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The SEC largely prevailed in the D.C. Circuit Court of Appeals in a suit changing the Rules promulgated by the agency under Dodd-Frank regarding conflict minerals. National Association of Manufacturers v. SEC, No.. 13-5252 (D.C. Cir. Decided April 14, 2014) [an enhanced version of this opinion is available to lexis.com subscribers].
Section 1502 of Dodd-Frank directed the SEC to develop and issue rules the use of “conflict minerals” from the Democratic Republic of the Congo or DRC and its neighboring countries. Conflict minerals are gold, tantalum, tin and tungsten which are extracted from what the Court called technologically primitive mining sites in the remote eastern Congo. Armed groups profit by extorting, and in some instances managing, the largely unregulated mining operations. The armed conflicts among the groups, which are characterized by extreme violence that is particularly sexual and gender-based, have been financed at least in part through the sale of the conflict minerals.
Dodd-Frank requires companies to disclose annually to the SEC if the minerals in their products “originated or may have originated in Congo” to help ensure activities involving such minerals do not finance or benefit the armed groups. If so, then the company must file an additional report with the SEC with a description of the products manufactured using the minerals.
As directed by Congress, the Commission developed rules which require covered issuers to conduct a “reasonable country of origin inquiry” regarding their conflict minerals. If, after the inquiry, the company determines that its conflict minerals did not originate in the covered countries, the issuer must disclose that conclusion to the SEC along with its predicate. If the issuer concludes that the conflict minerals did originate for a covered country – or if it cannot make that determination – a report must be prepared and filed with the Commission.
The District Court rejected the claims of Appellants. The Circuit Court largely affirmed.
Appellants presented a series of challenges to the Rules under the Administrative Procedure Act, or APA, and one claim under the First Amendment. Under the APA Appellants have the burden of establishing that the agency acted in an arbitrary or capricious manner or that its action constituted an abuse of discretion or was otherwise not in accord with the law. Here the Association has not met that burden.
First, the Association claims that the SEC should have included a de minimis exception. The Commission acknowledged that it has the authority to create such an exception. It found, however, that such an exception would be contrary to the statute and its purpose. In reaching this conclusion the agency relied on the text of the statute, context and policy concerns, inferring that “Congress wanted the disclosure regime to work even for those small uses.” This is sufficient the Court concluded.
Second, Appellant challenges the provision requiring that an issuer conduct due diligence if, after inquiry it has reason to believe that its conflict minerals “may have originated” in “covered countries.” This provision contravenes the statute which only requires that a report be submitted when the conflict minerals did originate in a covered country, according to Appellant.
In rejecting this claim the Court noted that the “Association has conflated distinct issues.” The statute does state that a report has to be prepared if the minerals originated from certain countries. It does not specify under what circumstances due diligence must be performed prior to filing that report. When a statute is silent or ambiguous with respect to a specific issue the Commission can exercise reasonable discretion in construing the statute. Here it has done that.
Third, the Court rejected the Association’s contention that the standard regarding due diligence was to low. The Commission adopted a low standard so that issuers who encountered warning signs regarding the origin of the minerals would make inquiry to learn the source. A simple good faith inquiry would permit an issuer to perhaps ignore a red flag. While the Commission’s rule here is expansive, it could have gone further.
Fourth, the Association’s claim regarding “persons described” is also incorrect. The statute specifically states that it applies to “persons described” and references manufactures of a product in which conflict minerals “are necessary to the functionality or production” of the product. If those persons file a report the statute requires them to describe products they “manufacture” or “contract to be manufactured.”
The Commission applied the final rule not only to issuers that manufacture their own product but also to those who contract to manufacture. The Association is correct that the “person described” section only speaks of manufactures and is silent about contracting to manufacture while another section uses that phrase. The silence in that one section, however, permits the Commission to use its delegated authority to determine the scope of the overall provision as it has done here. Its interpretation is reasonable.
The Court also rejected the Association’s final two points in this area. The temporary phase in rules which give large issuers two years and smaller ones four years are not inconsistent or arbitrary. Likewise, the Court did not “see any problems with the Commission’s cost-side analysis” which was “extensive.” While it is correct that the SEC did not conduct any analysis to determine whether the purpose of the statute could be achieved and relied on Congress for this point, that approach is permissible. The Commission was in fact required to promulgate the disclosure rule.
The Court did, however, sustained the Association’s First Amendment claim. Here the challenge is to the requirement in the final rules that an issuer describe its products as not “DRC conflict free” in the report and must post on its website. The requirement unconstitutionally compels speech, according to the Association. The Court agreed.
The critical issue here is the standard of review. The Commission argued that rational basis review is appropriate because the disclosure is purely factual and non-ideological. That standard of review is an exception used in certain instances when the disclosure is uncontroversial such as where the governmental interest is tied to preventing deception of consumers. Under this standard the government must show to compel speech that there is 1) a substantial governmental interest at stake, 2) which is directly and materially advanced by the restriction and 3) that the restriction is narrowly tailored.
This case does not meet the test. As the Court stated “it is far from clear that the description at issue – whether a product is ‘conflict free’- is factual and non-ideological. The label ‘conflict free’ is a metaphor that conveys moral responsibility for the Congo war. It requires an issuer to tell consumers that its products are ethically tainted . . . By compelling an issuer to confess blood on its hands, the statute interferes with that exercise of the freedom of speech under the First Amendment.” Accordingly, the decision of the district court was affirmed in part and reversed in part and remanded for further proceedings consistent with the Court’s opinion.
Circuit Judge Spinivasan concurred in the Court’s opinion regarding the APA challenges. He did not join the opinion with respect to the First Amendment issue. The question of whether the relaxed standard for reviewing compelled commercial speech applies only if the disclosure requirement serves a governmental interest in preventing consumer fraud is currently pending before the en banc court in another case. Under those circumstances a decision on the question should have been held until the resolution of that case.
For more commentary on developing securities issues, visit SEC Actions, a blog by Thomas Gorman.
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