The Centro decision - ASIC v Healey & Ors [2011] FCA 717

Articles Written by Richa Puri, Stephen Walmsley

Editorial

While there has been much press that the Centro decision has lifted the bar in relation to directors actively examining and questioning information contained in financial statements rather than being able to rely on management, in our opinion the decision does not really change or extend the scope of directors' duties. It may, however, be a harsh decision on the facts as determined in the case.

In our opinion, Centro does not establish new law - it does not require specialist financial or accounting expertise of directors nor require them to be involved in operational management of the corporation. Directors are required to provide a declaration in relation to the financial statements of their company, including declarations as to solvency and the statements providing a true and fair view of the financial performance and financial position of the entity and cannot delegate this responsibility to management.

Directors should read the financial statements in the context of their understanding of the company's business and financial position and apply an enquiring mind - no more and no less than one should expect of company directors.

The application of these basic principles to the facts as determined by the trial judge in this case may be regarded, by some, as hard. Centro was a complex business, with many material matters before the Board and the refinancing of debt was only one of a number of issues on the Board's radar screen, at a time (pre-GFC) when the refinancing of debt was pretty much taken as an issue of pricing, not an issue in its own right.

However, in our opinion, it seems a reasonable application of the law based on the finding of fact that the directors had not read the financial statements closely and had relied on management and the external auditor to get the accounting treatments right. It would be interesting to know if a different outcome would have been reached if the Board, when approving the financial statements, had considered the classification of the debts and made a conscious decision to classify them as non-current given the assurances of management that the debts would be refinanced. While these actions would again amount to an incorrect application of the A-IFRS accounting standards, it is more likely that the directors' reliance on management in this context would be considered reasonable, and that the directors would have properly discharged their duties in forming an opinion on the financial statements.

This case appears to stand for the principle that directors cannot abrogate their responsibility to be aware of the circumstances of the company when discharging their basic functions as directors, one of which is to make the declarations1 required of them by the Corporations Act in finalising the financial statements - that, in the directors' opinion, they comply with the accounting standards and give a true and fair view.

Rather than establishing new law, in light of its specific facts and the defence run by the directors, the only 'take-away' of general application from the decision is really to serve as a wake up call to those who may not be giving material matters facing their company the attention required of a director.

The decision

ASIC brought action against the seven directors (and the CFO) of the various companies operating within the Centro Properties Group for breaches of directors' (and officers') duties in relation to their approval of the Group's 2007 financial statements.

The directors approved the Group's financial statements (which were included in the 2007 Annual Report) which had classified $2 billion of liabilities as noncurrent and not disclosed US$1.75 billion of guarantees of short term liabilities of an associated company that had been given after the balance date (but before the financial statements were approved). ASIC alleged that the directors had breached their directors' duties by approving financial statements that had substantially understated the Group's short term liabilities by incorrectly classifying them as non-current liabilities and by failing to disclose the material post-balance date guarantees.

The Federal Court (Middleton J) found that in approving the financial statements, the directors failed to discharge their duties with due care and diligence as owed under sections 180(1), 344 and 601FD of the Corporations Act.2

Although the breach of duties centred on a failure to ensure that the financial statements accorded with accounting standards,3 and despite the position that directors, especially non-executive directors, are not expected to have a high degree of technical financial and accounting knowledge, the Court determined that the liabilities that were omitted "were well known to the directors, or if not well known to them, were matters that should have been well known to them". The Court found that, had the directors carefully considered the financial statements in the context of their knowledge of the Group's affairs and its financial position, each director would have noticed that short term liabilities of a significant amount were missing and questioned the omission.

As the duty of care owed is to be considered objectively, the Court considered that the duty of competence demanded of a director requires that they be able to read and understand financial statements, including the meaning of the concepts of 'current' and 'non-current' liabilities. Accordingly, what the directors subjectively knew or believed was irrelevant.

The directors argued it was not normal practice for NEDs to personally question the financial statements that had been prepared by a competent accounting team and recommended by a qualified auditor who is overseen by an experienced audit committee, particularly as neither management nor the external auditors alerted the directors to the possibility of disclosure errors in the accounts.

The Court accepted that the NEDs had appeared to follow usual practices for the approval of financial statements, and in practice it may be rare for an audit committee or NED to pick up on a failure to comply with accounting standards.

The Court found, however, that the audit committee's role of monitoring and oversight of financial reporting is not to the exclusion of the role of directors to independently form an opinion on the financial statements. This finding probably had much to do with the defence run by the directors, which was not that they had considered the financial statements and made an honest mistake in applying the appropriate accounting principles, but that they had not considered the financial statements in detail and relied on the accountants to make sure that the statements were right.

The Court did not assert that a director had to be familiar with every accounting standard, but that it was reasonable to expect them to be sufficiently aware and knowledgeable to understand what is being approved or adopted. Accordingly, the directors could not argue a blind reliance on the assurance from the external auditors that the financial statements accorded with relevant accounting standards.

Moreover, whilst the 'reasonable director' would not have personally verified the accuracy and accounting treatment of each figure in the financial statements, they would read the statements carefully in conjunction with the information that is available to them, which in this case, would have revealed the significant misclassification of the Group's short term debt.

The Court will hear submissions as to penalties for the directors in August.

Key observations

The case does not stand for the proposition that directors cannot rely on the opinion of others in performing their duties. Directors can rely on the work of and opinions of management and external advisors, provided this is reasonable in the circumstances. Reliance is not reasonable if the director ought to know that such work or opinions are not accurate in the context of the company's affairs, and in those circumstances the director is required to question the information before them.

Centro re-affirms that directors are to possess sufficient skill to read and understand the company's financial statements to form an opinion of solvency, and spells out the somewhat obvious fact that this requires some knowledge of basic accounting concepts and practices. The case does not go as far as to require directors to have a sophisticated knowledge or understanding of accounting standards. It does, however, suggest that the director should read and question these statements with the knowledge he or she has (or should have) by virtue of his or her position as a director.

The case serves as a reminder of the following duties and responsibilities of directors (both executive and non-executive):

  • non-executive directors should acquire (at the very least) a rudimentary understanding of the business of the company and become familiar with the fundamentals of the business in which the company is engaged
  • non-executive directors should keep informed about the corporate affairs and policies of the company, but (at least in the context of Centro) do not necessarily need to know detail of the day-to-day activities of the company
  • directors need to maintain familiarity with the financial status of the company by undertaking regular reviews of financial statements in the context of financial reports, the objective duty of skill or competence imposed requires directors to have the ability to read and understand financial statements before forming an opinion (which is expressed in the s295(4) declaration)
  • directors need to independently scrutinise the accuracy and contents of reports and important announcements that are before them for approval and, in doing so, make use of the information known or available to them
  • whilst directors can delegate to management, they cannot delegate the responsibility placed on them under the Corporations Act - the responsibility ultimately rests with the directors for the content of the financial statements
  • directors should have questioning minds (and turn their mind to key assumptions or qualifications), and
  • the complexity and volume of the information provided to directors is not an excuse for failing to properly read and understand the reports and other information provided to the Board for consideration. As directors have control over the material that is provided to them, they should allow more time to comprehend the information if needed.

1 Section 295(4)(d), Corporations Act.
2 Sections 180(1) and 601FD(1)(b) require company directors or officers to exercise their powers and discharge their duties with the degree of care and diligence that a reasonable person would exercise if they were in a similar position. Sections 344(1) and 601FD(1)(f)(i) require directors of a company, registered scheme or disclosing entity to take all reasonable steps to comply with, or to secure compliance with the Financial Reporting provisions of the Corporations Act in Part 2M.2 or 2M.3.
3 The Corporations Act (section 296(1)) requires financial reports to comply with Australian accounting standards, and AASB 101 describes when a liability is to be classified as current.

Important Disclaimer: The material contained in this article is comment of a general nature only and is not and nor is it intended to be advice on any specific professional matter. In that the effectiveness or accuracy of any professional advice depends upon the particular circumstances of each case, neither the firm nor any individual author accepts any responsibility whatsoever for any acts or omissions resulting from reliance upon the content of any articles. Before acting on the basis of any material contained in this publication, we recommend that you consult your professional adviser. Liability limited by a scheme approved under Professional Standards Legislation (Australia-wide except in Tasmania).

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