Two months after the Securities and Exchange Commission (SEC) issued its final conflict minerals rule, the initial shock may be wearing off, as companies increasingly recognize that the rule’s lack of a de minimis exemption and its January 1, 2013 start date for tracking reportable events mean that they need to take action now to be ready to file the required reports by May 31, 2014. Even with a newly filed legal challenge, the odds are against a stay of the rule, and compliance efforts are moving forward.
Pepper has provided a full explanation of the conflict minerals rule in other articles and a recent webinar available on our Web site, but in summary the rule obligates companies that are required to file periodic reports with the SEC and that manufacture or “contract to manufacture” products containing “conflict minerals” to investigate their supply chains. This inquiry is meant to determine whether specified materials originated in the Democratic Republic of the Congo (DRC) or eight adjacent, war-torn countries (the “Covered Countries”). The metals associated with conflict minerals are tin, tungsten, tantalum, and gold, and they are found in a vast array of manufactured products. Even trace amounts of these metals, if they are intentionally added to the product, are enough to bring a company within the rule’s scope. Various diligence, auditing, disclosure, and reporting obligations flow from what the company learns about the chain of custody of the conflict minerals it is using. Many companies that do not file SEC reports will also be swept into this regime, because their customers will demand assistance in fulfilling their chain of custody inquiry obligations.
In finalizing its rule, the SEC declined to provide definitions or specific limits for many key terms, saying those subject to the rule would have to make case-by-case factual determinations, based on their individual circumstances. It is already becoming clear that a number of these “gray areas” are particularly likely to present difficult judgment calls for companies as they implement their conflict minerals compliance programs. Some of the more important examples of terms that will pose challenges are as follows:
- “Product” – this basic term is undefined, and is already creating questions about how to interpret it. Looking at just two examples gives an indication of the issue. For instance, if a company is selling canned soup, is the product the soup, the can, or both? Similarly, if a company is selling pharmaceuticals that must be kept in a light-blocking or other special package to protect the drug’s integrity and efficacy, is the product the drug, the packaging, or both?
- “Manufacture” – the rule does not define manufacturing, other than by reference to the dictionary definition of “making goods or wares by hand or machinery, esp. on a large scale,” and by noting that the assembly of parts or components will be covered as well. However, the rule’s adopting release clarified that mining is not viewed as manufacturing.
- “Contract to manufacture” – in a concession to retailers, the SEC exempted outsourced products if a company’s “degree of influence” over the manufacture of the product was minimal. For example, if a retailer’s involvement in the manufacture of a product is limited to (i) the inclusion of training, insurance, or similar non-manufacturing aspects in the purchase contract, (ii) specifying brands or labels to be applied to the product, or (iii) servicing or repairing a product, it will not be considered manufacturing. But once beyond these safe harbors, it is unclear at what point a company’s degree of influence is significant enough to fall within the rule’s coverage.
- “Necessary to functionality,” “necessary to production” – both of these terms require judgment calls, and the rule provides some guidance, but no clear limits on what “necessary” means in this context. The guidance indicates that conflict minerals must be intentionally added to or present in the product (not an accidental by-product), necessary for the product’s intended purpose or to produce it, and if added to the product for purposes of decoration, the primary purpose of the product must be decorative or ornamental.
- “Reasonable country of origin inquiry” – if a company learns that its product contains a conflict mineral, it must conduct a “reasonable country of origin” inquiry. As with other critical terms, the SEC does not prescribe a method for this review, saying only that the inquiry must be “reasonably designed to determine whether any of its conflict minerals originated in the Covered Countries or are from recycled or scrap sources, and must [be] perform[ed] … in good faith.”
- “Reasonably reliable representations,” “reason to believe,” “may have originated,” “may not have come from” – these terms appear in the provisions on the supply chain inquiry and diligence process, referencing the “reasonably reliable representations” of upstream suppliers, “reason to believe” these representations are true, and “no reason to believe” conflict minerals “may have originated” in the Covered Countries or “may not have come from recycled or scrap sources.” All of these qualifiers should be viewed as compliance flags, requiring special attention during the supply chain review.
Many interested parties will be watching companies’ reports and disclosures under this rule: not just the SEC, but shareholders and investors, commercial customers and consumers, competitors, and watchdog groups. Some states have already prohibited procurement from companies that fail to comply with the conflict minerals rule, and others are considering this type of legislation. Rating systems are developing to rank companies by their diligence programs and by whether they are able to say their products are “DRC conflict-free.”
It is inevitable that a rule meant to regulate activities as complex as those involving conflict minerals cannot be written rigidly and must offer flexibility. At the same time, that flexibility gives rise to many “gray areas” that will require careful review and judgment in complying with the rule. Companies will need a well-planned and well-executed implementation strategy to ensure that their interests are properly safeguarded.