Comply or Explain: A Key Principle in Modern Corporate Governance

The Comply or Explain principle is a cornerstone of modern corporate governance, requiring companies to disclose their compliance with certain standards or explain why they have not complied.

This principle was first introduced in the UK's Combined Code on Corporate Governance in 1998, and has since been adopted by various countries and regulatory bodies.

Companies that fail to comply with the relevant standards must provide a clear explanation for their non-compliance, which is then disclosed to the public.

The Comply or Explain principle promotes transparency and accountability in corporate governance, allowing stakeholders to make informed decisions about the company.

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The "Comply or Explain" system originated in the United Kingdom. It's a system of governance where public companies don't have to adopt recommended governance standards, but instead, they issue an annual statement to shareholders explaining their compliance or noncompliance.

In this system, companies are required to issue a statement, but they can deviate from recommended practices if they feel they're not suitable for their specific situation. This approach has been adopted in other European countries as well.

The "Comply or Explain" system requires companies to either comply with certain provisions or disclose any departures and explain their alternative practices. This means companies have some flexibility, but also a responsibility to be transparent about their decisions.

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The "comply or explain" approach has its benefits and drawbacks.

One of the main benefits is its flexibility, which allows companies to tailor governance practices to their particular circumstances. This flexibility is particularly valuable given the wide diversity of companies listed on the London Stock Exchange.

The "comply or explain" approach promotes meaningful engagement with governance principles instead of mere superficial compliance. Companies are encouraged to reflect thoughtfully on their corporate governance frameworks and express their justifications to shareholders.

One significant advantage of the model is that it encourages transparency and market discipline. By mandating companies to reveal either their compliance or their rationale, the system enables shareholders and prospective investors to evaluate the governance quality independently.

However, the main drawbacks of the approach are that material compliance is difficult to enforce, an overemphasis on 'tick-the-box' compliance, and that corporations give perfunctory explanations for non-compliance.

Studies have shown that the lack of meaningful explanations is the biggest drawback of the "comply or explain" approach. Many studies point to the low quality of explanations given in comply or explain mechanisms in corporate governance and non-financial reporting regulations.

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Comply or explain is a principle used by various corporate governance codes to set minimum standards for companies. It's a straightforward approach that requires companies to either comply with the rules or provide a clear explanation for non-compliance.

In the UK, Germany, and the Netherlands, this principle is applied to audit committees, remuneration committees, and board authority. Companies are expected to identify any code rules they haven't followed, explain why, and describe their alternative solution.

Here are some examples of how this principle is applied in different countries:

Companies must develop and publish a policy stating how voting rights operate and how shareholders are engaged in the running of the company, subject to the "comply or explain" principle.

The "comply or explain" strategy has its roots in the UK, where it was first described in the influential Cadbury Report of 1992. This report was commissioned in response to financial scandals like Polly Peck and the Maxwell Group.

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The Cadbury Report suggested that companies should either conform to best practice principles or provide a well-reasoned justification for any non-compliance. This approach promotes transparency and accountability without enforcing obligatory legal standards.

The Cadbury Report was followed by other influential reviews, including the Greenbury Report (1995) and the Hampel Report (1998). These efforts culminated in the Combined Code on Corporate Governance, first issued in 1998.

The Combined Code formalized the "comply or explain" mechanism across a broader spectrum of governance practices. Today, the UK Corporate Governance Code is the principal instrument embodying this principle, administered by the Financial Reporting Council (FRC).

The Code applies primarily to companies with a premium listing on the London Stock Exchange, requiring them to report on how they have complied with its provisions in their annual reports. Companies that choose not to comply must provide a clear and meaningful explanation to their shareholders.

The "comply or explain" model operates within a "soft law" framework, which means its provisions are not legally binding in themselves. Instead, they derive force through the Listing Rules, which mandate disclosure of compliance or reasons for deviation.

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The "comply or explain" principle is a crucial aspect of corporate governance. This principle requires companies to follow certain standards or explain why they're not following them.

In the UK, Germany, and the Netherlands, companies are expected to adhere to this principle in their audit committees, remuneration committees, and board authority. For example, the UK Corporate Governance Code sets minimum standards for these committees.

Companies in Sweden must identify any code rules they haven't complied with, explain why, and describe their alternative solution. This transparency is essential for maintaining trust with shareholders and stakeholders.

The revised Shareholder Rights Directive of 2017 (SRD II) also follows the "comply or explain" principle. Companies must develop and publish a policy stating how voting rights operate and how shareholders are engaged in the company's running.

Here's a breakdown of the countries and their respective expectations:

The "comply or explain" approach has its fair share of challenges and criticisms. One of the most persistent issues is the variable quality of corporate explanations provided by companies that choose not to comply with the UK Corporate Governance Code, which often lack meaningful insight into their governance decisions.

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Numerous empirical studies have revealed that companies often offer vague, superficial, or "boilerplate" explanations that frustrate the ability of shareholders to assess whether non-compliance is justified. This undermines the system's integrity and weakens the intended market-based enforcement mechanism.

Institutional investors are often slow to respond forcefully, reflecting the broader issue of shareholder disengagement.

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Enforcement and supervision are crucial in ensuring that companies provide high-quality explanations for non-compliance. Several studies have proposed that increased public enforcement and supervision are necessary to monitor inadequate explanations (Lu 2021; Hooghiemstra 2012; Keay 2014; Seidl et al. 2013; Boiral 2013).

Public enforcement authorities need to take a more active role in monitoring compliance, as the explanation for non-compliance is the cornerstone of the comply or explain approach (Lu 2021; Hooghiemstra 2012).

Research has identified certain qualities of corporations that are associated with higher and lower levels of high-quality non-compliance explanations (2.4). These insights could be useful to stakeholders and public enforcement authorities.

The FRC has published guidance on what constitutes an explanation, providing a means of comparing the approach of those who prepare businesses' explanations with the expectations of those to whom they are addressed.

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The "comply or explain" approach has its fair share of criticisms and challenges. One of the biggest concerns is the variable quality of corporate explanations provided by companies that choose not to comply with the UK Corporate Governance Code.

Companies often offer vague, superficial, or "boilerplate" explanations that fail to provide meaningful insight into their governance decisions. This undermines the system's integrity by frustrating the ability of shareholders to assess whether non-compliance is justified.

Shareholder passivity is another significant issue. Many institutional investors lack either the incentive or the resources to monitor governance disclosures actively, which weakens the intended market-based enforcement mechanism.

The case of Sports Direct International plc (now rebranded as Frasers Group) is a notable illustration of these problems. The company was heavily criticised for its governance failings, including weak oversight of working conditions at its warehouses and poor board-level accountability.

The Sports Direct case highlighted the risks inherent in a regime that lacks strong enforcement mechanisms and depends heavily on investor activism to ensure compliance. This is reflected in the broader issue of shareholder disengagement.

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The system also favours form over substance, with companies sometimes complying with the letter of the Code while neglecting its spirit. This can create a false impression of good governance and diminish the credibility of the model.

Regulatory oversight is also a concern, with the Financial Reporting Council (FRC) having limited ability to sanction companies for inadequate explanations. This weakens the deterrent effect and contributes to the persistence of poor-quality disclosures.

Increased complexity in governance requirements, particularly with the rise of Environmental, Social, and Governance (ESG) factors, may outstrip the "comply or explain" model's capacity for effective regulation.

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The UK has been actively reforming its corporate governance standards to address the challenges of the "comply or explain" model. Significant reforms have been introduced in recent years to strengthen corporate governance standards.

The Financial Reporting Council (FRC) has been at the forefront of these efforts, with the revised UK Corporate Governance Code of 2018 placing a greater emphasis on long-term value creation and company purpose. This shift reflects a growing recognition that corporate governance must address not only shareholder interests but also broader stakeholder concerns.

The FRC has issued annual reviews of corporate governance reporting, identifying good practices and highlighting areas for improvement. These reports aim to foster a market of informed investors who can exercise effective oversight.

The government has announced that the FRC will be replaced by a stronger regulator, the Audit, Reporting and Governance Authority (ARGA). ARGA will have enhanced powers, including the ability to direct changes in company reporting and to impose sanctions where reporting is inadequate.

Companies are increasingly expected to disclose how their governance frameworks address issues such as climate risk, diversity, and social responsibility. The 2018 Code requires companies to report on how their policies and practices contribute to broader societal outcomes.

The FRC has also sought to encourage greater shareholder engagement through the UK Stewardship Code 2020. This code sets out best practice principles for institutional investors, aiming to address concerns about shareholder passivity.

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