This will be an important year for the Financial Reporting Council as it continues its slow transformation and transition into the tougher Audit, Reporting and Governance Authority (ARGA).
The regulator began the year by releasing its annual review of the quality of reporting against the UK Corporate Governance Code that it oversees. Although the latest review looked back to the year that had passed, its conclusions and recommendations could provide an early glimpse of what the future holds.
Commenting on the review’s findings, Sir Jon Thompson—the relatively new chief executive of the FRC—complained of companies “concentrating on achieving box-ticking compliance, at the expense of effective governance and reporting”.
This analysis aptly put its finger on a key challenge facing corporate governance. However, it would seem that companies are likely to employ exactly that approach when faced with the kind of regulator with stronger statutory powers that ARGA is envisioned to be.
Focus on flexibility
Despite the worrying trends exposed by the FRC’s review, both investors and boards continue to favour the kind of flexibility that the UK Corporate Governance Code has offered up to this point.
The code has underpinned the UK’s approach to corporate governance since the early 1990s and readily distinguishes the UK from many other jurisdictions, perhaps most notably the US.
The Sarbanes-Oxley Act, introduced in 2002, imposes a formal, extensive and detailed catalogue of governance rules upon American firms. To date, the code—with the FRC as its custodian—has largely allowed the UK to preserve a set of corporate governance norms that are non-legally binding, and easily understood and widely implemented by boards.
Arguably the most crucial aspect underlying the code’s success has been the principle of “comply or explain”, allowing UK-listed companies to explain their decision to diverge from specific requirements of the code while continuing to adhere to its principles.
Such an approach has thus far allowed the UK to steer clear of adopting a mandatory and legalistic set of standards that would be likely to encourage the perfunctory form of compliance by companies that Sir Jon Thompson rightly bemoans.
As the FRC completes its institutional overhaul and embarks on life as ARGA, it will be leaving behind the kind of inclusive “soft law” regulatory philosophy described above that has long underpinned the British approach to corporate governance.
Though the criticism of the FRC as a “toothless” audit watchdog may be warranted given that quality and reliability of audit continues to be questioned, the regulator in its existing incarnation has proved to be an apt overseer of the code.
As a matter of priority, policymakers should re-examine the case for entrusting oversight of the code to the new statutory audit regulator. It remains unclear how a statutory regulator tasked with disciplining audit firms will do much to encourage corporate engagement with the spirit of good governance. Such a regulator is more than likely to foster a wholly inappropriate formulaic and overly legalistic interpretation of the code.
As the new FRC CEO readily recognises, good governance is not a matter of complying with a multitude of hard and fast rules. Rather, good governance ought to entail applying principles developed with participants in a suitably flexible manner with a view to circumstances of individual companies.
An alternative approach
An alternative institutional design that policy makers may wish to consider is the establishment of an independent Corporate Governance Commission—similar to the German model—which effectively involves boards and their stakeholders, including institutional and retail investors, academics, auditors and trade unions.
The German approach not only embeds a high level of engagement by relevant business and civil society stakeholders but also works to ensure that the best practices articulated in the codes reflect the practical needs and experiences of market participants, as well as regulatory perspectives.
Adopting such a framework in the UK would allow ARGA to concentrate on its core task of improving the integrity of the statutory audit process while allowing the commission to preserve the flexibility and pragmatism that has long characterised UK corporate governance.
Carum Singh Basra is corporate governance policy adviser at the Institute of Directors.