Conflicts Start Early on Minerals Rule; 'Absolutely Insane'

The intent may be noble, but the new rule enacted by the Securities and Exchange Commission mandating disclosure of “conflict minerals” in a company's supply chain is likely to be an expensive, frustrating compliance challenge for years to come.

The SEC approved the rule on Aug. 22 by a 3-2 vote, as required by Section 1502of the Dodd-Frank Act. It will require a large swath of Corporate America to disclosure the use of several minerals mined in the Democratic Republic of Congo and adjoining countries and often used to finance militia groups there.

The final rule applies to public companies that use four specific minerals—tantalum, tin, gold, or tungsten—where the minerals are “necessary to the functionality or production” of an item the company either makes itself, or contracts a third party to make on its behalf. Companies will need to conduct “a reasonable inquiry” into the origins of those minerals, and disclose any use of them on a new Exchange Act filing, Form SD.

Companies must compile data every calendar year starting Jan. 1, 2013, and file their first Form SD by May 31, 2014. Required due diligence will include an audit of the conflict minerals report.

Compliance experts immediately panned the rule as impractical. Typical were the comments of Sanjay Shirodkar, counsel at the law firm at DLA Piper: “If you look at a large-cap company that might have 1,000 or more products that are impacted, the breadth of what they have to undertake is absolutely insane.”

The SEC did give filers some breathing room, but not much. For the first two years of compliance (or four years for smaller reporting companies), if a company can't pinpoint whether any conflict minerals in its supply chain somehow helped finance militia groups, those products can be considered “DRC conflict undeterminable.”

Still, the SEC estimates that the rule will affect as many as 6,000 listed companies, both foreign and domestic. Private businesses might also be pulled into the rule's orbit if they are suppliers to SEC-registered companies. And the rule includes no de minimus exception (neither did the original language from Congress), so even if a product might have only trace amounts of conflict minerals, a company must comply with the rule.

The SEC did retreat from an earlier proposal that would have required all businesses to determine their exposure conflict minerals, including those that don't actually manufacture the products they sell. That should exempt retailers from the scope of the rule—and businesses like Walmart, Target, and other retail chains did lobby fiercely to achieve precisely that aim.

But the final rule does require filings from businesses that have “any influence over manufacturing.” What does that phrase mean? “Nobody—including the SEC—really knows,” says Markus Funk, a partner at law firm Perkins Coie.

Another fear is that the conflict mineral rule forces the SEC to impose oversight over social policy and supply chain management—two subjects far removed from the agency's typical purview of financial reporting and investor protection.

“The SEC now expects companies to deploy lawyers, investigators, and auditors to dig through layers upon layers of suppliers and sub-suppliers,” Funk says. “It doesn't matter whether the suppliers and network of sub-suppliers are privately held or state-owned enterprises, how big and sophisticated they are, or where in the world they are located.”

Funk notes that the SEC's initial compliance cost estimate of $71 million “was off by over 5,600 percent.” (The agency later raised its estimate to at least $3 billion.) He suspects even the $3 billion figure is too low.

Costs, Benefits, and Enforcement

Jane Luxton, an environmental lawyer at law firm Pepper Hamilton, says the cost-benefit analysis for the rule is unique because while corporations will bear all the costs, the benefits flow to foreign policy and humanitarian objectives. Those benefits, while laudable, are not necessarily a corporation's responsibility.

“With new rules such as this, it's always unclear what the sanctions for non-compliance would be.”

—Michael Littenberg,

Partner,

Schulte Roth & Zabel

That reality may provide “a fair amount of ammunition for people who want to challenge the rule,” she says, especially since the SEC already lost in court in 2011 when a federal appeals court found that the agency did not do sufficient cost-benefit analysis of a rule to require shareholder access to the proxy statement. (The usual candidates for suing the SEC, the U.S. Chamber of Commerce, and the Business Roundtable, so far have not formally said whether they plan to do so.)

The full text of the rule runs more than 500 pages. Corporate lawyers immediately started delving into it, looking for answers to lingering questions. One top priority: the penalties for non-compliance.

“With new rules such as this, it's always unclear what the sanctions for non-compliance would be,” says Michael Littenberg, a partner at law firm Schulte Roth & Zabel. They agency will need to distinguish between deliberate non-compliance (say, refusing to file a Form SD or knowingly including false information in one), versus an issuer “who is coming to grips with a new rule, and maybe its disclosures just aren't as complete as they should be or it just couldn't gather the information they needed, but tried in good faith.”

JUST THE FACTS

The following is a selection from a “fact sheet” issued by the SEC on a new rule mandating disclosure of the use of “conflict minerals.”

The RuleThe final rule applies to a company that uses minerals including tantalum, tin, gold or tungsten if:

The company files reports with the SEC under the Exchange Act.

The minerals are “necessary to the functionality or production” of a product manufactured or contracted to be manufactured by the company.

The final rule requires a company to provide the disclosure on a new form to be filed with the SEC (Form SD).

Contracting to Manufacture:

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 requirements apply equally to domestic and foreign issuers.

Determining Whether Conflict Minerals Originated in the DRC or Other Covered Countries:

Under the final rule, a company that uses any of the designated minerals is required to conduct a reasonable ‘country of origin' inquiry that must be performed in good faith and be reasonably designed to determine whether any of its minerals originated in the covered countries or are from scrap or recycled sources.

The company also is required to:

Make its description publicly available on its Internet Website.

Provide the Internet address of that site in the Form SD.

DRC Conflict Free

If a company determines that its products are “DRC conflict free” then the company must:

Obtain an independent private sector audit of its Conflict Minerals Report

Include the audit report as part of the Conflict Minerals Report

Not Been Found to Be “DRC Conflict Free”

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

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.

DRC Conflict Undeterminable

For a temporary two-year period (or four-year period for smaller reporting companies), 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.”

Source: SEC.

Another question: Technically, Congress created the conflict mineral rule by amending the Securities Exchange Act. Therefore that might expose companies to various remedies already allowed under the Exchange Act, including private lawsuits.

“I'm sure that's going to be debated for a long time until somebody tests it,” says Mike Hermsen, a partner with Mayer Brown and former SEC staff attorney.

Much of the fine print in the rule focuses on highly technical matters—processes that, Funk says, “unless you know your production or metallurgist or an engineer, you wouldn't even begin to think about.”

“Companies are going to be figuring their way around in the dark for some time,” Littenberg says. “There certainly are some companies, particularly larger ones, that have been pretty proactive on supply chain management issues around the use of conflict minerals, even before the rule was proposed. But for the vast majority of companies out there, [the new rule] was really the equivalent of having a bucket of cold water dumped on their head.”

So what now? Littenberg offers a few steps for companies as they prepare:

·         Create an internal conflict minerals compliance team with voices from manufacturing, engineering, procurement, finance, and legal.

·         Study the Organization for Economic Co-operation and Development's framework for due diligence on conflict minerals; other non-governmental organizations have guidance as well.

·         Build a work plan, timeline, and budget for compliance. Assemble a database of supplier personnel that should receive conflict minerals compliance materials.

·         Send an initial written communication to suppliers educating them on the final rule and your company's compliance obligations. Develop questionnaires and certifications for suppliers and determine any additional supplier documentation, due diligence, and compliance requirements.

·         Develop a risk-management plan that includes procedures for suspending or terminating suppliers that ignore or disobey your procurement policies, and line up alternative sources for conflict minerals.

Luxton will be watching to see if other social agenda matters find themselves grafted onto the SEC now that a precedent has been set. Section 1502 of the Dodd-Frank Act may be starting with only four minerals in Central Africa, but it allows the Secretary of State to designate additional countries and minerals.

She points to California's Supply Chain Transparency Act, which went into effect in that state at the beginning of 2012. It requires disclosures on human trafficking and slavery for companies with $100 million in global sales if they employ even a single worker in California.

“Now that this vehicle exists [with the SEC], whatever popular concern that comes along could be plugged in,” she says. “It is wide open when you look at the possibilities.”