‘Comply or Explain’ at its best

Dramatic reactions to new guidelines that require the annual re-election of board members has hit the news today. The FT reports how three of the UK’s biggest investors have written to 700 companies to encourage them to “ignore” the provision in the 2010 Corporate Governance Code.

The paper’s wording is, however, perhaps unhelpful. Colin Melvin, Chief Executive of Hermes Equity Ownership Services – one of the companies involved in the letter sending – said he was encouraging companies to practise their rights and “explain” rather than comply. This is quite different to ignoring the provision altogether and, aside from whether director election practices should or should not be changed, the situation highlights the advantage of the UK Code.

If Corporate Governance in the UK resembled the US system, where legislation rather than codes of best practice constitutes the main determiner of corporate behaviour, today’s story would read quite differently. Large companies would be forced to undergo an upheaval in the foundational area of director election, to the displeasure of their major investors, or else risk expensive and hugely damaging legal action if they resisted the measures.

As it is, under the UK Code’s trademark “comply or explain” approach (see pp. 4-5 http://www.frc.org.uk/documents/pagemanager/Corporate_Governance/UK%20Corp%20Gov%20Code%20June%202010.pdf), the outcome of the FRC’s provision is positive despite being ill-received by some. While Legal and General and Fidelity welcome the new guidelines, the FRC has been forced to closely re-examine provision B.7.1 and defend its value to big names like Hermes, Railpen and the Universities Superannuation Scheme who oppose the measure and have laid out their reasoning to hundreds of FTSE 350 companies. In turn, if these companies choose to reject the Code’s call, they will explain their stance carefully to shareholders in the Annual Report. The atmosphere is one of rigorous dialogue and well-considered progress.

In the ever-changing, multi-faceted and oftentimes ethically equivocal realm of corporate governance, this is exactly the culture of intelligent exchange that is needed and that is fostered by the “comply or explain” approach. In the best practice system, power is placed not in the hands of central government or the judiciary, but where it belongs, in the hands of boards and, ultimately, shareholders.