This year organisations have a new reporting requirement to publish an annual statement about steps taken to ensure that their business and supply chains are free from slavery and human trafficking (or a negative statement).

The measure derives from the Modern Slavery Act 2015 (“MSA”) and has wide application. It affects UK and non-UK companies and partnerships that supply goods or services and carry on any part of their business in the UK, if they have at least £36 million in global turnover.

Information may be included about an organisation’s structure, its business and supply chains, internal policies and staff training, due diligence processes (internally and in supply chains), identification of key risk areas in the business, steps taken to assess and manage risk, and/or the effectiveness of any measures taken.

Affected organisations with a financial year end date of 31 March 2016 or later must publish the statement on their websites within six months of that financial year end. There are no financial or criminal penalties for non-compliance and, although injunctive proceedings are possible, the likelihood is arguably remote. Public scrutiny is the principal incentive for compliance.

We reported on this new requirement in our 2016 corporate developments update. Following publication of the first statements, we now take a look at the wider and future implications for PE houses and their portfolio companies.

Drivers for change

In the UK and internationally, there is increasing focus on transparency and ethical behaviour by businesses generally, with particular focus on labour practices and conditions.

The MSA statement is based on existing Californian legislation. The US is considering enacting similar national legislation and the EU will soon follow suit, with the introduction of large entity reporting obligations concerning social and human rights issues under the Accounting Directive.

Consideration of ESG (economic, social and corporate governance) issues will not necessarily be new to PE houses and their portfolio companies. In recent years we have seen increased focus on non-financial performance indicators, including ESG measurement, in investment decisions. For some, positive non-financial performance indicators are an investment requirement.

Companies subject to the Walker Guidelines should already report on human rights issues. Earlier this year, PERG updated its guidance “Improving transparency and disclosure: good practice reporting by portfolio companies” and cites good practice reporting as including details of action taken to address specific issues, such as overseas employment policies, and supply chain management monitoring, such as the use of labour.

Who in the portfolio is affected?

The threshold for being caught by this new requirement has been set intentionally low and many portfolio companies will need to comply. In terms of meeting the £36 million threshold, parent and subsidiary turnover is aggregated. Subsidiaries within the remit of the £36 million threshold in their own right will need to report separately.

Where a company’s UK business nexus is in doubt, government guidance is to take a common sense approach. There should at least be a demonstrable UK business presence so, for example, a UK listing may not in itself be enough. Existing analysis may assist, given that the demonstrable business presence concept mirrors that used under the Bribery Act 2010 guidance.

This article focuses on portfolio compliance, but managers and GPs should consider whether they are caught by the MSA requirements in their own right. Whilst LPs, funds and fund partnerships may satisfy the “commercial organisation” and turnover requirements, it is unlikely that they will be providing services or supplying goods in a meaningful way for the purposes of the regime. However, entities will need to be considered on a case-by-case basis.

Portfolio risk management

Assuming it will not be considered appropriate to make a negative statement, in terms of the work carried out in order to make the statement, MSA and ESG issues more generally should be considered throughout the investment lifecycle.

At acquisition stage, the extent of diligence will depend on the profile of the particular target business and enhanced diligence will be necessary in identified key risk areas. Any measures put in place need to be monitored and complied with on an ongoing basis in order to manage and control risk.

Sectors, locations and particular supply chains should be analysed. The more complex the supply chains and employment relationships or the more prevalent the number of low-skilled, temporary or seasonal workers, for example, the more likely there are to be issues.

Industries that may cause concern include agriculture and food, hospitality and domestic work, textile and electronics manufacture, and construction and mining. Geographically, where protective legislation is weaker, labour is cheaper and there is an absence of collective agreements or organised workforce, the risk is likely to be greater.

Questions should be asked and an assessment made about how and to what extent companies understand their obligations, what policies and procedures are in place, how they are implemented in practice, and whether training and reporting is evidenced in paper trails.

Supply chain risk management

The first step will be for any portfolio company within the remit of the £36 million threshold to identify its supply chain. This is not necessarily straightforward and guidance is vague (supply chain has its “everyday meaning”). In terms of a reasonable, proportionate approach, Tier 1 and other core suppliers, and those operating in high risk countries and sectors, should at least be considered.

Beyond that, assessment and judgment based on materiality and sensibility will need to be made. Part of the aim of this legislation is to uncover modern slavery where it may otherwise be more opaque (and arguably more prevalent), towards the bottom of global supply chains.

This may appear burdensome. However, the duty is not to eradicate slavery but to disclose steps taken and, in this way, encourage change from the top down. It may be possible to draw on measures, policies and procedures already in place in relation to similar areas of compliance, such as anti-bribery and corruption.

Bespoke supply chain management programmes that address slavery and other social and sustainability risks should be considered. Expectations should be set, for example through codes of conduct, supplier questionnaires or self-certificates, or in contract terms.

On-site audits may already be conducted. This could be extended to more collaborative methods, such as provision of training and raising awareness generally. This is not just about issue spotting but problem solving in the longer term.

The future

California has already seen a rise in activism and public “naming and shaming” for perceived non-compliance with supply chain transparency reporting, for example in the case of Nestlé (for further details see our coverage here).

The UK is not far behind, with several high profile prosecutions for modern slavery offences having taken place this year. In terms of the MSA reporting requirements, the Business & Human Rights Resource Centre now maintains a register of published statements and, together with other key stakeholders, has been proactive in publishing regular analysis of compliance (or not) with the requirements.

In the PE space, investors, LPs and lenders will want to see their investments well managed. Confirming publicly, or implying, that a business does not consider, manage or improve human rights and other ESG issues, could impact funding opportunities.

As well as potential reputational and brand damage, companies face a number of potential risk areas for any perceived failure to comply or adequately address issues. These include continuity of supply, NGO and other pressure group campaigns, consumer and investor activism, loss of customers, possible legal action and potential conflicts with employees or trade unions and, ultimately, the knock-on effect on the bottom line.

The good news is that many portfolio companies will already have measures in place that can be utilised. In unusual circumstances where a company needs to start from scratch, these processes will ultimately add value and likely address risks earlier on, prior to a future divestment.

The tide of transparency reporting and scrutiny is only going one way. The MSA sits on the crest of so-called new wave regulation, where regulatory governance comes from the private sector, backed by consumer and industry opinion, and where transparency is key.