Outside legal counsel will likely never put it so bluntly, but whenever a new regulation emerges one of their tasks is to determine how much wiggle room a company can count on.
Analysis of recent Securities and Exchange Commission rulemaking on the tracking and disclosure of the use of so-called “conflict minerals” in the supply chain, however, has been less about looking for loopholes and more about trying to decipher its many ambiguities and gray areas that are open to interpretation.
The rule, finalized by the SEC in August, requires companies to disclose information each calendar year on the source of “conflict minerals”—tantalum, tin, gold, and tungsten—in their products, using the new, electronically filed Form SD. Congress included the provision in the Dodd-Frank Act to address concerns over the role of these minerals in funding armed militias in the Democratic Republic of the Congo and adjoining countries.
Companies must conduct a “reasonable” country-of-origin inquiry to determine if the minerals originated from the covered countries; track and document the source and chain of custody; and include findings in a public Conflict Minerals Report.
Exactly what the standard is for a “reasonable” inquiry is just one of the many gray areas companies are finding as they dig through the more than 300-page rule. The rule doesn't provide overly specific guidance, giving issuers flexibility to tailor those tasks to their specific circumstances. The ambiguities, however, create tension, as companies worry about doing enough to comply with the regulation, without incurring unnecessary compliance costs.
Curtis Dombek, a partner with the law firm Sheppard Mullin, says the many questions that arise shouldn't come as a surprise. “The conflict minerals area is full of terms that are susceptible to a wide interpretation. If you want to go through the rule and look for important terms that are left undefined and potentially vague, you will find them,” he says.
Several questions are still unanswered by the final version of the conflict minerals rule. Below are some of the major open issues.
What exactly does ‘contract to manufacture' cover?
Companies that “contract to manufacture” a product from a supplier are subject to the conflict minerals rule, but the term isn't defined. The intricacies of “contract to manufacture” is “one of the biggest mysteries in this rule, with a lot of room for interpretation,” says Jane Luxton, a partner at law firm Pepper Hamilton.
It is among the terms the SEC uses to explain what products companies must evaluate for conflict minerals. Whether an issuer will be considered to “contract to manufacture” a product or simply to purchase it for resale depends on the degree of influence it exercises over the materials, parts, ingredients, or components that contain conflict minerals.
But even the SEC itself, in the final rule, says it does “not define the phrases ‘contract to manufacture,' ‘necessary to the functionality' of a product, and ‘necessary to the production' of a product.” Instead it offers “additional guidance for issuers to consider regarding whether those phrases apply to them.”
Luxton finds much of that guidance lacking. For instance, she says an SEC example of when a retailer wouldn't be subject to the rules isn't very helpful. In that example, a retailer that only has a manufacturer put its label on a device wouldn't be considered contracting to manufacture.
“The SEC adopting release to the rule carves out several circumstances from the scope of the rule but otherwise provides little guidance as to how much influence over the product's manufacturing is required,” says Amy Goodman a partner with the law firm Gibson, Dunn & Crutcher.
For example, the SEC has expressed the view that if a company specifies to the manufacturer of a product that a conflict mineral is to be included in the product, the company will be subject to the rule.
“The conflict minerals area is full of terms that are susceptible to a wide interpretation. If you want to go through the rule and look for important terms that are left undefined and potentially vague, you will find them.”
—Curtis Dombek,
Partner,
Sheppard Mullin
Another challenging interpretive issue under the rule is the question of what is a “product.” “Is something a ‘product' only if the company sells it, or does the conflict minerals rule extend beyond that, for instance to giveaways and promotional items?” Goodman asks.
As companies sort out their obligations rule, they are likely to face a number of lingering questions, including the issue of what it means for conflict minerals to be “necessary to the functionality” of a product, she adds. “Is the tin coating, used to prevent corrosion, on a can of hairspray or shaving cream necessary to the functionality of the product?”
How should a company root out its supply chain? The SEC rulemaking is more explicit about the resulting information it is looking for than the process that companies use to determine it. Instead, it hands over that responsibility to “a nationally or internationally recognized due diligence framework.” For now, a guidance framework established by the Organization for Economic Co-operation and Development is the only one available.
As for programs in place up the supply chain that provide chain of custody information back to the original source, a number of efforts are underway.
“But the only one that really has been approved is the one for gold—the gold supplement to the OECD framework,” says Luxton. “The others are in progress and encountering a fair amount of difficulty tracing a lot of the minerals, especially in the earliest stages between the smelter, which is a natural chokepoint, back to the mine.” A big reason, she says, is that many of these minerals are mined by artisanal, individual miners working with numerous intermediaries and middlemen.
Could a company be liable for criminal penalties?
Blake Coppotelli, a managing director with Freeh Group International Solutions, says criminal exposure is a very real possibility. The federal false statements statute, which prohibits concealment of material fact in a government form, could apply to Form SD.
CONFLICT MINERALS FACT SHEET
The following is from a fact sheet on the conflict minerals rule published by the Securities and Exchange Commission in August.
The Rule
The final rule applies to a company that uses minerals including tantalum, tin, gold or tungsten if:
The company files reports with the SEC under the Exchange Act.
The minerals are “necessary to the functionality or production” of a product manufactured or contracted to be manufactured by the company.
The final rule requires a company to provide the disclosure on a new form to be filed with the SEC (Form SD).
Contracting to Manufacture:
A company is considered to be “contracting to manufacture” a product if it has some actual influence over the manufacturing of that product. This determination is based on facts and circumstances, taking into account the degree of influence a company exercises over the product's manufacturing.
A company is not be deemed to have influence over the manufacturing if it merely:
Affixes its brand, marks, logo, or label to a generic product manufactured by a third party.
Services, maintains, or repairs a product manufactured by a third party.
Specifies or negotiates contractual terms with a manufacturer that do not directly relate to the manufacturing of the product.
The requirements apply equally to domestic and foreign issuers.
Determining Whether Conflict Minerals Originated in the DRC or Other Covered Countries:
Under the final rule, a company that uses any of the designated minerals is required to conduct a reasonable ‘country of origin' inquiry that must be performed in good faith and be reasonably designed to determine whether any of its minerals originated in the covered countries or are from scrap or recycled sources.
If the inquiry determines either of the following to be true:
The company knows that the minerals did not originate in the covered countries or are from scrap or recycled sources.
The company has no reason to believe that the minerals may have originated in the covered countries or may not be from scrap or recycled sources.
… then the company must disclose its determination, provide a brief description of the inquiry it undertook and the results of the inquiry on Form SD.
The company also is required to:
Make its description publicly available on its Internet website.
Provide the Internet address of that site in the Form SD.
If the inquiry otherwise determines both of the following to be true:
The company knows or has reason to believe that the minerals may have originated in the covered countries.
The company knows or has reason to believe that the minerals may not be from scrap or recycled sources.
… then the company must undertake “due diligence” on the source and chain of custody of its conflict minerals and file a Conflict Minerals Report as an exhibit to the Form SD.
The company also is required to:
Make publicly available the Conflict Minerals Report on its Internet website.
Provide the Internet address of that site on Form SD.
What Must Be Included in the Conflict Minerals Report:
Under the final rule, companies that are required to file a Conflict Minerals Report must exercise due diligence on the source and chain of custody of their conflict minerals. The due diligence measures must conform to a nationally or internationally recognized due diligence framework, such as the due diligence guidance approved by the Organisation for Economic Co-operation and Development (OECD).
Source: SEC.
“If there was more than one person involved in concealing material facts or making a false statement, you could also be liable for a conspiracy charge,” he says. “As with any criminal law issues on how a prosecutor would view something is very unpredictable.”
Another hazard is inherent in the relationship between conflict minerals and human rights abuses and armed renegade groups. “If there was evidence of what government perceives as a false statement resulting in especially egregious facilitation of one of these armed groups, or an especially large amount of funds going to one of them, you could see a prosecutor [pursuing] a company,” Coppotelli says. “The risks are uncertain in this area, but the stronger the compliance system the less likely the company is to face that risk.”
What happens if a company fails to file, or provides an incomplete form SD?
Robert Friedel, a partner with the law firm Pepper Hamilton, who specializes in securities law compliance, says that Form SD requirements, if not fully met, might not just incur direct sanctions by the SEC. They could affect company stock offerings, sales, and repurchases.
Affiliates of companies looking to sell stock are subject to various limitations, and making sure the company is current in all its SEC filings is among them, Friedel says. If the company hasn't filed Form SD, these insiders will not be able to sell securities on the public market. Companies looking to do a registered public offering will also face an SEC review to ensure they are current in all their filings.
Neglecting Form SD could also restrict companies from taking advantage of favorable regulations. Companies that are eligible to file a Form S-3, a simplified registration form, for example, could lose that opportunity if they fail to file Form SD, or are late doing so. That negligence could mean they couldn't take advantage of the filing until June 1 of the following year once they do file.
Can companies amend Form SD?
As a new requirement, companies may find they need to file an amendment to Form SD. The problem, Friedel says, is that there is not yet a means to do so with the electronic filing.
He expects disclosure standards will evolve over time as companies settle on an approach.
“Do they want to be on the leading edge of providing the most robust and full disclosure, or do they just want to do what's sufficient,” he says. “That's a perfectly fine choice to make and there is no obligation to be at the head of the class.”
If competitive pressures and a push from activists lead to a need for updating filings, however, some creativity is needed to make it happen. “Until the SEC creates a special document amendment code, companies that need to file an amendment should file under the SD code and simply call it, on the cover page, amendment number 1, 2, et cetera,” Friedel says.
With the first wave of conflict minerals reports due in May of 2014, companies and the SEC have some time to sort through the uncertainties, but not a lot. Without further guidance issuers will be forced to make some judgments. Says Goodman: “We may get more guidance from the SEC on these sorts of issues, but especially in areas of uncertainty, it is important that companies carefully document their determinations.”
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