United States: Judges Sharply Question SEC On Conflict Minerals Rule

Shortly after the Securities and Exchange Commission ("SEC") adopted its conflict minerals disclosure rule in August 2012, a coalition of business interests filed suit to challenge the SEC's rule as unduly burdensome. That legal challenge to the conflict minerals rule entered its latest stage on Tuesday, January 7, 2014, when three judges of the U.S. Court of Appeals for the District of Columbia Circuit ("D.C. Circuit") heard oral argument and sharply questioned the SEC about whether the rule exceeded the SEC's authority and the terms of the underlying statute. In an interesting twist, the judges' inquiries suggested that application of First Amendment principles involving compelled speech may hold the key to the future of the conflict minerals disclosure requirement. This Legal News Alert provides a summary of the issues raised during oral argument, as well as thoughts on the conflict minerals rule and conflict minerals compliance obligations going-forward. For those with particular interest in this issue, this Legal News Alert also provides a detailed account of the inquiries from the bench during oral argument.

While resolution of the legal challenge may ultimately reshape some aspects of the conflict minerals rule, it is unlikely that the requirement to investigate and report information about the sourcing of conflict minerals will disappear altogether, so prudent companies should continue to proceed with their conflict minerals due diligence and reporting obligations in the near term on the assumption that the existing rules will remain in place at least through the May 31, 2014 deadline for companies to file their first conflict minerals reports.

Background of Conflict Minerals Rule and Legal Challenge

Congress charged the SEC in Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") with adopting a rule requiring certain disclosures by publicly-traded companies regarding whether the sourcing of so-called "conflict minerals" in their products had potentially funded armed groups in the Democratic Republic of Congo ("DRC") or an adjoining country (collectively, the "conflict region"). The "conflict minerals" are currently defined as tin, tantalum, tungsten and gold. The SEC rule also imposed due diligence and reporting requirements on publicly traded companies that have reason to believe some of the conflict minerals contained in their products may have originated in the conflict region.

The SEC adopted its conflict minerals disclosure rule on August 22, 2012, and a coalition of business interest groups – the National Association of Manufacturers, the U.S. Chamber of Commerce, and Business Roundtable (collectively, the "Industry Challengers") – filed suit on October 19, 2012, attacking several aspects of the SEC's rule as arbitrary and capricious, unduly burdensome to industry, and contrary to the terms and intent of the underlying statute. On July 23, 2013, the U.S. District Court for the District of Columbia ruled against the challenge and upheld the SEC's conflict minerals rule as a valid exercise of the SEC's rulemaking authority. The Industry Challengers subsequently appealed that ruling to the D.C. Circuit, asking it to strike down the existing conflict minerals disclosure rule and remand the matter to the SEC for development of a new rule complying with the statutory language and intent of Section 1502 of Dodd-Frank. Thus, yesterday's oral argument before the D.C. Circuit represents the second stage of the legal challenge, after the first stage proved unsuccessful at the District Court.

Yesterday's oral argument was held before a three-judge panel consisting of Circuit Judge Sri Srinivasan (appointed by President Obama), Senior Circuit Judge David Sentelle (appointed by President Reagan), and Senior Circuit Judge A. Raymond Randolph (appointed by President George H. W. Bush).

Oral Argument

Oral argument in the case focused primarily on three aspects of the conflict minerals rule challenged in the litigation: (1) the SEC's decision not to adopt a de minimis exception to the rule; (2) the SEC's substitution of the broader "may have originated in the conflict region" trigger for due diligence/reporting obligations in the place of the narrower "did originate" language in the underlying statute; and (3) whether the reporting obligations imposed by the rule run afoul of First Amendment principles limiting the government's ability to compel private speech.1 Some of the more pointed questions from the bench concerned this last issue.

Summary and Outlook

The questions asked by judges at oral argument are often an imperfect predictor of the outcome of an appeal, but it did appear that two of the three judges (Randolph and Sentelle) harbor considerable skepticism about the SEC's existing conflict minerals disclosure regime, particularly the extent to which it compels companies to "speak" by posting information to their websites and identifying their own products as "not found to be conflict-free." Thus, the pointed questioning of the SEC by Judges Randolph and Sentelle during oral argument offers some cause for optimism for those hoping the Court will rule in favor of the Industry Challengers.

While the tenor of yesterday's oral argument suggests that at least some aspects of the legal challenge to the SEC's existing conflict minerals rules may ultimately succeed, companies should nevertheless proceed with their conflict minerals due diligence and reporting obligations in the near term on the assumption that the existing rules will remain in place. As an initial matter, it is far from certain that the Court will issue a ruling before companies' first conflict minerals reports are due in late May. Moreover, the deferential standard of review afforded to agency rulemakings still leaves ample room for the D.C. Circuit to join the lower court in upholding the SEC rule. Finally, even if the legal challenge succeeds, the most likely outcome is that the Court will remand the matter back to the SEC to adopt a new final rule more closely comporting with the statute, or one that eliminates objectionable aspects of the current rule. The only aspect of Section 1502 of Dodd-Frank that is directly challenged in the litigation is the "compelled speech" aspect that requires companies to post disclosures on their own websites or label their own products as "not found to be conflict-free." In this regard, while the Industry Challengers have attacked the current disclosure rule as unconstitutional under the First Amendment, they indicated at oral argument that they do not contest the government's ability under the First Amendment to require companies to report factual information about conflict minerals sourcing to the SEC, or the SEC's ability, based on that information, to categorize companies' products as "not conflict-free."

Thus, while the precise contours of companies' conflict minerals reporting and due diligence requirements may change if the legal challenge succeeds, it is unlikely that the requirement to investigate and report information about conflict minerals sourcing will disappear altogether. Indeed, the European Union ("EU") is in the process of developing and adopting its own conflict minerals policy (though the EU has indicated that it intends to focus the burdens of compliance as much as possible on the "upstream" portion of the mineral supply chain – i.e., the portion from the mines to the smelter/refiner – rather than manufacturers), and there will remain substantial public pressure for companies to develop "conflict-free" supply chains and steer mineral sourcing to certified "conflict-free" smelters or refiners as much as possible.

Detailed Account of Oral Argument

What follows is a detailed account of the panel's inquiries during oral argument, which provides some potential insight into the Judge's thinking on the issues raised in the legal challenge.

  • De Minimis Exception

Based on the questioning of counsel during argument, the panel appeared skeptical of the Industry Challengers' argument that the SEC erred in failing to provide a de minimis exception to the conflict minerals disclosure rule. Attempting to illustrate the burdens stemming from the lack of a de minimis exception, counsel for the Industry Challengers pointed out that the SEC's current rule would impose a conflict minerals tracing and reporting obligation on a company if a catalyst it used during production left even just one part per million of tin in the finished product. Judge Srinivasan questioned whether the company in the catalyst example may already have other avenues under the SEC's existing rule through which it could avoid a reporting obligation, even in the absence of an explicit de minimis exception. For instance, he asked, what if the company could show that a different catalyst or process could have been used to produce the product that would not have included tin? Would the company then be able to argue that the trace amount of tin left from the catalyst used by the company was not actually "necessary for the production" of the product, because a different method of production could have been used that would not have involved conflict minerals?

Judge Sentelle noted that Section 1502 was silent regarding whether a de minimis exception should be included in the SEC's rule, and he suggested that what the SEC had done – analyzing the intent of an ambiguous statute and reaching its own conclusion as to the statute's intent – was what executive agencies are asked to do in rulemaking proceedings under the Chevron standard (which affords agencies considerable deference in implementing ambiguous statutes). Judge Sentelle also asked counsel for the Industry Challengers whether he could cite a case in which the D.C. Circuit had struck down an agency's rule based on failure to include a de minimis exception. Counsel for the Industry Challengers acknowledged that he could not cite such a case, but pointed out that the Court had issued rulings upholding an agency's adoption of a de minimis exception in a rule even when the underlying statute was silent on the requirement for such an exception. Judge Sentelle countered that there is an important distinction between upholding an agency's decision to adopt a de minimis exception as a reasonable exercise of agency discretion, and striking down an agency's rule for abuse of discretion in failing to include a de minimis exception. He said the Industry Challengers were asking the Court to "break new ground." Counsel for the Industry Challengers clarified that they are not asking the Court to rule that the SEC was required to adopt a de minimis exception; rather, they are asking the Court to find that the SEC's failure to give meaningful consideration to the adoption of a de minimis exception was unreasonable, and remand the matter to the SEC to engage in reasoned consideration of the merits of potential de minimis exception language.

  • "Did Originate" Versus "May Have Originated"

The Industry Challengers contend that the SEC rewrote the critical standard in the statute for triggering a due diligence and reporting requirement, replacing the more narrow trigger in the statute (under which such obligations would be triggered by a finding that conflict minerals "did originate" in the conflict region) with a far broader and less certain trigger of the SEC's own making (under which the obligations would be triggered if the conflict minerals "may have originated" in the conflict region). To illustrate the impact of this change in terminology, counsel for the Industry Challengers cited the example of a company that could ascertain with 95% certainty that its conflict minerals did not originate in the conflict region. In normal parlance, he argued, no one would reasonably consider a 5% chance that conflict minerals might have originated in the conflict region as constituting a finding that the minerals "did originate" in the conflict region, the standard articulated in the statute for triggering a conflict minerals reporting obligation. Yet under the SEC's rule, which imposes a reporting obligation when the company has reason to believe conflict minerals "may have originated" in the conflict region, that 5% possibility would arguably be sufficient to impose a reporting requirement on the company, even in the face of a 95% certainty that the minerals did not originate in the conflict region.

Judge Srinivasan expressed some skepticism whether the SEC's choice of the term "may have originated" as triggering a conflict minerals due diligence/reporting requirement actually represents as much of an expansion as urged by the Industry Challengers, given that the Industry Challengers took no issue with the "have reason to believe" aspect of the standard. Because the "have reason to believe" concept represents something less than actual knowledge of the origin of the minerals, it already injects a degree of uncertainty into the standard for due diligence and reporting. Judge Srinivasan therefore questioned whether the Industry Challengers were merely quibbling over the degree of uncertainty necessary to trigger the due diligence and reporting requirement under the SEC's rule. In other words, he asked, would it not be more accurate to say that the distinction the Industry Challengers are making is between a test based on "probability" versus "possibility," rather than a distinction between a test based on certainty and one that allows for some uncertainty? Counsel for the Industry Challengers agreed that absolute certainty would not be required to trigger a due diligence and reporting requirement and acknowledged that a standard based on probability would more closely comport with the "did originate" language in the statute than a "possibility-based" standard where reporting would be triggered by even a 5% possibility that the minerals "may have originated" in the conflict region.

Counsel for the SEC countered that whether a company would need to undertake due diligence or file a conflict minerals report in the 95 percent/5 percent scenario described by the Industry Challengers would depend on the reasons underlying the 5% uncertainty. Noting that the SEC rule does not require a company to receive responses from all of its suppliers, she argued that a reporting and due diligence obligation would not be triggered, even under the "reason to believe may have originated" standard, if the 5% uncertainty is based simply on a lack of information or response from a small portion of the company's supply chain.

Judge Sentelle pressed the SEC regarding the statutory basis for its adoption of the "may have originated" trigger for the requirement that companies post their conflict minerals reports on their corporate websites. Echoing the Industry Challengers' argument, he noted that the statutory language would impose a reporting requirement only if the minerals "did originate" in the conflict region and pointed out that the SEC rule would require companies to post a disclosure under a much broader set of circumstances.

  • First Amendment Arguments

The most animated questioning from the panel centered on the Industry Challengers' argument that the conflict minerals rule and Section 1502 of Dodd-Frank represent government-compelled speech in contravention of the First Amendment. The Industry Challengers asserted that the conflict minerals regime unconstitutionally compels companies to make an ideologically-driven, rather than fact-based, statement about their own products – namely, that the products "have not been found to be conflict-free." This type of speech, they contended, forces companies to stigmatize themselves and denounce their own products based on information that is speculative, rather than fact-based. The Industry Challengers also objected to the requirement that companies post conflict minerals reports and information on their corporate websites, arguing that those websites "are our space." During argument, the Industry Challengers clarified that they do not challenge the requirement to report factual information about conflict minerals in their products to the SEC, and that their First Amendment challenge does not extend to the SEC's ability to take that factual information and make its own judgments about whether a company's products are "conflict-free." Rather, the objection is to the requirement that companies apply that "ideological" label to their own products and post conflict minerals information on their own corporate websites.

Referring to the "may have originated" standard adopted in the SEC's rule, Judge Sentelle pointed out that the SEC was compelling speech (via conflict minerals reports posted to a company's website) under a broader set of circumstances than would be required under the "did originate" standard articulated in the statute. "This is speech, compelled speech," he said. He asked the counsel for the SEC to identify the statutory basis for requiring posting of a conflict minerals report on a corporate website if a company has reason to believe conflict minerals "may have originated" in the conflict region. In response, counsel for the SEC pointed out that Section 1502 was silent concerning what reporting obligations a company might have if conflict minerals in its products "may have originated" in the conflict region, but Judge Sentelle countered that "silence does not empower" the government to compel speech.

Judge Randolph likewise seemed troubled by the First Amendment implications of the SEC's rule and asked SEC counsel whether the SEC has imposed other disclosure requirements, either by statute or rule, that are not keyed to safety or investor protection. Counsel for the SEC argued that the conflict minerals disclosure requirement does provide information relevant to investment decisions for socially conscious investors, but Judge Randolph countered that the "socially conscious investor" argument was a "slippery slope" when it comes to compelling speech by companies. Noting that there are other human rights concerns about labor conditions in overseas locations (including the use of child labor), he questioned whether Congress could cite the interests of informing "socially conscious investors" as the basis for requiring companies with overseas operations to disclose the wages paid to workers in overseas locations, or to disclose whether labor conditions in those overseas sites meet OSHA requirements or comply with child labor laws.

Judge Randolph also asked the SEC to identify the objective of the conflict minerals statute and to explain how the SEC's rule promotes that objective. When SEC counsel argued that the objective of the statute was to promote peace and security in the Congo region, Judge Randolph countered, "that is the end; how is this rule going to accomplish that?" He asked whether the objective of the rule was to have investors boycott companies not found to be "conflict-free" or to have consumers boycott the products of companies not found to be "conflict-free." "Aren't you trying to stigmatize these companies?" he asked SEC counsel.

Counsel for the Industry Challengers adopted Judge Randolph's point and agreed that the conflict minerals statute is "a shaming statute," designed to force companies to affix a "scarlet letter" to themselves and their products. Judge Sentelle questioned whether it was normal for the SEC to require disclosures aimed more at consumers than investors, noting that consumer-oriented disclosures would seem more appropriate for an agency such as the U.S. Food and Drug Administration.

Judge Randolph also seemed to have concerns about how private plaintiffs might seek to exploit the SEC's rule through class action lawsuits. He asked how the SEC intends to enforce the conflict minerals disclosure requirement, pointing out that he assumed the SEC would not have a team of scientists performing materials analysis on companies' products to verify whether their products contain tin, tantalum, tungsten or gold. Counsel for the SEC explained that the conflict minerals report would not be personally certified by a company's CEO like a 10-K statement, but that there would be potential for liability under Section 18 of the Securities Exchange Act if the conflict minerals report was fraudulent. However, she argued that such a cause of action would be subject to a high scienter standard, suggesting that scienter threshold would limit the prospect of class action lawsuits by investors based on conflict minerals reports. Judge Randolph remained skeptical, pointing out that "those kinds of suits never go that far."


1 The Industry Challengers have alleged a total of six legal flaws in the SEC's conflict minerals disclosure regime, though three of those issues were not discussed during oral argument. The aspects of the conflict minerals rule challenged by the Industry Challengers in their brief but not discussed during oral argument are: (1) the SEC's expansion of the rule to reach non-manufacturers who "contract for the manufacture" of products, instead of limiting obligations to companies that themselves manufacture products; (2) the SEC's decision to afford large reporting companies a shorter transition period than small reporting companies (two years versus four years) in which they can report their products as "conflict undeterminable," when larger companies will need to depend on information received from smaller companies in order to comply with the rule; and (3) the adequacy of the SEC's analysis of the impact of its conflict minerals disclosure rule and whether the burdens imposed by the rule would further the purposes of the statute (promoting peace and security in the DRC), as required of SEC rules under the Securities Exchange Act.

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