Now that companies are facing increasing scrutiny of their ESG practices by regulators, investors, customers, and the public at large, supply chain management and related ESG commitments (including the audit and enforcement hereof) are also receiving increased attention. Whether in the context of legal obligations to conduct ESG due diligence throughout the company’s supply chain, or simply to implement the company’s voluntary sustainability standards, ESG clauses should be appropriately drafted to ensure that they lead to the desired result.
Origin of ESG clauses
ESG clauses are a contractual instrument used by companies to encourage, demand or oblige their suppliers to improve their ecological and/or social governance and to take sustainable, climate-friendly and ethically aligned actions. Additionally, they are a way to address investors’ and customers’ (including consumers’, see here) concerns in this field and to address such concerns in every step of a supply chain.
Incorporating ESG standards into contracts throughout the supply chain can have several commercial benefits, such as improving customer relationships and reputational benefits for companies being seen as ecological and socially conscious. Additionally, ESG ratings and legislative initiatives requiring disclosure and reporting of environmental and social risks are rising. In this context, organizations such as the Organization for Economic Co-operation and Development (OECD) and the United Nations (UN) have recommended that companies influence their suppliers through contractual agreements to maintain and improve sustainability and responsible business conduct.
Additionally, in the EU, the proposal for a directive on corporate sustainability due diligence, which aims to foster sustainable and responsible corporate behaviour throughout global value chains, will soon require companies to seek contractual assurance from their business partners to ensure compliance with their sustainability goals and to perform ESG due diligence throughout their supply chain.
In this context, ESG clauses are increasingly inserted into commercial contracts. However, the way in which such clauses are drafted has a significant impact on how they are interpreted and enforced.
Different types of ESG clauses
ESG clauses come in different shapes and sizes and can relate to, inter alia, (i) environmental decisions, such as the use of specific products or packaging, shipment requirements, etc; (ii) human rights and the prohibition of engaging in child labor or the obligation to provide a healthy and safe work environment; and (iii) obligations to withhold from engaging in or working with companies linked to corruption, drugs of arms trafficking.
The way in which ESG clauses are drafted will significantly impact their scope, interpretation and enforceability. Below, we will highlight five key considerations for any contractual ESG commitment.
Key contractual considerations
As a preliminary note, whenever a supplier is asked to respect (internal or external) codes of conduct, policies or guidelines, such documents should be duly communicated to and known by the supplier, who needs to accept to be bound by them. Ideally, this is done by including these documents in the contract itself (for example, as an annex) or by providing a copy of the relevant documents to the supplier prior to the conclusion of the agreement and having the supplier sign for acceptance hereof. A mere reference to the existence of such documents (e.g., in general terms and conditions) or a link to the company’s website may lead to enforceability issues. The supplier could argue that it was not made aware of the required commitments and their extent. This will be especially true in case of internal policies or guidelines that are not widely known or which the supplier cannot be (reasonably) expected to know. The same consideration applies to any unilateral amendments made by the company to its codes of conduct, policies or guidelines.
1. Nature of the ESG commitment
In the light of the specific activities performed by a contracting party, it is important to evaluate the environmental and social risks its suppliers are exposed to and the extent to which they may pose risk to the company, its investors and its customers.
Once these risks or concerns have been identified, it is important to define them clearly and measurably in an enforceable contractual commitment. Any ESG clause must be drafted so that it is straightforward, for both contracting parties, (i) what is expected from the supplier, and (ii) how such expectation must be met. For example, if an ESG clause provides that the supplier must “act in an environmentally conscious manner” or “perform its activities ethically”, interpretation disputes may arise and it will be difficult to conclude at what point (and to which extent) the supplier will have (materially) breached this undertaking. Adding more specific targets and milestones reduces this risk.
Second, companies will need to decide whether the ESG commitments of their suppliers should be an obligation of means (i.e., a “best efforts” obligation) or an obligation of result within the meaning of Article 5.72 of the new Civil Code. For example, is it sufficient that the supplier uses all reasonable efforts to reach an expectation, or does it need to achieve a specific, measurable result?
The answer to this question will play an essential role when deciding whether the ESG commitment was met (or breached). More specifically, a party bound by an obligation of means commits itself (only) to use all reasonable efforts an ordinary, prudent contracting party of the same specialty would use in like circumstances. In other words, if the supplier fails to reach the expected commitment, it will not automatically be in breach of the contract. It will be for the company to prove the fault of the supplier. For this type of clauses, it may be helpful to include specific (measurable) indicators to assess the supplier’s efforts (e.g., by demonstrating what efforts should as a minimum be made). Conversely, if a party is bound by an obligation of result, the contractual fault is presumed from the moment the outcome has not been achieved and it will be for the supplier to prove that it was not at fault (i.e., that the result was not achieved due to force majeure). The clause itself must include all relevant indicators to assess the supplier’s behaviour.
2.“Essential” nature of the ESG commitment
Contractual clauses that are deemed “essential” for a contract to exist offer additional legal protection in various manners. For example, by explicitly designating an ESG commitment as an essential clause in a supply contract, a breach of this clause may more easily be invoked as a reason to unilaterally terminate the contract. Additionally, the supplier will in principle not be able to invoke a contractual exoneration clause to escape the performance of its essential obligations under an agreement. Conversely, the inclusion of ESG clauses in the company’s general terms and conditions, beyond the above-mentioned enforceability issues that it raises, leads to the presumption that they do not constitute an essential or substantial element of the contract, but only an accessory element.
3. Enforcement of the ESG commitment
Linking a specific consequence to the breach of an ESG clause will not only encourage suppliers to actually comply with their contractual ESG commitments, but will also provide the company with a clear solution in the event such obligation is not met.
Traditionally, parties could opt for (i) damages or (ii) a suspension or termination right (or a combination of both).
For ESG clauses specifically, it can be challenging to assess and quantify the damage suffered as a consequence of the breach (e.g., reputational damage). To mitigate this risk, parties could include a lump-sum indemnity which will be automatically due in case of a breach of the ESG clause. Important to keep in mind, however, is that the indemnity should still be meant to cover only the (potential) foreseeable damages in case of a breach of the ESG clause, but cannot be ‘punitive’ in nature. Alternatives are to require the breaching supplier to perform a certain obligation in kind or to donate to a recognized human rights or climate organisation.
Finally, when opting for a unilateral suspension or termination right, parties should ideally indicate in their agreement that a violation of the ESG clause will be considered sufficiently serious to justify such action. In the absence thereof, the seriousness of the breach and its consequences for the contractual relationship will have to be assessed by a court, on the basis of all relevant circumstances.
4. ESG documentation & audits
The enforceability of ESG clauses very much depends on the company’s ability to verify and monitor the supplier’s compliance with the obligations imposed by these clauses. Contracts therefore often include obligations for the supplier to proactively report on any progress made with respect to its ESG commitments, to regularly provide updated compliance documentation or certificates, to have an internal/external audit process, etc.
Additionally, ESG clauses are typically enforced through audit rights. ESG ‘due diligence’ in a supply chain context can include the involvement of technical, social, environmental and other experts. Several auditing and consultancy firms already provide tailor-made services for companies to carry out ESG due diligence in their supply chain. Typically, this type of audit does not only cover the company’s direct supplier, but also its own agents and subcontractors ‘down the chain’.
Finally, note that reporting and audit clauses can be tailored to the needs of the contractual relationship by including specific modalities. For example: audits to be conducted only during business days and during specific hours, audits only upon (reasonable) prior notice (or, conversely, without notice), possible involvement of a third-party auditor (which needs to have an international expert recognition), interval between audits, cost of the audit, confidentiality safeguards, etc.
5. Duplication of the ESG commitment throughout the supply chain
ESG clauses often provide for the obligation for the supplier to “pass-through” or duplicate its own ESG commitments (or essentially equivalent commitments) in relation to its own suppliers or subcontractors. Also this obligation can be included in the form of an obligation of means (“best efforts) or in the form of an obligation of result.
Additionally, the ESG clause could provide that the supplier’s own suppliers or subcontractors need to countersign the company’s code of conduct or ESG policy and that the supplier should provide a copy hereof to the company. As the chain is of course only as strong as its weakest link, the contract could also state that the company should provide its express written approval before any subcontractor can be engaged, and such subject to prior ESG due diligence. Again, this type of clause can take many forms.
ESG commitments have become an important part of many supplier contracts and supply chain risk management. However, to have the desired effect, one must pay attention to how these clauses are drafted and to which consequences such clauses may lead. Companies are advised to review their contract templates and (where needed) to update their supply contracts to ensure that they can successfully request their suppliers to take actions or decisions that are aligned with their environmental, social, and ethical goals, and to verify compliance with such commitments through supply chain due diligence.