ONE OF THE BACKBONES of the Corporate Governance Code has been the principle of comply or explain. However, in other areas of business regulation we rarely observe this approach in practice. Why is it so strong in corporate governance, why does it continue to be used and when is it the right approach?
Comply or explain is an approach that covers much of the content of the UK Code. The Code today contains over 50 ‘provisions’, which set out over 110 instances of what companies, boards, directors and others ‘should’ do. And yet there is no requirement to comply with these provisions, and companies can decide not to do so provided they give an explanation of any non-compliance.
Good and strategic use of comply or explain is good governance. Using comply or explain effectively means that businesses can provide market-based solutions that are worked out between companies and their shareholders without the need for regulatory intervention.
But comply or explain is not simply about having no requirements. It is an approach that positively recognises that an alternative to a provision is justified if it achieves good governance, and companies are prepared to be transparent. Departures from the Code are not seen to be breaches if the accompanying explanations can provide an insight into how a company is thinking, and how they are aiming to achieve good corporate governance.
Explain governance choices
It is not without difficulties. Investors often say that the explanations provided are perfunctory and do not do a good enough job of explaining how a company’s alternative arrangements support the relevant principle. Also, some companies claim that non-compliance affects market perception negatively and outweighs the benefits of pursuing an alternative that still delivers good governance and better serves their business.
If there is a failure to understand why a company has taken the comply or explain route there may be a need for mitigating measures while shared values and institutional arrangements take root. For a period of time, this might mean regulatory intervention. It should also be recognised that in a compliance regime, regulators can achieve the benefits of comply or explain by allowing long transitional arrangements and exemptions.
For better and continued use of comply or explain, there needs to be an awareness of its specific advantages. ICAEW has identified four areas where comply or explain can serve businesses and investors and have advantages over other alternatives;
• Innovation: when introducing aspirational new ideas and changes to company governance.
• Proportionality: a measured application of more demanding requirements, especially for smaller businesses.
• Avoiding box-ticking: encourages companies to think through overarching principles before automatically complying with provisions, because they have the option to ‘explain’.
• Long-term learning: assisting cultural change in companies that think deeply and regularly about how to meet the purpose and principles of corporate governance until it becomes part of their normal thought process.
If comply or explain is to work and be sustainable, people need to trust companies to demonstrate genuine commitment to good governance, and companies need to trust that their explanations will be given proper consideration.
Where this mutual trust exists, comply or explain can be seen as providing market-based solutions that are worked out between companies and their shareholders without the need for regulatory intervention.
A successful comply or explain policy depends on two conditions: shared beliefs and institutional arrangements. Both are important in establishing the mutual trust which is essential. Institutional arrangements need to ensure that explanations are a credible alternative to regulatory and legal enforcement of compliance.
Doubts about comply or explain arise mainly where it does not seem to deliver the advantages of innovation, proportionality, substance over form or long-term learning. We need to address or at least better understand these concerns when thinking about how widely the concept of comply or explain can be applied and sustained.
ICAEW’s paper ‘When is comply or explain the right approach?’ can be read in full at http://www.icaew.com/en/technical/corporate-governance/dialogue-in-corporate-governance/when-is-comply-or-explain-the-right-approach. It is the third paper in a series of five from our corporate governance team, asking questions arising from changes in capital markets and how they affect the foundations of existing corporate governance frameworks.
Jo Iwasaki is head of corporate governance at the ICAEW