CSRD: businesses warned over potential legal risks lurking in their DMA

James Hay and Caroline Boon of Pinsent Masons reported growing concerns from clients about their disclosure obligations following the outcome of expansive DMAs, which many are regretting in hindsight.

In some cases, they said, teams attempting to cope with complex guidance from the European Financial Reporting Advisory Group (EFRAG) have conducted unwieldy DMAs that have produced wide-ranging content which, in turn, is posing challenges in terms of public disclosures.

Hay, expert in sustainability reporting, said: “CSRD is different to other reporting regimes that businesses will already be familiar with – unlike, for example, gender pay gap reporting requirements where disclosure obligations are tightly prescribed, the CSRD puts the onus on in-scope companies to themselves determine what is ‘material’ information to disclose in the context of their business. The introduction of ‘double materiality’ is causing many companies to begin reporting on issues not previously considered relevant to their business. While this was an intended aspect of CSRD, many companies previously seeking to err on the side of caution are now at risk of over disclosing.”

Boon, who has practical experience preparing sustainability disclosures from working in-house in a previous role, said: “Businesses are now required to disclose more than ever, but sustainability reports should not be the tail wagging the dog. Companies risk losing their key, strategic messages in the reporting deluge. Further, the enhanced sustainability disclosures, especially in relation to first-time reporting of the DMA, have the potential to attract new legal risks.”

Michael Fletcher of Pinsent Masons said careful consideration of the implications of the DMA disclosure is required. He said litigation risks could arise as a result of new disclosures that shareholders or other readers of the sustainability report are neither sufficiently familiar with, nor expecting. For example, he said the DMA process may cause companies to identify potential human rights impacts in supply chains and declare these ‘material’ in contrast to their previous communications on the topic.

“It should be assumed that, with ESG-related litigation on the rise, there will be third parties scrutinising such reporting looking for disclosures that can give rise to claims,” Fletcher said. “Accordingly, all such reporting must be carefully considered in terms of content and its presentation.”

Hay responded that care should be taken to design a DMA process that reflects the nature of the business and balances legal and reputational risks with disclosure obligations, requiring the input of legal counsel. Boilerplate DMAs or strict adherence to industry-agnostic guidance are unlikely to faithfully represent a company’s sustainability profile and may identify material issues which are remote from its business, giving rise to these risks, he said.

“It is important to introduce new information with appropriate context,” Boon said. “Firms can protect themselves from potential legal risk by anticipating potential adverse reputational or litigation risks and addressing those points proactively in the disclosure. For example, key questions they could ask themselves include: on what basis has the issue been designated as material, or to what extent is this a company-specific versus industry-wide issue?”

According to Boon, the narrative around the outcome of the DMA, as well as the methodology followed, should be clearly explained, together with relevant assumptions and limitations.

“Reporting leads should collaborate with legal teams to ensure that appropriate disclaimers are included where necessary, including around the methodology section,” Boon said. “Thinking about a company’s impact on the environment and society is challenging, compounded by a consideration of its full value chain, and therefore it is unlikely to be accurate the first time around.”

“Many companies grappling with their first CSRD reports have not had time to conduct extensive stakeholder engagement and may have adopted proxies. This could cause the sustainability profile of their business to evolve over time. No doubt, as mature practice emerges and as higher quality sustainability information is shared among value chain partners, DMAs will more faithfully represent a company’s true position, but we are still in the early years of such extensive sustainability reporting and companies should ensure they have given themselves room to evolve their disclosures in future years,” she said.

Boon said that it is important for businesses to understand the implications of the “incongruence” the CSRD introduces between financial and sustainability reporting. That incongruence, she said, arises because the concept of materiality under the DMA is not the same as under financial reporting.

“Accordingly, it is essential that shareholders and other stakeholders who are reading the reports understand the inherent uncertainty in the determination of materiality when describing the DMA outcomes,” Boon said. “Given that European companies are required to present their sustainability report alongside their financial statements, reporting teams would benefit from legal support to draw out this nuance with appropriate disclaimers.”

Businesses subject to the CSRD and other reporting regimes should consider their regulatory requirements to be more than just a tick-box exercise, Boon said. Those that take that approach will miss the opportunity to relay important information to their stakeholders, she said

“Companies should seek to understand how the new CSRD regime can enhance their key commercial messages to stakeholders, how they can use the new disclosures to demonstrate an awareness of new and emerging risks, and to explain how sustainable practices are being integrated into business strategy,” Boon said.

This emphasis on pragmatism should be heeded by companies given recent regulatory uncertainty and political pushback on unduly burdensome disclosures. Hay said: “With its promised Omnibus Simplification Package, EU policymakers are planning to revamp sustainability-related due diligence and reporting rules including the CSRD, with some streamlining of requirements expected. This makes it even more important that businesses take action now to avoid unnecessary over-reporting and carefully manage what they say about what they are required to disclose.”

Pinsent Masons has produced a guide to help businesses understand what CSRD means in practice, as well as a scoping tool to let them check if and when they will be in scope for CSRD reporting.