Why Corporate Governance Codes still have a function to perform

Our recent paper (‘Thirty Years and Far from Being Done – Is It Truly Time to Abolish the UK Corporate Governance Code?’) discusses the arguments raised in an article by B. R. Cheffins and B. V. Reddy, entitled ‘Thirty Years and Done – Time to Abolish the UK Corporate Governance Code’ (the related OBLB post is available here), which calls for the abolition of the UK Corporate Governance Code (hereinafter, the UK Code) on the grounds of significant market benefits. Their view is that this would avoid duplication with respect to corporate governance principles already included elsewhere, and prevent the downsides of the abused box ticking habit; most importantly, the abolition of the UK Code could help to revive the UK's flagging equity markets.

Even though their considerations are limited to the United Kingdom, the pre-eminent role of the UK Code justifies some reflections upon the continued relevance of Codes in continental Europe, and particularly in Italy, which, like other EU countries, embraced the idea of corporate governance Codes long ago.

Corporate Governance Codes have been adjusted to new challenges in a flexible, swift, and innovative manner, for instance, by promptly incorporating sustainability-linked recommendations, while preserving one of their distinctive figures, ie mainly reputational sanctions.

At the same time, shareholders and stakeholders long for governance rules that strengthen managers’ accountability. This goal cannot be achieved through mere corporate and index guidelines. Rather, a joint effort of the Corporate Governance Codes and of the Stewardship Codes is needed. Such coordination is called for because we need to harmonize some basic aspects of engagement, such as how it is initiated and carried out, what it may focus on, what disclosure, if any, should precede and follow it, and so on.

Furthermore, Codes have often had the merit of facilitating considerable experimentation, and this feature is anything but outdated in the current ESG era, which would definitely take advantage of the flexibility provided by this tool.

After all, when Cheffins and Reddy argue that substantial compliance with the UK Code would still continue to be the rule even after its repeal, they acknowledge that the UK Code has performed well and that its recommendations are still relevant.

We agree with Cheffins and Reddy when they state that the ‘box-ticking’ approach has always been a pernicious element of Corporate Governance Codes. Yet, this practice is often prompted by proxy advisors and those unwilling to grasp the tailor-made content of the Codes’ recommendations. It is not an inherent feature of the Codes themselves. An incorrect application of the Codes, however widespread, should not deprive us of such a useful and versatile tool.

The need to distinguish the remarks related to the UK Code from those relating to continental Europe’s Codes becomes all the more striking when Cheffins and Reddy address the issue of the increasing governmental connection (ie, of the ‘quasi-governmental’ nature) of the Financial Reporting Council (‘FRC’), which is the body in charge of drafting and updating of the UK Code. Indeed, the FRC case appears to be an isolated one. Even in Germany, where the corporate governance code commission is appointed by the German Federal Minister of Justice and Consumer Protection, its members are selected from representatives of the management and supervisory boards of German listed companies and their stakeholders. Elsewhere in continental Europe we can only observe an increased but still vague interest of public bodies in the shaping of such Codes.

Moreover, even the link that Cheffins and Reddy identify between the costs increases stemming from more pervasive governance rules and companies’ delisting is weaker than it looks at first sight. While red tape is indeed a burden for listed companies, a high number of delisting transactions cannot easily be ascribed to the Codes’ impact: firms may exit public markets for a number of additional reasons which are likely to weigh more heavily in that decision than the burdens stemming from Codes.

The fact that—as Cheffins and Reddy note—in the US the only equivalent to Codes are the Commonsense Principles of corporate governance (which are not based on the comply or explain mechanism) does not mean that the comply or explain principle has no place in the US altogether, let alone that it should have no role elsewhere. While it is not widely used as an instrument of soft law in the US, it plays an important role in federal corporate governance statutes, namely, in the Sarbanes-Oxley Act and in the Dodd-Frank Act.  

That comply or explain can still serve a useful function, especially in signaling virtuous governance practices to investors, does not mean that it cannot be improved. In our paper, we suggest a refinement of the principle: explanations should only be required when their disclosure serves investors’ interests. Hence, we propose that the rule should be reformulated by requiring explanations: (1) following the determination by the company itself that they are useful; (2) when they are requested by a qualified minority of shareholders at the annual meeting.

Italy’s experience with its Corporate Governance Code supports our claims that Codes are flexible tools and that a box-ticking approach is not a necessary outcome of Codes.

As regards flexibility, the Italian Code, much like the UK’s and others, evolved since its first edition in 1999 to keep pace with the international debate on corporate governance. Most recently, its 2020 version steps up to the challenge of incorporating the new stakeholderist ethos for instance by identifying as one of the goals of the corporation the pursuit of its ‘sustainable success’, defined in turn as the creation of value in the long term for the benefit of shareholders, taking into account the interests of other stakeholders relevant to the company.

In the meantime, as a result of the transposition of an EU directive into the Italian Consolidated Law on Finance, the comply or explain principle became a statutory requirement and, by requiring companies to provide specific reasons for non-compliance, was formulated in such a way as to avoid box-ticking. As a matter of fact, mere compliance with the Code is not a foregone conclusion, as companies in fact disclose (and provide explanations for) various deviations from its recommendations.

Piergaetano Marchetti is Emeritus Professor of Company and Business Law at Bocconi University, Italy.

Maria Lucia Passador is Academic Fellow in Company and Business Law at Bocconi University, Italy.