Betty M. HuberGlobal Co-Chair of Latham & Watkins' Environmental, Social, and Governance (ESG) Practice
Paul DaviesPartner, Latham & Watkins, Global Co-Chair of ESG
In February 2022, the European Commission adopted a proposal for the Corporate Sustainability Due Diligence Directive (CS3D). The Commission proposal, which is intended to foster sustainable and responsible corporate behavior across companies’ global value chains, is part-way through the EU’s legislative process, with the Council and Parliament also now having each issued their initial positions on the CS3D, and the Commission, Council and Parliament set to negotiate a final version over the coming months.
This blog refers to the requirements outlined in the Commission’s proposal, unless stated otherwise. The proposal goes further than most current EU and US sustainability requirements, which often focus on disclosure or are sector-based. CS3D would effectively require subject companies to consider potential human rights and environmental impacts in their operations and corporate governance.
Betty Moy Huber and Paul Davies from Latham’s ESG practice joined Watershed to share an overview of the CS3D Commission proposal and what it could mean, in particular, for U.S. companies subject to it directly or indirectly.
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Betty Moy Huber is a Partner in Latham’s Corporate Department based in New York and Global Co-Chair of its Environmental, Social and Governance (ESG) practice. Drawing on over 25 years of experience, Ms. Huber advises boards, corporations, funds and other clients on ESG risk, strategy, disclosures and other regulatory matters.
Paul Davies is a Partner in Latham’s London office and also Global Co-Chair of its ESG practice. Mr. Davies advises a broad range of clients on the ESG aspects of global corporate transactions and provides ESG strategic and regulatory advice to companies across sectors and geographies.
What is the CS3D due diligence directive?
The CS3D Commission proposal establishes a corporate due diligence duty. The focus of such duty would introduce requirements for companies to integrate due diligence into their policies and to identify, end, prevent, mitigate, and account for the actual and potential negative human rights and environmental impacts of their activities. Companies would be required to conduct due diligence on their own activities as well as those of their subsidiaries and other relevant entities in their value chain with which they have an established business relationship.
As proposed companies may need to develop and implement “prevention action plans,” obtain contractual assurance from direct business partners that they will comply with these plans and verify compliance with them.
The Commission’s proposal imposes a range of new obligations on company directors, rooted in a duty of care. It clarifies that directors’ duties include how “directors are expected to comply with the duty of care to act in the best interest of the company.” Article 25 and 26 of the Commission proposal introduces a need to take account of the consequences of their decisions for sustainability matters (including, where applicable, human rights, climate change and environmental consequences) in the short, medium, and long term into the directors’ duty to act in the best interest of the company. Further, directors would be required to put in place and oversee the relevant due diligence processes.
Which entities are covered by the CS3D?
Under the Commission’s proposal, CS3D would cover about 13,000 EU companies and about 4,000 non-EU companies. In particular, per the Commission proposal, EU companies will be subject to CS3D if they fall in one of two groups:
- Group 1 (c. 9,400 companies): 500+ employees and €150M worldwide turnover
- Group 2 (c. 3,400 companies): 2 years later, companies in high impact sectors with 250+ employees and €40M turnover worldwide
Non-EU companies will be subject to CS3D if they have a significant EU presence:
- Non-EU companies (c. 2,600 in Group 1 and c. 1,400 in Group 2): Active in the EU with turnover threshold aligned with Group 1 and Group 2 generated in the EU
Small and medium-sized enterprises (SMEs) and micro enterprises would not be directly in scope of the proposal as currently drafted; however, the proposal acknowledges that SMEs and micro enterprises may nonetheless be “exposed to some of the costs and burden” imposed by CS3D as large in-scope companies are expected to pass on demands to their suppliers.
These thresholds are subject to the legislative negotiation process, so they may change. For example, in its recently agreed negotiating position, the Parliament proposed lowering the thresholds for non-EU companies, bringing more into scope. The Commission proposal cites as its rationale for subjecting non-EU companies directly, that large companies with “high turnover” in the EU have the capacity to conduct due diligence and due to that EU turnover, the “effects that the activities of these companies may have on the EU internal market …is sufficient for the Union law to apply to third-country companies.”
What is the timeline of the CS3D?
Although negotiations are underway, it is unclear when the final CS3D directive will be published. Once the CS3D is published, Member States will have two years to transpose CS3D into their domestic legislation.
The Commission’s proposal would apply to the largest companies two years after CS3D is entered into force. However, the European Council’s negotiating position would give the largest companies one additional year to comply with the rules after Member States have transposed CS3D into their domestic legislation, or three years from CS3D’s entry into force, which would be approximately 2030 based on current projected timelines.
Environmental adverse impacts and the need for a transition plan
Examples of the adverse environmental impacts that companies are expected to identify, prevent or mitigate can be found in the Annex to the Commission’s proposal. They include violations of a range of international environmental conventions.
More specifically, Article 15 of the proposal introduces a very tangible environmental requirement on certain in-scope companies – that they adopt a plan to ensure that the business model and strategy of the company are compatible with the transition to a sustainable economy and with the limiting of global warming to 1.5 °C in line with the Paris Agreement. This plan, commonly referred to as a transition plan, must identify, on the basis of information reasonably available to the company, the extent to which climate change is a risk for, or an impact of, the company’s operations.
The European Parliament’s proposed version goes even further – setting out transition plan requirements in greater detail, and introducing a requirement for companies with more than 1000 employees to tie any directors’ variable compensation to company performance against transition plan targets.
How will the CS3D be enforced?
- As the proposal, once finalized, will be a Directive, each of the twenty-seven EU Member States will be required to designate one or more supervisory authorities for CS3D. These national authorities will comprise the European Network of Supervisory Authorities, which entity will facilitate cooperation and information sharing between national regulators, and where appropriate, coordinated enforcement and supervisory action on cross-border companies.
- Civil liability: Member States are to ensure victims can bring claims for compensation for damages suffered as a result of failure to comply.
- Article 22 of the Commission proposal, if finalized, would introduce a new civil liability regime. Subject entities would be liable for failure to comply with the mandated due diligence obligation. Specifically, companies would be liable for damages if as a result of a company’s failure to meet its due diligence duty, an adverse impact that should have been identified, prevented or mitigated or brought to an end or minimized occurred leads to damage.
- The new liability standard could be leveraged by parties such as nongovernmental organizations (NGOs) to bring further litigation against multinational companies. ESG litigation is notoriously complex, costly and long running and there is increasing precedent for claims being brought. This can cause reputational damage and can take considerable management time.
- The rules of directors' duties would be enforced through existing Member States' laws. The Commission’s proposal does not include an additional enforcement regime in case directors do not comply with their obligations. However, there are currently different approaches between the European Council, European Parliament, and European Council on whether to include provisions on directors’ duties in CS3D.
What US companies should do now to prepare
Given that CS3D are effectively three different proposals that are being worked on in real time, non-EU companies should track developments with respect to CS3D closely.
Companies can begin familiarizing themselves with the proposed requirements and what steps they would need to take to be ready to comply with the directive once finalized.
