U.S. District Court Upholds Conflict Minerals Rule
Issuers Must File First Form SD in May 2014
A recent survey suggests that about one-third of public companies are still trying to figure out if the conflict minerals reporting requirements apply to them. Most public companies in the survey reported that they are still in the very early stages or have not yet even started compiling information needed to meet the requirements. The July 2013 PWC public company survey suggests that less than 5% of all public companies have gathered required information and are assessing it. The survey results may be accessed here.
The delayed reaction to the SEC’s conflict mineral rule –- finally promulgated in August 2012 more than two years after Congress enacted Section 1502 of the Dodd-Frank Act –- could be a reflection of the expected significant cost of compliance and the hope that the courts would respond favorably to arguments by business groups that the rule should be struck down.
Those hopes were dashed when in late July the U.S. District Court for the District of Columbia rendered its decision in the lawsuit brought by the National Association of Manufacturers (“NAM”), the U.S. Chamber of Commerce and the Business Roundtable. The court rejected the arguments of the plaintiffs that the rule should be struck down as arbitrary and capricious and/or as a violation of the First Amendment. Nat’l Assoc. of Manufacturers v. SEC, No. 1:13-cv-00635-RLW, slip op (D.D.C. July 23, 2013) (NAM v. SEC). The court’s decision may be found here.
As a result, it appears that the rule is here to stay –- at least for the first year of its applicability. Even if there is further activity In the courts, a changed outcome is not likely before the first report is due on May 31, 2014. Public companies must now move quickly to gather the data needed to ensure their compliance by the reporting deadline.
The Conflict Mineral Rule in Brief
In Section 1502 of the Dodd-Frank Act, Congress directed the SEC to promulgate disclosure requirements for companies that use “conflict minerals” – tin, tantalum, tungsten and gold. After a lengthy rulemaking process, the SEC adopted Rule 13p-1 by a 3-2 vote amid controversy about the
suitability of the SEC to engage in meaningful rulemaking about what really amounted to an international relations and human rights issue and the staggering estimated cost of compliance with such a rule by U.S. public companies.
The rule itself is just one sentence:
Every registrant that files reports with the Commission under Sections 13(a) or 15(d) of the Exchange Act, having conflict minerals that are necessary to the functionality or production of a product manufactured or contracted by that registrant to be manufactured, shall file a report on Form SD within the period specified in that Form disclosing the information required by the applicable items of Form SD as specified in that Form.
The SEC’s adopting release broke down the rule into three steps. Step one is to determine whether the rule is applicable to the public company. If the public company manufactures or contracts to manufacture a product and conflict minerals are necessary to the functionality or production of that product, the rule applies and the public company must move to step two.
Step two requires that the public company conduct a reasonable country of origin inquiry to determine whether the conflict minerals used in or for the production of the company’s product(s) originated in the Democratic Republic of the Congo (DRC) or a surrounding country (the “covered countries”) or are from recycled or scrap material. If a company determines that the conflict minerals originated from a covered country, or the company has reason to believe that the minerals may have originated from a covered country, and that they are not solely from recycled or scrap materials, then the company must undertake step three.
Step three requires that the public company exercise “due diligence” on the source and chain of custody of the identified conflict mineral(s) using a nationally or internationally recognized due diligence framework for the conflict mineral. In the case where the diligence reveals that the conflict minerals originated in a covered country or were otherwise not found to be “DRC conflict free” or from recycled/scrap metal, the issuer is required to provide a conflict minerals report detailing the diligence process and results, which report must be audited by an independent auditor using government auditing standards.
The Unsuccessful Court Challenge to the Conflict Minerals Rule
Challenge of the Rule under the Administrative Procedures Act. The plaintiffs in NAM v. SEC challenged the SEC’s promulgation of the rule under the Administrative Procedures Act (APA), claiming (a) that the SEC failed to discharge its statutory obligation to properly analyze the costs and benefits of the rule; and (b) that the SEC’s rulemaking was arbitrary and capricious in several other respects. The court rejected both sets of arguments.
SEC’s Alleged Failure to Properly Analyze the Costs and Benefits. The plaintiffs alleged that the SEC failed to conduct an adequate analysis of the overall costs and benefits of the rule, necessary in order to satisfy the SEC’s statutory obligations under Sections 3(f) and 23(a)(2) of the Securities Exchange Act of 1934 (the Exchange Act), and exercise its authority in a reasoned manner. In relying on the plain language of Sections 3(f) and 23(a)(2), the court found that the SEC is only required to “consider” the
impact that a rule may have on various economic related factors such as efficiency, competition and capital formation, and that a broader, wide-ranging benefit analysis was not statutorily required. The court indicated that this was particularly appropriate under the present circumstances, “where the resulting benefits Plaintiffs accuse the Commission of ignoring relate to humanitarian objectives that Congress concluded would be achieved by the rulemaking, rather than some sort of economic objectives underlying the Commission’s rule.” The court further 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 envisioned by Congress. The court was convinced that the SEC discharged its statutory responsibility, appropriately considering the rule’s impact on competition more generally as required by the Exchange Act.
SEC’s Alleged Underestimation of Particular Costs as Arbitrary and Capricious. The plaintiffs also alleged that the SEC inadequately quantified the expected costs of compliance with the rule. The court rejected this argument, finding that the SEC had received a wide divergence of cost estimates and was reasonable in combining those analyses in establishing a useful framework for understanding the various cost components. The court stated that the SEC’s methodology in this regard was “eminently appropriate.”
Failure to Apply a De Minimis Threshold. The court also rejected the plaintiffs’ allegation that the SEC was arbitrary and capricious in failing to provide for a de minimis exception to the disclosure requirements under the conflict mineral rule. The court concluded that because the statute was silent on whether there could be a de minimis exception, the SEC had the ability to make such an exception and had properly exercised its discretion not to. In support of this conclusion, the court cited, among other things, the SEC’s policy-based articulated rationale as to why adoption of a de minimis exception would be inappropriate.
Challenge of the Rule as Unconstitutional. In addition to the arguments under the APA, plaintiffs argued that the requirement under Section 1502 and the SEC’s Rule 13p-1 that issuers post conflict minerals disclosures on their websites violates the First Amendment protections against compelled speech. Website disclosure is required under Section 1502 and the conflict mineral rule if the issuer manufactures or contracts to manufacture products with conflict minerals that are necessary to the functionality or production of its products.
In examining whether the required website disclosure violates an issuer’s First Amendment rights, the court applied the “intermediate scrutiny” review standard. Under this standard, a challenged regulation will survive judicial review if (i) the asserted government interest is substantial, (ii) the regulation directly advances the government interest asserted, and (iii) the fit between the ends and the means chosen to accomplish those ends is reasonable. The plaintiffs acknowledged the substantial government interest in promoting peace in and around the DRC, and therefore did not challenge element (i), but focused their attack on elements (ii) and (iii). The court determined that element (ii) was satisfied based upon a deferential approach to Congress’ judgment (which the court stated is particularly applicable when the matter involves the intersection of national security, foreign policy and administrative law) that the conflict mineral disclosure will advance Congress’ interest in promoting peace and security in and around the DRC. With respect to element (iii), the Court determined that the fit between the goal of promoting peace and security in and around the DRC and required issuer web posting of conflict mineral disclosures to help accomplish this goal was a reasonable fit. The court reasoned that this requirement was proportionate to the interests sought to be advanced, particularly in light of the fact that Section 1502 and the conflict minerals rule only require that issuers publish copies of their conflict minerals disclosures verbatim on their websites that will have already been prepared for and filed with the SEC.
Plaintiffs in the NAM v. SEC case have until August 22 to file an appeal. In addition, because of the plaintiffs’ challenge to the constitutionality of Section 1502, there is also a period during which the U.S. Attorney General could seek reconsideration by the court of its determination on the constitutionality challenge.1/The latter is not likely. We are waiting for word as to whether plaintiffs will appeal. The outcome of any such appeal is not likely to be known until well into 2014. Accordingly, it is important that public companies undertake compliance efforts now.
Undertake the Step One Analysis: Does the Rule Apply? There are many ways to find the answer to the questions raised in step one. Some companies have begun with a list of their products and, working with procurement personnel, have determined whether any such products contain any of the four minerals. That inquiry leads to an analysis, typically with the assistance of legal counsel, of whether any of those minerals is “necessary to the functionality or production” of the product. Reference to the SEC’s FAQs can be helpful and can be found here.
Some public companies find that this is the most difficult step of the three-step analysis. It is unclear for some whether they “manufacture” or “contract to manufacture” a product at all or at least within the scope of Rule 13p-1. Reference to how others in their industry are resolving this question has been helpful for some.
If the answer is “no”, there is nothing further that a public company need do. No disclosures on Form SD or otherwise is required. If the answer is “yes”, the company must move to step two.
Conduct the Step Two Reasonable Country of Origin Inquiry. The SEC made clear in its adopting release that there is no one-size-fits-all approach to the reasonable country of origin inquiry (RCOI). The adopting release sets out general standards, but does not specify steps necessary to satisfy the requirement. What is certain is that the RCOI must be:
- “reasonably designed to determine whether the issuer’s conflict minerals did originate in the covered countries, or did come from recycled or scrap sources,” and
- performed in good faith.
Some companies are conducting the RCOI by seeking representations from first tier suppliers that the conflict minerals supplied to the public company did not come from a covered country. If a company requests and receives representations concerning the country of origin of the conflict minerals, has reason to believe the representations are true under the facts and circumstances, and has no notice of any “red flags” or other warning signs that the conflict minerals came from covered countries, the SEC’s adopting release indicates that the company should be entitled to rely on these representations.
Other companies are addressing their RCOI requirements using a certification process requiring their suppliers to certify either that (1) components provided by the supplier contain only those conflict minerals that are not from a covered country or are from recycled or scrap sources, or (2) any conflict minerals were processed only in smelters or refineries that are certified “conflict free” (such as under the Conflict-Free Smelter Program of the EICC).
Still others are using the EICC conflict minerals reporting template for their RCOI. This template is tied into a reporting “dashboard” which provides detailed information about the conflict minerals used by the supplier or provided by the supplier to the requesting customer. If step three diligence of the supply chain is required, the EICC dashboard will provide easy access to the internationally recognized OECD framework for the diligence of these conflict minerals.
Once the responses to the RCOI are in, companies must analyze the data to determine whether they need to move to the step three diligence.
If Necessary, Initiate Step Three Diligence. As indicated above, the results of the RCOI will determine a company’s next step. If the company knows or has “reason to believe” that its conflict minerals originated in a covered country and did not come from recycled or scrap sources, then the company must proceed to a diligence process. The company must more definitively determine the source and chain of custody of the conflict minerals. The company must use a “nationally or internationally recognized due diligence framework” for the specific conflict mineral. The OECD due diligence guidance satisfies this criteria and may be used to satisfy the rule.
Depending on the information learned in the diligence process, the company may then be required to prepare a conflict minerals report. That report must describe the measures taken by the issuer to diligence the source and chain of custody. In addition, unless the company’s products can be identified as “DRC conflict free”, the report must set forth a description of the facilities used to process the conflict minerals, the country of origin of the minerals and the efforts to determine the mine or location of origin. The report must also include a description of its products that have not been found to be “DRC conflict free.”
There is a two-year transition period (four years for “smaller” companies) during which the SEC has authorized companies unable to determine the origin of their conflict minerals (after conducting the diligence) to conclude that their minerals are “DRC conflict undeterminable”.
Our prior bulletin providing a more detailed description of the disclosure obligations under the conflict minerals rule is available here. Please feel free to contact your Bryan Cave lawyer or a member of our Corporate Finance and Securities client service group for more information or for assistance in compliance with these conflict minerals disclosure requirements.