Allens

Corporate Governance

Focus: The Centro decision and the approval of financial statements

29 June 2011

In brief: This week's Federal Court decision in relation to ASIC's case against Centro's directors demonstrates how demanding a director's duties in approving financial statements are. In order to meet those demands, Boards may seek to change the ways in which financial information is presented to them and how they review it. Partners Matthew McLennan (view CV), John Morgan (view CV) and Jeremy Low (view CV) and Senior Associate Simon Lewis report.

How does it affect you?

  • The Centro decision1 is a case about financial reporting. It demonstrates that the obligations on directors approving financial statements are onerous.
  • Care needs to be taken in trying to apply the Centro decision outside the context of financial reporting or in relation to accounting issues that are more complex than those at issue in this case.
  • The decision identifies limits on the extent to which directors can rely on management and external advisers. The law imposes special responsibility on directors for approving financial statements. They cannot simply delegate that responsibility. Where directors know enough to spot a possible error in draft financial statements, they must question management and their external advisers.
  • Directors must have a degree of financial literacy. This knowledge should extend at least as far as basic accounting concepts and conventional accounting practices. The decision leaves unclear the question whether a director's knowledge should extend beyond this and, if so, how far.
  • Information overload is not an excuse for failing to read, understand, and focus on material provided to the board, especially material relating to the approval of financial statements. If information overload is a problem for them, directors must cause management to decrease the volume of information or increase the amount of time available to absorb it.

The facts

Errors in the Centro accounts

The defendants were the Chief Financial Officer and directors of, most relevantly, companies within the Centro Properties Group (CNP) and companies (including a responsible entity) within the Centro Retail Group (CER).

At board meetings held on 6 September 2007, the directors approved the accounts, which were included in the CNP 2007 Annual Report and the CER 2007 Annual Report. The Annual Reports were released to the Australian Securities Exchange (ASX) in September 2007. On 13 December 2007, each of CNP and CER requested the ASX to halt trading in its securities. Between December 2007 and February 2008, CNP and CER made a series of announcements concerning corrections to the financial information contained in the 2007 Annual Reports.

According to the findings made by the Federal Court:

  • CNP's 2007 Annual Report failed to disclose:
    • about $1.5 billion of short-term liabilities by classifying them as non-current liabilities;
    • guarantees of short-term liabilities of about US$1.7 billion that had been given after the balance date of 30 June 2007; and
  • CER's 2007 Annual Report failed to disclose about $500 million of short-term liabilities that had been classified as non-current.  
ASIC's case

The Australian Securities and Investments Commission (ASIC) alleged that, in light of these omissions, the directors had contravened:

  • section 344 of the Corporations Act 2001 (Cth), which requires a director to take all reasonable steps to comply with, or to secure compliance with, the financial reporting obligations contained in Part 2M.3 of the Act (s601FD(1)(f) is to similar effect); and
  • sections180(1) and 601FD(1)(b) of the Corporations Act. Those sections impose on directors of companies (such as CNP) and officers of responsible entities of registered schemes (such as the trust within CER), a duty to act with care and diligence.
Two sets of issues

The errors in the 2007 Annual Reports of CNP and CER related to two sets of issues. The first was the classification of debt as current or non-current. The Corporations Act requires financial reports to comply with accounting standards made by the Australian Accounting Standards Board (AASB). AASB 101 describes when a liability must be classified as current.  Consistently with AASB 101, notes 1(w) and 1(s) of the accounts for CNP and CER respectively stated:

Borrowings are classified as current liabilities unless the Group has an unconditional right to defer settlement of the liability for at least 12 months after the balance sheet date.

  

The second set of issues concerned disclosure of post balance-date events. AASB 110 required the disclosure of material non-adjusting events that took place after the balance dated (30 June 2007) and before the approval of financial statements (6 September 2007).

Debt classification

Justice Middleton approached the debt classification issue in two stages. The first stage related to the directors' financial literacy and knowledge of the financial position of CNP and CER. The second stage related to the process of reviewing the accounts.

Broadly speaking, the court applied this approach as follows:

  • so far as the financial position of CNP and CER was concerned, the directors knew the entity's debt maturity profile including that, as negotiations were taking place to refinance or extend debt facilities, the expiry or maturity date of those facilities was short-term;
  • as to financial literacy, notes 1(w) and 1(s) of the accounts for CNP and CER contained all the information about the effect of AASB 101 which the directors needed to have in order to read the draft financial statements and apply their knowledge of the debt maturity profile;  and
  • with that financial literacy and that knowledge of the financial position of CNP and CER, proper diligence in reading the draft financial statements  would have caused each director to make enquiries of management, the audit committee and other members of the board and to have the financial statements corrected prior to resolving to approve them.
Post balance date-events

The court adopted the same approach in respect of the post balance-date guarantees. In summary:

  • the directors had knowledge of the guarantees and their magnitude; 
  • the directors (or almost all of them) were aware of the need to disclose post balance-date events; and
  • in the circumstances, proper diligence would have caused the directors to turn their mind to the absence from CNP's accounts of any disclosure about the guarantees and make appropriate enquiries with management.

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The judge's reasoning on duty

Justice Middleton summarised the duty of care and diligence in these terms:

... the objective duty of competence requires that 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 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.

  

This general duty had to be construed consistently and harmoniously with the s344 requirement to take all reasonable steps to comply with, or to secure compliance with, the financial reporting obligations of the Corporations Act. In this case at least, a director who complied with s344 would also fulfil the duty of care and diligence.  

In performing these obligations, directors are entitled to rely upon others. They may not, however, substitute reliance upon the advice of others for their own attention and examination of an important matter that falls specifically within the board's responsibilities, such as financial reporting. The judge emphasises this at several points in his reasons. He described the case as one about 'financial reporting and the role and responsibility of directors in relation to that task'. The Corporations Act imposed on directors the critical responsibility of approving and adopting financial statements. The Act did not permit directors simply to put the discharge of that responsibility in the hands of apparently competent and reliable persons.

This special character of a director's obligations in respect of financial reporting is reflected in the fact that the s344 obligation (and s601FD(1)(f)) is not qualified by the business judgment rule (s180(2)) or the statutory protection for reasonable reliance contained in s189 of the Corporations Act.

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The significance of the decision

Is this anything more than a case of obvious mistakes?

Justice Middleton has not expressly set out to restate the law. In his reasons, the judge relies on longstanding statements of directors' duties. The Centro decision is, however, a valuable illustration of how those statements of principle may be applied in a particular case.

A threshold issue in assessing the significance of the decision is whether the particular circumstances are such that it gives limited guidance about how a director ought to act in other circumstances. The judge acknowledges that ASIC's case was that the errors in the CNP and CER 2007 Annual Reports were so obvious that the conclusion that they had been negligent was inescapable. This is referred to by the judge as the 'Blind Freddy' proposition. The directors failed to see the obvious errors only because they relied exclusively on the processes which CNP and CER had in place and on their advisers. None stood back, armed with his own knowledge, and looked at and considered for himself the financial statements.

Looked at in this way, the Centro decision may be little more than a reminder of the need for directors to read, understand and focus upon documents which they approve. That much is not controversial. What is likely to stir debate, however, is the court's rejection of defences raised by the directors which might normally be considered compelling.

To what extent can directors rely on management and external advisers?

A significant feature of the Centro decision is that the court proceeded on the basis that the directors were reasonably entitled to place reliance on the processes which CNP and CER had put in place for the purposes of ensuring that the financial statements were accurate and complied with the accounting standards. In particular, the directors were entitled to place full trust and confidence in the competence of the CFO and the external auditors. The court accepted that neither management nor the external auditors raised any 'red flags' that ought to have alerted the directors to the errors in the accounts.

The obviousness of the mistakes in question is critical to understanding this aspect of the Centro decision. The court accepted that reasonable reliance on others is legitimate. Reliance ceases to be reasonable, however, when a director is aware of plain circumstances that would cause a prudent person to question what he or she was being told. Justice Middleton was satisfied that the mistakes in this case were so obvious that the directors could not simply accept the advice of management and the auditors. They had to question what they were being asked to approve.

How financially literate must a director be?

In reaching his decision, Justice Middleton accepted ASIC's contention that he was only required to consider whether the directors knew or ought to have known the effect of AASB 101 and 110. In their defence, the directors objected to this approach on the basis that it was borne of regulatory hindsight. Once a court held that directors needed to know some accounting standards, they would fall under a duty to know them all. This was because no director could know in advance which standards would give rise to relevant problems.

The Centro decision does not contain a direct answer to this 'floodgates' argument. The court acknowledged that 'it may well be that directors should have a degree of accounting literacy that requires a knowledge of accounting practice and accounting standards'  but did not expressly state how much such knowledge was required.

The uncertainty arising from this aspect of the Centro decision is likely to be a concern for many directors. It is important to bear in mind, however, that this case, like any other, turns on its own particular facts. The judge was not seeking to legislate for the future. There are many indications in the judgment, however, that the knowledge required is only of basic concepts and conventional practice. In this context, the judge's emphasis on notes 1(w) and 1(s) may prove to be particularly significant. Those notes made it clear that a liability was current unless there was an unconditional right to defer settlement for at least 12 months. The directors knew that the Centro group was negotiating with its creditors. Therefore they must have known that there was no unconditional right to defer settlement. The directors did not need a sophisticated knowledge or understanding of accounting standards to join these dots.

Managing information overload

There was evidence that each month the directors received a board pack about 450 pages long. One of the board packs that was particularly relevant was more than 1000 pages long. The directors argued that they could not be expected to scrutinise and cross-check this much material.

The court found that, as a matter of fact, the volume of information presented to the directors did not inhibit them in this particular case. By various means, each came to know the information that was material to the debt classification and post balance-date event issues.

Moreover, as a matter of principle, the court had little sympathy for this problem. The directors could control the information they received. If there was information overload, they should have prevented it. If there was still a lot of material to digest, they had to allow more time to read and understand it. This was especially so where something as important as financial reporting was concerned.

Directors who do not read, understand and focus on all the information provided to them are at risk of breaching their duty of care and diligence. In light of the Centro decision, directors who get more information than they can read in the time available need to apply pressure on management to decrease the volume of information or increase the amount of time available to absorb it. This is especially the case when the information in question relates to approval of financial statements. This case points to a need for boards to take a more deliberative approach to the fulfilment of their responsibilities in that context.

Footnotes
  1. ASIC v Healey & Ors [2011] FCA 717.

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