Comply or explain
Comply or explain is a regulatory approach used in the United Kingdom, Germany, the Netherlands and other countries in the field of corporate governance and financial supervision. Rather than setting out binding laws, government regulators set out a code, which listed companies may either comply with, or if they do not comply, explain publicly why they do not.
The purpose of "comply or explain" is to "let the market decide" whether a set of standards is appropriate for individual companies. Since a company may deviate from the standard, this approach rejects the view that "one size fits all", but because of the requirement of disclosure of explanations to market investors, anticipates that if investors do not accept a company's explanations, then they will sell their shares, hence creating a "market sanction", rather than a legal one. The concept was first introduced after the recommendations of the Cadbury Report of 1992.
Usage
The UK [Corporate Governance Code], the German Corporate Governance Code and the Dutch Corporate Governance Code 'Code Tabaksblat' use this approach in setting minimum standards for companies in their audit committees, remuneration committees and recommendations for how good companies should divide authority on their boards. Swedish company law requirements expect companies to identify any code rules which they have not complied with, explain why they have not complied, and describe their alternative solution.Under the revised Shareholder Rights Directive of 2017, companies must develop and publish a policy stating how voting rights operate and how shareholders are engaged in the running of the company, subject to the "comply or explain" principle.
Benefits and drawbacks of the Comply or Explain approach
The approach has both benefits and drawbacks.Benefits
The main benefits are that the approach offers flexibility to corporations, lowers their compliance burden, and stimulates discussion and for grounds in changes in legislation.Drawbacks
The main drawbacks are that material compliance is difficult to enforce, an overemphasis on ‘tick-the-box’ compliance and, most prominently, that corporations give perfunctory explanations for non-compliance. The lack of meaningful explanations is seen as the biggest drawback.Many studies point to the low quality of explanations given in comply or explain mechanisms in corporate governance and non-financial reporting regulations. In the UK, Germany, Greece, Italy and the Netherlands studies find that explanations for non-compliance with corporate governance codes are often inadequate. Similar results are found when studying non-compliance explanations in the realm of European non-financial reporting. This collection of research indicates that possible high levels of ‘compliance’ with corporate governance codes and non-financial reporting requirements are in fact much lower due to the large percentage of inadequate explanations.
Enforcement and supervision
Due to the drawbacks to the comply or explain approach, several studies have proposed that an increased level of enforcement and supervision is necessary in order to monitor inadequate explanations of non-compliance.. Since the explanation for non-compliance is the cornerstone of the comply or explain approach, authors are specifically calling on public enforcement authorities to take a more active role. Some researchers have found that there are certain qualities of corporations that are associated with higher and lower levels of high-quality non-compliance explanations. Studies conducted in Germany, Italy and the Netherlands give insights into which qualities often indicate high-quality non-compliance explanations. These insights could be useful to stakeholders wanting to monitor compliance and to public enforcement authorities if they are tasked with more stringent supervision.The FRC has published guidance on "what constitutes an explanation" as a means of comparing the approach of those who prepare businesses' explanations with the expectations of those to whom they are addressed.