What is meant by the comply or explain approach in corporate governance cite examples?

The purpose of corporate governance is to facilitate effective, entrepreneurial and prudent management that can deliver long-term success for a company. It’s the system by which companies are directed and controlled. And it provides a measure for shareholders to satisfy themselves that their company has an appropriate governance structure.

Therefore, a cornerstone of the Corporate Governance Code is the principle of ‘comply or explain’. Premium-listed companies must report each year how they have applied the principles of the Code, so that investors can evaluate the actions taken.

The FRC have just issued a revised version of the Corporate Governance Code for consultation. The new Code will apply to financial years from 1 January 2019 onwards, so 2020 reports will need to include the ‘comply or explain’ statement for this new Code. There will be no transition period.

Many companies seek to include a full compliance statement, and will no doubt want to continue this under the new Code too. This obviously demonstrates good corporate governance, and is also used by proxy advisers in their voting recommendations. But it may be tricky for companies to comply fully with the new Code, at least as soon as 2019 or perhaps for longer, because of some of its new requirements.

For example, the Code proposes three employee engagement methods (an employee director, a formal workforce advisory panel, or a designated non-executive director). Companies are likely to need some time to work out which method would suit their business and workforce best and then implement this method. As there are no transitional provisions, such companies may be non-compliant in the first year or so of the new Code. Would this lead to negative voting recommendations from some proxy advisors? If so, the company could suffer substantial shareholder dissent. What if a company decides that a totally different method of engaging with its workforce is far more appropriate? They would need to ‘explain’ rather than ‘comply’ continuously. But ironically, a company which takes time to work out the best way to strengthen its workforce’s voice in the boardroom should be lauded.

Companies may also wish to integrate this with another new Code requirement, to strengthen the voice of other non-shareholder stakeholders at board level. This is likely to add to the time investment needed to come up with the best way to achieve these twin requirements.

To prevent a substantial shareholder vote against resolutions, remuneration committees may need to spend more time explaining their position on employee/stakeholder engagement directly to their shareholders. This would add to the already increased burden on committees, possibly unnecessarily.

We will shortly have the public register of substantial shareholder discontent for any resolution with over 20% opposition (to be set up by the Investment Association by the end of 2017). It would be a shame if companies end up on the register simply because they were understandably taking time to work out how best to comply with the Code.

It’s clear that ‘one size fits all’ does not apply in the business environment. The new Code aims at a change in culture, to restore trust in business. Perhaps what we also need is a change in attitude to the rigid ‘comply or explain’ principle, so that a convincing explanation (of a departure from the Code) can be just as acceptable to proxy advisers, stakeholders and shareholders.

comply or explain principle means that the adoption of the codes is voluntary but the company should explain in their annual reports why they have not adopted the codes (Coombes and Wong, 2004; Solomon, 2010). While the Sarbanes-Oxley Act is rules- based pronouncement of US parliament and not a code, the UK reforms are principles- based (Solomon, 2010). European countries adopt “comply or explain”, codes, and OECD principles more than any country of the world (Becht et al., 2005). Countries preference for codes is because of its suppleness as it is not possible to alter the law always (Coombes and Wong, 2004). This explains, Coombes and Wong (2004) argue, why many countries, including the US are embracing “comply or explain” principles-based code of UK. The next section examines governance in Africa.

When I was a little boy, my papa rarely prescribed rules for us. He sparingly told us “do this” and “don’t do that.” Instead, he laid down the principles for our behavior. He made suggestions on how to behave. If he thought we went astray from the principles, he would give us our day in court and allow us to explain things. At the end of the day, however, he would judge whether our explanation was acceptable. That was his concept of parental authority.

Little did I know that more than 50 years later, the same approach would be adopted for regulating corporate behavior. This is known as the “comply or explain” approach in corporate governance. It is a regulatory approach used in some European countries and is now recognized under the OECD principles of corporate governance.

Under this, rather than setting rules, government regulators set a code, which publicly listed companies may either comply with or, if they do not comply, explain publicly why they do not. It is principles-based, rather than rules-based. It provides recommendations, rather than imposes rules. As the German Code of Corporate Governance states: “A well justified deviation from a Code recommendation may be in the interest of good corporate governance.”

The approach recognizes that good governance cannot prescribe a “one size fits all” solution. It recognizes the reality that not all companies are the same. It allows flexibility to address specificities of individual companies. This was highlighted by former Defense Secretary Gilberto Teodoro (an independent director for several listed firms) in his speech before the Shareholders’ Association of the Philippines, in which I serve as president.

The principle does not mean that the listed company can always explain away noncompliance. It must find alternatives that comply with good corporate governance. The company’s explanation should illustrate how its practices are consistent with the relevant principle and contribute to good governance.

Under this regime, the judge is the market. Companies are accountable to shareholders who can impose sanctions. In other words, “let the market decide” whether the firm’s standards and practices are good corporate governance. If the investors do not agree, they punish the company by selling their shares and, thereby, reducing its market value—a market sanction, rather than a legal one.

The Securities and Exchange Commission has embraced this approach under the Code of Corporate Governance for Publicly-Listed Companies. SharePHIL actively participated in the formulation of the new Code.
The new Code, approved on Nov. 10, 2016, and took effect on Jan. 1, 2017, replacing several rules-based corporate governance rules. Among those superseded were SEC Memorandum Circular No. 6, series of 2009 (Revised Code of Corporate Governance), SEC Memorandum Circular No. 11, series of 2011 (Term Limits for Independent Directors) and SEC Memorandum Circular No. 20, series of 2013 (Corporate Governance Training for Independent Directors Only by Sec-Accredited Training Providers)

The new CG Code for PLCs contains principles, recommendations and Explanations.

As the code states, the principles are high-level statements of corporate governance good practice and are applicable to all covered companies. The recommendations, accompanied by explanations, are objective criteria intended to identify the features of good CG practice that are recommended for companies operating according to the Code. Alternatives to a recommendation may be justified in particular circumstances if good governance can be achieved by other means.

The code also states that “[w]hen a recommendation is not complied with, the company must disclose and describe this noncompliance, and explain how the overall principle is being achieved by it. The alternative should be consistent with the overall principle. Descriptions and explanations should be written in plain language and in a clear, complete, objective and precise manner, so that shareholders and other stakeholders can assess the company’s governance framework.”

But since the market is the ultimate judge, the new code requires listed companies to state in their annual corporate governance reports whether they comply with the code provisions, identify any areas of noncompliance and explain the reasons for noncompliance.

Kudos to the SEC for taking this business-friendly approach. Some say this new approach may not be appropriate for the Philippines because we are fond of “palusot” (excuses), which may not sit well with international investors. As a consequence, they may dump our stock market in favor of other markets that remain truly faithful the principles.

For me, that is underestimating our market. The Filipino can and will.

Anyhow, let’s wait and see.

The author, former president and CEO of the Philippine Stock Exchange, is now the president of the Shareholders’ Association of the Philippines. His views in this column are solely attributable to him.

He may be contacted through [email protected]

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