Tuesday, April 05, 2011

European Commission Considers Historic Change in Corporate Governance Oversight and Use of Comply or Explain

The European Commission has begun a significant and historic effort to reform corporate governance with the publication of a green paper that could lead to broad EU legislative proposals later this year, including the tightening of the comply or explain model, which has been the bedrock of EU corporate governance. While most EU Members have voluntary corporate governance codes, the Commission has evidence of shortcomings in the application of these codes when reporting on the comply or explain basis. The information provided by companies is in general unsatisfactory and the oversight by monitoring bodies is insufficient. Thus, the Commission in an historic breakthrough is considering legislation to require more effective monitoring by securities regulators of company explanations of why they did not comply with a code provision, and even sanctions in egregious cases.

The Commission noted that the comply or explain approach in the EU has had its difficulties. Studies reveal important shortcomings in applying the comply or explain principle that reduce the efficiency of the EU’s corporate governance framework and limit the system’s usefulness. The green paper poses the need to reinforce certain requirements at EU level by including them in legislation rather than making recommendations.

Current legislation on company reporting promotes application of the corporate governance codes by requiring that listed companies refer in their corporate governance statement to a code and that they report on its application on a comply or explain basis. This means in practice that a company choosing to depart from a corporate governance code has to explain which parts of the corporate governance code it has departed from and why it has done so.

The Commission said that the overall quality of companies’ corporate governance statements when departing from a corporate governance code recommendation is unsatisfactory. They either simply stated that they had departed from a recommendation without any further explanation, or provided only a general or limited explanation. The Commission is considering mandating more detailed requirements for the information to be published by companies departing from the corporate governance code recommendations. The requirements should be clear and precise, said the Commission, since many of the present difficulties are due to a misunderstanding of the nature of the explanations required

In addition, the corporate governance statements that companies publish do not seem to be monitored as they should be. Financial market authorities or stock exchanges work within different legislative frameworks and have developed different practices. In any event, in most cases, they only have a formal role of verifying whether the corporate governance statement has been published. Few Member States have public or specialized authorities that check the completeness of the information provided, especially the explanations for not complying with a code provision.

The Commission said that comply or explain could work much better if monitoring bodies such as securities regulators and exchanges were authorized to check whether the available information and the explanations were sufficiently informative and comprehensive. The authorities could make the monitoring results publicly available in order to highlight best practices and push companies towards more complete transparency. Use of formal sanctions in the most serious cases of non-compliance could also be envisaged. The authorities should not, however, interfere with the content of the information disclosed or make business judgments on the solution chosen by the company.

One way to improve monitoring could be to define the corporate governance statement as regulated information within the meaning of Article 2(1)(k) of the Transparency Directive, 2004/109/EC, and thus make it subject to the powers of national authorities laid down in Article 24(4) of the Directive

More granularly, the Commission makes significant proposals on executive compensation. There should be mandatory disclosure of the company’s compensation policy and the individual remuneration of executive and non-executive directors. There should be a shareholder vote on the compensation statement, and also an independent board compensation committee. Importantly, there must be appropriate incentives which foster performance and long-term value creation by companies.
It is also crucial that the board ensures a proper oversight of the risk management processes. To be effective and consistent, noted the Commission, any risk policy needs to be clearly set from the top. The board of directors bears primary responsibility for defining the risk profile of a given organization according to the strategy followed. It is indispensable to define clearly the roles and responsibilities of all parties involved in the risk management process.

Proxy advisory services have an influence on voting decisions made by shareholders, which in some case may be substantial. Given the influence proxy advisors have on shareholders´ behavior, the green paper addresses the role of proxy advisors and has some concerns with regard to their functioning, such as the methods applied with regard to the preparation of the advice and possible conflicts of interest.

When proxy advisors also act as corporate governance consultants to investee companies, this may give rise to conflicts of interest. Conflicts of interest also arise when a proxy advisory services advise on shareholder resolutions proposed by one of their clients. The Commission is considering legislation requiring proxy advisors to be more transparent about their analytical methods, conflicts of interest and any methods for managing the conflicts, as well as whether they apply a code of conduct.