Comply-or-explain depends on explanations

The principle in corporate governance known as "comply or explain" makes the codes that use it voluntary. The term came into the corporate governance lexicon through the Cadbury Code in the UK. Published in 1992, it didn't actually use the term directly, though once in circulation, it stuck. The principle was an explicit acknowledgement on the part of the Cadbury committee of the difficulty of prescribing any formula for the complex set of issues and relationships on boards. Under this notion, companies need to take heed of code provisions, but they needn't follow them. They should, however, be transparent about how their practices differ from the code. The value of the exercise falls, then, on the quality of explanations of non-compliance.

Growing disquiet? There are signs, however, that while this principle still holds the attention of policy-makers in the European Union, the practice of it seems to be trying their patience. The European Commission's green paper, seeking views about possible future central legislative or regulatory action, signals an interest in making the quality of explanations rather less arbitrary. It makes reference to a study that

showed that the informative quality of explanations published by companies departing from the code's recommendation is – in the majority of the cases – not satisfactory and that in many Member States there is insufficient monitoring of the application of the codes. It is therefore appropriate to consider how to improve this situation.

That study, conducted in 2009 by the proxy voting service run by RiskMetrics with help from a variety of other organisations, looked at governance reports from companies around the European Union, examining a total of 1,141 cases of explanations that companies made about how they had deviated from whichever code they used as a benchmark. Only 39 per cent of the explanations were "sufficiently 'informative'", in the eyes of the researchers. Companies in France, Sweden, the Netherlands and the UK gave the best accounts of deviations from norms. Those in Denmark, Hungary, Portugal and Spain did the worst. By category of disclosure, statements on remuneration were the least informative. Only 27 per cent of such explanation met the standard of giving "specific" information or stating that the company was in "transition" to code compliance.

Compliance or defiance? Academic studies have also found fault with the quality of disclosures in corporate governance reports. But directors often grumble about all the bureaucracy associated with complying – even with complying through explaining the reasons. Let's take a hypothetical example. A longstanding director, a sophisticated, sharp accountant, sits on the audit committee. He's been around so long that he's seen three CEOs come and go, and he's able to smell the faintest whiff of fish in the accounts. But he's been around so long that the code says he's no longer "independent" and so no longer an appropriate person for the audit committee. What can you say, in a public document, about the "specific" value that director brings? Moreover, there's a real shortage of people with these skills and experience, so finding a replacement would be difficult. It might take two or three years for a good replacement to learn enough about the management accounts to know why the financial accounts didn't stink. An explanation saying – as many such do – that "the board is confident of Mr. Smith's independence of judgement" isn't specific, but what else can you say? Non-compliance isn't always defiance.

Policy direction? What happens next in the European consultation is far from clear. There's a centralising strain in EU policy-making, more pronounced in the past year or so, since Michel Barnier, the former French agriculture minister, took over the European Commission's directorate for the internal market. The UK authorities will no doubt resist any attempt to pull control to Brussels or to impose mandatory measures to replace "comply-or-explain". The green paper's questions on this issues point towards a possible direction of travel:

• Detailed explanations: Do you agree that companies departing from the recommendations of corporate governance codes should be required to provide detailed explanations for such departures and describe the alternative solutions adopted?
  
• Enhance powers of enforcement: Do you agree that monitoring bodies should be authorised to check the informative quality of the explanations in the corporate governance statements and require companies to complete the explanations where necessary? If yes, what exactly should be their role?

Neither points towards a less voluntary regime, though both suggest a more interventionist approach.

Source document: The 2009 study "Monitoring and Enforcement Practices in Corporate Governance in the Member States" is a 199-page pdf file.