Disclosure of environmental, human rights and social risks is moving from its home between the glossy pages of voluntary reports into the hard-nosed realm of mandatory legal requirements, as evidenced by recent developments in the European Union and India.
Corporate social responsibility (“CSR”) reports have proliferated in the past decade, but companies have largely disclosed environmental and social information in response to public or internal pressure and not because they were required to do so by law. Developments in the EU, India and China, which are significant markets for many multinational companies, represent what now is a growing trend toward compelling greater transparency in corporate reporting of nonfinancial risks and policies The EU, India, and China do not stand alone, however, as France, South Africa and others already mandate disclosure. These reporting obligations differ – sometimes significantly – in what they require and are, to date, largely untested. The scope of the disclosures are often not entirely clear, but likely will gain greater certainty and expand in reach over the next several years. What is clear is that the legal and reporting reality for global businesses is changing. Companies not only must achieve compliance with each particular law for its own operations and potentially its supply chain, but also must ensure consistency across jurisdictions and corporate affiliates. Compliance with the emerging CSR disclosure laws requires a hard look at potential sustainability risks and the policies responding to such risks. Moreover, apart from those risks, the emerging mandates materially raise the stakes in necessitating accurate and complete CSR reports and related disclosures through effective systems to identify, gather, evaluate, manage, validate and report information. As a result, companies may well need to reimagine the roles of their legal, marketing, compliance and auditing groups in order to respond effectively to the challenge of coordinating responsive filings to proliferating and divergent disclosure requirements. While there is an array of such requirements, due to their market size, the developments related to nonfinancial reporting in the European Union, India and China are particularly noteworthy.
On April 15, 2014, the European Parliament adopted Amendments to Directive 2013/34/EU (“Directive”), requiring disclosure by public companies and groups of nonfinancial and diversity information. The Directive represents part of a broader effort by the European Council to increase business transparency on social and environmental matters.
Scope of and Nature of the Reporting Directive Amendments
The Directive applies only to EU public company filers who have more than 500 employees, although each Member State is able to extend the requirements to smaller entities. The Directive applies to any company, regardless of their domicile, which files in the EU and has 500 employees in Europe. Companies covered by the Directive are required to disclose information on policies, outcomes and risks relating to environmental matters, social and employee-related aspects, human rights, and anti-corruption issues. Such disclosures must include the following:
- a brief description of the entity’s business model;
- a description of the policies pursued in relation to each of environmental, social, labor, human rights, and bribery matters, including the implemented due diligence processes;
- the outcome of the policies;
- the principal risks related to those matters linked to the entity’s operations including, where relevant and proportionate, its business relationships, products or services which are likely to cause adverse impacts in those areas and how the entity manages those risks; and
- nonfinancial key performance indicators relevant to the particular business.
As an example of the specified level of detail, with respect to environmental matters, the statement must include “details of current and foreseeable impacts of the undertaking’s operations on the environment, and as appropriate, health and safety, the use of renewable and/or non-renewable energy, greenhouse gas emissions, water use and air pollution.” If the company does not have a policy in relation to one or more of the specified areas, the entity must provide a “clear and reasoned explanation for not doing so.” In exceptional cases, Member States may allow for the omission of information when the disclosure would be seriously prejudicial to the commercial position of the company; otherwise, companies are to evaluate their risks, disclose their performance and identify their future responsive plans. The disclosure may need to extend beyond the company itself as the Directive states that, “where relevant and proportionate”, the statement should include information on “supply and subcontracting chains in order to identify, prevent and mitigate existing and potential adverse impacts.” Similarly, in discussing matters that have resulted or will materialize in “principal risks of severe impacts”, the entity must consider its own operations as well as “its products, services and business relationships, including its supply and subcontracting chains.”
In short, as with many other global reporting proposals and suggested standards, the EU Directive moves towards expanding company disclosure standards to include the supply chain and third parties. The EU Directive does not mandate the use of a specific framework for measuring the disclosure report. Rather, companies may employ international, European or national guidelines for developing the report (e.g., UN Global Compact, ISO 26000). Concise, useful information is required to be disclosed, not a detailed report. Disclosures may be made as a corporate entity rather than for each corporate affiliate. However, the Directive does specify that the nonfinancial statement should be in the management section of the company’s public filing. As many companies may choose to do, a separate CSR report can be filed replacing this obligation so long as it is referenced in the management section. Importantly, the EU Commission is to develop nonbinding guidelines to facilitate disclosure, including for “general and sectoral nonfinancial key performance,” taking into account current best practice, international developments and related EU initiatives. In terms of enforcement, the Directive states that Member States should ensure that “effective national procedures are in place” and that those procedures are available for “all persons and legal entities having a legitimate interest” in the Directive. Member States may also require third party assurance of the submitted nonfinancial statement or report.
Impact of the Reporting Directive Amendments
The EU Directive is expected to affect roughly 6,000 public companies who file in Europe. According to the EU, only 10 percent of those companies currently report information required to be disclosed in the EU Directive, so the EU Directive will dramatically increase the number of EU companies reporting environmental and social information. Further, the Directive obligates the EU Commission to evaluate the implementation of the Directive and provide a report within four years, including recommendations for further legislation. The EU Directive must now be adopted by the EU Member States in the Council and then be implemented into national laws by Member States within two years after the Directive enters into force. The Directive does not displace individual member country CSR reporting requirements such as those in France, leaving open for multinationals operating throughout the region complicated questions regarding whether to file one or multiple reports within Europe. Further, while the Directive provides for the issuance of “nonbinding” CSR performance guidelines and indicators, if such guidelines are developed, they could become functionally definitional in multiple markets as the applicable standard or methodology. For that reason, even for those who do not file in Europe, the progression of the EU CSR reporting requirements merits careful monitoring due to its potential major global market impact.
India passed the Companies Act in 2013, which legally mandates corporate CSR reporting. On April 1 of this year, the Companies (Corporate Social Responsibility) Rules went into effect implementing the new law. Subsequently, India’s Ministry of Corporate Affairs released Circular No. 21/2014 in June 2014, which aims to clarify this CSR mandate.
Scope of and Nature of the CSR Rules
The reporting requirement is tied to a provision that directs covered companies to spend a percentage of their profits on CSR activities in India. In particular, companies that meet any of the following financial conditions during any financial year must comply with the law: (1) companies that have a net worth of INR 5,000 million or more (US $ 160 million), (2) companies that have turnover of INR 10,000 million or more (US $ 83 million), and (3) companies that have a net profit of INR 50 million or more (US $830,000). Notably, the law is broad in its applicability, applying to all Indian companies, both public and private, that meet the financial criteria, as well as foreign companies doing business in India, including through an agent or electronically. However, if a company fails to meet the financial conditions for three consecutive years, then it is no longer required to meet the requirements of the Act. A company that falls within the scope of the law is required to annually contribute two percent of its average net profits from the preceding three financial years to CSR initiatives. The Companies Act specifies how to calculate average net profits. The Companies Act and Companies Rules detail a wide range of projects and programs that will satisfy this obligation including:
- eradicating hunger, poverty and malnutrition, promoting health care and sanitation and making available safe drinking water;
- promoting education, including special education and employment enhancing vocation skills, especially among children, women, elderly and the differently abled and livelihood enhancement projects;
- ensuring environmental sustainability, ecological balance, protection of flora and fauna, animal welfare, agroforestry, conservation of natural resources and maintaining quality of soil air and water;
- contribution to the Prime Minister’s National Relief Fund or any other fund set up by the Central Government for socio-economic development and relief and welfare of the Scheduled Castes, the Scheduled Tribes, other backward classes and women; and
- rural development projects.
Circular No. 21/2014 clarifies that the activities listed in the Companies Act are not necessarily exclusive and that the list should be “interpreted liberally” when determining whether an activity qualifies as a CSR undertaking. However, these activities must occur within India, and preference is to be given to the local areas where the company operates. Contributions or donations to political parties are specifically excluded, as are activities in the normal course of business of the company. According to Circular No. 21/2014, “one-off events” such as marathons, charitable contributions, and advertisements do not qualify as a CSR expenditure; the focus is to be on ongoing projects and programs. Likewise, costs incurred to fulfill statutory or regulatory obligations do not qualify under the Act. On the other hand, regular CSR staff and volunteers’ salaries can be factored into CSR costs. Companies are allowed to collaborate or pool resources with other companies in undertaking these projects and programs. And, costs incurred by a foreign holding company for CSR activities in India will qualify as a CSR expenditure of that company’s Indian subsidiary. Of comparable significance, to help oversee this effort, a company must establish a CSR Committee comprised of at least three members of the board of directors. Foreign companies are only required to have a two-member CSR Committee. However, one of those members must be an Indian resident that is authorized to accept service of process and other notices on behalf of the company. The other person shall be nominated by the foreign company. The CSR Committee is responsible for developing and recommending to the board a CSR Policy that identifies the CSR activities to be undertaken in compliance with the Act, implementation schedules for those activities, and monitoring of the company’s CSR performance. In addition, the CSR Committee must recommend a budget for those CSR activities and evaluate the company’s CSR efforts.
For foreign companies often with offshore board members, the operation of this committee and its membership has given rise to considerable concern. The obligation to fund CSR activities is coupled with a mandatory reporting requirement. The Board’s annual report must provide information on how the company is complying with the Companies Act, including the composition of the CSR Committee, an outline of the company’s CSR Policy and information on the projects/programs to be undertaken. Financial information must also be disclosed, including the company’s average net profit for the last three financial years and details on the money spent on CSR activities over the past year. Further, if the required two percent of average net profits have not been spent, then the annual report must provide an explanation. The first annual reports will be due April 2015. If a company has a website, then its CSR Policy must be made available online. It is unclear if the company’s entire annual report, including its average net profit for the last three years, must also be made available online.
Impact of the CSR Rules
The impact of the Companies Act will unfold over the next several years with particular interest by companies in the implementation and oversight of the two percent annual obligation, as well as the practicality surrounding the creation and operation of the CSR Committee. Due to the relative novelty of the mandatory formation of a CSR Committee with specified responsibilities, the Indian experience bears watching as a potential springboard for similar obligations in other emerging economies.
China entered the CSR arena with the issuance of a directive by the state-owned Assets Supervision and Administration Commission in January 2008 (“Instructing Opinions about State-Owned Enterprises Fulfilling Social Responsibility”). This Directive strongly encourages, though does not require, state-owned companies to adopt CSR practices and report on their CSR activities.
Scope of and Nature of the State-Owned Enterprises Social Responsibility Directive
The Directive specifies the following encouraged activities and reporting:
- Comply with laws and regulations, moral standards, business ethics, and industrial regulations and conduct their business honestly. State-owned companies should pay taxes on time, protect the rights of investors and shareholders, protect intellectual property rights, fulfill responsibilities stated in contracts, fight against improper competition, and eliminate corrupted behaviors in all business activities.
- Continuously improve their sustainable profitability. Corporate governance should be improved. Corporate management should be strengthened and business running costs should be reduced.
- Improve the quality of products and services. Corporations have a responsibility to ensure the safety of products and services. They should protect the rights of customers and handle complaints and suggestions of customers properly.
- Improve resource and environmental protection. State-owned companies should be the leaders in reducing emissions and increase inputs into environmental protection in addition to reforming the production process in order to reduce pollutants emitted.
- Promote innovation and technological development.
- Ensure work safety and improve accountability by implement mechanisms and systems to prevent serious occupational accidents.
- Protect labor rights and enter into employment contracts that fully comply with legal requirements. Discrimination against gender, ethnicity, religion and age should be eliminated. Employee representative mechanisms should be introduced or strengthened.
- Actively participate in social and community business (including donations and philanthropy) community construction and encourage employee volunteering.
Under the Directive, state-owned enterprises are also encouraged to develop a CSR reporting mechanism and regularly report on CSR implementation, strategy and policy. In addition, they are urged to strengthen the awareness of CSR in the corporation through education and training, combine CSR with corporate governance and strategy, and study the best practice and successful experiences of foreign companies in implementing CSR.
Impact of the State-Owned Enterprises Social Responsibility Directive
While this Directive is not mandatory and is focused only on state-owned companies, the Directive is likely to serve as a precursor for future mandatory nonfinancial reporting by other Chinese and foreign companies and ventures.
The developments in the EU, India, and China represent only several from among many in the growing trend of governmental requirements governing the mandatory reporting and disclosure of CSR information. These emerging mandates will impact directly many companies doing business in those jurisdictions, and indirectly affect thousands more who supply companies operating in them. Further, as early movers in the mandatory reporting world, their regimes will undoubtedly influence and shape the requirements to come in yet more countries around the globe.