The charges
ASIC alleged that the seven directors of Centro Properties Group and Centro Retail Group failed to discharge their duties with due care and diligence in approving the financial reports for Centro Properties Ltd, Centro Property Trust, and Centro Retail Trust for the year ended 30 June 2007. ASIC also contended that the directors, and the former chief financial officer, knew that the entities had very significant short-term interest bearing liabilities, and should have known that these liabilities were incorrectly classified in the 2007 financial reports.
ASIC alleged that the director contravened s 344(1) of the Corporations Act 2001 (directors to take all reasonable steps to comply with the financial reporting obligations of Part 2M.3) and s 180(1) (duty to act with care and diligence) of the Act. ASIC sought orders to disqualify the directors and officers from managing corporations and asked the Court to impose pecuniary penalties on them. At the commencement of the trial, the CFO filed an amended defence admitting most of ASIC’s allegations against him.
Justice Middleton made the following comment:
This proceeding is not about a mere technical oversight. The information not disclosed was a matter of significance to the assessment of the risks facing CNP and CER. Giving that information to shareholders and, for a listed company, the market, is one of the fundamental purposes of the requirements of the Act that financial statements and reports must be prepared and published. The importance of the financial statements is one of the fundamental reasons why the directors are required to approve them and resolve that they give a true and fair view.
Observations from the case
Company directors must take positive steps to review and form their own opinion on their company’s financial statements. These steps include reading and understanding the financial statements. “Reading” means carefully reading and reviewing, not simply skimming and then seeking assurances from the CFO and auditors. Directors cannot rely on management and auditors to complete the financial statements without critically assessing the work delegated to those people.
The finding partly states the obvious, but also sets out responsibilities with detail that has not appeared previously. Directors should compare their own actions and understanding against the findings.
The case law indicates that there is a core, irreducible requirement of directors to be involved in the management of the company and to take all reasonable steps to be in a position to guide and monitor. There is a responsibility to read, understand and focus upon the contents of those reports which the law imposes a responsibility upon each director to approve or adopt.
The Centro case dealt with matters such as:
- misclassification of $1.5 billion of debt as non-current liabilities, when the holders of that debt had the conditional power to seek repayment within 12 months
- non-disclosure of guarantees of short-term debt to an associated company provided after balance date.
The judge found that these matters were well-known to the directors, or should have been. They therefore had a duty to ensure that the financial statements accurately reflected them. While the directors were found guilty of breaches of duty of care and due diligence, but were not found guilty of a breach of duty to act honestly.
How much should directors know?
Directors can validly raise concerns about the difficulty of understanding complex financial accounting matters that require technical interpretation. However, the Centro case shows those concerns cannot be used to justify not taking various fundamental steps. Justice Middleton said in his judgement: “I do consider that all that was required of the directors in this proceeding was the financial literacy to understand basic accounting conventions and proper diligence in reading the financial statements.”
Justice Middleton did not necessarily expect a director to go through the financial statements line by line, as even doing that would not fulfil a director’s duties. Instead, he expected directors to focus on relevant issues and see whether they were properly reflected in the financial statements. He found that because the directors had discussed relevant matters about the loans at Board meetings and had been given Board papers on the subject, they should have applied that knowledge in forming their own opinion on the financial statements.
Board failings
Justice Middleton was able to make his findings because the evidence showed a number of failings:
- some directors admitted reading only the concise version of financial statements, and not the full set
- some directors only ‘skimmed through’ selected Board papers
- no directors questioned management or the audit committee about the relevant disclosures
- no director ensured the required declarations about the financial statements from the Chief Executive Officer and Chief Financial Officer were obtained.
These are examples of where the directors were held to not have taken “all reasonable steps” to ensure the financial statements were true and fair and to ensure that they and the company complied with the financial reporting requirements of the Corporations Act. A clear message from this case is that directors may need the advice of management and external advisors in assisting them to fulfil their duties.
However, they may not accept the information provided by those parties without careful review and questioning, using the knowledge and expertise that they bring to their position.
Action items
The Middleton judgement gives rise to a number of action items for directors, management and auditors to consider.
These include:
Directors
1. Commit to reading and questioning the financial statements based on the director’s individual knowledge. This should lead to greater questioning of management and auditors on financial reporting matters.
2. No longer rely solely on internal processes, the director(s) with the accounting expertise, the audit committee, and the external auditor to meet directors’ statutory obligations regarding the financial statements.
3. Re-familiarise themselves with procedures and controls in place over the financial reporting process and request additional information where necessary.
4. Spend more time on the financial statement component of the directors’ obligations and focus on what has changed since the previous reporting period and high risk areas, such as those identified by ASIC as part of its financial reporting surveillance program.
5. Keep a record of contemporary issues as a memory aid.
6. Understand accounting standards fundamentals, concentrating on the application of those accounting standards stated in the Summary of Accounting Policies in note 1 to the financial statements, and in the context of current economic and regulatory conditions, though training and financial reporting information services.
7. Review their understanding of the Corporations Act financial reporting requirements.
8. Consider a diagnostic review of the financial reporting process (including board charters) to highlight issues and weaknesses.
9. Look for advice beyond the external auditors.
10. Consider the need for an independent mentor to use as sounding board on financial reporting issues.
11. Incorporate the AICD publication How to Review a Company’s Financial Reports – A Guide for Boards into in-house director induction and update courses.
CEO, CFO and Company Secretary
1. Review quantum and complexity of board papers to ensure they are relevant and understandable. Consider highlighting the financial reporting implications of agenda papers and carry forward into the financial reporting process.
2. Inform the directors of new and revised accounting standards.
3. Organise training and briefings on accounting standards and the Corporations Act.
Auditors
1. Consider whether engagement letters need to be updated.
2. Improve governance communication on financial reporting issues, particularly in the context of the Clarity auditing standards.
3. Prepare for more scrutiny of the audit of financial statements.
More scrutiny needed
The 186-page Middleton judgement was released on 27 June 2011 and provided directors, management and auditors with precious little time to fully absorb the judgement and consider the implications for the 30 June reporting season, in particular, for internal processes and controls over financial reporting in the entity specific circumstances.
Some quick fixes will be introduced, in particular, for the directors to read the financial statements, apply their minds, and ask questions.
After the current reporting season, directors and management should undertake a more formalised process to assess how the Middleton judgement impacts the governance accountability and what changes are necessary to ensure compliance with the Corporations Act.
In due course, directors will have to become more familiar with the financial reporting requirements of the Corporations Act, and the fundamentals of accounting standards that impact the business. Enhanced structures will need to be placed around the financial reporting processes to the board. Directors will have to allow more time to focus on the financial reporting implications of transactions and events that affect the financial statements.
Directors will have to bring their minds to bear on financial reporting compliance in addition to strategic and monitoring roles. These changes will have a flow on effect to management and auditors.
