Board Dynamics, Efficiency and Effectiveness

CII Directors Guild 
By Arun M. Kumar & Sai Venkateshwaran
08-Nov-2017

My address at CII Directors Guild Platinum Programme, Bengaluru

I am delighted to be here to talk about a topic that has increasing importance for the Indian corporate environment. I compliment CII for undertaking this initiative on a director certification program.

And I applaud each one of you for recognizing the benefits of such programs and for investing the time to do so. I know many of you are experienced directors and you will have much to share. The area of governance is rapidly evolving and we have to learn from each other and contribute to shaping this field. It is a journey.

Corporate governance is complex; while it deals with corporate behaviors, it is ultimately about human behavior, and the extent of human judgement involved makes it all the more challenging a subject to navigate and understand.

And it’s as a part of this journey that the Uday Kotak led SEBI Committee on Corporate Governance recently submitted its recommendations with the goal of enhancing corporate governance requirements in India. The recommendations were partly based on the learnings from the implementation of the Companies Act 2013 and in part based on the growing challenges and complexities of today’s environment.

As these recommendations get codified into regulations and the law, we will have amongst the best corporate governance regulations in the world.  However, the real test will come from implementation.  The Committee recognized the need to move from compliance in letter to compliance with the spirit – that’s the heart of any corporate governance reform that you would want to drive in the companies and boards that you serve.

The Committee essentially worked with two guiding principles – protection of the interests of all shareholders and particularly minority shareholders and long-term value creation for all shareholders.  The Committee acknowledged the importance of the role that boards, its committees and independent directors have to play in achieving these objectives, and made several recommendations in that regard.

That brings us to the subject of this session – board dynamics, efficiency and effectiveness. The effective functioning of the board and its success are driven by three key elements – its culture, its composition and its focus on substantive areas.  Each of these key areas has a significant role in making the board more effective.

First let’s look at the board’s culture. What is ideal is a culture of open debate and challenge.

It is essential for board to have a culture of open debate and discussion for it to be effective.  The board must set the tone for how the organization conducts itself, and the chairman must set the tone for how the board conducts itself.  This tone drives the dynamics in the board room.  This tone must be in line with the vision and values of the company, which will guide it as it works towards long term value creation and in the process engages with diverse stakeholders.

The board will need to constantly manage several conflicting viewpoints and demands.  Whether these are balancing the long term interests of the company and the short term investor expectations or the demands of a dominant promoter shareholder or a high profile professional manager, the board has to arbitrate between diverse viewpoints and act in the interests of all stakeholders.  The board in general and the chairman in particular should also set the tone for compliance with the spirit of good governance rather than just comply with the letter of the law.

The UK’s Financial Reporting Council in its Guidance on board effectiveness states, “An effective board should not necessarily be a comfortable place. Challenge, as well as teamwork, is an essential feature.”  Therefore, the board needs to know when to engage, when to trust and when to challenge – both one another and management.  However, this doesn’t always happen.  A survey of directors conducted by KPMG’s Board Leadership Centre found that nearly 35 per cent of the respondents highlighted ‘board culture that does not encourage questioning and open discussion’ as one of the greatest barriers to build a high performing board.

Therefore the chairman of the board must act as a facilitator and foster an environment of open debate even if it is contentious.  This is a big cultural change in itself – some directors having to let go and take a step back, whereas some others need to step up.

In this context, the separation of the role of the CEO and Chairman becomes relevant.  It’s a topic that has been debated at length and there is no consensus – jurisdictions such as the UK and some countries in Europe are in favor of separation of the two roles, whereas in US the consensus has been the other way.  The debate becomes more nuanced when you overlay this with the context of prevalent ownership structures; in India, where most listed companies are still largely promoter owned and managed, this debate becomes more important.  The board’s role is to govern and provide oversight to management, whereas the CEO’s role is to focus on execution of the strategy. This is an argument for the separation of the two roles especially when there is sizeable public shareholding in a company.

Finally, the voice of the independent director plays an important role in changing the dynamics in the board room.  However, in many situations, a lone independent director’s views may not be heard, and it’s in this context that the role of the lead independent director becomes relevant.  He or she is expected to help enhance coordination amongst the independent directors and make them more effective by amplifying the collective voice of all the independent directors.  The culture of having more frequent exclusive meetings of independent directors should evolve over time.

Now let’s look at the second element on board composition – getting the right people on the board.

The Kotak Committee has recommended that the proportion of independent directors on all boards be increased to at least half the board size.  The Committee recognized the need for further refining the criteria for independence and the also the spirit of independence, including both objective and subjective assessments.  The Committee also focused on the existence of board inter-locks, which may run a structural vulnerability of quid-pro-quo, and has therefore recommended there be no inter-locks involving independent directors.

This recommendation comes together with that of having at least one woman independent director on the board.  A recent survey by KPMG shows that 68 per cent of the respondents believe that women help create a positive environment in the boardroom’s culture and dynamics and are better at providing constructive feedback.  Several global studies have also shown that women bring different perspectives to boardroom discussions, including those that relate to balancing the interests of diverse stakeholders.

Apart from having independent and women directors, it is equally important to make sure that the board members have the right skills, not just to deal with the challenges of the business today but also to help it navigate the challenges of tomorrow.  Businesses today are faced with challenges around increasing regulations, uncertain geopolitical outlook, and growing technological disruption, among others.  This would require boards to embrace several new skill sets that were hitherto not considered in an intentional way.  This is particularly important at a time when levers such as technology are both enabling the creation of newer business models while also exposing the company to several risks, including cyber security risks.

In the 2016 KPMG Board Leadership Center India survey, nearly 70 per cent of the respondents indicated that finding directors with both general business experience and specific expertise is one of the key barriers in building and maintaining a high performing board.  So it certainly is a challenge that needs to be addressed, if companies want to make the shift from being disrupted to being the disruptor. Boards will thus need diverse skills, identified objectively.

And it is not enough if you have a board that meets the skills and independence criteria. Boards must be engaged; there must be active participation and contribution, and thus the focus on minimum attendance and board evaluation becomes relevant.  As enablers to achieve optimal composition, the respondents to our survey overwhelmingly cited robust evaluations (87 per cent) and formal succession plans (77 per cent) as the most effective mechanisms.

Further, in today’s fast changing world, it is important for all directors to keep their skills updated through periodic formal and other trainings, and that’s where sessions like this play a big role.  Directors also need to have a pulse on the on-the-ground functioning of the company through periodic engagement with management.  With the roles of directors and the various committees being broadened, committee roles will take up significant time commitment. There is thus a need for a director to limit the number of directorships that he takes on, if he has to do justice to the role.

And lastly, to attract the right and best people, the risks and rewards need to be balanced.  The Committee has made specific recommendations on minimum compensation and the balancing of non-executive director compensation between the independent directors and other non- executive directors.  It has also mandated that every company take D&O cover for its directors.  Hopefully, these steps will pave the way for to good talent in the boardrooms.

Now coming to the third element – the board’s focus on substantive matters.

With the deluge of compliance and reporting requirements, very often the agenda for board meetings only caters to these matters, and the board doesn’t get time to focus on broader business issues.  Some companies therefore hold one board meeting exclusively to look at strategy and plans of the company.  Our survey highlighted that nearly half of the respondents are not entirely satisfied with strategy and risk being effectively addressed in boardroom discussions.

Recognizing this issue, the Committee has recommended that the number of board meetings be increased, and sufficient time be devoted to aspects like strategy, succession planning, budgets, risk management, ESG (environment, sustainability and governance) and board evaluation. These are all topics that are critical to the medium-term and long-term future of a listed entity.

KPMG’s CEO Outlook Survey 2017 found that 54% of CEOs said they are likely to transform their organizations into significantly different entities in the next three years.  Many of them are already leading customer-focused transformations (57%) or innovation-led transformations (56%) in their organizations.  CEOs also acknowledged ‘new technologies’ as being one of the biggest factors impacting the growth of their organizations in the next three years, with 63% of them making significant investments in that area.  With so much transformation and disruption on the anvil, it is imperative that boards focus on these areas, and regularly guide management in the execution of these strategies.

Recognizing these growing challenges, the Committee has recommended the formation of an information technology committee and a risk management committee to focus on risks including cyber security.

It is important to get the investor community to appreciate these changes. There is excessive short termism in the markets today, not just in India. Management is often caught up in working towards meeting quarterly expectations of the market rather than working towards what may be in the long term interests of the company.

When Paul Polman took over as CEO of Unilever, he announced that shareholders should no longer expect to see quarterly annual reports from the company, along with earnings guidance for the stock market. Unilever, he explained, was now taking a longer view.  He said, “Unilever has been around for 100-plus years. We want to be around for several hundred more years. So if you buy into this long-term value-creation model, which is equitable, which is shared, which is sustainable, then come and invest with us. If you don’t buy into this, I respect you as a human being but don’t put your money in our company.”

While quarterly reporting still remains mandatory in India, unlike in Europe and UK, it is important for boards to examine the correlation between performance goals and compensation and its alignment with the long term strategy of the company — and assess whether it is encouraging the right behaviors in executives.  This is where the enhanced role of the nomination and remuneration committee (NRC) is relevant.

Lastly, several instances of laxity in governance have been seen when it comes to monitoring group companies.  A lot of focus of the board goes into looking at the matters that relate to the listed company.  However, the reality is that a significant part of the business is done through subsidiaries and that’s also the part of the group that remains vulnerable to malpractices.  Considering this, the Committee has recommended that the audit committee and the board play a more active role in monitoring subsidiary companies and the material transactions they are involved in.

Lastly, the Committee has recommended that SEBI step up its monitoring of all corporate filings, with a specific focus on quality of financial reporting.  This will certainly enhance the rigor of compliance by both the companies and their auditors, and SEBI will have a significant role to play in enhancing the standards in this area.

Summing up, we are in a fast changing world, with significant and unprecedented changes being seen in both businesses and on the regulatory environment.  To make the most of these changes, and to propel the organizations towards a more sustainable future, boards have a central role to play, and as board members, each and every one of you has a very important role.

And as more changes come through in the area of corporate governance, I would encourage you to embrace these changes in its true spirit and make a difference to corporate India’s future.