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European Parliament proposal for a Corporate Due Diligence and Accountability Directive

  • Europe
  • Corporate
  • Employment law
  • Investment funds and asset management
  • ESG - ESG Corporate

06-07-2021

The European Parliament passed a resolution approving a proposed text of a Corporate Due Diligence and Accountability Directive (“Proposed Directive”) in March 2021.

In response to the Proposed Directive, the European Commission is working on an impact assessment and its own draft of a directive. This will be the beginning of the EU’s steps to address the “S” (social) in ESG, previously having focussed much of its attention on the “E” (environment). Media reports suggest internal EU tension over the detail and the proposals may be subject to change.

The Proposed Directive has not attracted anything like the scrutiny which other ESG initiatives, such as the SFDR and the Taxonomy, have had. But while the Proposed Directive is low key, it is very far-reaching in scope and impact. It is likely to present major challenges for firms, particularly those with lengthy and complex value chains. Firms should familiarise themselves with the proposed obligations now, rather than wait for the final legislation.

The Proposed Directive marks a transition from firms reporting, sometimes voluntarily, on human rights, environment and governance, to being subject to a pro-active duty to identify and assess their impact on human rights, the environment or good governance. The Proposed Directive focuses on firms’ operations, business relationships and value chains and notably applies to firms’ arrangements with both customers and suppliers. Firms must assess the harms which they cause, to which they substantially contribute and to which they are directly linked. If a firm identifies harm, it must publish a due diligence strategy setting out measures to address them.

In response to a consultation exercise, business organisations expressed concerns about the cost of compliance, as well as a need for greater legal certainty.

What are in-scope firms required to do under the proposal?

Due diligence strategy

The aim of the Proposed Directive is to impose obligations on firms to carry out due diligence on their operations and business relationships in an attempt to prevent adverse impact on human rights (including social and labour rights), the environment and good governance. Some Member States, including France, the Netherlands and, most recently, Germany, have implemented similar domestic requirements. The Proposed Directive aims to harmonise the approach across the European Union. The idea is that the due diligence will highlight any issues at an early stage and prevent harms from occurring rather than having to address them after the harm has been done.

This pro-active due diligence approach will be familiar to those businesses applying certain international frameworks such as the UN Guiding Principles on Human Rights and the OECD’s Responsible Business guidance.

The scope of the Proposed Directive is wide and obliges firms to identify, monitor and prevent certain harms. The Proposed Directive requires Member States to hold companies accountable for the harm they cause or to which they contribute. The victims of such harms will have right to bring legal proceedings.

For a firm to be held liable for a harm, its contribution to that harm will have to be substantial, to be determined by taking into account whether the firm increased the risk of the relevant harm occurring, the degree of foreseeability of the harm and whether the firm’s actions mitigated the harm in any way. The Proposed Directive requires firms to take “proportionate and commensurate measures” and make “efforts within their means” to prevent harms or address harms they identify.

Firms will be required to create a risk-based monitoring methodology to take into account the likelihood, severity and urgency of potential or actual impacts on human rights, the environment or good governance and whether their operations and business relationships cause, contribute to or are directly linked to any of those potential or actual adverse impacts.

In-scope firms will either have to:

 

  • conclude that their operations do not have or contribute to an adverse impact on human rights, the environment or good governance and make a public statement to that effect; or,
  • if they are unable to do so, establish a due diligence strategy to address the harms which they create or to which they contribute

 

It seems unlikely that many firms will be able to declare themselves to have a “clean sheet” and make the public statement. Presumably any firm which makes the public statement will be opening itself up to challenge and scrutiny.

Firm’s due diligence strategies must include:

 

  • the actual or potential adverse impacts on human rights, the environment or good governance likely to be present in its operations and relationships; the likely severity, likelihood and urgency of those harms; relevant data and methodology
  • a map of the firm’s value chain
  • policies and measures to prevent or mitigate potential or actual adverse impacts on human rights, the environment and good governance
  • a prioritisation strategy setting out how the firm will deal with adverse impacts identified; it is assumed that they will not be able to deal with them all at the same time

 

The confidentiality agreements typically seen in supplier and customer contracts may make it difficult to produce a map of a firm’s value chain unless such disclosures are permitted under an “as required by law” exception to confidentiality.

The Proposed Directive sets out an expectation that firms will apply the policies they put in place both to their own business and to the firms with which they do business. The cascade of policies might include agreeing framework agreements, incorporating contractual clauses in agreements or carrying out independent audits of their business partners. Importantly, the Proposed Directive imposes an ongoing monitoring obligation on firms to ensure that they are complying with the arrangements which they have put in place. Simply including appropriate terms in contractual arrangements with members of a firm’s value chain will not be sufficient.

This could cause a number of difficulties for firms. It is likely that firms will need to repaper existing relationships to include compliance clauses. These might include warranties, obligations in respect of audit and access rights, rights of disclosure to enable firms to comply with the obligation to publish their strategy, human rights and reporting, and enhanced termination rights, including immediate termination on discovery of catastrophic harms. Such provisions are likely to be harder to negotiate into upstream arrangements with customers.

Firms might seek to impose their policies on each other leading to a “battle of the policies”.

The due diligence strategy which in-scope firms have put in place is also likely to become an area of focus for buyers when undertaking M&A transactions. Buyers will be keen to understand the strategies and policies that have been put in place across the target group, and are likely to require specific warranties or other appropriate contractual protections in this area from sellers that such strategies and policies are compliant, given the legal and reputational implications of non-compliance.

Consultation and communication

Firms will have to consult with relevant stakeholders when putting together their due diligence strategy, for example trade unions and employee representatives.

In line with other ESG initiatives, firms will have various disclosure obligations including:

 

  • publishing the strategy on their website
  • communicating the strategy to employees, trade unions, business partners and local regulators
  • uploading the policy to a European centralised platform, which is likely to require the policy to be presented in a prescribed format to ensure comparability

 

The due diligence strategy will need to be evaluated annually for its effectiveness, in discussion with stakeholders.

The Proposed Directive requires firms to establish a grievance policy for stakeholders to submit complaints about potential or actual adverse impacts on human rights, the environment or good governance. Firms will have to report on the complaints.

What are the consequences when an adverse impact is identified?

Remediation

Firms are required to cooperate in remediating any harm caused “to the best of its abilities”. Any such remedy will need to be agreed upon by relevant stakeholders and may include financial or non-financial compensation, reinstatement, a public apology or some other form of remedy. Remediation under the Proposed Directive will not, however, prevent stakeholders bringing traditional civil and criminal proceedings in the usual way and stakeholders will not need to have exhausted remedies under the Proposed Directive before commencing litigation. The court will not be bound by any grievance process which has taken place.

The Proposed Directive will put firms in a difficult position in which taking steps to remediate a harm may be construed as an admission of liability or contribute to a finding of liability in subsequent civil proceedings, while the costs of that remediation are ignored when determining the quantum of liability in the same civil proceedings.

National supervision and enforcement

The relevant national regulator will be empowered to investigate firms and ensure that they are in compliance with the national law implementing the Proposed Directive. Penalties could include fines linked to turnover or temporary or permanent exclusion of firms from receiving state aid or participating in public procurement processes. If non-compliance could lead to irreparable harm, a firm’s activities may be temporarily suspended (or, for a non-EU undertaking, banned from operating in the EU’s internal market).

Civil liability

The Proposed Directive anticipates a national liability regime under which firms be held liable to provide remediation for any harm arising out of potential or actual adverse impacts on human rights, the environment or good governance to which they, or undertakings under their control, cause or contribute by acts or omissions. However, if firms can prove that they took all due care in line with the Proposed Directive to avoid the harm in question, or that the harm would have occurred even if all due care had been taken, they will not be held liable for that harm.

Whilst the Proposed Directive does not introduce personal liability for directors, directors will need to be mindful of their duties and obligations under local law where a firm is found to be in breach of its compliance or reporting obligations.

Which firms are within the scope of the Proposed Directive?

In line with other ESG directives, the Proposed Directive seeks include large undertakings along with all publicly listed, small and medium-sized undertakings and high risk small and medium-sized undertakings in its scope. In an ambitious attempt at extra-territoriality, the Proposed Directive seeks to apply its requirements to similar firms established outside of the EU if they sell goods or provide services into the EU. Such firms will be subject to the requirements of the Proposed Directive as implemented in the Member States in which they operate.

A parent company can write a strategy which encompasses its subsidiaries, however, if the subsidiaries deviate from the parent strategy they will have to note that in their own reporting.

What constitutes a business relationship?

The Proposed Directive defines this as subsidiaries and commercial relationships of a firm throughout its value chain, including suppliers and sub-contractors which are directly linked to the firm’s business operations, products or services.

What is a firm’s value chain?

Again this is defined by the Proposed Directive. It includes all activities, operations, business relationships and investment chains of a firm and includes entities with which the firm has a direct or indirect business relationship upstream or downstream and which either:

 

  • supply products, parts of products or services that contribute to the firm’s own products or services; or
  • receive products or services from the firm

 

It is the requirement for firms to impose their policies on both upstream and downstream business partners which makes “battle of the policies” conflicts likely.

What are the next steps?

The European Parliament passed a resolution approving a proposed text of the Proposed Directive in March 2021. The Commission is conducting an impact assessment and was expected to publish a draft directive in substantially the terms of the Proposed Directive in June 2021, however, the Commission missed this deadline and now says that the draft directive is expected before the end of 2021.

Once the Commission’s draft directive is prepared it will start work on non-binding guidance on how to comply, however, that guidance may not be available for 18 months. Firms should start working out how to comply with the directive before the guidance is available. The guidance is expected to take account of existing UN, ILO and OECD human rights, environmental and governance principles and guidelines, which firms can access now as part of their preparation.

If the directive is implemented in the usual way without any postponed provisions, it will need to be implemented by Member States within two years of its adoption, so may come into force as early as the first half of 2024.

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