February 16, 2012 What constitutes comply or explain?
A key part of any corporate governance regime for a FTSE company is compliance with the UK Corporate Governance Code (the “Code”). At the heart of this is the principle of ‘comply or explain’. That relevant companies should comply with the Code or, if they haven’t, explain the reasons why not.
Recently though there have been some questions raised about the quality of explanations provided by some companies; both by the European Commission and also by the Financial Reporting Council (“FRC”). So, what exactly does constitute a proper explanation? Well, the FRC has recently released a report on this to help us out.
The first thing to note is that ‘comply or explain’ only applies to the provisions of the Code and not the main principles which are mandatory. In the introductory section of the Code it states:
The principles are the core of the Code and the way in which they are applied should be the central question for a board as it determines how it is to operate according to the Code.
However, it goes on to say that “[i]t is recognised that an alternative to following a provision may be justiﬁed in particular circumstances if good governance can be achieved by other means” but only if the reasons for doing so are clearly and carefully explained to shareholders.
The FRC feels therefore that there is a recognition that the Code and the Listing Rules require a substantive explanation where a company has chosen not to comply with a provision. The FRC gives the example of a company that has combined the role of chairman and chief executive where a possible reason would be that ‘the board considered this was the right thing for the company’. This would technically be a reason but would not meet the criteria for a full explanation. Instead the Code requires that the company should explain how they have applied the principle that there should be a clear division of responsibilities at the head of the company and that no individual has unfettered powers of decision.
The report is an interesting read, especially for company secretaries and directors and worth having a look at if you have the time. However, probably the best summation of their views on what constituted an explanation is this:
[An explanation should be] full and include reference to context and coherent rationale. They should explain how the company is fulfilling the relevant principle of the Code and also whether deviation from its provisions is time limited. Ideally explanations should be sufficiently full to meet the needs of those shareholders who could not simply call up the company and ask for information, but larger shareholders also saw them as the foundation for further dialogue that should engender trust.
If you would like to read the full report it can be found here.