March 8, 2012

The SEC's Conflict Minerals Rule – An Overview for Public and Private Companies

By Michael R. Littenberg, Partner, Schulte Roth & Zabel LLP

The SEC's Conflict Minerals Rule – An Overview for Public and Private Companies

Under Dodd-Frank, the SEC has been tasked with adopting rules that will require public companies to disclose their use of conflict minerals, with enhanced diligence and disclosure obligations for minerals originating in the Democratic Republic of Congo (“DRC”) and its neighboring countries. The rule is intended to reduce a significant source of funding for armed groups that are committing human rights abuses in the DRC.

“Conflict minerals” consist of four specific minerals and their derivatives. The first three are cassiterite, columbite-tantalite (coltan), wolframite and their derivatives, which include tin, tantalum and tungsten and are often referred to as the “three T’s.” The fourth mineral is gold.

In late 2010, the SEC published its proposed conflict minerals rule.Under the proposed rule, registrants that use conflict minerals in their products or production processes must conduct diligence to determine whether the conflict minerals used originated in a DRC country.To the extent that the conflict minerals used originated in a DRC country, were from an unknown source or were from scrap or recycled sources, then the registrant must conduct additional supply chain diligence and prepare a Conflict Minerals Report.

Among other things, the Conflict Minerals Report must describe the measures that the registrant took to exercise due diligence on the source and chain of custody of its conflict minerals. The Conflict Minerals Report also must indicate any of the registrant’s products that are not “DRC conflict free,” which are those products that contain conflict minerals that originated in certain regions of the DRC countries or are of unknown origin. The Conflict Minerals Report is required to be audited and must be furnished with the registrant’s annual report.

To the extent possible, most registrants are expected to preemptively make changes to their supply chains in order to avoid having to disclose that their products are not “DRC conflict free.”

As proposed, the conflict minerals rule will take effect for a given registrant beginning with its first full fiscal year after the SEC adopts the final rule, although the SEC recently indicated verbally that the final rule will contain a yet-to-be disclosed phase in period. The SEC has indicated that it expects to adopt the final rule during the first half of 2012, although the adoption date already has been pushed back twice. Unlike some other Dodd-Frank rules, the proposed conflict minerals rules does not contain a blanket exemption or extended phase-in for foreign private issuers or smaller reporting companies.

The SEC estimates that approximately 6,000 registrants use conflict minerals and that approximately 1,200 of those companies will need to prepare a Conflict Minerals Report.

Although the conflict minerals rule technically applies only to public companies, it will have a significant impact on any company anywhere in the world, public or private, that is part of a registrant’s supply chain. In order to meet their obligations under the rule, registrants will need to collect supply chain information from their suppliers. Therefore, a significant number of private company suppliers also will need to be familiar with the conflict minerals rule and the obligations that their direct and indirect customers are likely to place on them.

All registrants will need to determine whether their activities trigger disclosure under the rule. This will require most registrants to do at least some conflict minerals diligence.

Diligence under the conflict minerals rule involves a three step inquiry, with increasing levels of diligence and disclosure depending on the registrant’s use of conflict minerals and their area of origin.

Step One requires a registrant to first determine if conflict minerals are necessary to the functionality or production of a product it manufactures or contracts to be manufactured. Many registrants that initially assumed their products were free of conflict minerals have discovered after a preliminary inquiry that in fact that is not the case. For example, the American Apparel and Footwear Association, a trade group whose members include many large designers, manufacturers and retailers in the apparel and footwear industry, noted in its comment letter to the SEC that there may be incidental use of conflict minerals in certain children’s shoes that light up and certain types of outerwear that contain heating elements. In addition, at the SEC’s October 2011 conflict minerals roundtable, a well-known manufacturer of food and beverage products indicated that it was surprised to learn that conflict minerals are used in some of its packaging.

If a registrant determines in its Step One diligence that conflict minerals are necessary to the functionality or production of a product it manufactures or contracts to be manufactured, it must move on to Step Two of the diligence process. Step Two requires a reasonable country of origin inquiry to determine whether the conflict minerals used originated in a DRC country.

The proposed rule does not specify what constitutes a reasonable country of origin inquiry. What constitutes a reasonable inquiry will depend among other things on the then current industry tracking infrastructure.

If a registrant determines that any of its conflict minerals originated in a DRC country, are from an unknown source or are scrap or recycled, the registrant must go on to Step Three, which, as discussed above, requires additional diligence and the preparation of a Conflict Minerals Report.

At present, the final conflict minerals rule has not yet been released and there are a number of uncertainties about the shape that the final rule will take.For example, industry groups have argued for a de minimis usage threshold, exemptions and/or phase-ins for smaller reporting companies and foreign private issuers, a temporary indeterminate origin classification to the extent that the source of conflict minerals cannot be traced and a due diligence safe harbor.The SEC’s final rule also will need to clarify the scope of the Conflict Minerals Report audit and who will be qualified to perform that audit. Finally, some groups have indicated that they may seek to challenge any final rule in court.

Until a final rule is adopted, it is premature for registrants to build out a full-scale conflict minerals rule compliance program.However, registrants that have not yet done so, should familiarize themselves with the proposed rule, assess the risks it presents to their business and develop an action plan for complying with the final rule once adopted.