Contractual Strategies for Implementing Corporate Due Diligence into Global Supply Chains

2024 has seen some significant regulatory developments which relate to environmental, social and governance (ESG) considerations in supply chains and business practices. These new regulations are important because companies have traditionally only been accountable for ESG considerations within their own operations, not necessarily for their subsidiaries and downstream partners. For due diligence to have any meaningful impact, it needs to consider the human rights and environmental impacts throughout the life-cycle of production, distribution and ancillary activities. Whilst new regulations will require companies to undertake due diligence and governments are able to impose liability for non-compliance, there still remains a question mark on how to achieve due diligence in practical terms. Essentially, this will require contractual assurances from business partners and measures to ensure compliance. Yet little is available on what these contractual mechanisms will look like. The following will look at contractual strategies for implementing ESG due diligence in relation to key regulatory developments.

1. Recent Regulatory Developments:

EU Corporate Sustainability Due Diligence Directive (CSDDD)

The most noteworthy development has been the approval of the EU Corporate Sustainability Due Diligence Directive (CSDDD or the Directive (EU) 2024/1760). The Directive will impose a duty on certain companies to undertake human rights and environmental due diligence as well as adopting and putting into effect a transition plan aligning the company with limiting global warming to 1.5 degree celsius. While many EU companies already have sustainability reporting requirements under the Corporate Sustainability Reporting Directive (CSRD or Directive (EU) 2022/2464); the CSDDD will apply to larger companies in high-risk sectors and will require proactive management of ESG impacts. Notably, directors of a company will have an enhanced duty of care to implement the CSDDD at a board level, which can open them up to increased risks that should be mitigated by good sustainability best practices.

The CSDDD acknowledges that implementation of due diligence will require obtaining contractual assurances accompanied by other contractual mechanisms with business partners, while Member States should also ensure that businesses have means for terminating relationships through their laws governing contracts. To this end, Art 18 of the CSDDD provides that the Commission shall adopt guidance about voluntary model contractual clauses, by 26 January 2027.

UK Sustainability Disclosure Standards (SDS)

To date, UK has only provided policy guidance specifically for financial products in relation to sustainability reporting (see Policy Statement PS23/16), but is developing SDS for companies on ESG and climate-related risks. The SDS framework will likely inform legislative reporting requirements for large or listed UK businesses to report under the UK SDS. The UK SDS will be based on the International Sustainability Board’s (ISSB) IFRS® Sustainability Disclosure Standards. According to the government’s latest update, it aims to make the UK-endorsed ISSB standards available in the first quarter of 2025. Like the EU’s CSDDD, the ISSB requires that companies report on scope 1, 2, and 3 emissions, additional non-climate sustainability and ESG reporting disclosure, and submit a detailed transition plan outlining how they are aligned with net-zero pathways. Like the CSDDD, companies will have to leverage their sustainability performance using contracts to implement ESD due diligence in their supply chains.

2. Contract Governance Strategies for Sustainable Supply Chains:

Traditional contract remedies are presently available to companies to govern their relationships with buyers, suppliers, and subcontractors. However, it is becoming increasingly clear that new types of contractual clauses are needed for a network approach to contracts. Recent case law has pointed out some of the flaws in trying to control buyer behaviour in relation to third parties.¹ However, until the EU Commission or the UK Sustainability Disclosure Technical Advisory Committee consider appropriate contractual clauses, there is little guidance on what steps to take. Fortunately, a team of professionals and academics have collaborated to found the Responsible Contracting Project (RCP) which is currently housed in Rutgers Law School’s Center for Corporate Law and Governance. In addition to the RCP, another group of professionals have collaborated to provide a Climate Clause Bank for many economic sectors, known as The Chancery Lane Project (TCLP). The RCP focuses on sustainability and human rights more broadly, while TCLP has a very narrow focus on achieving net zero and climate change mitigation with specific transactional settings.

Here are some of the key takeaways for contractual strategies for ESG due diligence.

a. Incorporate Shared Responsibility Commitments

Companies are not only required to conduct due diligence in their own activities, but in their chain of activities. This requires that the parties to a contract acknowledge their shared responsibility in a spirit of good faith and cooperation. Traditionally, contract law encourages parties to view each other in mutual opposition and to maximize individual benefit over the benefit of external factors, like the environment or the human rights of third parties. This will need to change as parties should avoid simply shifting responsibility or having one-sided obligations. The RCP provides a model clause for, “Mutual Obligations with Respect to Combatting Abusive Practices in Supply Chains”,² which requires that parties take a more collective responsibility for all ‘ agents and all subcontractors, consultants and any other person providing staffing for Goods’.

TCLP also provides a number of clauses to express the shared commitments between parties to net-zero, particularly through the use of preambles which they call “recitals” – both refer to clauses set out at the very beginning of a contract. An example of a climate recital is that, “The parties [have signed up to the Race to Zero and] acknowledge their common intention to:

(1) achieve their respective [decarbonisation OR net-zero] targets; and

(2) align with the objectives of the UNFCCC’s Paris Agreement…”

b. Include commitments to remediate adverse impacts, do not include immediate termination rights, but rather provide responsible exit clauses

This is linked to cooperative behaviour as opposed to more punitive measures. However, this point relates in particular to the CSDDD as contracts should be aligned with the spirit of the Directive which states that contractual termination due ESG-related reasons should be a last resort. Remediation should be available upon Notice where one party has reason to believe that the other party has breached a due diligence obligation. The breach should be investigated and a remediation plan submitted by the offending party. Parties can also agree to events that might trigger a commercial right to cure upon notice. The right to terminate should be reserved for certain “zero-tolerance” activities only. The RCP clauses envision a far more equal bargaining relationship between parties, and as such, unfair terms should be avoided. This stands somewhat in contrast to TCLP which provide immediate supplier termination clauses for reasons including:³

• A greener supplier has been found in good faith

• Using an alternative supplier will reduce the customer’s carbon footprint

• The supplier’s environmental activities have bought the customer’s reputation in to dispute

• The supplier acts in a way that reasonably justifies it inconsistent with good environmental practice and policy

Ultimately, companies will have to decide how punitive they wish to be. Provided that term is not unreasonable in accordance with contract law legislation, they are free to do so.

c. Fully consider your purchasing practices from day one

The RCP advises that purchasing practices should be adjusted to prevent and correct adverse practices. This means that where purchasing practices are likely to increase risk, the contractual terms should be adjusted. E.g. if it becomes apparent that the price agreed for a purchase order of textiles cannot reasonably include the costs fair working wages in your supplier’s factory, you should consider adjusting the price to be compliant with the CSDDD. Parties should adapt existing commercial clauses accordingly, and also agree to new shared due diligence commitments. E.g This could require that your supplier discloses certain information relevant to the commercial terms such as working conditions and living wages.

Purchasing practices may also be better informed through the use Due Diligence Questionnaires. TCLP has a Climate Change Change Due Diligence Questionnaire that poses questions so that buyers can reduce risk by using such information to seek appropriate climate warranties and indemnities from the seller.⁴ Companies can also use price adjustments and interest ratchet clauses to control the risks associated with purchasing practices and incentivise better performance.

References

1 Begum v Maran (UK) Ltd [2021] EWCA Civ 326.

2 RCP, Model Contract Clauses to Protect Workers in International Supply Chains, Version 2.0 (2021)

3 TCLP, Katie and Ben’s Clause ‘Termination for Greener Supplier’ (2023) https://chancerylaneproject.org/clauses/termination-for-greener-supplier/

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