SEC Adopts New Rule Requiring Disclosure of Conflict Minerals in Supply Chains

Newsletter
SEC Adopts New Rule Requiring Disclosure of Conflict Minerals in Supply Chains

August 24, 2012

On August 22, 2012, the U.S. Securities and Exchange Commission (SEC) adopted a new rule requiring companies to publicly disclose if they use conflict minerals that originated in the Democratic Republic of Congo (DRC) or adjoining countries (collectively referred to as the “covered countries.” The purchase of so-called “conflict minerals” allegedly benefits armed rebel groups in these countries. The conflict minerals include tantalum, tin, gold, tungsten or other minerals if they are deemed necessary to the functionality or production of a product manufactured by the disclosing company.

Compared to the original SEC proposal, this new rule was substantially modified. The SEC’s release of the rule is mandated by Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) to require companies to publicly disclose their use of conflict minerals. The rule requires all public companies to file a specialized disclosure report on a new form, Form SD, by May 31, 2014, and annually on May 31 every year thereafter. Every company is required to file for the same period – a calendar year – regardless of when its fiscal year ends. Each company filing a report on Form SD must make it available on its website.

This Flash Report summarizes some of the points included in the SEC’s release. It covers the following topics:

  • Basic requirements of the rule
  • Companies impacted
  • New Form SD increases exposure
  • The due diligence process
  • Information included in the conflict minerals report
  • Industries impacted
  • Independent audit requirement
  • Stakeholder interest

These topics are discussed below. Read the SEC’s press release and the 356-page adopting release.

Basic Requirements of the Rule

The new rule says that if a company acquires certain materials1 from the DRC or any of the adjoining countries2 (collectively the “covered countries”), it must disclose such activity in a new form to the SEC that must be included on its website. The rule further stipulates that the minerals must be necessary to the functionality or production of a product manufactured or contracted to be manufactured by the company. In effect, companies that use raw materials qualifying as possible “conflict minerals” for manufacturing purposes are required to disclose that fact and, if they aren’t sure, must conduct a due diligence country-of-origin inquiry to make a conclusive determination. The form of disclosure is a new form to be filed with the Commission, Form SD. The company’s approach and determination must be subject to an independent certified audit. These points are discussed further below.

Companies Impacted

The final rule applies to a company using such minerals as tantalum, tin, gold or tungsten if it files reports with the SEC under the 1934 Securities Exchange Act and the minerals are “necessary to the functionality or production” of a product manufactured or contracted to be manufactured by the company. For purposes of this rule, a company is considered to be “contracting to manufacture” a product if it has some actual influence over the manufacturing of that product. This determination is based on facts and circumstances, taking into account the degree of influence a company exercises over the product’s manufacturing. A company is not be deemed to have influence over the manufacturing if it merely:

  • Affixes its brand, marks, logo or label to a generic product manufactured by a third party.
  • Services, maintains or repairs a product manufactured by a third party.
  • Specifies or negotiates contractual terms with a manufacturer that do not directly relate to the manufacturing of the product.

The new requirements apply equally to domestic and foreign issuers filing with the Commission.

New Form SD Increases Exposure

Form SD will be “filed” with the SEC rather than “furnished.” It is regarded as a special filing and is not included in the annual report on Form 10-K or 20-F.3 Since the form is separate from a company’s Form 10-K or 20-F, it will not be covered by those forms’ CEO and CFO certifications under Section 302 and 906 of the Sarbanes-Oxley Act. Nor will the form be automatically incorporated into a company’s shelf registration statement. However, because it is “filed,” any materially “false or misleading statement” in the form will be subject to liability under Section 18 of the 1934 Securities Exchange Act.

The Due Diligence Process

Under the final rule, companies that are required to file a Conflict Minerals Report must exercise due diligence on the source and chain of custody of their conflict minerals. This is referred to as a “due diligence country-of-origin inquiry.” The due diligence procedures must be performed in good faith and be reasonably designed to determine whether any of the company’s minerals originated in the covered countries or are from scrap or recycled sources. The SEC mandates that the due diligence process conform to a nationally or internationally recognized due diligence framework or standard, such as the due diligence guidance approved by the Organization for Economic Co-operation and Development (OECD).4

If a company knows or has reason to believe that any minerals may have originated in one or more of the covered countries, or knows or has reason to believe that the minerals may not be from scrap or recycled sources, the company should file a Conflict Minerals Report with the SEC. In determining whether conflict minerals originated in the DRC or other covered countries:

If the company inquiry determines either of the following to be true:

The company knows that the minerals did not originate in the covered countries or are from scrap or recycled sources;
The company has no reason to believe that the minerals may have originated in the covered countries or may not be from scrap or recycled sources;
… then the company must disclose its determination, provide a brief description of the inquiry it undertook and the results of the inquiry on Form SD. The company also is required to make its description publicly available on its Internet website and provide the Internet address of that site in the Form SD.

If the company inquiry otherwise determines both of the following to be true:

The company knows or has reason to believe that the minerals may have originated in the covered countries;
The company knows or has reason to believe that the minerals may not be from scrap or recycled sources;
… then the company must undertake “due diligence” on the source and chain of custody of its conflict minerals and file a Conflict Minerals Report as an exhibit to the Form SD. The company also is required to make publicly available the Conflict Minerals Report on its Internet website and provide the Internet address of that site on Form SD.

Information Included in the Conflict Minerals Report

If a company determines that its products are “DRC conflict free” – that is, the minerals may originate from the covered countries but did not finance or benefit armed groups — then the company must undertake the following audit and certification requirements:

  • Obtain an independent private sector audit of its Conflict Minerals Report.
  • Certify that it obtained such an audit.
  • Include the audit report as part of the Conflict Minerals Report.
  • Identify the auditor.

If a company’s products have not been found to be “DRC conflict free,” then in addition to the audit and certification requirements, the company must describe the following in its Conflict Minerals Report:

  • The products manufactured or contracted to be manufactured that have not been found to be “DRC conflict free”
  • The facilities used to process the conflict minerals in those products
  • The country of origin of the conflict minerals in those products
  • The efforts to determine the mine or location of origin with the greatest possible specificity

For a temporary two-year period5, if the company is unable to determine whether the minerals in its products originated in the covered countries or financed or benefited armed groups in those countries, then those products are considered “DRC conflict undeterminable.” In that case, the company must describe the following in its Conflict Minerals Report:

  • Its products manufactured or contracted to be manufactured that are “DRC conflict undeterminable”
  • The facilities used to process the conflict minerals in those products, if known
  • The country of origin of the conflict minerals in those products, if known
  • The efforts to determine the mine or location of origin with the greatest possible specificity
  • The steps it has taken or will take, if any, since the end of the period covered in its most recent Conflict Minerals Report to mitigate the risk that its necessary conflict minerals benefit armed groups, including any steps to improve due diligence.

For some companies, the two-year transition period6 is a welcome modification from the requirement in the proposed rules to classify minerals that are “DRC conflict undeterminable” as not “conflict free” if the company is unable to determine the country of origin with certainty. As such, for those products that are “DRC conflict undeterminable,” the company is not required to obtain an independent private sector audit of the Conflict Minerals Report regarding the conflict minerals in those products.

There are special rules governing the due diligence and Conflict Minerals Report for minerals from recycled or scrap sources. If a company’s conflict minerals are derived from recycled or scrap sources rather than from mined sources, the company’s products containing such minerals are considered “DRC conflict free.” In addition:

  • If a company cannot reasonably conclude after its inquiry that the gold it uses is from recycled or scrap sources, then it is required to undertake due diligence in accordance with the OECD Due Diligence Guidance and arrange for an audit of its Conflict Minerals Report. Currently, gold is the only conflict mineral with a nationally or internationally recognized due diligence framework for determining whether it is recycled or scrap, which is part of the OECD Due Diligence Guidance.
  • For the other three minerals, if a company cannot reasonably conclude after its inquiry that its minerals are from recycled or scrap sources, until a due diligence framework is developed, the company is required to describe the due diligence measures it exercised in determining that its conflict minerals are from recycled or scrap sources in its Conflict Minerals Report. In such instances, the company is not required to obtain an independent private sector audit regarding such conflict minerals.

Industries Impacted

This new rule has a long reach. It will hit many manufacturers, industrial companies, fabricators, companies in the extractive industries and the like. The four conflict minerals are used in large quantities in electronic components and other manufactured products, and it is possible they may originate from the Congo and nearby areas. To illustrate, tungsten, also known as wolfram, is used in the production of integrated circuits. Gold is used in high-end wiring such as audio or USB cables because it is a good conductor. Tantalum is a rare metal that is used in the manufacture of mobile phones and computers. Tin is used as solder for circuit boards and other purposes. If companies use any of these targeted minerals, then Sections 1502 and 1504 of DFA require them to disclose to investors whether their products include minerals sourced to the covered countries.

Since the proposed release had been exposed for some time, some companies have tried to get ahead of the curve. For example, technology companies such as Intel, HP, Motorola Solutions and Apple have already established conflict-free programs ahead of the required SEC regulations, proving that clean supply chains are possible and profitable. Other companies have recognized the reputational issues associated with sourcing minerals from the covered countries given the human toll involved. To illustrate, when the U.S. Chamber of Commerce threatened to file a lawsuit against the SEC, asserting that the cost for cleaning up supply chains is too high for companies, major companies such as Microsoft, General Electric and Motorola rejected the Chamber of Commerce's stance against the regulations.7

The proposed release would have mandated that retailers selling products under their own brand name also abide by the rule. However, the final rule exempts companies that don’t directly manufacture their products. Despite this exemption, some retail industry officials are still assessing whether the rule provides a clear distinction between a retailer acting also as a manufacturer and has control over the composition of a product and the vast majority of retailers who do not possess such control.8

Independent Audit Requirement

The final rule calls for an independent audit under generally accepted government auditing standards (GAGAS) – either as an attestation engagement or a performance review. The objective of the audit is to 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 framework9 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. The SEC permits the auditor of the company’s financial statements to perform this audit as a “non-audit service.”

This Release Has Considerable Stakeholder Interest

Congress enacted Section 1502 of DFA10 because of concerns that the exploitation and trade of conflict minerals by armed groups is helping to finance conflict in the DRC region and is contributing to an emergency humanitarian crisis of such magnitude that some refer to it as one of the most critical human rights issues in the world. This requirement was attached to DFA to help combat the fighting in DRC and other covered countries, even though the subject matter has nothing to do with the financial crisis.

Despite the intent of the rule, it isn’t perfect. For example, it exempts companies (such as retailers) that do not produce a product but merely buy the rights to affix their private label on a generic product manufactured by a third party, creating in effect a loophole in accomplishing the rule’s objectives. In addition, some have expressed a concern over an uneven playing field for companies competing on the global stage with other firms domiciled in countries that are not requiring the same disclosure. Thus, investors desiring to invest in a particular industry may unwittingly shift capital from a company that is disclosing products that are not “DRC conflict free” to a company that does not disclose anything because it is not subject to the SEC’s rules. The irony is that both companies may be procuring conflict minerals from the Congo. One of the dissenting SEC Commissioners asserted that, while the rule’s concept is noble, its implementation was ineffective in achieving the desired goal.11  Some have even pointed out that, absent the Congressional mandate, the SEC would have never taken this action on its own.

With respect to many of the human rights activists and sustainable investing constituencies, they see the rule as an attempt to shame companies by making transparent their business activities that  directly or indirectly are fueling violent conflict, genocide and other brutal crimes against humanity and, in effect, force them to assume responsibility for the impact of their procurement practices on the people of eastern Congo. The rule’s intent of shining a spotlight on these companies can place a company in a position that few would want to be in. Those who support the new rule argue that companies able to declare their products as “DRC conflict free” could have a competitive advantage.

However, many activists see this new SEC rule as too little, too late. For example, while the Forum for Sustainable and Responsible Investment welcomed the SEC’s rule and saw its issuance as “an important step forward in providing greater clarity on material environmental, social and corporate governance disclosure to millions of investors," it asserted that the rules could have been stronger. Global Witness said the rule to allow companies to describe the origin of their minerals as undeterminable is "extremely disappointing." Global Witness also criticized the delays in implementing Section 1502 of DFA.12 These delays occurred primarily because of industry concerns that the rules were too burdensome and risked revealing competitive information, forcing the SEC to strike an appropriate balance in its rule-making. That said, the delays also allowed minerals trade to continue funding conflict.13

Still other parties, such as the Enough Project, have expressed disappointment that the SEC addition of a two- to four-year phase-in period was unnecessary. The implication of the phase-in period is that investors and human rights groups are likely to pressure companies to cleanse their supply chains more quickly and speed up their assessment of the origin of "indeterminate" minerals.14
Some investor groups were known to welcome the new rule as a much needed step for highlighting risks in a vulnerable area of a company's supply chain. In commenting on the proposed release, several investor groups asked the SEC to mandate that conflict minerals reports be "filed" as opposed to “furnished,” raising the exposure under the securities laws in the event of misleading disclosures. The objective is to enable investors to better understand the nature and source of a company’s procurement activities when making investment decisions.15

Finally, there are those who point out that the rule will add costs to the economy, impacting companies of all sizes. Some believe the SEC did not fully analyze the potential costs, supply chain complexities and other practical obstacles to implementing the final rule. The SEC states, “We recognize that the final rule will impose significant compliance costs on companies who use or supply conflict minerals, and in modifying the rule we tried to reduce the burden of compliance in areas in which we have discretion while remaining faithful to the language and intent of the Conflict Minerals Statutory Provision that Congress adopted.” On a macro basis, the SEC estimates “the initial cost of compliance [of the new rule being] approximately $3 billion to $4 billion, while the annual cost of ongoing compliance will be between $207 million and $609 million.” Some commentators estimated the costs as high as $16 billion. To avoid disproportionately higher costs for smaller companies, the SEC provided for a four-year phase- in period.

Summary

After proposing the rule in 2010, significant public input was received from multiple constituencies. In addition, the Commission hosted a roundtable in October 2011 to assist in finalizing the rule. Many changes from the proposal were incorporated in the final rule to address concerns about the costs and burden the rule imposes on issuers. In releasing the rule, Chairman Mary Schapiro stated, “I believe the final rule faithfully implements the statutory requirement as mandated by Congress in a fair and balanced manner.”

In this Flash Report, we have not attempted to cover everything included in the SEC’s rule on disclosure of conflict minerals, nor have we attempted to address all of the nuances in complying with the rule that are relevant to the matters we have covered in this Flash Report, nor have we covered all aspects of the guidance issued by the SEC’s rule. Furthermore, the Commission’s staff may issue guidance on the application of the new rule. For these and other reasons, the information in this Flash Report is not intended to be legal analysis or advice, and does not purport to address every issue that may impact companies or every possible third party response or interpretation of these matters. Accordingly, organizations should seek the advice of legal counsel or other appropriate advisors on specific questions related to the application of this rule as it relates to their business and unique circumstances.
1The term “conflict mineral” is defined in Section 1502(e)(4) of DFA to include: (A) columbite-tantalite, also known as coltan (the metal ore from which tantalum is extracted); cassiterite (the metal ore from which tin is extracted); gold; wolframite (the metal ore from which tungsten is extracted); or their derivatives; and (B) any other mineral or its derivatives determined by the Secretary of State to be financing conflict in the Democratic Republic of the Congo or an adjoining country.
2The term “adjoining country” is defined in Section 1502(e)(1) of DFA as a country that shares an internationally recognized border with the DRC, which presently includes Angola, Burundi, Central African Republic, the Republic of the Congo, Rwanda, South Sudan, Tanzania, Uganda and Zambia.
3The SEC originally proposed including these disclosures in Form 10-K or 20-F, but decided not to do so in the final rule to avoid increasing the already heavy year-end reporting process.
4The OCED framework provides a benchmark by which to measure a company's due diligence.
5Or four-year period for smaller reporting companies.
6Ibid.
7“SEC to Require Tech Companies to Disclose Use of Minerals from Conflict Zones,” Loek Essers, Computerworld, August 23, 2012.
8“Walmart, Target And Other Big Retailers Lobbied Successfully For Exemption From SEC Conflict Mineral Rule,” Huffintonpost.com, August 23, 2012.
9For example, an acceptable due diligence framework is set forth in the OECD Due Diligence Guidance.
10Section 1502 of the Act amends the Securities and Exchange Act of 1934 to add Section 13(p).
11The rule was adopted by a 3 to 2, party line vote.
12The SEC’s proposing release was issued in 2010.
13“SEC Rules on Conflict Minerals Show Small Progress – Rights Groups,” Debbie Carlson, NASDAQ, August 23, 2012.
14Essers.
15“Investors Welcome New SEC Rule Addressing Conflict Minerals in Supply Chains,” U.S. Politics Today, August 23, 2012.

Contacts

Dom Champa
Managing Director – Supply Chain Management
+1.203.905.2918
[email protected]
Sharon Lindstrom
Managing Director – Industrial Products
+1.312.476.6386
[email protected]
Rick Childs
Managing Director – Consumer Products & Services
+1.916.830.0107
[email protected]
Gordon Tucker
Managing Director – Technology
+1.415.402.3670
[email protected]
David Johnson
Managing Director – Energy & Utilities
+1.713.314.5020
[email protected]
 
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