Whilst the decision of the Australian Federal Court, earlier this week, in relation to proceedings brought against certain directors and the former CFO of the Centro Group is still very fresh, it is clear that there is potential for it to have a ripple effect for New Zealand directors.
Already, it seems clear that, at the heart of the 189 page judgment, is a clear indication that a director's 'reliance defence' is likely to be severely limited if that director had extensive knowledge of the issue in question.
Briefly, in proceedings brought by the Australian Securities and Investment Commission ("ASIC"), the court found that each of the directors and the CFO had breached their duty of care and diligence in relation to the relevant Centro entities and had also failed to take all reasonable steps to ensure compliance with the financial reporting obligations in the Corporations Act (2001) (Australia).
It is important to note that these were civil penalty proceedings. Central to ASIC's case was the claim that the directors had a duty to read and understand financial statements and apply the knowledge that they had (or should have acquired). In essence, ASIC claimed that the directors had breached their duties of care and diligence for reasons that included:
- the 2007 annual reports did not comply with the relevant accounting standards or give a true and fair view of the financial position and performance of the Centro entities because they failed to classify a significant amount of interest bearing debt as a current liability;
- the 2007 financial statements did not comply with the Corporations Act because they did not disclose the guarantees given by the Centro entities to an associated party as a significant post balance date matter (or as information that shareholders would reasonably require to make an informed assessment of the financial position, business strategies and future prospects) of the Centro entities;
- the directors' report in relation to the financial statements did not comply with the Corporations Act because it was given without first receiving the required declarations from the CEO and CFO.
It is important to note that the relevant provisions of the Corporations Act are very prescriptive and contain material differences to the obligations of an Australian company director to those of their New Zealand counterparts under the Companies Act 1993. Specifically, whilst both the Corporations Act and the Companies Act enable directors to rely on the advice of others (who they believe to be reliable and competent):
- the Australian provision also requires that a director must have made an "independent assessment" of the information having regard to their knowledge of the company and the complexity of the structure and operations of the company; and
- (by contrast) the New Zealand provision requires the director to make proper enquiry where the need for inquiry is indicated by the circumstances – and the director must have no knowledge that the reliance is unwarranted.
Central to the success of the ASIC case was the requirement, under the Corporations Act, for a director to take all reasonable steps to comply with, or to secure compliance with, the financial reporting obligations under the Act. ASIC argued that this required directors to personally undertake a line by line evaluation of the accounts looking for errors and inaccuracies. Alternatively, if this was not required the Court had to determine whether it was negligent for them to have failed to detect the relevant errors when they had been missed by both management and the auditors.
Whilst the problems faced by Centro appear to have become a cause celebre in the Australian business press, ASIC submitted that (long before the balloon went up) the board had been told of its financial problems, with detailed reports and tables, including a maturity profile of its debt. As a result, ASIC argued that the directors could not use the 'reliance defence' when tackled about certifying that Centro's financial statements that understated current liabilities by approximately $A2bn (because they were classified as non-current).
The Federal Court Judge found that each director had contravened their obligations under the Corporations Act because each had failed to take all reasonable steps to secure compliance, failed to take the steps that a reasonable person would take if they were in the director's position to ensure compliance and failed to exercise the degree of care and diligence required when reviewing the financial statements.
The Judge also concluded that the directors were all financially literate and experienced. However, he said that the central question was whether the directors had applied their own minds and knowledge of the company's affairs to the financial statements before approving them. On the basis of the evidence, the Judge found that they had not and in some cases had relied solely on management and external advisers. In this regard he concluded that the directors cannot substitute reliance for their own attention in an examination of an important matter that is specified (by law) to be their responsibility.
In a close parallel with the 2010 District Court decision in relation to Feltex, the Judge agreed with the defence that the directors did not need to do it all themselves and develop an intimate understanding of the complexities of the relevant financials standards. In this regard they were entitled to rely upon specialist advice. However, in order to do so they must take all reasonable steps to ensure the accuracy of that advice.
In this regard, the judgment continues that the directors of substantial listed entities are required to apply their own minds and carry out a careful review of the financial statements and the directors' report to determine that the information contained in that material is consistent with the director's own knowledge of the company's affairs and do not omit material matters known to them (or which should be known to them).
Again, on the evidence, the judgment found that significant matters that were not disclosed in the financial statements were well known to the directors (or should have been well known to them).
There is to be a further determination on the penalties (if any) to be met by the directors – after the Judge has heard further submissions.
Lessons for New Zealand Directors
Also, as noted above, whilst the Federal Court judgment applies similar principles to those relied on by the District Court in the Feltex decision, the burden of proof required to be achieved by ASIC in order to succeed was lower - because of the nature of the civil proceedings.
Since the Feltex decision, the New Zealand Government has empowered the new Financial Markets Authority 2010 ("FMA") to have "step in rights" to take action on behalf of investors for a breach of directors' duties. In addition, Cabinet decisions in relation to the root and branch review of securities law that were discussed in our March bulletin include providing the FMA with powers to take criminal proceedings against directors – but only in cases of serious misconduct. In this regard, Cabinet can be seen to trying to perform a delicate balancing act – including by not increasing the burden on directors to a level to a level that operates as a disincentive.
It seems likely that the Federal Court decision is not the last we will hear about Centro. There is a class action to come. Similarly the long tail of cases in relation to failed finance companies in New Zealand may shed further light on these issues in a New Zealand context. In turn, any such further litigation in New Zealand is likely to have an important bearing on the ultimate shape of the powers to be granted to the FMA once the securities law review process is completed.
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