1. Background
a. What's been published?
On 23 February 2022, the European Commission (the ‘Commission’) published its long awaited proposal for a directive on corporate sustainability due diligence “aimed at ensuring that undertakings . . . fulfil their duty to respect human rights, the environment and good governance” (the ‘Proposal’). The Commission, also published an annex, Q&A and Fact Sheet, providing more detail and guidance around the Proposal.
The Proposal is a significant development in the EU in terms of applying cross-sectoral mandatory obligations on companies to implement robust processes to manage human rights, governance and environment risks within their own business and value chains. The Proposal not only sets out companies’ obligations but also details of monitoring, enforcement and remedy actions giving the legislation real teeth.
Didier Reynders, Commissioner for Justice said: “This proposal is a real game-changer in the way companies operate their business activities throughout their global supply chain. With these rules, we want to stand up for human rights and lead the green transition. We can no longer turn a blind eye on what happens down our value chains.”
b. Why has the proposal been published?
The publication of the Proposal is the result of many years of pressure from civil society, NGO’s, businesses and the EU’s eventual call to action to create a harmonised EU framework on human rights and environment due diligence back in March 2018. Historically, global human rights due diligence obligations have remained voluntary in nature stemming from the UN Guiding Principles on Business and Human Rights, the OECD Guidelines for Multinational Enterprises, the UN Sustainable Development Goals and the goals of the Paris Agreement on climate change. The outcome is that the adoption of these obligations across industry remains inconsistent, short term and often companies have limited their due diligence to their first-tier supply chain.
At a national level, momentum for due diligence legislation has been consistently building with several initiatives being adopted at individual state level. The Netherlands has introduced its Child Labour Due Diligence Law, France has implemented its Corporate Duty of Vigilance Law and Germany passed its Corporate Due Diligence Act last year. Similar legislation is being considered in other EU states. Whilst, these national initiatives have been largely welcomed by industry and civil society groups, there is a risk for that these differing obligations will create fragmentation and an uneven playing field for businesses.
In 2020, the Commission published the results of its study on due diligence requirements through the supply chain highlighting deficiencies in the voluntary system and the need to align practices and level the playing field in the EU and in April 2020, the EU Justice Minister Didier Reynders followed with an announcement that the Commission would develop its proposal in 2021.
In March 2021, the European Parliament called on the Commission to submit a legislative proposal on mandatory value chain due diligence and in an unusual step submitted its own draft proposal.
The Commission’s proposal was initially expected to be unveiled in June 2021 but was subject to intense critique and several push backs by the EC regulatory scrutiny board and was therefore repeatedly postponed until 24 February 2022.
c. Next Steps and Timing
The Proposal will now pass to the European Parliament and Council for adoption according to the ordinary legislative procedure, a process which can last from 18 months to several years. Given, the expected intense scrutiny and debate we are likely to see a delay and further amendments to the current Proposal. Current expectations are that final adoption won’t be until 2023.
As the Proposal takes the form of a draft Directive, when adopted the requirements will need to be transposed into the laws of each Member States. As currently drafted Member States will have 2 years from the date the Directive enters into force to implement the requirements for the Group 1 large companies and an additional 2 years for Group 2 mid-size ‘high impact’ companies. So, it is unlikely that the new directive will have effect before 2025/27.
2. What does the proposal say?
a. Introduction
Under the Proposal, in scope companies will be required to monitor, prevent and account for actual and potential adverse human rights and environmental impacts in their own operations, those of their subsidiaries and entities within their global value chains with whom they have an established business relationship. Adverse impacts include, human rights issues such as forced labour, child labour, inadequate workplace health and safety, exploitation of workers, and environmental impacts such as greenhouse gas emissions, pollution, or biodiversity loss and ecosystem degradation. The annex to the Proposal provides a broad list of international instruments defining the rights, obligations and prohibitions to be taken into account.
b. Entities in Scope
The Proposal intends to maximize its external impact by applying obligations not only to companies incorporated within the EU, but also to non-EU companies which are active in the EU regardless of where they are headquartered. The Commission has estimated that the Proposal will capture around 13,000 EU companies and 4,000 non-EU companies.
The Proposal applies to the following:
EU Companies
Group 1 Large Companies: all EU limited liability companies of substantial size and economic power – with more than 500 employees on average and more than EUR 150 million in net turnover worldwide in the last financial year for which annual accounts have been prepared. The employee scope in the Proposal is significantly below that of the French and German national bills.
Group 2 Mid-Size ‘High Impact’ Companies: Other EU limited liability companies operating in defined ‘high impact’ sectors, which do not meet both Group 1 thresholds, but have more than 250 employees on average and a net turnover worldwide of more than EUR 40 million worldwide in the last financial year for which annual accounts have been prepared, provided that at least 50% of this net turnover was generated in one or more of the ‘high impact’ sectors. For these companies, the rules will start to apply two years later than for Group 1.
The Commission has aligned the definition of high-impact sectors with guidance from the Organisation for Economic Cooperation and Development and they are listed in the Proposals as (i) the manufacture of textiles, leather and related products (including footwear) and the wholesale trade of textiles, clothing and footwear; (ii) agriculture, forestry, fisheries, the manufacture of food products and the wholesale trade of agricultural raw materials, live animals, wood, food and beverages; and (iii) the extraction of mineral resources regardless of where extracted (including crude petroleum, natural gas, coal, lignite, metals and metal ores, as well as all other, non-metallic minerals and quarry products), the manufacture of basic metal products, other non-metallic mineral products and fabricated metal products (except machinery and equipment), and the wholesale trade of mineral resources, basic and intermediate mineral products, including metals and metal ores, construction materials, fuels and chemicals and other intermediate products.
When calculating the number of employees, part-time employees will be calculated on a full-time equivalent basis and temporary agency workers will be included as if they were workers employed directly for the same period of time by the company.
Non-EU Companies
A hotly discussed feature of the Proposal is its global reach. The Proposal intends to capture non-EU companies active in the EU with either:
an EU net turnover of more than EUR 150 million in the financial year preceding the last financial year (“Large Non-EU Companies); or
EU net turnover of more than EUR 40 million but not more than EUR 150 million in the financial year preceding the last financial year, provided that at least 50% of its net worldwide turnover was generated in one or more of the ‘high impact’ sectors.
The extra-territorial scope of the Proposal which applies to entities irrespective of where their head office is will have a significant impact on large global groups based in the US, UK, Asia and Australia that are caught by the turnover threshold. They will be required to appoint an EU-based representative to liaise with EU supervisory authorities as part of their extensive obligations (Article 16).
c. What about regulated financial undertakings?
The Commission confirms that regulated financial undertakings that fall within the Group 1 threshold are within scope of the requirements, even if they do not have a legal form with limited liability. They will not fall within Group 2 as the financial sector is not considered high impact.
d. What about SMEs?
As currently drafted, micro, small and medium-sized enterprises (SMEs) do not fall within the scope of the Proposal. Nevertheless, they may be indirectly affected by the new rules through business relationships with companies in scope as large companies are expected to pass on demands to their suppliers. Therefore, the Proposal expects Member States to provide specific support to SMEs, such as guidance and other tools to help them gradually integrate sustainability considerations in their business operations.
The exclusion of SMEs from the Proposal has already raised some significant backlash from civil society and NGO groups who have argued that this reduced scope from the initial EU Parliament proposal back in March 2021 excludes 99% of all business in Europe.
It remains to be seen whether these thresholds will be adjusted during the negotiation process.
e. Entire Value chain
The Proposal is expansive and requires in scope companies to implement human rights and environment due diligence measures that cover their entire supply chain and not just first tier up or down. This includes a company’s own operations, the operations of its subsidiaries and its value chain operations with entities with whom the company has ‘established business relationships’.
An established business relationship is defined as a business relationship, ‘whether direct or indirect, which is, or which is expected to be lasting, in view of its intensity or duration and which does not represent a negligible or merely ancillary part of the value chain’ (Article 3).
‘Value chain’ means activities related to the production of goods or the provision of services by a company, including the development of the product or the service and the use and disposal on the product as well as the related activities of upstream and downstream activities.
For regulated financial entities providing loan, credit, or other financial services (which is not defined), the Commission makes clear that “value chain” with respect to the provision of such services should be limited to the activities of the clients receiving such services, and their subsidiaries. In these circumstances, clients that are households and natural persons not acting in a professional or business capacity, as well as SMEs, should not be part of the value chain (Article 3).
So, whilst the Proposal does place parameters around due diligence obligations, companies will still need to look beyond their initial supply chain and consider not only their subsidiaries but also their suppliers, partners, subcontractors, sub-agents up and down their value chain when conducting their due diligence risk assessments. This may be particularly tricky and complex in situations where companies genuinely do not have the information to understand the full extent of the value chain. In such circumstances, where data gaps or information is not available, such an arrangement may need to be raised to a higher risk alert and appropriate systems and controls put in place.
3. Obligations on companies
a. Due Diligence Obligations
Companies’ due diligence requirements are set out in Articles 4 to 11 of the Proposal and include the following:
i) Corporate Policies (Article 5): Integrate due diligence into all corporate policies, have in place a due diligence policy and ensure the due diligence policy is updated annually. The due diligence policy should at the very least include (a) a description of the company’s short to long term approach to due diligence, (b) a code of conduct; and (c) a description of the processes put in place to implement and monitor due diligence obligations.
ii) Identification of actual or potential adverse human rights and environmental impacts (Article 6): Identify actual and potential adverse human rights and environmental impacts listed in the annex to the Proposal arising from their own operations, those of their subsidiaries and from their established business relationships throughout their value chains. For those companies in the high impact sectors, they only need to identify actual and potential severe adverse impacts relevant to the sector. The Proposal also establishes that financial undertakings providing credits, loans or other financial services are only required to identify adverse impacts before providing those services.
iii) Prevention, mitigation and remediation (Article 7): Take appropriate measures to prevent, or where prevention is not possible or not immediately possible, adequately mitigate potential adverse human rights impacts and adverse environmental impacts that have been, or should have been, identified. The Proposal lists various actions that may need to be taken. Appropriate measures are to be understood as measures that are reasonably available to the company taking into account the specific circumstances of the case and priorities.
iv) Bringing actual adverse impacts to an end (Article 8): Take appropriate measures to bring to an end actual adverse impacts which have been, or should have been, identified or, where they cannot be brought to an end, take steps to minimise the extent of their impact. The Proposal lists various actions that may need to be taken.
v) Complaints procedure (Article 9): Establish and maintain a complaint procedure that enables complaints (about any actual or potential adverse impacts) to be submitted by affected persons, trade unions or other workers’ representatives representing individuals working in the relevant value chain and civil society organisations active in areas related to the relevant value chain. Companies must inform their relevant workers and trade unions of their procedure and put in place representatives at the company to address such complaints.
vi) Monitor (Article 10): Monitor the effectiveness of their due diligence policies through reviews that take place at least one every 12 months.
vii) Publication (Article 11): Publish an annual statement on their website by 30 April each year to communicate the relevant due diligence measures taken by the company during the previous calendar year. Companies in scope of the Non-Financial Reporting Directive (to be amended by the proposal for a Corporate Sustainability Reporting Directive) will be required to report this information under those requirements.
b. Contractual Clauses
The Proposal places a key focus on the requirement for companies to seek contractual assurances from third parties with whom it has a direct business relationship to ensure that they will comply with the company’s code of conduct and any prevention action plan it may have to put in place. Those third parties would in turn be expected to seek corresponding contractual assurances from their partners - known as ‘contractual cascading’. The Commission will issue guidance on model clauses to assist companies with their compliance. Some industry groups have argued that these provisions may allow companies to essentially ‘pass the buck’ and contractually shift their responsibilities to their suppliers and third-party contractors.
c. Transition plans
Group 1 Large Companies and Large Non-EU Companies will have to adopt a transition plan to ensure that their business model and strategy are compatible with the transition to a sustainable economy and with the limiting of global warming to 1.5 °C in line with the Paris Agreement. The plan must identify, on the basis of information reasonably available to the company, the extent to which climate change is a risk for, or an impact of, the company’s operations (Article 15).
d. Directors’ Duties for EU Companies
The Proposal imposes additional duties on directors of in scope EU companies which include taking responsibility for adopting a due diligence policy, setting up and overseeing the implementation of the due diligence processes, and adapting the corporate strategy to take into account any adverse impacts that are identified in the due diligence project.
In addition, when fulfilling their duty to act in the best interest of the company, directors must consider human rights, climate change and environmental consequences of their decisions, in the short, medium and long term (Articles 25 and 26).
e. Civil liability
The Proposal introduces a civil liability regime which would allow people negatively affected by an EU company’s operation to take the company to court in an EU member state if the company did not sufficiently act to prevent, minimise, end, and mitigate the adverse impacts of its business activity.
f. Enforcement
National supervisory authorities will be responsible for supervising the new rules under the Proposal and may impose fines in case of non-compliance which will be calculated based on turnover or issue orders for corrective action.
A European Network of Supervisory Authorities will be established, to facilitate cooperation and alignment. EU companies will be supervised by the competent supervisory authority of the Member State in which they have their registered office. A non-EU company will be supervised by the supervisory authority of the Member State in which it has its branch. Should the non-EU company not have a branch in a Member State, or have more than one in different Member States, the competent supervisory authority will be that of the Member State in which it generates the most turnover within the EU.
4. How does the Proposal relate to other EU initiatives?
The Proposal makes clear that it is without prejudice to other EU legislation on human rights, environment and climate change and in the case of conflict the other legislation will prevail. The Proposal is intended to sit alongside and complement a number of other EU initiatives, in particular, the Taxonomy Regulation, the Directive on Human Trafficking, the Employer Sanctions Directive and the proposed Regulation on deforestation-free supply chain and Sustainable Products initiative.
The Commission aims for the Proposal to underpin the proposed Corporate Sustainability Reporting Directive which will expand on the reporting obligations under the EU Non-Financial Reporting Directive, and the SFDR. In scope companies will be required to incorporate their due diligence practices under the Proposal into their reporting obligations under the CSRD and SFDR.
5. What’s the position for the UK?
Whilst there is no equivalent single piece of legislation in the UK that mirrors the EU Proposal, we are seeing a growing trend and focus in this area in the UK. There are existing reporting requirements under the Modern Slavery Act. In addition, the UK's new Environment Act 2021 introduced a prohibition on the use of "forest risk commodities" which include due diligence and reporting obligations which the Government is currently consulting on. These proposals will make it illegal for larger businesses operating in the UK to use key forest risk commodities produced on land illegally occupied or used. Businesses in scope will also be required to undertake a due diligence exercise on their supply chains and to report on this exercise annually.
6. What should companies be doing?
Whilst the Proposal is not expected to come into force for several years, given the wide scope and significant obligations set out in the Proposal in scope companies should be taking action now to evaluate and adapt their own due diligence processes and internal governance obligations against the standards set out in the Proposal.
Such companies should consider the following:
- Set the tone at the top and ensure executives, boards and senior management are sufficiently trained and informed, engaged and committed to the firm’s due diligence obligations.
- Establish a due diligence advisory committee or give an existing committee responsibility and oversight of firm’s due diligence obligations.
- Assign key responsibilities and controls within senior teams – compliance, legal, business teams, procurement.
- Ensure staff and employees are fully informed and aware of their obligations and run regular awareness raising training.
- Engage with counterparties and key stakeholders to determine how to incorporate obligations into relationships, and operations. This will include the need to revisit terms of business, engagement, contracts etc.
- Run risk assessments and analysis to determine where data or oversight gaps exist and to identify risk factors to be mitigated.
- Review the Proposal against internal policies and procedures (i.e. codes of conduct, procurement and supplier policies) and current ESG risk assessment procedures and arrangements in order to determine updates required.
- Review the Proposal against external reporting obligations which will require updating and determine reporting or data gaps.
- Review and reinforce complaints, redress and whistleblowing policies.
- Ensure systems are put in place to regularly test and review systems and processes put in place and clear lines of communication with key stakeholders are maintained.
Conclusion
There is a long road ahead before a final directive will be adopted and the current Proposal is likely to undergo intense scrutiny and further changes as it travels through the various stages of negotiation. The immediate critique from businesses, industry bodies and civil society groups highlights how the Proposal has raised many complex and challenging issues in relation to scope and practical implementation. However, what is clear is that there is a growing demand and expectation for companies to actively engage in their human rights and environment due diligence responsibilities.
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