It has been twelve months since Justice Middleton of the Federal Court of Australia delivered his judgments on liability and penalties in ASIC’s case against the Centro directors. It is timely to revisit that decision in light of the recent settlements of the Centro class actions against various entities within the Centro Group and PricewaterhouseCoopers (PWC) for $200 million. In light of the settlement, a number of interesting legal issues remain unresolved, including the appropriate tests for establishing causation and calculating loss in securities class actions.
The Centro Decision: Australian Securities and Investments Commission v Healey and Others (2011) 196 FCR 291)
The judgment on liability in ASIC’s case against Centro’s directors, handed down on 27 June 2011, emphasised the duties of directors to take a diligent interest in and have the ability to understand financial statements, and to inquire about any potential deficiency in the accounts. Simply ‘rubber stamping’ financial statements may expose directors to liability.
ASIC made application under the Corporations Act 2001 (Cth) (the Act) for declarations of contravention against eight directors and for orders that each of the defendants pay pecuniary penalties and be disqualified from managing corporations. ASIC claimed that the directors had contravened sections 180(1) and 601FD of the Act by failing to exercise their powers and discharge their duties with the degree of care and diligence that a reasonable person would exercise in the circumstances, and section 344 of the Act by failing to take all reasonable steps to comply or secure compliance with financial reporting requirements.
The allegations concerned the directors’ approval of the consolidated financial statements of companies in the Centro group for the financial year ending on 30 June 2007, at a board meeting attended by the directors on 6 September 2007. It was alleged the 2007 annual reports of Centro Properties Group (CNP) and Centro Retail Group (CER) failed to disclose significant matters.
In the case of CNP, the report failed to disclose some $1.5 billion of short-term liabilities by classifying them as non-current liabilities, and failed to disclose guarantees of short-term liabilities of an associated company of about US$1.75 billion that had been given after the balance date.
In the case of CER, the 2007 annual report failed to disclose some $500 million of short-term liabilities that had been classified as non-current.
The directors proceeded to approve the annual reports notwithstanding these errors and they were subsequently released to the ASX.
The directors submitted, among other things, that ASIC’s contentions lacked any sense of reality and embraced a “counsel of perfection”. It was suggested by the directors that the standards which ASIC sought to place on the directors would, if accepted by the Court, cause the boardrooms of Australia to “empty overnight”. The directors pointed to the fact that the errors were not detected by anyone in Centro’s accounting team or by its external auditors, PWC. They argued that they were entitled to place reliance on the assurances and specialist advice provided by management and the external auditors, and that the failure of those professionals to detect the errors in question led to the result that the directors themselves had not breached the Act.
Justice Middleton found that each director did not take all reasonable steps to focus on, and failed to consider for himself the content of the financial statements, particularly as to short-term debt and whether the guarantees should have been disclosed. His Honour said that the failures were not ones of “mere technical oversight” but were matters of significance to the assessment of the risks facing CNP and CER. 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.
His Honour held that whilst directors were entitled to delegate to others the preparation of books and accounts and the carrying on of the day-to-day affairs of the company, each director was expected to take a diligent and intelligent interest in the information available to him, to understand that information, and apply an inquiring mind to the responsibilities placed upon him. His Honour found that if the directors had understood and applied their minds to the financial statements and recognised the importance of their task, each director would have questioned each of the matters not disclosed. Each director, in reviewing the financial statements, needed to inquire further into the matters revealed by those statements.
His Honour held that each of the directors had failed in their duties to exercise the degree of care and diligence required of them by law. Specifically, they failed to properly read and understand the financial statements; apply the knowledge they had or should have acquired to perform that task; make appropriate inquiries; and have apparent errors corrected. His Honour held that each of the directors was therefore in breach of ss 180(1), 344(1) and 601FD(3) of the Act.
The Penalty Decision
Other than the CFO, Mr Nenna, the defendants were directors of each relevant Centro company. Mr Healey was the non-executive Chairman. Mr Scott was the CEO, and the other defendants were non-executive directors. Each of the directors contested the application, however, Mr Nenna admitted contraventions of ss 180(1) and 601FD(3) of the Act.
The final orders proposed by the parties ranged from complete exoneration to the imposition of disqualification bans and pecuniary penalties.
Justice Middleton handed down his penalties judgment in August 2011. His Honour determined that:
- in the case of the non-executive directors, declarations of contravention were made with no other penalty imposed;
- in the case of Mr Scott (the CEO), he was not exonerated or disqualified from acting as a director, but declarations of contravention were made and a pecuniary penalty imposed at the lower end of the range, namely $30,000;
- in the case of Mr Nenna (the CFO), he was disqualified from acting as a director for two years and declarations of contravention were made but no pecuniary penalty imposed.
His Honour said that at the forefront of his consideration was the issue of general deterrence. In his Honour’s view the orders indicated the Court’s disapproval of the actions of each of the defendants.
The ASIC Response
Greg Medcraft, the Chairman of ASIC, openly welcomed the decision, confirming his belief that a clear message had been sent to boardrooms across the country about corporate accountability, stating:
“The central question in the proceedings was whether the directors were required to apply their own minds to, and carry out a careful review of, the proposed financial and the proposed directors report, to determine that the information they contained was consistent with the director’s knowledge of the company’s affairs, and that they did not omit material matters known to them or material matters that should have been known to them”
Mr Medcraft endorsed various statements made by Middleton J noting that:
“Each member of the board must bring and apply their own skill and knowledge when declaring financial statements are true and fair… This is not a responsibility company boards can delegate or merely rubber stamp”2
Mr Medcraft reassured the public that ASIC “will continue to take on the big and difficult cases” when ASIC believes it is in the public interest.3
The allegations made in the Centro case spurred a number of related actions in the Federal Court.
Centro Shareholders’ Class Actions
The Centro class actions were commenced in May 2008 against various entities within the Centro Group. PWC was joined to the proceedings in 2009 and a separate claim was brought against PricewaterhouseCoopers Securities Limited.
Like the ASIC action, these proceedings involved a consideration of the 2007 financial accounts. The claims concerned allegations that CER and CNP breached their continuous disclosure obligations and engaged in misleading and deceptive conduct by failing to properly disclose to the market in their 2007 accounts the full extent of CER and CNP’s maturing debt obligations (circa $2.7billion). The price of CNP and CER securities had fallen significantly during that period.
PWC was alleged to have made representations that were misleading or deceptive (or likely to mislead or deceive), or to have been knowingly involved in CNP’s alleged breach of its continuous disclosure obligations. PWC prepared a report to the investors in Centro Shopping America Trust in relation to its proposed merger with CER. The statements made in that report were alleged to have been misleading and deceptive.
It was an eagerly awaited trial and forecast to be an even more eagerly awaited decision – the questions of causation and calculation of quantum in securities class action disputes would finally be determined by an Australian Court.
The claims against PWC
The claims against PWC raised important issues in relation to the extent to which the knowledge of audit staff can be attributed to the statutory auditor (i.e. the audit partner who signs the audit report).
PWC asserted that, although the audit report was provided by the relevant audit partner on behalf of the firm, it was that partner’s opinion only. Accordingly, the representations made in the audit report could only be misleading or deceptive if that partner did not believe them or lacked a reasonable basis for believing them.
PWC also asserted that certain key matters in relation to Centro’s debt classification may have been known by other members of the audit team, but were not known by the audit partner, or could not reasonably have been known by him, and that those matters should not necessarily be attributed to the partner for the purposes of determining whether certain representations made in the audit report were misleading or deceptive.
The Settlement of the Centro Class Actions
The case commenced in March 2012 and was not scheduled to complete until the end of June 2012. On 9 May 2012 IMF, the key litigation funder, announced that it had entered a trading halt pending the outcome of negotiations between the parties. By 10 May 2012, following night-long negotiations, the parties announced that terms of settlement had been agreed.
As reported, the settlement involved a payment of $200m (including costs)4. The Centro companies contributed $95m to the settlement amount with the balance being contributed by PWC ($67m) and insurance proceeds ($38m).
The application for approval of the settlement was heard by Justice Middleton. In forming his view that the proposed settlement was fair and reasonable and in the interests of all group members, he took into account that “establishing liability was necessarily dependent on some difficult and controversial points of law” and that appeals would be inevitable. His Honour went on to say that such a process “brings greater uncertainty to recovery, and would involve substantial delay even if liability were to be established”.
His Honour did not identify the “difficult and controversial points of law”, however, they would no doubt include:
- the appropriate test for establishing causation;
- the appropriate method for calculating the loss in securities class actions; and
- regarding the claims against PWC, the extent to which the knowledge of members of the audit team can be attributed to the statutory auditor.
The Issue of Causation in Securities Class Actions
An issue in the Centro class action was whether:
- it is necessary for each group member to prove that they actually relied on the company’s contravening conduct in making the relevant investment decision (direct causation); or
- causation can be satisfied by mere reliance by the market on the company’s contravening conduct affecting the price at which each group member purchased and/or sold their securities (indirect causation).
This is an issue which is unsettled in Australian law primarily because all litigation in which the issue has arisen has been settled prior to judgment.
Because the causation question remains unresolved a related question about the evidential process by which claims in securities class actions are dealt with also is unresolved, in particular whether:
- group members’ claims can be dealt with en masse, with causation essentially being presumed; or
- each group member must individually establish that they actually relied on the company’s contravening conduct which ultimately caused their particular loss.
Calculation of Quantum
A commonly proposed method of calculating loss in a securities claim involves calculating the level of inflation in the share price as a result of the company’s failure to disclose bad news to the market. The objective of the inflation based approach is to determine the true value of the shares at the time of acquisition and determine the difference between the price paid for the shares and their true value at the time of purchase5 .
An alternative method that is often proposed when the shares in question have been sold is a simple calculation of purchase price less sale price.
The Significance of Unresolved Causation and Calculation of Loss Issues
In light of the class actions’ settlement, a number of interesting legal issues remain unresolved which include:
- The question of causation
The settlement effectively hi jacked the court’s opportunity to determine the causation question in securities class actions. It remains unanswered as to whether the requirement of causation can be satisfied by general notions of reliance or whether it is necessary for each group member to establish that they actually relied on the contravening conduct.
- The procedural process
Consequent on the question of causation remaining unresolved, the process by which claims for securities class actions are dealt with also remains unresolved. It is yet to be established if a case-by-case regime to determine if the company’s contravening conduct will be required to establish individual loss.
- The calculation of quantum
The appropriate method for calculating the loss in securities class actions is yet to be resolved. In the event that loss is calculated in accordance with the principles established in Potts v Miller the loss is limited to the loss caused by the breach or contravention. The court may also consider subsequent events such as market depreciation and other factors that are unrelated to the conduct in question when calculating the appropriate loss.
What to Expect Next
Twelve months have now passed since Justice Middleton handed down his much publicised decision in Centro. The dust has now settled and the expected flurry of legal activity has not eventuated.
There is no doubt that whilst the issue of causation and the consequential procedural questions remain unresolved, class action lawyers and litigation funders will keep their ears to the ground for the next big securities class action suit. The Australian path is yet to be determined.