European Union member states are in the process of adopting a United Kingdom-style ‘comply or explain’ approach that calls for companies to disclose the extent of compliance with corporate governance codes or explain deviations from them. The new directives are the Statutory Audit Directive (known as the Eighth Company Law Directive — approved in May 2006 and effective in June 2006) and the Company Reporting Directive (amendments to the Fourth and Seventh Company Law directives — approved in May 2006 and effective in June 2008). The Statutory Audit Directive is designed to ensure investors and other interested parties can rely fully on the accuracy of audited accounts. It is also intended to enhance the EU's protection against the type of financial scandals at Parmalat and Ahold. The directive clarifies the duties of statutory auditors and enumerates ethical principles to help ensure objectivity and independence.
The Company Reporting Directive introduces new rules requiring companies whose securities trade on a regulated market to produce a corporate governance statement in annual reports. The statement must refer to the corporate governance code applied by the company and explain to what extent the company complies with that code. Some believe the ‘comply-or-explain’ approach is well-suited to Europe, as it takes into account companies' individual circumstances and the differences between national legal and governance frameworks. Others are not so sure that this approach will work, especially in companies in continental Europe where controlling shareholders could ‘explain’ any code deviations to themselves.
European Union member states plan to adopt a United Kingdom-style ‘comply or explain’ approach for corporate governance as their governments adopt new European Commission directives but can the requirements live up to expectations?
The new directives are the Statutory Audit Directive that became effective in June 2006 (known as the Eighth Company Law Directive) and the Company Reporting Directive that is expected to become effective June 2008 (amendments to the Fourth and Seventh Company Law directives).
"The amendments are in part a response to the Enron, Worldcom and Parmalat scandals of the early 2000s," says Tim Copnell, a director for KPMG in the UK and director of KPMG’s Audit Committee Institute. "They seek to enhance confidence in the financial statements and annual reports published by companies across the EU by making corporate governance arrangements more transparent."
The ‘comply or explain’ approach calls for companies to disclose the extent of compliance with corporate governance codes or explain deviations from them. This approach has been championed in the UK, where such a system has been in place for nearly 15 years.
Some believe comply or explain is well suited to Europe, as it takes into account companies' individual circumstances and the differences between national legal and governance frameworks.
But there are several problems with ‘comply or explain’, according to some industry observers.
"The comply or explain approach works well in the City of London, where most of the people involved all know each other and have worked together for a long time," says Jaap Winter, a partner at the Amsterdam-based law firm De Brauw Blackstone Westbroek and chairman of the EU High Level Group of Company Law Experts. He is also a member of the European Corporate Governance Forum.
"This is not necessarily the case in Europe, and the approach may therefore not work at all on the [European] continent," Winter says.
The effectiveness of the approach depends on a company's impetus for doing it, whether it is due to corporate law, regulatory authorities or listing standards, Copnell says.
There also needs to be a high level of transparency with coherent and focused disclosures, as well as a mechanism for shareholders to hold company boards accountable.
While the European Commission (EC) adopted them in 2006, EU member states are still turning the amended directives into law. (The European Commission has given member states two years to adopt.)
The statutory audit directive is designed to ensure investors and other interested parties can rely fully on the accuracy of audited accounts. It is also intended to enhance the EU's protection against the type of financial scandals at Parmalat and Ahold. The directive clarifies the duties of statutory auditors and enumerates ethical principles to help ensure objectivity and independence.
The Company Reporting Directive introduces new rules requiring companies whose securities trade on a regulated market to produce a corporate governance statement in annual reports. The statement must refer to the corporate governance code applied by the company and explain to what extent the company complies with that code. One might think a common European directive would ensure consistency across Europe, but that's not necessarily the case, according to Copnell.
"There's danger that the way in which the directives are being implemented in different countries could undermine the success of the EU's approach and shape the debate with U.S. regulators on how best to secure good corporate governance," he says. "And this in turn may shape the way in which major emerging markets like China and India address governance."
While the Company Reporting Directive requires companies state the extent of compliance with a governance code, there is no requirement on member states to ensure a relevant code is in place. Some companies will likely be subject to a specific code (such as the Combined Code in the U.K.); others will likely be able to select a code of their choice.
In addition, due to the different ways in which member states implement the directives, there is the danger that some companies will have to abide by two contradictory codes — or not have to discuss compliance at all.
"For example, take a company incorporated in England and Wales but listed in Frankfurt rather than London," attorney Winter says. "As things stand today, such a company is not required as a matter of law or regulation to disclose the extent of its compliance with the U.K. corporate Combined Code."
In Germany, a foreign company listed on the Frankfurt exchange does not have to comply with German corporate governance codes. "As a result, [a company] falls between the cracks," Winter says.
Even when appropriate codes apply, there is not a consistent system to monitor the application of corporate governance codes to identify areas for improvement; there is no common understanding regarding the quality of explanations. Also, there is no common ground as to what constitutes an appropriate explanation. Even codes with apparently similar requirements will likely vary in line with cultural and historical differences.
"Regulatory authorities should limit their role to checking the existence of the statement, and to reacting to blatant misrepresentation of facts," Copnell says. "The examination of the quality of the statement should be left to the shareholders — but that assumes appropriate shareholder control mechanisms are in place."
Infrastructure challenges notwithstanding, it is far from certain that shareholders will be able to hold company boards accountable for their comply or explain decisions and the quality of their disclosures.
"Many companies listed in continental Europe have controlling shareholders," Winter says. "In such circumstances, the 'force for good' exerted by strong independent shareholders is effectively removed as controlling shareholders effectively ‘explain’ any code deviations to themselves."
Similarly, Copnell says that in cross-border scenarios, there are intermediaries and obstacles that can block investors' voting rights. If cross-border shareholders can't vote, then how can they influence governance?
Another potential pitfall is short-term activist shareholders. Intuitively, comply or explain works best when shareholders take a responsible approach to any compliance or non-compliance in the long-term interests of the company. However, short-term objectives may drive shareholder activists.
Winter advocates a non-shareholder dependent review mechanism for these issues. "The controlling shareholders are in too easy a position to 'explain' to themselves why they do not 'comply,'" he says. "Some independent control is necessary."
Others believe that numerous approaches to corporate governance in Europe will evolve as companies work at applying the new legislation.
"What we are more likely to see is a patchwork quilt of approaches evolving as national legislatures in Europe implement the directives," says Patricia Peter, corporate governance expert at the London-based Institute of Directors.
"What will likely happen then is that companies will themselves find the best ways of complying with these requirements across borders. European companies have a long history of doing that successfully."
Andrew Rosenbaum is a London-based freelance journalist covering business and finance.
The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG’s network of firms.