In Brief
In this article, we discuss:
- what litigation risk is;
- what ESG-related litigation risk Malaysian companies face in supply chains; and
- what Malaysian companies should do to decrease ESG-related litigation risk.
Malaysian companies are unaware of ESG-related risks in supply chains
As of 2024, Environmental, Social, and Governance (ESG) considerations have become increasingly important for businesses across industries. In Malaysia, company directors are duty bound to proactively and urgently apprise themselves of all aspects of climate change that can affect their companies. They must thus act to manage the full spectrum of climate related risks by integrating them into their corporate strategies, plans and actions, and ensure proper disclosure of such risks.1
In reality, very few company directors take that duty into account in their actions. The sad reality is that climate change or other ESG-related considerations hardly play any role in the average Malaysian director’s daily actions. This leaves both their companies and the directors themselves2 vulnerable and subject to disputes.
An area where Malaysian companies are particularly exposed to ESG-related litigation risk is international supply chain contracts. Supply chains have significantly increased in complexity over the last years. With an increasing number of stakeholders from various countries around the world involved in globalized supply chains, Malaysian companies face a diverse set of regulatory environments. When Malaysian companies often do not even keep up to date with changes to the law in Malaysia, staying abreast of foreign regulations is practically impossible.
Yet, the biggest hurdle that Malaysian companies face when it comes to managing their ESG-related is a lack of awareness. Usually, Malaysian companies are not even aware of the risks they are exposed to when they are involved in global supply chains. Even less so are Malaysian companies aware that they face a considerable risk of getting drawn into a dispute stemming from globalize supply chains.
Understanding these risks is crucial for companies seeking to manage their supply chains responsibly and mitigate potential adverse effects. This article aims to raise awareness among Malaysian companies so that they:
- appreciate that there is a considerable risk in globalized supply chains and in particular get a better understanding of the litigation risk related to ESG-matters;
- identify steps they should take to identify the risks they face; and
- can engage in effective risk management.
What is litigation risk?
Litigation risk refers to the potential for a company to become involved in legal proceedings, such as lawsuits or arbitration, which may result in adverse outcomes, financial losses, reputational damage, or other negative consequences. This risk arises from various factors, including contractual disputes, regulatory non-compliance, allegations of misconduct, or disagreements with stakeholders.
It is not possible to completely avoid litigation risk. However, this should never become an excuse to simply ignore litigation risk; company directors should ensure that their companies take all necessary steps to reduce litigation risk. While this may, in some circumstances, involve the need to spend a considerable amount of money, proper risk management will on average outweigh these costs.
The increased ESG-related risks from international supply chains
In international supply chains, ESG-related risks increase significantly in comparison to Malaysia-only supply chains. The risks increase in particular when there is a large foreign company involved as a purchaser. This foreign company is typically subject to much more stringent regulations, particularly in the environmental and the social domain, and may be under an obligation to ensure that its (sub-)suppliers follow these regulations also.
For instance, the German Supply Chain Responsibility Act (Lieferkettensorgfalts-pflichtengesetz) requires large German procurers to undertake a risk analysis. The purpose of this risk analysis is to understand any potential and actual human rights and environmental risks in their supply chain, both in their own business operations as well as those of their direct suppliers. When a German company that falls under this law is found in breach, it may be subject to a fine of up to 2% of that company group’s global, annual turnover (i.e., the turnover of the entire group which this company belongs to).
New legislation that is set to be passed by the European Union in the course of 2024 goes even one step further and foresees fines of up to 5%. Once the so-called Corporate Sustainability Due Diligence Directive will have been implemented by all EU Member States, EU companies with over 500 employees and a worldwide turnover exceeding EUR 150 million (as well as other categories of companies)3 may also be directly sued in their home countries (i.e., in the European Union) by affected parties. In other words, when companies falling under the scope of this Directive have not integrated human rights and environmental considerations into their supply chain management systems and individuals or communities are negatively impacted, they can file civil lawsuits against the company to claim compensation for the harm suffered.
Large procurers in the supply chain are under an obligation to among others contractually ensure that no violations of the required environmental and social standards happen. However, while this obligation applies throughout the supply chain, in reality few sub-suppliers, especially when they are further down in the supply chain, will have any regard to these standards.
This situation has already led to disputes and is set to lead to a significant increase in supply chain disputes in the future. ESG-related disputes will thus become the rule rather than the exception. Above all, when a large European company gets slapped with a huge fine, or is sued in its home country, it will likely rely on its contract and claim compensation from its direct supplier. The direct supplier will in turn want compensation from its own suppliers, these suppliers from their own suppliers, and so on.
Where do most risks lie for Malaysian companies?
The most important ESG-related risks in global supply chains are in the environmental and the social areas:
Environmental Risks
Environmental risks in supply chains encompass a wide range of issues, including pollution, resource depletion, deforestation, and greenhouse gas emissions. Suppliers may operate in regions with lax environmental regulations, leading to negative impacts on air, water, and soil quality. Additionally, unsustainable practices such as overconsumption of natural resources or improper waste disposal can contribute to environmental degradation and climate change.
Although Malaysia has adopted several laws to protect the environment, these laws are not up to par with the standards seen in other countries. In globalized supply chains, it is often insufficient to simply comply with these national norms – and in reality, many Malaysian companies don’t even do that.
Social Risks
Social risks in supply chains relate to labour practices, human rights violations, worker safety, and community relations. Companies may face challenges such as child labour, forced labour, discrimination, and unsafe working conditions within their supply chains.
Malaysia is heavily dependent on blue collar foreign workers, who are often employed in conditions that would be considered to amount to forced labour by international organisations such as the International Labour Organization4 and the Organization for Economic Cooperation and Development (OECD).5
Effective risk management – the steps every Malaysian company involved in global supply chains should do
Effective risk management involves identifying, assessing, and mitigating litigation risk through proactive measures such as compliance programs, legal safeguards, and dispute resolution strategies.
To manage litigation risk effectively, companies should implement a comprehensive approach that encompasses various strategies and best practices. The most important strategies Malaysian companies should take are as follows:
Stock-taking and assessment
Sad but true, with proper contract management being alien to many Malaysian companies, they are not even aware of what their risks are. The starting point must therefore be a stock-taking of the status quo (which contracts exist and what are relevant dates thereunder such as expiry dates, notification dates, etc.).
Conduct a thorough assessment of potential litigation risks within the organization, including analysing past litigation history, identifying potential areas of vulnerability, and evaluating the likelihood and potential impact of future disputes. This again requires a thorough assessment of the company’s contracts and may be difficult to undertake when internal systems of record-taking are insufficient.
The stock-taking as well as the listing of past litigation history is a process that a company will typically undertake itself. Only the company itself has all relevant contracts and data related to it available. However, in order to properly assess the potential litigation risk within the company, relying on expert external counsel, who has already undertaken this kind of assessment, is highly recommended. External counsel will typically be much better-suited to provide such advice than a general in-house lawyer is.
Implement compliance and governance processes
The stock-taking and risk assessment will have revealed where the company’s weaknesses are. External counsel will be able to provide advice on what compliance and governance systems should be implemented. These systems should involve a mitigation of all ESG-related risks, but also take into consideration all other risks that the risk-assessment has revealed.
With the help of external counsel, companies should thus establish robust compliance policies and governance frameworks to ensure adherence to legal and regulatory requirements, both in the field of ESG and in general. These policies should among others include regularly reviewing and updating policies, providing employee training on compliance matters and making sure that the compliance officer (or another person) will oversee the adherence to these standards.
Such systems do not work with proper documentation and record-keeping, which is a crucial part of any compliance and governance system. Accurate and detailed records of all business transactions, as wel as of all relevant communications and decisions must be maintained.
The compliance and governance system should also provide for effective dispute resolution strategies to resolve conflicts in a timely and cost-effective manner. When it comes to complex relationships in international supply chains, alternative dispute resolution methods such as negotiation and mediation are a must. Equally, when the contract partner is a company outside of Malaysia, for reasons of enforcement, arbitration is the preferred process over litigation.
Lastly, the compliance and governance systems should consider to what extent insurance coverage is necessary. Depending on what risks external counsel identified, this can be anything from a general liability insurance, to a specific insurance for selected contracts or a directors and officers (D&O) insurance. They all have one goal in common, which is the mitigation of the financial impact of disputes.
Conduct regular reviews
A compliance and governance system can only be well-suited at the very moment it is created. The moment there are changes to a company’s contracts – be it via the expiry of an existing contract, a contract amendment or a new contract – an update to this system may be warranted.
Obviously, it would go a step too far to demand a review every time there is a change to a contract; however, continuous monitoring and a review in regular interval, such as every quarter or every half year, depending on the number of contracts a company has engaged in, should become the norm. Regular assessments can help identify emerging risks, evaluate the effectiveness of mitigation measures and make adjustments as needed.
It may be necessary to involve external counsel in this process to keep abreast of the regulatory changes both inside and outside of Malaysia. Alternatively, companies with a plethora of contracts in a specific region (e.g. the European Union) may find it useful to instruct their external counsel to provide them with regular updates on ESG or other matters from that region.
By adopting a proactive and multifaceted approach to managing litigation risk, companies can minimize their exposure to legal disputes, both stemming from ESG and other fields, protect their interests, and safeguard their reputation and financial stability.
Conclusion: Promoting Sustainable and Responsible Supply Chains
In conclusion, ESG risks in supply chains are multifaceted and interconnected, requiring proactive management and collaboration across stakeholders. While these risks pose challenges, they also present opportunities for companies to promote sustainability, resilience, and ethical conduct throughout their supply chains. By incorporating ESG considerations into their business strategies, companies can enhance competitiveness, build trust with stakeholders, and contribute to positive social and environmental outcomes. Embracing sustainable and responsible practices not only safeguards against ESG risks but also fosters long-term value creation and strengthens the resilience of supply chains in an ever-changing world.
This article was written by Prof. Dr. Harald Sippel and only contains general information. It does not constitute legal advice nor an expression of legal opinion and should not be relied upon as such. Prof. Dr. Harald Sippel is admitted to the Austrian Bar as Rechtsanwalt and to the Malaysian Bar as a Foreign Lawyer. He regularly provides advice to European and Malaysian companies on matters of ESG.
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1 For details, see Tan Sri Zarinah Anwar, To’ Puan Janet Looi, Legal opinion on directors’ duties and disclosure obligations under Malaysian law in the context of climate change risks and considerations, para. 242 (available at https://commonwealthclimatelaw.org/wp-content/uploads/2022/07/CCLI-Legal-Opinion-on-Directors-Duties-and-Disclosure-Obligations-under-Malaysian-Law-in-the-context-of-Climate-Risks-22-July-2022-w-signatures.pdf).
2 Ibid., para. 129, which makes it clear that “[d]irectors risk acting in breach of their duties if they do not inform themselves of climate risks, incorporate a broader sustainability agenda in their companies’ operating and decision-making processes and take the required steps to address these issues.”
3 For details, see Harald Sippel, Corporate due diligence rules in the EU agreed: how this will impact Malaysian companies, available at www.lexology.com/library/detail.aspx?g=4953304f-594b-42a9-80ca-fcd51e11d673.
4 For an overview of forced labour as defined by the ILO, see www.ilo.org/global/topics/forced-labour/lang--en/index.htm.
5 For an overview of forced labour as defined by the OECD, see www.oecd.org/dac/gender-development/44896368.pdf.