CSCMP's Supply Chain Quarterly
October 16, 2019

Conflict minerals and corporate supply chains: The challenge of complying with Dodd-Frank

In just a few months, publicly traded U.S. companies will have to report their use of certain minerals and their derivatives to the government. Not ready just yet? Here's how to get your compliance efforts under way.

Managing public companies has always been a complex task, but it is becoming even more complex as the traditional roles and responsibilities of management are challenged in new ways. In particular, social and environmental considerations are taking an ever-more important place alongside regulatory and shareholder considerations. This development is having a significant impact on procurement and statutory reporting.

Traditionally, procurement teams managed a company's purchasing activities and provided associated information to the controller to support various required filings. Today, though, those same procurement and financial teams must develop a regulatory program that traces certain purchases through multiple suppliers—frequently back to an entity with which the reporting company has no formal relationship—and then report the results of these inquiries in a formal filing to the U.S. Securities and Exchange Commission (SEC). These results may cover thousands of the company's products.

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[Figure 1] Estimated reserves
[Figure 1] Estimated reserves Enlarge this image

Welcome to the world of conflict minerals.

Dodd-Frank 1502 and conflict minerals
Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank 1502) requires the SEC to hold public companies ("issuers") accountable for an explanation of where certain minerals and their derivatives originated. The first reports are due to the SEC in May 2014, and many companies are still trying to sort out the best approach for compliance with the new regulatory requirement.

The minerals named in Dodd-Frank 1502 include cassiterite, columbite-tantalite (also known as coltan) and wolframite. Why these minerals? Because they are the ones from which tin, tantalum, tungsten, and gold are derived, and significant amounts of these minerals are mined in areas controlled by armed groups operating in the Democratic Republic of the Congo (DRC) and the nine countries that surround it. (See Figure 1.) In Dodd-Frank parlance, these are known as the "Covered Countries," and Dodd-Frank 1502 directs the SEC to require companies that manufacture products containing tin, tantalum, tungsten, and gold—collectively referred to as "3TG" or "conflict minerals"—to document whether any 3TG in their products have been purchased from the armed groups suspected of committing human rights violations in the Covered Countries.

Beginning on February 1, 2013, any SEC issuer that manufactures—or contracts to manufacture—products in which materials derived from conflict minerals are "necessary to the functionality or production of the product" is obligated to report on the origin of those minerals. Common examples of products likely to contain 3TG include cell phones and many computer and electronic components, but they can also include products as diverse as paint and buttons on clothing. The SEC's final rule on Dodd-Frank 1502 indicates that the agency will view an issuer as having satisfied "the reasonable country of origin inquiry standard if it seeks and obtains reasonably reliable representations indicating the facility at which its conflict minerals were processed and demonstrating that those conflict minerals did not originate in the Covered Countries."

There are certain noteworthy exceptions within the rule. Product packaging is explicitly excluded, so a company whose products are packed in tin cans is not obliged to document the source of that tin. Moreover, a company that can document that the 3TG used in its products were derived from recycled or scrap sources is not obliged to pursue discovery of the metals' origins. Each such issuer must file a form documenting that the minerals came from recycled or scrap sources, but it need not pursue discovery beyond that.

That said, it is still expected that more than 6,000 companies doing business in the United States will file with the SEC, and that 75 percent of them will be obliged to file a "country of origin" report on the tin, tantalum, tungsten, and gold that goes into their products. Generally, they will be obliged to look back through the supply chain, as far down as the smelter that refined the original conflict minerals into the tin, tantalum, tungsten, and gold. As long as the smelter can reliably document that those minerals did not come from the Covered Countries, the issuer need not inquire any further. If, however, the smelter indicates that the minerals did come from the Covered Countries, then the issuer is charged with ascertaining whether or not the minerals that the smelter procured came from an operation controlled by armed groups.

The complexity of discovery
Complying with the rule is not a trivial exercise. Companies must report on not only the 3TG that they purchased directly, but also on the 3TG in parts and subassemblies they have purchased from suppliers. And that's where things can get very complicated.

Companies first need to identify which of their products contain 3TG. That can require an extraordinary exploration of a company's enterprise resource planning (ERP) systems. Consider the example of an automobile. With all the variations available for a given model, an automobile may have half a million parts. Moreover, the automobile manufacturer's ERP systems are unlikely to include a level of detail that enables it to see where 3TG are used in individual components. There may be certain components—electrical subassemblies, for example, or computer chips—that the system believes are likely to contain 3TG, and identifying those may not be difficult. There may be other components, however, in which the presence of conflict minerals will be less intuitively obvious. We might imagine that a car's windshield is made of glass and/or plastic, for example, but upon deeper inquiry we would discover that a reflective coating on the windshield is made from tin. Now the automobile manufacturer must discover whether the tin used in the tinting of its windshields came from a covered country.

Discovering which of these half-million parts include 3TG can pose a significant challenge in itself, but the challenge goes beyond the raw numbers. In all likelihood, the automobile manufacturer purchased the windshields from a supplier. From the standpoint of the automobile manufacturer's reporting responsibilities, that makes no difference; the SEC still wants to know whether the tin in that windshield came from a covered country and whether it financed armed groups. The automobile manufacturer has to contact its supplier and ask it to provide information about the origins of the tin in the reflective coating.

Some large suppliers may themselves be SEC issuers and will be obliged to complete reasonable country of origin inquiries of their own. In those instances, a large supplier may be happy to share the information it collects. But that's a best-case scenario. If the windshield supplier is a foreign firm or is privately held, it will probably not be asking its own suppliers where the tin for the coatings came from. To cite a hypothetical but not uncommon scenario, it may have purchased the coatings from a chemical company in Europe, which purchased the tin from an agent in Singapore. The agent in Singapore may have acquired the tin from many different smelters around the world.

According to estimates by the SEC, more than 100,000 companies around the world will ultimately be affected by this regulation—yet only the smallest fraction of them will actually be subject to SEC oversight. Getting credible information for 3TG from companies that are not subject to SEC oversight may prove to be a great challenge. The automobile manufacturer is obligated to ask the windshield manufacturer to provide information. The windshield manufacturer might query the chemical company in Europe, but it may be hard-pressed to justify the time and expense that would go into such an inquiry. What motive would the European chemical company have to invest the time and energy into getting information from the agent in Singapore? With each leap down the supply chain, people will be asking why they should put the time and money into gathering this information if the effort does not translate directly into short-term profits or long-term business.

In the end, despite its best efforts, the automobile manufacturer in our example may be unable to determine whether the tin in the windshield coatings came from the Covered Countries. The windshield manufacturer may have been unable to get any information from the chemical company, which was unable to get any information from the agent in Singapore, which did not want to take the time to contact all the smelters.

For the automobile manufacturer, this disappointment may be repeated many times. Remember that the windshield in question is just one of the half-million components that could go into the car.

The value of the good-faith effort
Will the SEC penalize an issuer that is unable to determine whether the 3TG used in its products came from the Covered Countries? The answer is a resounding it remains to be seen. The agency has made it clear that an issuer must perform due diligence and act in good faith to determine the country of origin, but the definition boundaries of "due diligence" and "good faith" have yet to be tested in this situation. Due diligence is supposed to be based on nationally or internationally recognized frameworks, such as the one included in the Organisation for Economic Co-operation and Development's OECD Due Diligence Guidance for Responsible Supply Chains of Minerals from Conflict-Affected and High-Risk Areas, developed in 2011. But only after the initial issuer reports are filed in May 2014 will we gain a better sense of what the SEC considers reasonable, diligent, and undertaken in good faith.

Many companies are relying on the fact that complying with this law uses a "reasonableness" standard versus an "absolute" one. "Reasonable" is not fully defined in Dodd-Frank 1502; however, the SEC does say that whether an effort is reasonable depends on the "facts and circumstances" of the company at that time, and that those may change over time.

Documenting due diligence and good-faith efforts, though, is of utmost importance. There is a grace period of two to four years, depending on the size of the issuer reporting to the SEC, during which an issuer can indicate that, in spite of its demonstrable good-faith efforts, it can only say that the 3TG in a product are "DRC conflict-undeterminable." The assumption here would be that not all of the issuer's suppliers provided information indicating whether their products contain conflict minerals. If at the end of that grace period the issuer is still unable to provide information about the origin of the 3TG in its products, it will be obliged to report that those products containing 3TG have "not been found to be DRC conflict-free."

It is worth noting that the SEC has not specified the penalties for failing to file, so we are left to assume that the penalties would be the same as those for any violation of the Securities Exchange Act of 1934, which states that false or misleading statements in any documents required under the act may result in liability to persons who buy or sell securities in reliance on these statements. Just what the liability might be in this instance has yet to be seen. Given the sensitivity of these disclosures, however, and the fact that they will be available to the public, there is an implicit "name and shame" penalty that may be of concern to issuers. Investors and consumers may be less likely to do business with a company that cannot warrant that its products are free of conflict minerals. One can readily imagine that a "Conflict Minerals Scorecard" (produced by a nongovernmental organization) is just around the corner, and that the threat of a bright light shined on a company's behavior might provide sufficient impetus for that company to change. If that works, we shouldn't be surprised to see expanded regulatory reporting expectations around other social metrics in the future.

The role of supply chain management
So what approach to reporting compliance is best, given the opacity of the waters into which we're about to plunge? Fundamentally, a company can meet its regulatory obligations via a three-stage process:

  1. Determine whether (or which of) its products contain conflict minerals or their derivatives
  2. Discover whether those minerals originated in Covered Countries and financed the armed groups
  3. Report on the findings

Of course, it's in the execution that these stages grow challenging. Let's look at each in turn.

. Determining the need to file
A company first needs to determine the extent to which 3TG are used in its products, and the simple fact is that no single person—and likely no single system—can provide a definitive answer to that question. Thus, management efforts have to start with the creation of a cross-functional team and the establishment of overall governance. The team responsible for developing the conflict minerals report must be able to tap into the organizational resources that will allow its members to acquire information at the product-design and product-sourcing levels.

Within large organizations or companies with highly complex products, this can be an interesting experience. You may find your conference rooms filled with people who have never met or spoken to one another before—yet these may be the people who have, together, created the individual parts that form your products. They have the knowledge that will provide many of the answers to the questions about which components contain 3TG elements.

At the same time, management of this regulatory responsibility must come from the highest levels of the organization. If an organization pushes responsibility for this effort deep into the personnel chain, the managers overseeing the project will lack the authority to gather the resources necessary for the inquiry; it will not appear to be an inquiry that matters at the highest levels of the enterprise, either—yet it does matter. Because the SEC is asking filers to report at the corporate level and to explain how the company plans to develop its program to become more effective over time, company leaders should be comfortable with the overall compliance approach. After all, one of them will be signing the reports filed with the SEC.

2. The discovery process
Once a company has determined that it is required to discover the country of origin for the minerals associated with certain parts or components, team members who are responsible for compliance should start contacting suppliers. The question that confronts an organization at this point is a simple one: Do you contact only those suppliers whose products you know to include 3TG? If you have a relatively small number of products, components, and suppliers—and if your information technology (IT) infrastructure provides the level of integration required to gain insight across your vendor master list—this may be the approach to take.

However, if a product includes thousands, or hundreds of thousands, of outsourced components, isolating only the products and suppliers linked to conflict minerals may not be a good use of anyone's time. Better to send a questionnaire to all of your suppliers and have them tell you whether any of the parts they provide contain these materials. As you can imagine, companies are taking both of those approaches, and everything in between. It is advantageous for companies to narrow their exposure as much as they can before surveying their suppliers, but this effort faces time and systems limitations. At a certain point, a "we aren't sure" assessment will warrant sending a survey to a supplier.

Moreover, companies need to develop a process for capturing and managing the responses provided by suppliers. Ultimately, the issuer needs to provide information to the SEC on a product or product-group basis, so the information received from suppliers must be organized in such a way that it can be mapped back to the products upon which the issuer is reporting. The systems holding that data must then be able to report the "country of origin" findings in a manner that meets the SEC's expectations (about which we'll say a few words shortly). Depending on the state of the company's IT infrastructure, it may require considerable IT expertise to create and manage such a reporting infrastructure, so an analysis of the existing infrastructure and processes is as critical a part of this exercise as anything else.

Program managers should be prepared to be dissatisfied with the responses they will receive. Some suppliers may quickly return a response that says, "Yes, we use materials that are sourced in Covered Countries." But because the issuer needs to prepare a conflict minerals report that addresses mineral use on a product basis, survey managers will find themselves pushing back on those suppliers and saying, "Can you tell me precisely which of the components you sell to me are exposed to minerals originating in these countries?" This will require more work on their part, which takes us back to the challenges of respondent enthusiasm covered earlier. (See the "Late to the game?" sidebar for more thoughts on survey preparation and management.)

Ultimately, the issuer must design into its management processes a way to show that it has made every effort to gain this information and validate its credibility. Remember: due diligence and good faith. You need to show both, even if, in the end, the results of those efforts are far from conclusive or complete.

3. Reporting the results
Issuers are required to report on the results of their discovery using a special disclosure form (Form SD), which the SEC has created specifically for compliance with Dodd-Frank 1502. Section D of Form SD notes, "This form is not to be used as a blank form to be filled in, but only as a guide in the preparation of the report meeting the requirements of Rule 12b-12 (17 CFR 240.12b-12)." Thus, individual issuers have some latitude in how they prepare their reports. If through its "reasonable country of origin" inquiry the issuer finds no evidence that its 3TG came from the Covered Countries, then it will file Form SD by itself. If it finds that its 3TG may have come from a covered country, then the Form SD filing must contain a full conflict minerals disclosure report as outlined in the form. The report must describe the measures taken to exercise due diligence, and it must include an external audit of the conflict minerals report that has been conducted in accordance with standards established by the Comptroller General of the United States. (See the "Tips for Dodd-Frank 1502 compliance" sidebar for more details.)

Issuers should make sure they have the proper infrastructure in place to capture and consolidate the information they need to present in this report, as it is required on an annual basis. That means involving IT and systems-integration resources to enable the creation of processes to track individual information requests from suppliers throughout the supply chain, as well as reporting systems that map the input from the field to the products in which the conflict minerals or their derivatives occur. The work performed in stages 1 and 2 can help an issuer anticipate these needs and define the requirements of the systems that will facilitate report preparation. Many leading companies are leveraging their existing infrastructure and, in some cases, using a third-party survey tool. They are looking toward long-term, comprehensive solutions that will incorporate not only conflict minerals compliance but also other anticipated social and environmental regulations.

An adaptable reporting infrastructure
Many issuers will look at the reporting requirements of Dodd-Frank 1502 as an end point in and of themselves. But rather than building a rigid process that will only serve to meet the needs of Dodd-Frank 1502, issuers would be well advised to look at their data-capture and reporting systems from a flexibility perspective. How can you refine your infrastructure so that it is more extensible; that is, so it can easily answer other, similar questions that may be posed by regulators in the future? In the long run, companies need an infrastructure that is integrated and flexible, one that can provide answers to supplier-related questions, including those that might not have been anticipated.

Consider: Under Dodd-Frank 1502, the U.S. secretary of state has the authority to add additional minerals to the list of conflict minerals. The European Union and Canada are developing their own sets of reporting requirements around conflict minerals. Some countries, including the United States, are considering legislation that would require companies to document that no child labor was used in the manufacturing of their products—or the components that go into their products. As use of the Global Reporting Initiative's G4 Sustainability Reporting Guidelines increases, companies may be asked to provide information on the environmental impact associated with each of the links in their supply chain. We could go on, but you get the point.

Questions will continue to be asked, and in today's connected world, income and expense are no longer calculated solely in terms of dollars and cents. Companies need to think about how to revise and adapt their IT infrastructures to become more flexible and more extensible. They need to determine how to do the same for their overall management structures as well. Collaboration across the enterprise—at the management and data levels—will be crucial to an organization's ability to deal not only with regulations such as Dodd-Frank but also with any new or expanded regulations they will have to comply with in the future.

Looking forward
Court challenges to the SEC's conflict minerals rule are already under way. The reporting requirements of Dodd-Frank 1502 may change as a consequence, but the basic premise is here to stay. Suppliers may grumble about—and perhaps even ignore—requests for more information today, but that won't last long. Sooner or later, every supplier is going to figure out that failure to be forthcoming with a clear history of its conflict minerals and derivatives will put it at a competitive disadvantage.

Think about it: Suppliers that are determined to get more business will see the information requirements of Dodd-Frank 1502 as a way to create a competitive differentiator. They may be pounding on the doors of that automobile manufacturer right now, asserting not only that they can build those tin-tinted windshields for a competitive price, but also that they will make compliance easy by providing a clean history of their conflict minerals all the way back to the smelter and all the way forward to the individual products that the issuer sells. Suppliers that are reluctant to help their customers get the information they need for Dodd-Frank compliance may see those customers shift their business to the supplier that is willing to help them meet their reporting responsibilities. Moreover, we can expect to see companies building compliance-related elements into supplier scorecards in the future.

There is much work to be done between now and May, when issuers must file that first Form SD. Many companies will file reports that identify the source of the tin, tantalum, tungsten, and gold they use as "DRC conflict-undeterminable," and if they can show that they pursued discovery in good faith, then they will likely satisfy this year's reporting requirements. But that's not a long-term solution. In the long term, it is important for issuers to push deeper into their supply chains to determine the origin of the minerals in use. Set up the management, governance, and infrastructure of your compliance teams with that need in mind. Focus on flexibility, and on working with your partners and suppliers to gather and share information more proactively and more effectively.

While the investments of time and money that go into data collection, reporting, and infrastructure development may seem daunting and without any immediate benefit to shareholders or consumers, in the long run there are clear benefits. With greater supply chain transparency, a company can understand the multiple tiers within its supply base. It can more effectively assess, monitor, and mitigate risks. It can see opportunities to streamline and reduce costs.

And guess what? All those benefits can be measured in dollars and cents.

Craig Coulter is a manager in the Climate Change and Sustainability Services Practice at Ernst & Young LLP. Niul Burton is a principal in the Supply Chain & Operations Advisory Services Practice at Ernst & Young LLP.

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