Compliance Week, February 2012 – Stephen Gilchrist comments on the European Commission planning to introduce a tougher model of corporate oversight

U.K. Gives More Guidance on Good Comply-or-Explain Disclosure

February 28, 2012

By Neil Baker

With the European Commission planning to introduce a tougher model of corporate oversight, Britain's Financial Reporting Council is fighting to defend its more flexible "comply or explain" approach.

The FRC's latest salvo is a report urging all companies to reveal more detail about their governance arrangements, even if they aren't doing anything unusual that needs explaining. But the regulator has admitted that companies with securities listed jointly in London and the United States could expose themselves to extra legal risks if they start make the kind of disclosures it wants to see.

The British approach to oversight of corporate governance""which has been widely adopted elsewhere in Europe""says companies must follow the general principles set out in the FRC's Corporate Governance Code. But companies do have choice in how they achieve the goals of the code. Each principle within it is accompanied by a set of more detailed provisions; companies must disclose any areas where they haven't complied and then explain how they still meet the principles of the code even if they are not following the letter of its provisions.

The European Commission, however, has grown uncomfortable with the comply-or-explain philosophy. Last year it published a consultation paper to pose ideas about how European corporate governance might need to change after the financial crisis; one suggestion was a tougher approach than comply-or-explain. Too many companies were neither complying nor explaining, the Commission said, and national regulators weren't doing anything about it. The Commission suggested that national securities regulators should be given powers to monitor the quality of companies' explanations and demand better disclosures.

A yearly look at governance compliance from Grant Thornton supports that argument. Its latest analysis shows that only 50 percent of FTSE 350 companies reported full compliance with the U.K. Corporate Governance Code.

But the FRC puts a more positive spin on those numbers. Its new report (titled "What Constitutes an Explanation Under Comply-or-Explain?") contends that two-thirds of the companies that didn't comply with the code did explain how they were meeting its principles. The other third did explain, but with less detail. "In no case did a company that failed to comply with a provision of the code fail to provide any explanation at all," the FRC said.

It argues that in most instances, a company that hasn't complied with the code will only have skipped one or two provisions""but that still leaves the company in compliance with 96 percent of the relevant parts. "This is a strong result, and it would be difficult to conclude that the compliance cost of more formal regulation could be justified simply to raise the figure by a mere four percentage points," the FRC says.

"Do we want the more prescriptive approach favored in Europe with accountability to a regulator? Or should""as the U.K. prefers""the shareholders be the arbiters of good governance?"

""Stephen Gilchrist,""Chairman,""Saunders Law

But the regulator does admit it has a compliance problem: "A very few egregious or notorious deviations can undermine support for the whole concept of comply-or-explain." The FRC isn't naming any names, but said its own analysis of 60 annual reports found explanations for non-compliance were "sometimes rather perfunctory." It continued, "They can come across as an assertion of difference rather than a full explanation of why the company in question has chosen to deviate from agreed best practice."

The best way to improve compliance, the FRC argues, is not tougher regulation (the European Commission's solution) but rather, more guidance for companies about what a good explanation looks like.

To that end, the Financial Reporting Council recently organized two meetings with senior investors and companies to thrash out some common ground, and a consensus did emerge. First, a good explanation must be specific to the company, not a generic off-the-shelf statement. Explanations also should only apply to deviations from the provisions of the code""not its principles, which are sacrosanct. And a company should give the context and historical background to its non-compliance. It should provide "a convincing rationale" for its actions and show how it is meeting the relevant principle of the code. Lastly, a good explanation should state whether the non-compliance is temporary and when the company will fall back into line.

OBSTACLES

Below is an excerpt from the FRC report on comply or explain detailing some of the obstacles to disclosure.

"| One corporate participant said concern about stakeholder reaction created a need to be clear to whom annual reports were directed. Many companies might feel comfortable with less rather than more disclosure. However, one investor said that active investors, in particular, place a great deal of faith in companies that can show they have thought about their governance arrangements and give cogent reasons for any deviation from the provisions of the Code. Another shareholder said that not all companies faced adverse media publicity. He cited the case of one company which did not have a permanent chairman but rotated the position among members of its board. This had not attracted media coverage because the company concerned was not a household name. The key to addressing these situations was engagement. This would engender trust and, when trust was there, an explanation was more likely to be accepted.

While participants recognized the difficulties facing some companies on disclosure, the general view, summed up by one participant, was that the process of explanation should involve recognition of a full audience of stakeholders but had to be directed primarily to shareholders. Dialogue with shareholders and an articulation of the governance arrangements could help address these issues.

From the shareholder perspective, a number of participants also mentioned the need for trust, particularly when boards were making judgments about independence. One corporate participants said that boards were not by-and-large malevolent towards shareholders, but both companies and shareholders had difficulty with issues that were subjective. Investors did not always understand the dynamics of boards and this sometimes made the latter unnecessarily defensive. Another corporate participant said there were few blatant abusers and explanations had been improving in recent years. One investor agreed with this though he said there were still information gaps. Another said investors should not be satisfied with just reading a governance statement. The issue was about dialogue. This was critical, even though investors did have to prioritize.

Source: FRC.

In more practical terms, one anonymous investor referenced in the FRC report said explanations should be "relevant, specific, and sufficiently informative, providing enough information to those shareholders who could not simply pick up the phone and talk to the company." Another said if shareholders felt that they needed a follow-up meeting, the explanation wasn't good enough.

The FRC's call for fuller disclosures might sound fine in theory, but some of the companies involved in the meetings were worried about saying more on their governance arrangements and any associated risks. They didn't fancy the extra attention they'd attract from the media, non-governmental organizations, and proxy agencies. Those with securities listed on a U.S. market feared litigation, the FRC said.

The answer to these worries is better engagement, the regulator believes. Hence its warning that all companies should be making fulsome disclosures, even if they fully comply with the code already. "This would engender trust and, when trust was there, an explanation was more likely to be accepted," it said.

Stephen Gilchrist, chairman of the law firm Saunders Law, says worries that fuller disclosures could expose companies to U.S. litigation are "overrated."

"If a major international company either complies with the code or provides a more coherent, discursive, and transparent explanation "| as to why it has departed from the Code, any perceived fear of a State-side attack from investors or other stakeholders should prove unfounded," he says. Companies must be careful, but "a sensible board should have no fears."

Gilchrist believes that, on balance, making the disclosures needed for comply-or-explain to work is better than having to deal with the European Commission's alternative.

"Do we want the more prescriptive approach favored in Europe with accountability to a regulator? Or should""as the U.K. prefers""the shareholders be the arbiters of good governance?" he says.

FRC Chairman Baroness Sarah Hogg said the FRC's comply-or-explain report was "designed to reinforce our approach at a time when Europe has shown signs of driving toward more prescriptive regulation with a consequent diminution of shareholder rights. It should also make shareholders better equipped to push for full explanations on the relatively rare occasions when these are not forthcoming."

She added: "The comply-or-explain approach to corporate governance has given us flexibility and enabled us to raise the standards of U.K. corporate governance over the years in ways that regulation cannot always achieve."