By Cydney Posner
At an open meeting this morning, the SEC adopted new rules relating to "specialized disclosures" mandated under Dodd-Frank. There were no questions asked by any of the commissioners on either rule-making, but there were split votes and heated debate nonetheless. No rules have yet been posted or press releases issued.
By a vote of three to two, to implement the requirements of Section 1502 of Dodd-Frank, the SEC adopted rules regarding disclosure and reporting obligations with respect to the use of conflict minerals. The final rules require public companies to disclose annually whether any "conflict minerals" that are "necessary to the functionality or production of a product" manufactured by the company originated in the DRC or an adjoining country (referred to as the "covered countries"). "Conflict minerals" refers to gold and the three T's — tin, tungsten and tantalum – which are used in a wide variety of products. Under the final rules, companies that manufacture products (or contract to have products manufactured) will be required to go through the same three-step process as proposed, but, in response to comments, the SEC has modified the mechanics used.
- First, each company would need to determine whether any conflict minerals were "necessary to the functionality or production of a product" manufactured by the company. If not, the proposed rules would not apply, and no disclosure or other action would be required. As proposed, no definitions of these various terms are provided given that the wide variety of uses would necessitate an unacceptably complex set of definitions. Instead, the release indicates a number of factors for companies to consider. The SEC did take the step, however, of eliminating "mining" from the definition of "manufacture."
- Second, if the rules were applicable, the company would then be required to conduct a "reasonable inquiry" to determine if the conflict minerals were from a covered country. Companies may use representations from facilities (presumably, facilities such as smelters) to certify that the conflict minerals did not originate in the covered countries or are scrap or recycled, provided that there is no reason to question the reliability of the representations. The company will also need to make a new filing describing the inquiry on new Form SD, which will be a calendar year report that must be "filed,' not furnished (as originally proposed), by May 31 each year. The report will therefore be subject to Section 18 liability, but the SEC notes that liability under that section has a good faith standard and requires a showing of materiality, reliance and damages. The filing will not be covered by management certifications and will not be incorporated by reference into other filings unless the company expressly incorporates it. Companies using recycled or scrap conflict minerals will also need to conduct a reasonable inquiry to confirm that the minerals are recycled or scrap. However, if the company reasonably believes the minerals are scrap or recycled, the company would be required to describe the inquiry on Form SD and, in a change from the proposal, the scrap minerals would be treated the same as other minerals (i.e., the company would not automatically be required to conduct supply chain due diligence and file a Conflict Minerals Report under step 3).
- Third, if the company knows or has reason to believe (based on warnings or other signs) that the conflict minerals originate in the covered countries (or if the company learns or has reason to believe that its minerals may not be recycled or scrap), the company will be required to conduct substantial due diligence on its supply chain to determine if the conflict minerals financed or benefited armed groups in the covered countries, furnish a "Conflict Minerals Report" and have an independent third-party audit. Notably, in response to comments, the SEC has changed the formulation so that, now, companies will no longer need to prove a negative (i.e., that any conflict materials it used did not originate in the DRC countries). The due diligence must conform to a national or international framework prescribed for this type of due diligence, such as the framework from the OECD. The third-party audit would be conducted under the GAO's Government Auditing Standards, such as the standards for Attestation Engagements or the standards for Performance Audits, called the "yellow book standards." The SEC has added an "audit objective," now requiring that the auditor opine or conclude that the diligence conformed to the criteria in the framework selected and that the description of the work conforms to the work actually undertaken. Companies will need to describe their products as "DRC conflict free," "not DRC conflict free," or, temporarily, "conflict undeterminable." This last category was added in response to comments and is designed to allow companies that, after due diligence, are unable to determine the source of their conflict minerals, to describe, for two years, those products as "conflict undeterminable" rather than "not conflict free." In addition, in that circumstance, no audit will be required during the two-year period. Smaller reporting companies may use the "conflict undeterminable" characterization for four years. After the transition period, companies will need to describe those products as "not DRC conflict free" (unless they have determined otherwise), have the required audit and describe steps they intend to take to mitigate the risk.
The fireworks surrounded the question of whether adequate cost-benefit analysis had been conducted (setting the table for possible future litigation) and, by extension, whether the SEC was the proper agency to propose these rules and conduct the necessary analysis. Chair Schapiro was emphatic in stating that it was Congress that chose to use the securities laws to accomplish its humanitarian goal and directed the SEC to adopt implementing rules. She noted that the SEC received over 400 comment letters, held extensive private meetings with stakeholders (over 140 separate meetings, according to Commissioner Aguilar) and convened a public roundtable to discuss the rules. Commissioner Walter noted that the staff had taken critiques of its cost-benefit analysis very seriously, and, it was clear from the reported analysis that the staff had revised its cost estimates up significantly based on public comment. (The current estimate is $3B to $4B for initial implementation costs and $206M to $609M in annual costs.) However, Commissioners Paredes and Gallagher were not convinced. While adamantly supporting the humanitarian goals, both expressed the view that the SEC had not provided any analysis of the "benefit" side of the equation and was really not the proper instrument for achieving Congress' laudable goals. Commissioner Paredes argued that the cost-benefit analysis was deficient in that there was no analysis of whether these rules –and the SEC's exercise of discretion in selecting various provisions –would actually promote the goal of peace and security in the DRC. What if, for example, as has been argued by some commentators (see my emails of 8/8/11, 8/10/11 and 9/30/11), the result of the rules is a de facto embargo on exports of minerals from the DRC that has the inadvertent effect of contributing to deterioration of the region? There is no reasoned basis provided, he argued, for concluding that the rule will help to bring about peace in the region. Moreover, the SEC does not have expertise to conduct that analysis. Commissioner Gallagher ran further with that argument, contending that Section 1502 is not about investor protection and, therefore, not part of the SEC's mission. The benefits involved in the rule, he argued, are not benefits to investors and, as a result, there is no empirical sense of the benefits versus the costs. Because the SEC cannot just infer benefits and has no tools to analyze the benefits, in his view, the SEC was really set up to fail in this provision. In addition, he argued, Section 1502 was not prescriptive and required the SEC to make choices; however, he believes it was unreasonable not to consider the choices made as part of the analysis. He argued that these choices increase the costs on all issuers and even on private company suppliers. For example, he expressed concern that there was no exemption for small companies, even though the costs will be fairly uniform across companies whose revenues vary widely. (Query whether the costs for a company with $100M in revenues will be close to the costs of, e.g., GE.) Commissioner Walter contended that no exemptions for small companies were included because of the view that exemptions could defeat the entire statutory system that Congress had constructed in Section 1502, which goes beyond the SEC. Further, Commissioner Gallagher questioned why no de minimis exception had been included or considered in the analysis, even though the impact on the goal would likely be negligible. In conclusion, he took exception to the use of the securities laws to achieve social and policy goals.
Disclosure of Payments by Resource Extraction Issuers
By a vote of two to one, with Chair Schapiro and Commissioner Paredes recusing themselves, to implement the requirements of Section 1504 of Dodd-Frank, the SEC adopted rules regarding disclosure and reporting obligations with respect to payments to governments made by resource extraction issuers. That section was designed to increase governmental accountability for the use of the wealth of the countries involved. These rules require each public "resource extraction issuer" to include in an exhibit to new annual Form SD information relating to any payment made by company, its subsidiary or any other company under its control to a foreign government (including companies owned by that government) or the Federal Government for the purpose of the commercial development of oil, natural gas or minerals, including the type and total amount of the payments made for each project and made to each government. "Commercial development of oil, natural gas, or minerals" includes exploration, extraction, processing, export and other significant actions relating to oil, natural gas or minerals, or the acquisition of a license for that activity. "Payment" includes any (not de minimis) payment made to further the commercial development of oil, natural gas or minerals, including taxes, royalties, fees (e.g., license fees), production entitlements, bonuses, dividends and other extraction benefits. "Project" is undefined. "De minimis" is defined to mean amounts that equal or exceed $100K in the company's most recent fiscal year. The rules generally track the language of Section 1504 and, except where there may be a conflict, the Extractive Industries Transparency Initiative. As with conflict minerals reporting, Form SD will be "filed,' not furnished, but not incorporated by reference into other filings. The information is required to be in XBRL, and the staff is working on the appropriate taxonomy. The SEC considered that some foreign countries my prohibit the disclosure, but was concerned that adoption of an exception for those circumstances would just encourage countries to take that step. The rules will apply starting with fiscal years ending after September 30, 2013, but a partial first report will be permitted in some cases.
Once again, the SEC could not quantify the benefits associated with these rules, but estimated the costs at $[440?]M to $1B for initial compliance (likely to be on the high end of that range), with ongoing costs of $200M to $400M. The staff did not take into account the potential loss from terminations of business in countries that prohibit disclosure. Commissioner Gallagher emphasized that he favored efforts to increase government accountability, but once again, he was concerned that these rules did not relate to investor protection and, therefore, the SEC was not "the right tool" to achieve Congressional objectives. Moreover, he reads Section 23 of the Exchange Act to prohibit the SEC from promulgating rules that are not for the protection of investors. However, even without that objection, he viewed the analysis as incomplete. He questioned why the rules did not use a materiality standard in defining "de minimis," and why the rules did not allow "project" to be defined as total payments to any country or why the SEC could not instead publish a compilation of payments by country instead. That approach would eliminate the risk of disclosure of otherwise confidential information to competitors, including state-owned companies that are not subject to these types of rules.