The weight of non-financial rules

by Professor Krish Bhaskar

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24 Jul 2014

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Carrying a heavy load

FOR THE EUROPEAN COMMISSION the final outcome of its less-than-catchy titled directive, The disclosure of non-financial and diversity information by certain large companies and groups, must be a disappointment. While not being a damp squib, the directive in its current form is broad, fuzzy and more than imprecise.

There is some controversy as to how it will be interpreted and its effect on the UK. Under the rules, certain public interest organisations will include a statement in their annual accounts about environmental, social and employee-related matters. This is in addition to human rights, anti-corruption and bribery issues and boardroom diversity.

The agreement, endorsed by the EU council of permanent representatives earlier this year, applies to large public interest entities (PIEs) (mainly listed companies and financial institutions) with more than 500 employees, affecting around 6,000 companies.

The intention is that the directive will help not just shareholders but a wider set of stakeholders such as the media, politicians and special interest/pressure groups. Nevertheless, global investors, representing more than £13tn of assets under management, may also be interested. Indeed, the Eurosif/ACCA survey of global investors in 2011 found that over 90% of investors were interested in such information, while 93% disagreed that current levels of non-financial disclosure were sufficient to assess materiality.

Disclosure politics
As is often the case, the politics of such disclosure has had a split response. This directive has its roots as a reaction to the global financial crisis; the diversity clause is directly intended to broaden directors to prevent ‘group-think' that may have contributed to the global financial crisis. It is the EC's attempt to make a set of conditions which might prevent another such crisis, though social justice has inevitably been included by a politically left-leaning European Parliament.

This directive can be traced back to 2011 and it has undergone several revisions, compromises and drafts. Michel Barnier, EC commissioner for the internal market and services, has voiced disappointment that these rules are less strict than the original spirit.

There was considerable discussion and compromises both by the EC and MEPs. The final draft directive was agreed on 15 April and will be adopted by the European Council shortly, though there is still some room for manoeuvre and opportunity to persuade the current government to make this less arduous than perhaps the EC intended.

The directive applies to all large companies: most, if not all, quoted companies, defined by the EU as the parent companies of PIEs and where the average number of employees during the financial year exceeds 500. This is greater than the previous UK benchmark of 250. For the UK, it will probably apply to most, if not all, FTSE 350 companies, some of the AIM companies, over 100 privately-owned companies, some unlisted financial institutions and a few other organisations.

The EC target of 6,000 companies may in effect be an underestimate. The intention was that SMEs should be exempted (under the so called ‘Think small first' initiative). Exactly what these criteria mean will be determined by each member state. So the FRC and the directive as enacted in UK law will be of paramount importance.

The scope of this directive is a little fuzzy, though not everyone agrees. Further guidelines and clarifications will likely be forthcoming from the FRC and UK policymakers

Flexibility
Reporting commentators have suggested that the requirements will create a level playing field in corporate disclosure throughout the EU, yet some European politicians believe the directive leaves "significant flexibility" for companies and member states to disclose relevant information in the way that they consider most useful in their reports.

Since this EU directive is also capable of substantial country amendments and tailoring, it is unlikely that this objective will be achieved in full. Each company has a degree of flexibility as well.

Indeed, a Deloitte survey of FTSE 350 reporting practice shows that many the top 50 companies have complied with the new UK narrative rules, and that many companies have had a reasonable stab at providing non-financial information. In this respect the UK is ahead of other EU countries.

In addition, the new requirement for boards to state that the annual report, taken as a whole, is "fair, balanced and understandable" will most often fall upon the audit committee in the first instance. All in all, audit committees are under greater scrutiny than they ever have been and that trend is only likely to continue. In this context, BDO released its third annual review of audit committee reporting, which found that as there is flexibility in the directive and no non-compliance sanctions at the moment. This may mean that this directive is less effective.

Of course, there is the ultimate sanction. The FRC can and has taken action against the preparers of reports. In response to a complaint on narrative reporting of Rio Tinto in 2011, the FRC asked the company to include additional information.

Nevertheless, the lack of detail on any penalty for non-compliance is worrying as some companies may see this as a reason not to follow the rules.

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