On Wednesday, the SEC took a long-awaited step in fulfilling one of its responsibilities under the Dodd-Frank Act. The U.S.regulator finalized a rule requiring public companies to disclose the use of conflict minerals—defined as cassiterite, columbite-tantalite, gold, and wolframite—in their manufacturing of products. More specifically, companies that use conflict minerals, necessary to the functionality or production of a manufactured product, must annually disclose whether any of those minerals originated in the Democratic Republic of the Congo or an adjoining country.
The use of these minerals is widespread in manufacturing companies, and the SEC acknowledges this new rule will apply to many public issuers. In perhaps a more poignant acknowledgement, the SEC admits that some companies may incur “significant compliance costs” as a result of implementing the new rule; although the SEC attempted to reduce this burden.
Why will compliance be so costly for companies? Those affected by the rule will have to undergo a rigorous multi-step process to determine the origins of the minerals. First, a public company must determine whether it uses conflict minerals in the production or functionality of a product. Under certain circumstances, companies contracting to manufacture a product must also take this first step. With no bright-line rules in place, each management team must rely on the SEC’s guidance to determine whether the rule applies. Companies concluding that their products are without conflict minerals are free of any additional regulatory obligations. Companies finding the opposite to be true, however, will be required to move to the next step.
Companies using conflict minerals will then conduct a reasonable inquiry into the minerals’ origins. If the inquiry reveals that the minerals come from the Congo or one of the surrounding countries, the company must then exercise due diligence on the source and chain of custody of the materials. Based upon this review, an additional independent audit may be triggered to assess whether proper due diligence measures were followed.
Finally, companies using any conflict minerals will be required to disclose the measures taken in a country of origin investigation and, in some cases, the identity of any products manufactured with conflict minerals. Additional disclosures may be required in certain circumstances.
This rule goes into effect on Jan.1, 2013, but the first reports with the described disclosures are due May 31, 2014. Until then, boards of directors have a significant oversight responsibility—while management will undertake the multi-step process, boards must ensure the inquiry and due diligence procedures are in compliance with the rule.
The description above only scratches the surface of a long and complex rule. Those interested in obtaining more information should take advantage of SEC resources and previous reports by NACD. We have followed this issue from the beginning and produced several informative pieces. For a brief synopsis of the rule and its implications, view our latest NACD BoardVision. For a deeper understanding of this rule’s background, view this Directorship article and this NACD blog entry.
Moving into May and the peak of annual meeting season, executive compensation is one of the top stories in the business media. To date, eight companies have failed their annual say-on-pay votes. With the bulk of annual shareholder meetings in the coming months, this number is expected to increase. This week, an editorial in the New York Times criticized the Securities and Exchange Commission (SEC) for failing to issue rules on another area of executive compensation—pay ratios—claiming the “main problem seems to be foot-dragging in the face of objections from corporate lobbyists.”
The article correctly identifies several factors. The SEC did delay issuing final rules on the CEO pay ratio until the second half of 2012, effectively postponing corporate disclosure of the ratio of chief executive pay to the company’s median salary until the 2013 proxy season. Also, a substantial number of comment letters have already been submitted to the SEC on matters regarding executive compensation disclosures, including some for which there are no rules pending. Lastly, the rules mandated for pay ratios in Dodd-Frank are unlike most other provisions in the legislation, in that Congress did not allow for much flexibility in crafting the final rules.
However, the NYT editorial did not mention several factors that have hindered progress for the SEC. According to the May 2012 Dodd-Frank Progress Report from Davis Polk, of the SEC’s 95 required rulemakings, the agency has missed the deadline for 56. When final rules are actually released, they are often met with criticism and lawsuits. Last summer the U.S. District Court of Appeals overturned the SEC’s proxy access rule on the basis that the agency had not conducted a thorough cost-benefit analysis. The SEC subsequently introduced a more robust economic analysis in its rulemaking process, leading to a missed deadline for releasing a final rule regarding the conflict minerals provision—which will require companies to track and disclose their use of minerals potentially sourced from the Democratic Republic of the Congo.
With the rigid mandates on the pay-ratio disclosure, the SEC is facing difficulties with one area not clearly defined: computing median compensation. While Dodd-Frank was explicit in the calculation of the ratio, it was not clear in how the median total compensation would be measured. This measurement leads to several questions: Does the compensation of every employee at an organization need to be computed? Should part-time employees be included in the calculation? Would international employees be included? If so, what foreign exchange rate would be used? Taking these questions into consideration, last August the AFL-CIO proposed the use of statistical sampling to calculate the median compensation, an option the SEC is taking seriously.
The argument is no longer whether pay ratio disclosures will have the intended effect of changing executive compensation. Instead, it is when and how these rules will be issued.
On Tuesday, the Securities and Exchange Commission (SEC) convened a roundtable for an area the Commission does not usually delve into: the humanitarian crisis in the Democratic Republic of Congo (DRC). As part of the Dodd-Frank financial reform legislation, the SEC was given the responsibility of drafting rules requiring publicly listed companies to disclose whether their products contain “conflict minerals.” In this context, the conflict minerals are tin, tungsten, tantalum, and gold produced in the DRC or adjoining countries, as well as any others the U.S. Secretary of State may designate as financing conflict in the DRC.
Although the SEC issued proposed rules on the disclosure in December 2010, it has since failed to meet its April deadline established for final rules, citing difficulties in drafting a rule that would not pose prohibitive costs of compliance for companies. To this end, the SEC convened a public roundtable representing corporations, investors and human rights advocates.
The first panel discussed what is covered by the rule, and what steps would be required to comply. Panelists included Sandy Merber, General Electric; Irma Villarreal, Kraft Foods Inc.; Yedwa Zandile Simelane, AngloGold Ashanti Ltd.; and Mike Davis, Global Witness. The panel discussed a series of questions the Commission had developed from the first round of comment letters including:
Should functionality be a test of whether a product is included in the report?
If the mineral is used as an ornament, should it be included?
Should rules include a de minimis point?
How to define “contract to manufacture” in rules
Unlike many of the rules to develop from Dodd-Frank, this did not trigger contention among those representing corporations, investors and advocacy groups. While the representatives from Kraft Foods and General Electric noted the practical impossibility of fully identifying the sources of all their products by the next reporting season, the other panelists, recognizing this, responded that they would be content with a “good faith” effort, improving year over year. Even so, the sheer scope of the rule’s potential impact demonstrates the difficulties the SEC faces in writing the rules, and for companies to comply. Villarreal noted that Kraft Foods has 40,000 different products with 100,000 suppliers.
The second panel continued to discuss the steps necessary for compliance as well as reporting. Panelists included Benedict S. Cohen, The Boeing Company; Jennifer Prisco, TE Connectivity; Darren Fenwick, Enough Project; Kay Nimmo, ITRI, Ltd.; and Darrel Schubert, Ernst & Young LLP and the Auditing Standards Board. Picking up where the first panel left off, the roundtable discussed further questions from the SEC, such as:
Should the disclosure be included in the annual report or in a separate report?
Should scrap and recycled minerals be exempt?
How should the country of origin be defined?
Who should conduct the audit? A Certified Public Accountant (CPA), or non-CPA?
Should the SEC specify a standard for the audit, and, if so, what standard?
The SEC faces a difficult task—draft rules that satisfy the Dodd-Frank requirements and advocacy groups, without imposing punitive costs or unattainable expectations on corporations. In light of the recent dismissal of proxy access rules from the U.S. Court of Appeals, the SEC must also create rules that will survive potential court challenges. As the voice of the director, NACD is currently drafting a comment letter. Stay posted for further developments in this area.