Less is more - a critical view of further EU action towards a harmonized corporate governance framework in the wake of the crisis.

• Published date: 01 January 2013
• Author: Wen, Shuangge
• Date: 01 January 2013

C. Current Procedural Harmonization: The Code-based Approach and Comply-or-Explain

1. The Background of Procedural Harmonization

Recognizing many Member States' calls for more flexibility, a combination of legislation and soft law enabling a "bottom-up" convergence and a broader use of alternative instruments to primary legislation have been stated as a main theme of EU action on corporate governance in the new millennium. It is suggested that a harmonized framework should be achieved over time via "a certain coordination" of national codes of practices based on "best practices," reflecting the tremendous growth in voluntary codes and guidelines in Member States during the past few decades. (141) Compared to traditional directives, which produced "a certain 'petrifaction"' (142) of corporate performances, these corporate governance codes are generally developed on a national basis and "bring a firm considerable legitimacy" (143) by reflecting what public or private organizations consider to be best practices. As described by the recent comprehensive EU report on corporate governance codes, "[t]he codes--together with market pressures--may serve as a converging force, by focusing attention and discussion on governance issues, articulating best practice recommendations and encouraging companies to adopt them." (144)

When delineating the new code-based approach, sweeping uniform European corporate governance code was rejected on the grounds that the specificities of Member States' corporate governance systems are so influential that a common EU code would either be meaninglessly abstract, or would become a very complex document aiming to be inclusive of all contingencies arising from diverse local practices and rules, which would not bring significant changes to the current landscape. (145) This accords with the well-accepted idea that European integration would work best when it supports, rather than undermines, the idiosyncratic values of Member States. To put this in a broader context, one might suggest that this code-based approach is one of the many responses to the forceful academic criticism of the excessive supranationalism exhibited in early Union harmonization practice. (146) Indeed, few would now disagree that a positive interventionist role should only be assumed by the Union in a cautious fashion, when its superiority over national or local action can be demonstrated. The principles of subsidiarity and proportionality contained in Article 5 of TEU are precisely constructed to tackle this issue by acknowledging the necessity of penetrating Union intervention in certain areas. (147)

To facilitate the anticipated trend of bottom-up convergence, the European Commission turned its attention to positively harmonizing not the substance, but rather the enforcement mechanisms, which, as will become clear, has been a rather disappointing process. Two further moves were introduced by the European Commission to accompany the code-based harmonization efforts. These were the establishment of the European Corporate Governance Forum in 2004 and the enshrinement of the Comply-or-Explain approach as imposed by Directive 2006/46/EC. (148) Under Article 46(a) of the directive, it is compulsory for a listed company to include a corporate governance statement in its annual report with reference to the national corporate governance code to which the company is subject. (149) While directives and recommendations continue to be introduced in specific areas, the code-based approach supported by mandatory application of the comply-or-explain principle is now scholarly termed "procedural harmonization," (150) and it operates as the major European approach to corporate governance. (151)

2. Doubts on Comply-or-Explain and Procedural Harmonization

The concept of comply-or-explain that underpins procedural harmonization initiatives first came to prominence in 1992 and is marked by the release of the Cadbury Report on the Financial Aspects of Corporate Governance. (152) It became mandatory in 2000 in the UK via the listing rules of the Financial Services Authority before it was introduced into the European corporate governance framework. (153) One impetus behind the EU espousal of this system was to relieve businesses from regulatory burdens and bureaucracy imposed by early efforts towards Europeanization. (154) Under Article 46(a) of Directive 2006/46/EC, companies are entitled to derogate from the principles explicated in the codes if clear explanations can be offered in annual reports for such derogation, which stands in sharp contrast to mandatory systems. (155) Compared with mandatory legislation, this comply-or-explain approach can better accommodate companies' individual circumstances, particularly the size and complexity of the company and the nature of the risks and challenges it faces. (156) Allowing consideration of the dynamic divergence and complexity of corporate practices, justified non-compliance encourages directors to modify their governance strategies and approaches in the light of evolving circumstances, and the flow and quality of information provided in the explanation can assist shareholders in appreciating the soundness of managerial decisions and pressing for a strategic change if they are not satisfied. (157)

Taking account of the disappointing results of previous substantive harmonization measures, this soft approach has been preferred by EU regulators since 2002 because it "fits well with the differences between national legal and governance frameworks," as well as "the variety of situations of individual companies." (158) From a practical perspective, there is a mandatory rule to either comply or explain, but the alternative of explaining non-compliance turns the actual governance guidelines contained in the Codes into optional rules. (159) It was also hoped that a constant flow of information regarding corporate practices might be assured via the implementation of this approach, providing a foundation for further legislation at the EU level. (160) Contemplating its anticipated advantages in comparison with mandatory systems, it came to prominence as the foundation of the new flexible EU corporate governance framework and was seen as the key to attaining long-term harmonization in the field. (161)

The EU's experience with the comply-or-explain approach, however, again challenges the effectiveness of the Union's integration activities regarding corporate governance. It further proves the point that a good national rule for corporate governance does not necessarily work as efficiently at the European level. Before being adopted into the EU corporate governance framework, the comply-or-explain approach was known as "the trademark of corporate governance in the UK," (162) and it has been in place since the beginning of voluntary codes. In the United Kingdom, where the comply-or-explain principle originated and has flourished, the approach has been well received by businesses and is highly praised for its flexibility. (163) Data also shows satisfactorily high rates of compliance with most provisions of the UK Corporate Governance Code by companies of all sizes. (164) When companies do deviate from the Code, most manage to clearly set out their reasons and the arrangements that they put in place to provide alternative safeguards. (165) The efficiency of the comply-or-explain principle has been nevertheless challenged ever since its arrival in European law. Recent studies described by the Green Paper cast doubt on its efficacy as an EU policy, referring to it as "reduc[ing] the efficiency of the EU's corporate governance framework and limit[ing] the system's usefulness." (166)

Much of the criticism so far has been pinpointed at the inherent flaws of comply-or-explain without challenging the unnecessary Union regulatory intervention. The flexible code-based system has been championed by the UK over the past fifteen years because of the prosperity of the UK's market-based economy and the strong role played by the London Stock Exchange as a self-regulatory body. (167) The comply-or-explain principle, reflecting its embedded environment, is principally based on the strong role played by the market in corporate control, primarily disciplining non-compliant companies by lowering their share prices. (168) This market-based economic background and self-regulatory tradition are not present in many of the other Member States, which calls into question the suitability of this approach in other nations. In practice, the sweeping implementation of comply-or-explain across Europe has had a more disruptive effect on national enforcement systems, which were established and operated in a coherent manner before the community measure. In over 60% of deviations, the principle has been abused by companies failing to provide sufficient explanation when they chose not to apply recommendations from the codes; "they either simply stated that they had departed from a recommendation without any further explanation, or they provided only a general or limited explanation." (169) It was suspected that many companies supported the comply-or-explain concept merely because they could easily get away with deviations. (170) With regard to the requirement of the German Corporate Governance Code to disclose the remuneration of company executive directors on an individual basis, only a small minority of firms (10 out of 126 in a 2002 sample and 22 out of 146 in a 2003 sample) actually complied with the suggestion. (171)

The efficiency of the comply-or-explain principle in European harmonization becomes even more questionable because the EU mandates the implementation, yet fails to cater for the complementary need for proper monitoring and disciplining mechanisms. This issue, according to Article 60(a) of the directive, is tackled by way of "self-governance" in Member States, which generates a multifaceted picture. (172) A number of different...