You Have to “Comply or Explain”. What Actually Counts as a Good Explanation?

“Comply or explain” is the phrase most boards use, but the Capital Markets Authority’s 2015 Code of Corporate Governance Practices for Issuers of Securities to the Public says it has moved away from comply or explain to “Apply or Explain”. A good explanation under that Code names the specific recommendation that has not been applied, gives a reason the board can defend, and states a timeline and the strategy for moving to full application. A reference to company size on its own gives the reader none of those things, and an explanation is not a way around a provision the Code makes mandatory.

Comply or explain became apply or explain

The Code was issued by the Capital Markets Authority under section 11(3)(v) of the Capital Markets Act, which lets the Authority prescribe notices or guidelines on the corporate governance of a company whose securities have been issued to the public or a section of the public. The Gazette notice says it applies to both listed and unlisted public companies. In section 1.1.1, the Code describes its approach as principle-based rather than rule-based, and says a satisfactory explanation for non-compliance “will be acceptable in certain circumstances”. The price is full disclosure to stakeholders, including the Authority, together with a firm commitment to move towards full compliance.

The same paragraph draws a line. The Code contains mandatory provisions, which it describes as the minimum standards issuers must implement, and where a requirement is mandatory it says companies shall comply with it. Issuers of restricted offers to sophisticated, institutional or professional investors are exempted from strict compliance with the mandatory provisions and may adopt them as best practice. Before you draft any explanation, therefore, check whether the provision you are departing from is a mandatory one. If it is, an explanation will not do the work.

What the law requires of an issuer that departs from the Code

The Capital Markets (Public Offers, Listings and Disclosures) Regulations, 2023 (Legal Notice 172 of 2023) revoked the 2002 Regulations (regulation 92). Paragraph 8.1 of the Thirteenth Schedule says every issuer shall comply with the Code. Paragraph 8.2 requires every issuer to disclose, in its annual report and on its website, its corporate governance practices and a statement by the directors on whether the issuer is applying the recommended practices. It adds that where the issuer has not fully applied them, the directors shall indicate the steps being taken to ensure application.

The disclosure is an account of a gap and of the plan to close it, not a standing licence to stay outside the Code. The Code’s implementation clause (1.1.3) points the same way: an issuer that had not implemented the Code within one year of its publication was to give the Authority its reasons for non-application and clearly indicate the time frame required and the strategies it would put in place towards full application. Confirm on the CMA website that the 2015 Code is still the current text before you rely on it.

What a good comply or explain statement contains

Paragraph (r) of the Code’s disclosure guideline (7.1.1) sets the minimum content. The board’s annual statement on compliance with corporate governance principles shall indicate the aspects of the Code which have not been applied, the reasons, indicative timelines and proposed strategies towards application. Turned into a checklist, a good explanation:

• identifies the exact recommendation by number and says in what respect it has not been applied;
• gives the actual reason, such as a transition in progress, a regulatory constraint or a considered alternative arrangement;
• describes what the company does instead to meet the objective behind the recommendation;
• sets an indicative date for full application and names who is responsible for delivering it; and
• says what the board will report next year, so the explanation is not repeated unchanged.

Three examples from the Code show how concrete this can be. Recommendation 2.3.3 says the functions of the Chairperson and the Chief Executive Officer shall not be exercised by the same individual. Recommendation 2.4.2 caps the tenure of an independent director at a cumulative nine years, after which the director may continue subject to re-designation as non-independent. Guideline (d) under 7.1.1 asks the board to disclose whether independent and other non-executive directors constitute at least two thirds of the Board. A company still short of any of these can explain precisely, by naming the director, the date and the replacement plan.

Departures from legal requirements are treated more strictly. Under 7.1.1(g) the board is to disclose that a legal and compliance audit was carried out, the level of compliance with laws, regulations and standards, and any material departures from required compliance, the causes and the measures to address them.

Treat the explanation as a board decision

The disclosure should record a decision the board actually took. Section 210 of the Companies Act, 2015 requires a company to ensure that minutes of all proceedings at meetings of its directors are recorded and to keep them for at least seven years, and failure is an offence carrying a fine of up to five hundred thousand shillings for the company and each director in default. A minute that records which recommendation the board considered, why it chose to depart, what alternatives it weighed and the date by which it expects to apply the recommendation is both the evidence behind the published paragraph and the board’s own record of its reasoning.

In our view, a practical sequence is to have the company secretary list every recommendation not yet applied before year end, ask the responsible director for the reason and the date, table the list at a board meeting, minute the decision, and only then draft the annual report wording.