The Proposed Directive on Corporate Sustainability Due Diligence – a step change in ESG litigation risk

The Proposed Directive on Corporate Sustainability Due Diligence (the “CSDD Proposal”), published on 23 February 2022, aims to impose obligations on companies, their subsidiaries and their value chains to identify and tackle adverse human rights and environmental impacts.

Given that the proposal is titled the “Corporate Sustainability Due Diligence” directive, it would be reasonable to assume that the main obligation is for companies to “identify” relevant risks and behaviour through due diligence. However, the proposed directive has far broader scope. It also requires companies to prevent and cease qualifying adverse effects on human rights and environmental impacts.

A previous Law-Now article focused on the general scope of the CSDD Proposal and its potential practical implications (Proposed mandatory corporate sustainability due diligence requirements for “companies” (cms-lawnow.com)). This article focusses on the litigation and regulatory risks arising from the CSDD Proposal which is open for consultation until 23 May 2022.

The Explanatory Memorandum to the CSDD Proposal states that “Voluntary action does not appear to have resulted in large scale improvements…”. Consistent with this statement, the CSDD Proposal does not rely on voluntary action; it has real teeth. It empowers affected parties to sue infringing companies for damages. It also sets up a regime for regulators to fine companies and/or require that wrongful conduct cease.

What companies are in the scope of the CSDD Proposal?

Our earlier Law-Now addresses which companies are in scope in detail (link) but, in brief, companies are within scope if they:

(a) are European and have 500+ employees and turnover of €150+ million; or

(b) are non-European with a European turnover of €150+ million.

Lower turnover thresholds apply for companies active in certain textile manufacturing, agriculture, and extractive industries.

What behaviour could companies be sued for?

The CSDD Proposal sets out three core obligations where there is litigation risk for breach. First, companies must take measures to identify actual and potential “adverse human rights impacts” and “adverse environmental impacts” arising from their operations, their subsidiaries’ operations and where related to their “value chain from established business relationships”. (We explain each of the concepts in quotation marks below.) Second, companies must take measures to prevent or adequately mitigate the impacts and potential impacts that they have or should have identified pursuant to the obligation in the preceding sentence. Third, companies must cease actual (but not potential) adverse impacts that they have or should have identified.

Parties affected by breaches of the above obligations can sue in damages.

Depending on the nature of the circumstances, the duties to prevent and to cease adverse impacts can require the company to:

• develop and implement a prevention action plan or a plan to correct the adverse impact;
• make necessary investments to prevent or cease the adverse impacts; and
• seek auditable contractual assurances from partners with whom the company has a direct business relationship to prevent or correct adverse impacts (“Auditable Contractual Assurances”). The Commission will adopt guidelines on model contractual clauses.

Where it is not possible to prevent, mitigate or correct adverse effects in its value chain, a company should not enter into new contracts or extend existing contracts with the relevant businesses in its value chain. Where the adverse impact is severe the company should terminate the relevant business relationship. The CSDD Proposal states that Member States should permit companies to terminate contracts in these circumstances. Although the wording in the CSDD Proposal is not entirely clear, presumably the intent is to prevent the terminating company from being sued for breach.

There is doubt on how these provisions will function in practice. It is unclear how this protection from being sued will operate if the contract itself is subject to non-European law. An obvious area where disputes between companies will arise is whether a specific adverse impact is “severe” enough to mandate termination.

Adverse human rights impacts and adverse environmental impacts

Given the potential litigation and regulatory consequences of causing “adverse human rights impacts” and “adverse environmental impacts”, it is worth exploring how these terms are defined. The CSDD Proposal states that the former is an “adverse impact on protected persons resulting from the violation of one of the rights or prohibitions” listed in the Annex to the proposed directive. The latter is an “adverse impact on the environment resulting from violation of one of the prohibitions and obligations pursuant to the international environmental conventions listed” in the Annex to the proposed directive.

The Annex is a list of international treaties on human rights and environmental protections, including:

• the Universal Declaration of Human Rights;
• the International Covenant on Civil and Political Rights; and
• the International Labour Organization’s core/fundamental conventions, including the Right to Organise and Collective Bargaining Convention 1949 and the Equal Remuneration Convention 1951.

The Annex also lists certain specific violations set out in international treaties, including: “violation of the right to enjoy just and favourable conditions of work including a fair wage, a decent living, safe and healthy working conditions and reasonable limitation of working hours”[1] and “violation of the prohibition of causing any measurable environmental degradation… that… harms the health, safety, the normal use of property or land or the normal conduct of economic activity of a person.”[2]

Thus, the CSDD Proposal converts a broad range of international “soft law” treaties into “hard law” obligations, and gives parties impacted by such breaches the right to sue in damages.

What is the “value chain” and what are “established business relationships”?

The obligations to identify, prevent and cease qualifying adverse effects applies to companies, their subsidiaries and also their “value chains” from “established business relationships”. Given that companies may face litigation and/or regulatory action for the operations of established business relationships activities in their value chains it is important to understand the scope of these terms.

The “value chain” means “activities related to the production of goods or the provision of services by a company, including the development of the product or service and the use and disposal of the product as well as the related activities of upstream and downstream established business relationships of the company…”.

An “established business relationship” is “a business relationship, whether direct or indirect, which is, or which is expected to be lasting, in view of its intensity or duration and which does not represent a negligible or merely ancillary part of the value chain”.

As can be seen, both “value chain” and “established business relationship” have broad meanings. Significantly, the former extends beyond the production of goods to also include the use and disposal of products. The wording of the latter suggests a low threshold, with “negligible” impacts on the value chain falling outside the definition.

If the CSDD Proposal was passed into law, companies that fall within its scope would need to run a potentially complex exercise to identify the conduct of upstream and downstream third parties that they could be liable for.

Right to sue for damages

Parties can sue for damage flowing from a company’s failure to prevent or cease the adverse impacts that they have or should have identified.

Companies will not be liable where they have put in place sufficient Auditable Contractual Assurances (described above), unless it was “unreasonable… to expect that the action actually taken… would be adequate to prevent, mitigate, bring to an end or minimise the extent of the adverse impact.” The fact that Auditable Contractual Assurances can protect a company from being liable in damages demonstrates their importance and the need to consider those mechanisms very carefully, including the limit of what is “reasonable”, beyond which Auditable Contractual Assurances do not protect against damages claims.

Where adverse impacts may have occurred, “the assessment of the existence and extent of liability” shall have regard to the efforts that companies have made to prevent or cease the adverse impacts that they have or should have identified. The reference to both existence and extent suggests that company activities may assist with defences on liability and also reduce the sum of damages awarded.

As noted above, the actionable “adverse human rights impacts” and “adverse environmental impacts” are those listed in the Annex to the proposed directive. Some of those instruments will be more susceptible to damages claims than others. For example, claims relating to damages caused by the contribution of pollutants to atmospheric climate change will face hurdles in causation as many other companies and governments will have contributed to the damage complained of. Other claims will face far fewer hurdles with causation, including claims from workers who sue for adverse working conditions and/or underpayment of salaries.

The only remedy set out in the civil liability provision of the CSDD Proposal is for damages; the proposed text does not mention injunctions. That said, like other directives, the CSDD Proposal merely sets out minimum standards for Member States and so it is open to domestic courts to make injunctive relief available. That would significantly increase litigation risk for companies as, provided they could show standing, NGOs could use the CSDD Proposal to enjoin a broad variety of conduct that was previously only proscribed by soft law.

Directors

The CSDD Proposal also imposes duties on directors of companies within its scope.

The CSDD Proposal requires that directors of relevant companies must take into account the consequences of their decisions for sustainability matters, including, where applicable, human rights, climate change and environmental consequences, including in the short, medium and long term. Member States’ domestic law for breaches of directors’ duty shall extend to these obligations.

Directors will also be responsible for putting in place due diligence actions and policies, with due consideration for relevant input from stakeholders and civil society organisations. Directors should also adapt the corporate strategy to take into account companies’ duties to identify, prevent and cease adverse human rights and environmental impacts.

The express right to sue set out in the CSDD Proposal only applies to breaches by companies and does not directly extent to directors. That said, by extending their substantive legal obligations directors could face increased litigation exposure under domestic law of Member States.

Regulatory enforcement

The CSDD Proposal provides that Member States shall empower a regulatory authority to supervise compliance with its key terms, including obligations to identify, prevent and cease actual or potential qualifying adverse effects.

Regulatory authorities will be able to investigate potential breaches, including through unannounced dawn raids. An investigation can begin on the regulator’s own volition or where a third party submits a “substantiated concern” that a company is breaching its obligations under the Directive. Substantiated concerns can be submitted by any third party with a “legitimate interest”. NGOs and activist groups would no doubt explore this avenue to prompt regulatory scrutiny.

Where a breach is identified, the regulatory authority can order compliance and/or issue a fine. Fines will be based on the company’s turnover and should be “effective, proportionate and dissuasive.” There is no cap on the level of fines that may be imposed.

Comment

If implemented, the CSDD Proposal would very significantly increase ESG litigation risk in Europe. It would convert numerous environmental, human rights and social rights treaties into hard law with a direct right to sue for adverse impacts and introduce tough regulatory powers. No less significant is its potential international reach. A non-European company with sufficient European turnover would be caught by the directive, extending to its value chain outside of Europe. Auditable Contractual Assurances will provide significant protection, but putting those arrangements in place would be a significant exercise and require negotiations with counterparties.

The text of the CSDD Proposal is being consulted on and may change. Even an attenuated version of the current draft could significantly increase ESG litigation risk.

Article co-authored by Dominika Gasiorowski, Trainee Solicitor at CMS.

[1] In accordance with Article 7 of the International Covenant on Economic, Social and Cultural Rights.

[2] In accordance with Article 3 of the Universal Declaration of Human Rights, Article 5 of the International Covenant on Civil and Political Rights and Article 12 of the International Covenant on Economic, Social and Cultural Rights.