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Corporate Governance – Boards Must Learn To Explain When They Don’t Comply

The extension of compliance with the UK Corporate Governance Code to all AIM-listed companies, as well as to the largest private businesses, has put a number of major corporate governance issues in the news. One of these is the ‘comply-or-explain’ principle, a fundamental part of UK governance from the beginning. Companies are ‘explaining’ when they don’t comply, but they aren’t doing a good job. Such an explanation should cover what principle of the Code the company is deviating from and why, and also relate all of this to any governance issues that have arisen in recent years.

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Not complying and not explaining why

When UK boards of directors do not comply with the Corporate Governance Code, they are obliged to their quarterly or annual reports, and on their websites, why they have not complied – in other words, what governance has been put in place instead of the one recommended by the Code and why this approach has been taken.

This approach is fundamental in UK corporate governance – since its inception, the Code has always encouraged a flexible approach to governance and avoided a ‘box ticking’ approach which would prescribe specific actions.

Yet Grant Thornton found in a survey that, while 62 per cent of the FTSE 350 comply with all strategic report requirements, only 14% provide high-quality, informative insights.

“Companies should be able to find the best approach for their particular circumstances and explain why other practices are not appropriate. It is the quality of engagement with, and explanation where there are departures from, the relevant code that are particularly crucial,” writes Charles Russell, at the London office of the law firm Speechlys.

Boards must show how the new Corporate Governance Code is applied

Companies are requiring the Chair to provide a clear explanation of how the company applies the Code in a corporate governance statement. The statement must be a detailed and logical exposition of the board’s actions, elaborating the board’s corporate governance structure, policies and actions. What should be avoided is a kind of list of Code requirements followed by a few words and references – there is too much of this scant compliance effort at major UK companies, according to the Financial Reporting Council (FRC).

The statement, Russell notes, should:

  1. Clearly articulate the Chair’s role and demonstrate their responsibility for corporate governance;
  2. Explain, at a high level, how the Code is applied by the company and how its application supports the company’s intermediate- to long-term success;
  3. Explain, in a clear and well-reasoned way, any areas in which the company’s governance structures and practices differ from the expectations set by the Code; and
  4. Identify any key governance-related matters that have occurred during the year, including any significant changes in governance arrangements.

Reaching all of the stakeholders: Will non-compliance succeed?

Where a board explains non-compliance, they should tread carefully, as regulators and shareholders will be scrutinising the explanation.

A recent study shows what is needed:

  • A clear indication of the principles that the company does not adhere to;
  • A brief summary of the principle from which the board deviated;
  • A detailed and lucidly written explanation that is adequate with respect to the company’s situation and that contains the reasons for non-compliance;
  • Information regarding the extent to which measures taken with regard to a given principle guarantee good governance;
  • An indication as to whether there are plans to apply the principle at some point in the future.

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The explanation should be aimed at a broad audience and should be easy to understand for a general reader. It should identify the best solution in this corporate governance area, and should indicate which principles the company does not apply right at the beginning of the corporate governance statement.

The statement should include details of the non-compliance action, specifically what that non-compliance action consisted of. With this should come an appropriately detailed explanation so that all stakeholders are able to understand the action and how it fulfils the needs of the company. All readers should be able to assess whether the non-compliance action was justified and why, and the action should be put into context and compared with past actions.

Without a doubt, the main audience for the statement is the shareholders, who are most likely to detect any flaw in the logic or quality of information found in explanations for shareholders. It is this quality that determines if the shareholder understands the processes occurring in the realm of corporate governance in a given company, the study notes.

Are they transparent to the shareholders? Do the shareholders understand the reasons driving the actions taken, and are they also able to understand the effects of these actions, and how they may affect the value of their shareholdings? Are the shareholders going to be convinced that the non-compliance solution adopted will work?

All of this is part of establishing a high level of corporate transparency. The credibility of the board is at stake when a non-compliant action is chosen as a viable path for the company.

But there is a potential reward in trying non-compliant solutions. If the actions taken prove to be effective, the board will have resolved an ongoing issue for the company.   What’s more, other company boards may want to adopt the same approach, and that is good for the innovative board’s credibility and reputation. Boards should not be afraid to try non-compliant solutions, but they should be aware of the potential consequences.

Diligent Governance Cloud provides complete solution

Governance Cloud is Diligent’s ecosystem of cloud-based governance tools that provides a complete solution to enable leading bodies of organisations to mitigate risk and govern collectively at the highest level.

Seasoned in the governance space, Diligent has been in the leading position in the market for more than 15 years, offering the industry’s leading, most secure and intuitive board management technology. Our deep customer insights and heavy investment in R&D have allowed us to expand our offering to support the full governance journey.

Whether you choose to start with only Diligent Boards™ or multiple, integrated tools, we are the only partner in the market you can grow with as your governance needs evolve.

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