“Soft Regulation”: Conforming with the Principle of “Comply or Explain” (CBR project)

Overview

Rationale and method

To encourage innovation and economic growth, governments advocate flexible proportionate risk-based approaches to regulation with minimal state intervention, where the level of monitoring and control is determined by the extent to which regulatees pose a risk. The success of such regimes depends not only on the ability of regulators to correctly identify levels of risk but also on regulatees’ attitudes to compliance. Understanding compliance practices and what drives them is of particular importance in assessing likely outcomes from voluntaristic forms of regulation such as national codes of corporate governance. One of the principal means by which regulatees can exercise a degree of flexibility in determining how they comply with regulations is by use of the comply-or-explain mechanism. This allows regulatees to either fully comply with a rule or explain why compliance is not possible or not optimal. The most prominent use of comply-or-explain is within codes of corporate governance. Yet while flexible approaches to regulation, particularly risk-based regulation, have been examined in some detail there has been little research on the actual practice of comply or explain.

To address this we set out to investigate the way directors of large listed companies perceive the choices they have to make regarding complying, or explaining deviations. Both comply and explain, are essentially compliant in that not to comply is equally acceptable under the code as long as an acceptable explanation is given. We studied decision-makers’ perceptions of the requirement to comply or explain in two countries, the UK and Germany – countries with broadly similar codes of corporate governance but contrasting political, legal and capital market structures and traditions. The differences between the two countries affect approaches to regulation, and in particular, the regulation of corporate behaviour. It is not just that UK directors are more familiar with self regulation than their German counterparts but rather that self-regulation itself is understood rather differently in the two countries. In the UK, each layer of control is separate. The state has responsibility for both general statutes and specific corporate law but delegates responsibility for control of areas unsuitable for hard law to appropriate organisations. However, in the German corporatist tradition, responsibility is jointly shared rather than divided. Control is thus co-produced using a form of co-regulation.

The empirical part of the project was carried out during 2007 and 2008. We employed a two phase qualitative research design consisting of (i) document analysis and (ii) substantive interviews, split between the UK and Germany. Our initial analysis of the corporate governance statements of the largest FTSE 100 and DAX 30 companies showed a degree of homogeneity so the number of statements analysed was increased to cover the largest 130 listed companies in both countries. The interviews had a different focus in the two countries, reflecting their different experiences of corporate governance codes. The UK interviews addressed how the code conditioned the work of the board, while in Germany they provided more detailed information on the code development process. The analysis and writing up occurred during 2008 and 2009.

Results and dissemination

Phase 1. Analysis of corporate governance statements

Compliance rates. The declared compliance rates in our study differ considerably. While over 50% of the UK companies analysed were fully compliant, the respective number in Germany was less than 15%. In both countries compliance levels dropped as company size decreased.

Justified deviations. Consistent with the best practice logic underpinning comply-or-explain one might expect to find justifiable explanations are primarily company specific but this is not the case. Such explanations account for just 50% of declared deviations in the UK and only 20% in Germany. Of these, transitional justifications from new entrants were fairly frequent in the UK where overseas listings are fairly common. In Germany, by contrast, the most common company specific explanation was board size.

Unjustified and poorly justified deviations. A large number of explanations were clearly not consistent with the principles underpinning comply-or-explain. Of these some were pure disclosures where non-conformance was stated without any obvious reason being given. While these amounted to just below 15% of deviations in the UK the respective figure for Germany was almost 40%. Both in the UK and Germany almost 10% of explanations were “empty,” or disingenuous. Taken together almost 25% of UK deviations, and almost 50% of German deviations were not properly justified.

Developmental deviations. A further interesting finding concerns what we referred to as a “principled justification” against the content of a particular code provision. A principled justification is an implicit criticism of the code drafters. For example, in Germany a number of companies stated they would not, as a matter of principle, impose a ‘reasonable’ deductible (personal excess) on their directors’ D&O (Directors and Officers’ negligence) insurance, partly because the Cromme commission would not clarify what was meant by reasonable.

Size effects. In general, there appeared to be significant differences in explanations amongst the different indices or size bands (top 30 companies, middle 50 and bottom 50). While evident in both countries these differences were more prominent in Germany. Smaller companies have less resources and some code provisions are of less relevance to them, while larger companies are more exposed to public scrutiny.

Phase 2. Analysis of corporate governance interviews

Sense of ‘ownership’. Most UK directors and company secretaries perceive the Combined code as embodying best practice as Cadbury intended, and as a consequence exhibit a sense of ownership of the code. This sense of ownership is rarely found amongst German directors.

The importance of monitoring. The dominance of institutional investors in the UK ensures interested and powerful monitors in what was always conceived of as a form of ‘market regulation’ whereas there are more family owned companies in Germany and bank finance plays a far greater role in the German capital market.

Pressure to conform. Both sets of interviewees felt considerable pressure to be fully conformant rather than engage with comply-or-explain. This was depicted often as a response to the costs of non-conformance, in terms of both resources and reputation, but is also related to the length of time the two codes have been in force and the extent to which they are considered to articulate best practice. Interestingly, the pressure interviewees felt on them to fully conform may be more perceived than real.

Comply-or-explain: reality-or-illusion? Although there was more enthusiasm for the comply-or-explain approach from UK interviewees than their German counterparts, in practice usage was greater in Germany. In the UK comply-or-explain seemed almost to serve as a security blanket – providing directors with reassurance that control over the governance of their companies had not been lost. In both countries many interviewees spoke of key rules as unbreakable, akin to hard law, which in Germany may well be true. Deviation is simply not acceptable. These rules form the bedrock of the code. A second smaller stratum of rules may have been or become sub-optimal and following substantial deviation may be amended and amalgamated into the first lower stratum. The final thin top layer consists of a very small number of rules such as board independence where temporary deviation may be unavoidable from time to time and it is these, and these only, where a valid explanation is deemed entirely acceptable.

Project leaders

John Roberts
Paul Sanderson
David Seidl

Project status

Completed

Project dates

2006-2010

Funding

ESRC