Corporate governance: Schrödinger’s cat and the evaluation of boards

A company’s board and an Austrian moggy may not initially have any obvious
connection, but recent corporate governance proposals from the Financial
Reporting Council that boards should be subjected to externally facilitated
evaluation at least every three years have more in common with Schrödinger’s
famous cat than you might think.

For those not up to speed with their quantum physics, back in 1935 Austrian
physicist Erwin Schrödinger composed a thought experiment involving a cat, a
steel box, an atom and some rather nasty poison. The experiment aimed to shed
light on the fluctuating nature of atoms (see box). The conclusion drawn was
that the cat was both alive and dead inside the box until it was opened and the
cat was observed. This is what is known as the observer’s paradox: observation
or measurement itself affects an outcome and the outcome as such does not exist
unless the measurement is made.

The concept may be derive from quantum physics, and many still struggle to
get their heads around the idea, but similar things could be said to be
happening all around us – even on the boards of the nation’s largest companies.

Good governance criteria

If we look at corporate governance and the FRC’s proposals, it is in
everyone’s interest for companies to be well governed and in an ideal world
boards, shareholders and the general public would welcome some assurance as to
the quality of governance in some of the country’s largest and most significant
companies. However, providing assurance over corporate governance is more
difficult than it might first appear.

It’s a fairly easy task to benchmark each company against a list of perceived
good governance criteria: does a company have X directors considered by the
board to be independent, does it have a risk committee, does it meet Y times a
year? Ultimately, though, this only gives assurance on organisational matters
and that is only half the issue.

Most observers would accept that good governance is not about organisational
or structural matters but about behaviour. What are the directors doing in
practice; what behaviours are they exhibiting; and what is the culture within
the board room? Getting assurance over these behavioural aspects of governance
is much more difficult than ticking some checklist of organisational criteria.

How could an independent observer tell if non-executive directors are
providing the executive team with constructive, independent challenges and
contributing fully to the development of strategy? How could they tell if the
chairman is promoting a culture of openness and ensuring the effective
contribution of all directors? How could they tell if non-executive directors
are able, both in theory and in practice, to express views to the board that are
different to those of the CEO – even in apparently successful companies? The
answer it would seem is to observe the board in practice – which is, of course,
the essence of what externally facilitated board evaluation is all about.

Independent facilitators, as recommended by both Sir David Walker and the
FRC, see the board in its natural environment and, through a variety of methods,
tease out any tensions and ineffective practices with a view to overall
improvement.

But this brings us back to Schrödinger’s cat and the paradox that observation
itself affects the outcome. The very presence of an assessor or external
facilitator may well affect the behaviour of the board. Equally, the outcome – a
more effective board – will not exist unless the assessment is made. That is to
say that regular and rigorous board assessment will improve board effectiveness.

For this reason, the FRC has to be applauded for proposing the external
facilitation of the board evaluation at least every three years. Certainly it is
the best chance we have of improving board effectiveness – not in the judgmental
sense of pass or fail but in the sense of continual improvement; and is one of
the few proposals that address the behavioural aspects of governance rather than
simply reinforcing perceived governance wisdom and refining governance
structures.

In-house assessments

External facilitation of board evaluation is not without its problems and its
critics. Putting aside Schrödinger’s cat, many corporates are quick to point out
that there are currently few organisations with sufficient quality and
experience to engage in external evaluation assignments.

This is somewhat of a paradox in itself as those very same organisations have
been merrily conducting their own in-house assessments since the revisions to
the Combined Code at the beginning of the millennium. One wonders how rigorous
many such assessments have been.

Nevertheless, getting the right individual or firm to facilitate the board
evaluation is an issue. A number of headhunting firms are – like the cat that
got the cream – very keen to offer board evaluation services to their clients.

But prospective buyers should think carefully about whether it is appropriate
for the same firm to evaluate the effectiveness of a board and recruit its
members.

Last, if the proposed revision to the UK Governance Code is to encourage the
behavioural shift that might be necessary in some organisations, consideration
should be given to establishing certain ‘ground rules’ for carrying out board
evaluation – whether internally or externally facilitated.

For example, perhaps boards should solicit feedback from major investors –
say those owning more than 5% of the company? This doesn’t get around
Schrödinger’s paradox, but it would certainly test the appetite of institutional
investors to actively engage with those companies in which they invest.

Board evaluation aide memoir

Think about improvement – not passing or failing.

* Focus on behavioural issues and corporate culture

* Focus on outcomes not activities

* Benchmark against aspirations, identified shortcomings and best practice

* Solicit feedback from major investors, management and other stakeholders

* Come away with actions and follow-up regularly

What’s in the box?

Schrödinger’s cat is a famous thought experiment, devised by Erwin
Schrödinger in 1935, which describes one of the key properties of quantum
mechanics – namely, that atoms can exist in different states and locations until
they are observed.

He imagined a cat locked inside a steel box with a “diabolical mechanism”
that would activate and kill the cat depending on the actions of a single atom.
The conclusion was that, since atoms can exist in more than one state, while the
box remained unopened, the cat was both alive and dead at the same time. Not
until the box was opened and the cat was observed would it actually become one
of those two definite states. This is the observer’s paradox – that the act of
observation and measurement itself affects the outcome and that there is no
outcome until the measurement/observation is made.

The idea may sound bizarre, but the principle of atoms having many
possibilities until the moment of measurement is today the backbone for one of
the most important branches of physics.

FRC’s proposed UK corporate governance code

* The board should state in the annual report how performance evaluation of
the board, its committees and its individual directors has been conducted.
(Provision B.6.1)

* Evaluation of the board should be externally facilitated at least every
three years. Where consultants are used a statement should be made available of
whether they have any other connection with the company. (New Provision B.6.2)

* The non-executive directors, led by the senior independent director, should
be responsible for performance evaluation of the chairman, taking into account
the views of executive directors. (Provision B.6.3)

Timothy Copnell is associate partner at KPMG’s Audit Committee
Institute.