Enter to open, tab to navigate, enter to select
Corporate governance: FRC report on what constitutes an explanation under comply or explain
Practical Law UK Legal Update 5-518-0507 (Approx. 6 pages)
Corporate governance: FRC report on what constitutes an explanation under comply or explain
by PLC Corporate
| Published on 15 Feb 2012 • United Kingdom |
The FRC has published a report of discussions between companies and investors on what constitutes an explanation under comply or explain. (Free access.)
Speedread
On 15 February 2012, the FRC published a report of discussions between companies and investors on what constitutes an explanation under the comply or explain approach in the UK Corporate Governance Code. In light of the debate in Europe about the future of comply or explain and whether there should be more prescriptive regulation, the FRC concluded that it would be appropriate to address the question of what constitutes an explanation under comply or explain to reinforce its approach.
The FRC has pulled together a number of conclusions from the discussions, including that:
- The starting point should be an improvement in the general quality of disclosure in relation to corporate governance and a clear explanation by each company as to how its corporate governance arrangements support its business model. The chairman could play an important part in this and the chairmen's statements could be fuller than they are currently.
- Companies that provide a clear explanation of their approach to corporate governance could find that shareholders are more prepared to accept their explanation if they choose to deviate from a particular provision of the Code.
- The key elements for a meaningful explanation are that it should:
The FRC is considering whether to reflect the outcome of these discussions in the revised UK Corporate Governance Code on which it is intending to consult later in 2012.
If you don't yet subscribe to PLC, you can request a free trial by completing this form or by contacting the PLC Helpline.
Background
UK Corporate Governance Code
During 2009 and early 2010, the FRC conducted an extensive review of the effectiveness of the Combined Code on Corporate Governance. Following this review, on 28 May 2010, the FRC published the final version of the UK Corporate Governance Code (the Code), which applies to all premium listed companies with a financial year beginning on or after 29 June 2010 (see Legal update, Combined Code review: UK Corporate Governance Code is published).
On 14 December 2011, the FRC published a report on developments in corporate governance 2011, which reviews the impact and implementation of the Code and the UK Stewardship Code since they were published in 2010 (see Legal update, Corporate governance: FRC report on implementation of UK Corporate Governance and Stewardship Codes).
The introductory section on comply or explain in the Code refers to the Code not being a rigid set of rules. It consists of principles (main and supporting) and provisions. It also refers to the Listing Rules requirement that companies apply the main principles of the Code and report to shareholders on how they have done so. The Code recognises that an "alternative to following a provision may be justified in particular circumstances if good governance can be achieved by other means. A condition of doing so is that the reasons for it should be explained clearly and carefully to shareholders, who may wish to discuss the position with the company and whose voting intentions may be influenced as a result. In providing an explanation, the company should aim to illustrate how its actual practices are both consistent with the principle to which the particular provision relates and contribute to good governance."
European developments: comply or explain
On 14 January 2010, the European Commission published a study on monitoring and enforcement practices in corporate governance in the member states. The study concluded that, despite deficiencies in the application of the comply or explain regime and in light of support for the regime, it should be strengthened, not abandoned (see Legal update, European Commission study on the monitoring and enforcement of corporate governance codes in member states).
On 5 April 2011, the Commission launched a public consultation to examine and evaluate the effectiveness of the current EU corporate governance principles for listed companies and to seek views on possible ways forward at EU level. The Commission published a green paper entitled "The EU Corporate Governance Framework" in which it examines three key areas, one of which is improving monitoring and enforcement of the existing national corporate governance codes by looking at how to apply the comply or explain approach more effectively (see Legal update, Corporate governance: European Commission green paper on corporate governance framework).
The report
The report, which is based on discussions between senior company and investor representatives, highlights a high level of compliance with the Code. It confirms that a large majority of companies who do not comply with one or more provisions of the Code provide a full explanation of their reasons. The FRC reports that it has carried out an informal review of a representative sample of around 60 UK annual reports and that this has shown that, in the UK, explanations for non-compliance sometimes come across as slightly perfunctory, highlighting the difference instead of providing a full explanation of why the relevant company has chosen to deviate from best practice.
In Grant Thornton's most recent annual survey, it found that 50% of FTSE 350 companies had reported full compliance with the Code, and that two thirds of those that do not comply provide a meaningful level of detail in their explanation, while the remaining third explain but with less detail. Most examples of non-compliance relate to only one or two provisions of the Code.
In light of the debate in Europe about the future of comply or explain and whether there should be more prescriptive regulation, the FRC concluded that it would be appropriate to address the question of what constitutes an explanation under comply or explain in order to reinforce its approach. This should also help to address the position of a minority who do not provide a full explanation of their reasons where they do not comply. The FRC, with the support of the London Business School, held discussion meetings between senior investors and companies in December 2011.
Explanations
Some of the key points that came out of the discussions include the following:
- The starting point should be an improvement in the general quality of disclosure in relation to corporate governance and a clear explanation by each company as to how its corporate governance arrangements support its business model. The chairman could play an important part in this and chairmen's statements could be fuller than they are currently.
- Companies that provide a clear explanation of their approach to corporate governance could find that shareholders are more prepared to accept their explanation if they choose to deviate from a particular provision of the Code.
- The comply or explain concept is more about mind-set and culture than box-ticking.
- There was a general recognition that explanations (and corporate governance reporting generally) needs to relate to the company's position, and not be generic.
- Explanations should be given for deviations from the provisions of the Code, not for deviations from its main principles, which companies are expected to apply.
- The key elements that were identified for a meaningful explanation are that it should:
- set the context and background;
- provide a clear rationale for the deviation that is specific to the company;
- state what mitigating action the company is taking to maintain conformity with the relevant principle of the Code and to address any additional risk; and
- indicate whether the deviation from the Code's provisions was limited in time and when the company intends to return to conformity with the Code's provisions.
- It is preferable for explanations to be sufficiently full to provide enough information for those shareholders who cannot call up the company to ask for information.
Participants in the discussions suggested that shareholders (through their trade associations) might wish to produce an annual report that contained examples of good and bad explanations, which would be helpful to companies.
Potential obstacles to greater disclosure
The discussions identified a number of potential obstacles to greater disclosure, including:
- The risk of litigation for companies with listings in other jurisdictions such as the US, in the areas of risk reporting and the outcome of board evaluations.
- Concerns as to the reaction of the media and other stakeholders.
- A number of participants also mentioned the need for trust, in particular when boards were making judgments about independence.
The general view expressed by participants was that the explanation should recognise the various stakeholders, although it has to be directed primarily to shareholders of the company.