Understanding comply or explain: UK Corporate Governance Code 2024

Published: 26 November 2024

6 minute read

In this In Conversation podcast episode, Adam Mohamed, Head of Communications, interviews Jessica Dahlstrom, Head of Corporate Governance, exploring the nuanced "comply or explain" approach in the UK Corporate Governance Code. They discuss how companies can effectively demonstrate good governance through thoughtful explanations of code departures, emphasising flexibility and meaningful reporting.

You can also listen on Apple podcasts or Spotify.

Transcript

0:10
Hello, and welcome to this In Conversation podcast here at the FRC.

0:14
My name is Adam Mohamed and I'm the head of communications here at the FRC.

0:20
And this episode is part of a larger series looking at the upcoming UK corporate governance code 2024, which comes into effect from January.

0:30
And specifically in this episode, we're looking at compliance.

0:33
And luckily enough, we're joined by the FRC's Head of Corporate Governance, Jessica Dahlstrom.

0:38
So thank you very much for joining us, Jessica.

0:40
Thank you very much for having me.

0:42
So before we go into more of the details, I think one thing we really need to clear First off the bat is comply or explain.

0:51
I think when we're talking about compliance, this is the big one that everyone kind of gets hung up on.

0:55
And I think often we hear it termed comply or else, much to the annoyance of everyone here at the FRC.

1:01
But can you just set out what do we mean when we say comply or explain?

1:07
Yes, definitely.

1:08
Well, comply or explain is a really important part of the corporate governance code and it's probably worth just going back to the sort of underpinning of the code.

1:18
So companies who follow the code are required by the listing rules to follow the code.

1:24
And the code consists of principles which are sort of a high level set of statements which are then underpinned by provisions which are more specific.

1:33
And when we say comply or explain, what we mean is we expect companies to apply the principles of the code, but take a comply or explain approach to the provisions, as I say, which are a little bit more specific.

1:45
So companies either choose to follow the provisions exactly, but if there's another way of doing things that works better for them, they can choose to depart from the provisions and provide an explanation instead.

1:59
And they have equal weight, shall we say.

2:01
So a good explanation is just as good as compliance.

2:05
Exactly.

2:06
Now of course we have given a lot of thought to the provisions and they do set out the elements of good governance practise.

2:12
But we recognise that good governance can take many forms and there are many different companies which follow the code.

2:18
And it's very possible that good governance for one type of company, for example Auk Financial Services Company, is different from good governance for a construction company that might be based abroad.

2:30
So the code recognises that and recognises the fact that a provision might not work for a particular company and therefore provides that flexibility to depart from the code.

2:41
And is that also to say that full compliance with the code doesn't necessarily equal good governance?

2:48
What we really like to see is a flexible approach taken both by companies but also by investors.

2:54
So it may be that a company is fully compliant with the code, having given a lot of thought to each of the provisions and being able to comply with that.

3:02
And that is a well governed company.

3:04
But there may be an equally well governed company that has chosen to depart and provide an explanation for the departure in its annual report.

3:13
So sometimes we say that a departure, provided it's a company by a good explanation could be better governance than blind compliance without having given proper thoughts of it.

3:25
It's really important though to emphasise the explanations and both from a company perspective, giving a clear explanation in the annual report, it is really important.

3:36
But from an investor perspective, we really encourage investors to read those explanations and to understand that, you know, a company may have taken a different approach and still be well governed.

3:47
I was about to ask over an investor perspective.

3:49
The guys who are using these annual reports, they shouldn't really.

3:52
Or should they?

3:53
I mean, prefer full compliance over explanations.

3:56
It sounds like what you're saying is that there's no necessity to prefer full compliance as long as those explanations are well thought through and appropriate for that company.

4:07
Exactly that.

4:08
This is where you referenced at the beginning, Adam, that people sometimes use the phrase comply or else.

4:13
And we really are trying to steer people away from that and do appreciate that it's sometimes difficult and investors and their advisors look at a large number of companies etcetera.

4:23
But we do really emphasise the value in looking in detail at the explanations that companies might have provided and really considering the fact that those may well be evidence of good governance, even if they are in fact a departure from the Code.

4:40
So I don't want to labour the point, but because we get this so often, like we've discussed, comply or else and all the rest of it is an explanation equal to full compliance.

4:52
Yes, a well explained departure from the code is equal to full compliance.

4:57
But it's really really important to emphasise that the explanation must be meaningful and give enough detail to the reader to understand the rationale for non compliance and why this is the best approach for the company.

5:10
So you mentioned there about giving enough detail and having that rationale.

5:14
Do you have any examples or what can you say about what makes a good explanation?

5:19
What constitutes a good explanation?

5:22
The FRC has published some material on this and do encourage people to look at our website and have a look at those publications.

5:29
But there are a number of key elements to what makes a good explanation.

5:33
And what we like to see really is for companies to provide some context and background as to why the non compliance has been chosen and then providing a convincing rationale for that.

5:44
Even better if the company can demonstrate perhaps that also considered any risks associated with the non compliance and how those might be mitigated.

5:52
And occasionally we get a situation where a company is temporarily not compliant with the code.

5:58
And in those instances it's good to indicate to the timeline how long might this be for?

6:03
What steps is the company putting in place to move towards compliance.

6:08
But the most important point out of all of that really is that the explanation is understandable to the reader and persuasive.

6:14
I suppose it needs to be to be used by somebody.

6:17
So we need to make sure they can understand what we're saying.

6:20
That's really important and I guess people really love examples.

6:24
I think we saw that in our last webinar that we did on this topic of UK Corporate governance Code 2024 coming into effect.

6:31
Do you have any more general examples of ineffective explanations or maybe a meaningful explanation what that would look like?

6:40
I think a good provision to use in this case is provision 19, which is the provision that deals with how long the chair has been in position.

6:50
And we do occasionally see situations where a company has had a chair tenure which is longer than what is specified in the code.

6:57
And you know, what doesn't make a particularly good explanation is simply stating that the chair's tenure has been extended and perhaps that the chair has valuable skills.

7:07
That's really not specific enough supposed to really be persuasive to the reader of the annual report.

7:14
So the types of things that companies could consider including in that instance is, you know, explaining perhaps the background why this has occurred.

7:23
And it could be that there's a change in other leadership at the company, which means that keeping the chair for a bit longer means more stability, perhaps outlining that this has been discussed with shareholders or other stakeholders and some safeguards that might have been put in place.

7:39
For example, role of the senior independent director and then a timeline for compliance.

7:44
And those types of elements would make an explanation much stronger compared to just saying this is what we're doing.

7:52
Fantastic.

7:53
Is there anything else for those looking to apply the new code in the new year when thinking about compliance or complying with the code that you'd want to really get across?

8:04
Before we wrap this up, I think the main thing just to draw people's attention to is that some of the changes that we've made in the 2024 code are exactly in this area and are to encourage better explanations for departure from the code, which we hope will benefit both companies and investors as it will help everybody appreciate more the flexibility of the code.

8:26
So first time that we're explicitly referencing explanations in the code, we hope that will, as I say, help people.

8:33
But really the main message that we'd like to get across is that the code is the flexible tool and that people hopefully should use it.

8:41
Well, that's brilliant.

8:42
Hopefully this podcast episode goes some way to enlightening people as to that being the fact.

8:47
Thank you very much.

8:48
As I said at the beginning, this is part of a series, so do head to the FRC website or our podcast channels.

8:54
And you can also find our latest annual review of corporate governance reporting on the website as well.

9:01
So just left to say thank you very much, Jessica for that Whistle Stop tour and I look forward to speaking to you.

9:06
See you soon.

9:08
Thank you very much.