486 CORPORATE GOVERNANCE

Blackwell Publishing IncMalden, USA

CORGCorporate Governance: An International
Review0964-8410Blackwell Publishing Ltd. 2006
September 2006145486496ORIGINAL ARTICLES
COMPLY OR EXPLAINCOPRORATE GOVERNANCE

Comply or Explain: market

discipline and non-compliance
with the Combined Code
Iain MacNeil* and Xiao Li

The comply or explain principle adopted by the UKs Combined Code on Corporate
Governance has now been in operation for 12 years. In this paper we focus on two aspects of
this regime. The first is the nature of the explanations that have been given by companies with
an established record of non-compliance (serial non-compliers) and the role of the market
in permitting deviations from the Combined Code. In particular, we consider the significance
of share price performance as a factor that is relevant in justifying non-compliance and the
extent to which investors appear to rely on this indicator rather than engage in the more
difficult task of judging the relative merits of the Code provisions against alternatives. Our
approach differs from much of the research linking corporate governance with financial
performance in that it focuses on the potential influence of financial performance (as measured
by share price) on governance structure rather than vice versa. Our study of FTSE 100 serial
non-compliers suggests that there is a prima facie link between share price performance and
investors tolerance of non-compliance with the Combined Code. The second issue we
examine is the link between the principle of comply and explain and the self-regulatory
status of the Code. We conclude that the benefits of flexibility generally associated with the
self-regulatory status of the Code are overstated and that the Code could be integrated into
mainstream company law.

Keywords: Corporate governance, Combined Code, comply or explain, regulation

Comply or explain: the underlying corporate governance codes based on the

philosophy comply or explain principle.1
The first consideration is flexibility. This is

T he development of corporate governance

*Address for correspondence:
The Law School, University of
Glasgow, Glasgow G12 8QQ.
Tel: + (0)141 330 5863; Fax:
+ (0)141 330 4900; E-mail:
i.macneil@law.gla.ac.uk
codes in the United Kingdom has, since
the process first began with the Cadbury
Report in 1992, proceeded on the basis that the
nature of the rules contained in the codes
should be based on the comply or explain
principle. The essence of the principle is that
compliance with the codes is not mandatory,
but that disclosure relating to compliance is.
Underlying the principle are two main con-
siderations which, taken together, have been
regarded as creating a strong case against a
regime based on mandatory rules such as the
Listing Rules to which the Code is appended.
Similar considerations are applicable to those
other countries which have also adopted
based on the judgement that it is not possible
to adopt a one size fits all approach to cor-
porate governance codes primarily because
companies subject to the codes differ materi-
ally in terms of size, structure and organis-
ation.2 Two observations can be made here.
First, flexibility is already a major feature of
the governance structure established by a
companys articles of association, at least in
the United Kingdom, where there are rela-
tively few mandatory rules relating to the
structure and composition of the board of
directors or the respective powers of the board
and the general meeting. However, that flexi-
bility operates at the stage of selection (or
amendment) of the relevant (default) rules,

2006 The Authors

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COMPLY OR EXPLAIN
not at the stage when observance of the rele-
vant rules is required. In that sense, the flexi-
bility associated with corporate governance
codes differs from the flexibility associated
with company law.3 Second, it is open to ques-
tion whether flexibility is an appropriate
response to the fundamental issue of whether
corporate governance codes are capable of
exerting a positive influence over financial
performance (Riley, 2002). Put another way,
flexibility becomes much less relevant if it is
not clear that corporate governance codes (in
any form) can lead to improved financial
performance. Research on the nature of the
link between governance and performance
(Dedman, 2002; Gompers et al., 2003; Weir
et al., 2003) has not demonstrated a clear
causal link between compliance with codes
and superior performance. Of course, to the
extent that corporate governance codes can be
regarded as pursuing other worthwhile objec-
tives (such as improved accountability), that
particular concern is reduced.
The second consideration, which is related
to flexibility, is the role of the capital market
in assessing the adequacy of a companys cor-
porate governance practices. The comply or
explain principle is based on the assumption
that the market will monitor compliance
with a code and will either (a) penalise non-
compliance through lowering share prices
(Easterbrook and Fischel, 1996) or (b) accept
(for whatever reason) that non-compliance is
justified in the circumstances (Anand, 2005).
According to this view, companies have an
incentive to comply because the code (at least
in the United Kingdom) represents the view
of institutional investors as to best practice
and therefore the onus is on a non-compliant
company to justify its position. A decision to
comply is likely to carry benefits for a com-
panys share price (Mallin, 2001). A decision
not to comply will reflect both the cost (in the
broad sense4) associated with compliance as
well as the credibility of the sanctions that are
likely to be imposed. A high cost of compli-
ance may well create an expectation within a
company that investors would regard non-
compliance as justified, but there remains the
risk that the companys assessment of this
issue would not be the same as that of inves-
tors, not least because assessment of the cost
of compliance is largely subjective. Even so, if
there are reasons why sanctions are unlikely
to be imposed (e.g. because the company is
performing well, investors are unlikely to
question governance practices), the risks to
the company may be regarded as relatively
low, even if non-compliance is a recurring
event (i.e. the company becomes a serial
non-complier).
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487
A third consideration, albeit one that was
not articulated during the development of the
Combined Code, but which seems to underlie
it, is the nature of the rules that are best suited
to implementing the corporate governance
agenda. The Combined Code, reflecting its
history and the interests of the organisations
that promoted its development, focuses
principally on what is termed in law and
economics parlance principal-agent issues
(Jensen and Meckling, 1976; Fama, 1980). This
is reflected in the emphasis within the Code
on board structure and composition as well
as an overriding concern to improve the
accountability of directors to shareholders.
However, it can be asked why disclosure
should be regarded as the best way to pursue
this objective, particularly when there is
already a well-developed body of law (in the
form of fiduciary duty) that has as one of its
primary objectives controlling the (inevitable)
principal-agent conflicts that arise in com-
panies. One answer that can be given to this
is that fiduciary duty, while appearing from
reported cases to be a strictly formulated
duty, is essentially an ex post standard that is
applied by courts to assess the conduct of
directors and others who may find them-
selves in circumstances in which their per-
sonal interest conflicts with that of their
company (Hansmann and Kraakman, 2004).
The essence of any ex post standard is that its
precise content in any given circumstances
remains subject to some uncertainty until
there has been an adjudication. By way of
contrast, the relatively precise requirements
of the Combined Code can be considered to
be an example of ex ante rules. They attempt
to control principal-agent issues ex ante by
creating board structures and procedures that
will minimise the likelihood of any question
of breach of fiduciary duty arising.5 As rules
they are more precise than the more broadly
formulated standard of fiduciary duty (albeit
narrower in scope), with the result that they
direct companies and directors more clearly
towards compliant conduct.
Comply or explain as a
disclosure obligation
The essence of comply or explain is that it is
a disclosure obligation. In this sense comply
or explain is comparable to the many other
disclosure obligations contained in company
law and listing rules, whose objective is to
inform investors. This section considers first
the nature of the disclosure obligation and
second the manner in which it is envisaged
that comply or explain will operate as a
Volume 14 Number 5 September 2006
488
mechanism that will encourage movement
towards optimal governance practices.
The Listing Rules and disclosure
The Combined Code of Corporate Gover-
nance6 does not form part of the Listing Rules
in the UK. This has the effect that the Com-
bined Code does not have the same legal
status as the Listing Rules, which are made
and can be enforced under statutory author-
ity.7 The UKLA Listing Rules8 do, however,
require that:
In the case of a company incorporated in the
United Kingdom,9 the following additional
items must be included in its annual report and
accounts:
(i) a statement of how it has applied the prin-
ciples set out in Section 1 of the Combined Code,
in a manner that would enable shareholders to
evaluate how the principles have been applied;
(ii) a statement as to whether or not it has com-
plied throughout the accounting period with the
provisions set out in Section 1 of the Combined
Code. A company that has not complied with the
Code provisions, or complied with only some of
the Code provisions or (in the case of provisions
whose requirements are of a continuing nature)
complied for only part of an accounting period,
must specify the Code provisions with which it
has not complied, and (where relevant) for what
part of the period such non-compliance con-
tinued, and give reasons for any non-
compliance.
The statement required by paragraph (i)
is generally referred to as the appliance
statement, while the statement required by
paragraph (ii) is termed the compliance
statement. It can be seen that the Listing Rules
require not just disclosure that there has or has
not been compliance, but a reasoned explan-
ation of non-compliance in respect of each
instance of non-compliance. This approach
forms the basis of the comply or explain
principle, because without adequate explan-
ation in the event of non-compliance there
can be no possibility of the market evaluating
whether or not it is justified.
Monitoring compliance
The disclosure obligation contained in the
Listing Rules provides a mechanism whereby
outsiders such as investors and analysts can
observe and monitor compliance with the
Combined Code. This is not to say, however,
that compliance is an objective matter on
which all observers agree. There is, for ex-
ample, considerable divergence between the
Volume 14 Number 5 September 2006
CORPORATE GOVERNANCE
percentage of companies who consider them-
selves to be fully compliant (47 per cent) with
the Code and those whom Pensions Invest-
ment Research Consultants Ltd (PIRC)
regard as fully compliant (34 per cent).10 More-
over, not all aspects of the Code are capable of
independent verification.11
This point carries implications for the oper-
ation of the comply or explain principle.
A company which believes that it complies
with the Code, but in reality does not, will
not provide a non-compliance statement and
therefore the market will not be called on to
exercise judgement in relation to that issue, at
least not immediately.12 However, as it seems
likely that the market will discover covert
non-compliance over time, the main effect of
differing views of compliance as between
companies and outsiders is to delay rather
than to prevent a finding of non-compliance.
Disclosing non-compliance
The scale of non-compliance
Two views can be taken of the scale of non-
compliance with the Combined Code. One is
that non-compliance is a substantial problem
because less than half of companies are fully
compliant with the Code. According to PIRCs
2004 Report (covering FTSE All Share compa-
nies) only 34 per cent of companies were fully
compliant.13 This would tend to suggest two
possibilities. The first is that the comply or
explain principle is working well and deliver-
ing flexibility to listed companies in respect of
their governance practices. Associated with
this would be the inference that the market
was performing the substantial task of judging
the merits of the (many) instances of non-
compliance. A second and more disturbing
possibility is that the market is not particularly
concerned about non-compliance and that
there are no credible sanctions.
An alternative view of the scale of non-
compliance is that in respect of any particular
provision of the Combined Code, it is rela-
tively low. According to PIRCs 2004 Review,
for example, there is no provision in respect
of which compliance falls below 80 per cent
and there are several in respect of which it is
quite close to 100 per cent (see Table 1). On this
view there remain a number of problematic
issues (such as a fully independent remunera-
tion committee, directors contracts to be one
year or less), but not a systemic problem of
non-compliance.
Reporting non-compliance
The objective of the comply or explain
approach is to allow investors to make
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COMPLY OR EXPLAIN 489

Table 1: Combined Code compliance 2004

Reported (%) PIRC adjusted (%)

Separation of Chairman/Chief Executive 92 n/a

Proportion and number of Non-Executives (1) 97 n/a
Assessment of independence of Directors (2) 99 84
Majority of NEDs independent (3) 94 n/a
Aggregrate of NED provisions (1 + 2 + 3) 89 n/a
Nomination Committee (aggregation of 4 rules)a 85 n/a
Composition of Remuneration Committee 87 52
Composition of Audit Committee 88 74
Fully compliant 47 34

This table measures compliance with the 1998 Combined Code for FTSE All Share companies (excluding
investment trusts) with financial years ending between 1 July 2003 and 30 June 2004 that held an AGM
between 1 November 2003 and 30 September 2004 (522 companies). The data are drawn from PIRCs
Corporate Governance Annual Review 2004.
a
The 1998 Combined Code had four requirements for nomination committees: that they are established
(except for small boards), that they have a majority of independent directors in the boards view, that the
members are identified and that the committee chairman is either a non-executive or the board chairman.

an informed assessment of whether non- commercial benefit in appointing them. Whilst

compliance is justified in the particular cir-
cumstances. An assessment that it is justified
would presumably be followed by acceptance
of the governance arrangements put in place
by the relevant company (no action),
whereas an assessment that it was not justified
would ultimately lead to calls (backed by
votes at shareholders meetings) for the com-
pany to fall into line.
Applying this rationalisation of the process
by which comply or explain rules operate to
the disclosure made by companies is not
straightforward, however. The main reason is
that non-compliance disclosures made by
companies are often extremely brief and unin-
formative.14 They either report no more than
the fact of non-compliance or present reasons
which are so sparse as to give rise to serious
doubt over whether investors could engage in
the sort of assessment referred to above. A
good example is Wm Morrison Supermarkets
PLC, which has a long record of non-
compliance. Its statements regarding failure
to appoint non-executive directors have been
as follows:
1994, 1995 The company does not have any
non-executive directors. Whilst there are no
immediate plans to alter the board structure the
directors will be mindful of the code of best
practice in this regard and will review the
situation from time to time.
1996 The company does not have any non-
executive directors (as required by paragraph 1.3
and section 2 of the code) as the board is
currently of the opinion that there is no
there are no immediate plans to alter the board
structure the directors will be mindful of the code
of best practice in this regard and will review the
situation from time to time
1997, 1998 The company does not have any non-
executive directors (as required by paragraph
1.3 and section 2 of the code) as the board is
currently of the opinion that there is no com-
mercial benefit in appointing them. The directors
are mindful of the code of best practice in this
regard and will review the situation from time
to time.
1999, 2000, 2001, 2002, 2003 The board is made
up entirely of executive directors as the board
is currently of the opinion that there is no
commercial benefit in the appointment of non-
executive directors.
200415 The company does not have any non-
executive directors on the board (A.2.1, A.3.1,
A.3.2, A.6.1). The directors are mindful of the
provisions of the combined code in this regard
and regularly review the situation.
These statements provide very little in the way
of reasoned explanations for non-compliance
with the central provisions of the Code regard-
ing the balance of the board of directors as
between executives and non-executives. The
reference to commercial benefit is a rather
opaque comment and seems overly dismissive
of the accountability objective of the Code pro-
visions. Nor, if the objective is to communicate
that financial performance is likely to be better
without non-executive directors, is the basis
for such a belief made clear. In short, an inves-
tor faced with disclosure of non-compliance in

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490 CORPORATE GOVERNANCE

this form would be unable to engage in any
serious evaluation and would therefore be
faced with either accepting the judgement of
the board or concluding that non-compliance
was unjustified. Moreover, given the restric-
tions imposed by the law relating to insider
dealing and market abuse, it is unlikely that
an investor or analyst would be able to gain
access to non-public information that would
provide the basis for a reasoned assessment of
non-compliance.
Excusing non-compliance
Process and substance of corporate
governance
The discussion above leads towards the con-
clusion that disclosure of non-compliance
does not provide investors with the basis for
making a proper evaluation. Rather, it sug-
gests that instead of engaging in detailed
examination and evaluation of instances of
non-compliance, investors may be routinely
adopting a proxy to judge the merits of non-
compliance. As shown in Table 2, there are
grounds for believing that proxy to be the
financial performance of the company as
measured by its share price. Table 2 shows the
non-compliance record of the major FTSE 100
serial non-compliers alongside the relative
performance of the companys shares over
three different time-periods (one, three and
five years). The five-year timeframe covered
by this table can be regarded as a mature
phase in the implementation of the Combined
Code in the United Kingdom, as the comply
or explain principle had by then been in op-
eration for over ten years and therefore many
of the transitional problems associated with
compliance should have disappeared.16 There
is clearly a link between non-compliance and
outperformance as only 3 of 18 serial non-
compliers record any period of underperfor-
mance during the five-year timeframe.17
At this point it is useful to characterise the
nature of the compliance decision as being a
choice between process (complying fully
with the Combined Code) and substance
(non-compliance, meaning that a company
chooses to create it own solution). Process is

Table 2: Non-compliance with the Combined Code among FTSE-100 constituents by comparison with relative share-price performance
(vs FTSE-100 index)

2004 2003 2002 2001 2000 Relative performance %a

20002001 20002002 20002004

Alliance Unichem CS CS CS CS CS +32 +77 +93

NC
Amvsecap NCS +35 +22 1
CR CR CR CR CR
Antofagasta NED +2 +47 +119
ICA
AUD AUD AUD AUD
CS CS CS CS CS
RC RC RC RC RC
DRC DRC DRC DRC
Associated British Foods CS CS CS CS CS +13 +52 +82
RC RC RC RC RC
AUD
DRC
Boots Group RC RC RC RC +9 +31 +53
DSC DSC
ICA
Bunzl CR CR CR CR CR +32 +85 +99
Carnival Corporation CS CS CS CS CS +4 +70 +152
CR CR
NCS NCS
DRC DRC

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COMPLY OR EXPLAIN 491

Table 2: Continued

2004 2003 2002 2001 2000 Relative performance %a

20002001 20002002 20002004

Compass Group DSC DSC DSC DSC DSC 48 42 44

Daily Mail & General Trust CS CS CS CS CS 11 14 12
RC RC RC RC RC
AUD AUD AUD AUD AUD
NC NC NC NC
SID SID SID SID SID
Liberty Internationalb RC NCS NCS NCS NCS +18 +47 +84
RC RC RC
(AUD) AUD
(NED) NED NED
Reckitt Benckiser CS CS CS CS CS +29 +82 +124
RC RC RC RC RC
SID
SAB Miller RC RC RC RC RC +2 +20 +43
Schroders NV CS CS CS CS CS +32 +10 +3
RC RC RC RC RC
SID SID SID SID
Shell Transport & Trading CR CR CR CR +6 +16 +14
RC RC RC RC RC
British Land CR CR CR CR CR 0 +30 +59
NED
Unilever DSC DSC DSC DSC DSC +21 +66 +78
CR CR CR CR CR
AUD AUD AUD AUD
NC NC NC NC
RC RC RC RC
NED NED NED NED NED
SID SID SID SID
WM Morrison Supermarkets AUD AUD AUD AUD AUD +12 +54 +74
RC RC RC RC RC
NC NC NC NC NC
CR CR CR CR CR
NED NED NED NED NED
AGM AGM AGM AGM AGM
Xstratac AUD AUD N/A N/A +12 +11 N/a
CS CS CS
RC RC RC
ICA

This table records non-compliance with the 1998 Combined Code. The Combined Code published in July 2003 will apply
to reporting years beginning on or after 1 November 2003.
a
The relative performance (R) calculation is based on monthly-average price data. It is derived from the formula R = AS
AF /AF, where AS is the area under the stock price line and AF is the area under FTSE 100 line. This method is used so
as to avoid the distorting effect of calculating relative performance by reference to specific dates, which does not provide
a true indicator of relative performance during the period as a whole. However, stating the relative performance for the
relevant periods by reference to specific dates (i.e. the price at the beginning and end of each period) would still produce
results that support a link between share price performance and tolerance of non-compliance with the Combined Code.
b
Non-compliance in brackets determined by external examiners.
c
One-year performance is from March to December 2002, three-year performance is from March 2002 to December 2004.

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Table 2: Continued
Key to non-compliance codes
NCS No compliance statement or no clear explanation for non-compliance
CR Combined role for chairman and chief executive
NED Non-Executive Director provisions
SID Senior Independent Director provision
AUD Non-compliance with an Audit Committee provision
NC Non-compliance with a Nomination Committee provision
RC Non-compliance with a Remuneration Committee provision
AGM At least 20 working days notice of AGM to be given
ICA Internal control assessment
CS Controlling shareholder presence of a shareholder with a 30%+ shareholding
DRC Directors remuneration contracts (performance-related pay measures)
DSC Directors service contracts (notice periods of longer than one year)
used here to refer to the implementation that
is necessary to give effect to a compliance
decision (e.g. appointing independent non-
executives), whereas substance refers to the
effect of a non-compliance decision, which is
to substitute the companys alternative solu-
tion for the standard solution adopted by the
Code. The process/substance decision can be
compared with the opt in/opt out choice that
a company faces in respect of the (many)
default rules of company law (MacNeil, 2001),
but the two situations are different in that first,
the Combined Code has no formal legal status
and second, no explanation need be offered if
a company decides not to follow the default
rules of company law.
The link between non-compliance and out-
performance can be rationalised if one takes
the view that investors operate a working
assumption that process (the governance
structure set by the Combined Code rules)
trumps substance (non-compliant governance
structures which a company regards as
superior) other than when financial perfor-
mance is sufficiently good, in which case
substance trumps process. The central point
is that investors seem willing to accept a com-
panys judgement as regards substance (the
optimal governance structure) when times are
good, but are less (or not) willing to accept it
when financial performance is poor (i.e. there
is reversion to process). From the behavioural
finance perspective, this can be regarded as a
form of cognitive bias whereby financial per-
formance is over-weighted in investors judge-
ment as to whether a company ought to
comply.
This approach has two consequences. First,
it makes life much simpler for institutional
investors who, when faced with instances of
non-compliance, are left with the relatively
simple question does it work? This has the
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CORPORATE GOVERNANCE
Listing rule 12.43A
A.2.1
A.3.1; A.3.2; A.6.1
A.2.1
D.3.1
A.5.1
B.2.1; B.2.2; B.2.3
C.2.4
D.2
Listing Rule3.12
B.1.4
B.1.7
appeal of being a simpler question than is
it likely to produce better results than the
(default) arrangements established by the
Combined Code? Second, it suggests that
the comply or explain approach is not work-
ing, at least not in the manner that was envis-
aged. That the Combined Code envisaged a
more active dialogue between non-compliant
companies and investors is made clear by the
Hampel Report:18
. . . companies should be prepared to review and
explain their governance policies including any
special circumstances which in their view jus-
tify departure from generally accepted best prac-
tice and on the other hand that shareholders and
others should show flexibility in the interpreta-
tion of the code and should listen to directors
explanations and judge them on the merits.
Comply or perform appears to be a more
appropriate description of the process because
the only real form of explanation that seems to
occur is a demonstration that non-compliant
governance structures carry financial benefits
for shareholders.19
Assessment
It is more difficult to judge whether this out-
come means that the comply or explain
approach has failed. As a disclosure obligation
it does not seem to work other than at the level
of signalling the fact of non-compliance. This
results from the limited nature of the explan-
ations given by non-compliant companies.
As a means of excusing non-compliance, it
appears to work quite well in that investors
actually demand more than explanation, they
require proof that non-compliant governance
structures have a positive impact on perfor-
mance. In this sense, investors have adopted
a stricter test for the approval20 of non-
2006 The Authors
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COMPLY OR EXPLAIN
compliant governance structures than was
originally envisaged21 by the comply or
explain principle. Whether this assessment
remains valid as a general explanation of
investors refusal to tolerate non-compliance
on the part of underperforming companies is
more difficult to judge as our study encom-
passes only those companies with actual
rather than only attempted non-compliance. It
may well be that there are some instances in
which companies have tested the water
with investors as regards non-compliance and
have concluded that it would not be tolerated.
However, in view of the control of the board
of directors over the compliance decision (dis-
cussed in more detail below), we suspect that
this does not occur frequently.
Investors also appear to have abandoned,
within the scope of the Combined Code, the
willingness to make judgements over gover-
nance and constitutional issues apparent in
other fields of company law, where they are
prepared to take a view without any link being
established with share price performance.22
Given that much of company law is concerned
with the principal/agent issues that are the
direct focus of the Code, it is not clear why
there should be such selective reluctance on
the part of shareholders to intervene in
governance issues on the basis of reasoned
argument alone. Perhaps it is simply that the
marginal benefits (if any) to be gained from
direct intervention in the governance structure
of an outperforming company are relatively
small and that in those circumstances it is wise
to defer to the judgement of the Board.
The legal status of the
Combined Code
We observed above that flexibility was a major
consideration supporting the adoption of
comply or explain as the appropriate legal
framework within which the Combined Code
should operate. Flexibility in this context can
be understood in two distinct ways. The first
is the choice that is offered to companies to
comply or not to comply with the Code. In
principle, that choice is already offered in
many other areas of company organisation
and operation by default rules of company
law. It is not clear from the operation of the
comply or explain principle why the Code
could not be integrated into company law as
a set of default rules that would be open to
disapplication through a resolution adopted
at a shareholders meeting.23 The flexibility
that is claimed to result from the comply or
explain principle does not seem to be differ-
ent in nature or degree from the flexibility that
2006 The Authors
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493
would result from adoption of the Code as a
set of default rules in company law.24 The
influence of the market would be broadly
equivalent under either approach as the role
of the market would be to direct the company
towards the optimal governance structure
either by amendment/rejection of default
rules or compliance/non-compliance with pro-
visions of the Code. The main difference is that
comply or explain offers a weaker role for
shareholders and a correspondingly stronger
role for the Board than company law. This out-
come results from the indirect method in
which comply or explain involves share-
holders in the compliance decision. Share-
holders are able to review compliance with the
Code ex post, but are not offered25 an oppor-
tunity to make that decision ex ante. Were the
Code to have the status of a default rule of
law, then following the standard approach, it
would apply unless disapplied ex ante by a
shareholders resolution.26 The strengthening
of the role of the Board in the compliance
decision by comparison with shareholders
appears somewhat ironic in view of the broad
objective of the Code of controlling the prin-
cipal/agent tension in listed companies.
It can also be noted that the approach
adopted in respect of the Combined Code
differs fundamentally from the approach
adopted in the United States to the implemen-
tation of post-Enron corporate governance
measures. The federal Sarbanes-Oxley Act of
2002 and the new listing requirements for pub-
licly traded companies governed by the New
York Stock Exchange are in the form of man-
datory rules, in respect of which companies
have no choice but to comply (Clark, 2005).
Underlying that approach was the idea that
restoration of public trust in public listed com-
panies and the securities market required gov-
ernance changes to be mandated rather than
left to the discretion of companies and markets
(Taylor, 2003).
The second way in which flexibility can be
understood is by reference to the ease with
which the Code can be changed. As a result of
its self-regulatory status the Code does not
have to go through the legislative process that
applies to company or securities law. This has
made a series of changes to the original ver-
sion of the Code possible within a timeframe
that would not be possible if legislative change
were necessary.27 However, the counter-
argument is that the self-regulatory status of
the Code leaves it open to capture by its
sponsors and that it then fails to reflect the
broader public interest in the governance of
companies. Moreover, as the distinction
between matters that are appropriate for the
Code and for mainstream company law
Volume 14 Number 5 September 2006
494
appears quite arbitrary (for example, as noted
above, both have a strong focus on principal/
agent issues), there remains the risk that the
scope of the Code can be expanded in a
manner that supplants the role of mainstream
company law.
Conclusions
The comply or explain approach to corpo-
rate governance has now been in operation in
the United Kingdom for more than ten years.
The scale of compliance has increased over
time, but there remains a significant incidence
of non-compliance. That, in itself, is not a
problem, as the Code did not claim to establish
the optimal governance structure for all listed
companies, hence the opportunity offered to
companies to adopt and explain their own
alternative solutions. The more problematic
issue is how non-compliance is monitored and
excused. On the basis of the data presented in
this paper, it appears that investors tolerance
of non-compliance is linked to some extent
with superior financial performance (in terms
of share price). This is not to say that outper-
formance causes non-compliance, but it does
seem to be the case that investors do not value
reasoned arguments for non-compliance and
prefer to use financial performance as a proxy
to determine when non-compliance can be
excused. Further research may well clarify the
relative significance of this factor by compari-
son with others as well as the process by which
investors monitor compliance.
Comply or explain does not appear to
deliver a role for the market that is in principle
different from that which would result from
the Combined Code being a default rule in
company law that was subject to an annual
application/disapplication resolution each
year at the AGM. The effect of comply or
explain is to distance shareholders from com-
pliance decisions and to strengthen the role of
the Board by comparison with the operation
of a default rule. Shareholders deference to
Board judgement and share price performance
within the field of application of the Code
stands in contrast to their willingness to inter-
vene in other principal/agent issues that fall
within company law but can be rationalised
on the basis that the marginal benefits arising
from intervention are likely to be small.
Finally, if, as is suggested here, financial
(share price) performance has some form of
causal influence over governance structure
(as a result of its link with excusing non-
compliance), then some re-evaluation may be
necessary of the research linking governance
structure with performance, at least to the
Volume 14 Number 5 September 2006
CORPORATE GOVERNANCE
extent that it has been assumed that gover-
nance structures were not influenced by finan-
cial performance.
Notes
1. Many other countries have adopted self-
regulatory codes of corporate governance, but
not all have chosen to follow the comply or
explain principle adopted in the UK. Within
the EU, most member states have now adopted
self-regulatory codes of corporate governance,
but only a minority have adopted the comply
or explain principle. Outside the EU, Canada
and Australia have adopted the comply or
explain principle. See generally the EU Com-
parative Study of Corporate Governance Codes
(Weil, Gotshal & Manges LLP, 2003).
2. The merits of flexibility were viewed by the
Company Law Review Steering Group (estab-
lished by the Department of Trade and Industry
to review UK company law) in the following
terms: Non-statutory regulation enables flexi-
bility and dynamism in the development of
rules and other guidance, while it tends to
permit in appropriate contexts a higher level
of generality or vagueness in expression,
combined with more sensitive discretionary
enforcement to meet the merits of varying
cases (Company Law Review Steering Group,
1999, p. 93).
3. We return to this issue later, when we consider
in more detail the appropriate legal status for
the Combined Code in the light of our study of
serial non-compliers.
4. The opportunity cost of compliance is the cost
associated with compliance with the Code by
comparison with the optimal arrangement.
Views on the optimal arrangement may well
differ as between a board of directors and
investors.
5. In terms of the Hansmann and Kraakman
(2004) analysis, the Combined Code consists of
rules governing appointment rights (to the
board) and decision rights (e.g. as regards audit
and nomination for election to the board of
directors).
6. For the current and previous version of the
Code see the FSA Handbook (Listing Rules)
at http://www.fsa.gov.uk (accessed April 15,
2005).
7. See Part VI of the Financial Services and
Markets Act 2000.
8. See FSA Handbook LR 9.8.6R (at http://
www.fsa.gov.uk). Non-compliance results in
breach of the Listing Rules, which can be sanc-
tioned by public censure, fine or suspension
from listing under the Financial Services and
Markets Act 2000. According to the Weil
Gotshal & Manges LLP (2003) Report, there
have been no instances in which the Financial
Services Authority has taken action against a
company for failing to make disclosures associ-
ated with the Combined Code.
2006 The Authors
Journal compilation Blackwell Publishing Ltd. 2006
COMPLY OR EXPLAIN
9. The reference to a company incorporated in
the United Kingdom makes clear that the
Combined Code does not apply to overseas
listed companies in the United Kingdom. In
this respect the United Kingdom differs from
some other jurisdictions (MacNeil and Lau,
2001).
10. See p. 9 of Pension Investment Research Con-
sultants Corporate Governance Annual Review
2004 (PIRC, 2004) and Table 1 below. Grant
Thorntons (2003) 2003 FTSE 350 Corporate Gov-
ernance Review estimates that 7 per cent of com-
panies fall into this category (p. 2).
11. PIRC comments at p. 9 of its 2004 Review that
interpretation is often required as to whether
there has been compliance as a result of drafting
ambiguities (in the Code) or because there are
different ways of understanding a particular
issue.
12. Assuming of course that the market cannot
independently discover non-compliance as it
occurs. It seems likely that the market will dis-
cover covert non-compliance over time, not
least because reports from organisations such as
PIRC are prepared specifically to inform insti-
tutional investors.
13. The scale of compliance is higher according to
accounting firm Grant Thorntons (2003) 2003
FTSE 350 Corporate Governance Review, which
suggests that 54 per cent of companies were
fully compliant.
14. PIRC comments at p. 9 of its 2004 Report:
Whilst in our experience explanations for
areas of non-compliance have improved, they
still too often represent little more than a state-
ment of the boards disagreement with a pro-
visions appropriateness for the company. This
is an unacceptable response in our view.
15. Since its takeover of Safeway in 2004, Morrison
has appointed two independent non-executive
directors. This process of falling into line can
be linked with underperformance in the share
price since the completion of the takeover.
16. This is not to say that transitional problems can
be ignored. To the extent that the Combined
Code developed and became more demanding
over time (bringing together the recommen-
dations of the Cadbury, Greenbury and Hampel
reports), there were (and still are) transitional
issues.
17. Moreover, in the case of one of the companies
with a period of underperformance (Amvescap
20002004), there were two periods of out-
performace.
18. Committee on Corporate Governance, Final
Report, January 1998, generally known as the
Hampel Report (London: Gee Publishing,
1997) para. 1.11.
19. It is ironic to note that a portfolio constructed
of serial non-compliers would have signifi-
cantly outperformed a portfolio based on fully-
compliant companies over the same period.
20. As noted below, the concept of investor
approval of non-compliance is more theo-
retical than real as the Board of Directors is
in a strong position to control compliance.
However, it is open to investors to exert ex post
2006 The Authors
Journal compilation Blackwell Publishing Ltd. 2006
495
control over such compliance decisions, ulti-
mately by the removal of directors.
21. See note 19 above and accompanying text.
22. It is, of course, possible that investors views on
any governance or constitutional issue may be
influenced by financial performance, but no
link comparable to that which we suggest oper-
ates in respect of the Combined Code has been
demonstrated in respect of those issues.
23. A variant whereby the Combined Code would
be integrated into the system of financial regu-
lation established by the Financial Services
and Markets Act 2000 has also been proposed
(Dewing and Russell, 2004). While that
approach might ensure more effective monitor-
ing and enforcement of compliance, it might
not prove easy to operate the comply or
explain principle within the system of (man-
datory) regulatory rules established under
that Act, from which no deviation is generally
permitted.
24. This issue was not directly addressed by the
Company Law Review Steering Group in
reaching its conclusion that soft law, such as
the transparency provisions underpinning the
Combined Code, should continue to be used
where greater flexibility is needed in applying
or interpreting provisions, and/or where dis-
closure and the pressure of informed opinion
can be an effective mechanism. See Modern
Company Law for a Competitive Economy,
Final Report at http://www.dti.gov.uk/cld/
reviews/condocs.htm (accessed April 15, 2005).
25. A sufficiently large group of shareholders
could table and require circulation among
shareholders of a resolution relating to the
compliance decision or even requisition an
extraordinary general meeting, but these
options do not appear to have been used.
26. Presumably non-compliant companies would
put such a resolution before the AGM each year,
much in the same way that (limited) disappli-
cation resolutions in respect of pre-emption
rights are routinely considered at AGMs.
27. The speed with which the Code has changed
can be contrasted with the slow process of com-
pany law reform following the establishment
of a review group by the DTI in 1998. The
Company Law Reform Bill, which represents
the outcome of the review, is currently before
Parliament.
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Iain MacNeil is the Alexander Stone Professor
of Commercial Law, University of Glasgow.
His research interests, publications and con-
sultancy are primarily in the areas of company
law and financial market regulation. Before
entering the academic world, he worked for an
investment bank in the City of London.
Xiao Li is a PhD student at the University of
Glasgow. His research interests include all
areas of corporate governance, especially
corporate governance and performance,
measurement of corporate performance and
the mutual relationship between corporate
restructuring and corporate governance.
2006 The Authors
Journal compilation Blackwell Publishing Ltd. 2006