Conflict Minerals – A Second Look
As the knowledge base expands with respect to the new SEC conflict minerals rules, we will provide additional alerts on specific topics that we believe are of the most interest. This alert focuses on two aspects of the new rules about which numerous questions have been raised: (i) the use of products to deliver other products, using electricity as our example, and (ii) the "retail" exemption from the "contracting to manufacture" language. It is important to note that the SEC has not yet provided additional guidance, and so this preliminary guidance may change. We understand that the SEC intends to provide additional guidance in the next few weeks. Until then, all advice remains based upon a careful reading of the adopting release, the insight available from some of the comment letters that resulted in inclusion of particular language in the adopting release, and discussions among the attorneys focusing on these issues.
Necessary to the Production of a Product
Electricity, by definition (and physics), does not contain any conflict minerals. Therefore, assuming that the SEC believes that it is a "product" (which is implied by the language quoted below; otherwise the reference to "power lines" would be unnecessary), by itself electricity does not result in any conflict minerals concerns. But, then, what about the plant and equipment used to produce, transmit and distribute electricity? The answer provided by the adopting release hinges on whether the plant and equipment are "'necessary to the production' of a product." The adopting release elaborates:
[A]n issuer should consider: (1) whether the conflict mineral is intentionally included in the product’s production process, other than if it is included in a tool, machine, or equipment used to produce the product (such as computers or "power lines"); (2) whether the conflict mineral is included in the product; and (3) whether the conflict mineral is necessary to produce the product. In this regard, we are modifying our guidance from the proposal such that, for a conflict mineral to be considered “necessary to the production” of a product, the mineral must be both contained in the product and necessary to the product’s production.
This language is important in two respects. First, it provides the example of "power lines." Together with other examples here and elsewhere in the adopting release relating to machine tools and other manufacturing equipment, we believe that the equipment used to produce, transmit and distribute electricity, in the hands of the producer of electricity, does not fall under the provisions of the conflict minerals rules. Second, the alternate requirement that the conflict mineral be contained in the product – the product here being electricity – again results in the exclusion of the equipment, at least in the hands of the producer of electricity, from the SEC's conflict minerals rules.
But this logic does not extend to everything that a producer of electricity may do. For instance, does it extend to utility-owned electric meters? We believe so, as they are analogous to power lines. Surge protectors that are billed separately? Light bulbs? Insulation and other energy conservation and demand management items that are sold to home owners? In these instances, we are not so sure. Sales of products at company-owned stores? Transformers and other equipment that is sold for in-the-fence use by customers? For these, we believe that the conflict minerals rules probably do apply. On this last point, we believe that the better analysis looks at the equipment from the perspective of the seller as a seller, and in that role a utility would be little different from Siemens or GE. Thus, a transformer would be a product, although it may get the benefit of the retail exemption discussed below.
In addition, our reading of the rules indicates that there is no distinction between providing equipment free of charge, leasing the equipment, or selling the equipment. For instance, say that a cable TV company provides a set top box that, in addition to the essential signal conversion equipment, also contains a digital video recorder, not unlike the device that TiVo might provide. The DVR is not essential to the transmission or conversion of the television signal, and this is true whether the set top box is provided free of charge, for a monthly fee or for purchase. The analysis of whether the set top box is covered by the conflict minerals rules will depend upon whether the set top box is a product in its own right or is analogous to a power line for electricity.
While the electricity and set top box examples are narrow, the analytical approach is what is important. We believe the role of the item is dispositive in this context, not the economic arrangement between the parties. And it is important to emphasize that the analysis depends on who is asking the question. In the hands of a cable TV provider or other utility, the conflict minerals content of a particular piece of equipment may be of no consequence. But to the manufacturer of that product, it probably is irrelevant that the down-stream user may not care about the conflict minerals. The manufacturer in all likelihood has a compliance responsibility.
Retail Exemption and Contracting to Manufacture
As originally proposed, the conflict mineral rules would have covered retailers that sold products containing conflict minerals where they contracted to have those products manufactured but otherwise had little or no input into their content. For example, if Sears were to have contracted with a major appliance manufacturer to provide it with Sears-branded washing machines – and washing machines are going to contain at least tin solder if not other conflict minerals as well – Sears would have been subject to the entire conflict mineral regime with respect to those washing machines. The trigger in the proposed rules was whether the product is "contracted by the registrant to be manufactured," and, as proposed, virtually every store-brand product, and many more would, have been covered.
The SEC was persuaded to narrow the scope of this language, and the adopting release provides that "[a]n issuer is considered to be contracting to manufacture a product depending on the degree of influence it exercises over the materials, parts, ingredients, or components to be included in any product that contains conflict minerals or their derivatives. The degree of influence necessary for an issuer to be considered to be contacting to manufacture a product is based on each issuer’s individual facts and circumstances." While this language leaves significant room for uncertainty, the SEC provides a safe harbor – the "retail exemption" – if the issuer does nothing more than:
(a) specify or negotiate contractual terms with a manufacturer that do not directly relate to the manufacturing of the product, such as training or technical support, price, insurance, indemnity, intellectual property rights, dispute resolution, or other like terms or conditions concerning the product, unless the issuer specifies or negotiates taking these actions so as to exercise a degree of influence over the manufacturing of the product that is practically equivalent to contracting on terms that directly relate to the manufacturing of the product; or
(b) affix its brand, marks, logo, or label to a generic product manufactured by a third party; or
(c) service, maintain, or repair a product manufactured by a third party.
The SEC preempted some efforts to be clever in this area by providing that if an issuer specifies the inclusion of a conflict mineral in a product, such as in a RFP, it will be deemed to have exerted sufficient "influence." Similarly, it rejected the suggestion by commentators that only "explicitly specifying" a conflict mineral would constitute sufficient influence. As a result, if specifying a certain performance level – say the hardness of a blade in a turbine or jet engine – by necessity results in the use of a conflict mineral, in this example tungsten-carbide, we believe the SEC would consider that sufficient influence to trigger the application of the conflict minerals rules.
We believe that this approach by the SEC will, and should, alter the purchasing habits of some issuers. Where an issuer plans on reselling a product without modification and can purchase an item without providing specifications – e.g., ordering a model 52 widget rather than specifying the performance criteria and materials – it generally should be able to avoid the conflict minerals rules with respect to the product. But there are limitations. The adopting release makes it clear that if the purchased product is further assembled into a larger product that is sold to a third party, the issuer will have responsibility for compliance with the conflict minerals rules. As a result, this approach applies only where the products are being purchased and resold pretty much "as-is."
Other Observations
Two observations on implementation: First, while there are interpretive and other important legal issues involved with the conflict minerals rules, the issues largely are ones that have to be solved by each company's purchasing
group with the support of IT, accounting, engineering and others. We believe there are very few qualified consultants with respect to the new rules – and many are learning on the fly. Most issuers are well-advised to retain
one of the established consultants while the supply lasts. Second, we believe every company needs to implement a conflict minerals policy. We have developed what we consider a "Goldilocks" version – not too hot,
not too cold, just right – but whatever approach is desired, each issuer that manufactures or contracts to manufacture products that contain, or even might contain, conflict minerals should adopt a policy. We do not believe
that these policies need board approval and, in fact, are disinclined to get that approval as it will limit future flexibility. But, to belabor the point, companies need conflict mineral
s policies.
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