Conflict Minerals: Are Purchases of Products for Internal Use Caught by the SEC Rules?
It has been six weeks since the SEC issued final rules relating to the reporting of conflict minerals. The rules apply to public companies that are subject to reporting requirements under the Securities Exchange Act of 1934 (so-called "issuers"). Issuers must report on the use of conflict minerals in their products. You can read a summary of the rules and an outline of how they are to operate in our Client Alert: SEC Adopts Final Rules on Conflict Minerals Reporting.
In a nutshell, the rules require issuers to examine their supply chains for conflict minerals and to disclose their use in public filings with the SEC. Conflict minerals are certain minerals (including gold and ores from which tin, tantalum and tungsten are extracted) that originate from the Democratic Republic of Congo and adjoining countries. These minerals are used in electronics such as mobile phones, computers and digital cameras, in jewelry, and a wide range of other consumer and industrial products.
The rules are mandated by Section 1502 of the Dodd Frank Wall Street Reform and Consumer Protection Act. As with many gifts from Washington, the complexity of the original legislative directive has mushroomed: the Dodd Frank provision runs for five pages. The SEC's final ruling, with explanatory memoranda, runs to 356 pages. Consultants, lawyers and solution providers have been monitoring and lobbying for the development of the rules since Dodd Frank was passed. The rules have spawned a mini-industry to advise on compliance and navigate the due diligence and reporting requirements.
With all this material and analysis you might expect that the rules would clearly define the circumstances in which reporting is required, but they do not. As a threshold matter, the rules apply to issuers that "manufacture or contract to manufacture" "products" (none of which is defined). You might assume that this means that the rules only apply to issuers who manufacture products for sale (whether they handle the manufacturing themselves or outsource it), and not to issuers who contract to purchase custom made products, or products made to the issuer's specifications, for their internal business use but, again, this is not clear. After considering several definitions of "manufacture" the SEC declined to adopt a definition because it believes the term is generally understood.
Many issuers that do not regard themselves as "manufacturers" do procure built-to-spec equipment for their internal use. These procurements could be viewed as contracts to manufacture products. Unless and until the SEC issues a clarification to exclude them from the scope of the rules, those issuers should analyze their supply chains to assess whether their built-to-spec product purchases fall within the ambit of the rules.
The SEC offered some guidance on this issue:
- Whether an issuer "contracts to manufacture" a product depends on the degree of influence it exercises over the materials, parts, ingredients or components to be included. This is a classic slippery slope: merely negotiating contract terms that do not directly relate to manufacturing (e.g. limitation of liability and indemnity) is not enough. Stipulating particular product specifications or components might be.
- Tools and machinery that are used to manufacture an issuer's products are not treated as part of the products themselves. For example, if an issuer contracts to purchase a custom made lathe and then uses the lathe to make tables, under the rules the lathe is not treated as a part of the tables. However, it is not clear whether the lathe itself would be caught as a product that the issuer contracted to have manufactured.
- Assembling components into a finished product may be sufficient to constitute manufacture of the product.
- There is no "de minimis" exception to the rules, so the presence of even small quantities of conflict minerals in an issuer's products requires analysis and compliance.
Hopefully we will see some clarifications to the rules soon. Meanwhile, procurement organizations need to consider their compliance obligations wherever they are involved in purchases of built-to-spec or custom products.
It is worth noting that in September 2011 California passed Senate Bill 861. This law prohibits California state agencies from doing business with issuers that are found, by court judgment or settlement with the SEC, to be in violation of the SEC's conflict minerals rules. Those issuers are barred from contracting with the State until they come into compliance. Other states may pass similar laws.