ESG: Environment – Social – Governance

European Commission’s proposed directive on corporate sustainability due diligence

On 23 February 2022, the European Commission adopted a proposal for a directive on corporate sustainability due diligence. The proposed directive provides for new European-level due diligence obligations for companies’ global value chains, tightening the existing requirements under the already-adopted German Act on Corporate Due Diligence in Supply Chains (Lieferkettensorgfaltspflichtengesetz, “LkSG”) in a number of areas. That means that the proposed directive will apply to a significantly wider range of companies: It requires full compliance with due diligence obligations at indirect supplier level, creates a new basis for civil liability for breach of due diligence obligations, and extends the list of protected objects.

Compared to the LkSG, the proposed directive contains significant additions in the following areas in particular:

1. Concept and scope of the value chain

With regard to indirect suppliers, the LkSG provides for significantly reduced due diligence, applying the duty standard to the company’s own business and direct suppliers only when there is “substantiated knowledge” of a violation. The proposed directive goes further:

  • The value chain is defined as all 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 of the product as well as the related activities of upstream and downstream established business relationships of the company.
  • The due diligence obligations relate to the company’s own business activities, “controlled” subsidiaries, and direct and indirect contractors in the value chain with which the company has an established business relationship. The extent to which the business relationship is classified as established must be assessed periodically, at least annually.

2. Scope of application

Unlike the LkSG, the proposed directive does not apply to all companies irrespective of their legal form. The proposed directive applies to companies that fall under its definition of company, particularly the explicitly specified legal forms and regulated financial undertakings:

  • The legal forms of company covered vary depending on whether the company is incorporated under the laws of a Member State or a third country. For Member State companies, a narrower definition applies, comprising corporations – in Germany, the Aktiengesellschaft (stock corporation), Kommanditgesellschaft (partnership limited by shares), and Gesellschaft mit beschränkter Haftung (limited company). If the company is established under the laws of a third country, a different definition of company applies; in Germany, this definition covers the partnerships offene Handelsgesellschaft (general partnership) and Kommanditgesellschaft (limited partnership).

The LkSG applies to companies with at least 3,000 employees or 1,000 domestic employees irrespective of their turnover. The proposed directive, however, significantly lowers these employee thresholds, but also incorporates cumulative turnover thresholds.

  • The proposed directive applies to companies established under the laws of a Member State if:
    • They have more than 500 employees globally and net turnover of more than EUR 150 million (Group 1) or more than 250 employees and global net turnover of more than EUR 40 million, of which at least 50% is generated in the textiles, agriculture, or minerals sectors (Group 2).
    • Companies established under the laws of a third country that meet the Group 1 or Group 2 turnover thresholds are also covered as Group 3.
  • The European Commission expects that the proposed directive will directly apply to around 13,000 companies in the EU and around 4,000 outside the EU. It may also apply indirectly to micro, small and medium-sized enterprises below the thresholds.

3. Due diligence required

In many respects, the proposed directive is more differentiated than the LkSG in terms of implementing due diligence and narrows companies’ implementation discretion:

  • Companies’ policies: Companies to which the proposed directive apply must integrate due diligence into their policies. This includes writing a strategy for meeting the due diligence requirements and updating it annually. The strategy must contain a description of the company’s approach, a code of conduct, and a description of both the processes implemented under the code of conduct and the measures taken to ensure compliance with the code of conduct internally and externally. This goes further than the policy statement required by the LkSG.
  • Identify adverse impacts: Companies must identify actual and potential adverse environmental and human rights impacts. The annex to the proposed directive lists the protected objects to be taken into account in more detail. That list extends beyond the objects protected by the LkSG. Companies in Group 2 and Group 3 only need to identify serious adverse impacts.
  • Prevent potential adverse impacts: Companies must prevent – or at least mitigate – adverse environmental and human rights impacts. In particular, they must develop a prevention action plan with clearly defined timelines; this is also conceivable with indirect business partners. In addition to a clearly defined timelines, the plan must also include meaningful indicators. Direct business partners must contractually commit to companies’ codes of conduct, their plans for preventive measures, and to seeking corresponding contractual assurances in turn from their partners. If necessary, companies must refrain from extending or temporarily suspend the relationship with the partner in question or terminate the business relationship with respect to the activities concerned if the potential adverse impact is severe.
  • End actual adverse impacts: Companies must bring to an end or minimise adverse impacts. If necessary, persons affected must also be financially compensated. Furthermore, a remediation mechanism with clearly defined timelines for action and indicators to measure improvements must be established; this is also conceivable for indirect business partners. The aforementioned obligations of business partners as well as the measures for affected business relationships also apply here.
  • Complaints procedure: Companies must establish a complaints procedure that covers the entire value chain. Access to the procedure must be provided to: a) persons who are affected or have reasonable grounds to believe that they might be affected, b) trade unions and other workers’ representatives representing individuals working in the value chain concerned, and c) civil society organisations active in the areas related to the value chain concerned. Companies must also establish a procedure for dealing with complaints, and inform the relevant workers and trade unions of this procedure. The complainant is entitled to request appropriate follow-up on the complaint and a right to meet with company representatives to discuss severe adverse impacts.
  • Monitoring: Companies must monitor the effectiveness of the due diligence policy and measures. The effectiveness of the measures within the value chain must be assessed both annually and on an ad hoc basis using appropriate indicators. The due diligence requirements are then updated based on the results of this assessment.
  • Communication: Companies must communicate publicly on their due diligence. In particular, this includes publishing a statement on their website by 30 April each year. The publication must report on the matters covered by the directive and relate to the previous calendar year.
  • Authorised representative: Companies must designate a person authorised to receive notifications from the supervisory authorities. The authorised representative must be provided with the necessary powers and resources to cooperate with the supervisory authorities. This builds on the tasks of the human rights officer under the LkSG.
  • The European Commission’s proposal provides for further obligations for companies depending on their categorisation.
    • Group 1 companies and Group 3 companies that meet the Group 1 turnover thresholds need to have a plan to ensure that their business model and strategy are compatible with the transition to a sustainable economy and with limiting global warming to 1.5°C in accordance with the Paris Agreement. The fulfilment of this duty shall be reflected in a variable remuneration of the companies’ directors.
    • The proposal also explicitly requires directors of Group 1 and Group 2 companies to set up and oversee the implementation of due diligence. The duty of directors to act in the best interests of the company is expanded to include consideration of the impact on sustainability concerns.
  • The EU Commission is expected to publish sector-specific guidance on due diligence compliance.

4. Sanctions and civil liability

  • The proposed directive provides for turnover-based fines, with the amount of the sanction and the competent national authority still to be designated by the Member States. Cooperation with the authorities as well as companies’ own remediation of adverse impacts will have a positive affect on possible sanctions. Companies sanctioned may be banned from accessing state aid.
  • The LkSG does not create a new basis for civil liability for the breach of due diligence obligations, but it explicitly leaves any liability established independently of the LkSG unaffected. The proposed directive, on the other hand, explicitly provides for civil liability for due diligence violations to prevent potential or bring to end actual adverse impacts. Liability is not limited to the company’s own violations; it is also conceivable in the case of violations by subsidiaries and suppliers.
  • This requires that non-compliance with the designated due diligence obligations causes adverse human rights and environmental impacts which, had due diligence been exercised, should have been identified, avoided, mitigated, brought to an end or reduced in severity, and this results in damage.
  • In this context, a weakened liability standard applies to indirect business partners where the obligations regarding the contractual implementation of due diligence have been fulfilled. However, this does not apply if it was unreasonable to assume that the measures were appropriate.
  • This new civil liability provision still needs to be transposed into national law by the Member States. When the directive is implemented by the Member States, this liability is also to be mandatory in cases where the law applicable to corresponding claims is that of a third country.

5. Timeframe and outlook

  • The European Parliament and the Council have yet to approve the European Union’s proposal. Member States have two years to implement the directive after it has been adopted. Once adopted, the directive will apply directly to Group 1 and Group 3 companies that meet the Group 1 turnover threshold. A further two years later rules will start to apply to Group 2 and Group 3 companies that meet the Group 2 turnover threshold.
  • Further European-level regulations have already been announced. In the wake of this, a legislative proposal by the EU Commission to promote decent work and sustainable recovery worldwide is in the works, but the wording has not yet been published.