SEC Proposes Conflict Minerals Disclosure Rules - Commodities/Derivatives/Stock Exchanges

The Securities and Exchange Commission, on December 15, 2010, published a release proposing new rules implementing disclosure requirements for reporting issuers that use conflict minerals originating in the Democratic Republic of the Congo or its adjoining countries. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd- Frank Act) requires the Commission to issue final rules regarding conflict minerals no later than April 15, 2011.

The proposed rules would require issuers to disclose their use of conflict minerals in their annual report on Form 10-K for a domestic issuer, Form 20-F for a foreign private issuer, and Form 40-F for an eligible Canadian issuer. The Commission is currently soliciting public comments on the proposed rules, which raises the possibility that certain aspects of the proposal could change prior to adoption of the final rules. The deadline for submitting comments is January 31, 2011. The Commission's proposal can be found at http://www.sec.gov/rules/proposed/2010/34-63547.pdf .

Conflict Minerals Provision of the Dodd-Frank Act

In an attempt to help curb the violence in the eastern Democratic Republic of the Congo, Congress included Section 1502 (the Conflict Minerals Provision) in the Dodd-Frank Act, which amended the Securities Exchange Act of 1934 (the Exchange Act) by adding Section 13(p). The Conflict Minerals Provision mandates the Securities and Exchange Commission to implement rules requiring any "person described" to "disclose annually" whether conflict minerals originating in the Democratic Republic of the Congo or an adjoining country (the DRC countries) are "necessary to the functionality or production of a product manufactured by that person."

Conflict minerals are used by a surprisingly large number of companies across a wide range of industries. Section 1502(e)(4) of the provision defines conflict minerals as cassiterite (the ore from which tin is extracted), columbite-tantalite (the ore from which tantalum is extracted), gold, wolframite (the ore from which tungsten is extracted), their derivatives, or any other minerals or their derivatives determined by the Secretary of State to be financing conflict in the DRC countries. These minerals are used in the production of countless products, including jewelry, cell phones, computers, video game consoles, digital cameras, solder and metal wires. As a result, the disclosure requirements set forth in the proposed rules have the potential to affect a greater number of reporting issuers than one might initially assume.

Under the statutory provision, if the conflict minerals originated in DRC countries, a described person must issue a report (the Conflict Minerals Report) that includes a description of the measures taken to exercise due diligence on the source and chain of custody of the minerals -- including a certified independent private sector audit -- and a description of the products manufactured or contracted to be manufactured that are not "DRC conflict free." "DRC conflict free" is defined as products that do not contain minerals that "directly or indirectly finance or benefit armed groups in DRC countries."

Overview of the Release

In order to implement the Conflict Minerals Provision, the Commission unanimously voted to propose rules establishing a three-step disclosure requirement:

First, the issuer would be required to determine whether it is subject to the Conflict Minerals Provision as a person for whom "conflict minerals are necessary to the functionality or production of a product manufactured by the person;"

Second, an issuer subject to the provision would be required to conduct a reasonable country of origin inquiry in order to determine whether its conflict minerals originated in the DRC countries, and disclose the results of the inquiry in its annual report;

Third, an issuer with conflict minerals that originated in the DRC countries, or an issuer that is unable to conclude its conflict minerals did not originate in the DRC countries, would be required to furnish a separate Conflict Minerals Report as an exhibit to its annual report. In the report, the issuer would be required to provide a description of its products containing conflict minerals that the issuer was unable to determine did not "directly or indirectly finance or benefit armed groups" in DRC countries.

Step 1—Determine if the Issuer is Covered by the Conflict Minerals Provision

The proposed rules would only affect public companies that use conflict minerals in their manufacturing process. The Conflict Minerals Provision covers "any person described" for whom "conflict minerals are necessary to the functionality or production of a product manufactured by such person." In its proposal, the Commission chose not to extend the statutory provision to every company. Rather, under the proposed rules, the Conflict Minerals Provision would only apply to an issuer if:

The issuer files reports with the SEC under Section 13(a) or Section 15(d) of the Exchange Act; and

Conflict minerals are "necessary to the functionality or production" of a product manufactured or contracted to be manufactured by the issuer.

Even though the language of the provision could have been interpreted broadly to apply to a wide range of private companies, the Commission has proposed to limit its application to reporting issuers. The Commission did not, however, include in the proposal exemptions for foreign issuers or smaller reporting companies, as it has done with other disclosure rules.

The Commission's proposed rules would not require all reporting issuers to make disclosure regarding their use of conflict minerals. The proposed rules would only apply to reporting issuers for whom "conflict minerals are necessary to the functionality or production of a product" manufactured or contracted to be manufactured by the issuer. The Commission chose not to define the term "manufacture," concluding that the term is generally understood.

According to the release, an issuer would be considered to have "contracted to manufacture" if it either has "any influence over the manufacturing of those products," or it sells "generic products under its own brand name or a separate brand name, regardless of whether it has any influence over the manufacturing specifications of the product," provided the issuer has contracted to have the product manufactured specifically for itself. In the release, the Commission made clear that the proposed rules would not apply to sales by a retail issuer of products manufactured by third parties if: (i) the retailer has no contract or other involvement regarding the manufacturing of the products; or (ii) the retailer does not sell the products under the retailer's brand name -- or a separate brand the retailer has established -- and does not have the products manufactured specifically for the retailer. As a result, if the rules are adopted as proposed, a retailer that is a public company will need to carefully scrutinize all of its store brand products to determine whether the retailer has contracted with a third party to have the products manufactured specifically for the retailer and, if so, whether those products contain conflict minerals.

While the Commission also chose not to define "necessary to the functionality or production," the Commission did offer some guidance as to when a mineral would be considered "necessary." According to the release, if a mineral is necessary the product would be covered without regard to the amount of the mineral involved. The Commission also stated that the proposed rules would apply to products where the conflict mineral is intentionally included in the product's production process and is necessary to that process, regardless of whether the conflict material is ultimately included in the final product. The issuer's use of a tool, however, that contains conflict minerals during the production process would not constitute "necessary to the functionality or production" of the product and would not need to be disclosed under the proposed rules.

An issuer that is not covered -- either because it is not a reporting issuer or because it does not use conflict minerals in its manufacturing process -- would not need to take any action, make any disclosure, or submit any reports under the proposed rules. On the other hand, an issuer that meets both conditions would move to the second step of the proposed rules.

Step 2—Conduct a Reasonable Country of Origin Inquiry and Disclose the Results

If conflict minerals are necessary to the functionality or production of a reporting issuer's products, then the issuer would be required to conduct a reasonable country of origin inquiry to determine whether the conflict minerals originated in the DRC countries. The proposed rules do not set forth what constitutes a reasonable country of origin inquiry.

According to the release, "the reliability of any inquiry would be based solely on whether the information used provides a reasonable basis for an issuer to trace the origins of the conflict minerals it uses." The Commission did note, however, that receiving reasonably reliable country of origin representations from the facility at which the conflict minerals were processed would satisfy the reasonable inquiry standard.

Under the Commission's proposal, an issuer that concludes its conflict minerals did not originate in the DRC countries would be required to disclose this determination and describe the reasonable country of origin inquiry process it used in reaching this determination in the body of its annual report under a separate heading entitled "Conflict Minerals Disclosure." The issuer would also be required to:

Make the disclosure regarding this determination available on its website;

Provide the Internet address of that site in its annual report and keep the disclosure posted on the website at least until it files a subsequent annual report; and

Maintain reviewable business records to support its determination that the conflict minerals did not originate in the DRC countries.

The issuer would not be required to make any further disclosures regarding its conflict minerals that did not originate in the DRC countries.

An issuer that concludes its conflict minerals did originate in the DRC countries, or that is unable to conclude its conflict minerals did not originate in the DRC countries, would be required to:

Disclose this conclusion in its annual report under a separate heading entitled "Conflict Minerals Disclosure" and note that the Conflict Minerals Report is furnished as an exhibit to the annual report;

Furnish the Conflict Minerals Report as an exhibit to the annual report and make the report publicly available on its website at least until it files a subsequent annual report; and

Provide the Internet address of that site in its annual report.

The issuer would not, however, be required to make any disclosures with regard to its conflict minerals in the body of its annual report. Posting the Conflict Minerals Report on its website is all the proposed rules require.

Step 3—Conflict Minerals Report's Content and Supply Chain Due Diligence

An issuer that determined its conflict minerals originated in DRC countries, or that is unable to conclude its conflict minerals did not originate in the DRC countries, would be required to furnish a Conflict Minerals Report as an exhibit to its annual report. In preparing the report, the issuer would be required to exercise due diligence on the source and chain of custody of the conflict minerals to determine whether these minerals directly or indirectly finance or benefit armed groups in DRC countries. The Commission declined to elaborate on the measures that would constitute due diligence, except to pronounce that these measures must include an independent private sector audit of the Conflict Minerals Report.

Those products containing conflict minerals that do not directly or indirectly finance or benefit armed groups in DRC countries would be considered "DRC conflict free." The Conflict Minerals Report for an issuer that is able to determine, after exercising due diligence, that its products are "DRC conflict free" would only need to include:

A description of the due diligence exercised;

A certification by the issuer that it obtained an independent private sector audit; and

An audit report prepared by the independent private sector auditor, which must include the auditor's identity.

In addition to the items listed above, the Conflict Minerals Report for an issuer that is unable to determine that its products are DRC conflict free would need to include:

A description of each product that is not "DRC conflict free," as well as descriptions of the facilities used to process those conflict minerals, the country of origin of those conflict minerals, and the efforts taken to determine the mine or location of the mineral's origin with the greatest possible specificity.

In its release, the Commission recognized that an issuer that is required to file a Conflict Minerals Report because it is unable to determine that its conflict minerals did not originate in the DRC countries may not be able to determine whether any of its products are or are not "DRC conflict free." Under these circumstances, the issuer would still need to identify its products as not "DRC conflict free" and provide the required disclosure to the extent the information is known. The issuer could, however, choose to include additional disclosure explaining that the products were labeled as not "DRC conflict free" because it was unable to determine the source of the conflict minerals, and therefore, could not determine whether the conflict minerals benefitted or financed armed groups in the DRC countries.

Note on Recycled Conflict Minerals

Under the proposal, products using conflict minerals that an issuer obtains from "recycled or scrap" sources would also be considered "DRC conflict free," although the proposed rules do not define when a conflict mineral is from a recycled or scrap source. Instead, an issuer seeking to label its products as "DRC conflict free" under this approach would need to provide its reasons for believing that its conflict minerals are from recycled or scrap sources. The release does offer some guidance as to what would be acceptable. According to the release, the Commission would consider conflict minerals recycled if they are "reclaimed end-user or post-consumer products," but not if the minerals are "partially processed, unprocessed, or a byproduct from another ore."

If the issuer's conflict minerals were obtained from recycled or scrap sources, the issuer would be required to disclose this information in its annual report and explain that the Conflict Minerals Report is attached as an exhibit. The Conflict Minerals Report should indicate that the recycled or scrap minerals are considered "DRC conflict free" and describe the due diligence exercised in reaching the determination that the minerals were obtained from recycled or scrap sources. The Conflict Minerals Report would not need to include a description of these products or disclose information regarding the minerals' origin.

Conclusion

The Conflict Minerals Provision requires issuers to provide their initial conflict minerals disclosure and, if necessary, their initial Conflict Minerals Report after the first full fiscal year following the promulgation of the final rules. An issuer that fails to comply with final rules would not satisfy the Conflict Minerals Provision and would therefore be subject to liability for violations under Sections 13(a) or 15(d) of the Exchange Act. Because the Commission is required to adopt final rules by April 2011, calendar-year end issuers will be required to include this disclosure in their annual reports for their 2012 fiscal years. While the comments currently being solicited by the Commission may cause the final rules to differ from the proposal in certain respects, we generally expect the disclosure requirements to remain largely as proposed. Therefore, reporting issuers should begin preparing for their initial disclosure by reviewing their use of conflict minerals and evaluating the supply chains of those minerals to determine their origins.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

United States: SEC Proposes Conflict Minerals Disclosure Rules