FRC clarifies comply or explain

20/February/2012

The concept of comply-or-explain is credited with successfully driving high standards of corporate governance and widespread improvements in UK regulatory practice.

Companies are expected to comply with the code – for example separating the role of chairman and chief executive – but can avoid it if they can adequately explain their actions to shareholders.

However, despite being an acknowledged central tenet of corporate governance since the 1990s, there are concerns in Europe about some aspects of comply-or-explain.

Research carried out for the European Commission in 2009 raised doubts, for example, about the quality of companies' reasons for non-compliance.

To that end, the Financial Reporting Council (FRC) – the UK's accounting and corporate governance regulator – wants to promote a better understanding of what constitutes an explanation under comply-or-explain.

The FRC has published a paper based on discussions between senior company and investor representatives facilitated for the FRC by the London Business School.

While it thinks there is a very high level of compliance with the UK corporate governance code, it feels more can be done to improve the "sometimes rather perfunctory" reasons given by companies for avoidance.

Indeed, companies' failure to provide sufficient information for non-compliance is true in "only a minority of cases", the FRC said.

The body cites research by Grant Thornton that found 50 per cent of FTSE350 companies report full compliance with UK corporate governance.

Two-thirds of those who do not comply explain with a meaningful level of detail, while one third explain but with less detail. In no case did a company that failed to comply with a provision of the Code fail to provide any explanation at all.
The FRC says companies should be encouraged to explain their governance more clearly.

Out of the discussions emerged four elements that should form part of a convincing explanation.

These are:

Set out the context and background

Provide a clear rationale which is specific to the company

Indicate whether the deviation from the Code's provisions is limited in time

State what alternative measures the company is taking to deliver on the principles set out in the Code and mitigate any additional risk

"The 'comply or explain' approach to corporate governance has given us flexibility and enabled us to raise the standards of UK corporate governance over the years in ways that regulation cannot always achieve," said Baroness Sarah Hogg, FRC chair.

"This exercise is designed to reinforce our approach at a time when Europe has shown signs of driving towards more prescriptive regulation with a consequent diminution of shareholder rights. It should also make shareholders better equipped to push for full explanations on the relatively rare occasions when these are not forthcoming."

The paper's conclusions could now form part of forthcoming consultations on reform to the governance code, Baroness Hogg added.