Is the EU Green Paper the end for ‘comply and explain’ corporate governance?

Regulators may start to challenge corporate ‘explanations’.

You could be forgiven for thinking that a ‘comply or explain’ approach to corporate governance is under threat. Whilst the recently released European Commission Green Paper on corporate governance is not the radical turn towards regulation that some of the more excitable commentary had warned of, it does raise a number of challenges. For example, it suggests that “securities regulators, stock exchanges or other authorities [could] check whether the available information… is sufficiently informative and comprehensive.” In a market like the UK, this might mean that the Financial Reporting Council becomes involved in deciding whether companies’ governance statements really provide an ‘explanation’ for non-compliance. From the outside this might not look like a major shift, but we think it would potentially be a significant one. At the company-specific level, the Green Paper also seeks views on whether the EU should “ensure” that the functions of chair and chief executive are separated, and on the introduction of a measure limiting the number of directorships that can be held. Questions on board diversity also suggest that a mandatory approach is a possibility. All in all there are enough signs to make those who fear more regulation a little more worried. But in one sense the Commission is reflecting some emerging opinion within the EU. For example, the recently elected Fine Gael-Labour coalition in Ireland has pledged to scrap the ‘comply or explain’ approach to governance that it has historically copied from the UK. We await with interest what measures will actually make it into the proposed binding code. A previous Irish Labour Party policy document included suggestions such as a mandatory separation of chair and chief executiveroles, a limit on directorships and a seven-year maximum tenure for non-execs. More generally it is not difficult to find critics in Europe of a purely market-driven approach to governance. Whilst the years immediately preceding the crisis might have suggested a general drift to a more UK-like approach, opponents of such a model now have a stronger position. The thing is that the UK itself has actually never been a purely ‘comply or explain’ regime. Over the years various elements of corporate governance have shifted from best practice into statute. Putting remuneration reports to a shareholder advisory vote is an obvious example. There is nothing revolutionary about continuing to review exactly where we draw the line between voluntary codes and legal requirements. Reasons why on occasion the UK has moved from a voluntary approach on an issue to a mandatory one include concern at a lack of progress, or to bring the whole market up to a certain standard. But we should also be aware that on occasion legislative or regulatory intervention can achieve more, and more quickly, than even collaborative shareholder engagement can hope for. For example, the reform of the structure of remuneration arrangements at financial institutions in the wake of the crisis has largely been backed by investors, but it has been driven by politicians and regulators. The FSA’s Remuneration Code has already had an impact on how staff in financial institutions are paid. It would have taken investors much longer to bring about such sector-wide change. Of course, we should always be wary mindful of bad policy, and regulations drafted in response to political pressure to ‘do something’ following a crisis. But we should also be very wary of siren voices arguing for the status quo. Such arguments

frequently invoke the unintended consequences of action, yet there is typically no recognition that inaction carries its own risks. In addition, those of us with longer memories will remember the same voices arguing against each substantive governance reform of the past 20 years on the basis that it would destabilise boardrooms and, by extension, the free market system itself. Of course what we have latterly realised is that boards are quite capable of doing that themselves, especially when the message from some quarters is that any attempt to fetter managerial freedom is the larger evil.Finally there is also the possibility that taking a mandatory approach to certain aspects of governance takes some pressure off investors. If we can put some principles where there is clear consensus into law (separation of powers perhaps) then this allows investors to direct their attention to other issues, like the skills and competence of board members. Therefore we think rather than posing a threat, the EC Green Paper provides an opportunity to review where the boundaries between best practice and law are drawn.
Alan Macdougall is Managing Director at PIRC