Dodd-Frank Creates New Investigation, Disclosure and Audit Obligations for High-Tech and Other Manufacturers
While most of the Dodd-Frank Wall Street Reform and Consumer Protection Act addresses financial institution regulation, a less publicized section known as the Conflict Minerals Law – Section 1502 – creates new investigation, disclosure and audit requirements for a large number of manufacturers who file periodic reports with the Securities and Exchange Commission (SEC). The SEC issued proposed regulations to implement the Conflict Minerals Law and requested public comment on them before March 2, 2011, after an extension of time to submit. Since the comment period ended, the SEC has not issued its final regulations, although it indicates on its website that it expects to issue them between August and December, 2011.
It appears that the SEC is carefully considering the scope of the final regulations because the new law and the proposed regulations have the potential to affect many industries and to require a large number of companies to expend significant time, internal resources and money complying with them.
Although the final regulations may differ in some ways from the proposed regulations, public company manufacturers nevertheless should take steps now to prepare to comply with the Conflict Minerals Law because both the new law, and undoubtedly the final regulations (once issued), will require manufacturers to take the time and effort necessary to examine their supply chains for Conflict Minerals and have a good understanding of how their Conflict Minerals are incorporated into their products and manufacturing processes.
Why did Congress enact the Conflict Minerals Law, and what are Conflict Minerals?
Exploitation and trade of so-called Conflict Minerals have been linked to the financing of violent armed groups in the Democratic Republic of the Congo (DRC) and adjoining countries. By enacting the Conflict Minerals Law, Congress sought to raise public awareness that some manufacturers incorporate into popular and widely used electronic devices (such as cell phones, laptops, cameras and video games), metals mined from territories mired in armed conflict, genocide and human rights violations whose leaders sell these metals to raise funds to perpetuate these atrocities.
Conflict Minerals include columbite-tantalite (coltan), cassiterite, gold, wolframite or their derivatives. On one year’s notice, the U.S. Secretary of State may add other minerals or their derivatives to the list if the Secretary determines they are used to finance conflict in the DRC or adjoining countries.
Conflict Minerals are found in a broad range of commercial and industrial products beyond consumer electronics, including medical devices and jet engine components. For example, cassiterite is used to make tin and can be found in countless electronic devices and industrial products.
What will the new law require of public company manufacturers?
Under the new law, public company high-tech and other manufacturers who incorporate Conflict Minerals into their products will need to examine (1) how critical Conflict Minerals are to the products they manufacture and their manufacturing processes – the new law applies to a public company manufacturer only if Conflict Minerals are “necessary to the functionality or production” of a product it manufactures or that it contracts to be manufactured for it; and (2) where their Conflict Minerals originate. Also, if a manufacturer’s Conflict Minerals come from the DRC or an adjoining country (or if the company cannot rule out that they come from the DRC or an adjoining country), it will need to prepare a Conflict Minerals Report, have it independently audited and furnish the audited report to the SEC in connection with the manufacturer’s annual report.
Public company manufacturers will need to post on their website whether they know or not whether the Conflict Minerals they incorporate or use originate from the DRC or an adjoining country. If they do originate there or they can’t determine whether they do, then they will need to post on their website the Conflict Minerals Report.
Is it illegal to use Conflict Minerals from the DRC?
The new law does not criminalize or make illegal the use of any Conflict Mineral in production. Instead, Congress hoped that purchasing choices made by an informed market would affect whether a company would continue to use Conflict Minerals from the DRC or an adjoining country.
How do the proposed regulations work?
The SEC’s proposed regulations create a three-step compliance regime. Due to the length of time it is taking the SEC to promulgate final regulations, some questions exist as to whether all of the proposed regulations will eventually become law. However, even if some details change, the parameters of the compliance regime are likely to remain. Consequently, it is important for public company manufacturers to understand what may be required of them and the steps they need to take to prepare to comply.
Step One: Determine whether the Conflict Minerals Law applies to your business
The Conflict Minerals Law itself does not clearly identify those businesses that will need to comply with it. Prior to the issuance of the SEC’s proposed regulations, a number of questions circulated about its scope and whether it could potentially apply to non-SEC reporting companies. The SEC’s proposed regulations clarify that only reporting issuers under Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the Exchange Act), for whom Conflict Minerals are “necessary to the functionality or production” of a product manufactured or contracted to be manufactured by such issuer would need to comply. Unlike the approach the SEC has taken previously with important new regulatory mandates (such as Sarbanes Oxley) to phase in new compliance requirements, the proposed regulations do not exempt smaller public companies from complying with the Conflict Minerals Law and its implementing regulations. The SEC did, however, invite public comment on whether it should temporarily exempt smaller companies and foreign private issuers.
In its proposed regulations, the SEC did not define the requirement that Conflict Minerals be “necessary to the functionality or production” of a product, but it did suggest that the test will not examine the amount of Conflict Mineral used in a product or to make a product. Although the SEC sought comments on the definition, it suggested that even small amounts might be necessary to the functionality or production if they are intentionally used and integral to the making of the particular product.
The Conflict Minerals Law applies not only to manufacturers but also to those who contract for the manufacture of products. As a result, those Original Equipment Manufacturers (OEMs) who purchase high-tech components and then incorporate them into a device they integrate are covered by the new law. In addition, while the Conflict Minerals Law would not normally apply to a retailer, or value-added reseller (VAR), the new law could regulate a retailer or VAR if the retailer or VAR contracted to have manufactured for it under its own private label a product which itself includes Conflict Minerals. Note also that the proposed regulations provide that a manufacturer who uses Conflict Minerals in a production process, even if the Conflict Minerals are not included in the final product sold to the public, are captured by the proposed regulations and the new law.
Again, the key test in step one is whether Conflict Minerals are “necessary to the functionality or production” of a product manufactured or contracted to be manufactured. If a public company manufacturer uses a Conflict Mineral, but its use is not necessary to the functionality of what it makes, then the manufacturer is not covered by the new Conflict Minerals Law, and the proposed regulations and would not need to make any disclosure about its Conflict Mineral use to the SEC or on its website.
Step Two: Undertake a reasonable inquiry to determine the country of origin of your Conflict Minerals
If a public company manufacturer determines that Conflict Minerals are necessary to the functionality or production of a product, the proposed regulations would require the manufacturer to make a reasonable inquiry to determine the country of origin of its Conflict Minerals.
If a public company manufacturer concludes after a reasonable inquiry that its Conflict Minerals did not originate in the DRC or an adjoining country, it would need to disclose in its annual report that its Conflict Minerals are “Conflict Free” – meaning that they originate somewhere other than the DRC or an adjoining country; it also would need to disclose the process it used to determine the country of origin. In addition, the manufacturer would need to post its conclusion on its website and maintain records demonstrating that its Conflict Minerals did not originate in the DRC or an adjoining country.
If a public company manufacturer concludes after a reasonable inquiry that its Conflict Minerals did originate in the DRC or an adjoining country, or if it cannot conclude they did not originate there, it would need to disclose its finding or its inability to so conclude in its annual report and on its website. In addition, the manufacturer would need to furnish the Conflict Minerals Report discussed below as an exhibit to its annual report and post the same information on its website.
Manufacturers should take some comfort that, at this step, the SEC’s proposed regulations would not require a manufacturer to determine with absolute certainty whether its supply of Conflict Minerals originates in the DRC or an adjoining country. Compliance will depend on each company’s peculiar facts and circumstances. The SEC indicated that at this step a manufacturer may make a less exhaustive inquiry than what is required of it to determine the source and chain of custody of Conflict Minerals in a Conflict Minerals Report required at step three.
Step Three: Prepare a Conflict Minerals Report
If a public company manufacturer determines after making the reasonable inquiry required at step two that its Conflict Minerals originate in the DRC or an adjoining country, or it cannot conclude that they do not, under the proposed regulations the manufacturer would need to prepare and furnish to the SEC and post on its website a Conflict Minerals Report. The Conflict Minerals Report would require more of the manufacturer than merely making inquiries with its suppliers. The proposed regulations would require the manufacturer to include each of the following in its Conflict Minerals Report:
- a description of the measures taken to ascertain the source and chain of custody of its Conflict Minerals
- a description of its products or processes that use Conflict Minerals that are not Conflict Free
- an identification of the facilities used to process the Conflict Minerals
- a description of the efforts used to determine the mine or location of origin of the Conflict Minerals
- a certification by the company that it obtained an independent private sector audit of the source and chain of custody of the company’s Conflict Minerals, and a copy of the audit report which identifies the entity that conducted the audit
The proposed regulations do not mandate that a manufacturer use a particular process to conduct its diligence, but they do require the manufacturer to disclose in the Conflict Minerals Report whether a nationally or internationally recognized supply chain diligence standard was used or not. Most importantly, the Conflict Minerals Law requires that the manufacturer have its supply chain diligence audited by an independent auditor. Audits clearly will increase the expense involved in complying with the new law, and the proposed regulations do not mandate the lengths to which the auditor must go to verify the manufacturer’s Conflict Minerals Report.
The SEC is undoubtedly considering comments addressing the Conflict Minerals Report and the nature of the proposed independent audit. Unlike conflict diamonds, which cannot be melted down and which retain their Kimberly registration (an international registration process which inscribes the place of origin on a diamond indicating whether it is a “blood diamond” coming from mines in and around the DRC), Conflict Minerals can be smelted into ingots and can be transshipped through third countries in an attempt to conceal their origin. Because Conflict Minerals lose their provenance (or traceability) after they are smelted, the smelters are an obvious point in the supply chain to verify the origin of Conflict Minerals. It is likely that the SEC will revisit this point in its final regulations.
Companies will have differing amounts of time to prepare and furnish their initial Conflict Minerals Report depending on their fiscal year-end. A manufacturer’s audited Conflict Minerals Report is not due until its first full fiscal year beginning after the date the SEC promulgates final regulations addressing Conflict Mineral Reports.
The SEC indicates in its proposed regulations that the information disclosed in annual reports, including the Conflict Minerals Report and the independent private sector audit, would be furnished and not filed with the SEC, and, as a result, a registrant would not subject itself potentially to liability under Section 18 of the Exchange Act. The registrant also would not incur potential Securities Act liability for the disclosure unless the issuer specifically incorporated by reference the disclosure into a Securities Act filing or a website posting constituted a free-writing prospectus and the disclosure did not meet the Rule 10b-5 standard. Moreover, the independent private sector auditor would not assume the liability of an expert, and consequently the registrant would not need to file the auditor’s consent with its annual report. Registrants that fail to comply with the Conflict Minerals Law would incur liability under Exchange Act Section 13(a) or 15(d), as applicable. The SEC sought comment on whether registrants should incur Section 18 liability and file rather than furnish the applicable Conflict Minerals disclosure.
Some key points to keep in mind about the Conflict Minerals Law include that it:
- applies to high-tech electronics and other manufacturers using Conflict Minerals who are required to file periodic reports with the SEC under Section 13(a) or 15(d) of the Exchange Act
- will require annual SEC and website disclosure about the origin of Conflict Minerals used in manufactured products and the processes used to make them
- applies to Conflict Minerals regardless whether or not they originate in the DRC or an adjoining country; Conflict Minerals is a term given to the named minerals themselves
- requires at least some additional disclosure in an annual report even if a manufacturer uses “Conflict Free” Conflict Minerals
- does not sanction using Conflict Minerals originating in the DRC or on adjoining country in production, but instead mandates public disclosure of the origin of and potentially the steps taken to identify the manufacturer’s supply chain for them
- if Conflict Minerals originate in the DRC or if their origin is inconclusive, it requires manufacturers to obtain an independent audit of their Conflict Mineral Report furnished to the SEC on their use of and supply chain for Conflict Minerals
Public company manufacturers using Conflict Minerals may wish to:
- investigate how clearly they understand their supply chains for Conflict Minerals and learn whether they have control over their supply chains from the mine until final incorporation into their products
- create internal controls to ensure they can document the full extent of their supply chains for Conflict Minerals, and maintain business records of all transactions in Conflict Minerals (the length of time to retain those records is unknown currently as the SEC sought comments on the appropriate length of the retention period)
- task a compliance officer with overseeing the company’s Conflict Minerals compliance (the SEC is considering whether to require an officer of the company to certify the independent private sector audit, and it is not yet clear what the consequences of such a certification would be and whether that officer would bear similar responsibilities as officers making certifications under Sarbanes-Oxley)
- determine whether any Conflict Minerals used come from recycled or scrap sources, as the SEC is considering whether to reduce the disclosure requirements if a Manufacturer’s Conflict Minerals come from recycled or scrap sources
- obtain representations and warranties in supply agreements concerning the origin of Conflict Minerals used in their products and their manufacturing processes
- consider whether the SEC reporting company itself imports the Conflict Minerals, uses the Conflict Minerals in its manufacturing process and incorporates Conflict Minerals into a product it manufactures, or whether a non-reporting subsidiary does these things
- determine where they want to disclose on their websites their use of Conflict Minerals and consider the public’s reaction to that disclosure; neither the law nor the regulations specify how conspicuous the disclosure must be on the manufacturer’s website, although the proposed regulations indicate the manufacturer would need to retain the posted information on the website until the company files its next annual report
- learn whether any of the Conflict Minerals they use may indeed finance or benefit armed conflict in the DRC and adjoining countries; if so, determine now whether they can find viable alternative sources of supply of these minerals from other countries (for example, Bolivia sources a significant portion of the world’s supply of cassiterite)
- continue to monitor not only the SEC’s activity but also other regulatory activity involving Conflict Minerals (California is the first state to consider its own regulatory regime for Conflict Minerals); in addition, monitor reaction to the new law and future regulations from the international community since, unlike the Kimberly process, the United States has taken the initial steps on the regulation of Conflict Minerals without first establishing an international framework for their regulation
monitor further regulation that could later address the commodities trading industry, since the Conflict Minerals Law only applies to manufacturers