Australia: Directors' Ability to Rely on Employees and Advisers - What does the Feltex Case tell us?

What was the case about?

In this case each of the directors of Feltex Carpets Limited (Feltex) faced two charges under section 36 A of the Financial Reporting Act 1993 (FRA) which requires that financial information prepared by a reporting entity comply with applicable reporting standards.

The charges were in relation to statements contained in Feltex's interim financial information for the half year ended 31 December 2005 (Interim Statements). The first charge was the failure to disclose that Feltex was in breach of covenants in one of its ANZ Bank Facility Agreements (ANZ Agreement). Second was the failure, as a result of that breach, to classify amounts due under the ANZ Agreement as a current liability. It was alleged that these failures meant that the Interim Statements were not compliant with the reporting standards and consequently the directors were in breach of section 36 A.

The directors all accepted that the Interim Statements had failed to comply with the applicable reporting standards in breach of section 36 A. However, they relied on the defence under section 40 of the FRA, that they had taken all reasonable and proper steps to ensure that the applicable reporting standards would be complied with.

When the Interim Statements were being prepared, New Zealand was in a transition period from its previous accounting standards (GAAP), to the adoption of the New Zealand equivalent of International Financial Reporting Standards (IFRS). Feltex had chosen (as an early IFRS adopter) to prepare the Interim Statements under IFRS. The change of standards also resulted in a change of the approach taken in the preparation of financial statements. The old standards favoured a substance over form approach, in comparison to IFRS which favour a form over substance approach.

Defence

The directors were aware that the new standards were complicated and that they had to be examined thoroughly for any significant changes. They argued that they had taken steps to ensure that there was a smooth transition to the new standards. These included establishing a comprehensive transition process and engaging Ernst & Young to prepare an IFRS assessment report identifying key areas and issues that needed to be addressed.

To further ensure that the Interim Statements complied with the new standards, the directors had engaged Ernst & Young to conduct a review of the Interim Statements and had sought declarations from Feltex's Chief Financial Officer (CFO) and Chief Executive Officer (CEO) in relation to compliance with the FRA.

Ernst & Young in their review said that there were no significant issues with IFRS compliance and had assured the directors that the Interim Statements were compliant with IFRS. Both the CFO and the CEO had assured the directors that the FRA was being complied with and that the company's internal financial controls were adequate and effective. A key component of the directors' defence was that they had relied on their advisers Ernst & Young in deciding that the Interim Statements complied with IFRS.

Decision

There had been no previous cases dealing with the particular defence used in this case. So in determining whether the directors could have relied on their advisers and whether that would amount to taking 'all reasonable and proper steps', the Court looked at the applicability of the Companies Act 1993 (CA) and common law cases which considered the extent to which directors are entitled to rely on the work and advice of others in approving company accounts.

The Court held that when dealing with obligations under section 36 A of the FRA, the directors are exercising and performing their duties as directors. As such the powers conferred on the directors under the CA apply. Section 138 of the CA allows directors to rely on professional and expert advice given by employees and professional advisers, provided that the directors act in good faith, make proper enquiries (where the need is indicated by the circumstances) and have no knowledge that such reliance is unwarranted. The Court stated that if directors satisfy the requirements of section 138, then they will have taken 'all reasonable and proper steps' to ensure that applicable requirements of the FRA would be complied with.

The previously decided cases considered by the Court also supported the proposition that directors are able to rely on advisers and employees provided certain criteria are met.

The Court held that in relying on Ernst & Young and the CEO and the CFO, the directors had taken all reasonable and proper steps to ensure that the applicable reporting standards would be complied with. The directors had acted in good faith, and there was nothing to put the directors on notice that further inquiry was needed or that their reliance was unwarranted. On that basis, the directors were found not guilty of the charges.

Other aspects of the case

The Court stated that there was overwhelming evidence that the directors were all honest men and that they had conducted themselves at all times with unimpeachable integrity.

Although Ernst & Young had not been a party or represented, the Court stated that if they had performed their review to a proper professional standard as the directors were entitled to expect, they would have identified and advised Feltex and its directors of the need to amend the Interim Statements to comply with IFRS.

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