How Court Could Shape a New Conflict Minerals Rule

A legal challenge to the Securities and Exchange Commission's Conflict Mineral Rule, which will require companies to disclose the use of certain metals throughout its supply chain, is heating up, and it could succeed in changing the final version of the rules.

A federal appeals court heard oral arguments from plaintiffs challenging the rule, including the National Association of Manufacturers, U.S. Chamber of Commerce, and the Business Roundtable, earlier this month, and the SEC's defense of it. Tough questioning directed toward the SEC by a three-judge panel led some legal experts to predict the court could deem the rule unconstitutional.

If the legal challenge succeeds, don't expect it to go away completely, however. If the plaintiffs win, the rule will likely be sent back to the SEC for a rewrite to address some longstanding business concerns, lawyers suggest. Based on issues flagged by the judges reviewing the case, a rewritten rule could eliminate mandatory Website disclosures and add exceptions for small amounts of the minerals in question.

"No doubt many of the concerns expressed during the hour-long oral argument are valid,” says Sonal Sinha, associate vice president at MetricStream, a provider of governance, risk, and compliance solutions. “The future of the Conflict Minerals Rule, in the manner it is currently written, remains uncertain.”

Issued by the SEC in August 2012, the rule requires companies to disclose information on the source of tantalum, tin, gold, and tungsten, minerals that have funded violent conflict in the Democratic Republic of the Congo and adjoining countries. Companies must conduct a “reasonable” country-of-origin inquiry to determine if the minerals originated from the covered countries; track and document the source and chain of custody; and include findings in a public report. Disclosures for the first year of the rule are due by May 1.

The legal challenge was initiated in October 2012, but the rule was upheld by Judge Robert Wilkins of the U.S District Court for the District of Columbia. The groups appealed that ruling. Among their arguments against the rule are that the SEC failed to do the proper cost-benefit analysis; acted arbitrarily when it imposed more stringent requirements than the statute required; and was wrong to extend the rule to those who contract with others for the manufacture of products.

First Amendment Issues

When the challenge was first filed, skeptics derided its claim that the rule also violates the First Amendment rights of companies. Based on the courtroom questioning, free speech issues may, in fact, be a decisive factor in vacating the rule.

“A lot of commentators dismissed it as no big deal and almost spurious,” says Marcia Narine, assistant professor of law at St. Thomas University, who has followed the case closely. The judges saw things differently and devoted nearly half of their questioning on this concern.

Plaintiffs asserted that the conflict minerals regime unconstitutionally compels companies to make an “ideologically-driven, rather than fact-based, statement about their own products,” says Frank Murray, senior counsel with the law firm Foley & Lardner, who also attended the hearing. This forces companies to “stigmatize themselves and denounce their own products based on information that is speculative, rather than fact-based,” they claimed.

Particularly problematic, is a requirement that companies post conflict minerals reports and information on their corporate Websites, part of a “name and shame” approach to encouraging social responsibility.

The plaintiffs, as relayed by Keisler, agreed they have no basis to argue against submitting conflict minerals reports directly to the SEC as part of its filing process, letting the regulator make judgments about whether they are sufficient. Posting that same information on company Websites, however, is a step too far, compelled speech, and is an intrusion onto their private property, the plaintiffs argued.

“Practitioners within the supply chain have been focused on the burdens of compliance and trying to report and track the conflict minerals in their products,” Murray says. “They have not really paid attention to what was considered an ivory tower argument about First Amendment principles.”

Nevertheless, because the court focused on that issue, compelling companies to label their products as not conflict free, “might taint the underlying statute,” he adds. How the court interprets the underlying First Amendment issue “could cause them to say Section 1502 of the Dodd-Frank Act is unconstitutional,” that aspects of that statute are unenforceable, and “call the whole regime into question.”

De Minimis Thresholds

A rewritten rule could also include a de minimis threshold that exempts reporting requirements for companies that use only small amounts of conflict minerals. The SEC, citing its Congressional mandate, declined to include such a threshold in its rule.

Thousands of companies could be exempt from the rule if baselines were put in place, Keisler said. The lack of a threshold means that if a catalyst used during production left just one-part-per-million of tin in the finished product, the sourcing scrutiny and reporting is still required.

“No doubt many of the concerns expressed during the hour-long oral argument are valid. The future of the Conflict Minerals Rule, in the manner it is currently written, remains uncertain.”

—Sonal Sinha,

Associate Vice President,

MetricStream

Although there was discussion that a revamped rule should include de minimis standards, Michael Littenberg, a partner at the law firm Schulte Roth & Zabel and head of its public companies (including conflict minerals) practice, is skeptical that the accommodation will help companies as much as they may think.

“Sometimes you get what you wish for, and what you wish for isn't necessarily better,” Littenberg, who attended the hearing, says. “People are bemoaning that there is no de minimis threshold under the rule, but once you introduce a threshold, depending on where you set it, for many companies there will be a lot of work that needs to go into just figuring out which side of it they are on. Conflict minerals usage relative to the threshold will likely need to be monitored on an ongoing basis and for many companies that may be more expensive and harder than just complying with the current rule. Many companies are unlikely to be able to reliably calculate their conflict minerals usage and will just have to file anyway.”

Keisler's own testimony conceded that the lack of an exception for small amounts of the minerals isn't necessarily unreasonable, but the SEC still had a responsibility to give it reasoned consideration, rather than an immediate dismissal.

‘May' Vs. ‘Did'

Plaintiff's raised concerns about linguistic choices made by the SEC in its rulemaking too, specifically use of the term “may originate” when assessing if minerals come from the Congo, versus the more specific phrasing of “did originate.” This means, according to plaintiffs, that even if a company can show a 95 percent certainty its materials were conflict-free, the 5 percent uncertainty ensures the reporting obligation is still triggered.

THE CASE AGAINST

The following is from a brief filed by petitioners—the U.S. Chamber of Commerce, National Association of Manufacturers, and Business Roundtable—prior to oral arguments last week appealing prior court decision to uphold the Securities and Exchange Commission's conflict minerals rule.

The Securities and Exchange Commission found that the rule will impose staggering costs on American businesses: $3 to $4 billion for initial compliance, and an additional $200 to $600 million per year for ongoing compliance, making this one of the costliest rules in SEC history.

By imposing extraordinary costs without showing they will achieve any benefits, the SEC violated the Administrative Procedure Act (APA) and the agency's heightened obligation under the Securities Exchange Act of 1934 to analyze the economic impact of its rules.

Of course, the Commission had to follow the congressional directive to impose a rule. But Congress did not mandate these massive costs. The pertinent statutory provisions are brief and general, imposing certain requirements and leaving the remainder to the Commission's rulemaking process. And in that process, the Commission both misconstrued those statutory requirements and acted arbitrarily in filling the gaps that remained. By refusing to create a de minimis exception, requiring companies to undertake an onerous “reasonable country of origin inquiry,” expanding the rule's scope to non-manufacturers, and providing for an irrational transition period, the Commission greatly multiplied the rule's unprecedented burden on U.S. companies, with no showing of benefits to the Congolese people.

Furthermore, the rule's authorizing statute itself violates the First Amendment by compelling companies to indicate publicly that their products contribute to human rights abuses in the DRC—a statement, for most companies, as unfounded as it is politically charged.

Sources: The U.S. Chamber of Commerce, National Association of Manufacturers, and Business Roundtable.

“The SEC tried to argue that the standard they put in place was actually an easier standard for companies to work with because even though it was a ‘may' standard, it wasn't really a higher standard because there was a ‘reason to believe' component put in there,” Littenberg says. Through guidance or a rewritten rule, the SEC could clarify its definition of “reason to believe.

“Some of the statements made by SEC counsel during the arguments “were interesting to hear from a compliance perspective” and may tip their hat as to what a revised rule or future guidance will bring, Murray says. If a company has that hypothetical 5 percent uncertainty as to where products originated based on lack of information, in Hardin's view that wouldn't trigger a reporting requirement, she said under questioning.

“It would be great if the SEC would say that,” Murray says. “You have advocates on one side saying the 5 percent uncertainty would trigger this reporting requirement and the SEC saying it wouldn't. It illustrates the disconnect. If they are making those kinds of value judgments, they ought to communicate them in advance, so people can rely on them when they file their reports.”

What's Next?

Littenberg wouldn't be surprised to see the SEC issue another set  of FAQs, now that  oral arguments have occurred.  Indications are that a set already has been drafted and will be released soon. “In addition to some of the many open interpretive questions under the rule, based on the questions and comments of the judges during oral arguments, the SEC also may decide to address some of the petitioners' arguments through guidance.”

No matter what the court decides, don't expect the rule to disappear completely. “I don't think companies should view this challenge as a silver bullet to slay the conflict minerals beast once and for all,” Murray says.

“Surely this isn't the end of the debate, or the end of the Conflict Minerals rule,” Sinha says. “In fact, this is just the beginning, and we will continue to see other similar rules and requirements in the future, not only in the U.S., but in other geographies as well. Organizations can either delay the inevitable task of creating a more sustainable and socially conscious supply chain, or they can use conflict minerals compliance as a competitive advantage, as they address the challenge head-on.”