Securities and Exchange Commission (SEC) Provides Guidance on Dodd-Frank Conflict Minerals Rule
The staff of the Division of Corporation Finance (Staff) of the Securities and Exchange Commission (SEC) recently published interpretive guidance in the form of frequently asked questions on several aspects of the SEC’s conflict minerals rule. The conflict minerals rule is embodied in Rule 13p-1 under the Securities Exchange Act of 1934, as amended (Exchange Act), and Item 1.01 of the SEC’s Form SD (Item 1.01, and together with Rule 13p-1, the Rule), which implement Section 13(p) of the Exchange Act.1 The Rule requires any company filing reports under Exchange Act Section 13(a) or 15(d) to disclose annually whether any gold, tantalum, tin, or tungsten (or a related ore) contained in and necessary to the functionality or production of the products the issuer manufactures (or contracts to have manufactured) originated in the Democratic Republic of the Congo (DRC) or adjoining countries.
The Rule and the SEC’s adopting release relating to the Rule (Adopting Release)2 left unanswered numerous questions about the Rule’s proper application. The Staff’s guidance resolves a number of those questions, including questions concerning what constitutes a product and what constitutes the manufacturing, or contracting for the manufacture, of a product for purposes of the Rule. The guidance also addresses several points regarding the compliance mechanics of the Rule.
Although the Rule is currently being challenged in the U.S. District Court for the District of Columbia, issuers should review the Staff’s guidance and continue to prepare to make any reports they may be required to make under the Rule. Those issuers required to report under the Rule must file their first reports on Form SD by May 31, 2014 for calendar year 2013. Issuers who wait for resolution of the court challenge to determine whether any of the products they manufacture or contract to have manufactured contain conflict minerals and to commence any necessary country of origin inquiries and supply chain due diligence may have neither the necessary information nor sufficient time to complete the required reports before the filing deadline.
This alert summarizes the Staff’s recent guidance.
Determining What Constitutes a Product
The Rule does not define the term “product” even though an understanding of that term’s meaning is crucial to understanding the Rule’s full reach. The absence of a definition of “product” raises interpretive questions because an issuer must manufacture or contract to have manufactured a product containing a conflict mineral that is necessary to the functionality or production of that product for the Rule to be applicable to the issuer. The guidance provides helpful insight into how the Staff interprets what may constitute a product for purposes of the Rule.
Packaging and containers of goods are not part of the product.
The Staff’s guidance provides substantial assistance to manufacturers of goods that do not contain conflict minerals or for which conflict minerals are not necessary to their functionality or production, but which goods, when sold, are wrapped or contained in packaging or containers that contain conflict minerals necessary to the functionality or production of the packaging or containers. The Staff interprets the Rule to apply in a manner that distinguishes between goods (which are themselves products) and the packaging or containers of the goods, and states that packaging or containers sold with a product are “not considered to be part of the product.”
Consequently, a food product free of any conflict mineral that is wrapped in packaging containing tin would not be considered a product containing a conflict mineral for purposes of the Rule. The Staff views this to be the case even though the packaging or container would be necessary to preserve the food product prior to consumption. As a result, issuers using conflict minerals (even in significant amounts) in self-manufactured or contract-manufactured packaging or containers for the issuers’ goods that do not contain conflict minerals will not be required to report such goods or their related packaging or containers under the Rule. However, an issuer that manufactures identical packaging or containers for sale to others must treat such packaging or containers as “products” and report with respect to such packaging and containers if otherwise required under the Rule.
The Staff notes, seemingly as an aside, that once a consumer starts to use the product enclosed in the packaging or container, the packaging or container is generally discarded. It is unclear whether the Staff included this statement to indicate that a situation in which a manufacturer of the packaged product urges or expects the consumer to retain the packaging for some purpose, such as the anticipated return of the goods (e.g., empty toner cartridges for laser printers), may result in a different conclusion.
Equipment used to provide services is not a product in certain circumstances.
Service providers, such as airlines, cruise lines, and drilling contractors, use equipment that they manufacture or contract to have manufactured to provide services to their customers. The Staff notes that in such instances it “would not object if issuers did not file reports on Form SD regarding the conflict minerals in the equipment that they manufacture or contract to have manufactured” if the equipment used to provide the services is:
retained by the service provider;
required to be returned to the service provider; or
intended to be abandoned by the customer following the terms of the service.
The Staff also states that it does not interpret equipment used to provide services to be “products” under the Rule.
For issuers that supply much, if not all, of the equipment they use to provide their services, such as drill ships, drilling rigs or drill bits used by drilling contractors, this guidance should be welcome. However, such issuers must keep in mind the Staff’s limitation of this interpretation to equipment that will not remain in the hands or control of the customer after the service in which the equipment is used has been completed and structure their service contracts accordingly. If the service provider delivers the equipment to the customer in the course of providing its services and that equipment has continuing utility for the customer after the issuer has completed providing its services, this helpful guidance may well not apply.
Tools, machines, and equipment used to manufacture products are not products.
The SEC made clear in the Adopting Release that if an issuer manufactured products not containing conflict minerals by using tools, machines, or other production equipment that it manufactured or contracted to have manufactured and that contain a conflict mineral, the issuer would not have to report under the Rule with respect to those products solely as a result of the use of such tools, machines or other production equipment. The Staff’s guidance confirms that if such an issuer sells such tools, machines, or equipment in the after-market, the issuer will not have to report the conflict minerals in such tools, machines, or equipment under the Rule.
Of particular interest in this guidance is the Staff’s statement that the tools, machines, or other equipment are not products of the issuer, and the Staff will not view the later entry of the tools, machines, or equipment into the stream of commerce as “transforming” them into products of the issuer. In the Adopting Release, the SEC discussed its view that materials, prototypes and other demonstration devices containing conflict minerals necessary to the functionality or production of those items were not “products” for purposes of the Rule, and further stated that: “[o]nce an issuer enters those items in the stream of commerce by offering them to third parties for consideration, the issuer will be required to report on any conflict minerals necessary to the functionality or production of those products.”3 This statement and the guidance appear to conflict in some respects and, as a result, issuers should take care in relying on this particular guidance in certain circumstances in view of the SEC’s prior statement.
An issuer providing services by using a tool that it manufactures or contracts to have manufactured and that contains any conflict mineral should be careful before choosing to conflate this guidance with the Staff guidance that equipment used to provide services is not a product, and concluding that a tool that the issuer uses to provide services and subsequently sells to the customer in a transaction separate from the services contract will not be a “product.” The Staff may conclude that, in light of the use of the tool to provide services and the related sale of the tool to the customer, the sale enters the tool into the stream of commerce in a manner that makes it a “product.”
Determining What Activities Constitute Manufacturing, or Contracting for the Manufacture of, Products
To determine whether an issuer must disclose information regarding conflict minerals under the Rule, the issuer must determine whether it manufactured, or contracted to have manufactured, any product that contains conflict minerals. The Rule does not define the terms “manufacture” or “contract to manufacture,” but the Staff’s guidance gives meaning to those terms in three limited circumstances.
Activities customarily associated with mining are not manufacturing
Instruction 1 to Item 1.01 states that an issuer mining conflict minerals is not considered to be manufacturing the minerals mined. The Staff noted that the instruction also applies to activities customarily associated with mining, such as transporting ores to a processing or refining facility or processing ore in certain ways. The Staff takes the view that an issuer that only engages in those activities customarily associated with mining conflict minerals is not considered to be manufacturing those minerals.
While the guidance recites a number of activities the Staff views as often involved in the mining of lower grade gold ore, the Staff generally leaves it to the issuer to determine if a particular activity relating to a conflict mineral is “customarily associated with mining.” Issuers intending to rely on this guidance should determine whether a significant portion of the other members of their industry have historically viewed the activity in question as being associated with the mining process, and be prepared to provide evidence that the activity is widely viewed as being associated with the mining process by the appropriate segment of the mining industry.
Physically placing identifying marks on generic, third party manufactured products is not contracting to manufacture.
In the Adopting Release, the SEC noted that an issuer is not contracting to manufacture a generic product manufactured by a third party if the issuer’s actions regarding the product involve no more than affixing the issuer’s brand, marks, logo or label to such a generic product.4 In its guidance, the Staff extends that position to etching or marking by other means a generic product manufactured by a third party with a logo, a serial number, or other identifier. This guidance merely expands the application of the principle underlying the SEC’s position in the Adopting Release to instances in which an identifying mark is added to a generic, third party manufactured product by a physical alteration of the product and not by affixing a label to the product.
Generic components containing conflict minerals in an issuer’s products require compliance.
The Staff makes clear that if a product manufactured by an issuer or that an issuer contracts to have manufactured includes a generic component manufactured by a third party that contains a conflict mineral, the issuer must conduct a reasonable country of origin inquiry with respect to the conflict mineral in the generic component. The guidance also makes clear that a generic component purchased from a non-manufacturing third party distributor is not different from a component that the issuer manufactures or contracts to manufacture.
Unfortunately, the Staff does not provide any guidance as to how an issuer may make an effective reasonable country of origin inquiry when a “generic” component is acquired from a source other than the product’s manufacturer, the issuer has no contact with the component’s manufacturer (and may not even be able to ascertain the identity of the manufacturer), and the distributor or component manufacturer has no incentive to cooperate with the issuer’s effort to make that inquiry. In light of the Rule’s lack of any de minimis threshold that must be crossed, or any minimum number of products that must be manufactured, before the Rule’s application is triggered, this guidance may cause issuers to shy away from including generic components in any product they manufacture or contract to have manufactured, which could lead to increased manufacturing costs for issuers and higher product costs for consumers.
In the Adopting Release, the SEC noted a three-step process for complying with the Rule.5The Staff’s guidance with respect to generic components appears to ignore a threshold question in that three-step process that must be answered in the affirmative before a country of origin inquiry is required, i.e., whether a conflict mineral contained in a product is necessary to the functionality or production of the product. Although the Staff’s intention with respect to this threshold question in this guidance may seem unclear, it seems unlikely that the Staff intends that a generic component containing conflict minerals would trigger a reporting requirement under the Rule unless the presence of the conflict minerals is “necessary to the functionality or production of the product.”
The other guidance focuses on mechanical aspects of the Rule.
Companies voluntarily filing reports under Exchange Act Section 13(a) or 15(d) (e.g., filing due to indenture or contractual requirements) must comply with the Rule.
An issuer must comply with the Rule as to itself and all of its consolidated subsidiaries, even if only a consolidated subsidiary of the issuer manufactures or contracts to have manufactured a product containing a conflict mineral necessary for the product’s functionality or production.
When an issuer must describe in a conflict minerals report products that it manufactures or contracts to have manufactured that have not been found to be “DRC conflict free” or “DRC conflict undeterminable,” it (1) may describe those products based on its own facts and circumstances and in terms commonly understood within its industry, and without using model numbers, and (2) must state clearly that the products “have not been found to be ‘DRC conflict free’” or are “DRC conflict undeterminable,” as the case may be.
Issuers determining that they manufacture or contract to have manufactured products containing conflict minerals originating in the DRC or an adjoining country that are necessary to the functionality or production of the product, but that are “DRC conflict free,” must still file a Form SD, along with a conflict minerals report that has been audited by an independent private sector audit. The conflict minerals report need not, however, identify the products containing the conflict minerals or provide certain other disclosures required by Form SD because the products are “DRC conflict free.”
Following an issuer’s initial public offering (IPO), the Staff will not object if the issuer starts any required reporting under the Rule with the first calendar year beginning no sooner than eight months after the effective date of the IPO registration statement.
An issuer’s failure to timely file a Form SD will not result in the loss of the issuer’s eligibility to use Form S-3 to register the offer and sale of its securities.
Unanswered Questions Remain
The Staff’s guidance, particularly the guidance regarding what constitutes a product or what constitutes the manufacturing or contracting to manufacture a product, is welcome and may eliminate or significantly reduce the burden and expense of compliance with the Rule for some issuers. The guidance is even more welcome because the pending litigation challenging the validity of the Rule may be more protracted than originally anticipated as a result of the transfer of the case from the U.S. Court of Appeals for the District of Columbia to the U.S. District Court for the District of Columbia.
Nevertheless, the Staff has failed to even address, much less resolve, important questions regarding the applicability of the Rule. For example, the Staff did not provide guidance as to what it will consider to be a reasonable country of origin inquiry. Unlike the guidance the Rule and the Adopting Release provide as to the nature of the supply chain due diligence that issuers must perform under the Rule in certain circumstances, neither the Rule nor the Adopting Release provides any significant guidance as to the nature of an acceptable reasonable country of origin inquiry. Thus, issuers are left to interpret when their country of origin inquiries are reasonable and adequate for purposes of the Rule. Specific guidance on this point would have been welcomed by many issuers.
The Staff, as they have done with respect to other rules, may provide further guidance as to the Rule’s application as they receive additional questions from issuers. As the Staff reviews the first Form SDs and conflict mineral reports filed in 2014, the Staff may find that it would have better served the issuers it regulates and those persons with an interest in the conflict minerals disclosures made if the Staff had given more extensive guidance regarding the Rule.
Issuers with questions about the applicability of the Rule will want to watch for any comment letters that the Staff sends to issuers commenting on their conflict mineral disclosures or making inquiries of issuers who do not file Form SDs but who manufacture or contract for the manufacture of products that may contain conflict minerals. Those comment letters may provide additional insight into the Staff’s views regarding compliance with the Rule.
1. See SEC Div. of Corp. Fin., Dodd-Frank Wall Street Reform and Consumer Protection Act Frequently Asked Questions - Conflict Minerals (May 30, 2013), available athttp://www.sec.gov/divisions/corpfin/guidance/conflictminerals-faq.htm. For background on the Rule, please see our client alert dated September 10, 2012, SEC Adopts Dodd-Frank Conflict Minerals Rule.
2. Conflict Minerals, Exchange Act Release No. 34-67716 (Aug. 22, 2012), 77 Fed. Reg. 56274 (Sep. 12, 2012) (codified in 17 C.F.R. Pts. 240 and 249b), available at http://www.gpo.gov/fdsys/pkg/FR-2012-09-12/pdf/2012-21153.pdf.
3. Id. at 56298.
4. Id. at 56291.
5. See the SEC’s discussion starting on page 56279 of the Adopting Release.