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24 November 2011

Every day our e-mail's in-box is filled with enthusiastic announcements of yet another diamond company being certified by the Responsible Jewellery Council (RJC) as "meeting the ethical, human rights, social and environmental standards as established by the RJC's Member Certification System." What these companies may not know (yet) is that the RJC is about to announce its diamond Chain of Custody standards, which - with the best will in the world - can never be properly adhered to by well over 98 percent of the RJC's diamond membership.

Of course, the RJC is nothing more than a private initiative aimed at providing its members with a brand that might inspire confidence among retailers and consumers. There is nothing wrong with this - bluntly speaking, whatever it does is none of our business. It's purely a matter for RJC members.

However, when the organization forces "mission impossible" standards on its members - when it sets conditions that will destroy value in their clients' businesses - and when it creates a compliance "myth," a compliance "fiction," in the diamond jewelry markets this becomes a grave concern for the entire diamond business. Inevitably, the falsehood of the RJC's claims will be exposed - backfiring not only on its members but also on the diamond industry at large. This must be avoided at any price.

These are serious words, and I will devote considerable time and efforts in explaining and highlighting these concerns in this and in future columns. All I would like to achieve today is to call on the RJC not to rush and inflict irreversible damage to its own organization, to its brand, and to the diamond business, and to postpone the scheduled introduction of its diamond Chain of Custody. Moreover, it should repair the flaws in its scope of certification mechanism rather than continue its "certification rush" to achieve a critical mass of downstream members and income to finance its annual £2 million overhead.

Concept Borrowed from Narcotics Enforcement

What is a Chain of Custody? The term was first used by law enforcement agencies in prosecuting international narcotics smuggling in their endeavors not just to jail the prostitute found smoking a few "joints," but to get to her supplier, to the wholesale importer, and to the actual producer source of the narcotics. What the courts needed was a way to trace back the narcotics to their source in a way that the evidence would be admissible in court.

Thus, the classic definition of Chain of Custody refers to "the chronological documentation or paper trail, showing the seizure, custody, control, transfer, analysis, and disposition of evidence, physical or electronic."

The idea behind recording the Chain of Custody is to establish that the alleged evidence is in fact related to the alleged crime, rather than having, for example, been planted fraudulently to make someone appear guilty.

Now Back to Raw Materials

It was the forest industry that first adopted the legal Chain of Custody concept. It created (in 2004) a standard that would provide an information link between the raw material included in a forest-based product and the origin of that raw material. This was done as consumers in growing numbers were seeking evidence of environmentally sound business practices and demanded reassurance and proof from forest-based industries that the wood they use comes from sustainably managed sources. Therefore, it was argued that businesses needed a reliable and credible mechanism to provide their customers with information about the origin of the raw material.

The Chain of Custody concept came closer to diamonds and jewelry with U.S. President Barack Obama's signing of the Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010. Beginning January 1, 2012, public companies (listed on U.S. stock markets) will have to begin assessing their compliance with new "conflict minerals" disclosure requirements, which refer to a list of minerals (excluding diamonds) from the Democratic Republic of Congo (DRC) and adjoining countries. There is no de minimis exception, so companies that use even the smallest trace amounts of relevant materials in their products or in their manufacturing process will be impacted.

The relevant part of Dodd-Frank (Section 1502) is intended to stop the exploitation and trade of conflict minerals in the DRC, which the U.S. Congress believes is helping to finance the conflict in the region. For years, various non-governmental organizations have sought to influence companies that use these minerals in their products to commit to source only conflict-free minerals. Section 1502 requires thousands of companies to disclose whether or not they use conflict minerals from the DRC and adjoining countries in their products.

Stating "we don't know" is not an option. NGOs are very likely to use public pressure to target companies that use or are unable to verify that they do not use conflict minerals to change their sourcing or improve supply chain controls. This is a message that should not be lost on the diamond industry.

The Jewelry Industry is Impacted

As gold is included in Dodd-Frank, the jewelry industry is clearly impacted - even though the law applies only to publicly listed entities. Since in the gold industry the raw materials pass a melting process in a limited (and well-defined) number of refineries, somehow it seems possible to create a paper documentary trail from source to jewelers.

Diamonds were not included in Dodd-Frank because our industry has the Kimberley Process, which, in spite of its shortcomings, is still considered the most effective and convincing way for keeping conflict diamonds from the markets. We were not "accidentally" left out.

The RJC has decided to include adherence to a Chain of Custody standard for the various metals in its membership requirements. There are good arguments for imposing the Dodd-Frank standards also on smaller, non-public companies. However, the RJC also wants to include diamonds in the Chain of Custody - which we believe is virtually impossible given the structure of our industry. This intent to include diamonds underscores how poorly RJC management actually understands the diamond business.

Let's look at the figures: A conservative estimate of the global annual production of polished diamonds is 1.1 billion stones. We calculate that 97.8 percent of the number of polished diamonds manufactured weighs less than 0.18 carat, that is, more than one billion stones annually. About 91 percent of the number of polished diamonds manufactured weighs less than 0.07 carat, that is, also about one billion stones annually.

For the Diamond Industry to Maintain Multiple Inventory Systems

As only a very few diamond mining companies support the RJC - and even among these some (including De Beers) have serious doubts about the implementation feasibility of the Chain of Custody - it is clear that only a small part of the global diamond production's Chain of Custody could actually commence with its mining source.

But this isn't the issue. The RJC wants its members to maintain two different kinds of inventories: one for those (rough and polished) diamonds for which there is a documented Chain of Custody (the "CoC-stock") and one for the non-CoC goods (let's call these the dirty or contaminated "CONT-stock").

As the administration of both the CoC- and the CONT-stocks is cumbersome and exceedingly expensive, it is assumed by the RJC that the diamond industry will evolve into a two-tier pricing system and that a consumer and jeweler will pay more for a diamond coming from a CoC-stock than coming from a CONT-stock. Thus, two identical diamonds would fetch totally different prices.

This is unlikely to happen in reality. Moreover, if one has two parcels of an identical category of diamonds in both CoC-stock and CONT-stock, is it realistic to assume that the diamantaire or his client will not mix the goods together? The RJC draft code says that when CoC-stock is mixed with CONT-stock, it loses the CoC-stock status.

Physical Properties of Diamonds and Trading Practices

Unlike metals, diamonds cannot be amalgamated or fused. Given that they are not fusible, it may seem that segregation based on origin should theoretically be more straightforward than for fusible materials such as gold. However, this would only be true if diamonds were homogeneous like gold.

In the case of diamonds, in addition to being heterogeneous in the general sense, each diamond is unique, with varying sizes, shapes and other physical properties caused by different impurities present in different proportions and locations within the crystal structure all of which directly affect the value of any given diamond.

The diamond's heterogeneity is expressed in parameters such as weight, shape, color and clarity for rough diamonds and weight, shape, faceting arrangement, depth, color, clarity and cut quality for polished diamonds.

This heterogeneity necessitates both isolating and aggregating individual stones and lots (called "parcels" in the trade) originating from diverse sources in order to achieve a parcel containing sufficient units of stones that fall within a set of parameters that is required by the client. The skills and expertise of the diamond merchant are his ability to create custom-made parcels to meet the requirements of his clients. In other words: the merchant's diamond skills, and the ability to optimize revenues, depend on being able to mix goods.

In the trade, parcels are mixed and even remixed multiple times depending on client demand and availability of supply. The RJC Chain of Custody is based on NOT mixing the CoC-stock with other stocks. To a diamond merchant, that doesn't make any commercial sense. It destroys value.

The RJC's Mining Partners - Having Second Thoughts

The RJC's initial funding came mostly from mining companies, especially De Beers, Rio Tinto and BHP Billiton. They had a reason: much money is being spent by clients to demonstrate that they meet Best Practice Principles or other corporate responsibility requirements. It was believed in the RJC's early years that a single certification by one objective organization could meet the requirements of multiple producers and would save money.

It didn't work out that way. So far, only BHP Billiton, which holds 2 percent of the world's rough production, and also Rio Tinto for some of its clients, make RJC certification a pre-condition for clients to purchase its rough. The RJC membership certification system is fundamentally flawed as it allows the client to "cherry pick" the part of his business group to be certified. In many instances, the RJC is not even aware of all the companies within a certain client group.

Thus, a company that defaults on his payments to banks and clients, or has unaudited and questionable books of accounts, or is engaged in multiple laundering or fraudulent practices litigation against partners or former partners, still has no problem whatsoever in getting certified by the RJC. Additionally, company groups that also contain units that actively traded in non-KP compliant Zimbabwe goods can get RJC certification through another group company.

It is our understanding that De Beers has already decided that the RJC certification will not be accepted as an alternative or substitute for its own client certification mechanism. Moreover, its own future membership in the RJC is far from certain.

As mentioned earlier, in its current "certification rush" to get to a critical mass of downstream members, the RJC is apparently not concerned with the possible spillover effect of disclosure of serious ethics infringements of one member on all members and on the perception of the RJC brand. Instead of focusing on getting its membership certification "right," the RJC is rushing to get its diamond Chain of Custody system accepted.

What the RJC seems to fail to understand is that each mining company sells directly to a select number of diamond companies through regular allocations, tenders and auctions - but that no diamond manufacturing and trading company can buy 100 percent of its rough diamond trading and polished diamond manufacturing requirements directly from the mining companies.

Disclosing Suppliers Names 

In the case of De Beers, for example, most of its sight boxes (which would qualify as CoC-stock) are being traded, and DTC sightholders generally purchase the bulk of their requirements on the market.

In order for the CoC-stock to retain that quality tier status, the buyer and his subsequent buyer - and the further subsequent buyer - should know from what DTC sightholder the goods originated. Forget about it. This will not happen. Even today, some DTC boxes are traded in ways in which the buyer doesn't know who the seller is, trusting the middlemen.

The boxes that are purchased from the mining companies always contain a range within a defined set of parameters and inevitably include portions that are not compatible with the manufacturer's production specialty and/or profile.  Furthermore, the compatible portion never satisfies 100 percent of the volume required for the company's manufacturing needs and capacities at any given point in time. Thus, the polished output of a DTC sightholder is virtually always mixed with non-DTC goods.

In order to fulfill the needs of individual diamond manufacturers, there is a very active and fragmented secondary market for rough diamonds consisting of other manufacturers, brokers and dealers through which one's shortages are filled and excesses are off-loaded.  As a result, rough diamond parcels from diverse sources are mixed and remixed - not only by one company but by the entire market trading amongst each other.

Extreme Trading Disruptions and Sourcing Troubles

For the RJC's Chain of Custody (CoC) system to work, each diamond - from mine to consumer - must ONLY pass CoC-certified hands. To be very specific, if a certain diamond (irrespective of whether it is a 10 carater or a one pointer) finds itself at any given time in the value-chain journey in the possession of a non-CoC-certified company, the CoC status is lost. The diamond becomes a less valuable, "contaminated" tier-two-status diamond.

Thus, the CoC system, according to RJC expectations, will lead to CoC-certified RJC members trading amongst themselves. This means, essentially, that the CoC-compliant diamantaires will be very limited in their sourcing ability. They cannot buy goods from non-CoC suppliers if they want to maintain their cherished CoC status. Of course, because of the segregation system, most CoC-compliant diamantaires will maintain two different sets of stocks in any event. But assuming that a diamantaire doesn't "switch" from the non-CoC inventory to the CoC-stock, it might become very difficult for him to meet client requirements - if his client demands CoC.

The bottom line is this: the introduction of separate inventory systems, the emergence of a two-tier pricing system (between diamonds that are considered "first class" and diamonds that are considered "cargo class"), the desire of CoC-approved traders, the prohibition to complete a CoC-stock shipment required by a client by adding a few stones from a non-CoC-inventory, will all lead to great dislocations in the pipeline.

Trust and Honor Basis

The awkward thing is that the RJC expects that external auditors can actually determine within any company whether certain carat totals truly represent the separate inventories. How will an auditor ever know that a 25 pointer of high quality was replaced with one of low quality?

But it is more than that: an auditor only audits one level in the pipeline. Assume that R. in New York bought a CoC-approved stone from M. in New York. While the auditor can see that M. is a certified CoC-man, he doesn't audit M.'s books - so maybe the stone came from M.'s non-CoC-stock? Moreover, the standard RJC audits take place once every three years! The holes in this system can easily compete with any decent Swiss cheese. With all the "noise" - we will truly never know if the CoC-man is indeed CoC-compliant.

The RJC's CoC system is very much on a "trust and honor" basis. You just have to believe the supplier - and the supplier's supplier. And when you visit Surat or Mumbai, where the diamond processing sector is based on subcontracting in which manufacturers give rough parcels with an "estimated yield" to subcontractors and receive the polished back - you just have to hope that no stones were switched. Whether the RJC accepts a "whole parcel" as being CoC-compliant or certifies each stone - one will truly never know.

Reliance on WDC System of Warranties

This is what I mean with the "myths" and the "fictions" - the Chain of Custody is a fiction that cannot truly be verified. What may "rescue" the RJC's CoC mechanism is their reliance on the self-regulation by the diamond trade's System of Warranties, introduced by the World Diamond Council (WDC) in context of the Kimberley Process Certification Scheme (KPCS). Here, the company's independent auditor is subject to government control (as specified in the KPCS enabling legislation in KPCS member countries), and the auditing of the audit is something that is foreign to RJC's audit system.

In the WDC's self-regulating system, a false representation can lead to criminal penalties and will trigger the expulsion of the infringer from the diamond business altogether. If you are a very serious cheater at the RJC, the very worst that can happen - heaven forbid - is that the member may be removed from RJC membership. That really must be a scary deterrent.

The Essential Flaw of the RJC's Proposed CoC Standard  

CoC is fully based on the segregation of trading inventory. This ignores the fact that the heterogeneous nature of diamonds requires categorization based on physical attributes that are also the basis of the diamond's value irrespective of the source of diamonds. Categorization by source is meaningless - and it runs against the diamond traders' needs to achieve a critical (sellable) mass in specific required quantities in categories required for a specific commercial purpose.  Accumulation requires collecting and combining units from various sources. There is no other way.

The overwhelming majority of the volume being traded has a unit value and profit margin that makes further categorization or segregation by source economically impracticable.  It will introduce overwhelming inefficiencies in purchase management, inventory management and sales management, that is, the entire business cycle.  Segregation by source will destroy value.  The fiduciary duty of any commercial enterprise is to create value, not to knowingly destroy it.

Some RJC observers have suggested "to start with bigger stones" (where a stone-by-stone tracking might be more feasible) and leave the melee parcels for later. That's pure hypocrisy: if the source of a large diamond is no good (in the eyes of the RJC), the smaller goods from the same source should not be viewed as CoC-compliant. Moreover, this reasoning ignores the fact that the additional cost of segregating a diamond is uniform regardless of size or value, whether it is a 100-carat diamond of the highest quality or a 0.01-carat diamond of the lowest commercial grade.

This author is all in favor of any concept, any idea or any system that will enhance transparency and provide all supply-chain stakeholders with greater comfort on the ethical sourcing and processing of diamonds. The flaws in the Kimberley Process Certification System (KPCS) need to be addressed - and with the United States at the helm as Chair, one can bet on it that KPCS reforms will become a high-priority matter.

But both the RJC and the KPCS participants must realize that polished certification through segregating "good" (CoC) or "no-good" (CONT) diamonds, will cause an irreconcilable distortion in prices. It will lead to smaller, lower value diamonds costing more than certain categories of larger, higher value diamonds. Moreover, no diamantaire wants to destroy value. If he would be required to maintain two stocks, he will do so - but carats will freely move in between categories, and there is no way this can ever be audited - and thus enforced - by third parties.

All of this will cause enormous confusion in the retail market and will damage consumer confidence, possibly irreparably. What the RJC has achieved so far is a deeply flawed certification system that will fail any objective test. It is now exacerbating the flaws by introducing a standard which no diamantaire will be able to live by - but he will play the part, if he has to.

Don't Let Them Scare You...

There is a tendency to "scare" the industry by suggesting that if it doesn't adopt such Chain of Custody system, the governments may impose it. That's hogwash. There are no plans whatsoever to introduce additional minerals in the Dodd-Frank legislation.

The U.S. Treasury, which is ultimately responsible for the KPCS, will not allow the introduction of any new element in the KPCS if it is not enforceable. In that context, the RJC's CoC mechanism is meaningless in the sense that it doesn't allow governments to get a better grip on the value chain - to the contrary, CoC will convolute the value chain rather than making it more efficient, transparent and accountable.

The RJC's CoC system will be based on myth and make-believe in the best of circumstances and turn RJC members into deceivers in the worst of circumstances. Both outcomes should be sufficient reason for the RJC to stop its daily mass-certification and review its fundamentals. If there is a need for the RJC - and by now I would put a question mark here - it needs to be able to demonstrate that its membership adds value rather than destroys it.