The EU aims to introduce mandatory supply chain due diligence obligations

At a Glance…

On 23 February 2022, the European Commission presented a legislative proposal for a Directive on Corporate Sustainability Due Diligence Directive (DD Proposal). In essence, the Directive requires certain companies to meet due diligence obligations with respect to human rights and environment and provides for an enforcement mechanism with possible sanctions and civil liabilities for non-compliance. The Directive will apply to both EU and non-EU companies that meet thresholds with respect to turnover and number of employees. Below, we explain the key elements of the DD Proposal.

Authors: Yves Melin; Jin Woo Kim; Isabel Fressynet and Anna Golouchko

The trend of introducing mandatory supply chain due diligence in the EU

Various supply chain due diligence schemes already govern the placing of goods on the EU market, and several more are currently being adopted by the two EU co-legislators, the Council of the EU (consisting of the member states) and the European Parliament (consisting of directly elected representatives). Schemes that are already in force include the Conflict Minerals Regulation (in force from January 2021), the Timber Regulation (in force from March 2013), the Forest Law Enforcement, Governance and Trade (FLEGT) Regulation (in force from December 2005) and the Kimberley Process Certification Scheme for conflict diamonds (in force from December 2002). Others that are at various stages of adoption and will enter into force in the coming years include the Carbon Border Adjustment Mechanism (CBAM) regulation, the Deforestation-free regulation, the Forced Labour Regulation, the Batteries Regulation). All of these schemes have one important thing in common: they all require importers to know how the products they place on the EU market were manufactured and to be able to present documentary evidence upon request to demonstrate it. This evidence must be obtained from suppliers or from the suppliers’ own suppliers. We will review each of these various schemes in a series of client alerts, starting with the Due Diligence Directive.

Key elements

In essence, the Directive requires certain companies to meet due diligence obligations with respect to human rights and environmental standards and provides for an enforcement mechanism with possible sanctions and civil liabilities for non-compliance.

Scope (companies): The Directive will apply to both EU companies and non-EU companies that meet thresholds with respect to turnover and number of employees. The Directive will apply to Group 1 companies (Large) from the second year after its entry into force, and to Group 2 companies (Medium-sized in high-risk sectors) from the fourth year after its entry into force.

• EU companies incorporated under the laws of EU member states:
  • Large EU companies (Group 1): Companies with more than 500 employees and a net worldwide turnover of more than EUR 150 million in the last financial year.
  • EU companies (Group 2): Companies with more than 250 employees and a net worldwide turnover of more than EUR 40 million in the last financial year, if at least 50 per cent of that net turnover was generated in one or more of the following high-risk sectors: (i) textiles, (ii) agriculture, and (iii) extraction of mineral resources.
• Non-EU companies incorporated under the laws of a third company:
  • Large non-EU companies (Group 1): Companies with a net EU-wide turnover of more than EUR 150 million in the financial year preceding the last financial year. There is no reference to the number of employees.
  • Non-EU companies (Group 2): Companies with a net EU-wide turnover of more than EUR 40 million in the financial year preceding the last financial year, if at least 50 per cent of their net turnover was generated in one or more of the following high-risk sectors: (i) textiles, (ii) agriculture, or (iii) extraction of mineral resources.Again, there is no reference to the number of employees.

The Directive covers whole value chains, but not beyond established business relationships

According to the Commission’s DD proposal, corporate due diligence duties apply to companies’ own operations and the operations of their subsidiaries and their entire value chains. However, this is only for companies within “established business relationships”, which the Directive defines as direct or indirect business relationships that are expected to be lasting and “which do not represent a negligible and ancillary part of the value chain”. This includes contractors, subcontractors and other entities in their value chains. Therefore, this goes much further than direct suppliers.

The Directive covers both human rights and environmental obligations

All companies falling under the scope of the Directive must address actual and potential adverse impacts on human rights and the environment resulting from violations of international conventions, as listed in the Annex of the Directive (e.g., the prohibition on child labour and the prohibition on exports of hazardous waste under the Basel Convention, etc.).

Large companies have additional climate change obligations

Large EU and non-EU companies (Group 1) must adopt a plan to ensure that their business model and strategy are compatible with a transition to a sustainable economy, as well as with limiting global warming to 1.5°C in line with the Paris Agreement. In particular, the plan must identify the extent to which climate change is a risk for, or an impact of, the company’s operations. If climate change is identified as a principal risk or a principal impact of a company’s operations, the company must include emission reduction objectives in its plan.

Due diligence obligations

Companies must fulfil the following due diligence obligations with respect to human rights and environment:

• Integrate due diligence into companies’ policies
• Identify potential adverse impacts on human rights and environmental impacts
• Prevent and mitigate potential adverse impacts
• End and minimise actual adverse impacts
• Establish and maintain a complaints procedure
• Monitor the effectiveness of due diligence policy and measures
• Publicly communicate on due diligence.

Directors’ duty of care

The DD Proposal also introduces duties for directors of EU companies to increase the engagement of directors in corporate sustainability due diligence. Directors of EU companies falling under the scope of the Directive must take into account the consequences of their decisions for sustainability matters, including human rights, environment and climate change in the short, medium and long term. This does not apply to non-EU companies.

Enforcement

Enforcement will take place both at a national level and an EU level.

At a national level, each EU member state will designate one or more supervisory authorities to supervise compliance with due diligence obligations after the Directive is transposed into domestic laws. The Commission will publish a list of the competent authorities. National supervisory authorities have broad powers to verify compliance with the Directive. National supervisory authorities must share with each other relevant information and provide mutual assistance in carrying out their supervisory work.

At an EU level, the Commission will set up a European Network of Supervisory Authorities, composed of representatives of national supervisory authorities and of the Commission, to facilitate the cooperation of authorities and the coordination of investigations, sanctions and supervisory practices.

Sanctions

When transposing the Directive into national law, EU member states must lay down rules on sanctions to be imposed for companies’ non-compliance with due diligence obligations. Sanctions could include orders to cease certain actions, pecuniary sanctions (fines) based on the company’s turnover, or interim measures. When deciding the imposition of sanctions, supervisory authorities must consider companies’ efforts to comply with any remedial action, any investments made and collaboration with other entities to address adverse impacts in value chains.

Civil liability

Importantly, the Directive allows victims to bring a civil liability claim before competent national courts and obtain compensation for damages. In principle, companies will be liable for damages if (i) they fail to prevent or mitigate potential adverse impacts on human rights and environment and fail to end and minimise actual adverse impacts, and (ii) as a result, adverse impacts occur and cause damage to third parties. Companies could be civilly liable for damages caused by their own operations and the operations of their subsidiaries and value chains.

However, companies will not be liable for damages caused by adverse impacts arising from the activities of indirect business partners if companies take appropriate measures to prevent such adverse impacts. This would particularly be the case if companies obtain contractual assurances from indirect business partners that they will comply with the companies’ codes of conduct.

Links with the Forced Labour Regulation

The Commission initially considered including a ban on forced labour products in the DD proposal but eventually decided to design a separate legal instrument to address forced labour. On 14 September 2022, the European Commission unveiled its proposal for the Forced Labour Regulation (FL Proposal) to eliminate forced labour in supply chains.

The Due Diligence Directive and the Forced Labour Regulation are two separate legal instruments. However, in practice, they are interlinked. Thus, companies are advised to cover human rights and environment (under the Directive) and forced labour (under the Regulation) when establishing compliance policies.

Looking ahead

The DD Proposal is currently going through the ordinary legislative procedure, which requires the European Parliament and the Council of the EU (composed of the member states) to formally adopt the proposal. While the DD Proposal is broadly supported by the European Parliament and the Council of the EU, they are currently establishing their final positions before the final negotiations, known as trilogue, start. Here is the latest on discussions of the DD Proposal at the time of writing this alert:

• According to the draft amendment prepared by the Parliament’s lead rapporteur Lara Wolters on 7 November 2022, the Directive should apply to full value chains, which include both upstream production and downstream use of a product. Further, the rapporteur aims to widen the scope of companies that fall under the Directive, lowering the threshold to 250 employees, rather than the Commission’s suggestion of 500 employees.

• Meanwhile, the Czech Presidency of the Council is working to agree on the Council’s position before the end of its term in December 2022. Several EU member states are pushing to carve out investors and asset managers from the scope of the Directive.

Under the current draft (the Commission’s DD proposal), once the European Parliament and the Council of the EU adopt the Directive, EU member states will have to transpose the Directive into national law within two years from the its entry into force. After the transposition, the Directive will apply to large companies (Group 1) right away and to companies in high-risk sectors (Group 2) two years afterwards. When the Directive actually enters into force will depend on how fast the three institutions manage to agree on a single text. At this point in time, that is anyone’s guess.

This article was initially published by Reed Smith LLp – here.