«Corporate Governance in the UK: is the Comply-or-Explain Approach Working? By Antoine Faure-Grimaud Sridhar Arcot Valentina Bruno DISCUSSION PAPER NO ...»
Corporate Governance in the UK: is the Comply-or-Explain Approach Working?
DISCUSSION PAPER NO 581
Corporate Governance at LSE, 001
DISCUSSION PAPER SERIES
Antoine Faure-Grimaud is Professor of Finance at LSE. He first joined the economics
department of the LSE in 1995 and spent a couple of years in the US (notably at
Harvard and Princeton). For all that time he has been a member of the FMG where he is now Director of the Corporate Finance research programme. His research interests are centred on the contracting issues related to the financing of young and innovative companies and on corporate governance. His current research interests include an analysis of the implications of bounded rationality for financial contracting, of the nascent market for corporate governance ratings, of the redundancy of multiple control rights in venture capital deals. Antoine is also the head of the PhD programme in Finance at LSE. Sridhar Arcot is currently a PhD student at the London School of Economics. His research encompasses both theory and empirics in corporate finance, more specifically in the venture capital and corporate governance areas. Prior to beginning his PhD, Sridhar worked for companies in the information technology and finance fields in the UK and India. Valentina Bruno holds a PhD in Finance from the London School of Economics (2006), where she specialised in applied economics and finance, with a focus on assessing the effectiveness of alternative corporate governance regimes. Since 2006 she is at the World Bank, where she worked on a corporate governance project in the Financial and Private Sector Vice-Presidency. She is now with the International Finance Team of the Development Prospects Group, where she is actively involved in the Global Development Finance Report. Her main research interests are corporate finance and governance. Any opinions expressed here are those of the authors and not necessarily those of the FMG or the LSE.
Corporate Governance at LSE
Corporate Governance in the UK:
is the Comply-or-Explain Approach Working?
By Sridhar Arcot, Valentina Bruno, Antoine Faure Grimaud Corporate Governance at LSE Discussion Paper Series No 001, November 2005 Introduction1 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. The exibility it o ers to companies, who can choose between complying with its principles or explaining why they do not, stands in sharp contrast to mandatory systems (e.g. SarbanesOxley Act in the US). The merits of such exibility are thought to lie in its ability to encourage companies to adopt the spirit of the Code, rather than the letter, whereas a more statutory regime would lead to a \box-ticking" approach that would fail to allow for sound deviations from the rule and would not foster investors' trust. Therefore the \Comply or Explain" model ultimately would lead to better governance and its basic premise has been adopted by several other countries (like Austria and Germany). This article takes stock of the Combined Code's achievements in the UK; in particular, it asks whether it led to too much compliance and too few explanations.
We nd that the Code fostered compliance, especially in areas not covered by its forerunner, the Cadbury Code. For example, such provisions include the appointment of a senior independent non executive director or 12 months service contracts for executive directors. It is encouraging to see that more than half of the non nancial constituents of the FTSE350 were fully compliant with the Code at the end of 2004. In addition, we found that on average less than 10% of all rms were not complying to a given single provision.
However the picture looks less rosy when looking at those rms that did not comply with the provisions of the Combined Code. We nd that the rms that did not comply with the Code The three authors are from the Department of Accounting and Finance at the London School of Economics and bene tted from the research support of the Financial Markets Group. They want to thank Howard Davies, Paul Davies, Tom Kirchmaier, Geo rey Owen and David Webb for stimulating conversations and helpful comments.
often did a very poor job explaining themselves. Even worse, in almost one in ve cases of non-compliances, rms did not explain their non-compliances at all. When an explanation is provided, most of time it fails to identify speci c circumstances that could justify such a deviation from the rule. Companies that do not comply tend to stick with the same (poor) explanation until they directly jump to compliance. Once compliant, either a company remains compliant or if it ceases to, does not provide good explanations as to why this is the case.
This suggests that companies do not use the exibility of the Code to ne-tune their governance to their changing circumstances. Rather, rms often seem to make a fundamental choice between compliance or non-compliance.
Interestingly, shareholders seem to be indi erent to the quality of explanations, while the provision of speci c explanations is in fact a way to identify good investment strategies, better than simply focusing on compliance. Returns on a portfolio of compliers do not exceed, signi cantly, those of non-compliers. In contrast, returns of non-compliers di er signi cantly according to the quality of explanations.
In light of those ndings, we identify areas where the Code could be strengthened with greatest
potential bene ts:
1. Provisions pertaining to the minimum percentages of non executive directors (at the time, one third) and independent non executive directors have the highest frequencies of compliance, above 95% in 2004. At the same time, in relation to these provisions, noncompliant rms are the most likely to give no explanation and the least likely to identify speci c justi cations. The latest revision of the Combined Code chose to make those provisions more stringent. This will presumably impact on compliance levels, whether the quality of justi cations of non-compliance will improve remains to be seen. An alternative route would have been to make those provisions compulsory for the remaining 5% of companies not already complying (and not explaining much).
2. Ways to foster shareholder's attention to explanations have to be found. Section 2 of the revised code contains main and supportive principles demanding: \Institutional shareholders should consider carefully explanations [...] (and) should give an explanation to the company in writing where appropriate [...] if they do not accept the company's position. They should avoid a box-ticking approach [...]." If possible, the inclusion of a provision in relation to this principle, could have potentially signi cant bene ts. The overall message to be conveyed is that full compliance may not be desirable and that therefore explanations have to be analysed to identify the circumstances where noncompliance is in fact a superior way to govern a company.
The Combined Code was in operation from 31st December 1998 to 31st October 2004. Its provisions are summarised below. The rst eight provisions are the object of this analysis, while the last three were left out for the following reasons. All companies in the sample complied or intended to comply on provision 9, relating to Directors' re-election. Judging compliance with provision 10, pertaining to pay-linked to performance required additional information and/or analysis, not available to us. Provision 11, relating to internal control, had to be left out for
the same reason as 10. The provisions2 we analyse are thus the following:
1. Chairman and CEO (A.2.1) (CEO/COB): There are two key tasks at the top of every public company - the running of the board and the executive responsibility for the running of the company's business. There should be a clear division of responsibilities at the head of the company which will ensure a balance of power and authority, such that no one individual has unfettered powers of decision.
2. Senior Non-executive Director (A.2.1) (SNED): Whether the posts (Chairman and CEO) are held by di erent people or by the same person, there should be a strong and independent non-executive element on the board, with a recognised senior member other than the chairman to whom concerns can be conveyed.
3. Non-executive Directors (A.3.1) (NEDs): Non-executive directors should comprise not less than one third of the board.
5. Service contracts (B.1.7, B.1.8) (Ser. Cont.): There is a strong case for setting notice or contract periods at, or reducing them to, one year or less.
6. Nomination committee (A.5.1) (Nom.): Unless the board is small, a nomination committee should be established to make recommendations to the board on all new board appointments. A majority of the members of this committee should be non-executive directors.
7. Remuneration committee (B.2.1, B.2.2) (Rem.): Companies should establish a formal and transparent procedure for developing policy on executive remuneration and for xing the remuneration packages of individual directors. No director should be involved in deciding his or her own remuneration. Remuneration committees should consist exclusively of independent non-executive directors.
8. Audit committee (D.3) (Audit): The board should establish an audit committee of at least three directors, all non-executive, a majority of whom should be independent, with written terms of reference which deal clearly with its authority and duties.
The next three provisions were not analysed, we list them for reference.
9. Director's re-election (A.6): All directors should be required to submit themselves for re-election at regular intervals and at least once every three years.
10. Pay-linked to performance (B.1): Levels of remuneration should be su cient to attract and retain the directors needed to run the company successfully, but companies should avoid paying more than is necessary for this purpose. A proportion of executive directors' remuneration should be structured so as to link rewards to corporate and individual performance.
11. Internal Control (D.2.1): The directors should, at least annually, conduct a review of the e ectiveness of the group's system of internal control and should report to shareholders that they have done so.
The Combined Code was reviewed by Sir Derek Higgs in his January 2003 report that suggested changes to some provisions and more stringent criteria for others. The changes incorporated into the Revised Combined Code, came into force in November 2004. Examples of stringent criteria are the additional eight contingencies de ning the notion of independence and new provisions that require boards to review their own performance.
The data comes from Arcot and Bruno (2005a). They analysed 245 UK non- nancial companies, belonging to the FTSE 350 index as of 31st December 2003 between 31st December 1998 to 30th June 2004 the period the Combined Code was in operation. Financial companies were excluded because the overall regulatory environment for those companies di ers signi cantly from that of non nancial companies. It is felt that those regulations, although not part of the Combined Code, may well interact with its provisions, and have implications for corporate governance and performance evaluation.