We are experiencing an evolution in supply chain regulation that focuses more on "due diligence" than particular results.
By Brad Brooks-Rubin
If you want something done right, do it yourself. So the old adage goes, anyway. But as we have come to know in the last decade, nearly every company outsources one or more critical elements of its business. Whether it is a core manufacturing process or back office function, the 21st century corporate model relies heavily on extensive supply chains and “outsourcing solutions” to remain competitive.
Along with the evolution in corporate function, we are also experiencing an evolution in corporate supply chain regulation. Whereas supply regulation previously relied on clear regulatory frameworks, like sanctions or anti-corruption laws, we now see the emergence of corporate due diligence and transparency reporting as the dominant model. As compliance goes in these systems, doing it yourself may no longer be so easy. Or even the best or legal approach.
Supply Chain Regulation
Consider first the “old” model. As an example, recently the Treasury Department’s Office of Foreign Assets Control (OFAC), the agency designated to administer economic sanctions, penalized a company based in the United Arab Emirates over $1 million for violating U.S. sanctions against Iran. Now, the penalty was not for devising an illicit deal in a hotel room in New York or establishing a front factory in Ohio, but rather for using an element of its supply chain to evade sanctions. In this case, the company tried to process sanctions-violating payments from the UAE through the U.S. financial system. Those payments were identified by U.S. banks, reported to OFAC, and a penalty issued against the Emirati company for knowingly causing a violation of U.S. sanctions.
There are clear rules to follow in this model of supply chain regulation. When there is a violation, penalties ensue. If you are a U.S. company and a foreign company causes an issue, like the aforementioned UAE company, you report them. Companies still need to work together, to some extent, but for the most part, each actor in the supply chain must develop and implement its own compliance system.
This model has proved limited, however, and we are experiencing now an evolution in supply chain regulation that focuses more on process and “due diligence” than particular results.
Due Diligence to Protect Human Rights
This may be due in large part to the issues subject to this newer form of regulation being more “conscience”-based than stemming from traditional concepts as national security or anti-corruption. Right or wrong, and regardless of whether it is because of cultural relativism, economic necessity or knowledge gaps, it is simply harder to enforce specific norms around most aspects of business and human rights. While many companies increasingly understand the economic drivers behind the recognition of, and respect for, human rights, it is safe to say there remains a long way to go.
As a result, the approach advocated by many NGOs and increasingly incorporated into regulatory systems is one of due diligence processes. Due diligence does not seek to penalize companies for a particular outcome but for the lack of trying to avoid the result. This model is perhaps best illustrated by Dodd-Frank Section 1502, focused on “conflict minerals” from the Democratic Republic of the Congo (DRC) and neighboring countries.
As a brief review, section 1502 of the Dodd-Frank Act establishes a rigorous three-step process concerning “conflict minerals” that will require reporting from all SEC annual filers, with the first reports due in May 2014. Section 1502 requires a company to determine whether gold, tin, tantalum, or tungsten are necessary, in any amount, to a product it manufactures, or contracts to manufacture. If so, the company must work with its suppliers to make a reasonable country of origin inquiry, specifically to identify whether the minerals originated in the DRC or any of its nine neighbors.
Following other steps and the exercise of “due diligence,” the company will then report to the SEC whether its products are “DRC Conflict Free” or “Not been found to be DRC Conflict Free;” for an initial phase-in period, the term “DRC Conflict Undeterminable” may be used. Due diligence must be undertaken according to an internationally accepted framework; at present, the only such framework currently available is the OECD Guidance for Responsible Sourcing of Minerals from High-Risk and Conflict-Affected Areas.
To be clear, there is no legal prohibition on the use of minerals from the DRC or any other country. Even if the minerals are purchased from an armed group in the DRC, the only requirement section 1502 imposes is public reporting, with the expectation that the conscience of the public square/market place will provide sufficient enforcement.
Unlike the sanctions or traditional model, where each company can be on its own to implement and evaluate compliance, downstream companies are almost entirely reliant on the cooperation of actors further up the supply chain for information needed for compliance. In the case of section 1502, the reasonable country of origin inquiry and OECD due diligence model will take many companies to actors in the same countries where their outsourcing solutions do: China, India or elsewhere in Asia and the developing world where minerals are processed. In some cases, these inquiries could stretch all the way back to the source.
Creating a Multiplier Effect
But will these actors provide the needed information? Will they understand and accept the conscience-based norms their U.S. and European customers are seeking to inform and enforce? Western governments have a role to play in conveying these messages to their counterparts and foreign actors, but this conversation remains one largely to be had at the business-to-business level. How far can that discussion go, in the short or even medium terms? A number of industry associations have taken laudable and proactive steps to try to provide a multiplier effect to promote education and cooperation, but more work remains here as well.
Will this need for outsourcing of compliance information and cooperation be the undoing, or at least the slowing, of the new model of supply chain regulation? The first set of section 1502 reporting in May 2014 – and the advocates’ responses to what may be disappointing results – should provide the best insights to date. And then we may have a clearer sense of the impact of supply chain changes on the potential for company compliance and consumer conscience.