2.1 Listed companies’ statements

Companies must adopt a corporate governance system that is not solely focused on profit maximisation and share price return, but goes beyond these goals and strives to achieve investment innovation, growth and economic performance. It is in this perspective that companies will not only ensure their success and remain attractive to other market participants ^[8] but also continue to play a key role in national economies. In an attempt to make corporate governance mechanisms much more visible, via disclosure obligations expressed in corporate governance statements, regulators found the “comply or explain” principle to be the ideal combination of disclosure and adaptability. On the one hand, disclosure as a principle is a theoretical catalyst for more informed and sophisticated decisions by investors, based on the information that companies provide regarding their corporate governance system. On the other hand, adaptability is a key issue with corporate governance statements, taking into account that companies’ structures vary widely both nationally and internationally.

The most important EU initiative on the corporate governance landscape was the adoption of the “comply or explain” principle through Directive 2006/46/EC, as previously mentioned. The EU fully endorsed the principle by inserting a new Article 46a into the 4th Company Law directive. ^[9] Companies whose securities are admitted to trading on a regulated market must include corporate governance statements in their annual reports. In turn, these statements must include information with regard to either the corporate governance code that the company has decided to abide by or the code that the company applies or any other information regarding corporate governance practices that go beyond the requirements of the national framework. Moreover, in cases in which a company decides to depart from a corporate governance code, fully or partially, it must give explanations on the reasons for such a decision. In the case of partial non-compliance, the company must clarify further which respective sections of the code are not followed.

More recently, Directive 2013/30/EU requires listed companies to disclose information with regard to certain corporate governance arrangements in their corporate governance statements following the “comply or explain” principle, according to the same framework provided by Directive 2006/46/EC. ^[10]

The “comply or explain” framework is extremely flexible and although it has not caused corporate governance strategies to converge, precisely because – quite wisely so – such a goal was never included in the EU or national regulatory agendas, it has nevertheless met with considerable popularity amongst regulators and market participants since it provides a commonly acceptable framework for the emergence of various disclosure trends and information that are not hampered in their originality and usefulness by the well-known rigidity of a hard law framework, identified with a stringent “one-size-fits-all” approach that would seem unrealistic in corporate governance (Kraakman et al., 2004). By knowing in advance that the principle allows a corporate entity either to comply with soft law rules or to deviate and explain the reasons for its “non-compliance”, a company has a much more convincing incentive – at least in theory – to be substantially more open regarding its corporate governance system. This in turn allows the recipients of this information to understand in a preferred way the company’s strategies and to evaluate it in a more informed and sophisticated way. The particular attachment to increased investor awareness and sophistication when it comes to evaluating the investee company is nothing new.

The ongoing expansion of disclosure trends for the benefit of investors at large can be undoubtedly explained by the revival of ownership theories in listed companies (Biondi, 2012) and, more specifically, the “shareholder primacy” model in corporate governance which, after having confronted and successfully dominated the “stakeholder theory” and “enlightened shareholder value” (Keay, 2012; See also Keay, 2009), focuses corporate managers’ attention exclusively on profit maximisation for the benefit of shareholders. ^[11] Nowadays, the primary purpose of publicly traded companies continues to be profit-oriented for the benefit of shareholders, ^[12] even if, as previously mentioned, listed companies should not only strive to maximise profit for shareholders but also contribute to economic growth and innovation, thus serving a multifunctional conceptual framework (Stout, 2013, p. 65).

Therefore, the centre of regulatory attention is inevitably channelled towards the formation and expansion of a holistic disclosure trend, whose list of recipients continues to include various market actors who interact with shareholders and are involved, directly or indirectly, in investment decisions (Enriques & Gilotta, 2014, pp. 4–7). It is thus expected that out of various disclosure statements, investors will be better protected or, at least, feel much more immune against inappropriate practices, developed either from corporate management or financial intermediaries with whom they continue to interact on capital markets.

It was therefore no surprise that the “comply or explain” principle was broadly accepted with regard to corporate governance statements and has confirmed its status as one of the most important regulatory tools in an increasingly diverse corporate landscape. By refocusing the debate on “shareholder primacy” in order to convey the message at the EU and international level that shareholders count, are efficiently protected and therefore securing their “confidence” to invest on a constant basis, the current regulatory agenda further strengthens their powers by acknowledging that they have rights to exercise and financial intermediaries have, in their respect, responsibilities to assume. The epitome of this “shareholder” regulatory focus is expressed via the assurance that all financial intermediaries associated with shareholders need to be part of this disclosure trend and make visible their practices as well as their overall methodologies.

Having become the “regulatory safety net” and the guarantee for the same flexibility for all market actors involved in the investment chain, the “comply or explain” principle keeps on being extensively used with regard to the exercise of stewardship responsibilities by institutional investors to their clients, i.e. the ultimate beneficiaries of the investment process.

2.2 Institutional investors’ statements

Institutional investors have recently come under the regulatory spotlight due to their stewardship responsibilities, namely the duties bestowed upon the executive management of the investor group as well as on the asset managers in charge of monitoring and developing their portfolios. According to one definition,

stewardship is responsible and thoughtful ownership. It is synonymous with an ownership mindset and adopts a long-term perspective, but with a focus on value creation […] It is also a mechanism to ensure the appropriate use of the power vested in institutions to properly and effectively manage the funds, such as savings and pension contributions, entrusted to them by the ultimate investors, the beneficiaries. (Foundation for Governance Research and Education, 2011,

p. 12)

There is no doubt that this stewardship trend is closely associated with the revival of ownership views and, more generally, the “shareholder primacy” theory, as explained above (Biondi, 2012, p. 4). Financial intermediaries are invited to show at which point they can become good stewards on behalf of shareholders in order to convey the message to the market at large that the centre of attention remains the ultimate beneficiaries, who are therefore encouraged to continue to invest in capital markets. Stewardship, if effectively implemented, therefore works as an additional guarantee (at least in theory) that intermediaries will act in the best interests of their clients and not in their own personal interests. The evolution and expansion of the stewardship movement reminds us of the evolution of agency issues arising from the separation of shareholding from control and management (Berle & Means, 1932), whereby directors had to ensure shareholders that they were acting in their best interests instead of abusing their power and becoming entangled in agency problems. It is therefore very interesting to see the evolution of this parallel conceptual tendency for intermediaries to be encouraged to show the market that they manage their clients’ assets effectively exactly because it is of vital importance for the latter to maintain their confidence both in company directors and in financial intermediaries with which their investment is entrusted.

The EU has not yet officially adopted any measures on stewardship although this issue is included in its policy agenda. While not the only EU Member State to have dealt with this issue, ^[13] the UK moved towards adopting the UK Stewardship Code in 2010. This Code contains a series of provisions to be used by institutional investors. To date, it represents the most sophisticated approach in Europe. ^[14]

Without analysing in-depth all the implications emerging from the principles of the UK Stewardship Code, it would be useful to mention that institutional investors are expected to disclose information on a series of issues, such as their policies on how they discharge their responsibilities towards their clients, how they manage potential conflicts of interest in the exercise of their duties, how they monitor investee companies, how they exercise their voting powers and, finally, they are expected to report periodically, or at least annually, to their clients on their stewardship activities. The revised version of the Code further developed a series of important issues for its recipients. ^[15]

It has set a target of increasing awareness of investment-related problematic issues and is attempting to change the current short-term mentality in the market ^[16] in an extremely flexible way since, contrary to national corporate governance codes as previously mentioned, institutional investors are not required to follow the Code but are simply encouraged to become its signatories and under that assumption are expected to disclose compliance with, or deviation from, its recommendations. The reason for this increased flexibility in this area is undoubtedly regulators’ desire to avoid, at least for the time being, counter-productive intervention in the area of institutional shareholders. By allowing a disclosure trend to emerge gradually via the encouragement of signing up the Code, it is expected that the increasing number of signatories will participate in this trend, thus allowing the rest of the market to understand the exercise of their activities. Although such an invitation might seem quite superficial, looking back in 2010 when the Code was first introduced, we have to consider it was the only possible regulatory approach that allowed, at that time, this disclosure trend to expand to other countries and which prepared the field for the European regulatory response that came recently with the proposal for a Directive aimed at encouraging long-term shareholder engagement (this will be discussed later in this paper). ^[17]

Therefore, the main objective of this stewardship trend is to give visibility and awareness of the need for a viable, constant dialogue between company management and institutional investors, which will hopefully generate a realistic alignment of their respective incentives and targets. Even though critics of the “shareholder democracy” and profit maximisation theory have wisely asserted that the alignment of shareholders’ and corporate boards’ interests was already expressed in short-term strategies (Aglietta & Rebérioux, 2005), the stewardship trend claims, at least in theory, the usefulness of a much more engaged dialogue which, by making shareholders much more aware of the complexities of the whole investment chain, will allow a realignment of different agendas not focused solely on short-term goals.

In fact, the Code refers to the concept of stewardship as something that “aims to promote the long-term success of companies in such a way that the ultimate providers of capital also prosper” (Stewardship Code, 2012a, p. 4). Stewardship thus encompasses various activities for different actors involved in the investment chain and invited by this regulatory tool, following the “comply or explain” principle, to adhere to certain standards or to justify their non-compliance.

Acknowledging, as in the case of company profiles, that institutional investors have inevitably different strategies, conceptions and focuses with regard to the exercise of their business activities, the “comply or explain” principle once again found itself at the centre of attention and was considered to be the only realistic tool to give the necessary flexibility to an ever-growing number of financial intermediaries to disclose information on their activities. Again, it is expected that out of this kind of flexible disclosure framework, their clients will be in a position to evaluate them better and to make informed decisions when choosing the investor group that will manage their capital.

Therefore, it comes as a plausible assumption that regulation continues to rely on the “comply or explain” principle to make various activities much more visible and subject to interaction and informed dialogue amongst market participants, with the long-term objective of finding a common point of reference and alignment between different objectives. Notwithstanding this regulatory framework’s “idealistic” purpose, which does not seem to fit perfectly with the prevailing short-term mentality of institutional investors (Villiers, 2010, p. 287; see also Ambachtsheer, Fuller, & Hindocha, 2013), encouraging market actors to interact, via the disclosure of their practices, might be a first step at the EU level to refocusing the debate on the necessity for “genuine” shareholder engagement, namely an engagement that does not focus solely on short-term strategies and shows a less myopic conception of the company’s long-term existence and continuity.

This view is not exempt from criticism and, more specifically, from the fact that interaction between market participants may arguably be only the consequence of long-term behaviour, not its cause. Indeed, it is difficult to assume that because various parties have a flexible framework whereby they can interact and evaluate one another, they will necessarily develop a constructive dialogue and adopt collectively long-term objectives. Nevertheless, following this line of interpretation, we risk relying upon the eventual scenario that participants that are already long-term oriented will develop such a dialogue on their own. This will marginalise all the beneficial outcomes that might result from educational purposes and the ongoing incentives to build dialogue between participants, acknowledging the different priorities of all parties involved but still building together a conceptual framework towards long-term strategies and objectives. Of course, under this ideological construction, speculative participants will never be part of the dialogue or may participate purely for “window-dressing” purposes since they will still be seeking financial incentives to move towards long-term strategies. But this should not prompt regulatory efforts towards maintaining a distance from various parties and leaving such an important issue exclusively to ad hoc initiatives. Dialogue should be generated in an already educated and sophisticated environment. For the level of education in capital markets to rise and for various parties to understand not only the benefits that they may derive from investment practices but also their own responsibilities in the entire investment chain, as well as the ramifications of their choices for other participants, the dialogue needs to occur upstream and present a convincing case for a long-term vision. If the educational and preventive prerogatives are lost, the communication gap will persist only to be bridged partially and periodically in cases where market participants with considerable power, resources and sophistication are in a position to influence their counterparties with regard to their long-term objectives.

The current EU agenda has included shareholder engagement as one of its distinctive features by conveying the message that this is a topic that must be dealt with at the EU level in the future. Apart from the publication of some recent informal talks with interested parties, ^[18] the European Commission had expressed its interest in promoting this agenda since the Green Paper on corporate governance in financial institutions and remuneration policies (Commission, 2013b) and the Green Paper on EU corporate governance, which received wide support from its respondents (Commission, 2011a). A much more decisive step was reached with the EC Action Plan in 2012, which further clarified the need for much greater shareholder engagement at the EU level with the announcement of an initiative, possibly through modification of the Shareholder Rights Directive, that would deal with the disclosure of voting and engagement policies, as well as voting records provided by institutional investors (Commission, 2012). The crucial step was finally reached with the proposal for a Directive to encourage long-term shareholder engagement and certain elements of the corporate governance statement (Commission, 2014).

Aiming to increase transparency in financial intermediation, article 3f of the proposal requires Member States to ensure that institutional investors and asset managers will develop an “engagement policy” that will define grosso modo the way they will exercise their activities with regard to the integration of shareholder engagement into their strategy, the monitoring of and dialogue with investee companies, the exercise of voting rights, the use of proxy advisory services and cooperation with other shareholders. ^[19] Most importantly, Section 3 of the same article expects Member States to ensure that this engagement policy includes policies that are purported to manage actual or potential conflicts of interest that may arise in this framework, while providing a non-exhaustive conflict-of-interest list. ^[20]

Apart from developing an engagement policy, the proposal expects institutional investors and asset managers to provide annual public disclosure of this policy, the framework of its implementation and the consequent results. ^[21] More generally, when they decide not to develop an engagement policy or to disclose its implementation and its results, institutional investors and asset managers are expected, following the “comply or explain” principle, to give a clear and reasoned explanation for this choice. The European Commission has justified the use of the “comply or explain” principle in the proposal by advancing the argument, similarly to other occasions in the past, that “Member States should have a degree of flexibility as far as the transparency and information required in this proposal are concerned, in particular in order to allow the norms to adequately fit into the distinct corporate governance frameworks.” ^[22]

Indeed, it has to be borne in mind that shareholding structures across EU Member States inevitably play a very important role in shaping corporate culture as well as cooperating with institutional investor groups. ^[23] Companies with dispersed shareholding tend to be more focused on short-term goals in order to respond effectively to pressure from institutional investors. The same argument cannot be used in family-owned companies, where the management board may surely continue to focus on longer-term goals in order to ensure the continuity and sustainable prosperity of the corporation. If this factor is taken into consideration, then the monitoring of these companies by institutional investors as well as their engagement strategies must vary to adapt themselves to national characteristics and to be able to operate according to the respective corporate landscape.

It is therefore legitimate to argue that the presence of institutional investors in various EU Member States will potentially become a driver for change of corporate governance cultures via increasingly dispersed shareholding structures and the need for more “shareholder friendly” governance strategies. Nevertheless, not having reached a completely harmonised framework on shareholding structures across EU listed companies, we must admit that, at least in the current phase, institutional investors cannot be expected to exercise their activities in the same way at the EU level since they interact with companies operating in markets with various socio-economic and cultural idiosyncrasies.

Therefore, the European Commission does not currently view the development of an EU Stewardship Code as a suitable or even realistic convergence model. The proposal for a Directive sets the minimum standards expected by institutional shareholders and asset managers to be ultimately formulated at the national level, as seen above. It remains to be seen whether this approach is preferred. Regardless of the potential efficiency of a future directive, the adoption of an EU Stewardship Code should not be completely disregarded. Such a code could broadly include the UK Stewardship Code’s provisions. Most importantly, it is certain that, once again, the “comply or explain” principle would be called upon for the task of boosting the visibility of the diversified business practices amongst institutional investors ^[24] and corporate boards ^[25] in various EU Member States, which will most probably continue to vary, functioning as a reflection of the respective corporate governance cultures with which they interact.

Regardless of the most suitable convergence regulatory tool in this area, it remains to be seen whether the future Directive will effectively promote this agenda and realistically strengthen the overall shareholder engagement trend.

2.3 Proxy advisor statements

The last area in which the “comply or explain” principle has been called into action more recently is related to the activities of proxy advisors. Proxy advisory firms are in charge of advising institutional investors and exercising the voting rights of the latter, who most often delegate these powers to such firms in an accelerating cost-saving framework. ^[26] The ever-growing influence of proxy advisors on institutional investors has triggered the need for the introduction of disclosure obligations in order to provide the necessary information to existing and potential clients on how they intend to exercise their activities and therefore allow them, as well as other market participants and regulators, to better understand their role and evaluate them in an adequate way.

In the Green Paper on corporate governance (Commission, 2011a, p. 14), the European Commission mentioned the possibility of regulatory intervention in this field, a statement that was recently followed by the proposal for a Directive aimed at encouraging long-term shareholder engagement, as will be analysed later in this paper (Commission, 2014). Feedback from stakeholders on the appropriateness of such an agenda was very positive, showing a clear preference for more transparency. The European Securities and Markets Authority (ESMA) subsequently began its own consultation period with various stakeholders, and in February 2013, published its Final Report (ESMA, 2013) on the results of the consultation and planning the introduction of an EU Code of Conduct, prepared by the Best Practice Principles Group (GBPP), an industry committee made up of proxy advisory firm representatives (GBPP, 2014). As we can observe, the regulatory choice for a Code of Conduct and the preparation of the Best Practice Principles for Shareholder Voting Research by an industry committee testify to the need for maximum flexibility as this is the first approach for the introduction of a disclosure framework at the EU level, with very few examples of similar attempts in EU Member States.

Before moving to the EU initiatives, it is necessary to draw some lessons from a comparative analysis between the UK and French frameworks. This will make the argument for more transparency at the EU level even more interesting since various national frameworks currently in place provide different disclosure spectrums and show the reason why the “comply or explain” principle needs to be maintained, at least for the time being, in the proxy advisory industry’s disclosure obligations. Therefore, by acknowledging and emphasising current divergent regulatory approaches in the UK and France, our analysis will present a more convincing argument for maintaining flexibility in this area. The argument for more flexibility focuses mainly on the fact that proxy advisory firms have not been previously subject to any disclosure obligations at the EU level, including some EU Member States, and it would be only utopic to assume that a uniform and widely applicable regulatory approach would bring substantial results in terms of transparency and comparability between different practices experienced at the EU level. It is therefore crucial for this initial period to contain a certain degree of flexibility, exemplified by the “comply or explain” concept, so that we can then see how the overall disclosure framework evolves in Europe before deciding to adopt more stringent measures. This argument becomes even timelier since the current EU regulatory policy adopts a rather different solution, as will be explained later in this paper.

Thus proceeding with the comparative analysis of the UK and French frameworks, it should be noted that the UK Stewardship Code, in its revised version and as analysed above, included the proxy advisory industry in a general way in its spectrum of application, thus expecting such firms to become voluntary signatories and to abide by its principles (UK Stewardship Code, 2012a). Conversely, the French competent authority (Autorité des Marchés Financiers, hereinafter AMF) adopted in 2011 a recommendation that, although it does not have binding force, takes a rather stricter approach than the UK one.

For example, acknowledging the risk of conflicts of interest when providing various services, the AMF recommendation asks proxy advisory firms to mention any possible ties to the company whose resolutions they are evaluating, to shareholders who have proposed resolutions at the general meeting for which the proxy advisors have provided a report for their clients, and lastly, to any persons who might control directly or indirectly the public company or majority shareholdings as mentioned above (Autorité des Marchés Financiers (AMF) 2011). On the contrary, the UK Stewardship Code contains a rather general obligation to publicly disclose the robust policy on managing conflict of interest that its signatories should develop.

Moreover, with regard to engagement with investee companies, the UK Stewardship Code leaves the signatory parties to determine the framework for this type of engagement, while providing some very general recommendations. Principle 6 of the Code states, for example, that “[i]nstitutional investors should disclose the use made, if any, of proxy voting or other voting advisory services. They should describe the scope of such services, identify the providers and disclose the extent to which they follow, rely upon or use recommendations made by such services” (UK Stewardship Code, 2012a, p. 9). Nevertheless, the AMF recommends that “the proxy advisor submit its draft report to the relevant company for review, failing which the proxy advisor shall clearly state in its analysis report that the draft was not submitted for review and explain the reasons why” (AMF, 2011, p. 3). Moreover, under the condition that the company has informed the proxy advisory firm of its resolutions, the board’s reports and any other documents, at least 35 days before the general meeting, it has at least 24 hours to communicate any eventual remarks or comments. The firm has to include in its analysis report, upon the company’s request, its comments on its voting recommendations, under the condition that those comments are precise, enlighten the shareholders on the draft resolutions and do not discuss the general voting policy. If applicable, the firm corrects any material mistakes detected in its analysis report and previously noted by the company concerned and ensures disclosure to the investors as quickly as possible (AMF, 2011, p. 3).

The comparative analysis aimed to show the different mentalities around the level and quality of interventionism in the proxy advisory industry. The UK Stewardship Code, following a much more flexible approach with very general guidelines applicable to a broad series of market participants, creates a rather acceptable framework for proxy advisory firms, leaving them the freedom to operate in the market and disclose their practices accordingly. On the other hand, the French recommendation – albeit not binding – aims to shape a much more stringent framework which has not been unanimously accepted, taking into consideration the criticism from some respondents to the ESMA report that this recommendation has already created an unfavourable environment for some proxy advisory firms in comparison with other legal advisors or non-European firms (ESMA, 2013, p. 18). This probably shows that the industry is not yet ready, in its entirety, to accept a stringent framework and instead prizes maximum operational flexibility and the subsequent laxity of applicable rules. Different regulatory approaches to shaping and suggesting a possible engagement with issuers make it even more arduous to achieve a European consensus on this matter.

Therefore, going back to the EU dimension of the regulatory approach in this area, it comes as no surprise that proxy advisory firms are not required to follow the Best Practice Principles for Shareholder Voting Research but are merely encouraged to become signatories, and under that assumption, are expected to disclose compliance with (or deviation from) the Principles. Even though this soft law tool might not currently be the ideal regulatory approach due to its extreme flexibility, ^[27] ESMA has also mentioned that if this process does not lead to satisfactory results or if market conditions create a need for more regulatory intervention, it will proceed to adopt more formal measures.

Regardless of the prospective regulatory framework applicable to proxy advisory firms, it is blatant that the “comply or explain” principle was the most obvious choice to start encouraging firms to disclose information about their practices while allowing them the maximum flexibility to deviate from the Principles recommended by GBPP without facing public criticism about the lack of engagement or willingness to participate in a soft law transparency framework. GBPP has therefore issued three main Principles, accompanied by guidance notes recommending how the Principles should be applied. The three Principles refer to the service quality (provision of services delivered in accordance with agreed client specifications and disclosure of research methodologies and, if applicable, “house” voting policies), the management of conflicts of interest (disclosure of a related policy that details the procedures for addressing potential or actual conflict of interest that may arise with regard to the provision of proxy services) and, lastly, the communications policy (disclosure of the policy for communication with issuers, shareholder proponents, other stakeholders, media and the public).

In their statements of compliance, proxy advisory firms should describe in a meaningful way how they apply the Principles and related guidance, disclose any specific information set out in the guidance, and where they do not comply with either the Principles or the relevant information, they should provide a reasoned explanation for their “non-compliance”. ^[28]

The most noteworthy issue, as far as the focus of this paper is concerned, is that the “comply or explain” framework has been unanimously accepted by the market participants in charge of this rulemaking initiative, due to its very flexible nature and the legitimacy it gives “non-compliance” since the latter forms part of the principle. It is therefore believed that, as we will show in the next part of this paper, the principle is perfectly adaptable to any kind of regulatory framework (binding Corporate Governance Codes for companies, non-binding Stewardship Codes, non-binding Codes of Conduct for proxy advisors) precisely because it legitimises both ideological stances, namely those of “compliance” and “non-compliance” with a certain set of principles. Nevertheless, this ideological openness with regard to the flexibility of the party responsible for disclosing its practices also gives an equal degree of flexibility to treat the principle superficially, knowing in advance that all possible positions will be legitimised by the “comply or explain” concept.

On the other hand, as recently emphasised by the EC, “[t]he Commission will consider an initiative in 2013, possibly in the context of the revision of the Shareholders” Rights Directive, with a view to improving the transparency and conflict-of-interest frameworks applicable to proxy advisors’ (Commission, 2012, p. 11). Indeed, with the proposal for a Directive aimed at encouraging long-term shareholder engagement and certain elements of the corporate governance statement (Commission, 2014), the European Commission moved in a rather surprising direction when it chose to require Member States to ensure that proxy advisory firms publicly disclose a series of information on an annual basis with regard to the preparation of their voting recommendations without any recourse to the “comply or explain” principle.

More specifically, proxy advisors will have to disclose the main components of the methodologies and models applied, the main information sources used, the eventual consideration and its content of national market, legal and regulatory conditions, the eventual dialogue developed with companies, the total number of staff involved in the preparation of their voting recommendations, as well as the total number of these recommendations provided in the year covered by the annual disclosure. ^[29] The proposal also provides that they should identify and disclose to their clients and the company concerned by their recommendations any actual or potential conflicts of interest that may exert an influence on their services, as well as the actions that they have taken to eliminate or mitigate this type of conflict. ^[30]

The first impression from the proposal for a Directive is that it creates a rather inconsistent framework with the EU Code of Conduct as previously analysed. This is due to the fact that, while very flexible, the Code of Conduct covers a considerable range of issues that, if combined with the related guidance, gives the market the chance to receive a considerable amount of information on proxy advisory firms. On the contrary, the European Commission seems to have opted for a much narrower focus of attention but without the flexibility of the “comply or explain” principle. This can possibly be explained by the need to convey the message that an absolute minimum “informational safety net” is guaranteed without recourse to a flexible disclosure framework but with more binding disclosure requirements. In this respect, the proposal mentions that “proxy advisors will only be subject to some basic principles to ensure accuracy and reliability of their recommendations.” ^[31] It therefore seems that the preference was clearly for a minimum of issues to be disclosed in a binding framework and thus without the risk of associating them with perfunctory explanations in case of deviation.

At the further level of analysis, it is rather unfortunate that the proposal chooses a rather different direction from that of the EU Code of Conduct at almost the same period. Would it not have been preferable to coordinate private and public efforts to shape an initial regulatory framework for proxy advisory firms in order to avoid further confusion and inconsistencies between different sources of rulemaking both at the national and at the EU levels? The main concern about the current proposal is that, by leaving it to Member States to require proxy advisors to disclose information on a specific series of issues, national frameworks will inevitably move towards this informational minimum without necessarily making the effort to trigger further reforms and create a more sophisticated and elaborate informational spectrum for the benefit of the rest of the market. At the same time, the Best Practice Principles for Shareholder Voting Research issued by GBPP will continue to exist at the EU level as a private-sector initiative and as a non-binding document that invites proxy advisory firms to become signatories and follow its more detailed principles while benefiting from the “comply or explain” framework.

The rather unfortunate result will therefore be that proxy advisory firms will be required to follow a minimum of binding disclosure requirements at the national level, while maintaining the discretion to adhere to (and probably not sufficiently engage with) a broader non-binding set of principles at the EU level. The main concern about this inconsistency is that it will become rather burdensome for the rest of the market to understand the information disclosed according to the prospective regulatory framework at both the national and EU levels. Moreover, it is rather unfortunate that the proposal for a Directive does not require proxy advisors to publicly disclose actual or potential conflicts of interest, but only to disclose them to their clients and the company concerned by their recommendations, whereas the EU Code of Conduct clearly favours public disclosure in this area. Although it is rather premature to predict the outcomes of these different regulatory initiatives, the EU agenda needs to take into serious consideration potential sources of informational inconsistency and confusion that will make the overall disclosure exercise somewhat burdensome and of little use to market participants. ^[32]

2.4 “One concept fits all”?

Having analysed the “comply or explain” principle across different areas of activity, namely the ones of listed companies, institutional investors in proxy advisors, aiming to show the growing trend in the use of the principle, one question inevitably arises: can we realistically expect the same informational outcome and rate of compliance or deviation from all the above-mentioned regulatees? The principle itself emerged as an alternative to the rigidity of the “one-size-fits-all” concept that seems unpractical in corporate governance and, although still being used across these sectors, it becomes crucial to distinguish between the various activities of regulatees and to show whether “one concept fits all”.

Listed companies rely, amongst other things, on a continuous flow of investment. Their shareholders are a decisive factor for their future, providing the capital for company operations and expansion opportunities. Also bearing in mind that shareholders are at risk of losing only their investment, with no other implications for their personal assets, the relationship that they build with an investee company is based exclusively on a common profit-making goal without any element of a “client – service provider” relationship. This observation leads us undoubtedly to the conclusion that 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.

Turning our attention to institutional investors or proxy advisors, the situation might be interpreted slightly differently since they provide management services to their clients, and these services are specified contractually. Therefore, it could be argued that the expectations of the recipients of information disclosed could be slightly greater with regard to the use of the “comply or explain” principle in both instances, namely they could expect either a higher rate of compliance or much more detailed explanations in the case of deviation. Moreover, it could be also argued that due to the presence of a “client – service provider” relationship, institutional investors and proxy advisors should feel less free to deviate from best practices not just because this would trigger further complaints from their existing clients but also because this could severely affect their reputation and attractiveness in the eyes of future clients.

On the other hand, the same situation could be interpreted inversely, namely that service providers, as long as they meet their contractual engagements to clients, should feel freer not to follow best practices if the current methods and operating strategies applied meet their clients’ expectations, even though they consist of alternative ways of doing business that do not coincide with the best practices included in a soft law code. Nevertheless, this latter opinion should be validated with reservation, since compliance with a set of best practices is not intended for existing clients alone but should, in the eyes of the regulator and the investor community, take into consideration wider implications and needs of future clients and stakeholders. This means that service providers should go beyond their contractual arrangements with their existing clients and strive to increase their reputation via the disclosure of useful information while containing commonly acceptable standards or, at least, providing a truly meaningful explanation when they choose not to do so.

The exact repercussions of deviation for all the aforementioned regulatees cannot be predicted with certainty because they interact with various parties and in different situations. As we will show later in the paper, the recipients of the information disclosed tend to prefer a “box ticking” approach to formal compliance instead of an in-depth analysis of a meaningful explanation provided in the case of deviation. Regulatees are therefore constantly under pressure to comply with the principles and to avoid the “non-compliance” scenario, and this inevitably prevents the “comply or explain” principle from fully exploiting its different forms and fields of communication with other parties. These should nevertheless not mean that “one concept fits all” since, as was shown, expectations and pragmatic considerations may differ according to the relationship between providers and recipients of the information disclosed. Hence both parts of the principle should be equally acceptable by its users, irrespective of the nature and source of the information. For such an objective to be met, further analysis is needed on how all parties use the principle and perceive the content of disclosure. After having analysed the three main regulatory fields in which the principle has been put into practice, we will thus need to “deconstruct” this ideological concept and show the veritable merits but, most importantly, the dangers arising from its superficial conception and use by market participants which will inevitably weaken it in the future unless a consensus can be reached on its role and usefulness.

3.1 Flexibility of the “comply or explain” principle

As previously mentioned, the “comply or explain” principle offers maximum flexibility to extremely diverse fields of activity, incentives and strategies. Various market actors’ unique idiosyncrasies cannot be channelled to a specific pattern and cannot be predictable in capital markets, where moral hazard, market manipulation and limited knowledge (along with ignorance) reach their apogee. ^[33] Therefore, the principle acknowledges the inherent deficiencies of every regulatory approach that would opt for a unanimously applicable framework without any possible derogation or flexibility. Our examination of the principle’s application to the areas of listed companies, institutional shareholders and proxy advisors, as developed in Part 1, shows that the common denominator is the extreme diversity of different market participants within a single sector, their difference in size or experience, or, taking the debate to the national, EU or international levels, their culture about how their activities should be thought of and carried out. It is exactly this difficulty in producing rules and expecting an extremely diverse business community to apply them in the same way that initially made the “comply or explain” concept so suitable to acknowledge, accept and legitimise the preservation of individual characteristics, under the condition that the party that does not comply, fully or partially, with a set of rules must explain the reasons for this choice.

Moreover, acknowledging this diversity, it has always been in the regulators’ best interests to develop a framework that encourages transparency without imposing stringent obligations. The prevalence of “principles-based” standards and soft law measures has fitted elegantly with the need to ensure this kind of regulatory flexibility and has undoubtedly been appreciated by the business community. In fact, the idea that the initial recourse to soft law measures was somewhat “biased”, aiming to preserve and accommodate business needs instead of encouraging companies to come forward in a more efficient way, cannot be entirely excluded from our debate. Therefore, quite legitimately so, the defenders of “hard law” measures continue to consider corporate governance in particular to be a legitimate area for much more intrusive regulation of companies’ lives. ^[34] The criticism of the laxity of soft law measures and parties’ considerable leeway to avoid greater transparency vis-à-vis the recipients of the information disclosed can be especially formulated with regard to the stewardship movement and the best principles for proxy advisors. Nevertheless, stewardship trends have only recently emerged and therefore there could still be an optimistic perspective that soft law will be sufficiently convincing in allowing parties to increase transparency on their activities and engage in a more fruitful way with other market actors. As the FRC wisely stated, “[t]he Stewardship Code, unlike the UK Corporate Governance Code, is still in its infancy and behavioural change will take time” (FRC, 2013, p. 4).

More generally, the criticism levelled against soft law measures, especially the “comply or explain” principle, is that the parties use it fairly superficially, and therefore the chance for more transparency and better communication is severely compromised.

3.2 Users’ superficial conception of the principle

4.1 The reinforcement of an engaged interaction between different market actors

Having emphasised the superficial conception and use of the “comply or explain” framework of both information providers and recipients, it is vital to begin any proposal by reconsidering the quality of engagement in the relationships built between market participants. Proven to be a very flexible disclosure tool for corporate governance statements, stewardship statements and proxy advisory statements, the “comply or explain” framework is ideally positioned to coordinate a nexus of potentially fruitful and interactive relationships with one common denominator: all parties that follow the principle, participate in the investment chain and should all be interested in evaluating and being evaluated by other market participants while respecting with the same rigour, flexibility and openness offered by this principle.

If companies, institutional investors and proxy advisors follow the principle with the same mindset, the engagement conundrum might be more realistically resolved since all parties involved in the investment chain will accept a priori that they have an equal chance to declare compliance with a set of rules or non-compliance associated with meaningful explanations. Under this assumption, all parties should equally value both ideological stances and the chances of rejecting a “non-compliance” statement will lessen.

As an overall impression, although the adoption of the “comply or explain” principle at the EU level has clear potential to better connect corporate boards with shareholders and stakeholders who may be affected by companies’ activities, via the provision of a series of information that can give rise to fruitful discussions and mutual understanding of business priorities, it has not yet been perceived as a realistic path of exposure and communication by both companies and investors. A consistent deficiency in the quality of the explanations provided, in a non-compliance scenario, will not only jeopardise the information provided to investors but, most importantly, will damage the principle itself and weaken its foundations. As has been wisely stated, “failure to provide an adequate explanation increases the risk not only of the company being perceived as acting illegitimately but also of the code being seen as lacking legitimacy” (Sanderson, Seidl, & Roberts, 2013, p. 6).

In order to overcome superficial and merely technical behaviour around the use of corporate governance statements, both companies and investors should start disconnecting their decision-making processes from short-term benefits that seem to be the source of this problematic situation. It would be useful to remember that corporate boards are under constant pressure to deliver results not just according to their own possible short-term targets but, most importantly, the targets fixed by their shareholders, which may demand an even more aggressive decision-making strategy. The preference for an aggressive strategy, which might well go against the company’s long-term performance, is justified in theory by the pressing need of corporate boards to satisfy the “dependence of markets on constant company-relevant data streams as a basis for stock allocation decisions and associated professional communications. This in turn creates a compelling pressure on corporate managers to generate fresh ‘news’ indicative of perceived business ‘progress’, in an effort to influence future share price movements.” ^[49] This general trend towards a short-term informational and operational focus, accentuated with a burdensome and ever-growing corporate reporting framework, does not allow much space for optimism with regard to the change of corporate culture and the reorientation of targets towards long-term objectives. Markets need constant confirmation of an optimistic corporate scenario in order to justify their investment decisions and reassure investors of the “rationality” of their short-term objectives. This cultural phenomenon is obviously unsustainable, for both companies and investors, since it draws the attention of market participants away from the need for business innovation and growth, and focuses predominantly on the illusionary shaping of optimistic news that is reflected in share price movements.

Corporate greed has of course been observed and severely criticised in the wake of various corporate and financial scandals, and it is very difficult to predict with certainty whether directors would reorient their strategies as soon as investor pressure for short-term returns would disappear (Weinstein, 2013, p. 54). But it would be at best illusionary to isolate management short-termism from the identical trend arising from the “bottom”, namely the investor community, for the reasons explained above. Moreover, financial intermediaries have long reproduced and enhanced the short-term investment trend due to the fact that their evaluation is based on short-term performance and the additional development of good stewardship activities on behalf of their clients is mostly irrelevant, hence the lack of incentive for engagement with companies (Wong, 2010, p. 409). Their evaluation is correlated with a market-based notion of performance, mainly driven by capital market gains and speculative trading, and is therefore detached from a stewardship culture. The recent proposal for a Directive aimed at encouraging long-term shareholder engagement, as previously analysed, contains further provisions that aim to increase the transparency of the investment strategy followed by institutional investors, as well as their arrangements with asset managers. ^[50] The provisions are surprisingly detailed for such an issue, which has for a very long time remained mostly a private matter between various financial intermediaries, and they are purported to engage institutional investors and asset managers in a disclosure exercise to the rest of the market to explain inter alia how their actions contribute to the medium to long-term performance of the assets invested.

It is therefore hoped that, if followed as expected, this type of disclosure will help both intermediaries and the rest of the market to obtain a common understanding of their respective activities and the contribution of the latter towards a different, namely more sustainable, investment mentality. ^[51] As previously mentioned, the merits and shortfalls of disclosure are inevitably unpredictable as the information provided can be used as a beneficial means of communication and interaction or as a profitable tool for speculative purposes. Encouraging market participants to expose their strategies and operating methods will inevitably be a very difficult and delicate task that may need much time before becoming a convincing argument and being seen as the only viable solution for a better investment environment. Moreover, the interaction between different parties cannot be guaranteed merely by the growing disclosure trends, as shown in this paper, since there is no proof – for the time being – that these parties would be willing to benefit from each other’s information and participate in a constructive dialogue. Therefore, under a more realistic scenario, this interaction could only occur between parties that have already engaged in long-term strategies and are in a position to link up with other parties following the same investment pattern.

Nevertheless, as was previously explained, it would be very risky to rely exclusively upon those parties that have already acquired sophistication and solid strategies for long-term investment for such a dialogue to occur. The reason for this scepticism is that the dialogue would only occur between these sophisticated parties and not regularly but when they would decide to develop an ad hoc dialogue with another contractually related party in order to ensure that their mutual objectives are met in a specific deal.

Therefore, acknowledging the perfectible character of disclosure trends as well as the risk of instrumentalisation by the users of information, it seems more plausible to invest in this regulatory path, whereby market participants are constantly encouraged to disclose information about their strategies and to make opportunities for dialogue with other participants more feasible. The availability of information will inevitably give rise to some speculative trends, but this would be offset by increasing awareness amongst parties and allowing them – for the first time – to be in a position to participate in a wider debate about balanced corporate governance and long-term goals. It is the educational element of disclosure that needs to be preserved even if some of its components will be sacrificed for short-term purposes.

Of course, such disclosure trends will function under the “comply or explain” principle and therefore the “safety net” of this educational effort will need to be strengthened with further efforts to convince parties that “compliance” and “non-compliance” related information are both useful for awareness and dialogue purposes.

The need to reconstruct the principle itself based on this new assumption is made even more vital due to empirical studies, mentioned below, showing that the main attitude of all involved parties is a mere “box ticking” approach and there is no need for better understanding of the individual circumstances that have driven a party to deviate from a set of rules.

4.2 The acceptability of the principle in both “compliance” and “non-compliance” scenarios

According to data gathered from interviews conducted with CEOs from amongst the 130 largest listed firms in the UK and Germany, companies in both countries feel under constant and increasing pressure to fully conform with all the principles of their national corporate governance code even though the “comply or explain” principle clearly allows them to deviate and provide a meaningful explanation for such a choice. Therefore, even if deviation is essentially perfectly compatible with the principle, in practice this opportunity is severely compromised since the conception of compliance remains attached just to the “comply” part of the principle for both companies and investors (Sanderson et al., 2013, p. 19). The constant pressure to conform fully to a set of best practices attests to another fundamental issue which refers to the inherent rigidity of the “comply or explain” principle up to a point where the latter begins worryingly to resemble the “one-size-fits-all” approach of hard law from which it was, purportedly, designed to escape. Indeed, although initially designed with the aim to offer flexibility and “breathing space” to companies that, for a certain period of time, may have found it more useful for their purposes not to comply, the principle itself, as it is currently interpreted and used by the market, has become so rigid that it seems practically impossible for a company to feel free not to comply for fear of facing dissatisfaction from the investor community.

Bearing this element in mind, it would of course be utopic to neglect that the twofold nature of the principle aims in essence to guide the regulatee towards formal compliance in the long term since the framework wherein it functions consists of best practices and not ordinary practices that may include any kind of practices, including alternatives to the best ones. In other words, the encouragement and invitation to comply with a set of best practices may imply that the latter are considered the preferred ones and that possible deviation is not always the preferred outcome. This underlying rigidity of the principle, whereby all regulatees are expected in essence to comply formally in the long run and not to deviate, should be seriously challenged as, if it persists in the common perception of the investor community, might have even worse repercussions on regulatees than the current ones.

Does this mean that the original design of the “comply or explain” principle considered that deviation should not necessarily have the same value and therefore same amount of appreciation by the market when it is disclosed as the regulatee’s position? It is our belief that the mechanistic perception of compliance as well as superficial rejection of deviation does not have its origins in the principle’s infancy but is mostly due to a distorted taste for “box ticking” and automated use of services that favour form (simple declaration of compliance) over substance (declaration of non-compliance along with explanations).

Of course, the superficial use of the principle and the automatic rejection of deviations need also to be interpreted as a sign of mistrust in the market and underlying belief that explanations will rarely inform the recipients of the information disclosed in a realistic way. This has partially originated in the continuous provision of perfunctory explanations by companies and risks expanding as a trend if the regulatory framework does not intervene for the improvement of the content of information in this area as well as the dialogue between market participants.

This ongoing situation should alarm all involved parties for the future of the principle since it should be borne in mind that attachment to just one part of the principle will make the whole disclosure process less convincing for future regulatory measures in the capital markets sector. As has been wisely observed, the “comply or explain” principle is essentially a

meta-legitimation mechanism in that it invites monitors to make judgments, not only on the legitimacy of regulatee action but also on the overall legitimacy of the underlying code and its provisions. They do this either in simplistically (and inappropriately) by counting deviations or in a more nuanced way by examining the quality of explanations given for deviating.

(Sanderson et al., 2013, p. 4)

But adding to previous worrying signals, the natural and mechanistic preference for “mere compliance” statements makes non-compliance statements even less attractive, and therefore ultimately useless for informational purposes. Such non-compliance statements tend to be perceived as a typical declaration about the impossibility of complying with the code, instead of triggering a further need to understand the overall philosophy of the corporate strategy described in such a statement. This situation can only reinforce the mechanistic use of the principle and weaken the need for more useful information since users would remain focused on “formal compliance” and ignore the information accompanying “non-compliance”. Market actors therefore run the risk of being increasingly less interested in understanding the true reasons behind “non-compliance” and favouring, almost automatically, mere compliance declarations without actually really understanding the superficial information received.

In other words, if the future regulatory target is to change this dynamic, a non-compliance statement, assuming it is well justified and gives useful insight into the company’s philosophy and reasons for deviation, should not be considered a failure in the company’s regulatory approach or compliance (Seidl, Sanderson, & Roberts, 2009). Companies’ most important task would therefore be the coherent disclosure of their philosophy which, though possibly not sufficient at all costs, provides useful data to investors and allows them to benefit much more from an enriching and understandable statement that targets and analyses deviation from a set of rules. This approach is strongly backed by the Financial Reporting Council (FRC), which has already clarified in the most obvious way that “[w]hilst shareholders have every right to challenge companies’ explanations if they are unconvincing, they should not be evaluated in a mechanistic way, and departures from the Code should not be automatically treated as breaches” (FRC, 2012c). The same emphasis is given in the UK Stewardship Code (2012a, p. 4) but, quite surprisingly, is absent from the Best Practice Principles for Shareholder Voting Research, prepared by the Best Practice Principles Group (GBPP) (2014).

It is therefore essential to strengthen this “open culture” for explanations of deviation from rules so that all parties can feel equally free to declare a deviation without the fear of being automatically criticised, or even isolated, from the rest of the market. ^[52] To enshrine such a culture in market actors’ consciousness, soft monitoring powers of the principle itself could be developed in order for monitoring bodies to provide an official dialogue framework between all involved parties in the investment chain and therefore give the “comply or explain” principle its full potential. Indeed, our proposals in the third and final part of this paper aim to show that since market participants have not been in a position or have avoided making full use of both parts of the principle, a reorganisation of the framework surrounding the principle should be put in place. This reorganisation needs to consist of soft monitoring exercised by a Panel belonging to the national competent authority and to which the paper will now turn. The main role of the Panel would thus be to change the dynamics between various market participants and guide them towards a much more “tolerant” perception of the principle, encouraging them to develop their strategies more openly and to participate in a fruitful dialogue instead of purely rejecting each other’s alternative positions.

4.3 The introduction of soft monitoring powers