ASIC has succeeded in its case against current and former officers and directors of the Centro group of companies.

Justice Middleton handed down his judgment on 27 June 2011, finding that each of the directors and the officer involved in the proceedings had breached duties of care and diligence under s180 and equivalent duties as officers of a registered managed investment scheme under s601FD of the Corporations Act.  In addition, the directors were found to have breached s344 of the Act by having failed to take all reasonable steps to comply with (or secure compliance with) the financial reporting obligations in the Act.

This important decision is the latest is a series of recent landmark pronouncements on directors’ and officers’ duties and follows the recent decisions in Fortescue and James Hardie.

Background to decision

The breaches related to disclosure in the 2007 annual financial reports of Centro Properties Group (CNP) and Centro Retail Group (CER).  Both reports classified liabilities as “non-current”, when the Federal Court considered that they should have been classified as current liabilities.  The amounts involved were $1.5 billion in the case of CNP and $500 million in the case of CER. 

Central question in the decision

The central question was whether (and the extent to which) the directors were required to apply their own minds to, and carry out a careful review of, the annual financial report to determine:

  • if the information it contained was consistent with the director’s knowledge of the Centro group’s financial affairs; and
  • that the annual report did not omit material matters known to them or material matters that should have been known to them.

A related question was the extent to which the directors could rely on others in satisfying their statutory obligations in relation to the annual financial report.

Standard of care expected of directors

Middleton J held that the duty of care and skill is an objective duty of competence that requires directors to have the ability to read and understand financial statements.  His Honour considered that these skills are necessary for an assessment of solvency and liquidity, which is an obligation imposed on directors by the Act.  He did not go so far as to say that directors should have a degree of accounting literacy that requires a knowledge of accounting practice and accounting standards - Middleton J considered that this “was not for decision” in this proceeding.

The directors had argued that this standard takes directors obligations  a step too far and such an interpretation of the statutory requirements would require “perfection”.  However, his Honour considered that all that was required was the financial literacy to “understand basic accounting conventions and proper diligence in reading the financial statements”. 

His Honour acknowledged that, in exercising their duties, directors are entitled to rely on others, at least except where they know (or ought to know) that reliance is not reasonable in the circumstances.  However that does not go so far as to abrogate the need to bring an independent and questioning mind to the exercise of their duties.

Importance of annual reporting obligations

The decision suggests that directors’ duties have special application in the context of financial reporting obligations, where the Act expressly places an obligation on the directors to declare that the financial statements and notes are, among other things, in compliance with the Act.  So much so, that directors cannot delegate their responsibilities to make these declarations.

Even though the obligation to prepare the annual financial report is an obligation placed on the entity (and not the directors), the directors cannot put the discharge of their specific obligations in the hands of others.  They have an important responsibility for the contents of the report.

While the obligations themselves cannot be delegated, directors are entitled to delegate various tasks to others and are entitled to rely upon specialist advice. 

On the facts, his Honour found that:

  • the directors were aware (or should have been aware) of the relevant accounting principles; and
  • each director could then make (and should have made) appropriate enquiries of management.

In this context, while there is no suggestion that reliance made by the directors was unwarranted or misplaced, his Honour considered that the directors relied solely on management and others to be properly informed of the information relevantly to be put into the financial statements.  They did not stand back and consider for themselves the financial statements, particularly in the context of the omission of matters that “could have been seen as apparent without difficulty”.

Accordingly, his Honour found that the directors had not taken reasonable steps to discharge their specific obligations under section 295(4), and nor had they discharged their general duty of care and diligence under s180(1), with respect to the 2007 annual financial report.

What does this mean for directors?

The timing of the decision is particularly important given the upcoming financial reporting season. 

As always, directors need to inform themselves as the financial affairs of the company to the extent necessary to form each year the opinions required of them to sign off on the accounts.  In light of this, directors should carefully review the details of the financial statements and reports.  It will not be sufficient for a director to simply rely on experts in preparing accounts - directors must apply an enquiring mind to their responsibilities.

Where necessary, directors should ask questions of management and advisers to ensure that they have adequately considered and disclosed any relevant matters before approving or adopting the relevant financial statements/reports.

Middleton J clearly considered that it is within the ambit of the board to control the information it receives.  Following the decision in James Hardie, some have called for a greater degree of information flow between management and the board, but commentary in this case makes it clear that this should not overburden the board.  Directors should take steps to prevent information overload and ensure they are given sufficient time to examine material provided to them for approval.  It is clear that complexity and volume of information cannot be an excuse for failing to properly read and understand the financial accounts.

Where to from here?

The Federal Court is yet to consider whether any of the directors or officers should be relieved from liability for the contraventions.  The hearing for relief from liability and penalties will be heard on 1 August 2011.