July 27, 2021

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The New Corporate Due Diligence Act: Potential Liability under Civil Law and Administrative Law | White & Case LLP

The key aspects of the German Act on Corporate Due Diligence Obligations in Supply Chains (“LkSG” or “Act”) have already been explained in our previous Client Alert. In the following, we will take a closer look at the liability consequences in the event of a violation of the obligations set out in the LkSG.

Background

On 25 June 2021, the widely discussed LkSG was approved by the Federal Council (Bundesrat) as well. This marks the German legal prelude to a development that international companies currently find themselves facing, which can be referred to as ESG, i.e. environmental, social and governance factors.

By passing the LkSG, Germany is following in the footsteps of various other European countries, such as France and the United Kingdom, where legislation to ensure compliance with human rights standards and a sustainable organization of supply chains were introduced several years ago in the form of the loi de vigilance and the Modern Slavery Act, respectively. As stated in the explanatory memorandum to the LkSG, given their high level of integration in global markets for sales and procurement, companies based in Germany have a particular responsibility to make sure that human rights are respected along their supply chains. This applies in particular to the very important automotive, engineering, metals, chemicals, textiles, food and beverages, wholesale and retail, electronics and energy supply sectors.

As a result, companies now find themselves obliged to implement the due diligence obligations imposed on them under the LkSG in their compliance and governance mechanisms on the basis of an appropriate risk management system. Although violations of the due diligence obligations set out in the Act are primarily sanctioned by means of administrative offense proceedings (with high fines of up to 2% of the average annual worldwide sales), the responsibility which companies have under civil law should be kept in mind. While it is not the intention of the legislator to establish a “new” basis for claims under tort law in the case of LkSG violations, general tort law (§ 823 para. 1 German Civil Code) provides those affected with a general gateway for bringing legal action. In the event of violations of the due diligence obligations under the LkSG, companies may therefore find themselves exposed to both administrative offense proceedings and claims brought in the civil courts.

Moreover, legal recourse to the German civil courts is made easier in cases involving violations of eminently important legal interests as defined in § 2 para. 1 LkSG, such as injury to life or limb. Those affected, who will in most cases be situated in other countries further along the supply chain, can make use of the special standing to sue provided for in § 11 LkSG.

Intention of the legislative process with regard to the options of taking legal action in Germany

In July 2020, the governing CDU/CSU/SPD coalition launched an initiative for a supply chain act because serious human rights violations had occurred in countries at the start of the supply chain, bringing the question of German companies’ responsibility for compliance with human rights standards by their suppliers into the focus of public attention. In the course of the ensuing, very heated political debate, the CDU/CSU in particular became increasingly concerned that German companies and especially medium-sized companies would find themselves facing considerable disadvantages in global competition. The leftwing party Die Linke and the Green party, on the other hand, criticized the legislative proposal as not going far enough.

The Greens in particular were in favor of a new basis for claims under tort law which would make it possible for companies to be held liable for damages in the event of a culpable breach of statutory due diligence obligations involving damage to life, limb, health, freedom or property. They also saw a need for new provisions on legal venue under the German Code of Civil Procedure opening up the possibility of jurisdiction for actions under the LkSG based on factual connection and context. This would have allowed even companies without a registered office or principal place of business in Germany or in another EU member state (or a state party to the Lugano Convention) to be sued jointly with another company at the latter’s general place of jurisdiction for payment of damages because of environmental or human rights violations in cases with a factual connection between the actions. The aim was further to make it possible to bring collective and representative actions before the German courts seeking compensation directly for those affected.

The Act that has now been passed stands as a clear rejection of these proposals: § 3 para. 3 sentence 1 LkSG makes it clear that a violation of any of the obligations arising from the LkSG does not give rise to civil liability under the Act itself. On the other hand, civil liability arising independently of the Act remains unaffected as stated in § 3 para. 3 sentence 2 LkSG. From a procedural aspect, § 11 LkSG provides that domestic trade unions and non-governmental organizations can have special standing to sue in civil court proceedings if eminently important legal interests as defined in § 2 para. 1 LkSG are affected.

Liability for administrative fines

For companies with average annual sales of more than 400 million euros, violations of the obligations set out in the Act can result in fines of up to 2% of their average worldwide annual sales (§ 24 LkSG). In addition, violations can result in exclusion from public procurement procedures for a period of up to three years (§ 22 LkSG). Although not every violation of a due diligence obligation constitutes an administrative offense, negligent violations of due diligence obligations may also be punished as administrative offenses. The fines provided for in the Act are staggered according to the due diligence obligation that has been violated in a specific case. The competent authority for investigating and punishing administrative offenses under the LkSG is the Federal Office of Economics and Export Control (BAFA).

High potential administrative fines

The highest potential administrative fines under the Act are those for violations of the duty to take preventive and remedial measures or of the duty to establish a complaints procedure.

The preventive measures to be taken in one’s own business (§ 6 LkSG) include, but are not limited to, the development and implementation of suitable purchasing practices or the establishment of risk-based control measures. Suitable preventive measures must also be taken with respect to direct suppliers, for instance by providing training or by agreeing on suitable contractual control mechanisms.

Remedial action (§ 7 LkSG) must be taken where a violation has already occurred or is imminent in the company’s own business or that of a direct supplier, including measures such as jointly developing and implementing a plan to address the violation or joining forces with other companies in the context of industry initiatives. In special circumstances, a temporary interruption or even a complete termination of the business relationship with the supplier may be required.

As regards the establishment of a complaints procedure (§ 8 LkSG), the persons named as contacts must be impartial and bound to maintain confidentiality and in addition, information on how to contact them and on how the complaints procedure will be conducted must be made publicly available.

Violations can be punished by a fine of up to 800,000 euros in the case of individuals and up to 8 million euros in the case of companies.

Where large companies with average worldwide annual sales of more than 400 million euros are concerned, it is even possible to impose a fine amounting to up to 2% of the average worldwide annual sales over the last three years. However, this risk of significantly higher potential fines will apply only in cases where appropriate remedial measures (§ 7 LkSG) have not been taken even though a violation of a human rights obligation or an environmental obligation has already occurred or is imminent in the company’s own business or at a direct supplier.

Medium potential administrative fines

A somewhat lower fine may be imposed in the event of a failure to define responsibility within the company for monitoring the risk management system to be set up (§ 4 LkSG).

If the company fails to perform or is late in performing an appropriate risk analysis in order to identify human rights risks or environmental risks in its own business and at its direct suppliers, this can also be punished as an administrative offense (§ 5 LkSG). The risk analysis must be carried out at least once a year and on an ad hoc basis if, for example, new products are introduced or a new business field is entered. In this respect, the following is, among other things, relevant: The nature and scope of the company’s business operations, the company’s ability to exert influence on whoever caused the violation of the due diligence obligation and the company’s own contribution towards causing the violation as well as the severity and reversibility of the violation.

Violations can be punished by fines of up to 500,000 euros in the case of individuals and up to 5 million euros in the case of companies.

Low potential administrative fines

For less serious violations, the Act provides for administrative fines of up to 100,000 euros for individuals and companies.

These fines relate primarily to violations of formal obligations such as the obligation to draw up an annual report on the fulfillment of the company’s due diligence obligations in the previous financial year and to make it publicly available free of charge on the company’s website for a period of seven years, no later than four months after the end of the financial year (§ 10 LkSG), and to submit it to the Federal Office of Economics and Export Control (§ 12 LkSG).

Assessment of fines to be imposed on companies

When a fine for a company is to be assessed, the significance of the administrative offense and the economic circumstances of the company must be taken into account (§ 24 para. 4 LkSG). All circumstances in favor of and against the company are to be weighed-up against each other. In doing so, the extent to which the company has undertaken any efforts to identify the violation and to redress the damage that occurred may be considered. Any precautions taken after the occurrence of the violation in order to prevent and identify any future violations may also be considered when assessing the fine.

Civil liability

LkSG as a potential basis for liability in tort?

§ 3 para. 3 LkSG explicitly makes it clear that no civil liability is established under the Act. This clarification appears to be unambiguous at first glance. However, seen in the context of general liability in tort the due diligence obligations laid down in the Act could be considered to be statutory duties of care to ensure public safety and organizational duties (Verkehrssicherungs- und Organisationspflichten) applying across legal entities and could therefore constitute a basis for liability under § 823 para. 1 of the German Civil Code. Under the law as it previously stood, corporate liability, for example due to third-party violations of property or health, failed because there was no basis for a finding of misconduct on the part of the company at the top of the supply chain. As a rule, the event giving rise to liability involved misconduct on the part of the supplier, but under tort law responsibility for such misconduct was not attributable to the company at the top of the supply chain. The reason for this is that the organizational duties which a company has under tort law – just like the duties it has under company law – are attributable only to the company itself and do not extend to suppliers outside the company.

However, even before the LkSG was passed, there had been a growing number of voices arguing that, with a view to international human rights and environmental standards, it was time for a departure from the principle that organizational duties in tort are incumbent only on the respective legal entity. The LkSG now imposes genuine statutory due diligence obligations on companies, aimed at encouraging the company to monitor the supply chain and organize the supply chain in a sustainable manner across all legal entities involved. This is the key change compared to the previous legal situation where such an obligation did not exist.

One point which is, however, open to question here is whether the due diligence obligations can be taken to be a connecting factor for an extension of the general tort liability under § 823 para. 1 of the German Civil Code. Although the wording of § 3 para. 3 sentence 1 LkSG (“A violation of the obligations under this Act shall not give rise to civil liability“) does not seem to support such an extension, a qualification has been added in the next sentence (“Any civil liability established independently of this Act shall remain unaffected.”). While the courts could therefore take the view that a violation of any of the due diligence obligations laid down in the Act does not directly give rise to liability under § 823 para. 1 of the German Civil Code (because liability would not be “established independently of this Act”), there is also a possibility that the courts could take the new (more extensive) statutory due diligence obligations into account in the context of general safety and organizational duties under § 823 para. 1 of the German Civil Code.

The starting point here is that, according to general principles, tort liability only imposes sanctions for the tortfeasor’s own unlawful conduct. The key question is whether it is possible to establish that the conduct required of a company includes careful selection and control of its suppliers, i.e. whether it is possible to derive from the company’s statutory due diligence obligations that it has safety and organizational duties relating to the economic activities of suppliers and applying across entities. However, this question has not been answered either in the LkSG or in the government draft of 19 April 2021 (BT-Drucks. 19/28649). Nor was this question explicitly addressed in the recommendation on the draft of 9 June 2021 that was submitted by the Committee for Labor and Social Affairs, even though the Green party had explicitly pointed out in connection with its Amendment Request No. 2 (Liability) that “German courts could evaluate the due diligence obligations within the supply chain as safety and organizational duties pursuant to § 823 para. 1 […] and could establish tort liability for companies on this basis” (BT-Drucks. 19/30505, p. 28). In this context, the legislators contented themselves with clarifying that violations of the statutory due diligence obligations do not give rise to liability under § 823 para. 2 of the German Civil Code (BT-Drucks. 19/30505, p. 28). The due diligence obligations might, however, indirectly lead to liability based on § 823 para. 1 of the German Civil Code when the safety and organizational duties in tort are specified.

It could be argued that the due diligence obligations are in character similar to safety duties in that the obligations extend not only to the company’s own business, but also and in particular to the business of the company’s direct and indirect suppliers, i.e. across legal entities, and could thus structurally very well be regarded as a connecting factor to safety and organizational duties in tort. In addition, the standing to sue provided for in § 11 LkSG allowing a transfer of the authority to file actions to domestic trade unions or non-governmental organizations in the event of violations of “eminently important legal interests arising from § 2 para. 1 [LkSG]” and generally intended to simplify the enforcement of rights would largely remain a dead letter if the due diligence obligations did not have to be taken into account in the context of safety and organizational duties within the meaning of § 823 para. 1 of the German Civil Code. Were that to be the case, as explained above, corporate liability would generally fail because the event giving rise to liability is usually misconduct on the part of the supplier, for which the company at the top of the supply chain is not responsible under tort law. § 11 LkSG is, however, intended to facilitate access to the German civil justice system for those affected by alleviating the risks associated with the costs of bringing an action, thus reducing at least the financial hurdle involved in seeking legal redress in Germany.

What speaks against this interpretation, however, is that, according to the systematic scheme underlying the Act, the due diligence obligations are to be enforced and sanctioned in administrative proceedings and using the means available for administrative offenses. The question therefore arises as to whether, in addition to this enforcement and sanction mechanism, the due diligence obligations could still (possibly indirectly) have the effect of establishing a safety duty and thus serve as a basis for liability under § 823 para. 1 of the German Civil Code. It is likely that, as stated by the Green party during the legislative process, the answer to this question will be left for the courts to decide.

Applicable law

In addition, it seems likely that difficulties will arise in relation to the principle set out in Article 4 (1) of the Rome II Regulation that in an action for damages in tort the applicable law will generally be the law of the country in which the damage occurred (place of effect principle). As damage will mostly occur abroad, the liability of a German company would be governed by foreign tort law.

However, it should be noted that German tort law applies to the benefit of the injured party according to Article 4 (3) Rome II Regulation if “the tort is manifestly more closely connected with” Germany than the country where the damage occurred as determined under Article 4 (1) Rome II Regulation. Recital 14 of the Rome II Regulation justifies this exception to the place of effect rule by referring to the requirement of legal certainty and the need to do justice in individual cases. This Recital could be engaged if a German company were to control the risks existing at the place of effect – for example due to the risk management system that must now be established, any preventive measures that are mandatory or through a code of conduct – in such a way that it has to be seen as bearing sole responsibility for the hazards that give rise to liability. In addition, the connection to the place of effect is typically associated with high costs and legal uncertainty. It therefore does not appear impossible that potential plaintiffs might attempt to compensate for the lack of protection associated with the place of effect rule by invoking Article 4 (3) Rome II Regulation.

In addition, companies could find themselves exposed to increasing liability risks under foreign tort law, as has been shown by a case brought before Dortmund Regional Court some three years ago, in which employees and surviving dependents asserted claims for damages against a German textile discounter following an accident in Pakistan. The distinguishing feature of this case was that the claims brought pursuant to Article 4 (1) Rome II Regulation were based on Pakistani tort law. The transnational reference did not prevent the claims from being asserted before German courts because Article 4 (1), Article 63 Brussels I Regulation allows German courts general international jurisdiction over disputes against German companies, irrespective of the law that is applicable to the claims that are asserted. Ultimately, the lawsuit failed because the claims for damages had meanwhile become time-barred under Pakistani law.

Conclusion and outlook

The introduction of the new Act creates new corporate due diligence obligations aimed at safeguarding respect for human rights and environmental interests. Companies need to be mindful of the fact that these due diligence obligations can extend to the entire supply chain, and must have suitable control and risk mechanisms as part of their compliance and governance system in place when the LkSG comes into force on 1 January 2023. Violations of due diligence obligations can be punished as administrative offenses and attract considerable fines. Although the Act does not introduce a new basis for claims and at first glance it may seem that nothing has changed, companies could nevertheless potentially be exposed to an extension of corporate liability in tort under § 823 para. 1 German Civil Code as a result of the Act’s provisions on due diligence obligations applying across legal entities. And, last but not least, the general ESG issues, which have already found their way into court proceedings in many European countries, will provide a further impetus for litigation in Germany. The LkSG is likely to be a prelude for further legislation in Germany and in all events, when seen in terms of the “big picture” it will presumably be no more than one small element in the current trend towards regulating ESG.

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