During late August, the SEC adopted its long-awaited conflict minerals rule, which it was required to adopt under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The rule is not yet on the radar-screen of most private equity and venture capital professionals. However, for the reasons discussed in this Alert, the rule is one that fund managers cannot afford to ignore.

The rule requires public companies — including those controlled by private equity, venture capital and other fund managers — to conduct supply chain diligence and make disclosures concerning specified “conflict minerals” to the extent that the minerals are necessary to the functionality or production of products manufactured or contracted to be manufactured by the public company. The first reporting period under the rule begins on Jan. 1, 2013.

Although less onerous than the proposed rule in many important respects, the final conflict minerals rule still will impose substantial compliance obligations on a significant portion of the public company universe across a wide range of industries. There is widespread use of the minerals covered by the rule and the SEC estimates that approximately 6,000 public companies will have disclosure obligations under it. Approximately 75 percent of these companies will be required to submit a Conflict Minerals Report, which requires enhanced due diligence on the source and chain of custody of the conflict minerals contained in the company’s products, and which generally must be audited.

Furthermore, although private companies are not directly subject to the conflict minerals rule, they will be indirectly affected by it, having compliance (although not public reporting) obligations to the extent that they are part of a public company’s supply chain. Some estimates place the number of affected private companies in the hundreds of thousands, ranging from small businesses to large companies and both domestic and foreign. Therefore, the rule will have a significant impact on many private equity- and venture-backed companies that are not, and never expected to go, public.

For many companies, compliance costs arising out of the direct or indirect application of the conflict minerals rule will be significant. Aggregate up-front compliance costs for public companies alone are estimated in the billions of dollars and ongoing annual compliance costs are estimated in the hundreds of millions of dollars. These figures do not take into account the compliance costs that will be incurred by private companies that are part of a public company’s supply chain. For most companies, the largest portion of the compliance costs is likely to relate to the supply chain mapping and tracing exercise and related systems upgrades that will be required by the rule. The compliance challenges are further magnified by the numerous “facts and circumstances” determinations required by the rule, as well as evolving diligence and audit protocols.

SRZ’s recent Alert on the subject provides a substantially more detailed discussion of the conflict minerals rule, as well as suggested near-term action items for portfolio companies and resources to assist in compliance.

In addition to these action items, we recommend that fund managers consider approaching conflict minerals rule compliance on a portfolio-wide basis. By doing so, managers will be able to reduce the costs of compliance by portfolio companies (in some cases substantially), ensure consistency of approach across the portfolio, better manage risk and possibly offset compliance costs through additional visibility and control over portfolio company supply chains and materials sourcing.

Furthermore, beginning now, for acquisition targets, the conflict minerals rule must be taken into account as part of the diligence process.