Global impact of the European Commission ESG draft Directive on corporate sustainability due diligence

Introduction

On 23 February 2022, the European Commission adopted a proposal for a Directive on corporate sustainability due diligence.¹  The impact of this legislation on companies meeting the required thresholds based in the EU and doing business in the EU is significant as, for the first time, these companies will have to ensure human rights and environmental due diligence is engrained in their core business activities.² 

Companies need to prepare now and take proactive steps to ensure they have adequate systems and controls in place to detect and mitigate human rights and environmental violations in their business and supply chain, and are aware of their revised and enhanced governance and public reporting requirements.

1) What is the scope of the application of the Directive?

The draft Directive applies to EU-based and non-EU based companies operating in the EU.³

The draft Directive will apply to EU-based companies if:

• They have more than 500 full-time equivalent employees and more than EUR 150 million in net annual turnover; or
• They have more than 250 full-time equivalent employees and more than EUR 40 million in net annual turnover with at least 50 per cent of this turnover generated in one of more of the following sectors (the “Sectors”):
  • The manufacture of textiles, leather and related products;
  • Agriculture, forestry, fisheries, food manufacturing, and the trade of agricultural raw materials, animal, food and beverages; 
  • The extraction of mineral resources (oil, gas, coal, metals, ores and non-metallic minerals, the manufacturing of metal products, non-metallic mineral products and fabricated metal products (except machinery and equipment);
  • The trade of mineral resources and mineral products (metals, ores, fuels and chemicals).

The draft Directive will also apply to non-EU based companies if:

• They generated a net turnover of more than EUR 150 million in the EU over the past year; or
• They generated more than EUR 40 million in net annual turnover in the EU over the past year and at least 50 per cent of their net worldwide turnover was generated in one or more of the Sectors.

Small and medium enterprises (SMEs) are not directly in the scope of the draft Directive.

2) Does the draft Directive apply only to company operations or also the operations of subsidiaries and others in the supply chain?

The requirements extend to qualifying companies’ own operations, the operations of their subsidiaries and the value chain operations carried out by entities with whom the company has an “established business relationship” which is defined as those business relationships which are direct or indirect/which are lasting in nature and which do not “represent a negligible or merely ancillary part of the value chain.”⁴

3) Which human rights and environmental rights does the draft Directive cover?

The draft Directive establishes minimum threshold requirements with which companies must comply to safeguard against the actual and the adverse impacts of human rights and the environment. 

Human Rights

The draft Directive includes rights protected by human right agreements “which directly impairs a legal interest protected”⁵ in a number of international instruments listed such as, amongst others, the Universal Declaration of Human Rights, the International Covenant on Civil and Political Rights, the International Convention on the Elimination of All Forms of Discrimination Against Women, the UN Convention on the Rights of the Child, the Palermo Protocol to prevent the trafficking of persons and the International Covenant on Economic, Social and Cultural Rights.⁶

The Environment

The draft Directive requires Member States to ensure that EU-based companies subject to the draft Directive “adopt a plan to ensure that the business model and strategy of the company are compatible with the transition to a sustainable economy” and limits global warming to 1.5 degrees Celsius under the Paris Agreement.⁷ In addition, the plan should assess whether climate change is a risk for the company’s operations and if it is a principal risk, the company should have in place objectives in order to reduce emissions.

4) Does the draft Directive impose an obligation on companies to carry out due diligence?

In effect, the draft Directive provides that companies should enact formal due diligence. processes. 

The draft Directive states that Member States must ensure that qualifying companies:

• Integrate due diligence practices into all corporate policies and designate authorised representatives.⁸ Qualifying companies must have in place a due diligence policy that reflects the company’s diligence approach, a code of conduct, and a description of the processes to implement due diligence and ensure compliance with the code of conduct.⁹
• Directors of the companies are required to take into account the consequences of their decisions for sustainability matters in the short, medium and long term in the fields of human rights, climate change and environmental consequences.  Furthermore, the board of directors of the qualifying companies will be responsible for putting in place and overseeing the due diligence actions and the company’s due diligence policies.
• Take appropriate measures to identify the actual and potential impacts of their operations and those of their subsidiaries and the operations that form part of their value chain on human rights and the environment.
• Prevent or adequately mitigate potential adverse impacts and take steps to bring actual adverse impacts to an end.  Where this is not possible, the company must minimise the extent of the adverse human rights or environmental impact.
• Carry out periodic assessments and monitor the effectiveness of their due diligence policies and measures.  The assessments are required to be conducted annually or whenever there are reasonable grounds to believe that significant new risks or impact may arise.
• Publicly communicate and report on compliance by publishing the results on the company’s website.¹⁰

5) What are the sanctions if companies fail to comply with the draft Directive?

Member States will be required to establish a supervisory authority to monitor and investigate the activities of qualifying companies, and can act when substantiated concerns are raised.¹¹

The supervisory authority has the power to:

• Require a company to remedy any breaches;
• Issue stop orders, impose financial sanctions based on the company’s turnover¹² and impose other interim measures to avoid the risk of severe and irreparable harm.¹³

6) Is a company liable to private litigation for breaching the draft Directive?

A company is subject to civil liability and damages for failing to comply with the draft Directive.¹⁴

However, if a company takes appropriate action to comply with the requirements imposed under the draft Directive, it will not be liable for damages for the adverse impact of an indirect partner with whom it has an established business relationship.  In such circumstances, the company’s actions will serve as a mitigating and potentially exculpatory factor. However, this exclusion does not apply to direct value chain entities.

Conclusion

The draft Directive will have a significant impact on EU and non-EU based companies meeting the thresholds once the requirements are transposed into the EU Member States’ domestic laws.

It will also have a profound impact on SME companies that do not meet the qualifying thresholds but wish to continue to do business with larger companies subject to the thresholds.

Most companies based or operating in the EU do not currently have adequate systems and processes to meet the demands of the draft Directive.  It is therefore critical that businesses act now and to take steps to ensure that they integrate human rights and environmental standards into their fundamental business practices.

Footnotes

1) https://ec.europa.eu/info/publications/proposal-directive-corporate-sustainable-due-diligence-and-annex_en
2) Once adopted by the European Parliament and the European Council, the Directive will enter into force on the twentieth day following its publication in the Official Journal of the European Union and EU Member States will have two years to transpose it into national law.
3) Article 2
4) Article 3(f)
5) Annex, Part 1, paragraph 21
6) Annex, Part 1
7) Article 15
8) Article 16
9) Article 5
10) Article 11
11) Article 17
12) Article 20
13) Article 18
14) Article 22