The Unintended Consequences of Mandatory Due Diligence

The EU Corporate Sustainability Due Diligence Directive (CSDDD) seeks improvements in companies’ societal impacts but carries risks of negative impacts, including on the developing countries where some supposed beneficiaries are located. Does the CSDDD recognise and mitigate such risks? The blog identifies provisions in the CSDDD that address the unintended consequences that mandatory human rights and environmental due diligence (mHREDD) requirements might have in developing countries. Once due diligence leaves the soft law domain of the UNGPs and becomes a legal compliance issue, supply chains and international trade are affected. Thus, if the risks of trading with some suppliers exceed the benefits, companies might comply with the CSDDD by placing unmanageable expectations on their suppliers or redirecting their value chains towards partners and countries where sustainability can be more easily monitored and improved.

Does the CSDDD introduce an illegitimate trade distortion that ends up hurting those it claims to protect? Is the risk of negative effects recognized in CSDDD? If so, what measures will be taken so non-EU companies are able to meet the new expectations and remain in European value chains? Such protective and supportive measures will influence the controversies around the extraterritorial reach of the CSDDD and other transnational due diligence laws.

Direct and indirect effects of mandatory due diligence

The CSDDD has direct and indirect effects. The direct effects refer to compliance by businesses within the personal scope of the Directive. These “in-scope” businesses are large companies headquartered in the EU, or non-EU companies that export into the EU market (Art. 2). The indirect effects are on contractors and other entities (“business partners”) in the value chains of in-scope companies. While not bound the CSDDD obligations, these direct and indirect business partners will need to meet expectations of in-scope companies to remain in their value chains (Preamble 69).

Non-EU companies, whether large or small, will be affected, directly or indirectly, by the CSDDD. As other supply chain regulations imposing due diligence, their effects will be extraterritorial and far-reaching. This regulatory approach is not without its critics. Some developing countries raise concerns that their exports to the EU will be hindered. Suppliers point to difficulties in meeting the request of lead companies without better terms and support. Some critics regard this mHREDD regime as punitive, discriminatory and even a neo-colonial imposition that increases the burden on the weakest entities in the supply chains. Such concerns are regularly raised in other areas such as free trade agreements that contain labour and other sustainability clauses. When the EU passed another due diligence law banning importation of commodities linked to deforestation, Brazil, Indonesia and other countries voiced displeasure, including at the WTO. To say the least, these due diligence laws are becoming controversial.

Risk recognised?

The CSDDD acknowledges the potential negative effects of mHREDD on non-EU businesses. These might happen because the CSDDD adopts a cascading strategy to cover the entire chain of activities: in-scope companies would place requests for information and improvement to their direct contractors which in turn have similar expectations from their own suppliers. This “cascade” down the value chain ensures that improvements are not confined to direct contractors but reach deep into production and (partly) distribution chains.

However, the risk is that in-scope companies will “transfer” obligations to their business partners (Preamble 66). To avoid that, the CSDDD establishes the principle of shared responsibility: in-scope companies have an obligation (“shall”) to seek contractual assurances from direct business partners (art 10.2(b)), but ensure that “responsibilities are shared appropriately” (Preamble 46, 54). A particular risk of this cascading strategy is on small and medium enterprises (SMEs). Neither EU nor non-EU SMEs are “in-scope” companies, but both will encounter the indirect effects of CSDDD.

As seen from various mitigation measures, the CSDDD recognized that the compliance burden can be shifted to business partners in multiple ways: through unfair contracting, responsible purchasing practices, inappropriate information requests, irresponsible and hasty termination of relationships, unpaid and duplicative social audits, and failing to offer necessary support.

To counteract the risk of negative effects, the CSDDD outlines both protective and supportive measures. A multitude of measures discussed below account for the vulnerability and risks faced by SMEs and the general aim is “to mitigate financial or administrative burden on SMEs” (preamble 69). Indeed, several of these measures become more stringent to protect SMEs; smallholders in agrifood supply chains are also mentioned.

Protective measures

Protective measures seek to avoid in-scope companies harming a direct or indirect business partner as they seek to comply with their CSDDD obligations. Four modalities are highlighted so companies desist from problematic practices.

First, companies are obliged to improve their outsourcing practices. The CSDDD recognizes that purchasing and distribution practices are an instance of “jointly causing” adverse impacts (Articles 10.2 and 11.3). Changes to such practices in food and agricultural chains are singled out to protect “agricultural producers with less bargaining power” (Preamble 47). The great variety of irresponsible purchasing practices is well captured in the Better Buying Index.

Second, as part of their due diligence, companies have an obligation to seek contractual assurances. In a nod to fair contracting, when assurances are obtained from SMEs, the terms shall be “fair, reasonable and non-discriminatory” (Articles 10.5 and 11.6).

Third, companies are obliged to take “appropriate measures for the prevention and mitigation”, which includes termination of business relations. The risk has been irresponsible exit and rushed terminations that themselves can harm human rights. This should be a “last resort” step, and the CSDDD usefully identifies numerous factors to guide the difficult decision for termination and temporary suspension of a business relationship (Art. 11.7). These factors also apply to a decision not to enter into a new relationship with a problematic business partner (Art. 10.6).

Fourth, obtaining information from business partners is inherent in due diligence. As companies are under an obligation to collect data, the risk is that in-scope companies will overburden business partners with information requests. Several safeguards are introduced such as an obligation to target data requests at the right level of the value chain (Art 8.4). Reporting standards are another limiting device to shelter small and medium-sized enterprises (SMEs) from excessive requests for information. Thus, noting that SMEs may “receive requests for sustainability information from customers, banks, investors or other stakeholders”, the Commission will adopt standards that provide “safeguards against disproportionate trickle-down effects on reporting requirements on SMEs which are in the value-chains of larger companies.”

Supportive measures

Supportive measures refer to measures that in-scope companies as well as the states should take to assist direct and indirect business partners. CSDDD outlines four modalities to assist business partners and other stakeholders. It adds clarity by identifying forms of support, including financial support. Just as with protective measures, there are provisions that calibrate support depending on vulnerability: non-SME, SMEs and SMEs facing bankruptcy.

First, CSDDD obliges companies to support some of their business partners. Thus companies “shall” provide “targeted and proportionate support” for SMEs in the forms of capacity-building support. Only when the SME risks bankruptcy due to compliance requests, shall the company provide financial support: “where compliance with the code of conduct or the prevention action plan would jeopardise the viability of the SME, providing targeted and proportionate financial support, such as direct financing, low-interest loans, guarantees of continued sourcing, or assistance in securing financing.” (Articles 10.2e and 11.3f). Thus, the novelty is that the CSDDD creates an obligation to offer financial support, but sets a high threshold.

Second, the CSDDD shifts the costs of social audits in some situations. Currently the practice is that suppliers pay for social audits. Only in the case of SMEs, the CSDDD imposes an obligation to pay for the audit: “Where measures to verify compliance are carried out in relation to SMEs, the company shall bear the cost of the independent third-party verification” (Articles 10.5 and 11.6). Another provision facilitates SMEs sharing these audit results with other companies (Articles 10.5 and 11.6), thus saving them money and reducing duplicative audits.

Third, the EU and member states are expected to support all companies – in-scope or indirectly affected – to implement mHREDD. Such support labelled “accompanying measures” (Art. 20) can take different forms. States offering financial support is envisaged only for SMEs (Art. 20.2). States may also facilitate multistakeholder initiatives (MSIs). The CSDDD shifts to a prescriptive tone when it obliges the Commission and/or states to issue guidance that sets fitness criteria for MSI and third-party audits. States are also obliged to set up portals and helpdesks to disseminate relevant information. (Art. 20.1) Alone among European states with due diligence laws, Germany has the Initiative for Global Solidarity that created Responsible and Inclusive Business Hubs in 8 countries to facilitate observance of the German supply chain due diligence act.

Fourth, CSDDD envisages the EU and Member State to support and collaborate with third countries through international trade and development cooperation instruments. That support includes “working with partner country governments, the local private sector and stakeholders on addressing the root causes of adverse human rights and environmental impacts” (Preamble 72). Support for third countries and cooperation is a standard component of EU free trade agreements.

Conclusion: A new “smart mix” of protective and supportive measures

CSDDD and other economic instruments with extraterritorial effects are relatively new and controversial in some quarters. To tackle this controversy, it is important to examine both the extent to which this risk of negative impacts from mHREDD are recognized and monitored as well as the measures to mitigate this risk. In its mitigatory measures, the CSDDD makes notable advances. The CSDDD appears focused mainly on protecting and supporting “indirect partners” and vulnerable SMEs, as well as assisting in-scope companies with a helpdesk (Art.21). There are also various provisions in the CSDDD referring to NGOs, defenders, and National Human Rights Institutions; these actors with a critical role to play and have received support through development cooperation focused on advancing corporate accountability. Facilitating exchanges and new collaborations in this ecosystem of capacitated actors should be a priority.

In devising a smart mix of mitigatory measures, the EU and member states should give due consideration not only to supplier-focused support but also to eco-system facilitation. That should not be limited to the “usual suspects” of national action plans (NAPs) on business and human rights processes; theoretically NAPs are able to facilitate these exchanges, but in practice have a mixed record. Other ecosystem facilitation measures could be multistakeholder initiatives (Art. 20.3) that have their own limitations, and information hubs (Art. 20.1). Other innovative collaborations for capacity building should be pursued, as also exemplified in an International Trade Centre’s  typology of “accompanying measures”.