanded to the SEC to reconsider inclusion of a de minimis exception in light of the statutory language, noting that the SEC properly exercised its discretion in finding that a de minimis exception was inappropriate and would undermine the impact of the final rules.  The court found that: “[T]he SEC was not required to exhaustively analyze each and every proposal it received during the rulemaking process.  Instead, given its ‘broader conclusion’ that conflict minerals are often used in minute amounts, the SEC believed that any type of categorical de minimis exception had the potential to swallow the rule and would be inappropriate.” 

In rejecting NAM’s First Amendment challenge, the court applied Central Hudson’s intermediate scrutiny test, under which a challenged regulation may survive if (i) there is a substantial government interest at issue, (ii) such interest is directly advanced by the regulation, and (iii) the means used to accomplish the purpose is reasonable.   Since there was no dispute that the first prong of the test was met, the court turned to the second prong and found that the SEC’s disclosure scheme directly and materially advanced Congress’s purpose of promoting peace and security in the DRC.  On the third prong, the court concluded that disclosure on a company’s website was sufficiently reasonable and that “the government need not ‘demonstrate a perfect means-ends fit,’ nor must it ‘satisfy a court that it has chosen the best conceivable option.’”

GAO Report Finds that In-Region Factors May Adversely Affect Impact of SEC Rules

In its July 2013 Report to Congressional Committees, “SEC Conflict Minerals Rule – Information on Responsible Sourcing and Companies Affected,” the GAO found that although various company and industry-wide initiatives may facilitate compliance with the conflict minerals rules, “other factors may affect the rule’s impact on reducing benefits to armed groups in the [Congo] and neighboring countries.”  In particular, the GAO noted the presence of “constraining factors such as lack of security, lack of infrastructure and lack of capacity in the DRC that could affect the ability to expand on efforts to achieve conflict-free sourcing of minerals…and thereby potentially contribute to armed groups’ benefitting from the conflict minerals trade.”

The GAO Report supports the concern many companies have expressed since the conflict mineral rules were adopted last year – while the humanitarian cause behind Section 1502 of Dodd-Frank is noble and just, the method to achieve the stated goal may in fact prove counterproductive.  The costs of compliance with the conflict minerals rules are encouraging some companies to change their sources of supply to ensure minerals are not sourced at all from the DRC and adjoining countries, rather than simply diverting their business to mines or smelters in the region that do not benefit or support militant groups.   Unfortunately for the legitimate businesses in the region, sourcing outside of the DRC appears viable given that the region accounted for less than 1% of the global tin supply and 12% of the global tantalum supply in 2011, and about 3% of the global tin supply and less than 1% of the global gold supply in 2010, according to U.S. Geological Survey data.  The GAO Report goes on to state that “[s]ome industry officials cited concerns about sourcing from the DRC, even through the in-region sourcing initiatives, because of the potential impact on brand reputation and financial risk.”  Thus, while Congress intended that the rules would minimize the flow of funds to militant groups, conflict-free mines and smelters are also being adversely impacted by the rules.

Now that the legal challenge to the conflict minerals rules has been decided by the district court, NAM will need to assess whether an appeal to the D.C. Circuit Court is warranted and/or beneficial to any possible Congressional lobbying efforts to amend Section 1502.  Regardless, SEC-reporting companies that were delaying diligence efforts pending the outcome of the district court’s decision will need to turn their attention to analyzing their products and identifying supply chain sourcing.  Even though the first conflict minerals reports (on Form SD under Rule 13p-1 under the Securities Exchange Act of 1934) are not due until May 31, 2014, many affected issuers have already established in-house compliance teams to assess the applicability of the rules to their products and have been working with their supply chains to confirm sourcing and/or alter sourcing requirements.

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About this Author

Barbara Jones, Greenberg Traurig Law Firm, Los Angeles, Private Equity, Corporate and Energy Law Attorney

Barbara A. Jones is a member of the firm’s Global Securities practice group and co-chairs the firm's Blockchain Task Force. She is also co-coordinator of the firm’s interdisciplinary Conflict Minerals Compliance Initiative. Barbara maintains a diverse corporate and securities law practice across industry groups, emphasizing complex international and domestic transactions, including blockchain/cryptocurrency transactions, private and public financings (including ICOs), dual listings, mergers and acquisitions, strategic collaborations and joint ventures, and licensing...