Tuesday, July 26, 2011

UK Regulator Endorses Comply-or-Explain Principle in Comments on Corporate Governance Green Paper

The UK accounting and auditing regulator strongly endorsed the continuing efficacy of comply-or-explain corporate governance codes in comments on the European Commission’s Green Paper on corporate governance. The comply-or-explain principle is recognized at the European level as an important tool for delivering good corporate governance, noted the Financial Reporting Council, but the Green Paper raises questions about its effectiveness. Comply-or-explain offers flexibility that is positive for economic activity, said the FRC, and should not be replaced or watered down with arrangements which might stifle entrepreneurialism. While asserting that comply-or-explain should be retained as an important principle in EU corporate governance, the FRC agreed with the Green Paper that it should be made to work more effectively, adding that there is a need for more reliable monitoring and a better quality of explanations.

For example, the FRC said that regulators should pick up on instances where there is no explanation for a breach of the Code. The Financial Reporting Review Panel, which reviews narrative and financial reporting, already monitors on behalf of the Financial Services Authority the mandatory corporate governance disclosures required under the 4th and 8th Company Law Directives, and the FRC is considering whether this role might be extended.

The Green Paper suggests that the quality of explanations might be improved by making company corporate governance statements regulated information under the Transparency Directive. This would give regulators the power to intervene directly where explanations were deemed inadequate. But the FRC fears that this approach could lead to situations where regulators would usurp the right of shareholders to assess the acceptability of explanations, which is an essential pillar of the comply-or-explain concept.

Such an approach cannot even be contemplated until there is a clear consensus in each market about what constitutes an explanation. The UK Code states that in providing an explanation companies should illustrate how their actual practices are consistent with the relevant principle of the Code, which is divided into high-level principles and more detailed provisions, with only the provisions being subject to comply-or-explain.

If there should be regulatory oversight, said the FRC, it must not intrude on shareholder judgments. What must be avoided is a compliance-driven box-ticking approach in which companies would be tempted to check in advance with regulators whether an explanation was appropriate, thereby placing shareholders outside the loop.

The FRC suggested that a limited acceptable scenario for regulatory oversight might be for shareholders to refer to the regulator explanations which in the shareholder’s view clearly failed to meet the agreed criteria, if engagement with the company had failed to elicit a more informative explanation. The regulator would then be able to insist on a better quality explanation. This should provide a particular boost to the quality of explanations, especially in countries where they are weak.

The FRC corrected two misconceptions about the comply-or-explain doctrine. First, the frequent assertion that comply-or-explain is self-regulation is incorrect. Indeed, a comply-or-explain approach depends on regulation to make it effective. There must be a formal requirement for transparency, so that companies covered by the regime are obliged to state publicly whether they comply with relevant provisions, explain publicly when they do not and demonstrate how the resulting governance arrangements meet the relevant principle. Thus, the comply-or-explain approach uses regulation to enhance accountability. It does not allow companies to regulate themselves.

Second, the political debate sometimes seems to revolve around the flawed notion that there is a choice between two systems: formal regulation or comply-or-explain. Even in the UK, where the comply-or-explain principle is probably most developed, market participants recognize the need for regulation. The key challenge is deciding on the right mix of formal regulation and comply-or explain provisions.

According to the FRC, comply-or-explain corporate governance codes have many advantages. They can be modified regularly to take account of changing market circumstances and to encourage incremental increases in standards, thus promoting continuous improvement. In the UK, the FRC normally reviews the Corporate Governance Code every two years. In other member states such as Germany, there is an annual review. It is not possible to amend legislation this frequently, said the FRC, and Codes are therefore more adaptable.

Also, Codes frequently focus on behavioral expectations which are difficult to capture in regulation or where regulation would be premature. For example, the practice of board evaluation has been growing in the UK since it was first recommended in the UK Corporate Governance Code in 2003. This is now being extended to encourage regular evaluation by an independent external reviewer, which in turn is encouraging the development of a more professional market in board reviews. The Code has thus brought about a change in culture with regard to board reviews and enabled expectations with regard to standards to be progressively raised. A regulatory approach would have been more difficult, reasoned the FRC, since it would have involved a one-off requirement to conduct board evaluation that would be difficult to impose when the market in board reviews was not yet developed.

It may even be possible to achieve more robust outcomes with a comply-or-explain Code than would be available through negotiation of Directives and regulation. An example is the arrangement for audit committees. Before the introduction of the 8th Company Law Directive in 2006, noted the FRC, the UK had already achieved virtually universal compliance with Code requirements for listed companies to have fully independent audit committees. Audit committees became a statutory requirement with the introduction of the Directive, but, because member states could not agree on the level of independence required, the Directive only requires one member of the committee to be independent. The UK Code outcome was thus more robust.