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A proposed EU regulation on corporate due diligence, aimed at rooting out human rights and environmental abuses in supply chains, will make compliance efforts by the bloc’s financial institutions trickier, lawyers say.

The European Commission unveiled its proposal for the new law in late February, in the wake of growing pressure over abuses such as slave labour, exploitation of workers and pollution in the supply chains of European companies sourcing from outside the EU.

Some EU member states, such as Germany and France, have already introduced similar legislation. The Commission’s proposal goes further than both of those regimes and seeks to harmonise the approach across the union’s 27 member states.

Broadly, the proposal obligates affected firms to create a human rights and environmental due diligence framework, identify possible “adverse impacts”, and mitigate and stop them. It also envisages a duty of care for directors.

While lawyers who spoke to GTR say that if the proposal becomes law, financial institutions will need to devote further time and energy to compliance, it places much less burden on financial entities compared to corporations.

Crucially, financial institutions would only be required to carry out due diligence on the client it is providing financial services to, and not other companies in that client’s supply chain.

Corporates – the proposed regulation would only apply to companies with more than 500 employees and €150mn in annual turnover – on the other hand, would be required to carry out due diligence on their entire “value chains”. They are also required to conduct ongoing monitoring of “adverse impacts” in those value chains, whereas financial services providers are only required to identify negative impacts “only at the inception of the contract”.

Providers of credit, loans and other financial services are also carved out of a requirement in the mooted law for firms to axe a business relationship when an adverse impact on human rights or the environment is severe and cannot be mitigated.

Financial services providers would not be required to terminate a relationship “when this can be reasonably expected to cause substantial prejudice to the entity to whom that service is being provided”.

Arthur Sauzay, counsel with law firm Allen & Overy, tells GTR that because European financial institutions already carry out due diligence under a plethora of existing regulations, “the actual additional effort will thus be linked to where financial institutions currently are in terms of practices”.

James Marlow, an associate with law firm Linklaters who has studied the proposal, says “if the proposal goes ahead, extensive diligence requirements will still apply to financial institutions”.

“There will undoubtedly be, for the vast majority of those entities caught, a need for a lot of work in designing and implementing systems which are responsive to the requirements of the proposal,” he adds, “as well as significant capacity building to ensure that risks and impacts are properly identified and managed”.

“This is likely to be the case in particular in relation to human rights, in respect of which current risk management systems tend to be at an earlier stage of maturity and where issues can be complex and nuanced,” he tells GTR.

But other parts of the proposal, such as making individual directors liable for human rights abuses, the creation of a civil liability mechanism and the designation of national regulators to oversee compliance, mean that “financial players need to be prepared, and are already looking at this very closely”, according to Sauzay.

The civil liability scheme would allow victims of human rights or environmental harms to sue an EU firm for damages caused by a company in that firm’s supply chain.

Campaigners have long advocated for the move, although the European Coalition for Corporate Justice, an umbrella group for corporate watchdog NGOs, said it was disappointed that a lawsuit would only be possible if the company in question is in an “established business relationship” that is expected to be “lasting”.

The NGO argues that “the proposal risks incentivising companies to switch suppliers regularly to avoid liability”.

 

SMEs out, impact on traders unclear

The Commission hopes the law will place more scrutiny on industries where abuses and environmental degradation are more likely to be present.

It wants the rules to apply to businesses with at least 250 employees and €40mn in turnover if they are active in “high-impact” sectors such as agriculture, textiles and mining, but two years later than for larger entities.

Non-EU firms would also be captured if the same thresholds are met for turnover generated inside the EU.

SMEs are excluded from the scope of the draft text, however, which the European Coalition for Corporate Justice says means that only 0.2% of EU companies are affected.

Calls for the proposal to target export credit agencies also appear to have been ignored.

Because the draft directive includes the “wholesale trade” of goods such agricultural goods and natural resources such as metals and fossil fuels, commodity traders who meet the thresholds could also be captured.

“It is unclear how the requirements would apply to commodity traders in practice – their business model and mode of operation is obviously quite different to that of a typical multinational, for example,” says Marlow.

“We expect the Commission to publish guidance, should the proposal progress, which might help here. We are also aware that exchanges such as the London Metal Exchange are already looking closely at due diligence requirements and responsible sourcing in this context.”

This approach mirrors the focus on trade in the EU’s existing regulation on conflict minerals and the proposed regulation on deforestation put forward last year, according to Sauzay.

“At the national level, we see that these players are already subject to due diligence obligations and the level of obligations is clearly rising,” he says.

The Commission’s proposal will now be subject to negotiations with the European Parliament and European Council and is unlikely to come into force for several years.

“The political tailwinds behind EU-wide action in this area are strong,” consultants Gibson Dunn say in a March 11 note, “particularly as national governments across the EU continue to implement their own legislative measures and the European Parliament has already advocated for similar legislation”.