Sunday, February 19, 2012

UK FRC Report Examines Adequate Explanation for Comply or Explain Corporate Governance Code

As a debate rages in the EU over what constitutes an adequate explanation for a company’s deviation from a provision in a comply or explain corporate governance code, the UK Financial Reporting Council issued a report setting forth the attributes of an adequate explanation. The consensus is that a meaningful and adequate explanation should set the context and historical background, should give a convincing rationale for the action the company is taking, and should describe mitigating action to address any additional risk and to maintain conformity with the relevant Code principle. Also, the explanation should indicate whether the deviation from the Code’s provisions was limited in time and when the company intended to return to conformity with the Code’s provisions. Ideally, explanations should be sufficiently full to meet the needs shareholders who cannot not simply call up the company and ask for information, said the FRC, and also serve as the foundation for further dialogue with large shareholders.

It was also noted that the comply or explain concept is more about mindset and culture than box ticking. There is no absolutely right answer. But there is a general recognition that explanations and corporate governance reporting generally should be specific to the company’s position, not generic boilerplate or off the shelf. The report emphasized that a company was still in compliance with the corporate governance code if it chose to deviate from one or more of its provisions and made a full and ample explanation. Explanations should also apply to deviations from the provisions of the Code, not to deviations from its main principles, which companies are expected to apply. Companies have to deliver on the main principles, which are not negotiable. However, the principles are expressed in general terms which allowed some latitude in their implementation.

The FRC rejected the European Commission proposal in a recent Green Paper for making corporate governance statements regulated information within the meaning of the Transparency Directive. This would mean that regulators rather than shareholders would have the task of deciding whether an explanation was sufficiently complete. The FRC believes strongly that explanations are directed to shareholders and it is up to them to decide whether to accept or reject explanations. For this to work, the market needs to develop and maintain a clear understanding of what constitutes an explanation. If regulators have a role it should be in support of shareholders rather than as a substitute for them.

The Green Paper itself goes some way to offering a definition by stating that companies should state clearly which corporate governance code rules they have not complied with, explain the reasons for each case of non-compliance and describe the solution they adopted instead. In the FRC’s view, a critical question is what exactly is meant by the word reason. It might, for example, be possible for a company to argue that the reason why it has combined the role of chairman and chief executive was simply that the board considered that this was the right thing for the company. That would be a reason in a technical sense, acknowledged the FRC, but the UK Governance Code demands that companies in this position explain how they have applied the principle that there should be a clear division of responsibilities at the head of the company and that no individual has unfettered powers of decision.

The FRC also posited that companies which offer a coherent explanation of their corporate governance approach are more likely to find that their explanation in a comply or explain situation is readily acceptable when they do choose to deviate from a particular provision of the Code. Thus, companies were urged to clearly articulate how their governance arrangements support their business model.

The report contribute to a growing consensus in the EU that the comply or explain approach can deliver greater transparency than formal regulation. For example, German officials have been skeptical of regulatory oversight of explanations. The German Corporate Governance Code Commission expressed concern with regard to the proposal for public monitoring of the quality of a company’s explanation when it does not comply with a corporate governance code recommendation. The Commission has fundamental reservations regarding a review by public authorities under a voluntary comply-or-explain code. German officials believe that monitoring by the authorities runs counter to a best practices Code. Either the markets and shareholders will react to deviations from the Code or they will not, they reason, and monitoring by the authorities will not change that dynamic.