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Erasmus School of Law Chris Hodge Erasmus University Rotterdam Corporate Governance Unit Burg. Oudlaan 50 Financial Reporting Council Room L4-32 Fifth Floor P.O. Box 1738 Aldwych House 3000 DR 71-91 Aldwych ROTTERDAM The Netherlands London WC2B 4HN Tel: +3110 - 408 1568 The United Kingdom Fax:+3110 - 408 9144 galle@frg.eur.nl Rotterdam, May 28, 2009 Subject: Comment on the Review of the Effectiveness of the Combined Code Dear Mr. Hodge, We have taken notice of your invitation as published in March 2009 to comment on the effectiveness of the Combined Code and fully approve your efforts to test the Code’s content and application against the fresh thinking that the financial crisis must provoke. Although we have no experience with the application of the Combined Code as such, we hereby take the liberty of responding to your invitation from a Dutch perspective. In the Netherlands we have a comparable corporate governance code with a ‘comply or explain’ mechanism since 2004. We would like to share our experiences with the application of the Dutch code against the background of the current financial crisis to contribute to your discussion in the United Kingdom. The comments below focus on the ‘comply or explain’ mechanism of the Combined Code (more specific par. 13 to 15 of your invitation to comment) since undersigned conducts PhD research to the application of the ‘comply or explain’ mechanism in the European Union as ...

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Extrait

Erasmus School of Law

Erasmus University Rotterdam

Burg. Oudlaan 50

Room L4-32

P.O. Box 1738

3000 DR

ROTTERDAM

The Netherlands

Tel: +3110 - 408 1568

Chris Hodge

Corporate Governance Unit

Financial Reporting Council

Fifth Floor

Aldwych House

71-91 Aldwych

London WC2B 4HN

The United Kingdom

Fax:+3110 - 408 9144

galle@frg.eur.nl

Rotterdam, May 28, 2009

Subject:

Comment on the Review of the Effectiveness of the Combined Code

Dear Mr. Hodge,

We have taken notice of your invitation as published in March 2009 to comment on the

effectiveness of the Combined Code and fully approve your efforts to test the Code’s content and

application against the fresh thinking that the financial crisis must provoke. Although we have no

experience with the application of the Combined Code as such, we hereby take the liberty of

responding to your invitation from a Dutch perspective. In the Netherlands we have a

comparable corporate governance code with a ‘comply or explain’ mechanism since 2004. We

would like to share our experiences with the application of the Dutch code against the

background of the current financial crisis to contribute to your discussion in the United

Kingdom.

The comments below focus on the ‘comply or explain’ mechanism of the Combined Code (more

specific par. 13 to 15 of your invitation to comment) since undersigned conducts PhD research to

the application of the ‘comply or explain’ mechanism in the European Union as supervised by

Professor Auke de Bos at the Erasmus University Rotterdam in the Netherlands.

In this comment we want to share our view - as coloured by our Dutch experiences - on the

‘comply or explain’ approach to contribute to the discussion on its effectiveness and the current

concerns. We start below with stressing the significant advantages of and positive developments

due to the ‘comply or explain’ mechanism. Thereafter, we consider its flaws and issues to

improve. Information on the experiences with the ‘comply or explain’ mechanism in the

Netherlands is provided for below. But above all, at the end of this comment we emphasize -

based on the experiences with its applications in the Netherlands and our own research - several

key issues that should receive attention to keep the ‘comply or explain’ mechanism effective in

the current and future timeframe.

Advantages and disadvantages of the ‘comply or explain’ mechanism

As almost all EU countries, in the Netherlands we opted for self-regulation with respect to

corporate governance. The Dutch Corporate Governance Committee phrases its preference for

self-regulation as follows: “

The particular merit of the Code as an instrument of self-regulation

lies above all in its influence on the behaviour of management board members, supervisory

board members and shareholders. The strength of the Code is proportionate to the extent to

which the company’s stakeholders endorse it and try to comply with it

” (Preamble 5 of the Dutch

Code). We believe that the ‘comply or explain’ mechanism has some major advantages above

compliance reached by hard regulation (as likewise stated in par. 13 of your invitation to

comment)

Codes and the ‘comply or explain’ mechanism are effective in stimulating discussion about

corporate governance issues. They educate the general public and investors about corporate

governance practices. Furthermore, they prepare the grounds for changes in company law

and securities law where such changes are deemed necessary;

‘Reputational’ and market forces can result in a high level of compliance; the capital market

will monitor the compliance and will penalise non-compliance through lowering share prices

or accept that non-compliance is justified in the specific circumstances. Improvements in

enforcement of and compliance with corporate governance regulation are more often the

result of bottom-up approaches (e.g. corporate governance codes), rather than top down

efforts (e.g. SOX).

Companies do not want lengthy explanations in their annual accounts

and therefore they comply except for those few points on which they have strong

justification for deviation;

A major advantage is that the ‘comply or explain’ mechanism has made corporate

governance practices much more transparent: due to the mandatory disclosures by the

‘comply or explain’ mechanism, the transparency regarding corporate behaviour of the

company and its directors has improved significantly.

The above advantages and achievements by the ‘comply or explain’ mechanism give raise to the

belief in its effective functioning.

However, in the current crisis the ‘comply or explain’ mechanism is being tested to a greater

extent than ever before (par. 5 of your invitation to comment). To remain its effective

functioning the flaws and the concerns raised on the ‘comply or explain’ approach (par. 15 of

your invitation to comment) should be acknowledged and challenged in the current and future

timeframe:

By all means the ‘comply or explain’ mechanism improves the formal compliance with

corporate governance codes. In their corporate governance chapter/paragraph/charter

companies state that they comply with the provisions of the applicable code, but difficult is

to verify whether they actually do comply with these provisions in practice. Material

compliance with the code is hard to measure and monitor; a problem which is inherent to the

chosen model. Nevertheless, constant attention for and supervision on actual material

compliance is a necessity to minimize this problem;

A new development is that in addition to the shareholders, others (such as auditors and

securities authorities) obtain a supervisory role regarding the ‘comply or explain’

mechanism as well. Although the shareholders only can examine compliance with the code

ex post, it is argued that this role should be reserved for the shareholders, since they are the

ones investing their capital in the company. A growth in supervisors is understandable due

As studied by Berglöf and Claessen (E. Berglöf and S. Cleassen (2004), Enforcement and Corporate Governance,

World Bank Policy Research Working Paper No. 3409) and Coombes and Wong (P. Coombes

and S. C. Y. Wong

(2004), Why codes of governance work. Corporate governance codes are definitely effective – within limits, The

McKinsey Quarterly No. 2 2004: pp. 48-53).

to the lack of supervision on the ‘comply or explain’ mechanism by the shareholders itself.

Therefore, awareness of their supervisory role, task and possibilities ought to be created and

emphasized, especially in the current circumstances;

The success of the codes also gives rise to the danger of ‘regulation creep’. New versions of

the already existing codes are much lengthier and add more detail. As a result of this,

compliance ‘made to measure’ becomes increasingly difficult. The authors of new versions

should closely consider the application of the comply or explain principle in practice and

from there on decide which additions, modifications or deletions in the new code are

necessary to keep the code efficient and feasible to comply with;

Overemphasis on compliance rather than explanation is a current worry. There is a tendency

to ‘comply or breach’; good corporate governance within a company is judged by ticking off

boxes instead of a deeper analysis of deviations ‘made to measure’. This threatens the

flexibility of the codes, which is one of their fundamental virtues, and can even lead to a

‘one size fits all’ mentality. Companies and board members should be challenged to analyze

their actual compliance with the code properly and if necessary give ‘made to measure’

explanations. This responsibility ought to be emphasized

in codes and considered as a part

of the policy or exercised supervision that directors annually want to be discharged from by

their shareholders.

Experiences from the Netherlands

Apart from the key advantages and flaws that need our attention above, several

recommendations can be derived from the application of the ‘comply or explain’ mechanism in

practice as well. In the Netherlands the Dutch Corporate Governance Code (as effective since 1

January 2004 and recently modified in 2008) incorporates the ‘comply or explain’ mechanism in

best practice provision I.1. Additionally the code itself and the ‘comply or explain’ mechanism

have gained legal force by special legislation since 1 October 2004 (sec. 391 par. 4 of Book 2 of

the Dutch Civil Code and sec. 3 of Staatsblad 747, 2004). The Dutch Monitoring Committee

Corporate Governance monitors each year the operation of the Dutch Corporate Governance

Code and its implementation. From its monitoring reports can be concluded that there seems to

be a general willingness to comply as much as possible with the corporate governance code and

companies only deviate/explain when necessary (an average of 5 explanations per company).

Certain trends are visible with regard to those parts of the code that are not always complied

with. A number of provisions figure constantly in the top 5 deviations, accompanied by a

specific set of explanations. The last 4 or 5% of the code seem hard to comply with. Either the

provisions are too detailed or other factors are at play. Possibly, these provisions need

adjustments or should be transferred to company law or securities law. The committee also drew

attention to the rather vague explanations such as the phrase ‘the company has its own

regulations’. Although more research is required, the increased standardization of the

explanations by deviations with code provisions is not a desirable development.

Such as in the recently modified Dutch Corporate Governance Code in Principle I: “

The management board and the

supervisory board are responsible for the corporate governance structure of the company and for compliance with this

code. They are accountable for this to the general meeting and should provide sound reasons for any non-application

of the provisions

”.

Recommendations

We believe that the ‘comply or explain’ mechanism is the most suitable approach for disclosure

on corporate governance by listed companies. Nevertheless, we recommend based on the above

that the following key issues should receive attention to keep the ‘comply or explain’ mechanism

effective in the current and future timeframe:

The quality and clarity of explanations due to the ‘comply or explain’ mechanism need

attention to prevent overemphasis on compliance rather than on proper explanation of the

code provisions;

Awareness for, supervision on and prevention of formal compliance whilst no material

compliance exists is necessary;

The authors of new (versions of) corporate governance codes should be aware of

overregulation and too many details which make compliance ‘made to measure’ difficult.

Provisions hard to comply with should if necessary be transferred to legislation or gain extra

attention from both supervisors as companies and directors the code is applicable to;

Especially in the harsh economic conditions under which companies are operating currently,

the transparency and disclosure on corporate governance practices by the ‘comply or

explain’ mechanism should be closely monitored and promoted to enhance its effectiveness.

The mechanism’s key strengths - transparent, flexible, ‘made to measure’, current and to

monitor compliance - should equally be embraced and guarded.

To conclude, we hope you will find the above to be a relevant contribution to your efforts and

would be happy to provide you with any additional information you may request.

Yours sincerely,

Business economics department of the law faculty of the Erasmus University Rotterdam

Assistant Professor Annika Galle

Univers
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