Companies warned about ‘comply or explain’

IN THE UK, corporate governance relies on trust.

Companies are supposed to comply with governance principles in the voluntary UK corporate governance code or explain why they have not done so.

The “comply or explain” principle is central to the UK’s revised corporate governance code, which was introduced in 2010.

The Financial Reporting Council (FRC), the UK’s accounting and corporate governance watchdog, says that although the vast majority of listed companies give full explanations for why they haven’t stuck to governance best practice – on things ranging from executive pay to assessing business risks – a minority fail to give a proper explanation to shareholders.

The FRC has examined about 60 UK annual reports as part of research into comply or explain. It found that companies’ explanations for not following the code were “sometimes rather perfunctory”. Put bluntly, some companies are blowing corporate governance a raspberry.

The FRC says that companies should be encouraged to explain their governance more clearly, including how it supports business strategy.

The European Commission has suggested tougher corporate governance regulations. In a recent green paper on the issue the Commission suggested that regulators rather than shareholders should decide whether an explanation for non-compliance is adequate.

The FRC disagrees, arguing that shareholders rather than regulators should have the final say on explanations. It also warns that introducing laws for corporate governance would be bad for businesses and shareholders.

How can the FRC encourage companies to take reporting on corporate governance more seriously? The FRC says it will consider how to improve the “comply or explain” principle when it updates the corporate governance code later this year.

Peter Montagnon, senior investment adviser at the FRC, says it’s looking into spelling out what it considers a meaningful explanation for why a company is not complying with the corporate governance code.

FRC research suggests that a thorough 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; and indicate when the company plans to comply with corporate governance norms.

Another option is for shareholder to hold companies to account by complaining to the FRC if they’re unhappy with companies’ explanations for not complying with the code.

If the complaint is justified the FRC could apply “some pressure” on the company to be clearer about its reasons for not following the code, Montagnon says, although he stresses that this is only an option and a decision hasn’t been taken.

Are shareholders bothered enough about corporate governance to make life difficult for boards? Shareholder revolts against company policies are still fairly rare, even on controversial issues like executive pay.

Pirc, which advises shareholders on corporate governance, says it broadly supports the “comply or explain rule”. But given that there is wide agreement on some governance principles, such as the separation of chief executive and chairman roles, it adds that there is an argument for making them mandatory.

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