Managing the Supply Chain

Supply Chain Management: why this is becoming a major legal challange

10-11-2022
The word of the year 2022 is not 'pandemic' but 'supply chain'; more specifically its management. Due in part, of course, to the COVID-19 pandemic, but certainly - and not least - as a result of the war in Ukraine, high prices of raw materials and energy, effects of climate change and (upcoming) ESG requirements. To that can be added nuclear threats, possible sabotage of gas pipelines and other important infrastructural facilities. Supply chain management in itself is not an easy task. It is clear that social and global developments have placed this issue high on the corporate agenda and, thus, also on that of the company lawyer. This chapter outlines the developments and how these should be taken into account from a legal point of view.

ESG

The legal developments in the field of ESG in relation to the supply chain are many. An MSCI table gives a good overview of issues that are relevant in the context of the Environment, Social and Governance tripod.

Europese Green Deal

On 11 December 2019, the European Commission presented the Green Deal, making clear its ambitious intentions: 'The European Green Deal sets out how to make Europe the first climate-neutral continent by 2050, boosting the economy, improving people's health and quality of life, caring for nature, and leaving no one behind.'

The Green Deal includes a roadmap of measures for improving resource efficiency in a clean circular economy and countering climate change, biodiversity loss and pollution. It also sets out the financial instruments and investments required and how to achieve an inclusive and fair transition. The Green Deal encompasses all sectors of the economy.

In view of the goals it contains, the Green Deal has given rise to strategies, pacts and action plans. In summary, these range from a proposed European Climate Law, an action plan for the circular industry in 2020 and a European battery alliance, to proposals to stop deforestation, innovate sustainable waste management, restore the soil and reduce carbon emissions, and plans to bring about a sustainable energy transition. All these strategies, pacts and plans will impact the supply chain, either directly or indirectly, not only in a European context but also outside Europe.

Important European Directives

Two draft European Directives will be extremely important in this respect moving forward: the Corporate Sustainability Reporting Directive (CSRD), which requires certain companies to report on sustainability, and the Directive on Corporate Sustainability Due Diligence (CSDD), which requires companies to monitor actual or potential adverse impacts on human rights and the environment within their 'value chains'. One of the most important innovations that these European Directives will drive is the ability to uphold, and possibly even enforce, ESG criteria throughout the supply chain. This is a first step towards the external application of ESG criteria.

CSRD

The CSRD was introduced by the European Commission on 21 April 2021 to strengthen the rules on transparency surrounding sustainability and other non-financial issues. This was prompted by the revision of the Non-Financial Reporting Directive (NFRD). The CSRD is intended to encourage companies to become more sustainable and to prepare them for the new economy.

Scope of the CSRD

The CSRD includes an extension of the scope of the NFRD, since more companies will become subject to the CSRD. The scope now extends to all large companies and all listed companies. A company qualifies as 'large' if it satisfies at least two of the following three criteria:

• more than 250 employees;
• an annual turnover of over EUR 40 million;
• over EUR 20 million in total assets.

The main characteristic of the proposal is that it imposes more far-reaching obligations with regard to sustainability reporting. For example, substantive reporting requirements relating to sustainability are expanded and clarified, and a limited audit (assurance) of the contents of the sustainability information will become mandatory. The reporting requirements are clarified, inter alia, by introducing a common set of reporting standards across Europe. Those reporting obligations also highlight the importance of the supply chain.

The CSRD strongly emphasises the crucial role of value chains when determining a company's carbon emissions and its environmental footprint. The aim of the CSRD is for all that information to be recorded as reliably, transparently and accurately as possible. Information from the supply chain is also relevant in order for a company to be able to determine its own environmental footprint. This means that companies that do not strictly fall under the scope of the CSRD can still be required to report on sustainability to their supply chain partners that are subject to the CSRD. For example, the recitals to the proposal state that reported sustainability information should also take into account short-, medium- and long-term time horizons and contain information about the company’s entire value chain, including its value chain both within and outside the EU, in as far as the company’s value chain extends outside the EU. A practical effect could be that chain partners assume a mutual contractual obligation to report on sustainability.

CSDD

On 23 February 2022, the European Commission published its proposal for a Directive on Corporate Sustainability Due Diligence (CSDD) in order to address adverse human rights and environmental impacts in value chains at a central level. This draft Directive contains far-reaching obligations for companies to prevent adverse impacts in respect of those topics within their supply chains. According to the European Commission, the Directive is a real game-changer in the way companies operate their business activities throughout the supply chain. In the words of the European Commission, the Directive should take a leading role in the green transition. 

The Directive has been presented to the European Parliament and the Council for approval. After approval, the EU Member States will have two years to transpose the CSDD into national law. The new legislation will entail compliance and liability issues in respect of ESG risks within the supply chain.

Scope of the CSDD

The CSDD will apply to the following companies:

• EU companies with more than 500 employees on average and a net worldwide turnover of more than 150 million euros in the last financial year for which annual financial statements have been prepared (‘group 1 companies’); 
• EU companies that do not come under group 1, but did have more than 250 employees on average and a net worldwide turnover of more than 40 million euros, provided that at least 50% of that net turnover was generated in one or more of the following (high-risk) sectors ('group 2 companies'): 1) the manufacture of textiles, leather and related products (including footwear), and the wholesale trade of textiles, clothing and footwear; 2) agriculture, forestry, fisheries (including aquaculture), the manufacture of food products, and the wholesale trade of agricultural raw materials, live animals, wood, food, and beverages; and 3) the extraction of mineral resources regardless where they are extracted from (including crude petroleum, natural gas, coal, lignite, metals and metal ores, as well as all other, non-metallic minerals and quarry products), the manufacture of basic metal products, other non-metallic mineral products and fabricated metal products (except machinery and equipment), and the wholesale trade of mineral resources, basic and intermediate mineral products (including metals and metal ores, construction materials, fuels, chemicals and other intermediate products).
• Non-EU companies that fulfil the conditions for group 1 or group 2 companies.

Obligations under the CSDD

The CSDD will apply to a company's own activities, as well as those of its subsidiaries and its 'value chain'. The importance for the supply chain is underlined by the definition of the value chain: ‘activities related to the production of goods or the provision of services by a company, including the development of the product or the 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.’

In essence, the proposed Directive imposes duties of care on companies. In order to comply with those duties of care, companies must:

• integrate due diligence into their policies;
• identify actual or potential adverse human rights and environmental impacts; 1) prevent and mitigate potential adverse impacts; 2) bring actual adverse impacts to an end and minimise their extent;
• establish and maintain a complaints procedure;
• monitor the effectiveness of their due diligence policy and measures;
• publicly communicate on due diligence.

Adverse impacts

In terms of potential adverse impacts, companies must:

• develop a prevention action plan in consultation with affected stakeholders;
• seek contractual assurances from business partners with whom it has a direct business relationship, for example the assurance that a business partner acts in compliance with the company’s code of conduct;
• make necessary investments, for example into management or production processes and infrastructures;
• provide support for SMEs with which the company has an established business relationship, where compliance with the stipulated assurances (compliance with the code of conduct or the prevention action plan) would jeopardise the viability of the SME; and
• in compliance with Union law, including competition law, collaborate with other companies to bring the adverse impact to an end.

The same obligations will apply to actual adverse human rights and environmental impacts, where any references to 'prevention plan' should be understood to read 'corrective action plan'. Furthermore, companies will be required to neutralise or minimise the adverse impacts, inter alia, by compensating the affected communities.

Impact of the CSDD on trade and industry

The obligations show that companies that come under the scope of the CSDD will be greatly impacted by the CSDD. Compliance with the CSDD is likely to impose a great regulatory burden on trade and industry. After all, it is not just the internal business operations that will have to be adjusted; the external business operations will be subjected to changes as well. Business partners within the value chain must be motivated and, where necessary, supported to comply with the obligations ensuing from the Directive. It is very likely that companies will have to go back to the drawing board to adopt policies to comply with those obligations. At the same time, companies will be required to try to include ESG criteria in the agreements with their business partners, which may present difficulties in negotiations.

In order to limit the regulatory burden for trade and industry somewhat, the European Commission has announced that it will introduce guidelines for voluntary model contractual clauses. These model contractual clauses will be designed to help businesses comply with the duty to use their best efforts to stipulate assurances from business partners.

Another important obligation imposed on companies is to take appropriate measures to monitor compliance with those contractual assurances. In concrete terms, this means that a company must first use its best efforts to stipulate contractual ESG assurances, and then verify compliance with those assurances. The CSDD refers to two options that may be used: the company may refer to 'suitable industry initiatives' or to independent third-party verification (audit). Where such third-party verification is carried out in relation to an SME, the costs will be borne by the company falling under the scope of the CSDD.

Directors' duty of care

The drastic rules of the Directive not only affect the companies themselves, but also the directors of those companies. The European Commission deems this necessary given its observation in the introductory considerations to the proposal that laws and regulations on directors' duties differ significantly between EU Member States. In this respect, the Commission notes that harmonisation of the due diligence rules and the fulfilment by directors of their duties in respect of the topics covered by the CSDD will benefit the functioning of the internal market and competition.

This means, in concrete terms, that Member States must ensure that, in the fulfilment of their duty to act in the interest of the company, directors must also consider the effects of their decisions for sustainability issues, including human rights, climate change and environmental impacts. It may be clear that this introduces a Union law duty of care for directors of companies that fall under the scope of the CSDD. Directors' liability will be discussed in further detail in Chapter 6 below.

Cooperation for purposes of sustainability

An important aspect in the implementation of the guidelines is the cooperation among companies. This could, in theory, be at odds with existing competition regulations. In this respect, the Netherlands Authority for Consumers & Markets (ACM) has communicated that cooperation among competing companies should be possible if it is aimed at sustainability, including combating the climate crisis. On 26 January 2021, the ACM published the Second draft Guidelines on Sustainability Agreements. These Guidelines provide a practical explanation of the application of the competition rules to sustainability agreements. For example, the Guidelines clarify what sustainability agreements are permitted and what the ACM's practice is when it comes to questions about sustainability agreements. The ACM has also promised not to impose any fines for collective agreements in which it is clear that the businesses involved followed the draft Guidelines in good faith. 

ACM Guidelines Sustainability Claims

The ACM Guidelines Sustainability Claims as published on 28 January 2021 are also worth reading. In these Guidelines, the ACM articulated, inter alia, five rules of thumb that can help businesses when phrasing sustainability claims. Sustainability claims, which is the term used by the ACM as an umbrella term for 'environmental claims' and 'ethical claims', should not be phrased carelessly. The ACM can take action at national level, as well as at European level, through cooperation with other regulatory authorities in other EU Member States, against unfair business practices.

The current 'climate' and impact on contracts

The pressure on companies to get actively to work on ESG is being increased from all sides. The supply chain is an important link when it comes to meeting ESG requirements. Companies that fall under the scope of the Directives, as well as those that do not yet fall under such scope, will have to scrutinise and, where necessary, adjust contracts. This will in any event include adjustments in terms of ESG obligations, incorporating ESG criteria in provisions and including legal consequences if ESG criteria are not satisfied. Furthermore, this may include incorporating disclosures and statements requiring contractual partners to declare that they will meet ESG requirements, even if those requirements should change in the future. It is also important to record what should be done in the unhoped-for event that they prove not to do so.

Other political and social developments are leading to more pressure on the supply chain as well. In particular, the developments around the war in Ukraine have caused prices to go through the roof. As a result, companies are increasingly being forced to go over their contracts in respect of price changes. This will not be any different for ESG and price change clauses. A question that may arise is whether price changes could be implemented if these were to be the necessary result of compliance with ESG obligations, for example new technologies to facilitate more sustainable business operations. In principle, the contract is leading, and a price change clause in which the right to make price changes is reserved in favour of ESG obligations could be helpful.

It is also important to focus contractual provisions, including provisions on force majeure, unforeseen circumstances and material adverse changes, on current and future developments. Will these types of provisions even provide a remedy in light of all these developments? It is conceivable that the situation may arise where compliance is still possible, for example because there is an alternative method for compliance, but that compliance comes at the expense of the ESG criteria. In principle, the contract could stipulate whether such a situation would qualify as force majeure or unforeseen circumstances and attach consequences to it. For that reason, it is crucial to make sure that contracts are up to date and to include provisions that are also ESG-proof.

Conclusion

Given the proposed amendments to the legal framework and the ever-changing political and social climate, managing the supply chain will, therefore, certainly be one of the greatest (legal) challenges in the coming years. An active and proactive attitude on the part of companies - as well as company lawyers - towards these developments could contribute to 'managing' this challenge.

Tips & Tricks

• Make ESG an explicit part of all decision-making processes within the company.
• Create multidisciplinary ESG teams (including Legal, Finance, Commercial, Risk & Compliance and Governance).
• Draw up, or adjust, a Code of Conduct and make it an integral part of agreements.
• When entering into new, or renewing existing, contracts, pay explicit attention to ESG requirements and identify them.
• Link price change clauses to the company's ESG goals and obligations.
• Check contractual provisions, such as force majeure, termination, dissolution, assurance and indemnification clauses, for ESG-related obligations and goals and adjust where necessary.
• Closely monitor the EU initiatives and the websites of, among others, the Netherlands Authority for Consumers & Markets and the Netherlands Authority for the Financial Markets.