The decision of the Federal Court in Australian Securities & Investments Commission v Healey & Ors  FCA 717 has no doubt raised anxiety levels for a number of non-executive directors, concerned that they must now become experts in accounting standards. While the decision certainly raises the bar for directors and will result in some longer than usual board meetings over the next few months as listed company boards review and approve their annual accounts, the good news is it stops well short of requiring directors to be expert accountants.
The key messages for directors and other officers from the decision are:
- approving the annual accounts is a core function of directors, for which they have specific responsibility under the Corporations Act – that responsibility cannot be delegated;
- while directors are not expected to have a detailed knowledge of all accounting standards, they are expected to be financially literate and have a basic knowledge of key concepts, such as the difference between current and non-current liabilities;
- while they can rely on others (internal and external) to prepare the accounts, directors need to review the accounts thoroughly and carefully, in light of the knowledge which they each have of the company's operations and financial position;
- directors are expected to raise questions of management and the auditors, if there are any discrepancies or issues which become apparent as a result of that careful and thorough review of the accounts; and
- directors need to manage the volume of information which is provided to them, or the way in which it is presented, to ensure that they can maintain an appropriate level of knowledge of the company's operations without being overburdened with detail.
While Middleton J has not yet made any decision on penalties, he has noted that the directors are all intelligent, experienced and conscientious individuals. There is no suggestion any of the directors were dishonest in any way or that they should have had any reason to question their reliance on the work carried out by management and the auditors. There were no adverse findings on the credit of any of the directors. We would expect that penalties will be at the lower end of the spectrum, particularly for the non-executive directors.
Middleton J did not consider that the formulation of a director's duty which he applied "would cause the boardrooms of Australia to empty overnight" but it may well cause some professional directors to consider how many appointments they can hold at any time and whether they wish to have the additional responsibility of sitting on an audit committee.
The basic facts in the decision can be stated quite simply:
- the Appendix 4E lodged with the ASX by the Centro companies in August 2007 disclosed no current interest bearing liabilities. When the accounts for the year ended 30 June 2007 were prepared, some of the non-current liabilities were reclassified as current liabilities. A note to this effect was only included in the accounts for one of the entities. This change in classification was not specifically brought to the whole board's attention;
- the final accounts did not accurately disclose the current liabilities of the companies. In respect of Centro Properties Group, the understatement of current liabilities was $1.5 billion and for Centro Retail Group, it was approximately $500 million. Those amounts were shown as non-current liabilities
- the directors had regularly been provided with information about the debt levels of the group companies, the maturity profile of the debt and the process of renegotiating debt facilities which had commenced shortly before the accounts were approved;
- the accounts of Centro Properties Group also did not disclose that it had given guarantees of the short term liabilities of an associated company, of approximately $1.75 billion, after the 30 June 2007 balance date;
- the board had approved giving the guarantees in July 2007 with further papers relating to the financing and guarantees provided to the board in August 2007;
- while the CEO and CFO signed a management representation letter addressed to the auditors and the board, they did not sign a statement to the board relating to the accounts in the terms required by section 295A of the Corporations Act, before the accounts were approved by the board; and
- when the ASX queried the inconsistencies between the Appendix 4E, the published accounts and subsequent announcements relating to debt refinancing and maturity dates, the Centro group initiated a review of the classification of current and non-current liabilities and subsequently acknowledged that the classification in the accounts did not accord with the relevant accounting standard.
ASIC brought civil penalty proceedings against each of the non-executive directors, the CEO and CFO alleging:
- breach of the duty in section 180 of the Corporations Act to act with care and diligence; and
- breach of the obligation in section 344 of the Corporations Act to take all reasonable steps to ensure a company complies with the accounting obligations in Parts 2M.2 and 2M.3 of the Corporations Act.
What standard applies to directors?
The Court found that directors (including non-executive directors) of substantial listed entities have the following duties:
- directors should have at least a rudimentary understanding of the business and the basic activities of the company and regularly review the accounts of a company to maintain their knowledge of the financial circumstances of the company;
- directors need to have a level of financial literacy sufficient to understand basic accounting concepts and conventions;
- they must read, understand (with the knowledge that the director has or should have as a result of their position) and focus on each document that comes before them before it is signed-off, approved or adopted;
- directors must carefully read and understand the accounts (and if not understood, enquiries ought to be made) before the accounts are approved;
- they must apply their own minds (rather than relying solely on the advice of internal management and external auditors) when carrying out a review of accounts; and
- they must satisfy themselves that the information contained in the accounts is consistent with their knowledge of the company's affairs and make enquiries when accounts are not consistent with this knowledge.
Directors are not (necessarily) required to identify errors that subject matter experts, such as the external auditors, may have missed.
Applying this standard to the Centro situation, the Court found that, as the directors had knowledge, or ought to have known, of the debt maturity profile and the guarantees which were given after the balance date, they had breached the duty of care and diligence by failing to identify the discrepancies in the accounts (which the Court described as being "apparent without difficulty upon a focussing by each director and upon a careful and diligent consideration of the financial statements") and to raise the issues for further consideration.
Can a director rely on management and the auditors?
Yes and no. A director can rely on management and the auditors to prepare the accounts, subject to the usual qualification that reliance is not permitted if the director has reason to suspect the delegate is not reliable and competent.
However, when it comes to approving the accounts, the directors have an explicit obligation under section 295(4) of the Corporations Act, to declare that the accounts are true and fair and comply with the accounting standards. This requires the directors to actively consider the question, drawing on the knowledge they each have of the company's operations and financial position. While some reliance on the work of others to prepare the accounts is permitted, the directors have ultimate responsibility for approving the accounts and cannot delegate that role.
In the Centro case, the Court found that the board had not given the required active consideration to the accounts, so did not discharge their duties.
Focus on the secion 295A certificate
Section 295A requires directors to receive a certificate from the CEO and CFO effectively certifying that the accounts comply with the Corporations Act before the board approves them.
The practice at Centro appears to have been that the management representation letter given to the auditors and the board also served as the section 295A certificate. The Court found that this was not compliance with section 295A as the letter did not state the CEO's or CFO's opinion on the accounts. There was no suggestion that the CEO and CFO did not hold the required opinions, but the Court found that the directors had not taken all reasonable steps to comply, and ensure the company complied, with section 295A before approving the accounts.
This seems to expect the directors to have a level of familiarity with the Corporations Act which many may struggle to achieve.
As directors will be double checking such certificates in future, it would be prudent for those who will be signing them to ensure the certificate matches the precise letter of the law, not just the substance of it.
Managing information overload
There was evidence given by the directors about the large amount of information they would receive each month, and each director's practice in reviewing that information.
The Court suggested that the Board should control the amount of information which is provided, to ensure that directors can focus on key information which they need to be aware of.
Given the complexity of many businesses and their financing arrangements and the diverse duties and potential liabilities imposed on directors, this is more easily said than done. It will be a challenge for management to decide:
- what information to include and what to omit from board papers; or
- what to include in "upfront" reports, rather than background or supporting papers,
in the quest to ensure directors have all key information readily to hand, but not too much information - not least because the key information omitted will always be identified with the benefit of perfect hindsight.
There are a number of steps which directors, management and advisers will seek to take, to avoid finding themselves in the situation of the Centro directors:
- further education on financial literacy, key accounting concepts and the company's and director's obligations under Part 2M of the Corporations Act;
- reviewing and investigating any changes between the Appendix 4E released to the ASX and the final accounts;
- a very careful review of the financial statements and an "inquisition" of management and the auditors, before the financial statements are approved by directors, for any potential inconsistencies between the information which directors know about the company and the information disclosed in the financial statements; and
- a focus on the extent of information which is provided to directors in advance of meetings or the timing of information being provided to the board. While it is trite to say that information should be provided in sufficient time to be reviewed and digested, this is particularly difficult for papers on substantial transactions or for the annual financial statements, which will often be reviewed and refined until very close to the time of the board meeting.