Thematic Issue on ‘The Comply or Explain Principle: Fair or Foul?’

1. Fair is foul, and foul is fair

2. Hover through the fog and filthy air

3. Shakespeare, Macbeth [Act 1.1.11–12]

1. Sergakis, Konstantinos (2015) ‘Deconstruction and Reconstruction of the “Comply or Explain” Principle in EU Capital Markets’, Accounting, Economics and Law: A Convivium, DOI 10.1515/ael-2014-0007.

2. Duhamel, Jean-Christophe (2015) ‘The “Comply or Explain” Approach as a Pascalian Wager’, Accounting, Economics and Law: A Convivium, DOI 10.1515/ael-2014-0021.

3. Biondi, Yuri (2015) ‘An Economic Analysis of ‘Comply or Explain Principle’ under a Review Panel Regime’, Accounting, Economics and Law: A Convivium, DOI 10.1515/ael-2014-0025.

4. Sergakis, Konstantinos (2015) ‘A Rejoinder on Mr. Duhamel’s Commentary’, Accounting, Economics and Law: A Convivium, DOI 10.1515/ael-2014-0024.

The famous French modern philosopher Pascal explained that believing in God was a fair bet: since there is there an eternal happy life to gain – a chance of infinite gain against a finite number of chances of losing stakes – a rational person should live as though God exists. ^[1] This commentary mainly wonders whether believing in the “comply or explain” approach as an effective tool to improve long-termism investments and dialogue between investors and companies does constitute then just a Pascalian wager.

“Comply or explain” is nowadays a very familiar soft law device. Its basic premise is to apply pressure on listed companies through mandatory transparency: to the degree that such corporations are scrutinized by investors, shareholders, and even stakeholders or public opinion, they are urged to modify their behaviour by adopting presumed ethical practices described in a corpus, a code of good governance practices. Indeed, as judge Brandeis said: “Sunlight is the best disinfectant ^[2]”. But this device is only the first aspect of “comply or explain” which fundamentally aims at avoiding the “one-size-fits-all” approach in corporate governance practices. Consequently, companies remain absolutely free to be non-compliant, but when doing so, the only obligatory rule is to explain such a choice in order to convince the outside world that being non-compliant is as much as appropriate than respecting the corporate governance code.

The device has enjoyed worldwide success. ^[3] As Mr Sergakis’ article describes it, “comply or explain” has been implemented, in European Union, by listed companies, proxy advisors and institutional investors. Each has to disclose the extent to which it complies with a code of best practices, failing which it has to explain the reason. But each operates in a different business context: proxies and institutional investors are services providers, not companies, whereas in a company, shareholders are not the clients of the running business. Accountability thus works in very different ways depending on whether someone pays in return of services, or invests in a company and owns stocks. Consequently, as Mr Sergakis writes, some of the implications concerning the substance of disclosures ought to be noticed, especially those aimed at justifying non-compliance:

companies should feel relatively free to use both parts of the “comply or explain” principle fully, because although there is an expectation from the investor community for their portfolio to generate profits, the means used to ensure their strategies’ success cannot be clearly identified and confined into a strictly contractual obligation to provide services in a predetermined way, as institutional investors or proxy advisors would do with their clients.

Mr Sergakis believes that such diverse applications of a single device substantiates that the “comply or explain” is not one concept fitting all. On the other hand, it is equally possible to posit that “comply or explain” is indeed a “one-size-fits-all” approach precisely because it is suitable for application for all kinds of businesses despite the diversity of the legal and financial relationships between providers and recipients of the information disclosed. But differences of opinions on this issue are certainly not very important; on the contrary, what is very important is the profound consensus about the failures of “comply or explain” to militate against the “one-size-fits-all” approach to governance and best practices themselves!

Actually, labelling and deploring disclosures as “box-ticking”, “window-dressing”, or “boiler plate” is quite frequent. ^[4] The disclosure practices of the listed companies highlight inconsistencies where statements of compliance and explanations are involved. Firstly, remarkably high rates of compliance testifies to the reality of the “one-size-fits-all” approach and substantiates that companies are not ready to use the flexibility of “comply or explain” to resist against “one-size-fits-all”, an effect partially induced by the very existence of one single corporate governance code. This strong tendency can be easily explained: the obligation to refer to a code of best practices implies that the rules written in this code are in fact best practices and not ordinary practices with the same value as alternative ones. The implicit pressure to be compliant leads to “one-size-fits-all” governance being an inherent, underlying result of “comply or explain” approach, since the compliance side comes to dominate its application. Secondly, companies are reluctant and uncertain to be non-compliant because they cannot predict the reactions of shareholders and investors in cases where they might deviate from compliance. This unpredictability emanates from a lack of dialogue: shareholders and investors are predominantly focused on short-term prospects and are thus diverted from evaluating the potential positive long-term effects of non-compliance. Hence, the explanations, when given, are frequently poor and stereotyped. Mr Sergakis’ article deals with all these issues, i.e. the investors’ reluctance to accept non-compliance and explanations, the lack of dialogue between market participants and companies (and more widely between regulatees and addressees), and the resulting box-ticking and window-dressing effects.

The currently well-known limits of “comply or explain” lead to question whether such a device can be effective; it is the main thrust of Mr Sergakis’ article. The author suggests a way to improve its implementation, namely by introducing a suitably pliable monitoring system based on independent “Review Panels” composed of experienced business professionals interested in the scope of disclosures. ^[5] Their main function would be ambitious. In sum: all parties involved in a “comply or explain” process may request a panel’s intervention which attempts to resolve disagreements or misunderstandings concerning both veracity or interpretation of a statement of compliance and quality of the explanation given to justify a deviation.

The crucial point to be examined here is the willingness of regulatees and addressees through the agency of a review panel to enhance “comply or explain” by transforming it into a method of long-term dialogue. Mr Sergakis seems to believe that such willingness might emerge precisely from the review panels’ educational virtues:

- education [of comply or explain users] can more feasibly occur within the scope of a neutral Review Panel that will continue to deal with various requests and to guide the parties involved in realizing the benefits of engagement in each and every occasion for dialogue. […] – the purpose of education will be to reorient their short-term goals for profit and show them that if they work collectively they may have a chance to achieve the same profit under a long-term perspective without compromising their position, while preserving in the meantime the stability of the system since speculation would not be their unique goal in the market.

This is a picture of quite an ideal investors’ world, not only based on the informational framework and focused on individual rational choice but also – and above all? – on a collective shareholder empowerment to serve the best interests of the company, which is irremediably a long-term task. Is it currently realistic to believe in such an investors’ world? Being dubious is certainly a reasonable position, insofar as the powerful neo-classical financial economics framework has been effective and successful in ferociously advocating that informational efficiency and individual rational choice basically govern investors and financial markets…

To sum up, while Mr Sergakis seems to consider that the improvement of “comply or explain” principle could influence the modification of companies’ and investors’ behaviours in favour of long-termism and dialogue, the reverse causal relation seems to us more plausible: only this primary – and also primarily – modification of behaviours could transform “comply or explain” into an effective disclosure device. It means that the “comply or explain” and all the initiatives in order to improve its functioning should be broadly seen as a Pascalian wager: we aren’t certain about its usefulness, but there is no clear-cut reason to abandon it! At worst, it is neutral and ineffective; at best, it will be an effective tool if investors ever decide to become long-termist and to develop a regular dialogue with companies. As Pascal wrote it: “If you gain, you gain all; if you lose, you lose nothing”. ^[6] But could this nonexistence of loss be challenged? Indeed, a more pessimistic hypothesis could wreck the wager, which consists to refute the “at worst neutral effect” on the users’ behaviour. Such a view is based on a potential counterproductive phenomena induced by the statements of compliance: by the way of strategic disclosures framed by supposedly best governance practices, the effect may be to maintain and foster a continued nurturing of investor’s faith, confidence, and beliefs. Hence, the “comply or explain” may partially contribute to a risky substitution of information for corporate advertising. This further analysis, which should also address the more general issue of the corporate purposes, is left to another day. ^[7]