1.2.1 The drivers behind the EU corporate governance developments and the comply or explain principle more specifically

This section functions as a prologue to the research. It explains why and how the comply or explain principle has been opted for in Europe, what the comply or explain principle precisely involves, and what its strengths and weaknesses are. The information provided in this section offers the context the research is embedded in as well as some basic, though inevitable, information to understand the research further. More in-depth information on a possible legal qualification of the comply or explain principle and on European corporate governance is provided in chapter 3 and chapter 4, respectively.

The corporate governance developments and discussion in the EU can be founded on three drivers: (i) the main driver at the beginning of this century was restoring the investor's confidence after the corporate scandals (such as Enron, Ahold and Parmalat), (ii) thereafter the aim to reach one single EU market and improving the competitiveness of EU companies1 gained importance (Consultation Action Plan 2005, p. 5). The above two drivers resulted in the third driver: (iii) to develop a modern regulatory framework for company law in the EU. Within this third driver the route the EU has taken with respect to corporate governance regulation is especially of interest: national corporate governance codes and Directive 2006/46/EC. To provide a comprehensive overview of the context of this research and the playing field in which the comply or explain principle is embedded, the three drivers are clarified further below. Under driver (i) a first preliminary explanation is also provided of the comply or explain principle itself.

Driver (i) Restoring the investor's confidence: In the beginning of the twentieth century just after the corporate scandals, countries attempted to draft regulation or legislation to prevent the occurrence of any more corporate scandals and to achieve a good corporate structure within their companies. This regulation had to help recover the decreased trust of shareholders in large companies, their managers and external auditors (Monks and Minow 2004, p. 1). Corporate governance codes, legislation and rules flourished in most western and also in a large number of developing countries.2 Driven by the financial scandal Enron in the United States of America (hereinafter the US), the famous US Accounting Industry Reform Act 2002 (known as the Sarbanes-Oxley Act or as hereinafter SOX) was drafted and enforced within a very short period of time. SOX gives extensive rules regarding corporate governance to not only the listed companies themselves, but also to the management, accountants, lawyers and securities analysts and is applicable to all listed companies in the US, including their advisors, irrespective of their country of residence. The US policy makers believed that by this harsh and extensive regulation the highest possible level of compliance with corporate governance regulation could be achieved, and thus new scandals prevented, lost confidence of shareholders hopefully regained and further problems between shareholders and directors decreased as much as possible (stated as agency problems by Jensen and Meckling in 1976 - see chapter 2). In the EU a different path was chosen to prevent the occurrence of more scandals and to fight the agency problems (Jensen and Meckling 1976); it was believed that what constitutes good corporate governance is continually evolving and 'one size does not fit all'. Therefore, policy makers had to provide the companies and their advisors with a range of flexibility for determining appropriate governance practices within a legal framework that mandates minimum requirements. How a company applies these minimum requirements varies according to company size, organisational complexity, shareholding structure and to other company characteristics (EU Comparative Study 2002, p. 68).

Most of the EU countries developed 'soft regulation' to make the companies behave in line with the principles of good corporate governance. Corporate governance committees, often especially established for this purpose, drafted corporate governance codes. Compliance with these codes was voluntary; they contained best practice provisions, recommendations or principles and the listed companies the code was applicable to had to choose whether to comply or not. However, to encourage this voluntary compliance the listed companies were obliged to comply with the applicable code or explain any deviations therefrom, nowadays better known as the 'comply or explain principle'. A clear and simple explanation of the comply or explain principle is: "A company should comply with the appropriate corporate governance code but ifit cannot comply with any particular aspect of it, then it should explain why it is unusable to do so"

(Mallin 2004).

The disclosure of the comply or explain principle takes place by means of a statement which is often part of the annual accounts. In a separate chapter or paragraph the company explains its corporate governance structure, the corporate governance policy, which corporate governance code is applicable, and above all to what extent it complies with this code and it explains the deviations from the specific provisions in the code. Henceforth in the underlying study, this paragraph or chapter in the annual accounts will be referred to as the corporate governance statement.

The UK Cadbury report from 1992 can be considered the first corporate governance code and simultaneously the first code that contained the comply or explain principle: "We recommend that listed companies reporting in respect of years ending after 30 June 1993 should state in the reports and accounts whether they comply with the Code and identify and give reasons for any areas ofnon-compliance. The London Stock Exchange intends to require such a statement as one of its continuing listing obligations " (Recommendation 3.7 of the Cadbury Report 1992).

Other countries, such as the Netherlands, Germany and Italy, soon followed the example of the United Kingdom (hereinafter the UK) by drafting corporate governance codes with (mandatory) comply or explain principles as well; still self-regulation but often with a legal embedding in listing rules or company law. In line with the EU route, nowadays all Member States have drafted some sort of corporate governance code. During these developments the playing field in which the issues of corporate governance and the comply or explain principle are embedded changed as clarified further under (ii).

Driver (ii) One single EU market and improving competitiveness of EU companies: Besides restoring the investor's confidence as sufficiently as possible, objectives such as improving the competitiveness of EU companies and above all one EU financial market gained importance. The necessity for EU-wide regulation or reform to develop the EU financial markets further was already recognised as from 19993 and slowly improved through the directives resulting from the Financial Services Action Plan issued in 1999. The objectives of the Financial Services Action Plan involved ensuring a single market for wholesale financial services, open and secure retail markets and state-of-the-art prudential rules and supervision. A general condition for such an efficient EU financial market is no legal or administrative barriers due to differences in national corporate governance arrangements, therefore an action point was to identify those possible barriers (Financial Services Action Plan 1999) and a logical next step was to develop a modern regulatory framework in the EU for company law.

Driver (iii) To develop a modern regulatory framework in the EU for company law: It was believed that a fundamental review was certainly due, since EU company law had not kept up with the development of corporate governance practices and standards (EU Company Law Action Plan 2003). Taking the then recent corporate governance developments into account - such as the blossoming of national codes - the EU had to decide on the recommended route to take. Two subsequent important initiatives involved the establishment of the High Level Group of Company Law Experts chaired by Jaap Winter in 2002 and the EU Company Law Action Plan as issued in 2003 (EU Company Law Action Plan 2003). In November 2002 the High Level Group published their Final Report on a Modern Regulatory Framework for Company Law in Europe. Their recommendations involved disclosure, shareholders' rights, board structures and transparency of board remuneration, auditing and - which is relevant in the underlying study - corporate governance regulation in the EU (Final Report High Level Group 2002, p. 44). With respect to corporate governance regulation they did not favour one single European code; such a code would not achieve full information for investors and would not significantly contribute to the improvement of corporate governance in Europe (Final Report High Level Group 2002, p. 9). They suggested that the EU play an important and active role in improving corporate governance and reaching convergence in Europe: it is the EU'staskto coordinate the efforts of the Member States to reach convergence on a continuous basis whilst taking account of the US developments (Final Report High Level Group 2002, p. 9) (Grazell 2002, p. 34).4 Subsequently in 2003, the EU Commission itself concluded in its EU Company Law Action Plan that: "the EU should not devote time and effort to the development ofa European corporate governance code" and the Commission observed that "the main differences between Member States are found in differing company law and securities regulation, as opposed to the corporate governance codes which, according to the March 2002 study, show a remarkable degree of convergence, and (...)that the existence of many codes in the EU is not generally perceived as a difficulty by issuers" (EU Action Plan 2003, p. 11).

The Commission was of the opinion that a common approach should be adopted at EU level with respect to a few essential rules and that adequate coordination of corporate governance codes should be ensured (EU Action Plan 2003, p. 12). As part of the action plan the Commission established the European Corporate Governance Forum (the ECGF) in October 2004.5 This group of experts gathered two to three times a year for high level meetings. Its task was to brief the Commission on the corporate governance developments in the Member States and simultaneously to evaluate these developments as well (Baums 2007, p. 3). The Forum's mandate expired in July 2011, but an important statement the Forum gave in February 2006 involved the comply or explain principle: "The 'comply or explain 'principle has become a feature of Europe's approach to corporate governance. (...) The Forum strongly and unanimously supports this approach, which is best suited to take into account the variety of situations of individual companies and fits well with the differences between national legal and governance frameworks. The Forum believes that, when it is effectively implemented, this is a better and more efficient approach than detailed regulation" (Statement of the ECGF on the comply or explain principle 2006). By means of this statement the forum made clear that no detailed regulation but principle-based regulation, self-regulation and the comply or explain principle should be the approach to improve corporate governance, realise convergence in Europe and improve the competitiveness of EU companies. The EU Commission itself also proceeded to act. Announcing measures to modernise company law and enhance corporate governance in the community were the objectives to aim for (driver (iii)).