United States: Broad Reach Of SEC’s Conflict Mineral Rules Affects Many Public Companies In The Consumer Product Industry

The Securities and Exchange Commission's conflict mineral rules adopted in August 2012 have been a topic of hot debate among not only manufacturing industry groups, but also retail industry groups, given the extensive conflict mineral diligence obligations imposed on public companies in the manufacturing and retail sectors.

The rules affect a wide range of consumer industries, including electronics, automotive, and jewelry. In addition, although many retailers are not covered by the rules, those retailers that exert some influence over the manufacturing process of the products they sell, such as by identifying the materials, parts or components to be included in the product, may be covered by the rules.

The SEC's conflict mineral rules were upheld by the U.S. District Court for the District of Columbia in July 2013 following a challenge to the rules by the National Association of Manufacturers, The Business Roundtable and the U.S. Chamber of Commerce. The plaintiffs appealed this decision and oral arguments for this case were held in January 2014, but it is not clear whether the court will reach its decision before the upcoming filing deadline for disclosures relating to the conflict mineral rules. We have provided below an overview of the rules as well as general guidance regarding compliance with the new rules. However, the rules are fairly unusual and complex and a number of aspects of the rules remain unclear, as discussed further below.

BACKGROUND ON THE CONFLICT MINERAL RULES

The rules require public companies to annually disclose information about their use of specific "conflict minerals" originating in the "Covered Countries." The "conflict minerals" are gold, columbite-tantalite (coltan), cassiterite, and wolframite (including their derivatives, tantalum, tin and tungsten). The "Covered Countries" are the Democratic Republic of the Congo, Republic of the Congo, Central African Republic, South Sudan, Uganda, Rwanda, Burundi, Tanzania, Zambia and Angola.

THREE-STEP COMPLIANCE PROCESS

The SEC's conflict mineral rules envision a three-step compliance process:

  1. First, a company must determine whether it is covered by the rules with respect to its use of conflict minerals.
  2. Second, a company that is covered by the conflict mineral rules must conduct a "reasonable country of origin inquiry" designed to determine if the conflict minerals originated in the Covered Countries or are from recycled or scrap sources.
  3. Third, a company that determines that its conflict minerals originated in the Covered Countries and are not from recycled or scrap sources (or has reason to believe that its conflict minerals may have originated in the Covered Countries and may not be from recycled or scrap sources) must exercise due diligence on the source and chain of custody of its conflict minerals. The company also may need to file a Conflict Minerals Report, as discussed further below.

Public disclosures by companies that are covered by the rules will be made using the new SEC Form SD. The first Form SD disclosure is required to be made with the SEC on May 31, 2014. The disclosure in the form will cover the calendar year beginning January 1, 2013. For each subsequent year, the Form SD will need to be filed by May 31 with respect to the prior calendar year.

Step 1 – Determining Whether a Company is Covered by the Rules.

A public company will be covered by the rules if conflict minerals are (1) "necessary to the functionality" or production of (2) a "product" (3) that is manufactured by the company or "contracted to be manufactured" by the company.

A. "Necessary to the functionality" of the product or production.

The SEC has provided certain factors that companies should consider in determining whether a conflict mineral is necessary to the functionality of a product, such as:

  • 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 generally expected function, use, or purpose; 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.

The SEC has also provided the following factors that companies should consider in determining whether a conflict mineral is necessary to the production of a product:

  • whether the conflict mineral is intentionally included in the product's production process, other than if it is included in a tool, machine or equipment used to product the product;
  • whether the conflict mineral is included in the product; and
  • whether the conflict mineral is necessary to product the product.

B. Meaning of "product."

The rules do not directly address the question of what constitutes a product. However, the SEC has stated that in order to be a product, it must be an item that enters the stream of commerce by being offered to third parties for consideration.

C. Whether a company "manufactures" or "contracts to manufacture" a product or component.

There is no definition in the rules of the term "manufacture," because the SEC believes that the meaning of this term is generally understood. The SEC has stated that a company is not considered to have manufactured a product if it only services, maintains or repairs a product. Whether a product is "contracted to be manufactured" by a company depends on the degree of influence the company exercises over the manufacturing of the product. This would include the company's influence over the materials or components to be included in the product. Whether a company exercises influence over the manufacturing of a product for purposes of the conflict mineral rules will be a fact-intensive analysis. Accordingly, this portion of the rule may apply to many retailers who exert some influence over aspects of the manufacturing process of the products they sell.

The SEC has made clear that in order to be covered by the rules, a company must have some actual influence over the manufacturing of the product. The SEC has further stated that a company should not be viewed as "contracting to manufacture" a product if it does no more than:

  • specify or negotiate contractual terms that do not directly relate to the manufacturing of the product;
  • affix its brand, marks, logo or label to a generic product manufactured by a third party; or
  • service, maintain or repair a product manufactured by a third party.

Step 2 – Reasonable Country of Origin Inquiry.

If a company determines that it is covered by the rules, it must conduct a "reasonable country of origin inquiry." This inquiry must be designed to determine if conflict minerals originated in the Covered Countries or come from recycled or scrap sources.

The rules do not provide the steps a company should follow to meet the reasonable country of origin inquiry requirement. However, the SEC has stated that one method of meeting the reasonable country of origin inquiry requirements would be to follow the "supplier engagement" approach in the OECD Due Diligence Guidance, which contemplates that a company would engage with the suppliers in their supply chain to make inquiries about the source of the conflict minerals as well as the smelters or refineries used to process the minerals.

If a company's reasonable country of origin inquiry results in a conclusion that the conflict minerals in the company's products came from recycled or scrap sources, then the company does not need to file a Conflict Minerals Report with the SEC. The rules provide that if the company's products containing conflict minerals from recycled or scrap sources, then the company can describe those products as "DRC conflict free."

Conflict minerals are deemed to be from recycled or scrap sources if the minerals are from recycled metals (which are reclaimed end-user or post-consumer products), or scrap processed metals (created during product manufacturing).

A company will not be required to proceed to Step 3 below (and therefore will not be required to file a Conflict Minerals Report as an exhibit to the Form SD) if the company knows or reasonably believes, following its reasonable country of origin inquiry, that the conflict minerals in its products did not originate in the Covered Countries, or that such conflict minerals came from recycled or scrap sources. For a company whose products contain conflict minerals but where the company is not required to file a Conflict Minerals Report, the Form SD filed by the company must describe the company's reasonable country of origin inquiry and the company's resulting determination that its products did not originate in the Covered Countries (or came from recycled or scrap sources).

Step 3 – Supply Chain Due Diligence and Conflict Minerals Report.

If a company knows (or has reason to believe) based on its country of origin inquiry that (1) the conflict minerals necessary to the functionality or production of its products did originate in the Covered Countries and (2) the conflict minerals are not (or may not be) from recycled or scrap sources, then the company is required by the rules to (A) exercise due diligence with respect to the source and chain of custody of the conflict minerals and (B) file a Conflict Minerals Report as an exhibit to its Form SD with the SEC. The due diligence exercise is aimed at determining the origin and chain of custody of the conflict minerals and whether the minerals financed or benefited armed groups in the Covered Countries.

The Conflict Minerals Report must include certain information, including a description of the measures taken to exercise due diligence on the source and custody chain of the conflict minerals as well as an independent private sector audit of the report. For calendar years 2013 and 2014 only, if the company conducts a due diligence inquiry but is unable to reach a conclusion as to whether its products containing conflict minerals are "DRC conflict free," it must still file the Conflict Minerals Report but no independent private sector auditor is necessary and the company would provide alternative disclosures, including describing the applicable products as "DRC conflict undeterminable."

CONCLUSION

The SEC's conflict minerals rules impose substantial due diligence and disclosure requirements on a broad range of public companies in the consumer products industry, and many interpretative issues with respect to the rules remain. With the first disclosures under the rules required on May 31, 2014, with respect to calendar year 2013, public companies should now have in place a system of controls and procedures designed to comply with the rules.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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