By James Hamilton, J.D., LL.M.
The comply or explain voluntary UK corporate governance code will not be replaced by a mandatory code, said Financial Reporting Council Chief Executive Paul Boyle. In remarks at the London Stock Exchange, he said that mandatory requirements will not necessarily improve the decision making or behavior of company management. He also examined the corporate governance of audit firms. Corporate governance is one of the FRC’s broad range of responsibilities, which also includes the oversight of financial accounting and independent auditing of financial statements. The rationale for having all of these issues under one regulatory roof, he explained, is that there are strong connections between corporate governance, corporate reporting, and auditing and assurance.
The FRC Chief Executive cautioned against concluding that the financial sector crisis should lead to a general tightening of governance standards across the UK corporate sector. The crisis is largely confined to the corporate governance of banks and other financial institutions. In that regard, he welcomed the appointment of Sir David Walker to review the corporate governance of UK financial institutions.
Under the comply or explain approach, a company must comply with the corporate governance code or explain why it did not comply. The explanation must be a reasoned one bereft of boilerplate. Comply or explain has been a feature of the regime since the Combined Code was first published in 1992. Over the years, the FRC’s has found widespread support for this flexibility on the part of both companies and investors
The UK places a great responsibility on institutional shareholders to monitor compliance with the corporate governance code These responsibilities of institutional shareholders are set out in Section 2 of the Code, he noted, which contains two main principles relating to the need for institutional shareholders to enter into a dialogue with companies and to make considered use of their votes. If the UK system of corporate governance is to be sustained, he emphasized, it is essential that a sufficient number and weight of institutional shareholders demonstrate a willingness and a capability to live up to those responsibilities.
The FRC chief acknowledged that some commentators have suggested that the UK system of comply or explain coupled with monitoring by institutional investors
is unsatisfactory and should be replaced by regulatory monitoring and enforcement. Noting that the FRC has considered and rejected this option, the chief executive explained that the oversight board was not able identify a more effective alternative in improving the practice of corporate governance in a manner that would be consistent with the principles that regulatory actions must be targeted and proportionate.
The corporate governance of audit firms has come to prominence as oversight boards and policymakers examine the consequences of a withdrawal of one of the Big Four audit firms. There are concerns about the risks associated with the current structure of the audit market in which the four largest firms have a large share of the market for the audit of the largest public companies. If any one of those firms was to exit the market, he noted, the costs to market participants due to uncertainty and disruption could be considerable.
In 2006 the FRC established a Market Participants Group (MPG), consisting of people from the corporate, investor and audit communities to advise on market-led steps which could be taken to reduce the risks. The MPG’s final report was published in October 2007. Not surprisingly, it concluded that there was no silver bullet solution to the
problem; but it did make 15 recommendations which it hoped would lead to a reduction in the risks.
One recommendation was that, since audit firms had duties beyond their owners to a wider public interest they should comply or explain with a code of corporate governance. The rationale for this recommendation was that the collapse of a major audit firm
could be damaging to other parts of the economy and that strengthened governance arrangements in the audit firms could make a contribution to reducing the likelihood of such a collapse and ensuring that the firms maintained an appropriate focus on the wider public interest.
The FRC vetted an independent working group, led by Norman Murray, to develop an appropriate governance code for audit firms. The Murray working group is expected to issue a draft code for public consultation in the next few months.
Another MOPG recommendation was that public companies should consider the need to include the risk of the withdrawal of their auditor from the market in their risk evaluation and planning. The rationale for this recommendation was that, since it would be both
impossible and undesirable to reduce to zero the possibility of a major audit
firm leaving the market, it was necessary to consider what steps market participants themselves could take to reduce the uncertainty and disruption costs which would result from such an event.
It would certainly be unfortunate if a company whose audit became unavailable to them for whatever reason found itself unable to appoint another firm of suitable scale and experience because of other commercial relationships it had with other potential auditors. This recommendation is now codified in the most recent version of the FRC’s Guidance on Audit Committees.