On 22 August 2012, the US Securities and Exchange Commission (SEC) issued final rules to implement the Conflict Minerals provision of the Dodd-Frank Act. These require companies with SEC reporting obligations (issuers) to account for the use of conflict minerals—tungsten, tantalum, tin and gold—in products they manufacture or have manufactured. The law intends to curtail funding of human rights abusers in the Democratic Republic of the Congo (DRC) and adjoining countries (collectively, the Covered Countries) by imposing transparency and accountability obligations on issuers that use conflict minerals sourced from the region.
These rules raise new challenges and increase costs for affected issuers. Global suppliers of these issuers also may risk losing business if they cannot provide necessary information about the goods they bring to the supply chain. The first annual reporting deadline is 31 May 2014.
Companies Subject to the Rules
Issuers must determine if conflict minerals exist in their supply chains and, if so, whether or not these minerals originated from the Covered Countries. The rules apply to issuers that manufacture or “contract to manufacture” products containing conflict minerals. The test is whether or not conflict minerals “are necessary to the functionality or production of a product.”
While the SEC did not define the terms “contract to manufacture” or “necessary to the functionality or production of a product,” it said it would look at
- Whether or not conflict minerals were intentionally included in any of the company’s products, particularly if the mineral’s primary function is for ornamentation or decoration, particularly in relation to jewellery
- The function the conflict minerals serve in the products
- The products’ intended use or purpose, e.g., if a conflict mineral is required for any of the myriad functions of a smartphone, it will be considered “necessary to the functionality” of the entire phone (this expansive view of functionality may be particularly troublesome for electronic parts manufacturers of some popular products, such as cars, computers, smartphones, gaming systems and medical equipment)
Similarly, whether or not an issuer contracts to manufacture products containing conflict minerals will depend on how much control or influence the issuer has over the manufacturing process. The SEC granted an express exemption for retailers and resellers that do not exercise any control or influence over the manufacturing process. A similar exemption was granted for companies that mine or contract to mine conflict minerals.
A possible approach for companies that manufacture products containing conflict minerals may be to assess whether a substitute mineral is possible to use instead, which would eliminate the need to undertake the compliance requirements associated with this rule change.
Supply Chain Due Diligence
An issuer that uses conflict minerals in any of its products must conduct a “reasonable country of origin inquiry” to determine if the conflict minerals originated in the Covered Countries or were from scrap or recycled sources. The results of this inquiry must be reported on the SEC’s new Form SD and on the company’s website.
Covered companies should ensure their diligence efforts are in keeping with established standards recognised in their industry or analogous regimes (e.g., the supply chain security measures mandated under the US Customs-Trade Partnership Against Terrorism), and also be sure to document all efforts.
It will be vital to create a written audit trail. It also may be necessary to hire specialists, depending on the complexity of the supply chain and whether or not a Conflict Mineral Report is needed (see below). Some companies have already begun requiring their suppliers to certify their products as “conflict free” and to provide relevant supporting information. Consequently, global supplying companies will need to undertake appropriate steps to evaluate and address the obligations imposed on them indirectly under the new rules.
Companies may also use the process as an opportunity to look for efficiencies in their supply chain, e.g., by reducing their overall number of suppliers or increasing their leverage with existing suppliers to achieve more favourable terms. Providing appropriate supplier incentives may be key.
Affected companies should take stock of their existing compliance systems and establish effective protocols for tracking and reporting this information (e.g., ensuring technology/website is updated, assigning appropriate compliance staff, incorporating conflict mineral requirements into audit checklists, following up on irregularities, etc.).
Conflict Minerals Report
If the company knows, or has reason to believe, that any of their conflict minerals originated in the Covered Countries and are not from scrap or recycled sources, the issuer must file and post to its website an independent, private sector-audited Conflict Minerals Report. This must detail the steps the company has taken to ensure the conflict minerals used in its products did not benefit militias committing atrocities in the DRC and surrounding countries, and identify any products that are not DRC conflict-free.
While these rules do not require any product labelling, manufacturers are able to certify in their Conflict Minerals Report if their products use DRC conflict-free minerals, if applicable. If, after its reasonable country of origin inquiry, a company cannot determine the origin of the conflict minerals used in its products, it will be allowed to report its products as Conflict Mineral Undeterminable for the first two years of the reporting requirement, or four years in the case of small issuers. This effectively gives issuers a two-year (or four-year) phase-in period during which to construct supply-chain tracking systems.
The Cost of Compliance
The new rules effectively require a full account of a manufacturer’s entire supply chain: issuers will need to trace the conflict minerals used in their products back to the smelters where they originated. As more conflict-free smelters in the Covered Countries are identified, the costs of ongoing compliance may be reduced considerably. The SEC estimates approximately 6,000 issuers will be affected and the cumulative compliance costs will be between US$2 and US$3 billion dollars initially, with the annual continuing cost of compliance ranging between US$206 and US$609 million dollars.
Challenges to the Rules
In light of the substantial compliance burdens, a few business groups have challenged the legality of the rules. In addition, the two dissenting commissioners commented that the SEC did not conduct a thorough enough cost-benefit analysis, and suggested that the rules could amount to a de facto embargo of conflict minerals from the region, which would worsen conditions in the DRC by depriving people who depend on mining for work.
The National Association of Manufacturers, the Chamber of Commerce and the Business Roundtable have launched a legal challenge to the rules in the DC Court of Appeals. The case is, however, expected to take 12 to 18 months for a ruling. Without congressional action, the rules are expected to remain in place for the foreseeable future.
Penalties for Non-Compliance
Because the final rules require companies to file the new Form SD with the SEC, rather than merely furnishing it, failure to comply with the new rules may subject reporting issuers to liability under Section18 of the Exchange Act, loss of their Form S-3 eligibility, exposure to shareholder or class action litigation and negative reactions from humanitarian groups and customers. There are no SEC penalties, however, for issuers that use conflict minerals that are not DRC conflict-free.
Be Prepared, Start Early and Engage Specialists
Covered companies should begin the process now of determining whether or not they are subject to the conflict minerals rules, and consult with compliance specialists as needed.