On February 23, 2022, the European Commission (Commission), published a proposal Directive on Corporate Sustainability Due Diligence, which would establish uniform EU requirements to promote compliance with certain international agreements on human rights and environment matters, and to take corrective steps.
The Commission’s draft directive is a modified version of proposals made previously by the Commission and the European Parliament, but remains ambitious and multifaceted. It reflects the EU consensus to make economic activity more compatible and sustainable with ESG (environmental.social.and governance) goals. This is illustrated by the myriad EU laws already in force.[1] or being proposed[2]Moreover, there are national laws in many EU member states.
This proposal would require action, including at the board and C-suite levels, to identify and combat certain human rights and environmental “adverse impacts.” It would mandate EU Member States to enact legislation imposing on large companies a duty to conduct due diligence with respect to such “adverse impacts” resulting from their operations and those of their subsidiaries, suppliers, customers and others in their “value chains,” including “upstream” or “downstream” actors, that are the subject of “established business relationships.”[3]In the event of non-compliance, national legislation would allow for civil and criminal sanctions.
The directive if and when adopted would require EU Member States to enact implementing legislation within the ensuing two years — but the text will likely be subject to debate and possible modification before it becomes final.
What Companies are Covered
The directive proposal would apply to two types of companies:
- Group 1, consisting of EU companies with a net worldwide turnover over €150 million and non-EU companies with net EU turnover over €150 million
- Group 2 includes:
- EU companies with net worldwide turnover over €40 million of which at least 50% is generated in three so-called high-impact sectors: (i) textiles, leather and related products (including footwear); (ii) agriculture, forestry, food products, beverages and certain related items; and (iii) mineral resources and metal products (broadly defined to include such items as hydrocarbons, fuels, chemicals, metals, other minerals, quarry products and fabricated metal products except machinery and equipment)
- Non-EU companies with EU turnover over €40 million, but with at least 50% of net worldwide turnover in high-impact sectors
The Commission estimates that around 9,400 EU companies, 2,600 non-EU businesses, and 3,400 EU companies would be in Group 1. Group 2 would include approximately 3,400 EU companies and 1,400 non EU companies. The directive would require that legislation from EU Member State be applied to Group 1 companies within two-years of its entry into effect and to Group 2 after an additional two-year period.
The directive does not require Member States that these measures be applied to companies outside of Groups 1 or 2, but small and medium-sized businesses (SMEs) will likely feel the effects of the proposed rules due to their participation in the value chain of Groups 1 or 2.
Adverse Human Rights/Environmental Impacts
The proposed directive will measure environmental and human rights against international conventions. An annex to the directive lists several international conventions, including the Universal Declaration of Human Rights, International Convention on Civil and Political Rights, International Convention on Economic, Social and Cultural Rights, International Labour Organization core/fundamental Conventions, and many international conventions on biodiversity, endangered animals, use of chemicals, disposal of waste and greenhouse gases. Large companies would be required to identify, prevent and mitigate adverse human rights/environmental effects resulting from their activities and those of their value chain partners. For Group 1 companies, all such adverse impacts would be relevant, but for Group 2 companies, requirements would extend only to “severe adverse impacts”[4]These are high-impact industries.
France is one example of such a country.[5] and Germany, have already enacted corporate sustainability due diligence laws; others — such as Austria, Belgium, Denmark, Finland, Luxembourg and Sweden — plan to do so in the near future. Many EU companies already have their own voluntary initiatives for sustainability. But according to the Commission, this fragmented approach has made progress “slow and uneven.” By proposing a unified EU-level approach to due diligence and other sustainability-related measures, the Commission hopes to create legal certainty for companies across the EU and encourage improvements on a much larger scale.
The proposal is also intended to address consumer demand to purchase sustainably sourced goods from socially-responsible companies. The Commission expects companies will benefit from rules requiring them to more closely manage their operations and supply chains, which will lead to earlier detection of problems and risks — including reputational risks.
New Due Diligence and Other Requirements
The proposal introduces seven detailed due-diligence and other obligations on covered businesses, which can be summarized here:
- A due diligence policy should be in placeInclude a company code for conduct and integrate it into all corporate policies.
- Identify and assess potential adverse effects arising from their own or their business partners’ operations.[6]
- Avoid or minimize potential adverse consequencesIdentified (or that should have gotten identified) through diligence.
- Reduce or eliminate actual adverse effectsIdentified (or that should have gotten identified) through diligence.
- Initiate a complaints procedure accessible to civil society organizations, trade unions and other workers’ representatives, and individuals who may be vulnerable to adverse impacts from a company’s activities.
- At least annually, assess the effectiveness of due diligence strategiesIn identifying and avoiding adverse effects along their global value chain.
- Publicate an annual statement on due diligence efforts. This could be incorporated into other required non-financial reporting.
ToPrevent, mitigate, end, or minimize the impact of adverse impactsCompanies would be required to take appropriate actions, such as investing in infrastructure and collaborating with industry stakeholders. The proposal also requires specific actions such as:
- Implementing and creating detailed plans to prevent or rectify violations of human rights and adverse environmental effects. Companies whose operations — or whose value chain partners’ operations — have already caused damage must offer financial compensation to any affected individuals and communities.
- Requiring compliance with the company’s code of conduct in contracts with established value chain partners. A company should also encourage companies it deals with to ask for their permission. Own To provide the same assurances, partners from the value chain are required.
- Further down the value chain, new contracts can be formed. A company that pursues new agreements to extend the reach of its code of conduct may be able to limit its liability for adverse impacts caused by indirect value chain partners’ actions.
- SME support through financial and other assistanceIn value chains that might not be able meet code of conduct obligations.
Companies that fail to comply with their due diligence obligations but are unable to avoid adverse consequences can be forced to terminate commercial agreements or suspend operations until they can prevent or minimize any negative outcomes.
A company’s failure to comply with its obligations could expose it to civil liability for adverse impacts stemming from its own actions, or the actions of its subsidiaries or global value chain partners. Victims would be entitled to recover damages for any harm a company “should have” identified, prevented, mitigated, ended or minimized.
National authorities could also impose administrative sanctions on companies, such as turnover-based penalties or orders to take remedial actions. Non-EU companies could be subject to enforcement in the Member State that has a branch. If it has multiple EU branches, it could also be subject to enforcement in those Member States.
The Commission’s proposal imposes on Group 1 companies additional obligations to combat climate change. Both EU and non-EU companies in this group would be required to come up with a plan to make the operation of their business “compatible with” the transition to a “sustainable economy” and limiting global climate change to 1.5° C, a goal identified by the Paris Climate Accords. They would also need to consider sustainability efforts when setting management bonuses.
Further, for EU companies in Groups 1 and 2, the proposal would introduce a “duty of care” for executives and board members, requiring that “when fulfilling their duty to act in the best interest of the company” they take account of short-, medium- and long-term sustainability matters.
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The Commission’s proposal will be carefully scrutinized during the coming months by the European Parliament and Council and by the public, including the business community and public-interest groups. Whether the Commission’s proposal will be approved intact is uncertain, but with or without modification, the result seems likely to include major new obligations for large companies operating in the EU.
[1] For example, Taxonomy Regulation 2020/852 of June 1, 2022The Sustainable Finance Disclosure Regulation 2019/2088 of Nov. 27, 2019, as well as the Non-Financial Reporting Directive 2014/95 (Oct. 22, 2014).
[2] Like the one above Corporate Sustainability Directive.
[3] Banks, insurers, funds, and other financial-sector entities are not allowed to include small and medium-sized businesses in their value chain.
[4] An impact would be judged “severe” if it either is “especially significant,” affects “a large number of persons” or “a large area of the environment,” is “irreversible” or is “potentially difficult to remedy.”
[5] For two consecutive years, companies must employ at most 5,000 workers in France and at the minimum 10,000 worldwide under the French law. It requires companies to establish, publish, implement and monitor a “vigilance plan” to identify and prevent risks of severe adverse impacts on human rights, fundamental freedoms, health and safety caused by activities of the company and its subsidiaries, as well as subcontractors or suppliers with which it has an “established commercial” relationship. The vigilance plan must include five components: risk mapping to identify, analyze and rank risks of adverse impacts; procedures for regular assessment of subsidiaries and subject suppliers and subcontractors; measures to mitigate or prevent serious harm; whistle-blowing mechanisms; and monitoring/evaluation of these measures’ efficacy. Although this French legislation has had a significant impact on the world, there have been proposals to strengthen it.
[6] This analysis would be required by all financial-sector regulatory entities before they start providing services to clients.
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