ISS will continue to examine bespoke governance arrangements that deviate from the Code's principles on their own merits, taking into account the company in question's own specific circumstances and explanations for such a move.

November 8, 2023

Proposed Changes to the UK Corporate Governance Code’s ‘Comply or Explain’ Principle

Proposed Changes to the UK Corporate Governances Code Comply or Explain Principle

On 24 May 2023, the Financial Reporting Council (“FRC”) launched a public consultation on its proposed revisions to the UK Corporate Governance Code (“the Code”). This represented the first proposed amendment in five years, following the Code’s revision back in July 2018. The consultation closed on 13 September 2023.

Since the announcement of the consultation, numerous organisations have provided a summary of the FRC’s proposed changes. The amendments include a strengthening of malus and clawback arrangements, an expanded remit for audit committees, especially in relation to sustainability and ESG reporting, and increased disclosures surrounding company risk management and internal control systems, to name just a few.

However, the proposed amendment that is perhaps the most important is that relating to the ‘comply or explain’ principle. As one of the cornerstones of UK corporate governance, the principle allows companies to deviate from market best practice and choose bespoke governance arrangements that they deem more suitable to their own circumstances and business operations. Recent research by the FRC illustrates that the number of companies in full compliance with the Code has been decreasing year-on-year. The regulator was pleased that an increasing number of companies were using the flexibility provided by the Code to go their own way in relation to governance arrangements.

Nonetheless, in recognition of this increased deviation from the Code’s principles, the FRC is proposing that further clarifications be made on what is expected of companies that choose to deviate. (Edit: Since this piece was written, the FRC has released an update, which states that it intends to take forward only a small number of its proposals in its consultation. It is unknown, as of yet, whether the proposed amendments to the ‘comply or explain’ principle are to be included in the new version of the Code.)

As the amended Code explains:

“When reporting on its governance activity the board should focus on outcomes in order to demonstrate the impact of governance practices and how the Code has been applied. Where the Board reports on departures from the Code’s provisions, it should provide a clear explanation.”

In recent years, one of the FRC’s common criticisms is that comply or explain disclosures are often formulaic in nature, with reporting often providing little detail in relation to what governance practices a company has actually carried out. Moreover, when companies deviate from the Code, an explanation outlining why their bespoke arrangements have proved more efficient and/or appropriate than those of market best practice is often lacking. This criticism coalesced into guidance on improving comply or explain reporting in early 2021. The guidance states the following:

“Explanations are key to the ‘comply or explain’ nature of the Code. A full and meaningful explanation for non-compliance should show that an alternative arrangement is more appropriate and beneficial in upholding high standards of governance. We encourage companies to write full and meaningful explanations, as this will offer investors and other stakeholders the opportunity to consider whether the quality of explanation achieves effective governance of the company even though there is a departure from the Code. It also demonstrates confidence that the company is taking governance seriously. We were disappointed with the quality of the explanations provided by companies for non-compliance with the Provisions of the Code and struggled to find robust explanations.”

Consequently, the FRC’s amending of the Code has been seen in some quarters as an attempt to remedy this earlier shortcoming and make it clear to companies what is expected of them in relation to the comply or explain principle.

Consultation responses to the proposed comply or explain principle amendments

During the consultation period, various institutional bodies responded to the FRC’s proposed amendments to the Code. Considerable text was produced in relation to the expansion of the audit committees’ remit and the strengthening of risk management and internal controls systems. However, the amendments proposed to the comply or explain principle were also addressed and are focused on here. Given the number of responses that the FRC received, it should be noted that the observations below should not be taken as comprehensive, or necessarily representative of all the consultation responses or of the UK corporate governance landscape as a whole. Numerous organisations chose not to disclose their responses publicly. As a result, the following observations are based on those consultation responses that are currently publicly available. The FRC will publish its own summary of responses in due course and give a full picture of the feedback in relation to the proposed amendments to the Code.

The Institute of Directors (“IoD”), in its response to the FRC’s consultation stated that, as a proponent of a principles-based approach to governance practices, it is an advocate of a Code that allows some degree of flexibility in relation to how its principles are applied. However, it is concerned that there is a tendency among some actors in the corporate governance space to view deviation from the Code as representative of poor governance. As a result, it contends that, in some cases, the Code can become a regulatory burden on some companies, encouraging them to comply fully with all of the Code’s principles, when alternative (and perhaps unconventional) governance arrangements might prove a superior option to their specific circumstances.

This concern was echoed by industry advocacy group TheCityUK, whose consultation response encouraged the FRC to be mindful of the risks associated in expanding its provisions, lest they be interpreted prescriptively in practice:

“We support the ‘comply or explain’ nature of the Code’s provisions and note the FRC’s efforts to reinforce this in the consultation. However, there is a disconnect between the FRC’s vision of “comply or explain” and the real-world experiences of listed companies. Firms report that this has sometimes translated into a “comply or else” situation, where some investors approach compliance with the Code as a box-ticking exercise without scope for flexibility. As a result, companies feel compelled to follow guidelines rigidly to avoid negative consequences such as shareholder backlash or potential penalties. Exercising such strict compliance leads to a formulaic approach.”

This ‘comply or else’ criticism was also present in UK Finance’s response. However, the trade association also noted that companies “need to be able to demonstrate and articulate their reasons for departing from the Code, how they link to the business strategy, and how the risks of divergence have been minimised”.

Specifically, with regard to the proposed focus on outcomes in relation to the comply or explain principle, the IoD stated that it had concerns. It acknowledged the need to avoid boilerplate language, and that outcomes-based reporting should be tailored to the specific circumstances of the company in question. However, the IoD also stated that there is uncertainty surrounding how outcomes reporting should be implemented in practice, and that the new Code could prove too vague insofar as it does not outline what outcomes should be presented. Namely, does such reporting address performance outcomes, the avoidance of scandals, or specifically governance process and/or policy outcomes? Moreover, how should a company provide evidence for a causal link between the adopted governance arrangements and positive governance outcomes? As a result, the IoD has called for more specific guidance and training in relation to how a company would approach formulating outcomes-based reporting. Otherwise, it fears that, in the absence of such guidance, there would be the risk that companies would default to a different type of boilerplate response, in which unjustified or tenuous links could be made in relation to the impact of specific corporate governance practices or arrangements.

This call for guidance is echoed in the joint-response of The City of London Law Society and The Law Society of England and Wales, which expects such guidance to outline what is meant by outcomes-based reporting and how companies can comply with the new requirement.

As illustrated above, many of the consultation responses that have been publicly disclosed have focused on the need to ensure that the flexibility provided by the comply or explain principle endures following the proposed amendments to the Code. Another concern that has been widely articulated, especially by representative institutional bodies, is that, without the requisite guidance, the proposed changes may not have the effect that the FRC desires, leading to an increase of ‘boilerplate reporting’.

However, not all responses have focused on the possible unintended consequences of the proposed amendments and how they can be mitigated. For instance, the Association of Chartered Certified Accountants (“ACCA”) highlighted in its consultation response “a lack of resources and underinvestment in governance”, which it contends has been “exacerbated by the rapid change and interconnectedness of risk”. It also associated governance failures with a lack of transparency, and therefore welcomed more disclosure surrounding an assessment of company governance frameworks and their outcomes, especially in relation to an alignment between company purpose, values, strategy, and risk appetite. The ACCA believes that the continuous monitoring of such frameworks, and the disclosure of the relevant processes, would allow companies to benchmark progress and ensure the alignment of their governance culture with a changing operational environment.  

ISS voting guidelines and the future of the comply or explain principle

ISS’ UK and Ireland Proxy Voting Guidelines for Benchmark Policy Recommendations sets out its general policy positions in relation to specific corporate governance issues. However, like the Code, ISS recognises that the comply or explain principle represents the foundation of UK corporate governance in practice. Consequently, it generally follows the guidance outlined in the Code in relation to the principle, which in turn leads to the assessment of any bespoke governance arrangements on a case-by-case basis.

If the FRC was to confirm that its proposed amendments in relation to the comply or explain principle will be enshrined in a new version of the Code, an analysis of possible changes (if any) to ISS’ UK voting guidelines would likely follow. This would involve engagement with both institutional investors and other UK market participants. However, it is worth emphasising that ISS will continue to examine bespoke governance arrangements that deviate from the Code’s principles on their own merits, taking into account the company in question’s own specific circumstances and explanations for such a move.

By: Tom Inchley, UK Research, ISS Governance

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