Authored by Anil Yilmaz, Lecturer in Law at the University of Brighton, and Rachel Chambers, PhD candidate at the University of Essex.
Background
The European Union, as stated in Article 3(3) of the Treaty on the European Union, aims to establish a unified internal market and foster sustainable growth. This growth should be characterized by balanced economic advancement, price stability, and a highly competitive social market economy. This economic model strives for full employment, social progress, and robust environmental protection and improvement. The Single Market Act of 2011 provided further detail on the characteristics of this “highly competitive social market economy,” advocating for novel business models that prioritize environmental and social considerations over pure financial gain. The Act outlined roles for both the EU and the industry in achieving this objective. While the European asset management industry was tasked with leveraging its influence to champion socially and environmentally responsible businesses, the EU committed to actions such as implementing new regulations on environmental and social reporting to ensure fair competition.
The Act also paved the way for the European Commission’s 2011-2014 Corporate Social Responsibility (CSR) Strategy. This strategy reinforced the objective of establishing EU-wide standards for social and environmental reporting. Despite CSR being on the EU’s agenda for over a decade, the 2011-2014 Strategy introduced a more precise definition of CSR and emphasized better alignment with global CSR approaches, such as the UN Guiding Principles (UNGPs). The Commission also expressed its intent to expand upon existing reporting requirements for companies as part of this Strategy.
Prior to the latest revisions to Directive 2013/34/EU concerning company reporting, EU law mandated that companies, excluding some small and medium-sized enterprises (SMEs), provide specific information in their annual reviews. This included financial and, when relevant, non-financial key performance indicators. These indicators, crucial for comprehending the company’s progress, performance, and market position, encompassed information related to environmental and employee matters. In November 2010, the European Commission initiated an online public consultation to gather opinions on the disclosure of non-financial data by companies. This consultation sought to broaden the scope of this disclosure and enhance the effectiveness of existing requirements.
Following the implementation of the 2011-2014 CSR Strategy, the European Parliament passed two resolutions in January 2013. These resolutions reiterated the importance of corporate transparency regarding environmental and social issues. They called for specific measures to combat misleading or false information related to CSR commitments and the environmental and social impacts of products and services. The resolutions also acknowledged the UNGPs’ role in enhancing corporate practices. The European Commission took a further step on April 16, 2013, by proposing an amendment to existing accounting legislation. This amendment aimed to improve the transparency of large companies on social and environmental matters, particularly concerning human rights. An agreement was reached by the European Parliament and the Council on February 26, 2014, with the European Parliament adopting amendments to the Annual Financial Statements Directive 2013/34/EU on April 15, 2014. This was subsequently adopted by the Council of the European Union on September 29, 2014.
The Reforms
The amendments introduced mandatory reporting of non-financial information for certain large companies. Under the new Article 19a, specific large companies under the jurisdiction of a member state are obligated to incorporate a non-financial statement within their annual management report. This statement should provide insights into the company’s development, performance, position, and the impact of its operations. Recital 14 defines the scope of this reporting requirement based on factors such as the number of employees, balance sheet total, and net turnover. “Certain large undertakings” subject to Article 19a are classified as public-interest entities with 500 or more employees (calculated on a consolidated basis for groups with the parent company governed by a member state’s law). Article 2(1) of the Directive defines public interest entities to include publicly traded companies, credit institutions, insurance providers, and any other entity designated as such by member states due to the nature or scale of their operations. According to the press release announcing the Council’s adoption of the Directive, approximately 6,000 public interest entities across the EU will fall under its purview.
Non-financial information, as per the Directive, encompasses “at a minimum, environmental, social and employee matters, respect for human rights, anti-corruption and bribery matters.” This statement should include a concise overview of the company’s business model, policies concerning the aforementioned areas and their outcomes, significant risks faced by the company (including those stemming from business relationships), risk management strategies, and due diligence processes employed to identify, prevent, and reduce negative impacts. Companies have the option to omit reporting on one or more of these aspects if they lack corresponding policies, provided they furnish a “clear and reasoned” explanation for this decision. An additional reporting exemption is available in exceptional circumstances where disclosing such information could severely jeopardize the company’s commercial standing. However, this exemption only applies if non-disclosure does not hinder a fair evaluation of the company’s impact and risk profile.
The recitals provide illustrative examples of information to be included in the report for each item and reference a range of national and international frameworks that companies can consult for further guidance. Meanwhile, the Commission will develop general and sector-specific non-binding guidelines for non-financial reporting. Member states have a two-year timeframe to transpose the new provisions into national law, with implementation slated for 2017. To ensure compliance, Recital 10 mandates that member states establish effective national procedures. Lastly, the responsibility of requiring independent verification of the non-financial information disclosed in the report rests with the member state implementing the directive.
Analysis
The adoption of this Directive, a hard-won victory, signifies a substantial accomplishment, both in terms of the reforms’ content and the symbolic progress it represents. These reporting requirements are comprehensive, exceeding the scope of comparable UK law by encompassing anti-bribery and corruption alongside environmental, social, employee, and human rights considerations. By mandating reporting on “the impact of [a company’s] activities” and “principal risks related to those matters linked to the undertaking’s operations,” the provisions prioritize the actual human rights risks and impacts—both on society and stemming from a company’s operations—and encourage focusing on the most critical risks. This approach compares favorably to UK non-financial reporting, which primarily centers on providing shareholders with information to assess a company’s financial performance. The requirement for group reporting on these issues within consolidated statements enhances stakeholder awareness of the impacts of both subsidiaries and their parent companies. While business partners are also within the scope, reporting on risks associated with supply chains and business relationships is only mandated “if relevant and proportionate.” The inclusion of risk management practices, such as due diligence, provides valuable insight into how companies address challenges in this domain.
Despite its merits, the new Directive has several shortcomings. Firstly, its coverage is limited. The European Commission’s initial proposal envisioned the Directive applying to around 18,000 companies—both listed and unlisted—meeting specific financial thresholds and employing 500 or more individuals. However, the adopted proposal covers only around 6,000 “public interest” companies. The exclusion of listed SMEs is particularly perplexing, given that these companies already adhere to annual reporting requirements and can still exert significant human rights impacts despite their size. Additionally, leaving the methods for enforcing obligations and independently verifying reports to member state discretion risks inconsistencies in application and a potential lack of enforcement should companies fail to comply.
Does it Improve Existing UK Requirements?
October 2013 witnessed the implementation of a new UK requirement for companies to prepare a strategic report. This report must include, when necessary for a comprehensive understanding of the company’s business development, performance, and position, information pertaining to social, community, and human rights matters. The inclusion of a materiality test within the statutory guidance accompanying this new regime sparked controversy. Under the “Materiality” section, the guidance suggests that companies include human rights-related information only “if its omission from or misrepresentation in the strategic report might reasonably be expected to influence the economic decisions shareholders make on the basis of the annual report as a whole.” As previously highlighted, the new European requirement adopts a different, more favorable approach from a human rights perspective by considering the impact on society at large.
The enforcement of UK law in this area remains weak, a situation unlikely to be significantly bolstered by the new EU legislation. In the UK, the Financial Reporting Council’s Conduct Committee is tasked with monitoring compliance with the Strategic Report Regulations. This committee can investigate potential cases of non-compliance and possesses the authority to petition the court for a declaration of non-compliance concerning a strategic report, potentially compelling directors to issue a revised version. However, these powers were seldom exercised under the previous statutory framework. Given that member state regulators will oversee compliance with the EU’s non-financial reporting requirements, it is vital that they have access to qualified personnel with sufficient human rights expertise to effectively assess the completeness and accuracy of the information provided.
Further reading: Barnard & Peers: chapter 9, chapter 14