2015 TSMC Annual Report

• TSMC Vision, Mission & Core Values
• Letter to Shareholders
• Company Profile
  1. An Introduction to TSMC
  2. Market/Business Summary
  3. Organization
  4. Board Members
  5. Management Team
• Corporate Governance
  1. Overview
  2. Board of Directors
  3. Major Resolutions of Shareholders’ Meeting and Board Meetings
  4. Taiwan Corporate Governance Implementation as Required by the Taiwan Financial Supervisory Commission
  5. Code of Ethics and Business Conduct
  6. Regulatory Compliance
  7. Internal Control System Execution Status
  8. Status of Personnel Responsible for the Company’s Financial and Business Operation
  9. Information Regarding TSMC’s Independent Auditor
  10. Material Information Management Procedure
• Capital and Shares
  1. Capital and Shares
  2. Issuance of Corporate Bonds
  3. Preferred Shares
  4. Issuance of American Depositary Shares
  5. Status of Employee Stock Option Plan
  6. Status of Employee Restricted Stock
  7. Status of New Share Issuance in Connection with Mergers and Acquisitions
  8. Financing Plans and Implementation
• Operational Highlights
  1. Business Activities
  2. Technology Leadership
  3. Manufacturing Excellence
  4. Customer Trust
  5. Employees
  6. Material Contracts
• Financial Highlights and Analysis
  1. Financial Highlights
  2. Financial Status and Operating Results
  3. Risk Management
• Corporate Social Responsibility
  1. Overview
  2. Environmental, Safety and Health (ESH) Management
  3. TSMC Education and Culture Foundation
  4. TSMC Volunteer Program
  5. TSMC i-Charity
  6. Social Responsibility Implementation Status as Required by the Taiwan Financial Supervisory Commission
• Subsidiary Information and Other Special Notes
  1. Subsidiaries
  2. Status of TSMC Common Shares and ADRs Acquired, Disposed of, and Held by Subsidiaries
  3. Special Notes
• Financial Statements
  1. Consolidated Financial Statements for the Years Ended December 31, 2014 and 2013 and Independent Auditors’ Report
  2. Parent Company Only Financial Statements for the Years Ended December 31, 2014 and 2013 and Independent Auditors’ Report
• Contact Information
• Downloads
• Previous Annual Reports
• CHINESE

TSMC Annual Report >  2015 > Financial Highlights and Analysis > Risk Management

Risk Management

Our Board of Directors plays a key role in helping the Company identify and manage economic risks. Our Risk Management organization periodically briefs our Audit Committee on the ever-changing risk environment facing TSMC, the focus of our enterprise risk management, and risk assessment and mitigation efforts. Our Audit Committee’s Chairperson also briefs the Board on such discussion and actions.

TSMC and its subsidiaries are committed to proactively and cost effectively integrating and managing strategic, operational, financial and hazardous risks together with potential consequences to operations and financial results. TSMC operates an Enterprise Risk Management (ERM) program based on both its corporate vision and its long-term sustainability, as well as on its responsibility to both industry and society. ERM seeks to provide the appropriate management of risks by TSMC on behalf of all stakeholders. A Risk MAP that considers likelihood and impact severity is applied for identifying and prioritizing corporate risks. Various risk treatment strategies are also adopted in response to identified corporate risks. The Company’s risk management includes the management of “strategic risks,” “operational risks,” ‘’financial risks,” “hazardous risks,” and “risks associated with climate change and non-compliance with environmental and climate related laws and regulations, and other international laws, regulations and accords,” etc.

To reduce supply chain risks, TSMC created a cross-functional taskforce comprised of members from fab operations, material management, risk management and quality system management to work with suppliers to develop business continuity plans, and enhance supply chain resilience capability to effectively manage the risks faced by its suppliers. As a result of those efforts, there was no interruption in TSMC’s supply chain in 2015.

As TSMC continued to expand production capacity with advanced technology in 2015, seismic protection engineering design, risk treatment practices and green factory projects were initiated and implemented, beginning in the design phase for all new fabs.

Risk Management (RM) Organization Chart

Organization Functions

Strategic Risks

Risks Associated with Changes in Technology and Industry

● Industry Developments

The electronics industries and semiconductor market are cyclical and subject to significant, and often rapid, increases and decreases in product demand. TSMC’s semiconductor foundry business is affected by market conditions in such highly cyclical electronics and semiconductor industries. Variations in order levels from customers may result in volatility in the Company’s revenues and earnings.

From time to time, the electronics and semiconductor industries have experienced significant, and sometimes prolonged, periods of downturn and overcapacity. Because TSMC is, and will continue to be, dependent on the requirements of electronics and semiconductor companies for its services, periods of downturn and overcapacity in the general electronics and semiconductor industries could lead to reduced demand for overall semiconductor foundry services, including TSMC’s services. If TSMC cannot take appropriate actions such as reducing its costs to sufficiently offset declines in demand, the Company’s revenues, margins, and earnings will suffer during periods of downturn and overcapacity.

● Changes in Technology

The semiconductor industry and its technologies are constantly changing. TSMC competes by developing process technologies using increasingly advanced nodes and on manufacturing products with more functions. TSMC also competes by developing new derivative technologies. If TSMC does not anticipate these changes in technologies and rapidly develop new and innovative technologies, or if the Company’s competitors unforeseeably gain sudden access to additional technologies, TSMC may not be able to provide foundry services on competitive terms. In addition, TSMC’s customers have significantly decreased the time in which their products or services are launched into the market. If TSMC is unable to meet these shorter product time-to-market, TSMC risks losing these customers. These factors have also been intensified by the shift of the global technology market to consumer driven products such as mobile devices, and increasing concentration of customers and competition (all further discussed among these risk factors). If TSMC is unable to innovate new technologies that meet the demands of its customers or overcome the above factors, its revenues may decline significantly. Although TSMC has concentrated on maintaining a competitive edge in research and development, if TSMC fails to achieve advances in technologies or processes, it may become less competitive.

Regarding the response measures for the above-mentioned risks, please refer to “TSMC Position, Differentiation and Strategy” of this Annual Report.

Risks Associated with Decrease in Demand and Average Selling Price

A vast majority of the Company’s revenue is derived from customers who use TSMC’s services in communication devices, personal computers, consumer electronics products and industrial/standard products. Any decrease in the demand for any one of these products may decrease the demand for overall global semiconductor foundry services, including TSMC’s services, and may adversely affect the Company’s revenues. Further, semiconductor manufacturing facilities require substantial investment to construct and are largely fixed cost assets once they are in operation. Because the Company owns most of its manufacturing capacities, a significant portion of TSMC’s operating costs is fixed. In general, these costs do not decline when customer demand or TSMC’s capacity utilization rates drop, and thus declines in customer demand, among other factors, may significantly decrease margins. Conversely, as product demand rises and factory utilization increases, the fixed costs are spread over increased output, which can improve TSMC’s margins. In addition, the historical and current trend of declining average selling prices (“ASP”) of end use applications places downward pressure on the prices of the components that go into such applications. If the ASP of end use applications continues decreasing, the pricing pressure on components produced by the Company may lead to a reduction of TSMC’s revenues, margin and earnings.

Risks Associated with Competition

The markets for TSMC’s foundry services are highly competitive. TSMC competes with other foundry service providers, as well as integrated device manufacturers that devote a significant portion of their manufacturing capacity to foundry operations. Some of these companies may have access to more advanced technologies and greater financial resources than TSMC, such as the possibility of receiving direct or indirect government bailout, economic stimulus funds, or other incentives that may be unavailable to TSMC.

The Company’s competition may, from time to time, also decide to undertake aggressive pricing initiatives in one or several technology nodes. Increases in these competitive activities may decrease TSMC’s customer base, its ASP, or both. If TSMC is unable to compete with any and each of these new competitors with better technologies and manufacturing capacity and capabilities, TSMC risks losing customers to these new contenders.

Risks Associated with Changes in the Government Policies and Regulatory Environment

TSMC management closely monitors all domestic and foreign governmental policies and regulations that might impact TSMC’s business and financial operations. As of February 29, 2016, the following changes or developments in governmental policies and regulations may influence the Company’s business operations:

The Taiwan Financial Supervisory Commission (FSC) requires listed companies, starting from January 1, 2015, to prepare their consolidated financial statements in accordance with the 2013 version of following FSC endorsed standards and interpretations: “International Financial Reporting Standards,” “International Accounting Standards,” and relevant Interpretations (collectively, “2013 Taiwan-IFRSs version”). TSMC has already prepared its 2015 annual and interim consolidated financial statements in accordance with 2013 Taiwan-IFRSs version and the Guidelines Governing the Preparation of Financial Reports by Securities Issuers.

Since the “Labor Safety and Health Act” of Taiwan was amended and renamed the “Occupational Safety and Health Act” in July 2013, the Ministry of Labor has been revising and publishing regulations regarding chemicals management in 2015, including the “Regulation of New Chemical Substances Registration” and the “Regulation of Controlled Chemicals Designation and Operation Permission”. Over the years, TSMC has consistently maintained a safe and healthy work environment with robust protective measures in place, and has taken robust measures to comply with these laws and regulations. With respect to environmental laws, the “Water Pollution Control Act” was amended in February 2015 and related regulations such as the “Water Pollution Control Act Enforcement Rules” and the “Water Pollution Control Measures and Test Reporting Management Regulations” were also amended and published accordingly. TSMC has been a leader on waste water treatment and has taken proper measures in compliance with latest laws and regulations. In addition, the “Greenhouse Gas Reduction and Management Act” was published in July 2015 in Taiwan in response to climate change, and related regulations are expected to be released over the next three years. TSMC has been implementing various long-term energy saving and carbon reduction programs since 2000 and will keep track of regulatory updates to ensure our compliance with these laws and regulations.

In September 2015, the Taiwan government relaxed its rules to allow semiconductor companies to establish 12-inch wafer fabs in mainland China through sole proprietorship. To seize the business opportunities in China, TSMC has submitted its investment application to the Investment Commission of Ministry of Economic Affaires (MOEA) for approval in December 2015 to set up a 12-inch wafer manufacturing facility and a design service center in Nanking.

Other than the above laws and regulations, it is not expected that other governmental policies or regulatory changes would materially impact TSMC’s operations and financial condition.

Operational Risks

Risks Associated with Capacity Expansion

TSMC performs long-term market demand forecast for its products and services to manage its overall capacity. Recently, TSMC has been adding capacity to its 300mm wafer fabs in the Hsinchu Science Park, Southern Taiwan Science Park and Central Taiwan Science Park, based on its market demand forecast. Expansion of the Company’s capacity will increase its costs. For example, the Company will need to purchase additional equipment, hire additional personnel and train personnel to operate the new equipment. If the increased capacity cannot be utilized effectively, TSMC’s financial performance may be adversely affected by these increased costs.

In order to mitigate the risk associated with capacity expansion, TSMC continuously watches the change of market conditions and works closely with its customers. When market demand is not as expected, the Company will adjust its capacity plans in a timely manner to reduce the impact on its financial performance.

Risks Associated with Sales Concentration

Over the years, TSMC’s customer profile and the nature of its customers’ businesses have changed dramatically. While it generates revenue from hundreds of customers worldwide, TSMC’s ten largest customers accounted for approximately 63% of net revenue in both 2014 and 2015, respectively. The Company’s largest customer accounted for approximately 21% and 16% of net revenue in 2014 and 2015, respectively. The Company’s second largest customer in 2015 accounted approximately for 16% of our net revenue, with approximately 9% in 2014.

This customer concentration results in part from the changing dynamics of the electronics industry with the structural shift to mobile devices and applications and software that provide the content for such devices. There are only a limited number of customers who are successfully exploiting this new business model paradigm.

Also, in order to respond to the new business model paradigm, TSMC has seen the change of nature in its customers’ business models. For example, there is a growing trend toward the rise of system houses that operate in a manner that makes their products and services more marketable in a changing consumer market. Also, since the global semiconductor industry is becoming increasingly competitive, some of our customers have engaged in industry consolidations in order to remain competitive. Such consolidations have taken the form of mergers and acquisitions. If more of our major customers consolidate, this will further decrease the overall number of our customer pool. The loss of, or significant curtailment of, purchases by one or more of the Company’s top customers, including curtailment due to increased competitive pressures, industry consolidation, a change in their designs, or change in their manufacturing sourcing policies, or practices of these customers, or the timing of customer or distributor inventory adjustments, or change in its major customers’ business models may adversely affect TSMC’s results of operations and financial condition.

TSMC maintains a close watch on these trends and works closely with its customers to respond to these changes and to strengthen the Company’s market position.

Risks Associated with Purchase Concentration

● Raw Materials

TSMC’s production operations require that it obtains adequate supplies of raw materials, such as silicon wafers, gases, chemicals and photoresist, on a timely basis. In the past, shortages in the supply of some materials, whether by specific vendors or by the semiconductor industry generally, have resulted in occasional industry-wide price adjustments and delivery delays. In addition, major natural disasters, political or economic turmoil occurring within the country of origin of such raw materials may also significantly disrupt the availability of such raw materials or increase their prices. Also, since TSMC procures some raw materials from sole-source suppliers, there is a risk that the need for such raw materials may not be met or that back-up supplies may not be readily available. TSMC revenue and earnings could decline if the Company is unable to obtain adequate supplies of the necessary raw materials in a timely manner or if there are significant increases in the costs of raw materials that the Company cannot pass on to customers. To reduce the supply chain risk and to manage the cost actively, TSMC is committing resources toward developing new supply sources. In addition, TSMC continually encourages its suppliers to reduce their supply chain risk by decentralizing production plants, and to intensify their cost competitiveness by moving their production site to Taiwan from higher-cost areas.

In the meantime, being aware of the risk of fewer back-up suppliers, TSMC is engaging early and deeply with suppliers on managing quality, and capacity issues because ramping at unprecedented speed leaves TSMC with very little time to re-tune its process. At leading technology nodes, TSMC requires world-class material quality, manufactured at world-class facilities, with world-class processes. In regard to streamlining the supply chain risk management, TSMC intensifies supplier site audits and extends supply chain best practices to suppliers’ suppliers to mitigate capacity and quality risks. Moreover, TSMC continually refines its planning system and enhances demand forecast alignments with critical suppliers for adequate supply capacity planning, especially for steep ramping of new nodes. TSMC developed a Supply Chain Risk Assessment for critical suppliers to put in place requirements on regulatory compliance, environmental impact and social responsibility. Any regulatory violations or any environmental impact event as well as failure of meeting TSMC’s expectation in sustainability requirements may result in business reduction or termination.

● Equipment

The Company’s operations and ongoing expansion plans depend on its ability to obtain an appropriate amount of equipment and related services from a limited number of suppliers in a market that is characterized from time to time by limited supply and long delivery cycles. During such times, supplier-specific or industry-wide lead times for delivery can be as long as six months or more. To better manage its supply chain, the Company has implemented various business models and risk management contingencies with suppliers to shorten the procurement lead time. Further, the growing complexities, especially in next-generation lithographic technologies, may delay the timely availability of the equipment and parts needed to exploit time-sensitive business opportunities and also increase the market price for such equipment and parts. If TSMC is unable to obtain equipment in a timely manner to fulfill its customers’ demands on technology and production capacity, or at a reasonable cost, its financial condition and results of operations could be negatively Impacted.

Risks Associated with Intellectual Property Rights

The Company’s ability to compete successfully and to achieve future growth will depend in part on the continued strength of its intellectual property portfolio. While TSMC actively enforces and protects its intellectual property rights, there can be no assurance that its efforts will be adequate to prevent the misappropriation or improper use of its proprietary technologies, software, trade secrets or know-how. Also, the Company cannot assure that, as its business or business models expand into new areas, it will be able to develop independently the technologies, patents, software, trade secrets or know-how necessary to conduct its business or that it can do so without unknowingly infringing the intellectual property rights of others. As a result, TSMC may have to rely on, to a certain degree, licensed technologies and patent licenses from others. To the extent that the Company relies on licenses from others, there can be no assurance that it will be able to obtain any or all of the necessary licenses in the future on terms it considers reasonable or at all. The lack of necessary licenses could expose TSMC to claims for damages and/or injunctions from third parties, as well as claims for indemnification by its customers in instances where it has contractually agreed to indemnify its customers against damages resulting from infringement claims.

TSMC has received, from time-to-time, communications from third parties asserting that TSMC’s technologies, its manufacturing processes, or the design of the semiconductors made by TSMC or the use of those semiconductors by its customers may infringe their patents or other intellectual property rights. Because of the nature of the industry, the Company may continue to receive such communications in the future. These assertions have at times resulted in litigation. Recently, there has been a notable increase in the number of assertions made and lawsuits initiated by certain litigious, non-practicing entities and these litigious, non-practicing entities are also becoming more aggressive in their monetary demands and requests for court-issued injunctions. Such lawsuits or assertions may increase TSMC’s cost of doing business and may potentially be extremely disruptive if these non-practicing entities succeed in blocking the trade of products and services offered by TSMC.

The Company has or expanding its manufacturing operations into certain offshore jurisdictions. To mitigate the risk of intellectual property misappropriation, TSMC has implemented heightened safeguards against such misappropriation.

If TSMC fails to obtain or maintain certain technologies or intellectual property licenses (or fail to prevent our intellectual property from being misappropriated) and, if litigation relating to alleged intellectual property matters occurs, it (i) could prevent the Company from manufacturing particular products or selling particular services or applying particular technologies; and (ii) reduce our ability to compete effectively against entities benefiting from our misappropriated intellectual property, which could reduce its opportunities to generate revenue.

TSMC has taken related measures to minimize potential loss of shareholder value arising from intellectual property claims and litigation filed against the Company. These measures include: strategically obtaining licenses from certain semiconductor and other technology companies as needed; timely securing intellectual property rights for defensive and/or offensive protection of TSMC technology and business; and aggressively defending against baseless litigation.

Risks Associated with Litigation

As is the case with many companies in the semiconductor industry, TSMC has received from time-to-time communications from third parties asserting that its technologies, its manufacturing processes, or the design of the semiconductors made by TSMC or the use of those semiconductors by its customers may infringe upon their patents or other intellectual property rights. These assertions have at times resulted in litigation by or against the Company and settlement payments by the Company. Irrespective of the validity of these claims, TSMC could incur significant costs in the defense thereof or could suffer adverse effects on its operations.

In June 2010, Keranos, LLC. filed a complaint in the U.S. District Court for the Eastern District of Texas alleging that TSMC, TSMC North America, and several other leading technology companies infringe three expired U.S. patents. In response, TSMC, TSMC North America, and several co-defendants in the Texas case filed a lawsuit against Keranos in the U.S. District Court for the Northern District of California in November 2010, seeking a judgment declaring that they did not infringe the asserted patents, and that those patents were invalid. These two litigations have been consolidated into a single lawsuit in the U.S. District Court for the Eastern District of Texas. In February 2014, the Court entered a final judgment in favor of TSMC, dismissing all of Keranos’ claims against TSMC with prejudice. Keranos appealed the final judgment to the U.S. Court of Appeals for the Federal Circuit, and in August 2015, the Federal Circuit remanded the case back to the Texas court for further proceedings. The outcome cannot be determined at this time.

In December 2010, Ziptronix, Inc. filed a complaint in the U.S. District Court for the Northern District of California accusing TSMC, TSMC North America and one other company of infringing several U.S. patents. In September 2014, the Court granted summary judgment of noninfringement in favor of TSMC and TSMC North America. Ziptronix, Inc. can appeal the Court’s order. In August 2015, Tessera Technologies, Inc. announced it had acquired Ziptronix. The outcome cannot be determined at this time.

In September 2013, Zond Inc. filed a complaint in U.S. District Court for the District of Massachusetts against TSMC, certain TSMC subsidiaries and other companies alleging infringing of several U.S. patents. Subsequently, TSMC and Zond initiated additional legal actions in the U.S. District Courts for the District of Delaware and the District of Massachusetts over several additional patents owned by Zond. In March 2015, all pending litigations between the parties in the U.S. District Courts for the District of Massachusetts and the District of Delaware were dismissed.

In March 2014, DSS Technology Management, Inc. (DSS) filed a complaint in the U.S. District Court for the Eastern District of Texas alleging that TSMC, TSMC North America, TSMC Development and several other companies infringe one U.S. patent. TSMC Development has subsequently been dismissed. In May 2015, the Court entered a final judgment of noninfringement in favor of TSMC and TSMC North America. DSS has appealed the final judgment to the U.S. Court of Appeals for the Federal Circuit. In November 2015, the Patent Trial and Appeal Board (PTAB) determined after concluding an Inter Partes Review that the patent claims asserted by DSS in the District Court litigation are unpatentable. DSS appealed the PTAB’s decision in January 2016. The outcome cannot be determined at this time.

Other than the matters described above, TSMC was not involved in any other material litigation in 2015 and is not currently involved in any other material litigation.

Risks Associated with Mergers and Acquisitions

During 2015 and as of the date of this Annual Report, there were no such risks for TSMC.

Risks Associated with Recruiting Qualified Personnel

The Company relies on the continued services and contributions of its executive officers and skilled technical and other personnel. TSMC’s business could suffer if we lose, for whatever reasons, the services and contributions of some of these personnel and we cannot adequately replace them. We may be required to increase or reduce the number of employees in connection with any business expansion or contraction, in accordance with market demand for our products and services. Since there is intense competition for the recruitment of these personnel, we cannot ensure that we will be able to fulfill our personnel requirements in a timely manner during an economic upturn.

Future R&D Plans and Expected R&D Spending

For additional details, please refer to “Future R&D Plans” of this Annual Report.

Changes in Corporate Image and Impact on Company’s Crisis Management

TSMC has established an excellent corporate image around the world based on its core values of “Integrity, Commitment, Innovation, and Customer Trust,” as well as its outstanding operations, rigorous corporate governance, and dedication to corporate social responsibility to pursue sustainable development, equality and justice, and a harmonious society to live and work.

TSMC was honored with awards for its achievements in operations, corporate governance, innovation, profit growth, investor relations, environmental protection and other fields in 2015. Amid TSMC’s continuing efforts to be a better corporate citizen and carry out its social responsibilities, the Company was not only selected as a component of the Dow Jones Sustainability Indices (DJSI) for a 15th consecutive year, but also recognized by the DJSI as the Semiconductors and Semiconductor Equipment Industry Group Leader for a third consecutive year, and led the group in 10 out of 21 categories, including operational eco-efficiency, product stewardship, supply chain management, human capital development, and talent attraction and retention, further strengthening the Company’s public reputation.

In addition, TSMC’s awards in 2015 include the Taiwan Institute for Sustainable Energy 2015 Taiwan Corporate Sustainability Award “Gold Medal For Sustainability Report” and “Sustainable Water Management Award”; the Taiwan Stock Exchange’s first Corporate Governance Award for listed companies, No. 1 in the R.O.C. Ministry of Economic Affairs “Top 20 Innovative Taiwan Companies”; No. 1 in the IEEE Spectrum’s “Patent Power Scorecard” for the Semiconductor Manufacturing sector, The R.O.C. Ministry of Economic Affairs Industrial Development Bureau “Green Factory Label”; The R.O.C. Environmental Protection Administration “Annual Enterprise Environmental Protection Award”; The R.O.C. Environmental Protection Administration “Energy Conservation and Carbon Reduction Action Mark”; The R.O.C. Environmental Protection Administration “Enterprise Green Procurement Award”; The R.O.C. Ministry of Economic Affairs “Excellence in Carbon Reduction Award” and “Excellence in Water Conservation Award”; The R.O.C. Ministry of Health and Welfare “Excellence in Health Award”; Ranked No. 1 for Large Companies in the CommonWealth Magazine Corporate Citizenship Award; The CSR Model Award for the GlobalViews Magazine Annual Corporate Social Responsibility Survey, and the GlobalViews Magazine CSR Model Award for “Promotion of Public Service”.

As an important member of the technology industry, TSMC has always endeavored to act as a positive force in society, and maintains departments such as Brand Management, Customer Service, Public Relations, Employee Relations, Investor Relations, Risk Management, Fab Industrial Safety and Environmental Protection, Internal Audit, and the TSMC Foundation to coordinate the Company’s resources and further enhance TSMC’s positive corporate image.

To address potential events that may affect the Company’s public image, including fires and workplace accidents, TSMC maintains an Emergency Response Procedure Manual, and health and safety supervisors for each fab hold meetings of the “Environment, Health, and Safety Technical Board” every month. In addition, relevant departments hold regular drills and continuously improve their emergency response and notification procedures. At the same time, TSMC has established communications criteria for all types of stakeholders, and the Public Relations Department is responsible for external communications. In the event of the above emergencies, all departments immediately deploy emergency response measures to reduce casualties and minimize the impact on the surrounding environment, Company property, and manufacturing operations, and also alert the Public Relations Department at the first stage of response to ensure smooth channels of communications to maintain the Company’s image.

Risks Associated with Change in Management

During 2015 and as of the date of this Annual Report, there were no such risks for TSMC.

Financial Risks

Economic Risks

● Interest Rate Fluctuation

TSMC are exposed to interest rate risks related to our debt issuances and investment portfolio. TSMC’s interest income and expenses are most sensitive to fluctuations in R.O.C. and U.S. interest rates. Changes in R.O.C. and U.S. interest rates affect the interest earned on the Company’s cash, cash equivalent and marketable securities and the fair value of those securities as well as interest paid on and the fair value of our debt.

TSMC’s investment policy is to achieve a return that will allow TSMC to preserve capital and maintain liquidity requirements. TSMC uses a combination of internal and external management to execute our investment strategy. TSMC typically invests in highly-rated securities, and limit the amount of credit exposure to any one issuer. The policy requires investments generally to be investment grade, with the primary objective of minimizing the potential risk of principal loss. TSMC’s investments in both fixed rate and floating rate interest earning securities carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than predicted if interest rates fall.

In order to limit its exposure to interest rate risks, on the liability side, TSMC finances its funding needs primarily through internal generation of cash and the issuance of long-term, fixed-rate debt. On the investment side, TSMC places its investment mainly in short tenor time deposits as well as in liquid and highly-rated short term fixed income securities to preserve principal and maintain liquidity. We have entered, and may enter in the future, into interest rate futures to hedge interest rate risk on our fixed-income investments.

● Foreign Exchange Volatility

More than half of TSMC’s capital expenditures and manufacturing costs are denominated in currencies other than NT dollars, primarily in US dollars, Japanese yen and Euros. In 2015, more than 90% of the Company’s revenues were denominated in US dollars and currencies other than NT dollars. Therefore, any significant fluctuation to its disadvantage in such exchange rates would have an adverse effect on TSMC’s financial condition. For example, because TSMC’s functional currency is denominated in NT dollars, every 1% depreciation of the US dollar against the NT dollar exchange rate may result in approximately 0.4 percentage point decrease in TSMC’s operating margin based on TSMC’s 2015 results.

Conversely, if the U.S. dollar appreciates significantly versus other major currencies, the demand for the products and services of TSMC’s customers and for its goods and services will likely decrease, which will negatively affect TSMC’s revenues. TSMC utilizes short-term debt denominated in foreign currencies and derivative financial instruments, including currency forward contracts and cross currency swaps, to partially hedge its currency exposure.

Fluctuations in the exchange rate between the US dollar and the NT dollar may affect the US dollar value of the Company’s common shares and the market price of the Company’s American Depositary Shares (ADSs) and of any cash dividends paid in NT dollars on TSMC’s common shares represented by ADSs.

● Inflation and Deflation and Resulting General Market Volatility

The global economy is becoming more vulnerable to sudden unexpected fluctuations in inflationary and deflationary expectations and conditions. Both high inflation and deflation adversely affect an economy, at both the macro and micro levels, by reducing economic efficiency and disrupting saving and investment decisions. Recently, dramatic fall in oil prices and negative interest rates in major world economies have exacerbated global fluctuations in inflationary and deflationary expectations. These macro-economic changes have resulted in general market volatility across all assets classes. Such fluctuations and volatility may negatively affect the costs of TSMC’s operations and the business operations of its customers who may be forced to plan their purchases of TSMC’s goods and services within an uncertain economy. Therefore, the demand for TSMC’s products and services could unexpectedly fluctuate severely in accordance with expectations of inflation or deflation as affected by macro market volatility.

Risks Associated with External Financing

Planning capital requirements is challenging in the highly dynamic, cyclical and rapidly changing semiconductor industry, especially during times of general market volatility in the fixed income, interest rates, foreign currencies, and equities markets. From time to time – and increasingly so for the foreseeable next few years – TSMC will continue to need significant capital to fund its operations and manage its capacity in accordance with market demand. TSMC’s continued ability to obtain sufficient external financing is subject to a variety of uncertainties, including:

• TSMC’s future financial condition, results of operations and cash flow
• General market conditions for financing activities
• Market conditions for financing activities of semiconductor companies
• Social, economic, financial, political and other conditions in Taiwan and elsewhere

Sufficient external financing may not be available to the Company on a timely basis, on reasonable market terms, or at all. As a result, TSMC may be forced to curtail its expansion and modification plans or delay the deployment of new or expanded services until it obtains such financing.

Risks Associated with High-risk/high-leveraged Investment; Lending, Endorsements, and Guarantees for Other Parties; and Financial Derivative Transactions

TSMC did not make high-risk or high-leveraged financial investments during 2015 and up to the date of this report.

TSMC provided a guarantee to TSMC Global, a wholly owned subsidiary of TSMC, for its issuance of US dollar-denominated senior unsecured corporate bonds of US$1,500 million in April 2013. As of February 29, 2016, TSMC and the Company’s subsidiaries had no intercompany loan outstanding.

The financial transactions of a “derivative” nature that TSMC entered into were strictly for hedging purposes and not for any trading or speculative purpose. For more information, please refer to the Annual Report section (II), Financial Statements. The fair market value of TSMC’s trading and available-for-sale financial securities is subject to prevailing market conditions and may fluctuate from TSMC’s carrying value from time to time, which may impact the returns of those securities.

To control various types of financial transactions, the Company has established internal policies and procedures based on sound financial and business practices, all in compliance with the relevant rules and regulations issued by the Taiwan Securities and Futures Bureau. TSMC policies and procedures include “Policies and Procedures for Financial Derivative Transactions,” “Procedures for Lending Funds to Other Parties,” “Procedures for Acquisition or Disposal of Assets,” and “Procedures for Endorsement and Guarantee”.

Risks Associated with Strategic Investments

From time to time, TSMC has made or will make a series of strategic investments. There is no guarantee that any of such investments will be successful commercially. Any such investment will incur risks, which may result in losses even with careful management. Any such loss resulting from such investments may result in significant impairment charges, lower profit margin and ultimately lower distributable earnings. For further information on these investments, please refer to “Subsidiary Information and Other Special Notes” of this Annual Report.

Risks Associated with Impairment Charges

Under Taiwan-IFRSs, TSMC is required to evaluate its investments, tangible and intangible assets for impairment whenever triggering events or changes in circumstances indicate that the asset may be impaired. If certain criteria are met, TSMC is required to record an impairment charge. TSMC is also required under Taiwan-IFRSs to evaluate goodwill for impairment at least on an annual basis or more frequently whenever triggering events or changes in circumstances indicate that goodwill may be impaired and the carrying value may not be recoverable. TSMC holds investments in certain publicly listed and private companies, some of which have incurred certain impairment charges disclosed in the Annual Report section (II), Financial Statements.

The determination of an impairment charge at any given time is based significantly on the projected results of the Company’s operations over a number of years subsequent to that time. Consequently, an impairment charge is more likely to occur during a period when the Company’s operating results are otherwise already depressed.

TSMC has established the process and system to closely monitor and assess the risk of any impairment charge. However, the management is unable to estimate the extent or timing of any impairment charge for future years, or whether such impairment charge required may have a material adverse effect on the Company’s net income.

Hazardous Risks

TSMC maintains a comprehensive risk management system dedicated to the conservation of natural resources, the safety of people, and the protection of property. In order to effectively handle emergencies and natural disasters at each facility, management has developed comprehensive plans and procedures that focus on risk prevention, emergency response, crisis management, and business continuity. TSMC has adopted local and international standards for Environmental, Safety and Health (ESH) management. All TSMC manufacturing fabs have been ISO 14001 certified (Environmental Management System), OHSAS 18001 certified (Occupational Health and Safety Management System), and QC 080000 certified (Hazardous Substance Process Management System). All manufacturing fabs in Taiwan have also been TOSHMS (Taiwan Occupational Safety and Health Management System) certified. The new fabs will also acquire the above certificates within 18 months after volume production.

The Company pays special attention to preparedness for emergencies or disasters, such as typhoons, floods, droughts caused by climate change, earthquakes, environmental contamination, large-scale product returns, service disruption of IT systems, strikes, pandemics (such as H1N1 influenza), and sudden and unexpected disruptions to the supply of raw materials or water, electricity, and other public utilities. TSMC has established a company-wide task force dedicated to managing the risk of a water shortage that might arise due to climate change. This task force keeps watch on the external supply and internal demand for water. Cross-company consolidations and external collaborations with public agencies are also ongoing in the industrial parks to ensure and sustain a stable water supply.

TSMC has further strengthened its business continuity plans, which include periodic risk assessment, risk mitigation, and implementation through the establishment of emergency task forces when necessary, combined with the preparation of a thorough analysis of the emergency, its impact, alternative actions, and solutions for each possible scenario together with appropriate precautionary and/or recovery measures. Each task force is given the responsibility of ensuring TSMC’s ability to conduct business while minimizing personal injury, business disruption, and financial impact under the circumstances. TSMC’s business continuity plan is periodically reviewed according to results of test scenarios or practical implementation for ensuring effective and successful business continuity. Customers are informed of TSMC’s strong business continuity capability in order to establish resilience and flexibility in both their supply chain and insurance placement.

The Company has also conducted a continuous improvement project, including evaluating building anti-seismic capability, holding earthquake emergency response drills, enhancing tool anchorage or seismic isolation facilities, training and preparedness for tool salvage, and has improved TSMC business continuity procedures with reference to ISO 22301 business continuity management.

TSMC and many of its suppliers use highly combustible and toxic materials in its manufacturing processes and are therefore subject to the risk of loss arising from explosion, fire, or environmental influences which cannot be completely eliminated. Although the Company maintains many overlapping risk prevention and protection systems, as well as fire and casualty insurance, TSMC’s risk management and insurance coverage may not be sufficient to cover all of the Company’s potential losses. If any of TSMC’s fabs or vendor facilities were to be damaged, or cease operations as a result of an explosion, fire or environmental influences, it could reduce the Company’s manufacturing capacity and may cause it to lose important customers, thereby having a potentially adverse and material impact on TSMC’s financial performance. In addition to periodic fire protection system inspection and firefighting drills, the Company has also carried out a corporate-wide fire risk mitigation project focused on management and hardware improvements.

Risks Associated with Climate Change and Non-compliance with Environmental and Climate Related Laws and Regulations, and Other International Laws, Regulations and Accords

The manufacturing, assembling and testing of our products require the use of metals, chemicals and materials that are subject to environmental, climate-related, health and safety, and humanitarian conflict-free sourcing laws (such as the U.S. SEC rule for filing Form SD to disclose the origins of certain strategic minerals), regulations and guidelines issued worldwide.

Although TSMC may be eligible for various exemptions and/or extensions of time for compliance, the Company’s failure to comply with any of these applicable laws or regulations could result in:

• significant penalties and legal liabilities, such as the denial of import permits;
• the temporary or permanent suspension of production of the affected products;
• unfavorable alterations in TSMC manufacturing, fabrication and assembly and test processes;
• challenges from customers that place TSMC at a significant competitive disadvantage, such as loss of actual or potential sales contracts in case the Company is unable to satisfy the conditions regarding conflict-free minerals sourcing laws or requirements by our customers;
• restrictions on TSMC operations or sales;
• damage to TSMC goodwill and reputation; and
• loss of tax benefits, including termination of current tax incentives, disqualification of tax credit application and repayment of the tax benefits that TSMC is not entitled to.

Existing and future environmental- and climate-related laws and regulations as well as applicable international accords to which TSMC is subject, could also require it, among other things, to do the following: (a) purchase, use or install expensive pollution control, reduction or remediation equipment; (b) implement climate change mitigation programs and “abatement or reduction of greenhouse gas emissions” programs, or “carbon credit trading” programs; (c) modify product designs and manufacturing processes, or incur other significant expenses associated with such laws and regulations such as obtaining substitute raw materials or chemicals that may cost more or be less available for our operations. It is still unclear whether such necessary actions would affect the reliability or efficiency of TSMC products and services.

The contingencies resulting from the actual and potential impact of local or international laws and regulations, as well as international accords on environmental or climate change, could harm the Company’s business and operational results by increasing expenses or requiring TSMC to alter its manufacturing, assembly and test processes.

Increasing climate change and environmental concerns could affect the results of our operations if any customers request that TSMC provide products and services that exceed any existing standard(s) of environmental compliance. If TSMC is unable to offer such products or offer products that are compliant, but are not as reliable due to the lack of reasonably available alternative technologies or materials, it may lose market share to competitors.

In addition, the Company’s inability to timely obtain environmental related approvals needed to undertake the development and construction of a new fab or expansion project may delay, limit or increase the cost of our expansion plans that could also in turn adversely affect TSMC’s business and operational results. In light of increased public interest in environmental issues, the Company’s operations and expansion plans may be adversely affected or delayed responding to public concern and social environmental pressures even if the Company’s operations comply with all applicable laws and regulations.

Further, energy costs in general could increase significantly due to climate change and other regulations. Therefore, TSMC’s energy costs may increase significantly if utility or power companies pass on their costs, either fully or partially, such as those associated with carbon taxes, emission caps and carbon credit trading programs.

TSMC believes that climate change should be regarded as an important corporate risk, which must be controlled to improve our competitiveness. Climate change risks include legal risk, physical risk and other risks. TSMC’s control measures are as follows:

● Climate regulatory risk control

The greenhouse gas (GHG) control regulations and agreements of countries around the world are becoming increasingly stringent. Enterprises are legally required to regularly disclose GHG-related information, and also limit GHG emissions. The cost of production, including materials and energy, may also grow along with future legal requirements, such as carbon or energy taxes. TSMC continues to monitor legislative trends and communicate with various governments through industrial organizations and associations to set reasonable and feasible legal requirements.

● Conflict minerals risk control

For additional details, please refer to the section of “Supplier and Contractor Management” of “Safety and Health” of this Annual Report.

● Climate disaster risk control

Abnormal climate caused by the greenhouse effect has increased the frequency and severity of climate disasters – storms, floods, drought, and water shortages – causing considerable impacts on business operations and supply chains. TSMC believes that climate change control should take into account both mitigation and adaption, and this requires cooperation among government, society and industry to reduce risk. To ensure electricity and raw water supplies, therefore, in addition to water-saving measures at the Company’s own facilities and those of upstream and downstream partners, TSMC participates in the Taiwan Science Park Industrial Union Experts Committee platform, and is actively involved in regular meetings with Taipower Company and the Taiwan Water Corporation to discuss supply and allocation for response issues.

● Other climate risk controls

Climate change is a concern to the global supply chain, necessitating energy conservation, carbon reduction, and disaster prevention. For example, The Electronic Industry Citizenship Coalition (EICC) has also required members’ suppliers to disclose GHG emissions information. TSMC not only discloses its own GHG emissions information each year, but it also assists and requires its suppliers to establish a GHG inventory system and conduct reduction programs. TSMC’s suppliers are required by TSMC to submit GHG emissions and reduction information as an important index of sustainability scoring in its procurement strategy.

To mitigate risks resulting from climate change, TSMC continues to actively carry out energy conservation measures, voluntary perfluorinated compounds (PFC) emission reduction projects, and GHG inventory and verification every year. TSMC has publicly disclosed climate change information every year through the following channels:

• TSMC has disclosed GHG emissions and reduction-related information for evaluation by the Dow Jones Sustainability Index every year since 2001.
• TSMC’s GHG-related information has been disclosed in its CSR report on the Company website annually since 2008. TSMC also provides information to customers and investors upon request.
• Since 2005, TSMC has been participating in an annual survey held by the nonprofit Carbon Disclosure Project (CDP), which includes GHG emission and reduction information for all TSMC fabs and subsidiaries.
• Every year since 2006, TSMC has followed the ISO 14064-1 standard to conduct a GHG inventory and acquire verification by an accrediting agency. TSMC also reports GHG inventory data to the Taiwan Environmental Protection Administration (EPA) and the Taiwan Semiconductor Industry Association (TSIA).

Other Risks

Potential Impact and Risks Associated with Sales of Significant Numbers of Shares by TSMC’s Directors, and/or Major Shareholders Who Own 10% or More of TSMC’s Total Outstanding Shares

The value of TSMC shareholders’ investment may be reduced by possible future sales of TSMC shares owned by the major shareholders.

One or more of our existing shareholders may, from time to time, dispose of significant numbers of our common shares or ADSs. For example, the National Development Fund, which owned 6.38% of TSMC’s outstanding shares as of February 29, 2016, has from time to time in the past sold TSMC shares in the form of ADSs in several transactions.

As of the date of this Annual Report, no shareholder owns 10% or more of TSMC’s total outstanding shares.

Risks Associated with Cyber Attacks

Even though we have established a comprehensive internet and computing security network, we cannot guarantee that our computing systems which control or maintain vital corporate functions like our manufacturing operations and enterprise accounting would be completely immune to crippling cyber viral attacks launched by third party to gain unauthorized access to our internal network systems to sabotage our operations and goodwill. In the event of a serious cyber attack, our systems may lose important corporate data and our production lines may be shutdown indefinitely pending the resolution of such attack. These cyber attacks may also attempt to steal our trade secrets and other intellectual properties and other sensitive information, such as personal information of our employees and proprietary information of our customers and other stakeholders. Malicious hackers may also try to introduce computer viruses or corrupted software into our network systems to disrupt our operations or spy for sensitive information. These attacks may result in us having to pay damages for our delayed or disrupted orders or incur significant expenses in attempting to re-establish control over our network. If we are not able to timely resolve the technical difficulties caused by such cyber attacks, our financial results as well as our commitments to our customers and other stakeholders may be materially impaired.

Other Material Risks

During 2015 and as of the date of this Annual Report, TSMC’s management is not aware of any other risk event that could impart a potentially material impact on the financial status of the Company.