Wednesday, September 5, 2012
THE SEC ADOPTS FINAL RULES ON CONFLICT MINERALS
Following much debate and delay, on August 22, 2012, the Securities and Exchange Commission (the “SEC”) issued final rules under Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act relating to the use of conflict minerals. The final rules, which were originally scheduled for release in April 2011, are aimed at curbing violence in the Democratic Republic of Congo (the “DRC”) by requiring public disclosure of all conflict mineral sourcing in the DRC and surrounding countries. The SEC has estimated that nearly 6,000 domestic and foreign reporting companies will be affected by the new rules, requiring them to review their supply chains and publicly disclose their use of tin, tantalum, tungsten and gold (the so-called “conflict minerals”), if any of those minerals are necessary to the functionality or production of a product that they manufacture or contract to manufacture. For companies subject to the rules, the SEC has created a new form, known as Form SD, for companies to use to make annual disclosures regarding their conflict minerals. Furthermore, if any of the conflict minerals originate from the DRC or any surrounding countries, the issuer must also file a Conflict Minerals Report with the SEC that describes its due diligence process and identifies any products that are not determined to be “DRC conflict free” and must obtain an independent private sector audit of the Conflict Minerals Report. The flowchart developed by the SEC, found on page 33 of the Final Rule publication, outlines the process for compliance.
I. Could These Rules Apply to Your Company?
The first step in complying with the SEC’s new rules is determining whether they apply to your company. The rules apply to any issuer that:
- Files reports with the SEC under Section 13(a) or 15(d) of the Exchange Act, including domestic companies, foreign private issuers, emerging growth companies and smaller reporting companies, and
- Manufactures or contracts to manufacture a product for which one or more conflict minerals are necessary to the functionality or production of that product or a component of that product. The rules do not apply to individuals or private companies.
What is a “Conflict Mineral”?
The SEC’s final rules define the term “conflict mineral” as “columbitetantalite (coltan), cassiterite, gold, wolframite, or their derivatives,” which are currently limited to tantalum, tin, and tungsten (subject to action by the Secretary of State to designate additional derivatives as conflict minerals in the future). Such minerals are considered “conflict minerals” under the final rules regardless of where in the world they are mined and even if they do not directly or indirectly benefit armed groups in the DRC and adjoining countries (i.e., are “DRC conflict free”): Angola, Burundi, Central African Republic, the Republic of Congo, Rwanda, South Sudan, Tanzania, Uganda, and Zambia (collectively, “Covered Countries”). The rules do not apply to conflict minerals that were outside the supply chain (i.e., they were smelted or fully refined or were outside the Covered Countries) prior to January 31, 2013, nor do they apply to conflict minerals derived from recycled or scrap sources.
Does Your Company “Manufacture” or “Contract to Manufacture” a Product?
While the SEC did not specifically define the term “manufacture” (noting that it is a term that is “generally understood”), the SEC did explain that it does not consider an issuer that only services, maintains or repairs a product containing conflict minerals to be “manufacturing” a product. With respect to the term “contract to manufacture,” the SEC explained that the term’s applicability will depend on the degree of influence exercised by the issuer over the manufacturing of the product or any materials, parts, ingredients or components to be included in the product. The “degree of influence” determination will necessarily be based on the specific facts and circumstances of the situation; however, the SEC stated that an issuer should not be viewed as contracting to manufacture a product if its actions involve no more than:
- Affixing its brand, marks, logo or label to a generic product manufactured by a third party;
- Specifying or negotiating contractual terms with a manufacturer that do not directly relate to the manufacturing of the product (such as training or technical support, price, insurance, indemnity, intellectual property rights, dispute resolution, or other like terms or conditions), unless the issuer specifies or negotiates taking these actions so as to exercise a degree of influence over the manufacturing of the product that is practically equivalent to contracting on term that relate directly to the manufacturing of the product; or
- Servicing, maintaining, or repairing a product manufactured by a third party.
Are Conflict Minerals “Necessary to the Production or Functionality” of a Product?
The SEC’s rules do not specifically define the phrase “necessary to the functionality or production” of a product, but the SEC has provided relevant guidance, including making it clear that a conflict mineral must actually be contained in the product for it to be “necessary to the functionality or production” of such product.
To determine whether a conflict mineral is “necessary to the functionality” of a product, a company should consider:
- Whether the conflict mineral is contained in and intentionally added to the product (or any component of the product) and is not a naturally-occurring by-product;
- Whether the conflict mineral is necessary to the product’s generally expected function, use or purpose; and
- If the conflict mineral is incorporated for purposes of ornamentation, decoration or embellishment, whether the primary purpose of the product is ornamentation or decoration.
To determine whether a conflict mineral is “necessary to the production” of a product, a company should consider:
- Whether the conflict mineral is contained in the product and intentionally added in the product’s production process, including the production process of any component of the product; and
- Whether the conflict mineral is necessary to produce the product.
II. Assuming Your Company is Subject to the Rules, What Are You Required to Do?
Reasonable Country of Origin Inquiry
If an issuer determines it is subject to the SEC’s new conflict minerals rules, the next step is to conduct a reasonable country of origin inquiry (“RCOI”) to determine whether or not its conflict minerals originate in any of the Covered Countries. The rules do not set forth what constitutes a RCOI, nor do they require issuers to determine the origin with 100% certainty. Instead, an issuer can satisfy the RCOI requirement by conducting an inquiry regarding the origin of its conflict minerals that is reasonably designed to determine whether any of its conflict minerals originated in the Covered Countries or are from recycled or scrap sources, and is done in good faith. A RCOI can differ for each issuer depending on the issuer’s size, products, relationships with suppliers, or other factors. The SEC declined to provide mandatory steps for the RCOI so that the rules can remain flexible and “evolve with available tracing processes” that are developed over time. For most issuers, however, a RCOI will involve, at a minimum, the issuer contacting each of its relevant suppliers to inquire about the conflict minerals’ country of origin.
If, after completion of a RCOI, an issuer (i) determines that its conflict minerals did not originate in any of the Covered Countries or that such conflict minerals are from scrap or recycled sources, or (ii) has no reason to believe that its conflict minerals may have originated in the Covered Countries or reasonably believes such conflict minerals are from recycled or scrap sources, then the company must disclose this determination and describe the RCOI it used to reach this conclusion in a new specialized disclosure report, known as “Form SD,” that is required to be filed with the SEC annually (described below). The issuer must also make the descriptions publicly available on its website and reference the website in its SEC filing. For these issuers, the process is then complete. These issuers are not required to maintain reviewable business records to support the country of origin conclusion, but keeping such records will prove beneficial should a challenge ever arise.
Due Diligence, Conflict Minerals Report and Independent Audit
If, after completion of an RCOI, an issuer (i) knows that its conflict minerals originated in the Covered Countries (and did not come from recycled or scrap sources or (ii) has reason to believe that its conflict minerals may have originated in the Covered Countries (and may not have come from recycled or scrap sources), then the issuer generally must complete three additional steps:
- exercise due diligence on the source and chain of custody of its conflict minerals;
- prepare a “Conflict Minerals Report”; and
- obtain a private sector audit of the Conflict Minerals Report.
The Conflict Minerals Report is required to be filed as an exhibit to the issuer’s Form SD and should describe the due diligence measures taken, among other things. The due diligence measures must conform with a nationally or internationally recognized due diligence framework, if such framework is available for the specific conflict mineral. An issuer must also obtain a private sector audit of its Conflict Minerals Report, which is meant to express an opinion or conclusion as to whether: (i) the design of the issuer’s due diligence measures as set forth in the Conflict Minerals Report conforms with the criteria of the nationally or internationally recognized due diligence framework that is used and (ii) that the issuer actually undertook the due diligence process described in the Conflict Minerals Report. The Conflict Minerals Report must also contain a description of an issuer’s products that have not been found to be “DRC conflict free.” (i.e., minerals that may have originated in the Covered Countries but that did not finance or benefit armed groups). The Conflict Minerals Report must disclose the facilities used to process the minerals that have not been found to be “DRC conflict free,” the country of origin of those minerals and the efforts to determine the mine or location of origin with the greatest possible specificity.
Exceptions; Temporary Transition Period
In response to numerous comments, the SEC provided for a number of exceptions and modifications to lessen the burden on issuers. For example, if an issuer exercises due diligence on the source and chain of custody of its conflict minerals and finds that the conflict minerals did not originate in the Covered Countries or that its conflict minerals did come from recycled or scrap sources, that issuer is not required to submit a Conflict Minerals Report. Instead, the issuer must simply file a Form SD, describing its determination, its country of origin inquiry, and its due diligence efforts and results. Additionally, the SEC’s final rules provide for a temporary transition period for issuers. For the first two years (four years for smaller reporting companies) after the effectiveness of the rules, issuers may describe their products as “DRC conflict undeterminable” if they are unable to determine that the minerals are “DRC conflict free” for either of two reasons:
- After a RCOI, an issuer concluded that its minerals originated in Covered Countries but even after due diligence, the issuer is unable to determine if conflict minerals financed or benefited armed groups; or
- After a RCOI, an issuer had reason to believe that its minerals may have originated in the Covered Countries and may not have come from recycled or scrap sources, but even after due diligence, the issuer is unable to determine the country of origin, whether the conflict minerals financed or benefitted armed groups, or whether the conflict minerals came from recycled or scrap sources.
Companies with “DRC conflict undeterminable” products must still file Conflict Mineral Reports describing their due diligence and steps they have taken or will take, if any, since their last report, to mitigate the risk their conflict minerals are aiding armed groups. The Conflict Minerals Report does not need to be audited during the transition period.
III. Timing and Liability
All issuers subject to rules must file a Form SD by May 31 of each year, reporting with respect to the preceding calendar year, with the first Form SD due on May 31, 2014 (reporting on the 2013 calendar year). The Form SD must address conflict minerals present in the issuer’s products for which manufacturing was completed in the preceding calendar year. For issuers that have recently completed an acquisition, an instruction to Form SD provides that the issuer may delay the initial reporting period on products manufactured by the acquired company until the first calendar year beginning no sooner than eight months after the effective date of the acquisition.
Because Form SD is required to be filed with the SEC (rather than furnished, as earlier proposed by the SEC), issuers will be subject to liability under Section 18(a) of the Securities Exchange Act of 1934 for any false or misleading disclosures in the Form SD, opening the potential for private rights of action in addition to the SEC’s ability to proceed against an issuer in an enforcement action. Unlike the proposed rules, officer certifications are not required.
It is worthy of note that the SEC has estimated the cost of initial compliance with the new rules to be between $3 billion and $4 billion, with subsequent annual compliance costs estimated to be between $207 million and $609 million. These exorbitant compliance costs are due in large part to the SEC’s recognition of the potential broad applicability of the rules to thousands of companies in multiple industries, as well as the expected significant costs for companies to develop procedures for the “reasonable country of origin inquiry,” establish necessary due diligence frameworks and pay for independent audits.
The rules do provide that issuers that obtain reasonable representations indicating the facility where its conflict minerals were processed and demonstrate those minerals did not originate in the Covered Countries or came from recycled or scrap sources will satisfy the RCOI requirement.
The Government Accountability Office (“GAO”) will establish the appropriate standards for the independent private sector audit, which will likely be existing Government Auditing Standards (“GAGAS”), such as standards for Attestation Engagements or Performance Audits.
We recommend that every public company, including our public company clients, begin to analyze now whether they are deemed to be manufacturing, or contracting to manufacture, products that may contain conflict minerals.
This Alert is for information purposes only and should not be construed as legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. For more information or an explanation about the matters discussed in this Alert, please contact either of the attorneys listed above.
IRS Circular 230 Disclosure – To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.