Boards risk being hamstrung by regulation, opting to comply rather than explain, even where there are unintended consequences

There is increasing pressure on and scrutiny of listed boards across Europe and in the US. In the UK, some influential voices have criticised non-executive directors for being out of touch, and having too narrow a perspective on value creation. There is concern that boards are being hamstrung by regulation, and the chilling effect of rigid assessment criteria imposed by proxy advisors and other assessors.

There is clearly a public expectation for listed company boards to be accountable and demonstrably adding value. A key aspect of effectiveness for a board is judgement around decision-making capability, cognitive diversity, self-awareness as a board, ability to navigate complexity and alertness to shareholder and stakeholder expectations.

As regulation and governance requirements increase, we frequently hear the concern expressed that boards are expected to comply and there is no tolerance for explanation. If true, where does judgement fit in?

Comply or explain is an important building block of UK corporate governance and has been adopted by a number of other codes internationally, including those in Germany and South Africa. Yet boards and chairs, for the most part, opt to comply. There are a number of reasons for this.

Chair tenure is one driver. The UK’s Financial Reporting Council was clear in introducing a nine-year overall tenure limit for chairs in the 2018 of its Corporate Governance Code. It was acknowledged there might be good reasons for a chair to stay on longer. This could include succession planning considerations that might, for example, be related to increasing diversity.

Unintended consequences

To the surprise of many, UK companies quickly complied – rather than explained – and this rapid compliance had the unintended initial consequence of reducing the already small proportion of female chairs.

Another governance topic on which a number of boards feel constrained is remuneration, for example, when competing for international executive talent. This can also impact access to talent. Some boards are willing to explain to investors rather than comply, but many find the process of engaging in order to explain to be practically virtually impossible.

Another reason boards are hesitant to adopt the explanation route - even if it might be a sensible course of action for the company - is the difficulty in engaging with shareholders. Individual shareholders have become a rare species, and most voting at AGMs is by institutions who vote by proxy. Many will follow the guidelines provided by proxy advisors, and vote in accordance with their recommendations on specific issues.

No room for nuance

While proxy advisors perform a useful function and reduce the analysis and voting workload for institutional shareholders, the volume of AGM resolutions they deal with means their recommendations can lack flexibility and nuance. And while some companies with sufficient market capitalisation may engage with advisors and shareholders directly to explain their position, it can be difficult for smaller companies to get the airtime to do this.

Shareholders surely want boards that are capable of exercising discretion and good judgement: they should arguably therefore feel short-changed if boards feel unable to exercise judgement on governance issues and at times be willing to explain rather than comply.

Of course, there is much that companies and boards can do to enhance shareholder engagement, but shareholders also have a role to play in fostering good judgement. It is hoped the UK Stewardship Code, still relatively new and focused on demonstrating engagement rather than largely theoretical policies, will bring about an improvement in this area.

There are risks for both companies and investors from a tick box approach to governance. On limited issues under specific circumstances there is surely merit in companies being prepared to engage with investors and to explain why the board has considered it appropriate – typically for a limited period of time - not to comply with a particular aspect of the Corporate Governance Code.

The judgement muscle is critical for boards and for companies. Shareholders and stakeholders benefit from effective governance. This implies boards with a good understanding of governance and what underlies expectations. At times and in limited circumstances, the right course of action for the company may involve non-compliance. It would be to the detriment of both shareholders and stakeholders, if boards lost the discretion to explain.

Fidelio is focused on developing high-performing boards and leadership teams characterised by sound judgement and the willingness to be guided by that judgement.

Gillian Karran-Cumberlege is founding partner of Fidelio.