Final Conflict Minerals Rule Requires Issuers to Make First Annual Disclosures by May 2014 for Calendar Year 2013; Supply Chain Diligence Will Affect Thousands of Firms Worldwide That Manufacture, Contract to Manufacture, or Supply Finished Goods, Components, or Raw Materials Containing Tin, Tantalum, Tungsten, or Gold
On August 22, 2012, by a 3-2 vote1, the US Securities and Exchange Commission (the Commission or the SEC) adopted Rule 13p-1 implementing the conflict minerals disclosure provisions in Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act).2 Section 1502 is intended to choke off the minerals trade as a source of funding for armed violence in countries in central Africa. Section 1502 sought to accomplish this goal by amending the Securities Exchange Act of 1934 (Exchange Act)3 to require SEC registrants to make annual disclosures if they manufacture products with certain minerals called “conflict minerals”. The Act defines “Conflict Minerals” to include the following ores and their associated derivative metals, regardless of their place of origin: gold, wolframite (from which tungsten is extracted), cassiterite (from which tin is extracted), and columbite-tantalite or coltan (from which tantalum is extracted).4 In particular, as confirmed in the Final Rule, Section 1502 requires that SEC registrants take the following steps in these annual disclosures:
- indicate whether Conflict Minerals are “necessary to the functionality or production of products they manufacture” or “contract to manufacture”, and, if so,
- indicate whether any such necessary Conflict Minerals originated in the Democratic Republic of the Congo (DRC) or an adjoining country (each defined in the Final Rule as a Covered Country5), and, if so,
- provide an audited report on its due diligence to determine whether these Conflict Minerals funded armed groups in a Covered Country.
Section 1502 required the Commission to issue rules implementing these requirements. The Commission adopted the Final Rule after receiving over 400 comment letters and holding 150 meetings with interested parties as well as a public roundtable in 2011. The Final Rule was adopted more than a year after the April 2011 statutory deadline. As one Commissioner noted, “[r]arely do issues come our way that are this outside the box.” The Final Rule clarifies several aspects of this statutory framework, but also leaves several important questions unresolved, as discussed below.
Introductory Note about Worldwide Reach and Multi-Sector Impact of the Final Rule
The Final Rule identifies (at 77 Fed. Reg. 56283-84) some of the common uses of Conflict Minerals in manufacturing processes:
- Tin: alloys, tin plating, and solders for joining pipes and electronic circuits
- Tantalum: electronic components, including mobile telephones, computers, videogame consoles, and digital cameras, and as an alloy for making carbide tools and jet engine components
- Gold: jewelry, electronics, communications, and aerospace equipment
- Tungsten: metal wires, electrodes, and contacts in lighting, electronic, electrical, heating, and welding applications
Accordingly, the Final Rule notes (at 77 Fed. Reg. 56284): Based on the many uses of these minerals, we expect the Conflict Minerals Statutory Provision to apply to many companies and industries and, thereby, the final rule to apply to many issuers.
Indeed, the Final Rule will directly and indirectly affect private and public companies around the world across sectors whose products include Conflict Minerals. Some comments submitted in the rulemaking process estimate the compliance costs of the Final Rule in excess of US$15 billion. The Final Rule estimates the initial compliance cost for issuers and suppliers to be as high as approximately US$4 billion.
Under the Final Rule, issuers must make any required conflict minerals disclosures on a calendar year basis, with the first disclosure required by May 31, 2014 for the calendar year 2013.6 To be prepared to comply with the Final Rule, many issuers already are instituting supply chain due diligence processes. These processes are filtering throughout the issuers’ supply chains, in turn affecting thousands of public and private suppliers around the world. Indeed, due to the breadth of companies that manufacture products using Conflict Minerals, contract for the manufacture of such products, or supply such products, the Final Rule will affect companies across industrial sectors, such as the following:
- Electronics (including circuits, wiring, and equipment)
- Industrial equipment and machinery
- Medical equipment
- Heating, welding, and plumbing
- Retail and wholesale firms, when they exert actual influence over the manufacturing of products that use Conflict Minerals (e.g., through certain types of OEM arrangements)
Overview of the Final Rule
The principal requirements of the Final Rule are outlined below. As discussed below, several key terms in the Final Rule were left undefined, which exposes companies to continued uncertainty on how the Final Rule will be enforced, and creates a need for guidance on how to comply.
Step One. The Final Rule requires issuers to determine whether Conflict Minerals are necessary to the functionality or production of a product they manufacture or contract to manufacture. As confirmed by the Final Rule, Section 1502 applies to all issuers7 who “manufacture” or “contract to manufacture” a product for which Conflict Minerals are “necessary to the functionality or production” (Covered Issuers). The Final Rule specifically declines to provide exemptions for foreign issuers or small or medium enterprises.
Limited guidance on the meaning of “manufacture” or “contracting to manufacture”. The Final Rule does not define these terms, but provides some guidance as to activities that fall outside their scope.
- Manufacturing – certain activities distinguished. The Final Rule (at p. 60) clarifies that the “mining” of Conflict Minerals does not constitute manufacturing. In addition, the mere servicing, maintenance, or repair of a product does not constitute manufacturing.
- Contracting to manufacture. Under the Final Rule, a company is considered to be “contracting to manufacture” a product (including a component) if it has “some actual influence” over the manufacturing of the product. In particular, whether an issuer is considered to be contracting to manufacture will depend on the “degree of influence it exercises over the materials, parts, ingredients, or components” to be included in the product that contains Conflict Minerals. The Final Rule clarifies that “actual influence” is not created merely by (a) using a brand, logo, or label on a generic product manufactured by a third party, (b) servicing, maintaining, or repairing a product manufactured by a third party, or (c) contracting with the manufacturer using terms that do not directly relate to the manufacturing itself. The contours of the “contracting to manufacture” standard, are thus narrower than in the Proposed Rule, under which merely contracting for the manufacture of a product would have been sufficient, “regardless of whether those issuers have any influence over the manufacturing specifications”. 75 Fed.Reg. 80592. The Final Rule still leaves important unanswered questions, though. In particular, the Final Rule does not make clear the level of influence an issuer must have over product specifications to rise to the level of “contracting to manufacture”. For example, the Final Rule states that specifying that the product include a Conflict Mineral would be sufficient; yet specifying, for example, that a cellphone must be manufactured to work on a certain network is not necessarily sufficient. 77 Fed. Reg. 56291-92.
- Necessary to functionality or production. The Final Rule also does not define the phrase “necessary to functionality or production” of a product. Instead, it observes that the determination will need be made based upon the “particular facts and circumstances”, and outlines factors that the Commission “believe[s] issuers should consider”. There is no exception for “de minimis” amounts of the Conflict Mineral, if the “necessary” test is met. The Final Rule does clarify, though, that Conflict Minerals will not be viewed as necessary to the functionality or production of a product that does not physically “contain” a Conflict Mineral.8
Necessary to Functionality. To determine whether a Conflict Mineral is “necessary to the functionality” of a product, the issuer should consider whether the Conflict Mineral:
- (a) is, in addition to being “contained” in the product, is intentionally added to the product or any component and is not a naturally-occurring by-product;
- (b) is necessary to the product’s “generally expected function, use, or purpose”; or
- (c) is incorporated for purposes of “ornamentation, decoration or embellishment” and the primary purpose of the product is ornamentation or decoration.
According to the Final Rule, “[b]ased on the applicable facts and circumstances, any of these factors, either individually or in the aggregate, may be determinative as to whether conflict minerals are ‘necessary to the functionality’ of a given product.” 77 Fed. Reg. 56295.
Necessary to Production. To determine whether a Conflict Mineral is “necessary to the production” of a product, in addition to evaluating whether it is “contained” in the product, the Final Rule states (at 77 Fed. Reg. 56279) that the issuer should consider the facts and circumstances, including whether the Conflict Mineral:
- (a) is “intentionally added” in the production process for the product or a component part (other than in a tool, machine, or equipment used to produce the product); and
- (b) is necessary to produce the product.
Step Two. A “reasonable country-of-origin inquiry” must be undertaken for Conflict Minerals that satisfy Step One. The Final Rule requires a Covered Issuer to conduct an inquiry into the country of origin of the Conflict Minerals. The Final Rule does not impose specific requirements as to how this inquiry must be conducted. Rather, it states that the inquiry must be performed in “good faith” and be “reasonably designed” to determine whether any of its Conflict Minerals originated in a Covered Country or are from scrap or recycled sources. The Final Rule recognizes that what is “reasonable” will depend on the issuer’s size, products, relationships with suppliers, and other factors. The inquiry can include obtaining representations from suppliers, as long as the issuer has “a reason to believe these representations are true”. A “conflict free” designation, such as for a smelter, by a recognized industry group or an independent private sector audit, can provide reason for such a belief. See Final Rule, 77 Fed. Reg. 56312. A 100% response rate from suppliers also is not necessarily required. Id.
- Results of the country-of-origin inquiry must be disclosed on a separate SEC Form SD. Based upon the reasonable country-of-origin inquiry, Covered Issuers must disclose one of two alternative determinations (described below), and briefly describe the inquiry and its results. This information must be disclosed on its Internet web site and on a separate Form SD that must be publicly filed with the Commission by May 31st of each year for the preceding calendar year. If the second determination is made, then an additional Conflict Minerals Report must be included with Form SD and other steps must be taken as described below.
Alternative1: All Conflict Minerals either originate outside a Covered Country, or from scrap or recycled source. This determination can be made either on the basis of knowledge, or on the basis of not having a reason to believe the determination is false, as follows:
- Conflict Minerals either did not originate in a Covered Country, or are from scrap or recycled sources.
- The issuer has no reason to believe that any of the Conflict Minerals minerals may have originated in a Covered Country, or otherwise may not be from scrap or recycled sources.
Alternative 2: Any of the Conflict Minerals originate in a Covered Country and not from a scrap or recycled source. In this case, the issuer would disclose the following determination:
- The issuer knows or has reason to believe that any of Conflict Minerals may have originated in a Covered Country, and that any such Conflict Minerals may not be from scrap or recycled sources.
Step Three. Supply chain of custody due diligence and a Conflict Minerals Report are required if the outcome of Step Two is “Alternative 2” above. If the country-of-origin determination falls under “Alternative 2”, then the issuer also must undertake “due diligence” on the source and chain of custody of the Conflict Minerals, file a “Conflict Minerals Report” as an exhibit to Form SD and disclose it on its Internet website. The following requirements apply to Step Three:
- Standards for supply chain “chain of custody” due diligence. Due diligence on the chain of custody of the Conflict Minerals must adhere to nationally or internationally-recognized standards for the specific type of Conflict Mineral. The only such standards identified in the Final Rule are in the Organisation for Economic Co-Operation and Development (“OECD”) Due Diligence Guidance for Responsible Supply Chains of Minerals from Conflicted and High Risk Areas (2011). Where the Conflict Minerals may originate from a recycled or scrap source, then a due diligence process must be used, and follow nationally or internationally-recognized standards if they exist for the Conflict Mineral at issue (for gold, the Final Rule points to the 2012 “Supplement on Gold” to the OECD Guidance).
- Classification of Conflict Minerals in the Conflict Minerals Report. The Conflict Minerals Report must classify the Conflict Minerals as either “conflict free” (not financing or benefiting armed groups) or “not conflict free”, or, during an interim phase-in period, as “DRC conflict undeterminable”. The latter classification is only permitted for the first two full calendar years of the Final Rule’s effectiveness (or the first four calendar years for smaller reporting companies, as defined in Exchange Act Rule 12b-2).
- Auditing and certification requirements. The chain of custody due diligence process must be subject to an independent private sector audit, unless all Conflict Minerals are found to be “DRC conflict undeterminable” during the temporary phase-in period (in which case no such audit is required). The issuer must certify that the audit has been completed, identify the auditor, and include the audit report in the Conflict Minerals Report.9
- Additional information in the Conflict Minerals Report on any Conflict Minerals that are “not conflict free”. If the Conflict Minerals are classified as “not conflict free”, then the Conflict Minerals Report also must identify (i) the products, (ii) the processing facility where they are manufactured, (iii) the country in which the Conflict Minerals originated, (iv) the efforts taken to determine the origin, and (v) steps taken and planned to mitigate risk of funding or benefiting armed groups (for “DRC conflict undeterminable” situations). The Final Rule recognizes that the second and third items in this list may not be known in “DRC conflict undeterminable” situations.
Liability risks arising from Conflict Minerals disclosures. In a change of approach from the Proposed Rule, the Final Rule requires that Form SD be “filed” under the Exchange Act. (Under the Proposed Rule, the Commission was considering whether to allow the disclosures to be simply “furnished”, a status that has fewer attendant liability risks.) Because Form SD will be filed, the disclosure will be subject to Section 18 liability under the Exchange Act for any damages to investors who rely upon materially misleading statements on Form SD or the Conflict Minerals Report. This is an additional theory of liability that could be asserted in a private shareholder suit, beyond other anti-fraud theories that could be asserted by the Commission or private shareholders. No certification by the issuer’s executives is required, and the issuer is not required to incorporate the disclosures by reference into registration statements.
Compliance Framework for Issuers and Suppliers of Goods in Their Supply Chains
As the effects of the Final Rule reverberate throughout supply chains worldwide, companies that manufacture, contract to manufacture, or supply products that may use Conflict Minerals (or supply the Conflict Minerals themselves) need to take steps immediately to prepare for this new regime. All companies in this position should take a series of steps to prepare for responding to due diligence requests from customers, making due diligence requests to suppliers, and in the case of SEC registrants, preparing a framework for obtaining any additional information needed for disclosures required by the Final Rule. These steps can be divided into two parts: an inventory, and a compliance program.
Part One: Conduct an inventory of products to determine which may contain Conflict Minerals. The first step is to determine whether Conflict Minerals are in fact found in any product in their product portfolio, in its current form or as it is expected to change through the end of 2013. Once this inventory is complete, for those products that do have Conflict Minerals, companies should evaluate whether the company manufactures or has actual influence over the manufacture of the product, and if so, whether Conflict Minerals are “necessary to the functionality or production” of the product. As suggested above, these may be difficult determinations in some cases, and it may be useful to seek legal guidance. This inventory process also will need to be repeated annually.
Part Two: Develop a Conflict Minerals Compliance Program. For any product that meets or may meet the “manufacture” and “necessary” criteria discussed in Part Two, a series of follow-on compliance issues will be raised. The Final Rule is complex, and requires a series of due diligence determinations and public securities filings to be made by SEC registrants. These due diligence questions will flow up the supply chains to other companies as well (whether public or private). It is therefore advisable that, as a best practice, any company with products identified in Part One (inventory) develop a Conflict Minerals Compliance Program. Such a program will help to ensure accurate information is gathered for filing on Form SD and any Conflict Minerals Report (if the company is an SEC registrant), to ensure reliable conflict minerals compliance assurances can be provided to prospective customers, and to develop a structured and effective process for identifying relevant suppliers of Conflict Minerals or components containing Conflict Minerals and obtaining supporting information and/or assurances from these suppliers. A best practice would be to develop a “supply chain map” for the pertinent products. The precise components of this program will depend, though, on a variety of factors, including the structure of the industry, the type of Conflict Mineral, the other parties in the supply chain (and their status as an SEC registrant as well as the nature of their Conflict Minerals Compliance Programs), and the status of the company (as an SEC registrant).