When is comply or explain the right approach?
Comply or explain has been part of the UK corporate governance framework since it was introduced with the Cadbury Code in 1992. It is much admired and used widely in many other countries throughout Europe and beyond.
However, following the financial crisis, there seems to be more pressure for a rethink among regulators. For example, the Competition Commission discussed the use of comply or explain in the context of audit tendering at length and decided to introduce mandatory tendering every 10 years. Furthermore, the Financial Reporting Council (FRC) has been stressing the important roles that the board, and above all the chairman, and shareholders play.
Despite this background, the use of comply or explain is prominent as a mechanism within the corporate governance framework. For example, there are over 50 “provisions” in the UK Corporate Governance Code (the Code) setting out over 110 instances of what companies, boards, directors and others “should” do.
The following provisions are the most familiar to us:
- the roles of chairman and CEO should not to be exercised by the same individual;
- a senior independent director should be appointed; and
- at least half the board, excluding the chairman, should comprise non-executive directors.
Despite the flexibility the approach presents, the level of compliance with the Code among the UK listed companies is very high. The majority of UK companies that deviate from the provisions only do so in relation to one or two provisions. Many companies report full compliance with the Code.
The benefits of comply or explain
The purpose of all corporate governance codes, legislation and regulations, regardless of whether they use comply or explain or not, is to promote good governance. So why is using a comply-or-explain based code appealing? In ICAEW’s new corporate governance thought paper, we discuss four unique benefits.
- Innovation enables a smoother introduction of new ideas and changes to the company governance code. Those who are not won over by the new ideas, or who see them as aspirational, will have less cause to argue against their introduction into a code if they have an option to explain.
- Proportionality allows a measured application of more demanding requirements, especially for smaller businesses. Companies can comply with the principle behind certain provisions even when they decide not to comply with a specific provision.
- Avoiding box ticking encourages companies to think through what the overarching principles are, before complying with provisions, because they have the option to explain. Companies comply with new provisions, only if they genuinely believe that doing so would improve their corporate governance.
- Long-term learning assists a cultural change in companies, by encouraging them to think regularly about how to meet the purpose and principles of corporate governance, through which companies may internalise these ideas over time.
Effectiveness of comply or explain
There is a general assumption that companies are genuinely committed to good governance when they are allowed to determine whether to comply or explain their non-compliance. In turn, companies need to trust that investors should pay due regard to their explanation.
The effectiveness of comply or explain depends on mutual trust but institutional arrangements are also important to provide a communication channel between the board and shareholders. Shareholders play a key role in monitoring the quality of explanations, to see whether they are a credible alternative to regulatory and legal enforcement.
These arrangements relate to shareholder rights and engagement, patterns of ownership, and legal and regulatory traditions. Together, these arrangements create incentives for shareholders to play the stewardship role, by scrutinising and challenging companies’ explanations.
Unfortunately, we cannot presume that either mutual trust or institutional settings as given, or to be in place forever once there. If companies repeatedly give poor explanations for non-compliance, this signals that there is little confidence in the value of communicating their ideas about good governance.
If markets react negatively to any instances of non-compliance, companies would not see the benefits of pursuing alternatives that deliver good governance, while better serving their business purpose.
Comply or explain can help good governance practice be better embedded in companies. However, it only works where there is a shared belief about what business should be doing and there is a mechanism to enable that communication.
Where these are not in place, comply or explain will very likely be ineffective and there will be a call for alternative strategies to address immediate issues in the short term.
This is the third of five papers in the ICAEW corporate governance series “Five Questions, New Challenges.” The series explores key questions and challenges arising from changes in capital markets and how they affect the foundations of existing corporate governance frameworks.
Jo Iwasaki FCA, Head of Corporate Governance, ICAEW
Non-Executive Directors Group, March 2014