Beveridge & Diamond
 

SEC Approves Final Conflict Minerals Rule

Beveridge & Diamond, P.C., August 24, 2012

UPDATE (9/14/12):  The Federal Register version of the rule was posted on September 12, 2012.  Please click here to access it.

On August 22, 2012, the Securities and Exchange Commission approved (by a 3-2 vote) the final rule on “conflict minerals.”

  • The rule implements the disclosure requirements mandated by Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
  • The final rule will require certain publicly traded companies to disclose whether they use “conflict minerals” in their products, and what efforts they have undertaken to ensure their use of those minerals does not contribute to the ongoing conflict in the Democratic Republic of Congo (“DRC”) and adjoining countries (known here as the “Covered Countries”). 

 “Conflict minerals” are defined for purposes of the rule to mean four commonly used minerals, regardless of their source of origin, as well as their derivatives: 

  • columbite-tantalite, also known as coltan (used to produce tantalum);
  • cassiterite (used to produce tin);
  • wolframite (used to produce tungsten); and
  • gold.   

The SEC issued a proposed rule in December 2010, which left open several important questions.  The final rule retains the overall three-step structure of the proposed rule, but clarifies several key points as to the applicability, scope, and timing of the conflict mineral reporting requirements.

This alert provides an overview of the notable provisions in the final rule, following the three-step process outlined by the SEC.  Beveridge & Diamond will be providing additional analysis of the final rule here, as well as in a webinar on September 12, 2012 (details below).

Step 1 – Scope and Applicability

As with the proposed rule, the first step under the final rule is to determine if the rule applies.

A company is subject to requirements in the final rule if:

  • it files reports with the SEC under Sections 13(a) or 15(d) of the Exchange Act; and
  • conflict minerals are necessary to the functionality or production of a product the company manufactures or contracts to manufacture. 

The final rule does not define the terms “manufacture,” “contract to manufacture,” “necessary to the functionality,” or “necessary to the production.” 

However, the final rule clarifies some key aspects of the rule’s applicability. 

  • The SEC rejected calls for an exemption for products that contain only de minimis amounts of conflict minerals.
  • It also clarified that the phrase “contract to manufacture” captures manufacturers that contract the manufacturing of components of their products, and that such manufacturers would be viewed as responsible for the conflict minerals in those products to the same extent as if they manufactured the components themselves. 
  • In a reduction of the scope of the proposed rule, however, the SEC clarified that the rule only applies to companies with products that actually contain conflict minerals.  To illustrate, a catalyst containing conflict minerals used in making a product is not “necessary to the production” of that product for purposes of this rule if the product itself does not contain conflict minerals.
  • The SEC also confirmed that, although the scope is not per se limited to conflict minerals that are intentionally added, the question whether the minerals were intentionally added “is a significant factor” in determining the necessity of the minerals. 

The final rule also clarifies the applicability of these requirements to companies that “contract to manufacture a product,” a provision that will be important to retailers and brands that do not themselves manufacture the products that they sell. 

  • The final rule clarifies that a company does not “contract to manufacture” a product if it does no more than (1) specify or negotiate contractual terms with the manufacturer that do not directly relate to the manufacturing of the product; (2) affix its brand, marks, logo, or label to a generic product manufactured by a third party; or (3) service, maintain, or repair a product manufactured by a third party.
  • As with the proposed rule, however, the SEC emphasized that this determination will ultimately depend  on the degree of control that company exerts over the manufacturing of the product. 
  • As a result, it will be important for companies considering whether they can take advantage of this new scope to carefully evaluate the degree to which they effectively control the manufacturing of such products.

The final rule also provides a new scope exemption for stockpiled conflict minerals, which it refers to as minerals determined to be “outside the supply chain.” 

  • The SEC recognized that some stockpiles of conflict minerals will exist when the first reporting period begins in January 2013.  Even though those conflict minerals could have contributed to conflict in the DRC region, the SEC recognized that once those minerals are processed or have left the region, it is unlikely their use will continue to contribute to conflict in the region. 
  • Therefore, the final rule provides an exemption for minerals that, prior to January 31 2013, were “outside the supply chain,” defined to include:
    • For columbite-tantalite, cassiterite, and wolframite minerals:  minerals that were smelted prior to January 31, 2013;
    • For gold, gold that was fully refined prior to January 31, 2013; and
    • For any conflict mineral that has not yet been refined or smelted, minerals that were located outside of the Covered Countries prior to January 31, 2013.
  • This initial exemption ensures companies will not have to conduct any inquiry or due diligence on materials processed before the beginning of the initial reporting period.

Step Two – The RCOI

As discussed above, a company must proceed to step two if it has determined that both its products and the minerals in them are in scope. 

Step two requires companies to conduct a “reasonable country of origin inquiry” (“RCOI”).  Put simply, this inquiry is designed to evaluate whether the minerals in a company’s supply chain originated (a) from recycled or scrap sources, or (b) from outside the Covered Countries. 

Step two matters because it determines whether a company is required to proceed to step three, which could involve the significant additional expenses associated with additional due diligence and (potentially) preparing a Conflict Minerals Report.

  • There is no need to proceed to step three to conduct further due diligence if, based on the RCOI, a company “knows or has reason to believe” that the conflict minerals in its supply chain either:
    • came from recycled or scrap sources; or
    • originated outside the Covered Countries.
  • By contrast, a company must proceed to step three if:
    • the RCOI leads to “knowledge” that they have conflict minerals from the Covered Countries; or
    • the RCOI gives them “reason to believe” that their conflict minerals “may have originated” in the Covered Countries.

With respect to the content of the RCOI standard, the final rule is substantially similar to the proposed rule. 

  • It confirms that the RCOI standard is not an absolute standard.  Certainty is not required; the rule requires only a reasonableness determination.  
  • The rule does not specify precise steps necessary to make this determination.  It notes instead that the content of the inquiry will:
    • vary depending on the facts and circumstances of every company, and
    • evolve over time.
  • The final rule does provide some new general standards, however: 
    • The RCOI must be “reasonably designed” to determine the origin of the minerals; and
    • It must be performed in good faith.
  • These general standards were arguably implicit in the proposed rule anyway, and are therefore unlikely to satisfy those who sought additional clarity from the SEC on the content of the RCOI process.

Nevertheless, the SEC did provide several helpful points of clarification about how the RCOI should be applied in practice.

  • It clarified that a company will 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.” 
    • It further specifies that, if a processing facility received a “conflict-free” designation by a recognized industry group, that would constitute reason to believe that such representations were true.
    • This clarification will provide a very strong inducement to companies to participate in established supply chain communication processes, such as the EICC-GeSI tool.
  • It also clarified that there is no requirement to receive such representations from every single supplier in a company’s supply chain. 
    • If the process is designed well and implemented in good faith, and if input is received from a substantial portion of its supply chain, this will suffice even if not all suppliers have responded.
    • However, the company must take into account warning signs or other circumstances that indicate that the minerals may have originated in the Covered Countries.
    • This approach roughly parallels the OECD’s “red flag” approach to signal when additional due diligence is required, based on a range of tools and methods to engage with suppliers and evaluate their performance.

 In addition, the final rule adjusted the standard for determining whether it is necessary to proceed to step three.

  • The proposal allowed a company to avoid step three only if it could affirmatively determine that its minerals did not originate in the Covered Countries.
  • The final rule loosens that requirement somewhat.  As noted above, a company can now avoid step three if it “knows or has reason to believe” that  the conflict minerals in its supply chain either:
    • came from recycled or scrap sources; or
    • originated outside the Covered Countries.
  • In principle, a company could also avoid step three if it has “no reason to believe” that its conflict minerals “may have originated” in the Covered Countries.
    • In practice, however, this prong of the new standard could be difficult to meet, given the open-ended language referring to mere possibility of origination in the Covered Countries, and given the importance of the region as a source for these minerals.
    • The applicability of this new “no reason to believe” element is therefore likely to require careful attention by companies seeking to avoid the requirement to conduct due diligence under step three.
    • For example, the SEC indicates that this prong would likely not be available if a company is aware that some of its minerals were processed by “mixed smelters” that include minerals from many countries.

Even if a company meets the standard for avoiding the requirement to move to step three, its obligations are not yet complete:

  • It must still file the new Form SD to “provide a brief description” of the RCOI process and the results of the inquiry.
  • It must also provide a link to the website where the disclosure is publicly available.

 Step 3 – Due Diligence and the Conflict Minerals Report

Under the final rule, a company that must proceed to step three does not necessarily have to prepare a conflict minerals report.  If a company conducts the due diligence and determines that the conflict minerals in its supply chain came from recycled or scrap sources or originated outside the Covered Countries, the company can file the Form SD and describe the measures taken to make that determination.

By contrast, companies that know or have reason to believe that their minerals may have originated in the Covered Countries or may not have come from recycled or scrap sources must prepare a Conflict Minerals Report.

Like the proposed rule, the final rule does not define the due diligence procedures that companies must use to evaluate their supply chains to complete a Conflict Minerals Report. 

  • Unlike the proposed rule, however, the final rule requires reporting companies to use a “nationally or internationally” recognized supply chain due diligence standard. 
  • The only such standard that currently exists is the Organisation for Economic Co-operation and Development (“OECD”) Due Diligence Guidance for Responsible Supply Chains of Minerals from Conflict-Affected and High-Risk Areas. 
    • The OECD Guidance has the explicit support of the U.S. Department of State, the governments of DRC and some of its neighbors, and some non-governmental organizations active in the region. 
    • A number of companies in the electronics industry have been involved in a pilot project to implement the OECD Guidance in advance of the final rule.

Independent Third Party Audit of the Conflict Minerals Report

Section 1502 requires that a company submit a “certified audit,” conducted by an independent third party, of its Conflict Minerals Report.  The final rule provides needed clarity about the audit objective (i.e., the question that the auditor is expressing an opinion on), which will in large part determine the scope and cost of audits.   The SEC chose to articulate a relatively targeted and non-burdensome audit objective in the final rule.

  • The final rule does not require an audit of the entire Conflict Minerals Report.
  • The audit scope is instead limited to an evaluation of whether the company’s due diligence framework comports with the international or national due diligence standards, and whether the company implemented its due diligence in the manner reported in the Conflict Minerals Report. 
  • The required audit does not include an evaluation of whether specific products are or are not DRC conflict free.

The SEC also abandoned a proposed requirement that companies certify the audits of their Conflict Minerals Reports.  Instead, the final rule requires that a company certify only that it obtained the audit, and then include the results of the audit in its Conflict Minerals Report 

Description of Products in the Conflict Minerals Report

The final rule adopts a new interim procedure that applies to companies that must file Conflict Minerals Reports.  For a transition period, companies that cannot determine that their products are “DRC conflict free” may describe their products as “DRC conflict undeterminable.”

  • This is a significant improvement over the proposed rule, which would have required companies facing uncertainty about the origin or status of their conflict minerals to describe their products as “not DRC conflict free.”
  • Issuers using this designation must still conduct due diligence and prepare Conflict Minerals Reports with information about their procedures and information that is known.
  • However, issuers that take advantage of this option will not be required to obtain an independent private sector audit of their Conflict Minerals Report.
  • This category will be available for a transitional period only:  the reports for the first two years for all companies, and four years for “smaller” companies.
  • This transition period is in response to criticism that companies were not yet equipped to make “DRC conflict free” determinations given the nascent state of supply chain communications, smelter audits, and traceability mechanisms on the ground.  Companies now have the chance to better develop and implement their due diligence procedures.

After that transition period, the final rule also changed the description that companies must apply to products that are not confirmed to be DRC conflict free. 

  • Such products may now be described as “having not been found to be ‘DRC conflict free,’” a formulation that avoids the potential stigma that would attach to products affirmatively identified as “not DRC conflict free” as originally proposed.

The SEC clarified that the final rule does not require companies to physically label any products.

It also clarified that companies are not required to describe products that are “DRC conflict free.”

  • Companies are free to do so provided their due diligence indicates the products are indeed “DRC conflict free.”
  • The final rule does not, however, draw any distinction between products that are “DRC conflict free” because they were sourced from outside of the region and products that are “DRC conflict free” because they came from non-conflict mines within the region.
  • The SEC therefore chose not to adopt calls by some companies to impose disclosure standards that would have drawn attention to this distinction.
  • As a result, the final rule arguably missed an opportunity to mitigate the risks that the rule will drive companies to push their supply chains away from the region entirely, rather than sourcing from responsible supplies within the region and therefore contributing to the improvement of the humanitarian situation on the ground there.
  • The rule does, however, permit companies to add clarifications or context to their disclosures, and companies that do source from within the region may take advantage of that opportunity. 

The final rule also leaves considerable flexibility regarding the manner of describing products that must be covered by a Conflict Minerals Report, provided that the description sufficiently identifies the products or categories of products that are affected.

Format of Disclosures

The final rule changed the format of disclosures. 

  • Instead of including the results of the country of origin inquiry and the Conflict Minerals Report in annual 10-K, 20-F, or 40-F reports, companies are now to use a new special disclosures form, Form SD.
  • Companies will report the results and description of the reasonable country of origin inquiry on Form SD.
  • Companies will submit Conflict Minerals Reports as exhibits to that form.

Significantly, the final rule requires Form SD to be “filed” rather than “furnished,” opening companies to liability under Section 18 of the Exchange Act. 

  • Section 18 imposes liability for material misstatements or omissions in SEC filings, which allows investors to bring suit if companies fail to comply with conflict minerals disclosure requirements. 
  • The SEC identified this potential liability as a source of potential costs to companies.

Timing

In another shift from the proposed rule, the timing of conflict mineral reporting obligations will be tied to a January-December calendar year, rather than individual companies’ fiscal years, with Form SD filings due by the end of May. 

  • The first reporting year will begin January 1, 2013.
  • Form SD filings covering that first year will be due May 31, 2014. 

This change was sought by several industry commentators and has several advantages:

  • It evens the playing field among companies with differing fiscal years.
  • It harmonizes the reporting period across the entire supply chain (which will allow significant efficiencies for suppliers who will be required to comply with supplier demands).
  • It allows companies more time to prepare the filing than would have been available under the proposed rule. 

It also, however, creates a new filing schedule that will not correspond with existing SEC filing schedules for many companies. 

Conflict Minerals from Scrap or Recycled Sources

The final rule includes several new provisions regarding the sourcing of conflict minerals from scrap or recycled sources.  The final rule is intended to avoid disincentives to using recycled materials while also ensuring that claims by issuers regarding the sourcing of such materials are legitimate.

Conflict minerals that are sourced from recycled or scrap materials are deemed “DRC conflict free” under the final rule.  As such, a product containing only conflict minerals from scrap or recycled metals would also be considered “DRC conflict free.” 

In a change from the proposed rule, the SEC has clarified its definition of conflict minerals from recycled or scrap sources to track the OECD definition.  Under the revised definition, both recycled metals from post-consumer products and scrap metals created during product manufacturing can qualify as DRC conflict free.  However, “minerals partially processed, unprocessed, or a bi-product from another ore” are not included in the definition of recycled metal.

As discussed above, the RCOI must be designed to allow the issuer to reasonably determine whether its conflict minerals are from recycled or scrap sources. 

  • If, based on this inquiry, the registrant determines or reasonably believes that its conflict minerals did come from recycled or scrap sources, this determination and a description of the inquiry must be provided in its disclosure report. 
  • If there is reason to believe the conflict minerals may not have originated from recycled sources, an issuer will be required to exercise due diligence and (potentially) file a Conflict Minerals Report.

Related Activity and Further Developments

OECD Due Diligence Guidance: Several companies representing entities up and down the conflict minerals supply chain are participating in a pilot implementation of the OECD Guidance. 

  • OECD has released periodic reports on the progress of the pilot, which detail some of the successes and challenges companies have found while implementing the guidance. 
  • Further information on this pilot is available here.

Some industry trade groups have been testing conflict minerals reporting compliance tools.  As noted above, these tools will likely serve as important elements in both the RCOI and due diligence processes that the final rule now requires.

  • EICC and GeSI, electronics trade groups, have developed a reporting template that companies can use to communicate among entities up and down their supply chain, and a program for certifying smelters as “conflict free.” 
  • Further information on the EICC-GeSI reporting template and the Conflict Free Smelter program is available here.

California and Maryland have enacted legislation that will bar any company that fails to meet its Dodd-Frank conflict minerals reporting requirements from state procurement contracts. 

  • Some private institutions have adopted similar policies. 
  • As implementation of the final rule progresses, other states and institutions are likely to follow suit.

The threat of litigation challenging this rulemaking has loomed for months.

  • It is clear that the SEC vastly underestimated the economic impact of the rulemaking in its proposed rule.  While the SEC adjusted its estimate upwards by more than an order of magnitude, some continue to argue those estimates do not reflect the real costs of implementation. 
  • The SEC may also face challenges that it failed to exercise its authority in a manner that gave adequate consideration to the likelihood that the rule would achieve the objectives of the statute.

Upcoming Webinar

Beveridge & Diamond offers a complimentary Products Law Webinar Series for clients.  The Conflict Minerals session will last an hour, starting promptly at noon Eastern time on September 12, 2012.  The session will review the new SEC disclosure requirements and address strategies for covered companies in light of industry and OECD initiatives.  Advance registration is required.  Please contact Linda Lam to register or for further information at llam@bdlaw.com or (202) 789-6136.

Links

Pre-Publication Release of the Final Rule

SEC Press Release and Fact Sheet

SEC Flow Chart Summary of the Final Rule

OECD Due Diligence Guidance and Pilot Project

EICC-GeSI Conflict Free Smelter Program and Conflict Minerals Template

B&D Client Alert: President Signs Into Law Conflict Minerals Legislation, July 21, 2010.

B&D Client Alert: SEC Issues Proposed Regulations Requiring Disclosure of Conflict Minerals, Dec. 17, 2010.

For a printable PDF of this article, please click here.

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