The Supply Chain Due Diligence Act in the Context of M&A Transactions and Structural Measures under Company Law

last updated on 25 October 2023 | reading time approx. 5 minutes

Since 1 January 2023, companies that have their head office, principal place of business, place of management or registered office in Germany and generally hire more than 3,000 employees (from 1 January 2024: more than 1,000 employees) in Germany have been obliged under the Supply Chain Due Diligence Act (German: Lieferkettensorgfaltspflichtengesetz – LkSG) to conduct human rights and environmental due diligence in their supply chains. The stated objective of the due diligence requirements listed in Section 3 para. 1 LkSG is to prevent or mitigate human rights-related and environmental risks, respectively to stop the violation of human rights-related or environmental obligations. The Act also provides for a complaints procedure as well as documentation and reporting obligations.

Since 1 January 2023, companies that have their head office, principal place of business, place of management or registered office in Germany and generally hire more than 3,000 employees (from 1 January 2024: more than 1,000 employees) in Germany have been obliged under the Supply Chain Due Diligence Act (German: Lieferkettensorgfaltspflichtengesetz – LkSG) to conduct human rights and environmental due diligence in their supply chains. The stated objective of the due diligence requirements listed in Section 3 para. 1 LkSG is to prevent or mitigate human rights-related and environmental risks, respectively to stop the violation of human rights-related or environmental obligations. The Act also provides for a complaints procedure as well as documentation and reporting obligations.

Below, some obvious and less obvious implications of the Supply Chain Due Diligence Act in the context of M&A transactions and structural measures under company law will be discussed.

Target as the major point of focus in an M&A transaction

In company acquisition as a classic example of an M&A transaction, the focus is on the target as an entity obligated under the LKSG. First, it is important to identify possible risks at the level of the target as part of a due diligence process. This may also be necessary if the target is only indirectly affected, for example because it is obliged under contracts with its offtakers to meet the due diligence requirements comparable to those outlined in the LkSG. Any identified risks but also unknown risks can be considered in the purchase contract, e.g. by adding indemnities and/or warranties. The specific content of the contract will depend on numerous aspects and will be impacted, not least, by the specific negotiating position.

Further implications of the Supply Chain Due Diligence Act for M&A transactions and structural measures under company law

It is equally important to assess the LkSG's implications for the acquiring or selling company. The situation is very similar with structural measures under company law in general, such as a merger.

In particular, the following aspects should not be ignored: 1. Do the implications of a particular transaction trigger the applicability of the LkSG? 2. If the LkSG is applicable, are there implications in terms of meeting the due diligence requirements, in particular with respect to the company's own business area?

1. Applicability of the LkSG

First, it is essential to determine the number of employees to know if the LkSG applies. The employee threshold is first determined based on the permanent staff of the company. The decisive factor is staff development planning, taking into account past and future-related aspects. Sufficiently specific decisions on changing the number of employees can also be considered in such planning.

The LkSG also contains a so-called group inclusion clause (German: Konzernzurechnungsklausel). This means that, in the case of affiliated companies, employees of all group companies hired in Germany should be taken into account when calculating the number of employees of the parent company.

For example, decisions that have already been taken by the management to reduce the number of employees are also considered relevant for determining the headcount. This is not only the case if it has already been decided to cut jobs, but also as a result of the sale of subsidiaries where their employees are or were to be taken into account by the parent company according to the group inclusion clause under the LkSG. Conversely, the acquisition of companies and the related increase in the number of employees can also trigger the applicability of the LkSG, again possibly taking into account the group inclusion clause. This also applies if the number of employees increases directly as a result of the merger of another company with the absorbing company.

2. Identification of the company's own business area

If the LkSG does apply to the acquiring or selling company or the company affected by a structural measure, questions also arise as to how such measures may affect the identification of the “own business area”.

The concept of the company's own business area results from the LkSG and the splitting of the supply chain into different sub-areas laid down therein, such as the company's own business area, the area of direct suppliers, and the area of indirect suppliers. Depending on the classification, different due diligence requirements apply or their scope varies. To put it simply, the company must generally meet the due diligence requirements with respect to its own business area and in relation to direct suppliers, while in relation to indirect suppliers only under certain additional conditions.

The company's own business area basically includes every activity of the company to achieve its objective. In addition, in the case of affiliated companies, the parent company's “own business area” also includes that of a group member if the parent company exercises decisive influence over that subsidiary. Such inclusion is to be determined on a case-by-case basis. What particularly matters here is whether the parent company may exercise influence and whether it actually does so. A takeover of major or all shares in the target is enough to prove that influence may be exercised. Influence is usually actually exercised when the parent company integrates the target into the existing group of companies and, for example, requires it to follow the company policies.

If an acquired company or a subsidiary becomes part of “own business area” as defined in the LkSG as a result of a structural measure under company law, the list of the due diligence requirements to be followed by the parent company is extended accordingly.

Attempts to bypass the law

At the same time, the aspects outlined in section II raise the question of whether it is possible to escape the applicability of the LkSG or to avoid the supply chain breakdown established in the LkSG.

1. Attempts to bypass the applicability of the Act?

Attempts to bypass the applicability of the Act could be generally made under company law, e.g. by spinning off individual business areas to establish independent subsidiaries, provided that employees of the subsidiaries do not have to be taken into account again by the parent company under the group inclusion clause.

However, such attempts should be viewed with extreme criticism, as negotiations are currently underway at the European level on an EU directive on corporate sustainability due diligence. In principle, this directive is comparable to the LkSG, but goes beyond it in many respects such as the scope of application. Although the directive has not yet been finally debated, we can expect stricter requirements to apply, in particular to employee thresholds, than is currently the case in the LkSG. Any attempts to escape the applicability of the LkSG, which is to be reformed in the near future, are thus likely to be a short-term workaround at best.

2. Attempts to bypass the supply chain classification?

The supply chain breakdown made by lawmakers into “own business area” and the actions of direct suppliers and indirect suppliers raises the question of whether a direct supplier can be classified as an indirect supplier, for example, by using purchasing companies as intermediaries.

If a company covered by the LkSG purchases its products directly from a supplier, the supplier should be classified as a direct supplier. If, however, the company purchases its products through an intermediary company, provided that this company does not belong to the company's own business area (this is a somewhat simplified understanding, partly debatable in detail), the direct supplier could theoretically be qualified as an indirect supplier. This would mean that the due diligence requirements as defined in the LkSG would only have to be satisfied if the conditions of Section 9 LkSG were met.

However, the lawmakers immediately spotted the issue and recognised relevant measures as attempts to bypass the law. Consequently, in such a case, an indirect supplier is considered a direct supplier.

3. Bypass option for foreign branch offices

The LkSG currently does indeed provide for one option to bypass the law. Foreign companies can be included if they have a branch office in Germany. Since the branch office as such is not independent of the foreign company, only the number of employees of the foreign company can be relevant for triggering the applicability of the LkSG (debatable). If the branch office itself has a few employees only, it could be transformed into an independent subsidiary, which is only captured if it itself reaches the thresholds that are relevant in the context of the LkSG. In view of European legal developments, however, the added value of such an approach is not clear-cut, as it is the application of national law implementing the EU directive in the country of the respective European company that would be relevant in the future.

Conclusion

For M&A transactions and structural measures under company law, it should be checked whether their implications fall within the scope of application of the LkSG or the need arises to identify the company’s own business area as defined in the LkSG. What is more, such measures need to be not only checked for whether they trigger the applicability of the LkSG but they are also of major importance in the context of codetermination under the One-Third Participation Act (German: Drittelbeteiligungsgesetz) or the Codetermination Act (German: Mitbestimmungsgesetz). And any attempts to bypass the LkSG should be made with caution. On the one hand, the lawmakers have partially addressed such attempts but, on the other hand, due to European legal developments, it is currently unclear what the supply chain laws will look like in a few years.