by Cydney Posner
The GAO has issued its annual conflict minerals report to Congress, entitled “Companies Face Continuing Challenges in Determining Whether Their Conflict Minerals Benefit Armed Groups.” The GAO is required to report annually on the effectiveness of the SEC’s conflict minerals rule in promoting peace and security in the DRC and adjoining countries (the “covered countries”) as well as on the rate of sexual violence in war-torn areas of the covered countries. (For a discussion of last year’s report, see this PubCo post.) This report is particularly instructive in outlining the many challenges to supply chain due diligence arising out of fraud risk associated with reliance by processing facilities on documentary evidence from upstream stakeholders and compounded by the complexity of processing operations. If the title of report didn’t clue you in, the bottom line is that, although the GAO’s reviews “indicate some progress in companies’ efforts to comply with some key provisions of the rule, they also indicate that companies continue to face some challenges in their supply chain due diligence efforts.” For most companies, the sources of their conflict minerals remain a mystery.
The Dodd-Frank conflict minerals rule requires reporting by public companies if they manufacture or contract to manufacture products that use conflict minerals that are necessary to the functionality or production of those products. Those companies are required to conduct a “reasonable inquiry” to determine if the conflict minerals used were from a covered country. If, based on that inquiry, the company knows or has reason to believe that the conflict minerals originated in the covered countries (or if the company learns or has reason to believe that its minerals may not be recycled or scrap), the company is required to conduct substantial due diligence on its supply chain to determine if the conflict minerals financed or benefited armed groups in the covered countries and to file a “Conflict Minerals Report” with the SEC. Under current guidance, companies that, following due diligence, state that any of their products are conflict-free will have to provide an independent private sector audit (IPSA).
The GAO report examines conflict minerals filings in 2015 (which report on activities in 2014), discusses the actions of the Department of Commerce regarding its conflict minerals-related requirements under Dodd-Frank and provides information on sexual violence in the DRC and three adjoining countries. The GAO analyzed a generalizable random sample of 100 SEC filings and interviewed relevant officials. (For a take on conflict minerals reporting in 2016 from the perspectives of two consultants, see this PubCo post.)
The GAO estimates that, as a result of conducting reasonable country-of-origin inquiries (RCOIs), 19% more companies that filed a Form SD in 2015 (as compared with 2014) reported that they knew or had reason to believe they knew the source of the conflict minerals in their products, based on the sample of filings GAO reviewed. However, 79% of SD filers performed due diligence and, of those, 67% reported they were unable to confirm the source of the conflict minerals in their products, while 97% reported that they could not determine whether the conflict minerals financed or benefited armed groups in the covered countries (the due diligence test for determining whether or not products are conflict-free). In interviews, the GAO heard that companies experienced difficulties in obtaining sufficient information from all suppliers to enable them to determine the country of origin of all conflict minerals in their products, that some suppliers did not respond to requests for information and that some information from suppliers was incomplete (although supplier follow-ups helped mitigate that problem in some cases). Companies also indicated that, to improve their due diligence efforts, they either planned or implemented actions such as shifting operations or encouraging those in their supply chains to shift from current suppliers to certified conflict-free suppliers, including language in new supplier contracts regarding the company’s expectations relating to conflict minerals and continuing follow-up with and providing training to suppliers.
The report was especially interesting in describing some of the challenges associated with the due diligence effort:
- Processing facilities rely on paper documentation from miners and exporters for information on source and chain of custody, and ore may pass through a number of traders and exporters before reaching a processing facility. The report indicates that “documentation of these stages may be falsified by smugglers or be incomplete, which may mask the actual source of the minerals being traded, according to some experts.”
- Certification programs “face operational challenges, including lack of infrastructure and government support. OECD reported in 2013 that as long as there are no traceability or certification schemes in place that cover the whole region, smuggling and contamination of conflict-free materials will continue to pose a threat to due diligence initiatives.”
- There have also been challenges to the integrity of these programs, such as the black-market sale of tin supply-chain-initiative tags in the DRC and in Rwanda. Various organizations have “commented that the DRC government lacks capacity to mitigate corruption and smuggling of conflict minerals. The UN Group of Experts reported in 2015 that, while there has been progress on traceability and due diligence efforts concerning minerals produced in the DRC, smuggling continues, and there is scant evidence of interest in traceability and due diligence by the governments of the DRC and Burundi.”
- The complexity of processing operations exacerbates the difficulty. For example, the processing of some minerals involves “many stages and distinct intermediate products. According to USGS officials, many processors perform only some of the refining work before selling intermediate products to other processors. Therefore, according to these officials, with each additional processing stage it becomes increasingly likely that minerals will change hands, complicating due diligence efforts that depend on chain-of-custody documentation by increasing opportunities for fraud or error, such as falsified source-of-origin documentation.”
- Another issue arises out of the purchase and commingling by processing companies of products from multiple suppliers. Commingling can occur at various stages of processing, from the “primary” processing facilities, which upgrade ore concentrate into metal and may source concentrate from multiple locations, to “secondary” processing facilities, where intermediate products with different mineral locations of origin are used as the “feed material” and may be commingled, making it more difficult to identify primary processing facilities and locations of origin and potentially introducing fraud and error at multiple points in the process. The report indicates that many “primary” processing facilities, “which turn ore or concentrate into a different downstream product, produce a limited range of possible intermediate products for a given mineral. As a result, the chain of custody for each refined form of mineral used, not simply each mineral type, may need to be examined independently.” In addition, these complexities may increase the cost required for disclosure efforts or result in missing information, requiring companies to survey second- or third-tier suppliers.
- Many companies reported that some suppliers were not responsive to surveys, potentially leading to incomplete information from all suppliers earlier in the supply chain. “Without information on all companies in its supply chain, a company cannot report knowing the source of all of its conflict minerals or whether any of its conflict minerals benefited armed groups.”
But the GAO is catholic in its criticism. Downstream companies (such as manufacturers) are chastised for often failing to “rigorously scrutinize certification statements, which, if done, might boost the credibility of due diligence efforts.” Moreover, the GAO reports, various officials complained that “downstream companies also do not shoulder much of the auditing cost burden placed on upstream companies, which may be reducing participation,” while “upstream companies and certification initiatives have struggled with the significant cost of conflict minerals traceability programs and voiced their concerns about downstream companies not sharing the burden sufficiently while benefiting from those programs.”
The GAO also pointed its finger at the Commerce Department. Although the report commended Commerce for producing lists of known conflict minerals processing facilities worldwide in 2014 and 2015 as required under Dodd-Frank, in 2015, Commerce used USGS data to create the list — even though the USGS uses a different definition for “processing facility” than does the SEC, OECD and the Conflict-Free Sourcing Initiative (CFSI), with the USGS apparently focusing on “primary” processing facilities to the exclusion of “secondary” facilities. That difference could dramatically affect the utility of the Commerce lists for reporting companies. Moreover, as of July 2016, Commerce had not performed an assessment of the accuracy of IPSAs or provided any recommendations for improving the accuracy of IPSAs, as required under Dodd-Frank. Commerce officials admitted that they didn’t know the first thing about IPSAs — well actually, the report said that they “stated that Commerce did not yet have the internal knowledge or skills to conduct reviews of IPSAs or to establish best practices.” However, Commerce is now doing outreach to the audit community and getting a team together. Given that only six IPSAs were filed in 2015, there may not be much to assess.
However, industry efforts are continuing to make some progress. According to the GAO, industry organizations are encouraging the participation of processing facilities in conflict-free certification programs, attempting to standardize the audit process and working to better align their programs with OECD’s due diligence guidance. As of April 2016, the GAO reports that the CFSI had gathered information on 332 processing facilities (of which 214, or about 64%, were compliant with CFSI standards). Some companies are actively encouraging suppliers to participate in these programs. In addition, industry participants are developing new technologies, such as “chemical fingerprinting,” which is designed to combat the risk of documentation fraud by allowing minerals to be traced to a location of origin based on distinct chemical signatures. But even these certification programs do not emerge unscathed: GAO reports that industry certification programs have been criticized for engaging in inefficient and redundant auditing, increasing compliance costs.