When a company, especially a public listed one, is faced with financial controversy, every one of its directors will be in the spotlight. It would be wrong to assume that mere attendance at board meetings would be sufficient for a director in discharging his or her duties.
While there are many matters a director must focus upon, one that is important but seemingly routine concerns the financial statements of the company.1 The Companies Act 19652 (“the Act”) has a myriad of compliance requirements for record keeping, accounts, disclosures and filing of returns for which a director is responsible, with criminal sanctions in the event of a breach of duty.
General duty of care, skill and diligence
Directors are subject to a combination of statutory, common law and equitable obligations in carrying out their functions and duties. At one time at common law:
“A director need not exhibit in the performance of his duties a greater degree of skill than may reasonably be expected from a person of his knowledge and experience. …
“A director is not bound to give continuous attention to the affairs of his company. His duties are of an intermittent nature to be performed at periodical board meetings, and at meetings of any committee of the board upon which he happens to be placed.… In respect of all duties that… may properly be left to some other official, a director is, in the absence of grounds for suspicion, justified in trusting that official to perform such duties honestly.”3
Today, directors can no longer be exonerated for their lack of knowledge.4 It is now incumbent upon them to acquaint themselves with the nature of the company’s business and to take reasonable steps to ensure that it is properly conducted.5
The intricacies of commercial life have led to an increase in the public’s expectations of the duty of a director.6 At the pace where business is conducted these days, little tolerance can be given to directors who do not take proactive steps in understanding their company’s affairs.7 The board’s duty is to place themselves in a position to guide and monitor the management of the company.8 A director should acquire at least a rudimentary understanding of the business of the corporation and be familiar with the fundamentals of the business and are under a continuing obligation to keep himself informed about the activities of the corporation.9 Given the supervisory and monitoring function of a director, the traditional view of directors having a “right” to obtain information should now be viewed as a “duty”.10
Specific requirements on financial statements
Generally, company directors and managers are required to ensure proper maintenance of accounting and other records as will sufficiently explain the transactions and financial position of the company.11 Directors are responsible for ensuring that the accounts laid before the annual general meeting are in accordance with the applicable approved accounting standards.12
The profit and loss account13 and the balance sheet,14 duly audited and laid before the annual general meeting (AGM), must be accompanied by a director’s report made in accordance with a resolution of the board, with respect to the profit or loss of the company for the financial year and the state of the company’s affairs.15 Every balance sheet and profit and loss account is also to be accompanied by a statement by the directors and a statutory declaration16 by a director.17 The statement by the directors must be made pursuant to a resolution of the board stating whether in the opinion of the directors, the profit and loss account and balance sheet are drawn up to give a true and fair view of the results and position of the company, and that the accounts have been made in accordance with the applicable approved accounting standard.18 The statutory declaration made by a director, should set forth his opinion as to the correctness of the balance sheet and profit and loss account.19
There are similar requirements in Australia on financial reporting. In particular, where a public listed company is concerned, a declaration must be made by the CEO or the CFO stating whether in his or her opinion:
- the accounts have been properly maintained;
- the financial statements are in compliance with the accounting standards;
- the financial statements give a true and fair view of the financial position and performance of the company; and
- the regulations governing financial statements and notes are satisfied.20
A report for the financial year must be signed by a director pursuant to a resolution of the board.21
ASIC v Healey
In Healey,22 the Centro Group23 failed to disclose significant matters in the annual report in which the consolidated financial statements were presented. Short-term liabilities had been misclassified as non-current liabilities and guarantees of short-term liabilities given after the balance date had not been included in the financial statements.
The Australian Securities and Investment Commission (“ASIC”) applied for declarations of contraventions against every director of the Centro Group for breach of the general duty of care and diligence,24 breach of the duties of an officer of entities25 and failure to comply with financial reporting duties.26 The court held that each director had failed to take all reasonable steps required of them and to exercise the degree of care and diligence required in law in approving the financial statements.27 A director is to be involved in the management of the company and to take all reasonable steps to be in a position to guide and monitor the company. “Reasonable steps” would depend on the circumstances and would differ based on the entity, the complexity of the entity’s business, the internal reporting procedures and the nature of the task the director is obliged to undertake. The general duty of care requires that a director acquire a basic understanding of the fundamentals of the business that he is involved in.28
Applying the mind
Directors have an irreducible duty and responsibility to read, understand and focus on the contents of the financial statements before approving them, which requires that they be familiar with the fundamentals of the business. In applying their mind to the financial statements, directors must determine whether the information contained in the documents presented to them is consistent with their knowledge of the company’s affairs.29 Noting that each director in the Centro Group had a background in either commerce or finance, as well as a standing in the industry,30 the court in Healey found that if the directors had applied their mind to the information provided, they would have been able to discover the inaccuracies in the financial statements.31
In order to fulfil their responsibility regarding the financial statements, directors need to have sufficient financial literacy. Middleton J in Healey remarked:
“… 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… [It] would not be possible for a director to form the opinion required by s 295(4)(d)32 without such an understanding. It is not suggested a director could vote in favour of a resolution in support of the required directors’ statements when he did not hold the opinions referred to at all.”33
Failing to acquire a sufficient level of financial literacy or familiarity with the company’s affairs can in itself amount to a breach of the director’s general duty of care and diligence.34
Knowledge of accounting
Although there is no general requirement that a director must be familiar with all conventional accounting practices, when a situation gives rise to an issue in a particular area, it appears from Healey that the directors must ensure that they acquire the requisite knowledge for addressing any issue appearing on the face of the accounts.35
A director should have a questioning mind and is expected to take a diligent and intelligent interest in any information provided.36 The role of the board is supervisory and appropriate inquiries must be made where the board is uncertain of information provided or is aware of some discrepancy. Although directors are not expected to spot an error immediately, they are expected to ask appropriate questions, of management or auditors, which would enable the errors to be detected.37 A director’s failure cannot be excused simply on the ground that others on whom they relied fell into error. Processes and advisors in place are not the substitute for a director from personally looking and considering the financial statements for themselves.38
The forgoing propositions in Healey were derived by the court from a close analysis of the relationship between the statutory duty of care and the statutory duty to ensure compliance with the financial reporting requirements.39
The markedly more stringent threshold for directors’ duties set in Healey was adopted by the High Court of Malaya in Khiudin.40 Bursa Malaysia41 had decided to take action against the CEO and two directors of a listed company for delays in the submission of accounts and for deviations in the financial results reported. The CEO argued that his functions related to the day-to-day business operations of the company and that financial matters were overseen by the Audit Committee and a CFO who was assisted by the entire Finance Department. There was also an appointed internal auditor and external auditor who were responsible in certifying the company’s accounts.
Adopting the position in Healey,42 the High Court held that mere reliance on the company’s external auditors to detect a defect in the financial statements was insufficient for a director’s to discharge his duty. Such reliance would also be unreasonable if, in fact certain audit concerns had been raised by the auditors to the audit committee, although the board had not informed by it.43
Delegation and reliance
Directors may rely on others, including management and external advisers, to prepare financial statements and advise on accounting standards. In Healey, the CEO and CFO had signed off on a management letter which was to give an assurance to the board of directors that the accounts were accurate. That assurance did not, however, absolve the directors of their duty to read and understand the financial statements themselves.44
In particular, responsibility for the director’s report cannot be delegated. 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.45
The fact that financial statements have been audited and signed off by qualified auditors does not negate a director’s supervisory function.46
The legislation makes no distinction between a non- executive director and a director with an executive role, and they are both subject to the same objective standard of care.47
At one time, the position in law was that a clear and careful distinction between the role of a managing director or CEO and that of non-executive directors on the board. While the former must carry out his or her duties in accordance with an objective standard of care and skill, the same standard could not realistically be applied to the latter, given the intermittent and part-time nature of their duties and the fact that the very diversity of companies and the variety of business endeavours did not allow of a uniform objective standard.48 It was later accepted that although not every director can be expected to have equal knowledge and experience of every aspect of a company’s affairs, non-executive directors should be subject to the same standard of care.49
Where the financial statements are concerned, it remains the collective responsibility of the board and no distinction can therefore be made between executive or non- executive directors.50
Although they may be held equally responsible for breach of the duty of care and diligence as well as the statutory requirements of financial reporting, the court may not impose the same sanctions on non-executive directors. In Healey (No 2), while the non-executive directors were only found liable for costs for proceedings, the CFO was disqualified and the CEO was subject to an additional pecuniary fine.51 No distinction was made in Healey, between a non-executive director who was sitting on the board’s audit and risk management committee and those who were not.52
Should failing to be diligent be a crime?
In Malaysia, breaches of directors’ duties under s 132 of the Act attract criminal sanctions. In contrast, certain breaches of director’s duties in the company legislation have been decriminalised in Australia. Where a breach of statutory provision on directors duties’ arises, the regulator (ASIC) can decide to apply for criminal sanctions or civil penalties. The rationale for such a move includes:
- the view that criminal penalties are only appropriate where conduct are genuinely criminal in nature;53
- where the offence carries a penalty of imprisonment, the courts were often hesitant to impose criminal sanctions where there was no fraud or dishonesty. In alternative to punishment of imprisonment, the modest fines imposed caused discontent in the community;54
- criminal standard of proof made it very difficult for the contravention to be publicly enforced;
- that the risk of imprisonment that comes with being a director is a disincentive to take on the role; and55
- the view that penalties should suit the offence and some administrative procedures that are trivial or unnecessary should not attract a penalty.56
Although there have been criticisms that the civil penalty proceedings are not being fully utilised by ASIC in Australia,57 the introduction of civil penalty proceedings in relation to certain breaches of directors’ duties might be the way forward for Malaysia.58 Because civil penalty proceedings do not carry the same moral reproach as in a criminal sanction, the courts may be less hesitant in punishing directors who are negligent in their duties but have not acted dishonestly.
Honesty and good faith
A directorship is not a sinecure and this is true even for non-executive directors. A director should have an enquiring mind and play an active role in questioning information provided to him if matters revealed in the financial statements call for such inquiries.59 In the making of the board resolution to approve the directors’ statement accompanying the financial statements, the minimum required of each director is that they remain informed of the financial affairs of the company to the extent necessary to form the opinion required for the resolution to be made.60 Directors should not only have basic knowledge of the affairs of the company, but also equip themselves with the fundamentals of accounting and finance in order to carry out their duties. This duty is applicable across the board and makes no distinction between executive and non-executive directors. It is clear from Khiudin61 that the standard of care required of a director in approving the financial statement is stringent as in Healey. This position is not incorrect owing to the commonality of company law in both jurisdictions and there would need to be good reasons to depart from the principles enunciated by the courts in Australia. LH-AG