Section 1502 of the Dodd-Frank Act passed by the U.S. Congress in 2010 is an attempt to curtail the financing of armed groups benefiting from the sale of conflict minerals contributing to the humanitarian crisis in the Democratic Republic of the Congo (DRC) region. The law requires companies using conflict minerals (tin, tungsten, tantalum and gold, otherwise known as 3TGs) that are “necessary to the functionality or production of a product” they manufacture to disclose their use. The Securities and Exchange Commission (SEC), the rule-making body, requires impacted companies under certain circumstances to conduct due diligence to determine the origin and chain of custody of their conflict minerals.
Complying with this Rule requires timely and accurate situational awareness of upstream conditions in the DRC region (particularly North and South Kivus in Eastern DRC) in order to have an effective conflict minerals compliance architecture. Indeed, many of the requirements in the SEC final rule and Organization for Economic Co-operation and Development’s (OECD) Due Diligence Guidance for Responsible Supply Chains of Minerals from Conflict-Affected and High-Risk Areas necessitate a rudimentary understanding of local actors, mine locations, groups controlling the mines and whether armed groups are illegally “taxing” minerals when transported along routes that they control. This basic understanding is needed in order to minimally verify representations made by suppliers, direct or indirect and to remediate identified “red flags.” Below are seven crucial reasons for covered companies to acquire a foundational upstream knowledge.
- Verification: There is an over-reliance on representations made by suppliers and smelters without proper vetting, exposing companies to noncompliance risk. This shortcoming can only be remedied by acquiring relevant upstream knowledge. Filers must be both proactive in understanding and identifying red flags in their supply chain and reactive in taking steps to address identified issues.
- Due Diligence: Conducting an effective risk-based due diligence and traceability require a practical ongoing process that will enable better understanding of the chain of custody. This includes illegal checkpoints where the mineral may be “taxed” by armed groups, thereby tainting the minerals even if originating from a conflict-free mine. This process requires some upstream familiarity.
- OECD Framework Implementation: The Organization for Economic Co-operation and Development’s due diligence guidance and framework, which is tacitly endorsed by the SEC, states that suppliers’ membership with conflict-free organizations is not solely a sufficient basis for a conflict-free claim. The UN Group of Experts (UNGoE) has questioned the reliability of some of the certifying organizations, thereby exposing a filer to substantial reputational risk. This makes upstream situational awareness training an important exercise. Ultimately, representations and filings made by registrants remain their responsibility.
- Red Flag Identification: The SEC and OECD state that “red flags” may not be ignored; knowledge of the local terrain to both identify and remediate issues of suspicious and undesirable practices is therefore implicitly required.
- Reliability and Accountability: Reliability of a Reasonable Country of Origin Inquiry (RCOI) declaration as required by the SEC is the responsibility of the filer. This obligation cannot be fulfilled without some minimal verification procedure if a covered company’s 3TG minerals come from the DRC or adjoining countries.
- Risk Management: Understanding the true nature of a filer’s risk exposures and how to effectively respond, prevent or mitigate them — whether they are chain of custody irregularities or misrepresentations made by a supplier as to mine ownership or country of origin — requires on-the-ground awareness. Notwithstanding possible SEC sanctions, the real and lasting consequences of noncompliance could arise when, for example, a link can be made between a filer’s product and forced child labor in a rebel-controlled mine. This situation would likely lead to damaged brand equity and a decline in shareholder value from possible divestiture by investors and fund managers. Additionally, registrants may experience a loss in revenues from consumers, many of whom are increasingly demanding that the products they purchase contain conflict-free materials, as can be seen on many college campuses today.
- Reporting Software and Templates: While leveraging reporting templates and off-the-shelf software for the SEC disclosure requirement is helpful from a time-saving and efficiency perspective, this does not replace the filer’s obligation to be accurate. Additionally, they are not particularly helpful when suppliers fail to respond or provide less-than-truthful answers to the survey or questionnaire sent out by filers. Effective verification of the suppliers’ and smelters’ responses to the conflict minerals reporting questionnaire requires a deeper knowledge of the fast-changing local conditions in high-risk areas.
There is an ongoing legal challenge as to whether an aspect of the SEC Rule violates the First Amendment. Most recently, the U.S. Court of Appeals for the D.C. Circuit on November 9, 2015, denied an en banc rehearing petitions by the SEC and Amnesty International, upholding a previous ruling that requiring registrants to describe their products as “not [having] been found to be DRC-conflict free” is compelled speech and a violation of the First Amendment. However, the conflict mineral traceability requirement still remains in effect. In light of the significant risk exposures to filers outside of the SEC mentioned above, the importance of acquiring relevant knowledge about the conditions in which 3TG minerals are sourced and used in the manufacture of end products by registrants cannot be overstated. The filer and at a minimum their direct suppliers must take steps to address this knowledge gap if and where it exists. Only then can a registrant rely on strong and defensible internal policies and procedures and reduce the likelihood of noncompliance and its associated risks.