A recent Australian court decision about the duties of directors of listed companies when considering the company's financial statements raises some important issues for New Zealand boards.
In Australian Securities and Investment Commission v Healy  FCS 717, ASIC brought proceedings against the directors of certain companies in the Centro Properties Group alleging that the directors failed to take all reasonable steps to ensure compliance with the financial reporting obligations of the Corporations Act 2001, and breaches of their statutory duty of care and diligence.
The allegations related to disclosures in the 2007 annual financial statements of Centro Properties Group and Central Retail Group. Those financial statements wrongly classified liabilities of about A$2.1 billion as non-current liabilities instead of current liabilities and failed to disclose certain post balance date related party guarantees.
The main focus of the directors' defence to ASIC's allegations was that they had taken all reasonable steps to comply, or secure compliance, with their obligations by engaging auditors to audit the financial statements and by following all the processes that could have been undertaken, including by obtaining all proper advice, to ensure that the financial statements complied with the Act. The directors argued that that they were entitled to rely on the assurance of Centro's auditors and Centro's highly experienced management team that the required disclosures had been made in the relevant financial statements.
The court's decision
The court held that each director is expected 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. The court found that, notwithstanding the fact that Centro had engaged auditors to audit the relevant financial statements, and that neither Centro management nor the auditors had detected, nor brought to the board's attention, the error as to the classification of the liabilities, the error was such that it could have been identified by the directors without difficulty if they had carried out a careful and diligent review of the financial statements.
The notes to the financial statements included a concise and correct statement as to the classification of current liabilities. The court held that if the directors had read the financial statements – as they should have done – they would then have understood the classification requirement and this, taken together with their factual knowledge of the facility terms, meant that they should have understood that there was an error in the classification of the liabilities as non-current liabilities.
Comparison with the Feltex decision
Interestingly, as part of the Centro directors' defence, the directors sought to convince the court to adopt the approach taken by Judge Doogue in the recent New Zealand District Court decision Ministry of Economic Development v Feeney & Ors (the Feltex decision).
In the Feltex decision the directors successfully defended criminal charges under section 36A of the Financial Reporting Act 1993 for errors that appeared in Feltex's 2005 interim accounts. The directors relied on the defence provided in section 40 of the Act that they took "all reasonable and proper steps" to ensure compliance with the Act. Judge Doogue dismissed the prosecution's argument that the directors themselves should have reviewed the lengthy and complex IFRS standards and then applied those to Feltex's interim financial statements. This proposition was found to be "utterly unrealistic", as "company directors will not have anywhere near the same level of knowledge and expertise in accounting standards that a specialist auditor will have and the best course for a director is to seek and follow the advice of an expert".
The judge in the Centro decision acknowledged that the views expressed by Judge Doogue were "instructive", but stated that each case must be decided on its own particular facts. In particular, the court noted that there was no question of ASIC contending that the Centro directors "should have done it all themselves and become familiar with the complexities of various accounting standards", noting that the directors "cannot and are not required to take on that task". In contrast to the facts in the Feltex decision, the court concluded that the Centro directors did not need a sophisticated knowledge or understanding of accounting standards to have identified the errors in the Centro group's financial statements. The critical factual difference between the two cases was that the Centro financial statements identified the relevant test for classification of "current" liabilities and the court held that this should have led the directors to identify the error.
Some commentators have suggested that the different results in the two cases arise because Feltex is a criminal case, whereas Centro was a civil case, and therefore different standards of proof applied. This is incorrect. The defence of "all reasonable and proper steps" was an affirmative defence that the Feltex directors needed to prove on the balance of probabilities. The criminal / civil distinction is therefore entirely irrelevant to the different results. Rather, the difference arises from the different facts of the two cases.
Lessons for New Zealand directors
Although both the Centro decision and the Feltex decision turn on their own particular facts, both cases highlight the high standard of care required of directors when considering financial statements.
Under both Australian and New Zealand legislation, directors are subject to special responsibilities for approving financial statements. The Centro decision suggests that such responsibilities necessarily require that directors of public companies have a degree of financial literacy, which should at least extend as far as an understanding of basic accounting concepts and conventional accounting practices to enable them to carry out their responsibilities adequately.
It is clear that directors must carefully review the financial statements (including notes) and accompanying papers provided to them, and have regard to the information they know about the company when undertaking that review. Directors will be expected to ask questions of management and advisers with respect to issues that arise from their review of the documents before approving the financial statements.
Both cases also identify limits on the extent to which directors can rely on management and external advisers with regards to approving and adopting financial statements. The courts in both the Feltex decision and the Centro decision acknowledge that reasonable reliance on others by directors is legitimate. However, the Centro decision indicates that a court is likely to find that such reliance is not reasonable when a director has sufficient knowledge to identify a potential error in the financial statements and fails to question management and the external advisers on the matter. Further, directors may not substitute reliance upon the advice of others for their own attention and examination of the financial statements. The court found that the Centro directors failed to see the errors in the financial statements that "could have been seen as apparent without difficulty", because they relied exclusively on the internal processes which the Centro group had in place and on their advisers.
In the Centro decision, the court held that the complexity and volume of information presented to the board cannot be an excuse for directors failing to properly read and understand important documents such as financial statements. The court's view is that the board is able to control the information it receives and should prevent information overload. In light of those comments, it would be prudent for all boards to review their practices to ensure that they are not overburdened with information.