This is the first of a multi-part series of EHS Journal articles that provide background and guidance on the final rules for Dodd-Frank Conflict Minerals (DFCM) published by the U.S. Securities and Exchange Commission (SEC) on August 22, 2012. For most companies, DFCM requirements become effective beginning in calendar year 2013.

The articles in this series are as follows:

Preface: 5 Myths About Dodd-Frank Conflict Minerals

Part 1: Background and Proposed Rule

Part 2: Conflict Minerals Final Rules: What Changed?

Part 3: DFCM by the Numbers (pending publication)

Part 4: Suggestions for Effective Compliance and Risk Management Systems (pending publication)

Rules and regulations are a product of history. Knowledge of the history of the rulemaking can provide insight into the final rule and its expectations. This article includes the following sections:

• Prelude: milestones in connecting sustainability and financial reporting
• Background of Dodd-Frank: how metals in your cell phone (and almost everything else) got into Wall Street reform
• Proposed Rules: summary of key provisions as originally proposed
• Review of Public Comments
• Doug Hileman’s Comments on the Proposed Rule and an introduction to Part 2 of this series

Prelude: Sustainability and Financial Reporting

Many of the major laws and regulations in the U.S. were enacted in response to an event. An oil spill in Santa Barbara; Love Canal in New York; Valley of the Drums in New Jersey; and the Valdez oil spill were events that shocked the nation and led to regulations that prevent and contain oil spills, manage hazardous waste, and clean up and pay for abandoned waste sites.

The beginning of sustainability is often cited as being associated with the Brundtland Report “Our Common Future,” published in 1987 by the United Nations World Commission on Environment and Development. This report, and a few pioneers thereafter, championed the notion of the “triple bottom line” (TBL) reporting. Under this notion, organizations should report their performance on an environmental, social, and economic/ financial basis. Financial reporting has been necessary since companies were formed; assurance over financial reporting probably dates back to the first time an investor lost money – a long time ago. Stakeholders have been trying to connect financial reporting with environmental or sustainability issues for decades. Notable milestones include:

• 1996: FAS 5, an accounting principle already in effect, required setting aside reserves for contingent liabilities. The American Institute of Certified Public Accountants (AICPA) published AICPA Statement of Position 1 96-1 (AICPA SOP 96-1), “Accounting for Remediation Liabilities.” SOP 96-1 confirmed that environmental remediation liabilities are, indeed, contingent liabilities, and provided guidance on criteria for determining cost estimates appropriate for establishing and maintaining environmental reserves.
• 2004: The Government Accounting Office (GAO) investigated stakeholders’ contention that they did not have sufficient environmental and social information to make investment decisions. The GAO report conceded that investors did not have the information they needed, but it was not the SEC’s responsibility to require it. GAO noted that the Global Reporting Initiative (GRI) provided a framework for voluntary reporting and the Carbon Disclosure Project (CDP) had begun an initiative around greenhouse gas (GHG) emissions, hinting that investors would be well-advised to look there instead.
• 2010: The SEC published guidance on financial disclosures for risks related to climate change. Investors concerned with climate change had been clamoring for SEC to require disclosures to shareholders in financial filings. However, as with SOP 96-1, this broke no new ground. SEC provided guidance on existing criteria for discussing material risks in financial filings to shareholders of publicly-traded companies. If company management deemed climate change – or any other issue – to be a material risk, they should use these criteria. Note that these “milestones” either explain the applicability of existing rules to environmental or sustainability issues, or decline to take further action. This makes it even more noteworthy that a new regulation connecting sustainability and financial reporting or disclosures would arise from Dodd-Frank – arguably, the first enforceable rule to do so.

Background of DFCM

Members of the U.S. Congress noted that political instability and human rights atrocities in the Democratic Republic of Congo (DRC) had been instigated, in large part, by warlords who profit off of mining tantalum, tin, tungsten, and gold. National borders are porous, so mining exports (and incoming revenues) can flow through neighboring countries. Companies who manufacture, sell, or are involved in production of goods that depend upon these four metals are making profits at the expense of people exploited by the warlords; furthermore, funding the warlords destabilizes the region and could pose security threats to the region or to the United States. Because the Congress found the potential nexus between American company profits and the funding of instability and atrocities troubling, it included Section 1502 in Dodd-Frank.

The degree to which a company makes profits that are derived from DRC warlords is something that could influence an investor’s decision to purchase, hold, or sell the stock in that company. Lawmakers agreed that this issue could have “a material effect,” and not just an incidental consideration, which is consistent with the requirements for financial disclosures. The result was Section 1502 (the “Conflict Minerals Provision”) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd- Frank”).

Proposed DFCM Rules

The SEC published proposed rules in the December 23, 2010 Federal Register. Many key requirements of the proposed rules are outlined below.

Applicability: The proposed rules would apply to companies that are required to file financial reports (as defined by SEC), and where “conflict minerals” are “necessary to the functionality or production of a product manufactured by such person [e.g., company].” The proposed rule applied to conflict minerals originating in the DRC or adjacent countries (“DRC Countries”).

Definitions: The proposed rule provided definitions for some terms, “conflict minerals.” It did not provide definitions of others, including “manufacturing.”

Evaluations: The proposed rule required companies to conduct evaluations in several steps:

• Applicability: The issuer must determine whether it is subject to the Conflict Minerals Statutory Provision (CMSP) by determining whether conflict minerals are is “necessary to the functionality or production of a product manufactured or contracted to be manufactured.”
• Origin: Conduct a Reasonable Country of Origin Inquiry (RCOI) to determine if conflict minerals originated in Covered Countries.
• Due diligence: Conduct due diligence on the supply chain of the four conflict minerals.
• Independent audit: If due diligence identified conflict minerals from DRC countries, or if it could not be proven otherwise (e.g., the source was not determinable), the proposed rules required an independent audit of the due diligence effort.

Conclusions: Companies would make conclusions at each iterative step. Depending upon its conclusion, companies may/ may not be required to take subsequent steps.

Documents: The evaluation would result in generation of several documents; some were named and defined, while others were implied.

• RCOI report summarizing results of the RCOI activity
• Due diligence report summarizing efforts on supply chain for conflict minerals
• Audit report from the independent audit
• Conflict Minerals Report consisting of all prior activities (due diligence, independent audit, etc.) as well as companies’ conclusions on these efforts.

Disclosures: Companies would make disclosures in conjunction with their financial filings as to the results of their evaluation. The extent of these disclosures would be determined by the results of the procedures, the conclusions of the independent auditor, and perhaps other factors.

• No: If the company found that any conflict minerals originated in DRC Countries, the company would be required to disclose this fact, along with its due diligence, independent audit report, and Conflict Minerals Report (CMR).
• Can’t Tell: If the company could not make a determination, the same disclosure requirements would apply.
• Yes: If a company determined that conflict minerals did not originate in DRC Countries, the proposed rules required the company to disclose that fact, and a short description of their effort, on the company website on an annual basis.

Rulemaking Comments and Discussions

The issues that arose during the public comment period provide insights on how various stakeholders viewed the provisions of the rule and potential problems with compliance. It is often useful to compare these comments with the final rule to understand how regulators may enforce the rule, and the meaning and limitations of what will be included in disclosures. Comments can also provide insights in other challenges companies may be facing, independent of this regulation. Some of the issues that arose in public hearings and via public comments are summarized below.

Materiality: Some commenters indicated that there could be conflict minerals in a few of their products, but those products make up a small portion of their sales. In some cases (for example, promotional items), they don’t even sell the “product.” Several concepts embodying materiality were suggested, including the quantity of the metals, purpose of the metals, the relevance of the product, or size of the company. Many comments drew upon the principle of materiality as it is used for other criteria for financial reporting and disclosures.

De Minimus: Commenters noted that many of their products contain very small quantities of tantalum or tungsten. Or, the minerals may be present as an impurity or a naturally-occurring element in a compound that is being used primarily because of another substance. Some comments requested relief for conflict minerals if they were present in only de minimus quantities.

It’s decoration: Some commenters noted that metals used for decoration are not “necessary to the functionality of the product” – a term that triggered inclusion in DFCM. Some commenters wanted criteria for excluding decorative materials from DFCM. Other commenters noted that the purpose of the metals made no difference to miners or warlords, and indicated it should be included in DFCM.

We’re a small company: Some companies noted that the complexity of DFCM, and the effort and changes that could be required, would be a significant undertaking. So massive, in fact, that they proposed the concept of “materiality” not just for how much conflict minerals could be in their products, or as a proportion of their sales, but according to the size of the company. Some commenters suggested that the requirement for DFCM be required only for companies with sales over a modest threshold.

It’s generic: Some companies noted they only place their label on a generic product, and they exerted no control over the manufacture or specifications of the product. These companies felt the responsibility should be on the companies that manufacture the products.

Supply chain reach: Commenters expressed concern on how far up their supply chain they would be required to go and noted that the trail of inquiry is likely to lead to many of the same companies.

The metal is used in our process, but is not part of the product: Some companies noted that they use materials as part of their manufacturing process, but the metals are not part of the product. One example is a catalyst used in petroleum refining. If the company is not selling a product with a conflict mineral, are they covered?

Acceptable inquiry and due diligence: There were many comments regarding standards to be used for the assessments, reviews, and reports required by DFCM. The Reasonable County of Origin Inquiry (RCOI) was not defined, possibly leading to questions regarding the way companies determined applicability. Commenters had different opinions on whether due diligence was required for all companies, or only companies that met certain criteria.

Audits: Several auditing frameworks were mentioned, including ISO 14001 (Environmental Management Systems) and the Office of Economic Cooperation and Development (OECD) standard for gold in the supply chain. Social Accountability International has standards. Others noted accounting principles and rules, although with likely migration from U.S. Generally Accepted Accounting Principles to International Financial Reporting Standards, this could pose confusion in years to come. Different standards require different skill sets or certifications. Selection of the applicable standard has some effect on who can audit, the availability of professional resources, and (if there are few credentialed resources) the cost.

We can’t tell: Commenters noted that they do not currently have good information on the source of conflict minerals for many reasons. Reliable information is difficult to get in these countries. The transfer of information down the value chain is not yet mature. “Indeterminate origin” is likely to be a conclusion. Audits, reports, and disclosures may not provide stakeholders with useful information, and would present a cost burden to the regulated community.

Conflict Minerals Report (CMR): The proposed rules indicated that a CMR should include a description and the results of the due diligence, the independent audit of the due diligence effort, and the results of the audit. Since this was a defined term, commenters indicated they wanted more guidance.

How, when, and where to disclose: The proposed rule required that companies disclose their DFCM information (COI inquiry, CFM Report, independent audit – whatever the company determines is required) in the company’s Form 10-K. SEC’s rationale was that companies already prepare and file these forms, and people (external financial auditors) are already reviewing and assuring the forms. Commenters raised several issues, including timing of reports, potential challenges for assurers, appropriateness of this different type of disclosure being in the 10-K, and potential liability of company executive officers. These comments highlight the fact that the mechanism, locale, overseeing authority, and content of disclosures matters.

This is going to be expensive: Many commenters noted that compliance with DFCM would be costly. For companies that would ultimately determine there were no conflict minerals from DRC Countries in their supply chain, this would be a lot of effort for nothing. Companies beseeched SEC to look for ways to reduce or eliminate costs.

Analysis of Proposed Rule Comments

I reviewed the proposed rule, and submitted comments to the SEC. Two major themes of my comments were:

Disclose or not; pick one. I commented that this would create a powerful incentive for conclusions and behaviors that were inconsistent with the intent of the rule, and with good governance practices. With no disclosure of their efforts, audits, or related information, investors and stakeholders would not be able to compare the rigor of companies’ investigations. Companies that delved into all components of their supply chain, undertook rigorous due diligence, conducted audits to high standards, engaged independent and experienced auditors, and disclosed comprehensive CMRs would be at a disadvantage. Companies that scarcely gave the rule a thought, did a cursory due diligence, and rigged the audit for a favorable outcome – all to determine “no conflict minerals here” – would be subject to no scrutiny.

Recognize and use many skill sets. Environmental auditing has been a profession for over 30 years. There is a certifying body for professional environmental auditors; that body — the Board of Environmental Auditor Certifications — is co-founded by the Institute of Internal Auditors, an organization with over 100,000 members worldwide. Social Accountability International is a respected non-governmental organization (NGO) that has developed standards for humane workplace standards in many industries, and has contributed to improving these conditions worldwide. I commented that, although this is an accounting rule, experience, frameworks, and practices in other disciplines would contribute significantly to developing and evaluating provisions of DFCM.

Conclusions and Introduction to Part 2

It was 20 months from the time SEC proposed the DFCM rule until it issued the final rule. It was 10 months from the last public hearing until the publication of the final rule. Commenters showed how complex the regulation is. The comments indicated the types of challenges, and the level of effort that would be required to comply. The economy is still in a painfully slow recovery. Did SEC resolve all the questions? Did SEC resolve any of the issues? Did I prevail upon SEC with my comments?

Part 2 of this series in the EHS Journal will review the DFCM final rule, including some things that changed — and some that didn’t — from the proposed rule.

About the Author

Douglas Hileman, P.E., CPEA, has over 34 years of experience in the environmental, safety and sustainability (ESS) fields. He worked for nine years in industry in environmental operations, corporate ESS program development, and due diligence. He has 25 years of experience in consulting, including six years as an in-house specialist at PricewaterhouseCoopers LLP. While at PwC, he supported financial audit teams for environmental liabilities, Sarbanes-Oxley compliance, and business processes, systems and controls. Mr. Hileman has conducted ESS audits of conformance with consent decrees, sustainability data and claims, and many other elements of ESS and served on the Board of Directors of the Auditing Roundtable. He is a Certified Professional Environmental Auditor, a Qualified Environmental Professional, and a member of the Institute of Internal Auditors. Information on his firm can be found at www.douglashileman.com.

Photograph: Child Miner, Democratic Republic of the Congo by Mark Craemer, published in Treehugger.com, June 9, 2009. Click here to see the entire slideshow “The Incredible Story of Conflict Mineral Mining in Images.”

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