EU's sustainability due diligence law will have 'broad scope of application' in the ESG space

The Commission’s proposal for a directive on corporate sustainability due diligence. could oblige 17,000 companies active in the EU to monitor their entire supply chains for violations of environmental, climate protection or human rights. Only small and medium-sized enterprises (SMEs) will be exempt from the new obligations, but they will also be affected if they are suppliers to larger companies.

The new rules would apply to corporations, including holding companies of other legal forms, as well as regulated financial services companies based in the EU which have more than 500 employees and achieve a turnover of more than €150 million a year. Any EU based corporation with over 250 employees and a turnover of more than €40m will also be obliged to monitor its supply chains if it is generating more than half of its turnover in one of the risk sectors defined by the proposed directive. These include the textile and food industries as well as the extraction, basic manufacturing and wholesale of mineral resources.

The rules under the directive would also apply to companies from outside the EU, regardless of their employee headcount, provided their business revenues in the EU reach these thresholds. The EU Commission assumes that a total of 13,000 companies in the EU and 4,000 non-EU companies will be affected if the new obligations were to come into force as outlined in the proposal.

The affected companies would have to identify actual and potential negative impacts of their business activities and their suppliers' business activities on human rights and the environment. They would have to take measures to prevent or significantly minimise these impacts. They would also have to monitor the effectiveness of measures taken and report on them publicly. Additionally, they would have to establish a complaints procedure through which violations of environmental and human rights can be reported directly to them.

Fines are to be imposed on companies that violate the rules of the directive. In addition, the proposed directive provides that people who have been harmed due to neglection of the due diligence duties can sue the companies for damages.

Additionally, companies with more than 500 employees and an annual turnover of more than €150m will be required to develop a plan to ensure that their business strategy is in line with the goal of limiting the global temperature increase to 1.5 degrees Celsius. The Commission wants to oblige directors "to set up and oversee the implementation of due diligence and to integrate it into the corporate strategy." The consideration of human and environmental rights should be understood as part of their duty to act in the best interest of the company, the Commission said.

Dr Eike W. Grunert, compliance expert at Pinsent Masons, said: "The proposed directive sets a further cornerstone to the ever rising international and national legislation addressing human rights and environmental risks in the supply chain, such as the UK and Australian Modern Slavery laws, and the Dutch Labor and French Duty of Vigilance Laws. The combination with climate protection requirements makes the proposed EU directive a unique piece of ESG legislation."

According to the Commission, the proposed directive will help to avoid legal fragmentation within the EU and thus minimise legal uncertainties for companies operating across the EU, since several EU member states have already enacted their own supply chain laws and other member states are working on similar laws.

For example, Germany enacted a Supply Chain Due Diligence Act last summer. It will come into force in stages from 2023 and obliges large German companies as well as foreign companies with a branch in Germany to take measures to ensure that both the businesses themselves and their suppliers in Germany and from abroad comply with certain environmental and social standards. The German Supply Chain Act will apply to corporations with at least 3,000 employees in Germany from 2023 onwards, regardless of revenue size. From 2024 onwards, it will also cover smaller companies with 1,000 or more employees.

Dr Grunert said: "Following the German Supply Chain Due Diligence Act passed in 2021, the proposed directive once again demonstrates the significance of the issue for companies. If the scope will be as broad as proposed, a much larger number of companies active in the EU will be obliged to take measures against human rights violations in their supply chain, as well as being exposed to additional liability risks. Unlike the German Supply Chain Act, the draft directive also addresses climate protection. Companies should therefore promptly address relevant risks in their supply chain in order to mitigate them with appropriate compliance measures."

The proposal will now be submitted to the European Parliament and the Council. If approved, the member states will have two years to transpose the directive into national law. Also, each member state would then also have to designate a national authority to monitor compliance with the directive.