ESG: Environment – Social – Governance

CS3D update

On 14 December 2023, the European Council and the European Parliament reached provisional agreement on the Corporate Sustainability Due Diligence Directive (“CS3D”). Although formal political agreement on the Directive is still pending and press reports cast doubt on whether it can be reached at all, a draft agreement (“the Draft”) has nevertheless been published. The following is a brief overview of the Draft, highlighting some of the main changes as compared to previous draft versions of the CS3D.

I. Changes to the personal scope of application

Primarily employee and turnover thresholds define the scope of the CS3D, with a distinction being made between EU and third country companies:

  • For EU companies, the employee threshold is generally more than 500 employees and the net worldwide turnover threshold more than EUR 150 million. There is no employee threshold for third-country companies, which are covered if they have a net turnover of at least EUR 150 million in the EU. According to the Draft, the CS3D now also applies to the ultimate parent company of a group if the group reaches this turnover threshold – and in the case of EU companies also the employee threshold – even if this is not the case for the ultimate parent company itself.
  • Like the European Commission’s proposal of 23 February 2022, the Draft applies to EU companies with at least 250 employees and net worldwide turnover of more than EUR 40 million, provided that at least EUR 20 million was generated in certain high-risk sectors. However, the catalogue of sectors considered to be high-risk has been updated in the preliminary agreement: Alongside the manufacture of food, the Draft now contains the manufacture of beverages and construction. The Draft also applies to third-country companies with a net turnover of more than EUR 40 million but less than EUR 150 million in the EU, provided that at least EUR 20 million was generated in one of the specified high-risk sectors. Once again, there is no employee threshold for such companies.
  • The CS3D also applies to EU and third-country companies that generated royalties of more than EUR 7.5 million under licensing or franchising agreements that ensure a “common identity” in the EU and a (EU companies: worldwide)/ (third-country: in the EU) net turnover of at least EUR 40 million in the last financial year. The number of employees a company has is irrelevant in this constellation.

The respective thresholds must be reached in two consecutive years. The way the number of employees is calculated differs in some respects from the method specified in the Act on Corporate Due Diligence Obligations in Supply Chains (Lieferkettensorgfaltspflichtengesetz, “LkSG”), with the concept of full-time equivalent (FTE) being a key factor. It should also be noted that the Draft covers not only corporations but also partnerships within the meaning of Annex II to Directive 2013/34/EU, i.e. general partnerships (oHG) and limited partnerships (KG) as well as comparable foreign legal forms, irrespective of whether their general partners are corporations.

II. Changes to the scope of protection

The legally protected human and environmental rights interests and agreements referenced by the CS3D have been adapted and clarified. The general human rights clause it previously contained has been deleted. The Draft now includes references to further United Nations Conventions including the International Covenant on Civil and Political Rights; the International Covenant on Economic, Social and Cultural Rights; and the Convention on the Rights of the Child. It also specifies what type of environmental adverse impacts are covered by the CS3D – namely any measurable environmental degradation such as harmful soil change, water or air pollution, harmful emissions, excessive water consumption or other adverse impacts on natural resources.

III. Scope of due diligence in the chain of activities

Unlike the Commission’s original proposal, the Draft no longer uses the term “value chain”, instead focusing on the “chain of activities”. The term “established business relationship” has also been abandoned.

The chain of activities covers activities of a company’s upstream business partners related to the production of goods or the provision of services by the company, including the design, extraction, sourcing, manufacture, transport, storage and supply of raw materials, products or parts of the products and development of the product or the service. It also includes activities of a company’s downstream business partners related to the distribution, transport, storage and disposal of the product, including the dismantling, recycling, composting or landfilling, where the business partners carry out those activities directly or indirectly for the company or on behalf of the company. It does not cover the disposal of the product by consumers or the distribution, transport, storage and disposal of a product that is subject to export control. It is worth noting that the provision of services in the downstream chain of activities is excluded.

IV. CS3D does not apply to financial services

There has been a controversial political debate whether to include the financial sector in the scope of the CS3D. As a compromise, the Draft now stipulates that financial services, i.e. the downstream chain of activities, will not be included by the CS3D for the time being at least. Financial companies will however have to fulfil the due diligence requirements laid down by the CS3D when it comes to the upstream part of their chain of activities. Only certain funds (AIFs as defined in Article 4(1) Directive 2011/61/EU and UCITS authorised in accordance with Article 1(2) Directive 2009/65/EC) are completely excluded from the scope of the CS3D. These decisions to include the financial sector in the scope of the CS3D are however subject to subsequent evaluation – and if necessary, revision.

V. Obligation to prevent and remedy adverse impacts

Changes have also been made with regard to the due diligence obligations laid down in the CS3D. For example, it includes adjustments to a company’s own business plan or business strategy as well as investments in factories, plants and operational processes as suitable measures to prevent or mitigate adverse impacts.

In addition, affected companies will be required to provide comprehensive support for business partners that are SMEs, including in the form of monetary payments, where compliance with their code of conduct would jeopardise the viability of the business partner.

VI. Reporting

Whereas the European Commission’s proposal stipulated that companies had to publish an annual statement by 30 April each year, the Draft now requires companies to publish their statement on their website no later than 12 months after the balance sheet date of the financial year for which the statement is drawn up. In addition, from 1 January 2029, the statements must be submitted to a national “collection body”, which is responsible for making the statements available on the European Single Access Point (ESAP). The ESAP is a central access portal where investors can get free, user-friendly, centralised and digital access to financial and sustainability-related information about EU companies and EU investment products.

The Commission will adopt a delegated act concerning the content of the reporting by 31 March 2027 at the latest. This act is intended to contain detailed information on the description of due diligence, potential and actual adverse impacts identified and appropriate measures taken with respect to those impacts.

It should also be noted that the obligation to submit an annual statement will take effect on three different dates, depending on the size and turnover of the companies affected, namely 1 January 2028, 2029 or 2030.

Companies subject to sustainability reporting under the Corporate Sustainability Reporting Directive (CSRD) or included in the consolidated sustainability report of their parent company are exempt from submitting annual statements.

VII. Obligation to adopt and implement a transition plan for climate change mitigation

The Draft continues to require companies to protect the climate. Large companies are obligated to adopt and implement a transition plan for climate change mitigation that aims to ensure that the company’s business activities are compatible with the 1.5°C target of the Paris Agreement and the objective of achieving climate neutrality as established in Regulation (EU) 2021/1119 (Article 15(1) CS3D). Companies that already report on their climate transition plan under the CSRD will be deemed to have complied with their obligation under Article 15(1) CS3D.

The obligation to adopt and implement a transition plan for climate change mitigation can be seen as a paradigm shift in corporate law. Currently, managing directors have the discretion to consider climate protection in business decisions under the business judgement rule, but can also prioritise other concerns. Once the CS3D has been transposed into German law, they will however be obliged to implement the climate transition plan to the best of their ability, even if this is at the expense of other concerns such as social aspects. There are likely to be cases in which the climate transition plan required by the Draft cannot be realised within the scope of a company’s existing business purpose or in which its implementation will jeopardise the existence and long-term profitability of the company.

Companies with more than 1,000 employees must have a policy in place to promote the implementation of their transition plan for climate change mitigation through, among other things, financial incentives to members of their administrative, management or supervisory bodies. This could lead to an obligation to include climate targets in the variable remuneration of such members, in particular of managing directors. The increasing trend of including sustainability targets in the variable remuneration of management board members of listed companies could spill over to many non-listed companies.

VIII. Directors’ duties

The provisions requiring directors of companies to take into account the consequences of their decisions for sustainability matters when fulfilling their duties, as well as to set up and monitor measures for the fulfilment of due diligence obligations have been removed. Under German law, however, directors are already – based on the duty of legality – responsible for implementing and monitoring fulfilment of the CS3D’s due diligence obligations. Even though the Draft no longer contains any explicit provisions on D&O liability, members of corporate bodies may be exposed to personal liability based on general principles (section 43 Limited Liability Companies Act (Gesetz betreffend die Gesellschaften mit beschränkter Haftung), section 93 Stock Corporation Act (Aktiengesetz)) if obligations arising from the CS3D are breached.

IX. Sanctions; civil liability; consideration in procurement procedures

The EU Member States will be responsible for laying down rules on sanctions for possible infringements of the CS3D, but must establish financial sanctions and a naming & shaming mechanism. The maximum fine for infringements is to be at least 5% of a company’s net worldwide turnover.

The CS3D still provides for a civil liability regime that permits claims for breach of human rights and environment due diligence obligations, but only for intent or negligence. However, participation in industry initiatives or the use of third-party verification or contractual clauses will not reduce liability. It should also be noted that the draft expressly excludes liability for the actions of direct or indirect business partners, meaning that companies can only be held responsible for their own sphere of influence. However, a breach of obligations within a company’s sphere of influence may relate to a violation of human rights and environmental protection by a business partner. The basis for any liability is not the business partner’s actions, but rather the breach of human rights and environment due diligence obligations under the CS3D.

In order to effectively enforce these claims, various procedural simplifications are to be introduced for potential claimants:

  • Evidence disclosure obligations allowing courts to order the production of documents (this mechanism already features in the new Product Liability Directive and similar Directives)
  • Prima facie evidence and disclosure obligations (“discovery light”)
  • Knowledge-based limitation periods of at least five years (longer depending on national law)

  • Admissibility of third-party standing for NGOs and trade unions 

  • Injunctive measures

  • Prohibition of excessively high litigation costs for claimants

Compliance with the obligations under the CS3D is also to be taken into account as an award criterion when awarding public and concessions contracts in accordance with the relevant EU directives.

X. Outlook

The text of the Directive is currently only available in draft form. Final agreement by the European Council and the European Parliament is still pending. According to press reports, the German government may abstain from voting in the European Council; it is uncertain whether other Member States will also reject the Draft. It is therefore somewhat likely that the content and wording of the Draft will still be amended or that adoption of the CS3D will fail.

If adopted by the European Council and the European Parliament, the CS3D would enter into force on the twentieth day following its formal publication in the EU Official Journal. Member States would then have two years to transpose it into national law. The German legislator will likely have to make several amendments to the LkSG. According to the current Draft, the acts transposing the CS3D into national law must apply to companies of different sizes based on the following schedule:

  • Three years after the CS3D comes into force in particular for EU companies with more than 1,000 employees and net worldwide turnover of more than EUR 300 million in the last financial year before the CS3D comes into force 
  • Three years after the CS3D comes into force in particular for third-country companies that generated net turnover of more than EUR 150 million in the EU in the last financial year
  • Four years after the CS3D comes into force for in particular EU companies with more than 500 employees and net worldwide turnover of more than EUR 150 million in the last financial year 
  • Five years after the CS3D comes into force for companies with more than 250 employees and net turnover of more than EUR 40 million (EU companies: worldwide/ third-country companies: in the EU; but not more than EUR 150 million) in the last financial year, where at least EUR 20 million was generated in a high-risk sector.

Once a final version of the CS3D is published, companies will essentially face the following legal tasks: Reviewing the applicability of the CS3D and, if necessary, reviewing existing risk management, risk analysis and supplier relationships to see if any adjustments need to be made. The allocation of responsibilities and the preparation and implementation of the necessary processes should therefore be tackled at an early stage. In particular, companies that are not currently subject to the LkSG but could be affected by the CS3D due to the wider scope of the Draft should start implementing the requirements of the CS3D early on.

Companies should also start to draw up climate transition plans (if not already doing so under their CSRD reporting obligations) and review existing remuneration systems with regard to the possible inclusion of climate-related incentives.

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