The European Commission’s (EC) approval of the joint request by Alrosa and De Beers for a gradual phasing out of their trading relationship was expected. The only clause not approved was the initial request for the continuation of some form of trading relationship beyond 2008, allowing purchases by De Beers of up to $275 million annually. In its legal commitment “De Beers undertakes that, in 2009 and thereafter, De Beers will not directly or indirectly purchase any rough diamonds from Alrosa. De Beers shall, in good faith, take all such steps as are reasonably practicable to ensure that it does not indirectly purchase rough diamonds originating from and sold by Alrosa to parties other than De Beers in circumvention of these Commitments.”

            The EC has taken no chances in leaving loopholes and a large part of its approval document is devoted to defining what constitutes an “indirect purchase” and how to monitor and detect such prohibited transactions. Says the EC’s decision: “An indirect purchase of rough diamonds from Alrosa shall occur where De Beers knows, or ought (on the basis of its diamond industry expertise) to know, that:

            (a) The rough diamonds originate from Alrosa; and

            (b) The third party from whom it purchases the rough diamonds makes the sale:

                        (i) On behalf of Alrosa, or

                        (ii) At Alrosa’s instigation, or

                        (iii) With Alrosa’s prior knowledge.

            Moreover, an indirect purchase of rough diamonds from Alrosa shall also occur where De Beers purchases from a third party rough diamonds where: (a) De Beers knows, or ought (on the basis of its diamond industry expertise) to know, that the rough diamonds originate from Alrosa; and (b) the third party has purchased those rough diamonds:

                (i) On behalf of De Beers; or

                (ii)  At De Beers’ instigation; or

                (iii)  With De Beers’ prior knowledge.”

            Basically, any company in which Alrosa is involved will, after 2008, never been able to sell to De Beers. This includes, for example, the Catoca mine in Angola. Says the EC: “purchases of rough diamonds from, or originating from, an entity that jointly controls, or is jointly controlled by, Alrosa Limited, those provisions shall only apply where De Beers knows or ought (on the basis of its diamond industry expertise) to know that that relationship of joint control exists.”

If De Beers fails to respect this purchase prohibition, the Commission could (and probably would) decide to impose fines of up to 10 percent of the company’s global turnover without having to establish if De Beers had violated the competition rules. That kind of threat is, probably, sufficient to keep anyone honest – and we don’t think the parties will intentionally breach their commitment.

            But the EC bureaucracy needs certainty. That’s part of its responsibility. Thus, the intriguing part of the EC approval – on which little concrete information has been published yet –  is the provision that an “independent third party (a “Trustee”) will be appointed by each De Beers and Alrosa to verify compliance with the commitments by De Beers and Alrosa respectively. The appointment and mandate of this Trustee will be subject to the Commission’s approval. A separate report for each of Alrosa and De Beers on compliance with the commitments will be submitted annually to the Commission.”

            In the agreements, both Alrosa and De Beers need to appoint a Trustee. The Trustee acting on behalf of De Beers is the more interesting party who needs to monitor De Beers’ compliance with the commitments. The Commission may, on its own initiative or at the request of the Trustee or De Beers, give any reasonable instructions to the Trustee in order for it to monitor compliance with the commitments provided herein in the fulfillment of its duties as Trustee.”

Trustee – also Forever?

            The concept of “monitoring” was introduced when De Beers and Alrosa were still requesting a never-ending agreement to purchase not more than $275 million a year. That is now prohibited – and, instead, there is a commitment NEVER to buy any Alrosa rough diamonds any more. That seems to imply that the task of the Trustee will last, if I may say so, also forever. What does the Trustee have to do? How will the Trustee be selected?

            The Trustee must provide the Commission with a written report once a year (and no later than 30 March of each year) beginning in 2006, of the implementation of the Commitments. In addition to these yearly reports, the Trustee must promptly report in writing to the Commission if it concludes on reasonable grounds that De Beers is failing to comply with these Commitments.

            The EC specifies that the Trustee shall (i) each year conduct such inquiries as are reasonably required to enable it to render the required report; and (ii) on any other occasion, at the request of the Commission or at its own discretion, conduct such inquiries as are reasonably required to enable it to render special reports when needed.

            It is clear that the Trustee will play an important role for many years to come; it is also clear that – from a technical and operational perspective – the task is exceedingly complex.

            Just as with the Ombudsman of Supplier of Choice, the Trustee will be nominated and appointed by De Beers itself. Moreover, the names of the candidates must be submitted not later than March 10, 2006 – less than two weeks from now.

            The EC’s decision says that “De Beers shall provide the Trustee with all such cooperation, assistance and information as the Trustee may reasonably require to perform its tasks. The Trustee shall have full and complete access (subject to reasonable notice) to any of De Beers’ books, records, documents, management or other personnel, facilities, sites and technical information, save for legally privileged advice, as the Trustee might reasonably require for the fulfillment of its duties under the Commitments and De Beers shall provide the Trustee upon request with copies of any such document etc.”

             Moreover, “De Beers shall make available to the Trustee one or more offices on their premises and shall be available for meetings in order to provide the Trustee with all information as is reasonably necessary for the performance of its tasks.” Furthermore, De Beers shall provide the Trustee with all managerial and administrative support that it may reasonably request.

            The monitoring – to check the honesty of the parties to the agreement – appears to become a quite elaborate mechanism involving many people. Says the EC: At the expense of De Beers, the Trustee may appoint experts, subject to De Beers’ approval (such approval not to be unreasonably withheld or delayed) if the Trustee considers the appointment of such experts to be reasonably necessary or appropriate for the performance of its tasks under the mandate, provided that any fees and other expenses incurred by the Trustee are reasonable. Should De Beers refuse to approve the experts proposed by the Trustee, the Commission may approve the appointment of such experts instead, after having heard De Beers.

            We do not know yet which independent third party will be appointed. De Beers must submit a list of one or more legal entities (including, in particular, international auditing firms) whom De Beers proposes to appoint as Trustee to the Commission for approval. The proposal shall contain sufficient information for the Commission to verify that the proposed Trustee fulfils the requirements and must specify (a) the full terms of the proposed Mandate, which shall include all provisions necessary to enable the Trustee to fulfill its duties under these Commitments; (b) the outline of a work plan, which describes how the Trustee intends to carry out its assigned tasks; (c) an indication whether the proposed Trustee will appoint an expert to fulfill its assigned tasks; and (d) a detailed explanation why De Beers considers the proposed Trustee to be independent and possessing the necessary qualifications. Any on-going or previous activities for Alrosa and De Beers should be reported.

             We expect that the Commission intends to see the appointment of a forensic auditing company that would go over the books of Alrosa and De Beers.

            Without being cynical, we doubt this will be effective.

            No purchases or sales through third parties are likely to be discovered by auditors, also if De Beers were to require that each open-market purchase ought to contain a declaration by seller stating that “these rough diamonds do not originate from Alrosa." Even if there were such statements, the independent third party auditor would not have any ability, nor have the jurisdiction, to check the veracity of such statement by a seller to De Beers.

How do you verify Honesty?

            How do you detect circumvention of the parties’ commitments? How do you check violations? This is a highly intriguing theoretical question. For all practical purposes, it would be suicidal for the new management at De Beers not to adhere to the commitments made to the EC. After all, De Beers sees legal compliance as a basic cornerstone of its corporate strategies. The company is highly motivated to demonstrate full compliance in Europe as this also provides the entry ticket into the United States. (The class action settlement in the United States is based on its compliance with the EC competition authorities’ approvals and requirements.)

            In all fairness, we would suggest to the EC to stay away from “auditors” and even rethink whether their objective can be reached without the appointment of a costly independent third party auditor. And if they do need such a party, it should appreciate that it should be based on market intelligence collection, rather than through reviewing company records. No auditors, but rather market players or insiders. Or “experts” in the language of the EC, to be hired by the Trustee.

            The EC must appreciate that the players in the very competitive rough diamond market would be the first to detect “signals” that not all the Russian rough available to the open market reaches the market – or detect whether possible proxies are involved in the purchases of Alrosa rough. Those market players – especially non-Sightholders – who have an interest in acquiring Alrosa rough, or who are trading in such rough, would be the first to realize that “something is wrong” – especially if the volumes are significant.

            If the EC does find it imperative to appoint an independent third party, its focus should be on understanding and, to a certain extent, monitoring the rough trade of Alrosa rough diamonds on the open market. The EC must secure the cooperation of the relevant parties in this. To give an illustration: all rough exported from Russia to any party requires a “Kimberley Process Scheme Certificate,” which indicates the export destination and recipient parties. As a matter of routine, Alrosa ought to be obliged to make copies of these certificates available to the independent third party that would enable it to recognize the community of possible “corroborators” in the event circumvention of the commitments would be attempted. 

            Presently, the volume and values of “open market” purchases by De Beers (and its Diamdel subsidiaries) is rather limited, and, in our view, the chances of an unintended, almost “accidental,” purchase are greater than conscious attempts to circumvent the commitments. The Third Party’s activities might keep the parties’ staff (especially in De Beers’ subsidiaries or in Alrosa’s overseas sales offices) “alert” and highly aware of the commitments. One might argue that the independent third party monitor’s appointment may have a preventive aspect as well – but I wonder whether there is a real need for such a role to begin with. 

            The commitment by the parties is two fold: (1) the agreed level of purchases and (2) prohibition of open market purchases by De Beers of Alrosa goods.

            Maybe the independent third party appointment, as far as detection of violations of “open markets” commitments is concerned, is not so crucial.

            For confirmation that the direct purchases are in accordance with the commitments, Alrosa’s and De Beers’ own corporate auditors could do the job – and the money to finance the independent third party could be saved.

            In the post-Arthur Anderson and post-Enron environment, accounting firms have become far more responsible and careful than ever before. Though the companies’ external auditors arguably could not fulfill the independent third party role, they are nevertheless better acquainted with the business than any other outside party.

            My suggestion: The EC should require a statement by the external auditors of De Beers and Alrosa in the two companies’ respective annual reports stating, “To the best of our opinion our clients are in full compliance with their commitments to the EC in respect to the Alrosa-De Beers Trade Agreement.” 

            To avoid that a hypothetical violation would involve DTC Sightholders, the EC could request the DTC to include a provision in its Sightholder documentation that “any Sightholder found assisting either the DTC or Alrosa in circumventing the commitments made in the trade agreement will automatically lose their sight allocation.” This will constitute a major deterrent to avoid any temptation to assist in circumventing the trade agreement.

            If the EC wants greater comfort it could insist that Alrosa, on all its sales invoices of sales to the “open market” insert a statement that, “the resale of the rough diamonds subject to this invoice to either De Beers or any third party acting on behalf of De Beers is a violation of the terms of sales of this transaction.”

            The EC ought to have comfort that in the present situation, especially if these aforementioned warranties are made, few players would, in any scenario, intentionally participate in any activity that may also represent a reputational and/or compliance risk to themselves.

            Maybe the considerable amounts of resources and funds for two expensive Trustees (with staff, offices, other experts, etc.) can be saved. Any costs by De Beers or Alrosa would probably be passed on to clients anyway – that’s not needed, certainly not now. Maybe, there is room to reconsider the need and the scope of the Trustees’ tasks.

            Have a nice weekend.