Regulations sprouting from Brussels will damage the UK’s corporate governance

Simon Walker
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In recent days, the implications of the EU regulatory reform agenda for the City of London have been widely reported. However, the financial sector is not the only area of vulnerability to future EU directives. Of wider concern is the growing risk that the UK’s distinctive model of corporate governance – underpinned by “comply or explain” – will be swept away by new Brussels proposals. Such a development would not be positive for UK companies or their shareholders.

Comply or explain has been a feature of UK corporate governance since the early 1990s. It permits deviations from the provisions of the UK Corporate Governance Code as long as meaningful justifications are provided to shareholders in annual reports. The code itself is published by the Financial Reporting Council and provides best practice recommendations on issues ranging from the composition and independence of the board of directors to the nature of the engagement process between board members, executives, shareholders and other stakeholders.

The rationale for comply or explain stems from the huge diversity of UK-listed companies. Business enterprises exhibit substantial variation in terms of their size, complexity, financing and ownership structure. Such diversity would not be well served by a one-size-fits-all approach to boardroom practice. Unlike conventional regulation, comply or explain solves this problem by allowing companies some flexibility in implementation, with positive implications for company effectiveness and value creation.

The influence of comply or explain extends well beyond the UK. Each of the EU’s 27 member states has a national corporate governance code applied on the basis of comply or explain. A particular advantage of the concept outside of the UK has been its capacity to promote international standards of governance while still accommodating differences in national business practices.

However, despite the obvious benefits of comply or explain, there are ominous signs that the European Commission is planning a shift to a more regulatory-oriented governance system.

A draft Capital Rights Directive (CRD IV) published in August proposed a range of mandatory governance requirements for the boards of EU financial institutions and a new role for the European Banking Authority in defining “regulatory technical standards” for board members.

Alongside the more intrusive role that is already being played by the Financial Services Authority (FSA) in UK boardroom governance activities (including involvement in chief executive and director appointment decisions), this implies a huge erosion in the application of comply and explain in financial sector governance.

Beyond the financial sector, a recently leaked draft EU regulation on auditing has suggested that the Commission is considering a radical new regulatory regime for external auditors and audit committees. According to these proposals, audit committees will no longer be permitted to apply their own judgement over issues such as the commissioning of non-audit services and the frequency of auditor rotation. The Commission is also considering a new requirement for joint audits with multiple auditors despite any significant evidence that this would improve audit quality.

In the coming months, the Commission will be publishing conclusions relating to its recent Green Paper on Corporate Governance. Given the apparent mood in Brussels for radical change, there is every chance that these proposals will introduce a further raft of prescriptive regulation into the boardroom, and further accelerate the demise of comply and explain.

Comply or explain is still a work in progress in a number of EU countries. Company explanations of deviations from governance codes can be inadequately informative, and there is a tendency to use boilerplate language.

Nonetheless, despite these challenges, comply or explain has proved itself to be, like democracy, the least-worst option in a world of imperfect governance systems. Although there have been isolated examples of UK companies that have failed to embrace its spirit, the UK Corporate Governance Code has had a major impact on underlying norms of company behaviour. On issues such as independent directors, audit committees and the role of the chairman, it has catalysed substantial change without the need for mandatory regulation.

Comply or explain has arguably been one of the most significant projections of UK “soft power” over the last two decades. It respects the principle that the oversight of a private sector company is ultimately a matter for its owners, not legislators. Although it does not guarantee corporate success, it has provided an effective governance principle for the overwhelming majority of UK-listed companies, particularly in comparison with the regulation-heavy model of the United States.

At a time when the overriding priority for government policy is the need to catalyse a UK economic recovery, the loss of comply or explain in the wake of a new wave of EU regulatory reform would be a major setback to the UK business community.

Simon Walker is director general of the Institute of Directors.

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