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From Securities Regulation Daily, April 14, 2014

Conflict minerals requirement ran afoul of First Amendment, yet bulk of rules upheld

By Mark S. Nelson, J.D.

The U.S. Court of Appeals for the District of Columbia today upheld much of the SEC’s final conflict minerals rules. The court however, found that a requirement that issuers disclose not “DRC conflict free” products in a filed report to be published on the issuer’s website violated the First Amendment. One member of the three-judge panel opted not to join the court’s First Amendment holding, but concurred in the rest of the opinion (National Association of Manufacturers v. SEC, April 14, 2014, Randolph, A.).

Transparency. Dodd-Frank Act Sec. 1502 created a disclosure regime by which companies whose products employ conflict minerals must undertake certain inquiries that can result in public disclosures on new Form SD or in a conflict minerals report. The sense of Congress recited in Sec. 1502 said the provision would bring transparency to the use of conflict minerals to fund conflict in the Democratic Republic of the Congo (DRC), which contributes to a humanitarian emergency typified by sexual- and gender-based violence.

The SEC proposed its conflict mineral rules in December 2010. After receiving hundreds of comments following two extensions of the comment period, the SEC issued its final rules in August 2012. The final rules were published in the Federal Register in September 2012 and became effective in November of that year. The SEC had pegged initial compliance costs at $3-$4 billion and annual compliance costs at $207-$609 million. The SEC, however, said it could not estimate the social benefits to be achieved under the rules. The final rules also did not include a de minimis provision.

The National Association of Manufacturers (NAM) and other industry groups sued the SEC claiming these rules failed to meet the requirements of the Administrative Procedure Act, the Exchange Act, and the First Amendment by pressing issuers to accede to a name-and-shame disclosure regime. The district court upheld the SEC’s final rules and granted summary judgment to the SEC. The D.C. Circuit affirmed the lower court in part, but reversed on the First Amendment issue. The case now goes back to the district court.

Key provision flunked First Amendment. The court’s opinion focused on the First Amendment issue. NAM argued that Sec. 1502 and the SEC’s final rule requiring a filed report, published on the issuer’s website, to state in appropriate cases that the issuer’s products are not DRC conflict free, violated issuers’ First Amendment rights.

The court first rejected the use of the rational basis test. The SEC had argued that the required disclosure was factual only, but NAM said it amounted to a blood-on-the-hands type argument intended to convey moral judgment about issuers whose products contain conflict minerals. The court also rejected intervenor Amnesty International’s argument (which the SEC did not join) that the SEC had general authority to regulate the securities industry. According to the court, this standard would go too far because the rational basis test is a First Amendment rarity that typically applies only to cases of consumer deception.

Moreover, although not deciding to use strict scrutiny, the court said the SEC’s final rule requiring the disclosure of not-DRC-conflict-free products would fail the narrow tailoring prong of the Supreme Court’s Central Hudson test. Here, the court said the SEC did not offer an explanation of why other less-restrictive means would not achieve the rule’s goals. NAM, for example, suggested that issuers could use their own language or that the SEC could produce a list of products based on issuers’ submissions.

The SEC and Amnesty International had argued that NAM’s alternatives would result in a less-effective final rule. But the court said the SEC could find other means to implement the challenged requirement. Said the court, “The Commission has failed to explain why (much less provide evidence that) the Association’s intuitive alternatives to regulating speech would be any less effective.”

The First Amendment issue drew a critique from Judge Srinivasan, who declined to join the court due to worries about the timing of the court’s conflict minerals opinion. Judge Srinivasan would have preferred that the court defer the First-Amendment ruling pending the outcome of an en banc hearing in another case that raises a similar issue that would distinguish between cases in which strict scrutiny applies and those in which the rational basis test applies.

Administrative procedure issues. The SEC’s final rules did not contain a de minimis rule for small amounts of conflict minerals. According to the SEC, because the Dodd-Frank Act lacked a de minimis provision, congressional intent was clear that the conflict minerals regime was to include even tiny amounts in order to achieve the humanitarian goals of the Dodd-Frank Act. The D.C. Circuit found the SEC did not act in an arbitrary and capricious manner by not including a de minimis exception to the conflict mineral rules. The court said the Commission reasonably construed Sec. 1502, as it may when it has interpretive authority.

NAM also challenged the scope of the SEC’s final conflict minerals rules. The SEC opted for a regime that requires issuer due diligence if the issuer conducts an inquiry that leads it to have reason to believe necessary conflict minerals may have originated in a covered country. NAM argued that this rule disregarded Sec. 1502, which requires a report if conflict minerals did originate in a covered country. The court said the SEC had construed two ambiguities in Sec. 1502: (1) when due diligence is needed prior to filing a report; and (2) what an issuer’s reporting duties are if it is uncertain where conflict minerals originated. The court said the SEC merely used its authority to fill gaps in the statute.

The court also rebuffed NAM’s argument that these provisions were arbitrary and capricious. For one, a regime without a due diligence requirement (and instead based on good faith inquiry) could let issuers overlook red flags. The SEC, said the court, required issuers not to ignore red flags but stopped short of requiring issuers who find no red flags during an inquiry to still conduct due diligence. Said the court, referencing the final rule, “By doing so, the Commission reduced the costs of the final rule, and resolved the Association’s concern that the rule will yield a flood of trivial information.”

The SEC also succeeded in convincing the court that its view of the “persons described” language in the statute backed its more expansive view that the conflict minerals rules should apply to those who manufacture or contract for products. The final rule also was not arbitrary and capricious just because it sought to prevent issuers from using contracting to avoid being subject to the manufacturing language.

The court upheld the separate phase-in periods for large and small issuers. Large issuers have two years to comply, while smaller ones have four years. NAM said this provision should fall because it treats issuers differently for no apparent reason. NAM also said small issuers are always part of much larger supply chains, but the court sided with the SEC’s reasoning that large issuers have greater leverage to gain supply chain information than do smaller ones. “Like the district court, we can ‘see the trickledown logic underlying the Commission’s approach,’ even if it does not hold in all cases,” said the court.

Economic analysis. Cost-benefit analysis has figured prominently in several recent cases involving the SEC and other federal financial regulators. Here, the court found no issues with the SEC’s cost-side analysis: The SEC considered both its own data and estimates offered by public commenters. Also, NAM did not vigorously dispute the SEC’s large cost estimates.

By contrast, NAM had challenged the SEC’s lack of a detailed benefit-side analysis, but the court noted that Congress had already made a judgment that disclosure would promote some benefits in the DRC. According to the court, the SEC had to adopt a rule in a milieu where data is scant, so it chose to reasonably rely on the judgment of Congress.

Said the court, “Here, the rule’s benefits would occur half-a-world away in the midst of an opaque conflict about which little reliable information exists, and concern a subject about which the Commission has no particular expertise.” The court added, “Even if one could estimate how many lives are saved or rapes prevented as a direct result of the final rule, doing so would be pointless because the costs of the rule—measured in dollars—would create an apples-to- bricks comparison.”

The case is No. 13-5252.

Attorneys: Jonathan Fredrick Cohn (Sidley Austin LLP) for National Association of Manufacturers, Chamber of Commerce of the USA, and Business Roundtable. Tracey Anne Hardin for the SEC.

Companies: Amnesty International; Business Roundtable; Chamber of Commerce of the USA; National Association of Manufacturers

MainStory: TopStory DistrictofColumbiaNews DoddFrankAct FormsFilings PublicCompanyReportingDisclosure

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