By: Antoine Del Sordo
Voluntary codes have progressively become an integral component of corporate governance regulations globally. A corporate governance code (“CGC”) is a non-binding set of principles, standards or best practices issued by a collective body, which regulates the internal governance of a corporation.1 The construction of these CGCs is based on the moral consensus reached by various stakeholders, including criteria from the international business community, public investors, government agencies and academics regarding commercial and corporate ethics.
These CGCs are enforced internally by the corporation through its board of directors, senior executives and/or officials. In addition, there is an enforcement by virtue of external means such as the market and the public opinion.2 This dual enforcement mechanism seeks to ensure adherence to these CGCs.
The evolution of soft law in corporate governance, mainly through the application of CGCs, has primarily focused on establishing standards that serve as a reference point for companies to evaluate their governance systems.
Furthermore, the rise in the adoption of soft law instruments 3 in specific aspects of corporate governance in a public company is frequently rationalized by the diversity and particularities of each corporate entity, making it challenging to formulate efficient rules that are universally applicable to all companies. Consequently, the CGCs recognize the need to permit deviations from established general legal standards from hard law instruments that consider the companies’ unique attributes, thereby enhancing the effectiveness and relevance of the corporate governance systems in place.4
The principle of “comply or explain” (“CoE”) as a soft law mechanism that has been implemented in numerous CGCs is that once a company adopts a CGC that contains this principle, it must either confirm its compliance with the CGC’s provisions or provide a justification for non-compliance if that is the case. In doing so, companies should elucidate the circumstances that resulted in the unsuitability of adhering to the stipulated provisions of the relevant CGC. The fundamental premise of the CoE concept is to ensure that the board of directors and other officials are accountable for actions taken or not taken, providing CGC with effectiveness.
Such principle initially introduced in the Cadbury Report of 1992 has become the symbol of corporate governance in the UK because it has been incorporated into numerous CGCs globally, including public companies from countries either with common law or civil law tradition. 5
However, in the vast majority of countries with a significant presence of companies that have adopted the CoE principle in their CGCs, generally there is no regulatory authority assigned to scrutinize corporate responses to the provisions of the CGC.6
Consequently, it falls upon the corporations themselves, the markets and other stakeholders to evaluate the appropriateness of the responses of the former. Particularly, the explanations for non-compliance with a provision of the CGC.7
The fundamental aim of the CoE principle is to equip shareholders and stakeholders with information that enables them to make informed evaluations about whether a corporation’s non-compliance can be justified considering its specific circumstances. In this context, the market plays a crucial role in this process by penalizing non-compliant corporations that fail to observe its CGC and do not provide adequate explanations for their actions, typically by assigning lower share prices.8 This approach underscores the importance of transparency and accountability in corporate governance.
However, a disadvantage that this soft law approach entails is that commonly, there are only very general guidelines given by CGC or even no provisions on how a company must explain its failure to comply, and because statements can be so different from company to company, it is extremely difficult to verify them if there is not a regulatory body that takes care of the above. The foregoing is also worsened by the fact that shareholders of public companies commonly fail to monitor their companies because of the cost and time it would represent.9 This highlights the complexities involved in ensuring corporate accountability and compliance in the absence of rigorous regulatory supervision.
Likewise, evidence suggests that institutional investors frequently conduct superficial compliance verifications to CGC without adequately considering the justifications offered by corporations in case of non-compliance with the CGC.10 In an attempt to address this, the UK, for example, has introduced the Stewardship Code. This Code aims to enhance the quality of interaction between institutional investors and companies to improve long-term shareholder returns and facilitate efficient governance. However, it does not solve the issue of inadequate explanations that companies provide when they fail to comply with CGC provisions.
Hence, establishing a regulatory body could address the significant drawback of regulating corporate governance through a soft law instrument such as the CGCs. This entity should have the authority to examine the disclosures made by companies subject to the CGC and assess the sufficiency of explanations offered in cases of non-compliance. Likewise, in severe cases of non-compliance or failure to justify deviations, the regulator, empowered by statute, could levy formal sanctions determined by hard law instruments.
Although this approach may lead to the forfeiture of certain perks associated with soft law, such as the imposition of sanctions ruled by statute and the continuous oversight of compliance by a government body of the CGCs, it would preserve other advantages, such as flexibility granted by the CoE principle, potentially enhancing the effectiveness of the CGCs and seeking a better equilibrium between hard and soft law.11
1 Karlsson-Vinkhuyzen, S and Vihma, A “Comparing the legitimacy and effectiveness of global hard and soft law: An analytical framework” (Blackwell Asia 2009) 400.
2 Junhai, L “Globalisation of Corporate Governance Depends on Both Soft and Hard Law” in Du Plessis, J and Keong Low, C(eds), “Corporate Governance for the 21st Century” (Springer 2017) 276.
3 Se entiende por instrumentos soft law como un conjunto de normas no vinculantes que incluyen recomendaciones, códigos de conducta, principios, etc. que reflejan la tendencia actual de la comunidad internacional. / Soft law instruments are understood as a set of non-binding rules that include recommendations, codes of conduct, principles, etc., that reflect the current trend of the international community.
4 Junhai, L (n 2) 277.
5 Keay, A “Comply or explain in corporate governance codes: in need of greater regulatory oversight?” (2014) 34(2) Legal Studies, 279.
6 Ibid.
7 Ibid.
8 Seidl, D “and others”, “Applying the ‘comply-or-explain’ principle” (2013)17(3) Journal of management and governance, 791.
9 Arcot, S “and others”, “Corporate governance in the UK: Is the comply or explain approach working?” (2010) 30(2) International review of law and economics, 194.
10 Keay, A (n 4) 290.
11 Cadbury, A “Corporate governance and chairmanship: a personal view” (OUP2002) 28.
