D.C. Court of Appeals strikes down conflict minerals rule "DRC conflict free" disclosure requirement on First Amendment grounds, but leaves other reporting requirements intact

April 18, 2014

Securities and Economic Sanctions Alert

Author(s): Kelly D. Babson

Despite a recent D.C. Circuit Court of Appeals decision striking down a provision of the Securities and Exchange Commission’s conflict minerals rule, companies should continue to conduct required due diligence absent further action by the courts or the Commission.

Earlier this week, in National Association of Manufacturers v. Securities and Exchange Commission, No. 1:13-cv-00635, the United States Circuit Court of Appeals for the District of Columbia found that the conflict minerals rule adopted by the Securities and Exchange Commission (the “Commission”) violates the First Amendment right of free speech to the extent it compels public companies to report to the Commission and state on their website that any of the products they manufacture or contract to manufacture have “not been found to be ‘DRC conflict free’” based on their supply chain diligence. However, the court of appeals upheld the decision of the trial court and rejected the challenges to other provisions of the rule, leaving a substantial portion of the rule intact. The conflicts minerals rule, which was adopted by the Commission in 2012 under the requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, requires public reporting companies whose products contain conflict minerals to investigate and disclose information regarding the source of such conflict minerals. The first conflict minerals reports under the rule must be filed by June 2, 2014. 

Conflict minerals regulations

The conflict minerals regulations adopted by the Commission do not ban companies from using conflict minerals in their products. What they do require is that companies who file reports with the Commission under sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, whose products require conflict minerals for production or functionality conduct a “reasonable country of origin inquiry” involving a good faith investigation of their supply chains reasonably designed to determine whether the conflict minerals contained in their products originated in the Democratic Republic of Congo or nine adjoining countries (the “Covered Countries”) or are from scrap or recycled sources. The conflict minerals currently covered by the rules include gold, columbite-tantalite (coltan), cassiterite, wolframite and their derivatives (tantalum, tin and tungsten). Companies must disclose the nature and results of their inquiry annually on Form SD, which must be filed with the Commission and posted on the company’s website.

If a company determines that the conflict minerals included in its products originated in the Covered Countries or has reason to believe that the conflict minerals may have originated in the Covered Countries or are not from recycled or scrap sources, the company is required to undertake a due diligence process with respect to the source and chain of custody of the conflict minerals used in its products and file a more detailed Conflict Minerals Report as an exhibit to its annual Form SD. In most cases, the company is also required to obtain an independent private sector audit of its Conflict Minerals Report and include a copy of the audit report in its Conflict Minerals Report disclosures. The conflict minerals rule requires the Conflict Minerals Report to detail the company’s due diligence and audit efforts, note which products have “not been found to be ‘DRC conflict free,’” and include as much information as known about the origin of the conflict minerals used in the company’s products.

D.C. Circuit Court of Appeals decision

The court first rejected the appellant’s arguments relating to the lack of a de minimis exception in the rules, the scope of the reasonable country of origin inquiry, the inclusion of companies that “contract to manufacture” products containing conflict minerals in the persons covered by the regulations and the applicable phase-in periods for smaller reporting companies and other companies. Turning to the First Amendment argument, the court concluded that the disclosure requirement that forced companies to describe products as not “DRC conflict free” in their public filings and on their websites constituted compelled speech. As a result, the requirement violated the First Amendment rights of companies subject to the rule.

The court was not persuaded by the Commission’s argument that the required disclosures were only factual. Rejecting the proposition that the disclosures contained no ideological statements requiring more exacting scrutiny than a rational basis review, the court stated that the disclosures were a statement about issuers’ role in the conflict and their moral responsibility. “The label ‘conflict free,’” the court wrote, “is a metaphor that conveys moral responsibility for the Congo war.” The court determined that the Commission did not provide evidence that its rules compelling speech were sufficiently narrowly tailored to meet a substantial government interest.

The full text of the decision can be found here. 

Implications for public companies: conflict minerals reporting

Although the court invalidated a central component of the conflict minerals disclosure requirements, much of the conflict minerals rule remains intact and must be followed by issuers. This includes the Commission’s requirement that public companies conduct due diligence on products they suspect contain conflict minerals. That being said, there is uncertainty regarding how the ruling will affect the June 2 deadline to file the conflict minerals reports. The D.C. Circuit Court remanded the decision to the U. S. District Court for the District of Columbia for further proceedings. As of Wednesday, the Commission had not issued a statement regarding its expectations for compliance with respect to the June 2 deadline for the first Form SD and Conflict Minerals Report filings under the current rule.

As a result of the upcoming deadline, absent further action on the part of the courts or the Commission to the contrary, public companies should continue due diligence efforts and preparations for drafting and filing the reports required under the rule. In addition, affected companies should closely monitor the courts and the Commission for further guidance and developments.

Implications for U.S. companies: export controls

Regardless of how the courts ultimately decide on the disclosure issue, companies must continue to comply with the limited economic sanctions imposed against certain individuals and entities in the DRC. Many of the same individuals and entities who are covered by the sanctions issued by the Department of Treasury’s Office of Foreign Assets Control (“OFAC”) are involved in the conflict mineral trade. As a result, any company with securities reporting concerns still should examine sanctions compliance.

The DRC sanctions are directed at foreign armed groups, Congolese armed groups and persons who recruit children to participate in armed conflict or target children in armed conflicts. They also cover certain individuals and entities that have supplied or sold arms or other military equipment, directly or indirectly, to the DRC, and individuals and entities that have materially assisted, sponsored or provided support for any of the groups or individuals described above. Individuals and entities that have been designated under the sanctions are listed on the Specially Designated Nationals (“SDN”) List.

The sanctions block all property and interest in property of these designated parties from being transferred, paid, exported or withdrawn, where the property or interest in property is in the United States or is in the possession or control of U.S. persons. They also prohibit transactions with any individuals or entities on the SDN List.

The DRC sanctions apply the “50 percent rule,” meaning that if an entity is 50 percent or more owned, directly or indirectly, by a person named on the SDN List, that entity is also sanctioned. This applies even if the entity is not itself listed on the SDN List. As a result, companies must conduct proper due diligence, particularly when dealing with conflict minerals, to determine if any entity with whom it is doing business has ties to individuals or entities on the SDN List.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

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