There is a 150 billion market that is created by different forms of forced labor in global supply chains [1]. As the problem is ubiquitous, many Western companies are part of these chains by subcontracting and outsourcing the manufacturing of products and services in third countries. Despite scandals, companies’ connections to unsustainable conditions in supply chains have remained mostly undiscovered. The EU Directive on Non-Financial Reporting is one of the latest initiatives to require companies to shed light on possible unfair employment practices, environmental destruction, human rights breaches and contribution to climate change. By increasing business transparency, may the directive have the potential to improve the status quo?
Non-financial reporting according to the directive
Having become effective last year, the first reports related to the EU directive on non-financial information (2014/95/EU, later the directive) are being expected in mid-2018. The reporting requirement only concerns companies that have more than 500 employees. Under the directive, approximately 8,000 large companies and financial corporations are required to disclose information about their business model, policies and their outcomes; and include a statement of risks and of their management. [2]
Required information should consists of main human rights, environmental, social, labor and corruption impacts and risks linked to their products, operations and services throughout their supply and chains.
Because the objective of the Directive is to understand a company’s development, performance and position, as well as the impact of its activities on society, the non-financial information to be disclosed needs to be “relevant and proportionate” in terms of risks and impacts linked to the company. Therefore, this information varies between companies from different fields of business.
According to a company’s reporting needs, there are several reporting standards, which vary in nature, scope and depth [3]. To facilitate reporting tasks, the European Commission has published Guidelines on Non-Financial Reporting [4], which ask to follow Sustainable Development Goals requirements for non-state actors, especially goals 5 and 12. By adopting suitable reporting frameworks, such as these standards, companies can significantly increase the quality, comparability and consistency of their non-financial reports.
Reports must include a company’s key risks in business, how these risks can be mitigated by due diligence processes and changed to do sustainable business in the future.
According to the United Nations Guiding Principles on Business and Human Rights, due diligence is the process through which enterprises can identify, prevent, mitigate and account for how they address their actual and potential adverse impacts [5]. This reporting requirement does not only include the risks of adverse impacts of a company’s own operations, products and services, but it extends to its external business relationships, including to its supply chains. [6]
Despite comprehensive disclosure requirements, the directive gives a company an opt-out from disclosure, if it provides a clear and reasoned explanation for not doing so. [7] By giving such an explanation, however, a company should consider reputational risks to its brand-value, and whether the information omitted is at the core of their operational activities, which are “relevant and proportionate”. Because omissions need to be justified, a poorly reasoned refusal to disclose key information may meet criticism by stakeholders and the public. Needless to say, a company cannot omit all required non-financial information, as it would lead to a breach of the minimum requirements of the directive.
Are companies to be held accountable for non-compliance?
Despite being a progressive regulatory leap to incorporate environmental, social and governance (ESG) issues into daily business thinking, the directive has many shortcomings.
FIRST, because there is no single standard how to make a sustainability report, there are obviously many approaches. As a key rule, companies’ legal experts should ascertain that compliance to any national laws related to the directive is flawless. If a company has made a public commitment to disclose ESG-information according to a specific reporting framework, this should be done to fulfil societal expectations in full. The risks are real: ESG related crisis situations have resulted in the loss of market value ($200bn in 100 cases total), senior executives losing their jobs, and ultimately high litigation costs or going out of business. [8]
The directive has many shortcomings
Mandatory disclosure provisions can potentially lead to remedial consequences. Although the directive aims to focus on the preventive measures to take human rights and environmental risks into account in a company’s business activities in the future, it can also have remediation purpose for harm that has already occurred. After making mandatory disclosure statements about risks, it is more challenging to avoid corporate liability, when a company knew or should have known about adverse impacts. The directive provides a potential tool towards accountability by increasing transparency, although it does not regulate due diligence standards or conditions of liability. Thus, the outcome of legal cases still remains uncertain. [9]
SECOND, because the directive does not specify reporting standards, this may lead to publish incomplete, false or otherwise misleading ESG-information. However, as a part of the annual report, such cases can invoke legal liabilities, if the severity of this information is significant and therefore it has financial consequences to the company as well. These kinds of operations, products and service potentially have significant environmental consequences [10] or include human rights related risks [11] If a company suffers a measurable financial loss after not disclosing information on such severe impacts, shareholders can take a derivate action against directors. Therefore, lying about emission levels of diesel cars or ignoring poor labor conditions in subsidiaries or supply chains can result in managerial liabilities.
The directive does not specify reporting standards
Because sanctions are applied to non-disclosure, not inaccuracy, the directive can evoke economic ‘social-actor’ sanctions. However, there is skepticism whether stakeholders may understand the societal impacts of companies’ activities in reports. [12]. To improve this, there are a few research projects, by Frank Bold and Shift Project, focusing on improving taxonomy and reporting standards, and materiality issues.
LAST, according to the directive, the non-financial report needs to be audited but the role of auditors and audit firms is only to check that the non-financial statement or the separate report has been provided. [13] However, Member States can require that the report needs to be verified by an independent assurance services provider. Companies can also choose to use auditing, which is focused on improving ESG-standards, such as Triplepundit.com. As the Commission’s report puts it, sustainability information should be identified with financial information by giving it “the same assurance rigor” as for auditing requirements for financial information. [14] Using the categorization “monetary” and “non-monetary” information could be considered [15] as ESG-related information has real value, especially in long-term.
The non-financial report needs to be audited
Although the directive is still lacking a proper apparatus to verify statements in sustainability reports, the directive takes a significant leap in improving the quality and quantity of transparency in business activities. Perhaps most importantly, these statements create real value for customers and wealth for shareholders, and their accuracy may be tested by different stakeholder groups.
Paving the way for sustainability
After the directive, the companies should no longer consider sustainability reports as a showpiece of being a good corporate citizen. On the contrary, legal and economic consequences may follow negligent or fraudulent reporting. States can use national law to set higher standards than the mere disclosure requirement, like the UK’s Modern Slavery Act or California Transparency in Supply Chains Act. On the other hand, Duty of vigilance law in France is not just mere disclosure requirement but it obliges companies to exercise due diligence, which makes them liable for ignoring certain human rights issues in their operations, subsidiaries and supply chains. Such laws are likely to increase, as there are many national action plans like in Germany and initiatives, such as Swiss Popular Initiative on Responsible Business, which make companies pay attention to sustainability issues throughout their operations.the Commission will conduct a fitness check of the EU framework on public reporting by companies, which includes non-financial reporting.
The Commission will conduct a fitness check of the EU framework on public reporting by companies, which includes non-financial reporting
As Article 3 of the directive requires the Commission to review the implementation of the directive, the Commission will conduct a fitness check of the EU framework on public reporting by companies, which includes non-financial reporting. The results of the check will be available in the second quarter of 2019. Furthermore, the Commission has prepared Sustainable Action Plan [16], which among other issues aims to strengthen financial stability by incorporating ESG-factors into investment decision-making, and to increase clarity on taxonomy, which in this context standardizes reporting requirements.
As for corporate accountability, the increased transparency empowers the legal toolkit to make corporations, which consider themselves proactive actors for sustainability, to keep their word. If there are human rights violations or environmental damages in supply chains, the directive can work as a wake-up call for companies to take their human rights and environmental issues more seriously. Using legal and sustainability experts, a company can ascertain that, by exercising proper due diligence, it has taken all the necessary and reasonable steps to avoid doing harm.
Notwithstanding current and upcoming transparency regulation, corporate responsibility is a part of a company’s intangible assets, which is concerning the interests of shareholders and wider group of stakeholders. Building reputation takes many years but it can be destroyed within a single night. Sustainability is a megatrend, which is going to bind companies legally to walk the walk instead of just talking the talk. As the non-financial reporting directive is just the beginning, wise companies should adapt to being sustainability at the heart of their business strategy and operations already before it is necessary to do so.
Sources
[1] ILO: ILO says forced labour generates annual profits of US$ 150 billion Visited 10 June 2018.
[2] Directive 2014/95/EU of the European Parliament and of the Council of 22 October 2014 amending Di-rective 2013/34/EU as regards disclosure of non-financial and diversity information by certain large under-takings and groups, para. 19.
[3] Different frameworks include national frameworks, Union-based frameworks such as the Eco-Management and Audit Scheme (EMAS), or international frameworks such as the United Nations (UN) Global Compact, the Guiding Principles on Business and Human Rights implementing the UN ‘Protect, Respect and Remedy’ Framework, the Organisation for Economic Co-operation and Development (OECD) Guidelines for Multinational Enterprises, the International Organisation for Standardisation’s ISO 26000, the International Labour Organisation’s Tripartite Declaration of principles concerning multinational enterprises and social policy, the Global Reporting Initiative, or other recognised international frameworks.
[4] The European Commission: Communication from the Commission — Guidelines on non-financial reporting (methodology for reporting non-financial information) C/2017/4234.
[5] Guiding Principles for Business and Human Rights: Implementing the United Nations “Protect, Respect and Remedy” Framework, United Nations 2011, art 17.
[6] Ibid art 19a(1). d, and preamble, para 8.
[7] Ibid art 19a(1).
[8] FTI Consulting: Communicating Through A Crisis: The Cost of Not Saying Sorry Visited 11 June 2016
[9] Bueno, Nicholas: The Swiss Popular Initiative on Responsible Business – From Responsibility to Liability. University of Lausanne, 2018. p. 17.
[10] COM(2018) 97 final.
[11] Vogue: 5 Years On From the Rana Plaza Collapse, How Much Has Actually Changed? Visited 10 June 2018
[12] Buhmann, Karin: Neglecting the Proactive Aspect of Human Rights Due Diligence? A Critical Appraisal of the EU’s Non-Financial Reporting Directive as a Pillar One Avenue for Promoting Pillar Two Action. Business and Human Rights Journal 2018, p. 45.
[13] Directive part. 16
[14] European Commission: EU High-Level Expert Group on Sustainable Finance: Financing a Sustainable European Economy. Final Report 2018. p. 56
[15] Haller A.: The Term ‘Non-financial Information’ – A Semantic Analysis of a Key Feature of Current and Future Corporate Reporting. Accounting in Europe, 2017, p. 18.
[16] COM(2018) 97 final.
