Regulatory requirements create confusion and disagreement.
by William P. Barrett
In U.S. business these days, it’s hard to find a more aptly named subject of a big legal dispute.
“Conflict minerals,” as most know by now, refers to certain key, high-value substances mined in African countries that are prone to armed groups, corrupt soldiers, forced labor and other human rights abuses. But the more relevant conflict for manufacturing and metals companies is the ongoing court battle challenging the power of the U.S. government to force public companies, and those that supply them, public or private, at their own expense to police and disclose the use of such minerals.
Pursuant to legislation that Congress passed and President Barack Obama approved in 2010, the U.S. Securities and Exchange Commission (SEC) issued detailed rules implementing the law last August. In October, three major lobbying groups for business—the National Association of Manufacturers (NAM), the U.S. Chamber of Commerce and the Business Roundtable—filed a lawsuit challenging the conflict minerals rules in the U.S. Court of Appeals for the District of Columbia. The appellate panel granted expedited handling of the case, meaning it likely will be heard this spring.
To be clear, the law does not ban the use by American business of conflict minerals. Rather, it mandates public disclosure of such use—as a badge of shame, perhaps. The measure resembles the conceit of Nathaniel Hawthorne’s famous work, The Scarlet Letter, in which adulteress Hester Prynne is forced to wear a red letter A on her clothes.
Depending upon one’s point of view, the SEC rules represent either outrageous social engineering and unnecessary costs to comply with an unenforceable law, or responsible corporate accountability. The business interests claim the SEC’s rules are overreaching, arbitrary and capricious, and that the price tag to business to follow the rules is as high as $16 billion. A cost, they say that is far in excess of any reasonable benefit. Citing a case striking down mandated graphic warnings on cigarette packs, business interests also say the First Amendment to the U.S. Constitution blocks the SEC from requiring such public disclosures about conflict minerals usage.
Human rights groups such as Amnesty International, which has won court approval to intervene and defend the rules, Global Witness and the Enough Project say business interests are grossly exaggerating the expense and should be far more interested in doing the right thing.
“This is one of the most critical moral issues of our time,” insists Sasha Lezhnev, a Washington, D.C.-based spokesman for the Enough Project.
The Uncertainty Leads to Expense
Although no disclosures are required until 2014, the rules officially took effect on Jan. 1 of this year. It’s possible the appeals court will invalidate part or even all of them. It’s also possible the rules will be upheld. So the uncertainty has forced businesses, especially manufacturers, to prudently spend money to set up systems to collect the required data so as to avoid SEC sanctions, and maybe lawsuits from shareholders.
“We work very closely with clients,” says Guido van Drunen, a Seattle, Washington-based partner in the forensic practice of accountancy at KPMG. For certain large companies, “it’s a massive undertaking.”
“We’re struggling a little bit,” says Karla Lewis, executive vice president and chief financial officer of Reliance Steel & Aluminum, the nation’s largest metals service firm.
The roots of the legislation lie in Africa’s second-largest country by land, the Democratic Republic of the Congo (DRC), which is blessed with stunningly abundant natural resources and cursed with stunningly abundant political instability. It is not to be confused with its much smaller neighbor, the Republic of the Congo. In particular, the eastern part of the Equator-straddling DRC has been enmeshed since 1998 in almost continual warfare, much of it aided and abetted by forces from neighboring countries. By some accounts, the death toll has been in the millions, from both warfare and illnesses untreated because foreign aid workers can’t operate safely.
The conflict has been driven and funded by trade in certain valuable minerals that human rights activists say are looted and mined under exploitative conditions. These include forced labor involving children, and unsafe working conditions, including fatal mudslides and tunnel collapses. The tools of control? Violence and rape.
The Legislation Conflict
Four years ago, Sam Brownback, then a Republican senator from Kansas (and now its governor), introduced the Congo Conflict Minerals Act of 2009, along with Democratic Sens. Richard Durbin of Illinois and Russell Feingold of Wisconsin (who was voted out in 2010). The measure required companies to verify and disclose their use of conflict minerals. The bill died in committee.
But its provisions were resurrected a year later and became Section 1502 of the giant Dodd-Frank Wall Street Reform and Consumer Protection Act. Sen. Durbin in testimony before the SEC explained the rationale for the legislation:
The United Nations calls the Democratic Republic of the Congo…the rape capital of the world. The unspeakable things that happen to the women and girls in that country in the name of this war we’ve recounted at some of our committee hearings. But looking into their desperate faces as they’re waiting for help and imagining what they have seen, what they have been through, what they have lived through is something you’re not likely to forget....I came back from the first trip with Sen. Sam Brownback, opposite political party but a close ally in this fight…And we said we have got to alert the American business community and the American consumers to the fact that our demand for products that contain these minerals could inadvertently be fueling this war and leading to this terrible suffering.
The massive Dodd-Frank overhaul of U.S. financial regulation was signed into law by President Obama on July 21, 2010. Technically, Section 1502 amended the Securities Exchange Act of 1934, one of the major New Deal laws establishing financial reporting standards in the United States.
Section 1502 specified the four metals of interest and the geography, which included the DRC and all eight adjoining countries. Known as “Covered Countries,” the group is comprised of Angola, Burundi, Central African Republic, Rwanda, South Sudan, Tanzania, Uganda and Zambia. The provision ordered the SEC to establish compliance rules. After a contentious rule-making process marked by heavy lobbying and missed deadlines, the SEC finally adopted regulations last summer by a narrow 3-2 vote. It is these regulations that are the subject of the pending court fight.
The rules apply to all publicly reporting companies where any of the four listed minerals are “necessary to the functionality or production” of an item the company either makes itself or contracts a third party to make. By some estimates this directly ropes in 6,000 public companies whose activities include some form of manufacturing. It also would force countless other private companies that supply such metals to public companies to show their materials pass muster.
Affected companies must conduct a country-of-origin inquiry to determine the supply source of the four minerals and pay for an independent audit of that inquiry. The results are to be reported to the SEC on a new Form SD. The first reports for calendar year 2013 are due by May 31, 2014. A company that is conflict-minerals-free will have it relatively easy. However, those actually using conflict minerals will have to inquire further and report all that in considerable detail and suffer the likely PR hit.
There is no reporting exemption for minimal use of conlict minerals, which is one point that business groups are challenging in their lawsuit. But there are some broad exemptions. For example, scrap and recycled metal falls outside the rules. Retailers like the Wal-Marts, Targets, Costcos and Best Buys that simply sell products made by others are also outside the scope. Companies that merely attach their brand or label to a product made by others are exempt, as well. There is a two- to four-year compliance grace period if a company is unable, in good faith, to determine if its raw materials are “DRC conflict-free.”
Like many new regulatory schemes, it’s not clear how enforcement will play out. The SEC has the power to levy fines and sanctions for inadequate compliance. The rules state that Form SD is to be “filed” with the SEC rather than “furnished”—a key distinction since the Securities Exchange Act of 1934 allows for private lawsuits over inaccurate filings. This raises the possibility of shareholder derivative lawsuits against public companies by fee-motivated plaintiff lawyers with no real clients other than themselves.
Also unclear is what constitutes compliance. Van Drunen, the KPMG partner, expects that a common-sense, risk-based approach will evolve. For example, he says, a manufacturer that uses tin produced in Montana would not have the conflict minerals risk that a manufacturer using sources in Africa would, and thus would have a far easier time from a compliance standpoint.
Van Drunen and others say it’s possible manufacturers largely can meet the requirements of the rules with a proper, good-faith paperwork trail from their suppliers. And that might mean after climbing a learning curve, suppliers can essentially use identical paperwork for all purchasers of the same material who need verifications.
The Cost-Benefit Conflict
Much of the court battle is expected to center around a cost-benefit analysis of the rules. In its notice of final rule-making published in the Federal Register, the SEC estimated the cost of initial compliance at $3 billion to $4 billion, and the annual cost of ongoing compliance at between $207 million and $609 million. The business groups suing think the actual costs will be four times greater, or more. Quentin Riegel, deputy general counsel of NAM, agrees that “whether the SEC has properly done its economic analysis” will be an issue during litigation.
However, Lezhnev, the Enough Project spokesman, says the NAM cost estimates were developed before the final SEC rules, which reduced the scope of coverage. He also says NAM estimates assume that every public company would incur huge costs for separate monitoring software, when in fact the firms can share or take advantage of free trade association software.
The Securities Exchange Act of 1934 bars the SEC from adopting rules that impose a burden that is not necessary or appropriate to fulfilling that law. So, the SEC action contained a discussion of considerable length about the benefits, most of which are attributed to the language of the legislation. “Congress likely sought to reduce the amount of money provided to armed groups engaged in armed conflict in the DRC,” the SEC majority wrote. At another point, however, the notice said these objectives “do not appear to be those that will necessarily generate measurable, direct economic benefits to investors or issuers.”
It seems obvious that the cost to individual companies will vary widely. KPMG’s van Drunen notes that a large business like the Boeing Company can have 500,000 parts in a single aircraft, all subject to scrutiny. But Lewis of Reliance expects her firm will be able to manage the new law without adding staff.
Undoubtedly, a fair amount of the initial costs incurred will be fees to lawyers and other experts to parse the language of the rules figuring out definitions, meanings, limits and work-arounds. Such professionals are always big winners in new regulatory schemes.
William P. Barrett is a veteran business journalist. He can be reached at email@example.com.