LkSG Relevant for Treasury on a Case-by-case Basis

The Supply Chain Due Diligence Act (LkSG) creates the legal framework in Germany to improve the protection of the environment as well as human and children's rights along supply chains. The German Association of Corporate Treasurers (GACT) spoke to Dr Julia Sitter from White & Case LLP about the relevance and need for action by Treasury departments.

The Supply Chain Due Diligence Act (Lieferkettensorgfaltspflichtengesetz, abbr. LkSG) came into force on 1 January 2023. Since then, companies with at least 3,000 employees have been obliged to comply with human rights and environmental due diligence obligations within their supply chains. The threshold for affected companies was lowered at the beginning of this year, meaning that since 1 January 2024 companies with at least 1,000 employees have been subject to the LkSG.

As the German Association of Corporate Treasurers (GACT) has learnt, many companies chose to address the question of the LkSG and its consequences at an early stage. This is also true of smaller companies which are suppliers to the companies addressed by the LkSG. In the meantime, many companies have implemented the LkSG by introducing codes of conduct, both with regard to their own customer relationships and to their position as suppliers. Corresponding clauses in supply contracts have been introduced to ensure compliance with due diligence obligations. In addition, many companies have decided to use so-called pass-on clauses to oblige their direct suppliers to include corresponding supply chain due diligence obligations in the agreements with their own suppliers. It should be noted that the businesses concerned do not impose the full catalogue of obligations under the LkSG on their suppliers – which the law does not require anyway.

Many areas within a company are involved in fulfilling the obligations of the LkSG. The GACT Risk Management working group asked Dr Julia Sitter, partner, lawyer and notary at White & Case LLP in Frankfurt am Main, what impact this law will have on the treasury departments of German companies.

GACT: Dr Sitter, has the implementation of the legal requirements shown that there is a relevance for treasury?

When companies began implementing the LkSG requirements it quickly became clear this was of central relevance for purchasing, legal, compliance and HR departments. We have not yet been able to identify any fundamental relevance for treasury departments in our consulting work. However, when it comes to the LkSG, the answer most frequently given is: it all depends. When it comes to the importance of the LkSG for treasury and the need for treasurers to familiarize themselves with the relevant requirements and reporting, companies need to look into the details relevant to their specific business.

GACT: Which banking, financial and finance services can be considered relevant and authoritative services within the meaning of the LkSG?

According to the LkSG, the term supply chain covers all the services (and products) provided by a company and includes all the steps taken in Germany and abroad that are required to provide the services. The supervisory authority responsible, the Federal Office for Economic Affairs and Export Control (Bundesamt für Wirtschaft und Ausfuhrkontrolle, abbr. BAFA), has published specific guidelines on the application of the LkSG to the credit and insurance industry. According to this guidance, the decisive factor for classification as part of a supply chain is whether a component or service fulfils a function in the finished product or plays a role in the manufacturing process and whether the product would not function smoothly without the component or service.

GACT: What role does a company's business model play in this?

Essentially, it does not matter which business model a company has. The supply chain can therefore also include financial products and financial services as well as IT or consulting services.

GACT: With regard to the banks: Which banking services are specifically affected by the LkSG?

The term banking services refers to both the regulatory core business and to all the other services offered by individual credit institutions. They are all covered by the definition of services in the LkSG. This includes lending, payment transactions and IT. However, according to one interpretation that can be found in the relevant literature, product development, compliance, risk and audit should also be included in principle if the areas concerned are subject to regulatory provisions. For the companies that utilize these services, it all depends on the importance of the respective service in the supply chain. In this respect, BAFA refers to the function or role of the service in the manufacturing process and/or finished product.

GACT: The LkSG therefore covers a wide range of services.

That’s right, the approach adopted by BAFA assumes a broad understanding of the term, but places restrictions on the organization of risk management, in particular in connection with the question of which risks a company must tackle first. Generally speaking: the LkSG’s concept of services does not cover acts that have no specific connection to the provision of services. However, the specific connection of an action to the provision of services is open to different assessments: According to guidance provided by BAFA, even the procurement of information and communication technology to equip business premises and the use of necessary external services, such as cleaning services for company-owned office space or commissioning market research companies, can form part of the supply chain as defined by the LkSG. In contrast, according to the literature (which is not uniform in this respect) the procurement of office material and actions by departments that only make a general contribution (such as canteen, facility management and security services) ought not to be seen as having a specific connection to the provision of services. The assessment of whether there is a specific connection to the provision of services will therefore generally come down to a case-by-case assessment.

GACT: What does this mean in terms of banking and financial services?

BAFA provides the following specific examples of financial services in its guidance: In the case of insurance companies, the investment of assets is said not to be part of the supply chain, and refinancing transactions are generally excluded as well. According to BAFA’s clarification, this applies unless, in the individual case concerned, there is a specific and consistent purpose-related link between the refinancing transaction and the banking service provided. According to BAFA, factoring and leasing transactions are also not included. And finally - and this should be of particular interest to treasurers - the supply of money, i.e., the provision of cash or cash-equivalent means of payment, does not constitute the provision of a service or supply within the meaning of the LkSG. One of the reasons BAFA gives for this is that the focus of such a contract is usually on making cash temporarily available to the contractual partner.

GACT: However, the seller of the leased asset is a direct supplier to the leasing company or credit institution and is part of its supply chain if it is a different person.

That’s right. BAFA has clarified this by explaining that the contractual relationship between the leasing company and the lessee is not part of the leasing company's supply chain. The same applies to sale and lease back transactions involving the same person, as the seller is also the customer of the leasing company or the credit institution and the focus of the transaction is the financing service thus provided. This also applies to entering into an order relationship where the leasing company joins a purchase agreement already concluded between the seller and the buyer or lessee of the asset to be financed.

GACT: What about hedging transactions that companies enter into with their banks?

According to BAFA, swap agreements and other derivative transactions in connection with (re-)financing transactions or on a stand-alone basis, forward transactions relating to commodities (provided they are to be settled in cash) and services typically provided by central securities depositories, trade repositories or data reporting service providers are also not included among the products or services relevant for the due diligence obligations under the LkSG. This is justified by pointing to the fact that, generally speaking, such hedging transactions do not establish a supplier-manufacturer relationship of the kind typical for the LkSG, and should instead be seen as representing a reciprocal financial transaction.

GACT: What conditions must be met for banks to be considered suppliers within the meaning of the LkSG?

Under Sections 2 (7) and (8) LkSG, a bank is considered a supplier to a company falling within the scope of the LkSG if it provides services which need to be supplied for the product to be manufactured or for the relevant service of the company to be rendered and used. Where a financing transaction entered into by a company active in the real economy and a credit institution has a clear and consistent purpose-related link with the products or services provided by the real economy company, these financing transactions fall under the provisions of the LkSG.

GACT: Can you give an example?

When a company takes out a loan from a bank, the bank is that company's direct supplier. A second example could be described as follows: If a supplier supplies a manufacturer (in our example, the company obligated under the LkSG) and takes out a financing loan for its product to be supplied, then the loan and the lending bank are also included in the supply chain. In this case, the lending bank is an indirect supplier to the manufacturer, i.e., the obligated company.

GACT: Do selected business processes, models or industries play a special role in the consideration of financial partners under the LkSG?

The general principles apply. If the role of the financial partner for the company is significant for the company's business activities and if as a result the financial partner is part of the supply chain, then as regards the company’s dealings with the financial partner the company is subject to the due diligence obligations of the LkSG in accordance with Section 1 (1) LkSG.

GACT: What should we pay particular attention to globally?

Particular attention has to be paid to financial partners in countries that have been identified as risk countries in the risk analysis, for example because of the occurrence of child labor or slavery or because health and safety regulations are disregarded. If a financial partner is an indirect supplier (for example because it grants a loan to a direct supplier and the direct supplier uses the loan to finance business practices that violate human rights or are harmful to the environment) then as regards the company’s dealings with the financial partner the company is subject to the due diligence obligations of the LkSG if it has substantiated knowledge of the rights violations.

GACT: Can you recommend how to deal with these issues in treasury?

As part of a company subject to the LkSG, a treasury department must comply with the company's requirements relating to the fulfilment of supply chain due diligence obligations. This includes, in particular, compliance with codes of conduct, but also participation in the risk analysis, (insofar as data has to be provided by the treasury department), and communicating the information needed in order to fulfil the documentation and reporting obligations.

GACT: What does this mean for the requirements for banks from a treasury perspective?

In principle, a banking service is part of a company's supply chain if the service fulfils a function in the finished product or plays a role in the manufacturing process and if this would not function smoothly without this service. Against this background, treasury departments can contribute to the contractual relationships with banks by calling up the reporting data relating to relevant banks and preparing it for use by their own company in terms of a holistic risk management approach towards the obligations arising under the LkSG. In such cases, it is therefore advisable for treasury to be part of the interdisciplinary project team.

The questions were asked by the German Association of Corporate Treasurers (GACT) Risk Management working group.

Translation: Laurent Faasch-Ibrahim