The Comply or Explain Model & Corporate Governance

Corporate governance is essential for companies to promote an ethical culture and ensure effective management that can achieve strategic goals and improve performance, which is critical for the firm’s long-term success. Therefore, it is necessary to direct and control companies as well as provide shareholders with an opportunity to evaluate the company’s governance structure. One of the commonly used regulatory approaches to corporate governance is the comply or explain model. According to Arcot et al. (2010), “the Combined Code of Corporate Governance, that was introduced in the UK in 1998, is widely regarded as an international benchmark for good corporate governance practice” (p. 1). The comply or explain model requires companies to comply with the Corporate Governance Code or provide reasons for non-compliance. The principles of the Code are regarded as effective guidelines that help the company improve its performance. In this regard, specialists and scholars debate whether the soft nature of the requirements of such an approach can improve corporate governance. This paper aims to critically discuss why the comply or explain model should ultimately lead to better governance and what the are prerequisites for the desired outcomes.

Benefits of the Comply or Explain Model for Corporate Governance

To begin with, it is necessary to outline the key benefits of the comply or explain framework that support the statement about the effectiveness of the approach with regard to corporate governance. One of the major advantages of this approach is its flexibility that takes into consideration the company’s size, specifics, and market environment (Gordon, 2020). Furthermore, market sensibility, self-regulation, and sustainable efficiency constitute other essential benefits associated with a successful implementation of the model.

Flexibility

One of the key principles of the comply or explain model is the recognition of alternatives to the Code’s regulations. As a result, there is a certain degree of flexibility associated with the framework. In other words, companies can choose to comply with the Code’s directives or provide adequate explanations for non-compliance. As reported by MacNeil and Esser (2021), flexibility can be considered in two ways within the corporate governance context: “first, as an element of rule design and compliance” (p. 7). Furthermore, MacNeil and Esser (2021) argue that it can be seen “as an element of self-regulation that facilitates evolution and adaptation in a more agile manner than is possible within a system of statutory regulation” (p. 7). In the contemporary economic environment, the flexibility of the comply or explain model can facilitate businesses’ recovery by adjusting corporate governance practices to particular characteristics, conditions, objectives, and challenges (MacNeil and Esser, 2021). As a result, more efficient outcomes can be expected in contrast to the traditional mandatory approach applied to different companies from various industries.

Market Sensitivity

Another benefit of the comply or explain framework is associated with a high level of market sensitivity. In other words, the principle of flexibility allows the market to determine the appropriateness of certain standards and regulations for individual companies (Arcot et al., 2010). Furthermore, given the availability of explanations to the general public, the comply or explain model allows for their evaluation. As a result, it can lead to drops in share prices and the company’s market value in case of non-compliance with the Code and inadequate reasoning. Market sensitivity can be considered an alternative to the legal sanction under the comply or else approach. Managers must consider the consequences of deviations from the Code and their effect on shareholders. In this regard, the role of the financial market as a judge addresses the incentive problem by combining multiple investors’ actions and reducing the cost of coordination (Quan, 2018). Overall, companies with efficient corporate governance can attract more investors, which results in a reduced cost of capital.

Self-Regulation

The comply or explain framework is characterized by another advantage, namely, the principle of self-regulation. As discussed above, shareholders and the market play the role of enforcement mechanisms under this approach. MacNeil and Esser (2021) claim that the self-regulation opportunities of the Cadbury Code “facilitated the later development of the Stewardship Code focusing on the role of shareholders as stewards for their ultimate investors” (p. 12). Consequently, the comply or explain model is characterized by a self-regulatory origin. As a result, companies are motivated to consider the public interests and the role of shareholders, which leads to a more effective approach to corporate governance. It is worth noting that the level and notion of self-regulation vary in different countries that adopted the framework.

Sustainable Efficiency

Although there is an ongoing discussion about the effectiveness of the comply or explain approach and its sustainability, research findings indicate a positive effect of soft legislation on corporate governance and sustainable efficiency. According to MacNeil and Esser (2021), a growing tendency with regard to the compliance rate can be observed in recent years. Furthermore, the framework continues to evolve to meet the current needs of various countries. For instance, Singapore adjusted the comply or explain model and introduced the division of mandatory principles and non-binding provisions (Quan, 2018). Furthermore, another opportunity for improved efficiency is presented by other changes made. Quan (2018) reports that Singapore companies are required to “explicitly state the Provision that is being departed from, the reason for the variation” and explain the compliance with the mandatory principle’s intent (para. 18). As can be seen, the comply or explain model can be associated with a high level of compliance and sustainable positive outcomes if implemented correctly. In addition, it requires transparency from companies, which facilitates the need for adequate explanations and a search for effective alternatives to the recommended practices.

Challenges to Address

Given the importance of the regulatory principles to evaluate how adequate the explanations of non-compliance are, it is necessary to mention certain challenges posed to the comply or explain model. As stated by Roberts et al. (2020), “visible compliance with the Code cannot itself be taken as a reliable proxy for board effectiveness” (p. 602). Hence, it is essential to ensure the involvement of regulatory bodies evaluating the explanations provided by companies and their appropriateness. Furthermore, the flexibility should not imply the voluntary nature of all corporate governance guidelines. For positive outcomes, it is essential to use the model wisely to address the needs and problems of the changing environment.

To conclude, the comply or explain model should ultimately lead to better governance due to the following characteristics: flexibility, market sensibility, self-regulation, and sustainable efficiency. They can result in better managerial decisions that consider corporate governance ethics and stakeholders’ interests and contribute to the company’s overall performance. However, it is essential to monitor compliance and evaluate the quality of explanations of non-compliance to avoid poor reasoning and increase investor confidence in a company.

References

Arcot, S., Bruno, V., & Faure-Grimaud, A. (2010). Corporate governance in the UK: Is the comply or explain approach working?. International Review of Law and Economics, 30(2), 193-201. Web.

Roberts, J., Sanderson, P., Seidl, D., & Krivokapic, A. (2020). The UK Corporate Governance Code principle of ‘Comply or Explain’: Understanding Code compliance as ‘subjection.’ Abacus, 56(4), 602-626. Web.

MacNeil, I., & Esser, I. M. (2021). The emergence of ‘comply or explain’ as a global model for corporate governance codes. European Business Law Review (Forthcoming, 2022). Web.

Quan, N. S. (2018). Comply or Explain 2.0: What’s the difference? The Business Times. Web.

Gordon, J. (2020). Comply or Explain (UK) – Definition. The Business Professor. Web.