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)

This article was first published in AccountancyAge.