In-scope companies would have to publicly identify “actual and potential” adverse impacts of their operations on the environment and/or human rights.

By Paul A. Davies, Michael D. Green, and James Bee

On 23 February 2022, the European Commission (the Commission) published a proposal for a Directive on Corporate Sustainability Due Diligence (the Directive). If approved, the Directive would require large companies based in the EU (and certain large companies based outside of (but operating in) the EU) to conduct due diligence on a number of ESG-related issues throughout their supply chain, with failure to do so leading to possible fines or civil liability.

The Directive is the latest example of the global trend toward regulatory oversight of supply chains, and follows related legislation such as the US Uyghur Forced Labor Prevention Act and Germany’s mandatory human rights due diligence law, both passed in 2021. (For more information, see Latham’s blog posts US Congress Passes Uyghur Forced Labor Prevention Act and New German Law Aims to Strengthen Global Human and Environmental Rights.)

In addition, the Directive requires certain large companies to prepare and adopt plans that identify the extent to which climate change is a risk for, or impact of, their company’s operations. Such companies must ensure their business model and strategy are compatible with a target of limiting global warming to 1.5 degrees Celsius.

What companies would fall within the scope of the Directive?

The Directive would extend to certain large companies operating or based in the EU. The thresholds are based on a combination of employee numbers, turnover, and industry type. Lower thresholds are set for both EU and non-EU companies that are viewed as operating in “high-impact” sectors, meaning that they generate over 50% of their revenue in sectors that the EU has determined to have higher-risk supply chains, including clothing, extraction of mineral resources, agriculture, and metals manufacturing.

The thresholds for each type of company are:

What would the Directive require of in-scope companies?

Supply Chain Due Diligence

Pursuant to the Directive, in-scope companies would have to publicly identify “actual and potential” adverse impacts on the environment and/or human rights of the operations of not only the company itself and its subsidiaries, but also “value chain operations carried out by entities with which the company has an established business relationship”. Such adverse impacts are stated to include forced labour, inadequate worker health and safety, exploitation of workers, greenhouse gas emissions, pollution, and ecosystem degradation.

The Directive does not define the concept of “established business relationship”, but notes that the “establishment” of such relationships should be reviewed at least every 12 months. Companies would then have to implement measures to prevent and mitigate potential adverse impacts, and bring to an end or minimise the extent of any actualised adverse impacts. The Directive includes a list of actions that companies in this context would be required to take, where relevant (e.g., seeking contractual assurances, making necessary investments, and providing targeted and proportionate support for SME suppliers).

In-scope companies would also be required to integrate due diligence into their corporate policies and implement a specific due diligence policy, which must be updated annually and the effectiveness of which must be regularly monitored. The Directive notes that directors of in-scope companies are responsible for putting in place appropriate policies and actions.

Climate Change Business Plan

Notably, the Directive would also introduce a requirement for certain companies (EU companies with global revenue over €150 million and over 500 employees and non-EU companies with EU revenue of over €150 million) to design a plan to ensure that their business model and strategy are compatible with the transition to a sustainable economy and with “the limiting of global warming to 1.5 degrees Celsius in line with the Paris Agreement”. This plan would have to identify the extent to which climate change is a risk for, or an impact of, the company’s operations.

For those companies that identify climate change as a principal risk for, or principal impact of, their operations, the plan must also include emissions reduction objectives. The Directive also states that any director who has variable remuneration that is linked to their contribution to the company’s business strategy and long-term interests and sustainability, should have the fulfilment of the plan factored in to such variable remuneration.

How will the Directive be enforced?

The Directive would not have direct effect, and so would have to be implemented by national legislation in each of the EU Member States. The Member States would have two years from the enactment of the Directive in which to complete this process.

The Directive contains enforcement provisions in both public and private litigation. Public enforcement (by way of fines) would be left to Member States, with the Commission noting that no new authorities would have to be created, and existing national authorities would be well-positioned to implement enforcement measures. However, the Commission has proposed to establish a European Network of Supervisory Authorities to help implement the Directive, in order to facilitate bloc-wide coordination and convergence of regulatory, investigative, sanctioning, and supervisory practices.

The Directive would create a separate civil liability regime under which private parties could sue and be sued in EU courts for damages incurred as a result of breaches. Persons negatively impacted by an EU company’s operation could sue if the company did not sufficiently act to prevent, minimise, end, or mitigate the adverse impacts of its business activity. However, the proposed civil liability regime is somewhat limited in scope — if companies secured contractual assurances from business partners in relation to compliance with their supplier code of conduct (and undertook appropriate verification measures accordingly), then they would be protected from civil claims.

Moving forward

The progress of the Directive may be an instructive regulatory harbinger, given the increasing global attention on supply chains and companies’ responsibility for the impact of their full value chains. The Directive will receive scrutiny from, and require ultimate assent from, the EU Parliament.

Latham & Watkins will continue to monitor developments in this area.