Raising the Bar on Year-Two Conflict Minerals Disclosures

The first batch of conflict minerals disclosures that companies filed with the Securities and Exchange Commission last spring were all over the map.

Some companies were rigorous in their vetting of suppliers, ferreting out the use of tantalum, tin, gold, and tungsten sourced from the war-torn Congo, while others were content to itemize suppliers and report back generalities about the few suppliers that returned questionnaires.

Now, in the second year of the Dodd-Frank Act regulation, expectations will be greater. “Everybody was handing in their pop quizzes last time without knowing how everyone else did,” Frank Murray, a lawyer with the law firm Foley & Lardner who specializes in supply chain regulation. “Now, at least, they know what the grading curve is.” Improving upon last year’s filings will be no easy task, however.

Raise the Bar

A guiding principle behind the legislation, and the goal of activists, is that conflict minerals disclosures should improve year-to-year. The SEC signaled that initial filings weren’t expected to be perfect—an assumption likely to carry over into upcoming filings—but there is an expectation of progress.

“Last year, we learned how to process supplier information into a filing,” Murray says. “The name of the game is to try to find ways to improve the process, to streamline it, and to get better information,” he adds. According to Murray, now that companies can see what their peers are including in the disclosures, some best practices will begin to emerge.

Companies are also gearing up to report if their products are free of conflict minerals or not. For calendar years 2013 and 2014 (2013-2016 for a “smaller reporting companies”), issuers are allowed a transition period to ramp up their supply chain assessments. For those two years, companies can declare that their products are “DRC conflict undeterminable,” avoiding the need for an independent private sector audit of the Conflicts Minerals Report filed with the SEC. Those audits will be required in subsequent years.

“The bar has been raised for the second year of filings,” agrees Kirsten Wallerstedt, senior regulatory analyst, global supply chain at 3E Company. “Issuers are looking forward to the impending end of the transition period, and see that if they don’t get their ducks in a row now, they are likely not to meet their goals for the May 2016 filing period.”

Second=year filings, she says,  should do a better job describing measures taken to follow the Organisation for Economic Cooperation and Development’s due diligence framework, an accepted protocol for conflict minerals programs in the eyes of the SEC. In year one disclosures, many companies “seemed to copy vague phrases from the OECD guidance,” using phrases like “established strong company management systems,” rather than actually describing the team they formed, the type of protocols they established, the actions they took with suppliers, and how they improved upon that process as they gained experience with it, Wallerstedt says. “These types of concrete examples of actions taken and policies followed would be more in line with what the law is asking for in these reports.”

Focus on Suppliers

Wallerstedt sounds the alarm that “the transition period is essentially over.” Anything manufactured after this year is reportable after the transition period. If issuers’ sourcing is not conflict-free by Dec. 31, they will not be able to report as conflict-free in the May 2016 reporting period anything manufactured in 2015. “If suppliers are not up-to-par next year, you have to report that in 2016,” she says. “You really want to get them up-to-par now, or at least moving toward being conflict-free, so there is a shot at being compliant for next year’s products.”

“Everybody was handing in their pop quizzes last time without knowing how everyone else did. Now, at least, they know what the grading curve is.”
Frank Murray, Lawyer, Foley & Lardner

A problem companies faced in year one was that many of them didn’t have systems in place that were “robust enough to do more than take their suppliers’ word at face value,” Wallerstedt says. Many suppliers didn’t respond, while others provided answers that were inconsistent or contained inaccuracies. “There wasn’t much reported by companies in their disclosures that discussed their process for dealing with these red flags,” she says. “This will have to change going forward in order to be compliant, or to be able to claim to be conflict free.”

“Issuers have gone from bare-minimum, just-get-that-form-in mode to high expectations of, and serious demands on suppliers,” Wallerstedt says. “Going forward, if suppliers aren’t playing ball, they are going to see consequences, maybe even termination of that business relationship. We’re already seeing a harder line emerging from many companies this fall than we saw in the spring.”

Improving outreach to suppliers is a major focus this year for Quantum Corp., a California-based expert in scale-out storage and data protection. “In the first year, the focus was to get responses from the majority of our suppliers and we are still working to attain 100 percent if we can,” says Garry Felker, manager of environmental health and safety and point person for the company’s conflict minerals program.

This year’s focus is on improving the quality of vendor information by working with suppliers to help them understand where problems lie and how to better assist due diligence efforts. Technology and automation solutions will be vital for meeting that goal, given the thousands of data entries that need to be reviewed, updated, and communicated back to suppliers. “We need a methodology for looking at their data, identifying where problems are, then going back to the supplier to ask, ‘can you help us fix them?’ If this can’t be pushed down through the supply chain we are not gong to get there,” Felker says.

Quantum plans to use third party software to launch a new program that will enable greater outreach, communication, and tracking of vendor reports.

“My largest focus right now is to get good clean data,” he says. “If I get a supplier who is either unable or unwilling to comply with the requirements of the SEC rule, we may consider taking them off the approved vendor list.”

Burning Questions About Smelters

Smelter due diligence is an area that is expected to show huge improvements in the next round of filings, Wallerstedt says. “The smelters really are the focus of this whole conflict minerals law, even though that is not always apparent,” she explains. “If companies can get their suppliers to move to conflict-free smelters, or can get the smelters in their network to get certified, then everyone’s job is done.”

ONE YEAR DOWN …

The following are some statistics on the first year of conflict minerals disclosures and Form SD filings, as compiled by the law firm Schulte Roth & Zabel and the Conflict-Free Sourcing Initiative.
In its required economic analysis, the Securities and Exchange Commission  estimated that approximately 6,000 issuers would have filing obligations under the Conflict Minerals Rule. This estimate was based on the number of issuers that fall under the Standard Industrial Classification codes that the SEC believed were most likely to result in filing obligations. Although these numbers were rough estimates, the actual number of Form SD filings was only 22 percent of the SEC’s estimate. A total of 1,315 Form SDs were filed.
As expected, there were few audits for calendar year 2013. Under the Conflict Minerals Rule and as clarified in a subsequent SEC FAQ, an independent private sector audit is not required during a temporary transition period if, after exercising due diligence over the source and chain of custody of its conflict minerals, the issuer determined that at least one of its products may be described as “DRC conflict undeterminable.” This transition period runs through calendar year 2016 for smaller reporting companies and calendar year 2014 for all other issuers. Subsequently, in its April 29, 2014 Statement on the effect of the April 14, 2014 D.C. Circuit Court of Appeals’ decision on the Conflict Minerals Rule, the SEC further scaled back the IPSA requirement, indicating that, pending further action, an IPSA will not be required unless an issuer voluntarily elects to describe a product as “DRC conflict free” in its Conflict Minerals Report. Given the current voluntary nature of the IPSA, there were only four IPSAs for calendar year 2013. The issuers and auditors are indicated below.
Most issuers filed both a Form SD and a Conflict Minerals Report. CMRs were filed with 77 percent of the Form SDs filed. In its economic analysis, the SEC estimated that approximately 75 percent of Form SD filers also would be required to file a CMR.
Sources: Schulte Roth & Zabel; Conflict-Free Sourcing Initiative.

The temptation last year was to “just do a data dump and report all of the smelters that are potentially in your supply chain,” Murray says. The expectation is to now move beyond company-level reporting to a breakdown of smelters by specific parts and products.  He concedes, however that it will “be a real challenge.”

Issuers in the coming year will have access to the CFSI list of known smelters—half of which are now certified as conflict free—as well as a list compiled by the U.S. Department of Commerce. “Using these lists to create a ‘master’ reference list of smelters will help companies quickly weed through lists gathered from their suppliers and create a consolidated list to use as a reference as they vet supplier data,” Wallerstedt says.

Because the OECD due diligence guidance is the only internationally recognized framework thus far, more companies should refer to it in the next reporting cycle, says Michael Rohwer, program director for the Electronic Industry Citizenship Coalition. Carefully monitoring CFSI’s active and compliant smelter lists will assist a risk assessment, and companies should also consider joining the Conflict-Free Sourcing Initiative to support an industry scheme to audit smelters and refiners and comply with the OECD framework.

“We look forward to reports that more clearly describe companies’ conflict minerals policies, rather than merely referring to their Websites,” Rohwer adds.

Get Ready for Audits

Only four companies audited their conflict minerals reports in year one of the rule; by 2016 the audits will not be optional. “Really dedicated companies have proactively gotten audits on their due diligence practices,” Wallerstedt says. “If they get an independent audit now, they can identify any issues early, before they have to report publicly on the audit in 2016.”

“Engage with your independent auditor long before the time comes that you need an audit,” Rich Goode, senior manager, climate change and sustainability services at Ernst & Young, says. “Most people are probably not going to need an audit until spring 2016, but it is probably not a good idea to call your auditor on May 15.”

In the meantime, Goode, during a recent webcast held by Green Status Pro, a firm that offers conflict minerals software solutions, suggests a trial run, in the form of a gap analysis, readiness assessment, or mock audit. “Before you get an audit, you probably want to have someone come in, look at your program, and point out issues that maybe would have precluded a successful audit,” he says. “Surprises are for birthdays, not audits.”

“Don’t expect conflict minerals due diligence and reporting to get much easier any time soon,” Felker cautions. “Sometimes with compliance programs, they are tough on the front end, but relatively light on maintenance once you have your processes in place. In this case, with the conflict minerals situation, it will continue to get increasingly complex as time goes on.”