Business and Technology · Governance in business organisations

Governance Codes: Rules-Based vs Principles-Based Approaches

Updated 11 October 2026 · Fact-checked

A governance code sets out good practice for how companies are directed and controlled. A principles-based code uses comply or explain: follow each provision or disclose and justify any departure. A rules-based approach makes requirements legally binding, with penalties for breach. In the exam, name the approach, then give its pros and cons.

Understand Governance Codes: Rules-Based vs Principles-Based Approaches

Corporate governance is the system by which companies are directed and controlled. A governance code is a set of standards for boards, covering things like board make-up, committees, pay, risk and audit. The question for regulators is how to enforce it.

There are two broad approaches. A principles-based approach gives broad principles and lets each company decide how to apply them. The best-known form is comply or explain: the company either follows each provision or tells shareholders where it does not and why. The UK Corporate Governance Code works this way. Compliance is not forced by law. Shareholders judge the explanation and can respond by voting or engaging with the board.

A rules-based approach sets detailed legal requirements. Companies must obey them and face penalties such as fines, criminal liability or loss of a listing if they do not. The US Sarbanes-Oxley Act is the usual example. It was passed after major corporate scandals and imposes legal duties, for example on internal control reporting and on directors certifying financial statements.

The OECD Principles of Corporate Governance are different again. They are international, non-binding principles that governments and regulators use as a benchmark when they write their own laws and codes. They are not a code a company signs up to. Many countries base national codes on them. Typical areas include shareholder rights, fair treatment of shareholders, the role of stakeholders, disclosure and transparency, and board responsibilities.

Most codes cover similar themes: a division of roles between chair and chief executive, a balance of executive and independent non-executive directors, board committees (audit, remuneration, nomination), fair and linked pay, risk management and internal control, and communication with shareholders. Poor governance can lead to fraud, weak controls, excessive risk taking, poor decisions, loss of investor confidence, a higher cost of capital, fines, reputational damage and even collapse.

Key formulas to remember

Comply or explain: Comply with the provision OR explain the departure and why; Principles-based. Not legally forced, but departures must be disclosed and justified to shareholders.
Rules-based approach: Legal requirement + enforcement + penalty for breach; Compliance is mandatory. Sarbanes-Oxley is the standard example.
Typical code provisions: Separate chair and CEO; balanced board with independent NEDs; audit, remuneration and nomination committees; risk and control review; Learn these as a checklist for 'outline the main provisions' questions.
OECD Principles: International, non-binding benchmark for national laws and codes; Not a company-level code. Do not say companies must comply with it.

How to solve Governance Codes: Rules-Based vs Principles-Based Approaches questions

Use this method for any question on governance codes and approaches.

1Read the verb. 'Explain', 'distinguish', 'identify' and 'state' need different depths.
2Identify the approach in the scenario: is compliance optional with disclosure (principles-based) or legally enforced (rules-based)?
3Define the term in one sentence, for example what comply or explain means.
4Link to the scenario: what did the company do, comply or depart from a provision?
5Give the advantage or disadvantage the question asks for, using the scenario facts.
6For provisions, match the issue to the right code area, such as board balance, committees or pay.
7For poor governance, name the effect and connect it to the cause given.
8Check your choice matches the number of answers required in multiple response questions.

Quickest way: Three-second approach test

When to use it: Use for objective test questions asking which approach, which feature or which statement is correct.

Ask: can the company legally choose not to comply if it explains? If yes, it is principles-based.
Ask: does breach lead to a legal penalty? If yes, it is rules-based.
Ask: is it a broad international benchmark for governments? That points to the OECD Principles.
Eliminate options with absolutes such as 'always' or 'never' unless the definition supports them.

Common mistakes in Governance Codes: Rules-Based vs Principles-Based Approaches

Saying comply or explain means companies may ignore the code.
Students focus on the lack of legal force.
Fix: State that departures must be disclosed and justified, and shareholders can act on weak explanations.
Saying rules-based systems are always better because they are enforced.
Enforcement sounds stronger.
Fix: Give both sides: rules are clear and enforceable but costly, rigid and can be met in form while avoiding the spirit.
Treating the OECD Principles as a binding code for companies.
The word 'principles' is mixed up with 'code'.
Fix: Describe them as non-binding international guidance that countries use to build laws and codes.
Listing code provisions without linking them to the scenario.
Students memorise lists and stop there.
Fix: Pick the provision that fits the facts, such as a chair who is also CEO, and say why it is a concern.
Describing poor governance effects only as 'fines'.
Students think only of legal penalties.
Fix: Include loss of investor trust, higher cost of capital, weak controls, fraud risk and failure.

Worked examples

Example 1

A listed company's code requires a majority of independent non-executive directors on the audit committee. The company has only one on a committee of three and says in its annual report that it is recruiting two more and will comply within a year. Which approach does this show, and is the company in breach of the law?

Show the solution

The company departed from a code provision and disclosed it.
It also gave a reason and a plan. This is the comply or explain pattern.
Comply or explain is principles-based, so the code is not itself law.
So departing is not a legal breach if it is disclosed and explained.

Answer: It shows the principles-based comply or explain approach. The company is not breaking the law by explaining its departure, although shareholders may judge the explanation.

Example 2

Explain two advantages and two disadvantages of a rules-based approach to corporate governance compared with a principles-based approach.

Show the solution

Advantage 1: clear, certain standards apply to all companies.
Advantage 2: legal enforcement and penalties give a strong deterrent against poor behaviour.
Disadvantage 1: rules are inflexible and can be a poor fit for different company sizes and structures.
Disadvantage 2: compliance can be costly and may encourage box-ticking, with companies meeting the letter but not the spirit.

Answer: Rules-based governance gives certainty and strong enforcement. Its drawbacks are rigidity and high compliance cost, with a risk of box-ticking.

Exam tips

Always name the approach using the exact term: comply or explain, or rules-based.
In 'outline provisions' questions, use short code headings: board balance, roles, committees, pay, risk and control, shareholder relations.
Keep OECD and national codes separate. The OECD is a benchmark, not a company code.
For scenario questions, quote the fact that shows the weakness, such as a dominant CEO or no independent directors.
In multiple response questions, read the required number of answers first and tick only that many.

Practice questions from Governance in business organisations

Governance Codes: Rules-Based vs Principles-Based Approaches in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Governance Codes: Rules-Based vs Principles-Based Approaches: frequently asked questions

What does comply or explain mean?

It means a company follows each code provision or tells shareholders which it did not follow and why. It is the main feature of principles-based governance. The market, not the law, judges the explanation.

What is the main difference between rules-based and principles-based governance?

Rules-based governance sets legally binding requirements with penalties for breach. Principles-based governance sets broad standards that companies may depart from if they explain. Principles allow flexibility, while rules give certainty.

Is the OECD code the same as the UK Corporate Governance Code?

No. The OECD Principles are international, non-binding guidance for governments and regulators. The UK Corporate Governance Code is a national code that applies to listed companies on a comply or explain basis.

What are the effects of poor corporate governance?

They include fraud, weak controls, poor decisions, loss of investor confidence and a higher cost of capital. Companies may also face fines, reputational damage and failure.