How the EU’s Sustainability Due Diligence Directive Could Reshape Corporate America

One of the most important developments in corporate governance is the growing divide between the US and the EU on issues of corporate social responsibility. The starkest example of this divide comes from the new EU Directive on Corporate Sustainability Due Diligence (CS3D). The Directive holds large corporations legally accountable for protecting various human rights and addressing environmental issues, such as forced labor, collective bargaining, biodiversity, and pollution. In fact, companies are required to prevent and remediate these social and environmental harms not just in their own operations, but also in the operations of their subsidiaries and even their suppliers and distributors. Importantly, the CS3D directly applies also to American corporations that generate significant revenues in the European market.

In a new paper, we examine how the Directive will be implemented and enforced in the US.

To provide the necessary background, we start by delineating the core requirements of the CS3D and its territorial outreach. The CS3D is more ambitious than any other ESG regulatory interventions so far. ESG regulatory interventions typically focus on reporting requirements. The CS3D, by contrast, imposes substantial risk-management obligations and mandates specific operational changes. The Directive requires that large corporations identify, prevent, mitigate, and account for the adverse effects that they create on human rights and the environment. The important point is that “adverse effects” are defined very broadly, with reference to numerous international conventions (in a lengthy annex to the paper we show that most of these conventions were never ratified in the US). As for the Directive’s outreach, our paper illustrates how most large American companies fall within its scope and how many large US law firms have already sent memos to their clients, alerting them to the corporate governance changes that they will need to undertake to comply with the CS3D.

The CS3D is thus very ambitious in both depth and scope. But the big question mark hovering over it is not what the Directive requires and to whom it applies on paper. The question is rather how the Directive will be enforced on the ground. After all, the CS3D does not mandate specific corporate conducts or expect companies to guarantee outcomes. Instead, it requires that companies put in place risk management policies and procedures to address those “adverse impacts.” Legislations of this ilk run the risk of turning into an exercise in box-ticking, namely, nudging corporations to adopt nice-sounding policies on paper without really changing their behavior on the ground. The only way to get large corporations to truly behave more sustainably is to acquire buy-in from the corporations’ top management. And the most effective way to change the tone at the top is to hold directors and top officers accountable when their corporations adversely affect human rights and the environment.

This is where our paper’s core contribution comes in, examining how the CS3D will affect the fiduciary duties of American directors and how it will be enforced through private litigation in the US. The oversight duty doctrine (often dubbed Caremark, after Delaware’s leading precedent) delineates the conditions under which directors can be held personally liable for not taking their company’s CS3D obligations seriously. Until recently, there was virtually no chance that plaintiffs could sustain oversight claims regarding how companies’ practices adversely affect human rights or the environment.

But a combination of the new legislation in Europe and a revamped approach to oversight duties litigation in the US is likely to change things and catapult human rights and environmental issues to the top of corporate boards’ agendas. The CS3D interacts with the oversight duty doctrine in several important ways. For one, the CS3D changes the nature of human rights and climate issues from largely discretionary issues to central legal risks. As a result, courts are more likely to fault directors not just for what they knew about adverse human rights and environmental effects but also for what they did not know (culpable ignorance). Further, the CS3D effectively transfers the responsibility for human rights and climate issues from sustainability or social responsibility departments to compliance departments. As a result, the Directive is likely to significantly increase the number of warnings about imminent risks (“red flags”) that escalate to the board level. And because the CS3D instructs each EU Member State to appoint supervisory agencies to monitor companies’ compliance with the Directive, the number and severity of warnings coming from outside the company are also likely to increase.

The upshot is that American directors and officers are likely to start facing scrutiny over what they did (or did not do) to ameliorate adverse effects on human rights and the environment. In other words, it is the combination of Europe ambitious regulation and the US (read Delaware) robust private litigation landscape that is likely to reshape corporate behavior on issues such as labor exploitation and environmental degradation.

Our paper then analyzes the unique dynamics of this CS3D-Caremark combination, and their normative ramifications. For example, we explain why adding the prospect of Caremark litigation reduces the chances that American companies engage in mere “cosmetic compliance” of the CS3D requirements. In addition, it may alter their incentives to object to ESG regulation in the US itself.

Whether these effects prove beneficial from a societal perspective is an open question that we cannot fully resolve now (we will have to wait a few more years before empirical evidence accumulates). What we can do now is to spotlight how the CS3D–Caremark combination should make us rethink our priors in longstanding normative debates. For example, we mentioned that the CS3D–Caremark combination deters cosmetic compliance by American companies. But the CS3D alone is not sufficient to deter cosmetic compliance by companies from European member states, where corporate law enforcement is much less intense than in the U.S. One could argue that this differential enforcement deepens the worry that the CS3D will end up creating a camouflaged non-tariff barrier to trade in the EU for American companies.

Our paper ends with some lessons for practitioners and judges, analyzing how the CS3D-Caremark combination is likely to have ripple effects on company reporting protocols, board committee structures, board composition, prefiling discovery rules, and so on.