29 June 2011

What does the Centro case mean for directors?

Directors must scrutinise company accounts.

That is the clear message emerging from Monday's Centro decision, and the message headlined in all the media reports of the decision.

What is equally significant for directors is what doesn't appear in the newspaper headlines – issues such as:

  • do directors have to be accounting standard gurus?
  • how do directors spot the ticking bomb buried deep in a massive board pack?

Background

ASIC argued that Centro's directors had breached their duties under sections 180 and 344 of the Corporations Act, because its 2007 annual accounts had not complied with the Corporations Act and the accounting standards:

  • the accounts had misclassified a number of borrowings as non-current liabilities when they were actually current;
  • just after the end of the 2007 financial year, Centro had given some guarantees as part of a transaction. ASIC argued that this was a material post balance date event and so should have been disclosed in the annual report; and
  • the board had not ensured that the CEO and CFO had provided the declaration of compliance required by section 295A.

Misclassification of current liabilities as non-current

Centro's 2007 annual accounts had misclassified a number of borrowings as non-current liabilities when they were actually current.

The directors argued that they could not be expected to know that the liabilities in question were current liabilities within the meaning of the relevant accounting standards. Among other things, they pointed out that:

  • there had just been a change in the relevant accounting standard and some greyness in its interpretation; and
  • the documentation relating to the borrowings was complex.

The Court dismissed the directors' argument for a number of reasons:

  • the accounting standard's meaning of non-current liability was "straightforward"; in this regard, the Court noted that it was clearly summarised in a note to the accounts - "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";
  • even if there had been greyness, the directors had not shown how that greyness resulted in their failure to notice the misclassification; and
  • the complexity of the documentation was irrelevant - the directors knew that the borrowings were maturing in the short term, and a basic understanding of the meaning of current liability should have led them to ask why the borrowings had not been classified as current liabilities.

Post balance date events

Just after the end of the 2007 financial year, Centro had given some guarantees as part of a transaction. ASIC argued that this was a material post balance date event and so should have been disclosed in the annual report.

The directors argued that, even if the guarantees were material, they had not breached their duties by failing to ensure that the guarantees were disclosed in the annual report.

On this point, the directors' argument was that they could not be held to have breached their duty through failure to notice an omission that had escaped the attention of both management and the auditors. They also argued that reasonable directors would have formed the view that the guarantees did not need to be disclosed because the borrowings which had been guaranteed were already included in the financial statements of companies which had been equity accounted for in the accounts.

The Court dismissed these arguments.

It said that:

  • the directors were aware of the need to disclose post balance date events; and
  • the directors were aware of the guarantees and of their magnitude.

It followed that the directors should therefore have turned their minds to the issue of whether disclosure of the guarantees was required. There was no evidence that they had done so. Relying on general assurances from management and the auditors about the accounts' compliance with the statutory requirements did not excuse failure to raise that specific issue.

The argument that a reasonable director could have formed the view that equity accounting for the guarantees meant that they did not have to be disclosed was also dismissed. There was no evidence that the directors had formed that view.

The section 295A certificate

Section 295A says that the directors of a listed company cannot make their section 295(4) declaration unless the CEO and CFO have declared that, in their opinion, the annual accounts comply with the accounting standards (among other things).

ASIC successfully argued that the document provided to the Centro board did not comply with this requirement.

The Court then held that the directors had breached their duties by not taking all reasonable steps to ensure compliance with section 295A.

The bigger picture

Accounting expertise of directors

The Court appeared to say that it was not laying down a general financial literacy standard for directors. The Court found that what was involved was a very large liability which, on a basic understanding of the meaning of "current liability", should have been disclosed in the accounts.

Nevertheless, it is clear that the Court did believe that a certain level of financial literacy is an essential qualification for directors:

"All that is being alleged is that where the accounts on their face refer, as here, to classification of debt and post balance date events, the director adopting and approving the accounts should have a knowledge of and apply the basic elements of the one or two standards relevant to this proceeding.

...

I do consider 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."

In the long term, this is likely to be a significant issue for directors. Where does one draw the line between "basic accounting conventions" (which directors are expected to understand) and the more arcane aspects of the accounting standards?

Reliance

The Court said that the importance of the annual accounts and the fact that the Corporations Act places specific responsibilities upon directors in relation to the accounts means that directors cannot delegate 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."

Again, this is a relatively simple concept given that the Court found that what was involved was a large current liability which was incorrectly classified. The Court was not dealing with allegations of mistakes or omissions buried in line items or in notes to the accounts.

Information overload

One aspect of the case has importance beyond the issue of the directors' scrutiny of the financial reports.

The Centro directors argued that the information about the borrowings was lost in a very large board pack.

One of the Court's comments on this argument may make unwelcome reading for most listed company directors:

"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."

If this is the new information oversight standard for board meetings, it could create problems for companies.

Most obviously, it may create tension between management and the board. It is not quite true to say, as the Court did, that management provides information to the directors "for a reason". Management provides the information for two reasons:

  • to ensure that board decisions are made on a fully-informed basis; and
  • to ensure that members of management do not incur personal liability for failure to properly advise the board.

Given this, it is not necessarily easy for a board to control the information it receives in order to prevent an information overload. Any push-back by the board on this front may encounter resistance from management. However, this decision highlights the need for boards to carefully manage this process and focus on the manner in which information is provided to the board. Boards need to ensure that they receive meaningful information and not merely data.

Of course, it may be that the judge intended to restrict his comments to information about the financial statements: he does draw a distinction between financial statements and "less significant documents". However, that begs the question of what constitutes "less significant documents". In the context of the Centro decision, the looming current liabilities and the material post-balance date events may have made the accounts the most significant documents before the board. At other times and in other contexts, a board may be confronting other issues and different priorities.

Even if the Court's finding that a board paper overload is no excuse for failing to read and understand those papers is restricted to matters and documents on which the directors have specific statutory duties, it seems the finding would clearly apply to matters such as takeovers (where the directors' recommendation is at the heart of the target's statement) and dividends (for which the directors have a specific statutory responsibility).

Where to now?

It is too soon to say that Centro marks a new line in the sand for directors: there may be an appeal from yesterday's decision.

Even if there isn’t an appeal, the decision may be sui generis (lawyerspeak for a one-off). The facts may be so unusual that the decision is not really applicable to other boards not facing similar circumstances.

Those are the optimistic responses.

Realistically speaking, it's unlikely that the trend of the last quarter century – in which the minimum standards expected of directors have continued to evolve – is suddenly going to stop. In the meantime, the Centro Court's comments about the responsibility of directors to look critically at financial statements and to understand basic accounting standards must be taken on board.

Disclaimer
Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this bulletin. Persons listed may not be admitted in all states and territories.
For more information, contact...
Email: Karen Evans-Cullen, Partner
Tel: +61 2 9353 4838
Email: John Elliott, Partner
Tel: +61 2 9353 4172
Email: Rod Halstead, Director - Strategic Corporate/M&A
Tel: +61 2 9353 4126
Email: Geoff Hoffman, Partner
Tel: +61 2 9353 4617
Email: Brendan Groves, Partner
Tel: +61 3 9286 6934
Email: Mark Paganin, Partner
Tel: +61 8 9426 8284
Email: Tim Reid, Partner
Tel: +61 7 3292 7014
Email: Brigitte Markovic, Managing Partner - Litigation
Tel: +61 2 9353 4131
Email: Zac Chami, Partner
Tel: +61 2 9353 4744
Email: Karen O'Flynn, Partner
Tel: +61 2 9353 4146
Email: Ross Perrett, Partner
Tel: +61 7 3292 7011
Email: Paul Fitzpatrick, Partner in Charge
Tel: +61 8 9426 8416