On August 22, 2012, the Securities and Exchange Commission (SEC) adopted disclosure rules that will impose new and significant responsibilities on issuers of publicly traded securities. The rules are designed to shed light on supply chains for certain valuable minerals that originate in the Democratic Republic of the Congo (DRC) and nine surrounding countries (Angola, Burundi, Central African Republic, the Republic of Congo, Rwanda, South Sudan, Tanzania, Uganda and Zambia, the “Covered Countries”) where money from mining operations often goes to finance war, slavery and human rights abuses. These rules also require an independent, private sector audit regarding the sourcing and supply chains for conflict minerals in an issuer’s products.

The SEC acknowledged the compliance burdens, but Chairman Mary L. Schapiro said these rules were necessitated by an act of Congress which recognized that “the exploitation and trade of conflict minerals by armed groups is helping to finance conflict in [Africa] and the emergency humanitarian crisis there warrants these disclosure requirements.”

Schapiro also announced the release of new rules requiring companies engaged in the development of oil, gas and minerals to disclose certain payments made to foreign governments or the U.S. government. The accompanying SEC release noted that these rules “would increase the accountability of governments to their citizens in resource-rich countries for the wealth generated by those resources.”

Both sets of new rules were legislatively mandated by Section 13(q) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) which was previously described in our July 2010 Securities Law Update entitled “Summary of Corporate Governance Changes in the Dodd-Frank U.S. Financial Regulatory Reform Act,” available on our website at: http://www.burnslev.com/apps/uploads/publications/Securities_Update_Dodd-Frank_July2010.pdf.

  • What follows is a detailed summary of the two sets of rules. With respect to the conflict minerals rules, this summary explains:
  • Which companies have products containing conflict minerals that are “manufactured” or “contracted to be manufactured” under the new rules; Which minerals are defined to be • “conflict minerals”;
  • What kind of “reasonable ‘country of origin’ inquiry” an issuer is required to perform with respect to components of its products;
  • What kind of disclosures an issuer is required to make concerning conflict minerals;
  • What kind of independent private sector audit an issuer must obtain for any required conflict minerals report;
  • Special provisions relating to scrap and recycled materials; and
  • The required methods and timing for disclosures.

The full text of the 356-page SEC Release no. 34-67716 regarding conflict minerals can be viewed at: http://www.sec.gov/rules/final/2012/34-67716.pdf.

With respect to the resource extraction payment rules, this summary explains:

  • The definition of a “resource extraction issuer” covered by the rules;
  • The definition of a “foreign government” or “the U.S. government” under the rules;
  • The types and amounts of payments to government entities that must be disclosed by resource extraction issuers;
  • The disclosures that must be made regarding payments to governments; and
  • The required methods and timing for disclosures.

The full text of the 232-page SEC Release no. 34-67717 regarding resource extraction payments to governments can be viewed at: http://www.sec.gov/rules/final/2012/34-67717.pdf.

Both sets of rules also introduce a new disclosure Form SD, which is explained below.

The effective dates for compliance are explained in this update as well, but generally issuers should be prepared to file their first reports regarding conflict minerals and resource extraction payments on Form SD by May 31, 2014.

CONFLICT MINERALS

The term “conflict mineral” is defined by rule to include cassiterite, columbite-tantalite, gold, wolframite, and their various derivatives, as periodically determined by the Secretary of State. The derivatives are currently limited to tin, tungsten and tantalum.

It is important to note that such minerals do not have to be associated with armed conflict or even with mining in the Covered Countries to constitute “conflict minerals” under the rules. However, issuers whose products contain conflict minerals may be able to describe their products as “DRC conflict free” if such a designation is applicable after following the procedures described herein.

Based on the many uses of conflict minerals, the SEC asserted that the conflict minerals provisions should “apply to many companies and industries and… issuers.”

Issuers Covered by the Conflict Minerals Provisions

The rules apply to issuers that manufacture or contract to manufacture products containing conflict minerals that are “necessary to the functionality or production” of the product.

Thus, companies are only subject to the new rules if:

  • They file reports with the SEC pursuant to Sections 13(a) or 15(d) of the Securities and Exchange Act (the “Exchange Act”);
  • They manufacture or “contract to manufacture” products; and
  • Conflict minerals are “necessary to the functionality or production” of their products.

Issuers who file reports pursuant to the Exchange Act explicitly include registered foreign private issuers and smaller reporting companies, according to the SEC.

To provide a transitional buffer, the rules do exempt any conflict minerals that were “outside the supply chain” prior to January 31, 2013. Minerals are outside the supply chain, by rule, only in the following instances: after gold has been fully refined; after columbite-tantalite, cassiterite or wolframite has been smelted; or after any conflict mineral or its derivatives that have not been smelted or refined are located outside of the Covered Countries. Applying the rules to these “already stockpiled materials” would not further the purposes of the statute, according to the SEC.

Similarly, minerals from scrap or recycled sources are also outside the scope of the rules because it is funds from mining in the Covered Countries that the Dodd-Frank Act has targeted.

  1. The Meaning of “Manufacture” and “Contract to Manufacture”

The final rules do not define the term “manufacture” because it is believed to be generally understood, but the SEC clarified that “we do not consider an issuer that only services, maintains or repairs a product containing conflict minerals to be ‘manufacturing’ a product.”

Likewise, the rules do not define “contract to manufacture” but the SEC stated that whether an issuer is contracting to manufacture a product depends on “the degree of influence exercised by the issuer on the manufacturing… based on individual facts and circumstances.”

An issuer will not be viewed as “contracting to manufacture” a product if its actions are limited to:

  • Specifying or negotiating contractual terms with a manufacturer that do not relate to the manufacturing, such as terms related to price, insurance or intellectual property rights;
  • Affixing its brand or label to a generic product made by a third party; or
  • Servicing, maintaining or repairing a product.

However, the phrase does include contracting for the manufacture of components of a product.

  1. Mining Issuers as Manufacturers

An issuer that mines or contracts to mine conflict minerals will not be considered as “manufacturing” or “contracting to manufacture” them unless the issuer also engages in or contracts for manufacturing related to conflict minerals, the SEC stated.

  1. When Conflict Minerals are “Necessary” to a Product

The SEC declined any bright-line definition for whether a conflict mineral is “necessary to the functionality” of a product, or “necessary to the production” of a product. However, the SEC did provide some guidance, noting that an issuer, in making such a determination, should consider:

  • Whether a conflict mineral is contained in and intentionally added to the product or any component of the product, and is not a naturally occurring byproduct;
  • Whether a conflict mineral is necessary to the product’s function, use or purpose; or
  • Whether the primary purpose of a product is decoration or ornamentation if a conflict mineral is incorporated for ornamental or decorative purposes.

Furthermore, the SEC stated that only when a conflict mineral is “contained in” a product should that conflict mineral be considered “necessary to the functionality or production” of the product, so conflict minerals used solely as catalysts in production would not be subject to disclosure. However, if a conflict mineral is used as a catalyst and is contained in any amount, including trace amounts, in the product, then that shall be subject to disclosure under the rule (as explained below).

By rule, the SEC has also provided that a conflict mineral must be “intentionally added” to a product to be covered by the rules, but declined to exempt products containing conflict minerals that were unilaterally added by an upstream party in the supply chain.

In determining whether conflict minerals are “necessary to the functionality” of a product, the issuer should examine whether the conflict mineral is “necessary to the product’s generally expected function, use or purpose,” the SEC added.

The SEC declined to include any “de minimis” exception, despite being asked to do so, noting that the Dodd-Frank Act focused on the necessity and not the amount of conflict minerals used.

Determining the Origins of Conflict Minerals

Under the new rules, an issuer must make a “reasonable country of origin inquiry” to determine whether it has conflict minerals in its products.

The SEC did not prescribe the exact steps constituting such an inquiry, but noted that the requirements might differ based on the issuer’s size, products, relationships with suppliers and other factors, adding that the inquiry must be performed in good faith and “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.”

Reasonably reliable representations from suppliers in the issuer’s supply chain may fulfill a reasonable inquiry under appropriate circumstances, such as when the representations come from suppliers that have received “conflict-free” designations from a recognized industry group that has required and conducted an independent, private sector audit of the suppliers’ facilities.

If, as a result of diligent inquiry, an issuer determines that its conflict minerals did not originate in the Covered Countries or did come from recycled or scrap sources, then the issuer will not have to file a Conflict Minerals Report with the SEC. This is similarly true if an issuer determines that it has no reason to believe that its necessary conflict minerals might have originated in the Covered Countries or that they might not be from recycled or scrap sources.

On the other hand, if an issuer’s diligent inquiry determines that its conflict minerals did originate or might have originated in the Covered Countries, and did not or might not have come from scrap or recycled sources, then such an issuer must submit a Conflicts Minerals Report.

Disclosure and Reporting Requirements

If an issuer concludes that it does not have to file a Conflict Minerals report for reasons stated in the preceding section of this update, then the issuer’s due diligence process and the results it yielded must still be disclosed in the new Form SD (which stands for “specialized disclosure”) so that interested parties can evaluate the degree of care the issuer used in its inquiry.

If, on the other hand, an issuer determines that it does have to file a Conflict Minerals report with the SEC for reasons stated in the preceding section, then it must include in that report detailed content that is specified by rule.

  1. Content of a Conflict Minerals Report

A Conflicts Minerals Report must include a description of the measures the issuer took to exercise due diligence on the sourcing and chain of custody of its conflict minerals. An issuer must also certify that it obtained an independent private sector audit of its Conflict Minerals Report and include that certification in the report, but the issuer’s audit certification need not be signed by an officer.

Unless an issuer’s products are all “DRC conflict free,” the Conflict Minerals Report must be filed and it must include a description of the facilities used to process any conflict minerals, the country of origin of those minerals, and any efforts to determine the mine or location of origin. Products are considered “DRC conflict free” only if it is certain they “do not contain minerals that directly or indirectly finance or benefit armed groups in the [Covered Countries].”

For a temporary period consisting of the first two years of reporting (or four years for “smaller reporting companies”), an issuer may describe its products as “DRC conflict undeterminable” if they are unable to determine that their conflict minerals did not originate in the Covered Countries.

In performing their due diligence, issuers may find it helpful to obtain a map of mineral-rich zones, trade routes, and areas under control of armed groups in the Covered Countries, which is available from the State Department.

  1. Due Diligence Standard for the Conflict Minerals Report

The final rules require that an issuer’s due diligence – in determining the source and chain of custody for its conflict minerals – must follow a nationally or internationally recognized due diligence framework. That framework must also be consistent with the Government Accounting Office (GAO) government auditing standards (known as “GAGAS”).

According to the SEC, the only such framework currently in existence is that approved by the Organization for Economic Cooperation and Development (OECD).

  1. Independent Private Sector Audit Requirement

Any auditor of a Conflict Minerals Report will need to conduct the audit using GAGAS standards, and must comply with any independence standards set forth by the GAO. The SEC noted also that a qualified independent public accounting firm could conduct the audit subject to the pre-approval requirements of Rule 2-01(c)(7) of Regulation S-X.

The objective of the audit is to enable an opinion or conclusion as to whether the design of the issuer’s due diligence framework is in conformity with the criteria set forth in the applicable nationally or internationally recognized framework, and whether the issuer’s description of its due diligence measures is accurate and consistent with its actual measures.

  1. Disclosure Treatment of Scrap and Recycled Minerals

The SEC stated that it would allow an issuer, if it wishes, to describe its products containing conflict minerals as “DRC conflict free” if they come from scrap or recycled sources, regardless of their original origins.

Conflict minerals will be considered as scrap or recycled if they are from recycled metals that are reclaimed end-user or post-consumer products, or scrap processed metals created during product manufacturing. This definition includes excess, obsolete, defective and scrap- metal materials that contain refined or processed metals.

However, an issuer must still exercise a further due diligence tracking inquiry if it has reason to believe that its conflict minerals thought to be from recycled or scrap sources “may not” be from such sources.

Method, Timing and Consequences of Disclosure Reports

Issuers will have to file their conflict minerals information with the SEC, together with any applicable Conflict Minerals Report and independent private sector audit report, as part of Form SD, a new Exchange Act form. Also, the Conflict Minerals Report must be provided as an exhibit to Form SD rather than being presented in the body of the report.

Because this information will be formally filed with the SEC, rather than just “furnished,” the information providers will be subject to private sector remedies for false and misleading statements under Section 18 of the Exchange Act.

The SEC also clarified that an issuer must provide its conflict minerals disclosures for the calendar year in which the manufacture of a product that contains any conflict minerals is completed, irrespective of whether the issuer manufactures the relevant product or contracts to have it manufactured.

The specialized disclosures will be due by May 31 of each year, reporting on the preceding calendar year, so all issuers will face the same deadlines. The first reporting period for all issuers will be from January 1, 2013 to December 31, 2013, and the first Form SD will be due on or before May 31, 2014.

The final rules specify that an issuer must also make its conflict minerals disclosures available on the issuer’s Website for at least one year.

PAYMENTS BY RESOURCE EXTRACTION ISSUERS

The resource extraction payment rules will apply to “all U.S. companies and all foreign companies that are engaged in the commercial development of oil, natural gas, or minerals, and that are required to file annual reports with the SEC,” regardless of the size of the company.

While the SEC was urged to include exemptions for certain issuers, such as smaller reporting companies and foreign issuers with similar reporting requirements under home country laws, it declined to do so.

By rule, a resource extraction issuer must disclose payments made by the issuer, any subsidiary of the issuer, or any entity under the control of an issuer, to any foreign government or to the U.S. federal government for the purpose of commercial development of oil, natural gas or minerals (those terms are defined and explained below).

Definition of “Resource Extraction Issuer”

The SEC made it clear that the resource extraction payment rules apply to all issuers that “are engaged in the commercial development of oil, natural gas, or minerals” without exceptions. Thus, the rules apply to government-owned companies and companies that might have contractual confidentiality obligations regarding payments to governments.

Definition of “Commercial Development of Oil, Natural Gas, or Minerals”

By rule, “commercial development of oil, natural gas, or minerals” includes the activities of “exploration, extraction, processing and export, as well as the acquisition of a license for any such activity.” But it does not include ancillary activities such as the manufacture of a product that is merely used in the commercial development of oil, gas and minerals.

“Processing” shall include “field processing activities,” such as extraction of liquid hydrocarbons, and it also includes the crushing and processing of raw ore prior to smelting, but not actual refining or smelting.

The term “export” includes all relevant exports from a host country, but not removal of a resource merely to the refiner, smelter or first marketable location.

Definition of “Payment”

The SEC also adopted rules and issued guidance regarding the statutory definition of “payment.” The Dodd-Frank Act provides that a payment subject to disclosure is one that:

  • Is made to further the commercial development of oil, natural gas or minerals;
  • Is not de minimis; and
  • Includes taxes, royalties, fees, production entitlements, bonuses and other material benefits that the SEC determines are part of the commonly recognized revenue stream for the commercial development of oil, natural gas and minerals.

The SEC explicitly added “dividends” and “payments for infrastructure improvements” to the list of payments that must be disclosed. But it clarified that “dividends” do not include dividends paid to common or ordinary shareholders. Similarly, “infrastructure payments” do not include charitable gifts to the community, such as payments to build a school or hospital, though they would include payments to build roads and bridges. Among the other clarifying instructions that the SEC issued was one stating that “fees” include “rental fees, entry fees, and concession fees.” Similarly, “bonuses” include “signature, discovery and production bonuses.”

Another pronouncement by the SEC clarified the meaning of “taxes” in the statute, explaining that taxes include “payments made for taxes levied on profits, income and production, but not payments for taxes levied on consumer consumption of oil, natural gas or minerals.”

Noting that issuers may have difficulty assessing the materiality of payments for disclosure purposes, the SEC adopted a bright-line “de minimis” threshold of $100,000 for disclosure. Consequently, by rule, “any single payment or series of related payments” that amounts to $100,000 will need to be disclosed by an issuer.

In order to deter mischaracterization of payments in contracts, the SEC also promulgated an anti-evasion provision that requires disclosure of any activity or payment that, although not characterized as a “payment” subject to disclosure, is in fact part of a plan or scheme to evade the required disclosure of all relevant payments.

The SEC also noted that the Dodd-Frank Act requires payment disclosures for each “project” related to commercial development, but declined to provide any further definition to that term on the basis that it is commonly understood in the industry. But the SEC did note that resource extraction issuers should not be required to disaggregate payments that are made for obligations levied on the issuer and not related to a particular project.

The SEC did not elaborate on the definition of a “subsidiary of the issuer, or an entity under the control of an issuer,” simply noting that “control” and “subsidiary” are already defined terms under Rule 12b-2 of the Exchange Act. Recognizing that these rules may raise some thorny questions for issuers, the SEC limited the kinds of payments that resource extraction issuers must disclose, excluding any payments not falling explicitly within the regulatory list of payments subject to disclosure.

Definition of “Foreign Government”

By rule, a “foreign government” shall include “a foreign national government, as well as a foreign subnational government, such as the government of a state, province, county, district, municipality, or territory under a foreign national government.” However, the “U.S. federal government” does not include state governments, municipalities or other non-federal entities.

Required Disclosures and Forms

The required disclosures regarding resource extraction payments must be made on the SEC’s new Form SD, which is not subject to officer certification. Issuers will be required to present their resource extraction payment information in XBRL interactive form in just one exhibit to Form SD.

An issuer’s XBRL tags should identify:

  • Total payments by category;
  • Currency used to make the payments;
  • Financial periods in which the payments were made;
  • Business segments of the issuer that made the payments;
  • The government(s) that received the payments; and
  • The project of the issuer to which the payments relate.

Issuers can take some comfort in the fact that the final rules do not require payment information to be audited or provided on an accrual basis.

Compliance Dates

Under the new rules, all resource extraction issuers will be required to file Form SD with the SEC for their fiscal years ending after September 30, 2013.

For fiscal years beginning on or after September 30, 2013, an issuer will be required to file a report disclosing payments for the full fiscal year. An issuer with a partial fiscal year ending after that date must still provide an initial partial year report. So, for example, an issuer with a December 31, 2013 fiscal year end would have to file an initial report on Form SD by May 31, 2014, disclosing payments made from October 1, 2013 through December 31, 2013.