On 27 June 2011, Justice Middleton of the Federal Court of Australia handed down his judgment in relation to proceedings brought by the Australian Securities and Investments Commission (ASIC) against certain directors and a former officer of Centro. He found that each of the directors and officer had breached their duty of care and diligence in relation to the relevant Centro entities and had failed to take all reasonable steps to ensure compliance with the financial reporting obligations in the Corporations Act 2001 (Cth) (the Act).
ASIC launched civil penalty proceedings in October 2009 in the Federal Court of Australia against current and former non-executive directors, the former CEO, and the former CFO of various entities within the Centro Properties Group (CNP) and Centro Retail Group (CER) (collectively Centro).
ASIC sought declarations that the relevant directors and officer breached their duties owed to entities within Centro in approving the Financial Reports.
CNP is a stapled entity, consisting of Centro Property Trust (CPT) (a managed investment scheme) and Centro Properties Limited (CPL). CER is a stapled entity, consisting of Centro Retail Trust (CRT) (a managed investment scheme) and Centro Retail Limited. None of the Centro entities themselves were party to the proceedings.
ASIC’s case was based upon a central proposition concerning the duty of directors to properly read and understand financial statements and to apply the knowledge they have or should have acquired to perform that task. Essentially, ASIC submitted that the directors had breached their duties of care and diligence and failed to take all reasonable steps to ensure compliance with the financial reporting obligations of CNP and CER under the Act for the following reasons:
2007 annual accounts
ASIC alleged that the financial reports of CNP and CER for the year ended 30 June 2007 (the Financial Reports) did not comply with the relevant accounting standards, or give a true and fair view of the financial position and performance of the entities, because they failed to classify a significant amount of interest-bearing liabilities as current liabilities.
After the end of the 2007 financial year, CNP provided certain guarantees in relation to the liabilities of an associated entity (a US joint venture between CNP and CER, known as New Plan). CNP had equity accounted for the investment in New Plan in its 2007 accounts. ASIC alleged that the CNP 2007 accounts did not comply with the Act because they did not disclose the guarantees as a significant matter arising post balance date nor as information that members of the company would reasonably require to make an informed assessment of the financial position of CNP or its business strategies and prospects for future years.
ASIC alleged that the directors’ declarations in relation to the Financial Reports did not comply with the Act, because they were given without first receiving declarations from the CEO and CFO (as prescribed under section 295A of the Act).
ASIC alleged that the directors failed to take all reasonable steps to secure compliance by CPL, CPT and CRT with sections 295A (directors’ declaration), 296 (compliance with accounting standards), section 297 (true and fair view) and 298 (annual directors’ report), and thus breached section 344(1) of the Act.
Section 344(1) of the Act requires a director to take all reasonable steps to comply with, or to secure compliance with the financial record keeping and reporting obligations in the Act (Part 2M.2 or 2M.3).
The critical question the Court was asked to determine was whether in the circumstances the obligation under section 344 to take all reasonable steps to secure compliance with financial reporting obligations required the directors to personally scrutinise each line in the accounts looking for accounting errors or apparent inaccuracies and, even if this was not required, whether it was negligent for them to have failed to detect the relevant errors where both management and the external auditor, Price Waterhouse Coopers (PwC), had previously missed those errors.
Relying on the same conduct, ASIC also submitted that the defendants had breached sections 180 and 601FD(3) of the Act. Section 180 of the Act provides:
A director or other officer of a corporation must exercise their powers and discharge their duties with the degree of care and diligence that a reasonable person would exercise if they:
- were a director or officer of a corporation in the corporation’s circumstances; and
- occupied the office held by, and had the same responsibilities within the corporation as, the director or officer.
Section 601FD(1)(b) is similar to section 180(1), but applies specifically to an officer of the responsible entity of a registered scheme. The case also concerns the ability of directors to delegate tasks to management and auditors and to rely on the systems and processes of the company (under sections 189, 190 and 198D of the Act).
Justice Middleton found that each director contravened sections 180(1), 601FD(3) and 344(1) of the Act in that each director:
- failed to take all reasonable steps to secure compliance with the Act;
failed to take all steps that a reasonable person would take if they were in the director’s position to ensure compliance by the relevant entity with the Act; and
- failed to exercise the degree of care and diligence required when reviewing the financial statements.
His Honour held that:
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.
Justice Middleton explicitly pointed out that the directors were intelligent, experienced and conscientious people and that there was no suggestion that the directors did not honestly carry out their responsibilities.
His Honour also emphasised that the proceeding was not about a “mere technical oversight”. Rather the central question was whether directors of substantial publicly listed entities are required to apply their own minds to, and carry out a careful review of, the proposed financial statements and the proposed directors’ report, to determine that the information they contain is consistent with the director’s knowledge of the company’s affairs, and that they do not omit material matters known to them or material matters that should be known to them.
In this vein, His Honour, relying on case law, affirmed that there is a core, irreducible requirement of directors to be involved in the management of the company and to take all reasonable steps to be in a position to guide and monitor. There is a responsibility to read, understand and focus upon the contents of those reports which the Act imposes a responsibility upon each director to approve or adopt.
Justice Middleton’s comments on the ability of directors to rely on management and auditors in relation to the financial accounts is also important. His Honour expressed the view that nothing decided in this case should indicate that directors are required to have infinite knowledge or ability. He explained:
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 the responsibilities placed upon him or her. Such a responsibility arises in this proceeding in adopting and approving the financial statements. Because of their nature and importance, the directors must understand and focus upon the content of financial statements, and if necessary, make further enquiries if matters revealed in these financial statements call for such enquiries.
However, in these circumstances it was found that 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. Accordingly, the financial statements, before they were adopted by the directors, were required to be read, understood and focussed upon by each director with the knowledge each director has or should have by virtue of his or her position as a director.
His Honour rejected the view that this requirement overburdens a director or, as suggested, would cause the boardrooms of Australia to empty overnight.
Justice Middleton did not determine whether any of the directors should be relieved from liability for such contraventions and the imposition of penalties (if any) in this judgment. The parties have been asked to formulate minutes for the purposes of the relief and penalty hearing, which has been set down for the first week of August 2011.
After delivering his judgment, Middleton J asked ASIC to consider, very carefully, its next step in relation to the relief and penalty hearing. His Honour explained:
There has been no suggestion made that the directors were dishonest. As I have said, each director was an intelligent, experienced and conscientious director. They relied upon extensive advice and processes which were not called into question so all I say is that that should be taken into account and all my reasons as to the next step that ASIC thinks should be taken.