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03.02.2023 | KPMG Law Insights

U.S. and China wrestle over architecture of global trade

An article by Boris Schilmar, first published on LTO

The Trump era, the Ukraine war and the Taiwan conflict show that the times of rapprochement between China and the USA are over: The times of rapprochement between China and the USA are over. Boris Schilmar explains how companies can adapt to the new situation.

The major economies of China and the USA – and, in their wake, the countries of the European Union – have seen their economic relations become increasingly intertwined in recent decades. For some years now, however, they have been in reverse gear. There is mutual denial of market access, increasing tariffs and sanctions. Regionally limited technological and industrial standards, the separation of research and development, export bans on raw materials and supplier products, and not least mutually exclusive legislation have triggered a decoupling process that is proving unexpectedly complex for many companies.

The challenges ahead require an individual solution involving the legal and compliance departments, which are responsible for organizing and monitoring the generally dynamic decoupling processes. Among other things, it must be clarified which departments are to be involved in the process and in what form the results of a geopolitical impact scan can be legally used and exploited. In addition, specific legal questions must be answered – for example, how the company and the Board of Management can be protected against legal risks.

Approaches for a legal analysis of the decoupling process

Depending on how the political confrontation between the U.S. and China escalates and how European policymakers position themselves in this dispute, legal aspects will come more to the fore.

Due Diligence of the Management Board/Managing Director

In the decisions to be made in connection with a geostrategic reorientation, perhaps even fundamental changes to the company’s own global value chain, the actions of the Board of Management are measured against the standard of care of “a prudent and conscientious manager” (Section 93 (1) sentence 1 AktG; similar to Section 43 (1) GmbHG). Breaches of the duty of care can, in the event of damage incurred by the company, give rise to personal and, in principle, unlimited internal liability of the management board or managing director vis-à-vis the company (Sec. 93 (2) Sentence 1 AktG, Sec. 43 (2) GmbHG).

A central duty of care of the management board is the preservation of the company as a going concern and its long-term profitability (Hüffer/Koch, AktG, Sec. 93 para. 7 and Sec. 76 para. 34). Depending on the individual case, (partial) withdrawal from a country may well have the potential to jeopardize a company’s long-term profitability if countermeasures are not taken.

Based on the fundamental idea that entrepreneurial decisions are seldom risk-free and that the Executive Board must retain the possibility of making decisions, after weighing up risks, which could prove to be erroneous and costly at a later point in time, if necessary, the legal framework set out in Section 93 (1) of the German Stock Corporation Act (AktG) admits the possibility of making decisions which could prove to be erroneous and costly at a later point in time. 1 sentence 2 of the German Stock Corporation Act (AktG) grants the Executive Board a relatively broad scope of discretion within the framework of the duty of care of a prudent and conscientious manager.

The parameters of a discretionary board decision that is free of error under the business judgment rule must be considered and adhered to whenever a company changes its geostrategy. In particular, corporate decisions in this regard should be strictly aligned with the interests of society, and the consideration processes should be conducted on a sufficient information basis, taking into account all relevant aspects, and documented in a comprehensible manner.

Obligations under sanctions law

It is then obvious that it is necessary to keep an eye on the U.S. sanctions as well as the Chinese sanctions and to map the sanctions monitoring in the existing compliance structures and the compliance organization that may already be required under sanctions law: German companies with interests in China face specific legal risks and civil and criminal penalties for compliance violations. The Executive Board or management bears ultimate responsibility for compliance with legal requirements in all relevant jurisdictions along the value chain of the individual company.

The key will be to integrate ongoing monitoring of the dynamic sanctions environment into existing compliance structures, enabling management to respond quickly, accurately and sustainably to changes in the political and global economic situation.

Concretized due diligence obligations under the Supply Chain Due Diligence Act

In the legal analysis and preparation of management board decisions, the German Supply Chain Due Diligence Act (LkSG) provides guidance in the systematic approach and interpretation of the due diligence obligations of the company and the members of the management board. In structural terms, the LkSG imposes a legally binding set of obligations on companies (including subsidiaries of foreign companies) headquartered in Germany with more than 3,000 employees with effect from January 1, 2023, which, as ultima ratio, can in itself justify the need to withdraw from China or at least certain Chinese regions (Wissenschaftlicher Dienst des Bundestages, cit. after Nasse, RAW 1/22, pp. 3-12 (p. 4 fn 11)). As of January 1, 2024, the scope of application will be extended to all companies with more than 1,000 employees.

With the aim of detecting and, where possible, preventing human rights violations along the company’s own supply chain, the LkSG specifies the due diligence obligations of the company and (thus also the due diligence obligations of the members of the management body) with regard to the definition and implementation of systemic processes for auditing and actively counteracting human rights violations. The structural approach and, at the same time, the canon of duties in connection with human rights violations can be found in §§ 4-10 LkSG: Based on an annual risk analysis (§ 5 para. 1 LkSG) of human rights and environmental risks in its own business area and at its direct suppliers, every company must establish an effective risk management system (§ 4 para. 1 LkSG).

According to the legal definition of § 4 para. 2 LkSG, such measures are to be regarded as effective which make it possible to identify and minimize human rights and environmental risks and to prevent, end or minimize the extent of violations of human rights or environmental obligations if the company has caused or contributed to these risks or violations within the supply chain.

On the basis of the mandatory risk analysis, Sections 6 and 7 of the LkSG then stipulate specific preventive and remedial measures that the company must take. This includes, among other things, the obligation to obtain assurances from contractual partners in the supply chain that certain human rights standards are being complied with and to monitor this on a regular basis.

Withdrawal from China as ultima ratio?

In individual cases, the amount of the fee required in accordance with § 5 Para. 1 LkSG, the risk analysis required by human rights-related risk considerations should anticipate the possible outcome of a geopolitical impact scan and, as an ultima ratio, suggest withdrawal from the Chinese market. This scenario resulting from the legislative motivation of the LkSG could be flanked in the overall consideration of the Executive Board by a case-by-case realization that the conflicting compliance requirements of the USA and the EU on the one hand, and China on the other, are not compatible. In this respect, the risk analysis specified under the LkSG will be an important tool in decoupling-related risk mapping.

Particularly relevant for German investors in China is China’s tendency to strengthen its own (state-owned) companies in a targeted manner within the framework of the Dual Circulation Policy and to give them competitive advantages, both on the domestic market and internationally. The goals are continued prosperity growth for the Chinese population and strengthening Beijing’s foreign policy influence over strong Chinese companies.

On the one hand, developments to date suggest that German investors with production sites in China will gradually be forced out of the Chinese market, while Chinese suppliers take their place. On the other hand, the Anti-Foreign-Sanctions-Law of the Chinese state government, which already came into force in June 2021, could make a (partial) withdrawal from China more difficult in individual cases.

The Ukraine War as a Decoupling Catalyst

Against the backdrop of the war of aggression against Ukraine, China has positioned itself politically between Russia on the one hand and the Western states on the other, which could further accelerate the decoupling process. If China were to support Russia more than it has in the past, Western countries might extend their sanctions to China as well. Such an escalation could drive geopolitical bloc formation and challenge the current infrastructure of the global economy.

In this situation, German companies with interests in China – from supply chains to cooperations and joint ventures to the sales market – must not only reposition themselves strategically, but also set the necessary legal course and develop exit strategies.

Do the existing contracts contain legally valid force majeure clauses that the company can invoke? Can contracts be terminated extraordinarily for other reasons? Is there a threat of claims for damages? What alternatives can be considered? What treatment of local employees is possible under labor law and advisable from the point of view of Group-wide personnel responsibility and corporate reputation?

Conclusion

The decoupling process poses challenges and risks in a fundamentally restructuring world. With regard to the decisions to be made, the business judgment rule grants the Executive Board a relatively broad scope of discretion within the framework of the duties of care of a prudent businessman. However, the relevant consideration processes should be strictly aligned with the interests of society, conducted on a sufficient information basis and taking into account all relevant aspects, and documented in a comprehensible manner.

An important orientation for a legally resilient approach is provided by the German Supply Chain Sourcing Obligations Act, which in itself can already be seen as the first milestone of the German legislator in the implementation of the decoupling policy and for this very reason proves to be a (currently still rare) interpretation aid in many respects. In particular – despite all the detailed criticism of the law – the requirements for the due diligence obligations of companies and management boards in connection with the decoupling process are specified.

In individual cases, withdrawal from China (or individual Chinese provinces) may prove to be ultima ratio. The legal issues to be resolved in the course of such a decision are similar to the challenges that many German companies are currently facing in connection with their legally required or reputationally imperative withdrawal from Russia.

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Contact

Dr. Dr. Boris Schilmar

Partner

Tersteegenstraße 19-23
40474 Düsseldorf

tel: +49 211 4155597130
bschilmar@kpmg-law.com

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