Another Supply-Chain Disclosure Rule Battle

It is a safe assumption that few companies would ever want to risk their reputation by associating with terrorist groups or abetting human rights violators.

Nevertheless, a new rule that would oblige companies to investigate if they are free of such ties in two particularly troublesome countries is meeting with resistance from industry associations and corporate lobbying groups.

The disclosure requirements announced last month by the Securities and Exchange Commission, which build upon the Iran Threat Reduction and Syria Human Rights Act enacted by Congress in August, may prove problematic. The new rules require the disclosure of dealings with these “rogue nations” by foreign affiliates of registered companies.

Although international sanctions have long been in place by the U.S. government, those requirements have never applied to foreign entities that are owned or controlled by domestic companies. According to the new rules, when foreign subsidiaries engage in business dealings that violate U.S. laws, their domestic parent company must disclose those dealings in quarterly and annual reports filed after February 6, 2013.

On Dec. 4, the staff of the SEC's Division of Corporation Finance published compliance and disclosure interpretations (C&DIs) clarifying the new disclosure requirements. The following activities and transactions are required to be disclosed if they “knowingly” take place by an affiliate controlled by a domestically registered company: providing goods, services, technology, or support that contribute to Iran's production of petroleum and related products; exporting goods, services, or technology that contribute to Iran's ability to acquire or develop weapons of mass destruction or advanced conventional weapons; dealings that aid human rights violations.

If an issuer, or any of its affiliates, finds it is involved in these activities, it must provide a detailed description in its reports. A separate SEC filing is also required. On Dec. 19, the SEC announced that issuers should submit these notices through EDGAR on a new form type called IRANNOTICE, expected to be available for use by Jan. 14.   

The new requirements fit within a recurring regulatory theme of 2012, that the SEC increasingly found its overview of companies shift from traditional core interests and into matters with a social-activism bent. Rules requiring disclosure of so-called “conflict minerals” from the Congo and reporting payments made to governments for oil, gas, and mineral extraction rights were high-profile mandates of the Dodd-Frank Act that stressed corporate responsibility and human rights advocacy beyond traditional financial matters. Disclosure requirements were intended to “name and shame” companies into desired behaviors.

There are comparisons to be made of those mandates to the new disclosure rules for companies with affiliates that do business with Iran and Syria. Like those other rules, the new requirements will require many companies to dig deep into their supply chain and reevaluate relationships with vendors and subsidiaries.

“The Iran disclosure requirements, like the conflict mineral requirements, contain many interpretive questions and are opaque in some instances and so are similarly challenging in that regard,” says Janice Brunner, an associate with the law firm Davis Polk & Wardwell. “The conflict mineral rules may be more onerous due to the extensive supply chain mapping and diligence that may be required. Companies may be in a better position to determine the extent of their activities with Iran, although the affiliate concept obviously complicates this exercise.”

Judith Lee, chair of the law firm Gibson Dunn's International Trade and Regulation Compliance practice, says energy and manufacturing companies have the most to be concerned about as they work to ensure that their foreign subsidiaries offer adequate and accurate disclosures, something they may be reluctant to do. While many countries already have sanctions of their own in place, “Chinese and Indian subsidiaries are having a lot of consternation and hand-wringing about how to disengage from Iran in the least painful way,” she says.

“The Iran disclosure requirements, like the conflict mineral requirements, contain many interpretive questions and are opaque in some instances and so are similarly challenging in that regard.”

—Janice Brunner,

Associate,

Davis Polk & Wardwell

“There are huge multinational companies headquartered in the United States, and they basically have to do an inventory of all their related companies to see which falls within this new definition,” Lee says. “For the really large companies it is quite an exercise and they are very concerned about it.”

As is often the case with rulemaking of this sort, some are concerned that some key terms in the CD&Is may be ambiguous or open to interpretation.

Lee says many of her clients have expressed concern about the SEC's use of terms like “affiliate.”

“The SEC has been asked directly to provide further guidance, and they have declined,” she says. “They said it is their normal standard, which is really fuzzy.”

Lee says the reluctance to offer additional clarity ties to other recent activism-minded Congressional mandates.

“The SEC didn't go out to Congress and solicit this new authority and new thing to implement,” she says. “This is kind of an unfunded mandate for them, something Congress has forced upon them. They understand that companies have a lot of anxiety and uncertainty, but it is not their initiative and they have all the answers.”

Not everyone is as concerned by the terminology used. As one attorney recently put it, the definition of affiliate is “something lawyers have complained about for decades,” similar to never-to-be-resolved interpretations of what constitutes materiality.

Davis Polk partner Michael Kaplan says the SEC guidance uses the term “affiliate” as defined in the Exchange Act's Rule 12b-2.

“We are not surprised that the staff is not providing more guidance on the definition of affiliate aside from referencing Rule 12b-2,” he says. “Whether someone is an affiliate under this definition flows through other securities laws and market practice developed around this concept in other contexts, although it remains that a fact and circumstances analysis in each instance can be a difficult interpretive issue.”

A “large, multi-national issuer would have to analyze whether its related companies constitute ‘affiliates' for securities laws purposes, which may be time and resource intensive,” he says.

Another question companies are asking is what activities or products might trigger the need for disclosure, as any item could, in theory, be used for a weapon.

SEC CD&IS

The following are from Compliance and Disclosure Interpretations, published by the Securities and Exchange Commission on Dec. 4, that are related to new disclosure requirements in the Iran Threat Reduction and Syria Human Rights Act.

Question: Section 219(b) of the Iran Threat Reduction and Syria Human Rights Act of 2012, signed into law on Aug. 10, 2012, specifies that new Section 13(r) of the Exchange Act “shall take effect with respect to reports required to be filed with the Securities and Exchange Commission after the date that is 180 days after the date of the enactment of this Act,” which would be February 6, 2013. If an issuer's periodic report is required to be filed on a date after February 6, 2013 — such as, for example, the 2012 Form 10-K for calendar year filers — is the issuer required to disclose Iran-related business activities pursuant to Section 13(r) if it files the periodic report on or before February 6, 2013?

Answer: Yes. We interpret “reports required to be filed” to include any periodic report with a due date after February 6, 2013, regardless of when the report is actually filed. [Dec. 4, 2012]

Question: If an issuer's annual report is required to be filed after Feb. 6, 2013, must it include disclosure of activities specified in Section 13(r)(1) that occurred during the fiscal year but prior to enactment of the Iran Threat Reduction and Syria Human Rights Act of 2012 on Aug. 10, 2012?

Answer: Yes. An issuer is required to disclose activities specified in Section 13(r)(1) that occurred during the period covered by the report, which, for a Form 10-K, is the entire fiscal year. For example, an issuer that files an annual report for the fiscal year ending December 31, 2012 is required to disclose any activities specified in Section 13(r)(1) that took place between January 1, 2012 and December 31, 2012. [Dec. 4, 2012]

Question: Section 13(r) covers activities by an issuer “or any affiliate of the issuer.” How is the term “affiliate” defined for purposes of Section 13(r)?

Answer: The term “affiliate” in Section 13(r) is as defined in Exchange Act Rule 12b-2. [Dec. 4, 2012]

Question: If an issuer and its affiliates have not engaged in any of the activities specified in Section 13(r)(1) during the period covered by the report, must the issuer include a statement to that effect in its periodic report?

Answer: No. Disclosure is required only if the issuer or any of its affiliates engaged in any of the activities specified in Section 13(r)(1) during the period covered by the report. [Dec. 4, 2012]

Question: If an issuer includes disclosure responsive to Section 13(r) in a periodic report filed with the Commission, will the disclosure become public?

Answer: Yes. All periodic reports filed with the Commission are made public automatically upon filing through the Commission's EDGAR system. [Dec. 4, 2012]

Source: SEC.

With respect to the sale of seemingly mundane items, the issuer does not have to offer disclosure unless it “knew or should have known” that the person to whom it sold the items was likely to provide them to Iran and contribute materially to a weapons program, says Davis Polk attorney Jeanine McGuinness.  

“This determination by an issuer necessarily involves some judgment, but unless the issuer knew that its purchaser intended to ship the items to Iran and that they would be used to enhance Iran's military capabilities, it is not clear that the issuer would be required to disclose the transaction,” she says.

The “To-Do” List

To ensure compliance with the new disclosure rules, the first thing companies should do is take an inventory of all of their interests in companies worldwide, Lee says.

“Depending on the type of entity you are dealing with that could be easy or difficult,” she says. “If you have a huge multinational company they are going to have lots of tentacles all around the world, and private equity firms are going to have investments in companies all around the globe.”

A client advisory issued by her firm lists key actions companies should consider. Among them:

Establish control and disclosure procedures to detect and identify reportable activities so the company can demonstrate that it has taken reasonable efforts to comply with the requirements.

Designate a specific person with responsibility for compliance with the new requirements, and implement the procedures needed to maintain necessary records and answer questions.

Require employees worldwide to report activities potentially subject to disclosure or sanctions.

Review existing contracts and consider whether to run a search of the counterparties to the contracts or payments against the Specially Designated Nationals and Blocked Persons List maintained by Office of Foreign Assets Control of The Department of the Treasury.

Supplement the director and officer questionnaire with additional questions that help identify reportable activities.

Companies should act quickly to tackle these and other policies.

Catherine Dixon, a partner with the law firm Weil, Gotshal & Manges, notes that the new disclosure requirements apply to all of 2012 for a calendar year reporting company, according to the SEC Staff's Compliance and Disclosure Interpretations on new Section 13(r) of the Exchange Act.  

“Companies are going to have to look back at activities during a period when what they were doing wouldn't necessarily have been considered material and therefore subject to disclosure,” she says. “They are going to have to hurry up and do that before their 10k is due. This is not something like conflict minerals and resource extraction payment disclosures, which will not have to be made via new Form SD until 2014.  That said, affected companies will need to collect information for all of 2013 in the case of conflict minerals, and in the case of resource extraction payments beginning in late September 2013.”