Tesco PLC is one of the most high profile and best known UK public companies. As the owner of a large chain of supermarkets, it has a deserved reputation for reliability.
However, Tesco has been on the front page of UK papers recently for all of the wrong reasons. The UK supermarket giant has found itself in the headlines following an alleged £250 million overstatement of its half-year profit, an amount equal to almost a quarter of its expected profit for the period. Tesco has described the error as being caused by an “accelerated recognition” of commercial income and delayed recognition of costs.
The over-statement of income came to light as a result of a whistleblower, and consequently Tesco appointed Deloitte to conduct an independent investigation. Tesco has also notified the UK’s Financial Conduct Authority. Pending the outcome of the investigation by Deloitte, four Tesco executives have been suspended, including the company’s UK Managing Director.
With the reporting season in Australia now winding up, and concerns about the reported profits of companies in the post-mining boom economy, Tesco’s predicament serves as a timely reminder to directors of Australian companies (in particular, ASX listed entities) of their duties as they apply to the review, adoption and approval of a company’s financial statements.
In this Alert, Special Counsel Peter Burge and Solicitor Shilpa Dougall consider the potential consequences for directors of a company registered in Australia, were it to discover an overstatement of such magnitude in its financial statements.
Potential implications under the Corporations Act
In the event of a “Tesco-style” overstatement in the financial statements of a company registered in Australia, sections 180 and 344 of the Corporations Act 2001 (Cth) (Corporations Act) would likely be the sections of most concern to directors.
Section 180 of the Corporations Act provides the statutory iteration of the duty of care and diligence applicable to directors and officers of companies in Australia. Section 344 provides that it is an offence for a director to fail to take all reasonable steps to comply with or secure compliance with Chapter 2M of the Corporations Act (financial reports and audit).
Section 180 has been the subject of judicial consideration in recent years, most notably in Centro (ASIC v Healey & Ors  FCA 717), James Hardie (ASIC v Hellicar  HCA 17) and Fortescue Metals (ASIC v Fortescue Metals Group Ltd  FCAFC 19).
Centro would be of particular relevance to a “Tesco-style” overstatement in Australia. In addition to section 180, in that case the Court also considered section 344.
The facts in Centro are well known but they are worth reiterating for present purposes. ASIC brought an action against the directors and chief financial officer of Centro, an ASX-listed company, for approving financial statements and a directors’ report which:
- failed to disclose crucial matters, including significant amounts of short-term debt and guarantees for short-term debt; and
- misclassified $1.5 billion of current liabilities as non-current liabilities.
In light of the Centro decision, if faced with a “Tesco-style” overstatement a court might in Australia, consider the following:
- How “plain” was the error – was the early recognition of the profits in the half-year guidance clearly reported? In Centro, the court was of the view that the misstatement of the current liability was plain on the face of the documents provided to the board. In Tesco’s case, the overstatement of profits amounted to approximately a quarter of Tesco’s expected profit for the period. A court would likely ask the question whether the error was obvious such that the directors, armed with their own knowledge, should have been alive to it and whether the failure to do so was negligent.
- Reasonable Reliance – could the directors argue that they had relied on the company’s audit committee and auditor? Section 189 of the Corporations Act enables directors to argue that they placed ‘reasonable reliance’ on the competence of professional or expert advice. One point of difference between the UK regime and that of Australia is that while Tesco’s half-year profit guidance did not apparently have to be audited, in Australia an ASX-listed company’s would have been (section 302 of the Corporations Act). However, notwithstanding that this half year guidance was not audited, Tesco’s auditor did highlight “the recognition of commercial income” as an “area of focus” in the company’s 2014 annual report. In the Australian context, had the auditors previously flagged such an issue, it would then arguably be incumbent on the directors to make appropriate enquiries.
- Quantity and complexity of financial information – could the directors argue that the quantity and complexity of the material they had to work through affected their ability to detect the error? This was one argument adopted by the directors in Centro. It is likely that the financial information of a FTSE-100 company with a former market valuation of in excess of £18 billion and over 500,000 employees would be voluminous and complex. However, Justice Middleton in Centro stated that the complexity and volume of information to be considered by directors cannot be an excuse for failing to properly read and understand financial statements.
Consequence of breach of Corporations Act
If the directors of an Australian company were faced with a “Tesco-style” overstatement and were found to have breached section 180 and section 344 of the Corporations Act, they could each be liable for a disqualification order, a pecuniary penalty or a compensation order.
This is in addition to the more prosaic impact of such an occurrence: Tesco’s share price plummeted in the days after the story broke resulting in approximately £2 billion being wiped off Tesco’s market capitalisation.
Lessons for directors of companies in Australia
Although Tesco is a UK registered company and so is subject to UK regulation, the company’s current circumstances serve as a timely reminder to directors of Australian companies, in particular ASX-listed companies, of their duties and obligations in relation to their company’s financial statements. In particular, directors should be reminded that:
- Directors (at least of ASX-listed companies) are required to have a certain degree of financial literacy – that is they should have the ability to read and understand financial statements and should have an understanding of accounting practice and standards. This does not require directors to be familiar with every accounting standard, but the directors should be sufficiently aware and informed to understand what is being approved or adopted. In particular, directors should be sufficiently engaged such that they make enquiries when they are not sure about something in the accounts.
- Directors should not assume that it is a defence to an action for breach of duty to argue that they have been given too much information to contend with.
- There are limits to the protection from liability provided by the delegation and reasonable reliance provisions in the Corporations Act. In particular, directors cannot delegate their “core, irreducible” responsibilities, including the declaration of compliance for financial statements.