How Does the Financial Sector Relate to the European Commission’s Proposal For a Corporate Sustainability Due Diligence Directive?

In the last few years, there has been a significant momentum behind imposing mandatory obligations on multinational enterprises (MNEs) to respect human rights and the environment. In 2017, France became the first Member State of the European Union (EU) to adopt and implement legally binding obligations on MNEs with the Loi de Vigilance. Following France’s footsteps, Germany adopted a law, Lieferkettengesetz, in 2021. Other Member States also got mobilized to adopt such laws, now the proposals being in the pipeline (The Netherlands, Belgium, Austria). Consequently, the EU started to work on legally binding rules as well to create legal certainty and a level playing field between the Member States. As such, the work of the European Commission produced the Draft Corporate Sustainability Due Diligence Directive in 2021. Furthermore, in December 2022, the Council adopted its position on the Commission Proposal. However, the road to the Council’s position generated much discontent among the Member States, especially regarding the Council’s proposal to leave it up to the Member States to decide whether to include the financial sector within the scope of the Directive. As the Draft Directive moves to the negotiation and trialogue phase, it remains to be seen how it will be adopted. In my blog post, I investigate the reasons why the financial sector is important for the future Directive, the obligations the financial sector has under the Draft Directive, and to what extent those obligations align with the United Nations Guiding Principles (UNGPs) and the Organization for Economic Co-operation and Development (OECD) Guidelines for Multinational Enterprises.

Importance of the Financial Sector

Financial institutions are vital in ensuring business respect for human rights and the environment, considering that they are major actors in the global economy. Therefore, their regulation regarding their human rights impact is essential, as their activities can have repercussions beyond the borders of the country where they are headquartered and the sphere of influence of the company managing them. For instance, when providing funding to a business client, a financial institution can be exposed to human rights concerns that are relevant to its client’s sector. There remains a risk that the financial institution itself can be associated with human rights abuses committed by its client. To make it more concrete, it could very well be the case that the financial institution is investing in companies that source conflict minerals or lending money to agricultural companies involved in land grabbing.

In addition, the latest Global Human Rights Benchmark from BankTrack (2022) has revealed that the world’s largest commercial banks still fail in their human rights responsibilities, as foreseen in the UNGPs. Thus, it becomes all the more critical that the future Directive covers the financial sector to address the already existing deficiency in the financial sector.

Obligations for the Financial Sector in the Draft Directive and Their Implications

The Draft Directive defines the scope of the financial sector in Article 3(a)(iv), which provides for a comprehensive list. However, while including the majority of the financial sector in the Draft Directive, the Commission also exempts the sector from many obligations, which significantly waters down the potential impact of the overall Directive (see here).

Firstly, according to Recital 30 and Article 6(3) of the Draft Directive, financial institutions only have to conduct due diligence once and before the contract’s inception. However, such a one-time approach to human rights and environmental due diligence (HREDD) complies neither with the UNGPs nor the OECD Guidelines. Principle 17 (c) of the UNGPs states that the due diligence process should be ongoing while recognizing that human rights risks may change with time as the company’s operations and context can evolve. Similarly, the OECD Guidelines also emphasize the ongoing nature of the due diligence process (Guideline 45). The main reason to determine the due diligence process as ongoing is to recognize the dynamic nature of the business activities and prevent the process from turning into a mere formalistic tick-box exercise (see p 222). Therefore, reducing due diligence to an activity to be conducted once before the start of the service provisions runs counter to the raison d’etre of HREDD.

Secondly, the financial sector is not included in the high-impact sectors (Recital 22 and Article 2(b)), contrary to the high-impact sectors list of the OECD. The reason for such exclusion is its specificities, especially regarding the value chain and services offered (Recital 22). It is indeed correct that certain characteristics of the sector, such as diverse and extensive business relationships, the complex landscape of regulatory obligations, and the nature of various transactions, bear the possibility of making the practical application of the due diligence processes quite tricky. However, the fact that the HREDD process would be complex does not justify shrinking its extent to being conducted only once before the contract.

The OECD Centre for Responsible Business Conduct has produced fit-for-purpose guidance to show companies how to operationalize due diligence requirements for different financial transactions and actors. Furthermore, the OECD and other organizations have instructed the financial sector companies on the matter (see here, here, here, and here). Again, although the integration of human rights concerns into the operations of the financial sector has been focusing on a few target issues where the negative impacts are obvious, there indeed is a trend to address human rights concerns in general in the sector (See here). There are even actors in the financial sector who are explicitly asking for a ‘robust, ongoing due diligence throughout the value chain.’

On the other hand, the Council proposes to leave it to the Member States to include the financial sector within the scope, which runs counter to the UNGPs. The UNGPs concern all business enterprises regardless of their size, sector, location, ownership, and structure (See General Principles, UNGPs). Consequently, the UNGPs embark on a risk and severity-based approach (not a sector based distinction) to HREDD. As such, when the Member States exclude the financial sector, UNGPs will be disrespected by actors who have committed to respecting them.

Thirdly, the value chain of the financial institutions is limited only to direct clients, which consequently excludes the entities in these clients’ own value chains, together with the direct clients that are Small-Medium Enterprises (Article 3(g)). This limitation bases the responsibilities on the size of the companies, whereas, as stated above, the UNGPs concern companies regardless of their sizes. Furthermore, this approach contradicts the current sector practice, evidenced by the Investor Alliance for Human Rights (see also here and here).

Lastly. the mitigation measures are limited for the financial sector as they are required not to terminate their relationship with a company where this termination could cause substantial prejudice to that company (Articles 7(6) and 8(7). Considering the leverage the financial institutions have over the companies, they should have the opportunity to divest when it is impossible to mitigate and end the harm. The use of leverage is also a crucial element in the UNGPs ( See Commentary to Principle 19).

Conclusion

Consequently, let alone the Council’s proposal, even the Draft Directive as it is, falls short of complying with the UNGPs and the OECD Guidelines which are accepted international standards in the field of business & human rights. Nevertheless, the Council still offered to make a carve-out for the financial sector with the push of France. It is disheartening to see a pioneering country in the field of business & human rights (by becoming the first Member State to adopt a vigilance law) try so hard to undermine the obligations of the financial sector. However, it remains a mystery to see how the Directive will be adopted.