The recent Federal Court decision of Australian Securities and Investments Commission v Godfrey [2017] FCA 1569 reads as a cautionary tale for directors. It follows in the same vein as the landmark 2011 Centro case, which gave many directors cause for concern over whether they were sufficiently financially literate so as to avoid breach of duties under the Corporations Act.

Patrick Godfrey, the managing director of Banksia Securities Limited (BSL), failed to take reasonable steps to secure BSL's compliance with financial reporting requirements under Part 2M.3 of the Corporations Act, which constituted a breach of section 344(1).

Mr Godfrey had failed to ensure that adequate provision was made in BSL's accounts for bad or doubtful debts. This was particularly serious in the circumstances as BSL's main asset was its loan portfolio, and it had a high debt to equity ratio. The deficiency in the provisioning was some $4 million for each of the June 2011, December 2011, and June 2012 financial reports. This resulted in an overstatement of profit, which affected shareholders and debenture holders.

The penalty applied to Mr Godfrey was disqualification from managing corporations for a period of five years, and a pecuniary penalty of $25,000.

The extent of a director's responsibility to be financially literate ‒ building on the Centro principle

It was accepted that there was no dishonesty on Mr Godfrey's part. The breach came about because Mr Godfrey did not realise that BSL's policies for determining impairment of loans were not appropriate, and were not consistent with AASB 139. This stemmed from a lack of understanding, related to an inadequate knowledge of the relevant financial matters.

Justice Moshinsky referred to the principle established in Australian Securities and Investments Commission v Healey (2011) 196 FCR 291 (the Centro case), that it is part of a director's duty to acquire a degree of financial literacy so as to be able to review financial statements and monitor the progress of the company. In the Centro case, it was found that the directors had failed to notice misclassified borrowings in the accounts of the company. The case marked out an uncertain new obligation on directors: it was established that some level of financial literacy was required, but it was not clear what that level should be. Some directors may have hoped that the Centro case was unusual enough not to be repeated, but ASIC v Godfrey makes it clear that the somewhat nebulous financial literacy obligation is here to stay.

In this case, it was particularly relevant that Mr Godfrey was the officer of BSL who had primary responsibility for making recommendations to the board about bad or doubtful debts. He therefore had a key role to play in ensuring that the company complied with Part 2M.3 of the Corporations Act. He had failed to ensure that BSL's policies relating to the assessment of impaired loans were consistent with the relevant accounting standard (AASB 139). It was held that Mr Godfrey ought to have acquired a greater degree of understanding, so as to properly discharge his duty. This seems to be a clear application of the Centro finding that directors need to have the financial literacy "to understand basic accounting conventions".

Importantly, it was made clear in the decision that none of these steps that Mr Godfrey ought to have taken could have been replaced by reliance on the management of BSL or its external auditors. Justice Moshinsky warned that "directors in analogous circumstances ought not to consider it appropriate to avoid that responsibility by delegating it to external auditors". Again, this applies the principle from Centro that directors "cannot substitute reliance upon the advice of management for their own attention and examination of an important matter that falls within the board's responsibilities". Mr Godfrey had taken on the role of making recommendations to the board of BSL, and he therefore had to adequately carry out that responsibility.

Co-operation with ASIC helpful in reducing penalty

Mr Godfrey had co-operated with ASIC throughout the process, producing an agreed statement of facts as well as proposed orders. Justice Moshinsky noted that from a policy perspective, it is generally desirable for courts to promote predictability of outcome in civil penalty proceedings by granting proposed orders where appropriate, as this encourages corporations to acknowledge contraventions early and avoids drawn-out litigation.

This decision confirms that there is generally very considerable scope for parties to agree on an appropriate remedy, and for the court to be persuaded that it is appropriate. In light of these considerations, the court found the proposed orders to be appropriate.

Disqualification for five years reflected the seriousness of the contravention (as the misstatements in BSL's financial reports were significant, and had significant consequences). Mr Godfrey was of good character and had not acted dishonestly, so the disqualification was not imposed for personal deterrence reasons. Instead, general deterrence was relied upon as the central reason for imposing a substantial disqualification period.

Justice Moshinsky initially had reservations about the fairly light pecuniary penalty of $25,000. However, the length of the disqualification period and Mr Godfrey's co-operation with ASIC were relevant factors leading to a finding that this penalty was appropriate. All of the proposed orders were ultimately accepted.

Implications for directors from the Godfrey decision

The key warning to take away from this decision is that directors must take responsibility for duties they have assumed, particularly those related to financial reporting. It is not sufficient to rely on external auditors or internal management processes. Adequate discharge of financial reporting duties requires a degree of financial literacy and may require familiarity with accounting standards that are particularly relevant to the circumstances.

The decision also gives directors accused of contraventions a clear incentive to co-operate with the regulator, and to arrive at an agreed penalty if possible. The acceptance of the relatively low pecuniary penalty proposed by the parties confirms that the court will grant parties considerable scope to agree on an appropriate remedy.