The SEC has issued its final rule to implement the "conflict minerals" disclosure requirements in Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"). The adopting release, Release No. 34-67716 (August 22, 2012), can be accessed here.
The SEC originally issued proposed rules to implement Section 1502 on December 10, 2010 with a comment period that was to have ended on January 31, 2011. A copy of the proposing release, Release, No. 34-63547, can be accessed here. Final rules were required to be published by April of 2011. The SEC formally extended the public comment period by 30 days and then spent nearly 17 months receiving thousands of comment letters -- including over 13,000 form letters from supporters of the rules -– meeting with many "interested persons" and hosting an SEC Roundtable. The vote to adopt the final rule was 3-2, with Commissioners Troy Paredes and Daniel Gallagher dissenting.
Section 1502 of Dodd-Frank amended the Securities Exchange Act of 1934 (the "Exchange Act") by adding Section 13(p), which requires the SEC to publish disclosure rules concerning the use of certain minerals that originate in the Democratic Republic of the Congo or its adjoining countries (the "Covered Countries" to use the nomenclature of the final rules). In adopting Section 1502, the apparent intent of Congress was to help to curb the violence in the eastern Democratic Republic of the Congo ("DRC") by requiring public disclosure of all conflict mineral sourcing in the DRC and surrounding countries -- another example of Congress using the public company reporting requirements to influence social policy.
To implement Section 13(p), the SEC has now adopted Rule 13p-1, which is just one sentence:
Every registrant that files reports with the Commission under Sections 13(a) or 15(d) of the Exchange Act, having conflict minerals that are necessary to the functionality or production of a product manufactured or contracted by that registrant to be manufactured, shall file a report on Form SD within the period specified in that Form disclosing the information required by the applicable items of Form SD as specified in that Form.
Essentially all of the new requirements are set forth in the Form, and there will be no amendments to Regulation S-K as originally proposed when the disclosures were to have been included in a registrant’s annual report on Form 10-K. Also unlike the proposal, the required disclosure will be “filed” and not merely “furnished”.
As applicable definitions and the nature and scope of the required disclosures are set forth in the new Form SD, references in this alert to the rule refer to Rule 13p-1 and the item requirements of and instructions to new Form SD. Form SD reflects the three-step process originally proposed by the SEC, but contains modifications to the mechanics of the steps. Reflecting the complexity of the rule, the SEC included in the release a flowchart of the rule’s application. A copy of that flowchart has been reproduced at the end of this alert for ease of reference.
The New Requirements
Definition of “Conflict Minerals”
Section 1502 defines “conflict minerals” as columbite-tantalite (coltan), cassiterite, gold and wolframite, or any of their derivatives,1/ and the SEC used this definition in its proposed rules. In the final rule, the proposed definition was modified only to limit reference to “derivatives” to the “3-T derivatives” of tantalum, tin and tungsten, in an effort to reduce ambiguity, subject to possible further action by the Secretary of State.2/
Step One – Issuers Covered by the Rule
Reporting Companies. The rule extends to all reporting companies, including foreign private issuers and smaller reporting companies. The SEC declined to include private issuers as suggested by some commentators (including two of the co-sponsors of the legislation).
“Manufacture” and “Contract to Manufacture” Products. The rule applies to reporting persons who directly manufacture products and those who contract to manufacture products. The rule does not define “manufacture” or “contract to manufacture.” Instead, the release states that the term “manufacture” is well understood and provides general guidance. Further, the SEC provided certain general principles for determining whether an issuer should be considered to “contract to manufacture.” First, “contract to manufacture” includes persons who contract the manufacturing of components of their products. In addition, the SEC retracted suggestions in its proposing release that an issuer who has “any” influence over a product’s manufacturing and an issuer who offers a generic product under its own brand name should be covered. The adopting release take the posture that an analysis is appropriate of the degree of influence an issuer exercises over “the materials, parts, ingredients, or components to be included” in a product, and that determinations on “contract to manufacture” will be based on the facts and circumstances of a particular issuer. Specifically excluded from the reach of the rule, however, are issuers who do no more than:
- Specify or negotiate contract terms with a manufacturer that do not directly relate to the manufacturing (e.g., training or technical support, price, insurance, etc.), except in unusual circumstances;
- Affix their brand, marks, logo or label to a generic product manufactured by a third party; or
- Service, maintain or repair a product manufactured by a third party.
Finally, the SEC reversed its position on mining companies as manufacturers. Under the proposed rules, an issuer that mined conflict minerals would be considered to be the manufacturer of those conflict minerals and an issuer that contracted for the mining of those minerals would be deemed to be contracting for their manufacture; both would have been subject to the rule as proposed. This has been expressly rejected by the SEC and removed from the final rule. “Necessary to a Product”. Section 1502 requires disclosure if conflict minerals are necessary to the functionality or production of a product. Like the proposed rule, the final rule does not define when a conflict mineral is “necessary to the functionality” or “necessary to the production” of a product. As with the concepts of “manufacture” and “contract to manufacture,” the SEC provides guidance by setting forth factors issuers should consider in making these determinations, such as:
- Whether a conflict mineral is intentionally added to the product (or any component) and is not a naturally-occurring by-product;
- Whether a conflict mineral is necessary to the product’s generally expected function, use or purpose; or
- If a conflict mineral is incorporated for purposes of decoration, whether the primary purpose of the product is decoration.
The release is clear that the product must actually contain the conflict mineral in order for it to be “necessary” to the functionality or production of a product. As a result, when a conflict mineral is used only as a catalyst and is completely washed away in the production process, it will not be deemed “necessary” for functionality or production for the purposes of the rule.3/
Finally, the release provides an extensive discussion of commentary and consideration of a de minimis exception to the applicability of the rule. The SEC declined to include one in the final rule; thus even trace amounts of the conflict mineral in the product is enough to trigger application of the rule.
Location, Status and Timing of Conflict Minerals Information. Included as part of step one, if it is determined that conflict minerals are necessary to the functionality or production of a product manufactured or contracted to be manufactured by an issuer, the issuer must make public disclosure relating to those conflict minerals in accordance with the rule with the filing of a Form SD. For a variety of reasons set forth in the adopting release, the SEC determined not to have the conflict minerals disclosure contained in an issuer’s annual report on Form 10-K (Form 20-K for foreign private issuers and Form 40-F for certain Canadian issuers), with the Conflict Minerals Report attached as an exhibit. Instead, an issuer must provide the required conflict minerals information in the new Form SD, with the Conflict Minerals Report as an exhibit to the Form (if the report is in fact required).
The Form SD must be filed by May 31 of each year, reporting on the preceding calendar year – regardless of the fiscal year of the reporting company.4/ The Form must include conflict minerals information for the calendar year in which the manufacture of a product that contains any conflict minerals is completed, regardless of whether the issuer manufactures the product or contracts to have it manufactured. In addition, the rule provides that the information must be disclosed on the company’s publicly available Internet website for one year, and under a separate heading in the Form SD entitled “Conflict Minerals Disclosure”, issuers must provide a link to that website. The first reporting period for all issuers will be the 2013 calendar year, with the first Form SD due on or before May 31, 2014.5/
Unlike the proposed rules, the SEC has determined that the disclosures will be “filed” instead of merely “furnished.” Issuers will therefore have Section 18(a) liability for such disclosures, opening the potential for private rights of action against an issuer based on the issuer’s conflict minerals disclosures under Rule 13p-1 in addition to the SEC’s ability to proceed against an issuer in an enforcement action.6/
Step Two – Country of Origin Inquiry
Once an issuer determines that conflict minerals are necessary to the functionality or production of a product manufactured or contracted to be manufactured by that issuer, the issuer must determine whether those conflict minerals originated in the Covered Countries or are from recycled or scrap sources. The final rule requires an issuer to conduct a “reasonable country of origin inquiry” in order to make this determination.
The adopting release, like the proposing release, acknowledges that such an inquiry may vary among issuers depending on their particular facts and circumstances (including an issuer’s size, products and relationships with suppliers). On the other hand, the final rule includes general standards governing the inquiry and the steps required:
First, the inquiry must be reasonably designed to determine whether the conflict minerals originated in the Covered Countries or came from recycled or scrap sources7/, and the inquiry must be performed “in good faith.”
An issuer can satisfy the standard if it “seeks and obtains reasonably reliable representations indicating the facility at which its conflict minerals were processed and demonstrating that those conflict minerals did not originate in the Covered Countries or came from recycled or scrap sources.” The issuer must have “reason to believe” that the representations are true and must take into account “warning signs” that the conflict minerals in fact came from the Covered Countries.
- According to the SEC, an issuer would have reason to believe representations were true if a facility received a “conflict-free” designation by a recognized industry group that requires an independent private sector audit of the smelter, or if an individual processing facility which is not part of an industry group independently obtained a “conflict-free” designation what had been the subject of a private sector audit that is made publicly available.
The issuer is not required to receive representations from all of its suppliers; the standard focuses on reasonable design and good faith.
- By way of example, the release stated that the Commission would agree that “if reasonable inquiry has been made, and no evidence of [Covered Country] origin has arisen, and if the origin of only a small amount of gold were still unknown, a manufacturer should be allowed to declare that its gold was not from the [Covered Countries] and is DRC conflict free.”
- This SEC believes that this approach is consistent with the guidance published by the Organisation for Economic Co-operation and Development (“OECD”) in June of 2012 for diligencing supply chains of conflict minerals.8/
- An issuer can satisfy the standard if it “seeks and obtains reasonably reliable representations indicating the facility at which its conflict minerals were processed and demonstrating that those conflict minerals did not originate in the Covered Countries or came from recycled or scrap sources.” The issuer must have “reason to believe” that the representations are true and must take into account “warning signs” that the conflict minerals in fact came from the Covered Countries.
Second, if the inquiry results in (i) a determination by the issuer that its necessary conflict minerals did NOT originate in the Covered Countries or DID come from recycled or scrapmaterials; or (ii) the issuer having no reason to believe that its conflict minerals may have originated in the Covered Countries or the reasonable belief that its conflict minerals are from scrap or recycled sources, then the issuer is not required to conduct due diligence on its conflict minerals’ source or chain of custody or file the Conflict Minerals Report as an exhibit to its Form SD. Instead, the issuer need only file the Form SD disclosing:
- The issuer’s final determination;
- A brief explanation of the country of origin inquiry it undertook in making its determination; and
- A brief description of the results of the inquiry it performed.
According to the adopting release, the change in focus was appropriate so that the issuer did not have to “prove a negative” to avoid the need for step three. As originally proposed, the issuer was required to establish that the conflict minerals did not originate from a Covered Country. At the same time, the SEC aims to ensure that issuers not be allowed to ignore or be “willfully blind” to signs or circumstances suggesting that the conflict minerals had originated from the Covered Countries.
Significantly, however, the adopting release acknowledges that an issuer may not be able to determine with certainty the origin of all of its conflict minerals. The following passage suggests what may become standard disclosure in the Form SD:
A certainty is not required to satisfy the reasonable country of origin inquiry standard. Disclosure indicating that the determination is uncertain is unnecessary. Consistent with this approach, issuers may explicitly state that, if true, their reasonable country of origin inquiry was reasonably designed to determine whether the conflict minerals did originate in the Covered Countries or did not come from recycled or scrap sources and was performed in good faith, and the issuer’s conclusion that the conflict minerals did not originate in the Covered Countries or came from recycled or scrap sources was made at that reasonableness level.
Step Three – Conflict Minerals Report and Supply Chain Due Diligence
Section 1502 requires an issuer that determines its necessary conflict minerals have originated in the Covered Countries to submit a Conflict Minerals Report. The report must include a description of the diligence measures undertaken by the issuer on the source and chain of custody of its conflict minerals. By statute, those measures “shall include an independent private sector audit” of the Conflict Minerals Report, although no such audit is required for issuers with “DRC conflict undeterminable” products during the temporary period discussed below.
The final rule provides that if the issuer knows that any of its necessary conflict minerals came from the Covered Countries and are not from recycled or scrap sources (as defined in the rule) or has reason to believe that they may have originated in the Covered Countries and has reason to believe that they may not be from recycled or scrap, then the issuer must exercise due diligence on the source and chain of custody of its minerals.
Due diligence using a recognized framework.The final rule provides that the due diligence to be performed by the issuer must conform to a nationally or internationally recognized due diligence framework if such a framework is available for the conflict mineral.9/
If the diligence reveals that the issuer’s conflict minerals originated from a source outside the Covered Countries or only came from recycled or scrap sources, then the issuer must only include in its Form SD a brief description of its inquiry and due diligence efforts and the basis for its determinations. No Conflict Minerals Report will be required.
In the case where the diligence reveals that the conflict materials (i) are "DRC conflict free" but originated in the Covered Countries; or (ii) were not found to be "DRC conflict free," the issuer must include a Conflict Minerals Report as an exhibit to its Form SD, which Report must be audited by a private sector independent auditor.
Where a private sector audit is required, the rule requires that the issuer include a certified independent private sector audit conducted in accordance with the standards established by the Comptroller General as part of its diligence on the source and chain of custody. The certification need not be signed by an officer; instead it need only take the form of a statement in the Report.
"DRC conflict free". The final rule defines "DRC conflict free" as products that "do not contain conflict minerals . . . that directly or indirectly finance or benefit armed groups" in the Covered Countries. If the issuer’s products are determined to be "DRC conflict free" the Report need not include information about the products but only a description of the due diligence measures the issuer undertook and the private sector audit.
If, however, the issuer does not know:
- that its conflict minerals did not originate in the Covered Countries;
- that its conflict minerals that originated in the Covered Countries did not finance or benefit armed groups (i.e., were not found to be "DRC conflict free"); or
- that the minerals came from recycled or scrap sources
then the issuer cannot state that its conflict minerals have been found to meet the definition of "DRC conflict free." Accordingly, the Conflict Mineral Report must state that the issuer’s necessary conflict minerals have not been found to be "DRC conflict free" and must include a description of those products, the facilities used to process the necessary conflict minerals in those products, the country of origin of those minerals and the efforts to determine the mine or location of origin "with the greatest possibly specificity."
The final rule allows issuers to add disclosure or clarification to their Conflict Minerals Reports. According to the adopting release, this allows issuers the ability to provide the statutory definition of "DRC conflict free" to make clear that this has a very specific meaning.10/
"DRC conflict undeterminable". In addition, the SEC has provided a temporary category of "DRC conflict undeterminable" for those situations where the diligence was unable to establish that the minerals did not originate in the Covered Countries, that the conflict minerals that did originate in the Covered Countries did not directly or indirectly finance or benefit armed groups or that the minerals came from recycled or scrap sources. This "DRC conflict undeterminable" category may be used for up to two reporting cycles following the effectiveness of the new rule (reports for 2013 and 2014). For smaller reporting companies, this alternative category will be permitted during the first four reporting cycles (2013, 2014, 2015 and 2016). Thereafter, all issuers will have to describe products in the Conflict Minerals Report as having "not been found to be ‘DRC conflict free’" – even if they are unable to conclusively establish that the products have "not been found to be ‘DRC conflict free.’"11/ The language of the proposing release, that the products were "not DRC conflict free" has been eliminated.
The adopting release suggests that this, coupled with the ability to provide additional disclosure and clarification, responds to the First Amendment concerns expressed by commentators that the rule impermissibly compels speech that is not of a commercial nature and that may be false or unfairly stigmatizing for some issuers.12/
Issuers with "DRC conflict undeterminable" products are required to provide a report that describes the products, the facilities used to process the necessary minerals in those products (if known), the country of origin (if known) and the efforts to determine the mine or location of origin "with the greatest possibly specificity." During the temporary period, however, they will not have to provide an independent private sector audit of that report.
Audit Report. The SEC release states that the existing government auditing standards ("GAGAS") will be applicable to the required audit report and that these could be used by the auditor to express a conclusion as to whether the design of the diligence measures are in conformity with the criteria set forth in a nationally or internationally recognized due diligence framework (such as the OECD’s "Due Diligence Guidance for Responsible Supply Chains of Minerals from Conflict-Affected and High-Risk Areas") and whether the issuer’s description of the measures it performed as set out in the Report is consistent with the process that the issuer undertook.
In addition, the adopting release states that entities conducting these audits must comply with any independence standards established by the Government Accounting Office.
Finally, in response to comments, the SEC included in the final rule an articulation of the audit objective for the required private sector audit:
[T]o express an opinion or conclusion as to whether the design of the issuer’s due diligence framework as set forth in the Conflict Minerals Report, with respect to the period covered by the report, is in conformity with, in all material respects, the criteria set forth in the nationally or internationally recognized due diligence framework used by the issuer, and whether the issuer’s description of the due diligence measures it performed as set forth in the Conflict Minerals Report, with respect to the period covered by the report, is consistent with the due diligence process that the issuer undertook.
It is worthy of note that the SEC’s economic analysis included with the adopting release suggests that the estimated cost of initial compliance with its final rule will be between $3 billion and $4 billion, with subsequent annual compliance costs estimated at between $207 million and $609 million. The broad applicability of the new rule is in part responsible for these stunning compliance costs. The need for the development of systems and procedures for both the "reasonable country of origin inquiry" and the necessary due diligence frameworks will add considerably to those costs.
We are recommending that all of our public company clients begin an initial analysis of whether they are or could be deemed to be engaged in the manufacture of products or to be contracting for the manufacture of products that may contain any of the identified conflict minerals. Given the long lead time to ensure compliance, an initial understanding of whether an issuer must do more needs to be established early.