Co-authored with Elly Brindle

With the introduction of ever more searching reporting requirements and heightened scrutiny by NGOs and the media, human rights issues feature increasingly prominently on the corporate compliance agenda. However, these developments also have a significant impact on private investors who play a critical role in funding commercial enterprise and who are inextricably linked to the operations of the companies in which they invest. In this blog post, we explore the “double-edged sword” that developing human rights reporting standards hold for the investment community and address ways in which investors might seek to limit their human rights risk exposure.

As we have outlined in previous blog posts, a growing number of jurisdictions, including the UK, have recently implemented (or are in the process of drafting) legislation intended to improve corporate reporting on modern slavery and broader human rights and supply chain issues. Large companies are introducing increasingly complex and searching due diligence and reporting systems in response to the developing human rights compliance landscape. This means that in recent years there has been significant growth in the amount of publically available information on the human rights impacts of larger companies, and this trend is only set to continue as further hard-law reporting requirements are introduced globally

This is, in many ways, a very welcome development for investors. It allows potential human rights risks to play a more significant role in investment decisions and also means that investors – assisted by initiatives such as the forthcoming Corporate Human Rights Benchmark– can better and more accurately scope and protect themselves against human rights risks that might arise in relation to potential investment targets.

However, increasing visibility over human rights risks also represents a significant challenge for investors. As businesses delve deeper into their supply chains, and the media and NGO sector pay closer heed to companies’ human rights commitments (and potential breaches of those commitments), the chances of latent human rights issues within any given company arising and being reported around the world rise exponentially.

Provided that such reporting leads to remedial action by the companies involved, this is certainly a positive development for those whose rights have been violated, and a victory for more transparent and responsible business conduct. That said, scandals can have a materially detrimental effect on a company’s value, and thus the value of an investor’s interest in the company. Indeed, earlier this week the Financial Times’ fund management supplement ran a full-page story (paywall) on the damage that human rights issues within a company’s supply chains can cause for investors, citing the commercial impact of the Rana Plaza factory collapse in Bangladesh on several high-profile European and American brands.

So what can investors do to mitigate risk? First, they must effectively embed human rights considerations within their investment decision-making processes. This means conducting thorough and informed human rights due diligence during target identification and in the early stages of a transaction, appropriately focused by geographical, sectoral and other risks, in order to assess both the actual risk linked to the target and the adequacy of a target’s compliance structures. It also means training deal teams and advisors to ensure that they comprehend the relevant human rights and labour issues involved and are able to spot them when they arise.

Second, where any human rights “red flags” are identified during the risk assessment process, an investment will require careful consideration. Whether actual or potential human rights risks can be mitigated must be determined on a case-by-case basis and an investor should consider carefully measures to mitigate risks by including appropriate contractual protection – i.e targeted human rights indemnities and warranties – in transaction documentation.

Thirdly and post-closing, investors may need to delve deeper into a target’s potential links to human rights issues. Some issues may be very difficult to spot during the initial due diligence phase and will only become apparent later on. Depending on the level of risk involved, this process might involve (for example) further due diligence, analysing and improving compliance policies and processes, and conducting training. Such measures can help identify at an early stage any issues previously overlooked, with managing residual risk, and decreasing the possibility that future issues occur.

There is plenty of information and assistance available for investors. In addition to the general assistance provided by the UN Guiding Principles on Business and Human Rights, the Principles for Responsible Investment provide a good, practical starting point for how an investor can embed appropriate processes in its investment activities. However, as human rights issues expand beyond the CSR context and crystallise into significant, hard-edged investment risks, investment firms may need to go further to ensure their processes are sufficiently sophisticated to reflect the changing risk landscape.