ABI: Analysis of UK Corporate Governance Code

31 December 2012

The ABI published a report Comply or Explain: Investor Expectations and Current Practices. The report deals with questions of what do investors want from Code explanations and how well are Code explanations meeting investor requirements and states key recommendations and conclusions.

The ABI has developed six key criteria to assist companies in preparing Code explanations. These have been designed with the intention of providing investors with the information necessary to consider whether the alternative approach a company has chosen in particular circumstances remains aligned with their interests. These should not be viewed as a rigid set of rules that provide a new set of requirements for companies to follow. The intention is simple: to improve the operation of the UK principles-based system – underpinned by ‘comply or explain’ – for the mutual benefit of companies and investors.

In summary, the criteria are:

1. Company specific context and historical background
2. Convincing and understandable rationale
3. Mitigating action to address any additional risk
4. Time-bound
5. Specify deviations from the provisions as well as from main principles
6. Explain how the alternative is consistent with the Code principles and contributes to the objective of good governance

The ABI reviewed a sample of Code explanations based on these criteria to understand the current quality of explanations and to highlight best practice and areas requiring improvement. The report findings endorse the decision of the FRC to clarify and strengthen the explanations guidance under the newly published September 2012 Corporate Governance Code.

The ABI welcomes this change and believes that, if followed effectively by companies, it will help to meet the requirements of investors. This should have a positive effect on the operation of ‘comply or explain’ and help provide more transparent governance disclosures. ABI members strongly support the role of Code explanations and attach as much importance to the role of good quality explanations as they do to basic compliance with Code provisions.

However, this report demonstrates that many company Code explanations fail to meet the requirements of institutional investors. Both companies and investors agree on the benefits of the ‘comply or explain’ system. They must work together to preserve the UK’s leadership position by improving its operation in the market. Unless there are improvements, the UK market remains at risk of having its principles-based approach displaced by mandatory, compliance-based European regulation.

Whilst early indications are that the UK Stewardship Code has led to an increase in the number of investors engaging with companies, the findings of this report underline the importance of retaining focus on the wider concept of stewardship, rather than the traditionally narrow range of issues limited for the AGM season.

This was encapsulated in the updated and broadened definition of stewardship in the newly amended Stewardship Code. Wider stewardship can be exercised by exerting more scrutiny over the quality of companies’ corporate governance disclosures and, more specifically, their Code explanations – contributing to improving corporate governance reporting and practices.

ABI members indicated that companies generally provide more complete oral explanations of Code deviations to major shareholders during engagement meetings, compared to the more limited annual report disclosures. Although this type of dialogue is to be supported, it should not derogate from the need for clear written disclosures:

• larger institutional investors can have a greater engagement burden and consequently be more inclined to focus on companies viewed as in some way problematic. This means they may not always be available for this type of dialogue
• equally, smaller investors may not have sufficient voice to access company representatives or in-house resources.

Poor quality written explanations may therefore:

• deny the wider market of information considered important by investors to understand companies’ corporate governance structures
• give the impression to the European Commission that the system of comply or explain is not fit for purpose
• expose companies to the ‘box-ticking’ approaches of investors more reliant on proxy advisers.

However, good quality explanations:

• are more likely to foster the aspirational nature of a voluntary, principles based approach
• facilitate flexibility in governance arrangements: as more investors understand better how deviations support a business, they are more likely to support differing approaches
• have a positive influence on the contest for the mantle of best-in-class. 

A clear positive from the findings is the beneficial role Chairman’s introductions are having on corporate governance disclosures. Not only they appear to give investors a clearer picture of the steps taken by boards to operate governance effectively but also, by providing fuller context, are more likely to lead investors to accept situations when a company chooses to explain rather than to comply.

Personal reporting on governance by Chairmen may considerably help overcoming the detrimental effect of “boiler-plate” which is so often the preferred and easy option in sensitive areas.

Smaller cap companies appear more likely to make poor quality disclosures even though many smaller companies may have more business-specific reasons as to why alternatives to the Code provisions may be suitable and in shareholders’ interests.

Improved explanations by these companies could have a significant impact on how the market perceives their business model and governance structure.

ABI's report

© ABI