INTRODUCTION

1. The "Comply or explain" principle :From a simple financial markets regulation to a wide method of regulation ?By Alain COURETProfessor at the Sorbonne School of Law

2. INTRODUCTION • The «comply or explain» principle was born in the field of financial markets regulation. • It is a technique that aims at ensuring transparency, by inducing a listed company either to sign up to a corporate governance code, or to explain why it does not apply such a code, or why it derogates from the provisions of this code. • It seems to be in the service of corporate governance and intends to improve the dialogue between companies and investors.

3. INTRODUCTION • The “comply or explain” principle is based on the idea that there is not a “ready-to-wear” approach in corporate governance ("one size fits all"). • A single governance structure is not desirable; instead, a certain mix of models should be accepted. • Nevertheless, some common standards can be developed ; a reference framework can be established that offers a guideline of best practices from which corporations may deviate if they explain their choice.

4. INTRODUCTION • Sometimes, the reference framework is dictated by the legislator, sometimes it is freely chosen. • Companies can thus build their own referential and deviate from the given framework.

5. EXPECTED ADVANTAGES : ● For corporations • The “comply or explain” principle is believed to improve corporations’ competitiveness, because the cost of compliance with a corporate governance code is lower than the cost of compliance with regulation, such as the Sarbanes-Oxley Act. • Moreover, this principle advocates a more flexible approach that allows companies to adapt themselves faster in a competitive environment. ● For the market • The main objective of the “comply or explain” principle is to reinforce the standards of good corporate governance in listed companies (“comply”), adding to legal requirements. • It provides at the same time a flexible framework that takes into account the specificities of each listed company particularities (“explain”).

6. HISTORY • 1992 Cadbury Report in UK was drafted to be applied according to the “comply or explain” principle: “Listed companies … should state in the report and account whether they comply with the Code and identify and give reasons for any areas of non-compliance”. • In 2000, UK imposed the application of this principle through the Financial Services Authority’s listing rules. • In Europe, the “comply or explain” principle was established by the directive of June 14, 2006.

7. OBJECTIVE • First, we will try to underline the modes of implementation of this principle by the financial markets regulation (I). • Second, we will try to examine whether we could consider this simple principle of financial markets regulation as a more general regulation model (II) ?

8. I - The modes of implementation of this principle by the financial markets regulation • How should the principle be implemented ? (A) • Which sanction should be provided in the event of the violation of the principle ? (B)

9. A - How to implement the principle? Three distinct recommendations in the European directive. • Apply a governance code or explain why we do not apply any code; • Comply with the code or disclose the derogations; • Disclose and explain why we do not comply.

10. 1 - Apply or explain The European directive of 14 June 2006 considers two hypotheses: - a company voluntarily refers to a Code (a), • or a company does not voluntarily refer to a Code (b). a. “When a company voluntarily refers to a corporate governance code…” Which Code could it be?

11. The majority of the European Member States chose to impose a single code France dit not apply this option

12. b. “When a company does not refer to such a corporate governance code…” ● Firstly, the chairman of the board shall indicate, in a annual report , “the chosen rules in addition to the legal requirements”. ● Moreover, the report shall explain the reasons why the company has decided not to apply any of the corporate governance code’s provisions.

13. 2 - Comply or disclose We assume that a Code has been selected. However, the company does not want to apply the whole code. • It must indicate which parts of the code it derogates from (“comply or disclose”). • This has been adopted by the German legislator, before the adoption of the European directive.

14. 3 - Disclose and explain • Formally, the explanations are often included in the annual report. • However, some Member States, such as Germany and Norway, are more demanding, and require a distinct specific report.

15. WHAT IS THE REAL EFFECTIVENESS OF PRACTICES IN THIS AREA ? The studies conducted on the European governance practices are very interesting. It can be noticed that : - 23% of the companies supplying “comply or explain” information were fully compliant. - 77% of companies reported at least one difference with the corporate governance code. The issues that differ from the Code’s recommendations are the following : • Administrative or supervisory board (35% of explanations) • Remunerations (28%) • Shareholders’ duties and rights (7%) • Audit (11%)

16. FRENCH SITUATION Now, let us examine the last report issued by the French AMF on the corporate governance and on the internal control : - Whereas 81% of the companies quote the AFEP-MEDEF Code as a reference code in corporate governance, 67% of them declare that they derogate from certain of its provisions. - More than 20% of the companies quoting the AFEP-MEDEF code do not respect the “apply or explain” principle by not giving any justification on this partial compliance (“never complain, never explain”?).

17. B – Which sanction for the principle ? • The underlying hypothesis is that the sanction is a non legal one (“soft law”)(1). • But we can also imagine legal sanctions (2).

18. 1 - Non legal sanctions - Sanctions take place mainly through the investors’ behaviour. - Some of these investors, for example the institutional investors, may be very powerful and dictate to companies in which they have invested, the respect of soft law rules. - If the companies do not respect those rules or do not give any convincing explanations, the investors can vote with their feet.

19. 2 - Legal sanctions - Firstly, we should refer to the administrative repression which is based on a breach of the competent authority of General Regulation : this regulation penalizes the communication of misleading information. - Criminal sanctions seem hardly conceivable. The legal basis of these sanctions is the offence of wrong or misleading information. - The managers’ civil liability is also hardly conceivable. How to prove the causal link between the misleading declaration of compliance or non compliance and the damage suffered ?And which damage?

20. II – The possible generalization of this principle as a model of regulation The principle is a feature of financial markets regulation in many countries worldwide and particularly in Europe. Should this principle be generalized Generalization of this model faces many obstacles : - Firstly, the model has to deal with its own limits (A). - Moreover, the application of the principle to other areas seems to meet additional obstacles (B).

21. A - The limits of the model in financial markets Firstly, the principle is based on the hypothesis of investor’s economic rationality : the investor is ready to penalize a fraudulent issuer There is a fundamental hypothesis.The influence of the compliance on the share price is the underlying idea of the “comply or explain” principle.

22. But studies conducted in several countries seem controversial. • Studies from Germany and the Netherlands showed that compliance or non-compliance do not have any significant effect on market. • Studies from Spain and the UK provided conflicting results. Certain Spanish studies display a positive correlation. - While several studies conducted in UK demonstrate impact only if the company is in crisis and presents bad performance, others show a more positive link.

23. The model is based on rigid requirements. Three pillars are generally considered as essential for the principle effectiveness : • a real obligation to comply or explain; • a high level of transparency, with coherent and focused disclosure; • and a way for shareholders to hold company boards ultimately accountable for their decisions to comply-or-explain and the quality of their disclosures.

24. B - The obstacles of an possible expansion of the principle Three types of expansion seem conceivable : - First, we may apply this principle to new actors (1). - Next, we could consider the extension of the principle on new matters such as the sustainable development or the company’s social responsibility (2). - Finally, we could consider the idea that this principle may be an alternative to rigid legal requirements (3) ?

25. 1 - Expansion to new actors - For instance, the “comply or explain” principle could be extended to institutional investors. - The British code on institutional investors’ liability, which applies to ISC members, provides that institutional investors should state publicly that the Code is not relevant to them and explain why, if they choose not to comply with it. - Another field of application concerns “charities” and IPCs (Institutions of Public Character). The governance code, suggested in November 2007 by the Charity Council of Singapore, and concerning these organizations, follows the “comply or explain” approach.

26. Moreover, a good conduct code for Non Governmental Organizations (NGOs) could be drafted in accordance with the “comply or explain” principle. - Some international NGOs operate in a hostile environment in some countries and may need to avoid disclosure of members or sources of financial support. - The “comply or explain” standard means that reasons should be given where disclosure does not take place.

27. 2 - Company’s social and environmental responsibility Could we also follow the “comply or explain” approach in the field of social and environmental responsibility ? The most important question is how to strike a balance between, on one hand, the desire to exempt small companies from too costly obligations compared to their financial capability and, on the other hand, the desire to encourage them to assume their social and environmental responsibility?

28. 3 - Comply or explain, alternative to disclosure regulation ? - Could we consider not to comply with a certain disclosure rules if this choice is justified ? - This hypothesis may only be conceivable in matters that require qualitative information, such as social responsibility and sustainable development.

29. Beyond particular cases, generalization is not really conceivable, unless a judge examines the accuracy of the explanations, which is quite unrealistic. Moreover, this system creates legal uncertainty : “how could one be sure that the derogation applied is valid?”