Since the beginning of the year certain companies have had to adhere to the due diligence requirements of the new German Supply Chain Act (LkSG). The act aims to safeguard human rights and the environment, focusing on slavery, lacking safety regulations, low wages, and environmentally inconsiderate manufacturing processes.

As of now the act is focused on enterprises with over 3,000 employees and headquarters in Germany. However, the act considers companies as more than singular concerns and recognises that their impact extends beyond their direct operations and consists of the companies along their international supply chains. Therefore, whilst its regulatory structure currently only specifies larger enterprises, small and medium sized enterprises (SMEs) are being caught in the middle as they often make up parts of bigger firms’ supply chains.

In practice this means larger firms introducing new contractual clauses to regulate and inspect the practices of SMEs along their supply chains, such as on-site inspections, training provisions, and corrective actions, to verify compliance with human rights and environmental regulations under the LkSG. In terms of penalties for breaches and non-compliance, larger firms under the direct scope of the LkSG can face severe fines amounting up to 2% of global sales. Whilst SMEs do not face the same fines, they are subject to contractual penalties from their partners as well as potential legal action from affected third parties. These contractual penalties could also be fines but can also include contractual termination. Whilst SMEs are not directly obliged to accept contractual changes complying with the LkSG, it is anticipated that it will become increasingly challenging for them to retain or secure contracts with larger firms. These larger companies could face fines, legal repercussions, and negative media attention for non-compliance with the LkSG regulations. As a result, they may push for SMEs to align with the Act's requirements to mitigate potential risks and liabilities. It is also expected that LkSG compliance will become standard in relevant contracts in future.

Due to the pressures from the proposed EU Supply Chain Directive on Corporate Sustainability and Due Diligence, Reed Smith anticipates the potential for tightening of regulations of the LkSG in the form of extended liability. Additionally, it is expected that the scope of the LkSG will be widened. The widening is expected to include companies with 500 or more employees and global net sales exceeding 150 million Euros. There will also be a more severe effect on SMEs as regulations are expected also to apply to companies directly with only 250 employees and global net sales exceeding 40 million Euros and conduct business in industries considered to be potentially damaging. The EU also proposed that the scope should even be widened to companies operating outside of these industries. 

It is advised that SMEs check whether they are in contracts with businesses which fall under the scope of the LsKG. In the likely case that they are, internal auditing and documentation of their business operations is recommended for preparedness to implement risk analysis and management systems. Having already consulted in matters relating to LkSG, Reed Smith is available for expert guidance on LkSG implementation and contractual changes.