Is "Comply or Explain" Here to Stay?
Sarah Jane Leake | Bloomberg Law
Confidence in corporate governance is integral to maintaining confidence in capital markets. With this in mind, the European Commission, in April, launched a consultation on how to improve corporate governance within European companies, with a view to achieving a level playing field in respect of governance matters throughout the EU.1 The consultation closed for comment on 22 July and many stakeholders have now published their formal responses to the Commission’s proposals.
Perhaps the most controversial question raised by the Commission was the effectiveness of the “comply or explain” doctrine, a principle deeply entrenched in the UK’s regulatory approach to corporate governance. The “comply or explain” mechanism is not, however, confined to the UK; many other Member States, Germany,2 for example, have adopted similar methods.
The UK’s corporate governance regime is rooted in the Corporate Governance Code (Governance Code), applicable to listed companies incorporated in the UK with a premium listing of equity shares. These companies are required to apply the principles set forth in the Governance Code and explain to shareholders in their annual financial reports how they have done so. Some deviation from the Code’s provisions is permissible, so long as the reasons for doing so are clearly explained and the underlying principle is met. The purpose of the “comply or explain” approach is to give companies some degree of flexibility – by allowing the market to decide what is appropriate. The Financial Reporting Council (FRC), custodian of the Governance Code, has previously rejected the notion of a “one size fits all approach,” primarily on the basis that this would not appropriately cater for the diversity of businesses operating within the UK.
The Commission expressed concern that the “comply or explain” approach applicable to many codes of conduct provides companies with a carte blanche for deviation. Feedback submitted, however, shows strong support among companies, investors, and regulators for the “comply or explain” regime, and emphasises that it plays an important role in delivering good corporate governance throughout the EU.
Defending an Established Regime
The FRC maintains that “codes underpinned by law, as in the UK, and including a ‘comply or explain’ approach, are the most effective means of driving up standards.”3 This view is strongly supported by a number of other influential entities in the UK, including the Department for Business, Innovation and Skills (BIS) and the Financial Services Authority (FSA) (together, the Authorities).4 The “comply or explain” approach, asserts the Authorities, gives companies the opportunity to develop governance policies and practices specifically tailored to their particular circumstances (e.g., size, sector, etc.). The GC1005 similarly endorses the regime, which it describes as the “culmination of extensive consultation and discussion in the UK over many years.”6 Representing the views of the FTSE 100, the CG100 opines that the approach has worked well in the UK to date, year-on-year driving good practice and improvement.
While the Commission’s aim to achieve a level playing field throughout the EU is considered “laudable,”7 the general view from the UK is that some flexibility must be preserved for individual Member States where difference practices remain acceptable for companies and stakeholders alike.
To ensure that the Commission appreciates the high degree to which the “comply or explain” promotes good governance in the UK, the FRC dispels two popular misconceptions.
First, “comply or explain” is not self-regulation. The regime relies on regulation to enhance accountability and does not simply allow companies to regulate themselves. For example, there must be a formal requirement for transparency, obliging companies to disclose whether they comply with the relevant provisions of the Governance Code, publicly explain when they do not, and demonstrate how their alternative arrangements meet the relevant provision. Shareholders, if dissatisfied with the explanations given, may exercise their legal right to dismiss the board.
Secondly, the FRC fears that the current debate revolves around the idea that there is a choice between two systems – formal regulation or “comply or explain.” This is not true. In the UK, where the “comply or explain” regime is probably the most developed in Europe, regulators and market participants alike recognise the need for effective underlying regulation. In the context of corporate governance, the FRC considers that one system cannot operate effectively without the other.
— Changing Behaviour
“Codes have a proven track record in changing behaviour,” claims the FRC.8 Once they are well established and respected, changes can be made relatively quickly. This, in effect, leads to speedier compliance. By way of example, in 1992 the first UK Code recommended the separation of the chairman and chief executive functions. In 1995 only 47.4 percent of companies complied with this recommendation. Now, over 95 percent of companies comply.
Given the diversity of businesses operating within the EU, flexibility is key. The London Stock Exchange alone covers over 1,400 companies in 40 sectors, each with different qualities. In many countries that have adopted the “comply or explain” approach, the degree to which a company complies is commensurate with its size. In Germany, for example, it has been reported that smaller companies generally take greater advantage of the ability to explain, whereas larger companies more often comply.
While law can be adapted to vary according to size,9 its flexibility to adapt to the more individual needs of companies is limited.
Since codes are more flexible, and can be individually tailored to meet specific needs, standards can be set higher than those contained in law. This is because law itself must be capable of consistent application across the spectrum.
The history of the UK audit committee provides a perfect example of codes setting and achieving higher standards. Under the 8th Company Law Directive,10 all listed companies are required to have an audit committee (or equivalent) comprised of at least one independent director. Before the Directive, which was implemented into UK law in 2008, UK listed companies were not required to have an audit committee. The UK Code, however, had been recommending audit committees since its establishment in 1992. While, initially, the Code recommended that the majority of members should be independent, this was changed in 2003 to provide that all members should be independent. Statistics show that in 2006, 100 percent of FTSE 350 companies had audit committees, with some 88 percent being fully independent. In this instance, code proved more effective than law in producing faster and better results.
— Evolving Over Time
Financial markets are in a constant state of flux. As codes are easier and quicker to change than law, they are better placed to respond to market developments. They can be redrafted and implemented without necessitating legislative change and so, themselves, are in a constant state of evolution. This promotes continuous improvement over time. Further, codes can provide for an easier transition period in which companies can, through trial and error, accept and adopt the best practice for their business.
— Reducing Moral Hazard
Research indicates that rules unintentionally turn governance into more of a box-ticking exercise that causes boards to focus less on developing forward-looking strategies. While this gives the impression of good governance, the reality may be very different.
Stricter regulation could give shareholders the false impression that corporate governance is being monitored effectively at times when it is not. Armed with this confidence, shareholder involvement would inevitably decline.
Accountable only to regulators, companies may act less carefully than they would otherwise. If they were made accountable to shareholders, however, companies are more likely to promote and practice good governance – especially since investors take companies’ corporate governance metrics into consideration when making investment decisions.
— Encouraging Convergence
Shareholders, as the main group holding boards to account, are best placed to promote best practice. Internationally, their activity can “act as a converging force on the quality of corporate governance.” This is because countries seeking international involvement are more than likely to adopt practices endorsed by other investors.
It is difficult to harmonise law throughout the EU, let alone across the globe. EU legislation, for example, can take years to develop. Exemplary conduct, however, can be contagious. Referring to the latest pan-European study, the FRC explains that corporate governance frameworks across the EU are increasingly converging.
— Incentivising Innovation
A strict rules-based regulatory environment is often perceived to promote an unthinking, box-ticking compliance culture. The versatility of the code, on the other hand, stimulates debate within companies on what constitutes good governance. This helps companies to pay more attention to governance issues.
The ability to comply or, in the alternative, explain encourages innovation. Companies that do not meet the code’s provisions and therefore have to explain their reasons for doing so have the freedom to think outside the box and adapt and develop best practices. Alternative approaches to compliance are considered beneficial as they can be tailored specifically to the unique circumstances of each individual company.
— Minimising Cost
Codes are typically less costly to follow than a stricter rules-based system. They give companies the flexibility to assess the relative costs and benefits of compliance in light of their own circumstances (yet in the event of non-compliance, credible justification must be given to shareholders). Rules, on the other hand, are applied without direct regard to cost for specific companies and the risk of disproportional impact. The FRC fears that without proportionality, companies will “be more likely to seek ways of getting around best practice”11 which, ultimately, will give rise to an avoidance culture.
Research indicates that the cost of section 404 of the U.S. Sarbanes-Oxley Act of 2002 (SOX) exceeded its potential benefits during the early years. For this reason, companies were initially opposed to the Act which was only seen as having a positive influence many years later. Based on SOX experience, a similar approach in the UK could cost each of the country’s largest companies around £2.18 million in the first year. In the GC100′s view, it would be inappropriate to introduce such a regime at a time when many Member States are already in financial hardship.
Shareholders play a key role in holding boards to account. Compared with other jurisdictions, the EU’s governance framework provides for strong shareholder rights, such as the right to information under Directive 2007/36/EC. Yet, the mere existence of shareholder rights does not necessarily ensure good governance. Shareholders therefore need to be encouraged to exercise their rights, and to do so in a more effective fashion.
In response to these concerns, last year the UK introduced the its first Stewardship Code, which seeks to facilitate engagement between shareholders and the boards of the companies in which they invest. Other Member States have taken similar action to address this problem. Last year, for example, the Portuguese securities and insurance regulators (CMVM and ASP) issued a set of recommendations for mutual fund and pension managers.
To be able to effectively monitor company performance, investors must have access to relevant and up-to-date information. Although the importance of information distribution is reflected in both law and codes, the FRC considers that legislation for basic rights in this regard is better achieved by law. Codes can build on the law by setting flexible targets for information-sharing which can be tailored to meet each individual company’s needs.
While many argue that the “comply or explain” approach should be retained as an important principle in EU corporate governance, they nonetheless agree with the Commission that some change is required to make it work more effectively. It is important, from the UK perspective that an appropriate balance is struck between prescriptive laws and regulations on the one hand and recommended practices on the other. Many Member States have much to gain from a rules-based regulatory regime. Similarly, many like the UK and Germany, to name a few, have much to lose.
“The different corporate governance systems of the Union,” affirms the FRC, “should not be viewed as an obstacle to free enterprise within a single market, but as a treasure trove of different solutions to a wide variety of challenges that has been experienced and overcome.”12
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