The EU, which is increasingly seen as the pacesetter in international ESG regulation, is continuing to take decisive steps on the path to achieving its strategy of toughening up ESG rules for large businesses.
On 23 February 2022, the European Commission published a long-awaited formal Proposal for a Directive on Corporate Sustainability Due Diligence.
Broadly, the Proposal aims at ensuring businesses conduct human rights and environmental due diligence of their own operations and the operations of their subsidiaries and supply (or "value") chains.
The Proposal sets out a list of specific actions companies are expected to undertake to stay compliant. These include integrating far-reaching due diligence processes into their internal policies, identifying, preventing and mitigating any potential adverse impact of their operations, establishing and maintaining a complaints procedure, etc.
In addition, certain companies are required, under certain conditions, to develop a plan to ensure that their business strategy is compatible with limiting global warming to 1.5°C in line with the Paris Agreement.
Notably, while the Proposal's primary focus is on EU-incorporated companies, it also applies to non-EU companies that generate turnovers in the EU in excess of certain thresholds. Therefore, for example, a UK company that trades in the EU and meets the turnover requirements would fall within the scope of the Proposal.
The Proposal envisages that each Member State should designate a national supervisory authority to supervise compliance with the corporate due diligence duty. For UK-incorporated companies, the competent supervisory authority would be that of the Member State in which the company has a branch or, if there are no branches or more than one branch, the Member State in which the company generated most of its turnover.
The supervisory authorities have the power to investigate compliance and impose administrative sanctions or liability for damages on those companies that fall foul of their obligations.
Once the Proposal becomes an EU Directive, UK companies with substantial EU turnovers may become exposed to potentially crippling liability for environmental and human rights breaches committed by their subsidiaries and supply chains.
The Proposal provides for a combination of administrative sanctions and civil liability. Although the Proposal leaves it to the Member States to determine the level of administrative sanctions for breaches, it requires that such sanctions should be effective, proportionate and dissuasive.
When pecuniary sanctions are imposed, they will be based on the company’s turnover.
More importantly, the Proposal sets out the requirement for Member States to lay down rules governing the civil liability of the company for damages arising due to its failure to comply with the corporate sustainability due diligence obligations. In other words, it introduces a direct cause of action allowing those affected by the adverse environmental and human rights impacts of a subsidiary's operations to bring a claim for damages against the parent company.
The UK approach
At the time of writing, there is no equivalent regime existing or being proposed in the UK.
Ever since the decision of the House of Lords in Salomon v Salomon & Co Ltd, separate corporate personality and limited liability of shareholders have been regarded as the cornerstone principles of the UK company law.
With limited exceptions, parent companies have been largely immune from liability for the actions of their subsidiaries. "Piercing the corporate veil" (i.e. looking beyond the separate personality of the subsidiary) has been possible only in very limited circumstances, as confirmed by the Supreme Court in Prest.
While there are cases in which a parent company may ultimately be liable for actions of its subsidiaries under English law, the circumstances in which liability arises are narrow. For instance, in Chandler v Cape plc, the Court of Appeal found that a parent company may, in appropriate circumstances, be responsible for inadequate employee health and safety practices of its subsidiaries.
However, outside these very fact-specific circumstances, UK parent companies can generally rely on the doctrine of limited liability to limit their exposure to risks associated with their subsidiaries' operations and practices.
To illustrate this point, suppose that a UK-headquartered clothing retailer has a network of European branches and subsidiaries and a net European turnover of more than €40 million. Suppose also that one of its smaller and more obscure subsidiaries has a track record of relying on child labour.
Under the current regime, the Modern Slavery Act 2015 does not go beyond requiring the UK company to produce and publish a slavery and human trafficking statement at the end of each financial year.
The statement should describe the steps the company has taken to ensure that slavery and human trafficking is not taking place in its supply chains or in any part of its own business. However, there is no duty on the parent company to take any specific steps nor any penalty for failing to take them.
If a person affected by the subsidiary's unethical practices brings a claim, it will generally be the subsidiary (and not the parent company) that will be responsible for any harm.
The Proposal goes much further in that it requires a UK parent company to identify and remove or reduce the risks of 'adverse impacts' arising out of breaches of the international standards. It also opens a path for any affected person or persons to bring a direct claim for damages (among other remedies) against the UK parent company.
The amount of damages sought may be substantial, depending on the extent and nature of the harm caused to individuals and communities. This is a stark contrast to the existing UK regime, whereby the parent company can generally expect its exposure to be limited to the amount of capital originally invested in the subsidiary.
Although a long and potentially complicated legislative process awaits the Proposal before it becomes law, it is important that directors of companies with operations in the EU begin reviewing and assessing their networks and supply chains to determine whether any changes are required to ensure compliance with the EU's ESG proposals.
In the context of M&A transactions, prospective acquirers should carefully consider any potential risks as part of their pre-transaction due diligence. When diligencing a large international group of companies, it may be easy to overlook a relatively small and immaterial subsidiary incorporated in an area with a poor human rights record.
However, once the Proposal is implemented, such subsidiaries may become a source of significant additional risk for investors.
This article was authored by Natalia Schuster, corporate partner at Fieldfisher.
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