The U.S. Securities and Exchange Commission (SEC) has issued fresh guidance for issuers on the requirements for compliance with the SEC’s new Conflict Minerals Rule and the SEC’s Disclosure Rules – both of which provide for transparency and disclosure of payments by resource extraction issuers to the governments where they operate.
Interest in these issues has been heightened recently as companies realize that these two rules will be applying to actions that are taking place on the ground now. Additionally, resource industry transparency has come to the forefront internationally with the European Union Parliament approving new transparency rules, and with Canadian Prime Minister Harper recently announcing that Canada would be establishing new mandatory reporting standards for extractive companies to improve the transparency of payments they make to governments worldwide.
This bulletin is divided into two parts. The first part of the bulletin highlights the key points of clarification on the application of the conflict minerals rule to assist companies in meeting their disclosure obligations. The second part summarizes the guidance provided by the SEC’s Frequently Asked Questions (FAQs) on its disclosure rules for resource extraction issuers.
Part One: SEC FAQs for Compliance with the Conflict Minerals Rules
The Conflict Minerals Rule arose from section 1502 of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, and was adopted by the SEC in August 2012. The first disclosure reports from issuers on the use of “conflict minerals” are due in a year’s time (May 31, 2014).
On August 2012, the SEC issued the final conflict minerals rule (the “Rule”) as required by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, detailing how companies must report the use of certain minerals—including tin, tantalum, tungsten and gold—originating from the Democratic Republic of the Congo or adjoining countries and which are believed to be financing ongoing conflict in the region. The Rule requires companies to make reasonable inquiry to determine and disclose the source country of those minerals. A public company that manufactures or contracts to manufacture products that contain the designated minerals must conduct a reasonable “country of origin” inquiry, and disclose the results of this assessment in the SEC's new Form SD. If designated minerals do, or might, come from covered countries, additional due diligence into the source and chain of custody of those minerals is also required, along with an independent third-party audit of that assessment.
The Rule applies to every issuer required to file reports under either 13(a) or 15(d) of the Exchange Act, including, as clarified by the FAQs, voluntary filers. IPO issuers must comply for the current calendar year if their registration statement goes effective before May 1 of that year. An issuer must file a disclosure on its behalf as well as on behalf of the subsidiaries included in its consolidated financials.
An issuer that acquires, or otherwise obtains control of, a manufacturer that manufactures, or contracts to manufacture, products containing conflict minerals must file a report regarding the acquired company's products. The report must be filed in the first reporting calendar year that begins no sooner than eight months after the effective date of the acquisition. Registered investment companies that are required to file reports pursuant to Rule 30d-1 under the Investment Company Act are not subject to the Rule.
A product is covered by the Rule if it is:
- Manufactured or contracted to be manufactured by a company, and
- Necessary to the functionality or production of the product.
In response to questions received, the SEC further clarified:
- An issuer that only engages in mining activities is not considered to be manufacturing those minerals. This exclusion includes the mining of lower grade gold ore, as well as the ancillary activities of mining, such as transporting the ore to a processing facility, crushing and milling the ore, mixing crushed or milled ore with cyanide solution, floating cyanide mixture through a leaching circuit, extracting gold from a leached circuit, smelting the gold into ingots or bars and transporting the ingots or bars to a refinery for refining.
- An issuer is not considered to be “contracting to manufacture” a product if its actions involve nothing more than “affixing its brand, marks, logo, or label to a generic product manufactured by a third party.” Labelling a product manufactured by a third party does not constitute "contracting to manufacture.
- An issuer is not required to report on conflict minerals contained in equipment that it manufactures or contracts to manufacture to the extent that the equipment is used for a service provided by the issuer and that: (a) the equipment is retained by the service provider; (b) is to be returned to the service provider; or (c) is intended to be abandoned by the customer following the terms of service.
- The sale of used tools, machines or other equipment that an issuer manufactured or contracted to manufacture for use in the manufacture of its products does not fall under the Rule.
- Packaging or containers sold with a product is not considered to be part of the product, even if the packaging or container is necessary to preserve the usability of the product up to, and following, the product's purchase, as it is generally discarded. This clarification is particularly significant for companies in the food and beverage and pharmaceutical industries, where packaging is designed, for example, to maintain product freshness (and therefore arguably necessary to the functionality of the product). The packaging may therefore contain conflict minerals while the actual products do not. Packaging and containers are still considered to be a product if the issuer manufactures and sells packaging or containers separate from the product contained in the packaging itself.
- Generic component parts contained in a product are subject to the Rule. For purposes of the Rule, the SEC does not distinguish between the components of a product that an issuer directly manufactures, or contracts to manufacture, and the generic purchased components included in the product. Products that contain generic components not manufactured by the company must conduct appropriate due diligence to ascertain the source of the minerals in the generic components included in their products.
It is important to note that, consequently, many private companies in the supply chains of impacted issuers will be impacted indirectly by the Rule. Public companies will need to know whether their suppliers’ products contain any conflict minerals for purposes of complying with their disclosure obligations. Suppliers should be prepared to respond to inquiries from their customers regarding conflict minerals in their supply chain.
The SEC affords some flexibility to issuers on how it describes products that have not been found to be “DRC conflict free” or which are “DRC conflict indeterminable”, permitting issuers to describe them based on "its own facts and circumstances." The SEC’s reasoning is that issuers are best positioned to know, and describe, its products in terms understood by the industry. An issuer is not required to describe its products using model numbers.
If an issuer determines that its covered products contain conflict minerals from the DRC or an adjoining country, but the products are “DRC conflict free”, the FAQs make clear that the issuer must still complete a Conflict Minerals Report in addition to its Form SD and obtain an independent audit of the applicable portions of the report. However, the issuer is not required to disclose the products containing those conflict minerals in its Conflict Minerals Report or provide the product description indicated in Item 1.01(c)(2) of the Rule because the products are conflict-free.
The failure to file a Form SD in a timely manner does not render issuers ineligible to use Form S-3, the simplified securities registration form.
Though the filing deadline for the first Form SD is not until May 31, 2014, it is critical for public companies that manufacture or contract to manufacture products (and private companies that supply the impacted issuers) to take steps now to develop compliance strategies and complete the necessary due diligence on its supply chains to ensure that they will be able to comply with the Rule when the time comes.
View the SEC FAQs on the Conflict Minerals Rule.
Part Two: SEC FAQs for Compliance with Payment Disclosure Rules
On May 30, 2013, the SEC published FAQs to guide and assist companies in complying with the relatively new Disclosure Rules, which provide for transparency and disclosure of payments by resource extraction issuers to the governments where they operate.
The Disclosure Rules, adopted by the SEC on August 22, 2012, pursuant to section 1504 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, require disclosure of certain payments to the U.S. federal government or foreign governments (and related entities) made by resource extraction companies for the purpose of commercial development of oil, natural gas, or minerals.
Our Bulletins on Section 1504 of the Dodd-Frank Act and the Disclosure Rules can be found on our website.
Resource Extraction Issuers
Only issuers directly engaged in the commercial development of oil, natural gas, or minerals must disclose payments to governments in accordance with the Disclosure Rules. The FAQs clarify that a reporting issuer that is not engaged in commercial development activities itself but whose subsidiary or entity under its control engages in those activities would be considered a resource extraction issuer and subject to the Disclosure Rules.
The Disclosure Rules do not apply to issuers providing services associated with the exploration, extraction, processing, and export of a resource. For example, companies are not subject to disclosure as a result of providing hardware and logistics to other companies for the purpose of exploring or extracting minerals. Companies engaged by an operator to provide hydraulic fracturing services or drilling services for the operator are also not themselves considered resource extraction issuers. However, if a service provider makes a payment that falls within the definition of "payment" to a government on behalf of a resource extraction issuer, the resource extraction issuer must disclose such payment.
Issuers engaged in transporting a resource from one country to another are generally not considered to be engaged in "commercial development," which includes in its definition "export" of the resource, provided that any such issuer does not have an ownership interest in the resource being transported.
For purposes of disclosure, a “mineral” is defined as any materials commonly understood to be minerals, i.e., materials extracted and gathered by means of mining activity such as metalliferous minerals, coal, oil shale, tar, sands and limestone, including any material for which disclosure is required (or could be required without regard to materiality) under Industry Guide 7, "Description of Property by Issuers Engaged or to be Engaged in Significant Mining Operations."
Payments and the Disclosure Rules
For payments to be subject to the Disclosure Rules, they must be made to further the commercial development of oil, natural gas, or minerals and take the forms of taxes, royalties, fees, production entitlements, bonuses, dividends, or payments for infrastructure improvements.
The following payments are not subject to the Disclosure Rules:
- Payments made to majority-owned government entities for services or activities that are ancillary or preparatory to the commercial development of oil, natural gas, or minerals, such as payments for providing transportation services to supply people or materials to a job site;
- Penalties or fines related to resource extraction; and
- Corporate-level income tax payments to governments on income not generated by the commercial development of oil, natural gas, or minerals.
Note that the Disclosure Rules do not require a resource extraction issuer to segregate income earned in resource extraction activities and to disclose taxes paid on such segregated income. A resource extraction issuer may disclose that the information includes payments made for purposes other than the commercial development of oil, natural gas, or minerals. However, when disclosing payments made to governments to further commercial development activities in a particular country, an issuer may elect to segregate income earned in exploration, extraction, processing and export from other income earned in that country, and disclose income taxes paid solely on the income generated by the commercial development activities.
Making Payment Disclosure
Resource extraction issuers are to present payment information on an unaudited, cash basis for the year in which the payments are made.
Similar to the FAQs relating to the conflict mineral rule also issued by the SEC on May 30, the issuer will not lose eligibility to use Form S-3, the simplified securities registration form, if it fails to file a Form SD in a timely manner.
The Disclosure Rules are part of an international movement toward mandatory rules for revenue disclosure by resource extraction companies. The European Union Parliament has approved new transparency rules and Prime Minister Harper recently announced that Canada would be engaging with the provinces (including provincial securities regulators), industry and First Nations to establish new mandatory reporting standards for Canadian extractive companies to improve the transparency of payments they make to governments worldwide. What remains uncertain is whether the federal government will adopt a provincial securities approach or seek to establish a federal reporting regime. An open question as well is whether the federal government will require disclosure of impact and benefit payments made by companies in the extractive sector to Aboriginal communities.