Two Lehigh Accounting Experts Uncover the Negative Impact of Conflict Mineral Disclosures on Capital Market 

When the U.S. Congress in 2010 passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which overhauled financial regulation following the 2007-2008 financial crisis, it included a section related to valuable natural resources extracted from conflict zones around the world.

Referred to as “conflict minerals,” these natural resources are sold to support continued fighting in a region. Such minerals from the Democratic Republic of Congo (DRC), for example, are critical to the development of consumer electronics. In the DRC and its adjoining countries, militias routinely commit atrocities against women and children, forcing them to work in mines in an effort to fund terrorist activity.

Developed by Congress as a response to such activities, Section 1502 of the Dodd-Frank Act requires U.S. public companies to disclose in their SEC filings detailed audited information related to the sourcing and use of conflict minerals from the DRC and its adjoining countries. This controversial disclosure requirement aims to reduce mining-supported violence, but has little to do with the overall goal of the Dodd-Frank Act, says Parveen Gupta, the William L. Clayton Distinguished Professor of Accounting.

“The basic idea was that if we will throw light on this problem through disclosure, there is a possibility that consumers will become sensitive and they will put pressure on these companies to source materials in a more humane way, or from different sources,” says Gupta.

Says Heibatollah Sami, the John B. O’Hara Professor of Accounting: “This is the first time that Congress used the SEC financial reporting regime to achieve a social and political goal.”

Whether or not the controversial move achieved these goals, says Gupta, is debatable—and up to experts in foreign and social policy to determine. But according to research conducted by Gupta and Sami, in collaboration with Masoud Azizkhani of the University of Tasmania in Australia and Shen Xu of Huazhong University of Science and Technology in China, Section 1502 did have an impact on information asymmetry—an imbalance of information between parties in a transaction—in U.S. capital markets.

The team conducted the study, which focused on information asymmetry as it exists between market-makers and informed investors vis-à-vis speculators, using cross-sectional regressions of a hand-collected sample of 1,835 firms and 183,500 firm-week observations.

Controlling for price volatility, share turnover and firm size, the team found that during the 50-week period following the filing date of conflict mineral disclosures, the bid-ask spread widens, trading volume declines and price volatility increases. The researchers then further validated these results by employing a difference-in-difference research design to compare the mineral disclosure subsample with the non-mineral-disclosure control group.

Says Sami: “[Conflict mineral disclosures] may distract investors from important financial accounting information. Sometimes, the annual reports for companies are hundreds of pages, and when you add additional disclosures like this—especially not related to financial reporting—it creates information overload for the investors. When there’s information overload, it creates an advantage for those that have sophisticated systems to analyze the financial statements and make decisions versus those that do not, which creates information asymmetry.”

The SEC’s current financial reporting and disclosure regime was designed to protect investors. The team’s findings suggest that using the regime in this way imposes unwarranted and adverse social consequences on market participants.

“There are people who had already warned that this could happen, and they surmised that one should not be using the SEC’s disclosure regime to achieve a foreign policy or a social policy goal,” says Gupta. “Essentially we document this and prove it with hardcore data, empirically speaking, and our recommendation to Congress is … [Section 1502] is hurting the capital markets in the United States ... There is a real economic backlash here.”

WHY IT MATTERS The team’s findings show that Section 1502 of the Dodd-Frank Act hurts capital markets by increasing information asymmetry and imposing adverse social consequences on market participants.

Photo by Marcus Bleasdale