European Commission takes huge step towards mandating corporate sustainability due diligence

On 23 February 2022, the European Commission adopted a proposal for a Directive on corporate sustainability due diligence. The proposal aims to foster sustainable and responsible corporate behaviour throughout global value chains. Specifically, the Proposed Directive establishes a corporate sustainability due diligence duty to address negative human rights and environmental impacts.

The Directive may apply to non-EU companies through its broad application. Importantly it is likely to set the scene for a global response to the issues of corporate sustainability and should be on the watch list of Boards and executive alike.

When the proposal was announced, Commissioner for Justice Didier Reynders said: “This proposal is a real game-changer in the way companies operate their business activities throughout their global supply chain. With these rules, we want to stand up for human rights and lead the green transition. We can no longer turn a blind eye on what happens down our value chains. We need a shift in our economic model. The momentum in the market has been building in support of this initiative, with consumers pushing for more sustainable products. I am confident that many business leaders will support this cause.”

Who would the Proposed Directive apply to?

The Proposed Directive will apply to EU limited liability companies in either Group 1 or Group 2.

• Group 1 includes all EU limited liability companies with more than 500 employees on average and a net worldwide turnover in excess of EUR 150 million in the last financial year.
• Group 2 includes other EU limited liability companies with more than 250 employees and a net worldwide turnover in excess of EUR 40 million in the last financial year, provided that at least 50% of this net turnover was generated in one or more of several high-impact sectors, such as textile manufacture and trade, agriculture or the extraction of mineral resources.

Small and medium enterprises (SMEs) are not directly included within the Proposed Directive. However, Australian companies and multi-national corporations should be aware that non-EU companies can also be caught by the Proposed Directive if they fulfil either of the following conditions:

• Group 1 – a net turnover in excess of EUR 150 million in the EU in the financial year preceding the last financial year; or
• Group2 – a net turnover in excess of EUR 40 million, but not exceeding EUR 150 million in the financial year preceding the last financial year, provided that at least 50% of this net worldwide turnover was generated in one or more of the high-impact sectors (some of which are identified above).

Australian, or non-EU companies generally, falling into the scope of the Proposed Directive will need to appoint an authorised representative established or domiciled in one of the EU Member States. This representative must be notified to a supervisory authority and receive communications from supervisory authorities on compliance matters.  

Proposed due diligence obligations under the Proposed Directive

The Proposed Directive sets out due diligence obligations for companies with respect to their 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.

There are six key obligations under the Proposed Directive:

1. Integrate due diligence into company policy. Companies must establish a proper due diligence framework by integrating due diligence considerations into their company policies and updating these policies annually.
2. Identify actual or potential adverse environmental and human rights impacts arising out of the company's operations, the operations of the company's subsidiaries, and of the business relationships established within the company's value chains.
3. Appropriately prevent, mitigate and remediate potential and adverse actual environmental and human rights impacts. Under the Proposed Directive, appropriate measures are defined as measures that are capable of achieving the objectives while being reasonably available to the company.
4. Establish and maintain appropriate complaint procedures to deal with complaints issued by actual or potential victims, relevant trade unions and other works' representatives, and relevant civil society organisations. They must also inform relevant works and trade unions of the various existing procedures.
5. Monitor the effectiveness of the company's due diligence policies and measures. This involves companies conducting periodic assessments of their own operations, subsidiaries and value chains to monitor compliance with the new obligations under the Proposed Directive.
6. Publicly communicate on due diligence. Companies already subject to the Non-Financial Reporting Directive (NFRD) do not have any additional reporting obligations. However, companies outside the scope of the NFRD must annually report on matters covered by the Proposed Directive.

Enforcement mechanisms

The Proposed Directive requires EU Member States to designate one or more national administrative authorities to supervise the application and ensure that the transposed act is effective. It also requires that EU Member States ensure that the supervisory authorities have the power to request information and carry out investigations.

The Proposed Directive contains a broad range of public enforcement mechanisms, including sanctions, fines and compliance orders, as well as private enforcement mechanisms where victims can hold in-scope companies to account for failing to comply with their obligations.

Addressing climate change

The Proposed Directive creates a specific mechanism for addressing climate change impacts. It requires that:

1. Large in-scope companies (ie. EU and non-EU companies) adopt a “plan” to ensure that the business model and strategy of the company are compatible with the transition to a sustainable economy and with the limiting of global warming to 1.5 °C, in line with the Paris Agreement. The plan should identify the extent to which climate change is a risk to the company's operations and if so, include emission reduction targets in the plan.
2. Climate change obligations are linked to directors, with climate change plans and outcomes directly considered when setting variable remuneration. This is qualified as it only occurs where variable remuneration is linked to the director's contribution to the company's business strategy and long-term sustainability objectives.

Protecting the safety and human rights of workers

While the proposed changes should not be cause for alarm for companies that are already complying with the current due diligence requirements under the Work Health and Safety Act 2011 (Cth), the Directive aims for a larger scale improvement, and will introduce enhanced human rights requirements and other potential areas for review. 

Measures a Company would take to comply with the Directive (and other ESG initiatives) include reviewing current workplace policies and conducing the audits of the Company's entire operations, including supply chains, to ensure their workers (including sub-contractor employees) have:

• access to safe and healthy working conditions;
• fair and adequate living wages;
• non-discrimination and rights to associate;
• adequate complaints procedures to address concerns;
• ability to organise unions and engage in collective bargaining;
• freedom from unlawful eviction and development; and
• freedom from forced and child labour.^[1]

However, care should be taken to consider what unintended consequences such actions may have as an organization must address issues it becomes aware of and therefore should take care before auditing things it cannot influence or control. Similarly, by taking on an active role in the supervision or management an organization may change the nature of the relationship, inadvertently creating employment relationships, increasing duty of care and even changing the nature of statutory roles (eg. Principal Contractor, designer, manufacturer importer etc and creating new strict statutory obligations). A company should seek advice when designing its supply chain assurance programs to ensure that they are consistent with the relationships intended.

Impact on directors' duties

The Proposed Directive ensures that directors must incorporate sustainability issues into their decision-making processes. This means that when directors act in the interests of the company, they have a duty of care to consider the human rights, climate and environmental consequences of their decisions and the likely short, medium and long-term consequences.

While the Proposed Directive does not cover all internationally recognised human rights, it does cover specific human rights relevant to business activity. This is still a broad range and includes such rights as the right to life, the right to freedom from slavery and human trafficking, economic rights, labour rights and the right to freedom from harmful degradation. The Proposed Directive also includes environmental rights, such as rights protected by specific international conventions and EU regulations on biodiversity, endangered species, mercury, toxic chemicals and waste, ozone depletion, and hazardous waste.

So what's next for the EC's Proposed Directive?

There are numerous steps to be completed before the Proposed Directive can be formally adopted. The European Parliament and Council will have to review, amend and finalise the text. Given the sensitive nature of the Directive, it is unlikely that the Proposed Directive will be adopted before 2023, with it not expected to come into effect before 2025 given that EU Member States will have to transpose the text into national law. The proposed Directive foresees that Member States will have 2 years from the date the Directive enters into force to implement the requirements relating to large companies, and 4 years for mid-size companies.

Although the EU has historically been very progressive in relation to climate change and human rights matters, the rapid uptake of ESG, net zero pledges and modern slavery matters suggests that other jurisdictions may also consider similar laws.

^[1] Forced labour is defined under the ILO Convention No.29, and can include forcing workers to work more overtime hours than allowed by national law, use of irregular, delayed, deferred or non-payment of wages as a means to bind employees to employment, restriction of workers’ movement, debt bondage and reliance on "labour discipline" for production.