Two Sides To Light Touch Regulation

The board directors of U.S. public companies should cast light on boardroom decision-making or have to justify keeping shareholders in the dark, according to an article published in Duke Law School’s Journal of Law and Contemporary Problems.

The creation of a new ‘directors’ duty to inform’, proposed by the article’s author, John Wilcox, chairman of U.S. board advisory firm, Sodali, would require directors to provide shareholders with a regular stream of information above and beyond the existing communications required in advance of specific votes or investment decisions.  

‘The duty should encourage open communication in the form of a narrative that tells the story of a board’s decision-making process and the strategic rationale for its choices…’ says Wilcox. ‘The substance of the narrative should be based on the judgment of the directors, not dictated by compliance requirements.’

This call for greater board transparency, touted as a potential solution to the irksome shareholder votes on executive pay, would see board adherence to corporate governance rules move away from a check-the-box mentality in favour of adopting the flexible and less prescriptive ‘comply-or-explain’ framework used in the UK.

Instead of a regulatory body, like the SEC, enforcing the duty to disclose, Wilcox would like to see shareholders holding the directors to account, much like they do in the UK, where listed companies are required to comply with the UK Corporate Governance Code or explain their reasons for not doing so in the annual report to shareholders.

‘There is a limit to the effectiveness of prescriptive rules and external metrics,’ he argues. ‘The financial crisis demonstrated all too clearly that compliance with rules and best practices does not ensure good governance. In some high-profile cases, companies’ full compliance with governance norms did little more than provide cover for weak board oversight, incompetence, and fraud.’

But this endorsement of the UK’s comply and explain framework comes at a time when the effectiveness of the soft law approach to corporate governance is being called into question on a European-wide level. 

On April 5th, the European Commission, the executive body of the 27-member state European Union, launched a four-month public consultation on corporative governance, announcing in a statement:  ‘One of the lessons of the financial crisis is that corporate governance, until now usually based on self-regulation, was not as effective as it could have been.’

The European Commission states its commitment in the consultation document to retaining the fundamentals of the ‘comply and explain’ approach. But at the same time, it can also foresee the need to ‘reinforce certain requirements at EU level by including them in legislation rather than making recommendations.’ 

‘A rule-based approach to corporate governance on a pan-European basis is not welcomed,’ says Robin Johnson, corporate partner at international law firm, Eversheds. ‘Overall, the UK model of institutions and corporates working around principles rather than rules remains the best model as it encourages disclosure and gives flexibility.’

The principal concern of the Commission is the level of detail given by companies who choose to depart from the rules rather than comply. The insufficiency of these explanations can be improved, the Commission suggests, by including more detailed rules for the information that needs to be disclosed by companies, alongside a monitoring role being conducted by a securities regulator or a stock exchange – the very antithesis of the comply and explain regime. 

In a recent survey of 100 European executive directors, conducted by the international law firm, Allen & Overy, 78% of respondents said corporate governance rules should only be enforced on a comply or explain basis. Commenting on the results, corporate partner Mark Wippell said, ‘The jury is out on whether any new Commission proposals will make a positive difference to the way businesses are being run or will simply do no more than increase the burden of red tape in what is already a heavily regulated area.’

As for the US, Wilcox believes there are two considerable factors that need to be surmounted before any voluntary ‘directors’ duty to inform’ can be brought to bear on boardroom opacity: ‘Directors of U.S. companies would have to overcome their habitual antipathy to shareholders…and institutional investors would have to give priority to their responsibilities as long-term owners.’

To encourage this two-way bargain, Wilcox suggests the adoption of a reciprocal code of conduct for institutional investors, similar to the UK’s Stewardship Code.

‘Last year the UK introduced a Stewardship Code as part of the new Corporate Governance code whereby [institutional investors] agreed to play a more active but supporting role on corporate governance,’ explains Johnson. ‘Institutions like Hermes have led the way in supporting this voluntary code seeing it as a way to avoid more prescriptive legislation being introduced.’

Over three quarters (78%) of the European executive directors polled for the A&O survey believe that institutional investors should abide by a code of conduct (with over half of respondents believing the code should be international).  

But encouraging shareholders to engage in the first place, let alone sign up to a code of conduct, is another of the corporate governance challenges that the European Commission is covering in its consultation. Lack of shareholder engagement is an issue in Europe in spite of the comply and explain regime. The cost of monitoring companies and the uncertainty of the outcome of any engagement are a few of the reasons given by the Commission for this shareholder apathy. 

One of the options being considered by the Commission is a requirement for institutional investors to publish their voting policies and records. This move toward reciprocal board and investor transparency on voting was supported by the vast majority of respondents to a previous consultation specifically covering corporate governance at financial institutions. 

Ultimately, though, the European Commission will wait for feedback on the current consultation before deciding whether or not to legislate to improve shareholder engagement, as well as the comply and explain framework. A summary of the consultation will be published in the autumn. 

In the meantime, the prospect of the U.S. moving toward the current European approach remains a long way off. ‘[B]oardroom windows at U.S. companies remain closed, with shades down and curtains drawn,’ Wilcox says. ‘A window into the boardroom can be opened only by the directors.’