Supply chain liability and ESG obligations: navigating litigation risks

Friday 1 December 2023

Ignacio Santabaya González
Pérez-Llorca, Madrid

Silvia de Paz Pérez
Pérez-Llorca, Madrid

María de Arcos Tejerizo
Pérez-Llorca, Madrid

Sustainability-focused litigation is gaining momentum across numerous EU nations. As legislation on responsible business conduct emerges, businesses must gear up for revisiting their due diligence code of conduct and their compliance mechanisms in environmental and human rights matters. There is a growing trend to pursue novel causes of action against companies for alleged misconduct not directly attributable to them, but to third parties operating across their value chain, for failing to prevent human rights or environmental breaches.

In June 2023, Germany’s main car manufacturers received a complaint filed with the German supervisory authority by a non-profit organization based in Berlin under the German Supply Chain Due Diligence Act. The complaint concerned the alleged use of forced labour of ethnic minority Uyghurs in their automotive supply chains. In France, several activists, environmental groups and non-profit organisations have filed claims with the French civil courts against big corporations under the French Duty of Vigilance Act for their alleged indiscriminate plastic use throughout their supply chains, or for their contributions to deforestation and violation of the rights of indigenous peoples in supply chain practices.

These claims pose unprecedented litigation risks, not only for corporations that have to abide by these regulatory frameworks, but also for their overseas commercial partners, who may bear the consequences of potential contractual indemnities, termination or suspension of contracts, and liability arising from noncompliance with heightened due diligence standards. This article will reflect on how corporations may anticipate and navigate litigation risks arising from supply chain liability. 

Corporate due diligence framework: the source of litigation risks

Corporate due diligence is a well-known notion across various corporate strategies and governance facets. However, its application in environmental sustainability and human rights has gained distinct prominence with the rise of ESG obligations. Several countries, including France with its Duty of Vigilance Act, and Germany’s Act on Corporate Due Diligence Obligations in Supply Chains, have already implemented a legal framework which enforces the duty of care of companies for acts committed by companies within their group, as well as by companies operating across their value chain. Others, such as the Netherlands, are progressing towards this path. Meanwhile, negotiations between the European Commission, the European Parliament and the Council of the EU ('trilogues') are taking place in order to adopt the Directive on corporate sustainability due diligence (the 'forthcoming EU Directive').1 

The forthcoming EU Directive aims at promoting responsible business conduct by enforcing due diligence obligations to identify, prevent, mitigate and remedy adverse impacts that companies may have on human rights and the environment through their activities, including the activities carried out across their value chains. As outlined below, this may lead companies seeking appropriate contractual indemnities with their business partners to ensure compliance with the company’s code of conduct, as well as suspending or terminating business with their partners when serious adverse effects are identified.

In essence, the EU is paving the way towards a structured regime where businesses are obliged to undertake comprehensive environmental and human rights risk assessments. Such analyses should culminate in a meticulous due diligence strategy which points to potential risk prevention measures, while also tackling any existing and potential adverse effects. 

For the purposes of this paper, it is worth noting that companies will have to ensure compliance by their subsidiaries in alignment with their duty of care mandates, as well as by any direct or indirect business partner that operates in their value chain. The European Commission’s proposed text of the forthcoming EU Directive uses a broad definition of the term 'value chain', which may include any commercial relationship that a company has with contractors, subcontractors or other companies that the company finances or that contribute to activities related to the company’s products and services. Accordingly, a company’s value chain consists of both its upstream and downstream activities, from manufacture processes to distribution, sale, transportation, storage and disposal of the products.

The manifestation of potential litigation risks: tracing liability

Most European frameworks on sustainability and due diligence are setting out a liability regime that includes both public and private enforcement of companies’ duties. For instance, Articles 20 et seq of the forthcoming EU Directive establish a system of both public monitoring by designated authorities within each Member State and a civil liability regime. Meanwhile, the German Supply Chain Due Diligence Act and the forthcoming Dutch Mandatory Human Rights Due Diligence Legislation envisage the public enforcement of these obligations, while not precluding the liability of companies subject to mandatory due diligence obligations.

It follows that non-compliance with the prescribed due diligence obligations can lead to sanctions and penalties imposed by the competent regulatory bodies. 

Moreover, the private enforcement of the sustainability due diligence framework will invoke the civil liability of companies for damages arising from noncompliance with their obligations to prevent, mitigate and remediate adverse effects in activities throughout their value chain. 

A civil liability regime would thus allow victims or representative groups to claim compensation for any damages that have arisen as a result of a company’s failure to take appropriate measures to identify, prevent and mitigate breaches by their commercial partners. For instance, failure to address labour rights transgressions or environmental harms by offshore partners. These are the kind of disputes that are on the rise today in EU countries such as France, Germany and the Netherlands, and other countries may follow suit once the forthcoming EU Directive is implemented by Member States. The European Parliament’s position to the text establishes that the limitation period applicable in Member States for these actions should be for at least 10 years.

Besides the litigation risks resulting from the direct application of these regulatory frameworks, a novel kind of litigation may arise between companies who have to abide by these regulations and third parties who may be based outside the EU, but who might bear the consequences of the newly imposed standards of due diligence.

Strategies for companies to navigate litigation risks arising from value chain liability

In light of due diligence regulatory frameworks, companies will face significant risks in the implementation of their contracts with suppliers and third parties operating in their value chain. Companies will bear major risks for the misconduct of their business partners, for which they will seek ways to protect themselves from litigation threats. Here are some measures that may be implemented:

Contractual indemnities

Companies will aim to include indemnities in the agreements with business partners operating in their value chain. Such provisions would be geared towards ensuring these partners conform to the due diligence standards set by the corporate group. 

While the inclusion of indemnities will not entail a transfer of liability towards the business partner, or exonerate the company from its own failure to prevent and mitigate adverse effects, it will provide entities with sufficient grounds to: (a) guarantee compliance with their due diligence standards; and, (b) as the case may be, it will allow companies to apply contractual penalties and/or claim any damages arising from noncompliance.

Nonetheless, contractual indemnities might not be enough for companies that may face litigation risks arising from third-party misconduct for over 10 years (in light of the limitation period that might be provided for under the forthcoming EU Directive’s civil liability regime). In order to ensure that the passage of time does not result in the impossibility of the company to pursue damages from their business partner for contractual breach, companies may want to seek the issuance of bonds and guarantees, so as to secure payment if and when the company’s liability arises.

It follows that the formation and implementation of business-to-supplier contracts within the value chain will be more complex and will aim at predicting  the consequences that may arise even after the termination of the business relationship.

Lastly, it is interesting to note what  the European Parliament’s position to the forthcoming EU Directive has stated under Article 7(2) in this regard. It established that indemnity clauses must be equitable, reasonable and non-discriminatory, whilst taking into consideration the capacity of trading associates. Should a partner struggle to meet due diligence requirements, it may be prescribed  under the forthcoming EU Directive that companies should not immediately disengage or terminate ties. Instead, it proposes that businesses should make the necessary investments and arrangements to promote their partner’s compliance capabilities.

Suspension or termination of business ties

As an additional protective measure, companies might contemplate the temporary suspension or, under severe circumstances, the termination of business contracts with offshore business partners where an adverse effect is identified. 

The forthcoming EU Directive will also envisage this  possibility. However, it recommends a cautious approach, suggesting contract termination only as a measure of last resort. It further mandates businesses to weigh the potential impacts that may be derived from termination against the adverse effects they intend to prevent or mitigate.

The limitations imposed by the forthcoming EU Directive for suspending or terminating business relationships if business partners do not comply with the company’s code of conduct may add uncertainty for both businesses and trading partners in their supply processes, e.g., insecurity regarding costs, prices and duration of contractual relationships. This may lead offshore suppliers to switch to partners that do not have to abide by sustainability due diligence standards, or rather to establish the laws of a non-EU Member State as the governing laws to the contractual relationship.

Leveraging contractual mechanisms for redress

Should companies be sanctioned and/or held liable for their lack of due diligence regarding third-party misconduct, they will be able to take legal action against their business partners for failing to adhere to conduct standards as required under their contract. In these cases, companies may seek legal recourse and judicial remedies against these partners for violating the agreed terms of conduct.

Given the typically transnational nature of these types of contracts, it is foreseeable that dispute resolution clauses will include the submission of such disputes to arbitration, with a consequent increase in arbitration proceedings arising from breaches of sustainability and human rights due diligence standards.

Concluding remarks

In light of the increasing due diligence requirements in European jurisdictions in matters concerning sustainability due diligence obligations, it can be expected that these regulatory regimes will have spill-over effects on third parties overseas with whom companies do business.
The following essential implications should be remarked:

Extraterritorial effects of European standards

As discussed above, more heightened sustainability due diligence obligations will be applied by European companies, and the transnational nature of international commerce and value chains will likely result in an extraterritorial effect of European regulatory frameworks. If due diligence norms mandate companies to prevent and monitor any potential adverse effects that are derived from the conduct of third-party entities operating across their value chain, it is likely that European companies will impose these same standards on their business partners

More complex business-to-supplier relationships

The increasing risks that must be borne by companies as a result of due diligence obligations will lead to the formation of more complex relationships with trade partners operating in their value chain. Supply contracts will need to foresee the possibility of companies facing sanctions and/or civil liability for third-party misconduct, even after the termination of the business relationship with their supplier.

Accordingly, companies may decide to include indemnities, as well as the application of penalties to trade partners and the issuance of guarantees and bonds, in order to secure remedies in the case that the company is sanctioned for any contractual breach by their partners. 

Rise in litigation and arbitration

With sustainability-focused litigation gaining momentum in various EU nations, an upsurge in civil liability litigation related to adverse impacts stemming from due diligence obligations is expected to be seen.

Litigation may arise from non-contractual breaches for companies that have failed to abide by their own due diligence obligations, in order to determine the existence of a breach and any damages arising therefrom that must be compensated. But it also may stem from contractual liability, whenever the adverse effects come as a consequence of a business partner’s failure to adequately comply with the contractual terms. 

Ultimately, novel frameworks of corporate due diligence being implemented within the EU will have important implications for both companies based both inside and outside the EU. This will influence corporate behaviour and will make it advisable for companies to review and adapt existing contracts with their business partners, and to update compliance protocols in anticipation of these changes, especially in future proofing against detrimental environmental and human rights outcomes.

1  On 1 June 2023, the European Parliament adopted its position on the Proposal for a Directive on corporate sustainability due diligence and amending Directive (EU) 2019/1937, published by the European Commission on 23 February 2022.