Brussels raises the bar
The Supply Chain Due Diligence Act (LkSG) will apply in Germany from 2023 onward. Currently, many companies are working to integrate the new requirements into their compliance management program. The EU commission proposes even stricter standards for sustainable business practices in various areas with its proposal for a directive on corporate sustainability due diligence. If the directive is ratified with the proposed content, the LkSG can be expected to see extensive amendment.
More companies affected
The proposed directive applies to all companies with more than 500 employees and annual net sales exceeding 150 million euros. In the risk sectors including the textile and leather industry, agriculture, raw materials extraction or metal processing, the new rules will apply to companies with 250 or more employees and net sales of 40 million euros or more (if at least 50 percent of the company’s revenue is generated by a risk sector). The directive will also apply to companies from third countries if they generate an annual turnover in the EU in excess of 150 million euros, or are active in a risk sector and have an annual turnover of more than 40 million euros (if at least 50 percent of this turnover is generated by a risk sector).
Small and medium-sized enterprises (SMEs) will not be directly affected. The proposal also stipulates accompanying supporting measures for areas with an indirect impact, such as when large customers require SMEs to provide proof of a “clean” supply chain. This includes platforms, portals, model contract clauses or financial aid.
Unlike the Supply Chain Act, the proposed EU rules only target stock corporations, such as AG, SE, KGaA or GmbH. Conversely, the thresholds at which the German LkSG applies are higher: companies with more than 3,000 employees as of 2023 and companies with more than 1,000 employees as of 2024.
Monitoring the supply chain in both directions
The due diligence requirements of the proposed directive also differ from those of the LkSG. However, they are also based around seven core elements:
- The due diligence obligations must be anchored in corporate policy. In contrast to the LkSG, the business model and corporate strategy have to comply with the 1.5-degree target stipulated by the Paris Climate Agreement. In the case of variable compensation, managers will receive incentives to contribute to minimizing climate change.
- This requires risk management that documents violations of human rights, occupational health and safety. Compared to the LkSG supply chain, the value chain is more broadly defined. It has to be monitored in both directions, placing a focus on both suppliers and customers.
- A risk analysis determines the extent to which the company has an actual or potentially negative impact on human rights and on the environment.
- Preventive measures must be implemented if violations are suspected.
- Companies are required to take all reasonable measures to avoid violations and even forgo using a specific supplier in the event of doubt. The effectiveness of the strategies and measures also has to be monitored.
- A complaints procedure must be established.
- Reporting requirements: Companies must publicly communicate how they fulfill their due diligence obligations.
Sanctions together with “naming and shaming”
If the due diligence obligations are not complied with, the proposed directive includes the threat of sanctions oriented on the company’s sales. The sanctions shall be made public to ensure a high level of reputation damage with a view towards “naming and shaming”.
Caution: the management is liable
The proposed directive requires member states to ensure that victims receive compensation should they suffer damages due to breaches of due diligence obligations. Injured parties from a third country receive particular protection: They are explicitly entitled to compensation if due diligence obligations do not apply along the supply chain in their country. Furthermore, the proposal also directly stipulates duties for the management: The company management is responsible for implementing and monitoring the due diligence obligations.
Status of the legislation
The legislative process has only just begun. The proposal will be submitted to the European Parliament and the Council of Ministers for approval and further amendments may still be proposed. If the directive is passed, member states will have two years to transition this into national law.
The primary differences between the EU proposal and the German Supply Chain Act consist of the broader application, civil liability along with the fact that corporate strategy will have to comply with the 1.5-degree target of the Paris Climate Agreement in future. The legislative initiative is part of a series of new regulations from Brussels, anchoring the Environment, Social, and Governance (ESG) criteria in companies’ business models and strategies. These regulations include the new reporting requirements stipulated by the Corporate Social Responsibility Reporting Directive or the EU taxonomy for assessing economic activities on the basis of ESG criteria. Climate and environmental protection together with social issues are clearly becoming more important for compliance as well as for financing conditions and consumer demand. We described the preparations that companies need to make for the German LkSG in our blog post from November 9, 2021. Compliance managers now need to keep an eye on the ongoing EU legislative process to save time and reduce costs. In the best case, there will be able to implement the expanded due diligence obligations in the compliance management systems all at once. At the same time, the responsible members of the management board and the management affected by these expanded obligations can be identified immediately and any necessary contractual amendments made. It is essential to bear in mind that both standard contracts and general terms and conditions will need to be modified accordingly.