Challenges for companies: the complexity of ESG regulation

Companies face increasing challenges as they navigate the complexities of regulations on sustainability reporting and compliance with human rights. With the introduction of reporting obligations regarding non-financial matters as well as of due diligence and transparency obligations in the areas of conflict minerals and metals and child labour, such rules have also been enshrined in Swiss law since 1 January 2022. The implementation of these regulations, which are still in their early stages, raises a number of questions, which require in-depth study in order to answer. Furthermore, there are still legal uncertainties that companies have to deal with.

We have summarised below some of these questions and considerations, which we believe to be particularly relevant to affected companies. The main focus lies in the question what companies fall within the scope of application of the corresponding obligations and on the reporting as such. Please let us know should you require additional advise.

The topics in detail

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1. What ESG regulations apply in Switzerland since 1 January 2023?
2. Who is affected by the non-financial reporting obligations?
3. Due diligence and transparency obligations regarding conflict minerals and metals and child labour: Which companies are affected from a territorial perspective?
4. Due diligence and transparency obligations on conflict minerals and metals: To which kind of minerals and metals and at what import or processing quantity do the obligations apply?
5. Due diligence and transparency obligations regarding child labour: Which companies can rely on the SME exemption in the context of groups of companies and to what extent can a risk-based approach be applied in the screening process?
6. When and how must reporting take place?
7. Is a focus on the Swiss regulations too narrow?

1) What ESG regulations apply in Switzerland since 1 January 2023?

As of 1 January 2023 – after a one-year transition period after the regulations came into effect – certain companies are required under Swiss law to report publicly on non-financial matters (in particular environmental matters such as CO₂ targets, social and employee matters, respect for human rights and the combating of corruption). The area of climate has been specified by the Federal Council in the Ordinance on Climate Disclosures, which came into effect on 1 January 2024.

At the same time, due diligence and transparency obligations were introduced regarding minerals and metals from conflict areas and child labour, which are critical from the perspective of a company's supply chain. The detailed regulations are set out in the Ordinance on Due Diligence and Transparency with regard to Minerals and Metals from Conflict-Affected Areas and Child Labour (DDTrO). If a company falls within the scope of application, it must comply with certain due diligence obligations. In particular, it must implement a supply chain policy and a management system and the traceability of its supply chain must be ensured. Compliance with the due diligence obligations in both areas (conflict minerals and metals and child labour) must be publicly reported on.

2) Who is affected by the non-financial reporting obligations?

According to Art. 964a of the Swiss Code of Obligations, only "companies of public interest" are subject to the obligation to report on non-financial matters.

On the one hand, this includes public companies domiciled in Switzerland (i.e. Swiss companies that have equity securities listed on a foreign or Swiss stock exchange or have outstanding bonds). It also includes Swiss companies that contribute at least 20% of assets or turnover to the consolidated accounts of another company domiciled in Switzerland that has equity securities listed on a stock exchange or outstanding bonds. The notion of "companies of public interest" also includes companies that require a licence, recognition, authorisation or registration from FINMA under the Swiss Financial Market Supervision Act, such as asset managers, banks and insurance companies.

These companies, however, are only subject to the reporting obligation regarding non-financial matters if they reach, together with the domestic and foreign companies they control, the following thresholds in two consecutive financial years: an average of 500 or more full-time employees and either a balance sheet total of more than CHF 20 million or a turnover of more than CHF 40 million.

3) Due diligence and transparency obligations regarding minerals and metals from conflict areas and child labour: Which companies are affected from a territorial perspective?

Companies with their registered office, head office ("Hauptverwaltung") or principal place of business ("Hauptniederlassung") located in Switzerland are subject to due diligence and transparency obligations regarding minerals and metals from conflict areas and child labour from a territorial perspective (Art. 964j para. 1 CO).

While the terms "registered office" and "principal place of business" leave little room for interpretation, there is some uncertainty regarding the term "head office". In principle, the head office is the place where the decision-making or the management of a company takes place. However, where is such head office located in constellations where foreign subsidiaries have a Swiss parent company? The answer to this question can be particularly difficult if, in addition to the mere control by a Swiss parent company, there are other links to Switzerland. The explanatory notes to the DDTrO contain a misleading passage that could give the impression that foreign subsidiaries are always within scope, due to the control by their Swiss parent company. However, in our view, such control is not sufficient to establish a "head office" in Switzerland. If the foreign subsidiary has a local management and conducts most of its business outside Switzerland, it should be excluded from the scope of application. These subsidiaries, however, are still relevant in the context of the threshold calculation for the import or processing of conflict minerals and metals (see Section 4) and the SME exemption in the area of child labour (see Section 5).

In our experience, authorities are – for the time being – not willing to make any reliable statements on the scope of the concept of "head office". There remains, also in this regard, a degree of legal uncertainty.

4) Due diligence and transparency obligations regarding conflict minerals and metals: To which kind of minerals and metals and at what import or processing quantity do the obligations apply?

The due diligence and transparency obligations regarding minerals and metals from conflict areas apply only to companies that, together with the companies they control, import certain quantities of minerals or metals containing tin, tantalum, tungsten or gold from conflict or high-risk areas into Switzerland or process them in Switzerland (even if they are sourced in Switzerland). For the relevant thresholds, the DDTrO refers to its Annex 1. In contrast, trading and processing outside Switzerland are out of scope.

The Swiss provisions do not explicitly state whether due diligence and transparency obligations only apply to the processing or importing of raw and semi-finished products or whether finished products are also covered by the provisions. As the EU Conflict Minerals Regulation only covers raw and semi-finished products and the EU regulation served as the model for the Swiss regulation, we believe that this should also be the case in Switzerland. Ultimately, the tariff numbers listed in Annex 1 of the DDTrO are decisive.

The due diligence and reporting obligations are limited to those minerals and metals that exceed the thresholds. It should be noted, however, that the thresholds need not be exceeded by minerals or metals from conflict areas. Rather, it is sufficient that even a small proportion of a certain mineral or metal originates from a conflict or high-risk area, provided that the thresholds per metal or mineral in total, together with the quantities of the companies controlled by the relevant company, exceed the thresholds set out in Annex 1 of the DDTrO.

5) Due diligence and transparency obligations in relation to child labour: Which companies can rely on the SME exemption in the context of groups of companies and to what extent can a risk-based approach be applied in the screening process?

In contrast to the regulations regarding minerals and metals from conflict areas, the legal regime regarding child labour does not (only) apply to products and services that are imported into or processed in Switzerland. Rather, all products and services produced or offered worldwide by a company with its registered office, principal place of business or head office in Switzerland may be affected.

Certain small and medium-sized enterprises are exempt from the due diligence and reporting requirements in the area of child labour (i.e. the SME exemption), provided that the use of child labour is not obvious. At first glance, this SME exemption appears to be clearly regulated by law. Companies are exempt from the obligations if they fall below at least two of the following three thresholds in two consecutive financial years: a balance sheet total of CHF 20 million, a turnover of CHF 40 million, and an annual average of 250 full-time employees. When calculating the thresholds, domestic and foreign subsidiaries controlled by the company must also be taken into account. What happens, however, if the Swiss parent company in a group exceeds the thresholds together with the Swiss companies it controls, but the Swiss subsidiaries themselves do not? Should the issue of child labour be further investigated only in relation to the products or services of the parent company itself, or also in relation to those of its subsidiaries? The answer to this question becomes particularly relevant if the parent company is a pure holding company and offers no or hardly any products or services itself.

According to the clear wording of the provision in the DDTrO, the domestic and foreign companies controlled by the company in question must be taken into account when examining the thresholds for the SME exemption. However, only the individual company that exceeds the thresholds – alone or together with the companies it controls – falls then within the scope. In the example above, this would concern the Swiss parent company only, and not the Swiss subsidiaries that cause the parent company to exceed the thresholds in the first place. In contrast, the explanatory notes to the DDTrO state that the SME exemption "naturally" only applies "if the company is not part of a group that fulfils these criteria".

Even if in certain contradiction to the wording of the DDTrO and despite dissenting opinions in the literature, we are – in accordance with the explanatory notes to the DDTrO – of the opinion that a Swiss subsidiary cannot rely on the SME exemption if the controlling Swiss group company exceeds the thresholds. A different view is unlikely to be compatible with the meaning and purpose of the provisions and would lead to inconsistent results.

Companies that do not benefit from the SME exemption are required to follow a two-step assessment procedure to determine whether there is a reasonable suspicion of child labour in their supply chains. The first step is to check whether the company is exposed to low risk and therefore falls outside the scope of application. Subject to an obvious use of child labour, this can be assumed if its products originate from (i.e. are "made in") countries where the risk of child labour is classified as "Basic" according to the UNICEF Children's Right in the Workplace Index. In the case of services, the relevant country is the one in which the services are primarily procured or provided. If the risk is categorised as "Enhanced" or "Heightened" in the index, a product- or service-specific suspicion check needs to be carried out in a second step in order to determine whether there is reasonable suspicion ("begründeter Verdacht") of child labour. It is largely unclear what is meant by "reasonable suspicion" and how and to what extent the specific suspicion check is to be carried out for potentially thousands of products or services and, according to the wording of the respective provision, for the entire upstream supply chain.

The explanatory notes to the DDTrO simply state that a suspicion is deemed to be reasonable if it is based on one or more specific and documented indications or perceptions that give rise to a risk that unlawful child labour is being used in the production of a product or the provision of a service. A photograph, for example, may serve as a possible indication. The UNICEF Children's Right in the Workplace Index may be an indication of reasonable suspicion of child labour, but is not sufficient on its own considering that the index already forms the basis for the previous step of the assessment. In order to carry out the suspicion check, the explanatory notes to the DDTrO further refer to the instruments that are also mentioned in the DDTrO for the implementation of due diligence obligations, such as on-site inspections, information from authorities, international organisations and civil society, consultation of experts and specialist literature, assurances from economic operators in the supply chain and other business partners as well as the use of recognised standards and certification systems.

We believe that a risk-based approach to suspicion checks is appropriate and in line with legal requirements. The higher the risk of child labour, the more intensive and comprehensive supply chain screening must be. In particular, this applies to complex supply chains. Therefore, companies should have a degree of discretion in the implementation of suspicion checks. In our view, a risk-based approach also allows for a differentiation between companies within the group of companies and third parties, considering that the risk of child labour varies and is typically lower for group companies.

6) When and how must reporting take place?

The provisions on reporting on non-financial matters as well as the due diligence and transparency obligations regarding minerals and metals and child labour were introduced on 1 January 2022 and apply for the first time to the financial year that began on or after 1 January 2023. Companies whose financial year began before 1 January 2023 (e.g. 1 July 2022) are not required to report on that financial year, but only on the following financial year (in the above example, the one ending on 30 June 2024). Since reporting requires action to be taken during the relevant financial year and due diligence obligations must be complied with during the relevant financial year regarding child labour and conflict minerals and metals, companies should assess early whether they fall within the scope of the regulations. This assessment preferably should be done at the beginning of the financial year for which reporting may then be required.

For all three areas, the reports must be approved by the highest management or administrative body of the company concerned. The non-financial report must also be approved by the body responsible for approving the financial statements (i.e. the annual general meeting) and then published electronically. The child labour and conflict minerals/metals reports must be published electronically within six months from the end of the relevant financial year. An external audit of the report is only required by law for the area of conflict minerals and metals.

If a company determines that it does not fall within the scope of the regulation(s), this finding must be documented in a comprehensible manner within the company. Unlike the report that must be published, there is no legal requirement for the internal documentation to be approved by a specific body. However, clear responsibilities at an appropriate level within the organisation are still advisable.

7) Is a focus on the Swiss regulations too narrow?

At the EU level, the Corporate Sustainability Reporting Directive (CSRD) exists as a counterpart to the Swiss reporting obligations on non-financial matters. The CSRD entered into force on 5 January 2023, with various transitional periods. It significantly expands the sustainability reporting obligations of companies in the EU. Swiss companies are also subject to the new reporting requirements if they generate net sales of more than EUR 150 million in the EU and have at least one subsidiary or branch in the EU. Switzerland appears to be aligning itself more and more with the EU rules on sustainability reporting. The Federal Council has recently decided to harmonise its non-financial reporting regulations with the CSRD to the extent that companies with 250 full-time employees (instead of the current 500 employees, see section 2 above) will be subject to the corresponding obligations.

In the area of corporate due diligence and transparency obligations along the value chain of companies, an EU directive is currently being drafted (the EU Corporate Sustainability Due Diligence Directive or CSDDD). Only recently, on 14 December 2023, EU legislative bodies reached a provisional agreement on its draft. Therefore, the CSDDD is expected to come into effect soon. Unlike the current Swiss regulation, the future EU supply chain directive will not only cover the areas of conflict minerals/metals and child labour, but will impose obligations on companies in relation to many other areas of human rights along the supply chain. According to a study commissioned by the Federal Department of Justice and Police (FDJP) and the Federal Department of Economic Affairs, Education and Research (EAER), several hundred companies in Switzerland are expected to be directly affected if they meet certain net sales requirements in the EU, whereas, unlike with the CSDR, no subsidiary or branch in the EU will be required in order to fall within the scope of the CSDDD. The study also indicates that several thousand Swiss companies will be indirectly affected by the CSDDD since obligations from business partners in the EU will be passed on to them. The Swiss legislator is expected to follow suit in this area as well.

For reasons of direct or indirect impact and to be prepared, international groups of companies in particular would do well to align themselves with international regulations. Where necessary, such measures can be supplemented by specific measures required by Swiss law. In the area of conflict minerals and metals, for example, full compliance with the EU Conflict Minerals Regulation already has the effect that such companies are exempt from Swiss due diligence and reporting requirements in this area.

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ESG

ESG – Environmental, social and governance

Expertise

14/11/2023

Legal Flash - The Federal Council Aims to Combat Greenwashing in Financial...

Background In 2022, sustainable investments worth around 1.98 trillion Swiss francs were made in Switzerland, according to the industry association Swiss Sustainable Finance (SSF). The number of cases of greenwashing by banks and financial service providers around the world has increased by 70 % in the last 12 months, according to RepRisk. On 30 September 2023, the Asset Management Association Switzerland (AMAS) Swiss Self-Regulation for Sustainable Asset Management entered into effect. Such sustainability self-regulation represents a further step in the transformation of the Swiss regulatory framework to integrate sustainable concepts, principles and rules. In addition, AMAS together with the SSF published the Swiss Stewardship Code, a guide to the exercise of shareholder rights by investors in Switzerland, on 4 October 2023. These new initiatives follow the Swiss Bankers Association (SBA) self-regulation on ESG integration issued by the SBA in June 2022, which entered into effect on 1 January 2023. From the perspective of the Swiss Federal Finance Department (FFD), however, these measures are currently not sufficient. The FFD has thus informed the Swiss Federal Council on 25 October 2023 that it intends to draw up a proposal for an ordinance for “prin­ciple-based state regulation” with regard to greenwashing in financial products by the end of August 2024, if the industry does not improve by then. Key Findings Swiss Self-Regulation for Sustainable Asset Management  The concept of “sus­tain­ab­il­ity” is of central importance for the application of sustainability self-regulation. A mere reference to individual elements or approaches to sustainability, such as exclusions of specific issuers or a simple ESG integration approach, is not considered a sufficient reference to sustainability. If reference is made only to the application of an ESG integration approach, it must be clearly stated that the collective investment scheme in question is not sustainable or is not managed sustainably. The same applies to a sustainable strategy that focuses exclusively on the exclusion approach. It is important to note that a reference to a particular approach, or a general reference to sustainability or ESG, can constitute a greenwashing risk irrespective of whether the sustainability self-regulation applies, if such reference is misleading, confusing or simply not appropriate to the nature of the assets or management. The application of comparable foreign standards – such as the EU Sustainable Finance Disclosure Regulation (SFDR) – is sufficient to meet the sustainability self-commitment issued by AMAS. The sustainability strategy with an indication of the investment approach pursued (e.g. exclusions, impact investing, thematic investing, etc.) must be made available to investors. The asset management agreement (directly or via an annex) shall specify the minimum proportion of investments that must comply with the sustainability requirements defined in the investment policy. Investors are informed about the sustainability approaches at least once a year in a report. For impact investing strategies, the annual reporting must show the extent to which the stated sustainability goals have been achieved. Key Findings Swiss Stewardship Code  The aim of this Code is to promote the active exercise of shareholder rights by investors in Switzerland by developing a more sustainable economy and increasing long-term returns for investors, taking into account sustainability risks. The Code is not binding. It is applicable on a voluntary basis and only makes recommendations. According to AMAS and SSF, the principles of the Code are aligned with the Global Stewardship Principles of the International Corporate Governance Network (ICGN). The Guideline addresses investors, as well as their asset managers and other service providers that deploy stewardship activities for investors. The Guideline complements existing civil and regulatory obligations. In other words, the Code does not conflict with such obligations or requirements, and compliance with its principles does not relieve investors and/or service providers from their respective obligations. In total, the guideline consists of nine principles for effective stewardship: (1) governance, (2) stewardship guidelines, (3) voting, (4) engagement, (5) escalation, (6) monitoring investees, (7) delegation of stewardship activities, (8) conflicts of interest, and (9) transparency and reporting. More information can be found here. Although this Code remains prin­ciples-based, it contains several specific recommendations and a clear methodology that can be of useful assistance to investors, asset managers and other service providers engaged in sustainable investment and stewardship. Conclusion The entry into force of sustainability self-regulation is another step in the transformation of the Swiss regulatory framework to integrate sustainable concepts, principles and rules. AMAS will continue to promote solutions and initiatives for an appropriate sustainable framework for the Swiss asset management industry, such as the Swiss Stewardship Code developed together with Swiss Sustainable Finance SSF or the promotion of the already existing Swiss Climate Score. Considering the intentions of the Swiss Federal Finance Department to potentially implement state regulation on greenwashing, the coming months will be decisive for whether Switzerland will opt for self-regulation, tough regulatory provisions or, even, a combination of both approaches.

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05/12/2023

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Consumers are increasingly focused on sustainability. Studies have shown that products with green claims sell better than others. But where are the limits of what is permitted when using green claims?

Publication