Nasdaq ‘Best Practices’ Proposal May Be Move Toward ‘Comply or Explain’

A combination of new regulations, market listing standards and best practices from a myriad of organizations will make for a patchwork corporate governance model in the United States at a time when simpler is better. That is what U.S. public company boards face in the coming months.

And that raises the question of what U.S. boards will do. Obviously, there really isn’t a simple answer. Now may be the time for U.S. companies to start looking abroad to see what their counterparts in Europe or Australia are doing. (Maybe the NASDAQ market has gotten a head start on this, according to its proposed corporate governance best practices. See below) Our brethren overseas seem to have mechanisms in place that are more open to addressing the corporate governance vulnerabilities than what exist today in the United States.

In many of the European countries, such as the United Kingdom, Germany and the Netherlands, use a “comply or explain” principle where companies that publicly trade sign an agreement to adhere to governance codes that address a number of issues, such as independent chair, shareholder communications and director qualifications. And if they can’t abide by a certain part of that code, the companies must say why.

In the UK, they have had something called the Combined Code since 1992. The Code is essentially a principles-based way to address corporate governance as opposed to a rules-based system, which exists in the United States. So instead of having separate regulations on issues such as remuneration (compensation) committee independence, independent board chair, annual board elections, or independent risk management committees, boards agree to abide by a code that encompasses all of those.

While it may not be perfect, it has improved corporate governance substantially, according to the Financial Reporting Council, a UK regulator whose mission it is to “promote confidence in corporate reporting and governance.” As part of its responsibilities, the FRC revisits the Combined Code’s effectiveness every couple of years. In its March 2009 review, it found that while many financial institutions suffered from governance failures, overall the Code continues to be effective throughout other industries.

There was one observation that stood out in that review: “Market participants have expressed a strong preference for retaining the current approach of ‘soft law’ underpinned by some regulation, rather than moving to one more reliant on legislation and regulation. It is seen as

better able to react to developments in best practice, and because it can take account of the different circumstances in which companies operate it can set higher standards to which they are encouraged to aspire.”

Apparently, the idea of more governance regulation is not too popular. Jon Lukomnik, founder of Sinclair Capital and a member of the International Corporate Governance Network, following a July 15, 2009 ICGN annual meeting in Sydney that “by and large the room rejected more regulation, preferring to use industry pressure to increase shareowner involvements with managements and boards on a voluntary basis.”

But at the same meeting, Stephen Davis, policy director of the Millstein Center for Corporate Governance and Performance at Yale, desperately called for more regulation. “We are in a country that requires people to vote in elections. It is time for governments to step in and require more voting and engagement and mandate reform of fund governance.”

Nasdaq in August did something that might steer the corporate governance discussion toward adopting some kind of “comply or explain” type of policy when it sought comments about adopting Corporate Governance Best Practices. The Nasdaq Listing and Hearing Review Council proposed a list of potential best practice recommendations that members would have to adopt on a “comply or disclose” basis. (See Nasdaq proposal here.)

Some of those best practices include:

• Executive sessions for independent directors at every board meeting.
• At those executive sessions, address issues such as tone at the top, use of self-evaluations for the board, whether or not independent directors are adequately involved in agenda setting, and the company’s risk management strategy.
• Continuing education programs for directors.
• Limits for directors on the number of outside boards they sit on.
• Annual director election.
• Independent board chair and/or independent lead director.

We should know very soon whether or not Nasdaq will adopt these practices since the comment period just expired Oct. 30.

On the other hand, the New York Stock Exchange is amending its listing standards to take care of some bookkeeping to align them with the recent SEC adoption of Item 407 of Regulation S-K, which requires disclosure about director independence and certain other aspects of a company’s corporate governance practices. Nothing is in the offing regarding best practices.

Judging by the reaction of one participant in The Conference Board Governance Center’s Oct. 28 Webcast Pressure Points for Boards: Improving Directors’ Performance in Times of Financial Stress, “comply or explain” might be a tough sell in the U.S.

“There are elements [of governance standards] that we borrow from each other,” Holly Gregory, a partner with Weil, Gotshal & Manges, said. “But there really are some fundamental differences.

“I don’t see us moving toward a European model. Certainly, Say on Pay is something. It is carried out in the UK and Australia is considering it. It remains to be seen if we have similar experiences.” She also cited the U.S. adversarial culture and the difference in the meaning of independent chair as reasons the European model would not work here.

That doesn’t necessarily mean that boards shouldn’t take a hard look at what they are doing across the Atlantic. It’s got to be better than dealing with hodge-podge of regulations that are sure to come.