Global Business 3rd Edition by Mike Peng

Exercise 63

South Africa's De Beers successfully managed the global diamond cartel throughout the 20th century. However, it is encountering major challenges in the 21st century.
The longest running and probably the most successful cartel in the modern world is the international diamond cartel headed by De Beers of South Africa. The cartel system underpinning the $80 billion a year industry is, according to the Economist, "curious and anomalous-no other market exists, nor would anything similar be tolerated in a serious industry." While De Beers successfully managed this cartel throughout the 20th century, it is now confronting major challenges in the 21st century. How did the cartel start? What are its driving forces? What are its current challenges? This case addresses these questions.
The Cartel
Although historically diamonds were rare, the discovery of South African diamond mines by the end of the 19th century brought an avalanche of stones to the global market. A key reason diamond prices were so expensive was because of the deeply ingrained perception of scarcity. Consequently, if there was an oversupply, prices could plummet. Cecil Rhodes, an English tycoon who founded the De Beers Mines in South Africa in 1875, sought to solve this problem by focusing on two areas. First, Rhodes realized that supply from South Africa, the only significant producer in the world at that time, should be limited. Second, because producers (diggers) had little control over the quality and quantity of their output, they preferred to deal with an indiscriminate buyer willing to purchase both spectacular and mediocre stones. Since most output would be mediocre stones, producers preferred to remove any uncertainty and to be able to sell all of their output. On the other hand, buyers (merchants) needed to secure a steady supply of stones (both high and low ends) in order to generate sufficient volume to polish and then retail. Rhodes's solution was to create an ongoing agreement between a single producer and a single buyer in which supply was kept low and prices high.
Putting his idea in action, Rhodes bought out all the major South African mines in the 1890s and formed a diamond merchants' association in the country, called the "Diamond Syndicate," to which he would sell his output. In such "single-channel marketing," all members of the Syndicate pledged to buy diamonds from Rhodes and sell them in specific quantities and prices. With such an explicit scheme of quantity-fixing and price-fixing, the diamond cartel was born. After Rhodes's death in 1902, the De Beers empire was strengthened by Ernest Oppenheimer, a German diamond merchant who had founded his own company, Anglo-American, in South Africa. Through cross shareholdings, members of the Oppenheimer family controlled both De Beers and Anglo-American (until the end of 2011-see below).
Industry Attributes
Most cartels collapse due to organizational and incentive problems. The longevity of the De Beers cartel, now running for more than 100 years, thus is an amazing case study of how to effectively run a cartel. At least three industry attributes contribute to the cartel's longevity. First, the industry has an extraordinarily high concentration. In Rhodes's day, De Beers not only controlled all of South African (and hence virtually worldwide) production, but also controlled all sales through its wholly owned subsidiary, Central Selling Organization (CSO), in London. In more recent times, the CSO evolved to be rebranded as the Diamond Trading Company (DTC), which continues its function as the distribution arm of De Beers.
Second, De Beers is the undisputed price leader. Sales of rough diamonds (called "sights") are managed by the DTC (previously the CSO) to an exclusive group of "cherry picked" merchants (known as "sightholders") from cities such as Antwerp, Johannesburg, Mumbai, New York, and Tel Aviv. Sightholders would inform the DTC of their preferences for quantity and quality. The DTC then matched them with inventory. During each sight, the DTC offered each sightholder a preselected parcel. The buyer either took it with cash or left it-no bargaining was permitted. Buyers usually took the parcel. If buyers did not like the system, they would not be invited again. This tactic allowed De Beers to control, down to the carat, exactly what and how many stones entered the market and at what price. To maintain the exclusivity of the sightholders, their number was reduced from approximately 350 in the 1970s to less than 100 sightholders in the 2000s. In 2011, only 79 sightholders were invited. Of these, approximately 30% came from Belgium, 25% from Israel, 20% from India, and 15% from the United States with the balance based in Britain, China, Japan, Latin America, South Africa, and Thailand.
Third, the friendly social relationships among participants of the cartel-for the most part-facilitate its long-term viability. "It's a personal business, face to face," said De Beers's chairman Nicky Oppenheimer (Ernest's grandson). "In uranium, everybody brings their lawyers. In diamonds, there are no lawyers sitting around. It's a handshake business."
Firm Capabilities
At least three firm-specific attributes are also behind the longevity of De Beers's cartel. First, De Beers has a very clear strategy: Expand demand, limit supply, and maximize long-term profit. In the postwar decades, thanks to De Beers advertising, diamond engagement rings have become almost compulsory in North America, Western Europe, and Japan. Increasingly anniversary rings are made of diamonds as well. In 1947, De Beers unleashed the clever "A diamond is forever" campaign, which in 2000 was voted by Advertising Age magazine as the best advertising slogan of the 20th century. The initial purpose was is simply to prevent the emergence of a market for second-hand diamonds, which would have significantly increased supply. Consequently, De Beers historically has able to take advantage of very inelastic demand to set prices, largely constrained only by the number of engagements and to a lesser extent major anniversaries in any given year.
Second, De Beers exhibits a high level of flexibility to adapt to new challenges. By the 1950s, South Africa was no longer the leading producer. Today, only 12% of the worldwide production is from South Africa, and Botswana and Russia outperform South Africa in rough diamond production by a wide margin (Exhibit 1). Out of necessity, De Beers had to reach out to other

producers. De Beers offered its capital and expertise to African producers in Botswana, Angola, and Namibia. As a result, De Beers still controls approximately 35% of the worldwide production-it is still the biggest diamond miner but no longer that dominant. If producers declined offers for joint production, De Beers would urge them to sell to De Beers. Appreciating the benefits of cooperation and the hazards of oversupply, many producers agreed. Even during the heyday of the former Soviet Union, which for political reasons did not acknowledge any business dealings with the then Apartheid-era South Africa, the Soviet government entered secret agreements with De Beers to participate in such collusion. The producers typically agreed to sell rough diamonds only to De Beers, which dictated prices. De Beers promised to purchase all of the output, rain or shine (prices might fluctuate due to changing demand), resulting in its huge stockpiles of diamonds. In exchange, the producers reaped the traditional benefits of a cartel: stable prices, guaranteed purchases, and little competition. At present, De Beers still controls approximately 45% of the rough diamond sales worldwide (Exhibit 2).
Perhaps most strikingly, De Beers possesses both the unique will and capability to enforce cartel arrangements. As in all cartels, the incentives to cheat are tremendous: Both producers and buyers are interested in cutting De Beers out of the process. As a price leader with a significant capacity to punish, De

Beers's reactions are typically swift and powerful. In 1981, President Mobutu Seko of Zaire (now known as the Democratic Republic of Congo) announced that his country, the world's leading producer of industrial diamonds, broke away from De Beers by directly marketing its diamonds. Although only 3% of De Beers's sales were lost, its "world order" would be at stake if such actions were unpunished. Consequently, De Beers drew on its stockpiles to flood the market, driving the price of Zairian industrial diamonds from $3 per carat to $1.80 and wiping out any financial gains the Zairians hoped to grab. While incurring disproportional losses, De Beers made its point. In 1983, Zaire crawled back on its knees and De Beers agreed, but only at terms much less favorable than those offered before.
In another example, many sight holders in Tel Aviv, a major diamond cutting and trading center, began to hoard diamonds purchased from the CSO in the late 1970s, hoping to combat Israel's rampant inflation. The disappearance of a substantial amount of diamonds from global circulation tightened supply, leading to skyrocketing prices and encouraging merchants elsewhere also to hoard and profit. While De Beers actually benefited from such higher prices in the short run, it realized that in the long run such an uncontrolled speculative bubble would burst. In response, in 1978, De Beers purged one third of CSO sightholders and kicked out the most aggressive Israeli speculators and some non-Israeli merchants who had done business with the Israelis. Cut off from their CSO supplies, speculative merchants were forced to draw down their stockpiles, thus restoring prices to normal levels and leading to a "soft landing" from the speculative fever.
Institutional Constraints and Maneuvers
De Beers is also a skillful player in understanding and manipulating the rules of the game. In South Africa, half of the stock market is composed of the stocks of De Beers (until its 2001 delisting), Anglo-American, and their vast empire of related firms. They control the pillar of South Africa's economy, namely, strategic minerals. For obvious reasons, the South African government- both during and after the Apartheid-is on friendly terms with De Beers, whose cartel has no fear of being prosecuted. To prevent further scrutiny, De Beers delisted itself in 2001 and has remained a private company since then.
De Beers also maintains friendly relationships with most governments of diamond producing countries. Its secret deals with the former Soviet government were indicative of its superb persuasive power, driving home the point that economics was more important than ideology (even during the heyday of the Cold War).
While De Beers historically has entered a number of joint production arrangements with host country governments in Botswana, Angola, Namibia, and the Democratic Republic of Congo, it would ship all its rough diamond output mined from Africa to London, where the diamonds would be sorted and then sold (first by the CSO and more recently by the DTC as noted earlier). However, the rules of the game are now changing. African governments are increasingly interested in cutting and polishing diamonds mined from their countries, which would add about 50% to the value of rough diamonds. This process is known as "beneficiation"-locating diamond processing activities in countries where the stones are extracted. "I am not going to say that beneficiation is something everyone in the [De Beers] business desires," acknowledged Gareth Penny, De Beers's managing director in a 2007 interview, "but in the end, diamond resources are national resources... Beneficiation is not about altruism but about good business; it creates much closer relationships with our partners."
In 2004, when the licenses for De Beers' two most profitable mines in Botswana came up for renewal, the Botswana government negotiated a beneficiation agreement with De Beers. In case De Beers disagreed, Botswana threatened to impose an export levy on rough diamond exports. In the end, De Beers agreed to sort in Botswana all the diamonds from its numerous sources around the world in a new $83 million facility entirely funded by De Beers. Botswana further demanded that De Beers's sightholders must also cut the diamonds in Botswana. Since Botswana is the current leader producing 26% of rough diamonds in the world, De Beers and its sightholders had little choice but to agree. These operations in Botswana commenced in 2009. Not surprisingly, governments in Angola and the Democratic Republic of Congo are also salivating for a piece of the action beyond mere diamond mining.
Finally, De Beers faces one major institutional headache: the US government argued that De Beers and its cartel were in clear violation of US antitrust laws, and unsuccessfully tried to prosecute it in 1945, 1974, and 1994. De Beers managed to stay beyond the extraterritorial reach of US laws until recently since it had no legal presence and no (direct) sales in the United States. All its diamonds are sold in London, and then sightholders can export them to the United States, which is legal. Technically, the imported diamonds are no longer De Beers's-they belong to independent sightholders. However, with 50% of the retail diamond buyers in the United States (in the 1990s),2 these legal actions prevented De Beers executives from being able to visit their buyers and retailers in the United States in fear of being arrested. Clearly, a solution was necessary.
Current Challenges
Overall, the De Beers group, which is now widely diversified despite its center of gravity in diamonds, has been highly successful. In over 100 years of history, it only lost money in 1915, 1932, and 2007. At present, De Beers employs approximately 23,000 people in more than 25 countries, including 20 mines currently in production in Africa and joint ventures and partnerships in Canada, Russia, and Australia.
Looking ahead, De Beers's three main challenges lie in (1) adapting to the changing industry structure, (2) dealing with pressures for corporate social responsibility, and (3) overcoming formal institutional barriers preventing it from directly operating in its largest market, the United States.
First, in terms of industry structure, De Beers is obviously no longer a monopolist. It is a leading player in an oligopoly that increasingly has to accommodate new players. Today, the cartel is less of a cartel than what it used to be. The rise of Siberian mines, which now produce 18% of the global output, poses sufficient market power to threaten De Beers's standing. The leading Russian producer, Alrossa, has collaborated with Lev Leviev Group, a leading Israeli diamond merchant headed by a Russian-speaking, Uzbeki-born, Israeli citizen. They have reduced sales of rough diamonds to De Beers, polished more diamonds in Russia, and marketed them directly. Outraged, De Beers, which invited Lev Leviev to become a sight holder in 1987, removed its privileges of a sight holder in 1995. But the tide is difficult for De Beers to turn back. However, on the bright side, with the increasingly difficult-to-control cartel, De Beers no longer needs to focus exclusively on defending the cartel and the industry at large. Instead, it has more freedom to make decisions to maximize its own profits, such as buying fewer stones at uneconomic prices.
Second, De Beers has been facing mounting pressures for corporate social responsibility (CSR), on at least three fronts. The first was the $1.2 billion worth of "conflict diamonds" that floated to the global market as a result of the civil war in Angola and Sierra Leone in the 1990s. In its traditional role of a buyer of the last resort, De Beers felt compelled to purchase the new supply; otherwise, it risked losing its tight grip on global supply. However, with "blood on its hands," De Beers encountered a public relations disaster, especially after the UN imposed sanctions on "conflict diamonds." Eventually, under tremendous pressure of consumer boycotts and activist campaigns, De Beers in 2000 initiated a "Kimberly Process" which, together with almost 70 governments and all the big industry players, committed the industry to a strict certification process for the legitimate origin of diamonds. The "Kimberly Process" has been in effect since 2003 and has reduced the number of conflict diamonds to 0.2% of global production. In 2006-2007, the Hollywood movie Blood Diamond again renewed public interest in conflict diamonds, yet De Beers reported that the movie did not dent diamond sales.
A second CSR area is the HIV/AIDS disaster, reportedly affecting 25% of the adult population in southern Africa. In 2003, De Beers became the first mining company to extend health insurance free of charge to HIV positive employees and their spouses and partners in South Africa, Botswana, and Namibia. This insurance coverage would remain in effect to employees after retirement or retrenchment.
A third CSR area is environmental protection. Diamond mining, if not properly managed, can easily cause environmental problems. De Beers thus has to pay careful attention to the environmental footprint of its operations. All its major operations have been ISO14001 certified.
Finally, facing rising competition, De Beers has sought to flex its muscle by developing a De Beers brand of diamonds and other luxury goods. It developed "Forevermark" diamonds, which are natural, untreated, and responsibly sourced. Forevermark diamonds have an icon and identification number inscribed on the table facet of the diamond. The inscription is about 0.05 ?m deep and applied using an undisclosed De Beers inscription technology. De Beers also formed a joint venture with a leading luxury goods firm, LVMH, and opened a De Beers LV store in London and three stores-within-stores in Tokyo.
However, its plan to open a flagship store in New York was frustrated because of the US government ban on its business due to its alleged antitrust violations. Nicky Oppenheimer, De Beers's chairman, openly wrote in his "chairman's statement" in the 2003 Annual Report that De Beers's core strategy was "to bend all our efforts to increasing worldwide demand for our product and ensure that diamond jewelry would henceforth outperform the rest of the luxury goods market"-in other words, increase demand, limit supply, and jack up price, exactly the "criminal" acts as charged by the US government. Essentially acknowledging "guilty as charged," Oppenheimer's 1999 speech to alumni of the Harvard Business School contained the following statements:
• "We set out, as a matter of policy, to break the commandments of Mr. Sherman [principal lawmaker for the Sherman Act of 1890]. We make no pretence that we are not seeking to manage the diamond market, to control supply, to manage prices, and to act collusively with our partners in the business."
• "This form of single channel marketing has exercised an extraordinary beneficial influence upon the whole of the diamond industry and particularly to many of the economies of Africa."
• "It is no accident that diamond prices have been more stable when compared with other commodities. The positive trend in rough diamond prices is due to De Beers's marketing efforts. And this is an effort which is in the interest of both the producer and the consumer, a strange and illogical coming together of opposites."
• "I believe that the attitude of the [US] Justice Department is at odds with American foreign policy, which seeks to support the reconstruction and development of Africa... It is always hard to argue that you are the exception to the rule but in the case of De Beers and the ultimate luxury-diamonds-I believe a review of US antitrust laws should form part of a new framework for engagement with Africa. Indeed, it would be in line with the spirit of the African Growth and Opportunity Act."
Is the Cartel Forever?
In the beginning of the 2000s, some changes were in the air. De Beers seemed to have decided to loosen its grip. More viable competitors, which not only included the few other big mining giants such as Alrosa, BHP Billiton, and Rio Tinto, but also smaller players such as Kimberly Diamond Group, Trans Hex, and Gem Diamonds, turned up the heat on De Beers. The industry started to look a bit more like many other competitive industries.
In July 2004, De Beers agreed to pay a $10 million fine to the US government, thus ending a 60-year-long impasse-it was first charged by the US government in 1945 and this recently settled case was initiated in 1994. De Beers eventually agreed to settle the charges with a total payment of $295 million in the United States. The following is the entire excerpt from the DeBeers website under "Ethics: Resolution of Actions in the United States" (accessed February 14, 2008):
In July 2004, De Beers entered a plea agreement with the US Department of Justice to resolve criminal charges against the company for an alleged conspiracy to fix the price of industrial diamonds. On the basis of payment of a US$10 million fine, the United States agreed it would not bring further criminal charges against De Beers, related companies, or any current or former directors, officers, employees, and agents for any act related to those price-fixing allegations as set out in the indictment. This marked the first important step in resolving US litigation issues outstanding against the company.
In November 2005, De Beers announced that agreement had been reached, and a preliminary approval order issued, to settle the majority of civil class action suits filed against the company in the United States. Since then, in March 2006, the three remaining civil class action suits were added to the November settlement agreement, resulting in an overriding global settlement agreement totaling US$295 million which has received preliminary court approval.
This settlement does not involve any admission of liability on the part of De Beers but will bring an end to all outstanding class actions. This represents an important step to improving our reputation in the largest diamond consumer market in the world and stands as clear evidence of our commitment to competition law compliance. De Beers continues to cooperate with the Court of the District of New Jersey to seek resolution of this litigation.
As part of the class action settlement, De Beers agreed to offer injunctive relief, which includes a general commitment to comply with antitrust laws of the United States, and specific prohibited conduct with third party producers and sightholders. Injunctive relief is a typical component of class action settlements in the United States. The injunctive relief further demonstrates our clear commitment to operating in accordance with competition laws around the world.
The $295 million De Beers agreed to pay would be divided roughly in half between diamond merchants and consumers. Anyone who bought retail diamonds in the United States between 1994 and 2006 could potentially get a refund, regardless of whether these diamonds came from De Beers or not, because diamonds prices were allegedly fixed and controlled by De Beers. The exact amount that each consumer would get depends on the number of eligible buyers who claimed a refund. At a maximum of 32% of a purchase price, a consumer could get up to $640 back on a $2,000 ring. However, here was a catch, if everyone claimed a refund, only $2 would come back on a $2,000 ring. The upshot? "Definitely don't show this story to your friends," according to a Chicago Tribune article published on January 21, 2008.
As captured by the title of the Chicago Tribune article, "diamond refunds are a consumer's best friend," consumers who unexpectedly received refunds would naturally be happy. De Beers's executives were also pleased because they could now travel to the United States without fear of arrest and the firm could now operate a flagship De Beers jewelry shop (in a joint venture with LV) on Fifth Avenue in New York.
In November 2011, the Oppenheimer family sold the entirety of their 40% stake in De Beers to Anglo American, thereby increasing Anglo American's ownership of De Beers from 45% to 85%. (The other 15% of De Beers' shares are owned by the government of Botswana.) The transaction was worth $5.1 billion in cash and ended the Oppenheimer dynasty's eighty-year ownership in the world's largest diamond miner. With so much change in the air, a question looming large on the horizon for De Beers executives and antitrust officials is: has the longest-running cartel really come to an end? This truly is a billion-dollar question.
Case Discussion Questions
Drawing on the resource-based and institution based views, explain why De Beers has been phenomenally successful.