Comply or explain: three ways to make a meaningful explanation

Thursday, March 15, 2012 | Posted by: Ben Langford
Categories: Governance, Thought Leadership | Tags: governance, FRC, Corporate Governance, FTSE 350, financial reporting, UK Corporate Governance Code, comply or explain, narrative reporting, institutional investors

Corporate governance compliance appears to have plateaued so the focus is now on explaining why a company has not complied and acted the way it has.

Here we review the current mindset behind the ‘comply or explain’ principle, which underpins corporate governance in the UK, and look at three suggestions to improve the quality of explanations.

In light of the current governance debate in Europe, the Financial Reporting Council (FRC) recently issued the discussion paper: What constitutes an explanation under comply-or-explain? Report of discussions between companies and investors (PDF). The paper is based on meetings with investors and companies, and also draws on the research undertaken by Grant Thornton for the 2011 FTSE 350 Corporate Governance Review.

Comply or explain in corporate governance
The concept of comply or explain underpins corporate governance in the UK. Its success relies on the quality of explanations where companies choose not to comply, as well as the ability and willingness of investors to critically challenge management on their rationale for non-compliance.

Grant Thornton’s 2011 Corporate Governance Review (PDF) shows that reported full compliance of FTSE 350 companies has reached a plateau at around 50%. This reflects the ‘one size does not fit all’ approach of the UK Corporate Governance Code, which takes the view that companies are best placed to design their own governance structure and practice.

It also reflects the evolution of the Code over time and its success in embedding good governance in UK boardrooms. Aspirational provisions can be easily introduced with early adopters making all efforts to comply and remaining companies having the option to wait and see. As the provision becomes accepted practice and is expected by investors, compliance will grow.

Comply or explain under scrutiny
In recent months, comply or explain has come under increasing scrutiny from the EU as to the quality of explanations provided. An EU green paper floated the idea of enforcing governance through legislative measures. This threat has prompted a vigorous response across Europe in defence of this model.

Supporters of comply or explain are aware that its success relies on the quality of explanations where a company chooses not to comply with specific provisions. These explanations are publicly disclosed and open to challenge from institutional and private shareholders alike.

The Grant Thornton survey shows that, of those companies who report non-compliance with at least one Code provision, two-thirds provide detailed explanations. But a small minority still don’t follow the spirit of the Code and fail to adequately justify their non-compliance.

The FRC convened two meetings in December 2011 with investors and companies to encourage a better understanding of the word ‘explanation‘, improve the current system of ‘comply or explain’ and ultimately stave off regulatory upheaval.

An explanation of ‘explain’
The FRC discussions recognised that: “Companies which provide a coherent explanation of their corporate governance approach are more likely to find their explanation is readily acceptable.”

As emphasised in our 2011 UK Corporate Governance Review, this is supported by the FRC’s plea for chairmen to personally comment on key aspects of governance and set the tone from the top. Less than half of the chairman’s statements analysed in our Review discussed corporate governance. This also echoes BIS proposals on narrative reporting which call for governance ‘highlights’ to be included in a strategic report.

There was also a recognition that boilerplate explanations were no longer acceptable.

Three elements were proposed for a meaningful explanation:

• Set the context and historical background.
• Give a convincing rationale for action being taken.
• Describe mitigating action to address any additional risk and maintain conformity with the relevant principle.

Although some corporates may see obstacles to increased disclosure, in the last year we have seen some truly innovative, informative and concise governance reports, which capture the company’s specific approach to governance demonstrating what can be achieved.

What do you think of the current advice? Would more emphasis on disclosure help or hinder your financial reporting? Let us know what you think in the comments.

Image: (CC) Bart Everson

You might also find these posts useful:

* Corporate Governance Review 2011: Four areas for FTSE 350 to refocus on
* Comply or Explain is working, says FRC
* Download our 2011 UK Corporate Governance Review (PDF)