On April 14, 2014, the U.S. Court of Appeals for the D.C. Circuit issued its long-awaited decision in the challenge to the SEC’s conflict minerals disclosure rule filed by the National Association of Manufacturers (“NAM”) and other industry groups, giving the challengers a partial victory on First Amendment grounds. NAM had challenged several aspects of the SEC’s rules as violating the Administrative Procedure Act (“APA”), the Exchange Act, and the First Amendment. The Court rejected the APA and Exchange Act challenges to the rules, but by a 2-1 margin found that certain aspects of the SEC’s rules violate the First Amendment by compelling issuers to engage in stigmatizing commercial speech about their own products. Whether that partial victory will result in meaningful changes to the SEC’s conflict minerals reporting regime remains to be determined, as the Court’s First Amendment ruling focused on the rule’s requirement that issuers use the particular descriptor “not found to be ‘DRC conflict free’” in describing their own products, leading to potential debate as to whether the constitutional issues with the rule are limited to those particular “magic words,” or whether the public reporting aspect of the rule requires a broader reconsideration and adjustment. This Legal News Alert provides a brief summary of the Court’s decision, as well as preliminary thoughts on how this might impact conflict minerals compliance issues for issuers and companies in their supply chains.
Court Rejects APA and Exchange Act Challenges
NAM had argued that several aspects of the conflict minerals rules exceeded the SEC’s rulemaking authority, contradicted the underlying statutory provisions on which they were based, or were otherwise arbitrary and capricious. Specifically, NAM challenged: (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; (3) the SEC’s expansion of conflict minerals due diligence and reporting obligations beyond just “manufacturers” to reach retail issuers who sell products that they “contracted to be manufactured”; and (4) the SEC’s adoption of a shorter phase-in period for large issuers (two years) than for small issuers (four years). The Court rejected all four of these challenges, finding that the SEC had reasonably exercised its broad rule-making discretion and its delegated authority to interpret and fill in the gaps in ambiguous statutory language.
NAM had also argued that the SEC violated the provisions of the Exchange Act by failing to perform an adequate cost-benefit analysis of its final rule. Specifically, NAM challenged the SEC’s acknowledged inability to quantify the social benefits of the rule or to determine whether the final rule would actually achieve its intended purpose of promoting peace and stability in the Congo. The Court rejected that argument, noting that the benefits of saving lives or preventing rapes in the Congo region cannot logically be weighed against the economic costs (measured in dollars) of the reporting requirements. The Court further found that, in passing Section 1502 of Dodd-Frank, Congress had already concluded that transparency and disclosure regarding the sourcing of conflict minerals would benefit the Congo, and the SEC could not have second-guessed Congress on that judgment and still fulfilled its obligation under the statute to adopt a conflict minerals disclosure rule.
First Amendment Issue: Compelled Speech
Two members of the three-judge panel found that the requirement that issuers report to the SEC and to state on their websites that any of their products have “not been found to be ‘DRC conflict free’” constitutes government-compelled commercial speech in violation of the First Amendment. The majority concluded that such compelled commercial speech is subject to heightened scrutiny when the disclosure at issue is not related to the government’s interest in preventing deception of consumers, an interest that the majority found was not implicated by the conflict minerals rule. The majority also remarked upon the stigmatizing impact of the description at issue, observing that describing a product as “not found to be conflict-free” is “a metaphor that conveys moral responsibility for the Congo war,” and conveys to consumers that an issuer’s products “are ethically tainted.” The SEC could not justify this interference with issuers’ free speech rights, the majority concluded, because the governmental objectives underlying the rules could be accomplished through less intrusive means – such as by having the SEC itself, not each respective issuer, describe products as “not conflict-free” based on the information reported in the issuers’ conflict minerals reports.
What the Decision Means for Issuers and Their Suppliers
By striking down one aspect of the SEC’s conflict minerals reporting requirements, the Court’s decision will unquestionably impact the initial conflict minerals disclosures issuers would otherwise be due to file by June 2, 2014 – but precisely what that impact will be is yet to be determined, as the SEC is no doubt reviewing the decision and evaluating its next steps. One option for the SEC would be to suspend the initial reporting obligation, pending a revision of the conflict minerals rules to remove the “speech” requirement that the panel majority found objectionable. Even if the SEC does not voluntarily suspend the upcoming obligation to file conflict minerals reports, NAM is likely to request that the D.C. Circuit order the SEC to stay enforcement of the conflict minerals reporting obligation pending the SEC’s revision of the rules to comply with the Court’s ruling. Whether companies would be required to file a conflict minerals report in the coming weeks could well turn on how broadly the SEC interprets the constitutional deficiencies in its rules. If the SEC reads the D.C. Circuit decision narrowly, it may conclude that the rules can be remedied simply by removing the obligation for issuers to use the words “not DRC conflict-free” in their reports, which may allow the SEC to maintain the current June 2, 2014 deadline for companies to file their initial conflict minerals reports. (Few issuers were likely to use that “not DRC conflict-free” descriptor in their initial conflict minerals reports anyway, as most issuers would presumably use the “conflict undeterminable” designation available to companies during the rule’s phase-in period.)
From a longer-term perspective, the Court’s decision largely validates the SEC’s ability to require companies to perform due diligence on, and provide factual information about, the sourcing of conflict minerals in the products they manufacture or contract to have manufactured. Thus, the decision will likely have little impact on the “nuts-and-bolts” of conflict minerals reporting for most issuers and their suppliers, as the First Amendment objections to the current rules center on the requirement that companies self-identify their products as “not found to be ‘DRC conflict free.’” The Court did not prohibit the SEC from taking the factual information provided in issuers’ conflict minerals reports and using that information to issue its own determination that companies’ products are “not DRC conflict-free.” In fact, the Court practically invited such a result, noting that “if issuers can determine the conflict status of their products from due diligence, then surely the Commission can use the same information to make the same determination.” The SEC may be unwilling to perform such a role, however, given the amount of resources that would be required to review the conflict minerals reports of all issuers and make such determinations – particularly when such supply chain considerations are outside the SEC’s traditional areas of expertise.
The extent to which the D.C. Circuit ruling will lead to substantive changes in issuers’ reporting obligations depends in large measure on how broadly the SEC interprets the First Amendment problems with the current rule. If the SEC interprets the D.C. Circuit decision as rendering the entire public reporting aspect of the existing rule constitutionally suspect, the SEC would need to fundamentally restructure the conflict minerals rules, which would require another round of notice and comment rulemaking. If the SEC interprets the D.C. Circuit decision more narrowly, as implicating only the “scarlet letter” aspect of requiring companies to self-identify as “not DRC conflict-free” in their conflict minerals reports, the SEC could seek to retain the existing due diligence and reporting framework, and merely remove the requirement that issuers expressly describe themselves or their products in their conflict minerals reports as “not DRC conflict-free.” Such a result would permit companies that meet the existing standards for identifying themselves or their products as “DRC conflict-free” to continue to tout their “conflict-free” status in their conflict minerals reports. Conversely, issuers unable to meet the “conflict-free” standards would not have to publicly declare themselves “not conflict-free,” but their “not conflict-free” status would be implicit (though unstated), based on their inability to describe themselves as “conflict-free.” This revised regime would be analogous to how the government regulates certain claims in food labeling: the government establishes the standards a product must meet before it can label (and market) itself as “organic,” but does not require products falling short of those standards to stigmatize themselves as “non-organic.”
Even if the D.C. Circuit’s ruling does not trigger a wholesale reexamination and restructuring of the conflict minerals reporting regime in the SEC’s existing rules, the D.C. Circuit’s decision will likely either: (a) shift from issuers to the government the responsibility for identifying an issuer or its products as “not DRC conflict-free,” or (b) make that designation implicit, rather than explicit, in an issuer’s conflict minerals report. However, by leaving intact the SEC’s existing policy choices with respect to companies’ duties to investigate the sourcing of conflict minerals in their supply chains, the D.C. Circuit’s ruling is unlikely to lead to a significant reduction in the due diligence and fact-gathering obligations imposed on issuers and their suppliers.
We will continue to monitor the SEC’s reaction to the D.C. Circuit’s ruling and will provide additional guidance as the SEC takes steps to address the decision.