The corporate governance debate is intensifying in the UK, with a regulator calling on companies to provide more clear explanations for why they choose to ignore corporate governance guidelines.
As part of its research paper into “comply or explain”, the Financial Reporting Council (FRC) examined about 60 UK annual reports and found that companies’ explanations for not following the code were somewhat lacking. Although the vast majority of listed companies do give full explanations for why they haven’t stuck to governance best practice — on things ranging from executive pay to assessing business risks — there remains a minority that fail to give a proper explanation to shareholders.
The research, based on interviews with senior management and investor representatives, suggests that companies should be encouraged to explain their governance arrangements more clearly, including how they support business strategy. Digging a little deeper into what these meaningful explanations might look like for why a company does not comply with the corporate governance code, the FRC research suggests that a thorough and more transparent explanation could have four elements:
- Set the context and historical background
- Give a convincing argument for not complying with the code
- Describe mitigating action to address any additional risk of not complying with the code
- Indicate when the company plans to comply with corporate governance norms
The FRC will consider these proposals amongst others for improving the comply or explain principle when it updates the corporate governance code (introduced in 2010) later this year. However in a recent green paper on this issue, to which CFA Institute responded, the European Commission suggested that regulators, rather than shareholders, should decide whether an explanation for non-compliance is adequate — leading to more prescriptive regulation and a subsequent diminution of shareholder rights. Currently, if investors are unhappy with the explanations given for non-compliance they have the option to pursue this with the company in question via the engagement process, or ultimately to dis-invest. Although not fully decided yet, the FRC does see a potential future role for itself here and is considering acting as “broker” to these kinds of discussions.
The FRC has warned previously against imposing rigid governance rules in the UK, believing this would be bad for business as well as for shareholders. The current UK flexible approach enables shareholders rather than regulators to have the last word, and ensures that shareholders are better equipped to push for fuller explanations when these are justified.