Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act created the Financial Stability Oversight Council, or FSOC, to identify and address threats to the stability of the U.S. financial system and the Office of Financial Research, or OFR, to support FSOC and Congress by providing financial research and data.

The Government Accountability Office, or GAO, has  made 10 recommendations to strengthen the accountability and transparency of FSOC and OFR’s decisions and activities as well as to enhance collaboration among FSOC members and with external stakeholders.

The GAO recommendations for FSOC include:

  • Keep detailed records (for example, detailed minutes or transcripts) of closed door sessions of principals meetings and to the extent possible make them publicly available after an amount of time has passed sufficient to avoid the release of market-sensitive information or information that would limit deliberations.
  • Establish formal collaboration and coordination policies that clarify issues such as when collaboration or coordination should occur and what role FSOC should play in facilitating that coordination.
  • More fully incorporate key practices for successful collaboration that GAO has previously identified. Internally, this could include working with agencies to rationalize schedules for rulemakings and conducting collaborative system-wide stress testing. Externally, this could include using professional and technical advisors including state regulators, industry experts, and academics.
  • Establish a collaborative and comprehensive framework for assessing the impact of its decisions for designating financial market utilities, or FMUs, and nonbank financial companies on the wider economy and those entities. This framework should include assessing the effects of subjecting designated FMUs and nonbank financial companies to new regulatory standards, requirements, and restrictions; establishing a baseline from which to measure the effects; and documenting the approach.
  • Develop more systematic forward-looking approaches for reporting on potential emerging threats to financial stability in annual reports. Such an approach should provide methodological insight into why certain threats to financial stability are included or excluded over time, emerging, and prioritize the latter.
  • Make recommendations in the annual report more specific by identifying which FSOC member agency or agencies, as appropriate, are recommended to monitor or implement such actions within specified time frames.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

 

The SEC recently released Frequently Asked Questions relating to provisions of the JOBS Act concerning coverage by research analysts of equity offerings by Emerging Growth Companies, or EGCs. An EGC is a company that was not a public company on December 8, 2011, and that had less than $1 billion (adjusted for inflation) in gross revenues in its most recently completed fiscal year.  A company ceases to be an EGC upon the earliest to occur of the following milestones: (1) it reaches $1 billion in gross annual revenue; (2) it has been a public company for 5 years; (3) it issues, or has issued in the prior 3 years, at least $1 billion in non-convertible debt; or (4) it becomes a “large accelerated filer” pursuant to SEC Rules.

This post provides some highlights from the FAQs and some further explanation.  For additional context on the complicated regulatory regime that is the backdrop for the JOBS Act, scroll to the bottom first.  One of the take-aways from the FAQs is that the SEC is interpreting the JOBS Act in the way that disrupts the fewest existing regulations.  Sometimes that means taking a narrow view of the JOBS Act (as with respect to Section 105(b)), and sometimes that means filling in the blanks inadvertently left by Congress (as with respect to Section 105(d)).

For further background on the JOBS Act, you can find a good summary and power point presentation here.

Testing the Waters and Rule 15c2-8(e)

Rule 15c2-8(e) under the Exchange Act relates to the solicitation of customer orders for the purchase of securities prior to the effective date of their registration.  Rule 15c2-8(e) requires a broker-dealer to take reasonable steps to ensure that, prior to the time an associated person solicits customer orders for securities that are not yet registered, a preliminary prospectus is delivered to the associated person.

Section 105(c) of the JOBS Act permits EGCs and their authorized representatives to engage in oral or written communications with certain classes of qualified potential investors prior to the filing of a registration statement – known as “testing the waters.”  The question is whether testing the waters by contacting potential investors prior to the filing of a registration statement conflicts with Rule 15c2-8(e).  In other words, how does a broker-dealer ensure delivery of a preliminary prospectus prior to the solicitation customer orders by an associated person if the associated person is testing the waters before a preliminary prospectus exists?

The SEC believes that “testing the waters” does not always rise to the level of solicitation of customers for purposes of Rule 15c2-8(e), and therefore the JOBS Act is compatible with the rule.  The SEC notes that testing the waters by informally asking potential investors whether they would invest in an offering, how much they would invest, at what prices, etc., is not a solicitation under Rule 15c2-8 if the potential customer is not asked to make a commitment to purchase the securities.

The SEC also notes that submitting a confidential draft registration statement for confidential review by the SEC pursuant to Section 106(a) of the JOBS Act does not constitute a “filing” of a registration statement for purposes of Rule 15c2-8, thus ensuring that issuers cannot pre-file draft registration statements early to allow associated persons of a broker-dealer to solicit customer orders outside the reach of Rule 15c2-8.

Communications Between Analysts and Investors

NASD Rule 2711(c)(6) prohibits investment bankers from directing research analysts to engage in sales, marketing efforts, or communications with a current or prospective customer regarding an investment banking transaction.

Section 105(b) of the JOBS Act, in turn, prohibits FINRA and the SEC from adopting or maintaining any rules that (1) restrict which associated persons of a broker, dealer, or FINRA member can arrange communications between a potential customer and an analyst, and (2) restrict an analyst from participating in communications with the management of an EGC if the communication is also attended by another associated person of the broker, dealer, or FINRA member who is not an analyst.

The SEC was posed with the question of whether the arranging activities that are prohibited-from-being-prohibited by the JOBS Act conflict with NASD Rule 2711(c)(6) by providing an indirect means for investment bankers to direct research analysts to engage in sales or marketing efforts.  The SEC does not believe there is a conflict because it characterizes the conduct described by the JOBS Act as consisting of little more than sharing client lists and scheduling phone calls.  The SEC also notes that other rules relating to customer communications, such as those that require such communications to be fair, balanced, and not misleading, would still apply to communications that fall within the scope of Section 105(b) of the JOBS Act.

Analyst Participation in Meetings with EGC Management

Prior to the enactment of the JOBS Act, analysts were prohibited from participating in meetings with a company’s management if investment bankers were also participating in the meetings.  The purpose of the rule was to create a firewall between the sales force behind an IPO and the analysts who would be writing about the IPO.  With respect to EGCs, section 105(b) of the JOBS Act now prohibits rules prohibiting meetings among the EGC management, investment bankers, and research analysts.

The goal of this provision of the JOBS Act was to avoid duplicative meetings (one with the investment bankers, a separate one with the research analysts) during a time when an EGC’s executives are already under significant time pressures.  Research analysts can now attend management meetings of an EGC along with investment bankers.

However, the SEC is interpreting Section 105(b) of the JOBS Act narrowly, such that it does not affect a variety of other rules relating to the conduct of research analysts.  As a result, research analysts are still prohibited by NASD Rule 2711 from participating in road shows or engaging in communications with customers about an investment banking transaction in the presence of investment bankers.  Research analysts are also unable to participate in “test the waters” communications.

Publication of Analyst Reports During Quiet Periods

NASD Rule 2711 contains prohibitions on the publication of research reports and public appearances (“quiet periods”) during certain specified time periods (1) after an IPO, (2) after the expiration of a lock-up agreement, (3) before the termination or waiver of a lock-up agreement, and (4) after a secondary offering.

With respect to EGCs, Section 105(d) of the JOBS Act prohibits rules that impose quiet periods following the IPO of an EGC or prior to the expiration of any lock-up agreement.  Technically, Section 105(d) of the JOBS Act only addressed quiet periods in the first of the four categories listed above.  However, the SEC believes that Congress intended to fully address all quiet periods, and so it interprets Section 105(d) as prohibiting each of the four types of quiet periods listed above with respect to EGCs.  The SEC also notes that FINRA is considering changes to NASD Rule 2711(f) to specifically eliminate these quiet periods for EGCs.

Regulation AC is Unaffected by the JOBS Act

Regulation AC requires research analysts to include with their reports certifications that the report accurately reflects the analyst’s personal views and a statement as to whether any of the analyst’s compensation is directly related to the views or recommendations contained in the report.  If any of the analyst’s compensation is related to the report, then additional disclosure is required.  Regulation AC also requires investment banking firms to keep certain records relating to the public appearances of research analysts.

Section 105(a) of the JOBS Act broadens the definition of “research reports” in Section 2(a)(3) of the Securities Act with respect to EGCs.  As a result, there was some concern that this broader definition would also require the Regulation AC certifications on a wider range of documents.  However, the SEC has clarified that the JOBS Act does not affect Regulation AC.  Whether a report qualifies as a “research report” for purposes of Regulation AC is an independent consideration of whether a document is a “research report” for purposes of the amended Section 2(a)(3) of the Securities Act.

A Note About the Regulatory Regime

The regulatory framework that forms the backdrop for this post can be confusing  and may be worth some additional explanation.  The first layer of regulation consists of the governing statutes themselves, the Securities Act of 1933 and the Securities Exchange Act of 1934. The second layer consists of the Securities Act Rules and the Exchange Act Rules, each promulgated by the SEC to implement the respective statutes.

The third layer consists of a host of secondary rules, such as the rules adopted by the New York Stock Exchange, which apply to all issuers listed on the NYSE, the rules adopted by the National Association of Securities Dealers, or NASD, and the rules adopted by the Financial Industry Regulatory Authority, or FINRA.  Before FINRA existed, NASD adopted a host of rules that apply to broker-dealers in the U.S.  In some cases, the NASD rules and the NYSE rules addressed substantially the same topics, but in slightly different ways. In 2007 the enforcement arm of the NYSE combined with NASD to form FINRA.  In an effort to resolve duplication of rules, new FINRA rules are being adopted over time to replace the dual NASD and NYSE rules.  As a result, there are currently effective FINRA rules side by side NASD and NYSE rules that are also still effective.

The fourth layer of regulation for our purposes consists of the JOBS Act, which is really just a set of amendments to our first layer of regulation.  For our purposes, though, it is conceptually useful to think of the JOBS Act as a separate layer.  The JOBS Act works not by affirmatively authorizing certain conduct, but by prohibiting the SEC and FINRA from adopting or maintaining rules that prohibit certain conduct.  The JOBS Act prohibits the SEC and FINRA from prohibiting certain conduct.

The conduct that is the subject of this post is governed in part by NASD Rule 2711 and NYSE Rule 472, which have not yet been consolidated into a new FINRA rule. In this post, I refer only to NASD Rule 2711 as a matter of convenience, but the two rules are conceptually indistinct for our purposes.

Check jobs-act-info.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

The SEC recently adopted final rules under the Dodd-Frank Act that require issuers to disclose payments made to governments if:

  • The issuer is required to file an annual report with the SEC.
  • The issuer engages in the commercial development of oil, natural gas, or minerals.

The new disclosure requirements apply to domestic and foreign issuers and to smaller reporting companies that meet the definition of resource extraction issuer.

In addition, the issuer is required to disclose payments made by a subsidiary or another entity controlled by the issuer, which is to be determined by the issuer based on a consideration of all relevant facts and circumstances.

What Must Be Disclosed:

Under the new rules, a resource extraction issuer is required to disclose certain payments made to a foreign government (including subnational governments) or the U.S. government.

Resource extraction issuers need to disclose payments that are:

  •  Made to further the commercial development of oil, natural gas, or minerals.
  • “not de minimis”
  •  Within the types of payments specified in the rules.

The rules define commercial development of oil, natural gas, or minerals to include exploration, extraction, processing, and export, or the acquisition of a license for any such activity. The rules define “not de minimis” to mean any payment (whether a single payment or a series of related payments) that equals or exceeds $100,000 during the most recent fiscal year.

The types of payments related to commercial development activities that need to be disclosed include taxes, royalties, fees (including license fees), production entitlements, bonuses, dividends, and infrastructure improvements.  The new requirements clarify the types of taxes, fees, bonuses, and dividends that are required to be disclosed.

The rules require a resource extraction issuer to provide the following information about payments made to further the commercial development of oil, natural gas, or minerals:

  •   Type and total amount of payments made for each project.
  • Type and total amount of payments made to each government.
  •  Total amounts of the payments, by category.
  •  Currency used to make the payments.
  •  Financial period in which the payments were made.
  • Business segment of the resource extraction issuer that made the payments.
  • The government that received the payments, and the country in which the government is located.
  • The project of the resource extraction issuer to which the payments relate.

The new rules leave the term “project” undefined to provide resource extraction issuers flexibility in applying the term to different business contexts, but provide guidelines on the SEC’s view of what qualifies as a project

How It Must Be Disclosed:

The new rules require a resource extraction issuer to disclose the information annually by filing a new form with the SEC (Form SD). The information must be included in an exhibit and electronically tagged using the eXtensible Business Reporting Language (XBRL) format.

When It Must Be Disclosed:

A resource extraction issuer would be required to file the form on the SEC public database EDGAR no later than 150 days after the end of its fiscal year.

A resource extraction issuer would be required to comply with the new rules for fiscal years ending after September 30, 2013. For the first report, most resource extraction issuers may provide a partial report disclosing only those payments made after September 30, 2013.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

 

 

Privately offered funds, such as hedge funds, venture capital funds and private equity funds, typically rely on Section 4(a)(2) and the Rule 506 safe harbor to offer and sell their interests without registration under the Securities Act.   In addition, privately offered funds generally rely on one of two exclusions from the definition of “investment company” under the Investment Company Act, which enables them to be excluded from the regulatory provisions of that Act. Privately offered funds are precluded from relying on either of the two exclusions set forth in Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act if they make a public offering of their securities.  

 Section 3(c)(1) excludes from the definition of “investment company” any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 beneficial owners, and which is not making and does not presently propose to make a public offering of its securities. Section 3(c)(7) excludes from the definition of “investment company” any issuer whose outstanding securities are owned exclusively by persons who, at the time of acquisition of such securities, are “qualified purchasers,” and which is not making and does not at that time propose to make a public offering of its securities.

 The JOBS Act directs the SEC to eliminate the prohibition against general solicitation for a new subset of Rule 506 offerings, and makes no specific reference to privately offered funds. Section 201(b) of the JOBS Act also provides that “[o]ffers and sales exempt under [Rule 506, as revised pursuant to Section 201(a)] shall not be deemed public offerings under the Federal securities laws as a result of general advertising or general solicitation.”

 In the proposing release on the JOBS Act rules which eliminate the restrictions on general solicitations for certain offerings, the SEC stated that it  historically has regarded Rule 506 transactions as non-public offerings for purposes of Sections 3(c)(1) and 3(c)(7).  The SEC further stated it  believes the effect of Section 201(b) is to permit privately offered funds to make a general solicitation under amended Rule 506 without losing either of the exclusions under the Investment Company Act.

 While the SEC’s statements may seem generous to some, hedge funds, private equity funds and venture capital funds should be aware that there may be significant limitations on the content of any advertising as we explained here.

 Check jobs-act-info.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

 

Pursuant to Section 201(a)(2) of the JOBS Act, the SEC recently proposed rules to eliminate the prohibition against general solicitation and general advertising in under Rule 144A offerings.  Under the proposed rules, securities sold pursuant to Rule 144A could be offered to persons other than QIBs, including by means of general solicitation, provided that the securities are sold only to persons whom the seller and any person acting on behalf of the seller reasonably believe is a QIB.

In the proposed amendments, the SEC proposes to eliminate the references to “offer” and “offeree” in Rule 144A(d)(1).  Accordingly, as amended, the rule would require only that the securities are sold to a QIB or to a purchaser that the seller and any person acting on behalf of the seller reasonably believe is a QIB.  Under this proposed amendment, resales of securities pursuant to Rule 144A could be conducted using general solicitation, so long as the purchasers are limited in this manner.

Rule 144A currently provides a list of non-exclusive methods of establishing a prospective purchaser’s ownership and discretionary investments of securities for purposes of determining whether the prospective purchaser is a QIB.  The SEC is requesting comments regarding how this non-exclusive list has worked in practice; whether issuers favor a non-exclusive list and whether the non-exclusive list has resulted in an assumption or practice that the listed methods are “de facto” requirements.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

Section 201(a) of the JOBS Act directed the SEC to amend Rule 506 of Regulation D in order to allow for the use of general advertising and general solicitation in Rule 506 offerings in which all of the purchasers were accredited investors.

On August 29th, the SEC proposed amendments to Rule 506 to carry out the direction of the JOBS Act through new Rule 506(c).  Rule 506 offerings are a central component of equity financing in the U.S.  Rule 506 offerings accounted for an estimated $895 billion in capital raised in the U.S. in 2011, compared with $984 billion raised through registered offerings.  The 2010 estimates are $902 billion from Rule 506 offerings and $1.07 trillion from registered offerings.  And the estimates of the amount of capital raised in Rule 506 offerings are most certainly low, since they were compiled based on a review of Form D filings, which in some cases need not be amended to report additional sales. For more on the importance of private offerings in the U.S., take a look at some of our previous coverage. Whereas in the past, an issuer conducting a Rule 506 offering was prohibited from using any means of general solicitation or advertising to attract purchasers (such as open invitation seminars or publicly distributed advertisements), after the implementation of proposed Rule 506(c), you may see advertisements for private investment opportunities in magazines and newspapers, all over the internet, or on billboards.

With the importance of Rule 506 and the magnitude of this proposed change in perspective, here are some of the take-aways from the SEC’s proposing release (if you want a little more background on Rule 506 and accredited investors, scroll down first).

Proposed Rule 506(c)

Proposed Rule 506(c) provides that, in order for an offering that makes use of general solicitation or general advertising to qualify for exemption from registration under Rule 506 of Regulation D, all of the purchasers must be accredited investors, and the issuer must “take reasonable steps to verify that purchasers of securities . . . are accredited investors.”  The additional requirements in Rule 506(c) apply only to those offerings that make use of general solicitation or advertising, and they do not affect an issuer’s ability to conduct Rule 506 offerings without the use of general advertising or solicitation, just as before.

Reasonable Belief in Accredited Investor Status

Rule 501(a) defines an accredited investor, in part, as a person “who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories” (my emphasis). Section 201(a)(2) of the JOBS Act, which directed the SEC to adopt an amendment to Rule 144 under the Securities Act, specifically made reference to a “reasonable belief” standard for determining whether a purchaser is a qualified institutional buyer, yet Section 201(a)(1) of the JOBS Act, relating to Rule 506, did not expressly use the term “reasonable belief.”  This led some to wonder whether the “reasonable belief” portion of the accredited investor definition was being eliminated.  The SEC answers in the proposing release that the reasonable belief component to the accredited investor definition is not, in fact, being eliminated:

“In our view, the difference in the language between Section 201(a)(1) and Section 201(a)(2) reflects only the differing manner in which the reasonable belief standard was included in the respective rules at the time they were adopted, and does not represent a Congressional intent to eliminate the existing reasonable belief standard in Rule 501(a) or for Rule 506 offerings.”

Reasonable Steps to Verify Accredited Investor Status

While the SEC’s proposing release does not provide a clear definition or standard for how an issuer can demonstrate that it has taken “reasonable steps” to verify that all of the purchasers in a Rule 506(c) offering are accredited investors, the release does provide some helpful insight into how the SEC will likely interpret this flexible standard:

  • There is no set definition or objective test for what steps would constitute “reasonable steps” in any given transaction or situation.  The SEC describes it as a flexible test that depends on the facts and circumstances of each transaction.
  • The SEC envisions that a number of factors would be taken into consideration in determining whether the steps taken by the issuer were “reasonable” under the circumstances, including:
    • the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
    • the amount and type of information that the issuer has about the purchaser; and
    • the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.
  • Steps that might be reasonable in one situation would not necessarily be reasonable in another.
  • The SEC seems to be indicating that verification from a third party source – such as a broker dealer or accountant who the issuer has a reasonable basis for believing – or through the production of documents – like W-2s or public securities filings or FINRA BrockerCheck – are preferred over representations directly from the purchaser.  Without more, a purchaser’s representation of accredit investor status would be insufficient to meet the “reasonable steps” standard.
  • The proposing release makes reference to the probable rise of offering portals in footnote 53: “For example, in the future, services may develop that verify a person’s accredited investor status for purposes of proposed Rule 506(c) and permit issuers to check the accredited investor status of possible investors, particularly for web-based Rule 506 offering portals that include offerings for multiple issuers.”
  • In footnote 51, the SEC explains that in some cases, an issuer may be able to satisfy Rule 506(c) without taking any steps; in other words, in some cases, “reasonable steps” may consist of not taking any steps: “If an issuer has actual knowledge that the purchaser is an accredited investor, then the issuer would not have to take any steps at all.”
  • The fact that a purchaser is able to meet a high minimum investment amount without third party financing is a factor that could be used to reasonably verify accredited investor status, and in appropriate cases could, taken alone, be sufficient to demonstrate that the issuer took reasonable steps to verify accredited investor status.
  • An issuer should retain “adequate records that document the steps taken” to verify accredited investor status, since the issuer has the burden of proving that it is entitled to the Rule 506(c) exemption.

Additional Background on Regulation D and Accredited Investors

Generally, sales of securities must be registered under the Securities Act, unless an exemption from registration applies.  Section 4(a)(2) of the Securities Act contains an exemption for transactions “not involving any public offering.”  Rules 501 through 508 under the Securities Act, which are known as Regulation D, provide a safe harbor in connection with a use of the private offering exemption.  While complying with the requirements of Regulation D are not the only way to take advantage of the private offering exemption, Regulation D provides certainty to issuers that if they meet its requirements, the offering is exempt as a private offering.  There are actually several different ways in which offerings can qualify for the Regulation D safe harbor.  One way is through Rule 506, which allows an issuer to sell an unlimited amount of securities to an unlimited number of purchasers who are accredited investors, and up to 35 purchasers who are not accredited investors but who meet a certain threshold of investment sophistication, provided that the terms and conditions of Rules 501 and 502 are also satisfied.

An “accredited investor” is an investor that falls into 1 of 8 categories set forth in Rule 501(a), including a bank, a private business development company under the Investment Advisers Act of 1940, a tax exempt organization with at least $5 million in assets, and certain natural persons who have a net worth of at least $1 million, or who had an annual income of at least $200,000 individually, or at least $300,000 together with a spouse, in each of the last two years.  In the past, a person could count the value of a primary residence towards the $1 million net worth threshold.  However, Section 413(a) of the Dodd-Frank Act provided that the value of a person’s primary residence could no longer be counted for purposes of the net worth calculation.

Check jobs-act-info.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

Among the many statutory and regulatory changes brought about by the Dodd-Frank Act was the enactment of new Section 13(p) of the Securities Exchange Act of 1934, which requires some reporting companies to determine whether “conflict minerals” are necessary to the production or functionality of any product they manufacture, and if so, to disclose whether those conflict minerals originated in the Democratic Republic of the Congo (DRC) or an adjoining country.

Section 13(p) also directed the SEC to develop new rules under the Exchange Act to implement this new requirement, and on August 22, 2012, the SEC revealed the final version of new Rule 13p-1 and new Form SD under the Exchange Act.  Unless otherwise noted, the SEC’s adopting release, which comes in at 356 pages with 917 footnotes, is the source of all quotations in this post.  In the adopting release, the SEC endorses a three step framework as a way of thinking about Rule 13p-1:

Step 1:  An issuer must determine whether it is subject to the requirements of the conflict minerals statutory provision.  The provision applies where  “conflict minerals are necessary to the functionality or production of a product manufactured by such person.”

Step 2:  Issuers within the scope of step one must conduct a reasonable country of origin inquiry regarding the origin of its conflict minerals.  To satisfy the reasonable country of origin inquiry requirement, an issuer must conduct an inquiry regarding the origin of its conflict minerals that is reasonably designed to determine whether any of its conflict minerals originated in the covered countries or are from recycled or scrap sources, and must perform the inquiry in good faith.

Step 3:  Step three applies to issuers who know their conflict minerals came from the Democratic Republic of the Congo or have reason to know that may have.  An issuer must exercise due diligence on the source and chain of custody of its conflict minerals and provide a conflict minerals report describing its due diligence measures, among other matters.

This post focuses on Step 2: the reasonable country of origin inquiry.  By way of refresher, “conflict minerals,” according to the SEC, consist of:

  • Columbite-tantalite, or coltan, which is the ore from which tantalum is extracted. Tantalum is used in electronic components found in cell phones, computers, gaming consoles, and digital cameras, and as an alloy for making carbide tools and jet engine components.
  • Cassiterite, the ore from which tin is extracted. Tin is used in alloys, tin plating, and solders for joining pipes and electronic circuits.
  • Gold, which, apart from its jewelry related applications, is also found in electronic, communications, and aerospace equipment.
  • Wolframite, the ore from which tungsten is extracted.  Tungsten is found in metal wires, electrodes, and contacts in lighting, electronic, electrical, heating, and welding applications.

Considering the many industries and products that are represented by the manufacture of products containing conflict minerals, the potential scope of Rule 13p-1 is staggering.  In what can only be called an understatement, the SEC notes that, “Based on the many uses of these minerals, we expect the Conflict Minerals Statutory Provision to apply to many companies and industries and, thereby, the final rule to apply to many issuers.”

After a company has determined that it is subject to Rule 13p-1 and that it manufactures products for which conflict minerals are necessary, it must conduct a reasonable country of origin inquiry in order to determine whether the conflict minerals in its products originated in a “covered country” – the DRC or one of its adjoining countries, such as Angola, Burundi, Central African Republic, the Republic of the Congo, Rwanda, South Sudan, Tanzania, Uganda, and Zambia.

Reasonable Country of Origin Inquiry

In an effort to make the rules broad, flexible, and adaptable to changing tracing methods that may allow for more accurate determinations of the sources of conflict minerals in the future, the SEC chose to leave the phrase “reasonable country of origin inquiry” undefined in the final rule. The specifics of the reasonable country of origin inquiry and the steps involved in the inquiry “depend on each issuer’s particular facts and circumstances.”  Having said that, the SEC does provide some general guidance on the meaning of the phrase:

  • The inquiry must be reasonably designed to determine whether the issuer’s conflict minerals originated in a covered country (or came from recycled or scrap sources, which is another avenue out of the due diligence at Step 3).
  • The inquiry must be performed in good faith.
  • The issuer cannot ignore red flags indicating that its conflict minerals originated in a covered country.
  • It isn’t necessary that an issuer hear back from all of its suppliers if it has made the reasonable inquiry in good faith and has a reasonable basis for concluding, based on the responses that it did receive, that its conflict minerals did not originate in a covered country.
  • An issuer need not determine with absolute certainty whether conflict minerals originated in a covered country.

Representations from Facilities and Suppliers

An issuer may be able to meet its reasonable country of origin inquiry by asking its facilities or suppliers for representations that the conflict minerals did not originate in a covered country.  However, the issuer “must have a reason to believe these representations are true given the facts and circumstances surrounding those representations” and cannot ignore warning signs or red flags. This requires more than trusting your facility manager. The SEC explains:

“An issuer would have reason to believe representations were true if a processing facility received a ‘conflict-free’ designation by a recognized industry group that requires an independent private sector audit of the smelter, or an individual processing facility, while it may not be part of the industry group’s ‘conflict-free’ designation process, obtained an independent private sector audit that is made publicly available.”

On the other hand, a red flag, in the eyes of the SEC, could be something as simple as a company learning that some of the conflict minerals it uses were processed at a smelter that sourced raw material from a variety of countries, including one or more covered countries.

The OECD Guidelines

Issuers looking for some reassurance that their reasonable country or origin inquiry is robust enough to satisfy Rule 13p-1 may look to the Organisation for Economic Co-operation and Development (OECD), which in 2011 published its Due Diligence Guide for Responsible Supply Chains of Minerals from Conflict-Affected and High Risk Areas.  The OECD guidance is endorsed throughout the SEC’s adopting release a source of standards for the due diligence to be conducted at Step 3, but also for the reasonable country of origin inquiry. The SEC indicates that the “supplier engagement approach in the OECD guidance where issuers use a range of tools and methods to engage with their suppliers . . . to determine if the further work outlined in the OECD guidance – due diligence – is necessary” is the appropriate analog to the Rule 13p-1 reasonable country of origin inquiry.

After the Reasonable Country of Origin Inquiry

Depending on the outcome of the reasonable country of origin inquiry, the issuer either concludes the conflict minerals exercise, or proceeds to the more rigorous due diligence required at step 3.  If the issuer determines that its conflict minerals did not originate in a covered country, or that its conflict minerals came from recycled or scrap materials, or if the reasonable country of origin inquiry is inconclusive, but the issuer “has no reason to believe that its conflict minerals may have originated in the Covered Countries or the issuer reasonably believes that its conflict minerals are from recycled or scrap sources,” then the issuer only needs to disclose this determination in its Form SD filing and briefly describe the reasonably country of origin inquiry and the result the company came to.

If after reading this post you’re thinking that the reasonable country of origin inquiry seems to be a messy, fuzzy, uncertain and potentially very costly endeavor, you should know that the SEC does not share your view: “we believe the reasonable country of origin inquiry standard provides a clear way for issuers to make the necessary determination.”

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

The SEC describes application of the conflicts mineral rule as a three step process:

  • Step 1:  An issuer must determine whether it is subject to the requirements of the conflict minerals statutory provision.  The provision applies where  “conflict minerals are necessary to the functionality or production of a product manufactured by such person.”
  • Step 2:  Issuers within the scope of step one must conduct a reasonable country of origin inquiry regarding the origin of its conflict minerals.  To satisfy the reasonable country of origin inquiry requirement, an issuer must conduct an inquiry regarding the origin of its conflict minerals that is reasonably designed to determine whether any of its conflict minerals originated in the covered countries or are from recycled or scrap sources, and must perform the inquiry in good faith.
  • Step 3:  Step three applies to issuers who know their conflict minerals came from the Democratic Republic of the Congo or have reason to know that may have.  An issuer must exercise due diligence on the source and chain of custody of its conflict minerals and provide a conflict minerals report describing its due diligence measures, among other matters.

This blog post will focus on step three.

Content of the Conflict Minerals Report

The final rule requires any issuer that, after its reasonable country of origin inquiry, knows that its conflict minerals originated in the covered countries and did not come from recycled or scrap sources to provide a conflict minerals report.  The report must include a description of the measures the issuer has taken to exercise due diligence on the source and chain of custody of those conflict minerals.

The final rules also require an issuer that, after its reasonable country of origin inquiry, to include a conflict minerals report if the issuer:

  •  had reason to believe that its minerals may have originated in the covered countries and may not have come from recycled or scrap sources and,
  • after the exercise of due diligence, still has reason to believe that its minerals may have originated in the covered countries and may not have come from recycled or scrap sources.

The final rule does not require a physical label on any product. Instead, the final rule requires that an issuer describe in its conflict minerals reports any products that have not been found to be “DRC conflict free,” as defined in the final rule.

The  rule also requires, unless an issuer’s products are “DRC conflict free,” that the conflict minerals report to include a description of the facilities used to process those conflict minerals, the country of origin of those conflict minerals, and the efforts to determine the mine or location of origin with the greatest possible specificity.

There is special temporary relief for step three issuers.  Issuers that have proceeded to step three may not be able to determine that their:

  •  conflict minerals did not originate in the covered countries,
  •  their conflict minerals that originated in the covered countries did not directly or indirectly finance or benefit armed groups, or
  •  conflict minerals came from recycled or scrap sources.

The final rule permits such issuers to describe products containing those conflict minerals as “DRC conflict undeterminable.” An issuer with products that are “DRC conflict undeterminable” is required to exercise due diligence on the source and chain of custody of its conflict minerals and submit a conflict minerals report:

  • describing its due diligence;
  • the steps it has taken or will take, if any, since the end of the period covered in its most recent prior conflict minerals report to mitigate the risk that its necessary conflict minerals benefit armed groups, including any steps to improve its due diligence;
  • the country of origin of the conflict minerals, if known;
  • the facilities used to process the conflict minerals, if known; and
  • the efforts to determine the mine or location of origin with the greatest possible specificity, if applicable.

The “undeterminable” reporting alternative, however, is only permitted temporarily. For all issuers, this alternative will be permitted during the first two reporting cycles following the effectiveness of the final rule, which includes the specialized disclosure reports for 2013 through 2014. For smaller reporting companies, this alternative will be permitted during the first four reporting cycles following the effectiveness of the final rule, which includes the specialized disclosure reports for 2013 through 2016. Beginning with the third reporting period, from January 1, 2015 to December 31, 2015, for all issuers and the fifth reporting period, from January 1, 2017 to December 31, 2017, for smaller reporting companies, every such issuer will have to describe products in its Conflict Minerals Report as having “not been found to be ‘DRC conflict free.’

The final rule requires an issuer with conflict minerals that originated in the covered countries to determine whether those minerals directly or indirectly financed or benefited armed groups in the covered countries. The conflict minerals statutory provision states that products are “DRC conflict free” when those products do not contain conflict minerals that “directly or indirectly finance or benefit armed groups” in the covered countries.  An “armed group” is defined as “an armed group that is identified as perpetrators of serious human rights abuses in the annual Country Reports on Human Rights Practices under sections 116(d) and 502B(b) of the Foreign Assistance Act of 1961,” as they relate to the covered countries.

Due Diligence Standard

The rule requires that an issuer describe the due diligence it exercised in determining the source and chain of custody of its conflict minerals. The rule requires that an issuer’s due diligence follow a nationally or internationally recognized due diligence framework.

The OECD’s “Due Diligence Guidance for Responsible Supply Chains of Minerals from Conflict-Affected and High-Risk Areas” satisfies the SEC’s criteria and may be used as a framework for purposes of satisfying the final rule’s requirement that an issuer exercise due diligence in determining the source and chain of custody of its conflict minerals.

Independent Private Sector Audit Requirements

For issuers who reach step three, an independent private sector audit is generally required except:

  •  for issuers relying on the temporary “undeterminable” reporting alternative regarding the products that are DRC conflict undeterminable; and
  • step thee issuers that ultimately determine the conflict minerals did not originate in the covered countries.

 In circumstances in which an independent private sector audit is required, the final rule requires that an issuer include a certified independent private sector audit conducted in accordance with the standards established by the Comptroller General of the United States as part of its due diligence on the source and chain of custody of its conflict minerals. Further, the final rule states that the audit constitutes a critical component of due diligence. To implement the conflict minerals statutory provision’s requirement that issuers “certify the audit,” an issuer must certify that it obtained an independent private sector audit of its conflict minerals report and include that certification in the conflict minerals report. The issuer’s audit certification need not be signed by an officer.  Instead, the certification takes the form of a statement in the conflict minerals report that the issuer obtained an independent private sector audit.

Under the conflict minerals statutory provision, the GAO is to establish the appropriate standards for the independent private sector audit. The GAO staff has indicated to SEC staff that the GAO does not intend to develop new standards for the independent private sector audit of the Conflict Minerals Report. GAO staff have also informed the staff that existing Generally Accepted Government Auditing Standards, or GAGAS, such as the standards for Attestation Engagements or the standards for Performance Audits will be applicable.

Entities performing an independent private sector audit of the conflict minerals report must comply with any independence standards established by the GAO, and any questions regarding applicability of GAGAS on this point should be directed to the GAO. The SEC did not adopt any additional independence requirements.

The final rule states that the audit’s objective is to express an opinion or conclusion as to whether the design of the issuer’s due diligence framework as set forth in the conflict minerals report, with respect to the period covered by the report, is in conformity with, in all material respects, the criteria set forth in the nationally or internationally recognized due diligence framework used by the issuer, and whether the issuer’s description of the due diligence measures it performed as set forth in the conflict minerals report, with respect to the period covered by the report, is consistent with the due diligence process that the issuer undertook.

Recycled and Scrap Materials

Under the final rule, if an issuer has reason to believe, as a result of its reasonable country of origin inquiry, that its conflict minerals may not have been from recycled or scrap sources, it must exercise due diligence. The issuer would then be required to provide a conflict minerals report if it is unable to determine that the conflict minerals came from recycled or scrap sources.

Conflict minerals are considered to be from recycled or scrap sources if they are from recycled metals, which are reclaimed end-user or post-consumer products, or scrap processed metals created during product manufacturing. Also, based on the OECD definition, the final rule states that recycled metal includes excess, obsolete, defective, and scrap metal materials that contain refined or processed metals that are appropriate to recycle in the production of tin, tantalum, tungsten and/or gold. The final rule states further, however, that minerals partially processed, unprocessed, or a byproduct from another ore will not be included in the definition of recycled metal.

The final rule only requires an issuer with conflict minerals from recycled or scrap sources to exercise due diligence if it has reason to believe, following its reasonable country of origin inquiry, that its conflict minerals that it thought were from recycled or scrap sources may not be from such sources. If so, as is true for issuers with conflict minerals from newly mined sources, the issuer must exercise due diligence that conforms to a nationally or internationally recognized due diligence framework, if such a framework is available.

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Background

On August 22, 2012, pursuant to the Dodd-Frank Act, the SEC adopted final rules requiring certain companies to disclose their use of conflict minerals if those minerals are “necessary to the functionality or production of a product” manufactured by those companies. The conflict minerals include cassiterite, columbite-tantalite, wolframite, tantalum, tin, gold or tungsten.

The goal of the disclosure requirement is to address concerns that the exploitation and trade of conflict minerals by armed groups is helping to finance conflict in the DRC region and is contributing to an emergency humanitarian crisis.

Threshold Questions

A company is not required to comply with the conflict mineral disclosure requirements if it is able to answer “no” to any of the following questions:

 

  1. Does the company file reports with the SEC under Section 13(a) or 15(d) of the Exchange Act?
  2. Does the company manufacture or contract to manufacture products?
  3. Are conflict minerals necessary to the functionality or production of the product manufactured or contracted to be manufactured?

SEC Guidance on Applicable Thresholds

Assuming the other requirements are satisfied, the final rules apply to any issuer that files reports with the SEC under Section 13(a) or 15(d) of the Exchange Act, including domestic and foreign issuers and small reporting companies.

In order to determine how the answer threshold questions (2) and (3) above, the SEC has provided the following guidance regarding the applicable terminology without actually defining such terms:

 

  • Contract to Manufacture:  The guidance states that whether an issuer will be considered to “contract to manufacture” a product depends 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. An issuer will not be considered to “contract to manufacture” a product if it does no more than take the following actions:

(1)        the issuer specifies or negotiates contractual terms with a manufacturer that do not directly relate to the manufacturing of the product (unless it 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);

(2)        the issuer affixes its brand, marks, logo, or label to a generic product manufactured by a third party; or

(3)        the issuer services, maintains, or repairs a product manufactured by a third party.

  • Necessary to the functionality or necessary to the production: The determination of whether a conflict mineral is deemed “necessary to the functionality” of a product depends on the issuer’s particular facts and circumstances. However, the guidance suggests that in making such determination, an issuer should consider:

(1)        whether the conflict mineral is intentionally added to the product or any component of the product and is not a naturally-occurring by-product;

(2)        whether the conflict mineral is necessary to the product’s generally expected function, use, or purpose; and

(3)        if conflict mineral is incorporated for purposes of ornamentation, decoration or embellishment, whether the primary purpose of the product is ornamentation or decoration.

  • Necessary to the production:  The determination of whether a conflict mineral is deemed “necessary to the production” of a product depends on the issuer’s particular facts and circumstances. However, the guidance suggests that in making such determination, an 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, 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. The SEC will not consider a conflict mineral “necessary to the production” of a product if the conflict mineral is used as a catalyst, or in a similar manner in another process, that is necessary to produce the product but is not contained in that product.

Further, the final rule does not treat an issuer that mines conflict minerals as manufacturing those minerals unless the issuer also engages in manufacturing. Additionally, the final rule exempts any conflict minerals that are “outside the supply chain” prior to January 31, 2013. Under the final rule, conflict minerals are “outside the supply chain” if they have been smelted or fully refined or, if they have not been smelted or fully refined, they are outside the Covered Countries.

Finally, the final rule allows issuers that obtain control over a company that manufactures or contracts for the manufacturing of products with necessary conflict minerals that previously had not been obligated to provide a specialized disclosure report for those minerals to delay reporting on the acquired company’s products until the end of the first reporting calendar year that begins no sooner than eight months after the effective date of the acquisition.

If applicable, the final rule requires a company to provide the disclosure on a new form to be filed with the SEC (Form SD).

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The Commodity Futures Trading Commission (CFTC) has proposed to exempt specific transactions in FERC-administered ISO and RTO markets and the Electric Reliability Council of Texas (ERCOT) from the provisions of the Commodity Exchange Act (CEA).   The CFTC’s proposed exemption defines – then exempts as defined – the following specific transactions  from the CEA in the CAISO, PJM  NYISO, ISO-NE, MISO and ERCOT (hereinafter the “Petitioners.”)

             (i) Financial Transmission Rights

             (ii) Energy Transactions – transactions in the Day-Ahead Market or Real Time Market

             (iii) Forward Capacity Transactions

             (iv) Reserve or Regulation Transactions

No transactions, other than the ones specifically defined, would be exempt from the CEA.  As an example, the CFTC rejected exempting transactions that could be considered a “purchase or sale of a product or service that is directly related to and a logical outgrowth of any of the Petitioners’ [ISOs and RTOs, ERCOT] core functions as an ISO/RTO .. and all services related thereto.”   

More specifically, the CFTC refused to exempt virtual bids/transactions and convergence transactions except to the extent that such transactions would be within the four transactions specifically indentified.

The CFTC proposed two specific conditions on the exemptions – (1) that ERCOT enter into an acceptable information sharing agreement with the CFTC and (2) that no RTO or ISO is required to inform a member of the ISO or RTO prior to responding to a subpoena or request for information from the CFTC.

The CFTC is considering and seeking comments on whether to condition the exemption granted in at least two other ways.  First, the CFTC is considering whether each Petitioner must “comply with and fully implement, the requirements set forth in Order No. 741 [credit reforms final rule]” (emphasis added.)   One obvious question is what the CFTC means by “fully implementing” and whether it would rely on a FERC determination or make an independent determination that an ISO/RTO and ERCOT has complied with and fully implemented Order No. 741.   In addition, an issue will be whether ERCOT has complied with and implemented Order No. 741, given that it was not subject to the requirements of Order No. 741.

Second, the Petitioners represented that they either were or planning to become “central counterparties” – i.e., within a particular market, the buyer to every seller and the seller to every buyer.   The CFTC is concerned, however, whether the central counterparty structure would give the ISO/RTOs set-off rights in bankruptcy and is considering and seeking comment whether to condition the exemption on the submission of a “well-reasoned legal memorandum from, or a legal opinion of, outside counsel that, in the Commission’s [CFTC’s] sole discretion, provides the Commission with adequate assurance that the approach selected by the Petitioner will in fact provide the Petitioner with set-off rights in a bankruptcy proceeding.”  

Comments on the proposed exemption are due thirty (30) days from publication in the Federal Register.