Increasing ESG and regulatory scrutiny on ethical supply chains

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Peter Leon | Partner | Africa Chair | Herbert Smith Freehills | mail me | 

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What are the legal implications for international oil companies (IOCs) operating in host countries where supplier due diligence is a challenge?

• The short answer to the question is that IOCs face ever increasing legal risk.
• The legal risk is the product of the legal frameworks which regulate the IOCs and their operations as well as the nature and characteristics of their operating environment.

Legal framework

• The upstream, midstream and downstream operations of IOC companies are often located outside the jurisdictions where they are incorporated. IOCs are therefore required to comply with the governance and reporting requirements imposed under the laws of the jurisdictions where they are incorporated (home state) as well as the general legal obligations imposed under the laws of the jurisdictions where they operate (host state).
• In some cases, the requirements imposed under the laws of the home state are affected by the requirements imposed under laws of the host state. For example:
  • The EU’s Non-Financial Reporting Directive (Directive 2014/95/EU (Reporting Directive)) provides that a ‘large’ IOC that is headquartered in the EU must disclose information on the way it operates and how it manages social and environmental risks;
  • Such companies must publish information related to environmental matters, social matters and the treatment of employees, respect for human rights, anti-corruption and bribery, and diversity on company boards.
  • Several of the prescribed topics are affected by the activities conducted in the host state.
• On 21 April 2021, the EU Commission adopted a proposal for the Corporate Sustainability Reporting Directive (the Sustainability Directive). The Sustainability Directive would amend the existing reporting requirements of the Reporting Directive. The proposal:
  • extends its scope to all large companies governed by the EU law of, or established in, an EU member state and all European stock exchange-listed companies. The new requirements may also extend to global businesses with operations in Europe;
  • requires the audit (assurance) of reported information;
  • introduces more detailed reporting requirements, and a requirement to report according to mandatory EU sustainability reporting standards; and
  • requires companies to digitally ‘tag’ the reported information, so it is machine readable and feeds into the European single access point envisaged in the capital markets union action plan.
• An IOC’s ability to report on matters regulated under the laws of the home state may therefore be affected by:

• • the requirements imposed under the laws of the host state; and
  • the IOC’s ability to conduct the required due diligence activities in the host state.

• In addition to the requirements imposed under the laws of the Home and the host state, companies in the extractives sector are often members of international initiatives which impose voluntary disclosure and reporting requirements on them. Examples include the UN Global Compact and the Voluntary Principles on Security and Human Rights Initiative.
• The simultaneous operation of the different legal and voluntary frameworks may impose a significant burden on IOCs.

Operating environment

• The oil and gas industry is characterised by large investments, major technological challenges and significant commercial and political complexity. The very nature of the business operations as such may expose participants in the sector to a great variety of financial (including bribery and corruption), health and safety, political, as well as environmental risks.
• Due diligence and compliance management practices are therefore essential to the successful navigation of increasing regulation, environmental concerns and ethical business practices. The inability to conduct comprehensive due diligence processes will necessarily have an impact on the business operations.
• In light of the legal requirements and practical realities faced by IOCs, the majority of companies undertake supply chain due diligence as a matter of routine, including, but not limited to, due diligence in relation to anti-bribery and corruption (ABC), sanctions and human rights risks.
  • The European Commission, together with the British Institute of International and Comparative Law, conducted a study which was mandated to ‘carry out analytical and consultative work … to assess the possible need to require corporate boards to develop and disclose a sustainability strategy, including appropriate due diligence throughout the supply chain’. [own emphasis added]
  • The study found that over one third of business respondents indicated that their companies undertake due diligence taking into account all human rights and environmental impacts, and a further one third of the respondents indicated that their companies undertake due diligence limited to certain areas.
• The need to conduct thorough due diligence processes obviously increases in high-risk markets where material risks – such as ABC, sanctions and human rights – and related ‘co-morbidities’ may be present. Legal risk generally also translates into financial risk for IOCs.
  • For example, a recent United States (US) sanctions prosecution highlighted the importance of undertaking a human rights due diligence as part of an effective sanctions compliance programme: the US Office of Foreign Assets Control (OFAC) issued a maximum penalty in excess of US$40 million to e.l.f Cosmetics Inc. after their compliance programme failed to detect that approximately 80 per cent of the false eyelash kits it imported from suppliers in China contained materials sourced from North Korea (which is under US sanctions).
  • The Lava Jato investigation in Brazil, which concerned kickbacks allegedly paid in return for contracts at the state-run oil company, is another example of the potential financial consequences. The bribery scheme, one of the biggest ever registered in Latin America, resulted in the second-largest fine imposed under the U.S. Foreign Corrupt Practices Act (FCPA): US$1.78 billion against Petrobras.
• Effective due diligence may be more difficult (and risks may be higher) in countries which are extremely corrupt, have a poor human rights record or which are under sanctions, which usually means increased due diligence effort is required.
  • For example, it will usually not be sufficient to rely only on supplier questionnaires and database checks; instead, it may be necessary to conduct ‘on the ground‘ or other targeted due diligence.
• Having a comprehensive approach is also important: in 2018 OFAC issued an advisory relating to the United States’ sanctions against North Korea specifically recommending that businesses undertake human rights due diligence in accordance with international standards in order to ensure compliance with US sanctions.

Domestic laws versus EU laws

What will happen when laws requiring local procurement conflict with upcoming legislation like EU supply chain due diligence requirements? In your opinion, what can be done to ensure that international laws don’t clash with local content requirements, how can all parties best collaborate?

• Short answer: IOCs will be required to comply with the stricter requirements where domestic laws conflict with EU laws. The draft directive, which was included as an annex to the European Parliament Resolution of 10 March 2021 with recommendations to the European Commission on corporate due diligence and corporate accountability (Draft Directive), however offers some reprieve to IOCs where they are able to show that they took all due care in line with the Draft Directive to avoid the harm in question, or that the harm would have occurred even if all due care had been taken.
• The Draft Directive

• • Voluntary due diligence and national or sectoral legislation may not be sufficient to combat recurring issues such as child or forced labour, pollution, land grabbing and corruption.
  • To encourage companies to take action to ensure human rights and reduce environmental impacts in their supply chains, the European Parliament passed a resolution (2020/2129(INL) requesting the European Commission to prepare and submit legislative proposals for EU-wide ‘mandatory supply chain due diligence’ and setting out a number of suggestions as to what that legislation should contain (EU Resolution).
  • The European Parliament’s recommendations were recorded in a Draft Directive which was included as an annex to the EU Resolution.
  • The Draft Directive, among other things:
    • imposes an EU mandatory due diligence framework requiring companies to take responsibility for their supply chains. This includes new wide-ranging Environmental Social Governance (ESG) due diligence requirements on the whole value chain of companies established or operating in the EU;
    • would oblige EU Member States to legislate to require that companies carry out due diligence with respect ‘to potential or actual adverse impacts on human rights, the environment and good governance in their operations or business relationships’.
  • IOCs whose activities fall under the scope of the proposed legislation will be required to carry out a comprehensive due diligence of their operations and direct and indirect business relationships, upstream and downstream, in and outside of the EU, and publish a statement that they have identified no potential or actual risk to human rights, the environment or good governance, as well as the data and methodology used.
  • If risks have been identified, companies will be required to publish, implement and report annually on their due diligence strategy and policies to monitor and address those risks (including a description of their value chain), and ensure that their business and business partners conform to that strategy: for example, independent audits of suppliers and service providers, additional undertakings in contracts, requirement to adhere to codes of conduct, etc.
  • Sanctions for non-compliance are yet to be defined but may include proportionate but dissuasive administrative fines, financial or non-financial compensation, reinstatement, public apologies, restitution and injunctions, as well as exclusion from public procurement, state aid or export credit agency facilities. Crucially, sanctions can be cumulative with civil liability.

• Conflicts

• • Article 19 [Civil liability] of the Draft Directive:
    • Imposes a duty on EU member states to ensure that they have a liability regime in place under which companies can, in accordance with national law, be held liable and provide remediation for any harm arising out of potential or actual adverse impacts on human rights, the environment or good governance that they, or companies under their control, have caused or contributed to by acts or omissions.
    • Confirms that companies which respect the due diligence obligations imposed under the Draft Directive are not absolved of any liability which they may incur pursuant to national laws. While ‘national laws’ in this article refer to the laws of EU member states, it is reasonable to assume that the same principle will apply to host state laws.
    • Provides that proof that they took all due care in line with this Draft Directive to avoid the harm in question, or that the harm would have occurred even if all due care had been taken, are not held liable for that harm under the Draft Directive.

• Ultimately, IOCs that follow international best practice (such as the OECD Due Diligence Guidance for Responsible Supply Chains) will be best placed to navigate the different legal regimes.

Practical steps

What are practical steps that IOCs can take to ensure they can continue to purchase as much locally despite these increasing regulatory and investor pressures on supplier due diligence?

• For IOCs, there will usually be an imperative to build long term relationships with local suppliers – this presents an opportunity and an incentive to engage with suppliers to improve their ESG and ABC performance.

• • Extractive Industries: The Management of Resources as a Driver of Sustainable Development (2018):
    • A number of extractive industry companies have introduced supplier development programmes that attempt to reduce the constraints and skill gaps.
    • Such measures have had their successes. They are mainly effective in the long term, underlining the need to manage expectations and for local communities to be engaged in the process to avoid disappointments.

• It may also be necessary to collaborate with the host government in capacity development efforts – and to involve home country governments in particularly high risk / sensitive contexts. In this regard, the OECD’s Costs and Value of Due Diligence in Mineral Supply Chains (2021) position paper (which consider issues that are also relevant in the oil and gas sector) provides that, while the specifics of the challenges vary across geographies, potential ways forward that could alleviate some of the stresses on private sector actors in the short/medium/long-term include:

• • Financial and logistical support for on-the-ground due diligence capacity building and monitoring activities.
  • Investments in security, finance, and infrastructure in host states to reduce opportunities for illicit activities in the formal market (for example, tax administration and financial services).
  • Support for government and industry self-regulatory enforcement efforts to combat the trade in illicit material or material without due diligence.
  • Greater implementation of due diligence requirements in trading and consuming countries through the adoption of due diligence rules and government-backed support measures. This will obviously be more relevant to participants in the midstream and upstream components of the oil and gas sector.

• Prescribing supplier requirements which are benchmarked to widely accepted international standards is important.

• • While the standards imposed under US and EU laws provide a useful starting point, it is important to incorporate best practice standards.
  • Important examples include the UN Guiding Principles on Business and Human Rights, the standards considered under the World Bank’s Supply Chain Security Guide and the ISO 29001, Petroleum, petrochemical and natural gas industries – Sector-specific quality management systems – Requirements for product and service supply organisations which the International Standards Organisation published in 2020.

• Addressing the perceived ‘gap’ between international and local standards which, may be more apparent than real. For example, forced labour and other human rights abuses may occur in a jurisdiction not because of inconsistent/non-existent domestic law but because of inadequate enforcement, corruption, or similar institutional issues.
• Finally, IOCs could also work together on certain host state initiatives. This can be effective and resource-efficient, but it is important to be wary of possible competition law violations. Competition law recognises that it may, in certain circumstances, be legitimate for competitors to collaborate and discuss matters that are of general importance to an industry, for example health & safety issues.

• • Collaboration on such matters can take many forms, ranging from ad-hoc cooperation amongst small groups of companies to sector wide initiatives or initiatives coordinated by industrial or trade associations.

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