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little desire for substantial change. Investors told us that they considered the relative lack of prescription in the guidance was seen as an important factor in its success, as it had enabled companies to apply the guidance in the way that was most appropriate to their circumstances. As a result, only limited changes were made to the guidance. I take this to be a strong endorsement by the market of the UK approach to corporate governance. While the Government felt it appropriate to change the manner in which the accountancy and auditing profession was regulated when the WorldCom and Enron scandals erupted, it did not consider legislation on internal controls to be necessary, and was content for the market, via the FRC, to take the appropriate reviewing action.

There was very little support for introducing requirements similar to those under Section 404. This was partly because experience in the US had highlighted concerns about costs. But there was also a concern, from investors in particular, that requirements of that sort might lead to a mechanistic focus on compliance rather than substantive assessment and management of risk, undermining what was seen as one of the main strengths of the UK approach.

The support from the UK investment community was also important in attempting to influence the debate at an EU and international level. Proposed legislation is often justified as being necessary to protect investors. As a result of the review of the Turnbull guidance, we were able to demonstrate that, in the UK at least, investors did not consider any benefits they might gain from Section 404 type legislation to be worth giving up the value they obtained from the existing system.

While it was undoubtedly the costs associated with implementation of Section 404 in the US that led other jurisdictions to pause for thought, I believe our review helped to demonstrate that other models are available. This appears to have had some resonance even in the US. In May 2005 a Bill was introduced to both Houses of Congress that would have required the SEC and PCAOB to ‘jointly conduct a study comparing and contrasting the principles-based Turnbull Guidance of Great Britain to the implementation of section 404 of the Sarbanes-Oxley Act of 2002’.

Challenges to comply-or-explain

The code-based approach to promoting good governance only succeeds if it enjoys the consent of the market. It requires both companies and investors to recognise their responsibilities and operate within the spirit of comply-or- explain. If either party fails to do so, the system breaks down. As much attention must be paid to the manner in which a code is implemented as to its contents.

As noted, one of the points that most concerned companies when the Combined Code was revised in 2003 was that any increase in the number of provisions might encourage box-ticking on the part of investors: a greater focus on checking compliance with the provisions rather than on the application of the principles of good governance. Even though the number of provisions in the

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2003 Code is hardly changed from its predecessor, that concern remained. To avoid it becoming a serious issue for any company requires good explanation by the company and a proper consideration of such an explanation by investors.

In fact, when the FRC consulted companies on how the Combined Code was working in 2005 it appeared that their worst fears had not been realised. We were told that, for the larger companies at least, their major shareholders were generally willing to engage in discussions and to treat each explanation on its merits. These appeared to be borne out by surveys conducted by NAPF and the Investment Management Association which found that fund managers were committing more resources to engagement with companies.17

However there was criticism of perceived box-ticking on the part of some investment institutions, intermediaries such as rating agencies and the media, which tends to present cases where companies have chosen to explain rather than comply as ‘a breach of City rules’, when this is clearly not the case.

One could say that, as long as the company’s main shareholders remain content, they should be big enough to ignore the box-tickers. But if a board believes it will be publicly criticised for non-compliance even when shareholders have accepted their explanation and are supportive, one can understand why they might think it easier simply to comply. Anecdotal evidence suggests that some companies are defaulting to compliance regardless of their circumstances rather than run the perceived risks of explaining. There is an ongoing challenge to ensure that comply-or-explain does not drift into ‘compliance for compliance’s sake’. There is a role for the regulator in educating the market and the media.

Having said that, it is not good enough for companies to lay any blame entirely on the attitude of investors. Companies cannot assume that any explanation will be acceptable, and should aim to demonstrate to their shareholders that they are applying the principles of the Combined Code through their chosen governance practices. The better they are able to do so, the more amenable shareholders will be to accepting the explanation.

Most of the Combined Code is followed by most companies, with explanations of non-compliance being the exception, and a diminishing number of exceptions being noted as companies adjusted voluntarily to the 2003 Combined Code. However, while most companies apply the Combined Code responsibly, there are a few that have clearly mistaken its light touch approach for a soft touch. A number of the annual reports that the FRC studied as part of its review gave boilerplate explanations which, in effect, gave no explanation at all. This can give the impression that they have simply not bothered applying the Code. Companies cannot expect to be given an easy ride in those circumstances, and need to understand that if such behaviour were to become widespread it could lead to pressure from investors for regulatory action if they felt that comply-or- explain was failing.

17 See note 13.

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One dog that has not barked to any serious extent since the new Combined Code was introduced in 2003 has been that of the position of smaller listed companies, which for the purposes of the Combined Code are defined as those outside the FTSE 350. Having (apart from the requirement for only two independent non-executive directors) otherwise wished to be treated the same as larger listed companies, the smaller companies, like their larger counterparts, have simply got on with implementing the new Combined Code. However, that does not mean that it has all been easy going. Clearly, larger companies are more resource-rich to deal with any implementation issues. Also, even with a requirement for only two independent non-executive directors, there has been, and still is, relatively quite a lot of recruitment required.

The research done so far has not thrown up great problems. Research carried out by Manifest on behalf of the FRC in 2005 found high rates of compliance with many provisions of the Code among smaller companies. However, there is some anecdotal evidence that comply-or-explain may not work as well for smaller companies as it does for larger companies, primarily because the investment institutions will target their own limited resources on those companies that are a significant component of their investment portfolio (in effect this means the FTSE 100 companies, which at the end of 2004 accounted for 80 per cent of the value of the London stock market18). This means that smaller companies are less able to have a constructive ongoing dialogue with their main shareholders. This may leave them feeling more exposed to pressure from the box-tickers and therefore more inclined to default to compliance.

Looking further ahead, one of the biggest challenges for comply-or-explain will be to cope with changes in the structure and composition of the London stock market. The assumption underlying comply-or-explain is that boards and shareholders are united by a common interest in the long-term health of the company and sustainable shareholder value, and that the nature of the dialogue between them will therefore be about what governance practices will best be able to deliver these objectives.

The London stock market today looks very different from 1992 when the Cadbury Committee first created the concept of comply-or-explain. At that time pension funds and insurance companies – who are traditionally seen as longterm investors – held over half the total equity in the London market. Their share has fallen consistently ever since, and by 2004 was less than one third of total equity. In recent years, we have seen a growth in hedge funds and other investors that are perceived as having a more short-term focus. A potentially more significant development has been that overseas investment in London has risen from 13 per cent in 1992 to 40 per cent in 2006.19

18‘Share Ownership: A Report on Ownership of Shares as at 31st December 2006’, Office for National Statistics, June 2007.

19See note 11.

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One possible implication of the changing investor base, and in particular of the increased number of overseas investors, is that investors’ views on what constitutes good governance – and consequently what they expect of companies – may change. Some European companies have already had experience of this at the hands of US and UK investors. I do not necessarily see this as a cause for concern as long as the pressure for change comes from the market, not from regulators. As demonstrated earlier in this chapter, views on what constitutes good governance change over time, and as markets become truly global it is only to be expected that this will have an impact on corporate behaviour. The Combined Code and comply-or-explain should be flexible enough to adapt.

I would be more concerned if investors were to walk away from comply- or-explain, either because they did not see it as their role to encourage good governance in the companies in which they invest or because they imported expectations that only a prescriptive approach could deliver improvements in standards of governance. Either of these eventualities could put pressure on the Government or regulators to take action that might reduce the current flexibility and the attractiveness of the London market. Equally, the present benign position of the European Union could change.

Conclusion

The evidence is that market-based regulation works best in the UK. I would argue that it is the best system for any market-based economy. When combined with a comply-or-explain approach, it provides the necessary flexibility to suit all types of companies, and the adaptability to change as circumstances and attitudes to corporate governance change. The role of government should be to provide a supportive regulatory framework, but it should not legislate in detail. Sarbanes-Oxley is a classic example of the problems caused by overly specific legislation.

One area which is key to being able to allow market-based regulation to operate is that shareholders should have adequate rights. The EU is working on this and has in general so far followed in corporate governance a sensible approach very much along market-based lines. Forces arguing for more prescription should be resisted. If action is needed at EU level, it should underpin the comply-or-explain approach, for example by promoting shareholders’ rights. The present approach brings the twin benefits of encouraging, not stifling, entrepreneurial drive by boards, while providing the transparency investors need to have, either to know how their investment is being handled (or take action if they do not like it), or to decide to invest in the first place. It remains fit for purpose.

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