Goodbye soft law: EU rules on sustainable corporate governance

The European Union has a track record of regulating supply chains. Covid-19 focussed minds further on their safety and transparency, often coupled with calls for an elusive ‘strategic autonomy’. Incoming sustainable corporate governance rules will change risk assessments for EU-based companies with complex supply chains, their trading partners, and investors.

What is on the table

In the first half of 2021, the European Commission will publish a set of legislative proposals that will create legal duties for Boards of Directors to carry out appropriate due diligence processes to identify and address human rights abuses and environmental harm throughout the value chain of their companies. These obligations may also apply to third-country enterprises placing products on the EU market.

At the time of writing, it appears possible that the due diligence obligation would be enforced through two mechanisms: oversight by competent member state authorities and a civil liability of companies, combined with enhanced Non-Financial Reporting requirements. The latter would allow both investors and civil society to better scrutinise business conduct and governance standards of companies.

Currently, it appears likely that the new instrument would have a broad horizontal scope. It might be complemented by mandatory or voluntary sector-specific frameworks, such as for supply chains in agriculture, extractives and minerals, the textiles and garments sector, or lending and securities underwriting. The Commission is also assessing the merits of an alternative ‘thematic’ approach, focussing for example on issues such as modern-day slavery or child labour, across sectors.

Channelling money into sustainable businesses

The sustainable corporate governance initiative is rooted in many policy drivers. One of them is the EU’s intention to channel private investment into sustainable businesses. In 2018, the EU High-Level Expert Group on Sustainable Finance recommended to strengthen board members’ legal duties with the declared aim to overcome ‘short-termism’. The idea is to ensure companies implement effective sustainability strategies, not to push back against shareholders’ interests.

This dovetails with growing evidence that superior performance on material ‘ESG’ issues leads to superior financial performance of companies. Covid-19 and the ensuing recession are unlikely to undermine this development. For investors, it is reasonable to assume that companies that are managed in line with societal megatrends are likely to be more resilient in times of crisis.

To empower green investors to put their money where their mouth is, the EU is currently developing proposals for a strengthened, mandatory Non-Financial Reporting framework. While investors will appreciate the drive to standardise such reports, they will also want to ensure they are ‘material’ in the sense that they link to corporate strategy and core operations of very diverse businesses. The EU must find ways to ensure the materiality of individual NFR reports to replace ‘green washing’ with ‘sustainable value creation’.

Policy roll-over

As regards due incoming diligence requirements for value chains, the European Commission will develop legislative proposals based on external studies and an ongoing stakeholder consultation that will close in February 2021. The Commission is expected to follow existing international soft law initiatives, such as the UN Guiding Principles on Business and Human Rights, the OECD Guidelines for Multinational Enterprises, or the ILO Declaration of Principles Concerning Multinational Enterprises and Social Policy.

This means the sustainable governance package is unlikely to create new commitments from scratch. It will, however, mark the step from merely incentivising companies to follow certain ‘policies’ and to publish reports about their ‘intentions’ to forcing boards to establish compliance structures and to own the ‘outcomes’ of their business activities. This is a new quality entirely.

Especially the prospect of facing civil liability for avoidable harm across complex supply and value chains would be a daunting prospect for many companies. In practice, the new sustainable governance framework might require EU businesses to enforce standards throughout their operations that the European Union itself was not able to impose when negotiating international agreements.

Cutting out high risk jurisdictions?

New sustainable corporate governance obligations would markedly increase the legal risks for Directors of doing business in countries with comparatively low human rights or environmental standards. Boards of Directors may in individual cases decide to disengage from certain high-risk areas. Jurisdictions with a comparatively better risk profile and track record might be able to attract trade and investment flows. Third country governments and business associations have a palpable interest to engage early with both EU institutions and European business partners to mitigate risk.

Daniel Brinkwerth is a Partner at the Flint’s Brussels office. You can find out more about how Flint helps businesses navigate European policy changes, make well-informed decisions and engage effectively with EU institutions here: https://flint-global.com/expertise/policy-and-political-analysis/european-policy-development/