Rules-based system

In the rules-based system, companies adhere to the rules or pay

penalties.

 ADVANTAGES
1. Clarity
2. Standardisation
3. Penalties are a deterrent against bad CG
4. Easier compliance with the rules, as they are unambiguous, and
can be evidenced
 DISADVANTAGES
1. Can create just a "box-ticking" approach
2. Not suitable to all possible situations.
3. Creates unnecessary administration burden on some companies
4. One size does not necessarily fit all.
5. Expensive

Principles-based System (Comply or explain)

In the principles system, companies adhere to the spirit of the “rule”, or

explain why it hasn’t.

This does not mean the company has a choice not to adhere.

It just means it can TEMPORARILY explain why it has not.

The punishment for this non-adherence will be judged by investors.

 ADVANTAGES
1. Not so rigid, allows for different circumstances.
2. Allows companies to go beyond the minimum required.
3. Less of an admin burden.
 4. Can develop own specific CG and Internal controls (For example
physical controls over cash will be vital to some businesses and
less relevant or not applicable to others.
 DISADVANTAGES
1. The principles are so broad that they are of very little use as a
guide to best corporate government practice
2. Not easier compliance as with the rules, as they are ambiguous,
and can not be evidenced
Principles v Rules More Detail

 Principles
The principle of ‘comply or explain’ means that companies have to take
seriously the general principles of relevant corporate governance codes.

Compliance is required under stockmarket listing rules but non-

compliance is allowed based on the premise of full disclosure of all
areas of non-compliance.

It is believed that the market mechanism is then capable of valuing the

extent of non-compliance and signalling to the company when an
unacceptable level of compliance is reached.

On points of detail companies could be in non-compliant as long as they

made clear in their annual report the ways in which they were non-
compliant and, usually, the reasons why.

This meant that the market was then able to ‘punish’ non-compliance if
investors were dissatisfied with the explanation (ie the share price might
fall).

In most cases nowadays, comply or explain disclosures in the UK

describe minor or temporary non-compliance.

Some companies, especially larger ones, make ‘full compliance’ a

prominent announcement to shareholders in the annual report,
presumably in the belief that this will underpin investor confidence in
management, and protect market value.

Remember though that companies are required to comply under listing

rules but the fact that it is not legally required should not lead us to
conclude that they have a free choice.
 The stock market takes a very dim view of most material breaches,
especially in larger companies.

Typically, smaller companies are allowed (by the market, not by the
listing rules) more latitude than larger companies.

This is an important difference between rules-based and principles-

based approaches.

Smaller companies have more leeway than would be the case in a

rules-based jurisdiction, and this can be very important in the
development of a small business where compliance costs can be
disproportionately high.
 Rules
Rules-based control is when behaviour is underpinned and prescribed
by statute of the country’s legislature.

Compliance is therefore enforceable in law such that companies can

face legal action if they fail to comply.

US-listed companies are required to comply in detail with Sarbox

provisions.

Sarbox compliance can also prove very expensive.

The same detailed provisions are required of SME's as of large

companies, and these provisions apply to each company listed in New
York.