Section 149 of the Companies Act 2013 has come into force from April 1, 2014, which mandates review of the performance of the chairperson of the company, non-independent directors and the board, by independent directors.
According to the provision of the Act, independent directors will meet separately, at least once in a year, for this purpose. The requirement is applicable to listed companies and some other classes of companies to be specified in the rules to be issued by the government.
This provides an opportunity for companies to continuously improve and transform a 'good board' to a 'great board'. Boards, which will take the 'tick box' approach and declare that 'we are OK', will miss the opportunity to improve the board effectiveness.
The objective of the evaluation is quite simple. It is to measure how the chairman, board, committees and individual directors have contributed to improving the company's health and ensuring perpetual success of the company.
However, developing evaluation parameters and the process to achieve this simple objective is complex. The same size does not fit all. Therefore, like regulators in other jurisdictions, the government has not prescribed the review process. Every board has to develop its own process and parameters.
Review of the performance of individual non-independent directors also includes review of the performance of the CEO. The new provision in the Companies Act definitely aims at empowering independent directors and strengthening the institution of independent directors. The power equation within the board is bound to change with effective implementation of the new provision.
The experience of the UK, the US and other countries, shows that such a change does not weaken the management. It rather strengthens the CEO. In order to avoid tension within the board, it is crucial that both - the CEO and independent directors - understand each other's rights and responsibilities.
Independent directors, in their zeal, should not usurp the CEO's right to run the company. The board's role is limited to advising and monitoring the management.
There are many factors that will determine the way the provision will be implemented in practice. The crucial one is the level of independence of independent directors.
If, independent directors are not independent in its true sense, the review of the CEO, other directors and the board will turn out to be a ritual. The Companies Act stipulates: "appointment process of independent directors shall be independent of the company management." Today's reality is different.
In most private sector companies, independent directors are appointed with the approval of the CEO and the promoter. Therefore, in the private sector, the review will not be effective unless the appointment process is changed, not on paper only, but in practice.
The Remuneration and Nomination Committee should be allowed to work independently. However, that does not mean that the views of the CEO and the promoter should be ignored.
The committee should consider their views before finalising the names. However, the CEO and the promoter should not have an overwhelming influence on the appointment of independent directors. This will happen only in those companies in which the CEO and the promoter take initiatives to change the process.
The problem with public sector enterprises (PSEs) is different. In PSEs, the appointment process of independent directors is independent of the company management. However, in a PSE board, the government nominees enjoy more power than independent directors. This power equation will act as a constraint in effectively implementing the provision of the Companies Act. The solution lies in better appreciation of independent directors' role by government nominees. Although the actual review will take place at the end of the year, to be effective, the process should start immediately. The first step is to document the responsibilities of the board and its priorities for FY15.
Responsibilities are generic, but priorities depend on the company's business strategy, positioning, the current financial position and new initiatives. The next step is to decide the review process. It may be informal or formal.
The board should deliberate and decide the process and designate the independent director (for example, chairman of the Remuneration and Nomination Committee) who will lead the process. It should also decide how it would use the feedback. This is crucial and sensitive, but an important issue.
Will the board review a reality in practice? Let us not expect that the review, even in respected companies, will be effective from the very first year. That has not happened anywhere in the world. We should expect only a humble beginning.
Affiliations: Professor and Head, School of Corporate governance and Policy, Indian Institute of Corporate Affairs; Advisor (Advanced Studies), Institute of Cost Accountants of India; Chairman, Riverside Management Academy Private Limited