Why the SEC’s New Conflict Minerals Rules Scare Me (And Why They Should Scare You)

You’ve probably seen a number of articles addressing the SEC’s new disclosure requirements relating to conflict minerals, implemented pursuant to Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Although the basics are deceptively simple, once you dig a little deeper, you realize there’s a lot hidden beneath surface. I’ve listed some of the top concerns below, followed by a summary of each and a description of the basics of the SEC’s final rule:

  • The Rule May Apply to You Even Though You’re Certain That It Doesn’t
  • This is not Your Typical Disclosure Rule—Conflict Minerals are Now Potentially Per Se Material
  • You Will Need a Team of Employees and/or Consultants from a Cross-Section of the Organization to Comply with the Rule
  • Unless You Have Absolutely No Products to Which the Rule Applies, You Will Have to Develop and Make Public a Conflict Minerals Policy
  • Compliance is Going to be Expensive
  • There are Things You Can Do Now to Avoid Application of the Rule or to Lessen the Costs of Compliance with it, But Time is Running Out
  • Although Requirements are Relaxed During a Phase-In Period, Audits May Still be Required with Respect to the First Report Due for Calendar 2013
  • Form SD and the Conflict Minerals Report Are Filed, Not Furnished.

The Basics

  • Conflict minerals are currently defined to be, in simplest terms, gold, tin, tantalum and tungsten.
  • The SEC rule applies to issuers (“covered issuers”) registered under the Securities Exchange Act of 1934 that manufacture or contract to manufacture products that contain conflict minerals that are necessary to their functionality or production.
  • Covered issuers must initially conduct a “reasonable country of origin inquiry” to determine if the conflict minerals originated in The Democratic Republic of the Congo or adjoining countries or came from scrap or recycled sources.
  • If, following such inquiry, the issuer has reason to believe that its conflict minerals may have originated in the covered countries and may not have come from scrap or recycled sources, the issuer must conduct due diligence on the source and chain of custody of its conflict minerals.
  • All covered issuers must file a Report on Form SD, and depending upon the results of the above inquiry/due diligence, covered issuers will be required to include a conflict minerals report containing additional, more detailed information. All filed information must be posted on the issuer’s website, as well.
  • Those issuers required to perform due diligence will be required to represent whether their covered products are or are not “DRC conflict free,” or for a limited two-year period (four years for small business issuers), are “DRC conflict undeterminable.” The final rule defines a “DRC conflict free” product to mean a product that does not contain conflict minerals necessary to the functionality or production of the product that directly or indirectly finance or benefit defined armed groups in the covered countries.
  • Again, depending on the results, those issuers conducting due diligence may be required to have an independent auditor audit whether their due diligence efforts were in conformity with, in all material respects, the criteria set forth in the due diligence framework utilized, and whether the issuer’s description of the due diligence measures it performed is consistent with the due diligence process it undertook.
  • These reporting requirements become effective for the calendar year 2013, with the first reports due to be filed on May 31, 2014.

The Concerns

  • The Rule May Apply to You Even Though You’re Certain That It Doesn’t

The conflict minerals rule does not define the terms “product,” “manufacture,” “contract to manufacture,” “necessary to the functionality” or “necessary to the production.” As a result, a number of key interpretive questions remain unanswered. For example, if you sell tomato soup, is your product the soup or is it a (tin) can of soup? The answer is obviously very important in determining whether or not your product contains conflict minerals. Taking the question further, if you produce a decorative holiday package for your product, such as a collector’s tin of cookies, could that change the answer and possibly cause the package to become the product? In addition, if you’re a wholesaler that simply resells products, you could be covered to the extent that you exercise control over the manufacturing process. How much control is enough? The final release says that whether an issuer is deemed to contract to manufacture a product depends on (i) whether the issuer exerts “some actual influence” over the manufacturing of the product and (ii) the degree of influence that it exercises over the parts, materials, ingredients or components of a product. The degree of influence required will depend on the issuer’s individual facts and circumstances. Taking the soup example, if the issuer exercises control over the quality of the soup, but not the can, could that be enough to subject the issuer to the rule? The final release notes that the degree of control that is sufficient to subject an issuer to the rule does not have to be “substantial.” Hopefully, some of these interpretive issues will be addressed by the SEC staff, but most issuers can’t wait until the interpretations are published to start thinking about these issues. Those that do may find that they’ve missed an opportunity to take proactive action now, as discussed further below.

  • This is not Your Typical Disclosure Rule—Conflict Minerals are Now Potentially Per Se Material

Most disclosure rules are designed to elicit information that is important to investors in making decisions about whether to buy or sell an issuer’s securities or whether to vote their shares, generally based on financial, executive compensation and corporate governance-related information. The conflict minerals rule is designed with one purpose in mind: to help dissuade issuers from making business decisions (i.e., the purchase of conflict minerals) that will result in money being funneled to support armed groups that are perpetrators of human rights abuses in the covered countries, and as a result, to further the humanitarian goal of ending the violent conflict in those countries. To the extent investors do care about an issuer’s use of conflict minerals, it is likely to be for these humanitarian reasons, and not for the reasons investors typically evaluate an issuer’s performance. As a result, the conflict minerals rules may result in significant expenditures as well as management time and effort being directed towards an area that an issuer’s investors may not find of particular concern or interest and which may only relate to a very small portion of the issuer’s business. There is no de minimis exception of any type to this rule. For some companies, it is possible that the cost of complying with the rule could exceed the profits or even the revenues from covered products. Despite the fact that conflict minerals impact a small, seemingly immaterial portion of an issuer’s business, that does not mean that the issuer will not be required to devote a material amount of money and management time to investigating the applicability of and complying with the rule.

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