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By: Radu Mares
In February 2022 the European Commission has published a Proposal for a new Directive, a Directive on Corporate Sustainability Due Diligence (CSDD). Large companies with operations in the EU space will be obligated to take measures to protect human rights and the environment under threat of civil liability and administrative sanction. The Directive will have effects even outside the EU because companies are required to take measures throughout their ‘value chains’. What explains this meteoric rise of this Directive on corporate accountability? How come there is support in business circles for this proposal? The Directive needs to be understood in the context of the Green Deal which emphasizes sustainable finance and a ‘just transition’ to a green economy.
The proposed Directive creates a new obligation of due diligence and thus mandates managements systems to prevent and remedy harms to human rights and the environment. It applies to all industries and companies of a certain size, including from the financial sector. EU companies will have responsibilities regarding their subsidiaries and some contractors wherever they might operate; non-EU companies exporting goods into the EU market are also covered. Companies that have influence over subsidiaries will be obligated to exercise it. Companies with contractors should use contractual clauses and perform audits to fulfill their due diligence.
Due diligence obligations will be enforced through civil liability and administrative supervision, with a due diligence defense. The Proposal appears to significantly change corporate law as companies might be found more easily liable for their subsidiaries’ misconduct, and cannot invoke as before the ‘corporate veil’. However the Directive does not change the law of negligence as plaintiffs will still have to demonstrate the constitutive elements of civil liability to obtain remedies from parent companies. The Directive will have extraterritorial effects and this is possible due to international production systems. Indeed this is a value chain legislation that covers both the upstream entities (production) and downstream entities (distribution).
This proposed Directive has a dual nature. It is corporate accountability legislation because it protects societal interests from wrongful business conduct. It is also a corporate governance instrument telling directors to discharge ‘their duty to act in the best interest of the company’ by taking a longer-term perspective and being more mindful of their stakeholders. In this way the Directive seeks to simultaneously advance accountability to society and to investors. It reflects the belief that EU law can and should promote competitive and socially responsible business activity.
Support from business circles
The proposed Directive attracted a surprising level of business support. In February 2022 a group of large businesses called for a Directive with a civil liability component. The study commissioned by the EU already documented a high level of support among diverse stakeholders for mandatory due diligence. Just a few years ago such a law would have met fierce resistance from the business sector.
There are several reasons why this has not happened. With trillions of euro about to be invested in the green transition, companies and investors alike sense business opportunities and also risks that some business models will become obsolete. Having a law on due diligence will provide predictability and legal certainty on expected conduct on topics that are still socially contentious. An EU-wide legislation also avoids legal fragmentation and diverging national laws given that some EU member states (Germany, France) already passed their own laws. The Directive also protects against unscrupulous competitors and thus levels the ‘playing field’ by imposing compliance costs on all competitors.
Package of laws
The Directive is a part of a regulatory package to decarbonize economies. In the transition to a green economy, the EU considers that the private sector plays an indispensable role. The main reason why this Directive exists has to do with the EU Green Deal adopted in 2019 and the emphasis it places on sustainable finance. Composed of basically five instruments, this package of EU laws concerns the interface between the real economy and the financial economy. In essence, companies will have to meet some standards and disclose information, and financial actors will be expected to use of this information to allocate funds to sustainable activities and companies. It is the supply-demand equation on sustainability data that the EU intends to regulate.
On the supply side, real economy companies have to supply sustainability information under the Non-Financial Reporting Directive (NFRD) adopted in 2014. Due to unsatisfactory compliance, the European Commission proposed in 2021 a new and more stringent Corporate Sustainability Reporting Directive (CSRD) will replace the NFRD. The proposal of CSDD will further enhance the information flow by mandating companies to set up risk management systems, and report on them; previously these due diligence systems were optional and expected as a by-product from a mere obligation to report under the NFRD.
On the demand side, financial actors have to report on how they integrate sustainability risks under the Sustainable Finance Disclosure Regulation (SFDR) adopted in 2019. To enable financial actors to act and facilitate such integration, the EU adopted the Green Taxonomy Regulation in 2020 which provides criteria to distinguish green economic activities from the rest; the Taxonomy refers to respecting human rights as ‘minimum safeguards’. This Taxonomy Regulation was a regulatory novelty that began with green side and is evolving very quickly to cover the social side. In February 2022, a report on a Social Taxonomy based on human rights was released. Furthermore, some large financial companies will have to undertake their own due diligence under the proposed CSDD; furthermore, the Commission indicated in its Strategy for Financing the Transition to a Sustainable Economy in 2021 the possibility to mandate due diligence for some financial actors (banks, insurers, credit agencies).
So, the proposed CSDD is part of the EU legislative framework on sustainable finance. To be recalled, this is a value chain legislation with extraterritorial effects beyond EU borders and there are other measures bearing on value chain and international trade that complement and reinforce the CSDD. Such measures create an enabling policy environment for the CSSD and will positively affect compliance in European and global value chains. There is an intra EU set of policies and extra an EU package of policies.
Regarding the intra EU package, there are labour, human rights and environmental legislation creating obligations and liabilities for EU operators for the benefit of residents in the EU space. Such laws are confined to the EU space as are broader instruments such as the EU Charter of Fundamental Rights and the European Pillar of Social Rights from 2017.
Regarding the extra-EU package, the most notable are the EU trade instruments that create sustainability obligations for exporting states. The EU’s commitment to value-based trade is explained in the Trade Policy Review from 2021. EU’s framework for development cooperation is now the Post-Cotonou Agreement from 2021; covering over 100 developing countries, it refers to responsible business conduct and stresses the importance of human rights, and rule of law in development.
The EU thus uses a wide variety of instruments in an increasingly integrated manner. The CSDD is a new value chain legislation, and the EU seems committed to achieve policy coherence by introducing new instruments and strengthening its older instruments with impact on public and private actors along the value chains. The CSDD thus has to be understood in this rapidly emerging EU regulatory ecosystem for global value chains and the distinct role this Directive will play therein. The EU also intends to become more involved in the negotiation process at the UN regarding a legally binding instrument on corporate human rights accountability.
The CSDD Directive will produce effects starting in 2026 the earliest as it goes through the usual EU legislative process. Currently the EU is taking the leading role globally in enacting the ‘smart mix’ approach to regulating businesses anticipated in the UN Guiding Principles on Business and Human Rights. What is remarkable is the policy coherence that EU displays in its regulatory ambitions. This process placed in a historical context is remarkable in itself. Thus in just a decade the EU legal landscape on corporate responsibilities has transformed beyond recognition.