Featured Expert Contributor — Corporate Governance/Securities Law

bainbridgeStephen M. Bainbridge, William D. Warren Distinguished Professor of Law, UCLA School of Law.

Section 1502 of the 2010 Dodd-Frank Act required the Securities and Exchange Commission (SEC) to develop disclosure rules requiring public companies to disclose whether their products contained “conflict minerals.” The minerals in question included cassiterite, columbite-tantalite, gold, wolframite, or their derivatives, all of which are used in a variety of common products, including computers, smart phones, and other everyday technology. In order to be deemed conflict minerals, they had to be sourced from the Democratic Republic of the Congo (DRC) or its adjoining countries.

Congress believed that various armed factions in the DRC and its neighboring countries were using the proceeds from trafficking in conflict minerals to finance their violent activities, which include high levels of sexual- and gender-based violence. Although justified as a means of giving investors information about the products manufactured by companies in which they were or might become invested, the record makes clear that this was really an example of therapeutic disclosure. In other words, disclosure that is less intended to inform than it is to change corporate behavior. Congress believed that requiring companies to disclose their use of conflict minerals would force such companies to seek alternative sources of such minerals and seek to alleviate the conflict, thereby depriving the factions of much of their income.

Section 1502 and SEC Rule 13p-1 thereunder were controversial from the outset. Critics argued that therapeutic disclosure was unwise securities regulation policy, because it involved SEC in substantive regulation of business rather than the reporting of finances and operations that is its core mission.

As for the substance of the rule, critics complained that it would prove highly costly. A 2015 Tulane University report found that the total cost for 1,300 reporting companies to comply was just under $710 million, which amounted to just under $546,000 per issuer to comply for just one year. As usual with disclosure regimes dictated by Sarbanes-Oxley (SOX) and the Dodd-Frank Act, smaller issuers bear a disproportionately large compliance burden.

In addition, critics complained that the rule was having no meaningful effect on the various conflicts raging in the DRC and its environs, a critique that was confirmed by a UN Security Council report from late December 2016. It found that systems for certifying minerals as conflict free were weak, violence had increased (mainly due to a delay in DRC presidential elections), and there were continuing widespread reports of gross human rights abuses.

A 2015 decision by the US Court of Appeals for the DC Circuit struck down a key part of the rule, finding that the requirement for reporting companies “to report to the Commission and to state on their website that any of their products have ‘not been found to be ‘DRC conflict free’” violated the First Amendment. In response, SEC adopted a policy that still requires companies to make various disclosures about their efforts to determine if their products contain conflict minerals.

On January 31, 2017, Acting SEC Chairman Michael Piwowar asked the SEC staff to review its standing policy on conflict mineral disclosure, explaining that:

I did so not from any lack of familiarity with or sympathy for the plight of the beleaguered people of the Democratic Republic of the Congo region. As I noted in my public statement, ‘while visiting Africa last year, I heard first-hand from the people affected by this misguided rule,’ which has caused a ‘de facto boycott of minerals from portions of Africa.’ I am concerned that ‘withdrawal from the region may undermine U.S. national security interests by creating a vacuum filled by those with less benign interests.’ Nevertheless—whatever the purported benefits of the rule may be—I believe it is categorically wrong to use shareholder assets to fund a humanitarian effort better left to executive agencies with the requisite experiential knowledge.

Unless at least one of the various proposals circulating in Congress to repeal much of Dodd-Frank, most of which include repealing § 1502, come to fruition, SEC cannot just unilaterally revoke Rule 13p-1. Some conflict mineral rule is clearly required by statute. But the review ordered by Chairman Piwowar could result in considerable relief for affected companies.

To be sure, there are those who argue that § 1502 is clear in its mandates and that no deviation therefrom is permissible. But as former SEC Commissioner Daniel M. Gallagher observed when Rule 13p-1 was adopted, however, “[e]xemptive authority is inherently a part of the SEC’s rulewriting authority.”

Gallagher suggested two sensible exercises of that authority with regards to the conflict minerals rule. First, create an exemption for smaller issuers from some or all of the compliance requirement. Such an exemption would be consistent with the precedent set with SOX § 404, whose considerable costs were eventually alleviated by exempting non-accelerated filers from having their internal controls attested by their outsider auditor.

Second, exempt issuers whose use of conflict minerals was de minimis. As Gallagher explained, although such issuers would face substantial costs, their “compliance with [the] rule could have, at most, a small and indirect impact, if any, in ameliorating the problem—a negligible benefit.”

In addition to these sensible tweaks, SEC should also consider whether its exemptive authority extends to converting the conflict minerals rule into a comply-or-explain requirement. Such requirements are commonly used in the UK and are increasingly being adopted in the US. In essence, the requirement is not that companies comply with an expensive and complex process of determining whether their supply chain contains conflict minerals and then provide the required disclosures, but rather than companies choose either to comply or explain why they chose not to do so.

Comply or explain creates a market in which companies and investors can match up, reducing search costs for investors and capital costs for issuers. Investors who care about the conflict minerals issue and believe corporate engagement will help solve the problem can invest in companies that chose to comply and avoid those that explain—in their required periodic disclosure reports—that they have opted not to do so. Conversely, investors who are less concerned with conflict minerals, can opt for companies that have opted out of the regime.

Finally, although I suggested above that § 1502 leaves SEC no wriggle room to get out of having some form of conflict minerals rule, the same is not true of the President. That section of Dodd-Frank contains a national security provision, requiring SEC to revise or temporarily waive the rule “if the President transmits to the Commission a determination that … such revision or waiver is in the national security interest of the United States and the President includes the reasons therefor….” Although the resulting exemption is limited by statute to a maximum period of two years, nothing in the statute prohibits the President from issuing such determinations on a rolling basis every two years.

Interestingly, in directing SEC staff to undertake the upcoming review of the rule, Acting Chairman Piwowar stated that high cost of the rule is putting legitimate operators out of business and that the resulting “withdrawal from the region may undermine U.S. national security interests by creating a vacuum filled by those with less benign interests.” (Emphasis supplied.) This looks like a clear invitation to the White House to short circuit SEC review by issuing the required determination.

In sum, it looks like change is coming to the conflict-minerals disclosure regime. Whether it will happen through Congress repealing § 1502 as part of sweeping Dodd-Frank review, significantly revised by SEC, or put on a two-year hold by the White House is not certain. The odds of at least one of those events happening soon, however, seems high.