European Commission presents draft European Sustainability Directive

1.Introduction

The European Commission has taken a long time to present the proposal for a European Sustainability Directive. The European Parliament has urged the Commission to act several times.[1] There was a chance to present a regulatory proposal that would define what corporate responsibility will mean in the future in a thoughtful and measured way, which would, in particular, protect companies in competition that act responsibly for human rights, the environment and climate protection. The result now is a set of rules the regulatory technique of which is open to criticism in key respects, whose foundations tend to be incomplete and which is based neither on recognized standards nor on empirical research. We limit ourselves here to pointing out the essential differences between the draft Directive and German Act.

2. Personal scope of application

The German Act on the Entrepreneurial Duty of Care in Supply Chains will come into force on January 1, 2023, and will then be applicable to companies with at least 3,000 employees, and from January 1, 2024, to companies with at least 1,000 employees. The draft Directive, in contrast, lowers the number of employees and at the same time introduces minimum turnover thresholds:

• According to the Commission's proposal, companies established in the EU have to apply the new rules if they employ an average of more than 500 employees and have generated a worldwide net turnover of more than EUR 150 million in the last financial year.

• In addition, companies that employ an average of more than 250 employees and have achieved a worldwide net turnover of EUR 40 million are covered if they generate at least half of their turnover in a high-impact sector. The high-impact sectors include textiles and food production, agriculture and forestry, extraction of minerals and metal production.

A new feature compared to the German Act is the application to companies outside the EU independent of the existence of a branch in the EU: If the company has been established outside the EU, it must apply the new rules if it has generated a net turnover of more than EUR 150 million in the internal market in the penultimate financial year.[2] This extension of the rules to companies based outside the EU is to be welcomed. This broadens the level playing field. However, in which way effective supervision can be achieved in this case is still largely left unanswered by the Directive.

Practical advice:

• Compared to the SCA, the draft Directive provides for a significantly extended personal scope of application. This is not determined solely on the basis of the number of employees, but also introduces a minimum turnover threshold. In addition, being active in a high-impact sector can also lead to the application of the law.

• The employees of group companies are not included in the determination of the applicability thresholds.

• In contrast, the concept of an undertaking is narrower than in the SCA: While the SCA covers companies irrespective of their legal form and even natural persons at the head of a group of companies, the draft Directive only applies to corporations (SE; AG; KGaA and GmbH) and commercial partnerships which are exclusively owned by corporations, as well as – in this special case irrespective of the legal form – to insurance companies and financial sector entities.

3.Due diligence obligations within company groups

The draft Directive imposes a responsibility on companies to safeguard protected human rights and environmental concerns not only for their own business operations. Rather, the company is also responsible for ensuring that the protected human rights and environmental concerns are observed in the value chains of its dependent subsidiaries. Under the German Act, only such group companies are included over which the company exercises a determining influence. A regulation on the uniform and joint fulfilment of the statutory due diligence obligations in the group is missing in the proposed Directive as well as in the German Act.

4. Protected rights

The proposed Directive distinguishes between two types of protected rights:

(i) human rights and environment-related prohibitions explicitly mentioned in the Annex to the Directive (e.g. prohibition of child labor and forced labor), and

(ii) prohibitions or rights arising from the international conventions on the protection of human rights and the environment specified in the Annex.

In terms of legislative technique, this is reminiscent of the distinction between human rights prohibitions in § 2(2) SCA and protected legal interests in § 2(1) SCA. This legislative technique is worthy of criticism. It is not acceptable that neither the German nor the European legislators are able to clearly determine which human rights and environment-related prohibitions and rights companies must protect in their supply chains.

Practical advice:

• The list of explicitly specified human rights-related prohibitions is longer than the catalogue in § 2(2) SCA, and the list of international conventions on the protection of human rights and the environment is longer than the list in the Annex to § 2 SCA. In the area of environmental protection, in particular, the scope is extended by additional conventions.

• However, the draft Directive not only goes well beyond the German SCA, but also far beyond the Guiding Principles on Business and Human Rights of the United Nations Human Rights Committee.

5. Value chain

While the German Act regulates the own business area up to the customer's factory gate as well as the supply chains (upstream) and only provides for a customer check in the case of financial services of particular importance, the proposed Directive also covers direct or indirect business relationships in the downstream parts of the value chain, i.e. primarily with customers. The downstream area is intended to even include recycling and disposal. The trigger for the obligations outside the own group of companies is to be the existence of an established business relationship. The proposed Directive defines this as a business relationship 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. This is only at first sight a clear restriction of the scope of the Directive. In particular, the recitals clarify that all downstream links in the value chain are considered to be an established business relationship if and because the business relationship with the immediate counterparty falls under this definition.

Practical advice:

• The German Act regulates the company's own business area (up to the customer's factory gate) and the upstream supply chains.

• The proposed Directive covers the entire value chain (upstream and downstream).

• While the obligations under national law with regard to indirect suppliers are only triggered in the supply chain and only in the case of positive knowledge of a breach or risk, the draft Directive includes indirect business relationships without such a restriction.

6. Specific duties of care (“Due Diligence”)

At the core of the German and European regulations are the duties of care. The draft Directive and the SCA are, ultimately, based on the same principle with regard to the structuring of the duties of care: A risk management system (in the terminology of the draft Directive a “due diligence” system) must be implemented and potential or actual adverse effects on the protected legal positions must be identified by means of a risk analysis, which must then be countered with preventive and remedial measures. In addition, both sets of rules include accompanying measures such as the establishment of a complaints procedure, reporting and a regular and ad hoc review of the effectiveness of the measures.

a. Integration of due diligence into corporate policy

Companies are expected to integrate due diligence into their all their corporate policies and establish a due diligence policy. The latter has to contain the following components:

• a description of the company’s approach to due diligence, including in long-term corporate policy,

• a code of conduct describing the rules and principles to be followed by employees and subsidiaries, and

• a description of the processes put in place to implement due diligence, including the measures taken to ensure compliance with the code of conduct and its application to established business relationships.
  
  

The policy is to be updated and published annually.

Practical advice:

As a result, these obligations appear comparable to the obligation to draw up a human rights declaration under national law.

b. Identification of actual and potential adverse impacts – risk analysis

Companies have to take appropriate measures to identify actual and potential adverse impacts on the protected human rights and environmental legal interests arising from their own operations and those of their subsidiaries. This also applies to such impacts in established business relationships that are part of the company's value chain. Companies that are subject to the personal scope of application only because they belong to a high-impact sector are only obliged to identify such actual or potential adverse impacts that are relevant to the respective risk sector. The financial and insurance sectors are subjected to particularly extensive obligations: Human rights and environment-related risks are to be analyzed before providing credit and financing or providing (re)insurance, both in relation to the clients and their subsidiaries, if the latter are related to the measure.

Practical advice:

Compared to national law, the obligation to carry out a risk analysis is extended in three respects: It comprises

• not only a parent company’s own business area, but also that of its subsidiaries;

• not only the supply chain, but the entire value chain;

• indirect business relationships not only in the case of positive knowledge of a human rights or environment-related risk or violation, but as such.

In practice, the entire value chain is fully or even almost fully transparent only in extremely rare cases. In particular, it is unclear how companies are supposed to fulfil their duty of risk analysis in this case. In this context, the European legislator imposes vague obligations on the national legislator to create informational transparency.

c. Prevention and mitigation of potential adverse impacts

Companies have to take appropriate measures to prevent or adequately mitigate identified or identifiable potential adverse impacts.

According to the relevant provisions, the following measures may be required from the perspective of the European legislator:

• The definition of a prevention action plan, if the nature and complexity of the measures required make this necessary.

• Seeking contractual assurance of compliance with the code of conduct and, as necessary, the prevention action plan from direct business partners. The company may also be obliged to require the direct business partner to seek corresponding contractual assurances from its business partners, provided that these business partners are also part of the company's value chain (“contractual cascading”).

• Investments in management and production processes and infrastructures.

• Support for small and medium-sized enterprises with which the company has a business relationship if their economic viability would be jeopardized by compliance with the code of conduct or the prevention action plan.

• Collaboration with other entities.

If these measures do not prevent or mitigate potential adverse impacts, a company may also be obliged to seek to conclude a contract with a partner with whom it has only an indirect relationship, with a view to achieving compliance with the company’s code of conduct or its prevention action plan.

Practical advice:

While obliging the contractual partner to a Business Partner Code of Conduct and contractual pass-on clauses are also known from the German regulation, the investment and support obligations provided for in the draft Directive as well as the obligation to enter into contractual commitments with a contractual partner that has so far only been an indirect one are a novelty from a German perspective. If potential adverse impacts cannot be prevented or adequately mitigated with these measures, companies are required to refrain from entering into new or extending existing relations with the business partner in connection with or in the value chain of which the impact has arisen. In addition, they must temporarily suspend the commercial relationship, while pursuing prevention and minimization efforts, if there is reasonable expectation that these efforts will succeed in the short-term. If the potential adverse impact is severe, the business relationship is to be terminated permanently. An exception applies with respect to companies in the credit and finance industry, when they can be expected to suffer substantial prejudice from the termination of the relationship.

d. Bringing actual adverse impacts to an end

Companies are to be obliged to take appropriate measures to bring actual adverse impacts to an end. If these cannot be brought to an end in this way, they must in any case be minimized. Where the adverse impact cannot be immediately brought to an end, companies must develop and implement a corrective action plan. In addition, companies are to be obliged – in this respect completely different from the German SCA – to pay damages and financial compensation to the parties affected (regarding the obligation to pay damages, see also under 8. below).In addition, the same measures are to be taken as for the prevention and mitigation of potential adverse impacts (see 6.c. in this regard), i.e. seeking appropriate contractual assurances in the value chain (including contractual cascading), investing in management and production processes as well as infrastructure, providing support to small and medium-sized enterprises with which the company has an established business relationship, and collaborating with other entities. The consequences provided for in the event that adverse impacts cannot be brought to an end or mitigated by these measures are also comparable: The company has to refrain from entering into new or extending existing relations with the business partner in connection to or in the value chain of which the impact has arisen. Rather, the company has to temporarily suspend the commercial relationship while pursuing efforts to bring to an end or minimize the extent of the adverse impacts. Only if the adverse impact is severe, a permanent termination of the business relationship is considered to be warranted. Again, an exception applies to the credit and finance industry where substantial prejudice has to be reasonably expected to be caused.

e. Complaints procedure

As is the case under German law, companies are to be obliged to set up a complaints procedure. This is intended to enable persons who are or might be affected, workers' representatives representing individuals working in the value chain, as well as civil society organizations active in the areas related to the value chain, to report legitimate concerns regarding actual or potential adverse human rights impacts and adverse environmental impacts with respect to the company’s business operations, the operations of its subsidiaries or the value chain. In contrast to German law, the draft Directive provides for the obligation to set up public reporting channels at the supervisory authorities to receive reports of due diligence violations. In addition, the scope of application of the EU Whistleblower Directive is to be extended to the reporting of violations of the requirements of the Sustainability Directive and the protection of the reporting persons.

f. Monitoring

As under German law, companies have to assess – annually as well as on an ad hoc basis – the effectiveness of the measures to identify, prevent, mitigate, bring to an end and minimize adverse impacts on protected human rights and environmental legal interests.

g. Public reporting

Furthermore, the draft Directive provides for an extension of the CSR reporting obligation. Companies that are not already subject to CSR reporting requirements in the (consolidated) management report according to the requirements of the CSR Directive or the national implementation laws will in future have to publish a report on compliance with the new legal requirements by April 30 of each year. More specific criteria are to be stipulated by the national legislator.

Practical advice:

As is well known, the corresponding German regulation was widely criticized because the German legislator, contrary to indications to this effect from practice, has not made it possible to integrate the report into the non-financial statement/consolidated statement pursuant to §§ 289f, 315b of the German Commercial Code (Handelsgesetzbuch – HGB), which already requires information on the avoidance of human rights violations as well as occupational health and safety and environmental issues. The EU legislator does not want to impose such error-prone duplication on companies. Nonetheless, companies are advised to follow the legislative developments at the European and German level on the planned extension of CSR reporting obligations.

7. Climate protection

Companies established in the territory of the EU, which employ an average of more than 500 employees and have a worldwide net turnover of more than EUR 150 million, as well as companies established in third countries, which generate a net turnover of this amount within the territory of the EU, are – and this is a complete novelty compared to the German SCA – subjected to a responsibility to combat climate change. In the future, companies must align their business model and strategy to be consistent with the transition to a sustainable economy and with limiting global warming to 1.5 °C, in line with the Paris Agreement. For this, they must develop an implementation plan. The plan must be based on an analysis of the risks that climate change poses to the company. This plan also has to show whether climate change is a principal risk to the company's operations and whether it has a principal impact on climate change. If this is the case, the company is obliged, in addition, to include specific emission reduction objectives in this plan. The special incentivization or, respectively, obligation of directors in this context is noteworthy: The fulfilment of the targets provided for in the plan is to be taken into account in setting the variable remuneration of the company’s directors in order to contribute to the business strategy, long-term interests and sustainability of the company. In this context, the aim is to ensure that clear and understandable criteria are established for the granting of any type of variable remuneration.

Practical advice:

The Paris Agreement on climate change is addressed to states. They must make climate protection contributions and develop and implement national action programs. However, the Paris Agreement does not contain any obligations for companies. It is also not clear from the Agreement how companies can contribute to achieving the agreed climate protection targets, other than by fulfilling their obligations under national climate protection laws. Legally speaking, the regulation in the Directive is nothing more than a set of programs, but not a set of obligations for companies, with the exception of the requirement to draw up a company's own climate protection plan.

8.Civil liability

The stringent nature of the draft Directive is most apparent in the area of civil liability: In the event that a company fails to comply with the due diligence obligations and an adverse impact occurs which could have been prevented, brought to an end or mitigated through the appropriate measures and leads to damage, the draft Directive explicitly provides for civil liability of the company. In contrast, liability for damages caused by the activities of indirect partners is generally to be excluded if the company has sought a contractual assurance of compliance with the code of conduct and, if applicable, the prevention action plan or the corrective action plan, and has verified compliance with such assurance through appropriate measures. In this case, liability is only to apply if, in the circumstances of the individual case, it was unreasonable to expect that the action actually taken was adequate. According to the draft Directive, due account is to be taken in the assessment of the existence and extent of liability of the company’s efforts regarding the fulfillment of the required measures. Under German law, such considerations can only be relevant with regard to the existence of liability; a determination of the extent of liability on the basis of these criteria is, in the absence of contributory negligence on the part of the injured party, alien to German civil law.

Practical advice:

Following heated discussions during the legislative process, the SCA does not contain an independent civil liability provision for violations of human rights and environmental due diligence obligations. However, it is expressly stated that any civil liability established independently of the Act remains unaffected. One of the most controversial innovations during the legislative process was also retained: Domestic trade unions and non-governmental organizations can assert human rights violations committed abroad in their own name before German courts for the benefit of the persons concerned (representative action). In the event of breaches of organizational duties, the members of corporate bodies are particularly at risk of internal liability vis-à-vis the company.

Practical advice:

The liability provided for in the draft Directive is internationally mandatory to be applied by the courts of an EU member state. Since, in principle, the law of the state where the damage occurred is relevant, EU courts often have to apply the law of a third state. The draft Directive aims to ensure that injured parties receive compensation even if and because they bring an action before an EU court, but the applicable law of a third country does not provide for such a legal basis for liability. The legislator has not regulated the important question of the burden of proof. It is therefore left to the national legislator.

9. Sanctions

In addition to civil liability, companies are also to face fines if they infringe due diligence obligations. These are to be calculated based on turnover. So far, the SCA only provides for such fines in some cases and for companies of a certain size. The draft Directive also stipulates that any decision on administrative sanctions must be published ("naming & shaming").

10. Support in implementation

The Commission is to support companies in implementing the obligations and provide model contract clauses and guidelines. This promise of legislative or regulatory assistance is known under German law from the BAFA's guidelines. However, the practical implementation of the legal requirements would be made considerably easier for companies if such models and guidelines were available before the law came into force.

11. Conclusion

An EU-wide regulation is to be welcomed in principle as a first step towards creating a level playing field with regard to supply chain responsibility in order to avoid competitive disadvantages for companies operating within the territory of the EU. Even if the draft Directive is based on a regulatory technique comparable to that of the SCA, the provisions differ considerably in detail. If the Directive were to be adopted in its current or a similar form, German companies would face considerably stricter requirements compared to the status quo. Companies that are already in the process of implementing the requirements of the SCA are advised to keep an eye on developments at EU level. Furthermore, due to the more stringent design of the personal scope of application, companies that will not be subject to the provisions of the SCA are also called upon to examine what effects the enactment of a corresponding Sustainability Directive and its subsequent implementation into national law will have on them.

Practical advice:
The draft Directive is only the first step in the European legislative process. Both the European Parliament and the EU Council of Ministers need to approve the Directive. Both bodies may propose amendments. A final decision can therefore be expected in 2023 or 2024 rather than this year. Since EU Directives do not have direct effect in national law, the German legislator must transpose the requirements set out in the Directive into German law within a two-year transposition period after the Directive has been enacted. Even such an amended SCA will probably not come into force immediately. Until then, the SCA will apply in its current version. Due to the long lead time and the numerous possibilities for change, a proactive implementation of the requirements of the current draft Directive is only recommended to companies if and to the extent that the European draft and the requirements of the SCA largely run in parallel, such as with regard to the complaints mechanism.

This client information merely contains an overview of the topic it addresses, without liability. It is no substitute for legal counsel. At your disposal with regard to this client information and for further advice.

[1] Exactly one year ago, on March 10, 2021, it presented its own initiative proposal, highly unusual in EU regulatory practice.

[2] For companies that have generated at least 50 percent of their turnover in a high-impact sector, the threshold is between EUR 40 and 150 million.  The number of employees is no longer relevant.