The SEC has proposed rules mandated by the Dodd-Frank Act that would require new disclosures by public companies concerning conflict minerals that originated in the Democratic Republic of the Congo or an adjoining country. Specifically, companies would be required to disclose annually whether they use “conflict minerals” that are “necessary to the functionality or production” of a product that they either manufacture or contract to be manufactured that originate from the Democratic Republic of the Congo or adjoining countries, referred to as “DRC countries.”  The conflict minerals are cassiterite, columbite-tantalite, gold, wolframite or their derivatives. These minerals are essential to many products – from jewelry to cell phones to jet engines.

The proposed SEC rules would require public companies to perform due diligence on their supply chain.  Hence, private companies that supply public companies may be contacted as part of this due diligence process.  While the Dodd-Frank Act required the SEC to issue final rules by April 15, 2011, the SEC has not yet done so.  The current version of the SEC’s publicly announced rule making schedule requires the SEC to adopt final rules between August and December 2011.

Further details are below.

The SEC Has Preliminarily Determined that Private Companies are Not Subject to the Disclosure Provisions

The SEC’s proposed rules would apply to any issuer that files reports with the SEC under the Exchange Act, provided that the issuer is a “person described” under Section 1502 of the Dodd-Frank Act, referred to as the “Conflict Minerals Provision.” The Conflict Minerals Provision defines a “person described” as one for whom conflict minerals are “necessary to the functionality or production of a product manufactured by such person.”   The SEC noted that the provision could be read to apply to any company, including companies that are not subject to SEC reporting requirements, or individuals, so long as conflict minerals are necessary to the functionality or production of a product manufactured by that entity or individual. The SEC believes such a broad reading of the provision, however, does not appear warranted given the provision’s background and its location in the section of the Exchange Act dealing with reporting issuers.  However, it has solicited further comments on this issue, which may be incorporated in the final rules.

The Analysis for Public Companies

Although private companies will likely not be subject to reporting requirements under the Dodd-Frank Act, it appears they probably will be contacted by public companies affected by the Dodd-Frank Act exercising supply chain due diligence.  To understand the impact on private companies, it is necessary to review the three step analysis that the SEC says is applicable to public companies.

The first step for public companies required by Section 1502 of the Dodd-Frank Act is for the issuer to determine whether it is subject to the Conflict Minerals Provision. An issuer is only subject to the Conflict Minerals Provision if it is a “person described,” which the Conflict Minerals Provision defines as one for whom “conflict minerals are necessary to the functionality or production of a product manufactured by such person.”  If an issuer does not meet this definition, the issuer would not be required to take any action, make any disclosures, or submit any reports.  If, however, an issuer meets this definition, that issuer would move to the second step.

The second step would require the issuer to determine after a reasonable country of origin inquiry whether its conflict minerals originated in the DRC countries.  If the issuer determines that its conflict minerals did not originate in the DRC countries, the issuer would disclose this determination and the reasonable country of origin inquiry it used in reaching this determination in the body of its annual report.  If, however, the issuer determines that its conflict minerals did originate in the DRC countries, or if it is unable to conclude that its conflict minerals did not originate in the DRC countries, the issuer would disclose this conclusion in its annual report and move to the third step.

Finally, the third step under the Conflict Minerals Provision would require an issuer with conflict minerals that originated in the DRC countries, or an issuer that is unable to conclude that its conflict minerals did not originate in the DRC countries, to furnish a “Conflict Minerals Report.”   In the Conflict Minerals Report, the issuer would be required to provide, among other information, a description of any of its products that contain conflict minerals that it is unable to determine did not “directly or indirectly finance or benefit armed groups” in the DRC countries.   The issuer would identify such products by describing them as not “DRC conflict free.”  If any of its products contain conflict minerals that do not “directly or indirectly finance or benefit” these armed groups, the issuer may describe such products as “DRC conflict free,” whether or not the minerals originated in the DRC countries.

Supply Chain Due Diligence

The proposed rules that would require issuers to disclose, based on their reasonable country of origin inquiry, whether their necessary conflict minerals originated in the DRC countries or that they are unable to determine, after such a reasonable country of origin inquiry, that their conflict minerals did not originate in the DRC countries. The proposed rules do not specify what constitutes a reasonable country of origin inquiry.  Instead, the proposed rules would require an issuer that determined its conflict minerals did not originate in the DRC countries to disclose its reasonable country of origin inquiry in making its determination.

Under the SEC’s proposal, the reliability of any inquiry would be based solely on whether the information used provides a reasonable basis for an issuer to be able to trace the origin of any particular conflict mineral it uses.  For example, the SEC stated it would not satisfy its proposed rules for an issuer to conclude that it is unreasonable for it to attempt to determine the origin of its conflict minerals solely because of the large amount of conflict minerals it uses in its products or the large number of its products that include conflict minerals.  Instead, that issuer would be required to make a reasonable country of origin inquiry as to the origin of all of its conflict minerals that are necessary to the functionality or production of its products that it manufactures or contracts to be manufactured to determine whether those conflict minerals originated in the DRC countries.

The SEC recognizes the possibility that issuers who have conducted a reasonable country of origin inquiry may nonetheless not be able to determine with absolute accuracy the origins of their conflict minerals. The SEC does not believe, however, that it is appropriate for its rules to permit issuers to satisfy their country of origin disclosure requirement by concluding that there is “no evidence” that their conflict minerals originated in the DRC countries and, thereby, not be required to provide any further information regarding their conflict minerals.  Therefore, under the SEC’s proposed rules such an issuer would still be required to file a Conflict Minerals Report and, therefore, would be required to exercise a greater level of investigation into the source and chain of custody of its conflict minerals.

The SEC’s proposed rules do not state what a reasonable country of origin inquiry would entail because it believes that necessarily would depend on the issuer’s particular facts and circumstances. The SEC noted that the reasonable country of origin inquiry requirement is not meant to suggest that issuers would have to determine with absolute certainty whether their conflict minerals originated in the DRC countries, as the SEC has often stated that a reasonableness standard is not the same as an absolute standard.

What Next?

Private companies that may supply public companies should begin to consider the impact of the Conflict Minerals Provision.  One first step may be to consider what public company customers might be impacted by the Conflict Minerals Provision and what components are supplied to the companies.  The next step might be to determine the feasibility of tracing those components back through the supply chain to determine if it will be possible to assist public company customers to determine if its products are DRC conflict free.  Some private companies may not wish to assist public companies in this process if it would require disclosure of trade secrets or confidential information.

Given that the SEC has not yet issued final rules, the timing for these disclosures is difficult to predict.  In the proposing release,  the SEC stated “Assuming we adopt rules in April 2011, as required by the statutory provision, a December 31 fiscal year-end issuer would first have to provide conflict minerals disclosure or a Conflict Minerals Report after the end of its December 31, 2012 fiscal year.”  Many of the comment letters submitted included helpful suggestions that the rules be phased-in over a period of time.

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