Every now and then the decision of a single judge can rock the boardrooms of an entire nation. On 27 June 2011, Justice Middleton of the Federal Court of Australia delivered the Centro Decision1. Ever since, law firms have been busy advising worried directors asking, "What does the Centro Decision mean for me?"
The wriggling of directors in the chairs of the nation's boardrooms caused by the Centro Decision has come about mainly from the Court's unequivocal comments in the decision that:
- directors are expected to have at least a basic level of financial literacy; and
- directors can't exercise "sole reliance" on external experts (including their external auditors).
The Centro Decision
The Centro Decision is a decision made in proceedings taken by the Australian Securities and Investments Commission ("ASIC") against 8 officers - the Chief Executive Officer, 6 non-executive directors, and the Chief Financial Officer - of the Centro Property Group ("Centro"). ASIC alleged various breaches of the Corporations Act 2001 ("Act") including section 180(1) - duty of directors and other officers to exercise care and diligence, and section 344(1) - failing to take reasonable steps to comply with Part 2M.2 (financial records) or Part 2M.3 - (financial reporting).
ASIC‟s contention was that the defendants failed to take all "reasonable steps" to comply with or secure compliance with financial reporting obligations in the Act, including a failure to exercise reasonable care and diligence before providing the directors‟ declaration pursuant to section 295 of the Act.
The breaches arose because the Centro accounts examined in the case:
- contained approximately $2 billion dollars of short-term liabilities incorrectly classified as a non-current liability, when this amount should have been declared as a current liability; and
- failed to disclose guarantees of short-term liabilities for an associated company amounting to approximately US$1.75 billion where those guarantees were given after the balance date, but prior to approval by the Board of the financial statements.
The Court agreed with ASIC, and found the entire Board and the CFO had breached their statutory duty as directors and other officers to exercise care and diligence. The hearing on appropriate penalties is set for later this year.
The finding has alarmed many directors because the Centro Board had adopted financial statements for its Annual Report and made the directors‟ declaration to be included in the Annual Report after receiving approval from the external auditor, and in reliance on their own CFO.
Directors must have basic "financial literacy"
The Court took the view that a director lacking sufficient financial literacy can't form an independent opinion in order to provide the directors‟ declaration required by section 295 of the Act, under which directors declare "whether, in the directors' opinion" (underlining added), the financial statements and notes in an annual report:
- give a true and fair view of the financial position and performance of an entity; and
- are in accordance with accounting standards.
The Court didn't go as far as to spell out‟ the level of financial literacy required of a director, saying it depended on the particular organisation, its size, complexity of operations, nature of business, and so forth. As a general statement, the Court gave the following guidance on the level of financial literacy required to show a director has the required objective standard of competence relevant to exercising care and diligence in relation to financial statements:"... the directors have the ability to read and understand the financial statements, including the understanding that financial statements classify assets and liabilities as current and non-current, and what those concepts mean. This classification is also relevant to the assessment of solvency and liquidity. Equally, a director should have an understanding of the need to disclose certain events post balance sheet date."
The Court held that directors don't have to "personally scrutinise each line of accounts looking for accounting errors or apparent inaccuracies", but that "a director had failed to exercise care and diligence in approving accounts, by failing to make relevant enquiries or raise matters that ought to have been raised, and, in consequence, had failed to take all reasonable steps to secure compliance with the Act". (underlining added)
Directors need to know about Accounting Standards
The Court commented that directors are not required to have detailed knowledge of accounting standards, but they should at least understand the central concepts of the main accounting standards that impact on their organisation's financial statements. For example, the Court found that the Centro directors should have had a basic understanding of:
- the classification of debt as current or non-current as required by the Australian Accounting Standards Board ("AASB") in AASB 101 ; and
- the requirement to disclose material non-adjusting events in accordance with AASB 110 that took place between the balance date (30 June 2007) and approval of the financial statements by the Board in September 2007.
Implications for Directors Generally
Some commentators have said that the Centro Decision does nothing more than re-iterate the principle embedded in the common law for over 100 years that directors are required to bring an "independent and enquiring mind" to their role in order to discharge their duty to act with care and diligence. Others say that the duty of a director to act with care and diligence, particularly in relation to signing off on an organisation's financial statements as required of them by section 295 of the Act, has been elevated to a higher and unprecedented level by the Centro Decision. Both points have some validity.
The Centro Decision has the following implications for directors generally.
- Review your level of financial literacy – do you understand basic accounting concepts contained in accounting standards used to prepare your organisation's financial report such as "current" and "non-current" liabilities, the definition of "profit" (which is also relevant for payment of dividends), requirements to disclose material factors post balance-sheet date, the meaning of "assets" for the purposes of the accounts, and so forth? If not, obtain some training because the Court commented that a failure to take steps to acquire a sufficient degree of financial literacy could in itself be a breach of the statutory and common law duty to exercise care and diligence in performing your directors' duties.
- Have you read the sections of the Act relevant to directors‟ duties? The Court found that failure to read and understand the relevant sections may in itself be a breach of a directors‟ duty to exercise reasonable care and diligence as directors can't perform their statutory duties if they don't know what they are.
- When expert reports are given to you, do you read them and raise questions about them if you don't understand something, or if you think they fail to reflect your understanding of the subject matter? The Court stated that directors have a "responsibility to read, understand and focus upon the contents of those reports which the law imposes a responsibility upon each director to approve or adopt." While not directly stated, in our opinion the Centro Decision means that directors cannot simply adopt whatever is tabled before them on the basis an expert has provided the document. Directors are required to "take a diligent and intelligent interest in the information available to him or her, to understand that information, and apply an enquiring mind to the responsibilities placed upon him or her....there must be more than mere 'going through the paces".
- Do you read the financial statements and the Annual Report, including the notes, before signing off on them as a Board? Do you identify all the statements attributed to the Board or the company as a whole in the document, understand those statements and agree with them? If not, is there a process for you to raise questions with the appropriate people before you sign off?
- Do you identify all the accounting standards specifically mentioned in the financial statements and the Annual Report, including the notes, before you sign off on these documents? Do you understand the key concepts in those accounting standards? Have you asked your experts to explain to you what key accounting standards apply, and what the key concepts are that are contained in those accounting standards, so that you can have a basic understanding of them?
Have you taken all "reasonable steps" to ensure you have sufficient knowledge to make the declaration before giving the directors' declaration in an Annual Report2. The Court found that failure to take "reasonable steps" was a major reason why the Centro directors had breached their directors' duties. The Court also said "reasonable steps" will differ depending on the particular organisation, but at a minimum they include:"a director must become familiar with the fundamentals of the business in which the corporation is engaged; a director is under a continuing obligation to keep informed about the activities of the corporation; directorial management requires a general monitoring of corporate affairs and policies, and a director should maintain familiarity with the financial position of the corporation."
Reasonable steps" will also include having reliable procedures which the Court found include:
- having a qualified, competent and well resourced financial management team, or access to one;
- engaging a highly reputable accounting firm to assist in preparation of financial statements and assess compliance; and
- using an appropriately constituted audit committee.
- Do you read your whole Board pack and all other information (including expert reports) that is given to you in your capacity as a director? The Court found that all directors must read and understand all the material in Board papers, financial reports and all other material that comes before them. If they don't understand any part of it, they are required to make enquiries including by asking questions of management or advisors so that they do understand the material.
- Is there a process in your organisation for referring questions to management and receiving adequate responses?
- Does your organisation have a procedure for preparation of financial statements? This includes an audit committee with suitably qualified and experienced people and competent financial team, and access to a reputable firm for accounting/auditor tasks.
- Do you get enough time to read and understand the Board pack before Board meetings?
- If you have been appointed because of particular skills and expertise, do you have access to information from the part of the organisation to which those particular skills and expertise relate? Is there a process for you to raise questions with key managers in that part of the organisation? The Court found that a part of exercising care and diligence required of a director is to bring your competency in those particular areas into play as a Board member.
- Do you know who the Chief Executive Officer, Chief Financial Officer and other key managers are in your organisation? Is there a process for Board members to ask them questions, particularly about matters in the Board pack and other information given to you as a Board member?
This is likely to be a key focus area for directors going forward. Please contact us if you would like any further guidance in relation to the Centro Decision, or director's duties generally.
1 Australian Securities and Investments Commission v Healey  FCA 717
2 Pursuant to section 295(4) of the Act as to solvency and compliance with the Act including section 296 (compliance with accounting standards) and 297 (true and fair view)
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.