Transnational Private Regulation of Environmental Sustainability through Commercial Contracts. Reassessing Contractual Governance in Global Supply Chains

1 Introduction

Over the last fifteen years, sustainability requirements have become relevant both to access global chains and to trade within them. Sustainability affects both production and consumption. The sustainability principles define standards related to products and processes that may determine both (1) access and exit from the chain and (2) specific contractual obligations concerning both processes and products. The growing importance of sustainability and fundamental rights protection in supply chains has imposed a radical change in transnational commercial contracting, moving from a dominant commercial logic into a regulatory perspective.^[1]

The implementation of sustainability requirements along the chain has a significant distributional impact.^[2] Who bears the cost of standards’ implementation? Who decides how costs are allocated along the chain? Which legal principles affect the distribution of power and the contractual terms that define who bears the costs of implementation and the costs of remediation when sustainability violations occur? The new proposed contractual terms indicate that these costs should be shared according to a cooperative process between the chain leader (usually the Buyer) and the suppliers.^[3] 28

Implementation of transnational standards requires collaboration among the firms and especially the involvement of small and medium enterprises whose financial and cognitive resources might be extremely limited. Practices and the most recent legislation on due diligence obligations establish a chain leader’s legally enforceable duty to assist suppliers, that is the premise of the cooperative relationships in supply chains.

Global supply chains significantly contribute to the implementation of transnational sustainability standards.^[4] This contribution is often overlooked both by the students of transnational private regulation and by those of transnational commercial contracts. This paper, building on previous work, assesses the scope and effectiveness of private regulatory instruments regulating sustainability in global chains. It examines, in particular, how transnational commercial contracts can contribute to regulate cross-border sustainability standards concerning both products and processes, and implement them along global chains. It shows that the private regulatory power, exercised by the chain leader(s), often in collaboration with other participants in the chain, is wide but limited and subject to risks of abuse. It contends that the exercise of private regulatory power should be correlated to the introduction of accountability regimes and more specifically to legal liability.

Private actors regulate environmental and social factors affecting global production and distribution. Within transnational private regulation, a prominent role is played by transnational enterprises for their influence on global supply chains governance. Chain leaders bear responsibility to prevent, mitigate, and repair environmental harms occurring within the chain. The chain leader is the firm with the strongest contractual and market power that defines the economic and legal requirements, including sustainability, to access, remain, and exit from the chain.^[5] The leadership in the chain may be exercised by more than one firm, thereby shifting from a unipolar to a multipolar chain.^[6] In multipolar chains the private regulatory29 power is distributed between lead firms and suppliers.^[7] But even in unipolar chains, the power is distributed between the lead firm and, especially, tier one suppliers. Distribution of power influences the choice of instruments to implement sustainability standards and the allocation of costs and additional value stemming from the improvement of environmental performance.

The chains may present various regulatory power distributions with different degrees of asymmetry of power and liabilities among participants.^[8] In some chains the centralized control of the chain leader is very strong, in others there is a significant degree of delegation and discretion to define the modes of standards’ implementation. Regulatory power distribution influences the architectures of contracting within the chain. We shall examine different contractual architectures depending on the distribution of private regulatory power along the chain.

The governance of the chain requires a supply chain management that is not limited to the leader and its internal organization but includes the entire chain.^[9] Sustainable supply chain management includes (1) mapping the chain, (2) formulating the suppliers’ access requirements through a qualification system, (3) assessing the environmental impacts of production, processing, packaging, and distribution, (4) identifying the regulatory gaps in the chain, (5) defining the measures necessary to fill them out, (6) evaluating suppliers’ performances on environmental issues, (7) reporting the results of the adopted measures, (8) solving conflicts among chain’s participants and providing remedies (9) sanctioning and remedying for infringements.

Changes of governance have occurred for the use of digital technologies and the transformation of the role of intermediaries shortening the length of chains.

The performance of the outlined functions involves a very large number of participants and constitutes a form of transnational private regulation (TPR). Private regulation of supply chains deploys both legal and social norms, formal and informal30 governance.^[10] It regulates entry, exit and the role of suppliers within the chain. Whether TPR is effective and what is the degree of compliance with the standards deserve careful empirical scrutiny.

The field of sustainability implementation concerns not only private but also public and hybrid standards, among which stand out the UN Guiding principles on business and human rights, UN sustainable development goals and the ESG.^[11] Guidelines on sustainable management and responsible conduct have been issued by international organizations to implement the development goals.^[12] Transnational private regulation of sustainability interplays with international and national environmental regulations and due diligence obligations.

Legal standards related to sustainability have to go beyond the thresholds of public mandatory regulations set in the countries where the firms participating in the chain operate. Hence, usually, the private environmental standards are stricter than local public mandatory standards.^[13] To access the chain, enterprises have to meet and comply with those mandatory standards.^[14] In most cases these standards are obligatory for the firms belonging to the chain.^[15] 31

The production of transnational sustainability standards presents different features and geographical specificities. Increasingly southern and eastern chains have defined their own sustainability standards which may not coincide with the more established western standards.^[16] Standards’ differentiation can increase regulatory fragmentation and increase governance costs across the globe.

The supply chain is one of the vehicles through which implementation occurs. Standards can be implemented with transnational commercial contracts. Regulatory provisions in the contracts require a high level of inter-firm collaboration to implement and report sustainability performances.

The modes of implementation of sustainability through commercial contracts depend on the structure of the chains.^[17] Chains’ structures differ and strategies of implementation have to adjust accordingly.^[18] The adjustment of implementing instruments is driven by economic and institutional factors and the culture of the business community. The differences among chains concern distribution of contractual power, information asymmetries, technological capabilities. The standards’ implementation may require adaptation to the chain’s structure and to the specific regulatory regimes of the countries where the chain’s participants operate.^[19] Hierarchical chains require different instruments from relational chains; in particular, the degree of contractual standardization and completeness differs. The rules can be defined centrally by the leader or co-designed with suppliers and stakeholders. Distribution of power influences the contractual architectures of the chain. It shapes the modes of coordination and the instruments of cooperation among chains’ participants when implementing environmental obligations concerning for example product eco-design, CO₂ emissions, waste disposal.32

The level of suppliers’ awareness and resources to comply with demanding environmental standards significantly differs within and between chains. Global problems often require local solutions that reflect legal, socio-economic, and cultural specificities. Local regulatory solutions are the product of decentralization of decision-making power. Decentralization of regulatory power calls in turn for regulatory delegation. Delegation to first tier suppliers influences the instruments’ choice to regulate sustainability and the architecture of contracting. In particular, the relevance of coordination increases with delegation of regulatory power to suppliers and their subcontractors and to third parties. Usually, power concentration is combined with standardization of contractual relationships, whereas delegation is associated with a more intense use of relational contracts.

Chain leaders regulate through a wide range of instruments. The qualification systems and the architecture of contracting represent the most relevant ones.

Transnational commercial contracts play a pivotal role when outsourcing and offshoring are significant. Their role is more limited when chains are vertically integrated and located within the same jurisdiction. In these instances, domestic contract laws define the dominant pillars of the architecture of contracting within the chain.

Transnational commercial contracts have come to perform a significant regulatory function.^[20] Not only do they regulate trade by way of regulating exchanges of goods and services when firms are located in different jurisdictions, but they also regulate environmental, social and labor, data protection standards, to name a few areas. Often in the latter case the standards designed by transnational private regulators are the expression of multiple stakeholders, including international organizations (IOs). Contracts can regulate both processes and products.^[21]

Contractual relationships along the chain are collaborative and a duty of fair collaboration features in every contract. Contracting along the chain usually occurs among repeat players who develop their social norms together with those defined by the chain leader. The essential ingredient is mutual trust among chain’s participants, necessary to support long-term collaborative relationships.

The regulatory turn in transnational commercial contracts reflects a wider transformation of a chain’s risk management that includes not only business risks but also the management of environmental and social risks. Violation of environmental and social obligations can lead to contractual termination suggesting that33 these obligations have gained importance and relevance in the contractual regulation;^[22] they can no longer be considered ancillary to the main obligations about price and quantity. This integration has had a relevant impact on due diligence and compliance instruments within chains.^[23]

Such regulatory function is (1) partly driven by endogenous factors e.g. the information flow and the asymmetry among the parties responsible for the implementation, the coordination of standards implementation related to processes and products along the chain, and (2) partly related to exogenous factors, like the increasing parental liability for violations of human rights and specifically failure to monitor application of suppliers’ compliance with human rights.^[24] Unlike the domestic domain, where contract and regulatory law have so far remained quite separated, in transnational law they are blended, partly for the lack of transnational public regulators, partly for the complexity of global chains, spread across several countries.^[25]

Contracts allocate environmental risks, costs of prevention and costs of remediation, when environmental harms occur.

The use of transnational commercial contracts to perform regulatory functions needs adaptation of the doctrines developed in transnational commercial law. Especially the notions of breach and remedies differ since the commercial and the regulatory objectives related to sustainability do not coincide. Violations of environmental and social standards create negative externalities; they affect third parties’ interests: the environment, the employees, and the communities. Hence, regulating environmental externalities through contracts may require specific rules to measure performance, to evaluate violations, and to combine remedies with private sanctions.

The focus of this paper is on the contractual governance of supply chains determined not only by the architecture of contracting but also by the increasing role of due diligence obligations defined by both international and national legislation.^[26] 34 The paper proceeds as follows: section II describes the features of private regulatory powers in the supply chain, section III analyzes the regulatory functions of transnational commercial contracts in supply chains, section IV examines the qualification system and the rules concerning entry and exit from the chain, especially in relation to environmental thresholds and standards, section V addresses the enforceability of sustainability contractual terms, section VI analyzes the remedies concerning environmental harms. Section VII discusses the functions of private contractual sanctions, section VIII concludes.

2 Private Regulatory Power in Global Chains – Concentration versus Delegation – Agency Costs and Incentives’ Design

Sustainability standards are often the outcome of a multistakeholder process where NGOs and international organizations cooperate with transnational enterprises to define and select the most appropriate regimes for the chain. The regulatory power can be shared among various chains’ participants and between firms and stakeholders. Standards are implemented through contractual terms.

The expansion of transnational private regulation is partly driven by the shortcomings of local public regulation in the field of social and environmental sustainability. Global chains have transnational scope whereas local public regulators lack the power and the capacity to engage in extraterritorial oversight of global production processes affecting the environment and the working conditions of employees.

Transnational private regulators include but are not limited to chain leaders. Both standards and model contract clauses have also been drafted by trade and lawyers’ associations.^[27] Trade associations integrate the standards with specific elements related to the industry they represent. Lawyers’ associations, instead, have devised general clauses and used policy annexes to diversify the terms according to the needs of the specific industry or of the supply chains.^[28] A strong influence on the35 architecture of contracting is played by certification and in particular by the chain of custody models.

Private regulators can use coercion and/or persuasion that can translate into mandatory or voluntary instruments within the contractual tool kit.

Chain leaders, when governing chain’s sustainability, combine preventive measures and ex post liability rules. They engage in preventive action and force the chain’s participants to adopt precautionary measures as a requirement to access and to remain in the chain. Prevention may result in thresholds or paths. The former determines access with minimum level, the latter define a path towards the improvement to implement environmental and social standards. Transition plans related to climate change represent a good illustration of strategic preventive action involving the chain’s environmental policy.^[29]

Chain leaders also deploy ex post enforcement based on liability rules when parties violate the commitments to comply with sustainability obligations. Hence the private regulatory tool kit includes both ex ante and ex post instruments.

The regulatory power of chain leaders encompasses standard setting, monitoring, and enforcement.^[30] Different legal instruments can be used to exercise this power, depending on the regulatory tasks, the objectives, and the structures of the chains.

3 The Regulatory Functions of Contracts – Sustainability Obligations in Transnational Commercial Contracts

Sustainability includes both transnational environmental and social standards but their implementation through the chain may require different contractual44 instruments.^[61] This analysis focuses on the environmental aspects but some of the issues related to supply chain regulation encompass both dimensions.^[62]

Environmental standards concern both products and processes. Both dimensions involve multiple actors in the supply chain from product design to product implementation and reuse.^[63] Even within environmental standards differences may require specific regulatory instruments depending on the objectives e.g. preserving biodiversity, contrasting climate changes, reducing carbon emissions, promoting circular economies. Often the implementation of sustainability requires changes at the chain rather than the firm level. For example, in the case of regenerative agriculture the necessity to involve multiple actors determines the need to coordinate obligations concerning not only farmers but also land owners, input providers, and processors.^[64] 45

The examples in the analysis below are drawn from carbon emissions and disposal of hazardous wastes, but the general framework related to the instruments’ complementarity in chain’s governance may also be applied to other environmental areas.

Multiple private regulatory instruments are available, and the choice is partly driven by the ability to involve and control remote participants in the chain, located in different jurisdictions.^[65] The degree of power centralization affects the choice of instruments.

Among the regulatory instruments with direct impact there are programs designed by chain leaders.^[66] Environmental programs directly influence the production and distribution processes by introducing new technologies or revise sourcing and logistics, including policies to minimize transportation, and storing costs. Programs can translate into environmental plans referred to individual firms or clusters. In the case of environmental obligations, often the first-tier suppliers are required to submit an environmental plan that reflects the state of the technologies available at time of their enrollment in the qualification system and the steps to improve their environmental performance over time.^[67] The plans have to map and assess environmental risks and define the preventive measures that avoid or mitigate environmental harm.

These plans may also be related to the specific environmental performance defined in the contract. This is the case for carbon emissions where a general plan46 concerning emission for the year is linked to a specific target concerning the production process in which the parties are involved.

It is important to underline that sustainability requirements have to be complied with by all those who participate in the chain, together with the other requirements.^[68]

Chain of custody regimes for sustainability ensure coordination when certifiers are involved.^[69] These obligations have a double implication: (1) individual enterprises have to define a suitable internal governance to comply with those standards and (2) they have to undertake more specific obligations when they engage in individual transactions and perform the contractual tasks. Sustainability requirements have been integrated in the more general supplier codes so that all suppliers, including subcontractors, have to abide by them.^[70] For the chain leader, the obligation concerns the governance of its own firm and that of the supply chain including suppliers and their subcontractors. Whether the sustainability principles are effectively enforced in the chain remains an open question.47

Contractual relationships in supply chains are often long term and repeat, although spot transactions may also be used, depending on the chain structures and on market conditions.^[71] Relational chains present contracting features different from hierarchical and captive chains. Usually, the former feature higher contractual incompleteness than the latter. However, crises may destabilize contractual relationships and transform their features, forcing the parties to redefine the obligations and to allocate costs. Relational contracting can be subject to standardization in order to coordinate the various nodes of the chain. The degree and the mode of contractual standardization may vary depending on the characteristics of the chain.

Within the contracts different aspects co-exist. The sustainability requirements in commercial contracts are often regulated separately from the quality and safety standards concerning products and processes.^[72] For example, in agrifood chains parties have to comply with the principles of sustainable agriculture usually defined in separate documents.^[73]

The features of regulatory contract law may differ from those regarding commercial aspects. For example in relation to the breach, the distinction between fundamental and non-fundamental breach that characterizes the conventional contractual liability differs from the notion of serious and minor violation typical of regulatory violations. The former usually focuses on the consequences of the breach, the latter, instead, mainly on the gravity of the violation and only secondarily on the consequences. Clearly the regulatory function of contracts implies that deterrence48 features more prominently in sustainability than it does in the context of purely commercial issues related to conformity of the good or service.

An example of environmental commitments in global chains using commercial contracts is the reduction of CO₂ emissions.^[74] The net zero target plans, defined according to the guidelines of Target based science initiative (TBSI), is a good illustration. The development of science based targets for decarbonization permits the adjustment of the targets to scientific and technological innovations.^[75] Multinational enterprises are required to define plans that involve their suppliers.^[76]

The costs of the emissions are relevant to define the targets and the consequences of the failed performance. Carbon pricing has been recognized as an effective instrument to police CO₂ emissions.^[77] It is usually distinguished between external (public driven) and internal (private driven) carbon pricing.^[78] Carbon pricing has to be science based.49

Chain leaders set targets of emission reduction for the whole chain and impose obligations on the suppliers and the subcontractors to reduce the emissions and meet the targets. Emission reduction by the participants in the supply chain is often regulated by programs that parties subscribe to. Emission reduction and carbon offsetting are considered among the most relevant strategy and a policy debate is ongoing about their equivalence.^[79] Among the instruments a voluntary carbon market (VCM) has gained increasing importance.^[80] Through offsetting emissions, enterprises can finance projects by purchasing credits.^[81] These credits offset the emissions they produce. Offsetting can occur within global chains or in open markets.

In relation to decarbonization the distinction between carbon compensation and carbon neutralization is highly relevant to describe the regulatory policies for the chain.^[82] Compensation refers to offsetting whereas neutralization refers to carbon50 removals. They require different regulatory instruments. Usually, companies adopt both strategies with a different combination over time.^[83]

Accounting and reporting carbon emissions may differ depending on the actors within the chain. The Green house Gas (GHG) protocol distinguishes between scope 1, 2, and 3.^[84] Scope 1 includes direct on-site emissions. Scope 2 includes indirect on-site emissions (e.g. purchased electricity). Scope 3 includes upstream or downstream emissions in the value chain outside a company’s own operations. Scope 3 concerns suppliers that may be subject to operational and (or) financial control by the chain leader.^[85] The great bulk of violations occurs in the scope 3 level.^[86] The main obstacle to implement transnational standards along global chains is with the subcontractors, often small or micro enterprises with little technological capacity and limited financial resources to afford the costs of emission reduction.^[87]

A great deal of progress has been made in the last ten years to reach out to the upstream part of the chain but problems concerning knowledge and resources still present daunting challenges. To improve monitoring and coordination of carbon emissions, lead firms have provided electronic platforms to track emissions along the chain and report the individual performances.^[88] 51

Another example of environmental obligations, implemented through transnational commercial contracts, concerns the use of hazardous substances in the production process.

Violations of environmental contractual obligations may lead to sanctions and remedies. But rewards can also be used.^[89] Carrots have grown over sticks especially when initial organizational and technical capabilities are low.^[90] Sustainability private regulatory models combine coercion with persuasion and, to a limited extent, finance behavioral changes. Supply chain policies combine rewards and sanctions to promote improvement that can lead to upgrading.^[91] This essay focuses more on remedies and sanctions but refers occasionally to the parallel system of rewards that is in place.

In the next section the analysis focuses on two sets of instruments deployed to regulate the composition of the chain and contracting: (1) the qualification system that defines requirements to access the chain and (2) the General terms and Conditions that determine the modes and content of contracting together with supplier codes and ethical codes.

It is important to distinguish between failure to comply with sustainability requirements listed in the qualification system (direct power over contractors and subcontractors) and breaches of contractual terms that include environmental obligations concerning waste disposal, hazardous substances, emission reductions, etc. In the former case the consequences of the violation can be downgrading in the ranking of the qualification system and a request to submit and comply with a remediation plan, or, for more serious violations, suspension or exclusion from the52 chain.^[92] In the latter, remedies and sanctions, including pecuniary sanctions, can be administered by the contractual party directly or through judicial intervention.^[93] The analysis of the administrative sanctions that local public regulators can administer is not considered in this paper albeit very relevant. Administrative sanctions complement both the private sanctions imposed by the chain leader and the remedies of the contractual counterparty (first or second tier supplier).^[94] EU legislation has recently introduced environmental legislation that combines administrative sanctions and civil remedies for violations in supply chains.^[95]

4 The Qualification System to regulate Access and Exit to the Chain and Its Role for Sustainability Performance

Qualification systems and procurement have changed both functions and identity over time.^[96] They used to be tools to select the best commercial partners. They have become instruments to evaluate the regulatory capacity and the ability to implement regulatory standards within the chain, in addition to the more traditional functions. Among the requirements for the qualification system stand out the53 capacity to implement sustainability, including both environmental and social standards.^[97]

The qualification system defines requirements to access, to remain in the chain, and the occurrences that may justify forced exit from the chain. The scope of qualification systems may include only first tier suppliers or extend to subcontractors and second or third tier suppliers.^[98] These requirements include commercial quality, sustainability, ethical integrity, and technical capacities of the requesting party.^[99]

Suppliers are registered, classified, and ranked with the qualification system.^[100] The status within the chain lasts for three or five years and then the enterprise is subject to a new evaluation.^[101] The qualification system defines the minimum requirements to become a supplier in the chain. It is usually comprehensive, and54 encompasses not only commercial but also integrity, (corruption related requirements), and sustainability requirements.^[102] The qualification system may include not only first tier but also second, and third tier depending on their size and stability. It can rank the suppliers and allocate business opportunities accordingly.

The qualification architecture is built on a ranking system connected to the risks of non- compliance with sustainability and other requirements.^[103] The suppliers may be classified according to their strategic relevance and subject to a differentiated system.^[104] They are ranked within the qualification system according to their level of risks calculated with objective indicators.^[105]

The qualification system can define sustainability performance targets that would not be feasible in the context of individual contracts. For example, climate transition plans to achieve ESG goals.^[106] Hence, not only the qualification system provides complementary regulatory tools, but it also permits planning and oversight that reduces the shortcomings of the cascading compliance models.

Parties that participate in the chain must all respect the sustainability requirements of the qualification system, regardless of the existence of a direct contractual relationships with the chain leader.^[107]

The qualification system is related to procurement. Procurement regulates both access and participation to the chain’s activities. It can refer to a single firm or to a group. In the case of a pyramidal group the analysis of the qualification system focuses on both the parent companies and the subsidiaries. Procurement oversees suppliers’ performance evaluation. Not only evaluation by the chain leader is made to grant access to the chain, but also during the collaboration the chain leader’s55 procurement puts in place an evaluation system with score cards that measure the overall performance, including sustainability.^[108] The performance evaluation system bears consequences on the positions of the suppliers in the ranking and can determine their upgrading and downgrading.^[109]

Access to the chain follows a procedure to verify the existence of the requirements.^[110] The suppliers do not have a right to access the chain; the evaluation, based on the qualification system, is left to the discretion of the competent body, a supplier qualification committee, usually chaired by the chain leader.^[111] The access to the proceedings is not participatory and it usually does not prescribe any procedural guarantees for the party seeking access to the chain. Hence usually the party seeking access to the chain does not have a right to be heard and a right to complain in case of rejection.

Risk assessment concerning the suppliers is a key feature of both the selection system and the allocation of business opportunities among the registered suppliers. It is based on the attribution of levels of risk to the suppliers. Suppliers are ranked not only the by their performance but also by the risks of due diligence violations.

Through the qualification system the chain leader can exercise direct control over second and third tiers with whom it does not have direct contractual relationships.

Suppliers are subject to continuous monitoring by the chain leader procurement units and to auditing by independent organizations that evaluate the compliance with the requirements.^[112] They evaluate the level of risks associated with56 organizational and contractual performance.^[113] Accordingly, the level of risks related to individual suppliers changes in relation to their contractual performances.

A key feature of evaluation depends on whether the contractor operates within the chain exclusively or engages also in transactions with competitors of the chain leader.^[114]

The initial access requirements, defined in the qualification system, may be upgraded with specific programs designed by the chain leader. Access to the chain can be immediate or gradual, based on a process that allows the requesting supplier to meet the requirements over time.^[115] The position in the chain can also be affected by sustainability performances. The chain leader may set more ambitious targets over time and support the suppliers in their efforts to modify production processes, including transportation and packaging.^[116] Climate change transition plans, for example, engage the enterprises into a long term transformation that affects their processes and their governance. These targets can define long term commitments by the chain leader and its contractors independently from contractual specific obligations. The CO₂ emissions reduction programs of the entire chain show that frequently chain leaders collaborate with their suppliers to ensure the achievement of the target.^[117] Hence, on the one hand57 common plans and investments are made; on the other hand, compliance checks on the supply chain are performed.^[118] If targets are not met, collaborative strategies are developed to identify the causes and to improve sustainability performances. In extreme cases of failure to perform, however, the suppliers can be excluded from the chain.

Failure to comply with the qualification committee’s instructions may lead to the suspension or the exclusion from the qualification system and, consequently, from58 the chain.^[119] These measures, instead, have the nature of private sanctions. Clearly there might be post-contractual obligations that persist even after exiting the chain. This is certainly the case for environmental violations whose responsibility remains, despite forced exit from the chain.

When suspension is combined with the requirement of an improvement plan both functions (promoting and sanctioning) co-exist.

The functional differences between the improvement plans, suspension, and termination require different procedural requirements and the application of different principles depending on the remedial or sanctioning nature of the measure. Private sanctions related to the qualification system, as we shall see, have to be effective, proportionate, dissuasive.^[120]

Whereas the chain leader has direct power to downgrade, to sanction with suspension, and to exclude subcontractors from the chain based on the qualification system, it faces limitations for the privity of contract to sanction directly the violations committed by subcontractors according to the contractual terms.

5 The Broader Functions of Commercial Contracts and Contract Laws to Achieve Environmental Regulatory Objectives

Governing sustainability in global chains calls for a multi-instruments strategy to control firms’ capabilities and performances. Environmental requirements encompass those necessary to participate in the chain and those specifically related to the contractual performances. The former measure the organizational features to implement environmental standards and refer to the capacity of the enterprise; the latter concern the ability to perform and to engage in production and distribution processes compliant with the environmental standards. In the previous section the qualification system has been analyzed. In this section the complementary instrument of contractual architecture and terms concerning sustainability is examined.

The chain leader may have direct control over the choice of subcontractors made by the supplier. Accordingly, the supplier can be authorized to subcontract, and the chain leader must approve the list of subcontractors once the compliance with the requirements has been verified.^[121] Unlike the qualification system, where there is59 direct control with long term duration, in this instance there is a case-by-case verification by the chain leader related to each procurement contract. The choice between integrating the subs in the qualification system or verifying case by case, depends on the strategic importance of the subcontractors and the frequency of their participation in the chain’s activity.

The General Terms and Conditions (GTCs) define the content of contracts deployed within the chain. They usually include terms concerning environmental sustainability that may be supplemented by separate general principles and guidelines, issued by the chain leaders, and incorporated by reference in the contracts.^[122] These terms impose costs on the parties for the benefit of third parties (environmental protection and employees).

When the deployment of GTCs is imposed on suppliers with their subcontractors there is a clear limitation of private autonomy. When there are conflicting interests, as can for example happen in relation to remedies, the parties can deviate from GTCs and even if they reproduce the clause, one of them can claim its voidness for abuse of dominant position or the abuse of economic dependence.60

Transnational commercial contracts have become instruments to implement sustainability and in particular environmental standards.^[123]

Regulation of sustainability obligations in commercial contracts includes the definition of (1) standards and the possibility to differentiate depending on size and capabilities of suppliers, (2) performance indicators, (3) criteria to establish the severity of violations, (4) remedies, and (5) sanctions. In some instances, the chain leader only prescribes remedies; in others it also includes private sanctions. Private sanctions are usually associated with a breach of contractual regulatory requirements, thereby accentuating the role of the chain leader as a transnational private regulator.

The enforcement of these obligations poses daunting challenges to the conventional contract law and forces to rethink the remedial and sanctioning strategies usually applied to commercial terms (quality and price). It should be underlined that supply chain governance requires prevention, mitigation, and redress. Hence enforcement choices should be seen in relation to the model of chain’s governance.

We first examine who can enforce the terms and subsequently how can the sustainability terms be enforced. The section concludes with a detailed analysis of remedies for breach.

The chain leader defines the standards that contractors have to meet when they engage in individual transactions. Parties within the chain are obliged to draft their contracts accordingly. The first-tier supplier has an obligation towards chain leader(s) to warrant subcontractors’ compliance with environmental obligations.^[124] The suppliers must ensure that subcontractors comply with the standards61 defined by the chain leader. Both parties may however lack incentives to enforce those terms and collude. What are the legal instruments available to the chain leader to ensure that the terms are included in the contracts and to enforce them when it is not party to the contract?

Contracts that do not comply with the GTCs cannot be modified unless a specific clause empowers the chain leader to seek contractual changes. The chain leader cannot directly enforce subcontractors’ obligations towards the suppliers for lack of privity.

When violations occur the chain leader obliges first tier suppliers to seek remedial actions towards second and third tier suppliers. Here both monitoring and enforcement are indirect and decentralized. The problems related to indirect enforcement concern the incentives of suppliers to monitor performance and to enforce environmental standards. Unlike the commercial issues, where suppliers have incentives to monitor and enforce the obligations related to the conformity of goods and services delivered by their contractors, in the case of environmental standards often second and third tier suppliers lack the incentives to monitor since compliance with environmental standards usually does not confer them direct benefits whilst often requires bearing costs. For this reason, the indirect enforcement power of the chain leader operating with the cascading compliance regime may lead to suboptimal results and must be complemented by the qualification system where the chain leader holds direct enforcement powers.

When direct power exists, are environmental obligations enforceable through conformity terms or do they need specific terms? According to the conventional view of conformity a good or a service can be perfectly fit with the specifications and yet violations of environmental and social standards might have occurred. However, a broader notion of conformity can also include process standards and in particular sustainability obligations.^[125] Hence conformity can be used to enforce environmental62 rules concerning processes that result in products that may be fit for commercial purposes but not for sustainability. The new legislation on due diligence provides independent instruments to enforce environmental obligations without necessarily expanding the scope of conformity.^[126]

Environmental terms incorporated in the contract differ from the commercial terms in relation to the notion of breach and to the content and objective of remedies.^[127]

Liability for violations of environmental obligations is imposed on the infringer by contractual arrangements. Environmental obligations concerning production processes often apply along the entire chain in order to ensure certifiability of the final product necessary to access a particular market. Not only suppliers have to comply, but they also have to monitor subcontractors’ compliance. Failure to monitor subcontractors can give rise to suppliers’ liability along the chain. Due diligence obligations may lead to the extracontractual liability of the chain leader. Different liability models are in place. Some are discrete, others are shared.

The Model Contract clauses 2.0 recently published by the American Bar Association (ABA) have replaced the previous either/or model with a shared liability approach.^[128] A similar approach has been taken at European level.^[129] Shared liability usually results in joint liability.^[130] The shared responsibility model between suppliers and buyers adopted by MCC 2.0 pursues the objective of encapsulating the strong interdependences between parties’ performances required by the implementation of sustainability standards along the chain.^[131] However, there is a risk of a misalignment between the allocation of regulatory powers and the63 distribution of liabilities. The power of chain leaders may not reflect their share of liability. Such misalignment can negatively affect suppliers’ incentives and reduce the effectiveness of contracts as regulatory instruments to implement sustainability. Hence the shared responsibility should always reflect the concrete distribution of powers between the parties along the chain.^[132] Shared liability should not be limited to the contractual parties but also include the chain leader when it is not party to the contract.

Therefore, on the one hand transnational commercial contracts include a regulatory function, on the other hand the specificity of private environmental regulation requires the introduction of specific notions related to breach and remedies and possibly other elements of the contract. For example, the breach of contractual environmental obligations is regulated with criteria different from those related to quantity and safety. The distinction between minor and major violations encompasses both an analysis of the seriousness of the consequences for the environment and an assessment of the negligence or intention to cause that harm.

First tier contractual suppliers’ liability towards the chain leader is usually strict and not fault based. Contractual strict liability usually applies both to the supplier’s obligation and to their duty to monitor subcontractors. When the remediation plan concerns subcontractors’ conduct, the first-tier supplier is responsible towards the chain leader for the compliance with the plan even if the breach depends on the subcontractors’ activities and the misuse could not have been prevented by their due care.

If the breaching party does not deliver a remediation plan or does not comply with it, then the non-breaching party has the power to seek more severe remedies like contractual suspension or termination. However, as underlined before, the chain leader cannot impose these measures on subcontractors unless the contract contains a specific authorization term.

6 The Enforcement of Sustainability Contractual Terms in Global Chains: Remedies for Breach

Control over standards’ implementation depends on the chain’s governance and the modes of enforcement. Enforcement of contractual terms can be direct or indirect. Breach of sustainability standards included in commercial contracts may lead to the adoption of both remedies and private sanctions. Remedies include both preventive64 and reactive measures. They specifically address the violation of environmental obligations but may also concern delivery of goods and services produced with environmental harms.

Remedies for breach of sustainability contract clauses concerning environmental standards can include correction, restitution, compensation, and termination.^[133]

Remedies for breaching environmental obligations sensibly differ from those related to breach of quality or safety requirements. The objective of prevention and the focus on correction rather than compensation characterize the remedial pyramid. They have to be consistent with the precautionary principle. However, the chain leader has less control over the choice and effectiveness of remedies selected by the supplier against its subcontractors for violations of environmental harms.

Remedies are generally articulated in an escalating form that moves from collaborative to hierarchical enforcement.^[134] Usually corrective remedies come first, followed, in case of persisting non-compliance, by the contractual65 suspension of the counter performance and, eventually, by the possibility to terminate the contract. In some instances, these remedies are either complementary or alternative and sequential, depending on the discretion of the chain leader. For example, correction of the causes of the environmental harm may be combined with performance suspension or may precede it. Compensation is not often used as a contractual remedy since the party who is seeking the remedy is not the victim in case of environmental harm. Contracts can allocate the liability costs of environmental harm caused by chain’s activity as for example in the case of the use of pesticides in agriculture where there is both a harm to health and to the environment. However, if the creditor is liable towards third parties the breaching party can be asked to indemnify him for the losses incurred because of the strict liability regime.^[135]

Prevention and reparation of environmental harm take priorities over compensatory remedies that monetize the environmental harm and termination that may leave the harm where it falls. Even in case of serious violations, termination of the contractual relationship might not be the most appropriate remedy for environmental violations. Interestingly the new EU legislative proposals condition contractual termination to the absence of contribution to the violation. When the other party has contributed to the violation it cannot seek termination.^[136] When termination occurs the breaching party may still have post-contractual obligations to repair the environmental harm that would otherwise only rest on extracontractual liability.

Corrective remedies should have priority since they are the most consistent with the precautionary principle. A similar conclusion holds for the contractual violations of social standards.^[137] They usually result in remediation plans where the breaching party commits to repair the negative consequences according to objective indicators and a timeline. It should be underlined that remediation plans can also be required for66 preventive reasons where there is risk of violation not yet materialized.^[138] If the violation has been committed by several parties the remediation plan can be collective and address the consequences for the entire chain.

Remediation plans can take the form of an agreement between the infringer and the counterparty where the former makes enforceable commitments to the latter to eliminate the harm. If the other party is also responsible for the adverse impact caused by the violation it should be involved in the remedial plan and take responsibility to repair the harm caused. These agreements often include provisions aimed at benefitting third parties who can have an enforceable right against the party responsible to execute the plan. Breach of remediation plans can lead to remedies.

The identification of remedies, especially when they address not only the consequences but also the causes of the harm, can lead to coordination among various chain’s participants since often the violation concerns several parties along the chain. This is certainly the case when multiple breaches materialize but even when a single breach occurs with cascading effects over the contractual relationships downstream.

Take the example of the use of hazardous substances. The contractor (first tier supplier) is responsible for the appropriate use of hazardous substances. The contractor may also be responsible towards the chain leader for the misuse of hazardous substances by its subcontractors. At times the GTCs also envisage a liability of the subcontractor towards the chain leader for violations of sustainability obligations.^[139]

In case of breach consisting in the misuse of hazardous substances, remedies initially pursue correction rather than punishment. They are grounded on the interdependence among performances along the chain and the necessity to keep the contractual relationships working even if there is a breach. Termination of contract would be disruptive when performance interdependence is high. It is67 necessary to continue the production process and, at the same time, to remedy the environmental breach. The supplier has to deliver a remediation plan either when the misuse of hazardous substances is its responsibility or when it is the responsibility of the subcontractors. Remediation plans include actions by several actors that have to address the causes of the breach and the reparation of the harmful effects.

When there is a breach of contractual environmental obligations (e.g. violation of the prohibition to use hazardous substances, violation of the obligation to process the material with environmental effective technologies) the supplier may be required, in addition to reparation, to revise the environmental plan and to indicate the necessary corrections, by drafting a remediation plan in order to:

1. restore the correct level of environmental protection associated to the contractual performance;

2. prevent accidents and violations from happening in the future.

Contracts can be suspended until the corrective measures have been fully implemented and the preventive measures adopted to ensure that future accidents will not occur again. Suspension of the contract may also have consequences on the qualification position of the breaching party.^[140]

Contracts can be terminated in case of very serious and persistent violations, with consequences on the qualification position, for example downgrading.^[141] 68

In addition to remedies, especially for sustainability obligations, pecuniary sanctions may be levied.^[142]

7 Pecuniary Private Sanctions in the Qualification System and in Transnational Commercial Contracts

Private sanctions imposed on parties within the chain for environmental violations have to be effective, proportionate, and dissuasive.^[143] Private sanctions and remedies for violations of sustainability obligations are strongly correlated. They pursue complementary objectives. They can be cumulated.

The combination of penalties and remedies may differ depending on whether the non- breaching party wants to remain in the contractual relationship or terminate the contract.^[144] 69

In the conventional view sanctions deter, remedies repair. Sanctions primarily focus on the infringer’s conduct. Remedies focus on the victim which, in the case of environment, is usually the community (local and/or global).

Private sanctioning power can have different grounds: it can be based on the qualification system and apply to all chain’s participants, or it can be grounded on contracts and be limited by the principle of privity to the contractual counterparty. We shall examine both hypotheses and evaluate whether pecuniary sanctions may have different objectives depending on whether the violation concerns the qualification system or the contractual obligations or both.

In global supply chains the private authority e.g. the chain leaders levy private sanctions. Pecuniary sanctions imposed by the chain leader deserve special attention since they may combine various functions: deterrence, reparation, and innovation.

Private pecuniary sanctions imposed by the chain leader for violations of the qualification system differ from administrative sanctions administered by local public authorities. Administrative sanctions for both environmental and social violations are usually administered by national public authorities.^[145] Private sanctions, instead, can be levied by the chain leader without any jurisdictional boundary.

Private sanctions should deter violations, but they can also contribute to improve environmental innovation. When, as it is often the case, the money coming from the private sanctions goes to a fund directed at improving environmental performance by firms in the chain, the pecuniary sanctions combine punitive and educational functions.^[146] Those responsible for violations pay the costs of environmental innovation along the chain.

What are the principles applicable to private pecuniary sanctions?

The Supplier Codes or the more specific regulatory instruments devoted to sustainability do not usually specify principles concerning the determination of sanctions and the procedural guarantees associated to sanctioning. It is contended, however, that the principles of effectiveness, proportionality, and dissuasiveness should be applied by chain leaders when determining whether the sanction is appropriate and what should their amount be.^[147] Even if no specific reference to the principle of proportionality is usually made in the chain leader’s GTCs or sustainability principles70, it is a general principle that should be applied to both civil and administrative sanctions. More broadly, it is suggested that private regulators be subject to the substantive and procedural rules concerning administrative sanctions but for the principle of legality. Hence no specific legislative rule is needed to empower the chain leader to impose sanctions unlike the case of administrative authorities. They can be referred to the principle of freedom of contract.

The sanctioning structure, according to the principle of proportionality, should be correlated to the severity of the violation and be designed according to the principle of escalation. Less severe violations should be punished with lower pecuniary sanctions. The amount could increase with the severity of the breach, the magnitude of the consequences, and when the violation is repeat. If remedies differ depending on the seriousness of the breach the combination with pecuniary sanctions should be designed accordingly.

The potentially sanctioned party should be entitled to due process and procedural guarantees. Before the private sanction can be imposed, there has to be a proceeding where the potentially sanctioned party has to be informed about the violations and has the right to defend and respond to the accusations.

The private sanction should certainly be motivated and the chain leader or the competent committee should state why the sanction is necessary and indicate the criteria to determine the amount of the sanction. If the procedural guarantees are not complied with, the private sanction could be voided in judicial proceedings.

Not only private sanctions can be used when the qualification system requirements are breached but also in relation to specific contractual performances. Private sanctions in transnational commercial supply contracts are not unusual. Pecuniary sanctions can be deployed when there is a breach of sustainability obligations.^[148] In theory, private pecuniary sanctions can be used by both the chain71 leader and/or by the contractors when a breach of contract occurs. In practice, the sanctioning power is usually conferred to the chain leader.

Sanctioning is related to violations concerning contracts between the chain leader and the suppliers. The chain leader can impose a sanction for breaches of environmental standards committed by the contractor. The maximum amount is usually determined by the terms and conditions issued by the chain leader.

The chain leader can impose pecuniary sanctions also to non contractual parties within the limits posed by the privity principle. In order to avoid the violation of privity the sanctioning power must be based on a clause in the contract between the contractor and the subcontractor that authorizes a third party (the chain leader) to impose the sanction against the infringer. If such a clause is missing the chain leader cannot impose any sanction on subcontractors for violations of contractual obligations for lack of contractual privity.

What is the relationship between private sanctions and remedies for contractual sustainability violations? The focus here is on the private sanctions administered by the chain leader against its contractors for violations committed by the contractors or by the subcontractors of which the contractor is responsible for, based on specific contract terms.

Are remedies and private pecuniary sanctions related? In case of an affirmative answer how are they related?

When private sanctions are administered, do their functions change depending on the type of remedies they are associated with?

In theory, sanctions and remedies can be either alternative or complementary. In practice, they complement each other. In the case of sustainability’s violations, remedies are of great relevance because environmental harms can be remedied, mitigated, or eliminated through corrective and restitutionary remedies. Pecuniary sanctions do not usually perform any of these functions. They deter, punish and promote organizational changes.

As mentioned earlier from the very limited available empirical evidence it appears that sanctions administered by the chain leader can operate with all three families of remedies e.g. corrective, restitutionary, and compensatory.

Private pecuniary sanctions issued by the chain leader can be combined with corrective remedies sought by the contractual non breaching party.^[149] For example, the pecuniary sanction can complement environmental remediation and contribute72 to deter the violation which would be absent if the consequences of the violation were limited to remediation.

Pecuniary sanctions can also be combined with compensation when the breach of environmental obligations entails damages for the non-breaching party.

When pecuniary sanctions are combined with contractual suspension or termination or with forced exit from the chain the deterrence function characterizes both measures. In this instance the complementarity between private sanctions and remedies is limited, and the principle of proportionality may require a different approach to the choice and the definition of the amount of the sanction.

The proportionality evaluation concerning sanctions should internalize the remedy is combined with.^[150] Hence the use and the content of private penalties imposed by the chain leader should be correlated to the function and content of the environmental remedy/ies sought against the infringer. The amount of sanctions should be also correlated to the costs of the remedy, especially when remediation imposes radical changes to production or distribution processes.

The application of the principles of effectiveness, proportionality, and dissuasiveness is particularly important when private sanctions are combined with administrative sanctions levied by local public regulators. When, for example, a contractor who has violated environmental rules can be subject to both sanctions. In this case the party determining the content and amount of the private sanction should consider the public pecuniary sanctions in order to define its proportionality and dissuasiveness. When, in addition to the private and the administrative sanctions, remedies with a deterring function like contractual suspension or termination are deployed the principle of proportionality can avoid or mitigate overdeterrence.

8 Concluding Remarks

Private regulators exercise standard setting, monitoring, and enforcement powers to govern their global supply chains and design the contractual architecture relevant to implement sustainability standards. The regulatory power is distributed between chain leaders, suppliers, retailers, and third parties (intermediaries). Increasingly big suppliers are gaining bargaining power that affects the allocation of regulatory power along the chain.^[151] Power distribution influences the choices of private regulatory instruments to implement sustainability standards. National and transnational commercial contracts play a significant role both for the implementation and the enforcement of the standards.73

Distribution of power within the chain occurs in different ways among which prominently stands delegation by the chain leader to the suppliers. The balance between concentration and delegation of private regulatory power differs in relation to standard setting, monitoring, and enforcement. More concentrated in standard setting, shared in monitoring, decentralized for enforcement. The chain leader(s) hold standard setting power, share monitoring powers, and significantly rely on suppliers for the enforcement of contractual terms.^[152]

The combination of concentration and delegation of regulatory power depends on the application of private autonomy to transnational commercial contracts. Excessive concentration may undermine choice, reduce private autonomy, and violate the principles that regulate national and transnational contract laws even when they pursue regulatory objectives.

Technologies are increasing the possibility for direct control by chain leaders through electronic platforms and their ability to monitor sustainability performances of parties not in privity. Hence technology is contributing to the introduction of new governance models in global chains that redistribute regulatory power between chain leaders and first tier suppliers.

Two sets of private regulatory instruments can be used: on the one hand the qualification system that regulates access, participation, and exit from the chain; on the other hand, GTCs and specific environmental standards that define the content and the remedies of contractual terms deployed in global chains to define environmental performances.^[153] Qualification systems regulate entry, position and exit from the chain. Once the supplier is included in the chain, it is subject to a monitoring system to verify the persistence of requirements over time.^[154] Usually, yearly verification occurs, and the assessment is repeated every three or five years.^[155]

During their participation in the chain, the suppliers can be upgraded or downgraded depending on their performance and the level of risk. The position in the ranking can determine access to or exclusion from business opportunities within the chain74. When performance is below the desired level, an improvement plan is required and set in place to ensure future better performance. Hence different types of regulatory instruments may be used to impose changes on the suppliers’ organizational systems to improve sustainability performance. These measures do not have sanctioning nature but are aimed at promoting performance’s improvements and preventing failures.

In the GTCs the chain leader(s) may only refer to suppliers with whom there is privity of contract and include an obligation to impose the same obligations on subcontractors (so called pass-on clauses that define the cascading compliance model). The contractual remedies for sustainability violations, enforceable by the chain leader, can only apply to its direct contractual partners. It can interfere with contracts between parties belonging to the chain only if empowered by a contract clause.

The control by the chain leader over compliance with environmental obligations is both direct and indirect. Direct control operates through the qualification system and monitoring contractual performance in contracts with direct suppliers. Indirect control concerns the contractual relationships to which the chain leader is not a party. Indirect control, usually operates through the cascading compliance, is based on first tier suppliers contractually obliged to monitor and assure compliance with environmental standards of their subcontractors.

The analysis has shown that it is only the combination of direct control, with the qualification system, and indirect control, through delegation to suppliers and third parties, that can provide an effective governance of sustainability in global supply chains.

As highlighted earlier, the chain leader can impose on contractors a duty to ensure compliance of subcontractors with sustainability standards and introduce contractual clauses that make the contractor accountable not only for failure to monitor the sub-contractors but also for the violations committed by them that were foreseeable or preventable at a reasonable cost. The contractors’ liability for violations of sustainability principles by subcontractors is usually strict, not fault based. Through these duties and the associated liabilities, the chain leader exercises indirect control over the enterprises with which it does not have direct contractual relationships. Interestingly, the model contract clauses recommended by ABA in the US propose a radical change, shifting to fault. Accordingly, there would be two liability regimes in transnational commercial contracts: one strict, for commercial clauses and warranties, and one fault-based, related to regulatory provisions like environmental and social standards.^[156]

The analysis has shown that power warrants both direct and indirect control to the chain leaders over standards’ implementation. Power is or should be correlated to liabilities. Liabilities towards parties not in privity is usually extracontractual.75

The legislation on due diligence and the liability of the chain leader will increase the incentives to monitor and organize implementation of environmental standards at supply chain level but will not replace transnational private regulation of contracts with environmental national regulations.

Environmental violations within supply chains can be enforced through a private system that encompasses both remedies and private sanctions. Such a tool kit combines ex ante preventive measures with ex post remediation and liability. Remedies and sanctions can be cumulative since they pursue different complementary objectives. Penalties can be combined either with compensation or with termination. Sanctions deter, remedies repair. Remedies are also cumulative since corrective measures, aimed at repairing environmental harms, can be combined with the suspension/termination of contractual performance or with measures directed at changing the production or the distribution process in order to eliminate or mitigate the environmental harm.^[157] The interplay between the qualification76 system and the contracts allows differentiation between minor, serious and very serious violations that can lead to the expulsion from the chain and the interruption of any contractual relationships with the infringer without exclusion. The principles of effectiveness, proportionality and dissuasiveness should be applied to private sanctions similarly to their application to administrative sanctions even if the chain leader does not explicitly refer to them in its supplier code or in the GTCs.

The combined use of the qualification system and of both sanctions and remedies for environmental violations provides the chain leader(s) with adequate enforcement powers that should be correlated with due diligence liability.

The chain leaders’ powers to set standards, monitor compliance, and enforce rules is (or should be) correlated to the liabilities towards third parties for the violation of sustainability standards. They are liable for failure to exercise their powers or for exercising them ineffectively by adopting chain’s governance models that do not provide adequate incentives and sanctions for the chain’s participants. Technology can contribute to a more effective control of sustainability performances and evaluation to prevent rather than remedy environmental violations. It usually results in power concentration, but it depends on the architecture of the platform.

In the exercise of the regulatory power, the choice of instruments is affected by the liability regimes recently introduced. The challenge to institutional design is to align powers and liabilities and their distribution among a chains’ participants.