Supply chains – not only an operational issue…

…no, since January 1, 2023, possibly also a legal one: On that day, the “German Act on Corporate Due Diligence Obligations in Supply Chains” came into force. After the pandemic years drastically demonstrated to Western industrial societies the fragility of supply chains – be it due to production losses caused by the Chinese central government’s pursuit of the so-called “no-covid strategy” (here, in German) or the blockade of the Suez Canal by the freighter “Ever Given” (here, in German) – the next tightening of supply chains is now looming, at least in Germany, this time through legal rules.

Background, goals & core principles

With the “German Act on Corporate Due Diligence Obligations in Supply Chains” („Gesetz über die unternehmerischen Sorgfaltspflichten in Lieferketten“, “LKSG“, for an English translation, cf. below) of July 16, 2021, the German government is implementing its perception of the United Nations’ “Guiding Principles on Business and Human Rights” (here) as part of the “National Action Plan for Business and Human Rights” of 2016 ( „Nationaler Aktionsplan für Wirtschaft und Menschenrechte“, here, in German) in Germany. According to this plan, the Act is intended to “oblige companies doing business in Germany above a certain size [to] better fulfill their responsibility in the supply chain with regard to respect for internationally recognized human rights by implementing the core elements of human rights due diligence. This is intended, on the one hand, to strengthen the rights of people affected by corporate activities in supply chains and, on the other hand, to take into account the legitimate interests of companies in legal certainty and fair competitive conditions.” (see Explanatory Memorandum RegE-LkSG, pfd. p. 1).

Accordingly, § 2 LkSG contains a catalog of “protected legal positions”, which are initially derived from the Convention on the Protection of Human Rights listed in the Annex to the LkSG. These roughly include the protection of certain groups of people, such as the prohibition of child labor or prohibitions of discrimination. However, the content of the law is not limited to ensuring compliance with human rights, but also aims to minimize “environment-related risks” in the supply chains of the companies covered (see § 2 (3) LkSG, e.g. in conjunction with § 3 LkSG). This includes, for example, the prohibitions on the deprivation of livelihoods, the causing of environmental pollution or the use of certain chemicals (esp. mercury) and the shipment of hazardous waste.

Under § 3 (1) LkSG, companies are essentially “required to exercise due regard in their supply chains for the human rights and environmental due diligence obligations set out in this section with the aim of preventing or minimizing human rights or environmental risks or ending the violation of human rights or environmental obligations.” The so-called “effort standard” of the LkSG is expressed in this reservation of reasonableness of all due diligence obligations: “The due diligence obligations establish a duty of effort and not a duty of success. Companies do not have to guarantee that no human rights or environmental obligations are violated in their supply chains. Rather, they must be able to demonstrate that they have implemented the due diligence requirements described in more detail in §§ 4 to 10, which are feasible and appropriate in light of their individual context.” (see Explanatory Memorandum RegE-LkSG, pdf. p. 45).

Companies affected & required compliance

Directly covered by the scope of application since January 1, 2023 are companies (regardless of their legal form) that have at least their registered office in Germany and generally employ more than 3,000 employees in Germany, cf. § 1 LkSG with further specifications. The number of employees required for coverage under the LkSG will be lowered to 1,000 employees effective January 1, 2024. However, via the coverage of so-called “direct” (cf. § 2 (7) LkSG) and “indirect” suppliers” (cf. § 2 (8) LkSG), the number of companies actually covered by the scope of the Act is likely to be far greater than the explicitly stated employee numbers would initially suggest. Thus, a “direct” supplier is anyone who is the direct contractual partner of the company covered by the LkSG, insofar as its service or delivery is “necessary” for the production of the goods or provision of the service. “Indirect” suppliers are those who do not have a direct contractual relationship with the covered entity, but to the extent that their service or supply is again “necessary” for the production of the goods or provision of the service. “Direct” suppliers must be included directly in the risk analysis of the covered company in accordance with § 5 LKSG. Pursuant to § 9 LkSG, the company must also set up a complaints system to enable “persons” to point out human rights violations and environmental impairments within the meaning of the LKSG at “indirect” suppliers. Accordingly, the company must also adapt its risk management system to be established pursuant to § 4 LkSG. If the company receives “substantiated knowledge” of possible human rights violations and environmental impairments at an indirect supplier, it must work through the catalog of measures pursuant to § 9 (3) LKSG (risk analysis, preventive measures, remedial measures) and, if necessary, even influence this indirect supplier accordingly. There are no size restrictions for these “direct” or “indirect” suppliers.

The management of companies covered by the scope of application of the Act must observe a large number of due diligence obligations (for a list, see the overview under § 3 LkSG). While the establishment of a risk management system pursuant to § 4 LkSG and the obligation to conduct regular risk analyses pursuant to § 5 LkSG still follow the “normal” structure of a compliance management system, the submission of a “declaration of principles on the human rights strategy pursued by the company” required pursuant to § 6 (2) LkSG is likely to go beyond such normal standards. Although the definition of a company-internal responsibility, for example through the appointment of a human rights officer, is found under § 4 LkSG, similarly also in the German Money Laundering Act (“Money Laundering Officer”), it is clear from the reference to the GWG how extensive the measures to be implemented by the companies covered are likely to be. The obligation to take preventive measures (§ 6 LkSG) and, if necessary, remedial measures (§ 7 LkSG), to set up an “appropriate” internal complaints management system (§ 8 LkSG) and to fulfill extensive documentation and reporting obligations (§ 10 LkSG) “round off” the law.

Public monitoring & sanction mechanisms

The legislator ensures effective enforcement of the LkSG by granting considerable powers to the administratie authorities. Responsible for monitoring compliance with the requirements of the LkSG is the Federal Office of Economics and Export Control (“Bundesamt für Wirtschaft und Ausfuhrkontrolle“, “BAFA“, cf. § 19 LKSG, to the website cf. here), which is subordinate to the German Ministry for Economic Affairs. To this aim, the fourth section of the LKSG (§§ 12 et seq. LKSG) grants BAFA extensive powers. For example, BAFA will evaluate the annual due diligence reports of companies affected by the regulation, it may enter business premises, question personnel and demand the surrender of documents, order measures and publish handouts on interpretations of the law.

Persons affected by human rights violations or environmental pollution as defined in sec. § 2 LkSG may apply to the BAFA for action in accordance with § 14 (1) No. 2 LkSG. If a violation of a duty of care on the part of the company comes into consideration, the BAFA must take action according to dutiful interest pursuant to § 14 (1) No. 2 LkSG; if it remains inactive, the persons affected may file an action for failure to act with the administrative court. Alternatively, the persons affected by human rights violations or environmental pollution within the meaning of § 2 of the LkSG may, pursuant to § 11 of the LkSG, authorize a domestic trade union or non-governmental organization to take legal action to enforce their rights. Finally, according to § 3 para. 3 LkSG, the LkSG does not create a new basis for the enforcement of civil claims of people harmed by human rights violations or environmental pollution, but according to at least parts of the literature, the LkSG should also be observed by German courts (as far as they have jurisdiction) as a standard of obligation in the context of the application of foreign tort law.

(Negligent (!)) violations of the obligations of the LkSG are classified as administrative offenses under § 24 LkSG, which can result in the imposition of substantial fines. Depending on the significance of a due diligence obligation violation, BAFA can impose fines ranging from Euro 100,000 to Euro 800,000. This fine framework also applies personally to business managers and human rights officers acting on their own responsibility who have neglected their duties. For corporations, the maximum amount is increased to EUR 8 million (cf. § 24 (2) sentence 2). If the breach of duty has caused damages, the amount of the fine under § 24 (4) sentence 4 no. 7 depends, among other things, on the extent to which the company has endeavored to make amends. Instead of a fine within the aforementioned framework, a fine of up to two percent of the average (worldwide) annual turnover may also be imposed on legal entities or associations of persons with an average (worldwide) annual turnover of more than EUR 400 million in the event of breaches of the obligation to initiate remedial measures or to implement a corresponding remedial concept.

In addition, under § 22 of the LkSG, BAFA is to exclude such companies from public tenders for a period of up to three years until they have proven that they have cleared themselves in accordance with Section 125 of the ARC and have been legally sentenced to pay a fine of at least EUR 175,000.

Critical appraisal

When evaluating the law in the (popular) economic context, one must first credit the legislator with the fact that the industry’s corresponding self-regulatory capabilities in this area actually appear to be less than effective and efficient (see, by way of example, just here or here, in German). However, even against this background, the question is whether the legislature has not disproportionately interfered with the market economy order with its action. “The civil law expert is amazed, and the antitrust law expert is surprised,” write Ekkenga/Erlemann in ZIP 2022, 49 (here, in German), not entirely without reason: “The liberal-social market order, characterized by the conception of autonomously operating suppliers and consumers, is to be drastically curtailed in large parts, if not abolished. The purchase, work supply or service contracts with the service providers are now flanked by legally shaped principal-agent relationships, in which the demanders not only provide remuneration services, but also become encroachers in the truest sense of the word by assuming police functions of ecological and humanitarian danger prevention vis-à-vis the providers.” The Wirtschaftswoche sounded a similar horn when it wrote back in September 2021, “The Supply Chain Act is deficient on at least two levels. It places an original government task in the hands of companies. And it is based on normative, scientifically unfounded value judgments that must be rejected from the perspective of utilitarianism and libertarian property ethics.” (here, in German).

Also, the “legal certainty for German companies” expressly desired by the legislator (see quote above) is likely to manifest rather wishful thinking in view of the vague standards specified by the law itself, especially for the “duty of care”, because the fulfillment of the due diligence obligations within the framework of what is appropriate is to be determined concretely for the respective supply chain relationship, whereby the requirements for the adequacy proviso remain largely undefined – and thus at the discretion of BAFA and subsequently the courts (see already the constitutional concerns of the German Lawyers’ Association, here, in German).

In addition to the legal and technical criticism of the structure of the law, there is the further practical question of whether the legislator has not imposed a considerable competitive disadvantage on the German economy with this law, contrary to its own intention. For example, a managing director of the Strabag Group recently declared, “We are ending the classic construction business in Africa” (here, in German), because the risks that could be incurred by the entire Group as a result of a violation of the LkSG would, in the view of the company’s management, not be in proportion to the sales generated on the continent. Business associations also raised doubts about BAFA’s announced implementation of the LKSchG with a “sense of proportion” (here, in German).

Finally, the question arises whether human rights violations and environmental damage will actually be minimized with the help of the LkSG. The Handelsblatt (here, in German) already expressed doubts about this with regard to the circumstances of the construction activities on the occasion of the Soccer World Cup in Qatar. However, such doubts also appear to be justified because it is precisely the business community that is being “forced to face” the very task that was previously certified as not having cut a good figure in the prevention and elimination of grievances.

Further development

However, this criticism is unlikely to persuade the German government to rethink its principles: Although the German government committed in its draft legislation at the time to evaluating the LkSG by June 30, 2026, it did so only with regard to the achievement of human rights protection in supply chains or the extent to which the legal regulation at the national level creates legal certainty for German companies (see RegE-LkSG, pdf. p. 34). In addition, it is to be evaluated by June 30, 2024 – also in light of European legal developments (see below) – whether the personal scope of application of the standard should be adjusted by lowering the threshold of company size categories. These formulations alone do not lead us to expect that the concerns outlined above regarding regulatory problems or the economic impact of the regulations on German companies will be taken into account in the evaluation, or that at least the scope of companies covered by the LkSG will be narrowed in the future after all.

This is also against the backdrop of the European Union currently launching its own directive: In February 2022, the EU Commission presented a proposal for an EU directive on due diligence obligations for companies in the area of sustainability (more information here), which in some cases even goes further than the German regulation that has just come into force. For example, the number of companies directly covered by the directive is likely to be even higher than under the LkSG, if only because the number of employees required for this in so-called “high-risk sectors” is to be reduced to just 250. The draft also provides for covered companies to be required to draw up a plan to ensure that the company’s business model and strategy are in line with the Paris Agreement on limiting global warming to 1.5 degrees Celsius. The current timeline is for the directive to enter into force in 2023 at the earliest, but with a two-year transition period.

Effects & assistance for medium-sized companies

In view of the fact that the LkSG also covers so-called “indirect” suppliers, irrespective of their respective size, a large number of companies, including smaller SMEs, are likely to find themselves unexpectedly within the scope of the Act. Perhaps they are not aware of it at present, but in the course of the year at least some of them are likely to receive forms for so-called “declarations of conformity” from business partners. Signing these declarations is supposed to confirm “conformity” (compliance!) with the goals and obligations of the LkSG. So far, so bad, at least if these companies are not themselves aware of their downstream supply chains. Consequently, a “domino effect” is likely to emerge in the course of the year – with declarations of conformity being “passed through” in each case. How reliable these declarations can be without the “back-up” of an own at least cursory investigation of the circumstances of the respective supplier / service provider (see here on the “KYC” process) is likely to be shown by future court decisions.

The BAFA has already provided further information on the Internet in the run-up to the entry into force of the LkSG and published several “handouts” (here, in German). In addition, the German Federal Ministry of Labor and Social Affairs offers further implementation aids under “CSR in Germany” (here, in German). However, these working aids – as well as this post – can only serve as a first entry point into a more in-depth professional discussion of this topic. “In view of the actual and legal complexity and indeterminacy of the terms used in setting up the structures, it makes sense to have external support from legal experts,” as a well-known law firm recently said in a presentation.

German Act on Corporate Due Diligence Obligations in Supply Chains of July 16, 2021

Gesetz über die unternehmerischen Sorgfaltspflichten in Lieferketten, BGBl. I, 2021, S. 2959 (in German)
RefE-LkSG – pdf here (in German)
RegE-LkSG – pdf here (in German)

EU-Commission, Proposal for a Directive on corporate sustainability due diligence and annex

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