An introduction to the German Supply Chain Due Diligence Act

On January 1, 2023, the German Supply Chain Due Diligence Act (Lieferkettensorgfaltspflichtengesetz) (hereinafter, “LkSG”) took effect, imposing certain obligations on covered organizations with respect to the conduct of due diligence implicating adverse environmental and human rights impacts in supply chains. Broadly applicable to companies organized under German law and with a physical presence in Germany, the LkSG requires companies to both identify and rectify certain specified abuses by either preventing or minimizing them altogether or bringing them to a complete end, once identified. The LkSG is the latest in a litany of new supply chain regulations that collectively seek to hold companies accountable for the perpetuation of environmental degradation and activities that violate the inherent dignity of the human person.

Human rights and environmental impacts defined

For the purposes of the LkSG, the phrase “human rights and environmental risks” is intentionally expansive. On the human rights side, these risks include: (1) any form of forced labor, including child labor, human trafficking, slavery and torture; (2) disregard for occupational safety and health obligations; (3) obstruction of the worker’s right to freely associate (i.e., join and participate in trade unions); (4) discrimination in employment, to include application of policies or practices that result in unequal pay; (5) withholding of an adequate living wage; (6) contributing towards pollution that is detrimental to a person’s health; (6) unlawful eviction and seizure of land or water that provides livelihoods; (7) utilization of so-called “security forces'' by a covered entity or direct supplier that results in cruel, inhumane or degrading treatment; and (8) any act or omission that seriously impairs the rights of a protected legal position as designated in the LkSG’s annex. Conversely, acts of environmental degradation include: (1) unlawful manufacturing of mercury-based products, including the utilization of mercury and related compounds in manufacturing processes; (2) unlawfully producing and utilizing identified chemical pollutants; (3) unsound handling, collection, storage and disposal of waste; and (4) illegal exportation/importation of hazardous and other waste.

LkSG requirements in brief

The LkSG broadly requires certain covered entities—namely, all forms of commercial enterprises that have their primary operations or a base in Germany, and at least 3,000 employees—to establish and maintain an effective supply risk management system. The risk management system in question consists of: (1) the appointment of a responsible official with authority to oversee the organization’s due diligence efforts; (2) conducting regular risk analyses; (3) adopting a human rights strategy and accompanying policy statement; (4) taking appropriate remedial action in response to identified abuses; (5) implementing and maintaining a system to receive complaints that enables persons to identify both risks and potential violations; (6) take certain actions with respect to a covered entity’s indirect suppliers; and (7) document and report (on an annual basis) the entity’s efforts with respect to each of the foregoing.

Perhaps the most important attribute of the LkSG is the specific requirement that it imposes on covered entities to conduct regular due diligence risk analyses consistent with the requirements of Section 5. Pursuant to that section, covered entities are now legally obliged to identify both human rights and environment-related risks in the context of its “own business area” and at the level of its “direct suppliers.” Identified risks are to be “weighted and prioritized” consistent with: (1) the nature and extent of the covered entity’s business activities; (2) the ability of the covered entity to influence the party directly responsible for a risk or violation contractually or otherwise; (3) the severity of the violation, its potential reversibility, and the probability of recurrence; and (4) the nature of the “causal contribution” of the covered entity to the risk or violation. Once conducted, the risk analyses must be communicated internally to all relevant “decision-makers” including the enterprise’s board of directors and its procurement/purchasing team, among others. Pursuant to Section 5(4) of the LkSG, risk analyses in relation to human rights abuses and environmental threats must be conducted at least one per year and on an ad hoc basis “if the enterprise . . . expect[s] a significantly changed . . . or expanded risk situation in [its] supply chain” as a result of the introduction of new projects or entry into a new business field.

But the due diligence required by the LkSG is more expansive than the mere identification of potential threats and actual violations. Pursuant to Sections 6 and 7 of the LkSG, covered entities are also obliged to adopt preventive measures and remedial actions with respect to identified risks and actual abuses. For the purposes of LkSG Section 6, such preventative measures are required both with respect to the entity’s own business activities and those of its direct suppliers. In considering what preventative measures to adopt with respect to its own activities, Section 6(3) specifies that the organization must: (1) faithfully implement the human rights strategy articulated in the organization’s policy statement by adjusts business processes to account for the importance of such considerations; (2) develop and implement procurement strategies and purchasing practices that prevent or minimize identified risks; (3) deliver relevant training to the covered entity’s personnel in business areas prone to interact with parties known to pose a potential human rights or environmental risk; and (4) adopt risk-based control measures to verify compliance with the human rights strategy articulated in the policy statement. Similar obligations are imposed on a covered entity’s direct suppliers, although as a practical matter, Section 6(4) recognizes the inherent difficulty of procuring a third party’s voluntary compliance with the LkSG’s due diligence obligations by allowing covered entities to rely primarily on contractual assurances, supplemented by initial and further training measures, and mutually acceptable control mechanisms to verify compliance by the direct supplier with its obligations to the covered entity. Notably, Section 6(5) requires covered entities to review the overall effectiveness of their preventative measures at least once per year and more often if the commercial circumstances faced by the covered entity so warrant.

A covered entity that discovers actual violations in the form of environmental degradation or human rights abuses is further obliged by LkSG Section 7 to take immediate action to end or minimize the extent of the violation. If the violation occurs in the entity’s own business area within the physical bounds of Germany, the law is clear that the violation must be ended at once. The obligation to take remedial action extends to both the entity itself and to its direct suppliers. If a violation at the direct supplier level is incapable of immediate cessation, then Section 7(2) requires the entity to “draw up and implement” a roadmap for ending or minimizing the violation “without undue delay.” Such a roadmap must include a “concrete timetable” for ending or minimizing the violation, along with a description of the efforts taken by both the covered entity and direct supplier on a collaborative basis to effectuate cessation or mitigation. Consideration must also be given by the covered entity to “joining forces with other enterprises in sector initiatives” to exert collective pressure on the direct supplier to end or minimize the violation in question and to temporary suspension of business activities with the direct supplier. Termination of a direct business relationship is a last resort and required under the LkSG only if the human rights-related violation involves a protected legal position or if the environmental violation is “assessed as very serious.” Termination is also appropriate in circumstances where the implementation of remedial measures has proven to be ineffective and the covered entity has no other “less severe” means at its disposal to end or minimize the abusive practice.

While the principal aim of the LkSG is the commercial activities of covered entities and their direct suppliers, organizations also have certain obligations with respect to the activities of their indirect suppliers when the covered entity has “actual indications” (substantiated knowledge) that suggest a violation of a specified human rights-related or environment-related obligation. Under those circumstances, covered entities are obliged by LkSG Section 9 to carry out a risk analysis, adopt appropriate preventative measures (including control measures and the provision of support for the prevention/avoidance of the risk), and devise and implement a prevention, cessation or minimization plan.

LkSG oversight and penalties for non-compliance

Enforcement of the LkSG is legislatively delegated to Germany’s Federal Office for Economic Affairs and Export Control (“BAFA”). Among other things, BAFA has the authority to monitor a covered entity’s compliance with its due diligence obligations respecting human rights and environmental considerations and detect, end and prevent violations by issuing “appropriate and necessary orders” in an administrative context. This includes the ability to summon people and require entities and persons to furnish documentation with respect to affiliated enterprises, direct and indirect suppliers, as well as to require covered entities to submit to corrective action plans and/or take “specific action” aimed at the satisfaction of its legal obligations. Failure to comply with the LkSG’s substantive provisions—either intentionally or negligently—can lead to the imposition of significant financial penalties of up to EUR 800,000. Moreover, for financial penalties exceeding EUR 175,000, a covered entity can be excluded from participation in public procurement activities.