UK Reaffirms Comply or Explain Model for Corporate Governance as Financial Crisis Roils

Despite concerns that the comply or explain principle of corporate governance may not be robust enough in light of the financial crisis, the principle recently received a strong endorsement from the Walker Report on corporate governance, as well as from UK senior officials. There is no indication that the UK and other EU member corporate governance codes will abandon comply or explain in favor of a US-type Sarbanes-Oxley model, which they view as prescriptive and rules-based. Their main bow to the financial crisis is a call for increased shareholder vigilance and a closer inspection of company explanations.

The Walker Report said that, combined with tougher capital and liquidity requirements and a tougher regulatory stance on the part of the FSA, the comply or explain approach to guidance and provisions under the Combined Code provides the surest route to better corporate governance. The relevant guidance and provisions require amplification and better observance, conceded the report, but there are no proposals for new primary legislation. There is, however, widespread criticism that fund managers and other institutional investors give inadequate weight to explanations of non-compliance with code provisions.

Comply or explain was never intended to be a check-the-box exercise. Rather, the explanation for not complying with a code provision must be reasonable and avoid boilerplate. Boards that provide inadequate explanation for non-compliance, and investors who appear to disregard reasonable explanations, should expect to come under increasing pressure to explain their positions.

Regulators recognize that non-compliance may be justified in particular circumstances if good governance can be achieved by other means. A condition of non-compliance is that the reasons for it should be explained to shareholders, who may wish to discuss the position with the company and whose voting intentions may be influenced as a result. A clear and well-founded explanations which support actions to enhance the long term value of the firm should be acceptable to shareholders

The comply or explain approach has been in operation since the Code’s beginnings in 1992 with the seminal Cadbury Report, noted the Walker Report, and the flexibility it offers is valued by company boards and by investors in pursuing better corporate governance. The Cadbury Report notes that a voluntary corporate governance code, coupled with disclosure, will prove more effective than a statutory code.

The Walker Report concludes that conformity has overall been good in the sense that where boards do not comply, they generally explain. But research by Grant Thornton UK LLP revealed that the quality of explanations appears to have been variable. In this respect, the report emphasized the need for greater shareholder attentiveness to such disclosures in their engagement with the companies.

Echoing the Walker Report, FRC Chief Executive Paul Boyle recently said that the comply or explain UK corporate governance code would not be replaced by a mandatory code. He said that mandatory requirements will not necessarily improve the decision making or behavior of company management. 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 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 investorsis 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.

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