Chairman of the Financial Reporting Council, Sir Winfried Bischoff, has recently made clear the body’s intention to focus its work on the quality of explanations made by companies that choose not to comply with the UK Corporate Governance Code. But will this lead to better corporate governance?
This post looks at the reasoning behind comply or explain, the quality expected of explanations and why monitoring of such explanations is required.
Why does the UK have the ‘comply or explain’ approach?
The Combined Code of Corporate Governance, that was introduced in the UK in 1998 and subsequently revised and updated, is viewed as a benchmark for good corporate governance practice around the world, and has been mirrored in other jurisdictions including Germany and Australia.
The great flexibility it gives to companies to choose between complying with its principles or explaining why they do not, stands in admirable contrast to many other jurisdictions.
The comply or explain approach avoids forcing corporate governance to become a tick-box exercise. Comply or explain aims to encourage good corporate governance practice whilst allowing for deviations from the code for good reason. Sir Bischoff said:
“The ‘comply or explain’ principle gives companies flexibility and makes it possible to set more demanding standards than hard rules. Requiring companies to report to shareholders rather than regulators means that an assessment about whether a company’s governance is adequate is taken by those in whose interest the board is meant to act.”
However, what use is making companies explain non-compliance if the quality of such explanations are not monitored? This is exactly the issue that the FRC aim to remedy.
The Financial Reporting Council will look at the quality of explanations provided by companies that choose not to comply with UK Corporate Governance Code, with further work being conducted during the rest of this year to monitor company’s explanations when they are not compliant with the code.
What quality is expected of explanations?
The FRC has held numerous discussions surrounding what constitutes an adequate explanation under the ‘comply or explain’ approach and in 2012 three basic elements were derived:
- Set the context and historical background.
- Give a convincing rationale for the action.
- Describe mitigating action to address the deviations from the code.
Another important factor was giving an indication of whether any deviation from the code was limited and whether and when the company intended to return to conforming with the provisions of the code.
The FRC then considered whether to incorporate these principles into a revised version of the code and thus they manifested themselves in the 2014 corporate governance code.
The UK Corporate Governance Code 2014 provides that companies when making an explanation should outline how the practices although not strictly complying with the code are consistent with the principle to which the particular provision relates. They should also explain how their practices contribute to good governance and promote fulfilment of their business objectives. In addition, the explanation should set out the background to the deviation, provide a clear rationale for the action, and highlight any mitigating action taken to limit any additional risk and enhance conformity with the relevant principle. Also, where deviation from a provision is intended to be for a limited time, the explanation should state when the company expects to conform with the provision of the code.
Will regulation of explanations improve corporate governance?
At present, there is no provision for any statements by companies to be assessed by any regulatory body. The comply or explain approach works in consistency with the shareholder value principle – that the company is run for the benefit of the shareholders and thus it is ultimately down to the shareholder to regulate. Under the current system the shareholders must determine whether the explanation of the company’s actions in relation to the code’s provisions is sufficient, and it is up to the shareholders to take action if they believe they are not. This approach empowers shareholders to evaluate whether non-compliance is justified in the eyes of the owners of the company taking into account all of the company’s circumstances. Looking at it this way, it seems that the shareholders may be best placed to determine whether deviations from the code are justified as they will be far more knowledgeable about the history, background and inner workings of the company.
However, having a regulatory body inspect the quality of explanations may further protect shareholders who are unable or unwilling to take action in the event of unsatisfactory explanations. Furthermore it will also encourage a culture of providing full and high quality explanations for a company’s actions when they choose to deviate from the code which in turn may encourage those running the company to think more thoroughly about alternatives to deviating from the code, or why a deviation is truly necessary.
Image credit: reynermedia via flickr
Emma Flood Curated Media
Latest posts by Emma Flood Curated Media (see all)
- ELB Securities v Alan Love and Prestwick Hotels Limited – A Warning For Companies - October 8, 2015
- The UK Modern Slavery Act 2015 – Can corporate disclosure change the world? - September 3, 2015
- Comply or Explain Better – Will Assessing the Quality of Explanations Lead to Better UK Corporate Governance? - May 11, 2015
