Germany Update: Environmental Social Governance due diligence obligations for SMEs?

Since 01.01.2023, the Supply Chain Due Diligence Act (LkSG) has applied to companies of a certain size. It obliges the companies covered to prevent risks with regard to human rights and environmental violations along the supply chain and to remedy violations. However, the LkSG is only one building block in a veritable legislative wave, which is summarized under the abbreviation “ESG” primarily pursues socio-political goals and was mostly initiated by the European legislator within the framework of the Green Deal. Described by some as a “tsunami” or even as a “project of the century”, the objectives of this new legislation do not leave small and medium-sized enterprises (SMEs) unscathed, even where only large companies or capital market-oriented companies have been obliged so far. At the latest with the implementation of the CSRD Directive, SMEs will also continue to be held accountable from the 2025 financial year.

What does ESG mean?

The abbreviation ESG stands for Environmental Social Governance. Since the Paris Climate Agreement of 2015 in particular, this has included legislation that has environmental and climate protection as its central subject. It is true that human rights, social and environmental aspects have been the subject of reporting obligations for capital market-oriented companies for some time under the heading of Corporate Social Responsibility (CSR) – in Germany in particular on the basis of §§ 289b et seq. of the German Commercial Code (HGB), which go back to the so-called CSR Directive of the EU of 2014 and have been in force since April 2017. With the buzzword Environmental Social Governance, however, environmental and climate protection has moved considerably into the foreground. Most recently, on the basis of the so-called Taxonomy Regulation, which has been in force since 01 January 01 for certain capital market-oriented companies and financial market participants and pursues the goal of directing capital flows and, in particular, private investments into sustainable economic activities.

Does it also apply to small and medium-sized enterprises (SMEs)?

A general legal obligation for companies, regardless of size, to align their activities with the national climate and sustainability goals does not exist – so far. However, sustainability aspects have already found their way into the German Corporate Governance Code (GCGC): Since 28.04.2022, the recommendation for the Supervisory Board applies, whose competence profile should “also include expertise on sustainability issues of importance to the company” (recommendation C.1). Furthermore, Recommendation D.3 states: “Accounting and auditing also include sustainability reporting and its auditing.” – The Management Board and Supervisory Board of listed companies must declare this annually (“comply or explain“).

Even obligations that apply directly only to publicly oriented companies or companies above a certain size already have regular effects on SMEs. For example, § 6 Abs. 4 LkSG obliges companies within the scope of the LkSG to anchor “appropriate preventive measures vis-à-vis a direct supplier“. Human rights and environmental expectations must be taken into account when selecting a direct supplier. The obligation is accompanied by the requirement of a corresponding contractual assurance from the supplier, the provision of training and further education and the agreement of appropriate contractual control mechanisms. In this way at the latest, SMEs in their role as suppliers are also included in the corresponding obligation regime.

CSRD Directive and current EU legislative projects

The current legislation of the EU, however, goes much further. The Corporate Sustainability Reporting Directive (CSRD Directive) adopted on 14 December 2022, which replaces the CSR Directive, significantly expands the sustainability reporting obligations already applicable to capital market-oriented companies and covers significantly more companies: reporting obligations and disclosures on environmental, sustainability, social and employee matters as well as on combating human rights violations, Bribery and corruption, among others, will also apply from the 2025 financial year to SMEs that meet at least two of the three criteria for large companies according to § 293 HGB; these are: sales revenues in the financial year of more than 40 million euros, a balance sheet total of over 20 million euros or more than 250 employees on an annual average.

Reports must be made on the effects of the various sustainability aspects on the company as well as on the effects of the company’s business activities on its environment (“double materiality“). Two examples show how far-reaching the reporting obligations are: In the management report, for example, the company must provide information about the time-bound sustainability goals it has set itself. It shall also provide, inter alia, information on how the company intends to ensure that its business model and strategy are consistent with the 1.5°C target of the Paris Climate Agreement, including related implementing measures and financial and investment plans. It remains to be seen how the German legislator will implement the Directive. In view of the concrete requirements, however, there is hardly any room for manoeuvre in some cases. Sustainability reporting is also to become part of the audit and will thus ultimately be placed on a par with financial reporting in several steps.

For SMEs within the scope of the CSRD Directive, the urgent question therefore arises as to how the necessary information and data can be collected, assigned and evaluated company-wide in the future. Capital market-oriented companies had a multi-year preparatory phase on the basis of the CSR guideline for the development of corresponding responsibilities and information flows. For the SMEs covered by the CSRD Directive in the future, there are just under two years left to set up their organisation accordingly. The same applies to the formulation and implementation of sustainability goals in the relevant areas by management.

In addition, another proposal for a directive by the EU Commission for the so-called Corporate Sustainability Due Diligence Directive (CSDD Directive, also known as the “EU Supply Chain Directive”) is currently in the EU legislative process. At EU level, on the one hand, the objectives of the LkSG are taken up again. However, the proposal for a directive goes beyond that. Particularly noteworthy for company law: The definition of due diligence obligations for directors is to be broadened in general to include “the short-, medium- and long-term consequences of their decisions for sustainability aspects”. The Sustainable Finance Advisory Board set up by the Federal Government has already presented corresponding recommendations for Germany (Final Report, p. 96). The proposal for a directive also provides for sanctions and civil liability in the event of breaches of duty. The directive is expected to be adopted in 2023. The development of further specifications is therefore clearly only at the beginning.

Result

The new requirements are likely to pose considerable challenges for many companies. It is not enough to make the company’s business activities increasingly sustainable within the framework of free management discretion. Specific requirements and reporting obligations on the various sustainability aspects, as introduced by the CSRD Directive, require fundamental organisational efforts. The required disclosures also require that the Executive Board has dealt in detail with the relevant sustainability aspects and has implemented corresponding goals and measures.

It is therefore advisable in any case to deal with the topic at an early stage, both strategically and organizationally. This is not least against the background that the interest of readers of such reports, which also include investors, investors, stakeholders and the interested public in general, will continue to increase. The new requirements are also likely to present companies with conflicting objectives in some places (profitability vs. sustainability). These should be considered at an early stage. Also in view of the fact that further legal requirements on sustainability aspects undoubtedly follow.

By MELCHERS, Germany, a Transatlantic Law International Affiliated Firm.  

For further information or for any assistance please contact germany@transatlanticlaw.com

Disclaimer: Transatlantic Law International Limited is a UK registered limited liability company providing international business and legal solutions through its own resources and the expertise of over 105 affiliated independent law firms in over 95 countries worldwide. This article is for background information only and provided in the context of the applicable law when published and does not constitute legal advice and cannot be relied on as such for any matter. Legal advice may be provided subject to the retention of Transatlantic Law International Limited’s services and its governing terms and conditions of service. Transatlantic Law International Limited, based at 42 Brook Street, London W1K 5DB, United Kingdom, is registered with Companies House, Reg Nr. 361484, with its registered address at 83 Cambridge Street, London SW1V 4PS, United Kingdom.