Conflict Minerals Rules: How Should Companies Start Approaching This Development?

Now that the SEC has, at long last, adopted the conflict mineral disclosure rules required by Section 1502 of the Dodd-Frank Act, many companies are asking about the impact of the rules on them and what new disclosures will be required. The SEC estimates that about 6,000 companies that file reports with the SEC under the Securities Exchange Act of 1934 (the "Exchange Act") will need to conduct some diligence in response to the new rules and file a new special disclosure form ("Form SD"), and it is anticipated that about 75 percent of these companies will need to prepare a conflict minerals report (a "CMR"). Although Form SD will not be required for every public company, now is the time that companies should analyze whether additional disclosure will be required and, if so, start thinking about the next steps.

Below are five common questions that companies may have about the new disclosure requirements:

1.  Will the Conflict Mineral Rules Apply to My Company?

The conflict mineral rules apply to a company that uses "conflict minerals" if it files reports with the SEC under the Exchange Act and if such minerals are "necessary to the functionality or production" of a product manufactured "or contracted to be manufactured"  by the company. So, companies that do not file reports under the Exchange Act or that do not manufacture or contract to manufacture products are exempt from the rules.

A.     What are the conflict minerals?

The conflict minerals are cassiterite, columbite-tantalite, gold, and wolframite.  They are more commonly known by their derivatives—tin, tantalum, gold, and tungsten, respectively, or by the shorthand Three T's and a G.

B.     What does it mean to be "contracted to be manufactured?"

The SEC refused to define the term "contracted to be manufactured" because they felt the concept is "intuitive at a basic level." The rule release provides that in general, the question of whether a company contracts to manufacture a product depends on the degree of influence exercised by the issuer on the manufacturing of the product based on the individual facts and circumstances surrounding an issuer's business and industry. The SEC did give some guidance as to situations it would not regard as instances of contracting to manufacture. Those include situations that involve only:

• Specifying or negotiating contractual terms with a manufacturer that do not directly relate to the manufacturing of the product;
• Affixing a company's brand, marks, logo, or label to a generic product manufactured by a third party; or
• Servicing, maintaining, or repairing a product manufactured by a third party.

C.     What does it mean to be "necessary to the functionality or production?"

 Similarly, the SEC specifically declined to define the term "necessary to the functionality or production." In determining whether conflict minerals are necessary to the functionality or production of a product, the rule release advises companies to consider the following factors:

• Whether a conflict mineral is contained in and intentionally added to the product or any component of the product and is not a naturally occurring by-product;
• Whether a conflict mineral is necessary to the product's general expected function, use or purposes; and,
• If a conflict mineral is incorporated for purposes of ornamentation, decoration, or embellishment, whether the primary purpose of the product is ornamentation or decoration.

There is no de minimus exception to the rules. If any amounts of conflict minerals are necessary to the functionality or production of a product manufactured or contracted to be manufactured by the company, a reasonable country-of-origin inquiry, as described below, needs to be conducted.

Although the conflict mineral rules do not apply to private companies, private companies who supply products to public companies should be aware of the potential impact of the rules on their customers, who may request certifications regarding product sourcing for their own due diligence.

2.  What Should My Company Do Now If the Conflict Rules Apply?

If you have determined that conflict minerals are necessary to the production or functionality of a product your company makes or contracts to make, you need to conduct a reasonable country-of-origin inquiry ("RCOI") to determine whether the conflict minerals come from the Democratic Republic of Congo or an adjoining country (Angola, Burundi, Central African Republic, The Republic of the Congo, Rwanda, South Sudan, Tanzania, Uganda or Zambia) (collectively, the "DRC countries"). Under the rule, the company's RCOI must be:

• Conducted in good faith and
• Reasonably designed to determine whether the issuer's conflict  minerals originated in the DRC countries or are from recycled or scrap resources.
• A company does not need to perform addition due diligence if, based on its RCOI:
• It determines that its conflict minerals originated outside the covered countries or came from recycled or scrap sources; or
• It has no reason to believe that its conflict minerals may have originated in a covered country, or it reasonably believes that its conflict minerals are from recycled or scrap sources.

In those cases, it must file a Form SD, as discussed below.

If you determine, based on the RCOI inquiry, that your conflict minerals have come from one of the DRC countries, then the company will have to do more detailed due diligence following a nationally or internationally recognized framework. At present, it appears that the only nationally or internationally recognized due diligence framework available is the due diligence guidance approved by the Organisation for Economic Co-operation and Development ("OECD").

Therefore, companies that suspect that they will be subject to the rule should:

• Consider creating a conflict minerals compliance committee, which can be a subcommittee of the disclosure committee, but should include members of the operations team;
• Begin to assess which products may be implicated by the rules;
• Become familiar with the OECD due diligence guidance;
• Assemble information about suppliers;
• Develop a plan for contacting suppliers; and
• Discuss whether to engage outside consultants and coordinate with their financial auditors whether they will be able to audit the CMR, which is described below.  

3.  What Will My Company Be Required to Report? 

Assuming that you conclude, after the detailed due diligence described above, that your conflict minerals originated (or may have originated) in one of the DRC countries and are not from recycled or scrap sources, your company will need to file a CMR on a Form SD. 

The three-part CMR will be an exhibit to the Form SD and will also need to be made publicly available on your website. The first part of the CMR will contain details related to your due diligence inquiry, including details on the source and the chain of custody. This is the only part of the CMR required to be audited by an independent private sector auditor. The independent auditor has to conclude that the diligence measures disclosed in your CMR conform to a national or international standard and that the diligence measures described in your CMR were actually undertaken by your company. The second part of your CMR must include a description of any products that are not found to be "DRC conflict free." While the SEC did not specify what this description should look like, we expect that most companies will probably list products or components or products which have not been found to be "DRC conflict free." The third part of your CMR must describe the smelter or refiner used to process the conflict minerals, the country of origin of the minerals and the efforts to determine the mine or location of origin with the greatest possible specificity. 

Given the difficulty in determining whether a product is "DRC conflict free," the SEC has provided an interim phase-in period of four years for smaller reporting companies and two years for all other companies. During this time, an issuer may classify its products as "DRC conflict undeterminable." An issuer can take advantage of this designation during the interim period if it cannot determine the source after supply chain diligence, and it will not be required to have the audit report in the CMR cover any such products. Companies that wish to take advantage of this temporary relief still must prepare and file a CMR and disclose the steps taken to mitigate risks that the conflict minerals benefit armed groups, including any steps to improve due diligence. Given this, the interim phase-in period does not mean that companies can avoid having to think about compliance for either two or four years.

The Form SD and any exhibits (including the CMR) will be filed, not furnished, for purposes of the Exchange Act. However, these documents will not be automatically incorporated by reference into registration statements under the Securities Act of 1933. A Form SD will be required to be signed by an executive officer of an issuer, but will not be subject to the CEO/CFO certifications. As a practical matter, you should consider which of your employees will be charged with this diligence and which executive officer will execute the Form SD.  

In addition to reporting obligations under Form SD, you should also think about whether it makes sense to include a risk factor in your next periodic report under the Exchange Act. In drafting any such risk factor, you should focus on the risk you are trying to convey, such as the cost of compliance or increased sourcing costs in the event that your company will decide to use alternative sourcing. While documenting increased risk factors might be a good idea for many companies that are subject to the rule, the disclosure should put the risk in appropriate context for the investor to assess its significance. As always, a description of any risk factors should be tailored and not boilerplate.

4.  When Will Form SD Be Due?

Companies must comply with the final rule for the calendar year beginning January 1, 2013, with the first reports due on or before May 31, 2014. All companies must report on a calendar-year basis instead of an issuer's fiscal-year basis, as proposed. 

Conflict minerals that are "outside the supply chain" before January 31, 2013, are exempt. This means that minerals that are smelted or refined or are outside of the covered countries before this date do not need to be covered in an issuer's first report.

In addition, there is a permanent transition period for companies that acquire a non-reporting, private company. For any such acquisition, reporting is not required until the end of the first reporting calendar year that begins not less than eight months following the acquisition.

5.  What Additional Costs Can My Company Expect? 

This is still a big question mark. The SEC's adopting release estimates that the initial industry-wide cost to companies of implementing the conflict minerals rule would be around $3 billion to $4 billion. The annual cost could run between $207 million and $609 million, including expenses for due diligence and investigations to determine the origin of the materials.

For your company, you should start thinking about the external and internal costs that will be required in creating an internal compliance team and drafting policies, questionnaires and supplier contract provisions as outlined above. In addition, you might also think about whether additional internal hires might be needed to manage this process.

With respect to the costs of due diligence and an independent private sector audit, if required, there are still some uncertainties. As noted above, at present there is only one nationally or internationally recognized framework for more detailed due diligence, and the requirements of the OECD framework are extensive. In terms of the private sector audit, while some companies may choose to use their existing independent auditor, it is likely that there may be some other types of private sector auditors that may offer this service, since the nature of this audit does not require a PCAOB firm. While it may be too early to engage these professionals, the time is right to start planning for the new rules and the increased costs they are sure to require.