The Centro Properties Group ruling is one of the most significant judgments we have had in the areas of corporate law and corporate governance in a number of years.
Federal Court Judge John Middleton ruled on Monday that Centro’s directors breached the Corporations Act when they failed to notice massive errors in the company’s accounts.
The importance of this decision is clear in what Justice Middleton said about the responsibilities of company directors for financial statements.
He said said that all Australian company directors need to read, understand and focus on their companies’ financial statements.
This is one of the key responsibilities of all company directors. What the judge said here is not only important for Centro, but also has implications for all company directors.
There are a number of important implications of this judgment, all of which stem from the judge’s focus on this fundamental responsibility of directors for the financial statements of the company.
The first implication is for the qualifications of directors.
The judge said that directors need to have a minimum level of what he calls “financial literacy”.
Companies will need to ensure that directors have sufficient financial literacy, and if they don’t, then they need to obtain it through some form of education.
This isn’t a new message - we have known that directors are responsible for the financial statements – it’s in the Corporations Act.
But this judgment gives this responsibility a sharp focus because some very prominent non-executive directors of a very large company have been found to have breached their duty of care by not properly taking responsibility for the financial statements.
One possible conservative approach for boards to take in response to this judgement would be for them to say, “what we need to do is make sure that all our directors are financial experts.”
This would cut against a trend to ensure diversity in the boardroooms of Australian companies.
It is is clear that boards need to have people with a range of skills, experience and backgrounds, and that makes for a successful company.
The message of the judgment should not be that all directors need to be financial experts or that companies should narrow the type of the people they appoint as directors.
Rather, the message is that companies should continue to have diverse boards – and perhaps even more-diverse boards than we have today – but they should ensure that all directors have sufficient knowledge to understand the financial statements.
A second implication of the judgment, which is also related to the level of financial literacy on boards, is what directors actually do with their financial skills.
The judge says that all the directors need to be reading, understanding and focussing upon the financial statements.
They need to be applying what he calls “proper diligence” to the financial statements.
This is quite an important issue because it would be true to say that there are probably a great number of directors who do not read the financial statements in detail.
Why not? They may say that, firstly, their company has a chief financial officer upon whom they rely to ensure the accuracy of the financial statements. Secondly, the company may have a professional auditor – an audit firm – upon which they can rely.
Perhaps the company has an audit committee, or some directors might have been specifically appointed because of their financial expertise.
So it might be that a director says, “well, I’m surrounded by financial experts, so I don’t need to read the financial statements.”
This is clearly contrary to what the judge has said.
This is a reason why we will see an ongoing debate about this judgment, because some directors might say that the judge has set the standard too high for non-executive directors.
We need to remember that the breaches of duty in this case apply specifically to Centro and to that company’s directors and executives.
The judge identified some worrying deficiencies within management at Centro, in terms of preparing the financial statements. And the judge also identified what he saw as deficiencies in the board process, in terms of reviewing the financial statements.
So, there is a difference between what the judge says about the important responsibility of directors for the financial statements and the actual breaches of the duty of care by the directors and executives of Centro.
Another implication of the judgment relates to the information that directors receive. In the Centro case, there was evidence that directors received huge volumes of information every four weeks for board meetings, and they didn’t read it all.
They each gave evidence about the sorts of documents they would selectively read of the huge volume of information they received.
This is a very important issue for companies. They must ensure that the information directors receive from management is focussed, and relevant.
In other words, companies must ensure that their boards are not swamped with a volume of information that makes it difficult for directors to focus on what is important.
Here the judge makes a point that we have always known – the board is responsible for the volume of information and the form of the information that it receives. It’s not up to management to determine this.
Delegation and reliance
Another point to come out of the judgment concerns the relationship between directors – particularly non-executive directors - and management – in terms of delegation and reliance.
Delegation and reliance are essential parts of all large organisations. The Centro directors were entitled to rely on auditors and management, but the judge found that they didn’t get the balance right between reliance and “proper diligence”.
In fact, the judge says that on a number of occasions the directors relied solely on others to advise them.
A bigger role for ASIC?
There is also an interesting message arising from this judgment about the role of the Australian Securities and Investments Commission (ASIC) in setting the standards for directors.
ASIC initiatied the Centro litigation for breaches of duty by the directors and executives, in what was the latest of a series of cases where the corporate regulator has alleged that directors or company officers breached their duty of care by not fulfilling their responsibilities.
ASIC hasn’t always been successful in proving thes cases, but they are important cases, particularly where it brings a case against an entire board.
Aside from the Centro case, ASIC alleged breaches of duty by the entire board in the well-known James Hardie case, which is currently on appeal before the High Court.
The message here is that the corporate regulator is active in arguing before courts what is the appropriate standard by which company directors should act.
Australian companies and their boards will no doubt be carefully considering the best steps to take to ensure they don’t face the same kind of troubles as Centro.