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Time to Consider Application of the Conflict Minerals Rule

11.26.12

The Securities and Exchange Commission’s Conflict Minerals Rule, Rule 13p-1 (.PDF), mandated by Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which added Section 13(p) to the Securities Exchange Act of 1934, was adopted on August 22, 2012, and became effective November 13, 2012.  The Rule will require a number of public reporting companies to, among other things, file with the SEC a new annual report, Form SD.  The initial Form SD is due by May 31, 2014, covering the 2013 calendar year.  Although the Rule’s required initial report now seems quite distant, and although there is a lawsuit filed by the National Association of Manufacturers and others challenging the Rule (.PDF), the time that may be necessary for many companies to comply with the Rule’s requirements, and the effort and cost of that compliance, suggests that companies should consider application of the Rule sooner rather than later.

The Rule requires – as a public-policy matter rather than as a matter of keen interest to most investors – that certain public companies disclose the use (or not) of conflict materials in their products or the production of their products.  “Conflict minerals” essentially are gold, tantalum, tin, and tungsten that originate from the Democratic Republic of the Congo or any of the adjoining countries (collectively, the “Covered Countries”).  Those four minerals are widely used, especially in the jewelry, electronics, automobile, aerospace, medical-device, and industrial-machinery industries.  The Rule imposes a reporting requirement only on a public company that “manufactures” or “contracts to manufacture” a “product” for which conflict materials are necessary to the product’s functionality or production.  If a company has no “product” that it “manufactures” or “contracts to manufacture,” or if none of the products that it manufactures or contracts to manufacture contains conflict minerals that are “necessary to the functionality or production” of those products, then the company need not be concerned about compliance with the Rule.

Nevertheless, determining whether the Rule applies may not be an easy matter.  It may require a company to make a number of judgments. The Rule does not define any of the key terms (1) “product,” (2) “manufacture” or “contract to manufacture,” or (3) what is “necessary to the functionality or production” of a product; and the SEC has provided only some guidance about the meaning of terms (2) and (3).  As an example regarding “product,” does a transportation or trucking company provide only a service, or does the necessary use of a vehicle to provide the service mean that it is (also) providing a “product”?  As another example, regarding “contract to manufacture,” the SEC has indicated that it involves more than merely negotiating and entering into a contract with another party to manufacture a product; it requires some actual influence over the manufacturing.  But the extent of that influence that will constitute contracting to manufacture is not clear.  Accordingly, each public company will be responsible for determining whether those undefined terms apply to it.  The Rule does not contain any exception for the number or materiality of a product; even a single product, resulting in de minimis revenue, can trigger application of the Rule.  Also, there is no exception for a smaller reporting company.

If a public company determines that it is subject to the Rule, then it must perform a “reasonable country-of-origin inquiry” to determine whether any of the conflict minerals originated in any of the Covered Countries.  The SEC has not specified what such an inquiry must consist of or include to be “reasonable” under the Rule, though it would likely involve some due-diligence review and tracing of the supply chain and certifications from suppliers.  Even if the company concludes that, in the strongest case, its conflict minerals did not originate in the Covered Countries, the company will be obligated to prepare and file a Form SD with disclosure regarding its inquiry.

If the company, because of its inquiry, knows or has reason to believe that the conflict materials may have originated in any of the Covered Countries, then the company must further (1) conduct due diligence on the source and chain of custody of the conflict materials using a nationally or internationally recognized due-diligence framework and (2) obtain an independent audit report regarding such due-diligence review.  The company will then be obligated to provide a “Conflict Minerals Report” as an exhibit to its filed Form SD.  The scope of that Report will depend on whether the products are or are not found to be “DRC conflict free” (i.e., essentially products containing conflict materials that do not finance or benefit armed groups in the Covered Countries).

OUR TAKE:  Except for those reporting companies that clearly will not be subject to the Rule, companies may have some significant work ahead of them to determine the scope of the Rule’s effect on them.  That work may require the careful analysis of the Rule and the company’s business by executives and compliance personnel, the engagement of additional in-house personnel or outside advisers, and the consequent expenditure of funds by the company. Therefore, it would be prudent for those companies now to consider possible compliance with the Rule as a significant project and to plan or budget for the time and expense accordingly.

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