ESG and the Supply Chain

A company risks legal, reputational, and economic damage if its suppliers:

Through an emphasis on corporate social responsibility (CSR), consumers have been holding companies accountable for unethical behavior within the companies’ supply chains for some time. More recently, many investors and other corporate stakeholders have been considering ESG factors when evaluating a company’s performance and long-term viability and making investment decisions.

Additionally, governments, legislators, and regulators are now starting to require companies to disclose more information regarding their own practices and those of their suppliers. For example, in March 2022, the Securities and Exchange Commission (SEC) proposed new and amended rules to enhance and standardize disclosure regarding:

Consequently, many large public companies and private companies doing business in the US have started to:

This article:

(This article does not address international ESG laws or ESG-related obligations applicable to federal government contracts.)

ESG and CSR Defined

The terms ESG and CSR are sometimes used interchangeably. It may be more accurate to view ESG and CSR as two sides of the same coin. CSR may be summed up as a company’s sustainability efforts, that is, company actions aimed at having a positive impact on society and the environment. ESG refers to how investors and other stakeholders measure those sustainability efforts to assess the long-term viability of companies. (For more on the relationship between ESG and CSR, see Environmental, Social, and Governance (ESG): Overview on Practical Law.)

ESG

Generally, ESG is an umbrella term for a broad range of environmental, social, and governance factors that seek to provide investors with objective, quantifiable performance indicators. These factors can be described as follows:

Arriving at a standard or universally accepted definition of ESG has been elusive. ESG factors that are relevant to a company differ depending on the industry and jurisdiction. Additionally, the prominence of particular factors may vary over time. For example, many companies had to quickly adopt health and safety measures for their employees during the COVID-19 pandemic.

(For more on ESG generally, including a discussion of the various global sustainability organizations and initiatives, such as the United Nations Global Compact, as well as ESG standards, voluntary disclosure frameworks, and ratings, see Environmental, Social, and Governance (ESG): Overview on Practical Law.)

CSR

Often referred to as corporate responsibility, corporate philanthropy, sustainability, business ethics, stakeholder theory, or corporate citizenship, CSR is defined differently by various international organizations and industry groups. The World Business Council for Sustainable Development (WBCSD) and the European Union (EU) published commonly used definitions of CSR:

In essence, when a company adopts CSR policies and practices, its planning and decision-making reflect the potential impact of its corporate actions on various stakeholders and constituencies.

Importance of ESG

There are several reasons to take ESG seriously, including:

Recent events have created some headwinds for ESG in the US (see Thomson Reuters Institute, Special Report: ESG Under Strain (Nov. 10, 2022)). ESG is becoming increasingly politicized, with a number of states seeking to restrict the use of ESG investing for state funds and prohibiting the use of ESG factors by financial firms (for more information, see ESG and State Law in 2022: Conflicts and Trends and Key Developments in State ESG Law: 2022 Tracker on Practical Law). Moreover, the conflict in Ukraine and the resulting increases in energy prices may, in the short and medium term, increase the demand for fossil fuels. Despite these challenges, it is likely that ESG-minded investors, consumers, and regulators will continue to drive companies to earn their social license (see McKinsey & Company, Does ESG Really Matter — and Why? (Aug. 10, 2022)).

Investor and Consumer Sentiment

Since it was first introduced as a term at the 2005 Who Cares Wins conference, ESG has become increasingly important for investors and, consequently, for companies. In 2022, the number of publicly traded companies that published a sustainability report reached an all-time high, with 96% of S&P 500 companies and 81% of the Russell 1000 companies doing so (see Governance & Accountability Institute, Sustainability Reporting Trends). New investments in sustainable funds reached $87 billion in the first quarter of 2022, and the total value of global sustainable assets was $2.5 trillion after the first half of the year (see McKinsey & Company, Does ESG Really Matter — and Why? (Aug. 10, 2022)).

Consumers also continue to be an important driving force for ESG, with many companies touting their sustainability efforts and ESG programs as part of their marketing and advertising efforts. In some cases, companies have overstated those efforts or made misleading claims about the environmental impact of their products or services, a practice referred to as greenwashing, and regulators are starting to hold them accountable for doing so (for more information, see SEC Charges Company with Making False Statements in Sustainability Reports and Public Filings on Practical Law).

Legislative and Regulatory Initiatives

Certain existing and pending legal requirements impose disclosure obligations that are intended to encourage companies to address ESG-related issues in their operations.

These requirements do not mandate that companies take affirmative steps to adopt particular policies regarding their own supply chain practices or their suppliers’ practices. Rather, affected companies are required to disclose their policies regarding certain activities that have been deemed offensive to human dignity. These disclosures include:

(For more on ESG-related legal requirements relevant to the supply chain, see Legislation and Regulations Impacting the Supply Chain below.)

Legal Risk

With an effective ESG policy that is carefully drafted and properly enforced, a company can better:

Additionally, an effective ESG policy has a positive effect on relations between the company and its shareholders and other corporate stakeholders, employees, regulators, and government authorities.

Reputational Capital and Competitive Advantages

A company that defines its corporate culture with reference to ESG imperatives can leverage that commitment to forge powerful and lasting relationships with important stakeholders. ESG policies can differentiate a company’s brand, culture, and corporate identity and positively influence the decision-making of consumers, partners, investors, and talent. With reputational capital, a company can:

Legislation and Regulations Impacting the Supply Chain

In contrast to other jurisdictions such as the UK and EU, there are no overarching laws that specifically regulate ESG in the US to date. However, a number of ESG-related laws and regulations have been enacted at the federal and state levels that affect the supply chain.

Federal Laws and Regulations

Federal ESG-related laws and regulations affecting the supply chain include:

Additionally, if passed, the pending Business Supply Chain Transparency on Trafficking and Slavery Act of 2020 (BSCTTSA) would amend Section 13 of the Securities and Exchange Act of 1934 (Exchange Act) (15 U.S.C. § 78m) to mandate reporting companies to disclose their efforts to address forced labor, human trafficking, slavery, and the worst forms of child labor within the companies’ supply chain. The BSCTTSA is the federal version the California Transparency in Supply Chains Act of 2010 (Supply Chains Act) (see California’s Supply Chains Act below).

Conflict Minerals Rules

In 2012, the SEC adopted final rules implementing the conflict minerals disclosure requirements (Conflict Minerals Rules) set out in Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) (15 U.S.C. § 78m(p)). The Conflict Minerals Rules are intended to reduce trade and exploitation of conflict minerals believed to be financing violent conflict in the Democratic Republic of the Congo (DRC) and the adjoining countries of:

Section 1502 added new Section 13(p) to the Exchange Act, which directs the SEC to adopt rules requiring reporting companies to disclose information regarding the use of conflict minerals that originate from the DRC or an adjoining country in the products they manufacture or contract to manufacture. The final rules require all affected companies to conduct due diligence and make annual disclosures on SEC Form SD by May 31 of each year, except that if that day falls on a Saturday, Sunday, or holiday, then on the first business day following (Exchange Act Rule 0-3(a)). As discussed below, Section 13(p) has been the subject of a legal ruling.

The minerals covered by the rules, which are included in many common products but are particularly common in electronics components, include:

Under the final rules, if conflict minerals are necessary to the functionality or production of a product that a company manufactures or contracts to manufacture, the company (affected company) must conduct a reasonable country of origin inquiry to determine whether the conflict minerals both:

If so, the affected company must perform heightened due diligence on the source and chain of custody of the conflict minerals that conforms to a nationally or internationally recognized due diligence framework. If the affected company determines otherwise, it must describe its reasonable country of origin inquiry and the results on Form SD.

If the affected company’s heightened due diligence reveals either that its conflict minerals did not originate in the DRC or an adjoining country or that the conflict minerals came from recycled or scrap sources, it must still describe its reasonable country of origin inquiry, its due diligence efforts, and the results of both on Form SD. If the affected company’s heightened due diligence reveals otherwise, the affected company must file a Conflict Minerals Report as an exhibit to Form SD.

The Conflict Minerals Report must:

(For more on complying with the Conflict Minerals Rules, see Conflict Minerals Diligence and Conflict Minerals Disclosure Requirements Checklist on Practical Law.)

On August 18, 2015, the DC Circuit issued an opinion reaffirming its 2014 ruling that Section 13(p) and Section 1502 violate the First Amendment to the US Constitution to the extent they require companies to report to the SEC and state on their websites that any of their products have “not been found to be ‘DRC conflict free’” (Nat’l Ass’n of Manufacturers v. SEC, 800 F.3d 518, 530 (D.C. Cir. 2015); for more on the 2015 ruling, see Conflict Minerals Challenge: DC Circuit Reaffirms Decision on Rehearing on Practical Law; for a discussion of the practical implications of this litigation, see Conflict Minerals Diligence on Practical Law).

The FCPA

The FCPA (15 U.S.C. § 78dd-1 to 15 U.S.C.§ 78dd-3) prohibits subject companies from offering or paying anything of value to any person while knowing that any portion will be offered, given, or promised to foreign government officials to assist in obtaining or retaining business (for more on the FCPA, see The Foreign Corrupt Practices Act: Overview on Practical Law).

The TFTEA

President Obama signed the TFTEA on February 24, 2016. Among other things, the TFTEA amended the Tariff Act of 1930 and eliminated the long-standing “consumptive demand exception” to the prohibition against importing goods produced by convict labor, forced labor, or indentured labor. Previously, this exception allowed such goods to be imported in order to meet US consumptive demands.

CAATSA

President Trump signed CAATSA on August 2, 2017. Among other things, CAATSA creates a rebuttable presumption that forced labor was used in products made by North Korean nationals or citizens, wherever located.

The UFLPA

President Biden signed the UFLPA on December 23, 2021. The US enacted the UFLPA to support the prohibition on the import of goods made with forced labor in the Xinjiang Uyghur Autonomous Region (XUAR or Xinjiang) of China. The UFLPA took effect on June 21, 2022.

State Laws

Some states have also enacted ESG-related legislation affecting the supply chain.

For example, Maryland’s House Bill 425 (2012 MD H.B. 425 (NS)), which became effective on October 1, 2012, prohibits state agencies from obtaining supplies or services from companies that violate the Conflict Minerals Rules.

Additionally, California has enacted two pieces of legislation affecting supply chains in the ESG arena:

California’s Supply Chains Act

The Supply Chains Act (Cal. Civ. Code § 1714.43) applies to a company if it meets all of the following criteria:

A business covered under the Supply Chains Act must disclose to what extent, if any, it:

The information must be disclosed either:

A California Attorney General’s action for injunctive relief is the exclusive remedy for a violation of the Supply Chains Act. While private plaintiffs have no right of action under the Supply Chains Act, they may be able to bring claims under other statutes, such as the California Unfair Competition Law or the Consumer Legal Remedies Act.

(For more on the Supply Chains Act, see The California Transparency in Supply Chains Act: Overview on Practical Law.)

California Senate Bill 861

California’s Senate Bill 861 (2011 CA S.B. 861 (NS)), which became effective on August 22, 2012, requires any public company contracting with the State of California to comply with the Conflict Minerals Rules (see Conflict Minerals Rules above).

Supplier Codes of Conduct

Led by large retailers with considerable bargaining power, companies have been establishing standards for how their suppliers treat their workers and the environment. These minimum standards are often set out in a supplier code of conduct that the vendor must observe to do business with the company (for a model supplier code of conduct policy, with explanatory notes and drafting tips, see Supplier Code of Conduct Policy on Practical Law). Supplier codes of conduct, also referred to as vendor codes of conduct or responsible sourcing standards, are usually posted on company websites and sometimes incorporated by reference into the company’s supply chain contracts. Companies also require their suppliers to place posters in supplier facilities informing their workers of these minimum standards (for a model supplier code of conduct poster, with explanatory notes and drafting tips, see Supplier Code of Conduct Poster on Practical Law).

ESG Clauses in Supply Chain Contracts

Companies with the requisite bargaining power have also been increasingly including ESG-related representations and covenants in commercial contracts with suppliers and vendors. For example, companies may require their vendors to:

While clauses requiring suppliers to reduce their GHG emissions are still rare, the SEC’s pending climate disclosure rules may provide public companies with an increased incentive to impose obligations on their suppliers to help them comply (for more on climate-conscious clauses, see ESG Clauses Increasingly Incorporated in US Supply Chain Contracts on Practical Law).

Creating an ESG Supply Chain Policy

A comprehensive ESG program generally includes policies and procedures to address various ESG risks and opportunities. This article only considers the creation of an ESG policy for a company’s supply chain.

At a high level, when establishing a new ESG policy for the supply chain or reviewing an existing policy, a company should:

Working Group

Any company that wishes to establish a new ESG policy or to review its existing policy should first assemble a working group composed of the appropriate legal and operational leaders. Companies often establish such working groups to manage and oversee their ESG program, including establishing appropriate disclosure controls and procedures for collecting, verifying, and reporting ESG information. Members may include key operations executives, communications executives, risk management executives, human resource professionals, and in-house counsel. In time, and depending on the size of the company, the working group may also establish committees and sub-groups at various levels of the company.

The working group or a subset of the working group should be involved in the drafting or approval of any supply chain policy. The working group should also oversee the process of communicating the policy internally, including to senior management and the board of directors. While the board will typically not be involved in approving the policy, it should be notified of the policy’s existence and understand its role in helping the company meet its ESG objectives.

Company Objectives

A company’s ESG supply chain program should be shaped by:

The working group should have a clear understanding of existing and proposed ESG-related legislation affecting the supply chain (see Legislation and Regulations Impacting the Supply Chain above).

The working group should also be familiar with voluntary sustainability reporting frameworks developed by global sustainability organizations and initiatives. As there is currently no standardized mandatory ESG disclosure framework in the US, companies can look to organizations and initiatives such as the United Nations Global Compact, the Global Reporting Initiative, and the Sustainability Accounting Standards Board for guidance. (For more on sustainability organizations and initiatives, see Environmental, Social, and Governance (ESG): Overview on Practical Law.)

The working group should also consider existing and current:

Synergies can be obtained from coupling the development of an ESG program with marketing, branding, communications, financial reporting, and investor relations efforts. The working group should regularly analyze the ESG areas that pose the most risk and present the greatest opportunity to the business. The working group should be particularly alert to identifying and prioritizing activities that could potentially:

Potential Challenges

When complying with legislation and developing and implementing ESG programs for the supply chain, companies often face obstacles that can be time-consuming or expensive to overcome. These include:

Commitment to ESG

A company must be prepared to commit to the ESG policies it establishes at every level. As with other corporate policies, a commitment to ESG demands:

(For more on designing, implementing, and enforcing an ESG supply chain compliance program, see Developing an ESG Supply Chain Compliance Program on Practical Law.)

This article is based on an original version by Ron C. Llewellyn of Fenwick & West LLP and Ashley C. Walter of Orrick, Herrington & Sutcliffe LLP.