On August 22, 2012, the Securities and Exchange Commission (the “SEC”) issued final rules (the “Rules”) requiring (i) disclosure of whether products manufactured or contracted to be manufactured by public companies contain “conflict minerals” that originated in the Democratic Republic of the Congo (“DRC”) or an adjoining country (the “Covered Countries”), and (ii) disclosure by resource extraction issuers of payments made to the U.S. federal or a foreign government for the purpose of the commercial development of oil, natural gas or minerals pursuant to Sections 1502 and 1504, respectively, of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd- Frank Act”). [1]  

Background on Conflict Minerals

Since the SEC issued the proposed rules in December 2010, many companies have started establishing compliance programs for their conflict minerals supply chains. Because companies have complex, international supply chains with as many as thousands of suppliers and sub-suppliers providing components, tracing the chain of custody from components to mines is both an expensive and challenging undertaking. Indeed, the U.S. Chamber of Commerce continues to threaten a lawsuit against the SEC, similar to the proxy access challenge, asserting that the cost for monitoring such supply chains exceeds the benefits. Although Section 1502 of the Dodd-Frank Act is not intended to ban use of minerals originating from the Covered Countries, public companies will face potential liability for failing to accurately disclose sourcing practices and could face reputational harm from the failure to keep conflict minerals out of their products. The first conflict minerals disclosures will be due May 31, 2014 for all issuers. However, in a significant change from the proposed rules, the Rules allow for a two-year phase-in period (four years for smaller reporting companies) during which a company may disclose that it is unable to determine whether its products originated in the Covered Countries or financed or benefited armed groups.  

What are conflict minerals and why does the SEC care?

The Dodd-Frank Act defined “conflict minerals” as four specific minerals and their derivatives: columbite-tantalite (the metal ore from which tantalum is extracted), casseriterite (the metal ore from which tin is extracted), wolframite (the metal ore from which tungsten is extracted), and gold. These metals are key elements in electronics products such as cell phones and personal computers, cars, planes and many other everyday products. In addition, the Secretary of State may make a determination as to whether any other mineral or derivative thereof is financing conflict in the Covered Countries.

Congress enacted Section 1502 of the Dodd-Frank Act to quell the emergency humanitarian situation in the DRC region. Congress intended to bring public pressure to bear to stem extreme levels of violence, particularly sexual and gender-based violence, by armed groups profiting from the exploitation and trade of conflict minerals in the DRC and adjoining countries. Congress was concerned about the control over mines exerted by these armed groups, who demand taxes, bribes and other payments for minerals extracted or transported from the mines along routes that they control. Section 1502 amends the Securities Exchange Act of 1934 (“Exchange Act”) to add Section 13(p).  

To determine whether, and the extent to which, disclosure is required under the new Rules, companies will need to conduct a three-step analysis.  

How do companies determine if they are subject to the conflict minerals rules?

The first step each public company must take is to determine whether its products contain conflict minerals and whether it manufactures or contracts to manufacture them. Public companies will only be subject to the Rules if the company is a reporting issuer whose products contain conflict minerals that are “necessary to the functionality or production of a product manufactured or contracted to be manufactured” by that company. If a company does not manufacture or contract to manufacture products or if it does not use conflict minerals in its products, then the company is not subject to the Rules and is not required to make any disclosures. If a company does determine that conflict minerals are necessary to the functionality or production of its products then it must go on to step two, discussed below. The Rules apply equally to foreign private issuers and smaller reporting companies.  

The SEC provided guidance beyond that provided in the proposing release on what constitutes “necessary to the functionality or production of a product manufactured or contracted to be manufactured.” In a significant departure from the proposing release, the Rules exclude issuers that merely affix their own brand, marks, logo, or label to a generic product manufactured by a third party. In another significant change, an issuer that exerts “any” influence over a product’s manufacturing will not automatically be considered as one that has “contracted to manufacture” that product. Under the Rules, an issuer is considered to be contracting to manufacture a product depending on the degree of influence it exercises over the materials, parts, ingredients, or components to be included in the product. The SEC clarified that although the degree of influence necessary for an issuer to be considered “contracting to manufacture” a product is based on facts and circumstances, an issuer will not be considered to be contracting to manufacture a product if it does no more than: specify or negotiate 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 concerning the product; or, service, maintain or repair a product manufactured by a third party.  

In addition, the SEC clarified that mining of conflict minerals, without further manufacture, is not considered manufacturing and therefore does not require issuers to make the disclosures under The new Rules.  

For companies that use conflict minerals, what is the next step?

Once an issuer has determined that conflict minerals are necessary to the functionality or production of a product manufactured or contracted to be manufactured by that issuer, then the second step is for the company to conduct a reasonable country of origin inquiry to determine the origin of the conflict minerals.  

If the issuer, based on this reasonable country of origin inquiry, finds that:

  • the conflict minerals did not originate in the Covered Countries or were from scrap or recycled sources, or
  • the issuer has no reason to believe that the conflict minerals may have originated in the Covered Countries or were from scrap or recycled sources,  

then the issuer must file a new Form SD (specialized disclosure form) that discloses its determination, describes the reasonable country of origin inquiry it undertook and the results of the inquiry. Further, the issuer must disclose the same information on its internet website and provide a website reference in its Form SD. [2] Because the conflict minerals disclosures are made on new Form SD rather than in an issuer’s annual reports, the disclosures are not subject to the officer certifications on internal control over financial reporting and disclosure controls included in Form 10-K. In addition, Form SD is not required to be incorporated by reference into registration statements under the Securities Act of 1933. The SEC notes that an issuer’s policies with respect to the sourcing of conflict minerals will generally form a part of the issuer’s reasonable country of origin inquiry, and therefore would generally be required to be disclosed in the issuer’s Form SD. Following initial disclosure on Form SD, companies would include the information on an annually filed Form SD. It is worth noting that if the issuer makes the determination as set forth above, then no further due diligence is required, as described below.  

The SEC did not provide a blueprint on what would be a “reasonable country of origin” inquiry, but did note that it must be “reasonably designed to determine whether the issuer’s conflict minerals did originate in the Covered Countries, or did come from recycled or scrap sources, and must be performed in good faith.” Based on SEC guidance, receiving representations from providers that the conflict minerals did not come from the Covered Countries or were from recycled or scrap sources would largely satisfy this inquiry, unless the issuer had reason to believe that such representations were inaccurate. Pursuant to the SEC guidance an issuer may satisfy the good faith standard if it “seeks and obtains reasonably reliable representations indicating the facility at which its conflict minerals were processed and demonstrating that those conflict minerals did not originate in the Covered Countries or came from recycled or scrap sources.” These representations could come either directly from the facility or indirectly through the issuer’s immediate suppliers. However an issuer must have a reason to believe these representations are true and must take into account any red flags indicating that its conflict minerals may have originated in the Covered Countries or did not come from recycled or scrap sources. An issuer would have reason to believe representations were true if a processing facility received a “conflictfree” designation by a recognized industry group that requires an independent private sector audit of the smelter (where mineral ore is converted into metal), or an individual processing facility obtained an independent private sector audit that is made publicly available. Moreover, the issuer is not required to receive representations from all of its suppliers as long as it does not ignore warning signs or other circumstances indicating that the remaining amount of its conflict minerals originated or may have originated in the Covered Countries. As an example, the SEC said it would agree that, “if reasonable inquiry has been made, and if no evidence of [Covered Country] origin has arisen, and if the origin of only a small amount of gold were still unknown, a manufacturer should be allowed to declare that its gold is not from the [Covered Countries] and is DRC conflict free.”  

In the event that the issuer is unable to determine the origin of the conflict minerals or it has reason to believe that the conflict minerals are from a Covered Country, then the issuer must move on to step three to conduct due diligence that goes beyond inquiry and involves further steps to establish the source and chain of custody of the minerals. Also, as described below, step three due diligence will require companies to make additional disclosures in its Form SD.  

What due diligence is required to be conducted or disclosed under the conflict minerals rules?

An issuer must proceed to step three and conduct due diligence on its conflict minerals’ source and chain of custody if the issuer, after conducting a reasonable country of origin inquiry:

  • knows that its conflict minerals originated from the Covered Countries and were not from scrap or recycled materials, or
  • has reason to believe that the conflict minerals may have originated from Covered Countries or may not be from recycled or scrap sources.

The due diligence conducted with respect to the source and chain of custody of the conflict minerals must follow a nationally or internationally recognized framework. The SEC specifically referenced the due diligence framework of the Organisation for Economic Co-operation and Development (“OECD”) [3] as one that satisfies the SEC’s criteria and may be used as an “internationally” recognized standard. The OECD due diligence guidance provides a five step framework for due diligence. In addition, the OECD supplements on each of the conflict minerals provides guidance on supply chain due diligence for upstream companies (companies that fall between the mine and the smelter in the supply chain) and downstream companies (companies that fall between the smelter and retailers of finished products). Smelters are a critical point in the supply chain for due diligence because smelters aggregate minerals from many sources. As such, the OECD supplements provide that downstream companies should review the due diligence smelters conduct in their sourcing. This is because it may not be feasible for downstream companies to trace the chain of custody of minerals further upstream than the smelter.  

Further disclosures depend on the results of the due diligence on the source and chain of custody of the conflict minerals. If as a result of this due diligence, the issuer determines that the conflict minerals did not originate from the Covered Countries or were from recycled or scrapped sources, then the issuer need only file a Form SD that briefly describes the reasonable country of origin inquiry and the due diligence measures taken as a result thereof but need not file a Conflict Minerals Report as an exhibit to its Form SD nor conduct an audit, as described below.  

An issuer must file a Conflicts Minerals Report if, as a result of its due diligence, it determines that:

  • its minerals may have originated from the Covered Countries but did not finance or benefit armed groups, (“DRC Conflict Free”);
  • its minerals did originate from the Covered Countries or are not from scrap or recycled sources, and financed or benefited armed groups in the DRC, (“Not DRC Conflict Free”); or
  • it has reason to believe that the conflict minerals may have originated from Covered Countries and may not be from recycled or scrap sources (“Not Been Found to be DRC Conflict Free”). [4]

The SEC added a phase-in provision whereby within the first two years (four years for smaller reporting companies), an issuer may describe its products as “DRC conflict undeterminable” if the issuer cannot determine, after conducting due diligence on the source and chain of custody, whether the minerals in its products originated in the Covered Countries or financed or benefited armed groups in those countries. In this case, the issuer must file a Conflict Minerals Report, which in addition to the disclosures required when a determination is that the minerals are “Not Conflict Free”, must also disclose what steps it will take, or has taken since the last Conflict Minerals Report, to mitigate the risk that the conflict minerals do not support armed forces in the Covered Countries including steps to improve the due diligence inquiry. During this DRC conflict undeterminable phase-in period, companies will not be required to obtain an audit, described below.  

In addition to filing a Conflict Minerals Report as an exhibit to the Form SD, an issuer must obtain an independent private sector audit of its Conflict Minerals Report, include the audit as part of its Conflict Minerals Report and certify that it obtained an audit, as described below. Unless the issuer determines that the minerals are “DRC Conflict Free”, then the Conflict Minerals Report must describe the products that have not been found to be “DRC conflict free”, the facilities used to process the conflict minerals in those products (e.g., the smelter or refinery through which the issuer’s minerals pass), the country of origin of the conflict minerals in those products, and the efforts to determine the mine or location of origin with the greatest possible specificity.  

The objective of the private sector audit is to determine, in the auditor’s opinion, whether (i) the design of an issuer’s due diligence framework as set forth in the Conflict Minerals Report is in conformity with, in all material respects, the criteria set forth in the nationally or internationally recognized due diligence framework used by the issuer, and (ii) whether the issuer’s description of the due diligence measures it performed as set forth in the conflict minerals report is consistent with the due diligence process that the issuer undertook. Whether products are DRC Conflict Free is not the subject of the audit. An issuer must certify that it obtained an independent private sector audit of its Conflict Minerals Report. Unlike certifications provided in periodic reports, the certification is not a separate exhibit but rather takes the form of a statement in the Conflict Minerals Report that the issuer obtained an independent private sector audit. The final rule clarifies that the audit certification need not be signed by an officer (unlike the certifications provided in periodic reports).  

Who must make resource extraction payment disclosures?

Congress enacted Section 1504 of the Dodd- Frank Act to increase transparency of payments made by oil, natural gas and mining companies to governments in an effort to help empower citizens of those resource-rich companies to hold their governments accountable for the wealth generated by those resources. Section 1504 added Section 13(q) to the Exchange Act. All “resource extraction issuers” are subject to the new disclosures. The SEC defined “resource extraction issuer” as an issuer who files an annual report with the SEC and is engaged, or any of its subsidiaries or controlled entities are engaged, in the commercial development of oil, natural gas or minerals.[5] This includes foreign issuers who file annual reports on Form 20-F or 40-F and smaller reporting companies as well. However, not all foreign issuers are subject to the resource extraction disclosures. Foreign companies who qualify for Exchange Act reporting exemption under Rule 12g3-2(b) are not required to make the disclosures. To qualify for the exemption under Rule 12g3-2(b) a company’s primary trading must occur in a non-U.S. jurisdiction, it may not be listed or have publicly offered its securities in the U.S. and it must publish its foreign disclosure documents on its website.  

The SEC did not create any exemptions for resource extraction issuers. Such issuers must make the required disclosures even if (i) their domestic laws prohibit such disclosure, (ii) they are complying with an alternative disclosure regime, or (iii) they are otherwise bound by a confidentiality or nondisclosure agreement. Furthermore, there are no size exemptions; smaller reporting companies must make the same disclosures as large accelerated filers. In sum, these Rules are far-reaching and will require companies to perform an analysis of all of their subsidiaries’ activities as well as determine for new acquisitions, whether the entity makes any payments in question.  

What are the new disclosures for resource extraction payments?

Resource extraction issuers will use Form SD to disclose payments. The issuer must disclose any payments made to the U.S. federal government or any foreign government or division or subnational unit (e.g. states) thereof. Payments made to domestic states are excluded from disclosure. However, payments made to foreign government majority-owned companies do qualify for disclosure. As a result, resource extraction issuers should be vigilant in monitoring the persons or entities they pay in order to determine whether the governmentowned company payment rule is triggered.  

A resource extraction issuer need only disclose the payments that are made to further the “commercial development” (including exploration, extraction, processing and export, or the acquisition of a license for such activity) of oil, natural gas or minerals. The SEC noted that only activities that are “directly related” to the commercial development of oil, natural gas or minerals would be required; ancillary or preparatory activities, such as providing tools for extraction, transportation (other than for export) or marketing, would not fall within this definition. Issuers cannot re-characterize activities to avoid meeting this “commercial development” definition.

“Payments” include taxes (other than consumption taxes), royalties, fees (license fees, rental fees and entry fees), production entitlements, bonuses, dividends and infrastructure improvements. If there are questions as to whether certain types of monetary or other transfers qualify as payments, the SEC specifically referred issuers to the types of payments required to be disclosed under the Extractive Industries Transparency Initiative, or EITI’s framework. The SEC noted that dividends that are paid as ordinary dividends to governments and common shareholders will not be considered payments, although any dividends in lieu of another revenue stream would be considered payments. Furthermore, any payments for nonsocial infrastructure improvements or other in-kind payments, in lieu of other payments or made as a condition of extraction, would be considered payments subject to disclosure. Issuers cannot re-characterize monetary transfers to avoid meeting this “payment” definition.  

The Rules provide for a “de minimis” disclosure threshold so that only payments equal to or exceeding $100,000 for a given fiscal year, either as a single payment or series of payments for a project, need be disclosed. Critics have attacked the “de minimis” threshold of $100,000 as too low with Commissioner Gallagher, in voting against the rule, stating: “But it is very unlikely that there is any reporting company affected by this rule for which $100,000 is ‘material.’ In other words, viewed from the standpoint of any extractive industries issuer, the release has defined “not de minimis” to mean “de minimis.”  

Resource extraction issuers must disclose payments on a “project” basis. Unfortunately, the SEC did not define “project” but did note that simply disclosing payments by country would not meet this definition. Issuers will be required to determine what a project consists of based on the specific facts they encounter.  

Form SD will also require XBRL interactive data files as an exhibit to the form. These data files must disclose the following:

  • the total amounts of the payments, by category;
  • the currency used to make the payments;
  • the financial period in which the payments were made;
  • the business segment of the resource extraction issuer that made the payments;
  • the government that received the payments, and the country in which the government is located; and
  • the project of the resource extraction issuer to which the payments relate.  

The SEC is currently working on the taxonomy for these data files.  

Form SD disclosure is required no later than 150 days after the end of the resource extraction issuer’s fiscal year.  

When do these rules take effect?

Conflict Minerals: The conflict minerals rules require that disclosures be made for the 2013 calendar year (regardless of the issuers fiscal year end) with the first Form SD report due on May 31, 2014. The triggering event for the disclosure is the completion of manufacturing for the product, so if an issuer does not manufacture any products in 2013, then it need not provide a report for that year even if it contracts for the manufacture of the product on December 26, 2013, but that product is not completed during the 2013 calendar year. Conflict minerals stockpiled before January 31, 2013 and used in products will not trigger disclosure.  

Resource Extraction: Issuers must comply with the resource extraction disclosure requirements for fiscal years ending after September 30, 2013. For issuers with fiscal years ending on December 31, 2013, this will require a partial year report for payments made between October 1, 2013 and December 31, 2013. The next report for such issuers with fiscal years ended on December 31 would be after the 2014 calendar year.

How is Form SD treated under the Securities Laws?

The SEC requires Form SD to be “filed” rather than “furnished.” This includes the Conflict Minerals Report and the private sector audit report. This has the effect of exposing the issuer to Section 18 liability under the Exchange Act, although proving a Section 18 claim requires reliance and damages— two elements which may be difficult to prove with respect to materials contained in Form SD. The issuer would still be potentially liable for the antifraud provisions of the Exchange Act, including Rule 10b-5, for materially misleading statements.  

Tips for Compliance—Conflict Minerals

Companies should begin by establishing an annual compliance plan that includes an applicable set of OECD guidelines and supplements or some other nationally or internationally recognized framework. As a next step, companies ought to create an internal conflict minerals supply chain group that includes personnel from manufacturing, procurement and SEC compliance to coordinate implementation. Companies should adopt and commit to a supply chain policy and structure internal management systems to support supply chain due diligence. To identify the use of conflict minerals in components and processes, companies may review bills of materials, interview engineers and experts and develop lists of current suppliers that use these metals in their parts or components. Finally, companies should establish internal processes to:

  • Develop a policy statement and communicate this information to suppliers;
  • Send “dear supplier” letters advising suppliers that the company is subject to the SEC’s conflict minerals provisions and request that suppliers conduct due diligence to determine the source;
  • Send due diligence questionnaires to suppliers and evaluating responses for potential “red flags”;
  • Identify alternative sources of conflict minerals or of products obtained from suppliers that use conflict minerals or consolidating suppliers if unable to obtain the requested information from suppliers;
  • Include in procurement contracts a prohibition on providing parts that use conflict minerals that directly or indirectly finance or benefit armed groups in Covered Countries;
  • Include in supply contracts provisions that require suppliers to provide information with respect to meeting the company’s reporting obligations on a timely basis and cooperating with any inquiry or audit by the company with respect to the conflict minerals supply chain; and
  • Assess the reputational importance of its products being DRC conflict free to its shareholders and end users.  

Tips for Compliance—Resource Extraction Payments

Resource extraction issuers should consider taking the following steps:

  • Survey country, region and segment executives and review contracts to consider how certain resource extraction activities meet the definition of a “project”;
  • Review contracts with foreign countries to determine whether any obligations of the issuer (such as building infrastructure within the country) would qualify as “payments” as described above;
  • Work with internal accounting personnel and outside auditors to internally monitor the flow of payments (including taxes) and classify such payments within the project framework as described above. Within the project framework, allow for exclusion of any amounts paid to U.S. states or under $100,000 in the aggregate;
  • Review current and future contracts to provide for appropriate carve-outs, to the extent not already within the contract, for disclosure of payments pursuant to securities laws and specifically Form SD as required; and
  • Review the EITI’s framework on a consistent basis.

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