The Why and What of Responsible Contracting
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Responsible contracts make the commitment to HREDD between buyers and suppliers across the supply chain legally binding. They also facilitate the flow of information between the contracting parties and across the supply chain. That information can be used for multiple purposes, including to better equip portfolio companies to conduct comprehensive HREDD and prevent adverse HRE impacts, address inquiries from regulators, such as the U.S. Customs and Border Protection (CBP) agency, to report on non-financial performance in accordance with the EU Corporate Sustainability Reporting Directive (CSRD), and to provide more effective and speedy HRE remediation, when/as needed.
Investors need to engage with their portfolio companies to ensure that they are using their contracts to support and not undermine effective HREDD processes. For HREDD to be effective, companies should move away from the traditional one-sided, strict compliance model of contracting toward a due diligence-aligned model that is dynamic, responsive, cooperation-based, and supported by responsible purchasing practices. |
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Why are contracts important for promoting human rights in global supply chains?
Along with supplier codes of conduct, contracts are the most widely used tool for managing supply chain risks, including HRE risks. Contracts take a company’s policies, which, on their own, are unenforceable, non-binding documents, and make them binding. Otherwise put, when HRE policies are incorporated in contracts, they become legally binding and enforceable. Contracts therefore make soft policies hard and make it possible for these policies to “go global” by binding parties operating in different parts and legal jurisdictions of the world.
Unfortunately, although contracts are widely used to manage supply chain risks, they are typically misused for purposes of managing HRE risks. All too often, companies use their contracts to shift HRE risks and responsibilities onto their contract counterparties and other actors in their supply chains. The responsibility for mitigating HRE risks is typically placed on the shoulders of the less powerful party (usually the producer-country supplier) by the more powerful party (usually the consumer-facing buyer / brand / retailer), with little acknowledgement that HRE risk may be caused in whole or in part by the acts (e.g., purchasing practices) and omissions (e.g., lack of assistance) of the more powerful party. To formalize this type of risk-shifting, suppliers are frequently required to make a contractual promise (by way of a representation or a warranty) that there are no HRE violations anywhere in the supply chain and that all is perfect. Such promises are unrealistic because there is no such thing as a perfectly clean supply chain, but they are also dangerous because they incentivize suppliers to hide infractions out of fear of losing the contract and to push infractions further out of the buyer’s view, where they are even less likely to be addressed. In addition to bearing the bulk of the contractual risk, suppliers are often expected to assume the costs associated with upholding HRE standards, usually without support, financial or otherwise, from their buyers. Moreover, suppliers often contend with prices that do not cover the costs of production, let alone the costs associated with responsible business conduct, and other poor purchasing practices.[1] These dynamics combine to create serious commercial pressures on suppliers, which are passed on to workers and their communities.[2] While risk-shifting may be effective for some aspects of supply chain risk management, it is ineffective, and even dangerous, for purposes of managing HRE risks. A key take-away from this Investor Guidance is that, when it comes to preventing adverse HRE impacts, risk-shifting is not the same thing as risk management. Risk-shifting contracts tend to aggravate HRE risks, not mitigate them. Investors should understand that when their investees use their supply chain contracts to shift HRE risks onto their business partners and suppliers, this is unlikely to support effective HRE risk management or better HRE outcomes. The most effective way to manage HRE risks is to proactively mitigate them to prevent their escalation into harm or actual adverse impacts. And this is what HREDD is all about— prevention. As explained below, moving toward responsible contracting is not only more effective for preventing and remedying adverse impacts, but also for achieving compliance with rapidly-evolving legal requirements, including the new HREDD laws, sustainability reporting laws, and trade sanctions laws. To serve as effective components of HREDD processes, supply chain contracts should move toward a responsible contracting model whereby both parties commit to cooperate in carrying out ongoing, risk-based HREDD, to share responsibility for upholding HRE standards, and to cooperate to provide remedy to victims in the event of an actual adverse impact. The shared-responsibility approach supports more balanced buyer-supplier relations and more effective implementation of human rights policies and risk management processes that can in turn support better HRE outcomes in global supply chains. It also enables better legal compliance. [1] Examples of poor purchasing practices include: imposing prices that are too low to cover production costs (including labor costs); making last-minute changes to orders; requiring suppliers to assume HRE-related costs without providing additional—technical or financial—assistance; making unfair retroactive modifications to payment terms (e.g., asking for steep discounts after the order has been completed or shipped); inaccurate forecasting of how much of suppliers’ production capacity should be reserved and not paying for unused reserved capacity; short turnaround on delivery of goods, accompanied by steep penalties for delays; and irresponsible exit. [2] For example, in the face of COVID-related lockdowns, many buyers unilaterally invoked force majeure clauses in their contracts to get out of their contractual obligations to purchase from suppliers without considering the human rights impacts of their decisions. Suppliers, in turn, reduced their labor forces, passing on the economic impact to workers (and their families and communities). The order cancellations also generated a serious wage theft epidemic, whereby millions of dollars of wages – for completed work – were never paid to workers. For example, Ramatex, a Nike supplier, closed a factory during the pandemic and failed to make required severance payments to over 1,500 workers. Neither Ramatex nor Nike have compensated the workers to date, despite public reporting on the issue, and repeated investor inquiries. What are responsible contracts?
The RCP Toolkit contains several tools that can be employed to support better contracting practices that in turn support better HRE outcomes and better legal compliance. It is comprised of:
The MCCs 2.0, the SMCs, and the EMCs (together, the Clauses) are template contractual provisions designed to help buyers and suppliers better respect human rights in their supply chains. The Clauses are designed to give the parties and their counsel a starting point to contractually codify HREDD processes for purposes of improving HRE outcomes in their supply chains. They achieve this by translating the shared-responsibility principles enshrined in the UNGPs and the OECD Guidance into contractual obligations. The Clauses are modular, meaning they are designed to be selected, edited, and adapted by adopting companies. As such, the Clauses are not a one size fits all, and simple copying and pasting should be avoided. Rather, the Clauses should be selected and tailored by internal and external counsel according to the specific needs of the contracting parties as part of the companies’ due diligence processes. The Clauses reflect the three core principles of responsible contracting or the 3 “Rs” of responsible contracting:
[1] The MCCs 2.0 and the Buyer Code were developed by a working group formed under the auspices of the American Bar Association’s (ABA) Business Law Section and published in 2021. [2] The SMCs 1.0 were developed by RCP in collaboration with the German development agency, GIZ, and the Sustainable Terms of Trade Initiative specifically to respond to a request from apparel manufacturers and suppliers for contractual tools to bring into negotiations with brands. The SMCs 1.0 were published in September 2023. A simplified version of the SMCs is forthcoming in 2024, along with a SMC Drafting Guide. [3] The EMCs adapt the MCCs 2.0 for the more capacious and demanding European legal context. The EMCs are being developed by the European Working Group, an independent working group composed of legal practitioners and academics representing France, Germany, Italy, the Netherlands, Poland, Portugal, and Spain, as well as legal experts from the UK and the US. How is contracting relevant to HREDD?
Contracts are a mechanism for allocating risks, rights, and obligations between the parties—the buyer (and/or its representatives) and the supplier. How supply contracts are negotiated, the terms they contain, and their performance—how buyers and suppliers play out their contractual relationship— affects how well the human rights of workers are protected and how environmentally safe their communities will be. Used properly, contracts can function as a key component of HREDD.
Most traditional contracts rely on unrealistic promises of perfection and often place the supplier in breach of contract on day 1; these are out of sync with the HREDD approach. In addition, traditional contracts are generally focused on mitigating company risk, which is distinct from HRE risk. Furthermore, traditional contracting overlooks the buyer’s responsibility to manage its own actions and behaviors in such a way that supports—rather than undermines—positive HRE outcomes, while HREDD recognizes that a buyer’s own behavior, including its purchasing practices, can significantly contribute to adverse impacts. Finally, traditional contracts prioritize contract remedies that flow between the parties—not to victims—such as suspension of performance or payments, rejection of goods, immediate termination, and money damages, while HREDD requires that the parties (buyer and supplier) provide for, or cooperate in providing, remediation to the adversely impacted stakeholders. For these reasons, traditional contracts are often used to allow buyers to contract out of their HRE-related responsibilities instead of discharging them. 
When it comes to managing HRE risks, then, HREDD places cooperation, prevention, and remediation far ahead of termination—precisely the opposite of what is achieved through traditional contracts. And since, as discussed below, HREDD, and more specifically, effective HREDD, is now becoming a legal requirement for many companies through new legislation, the inconsistency between traditional contracts and responsible, due diligence-aligned contracts should matter to investors. Why should investors care about contracts?
Investors should care about responsible contracting for several reasons related to their corporate engagements, as well as to their own obligations as responsible investors.
On company compliance: First, as discussed above, companies that adopt (and adapt) the responsible contracting tools effectively could achieve alignment with the UNGPs and the OECD Guidelines, as well as better legal and regulatory compliance. Second, responsible procurement or purchasing is a key element of responsible business conduct, as well as prudent long-term, risk-sensitive business governance. Know the Chain (KTC) benchmarks companies across the food and beverage, footwear and apparel, and information and communications technology sectors and reviews purchasing practices as part of its evaluation process. In 2020, the average score on purchasing practices was 23 out of 100 across all three sectors, making purchasing practices one of the lowest scoring factors in the benchmark. This means that companies across all three of these sectors are either engaging in unethical recruitment practices or have yet to integrate human rights obligations into their relationships with their suppliers. This can lead to material risk in the short and long term. Supply chain instability may result in negative performance in the short term, while investments in a cooperative relationship between buyer and supplier that avoids such disruption can decrease turnover, increase resilience, and foster a healthier and more productive workforce. In addition, there is a growing body of research indicating that companies that are stronger on ESG metrics tend to perform better over time and present less investment risk (e.g., less litigation risk, less reputational risk, greater sustainability). Long-term risk analysis is particularly essential for pensions and index investors required to maintain their investments in a company for as long as the company is in the index, which could be decades. With the RCP Toolkit, investors have a tool to use with companies to improve their financial, as well as HRE performance. Contractual provisions, such as those contained in the RCP Toolkit, are a valuable tool for investors to clarify expectations with portfolio companies regarding ESG-related performance, validation, and data reporting. Indeed, large institutional investors are leading the call for decision-useful information on a company’s performance on ESG factors. The most significant ESG disclosure drivers for companies are the evolving legislative and regulatory requirements, such as the CSRD; the continuing integration by mainstream investors of ESG factors into investment decisions, ongoing portfolio monitoring, and engagement; and the proliferation of impact funds, or funds that are formed with the intent of achieving a specific ESG-related impact alongside risk-adjusted financial returns. On investor compliance: Finally, while neither the UNGPs nor the OECD Guidelines explicitly outline a role for investors in supporting HRE outcomes, the obligation to avoid causing or contributing (and preventing and mitigating) adverse impacts applies to all business sectors. The OECD’s report, Responsible Business Conduct for Institutional Investors: Key Considerations for Due Diligence under the OECD Guidelines for Multinational Enterprises, makes clear that institutional investors have an obligation to conduct due diligence across their investment portfolios to assess the HRE risk associated with particular investments. Specifically, they should: 1) adopt HREDD-aligned policies and management systems for investors; 2) identify actual and potential adverse impacts within (potential) investment portfolios; 3) use their leverage to influence investee companies causing an adverse impact to prevent or mitigate that impact and; 4) document, track, and communicate about the manner in which adverse impacts are addressed by the portfolio company and the investor; and 5) provide remediation where the investor has caused or contributed to an adverse impact. Investors should shoulder their responsibility under the UNGPs and the OECD Guidelines, as well as watch legal developments closely and equip themselves to engage with companies on how they are integrating HRE matters and, when applicable, HREDD requirements, into their processes, including their supply contracts. [1] They should use their leverage to promote a different, due diligence aligned approach to contracting (supported by responsible purchasing practices) referred to here as responsible contracting. [1] Investors were included in an earlier draft of the CS3D. Article 8a required institutional investors and asset managers “to engage with the investee company and exercise voting rights . . . in order to induce the management body of an investee company to bring the actual [adverse impact] to an end or minimize its extent.” While inclusion of the financial sector in due diligence obligations was reserved for a future date (and the future of the CS3D is uncertain), investors may, in future, need to get ready to meet new legal requirements. Why is HREDD-alignment so important? The turn toward mandatory HREDD legislation.
HREDD, as set out in the UNGPs and OECD Guidance, is the foremost standard for managing human rights impacts in supply chains. Although these international instruments remain ‘soft law’ in most jurisdictions, an increasing number of national and supranational laws are either in force or coming into existence requiring in-scope companies to conduct HREDD in their own operations and supply chains in line with the UNGPs and OECD Guidance.
Examples of mandatory human rights and environmental due diligence (HREDD) laws and sustainability disclosure laws already enacted include:
Another law of interest to investors and that is already in force in the EU is the CSRD, which requires large companies to make sustainability related disclosures based on a “double materiality” standard. Under that standard, companies must report on: (1) the impacts of their activities on people and the environment, and (2) how they are being affected and expect to be affected by sustainability matters. The contents of these reports could affect portfolio companies’ share prices, but also serve as a kind of HREDD alarm system in that, if a company’s reports reveal many or significant HRE issues, that could indicate that there will be other compliance problems down the line under the HREDD laws (especially if the CS3D is eventually adopted in the EU). Yet another significant development is the EU Taxonomy Regulation. A cornerstone of the EU’s sustainable finance framework, the EU Taxonomy Regulation helps direct investments to the economic activities most needed for a just transition in line with the European Green Deal objectives. The Taxonomy is designed to ensure that investments or activities labeled as “Taxonomy-aligned” meet certain minimum governance standards and do not violate social norms, including human rights and labour rights. The Regulation specifies that one of the three criteria for economic activities to be considered sustainable is that they are “carried out in compliance with the minimum safeguards.”[1] This includes an assessment as to whether or not the company has established an adequate HREDD process as outlined in the UNGPs and OECD Guidance. Contracting practices form a critical component of broader HREDD practices and should be considered in the evaluations of UNGP-alignment. The EU is also in the process of negotiating the final text of the CS3D under which companies that generate above a certain threshold of revenue within the EU—regardless of whether they are EU companies—will be required to conduct HREDD within their own operations and supply chains. At this time, the latest consensus text for the CS3D clearly articulates that contracts should not be used to transfer HREDD-related responsibilities from in-scope companies to other companies (e.g., suppliers) in their supply chains. Additionally, responsible purchasing practices (e.g., fair pricing that covers a living wage or a minimum wage, whichever is higher, and providing assistance to business partners to uphold HRE standards) are discussed in the text as an important component of effective HREDD. As such, rather than pursuing the traditional, risk-shifting contracting approach, in-scope companies would be better off proactively aligning their contracts with due diligence principles, as proposed in the SMCs, the MCCs 2.0, the EMCs, and the broader, still-expanding RCP Toolkit, which will soon include Responsible Investor Model Clauses (RIMCs). All of the Clauses in the RCP Toolkit are drafted to align with both best practice and existing and emerging legislation. In addition, the due diligence processes that underlie a commitment to responsible contracting will also better position companies to avoid importing goods made with forced labor into the United States, risking enforcement under the Tariff Act of 1930 or the UFLPA. In the event that a Withhold Release Order (WRO) is issued and goods are stopped at the border under suspicion of being made with forced labor, the due diligence collected will help the company either contest the WRO and have the goods released or to remediate and have the WRO lifted. [1] See also Final Report on Minimum Safeguards. Platform On Sustainable Finance. Oct 2022. https://finance.ec.europa.eu/system/files/2022-10/221011-sustainablef inance-platform-finance-report-minimum-safeguards_en.pdf |
