Exclusion from the award of public contracts under the German Supply Chain Act: sharp sword or empty threat?

With aims to embed human rights and environmental protections throughout supply chains, the German Supply Chain Act (Lieferkettensorgfaltspflichtengesetz) (LkSG) comes into force on 1 January 2023. As part of our ongoing series covering various aspects of the new legislation, this blogpost focuses on one particularly harsh sanction within the LkSG and its possible implication for companies: the exclusion from the award of public contracts in the event of a breach of standardised due diligence obligations.

Exclusion from the award of public contracts as part of the LkSG

Given that enforcement of the highest human rights and environmental standards is the watchword for the LkSG, it is easy to understand why this particular sanction is included in the legislation. Public authorities must ensure that the various legal requirements are observed by private actors. It should no longer be possible to generate competitive advantages over companies acting in accordance with the law by resorting to eg human rights violations. But it is not only the private sector that plays an important role here. Because public authorities wield enormous market power in, eg public procurement, it stands to reason that the public sector acts as a role model in conducting responsible business.

Thus, the exclusion from the award of public contracts pursues two goals. First and foremost, it aims to ensure fair competition between market actors who abide by the rules by excluding competitors in the event of serious misconduct. Second, it is designed to protect the integrity of the state by not being associated with market actors whose competitiveness derives, at least in part, by human rights violations.

Conditions for the imposition

The conditions under which an exclusion from the award of public contracts can be imposed are stipulated in Section 22 LkSG:

• There must have been proceedings on the award of a supply, works or service contract by a contracting authority or a sector contracting entity.
  
• Because of these proceedings, a legally established violation of the LkSG with a fine regularly amounting to at least €175,000 must have been imposed.

For the imposition of the public procurement restraint, the existence of a public contract regulating the award of a supply, construction or service contract by a contracting authority or a sector contracting authority is required. The contracting authorities are listed in the Act against Restraints of Competition (Gesetz gegen Wettbewerbsbeschränkungen) (GWB). The LkSG does not impose any restrictions on the scale of the public contract.

The core prerequisite for the exclusion from the award of public contracts, the violation of a duty of care of the LkSG imposed with a fine, must be legally established. This means that no appeal against the penalty notice has been or may be filed.

To justify the harsh consequence of the exclusion from the award of public contracts, the violation must reach a certain level of severity, which is determined by reference to the fine imposed in the individual case. At first glance, however, the legally provided threshold is not very high. If the fine amounts to €175,000 or more, a sufficiently serious violation is assumed. Having said that, in certain constellations the threshold is higher and a possibility of inflicting an exclusion from the award of public contracts is linked to a mandatory fine of €1.5m or €2m, or a fine that represents at least 0.35 percent of the average annual turnover of the company. This differentiation of the amount of the fine ensures – as an expression of the principle of proportionality – that exclusion from the award of public contracts can only be imposed in the case of serious violations of specific due diligence obligations (defined in more detail by the LkSG).

Consequences

Even if the above-mentioned conditions are met, the exclusion from the award of public contracts is not necessarily inevitable. The decision as to whether and for how long to impose the exclusion from the award of public contracts is a discretionary decision on the part of the contracting authority. Nevertheless, the wording of Section 22 LkSG ‘should be excluded’ suggests that the exclusion is the rule and only atypical individual cases allow for a different decision. Such special circumstances may lie in an existential threat to the contractor.

Bearing the discretionary nature in mind, a uniform and consistent decision-making practice may be established in the future and thus bind authorities. Companies concerned may very well be able to raise a claim referring to Article 3 of the German Constitution (Grundgesetz) and an established practice with regard to the assessment of cases. Nevertheless, such a standardised approach has yet to be established.

The ‘ban’ imposed can have immediate and far-reaching consequences. The company affected is not only excluded from future tenders, but the company’s already successful ventures may also be affected. If a company has already been awarded a contract by the authorities, a penalty notice excluding the company from the award of public contracts issued thereafter may lead to a termination of said contract.

The period of such an exclusion can last for up to three years. The contracting authority must choose a ‘reasonable period of time’ and consider the duration, the type and severity of the due diligence violation, as well as potential future consequences for the company. Thus, regarding the length of the exclusion from the award of contracts, there is the possibility for the company to apply mitigating circumstances.

If the company is dependent on the award of public contracts (eg companies operating in the energy and transport sectors relying on supply, construction and service contracts) the consequences of exclusion are obvious: a de facto ban on all activities almost certainly leading to insolvency. But even in the case of a company that does not necessarily have to rely on public procurement, the consequences can still be far-reaching. The reputational impact such an exclusion might have is a barely calculable side-effect and a serious competitive disadvantage. Therefore, spill-over effects may continue to affect the company well beyond the period of the freeze.

A way out

In light of these harsh and potentially existentially threatening consequences, it is good news for companies that the LkSG, referring to the existing regulation in Section 125 GWB, provides for the possibility of self-cleaning. The company thus can create conditions to be considered again.

Successful self-cleaning requires three cumulative conditions to be met:

1. The company has paid or undertaken to pay compensation for any damage caused;
   
   
2. has comprehensively clarified the facts and circumstances relating to the offence or misconduct and the damage caused thereby by actively cooperating with the investigating authorities and the contracting authority; and
   
   
3. has taken concrete technical, organisational and personnel measures that are suitable to prevent further violations.

The company can provide evidence of these three prerequisites to the contracting authority or to the Federal Cartel Office (Bundeskartellamt) (BKartA). As soon as the BKartA recognises the self-cleaning measures as sufficient, this decision also binds the contracting authority. In the event of a rejection by the BKartA, however, the contracting authorities are not bound.

Fair and square – exclusion from awards now daily business? 

The fact that the imposition of the public procurement bans and the exclusion from public contracts represent the sharpest sword in the sanctions catalogue of the LkSG and are only chosen as a last resort, quickly leads to the thought that the relevance in business practice is low and that one's own company will supposedly not be affected. In short: the imposition of an exclusion from the awards of contracts appears to be ‘far away’ and may not be recognised as a factor influencing the company.

However, underestimating the reality of this sanction would be playing with fire. The exclusion from the award of public contracts is already well established in German law and among others included in Section 21 Act to Combat Undeclared Work and Unlawful Employment (Schwarzarbeitbekämpfungsgesetz), Section 19 Act Regulating a General Minimum Wage (Mindestlohngesetz) and Sections 123, 124 GWB. Therefore, authorities know how to handle it. Furthermore, at the European level public procurement law is currently already characterised by a high level of dynamism, particularly due to the energy and related crises. As a result, caution is key at this point, especially in view of the significance of LkSG and its extensive media coverage, it can be assumed that all sanctions imposed by the LkSG will be forcefully applied if the requirements are met.