PROTIVITI FLASH REPORT California Law Requires Companies to Disclose Efforts to Ensure Supply Chains Are Free of Slavery and Human Trafficking February 6, 2012 The California Transparency in Supply Chains Act ( Act ) became effective on January 1, 2012. The objective of this social policy-driven legislation is to eliminate slavery and human trafficking from product supply chains of companies operating in California. Its focus is on increasing transparency by requiring companies to disclose their efforts to ensure their supply chains are free of these illegal activities. This Flash Report discusses the requirements of the law and offers suggestions on what companies subject to the Act should be doing. The Act s Requirements The Act requires retail sellers and manufacturers doing business in [California] to disclose their efforts to eradicate slavery and human trafficking from their direct supply chains for tangible goods offered for sale. It applies to retailers and manufacturers operating in California with annual worldwide revenues of more than $100 million. It is estimated by the California Franchise Tax Board that there are 3,200 major companies trading or based in California that will be affected by the law. A company is deemed to be doing business in California if any of the following conditions are met: The company is organized or commercially headquartered in California. The company s sales in California for the applicable tax year exceed $500,000 or 25 percent of its total sales, whichever is less. The company s real and tangible personal property in California exceeds $50,000 or 25 percent of the company s total real and tangible personal property, whichever is less. The company s paid compensation amount in California exceeds $50,000 or 25 percent of its total paid compensation, whichever is less. Those companies subject to the Act s disclosure requirements shall, at a minimum, communicate to what extent, if any, the company performs each of the following: Verifies whether risks of human trafficking and slavery in product supply chains are evaluated and addressed, including whether such verification is conducted by a third party. Conducts audits of suppliers to evaluate supplier compliance with company standards for trafficking and slavery in direct supply chains, including whether or not the audit was performed unannounced by an independent party.
Requires direct suppliers to certify that materials incorporated into their products comply with the laws regarding slavery and human trafficking of the country or countries in which they do business. Maintains internal accountability standards and procedures for addressing employees or contractors failing to meet company standards regarding slavery and trafficking. Provides training on human trafficking and slavery to company employees and management with direct responsibility for supply chain management, with emphasis on mitigating risks within product supply chains. The Act s focus is on transparency, and therefore, it does not require implementation of any of the above steps, only disclosure on whether or not such steps are carried out. In addition, the Act does not require companies to stop working with suppliers involved with human trafficking and slavery. That said, failure by a company to disclose its efforts with regard to the above matters could result in the state attorney general taking action to ask for injunctive relief, meaning requiring the company to comply. Typically, a party that fails to comply with an injunction faces criminal or civil penalties, which result in damages or sanctions. In this case, that could mean a cessation of the right to do business in California. In addition, the Act makes it clear that it does not limit any remedies available for a violation of any other state or federal law. To comply with the law, each retailer and manufacturer must post a conspicuous link to its disclosure on the home page of its website as well as make the disclosure available in writing upon request. In the rare situation that a company doesn t have a website, the written disclosure must be made available to consumers within 30 days after the company receives a request for it. Nothing in the law protects companies from additional liability, such as false advertising or misrepresentation, under other state or federal laws. Impact of the Act We are unable to determine if anyone has estimated the potential cost burden the Act might pose on companies doing business in California. That s just as well because the actual cost is driven more by a specific company s circumstances, making generic estimates meaningless. The cost drivers include, among other things, the extent of a company s operations in high-risk countries, the number of audits required to verify compliance, the nature of those audits (e.g., whether they are based on self-assessments through the Supplier Ethical Data Exchange [Sedex] or site visits by third-party auditors), the extent of remediation efforts required, and whether changes in supplier relationships are required. 1 While California may be the first state to pass this legislation, others are likely to follow. In addition, a bill was introduced in Congress last year, modeled after the California law. If passed, the bill would require publicly traded companies to disclose in their annual reports to the Securities and Exchange Commission all measures taken to counter forced labor, human slavery, trafficking, and child labor within companies supply chains. Therefore, federal legislation is possible. Interest is not limited to the United States. Efforts to combat human trafficking and slave labor have placed growing pressure on large, global companies throughout the world to collaborate towards eradicating trafficked and forced labor from their supply chains. Thus we can expect companies worldwide to become more transparent about their efforts to eliminate all forms of human rights abuses contributing to the products they manufacture and sell. 1 Sedex is a non-profit organization dedicated to driving improvements in responsible and ethical business practices in global supply chains, including labor standards, health and safety, the environment, and business integrity. Protiviti 2
Given the complexity of company supply chains and the multitude of contractors, recruiters, suppliers and other parties used throughout a production process, there can be significant risks to companies from human rights issues. In many respects, this legislation should stimulate increased company awareness of these risks, including knowledge of the ways that traffickers may use a company s products, services, or workplaces in connection with their illegal activities. Failure to consider and address these risks may result in public protests, business interruption, and potential litigation, all of which can lead to adverse publicity, loss of consumer trust, reputation damage, brand erosion and impairment in shareholder value. We are aware that many companies have questions and uncertainty regarding the new law. These were evident in the findings of Protiviti s soon-to-be-released 2012 Internal Audit Capabilities and Needs Survey. In the study, internal audit executives and professionals in the manufacturing industry (from organizations based throughout the United States, as well as in other countries) cited the new California supply chain law as the top area in need of improvement, and thus a top priority for their organizations. Companies will want to consult with legal counsel on these questions, particularly if the California attorney general does not provide guidance on the Act s provisions. Questions include the following: (1) Presumably the reference to direct supply chains is a reference to Tier 1 suppliers. What about Tier 2, Tier 3 and other suppliers further up the chain, i.e., suppliers of a direct supplier? (2) What is meant by materials incorporated into products? Is there, or should there be, a materiality threshold of some kind, or does this provision cover everything from screws to large component parts? What if a direct supplier has issues in its supply chain and is unaware of them, and the tainted materials are ultimately incorporated into the company s product? (3) How does this disclosure fit within the company s broader corporate social responsibility disclosures? (4) How does the state define doing business in California for organizations without physical facilities in the state? For example, does a manufacturer with no operations (i.e., neither physical facilities nor sales) in California but a supply chain that runs through the state via shipping ports in Long Beach have to comply? What about sales to California residents on the Internet? (5) If a manufacturer or retailer is not in compliance, how long do they have to address gaps before being subject to action by the California attorney general? (6) What if a direct supplier of a company engages in trafficking and slavery in its supply chain but alleges that such activities do not affect the company s products? Will issues arise with respect to traceability of such activities to the specific materials they taint to ensure no tainted materials are supplied to the company and incorporated into its products? (7) What if a company with lines of business doing business in California has issues with respect to specific products of a specific line of business that is not doing business in any way, direct or indirect, in California? Do the disclosure rules apply? (8) How will the California attorney general monitor and enforce compliance with the Act? (9) Will this legislation, and others like it, create exposure to litigation from victims of human trafficking for actual, compensatory and punitive damages from companies failing to take appropriate steps to eliminate slavery and trafficking from their supply chains? Protiviti 3
(10) Will similar laws be enacted in other states, at the federal level or in other countries? If so, when are such laws expected to go into effect? The above questions are illustrative only and are not intended to be all-inclusive. Steps for Companies to Consider for Purposes of Compliance With respect to compliance, companies need to read the law carefully and consult with their legal counsel. This is particularly important because of the lack of detailed guidance and the questions executives may have in terms of the applicability of the Act to their companies circumstances and the best approach to comply with the Act s provisions as well as any other related laws and regulations to which the company may be subject. With the above caveat, we provide some suggestions below for companies and their counsel to consider: Adopt appropriate human rights standards: Develop a policy statement that clearly articulates the company s standards in regards to human rights issues and its position that its reputation, brand, products and services not be associated with human rights violations. For example, some companies give recognition to the Universal Declaration on Human Rights. 2 Companies are advised to seek help in identifying the standards they use. Acknowledge extent of ability to influence behavior: One major global company asserts in its disclosure that its commitment to human rights must consider the strength and sphere of its influence on its business partners and others in the context of its relationship with those parties and the nature of its transactions with them. For example, the ability to influence behavior is strongest when dealing directly with employees and direct business partners such as suppliers and joint venture partners in which a company holds a controlling interest. The ability to influence positively the communities in which a company s plants and businesses are located, as well as governments, depends on many factors, e.g., whether the government is a customer, the substance and enforcement of existing local laws, the human rights issue in question, and the extent of the company s operations within a given country. The point is that human rights involve complex issues and a given company, by itself, may have limited influence in specific circumstances involving human rights abuses. Articulate roles and responsibilities: Specify who is responsible and what is expected of them. This definition of responsibility starts at the top, with a designated senior executive, and cascades downward to the business units, functional leaders, compliance officers and the broader employee group. Acknowledge the standards: Require each supplier to commit to the company that they adhere to the standards. Supplier agreements: Require suppliers to accept the relevant principles set out in the company s human rights standards by incorporating them in the supplier agreement. The willingness of suppliers to accept these principles should be an integral part of the company s supplier selection and evaluation process. Assess risk: Periodically review the supplier base and assess all potential suppliers to determine the level of risk associated with each insofar as compliance with the company s standards is concerned. This process may entail segmenting direct, material suppliers into risk categories (i.e., low, medium and high) based on management s knowledge of the industries and the inherent risks of the country of origin. For example, one company selects high-risk suppliers using a country-based risk approach based on its country index for sustainability risks 2 Available at http://www.un.org/en/documents/udhr/index.shtml. Protiviti 4
derived from risk assessments of various international indices such as the Corruption Perception Index published by Transparency International. Another company assesses risk by considering such factors as security of personnel and assets, potential for violence, historical human rights records, and the existence or non-existence of rule of law. For example, regular supply chain risk assessments could be directed to evaluating high-risk sectors, regions and commodities frequently associated with human rights violations. The U.S. State Department s Trafficking in Persons Report may be useful in this regard, as it ranks countries on anti-trafficking measures. 3 In addition, the U.S. Department of Labor s List of Goods Produced by Child Labor or Forced Labor (available at www.dol.gov) cites goods from countries that the agency believes are produced by child or forced labor in violation of international standards. Verify compliance: Conduct audits of higher risk suppliers, on either an announced or unannounced basis, to ensure full compliance. Depending on the relative risk by supplier, a company may choose to rely on supplier acceptance of its policies and standards or conduct on-site audits (by either company personnel or through independent auditors). With respect to the latter, if a company conducts social accountability audits, it may consider adding a section addressing anti-slavery and human trafficking questions. Through an addition of this nature, its internal auditors (or independent auditors or third-party consultants, if any are used) can evaluate whether manufacturers have written policies and procedures in place addressing the specific areas in question. Another option is to verify compliance through participation in Sedex. With respect to Sedex: If a supplier is a member, it may complete a self-assessment questionnaire and share it with multiple customers, along with audit reports and certifications. By allowing suppliers to share the same data with many customers, Sedex helps reduce the need for multiple audits, increasing cost-effectiveness and allowing parties to concentrate on making the necessary improvements. Regardless of the verification procedures, it is important that management focus on ensuring the right questions are being asked of high-risk suppliers. Request improvements: The above activities enable the organization to establish a baseline for driving improvements. The data compiled from supplier audits, questionnaires and other input are used to determine whether specific suppliers meet the company s requirements or whether the company needs to define further development measures and goals in collaboration with the supplier. Action plans drawn up with suppliers should be documented centrally and their implementation tracked to ensure progress according to an agreed-upon timetable. As companies within an industry gain experience and disclose issues, pressure will mount on suppliers to take corrective action. This, of course, is exactly what the proponents of the Act had in mind. The idea is that through collaboration with suppliers, companies can drive opportunities for improvement. Conduct training: Consider training procurement employees to identify and respond to supply chain risk issues involving human rights. Training content should be updated regularly and adapted to the needs of the targeted personnel. Respond to noncompliance: Determine protocols for situations in which it is determined that a supplier is not in compliance with the company s policies and standards. For example, should the company provide the supplier with the opportunity to remedy the potential non-compliance through the implementation of a corrective action plan? If so, what are the requirements to verify the remediation plan through a subsequent audit? How much time should the supplier be allowed to remediate the condition before it is eliminated from the company s supply chain? 3 Available at http://www.state.gov/j/tip/rls/tiprpt/2011/. Protiviti 5
What about serious infringements, i.e., should they result in immediate termination of supplier contracts? Disclose progress: Specify the steps taken in response to the requirements of the law. Disclose the nature of the company s policies and standards, the scope of its review of its supplier base, the scope of its audits and other verification activities, the results of such activities, the extent of training and acknowledgement programs, and other collaborative and due diligence activities to comply with its obligations under the law. Other practices: Some companies disclose that they do not maintain any long-term contracts or commitments with suppliers and are therefore free to take their business elsewhere should a supplier fall short of their expectations. Some legal experts have advised retailers and manufacturers as a best practice to require suppliers to verify compliance with human trafficking and slavery laws in the countries in which they operate. We are aware of some companies extending the scope of their review to material, indirect suppliers (tier 2, tier 3, etc.). Summary Prior to the Act s enactment, companies only had to issue disclosure around such matters as child labor. Now the net is cast more broadly. It s easy to think that slavery is a problem that only touches impoverished people in Third World countries. But nearly every American has a direct personal connection. The problem of human trafficking and slavery is so widespread, it would be virtually impossible to find a home, school, church or business that doesn t contain slave-tainted goods. It could be coffee, cocoa, computers, cell phones, cars or clothing. The sad reality is that many goods are still manufactured in sweatshop slavery conditions, or with raw materials that are farmed or mined by slaves. In addition, according to the National Human Rights Center in Berkeley, California, forced laborers exist in the United States; therefore, it is not just a problem for impoverished nations. The California law is an important step in rooting out these human rights abuses by requiring transparency. Companies failing to fully investigate and disclose these abuses in their supply chain could face significant consequences. In addition, companies that do not undertake sufficient steps to check their supply chains should anticipate investigative journalists to seek out any abuses in their supply chain and exploit them in the media, including vivid descriptions of the working conditions. Protiviti 6
About Protiviti Protiviti (www.protiviti.com) is a global consulting firm that helps companies solve problems in finance, technology, operations, governance, risk and internal audit. Through our network of more than 70 offices in over 20 countries, we have served more than 35 percent of FORTUNE 1000 and Global 500 companies. We also work with smaller, growing companies, including those looking to go public, as well as with government agencies. Protiviti is a wholly owned subsidiary of Robert Half International Inc. (NYSE: RHI). Founded in 1948, Robert Half International is a member of the S&P 500 index. Contacts Carol Beaumier Richard Childs Sharon Lindstrom +1.212.603.8337 +1.916.830.0107 +1.312.476.6386 carol.beaumier@protiviti.com richard.childs@protiviti.com sharon.lindstrom@protiviti.com 2012 Protiviti Inc. An Equal Opportunity Employer. Protiviti is not licensed or registered as a public accounting firm and does not issue opinions on financial statements or offer attestation services.