1. Executive Summary
________________________________________

‘Do directors have to be accounting standard gurus?’
‘How do directors spot the ticking bomb buried deep in a massive board pack?

These are some of the questions making top headlines following the Centro case decision made by Justice Middleton of the Federal Court on the 27 June 2011.

The issue of contention was whether the directors had sufficiently carried out a review of the financial statements, and if they had, whether the information was consistent with the directors’ knowledge of the company’s operations and whether the accounts contained all material information that should have been reported on and known to the directors.

ASIC successfully won the case with the eight defendants (Chief Executive Officer, Chief Financial Officer, Chairman and 5 other non-executive directors) found guilty of failing to identify and disclose significant errors in the 2007 consolidated financial statements of Centro Properties Limited, Centro Property Trust and Centro Retail Trust (collectively referred to as Centro).

Financial statements are essential for the accurate assessment of risks faced by any company. The decision in the Centro case clearly emphasises this point. Directors should be well equipped with basic accounting knowledge and be conscious of their duty to properly assess and review financial statements. It was also highlighted that directors should be warned against simply delegating financial reporting obligations to other qualified and trusted professionals.

ASIC is seeking that each of the defendants pay pecuniary penalties and be disqualified from managing corporations.

The pessimists of the world have interpreted Justice Middleton’s message as a rise in expectations of the duties and responsibilities of directors, making the role of a director next to impossible to perform. Others are not surprised by the outcome and believe it is positive in providing clarity on the responsibilities of directors. The underlying message of the case is to increase awareness of the existing legislation, and to remind directors of the duty they owe to their shareholders. The situation proposed in this case is unique and with an increased awareness, an oversight of this magnitude is unlikely to reoccur.

2. The Impact of the Centro Case Judgment
________________________________________

Implications for Directors

The level of understanding required in reviewing and approving financial reports, and providing the declaration required by section 295(4) of the Act, may exceed the capabilities of many directors worldwide. Whilst the Act has some provision for reliance on information provided by an employee who he or she believes is ‘reliable and competent in relation to the matters concerned’ , this is only valid and reasonable if an ‘independent assessment of the information or advice’ is made by the director.

Justice Middleton also emphasises: ‘This is not to say that directors are not entitled to seek assistance in carrying out their responsibilities, and may rely on others’ however ‘the extent of the reliance should not be taken too far.’

The decision may be interpreted by some directors as an explicit implication that directors should no longer loosely comply with s 189 of the Act, but should take full accountability of its declaration of the company’s financial report. This is particularly relevant to non-executive directors, especially those without accounting qualifications.

Knowledge of Accounting Standards

The Centro decision provides little clarity as to what level of enquiry and assessment of the financial statements is required.

An increase in time and effort required from directors aside, the interaction between directors and senior management may also be impacted with the issues of trust and accountability being areas of potential increased contention. Will directors be required to question every minute detail and play the role of devil’s advocate? A company that adopts this behaviour may be viewed as one with management and directors protecting their own interests rather than devoting their talents, skills and resources to achieve a profitable outcome for shareholders. How do companies achieve the optimal balance without compromising relationships with management, shareholders and retain confidence and trust with its stakeholders?

The case was not focused on a stringent or specific level of accounting expertise required of directors, and does not imply that all directors should acquire accounting qualifications, but instead was a case of failure to undertake a reasonable duty of care owed to shareholders in disclosing the company’s liabilities. The Court implies that an oversight of such material significance could have been prevented with little investigation:
‘The omissions in the financial statements ... were matters that could have been seen as apparent without difficulty … upon a careful and diligent consideration of the financial statements’ .

It is reasonable to expect that directors possess a basic level of accounting knowledge. The Centro directors had the skills and ability, albeit combined, to identify the material risks facing the company. Justice Middleton concluded that:
‘All that was required of the directors in this proceeding was the financial literacy to understand basic accounting conventions and proper diligence in reading the financial statements.’

Denis Pratt, CPA Australia Head of Accounting Policy, is not surprised by the outcome of the case and indicates that it helps define the role and responsibilities of directors. ‘A director needs to have a minimum standard of how accounting works…that the accounts conform with the requirements. [The decision] is not saying that board members have to be expert, but they need to ensure there’s a good communication process and that they query and question the accounts.’

Information Volume Control

Directors today are often overloaded with information that they are required to read, review and approve. It is in management’s best interest to provide the most accurate information in a timely manner to ensure the board are able to make the best decisions for the company. The directors rely heavily on the information presented to them.

Many directors sit on more than one board and are involved with the strategy and decision making for companies of varying natures.

One of the arguments used by the directors in the Centro case was that the critical information relating to the borrowings was lost in a very large board pack. This argument was dismissed by the Court with Justice Middleton stating:

‘A board can control the information it receives. If there was an information overload, it could have been prevented. If there was a huge amount of information, then more time may need to be taken to read and understand it. The complexity and volume of information cannot be an excuse for failing to properly read and understand the financial statements. It may be for less significant documents, but not for financial statements. [T]he directors were in possession of the information. The information was provided to the directors by management for a reason.’

The harsh reality of this statement has potential to spark a few issues. It is obviously not as easy as the Court claims to reduce the information received to prevent information overload. Management is unlikely to provide superfluous information as part of a board pack, which is an obvious display of counter-productive behaviour. A request from the board to reduce the documentation provided to them is likely to offend and upset management, again putting unnecessary pressure and tension on the board-management relationships. This may also pose restrictions and add to time and effort required from management to review and implement tighter filters on the flow of information through to the board.

Addressing this issue will require some discipline. The board must emphasise that information provided by management be in a manner that facilitates an efficient understanding of the key issues and that all information provided is meaningful and assists with the effective performance of their duties.

On the contrary, Justice Middleton’s statement contained a humane component, which excuses directors, to an extent, a comprehensive understanding for ‘less significant documents, but not for financial statements’ . The distinguishing between significant and less significant documents helps directors draw a line between those that are more important and require utmost attention.

In the Centro decision, the upcoming current liabilities and the material post-balance date events represented the most significant documents before the board.

The directors may still deem the expectations of them unreasonable, however, the Court’s decision to penalise the board is a message to all directors to perform their duty of care. The negligent behaviour of the directors in this particular case is a difficult battle to fight as it is hard to convince anyone that material issues such as takeovers and financial positions can be overlooked.

Legal Compliance

The legal implications of the Centro directors’ negligent behaviour contravened sections 180(1), 344(1) and 601FD(3) of the Act. The Court emphasises that the act places an importance on the financial statements and dismisses any attempt at delegating those responsibilities:
Directors cannot substitute reliance upon the advice of management for their own attention and examination of an important matter that falls specifically within the Board’s responsibilities as with the reporting obligations. The Act places upon the Board and each director the specific task of approving the financial statements. Consequently, each member of the board was charged with the responsibility of attending to and focusing on these accounts and, under these circumstances, could not delegate or ‘abdicate’ that responsibility to others.

The above statement relates directly to section 189 of the Act regarding the reliance on information or advice from others. It has been made apparent in this case that this section of the Act is unlikely to be applied successfully in future cases that involve financial statements and disclosure of material information that impact a company’s exposure to risk. Justice Middleton confirms this:
‘Directors are entitled to delegate to others the preparation of books and accounts and the carrying on of the day-to-day affairs of the company. What each director is expected to do is 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 [their] responsibilities’.

This section briefly explains each of the sections of the Act contravened.

Section 180(1) Care and Diligence
This section of the Act applies to all eight defendants as they qualify as either directors or other officers of Centro. The negligent acts displayed by all defendants in failing to identify and disclose the company’s true financial position does not meet the requirement of discharging ‘their duties with the degree of care and diligence that a reasonable person would exercise’ . The defendants were required to provide evidence that they took reasonable steps to ensure compliance by a company of its obligations in relations to accounting records, but were unsuccessful.

Section 344(1) Sanctions for Contraventions
A defendant is found liable for contravention of this section if compliance with Part 2M.2 (Financial Records) or 2M.3 (Financial Reporting) is not achieved. Contained within Part 2M.3 are the following sections where non-compliance was also identified:
• Section 295(4) of the act required directors to declare in their ‘opinion, there are reasonable grounds to believe that the company, will be able to pay its debts as and when they become due and payable’ .
• Section 295A(1) requires that a director’s declaration in the above-mentioned section ‘must be made only after a person who performs: (a) a chief executive function; or (b) a chief financial officer function’ . In his decision, Justice Middleton stated ‘it is in dispute whether Mr Scott and Mr Nenna did at any time give to the directors a declaration under s 295A of the Act in relation to the financial records and the financial statements of CPL’ .

Section 601FD(3) Duties of Officers of Responsible Entity
This section details the behavioural acts required by directors and officers to avoid accusations of negligence and non-compliance with other sections of the Act. Qualifying defendants are required to act honestly, and exercise care and diligence, act in the best interests of stakeholders and not utilise information obtained for interests other than that of the company. The court stated that there was no suggestion that the failure to recognise and take action in relation to these errors was intentional or dishonest, but there has been a breach of the care and diligence clauses by not taking sufficient action to protect the interests of the company’s shareholders:
‘This proceeding is not about a mere technical oversight. The information not disclosed was a matter of significance of the risks facing [Centro]. The importance of the financial statements is one of the fundamental reasons why the directors are required to approve them and resolve that they give a true and fair view… The significant matters not disclosed were well known to the directors, or if not well known to them, were matters that should have been well known to them’.

Compliance from a legal aspect arising from this case has not introduced any new concepts, but is a mere reminder that the sections in the Act are there to ensure the interests of the shareholders are protected, and those in the roles of directors and officers owe a duty of care to them. The significant value of the oversight is also another factor attributing to the lack of care displayed by the directors.

3. Conclusions
________________________________________

The contentions surrounding the outcome of the Centro case continue, as many argue that the expectations of the roles of directors have become unreasonable. The case did not set any mandates, introduce new concepts to legislation or changes to the role of directors. It is merely a case of penalising the Centro Board for failure to disclose such material figures that hide the risks the company is in fact facing.

The main underlying messages include:-
• Review of company’s financial statements demands detailed attention, where delegation of responsibility is deemed unacceptable.
• Directors are required to critically examine all financial reports, and consider them in relation to their own accumulated knowledge of company affairs and activities.
• Directors must be sufficiently familiar with critical accounting standards to know what should be included in financial statements and whether there are any material omissions.
• Provision of too much information may mean that directors are unable to focus on the critical details.

The outcome although devastating for some, provides further clarity for the role of directors and should be viewed as a positive outcome. Directors are roles of highest respect and should be coupled with the responsibility in ensuring the most optimal outcome for the future of the company as well as the immediate benefits to the shareholders and interested stakeholders. This is an overall evolution of corporate governance and the uncertainties will continue to unfold as more of these cases are contested.

4. References
________________________________________

Articles / Books / Reports

Du Plessis, Jean Jacques, Anil Hargovan & Mirko Bagaric, Principles of Contemporary Corporate Governance (Cambridge University Press, 2nd ed, 2011)

Cases
ASIC v Healey [2011] FCA 717

Legislation

Corporation Act 2001 (Cth) s 180
Corporation Act 2001 (Cth) s 344
Corporation Act 2001 (Cth) s 601FD
Corporation Act 2001 (Cth) s 294
Corporation Act 2001 (Cth) s 295A

Other

‘ASIC sends warning to directors on approving accounts’, Spark Helmore Lawyers, October 2009,

‘Directors Wary of Ruling in Centro Case: Report’, News-Economy, Business Spectator, 29 June 2011,

Heffernan, M ‘Directors responsibilities clearer after Centro case: expert’, Smart Company, 29 June 2011,

Savage, B, ‘From CEO to non-executive director’, CEO Forum Group,
Warnick, L and Chong, T, ‘Centro Case – the Central Messages’, Lavan Legal, 07 July 2011, http://www.lavanlegal.com.au/index.php/publications/publicationdetail/centro_case_the_central_messages

Whaley, J, ‘Court puts spotlight on directors after Centro fails to disclose billions worth of liabilities’, Herald Sun, 28 June 2011,