The lessons for not-for-profits in the Centro judgement

Although the Centro ruling applied to a listed company, directors of not-for-profits should take notice. AAP

The flood of media coverage following the landmark Centro Properties Group findings has left directors from both the public and private sector concerned over an apparent increased level of expectation when it comes to financial literacy.

For the not-for-profit (NFP) sector, lessons from the Centro judgement are somewhat complicated because the case centres on financial disclosure for a listed company.

Since regulatory requirements and legal tests for the duty of care vary with the kind of company or organisation involved, any findings made in the case need to be sufficiently abstracted to a NFP context and may vary based on any individual entity’s circumstances.

While the vast majority of NFPs remain unincorporated, there has been a distinct move within the third sector towards becoming registered as a legal entity. The largest NFPs tend to be Corporations Act entities (relatively steady at around 11,000) whereas the largest growth has been in incorporated associations (around 140,000).

Reasons for incorporation vary. Often, government funding contracts require this type of corporate structure. Similarly, many NFPs see benefits in limited liability and the flexibilities enabled by a corporate form.

Larger NFPs tend to be Corporations Act entities due to the flexibility on offer – for instance, those working across state boundaries may choose a Corporation Act form as legal requirements and duties will not vary by State.

What happens under the Corporations Act impacts NFPs for several reasons. NFPs sometimes mimic the governance practices of the for-profit world.

In some states, the relevant legislation governing incorporated associations has similar duties or are vague, which makes decisions based on Corporations Act duties a good guide for prudent executives, directors or management committee members. Thus, the findings in Centro do have implications for both incorporated and unincorporated NFPs.

Centro’s impact

Briefly, some key facts of the Centro case. Among other things, the board of Centro signed off financial statements with major errors in them. The statements misclassified US$1.5bn in short-term “current” liabilities as non-current, and did not disclose US$1.75bn of guarantee granted after the balance date.

Justice Middleton noted “this proceeding is not about a mere technical oversight”. The error grossly misstated the company’s funding obligations and understated the risks facing the company.

The judge specifically referred to the shareholders in this publicly listed company, who would rely on this information to make critical decisions and who may have been led to believe the company faced less risk than it did. The errors had potential consequences for shareholders and the market as a whole.

While the judgment highlighted the importance of a company’s financial statements (in the context of a listed company) and the corresponding level of focus a director must place on the statements to ensure they accurately represent a “true and fair view”, he also noted that “[t]he financial literacy required … was not complicated”.

Neither ASIC nor the court found the directors lacked in financial literacy or honesty in carrying out their duties. In fact, their backgrounds and experience were evidence alone that they possessed sufficient skill in the area.

The directors’ oversight came in an over-reliance placed on internal processes, management and their external advisers. No director identified what ASIC described as “obvious errors”, despite most submitting they were aware of the company’s situation and relevant reporting obligations.

The judge specifically noted that “no director stood back, armed with his own knowledge, and looked at and considered for himself the financial statements”. The problem therefore lay in the lack of review and a total reliance on others.

The judge made note that while it is fine to delegate, the ultimate responsibility sits with the directors who must “take a diligent and intelligent interest in the information available” and “apply an enquiring mind”.

Importantly, the judge emphasised that ASIC was not alleging the directors needed to “get it right”, but had they “acted accordingly, by for instance, asking the appropriate question of management” that the errors should have been detected.

As a defence, the directors referred to the excessive quantity of information presented to them to read. This was not accepted by the judge who noted that directors can control the volume and relevancy of information presented and that “complexity and volume of information cannot be an excuse for failing to properly read and understand the financial statements”.

Lessons for NFPs

Will this case have implications for directors of NFP organisations? There are several reasons why it will, but the key principle is that while directors of non-profits may not be subject to the same level of expectations placed on listed companies, all governors of NFPs will owe a duty of care and diligence whether at common law or in a specific act that applies to their organisation.

The degree of care required of directors is likely to increase based on the assessed level of associated risk. In the Centro case, Justice Middleton commented that “the higher the office that is held by a person, the greater the responsibility that falls upon him or her”.

The lessons here for NFP board members is clear:

While it is acceptable to delegate, you cannot delegate obligations set out in legislation and in contracts – for example with funders such as government. In these instances, you should take special care that you fulfil your legal duties.

The more important a matter or decision to the organisation, the more interest you need to take in it. This might extend beyond financial matters for a NFP. Legislation and your contracts may assist you to highlight these areas. Pay particular attention to where outside parties will rely on you carrying out your duties.

It also important to recognise that any delegation cannot be a “blind” delegation. You might not have special expertise in an area, but you are expected to stand back and consider whether the decision makes sense to you. If you have a question, you must ask it.

Be careful of relying on advice that appears to be wrong. You need to question it, even if the advice you have received is advantageous for your organisation. Ask the “dumb” questions rather than making assumptions.

Your flow of information is critical – ensure the volume of board papers is appropriate, that key matters are highlighted and that the information is comprehensible to all directors. Periodic reviews of your board and its processes can help here.

All directors of an incorporated NFP would be expected to understand the broad financial position of the organisation they govern. Without this knowledge, they cannot fulfil their duty to monitor the affairs of the organisation and make judgments appropriately around matters of solvency.