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Pratip Kar: How to evaluate company boards

The new Companies Act provisions on the performance evaluation of boards need to be unambiguous and their implementation realistic if compliance is to be expected

Pratip Kar 

Pratip Kar

Compliance with the new provisions of the Companies Act 2013 (the Act) and its battery of Rules have kept the boards of companies, as well as their managements, lawyers, and 'external experts', frenetically busy for the last couple of months. One of the many provisions of the Act which has set the cat among the pigeons is the "performance evaluation" of boards and directors. The Indian corporate sector, which had long resisted its introduction, fruitlessly hoped for an evangelist to appear in the last hour and postpone its implementation, saying "India is not ready for it". In addition, bewilderingly overlapping provisions are spawning multiple "suitable" interpretations, adding to the confusion, and making compliance difficult.

To simply observe and follow rules has always been the established role of compliance. But this attitude towards compliance may not suffice for businesses today. Evidence from compliance failures shows that compliance with the letter and the spirit of any law can alone make compliance a tool for enabling the material improvements intended to strengthen business enterprises. In the face of ever-growing complexities and enhanced regulatory requirements, firms require this broader and enlightened approach to compliance.

The act of compliance in any field is a complex one. At a fundamental level, it involves behavioural issues. And at a practical level, compliance unequivocally rests on an unambiguous understanding of what needs to be complied with. Knowledge and appreciation about the utility of compliance enhance the propensity to comply. A clear and stringent penalty structure going hand in hand with a transparent and efficient enforcement mechanism significantly increases the level of compliance. Contrariwise, discordance between these, or their absence, results in the weakening of compliance.

Annual performance evaluation of boards and directors is an acknowledged global best practice. It has been mandated in India for the first time in the Act, for all listed companies and for an overwhelmingly large number of unlisted companies. But this very well-intentioned and forward-looking provision amply illustrates all the above points.

The first reference in the Act to the annual performance evaluation is found in Section 134 which enlists the new enhanced disclosure requirement in the Directors' Report section of the Annual Reports of companies. The clause (p) of sub-section (3) of Section 134 requires every listed company and every other public company having a paid-up share capital of Rs 25 crore or more to include in the Directors' Report "a statement indicating the manner in which formal annual evaluation has been made by the board of its own performance and that of its committees and individual directors". Performance evaluation being indubitably a significant provision of the Act, it is strange that it has been tucked away in a clause of a sub-section, instead of appearing as a standalone section.

Be that as it may, the provision by itself is precise and unambiguous. There is clarity in what needs to be complied with and who should comply; the consequences of non-compliance are also enumerated in sub section (8) of Section 134. But the Act does not leave the subject of performance evaluation to this sub-section only. As one manages to muddle through the Act, one finds multiple clauses and sub-sections dealing with the same matter. This gives rise to several puzzlements.

First, subsequent references in the Act are burdened with inconsistencies. For example, while clause 134(3)(e) makes the board responsible for making the "formal annual evaluation of its own performance and that of its committees and individual directors", sub-section (3) of Section 178 requires the Nomination and Remuneration Committee to "carry out the evaluation of every director's performance". In Schedule IV of the Act, one discovers the independent directors too are required to do the same job, i.e. to "review the performance of the non-independent directors and the Board as whole", and "the performance of the chairperson of the company, taking into account the views of the executive and non-executive directors". One remembers Bertrand Russell's observation: "Everything is vague to a degree you do not realise till you have tried to make it precise". How wonderfully the Act epitomises it!

Second, a multitude of overlapping and inconsistent requirements without a clear purpose and intention, leads to proffering of varying interpretations and makes the requirements exist only on paper, either not ingrained or poorly applied in companies. This hurts compliance. A rational reader may be befuddled both on what needs to be complied with and who is collectively or severally responsible for the various evaluations - the board, or the Nomination and Remuneration Committee, or the independent directors?

Third, the very wide applicability of the provision - to not only more than 5,000 listed and not-suspended companies (1,479 on the NSE and 3,965 on the BSE) but also to public companies with paid-up share capital of Rs 25 crore or more, whose number runs into the hundreds of thousands - makes enforcement ludicrously impractical.

There are two ground realities which need to be taken into account. First, the general lack of faith of a large part of the Indian corporate sector on the need and efficacy of the board and individual director evaluation. Second, a very large part of India's corporate sector comprises family-managed companies. Unless executed carefully, these two realities may well turn a very desirable provision of the Act into an annual box-ticking and profligate exercise. A much simpler and more effective solution would have been to leave the provision to rest only in clause 134(3)(p) and expand its coverage in phases, through the Rules.

The underlying principles governing the processes and methodologies of evaluation of the board and individual directors are now more or less standardised in the US, UK and most of the OECD countries. The levels of disclosures, though, vary. Some regulators in these markets mandate disclosures of the process, parameters, outcomes and action plans arising from evaluation; many others have still kept board evaluations voluntary.

Board evaluation, through self-evaluation or by a third party, is a powerful tool to uncover the real issues that inhibit a board's effectiveness. But it is not a panacea. It needs to be carefully designed if it is to go beyond a box-ticking survey.

Evaluations of individual directors usually are more delicate. If not done properly, these could exacerbate tensions and apprehensions of individual directors. The evaluation exercises would not be fruitful if these do not result in a concrete action plan for the board, the committees and the directors. But for all this to happen, individual directors must be able to give their freely and frankly about the board's and individual directors' performances, irrespective of whether the company is family-run or professionally managed. Confidentiality then becomes a prerequisite for the success of the entire evaluation process. The relevant sections of the Act collectively do not guarantee that.

The writer was executive director of Sebi

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First Published: Sat, April 11 2015. 21:50 IST