With effect as from January 1, 2023, the German Supply Chain Act dated July 16, 2021 (Gesetz über die unternehmerischen Sorgfaltspflichten in Lieferketten – Lieferkettensorgfaltspflichtengesetz) will enter into force.
Undertakings of a particular size shall take responsibility for, and implement diligence standards with respect to, human rights-related and environmental risks in supply chains. An undertaking which is subject to the German Supply Chain Act, but not in compliance with the requirements stipulated thereunder, may face significant sanctions.
Scope of Application
Personal Scope of Application – Which Undertakings are In Scope?
The German Supply Chain Act applies to any undertaking, irrespective of its legal form, which has its head office, principal branch, administrative headquarter or registered seat in Germany and employs at least 3,000 employees in Germany on a regular basis (including employees seconded abroad). Employees in Germany of affiliated companies are taken into account when calculating the headcount of the parent entity.
In addition, the personal scope of application of the German Supply Chain Act extends to undertakings, irrespective of their legal form, with a branch established in Germany and having at least 3,000 employees working in Germany on a regular basis.
As from January 1, 2024, the (initial) headcount threshold of 3,000 employees will be lowered to 1,000 employees. This change will considerably enlarge the scope of application of the German Supply Chain Act, since affiliated companies’ employees will (continue to) be counted towards the headcount of, and therefore attributed to, the parent entity. In addition, further reductions of the (lowered) headcount threshold shall be evaluated by mid-2024.
Material Scope of Application – Which Activities are In Scope?
The name of the German Supply Chain Act says it: The new regulation covers an undertaking’s supply chain in its entirety, including all products and services of the undertaking, and all steps (in Germany and abroad) that are required to manufacture the relevant products and to provide the services, from the extraction of the raw materials to the delivery to the end customers.
Actions of an undertaking in its own business, as well as actions of direct and indirect suppliers fall within the scope of the German Supply Chain Act. As regards affiliated companies, in case the parent entity has decisive influence on an affiliated company, such affiliated company will be considered as part of the parent entity’s own business.
Diligence Obligations and Appropriate Measures
Under the German Supply Chain Act, an undertaking is obliged to exercise diligence in its supply chain with respect to human rights and environmental matters in order to identify, prevent and mitigate human rights-related and environmental risks, and to eradicate infringements of human rights-related and environmental obligations.
In particular, the German legislator envisages to prevent child labor, forced labor and unequal treatment in employment, and to preserve the employees’ right to organize and bargain collectively, occupational health and safety as well as appropriate remuneration standards (including minimum pay). Further, the German Supply Chain Act intends to avert environmental risks.
What’s to be done – Overview of the Diligence Obligations
Undertakings shall take appropriate efforts to address, and deal with, human rights-related and environmental risks and deficiencies in supply chains. The German government’s reasoning particularly expresses that undertakings must only prove their compliance with the diligence obligations stipulated under the German Supply Chain Act, but are not required to warrant the absence of any infringements of human rights-related and environmental obligations in their supply chains.
The diligence obligations are recognized to be, and therefore structured as, long-term obligations, which are built upon, and relate to, one another, including, inter alia:
- Implementation of a risk management system;
- Conduct of risk analysis (on a regular basis);
- Implementation of a complaints procedure;
- Preventive and corrective measures; and
- Documentation and reporting.
The appropriateness of the efforts (and measures) to be taken depends on the manner and scope of the undertaking’s business activities, the undertaking’s control and influence, the risk potential (i.e., the severity, reversibility and likelihood of an infringement), and the undertaking’s contribution to the risk or infringement.
How to identify Risks and Infringements – Risk Management System, Risk Analysis and Complaints Procedure
The risk management system (including the risk analysis) shall form part of the relevant business processes, enable the undertaking to monitor its supply chain and relevant business processes, help to identify and assess relevant risks, and, therefore, create a solid basis for an undertaking’s compliance with its diligence obligations (in particular, the identification of situations where preventive or corrective measures should be enacted). An undertaking shall procure for an internal allocation of responsibility (e.g., by appointing a human rights officer).
As the undertaking’s access, control and influence differ throughout the supply chain, the risk analysis relates primarily to the undertaking’s own business and its direct suppliers.
- The risk analysis with respect to the undertaking’s own business and its direct suppliers must be conducted at least once a year and as warranted (in particular, in case of significant risk changes (e.g., by introducing new products or launching new projects)).
- The obligation to perform a risk analysis may also apply to indirect suppliers, in case there are actual indications that human rights-related or environmental obligations might be infringed by an indirect supplier.
In case of an improper structuring of the direct supply relationship or any evasive transaction to circumvent diligence obligations with regard to direct suppliers, an indirect supplier will be considered as direct supplier for purposes of the risk analysis (and also with respect to the diligence obligations). For instance, this might be the case if an intermediary is interposed, who formally acts as direct supplier, but does not conduct any relevant business activities or does not have a permanent representation in the form of business premises, personnel or equipment.
The (internal or external) complaints procedure functions as an (additional) instrument to gather information by providing a point of contact for individuals to address, and point the undertaking to, potential human rights-related or environmental risks and infringements, either in the undertaking’s own business, or at its direct or indirect suppliers. Any findings resulting from such procedure shall be given consideration in the undertaking’s risk analysis, and when assessing the effectiveness of preventive or corrective measures. The effectiveness of the complaints procedure itself shall be reviewed at least once a year and as warranted.
How to address and react to Risks and Infringements – Preventive and Corrective Measures
Preventive measures shall counteract risks associated with an undertaking’s supply chain. An undertaking shall implement appropriate preventive measures for its own business and its direct suppliers, with a focus on those areas that are (most) relevant with respect to human rights-related and environmental risks. In particular, such prevention relates to, and affects, the undertaking’s implementation, structuring and conduct regarding procurement strategies, purchasing practices, supplier selection, contractual commitments of suppliers to comply with the undertaking’s diligence obligations (and, as the case may be, to forward the relevant obligations in the supply chain), training sessions and control mechanisms.
As part of the preventive measures, the undertaking’s management must issue a declaration of principles concerning its human rights strategy, including, inter alia, information on the procedures through which the undertaking fulfills its obligations under the German Supply Chain Act. This declaration shall provide the basis for an undertaking’s (continued) development of (internal and external) conduct guidelines, as well as for contract drafting and negotiations.
If the undertaking becomes aware that an infringement of human rights-related or environmental obligations in its own business or at a direct supplier has occurred or is imminent, it must without undue delay take appropriate corrective measures to prevent, to terminate or to mitigate the infringement. As is the case for the risk analysis, an indirect supplier will be considered as direct supplier if there is an improper structuring of the relationship with a direct supplier or any circumvention measure to avoid diligence obligations concerning direct suppliers.
- In case an infringement takes place in the undertaking’s own business in Germany, given the undertaking’s existing control and influence, and its contribution to the infringement, the corrective measures must result in the termination of the infringement. If the infringement occurs at the undertaking’s own business outside of Germany or at an affiliated company that, due to the undertaking’s decisive influence on such company, is considered to form part of the parent entity’s own business, the corrective measures must generally result in the termination of the infringement.
- In case of an infringement takes place at direct suppliers that cannot be terminated in due course, the undertaking must without undue delay create and implement a concept to terminate the infringement, which may also comprise the cooperation with other undertakings. If the relevant direct supplier does not act in accordance with the requirements set forth in the remediation concept, the undertaking shall temporarily suspend the business relationship. If severe infringements are at issue and there are no other (more lenient) alternatives, the last resort might even be the termination of the business relationship with the relevant supplier.
The effectiveness of preventive or corrective measures, respectively, must be reviewed at least once a year and as warranted (in particular, in case of significant risk changes). If needed, the measures shall be updated and revised without undue delay.
As regards indirect suppliers, given that the undertaking’s possibilities of exerting influence are limited, the German Supply Chain Act provides for a different approach: If an undertaking becomes aware of actual indications that an infringement of human rights-related or environmental obligations at an indirect supplier might be possible (substantiated knowledge), it must – without undue delay and as warranted – conduct a risk analysis, take appropriate preventive measures with respect to the originator (such as control measures or support), create and implement a remediation concept and, as the case may be, amend the declaration of principles concerning its human rights strategy.
How to show Compliance – Documentation and Reporting Obligations
An undertaking subject to the German Supply Chain Act must document (internally) its compliance with the diligence obligations on an ongoing basis. The relevant documentation is necessary to prove compliance and needs to be retained for seven years.
Once a year, the undertaking has to prepare a report about its compliance with the German Supply Chain Act. This report has to be published no later than four months following the end of its financial year on the undertaking’s website (for a term of seven years). The reporting obligation shall enhance transparency and provide the basis for governmental control. The report must at least comprise information on
- whether (and which) human rights-related or environmental risks or infringements have been identified;
- which measures have been taken by the undertaking to comply with its diligence obligations;
- how the undertaking views and assesses the impact and effectiveness of the measures; and
- which consequences the undertaking draws from the assessment for future measures.
In case of intentional or negligent violations of an undertaking’s obligations under the German Supply Chain Act, depending on the concrete infringement, the German Federal Office of Economics and Export Control (Bundesamt für Wirtschaft und Ausfuhrkontrolle) may impose a fine of:
- up to EUR 8 million; or
- up to two percent of the average annual turnover, in case of undertakings with an average annual turnover of more than EUR 400 million.
In the latter case, the global turnover of all undertakings that together with the relevant undertaking form an economic unit will be taken into account.
In addition, an undertaking may be excluded from public procurements in Germany for a period of up to three years, in case a fine of at least EUR 175,000 is imposed.
Further, an administrative penalty payment of up to EUR 50,000 may be imposed on an undertaking to procure for enforcement of administrative acts based on the German Supply Chain Act.
The German Supply Chain Act sets new standards regarding diligence obligations with respect to supply chains. It is to be expected that further steps in this field will be taken in due course.
The German government explicitly stated that the protection of human rights constitutes a long-term task, and that the effectiveness of the newly implemented provisions will be further evaluated. In particular, a further lowering of the headcount threshold shall be evaluated by mid-2024.
Also, on a European level, the diligence in supply chains shall become a greater focus of attention. In March 2021, the European Parliament adopted a resolution with recommendations to the European Commission on corporate due diligence and corporate accountability, also comprising recommendations for drawing up a EU Directive in this respect. According to the European Parliament’s resolution, diligence obligations shall apply to (i) large undertakings governed by the law of a EU Member State or established in the territory of the EU, (ii) all publicly listed small and medium-sized undertakings as well as high-risk small and medium-sized undertakings, and (iii) large undertakings, publicly listed small and medium-sized undertakings and small and medium-sized undertakings operating in high risk sectors, which are governed by the law of a third country and not established in the territory of the EU when they operate in the EU market selling goods or providing services. It remains to be seen which scope of application will be set forth in the draft Directive of the European Commission that is expected for spring 2022. However, it appears likely that the scope of such EU Directive will stipulate diligence obligations similar to those introduced by the German Supply Chain Act (which was already drafted with an eye to the developments on the European level).
Undertakings should assess, and – on an as needed basis – improve their handling of human rights-related and environmental risks in light of the provisions of the German Supply Chain Act. In this respect, efficient use of the lead times given under the new law should be made. Non-compliance will not only pose a risk of significant sanctions, but also damage the undertakings’ reputation (in particular, given the upcoming reporting obligations).
The German Supply Chain Act provides guidance for implementing, structuring and monitoring the mechanisms to comply with the diligence obligations in the supply chain, while giving undertakings discretion as to how to organize the relevant measures and to incorporate them in existing structures and processes. Undertakings should also be on the lookout for information, support materials and recommendations concerning the observance of the German Supply Chain Act to be published by the German Federal Office of Economics and Export Control.
Various aspects referred to in the German Supply Chain Act might already be addressed (at least to a certain extent) in the codes of conduct implemented by undertakings. In particular, such codes of conduct, but also supplier questionnaires as well as general terms and conditions appear as appropriate means to deal with the diligence obligations stipulated under the German Supply Chain Act. The newly implemented requirements should also be given due consideration when entering into new agreements with (direct) suppliers. In addition, the need for an amendment of existing agreements should be verified. Undertakings might consider including extraordinary termination rights in their supply agreements to deal with situations where a supplier is (persistently) violating human rights-related or environmental obligations (as last resort, but also to procure for leverage). The implementation of additional information and cooperation obligations for suppliers appears useful to provide for a joint and coordinated approach for both, the undertaking and its supplier, in case any human rights-related or environmental risks or irregularities are at issue. Viewed from another perspective, suppliers (even those that are not themselves subject to, but have business relations with undertakings in scope of the German Supply Chain Act) will likely face, and should be prepared to meet, relevant requests raised by their contractual counterparties in the near future.
From an M&A perspective, the relevant risk exposure under the German Supply Chain Act should not be underestimated, in particular in light of the significant fines that may be imposed. The requirements of the German Supply Chain Act will need to be considered in due diligence when reviewing supply agreements and codes of conduct. It should furthermore be borne in mind that, as from the closing date, the aggregated headcount of the target (and its subsidiaries), on the one hand, and the entities of the purchaser group, on the other hand, might exceed the applicable headcount threshold and, therefore, trigger diligence obligations under the German Supply Chain Act for the first time. Against this background, potential issues arising from the German Supply Chain Act should be taken into account in the course of any transaction involving German undertakings.