The Corporate Sustainability Due Diligence Directive: a milestone or a missed opportunity?

24 May 2024 marks an important step forward for EU sustainable finance regulatory framework: the European Council formally approved the Corporate Sustainability Due Diligence Directive (CS3D). The final text, however, is much less ambitious than the initial proposal advanced by the European Commission. This raises critical questions about the dynamics of the negotiation, the competing interests involved and the effectiveness of the new rules as well as their consistency with the broader financial regulation framework. Is the CS3D a significant achievement or a missed opportunity?

The purpose of the Directive

The CS3D aims to foster the contribution of corporations to the sustainability transition by holding them accountable for adverse environmental and social impacts of their business activity. To this end, it imposes new conduct obligations on in-scope companies, including:

1. Risk-based human rights and environmental due diligence aligned with the international standards set out by the UN and the OECD.
2. Adoption and implementation of climate transition plans ensuring, through best efforts, that business models and strategies are compatible with the goals of the Paris Agreement and, more broadly, a green economy.

These conduct duties are designed to complement the relevant disclosure obligations provided in the Corporate Sustainability Reporting Directive (CSRD), making the two directives ‘twin initiatives’. However, the CS3D only covers a subset of the companies under the scope of the CSRD as it only applies to the largest European and non-European companies active in the single market with a turnover of €450 million and at least 1000 employees. Compliance with these new duties is ensured by a combination of civil and administrative liability regimes.

The starting point of the negotiations

While the above reflects the final text, the original draft was much broader in scope. The journey to adoption of the CS3D started in July 2020 with the launch of the Sustainable Corporate Governance Initiative. According to findings published by the Commission, the main obstacle to securing  the contribution of companies to the sustainability transition was seen as an excessive short-term and profit-oriented focus of corporate behaviour, which was argued to derive from a narrow interpretation of directors’ duties under national company law.

To tackle this problem, the Commission’s initial CS3D proposal issued in February 2022 envisaged a broader reform of directors’ general duties, providing that when acting in the best interest of the company directors shall take into account sustainability matters, including human rights, climate change and environmental consequences.

The Council rejected the wider strategy with the following arguments: i) a lack of empirical evidence on short-term biases in corporate behaviour and their link with unsustainable practices; ii) concerns over violating subsidiarity and proportionality principles by overreaching harmonisation of national laws; and iii) an over-broad definition of ‘value chain’ putting undue responsibility on companies, especially in financial services.

Similar concerns were supported by a substantial proportion of corporate law scholars and anticipated by the Regulatory Scrutiny Board even before the publication of the first draft of the CS3D.

Where the negotiations ended

The legislative process led to controversial negotiations. The main disagreements concerned the scope of application of the Directive, which had been gradually diluted. Eventually, only 0.05% of EU companies will be subject to the new requirements, which is 70% less than previously agreed.

Other notable changes include:

• removal of the general duty of care and civil liability of directors with respect to sustainability matters;
• removal of the duty to link directors’ remuneration to climate-related performance;
• removal of the duty of directors to adapt company strategy in consideration of the actual and potential adverse impacts identified in the due diligence process (now envisaged as a voluntary measure);
• replacement of the term ‘value chain’ with the narrower definition of ‘chain of activity,’ which excludes the use and disposal of companies’ products and services from the scope of due diligence; and
• limitation of the due diligence duties of financial undertakings to the upstream part of their chains of activities, thereby excluding scrutiny of the activities of their clients.

A landmark achievement?

It is early to say whether the final text has the potential to drive a shift in corporate behaviour towards sustainability.

Certainly, the new mandatory transition plans aimed at adapting business models to climate neutrality goals can be a trailblazer, particularly as they will force companies (including financial service providers) to take into account their Scope 3 emissions. However, the scope of such plans will be limited and only encompass climate sustainability.

As to the due diligence obligations, much will depend on how companies will implement their new duties and how Member States will supervise and enforce them.

In any case, this Directive leaves unresolved some fundamental issues on which Member States could not reach a consensus: the role of directors and the nexus between corporate governance and sustainability, and more broadly the role companies and financial markets at large should play in the transition.

Any lessons learnt?

It is notable that more progress towards sustainable corporate governance seems to emerge in larger international fora. For example, the G20/OECD Principles of Corporate Governance as last amended in 2023, not only include an entirely new Chapter VI on corporate sustainability and resilience but they also provide, under Principle V.A., that board members should act ‘in the best interest of the company and the shareholders, taking into account the interests of stakeholders’.

This raises questions about the EU legislative process and which strategies can facilitate consensus in such complex areas going forward. Certainly, the disruptive nature of the changes proposed by the Commission may have benefited from more robust supporting evidence. In addition, more principle-based legislation better aligned with existing Member State laws might have had a greater chance of success, considering the limited EU remit in this area and the strong entrenchment of company law in national jurisdictions.

Going forward, should the CS3D be revised in the future, it would be helpful to clarify its underlying strategy, as compared to that of the revised Shareholder Rights Directive (SRD2). While they are both presented as tools to promote long-term corporate behaviour, there is an inherent trade-off between empowering shareholders and broadening the prerogatives of directors.