In a July 23, 2013 opinion, the U.S. District Court for the District of Columbia upheld the SEC’s rule requiring disclosure of companies’ use of conflict minerals originating in and around the Democratic Republic of the Congo (“DRC”).  The decision underscores the importance of due diligence provisions under the new law, which come into effect for large issuers during this reporting year, and should be incorporated into May 2014 reports.

Background

In August 2012, the Securities and Exchange Commission (“SEC”) adopted a rule, mandated by Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, requiring companies to review and disclose their use of in certain products of certain minerals originating from the DRC.  The minerals, designated “conflict minerals” because of their role in financing armed conflict between groups in the DRC, are listed in the statute and regulations as columbite-tantalite (coltan), cassiterite, gold, wolframite, or their derivatives.  The derivatives most commonly extracted from the ores listed in the rule are tantalum, tin, tungsten, and gold.  The main aim of the rule is humanitarian: to end human rights abuses in the DRC by promoting awareness of funding through conflict minerals and causing companies to exercise due diligence through their supply chain.

The rule follows what the SEC describes as a three-step process. First, the rule only applies to companies that are issuers under the Exchange Act, for which conflict minerals are necessary to the functionality or production of one or more of their products.  This definition includes issuers whose products containing conflict minerals are contracted to another manufacturer, with some exceptions for, e.g., companies that only contract to put their trademark on products manufactured by a third party.

Any companies meeting the description under step one are required to proceed to step two, which is conducting reasonable due diligence into the country of origin of their conflict minerals.  The Final Rule promulgated by the SEC did not prescribe the steps required for such diligence, as it described that the facts and circumstances of each company may differ.

Under step three, an issuer must then generate a conflict minerals report if, based on its country of origin inquiry, it knows or has reason to believe that it has necessary conflict minerals that originated in the DRC or adjoining countries and did not come from recycled or scrap sources.  The report, which would cover due diligence conducted and other matters, is to be filed as an exhibit to the SEC Form SD, and to be made available to the public on the issuer’s website.

The rule provides for a temporary transition period of two years for all issuers, and four years for smaller reporting companies, as described in Rule 12b-2 of the Exchange Act.  Larger issuers must must comply with the rule for calendar year 2013, and first reports under the rule are due on May 31, 2014.

The Court Decision

Three business groups, the National Association of Manufacturers, U.S. Chamber of Commerce, and Business Roundtable, brought suit against the SEC under the First Amendment to the U.S. Constitution, arguing that obligating companies to publish conflict minerals disclosures on their own websites violated the U.S. Constitution, and the Administrative Procedure Act, 5 U.S.C. §§ 701, et. seq., challenging various aspects of the law as arbitrary and capricious.  Among other arguments, the plaintiffs argued that the SEC had failed to properly consider the costs and benefits of the law.  A variation of this argument, focusing on the number of businesses that would be affected by the rule and the costs associated with compliance, was reflected in comments and industry concern raised during the long process of the implementation of the conflict minerals rule.  Further, it was not clear whether the rule would have its intended effect of reducing conflict in the DRC.  [Sheppard Mullin Feb. 2012 blog article]

The Court dismissed these arguments, and upheld the statute.  With respect to the benefits of the Rule, the Court noted that the SEC appropriately deferred to Congress’s judgment on whether the rule would achieve its intended benefit.  With respect to the costs, the Court ruled that the SEC had considered all of the costs estimates submitted to it and struck a balance that it found reasonable, which was therefore not arbitrary and capricious.  The Court further held that the lack of a de minimis exception was a permissible reading of the statute.

Analysis

While the result at the U.S. District Court may be appealed, the Court’s decision means that issuers whose products contain conflict minerals should begin the three-step process laid out under the rule to determine whether they must prepare and file a report.  Of course, any determinations that would exempt an issuer from the rule’s reporting requirements – such as that conflict minerals are not “necessary” for the product – should be documented in the event that they are later questioned.

More generally, the Court’s decision underscores the importance that the SEC places on due diligence directed by the company, according to a “reasonable” measure of the company’s own facts and circumstances.  Diligence under company-directed circumstances such as these is not unique to conflicts minerals, and also shows up under the U.S. Foreign Corrupt Practices Act or U.S. export controls.  As in those schemes, the “reasonableness” requirement of due diligence places the onus on a company to create a well-considered program for inquiring into its supply chain.  This requirement is particularly important in the context of conflict minerals since the level of diligence required under the conflicts minerals rules may run deeper into the supply chain than for analogous areas of law.