The EU Proposal on Corporate Sustainability Due Diligence and the Mystique of Complete Corporate Separateness

The European Commission’s recent proposal for a directive on corporate sustainability due diligence (the Proposal) is the latest and boldest attempt to harness corporate law in fighting human rights violations and climate change. The Proposal shows the vigor of what I have called ‘the rise of international corporate law’—as reflected, among other things, in the United Nations’ (UN) decades-long effort in recruiting large corporations and institutional investors to mitigate the ‘governance gaps’ of globalization. UN-driven corporate governance has been highly influential—think the astonishing rise of ESG, a concept first advanced by a UN-sponsored Global Compact report in 2004, and the influential Guiding Principles on Business and Human Rights of 2011 (the Guiding Principles), led by Kofi Annan’s Special Representative John Ruggie. The EU Proposal does not mention ESG explicitly, but cites the Guiding Principles more than 10 times.  

The Proposal contains various bold and controversial innovations, such as the imposition of detailed mandatory human rights due diligence procedures subject to administrative law enforcement in the Member States, as well as new legal requirements that directors consider ‘consequences of their decisions for sustainability matters, including, where applicable, human rights, climate change and environmental consequences, including in the short, medium and long term’. While promoting such untested ‘legal implants’, the Proposal neglects low-hanging fruit by failing to curb the role of corporate subsidiaries’ legal ‘separateness’ in promoting negative externalities, such as environmental damage and human rights abuses. It also relies on entity-based, rather than group-based, triggers for the application of the Directive—a mechanism that creates distortions and induces regulatory arbitrage. 

Law-and-economics scholars have long called out the inefficiency of limited liability for corporate torts, especially in corporate groups (see here and here). Brazil, for instance, has largely eliminated limited liability of parent companies for environmental and labor obligations of subsidiaries. The Proposal, however, clings to the existing norm in most jurisdictions by conditioning parent company liability on the existence of misconduct by the parent company itself. It requires a showing of the company’s own failure to comply with its due diligence obligations under specific conditions—a requirement that can both burden and frustrate liability suits for harm caused by subsidiaries.

The Proposal’s approach appears to reflect prevailing fallacies and myths regarding the consequences of corporate personhood. As I argue in a recent working paper, legal discourse about business entities has displayed a logical fallacy regarding the meaning of corporate separateness, which suggests that corporate personality logically entails insulation between the corporation and shareholders for all purposes. This is a non sequitur resulting from a fallacy of equivocation, given the ambiguity of the term ‘separate’: from the fact that corporate personality constitutes a separate (in the sense of distinct) nexus for the imputation of legal rights and duties, it does not follow that the corporation and its shareholders are legally separate (in the sense of insulated) in all instances.

This area is also permeated by myths, such as the idea that parent companies do not control subsidiaries (see here) or that the law requires fraud or exceptional circumstances to overcome corporate separateness in all contexts (see my article here). UN Representative John Ruggie tried to navigate these fallacies and myths when conceiving the Guiding Principles on Business and Human Rights. In his book 'Just Business', Ruggie explains his attempt to reconcile what he viewed as ‘very strong public policies in favor of legal autonomy’ in most states with firms’ routine assessment of enterprise-wide risk, including in subsidiaries. It turns out, however, that conventional accounts of ‘legal autonomy’ greatly exaggerate the law’s respect for legal insulation of subsidiaries. Not only do various other areas of law routinely peek behind the corporate veil to attribute shareholder rights or characteristics to controlled firms, but corporate law itself increasingly disregards corporate separateness for purposes of investor protection by granting shareholders ever greater pass-through rights in corporate subsidiaries (see current research summarized here). Not even corporate law itself treats separateness (in the sense of legal insulation) as sacrosanct.

Limited liability of corporate parents for subsidiary torts is by no means a logical corollary of corporate personhood, but rather a questionable policy choice. Beyond efficiency considerations, the growing concerns about global inequality also favor a stronger system of parent company liability.

The system of administrative enforcement of human rights due diligence envisioned by the Proposal has certain shortcomings: not only can it encourage ‘box ticking’ and a ‘race to the bottom’ among Member States offering lax enforcement, but payment of any fines would revert to the coffers of wealthy European jurisdictions. By contrast, parent company liability has distributional benefits by offering an avenue for compensating the very victims of human rights abuses and environmental disasters, typically more vulnerable persons located in the Global South.

Finally, the Proposal also unduly upholds legal insulation of subsidiaries (in the form of regulatory partitioning) in determining the scope of its coverage. The relevant thresholds based on a minimum number of employees and net turnover are measured at the entity level, not at the group level. In doing so, the Proposal deviates from the approach adopted in the Non-Financial Reporting Directive, which defines the relevant triggers on a group-based and consolidated basis. The Proposal’s entity-centric thresholds result in an unlevel playing field—since the application of the Directive may hinge on the subsidiaries doing business in the EU—and encourages regulatory arbitrage through the creation of additional subsidiaries.

In sum, the Proposal advances several measures seeking to mitigate negative externalities of businesses and to close governance gaps concerning human rights and environmental protection. However, by choosing to uphold asset partitioning with respect to torts committed by corporate subsidiaries, as well as by adopting an entity view in determining the Directive’s scope, the Proposal undermines its central objectives by continuing to encourage the use of corporate personality for purposes of externalization of risk and regulatory arbitrage. 

Mariana Pargendler is Professor of Law at Fundação Getulio Vargas School of Law in São Paulo and Research Member of the European Corporate Governance Institute (ECGI)

This post is published as part of the OBLB series on 'The Corporate Sustainability Due Diligence Directive Proposal'