Directors' Liability for Mistakes in Financial Statements

First published in NZ Lawyer, 12 August 2011.

To what extent are directors responsible for errors in a company's financial statements? A far-reaching decision by the Federal Court of Australia suggests that directors may be liable for mistakes in the accounts, even if both the company's management and auditors fail to pick up the errors.

In Australian Securities and Investments Commission v Healey [2011] FCA 717 (Centro), Centro Property Group (CNP) and Centro Retail Group (CER) failed to classify certain liabilities as current and failed to disclose certain post balance date events. Justice Middleton ruled that although directors can rely on expert advice, they cannot abdicate their own fundamental responsibility to review and approve the company's financial statements.

His Honour ruled that directors must have sufficient knowledge of conventional accounting practice, and must apply that knowledge based on information they received as directors. If the directors detect an apparent error, they must ask questions of management or the auditors.

Justice Middleton found that the Centro directors knew or should have known of the relevant accounting principles. He also found that earlier board papers had disclosed the existence of the current liabilities, and that the board knew of the post balance date events. However, no director asked any questions of management or the auditors about what His Honour called "obvious" errors in the accounts.

As a result, even though the auditors and management signed off on the accounts, and even though the directors acted honestly, Justice Middleton found that every member of the board breached his duties to take all reasonable steps and to be diligent and careful in approving the financial statements.

Background

The Centro group is an Australian group that owns and manages shopping centers in Australia, New Zealand and the United States. CNP and CER were both companies in the Centro group, with identical boards. The boards consisted of the group's CEO, a non-executive chairman, and five other non-executive directors.

On 6 September 2007, the directors approved the financial statements of CNP and CER as at 30 June 2007, resolving that the statements gave a fair and true view of the companies' financial position and performance.

However, CNP had liabilities of A$1.5 billion and CER had liabilities of A$600 million that were all due to mature in the next 12 months. These liabilities should have been recorded as current in the companies' financial statements, but were not.

In addition, CNP gave guarantees after its balance date in favour of an associated company totalling US$1.75 billion. Although accounting standards require material post balance date events to be disclosed, CNP's financial statements mistakenly failed to disclose the guarantees.

ASIC's Claim

ASIC claimed that in approving the accounts, the directors breached sections 344 and 180 of the Corporations Act 2001 (Cth).

Section 344 requires directors to take "all reasonable steps to comply with, or secure compliance with" sections 296 and 297. Section 296 states that financial reports must comply with the applicable Australian accounting standards, and section 297 requires financial statements to give a true and fair view of the financial position and performance of the company.

In addition, section 180 requires directors to exercise their duties "with the degree of care and diligence that a reasonable person would exercise" in the same position.

ASIC sought a declaration that the directors had contravened sections 180 and 344, and orders that the directors pay pecuniary penalties and be disqualified as directors.

The New Zealand analogues to section 344 are sections 36 and 36A of the Financial Reporting Act 1993, which impose criminal liability on directors if financial statements do not comply with applicable reporting standards. It is a defence under section 40 if a director proves on the balance of probabilities that the directors took "all reasonable and proper steps" to ensure compliance with the reporting standards.

New Zealand's Companies Act 1993, of course, also imposes a duty of care similar to Australia's Corporation Act. Section 137 of the Companies Act provides that directors must " exercise the care, diligence, and skill that a reasonable director would exercise in the same circumstances".

Scope of Directors' Duties

Justice Middleton began his judgment by outlining directors' basic responsibilities under sections 180 and 344. Although directors are not required to be involved at an operational level, there is a "core, irreducible requirement" of directors to guide and monitor the management of the company. Centro at [16].

Directors must therefore acquire at least a rudimentary understanding of the company's business. They must be familiar with the fundamentals of the company's business. They should keep informed about the company's activities, monitor corporate affairs and policies, and have a questioning mind. And directors must be familiar with the company's financial status by regularly reviewing and understanding financial statements.

Although directors are entitled to rely both on others and on processes they have put in place, such reliance "does not discharge the entire obligation upon the directors". Centro at [240]. Directors cannot substitute reliance on management for their own review of the financial statements. Neither an audit committee nor the financial expertise of other directors exempts all directors from reviewing the accounts. And even full audit clearance from the company's auditors does not excuse the directors from their own fundamental duty to review and understand the financial statements.

Justice Middleton held that directors must have "sufficient knowledge of conventional accounting practice concerning the basic accounting concepts in the accounts", and must apply that knowledge based on all of the information they received as directors – even if the information was provided in a different context. Centro at [211], [229]. If the directors detect an apparent error in the financial statements based on the information they know or should have known as directors, they must then ask appropriate questions of the auditors and management.

Directors' Knowledge of Accounting Principles

His Honour found that although a director need not be "familiar with every accounting standard", given that CNP's and CER's accounts refer to the classification of debt and post balance date events, the directors must know and apply "the basic elements of the one or two standards relevant" to those issues. Centro at [203], [206].

The directors argued that application of accounting standards is a specialist field of expertise, and that it would set an unreasonably high bar to require directors to obtain a working knowledge of the entire range of accounting standards. However, Justice Middleton observed that a note to the financial statements explicitly stated that borrowings are current unless the companies had an unconditional right to defer settlement for at least 12 months. That, he said, was all each director needed to know to have sufficient knowledge of the relevant accounting standard.

The directors also submitted that there had been a recent change to the accounting standards, which resulted in the error made by management and the auditors. However, His Honour found that there was no evidence to suggest that this was a contributing factor to the directors' actions.

Directors' Knowledge of the Liabilities and Guarantees

Justice Middleton also found that each director knew of the current liabilities and guarantees that should have been recorded in the accounts.

The directors argued that it was an unreasonable "counsel of perfection" to require them to scrutinize and cross-check earlier board papers against the draft financial statements. For example, ASIC argued that the board should have been aware of two pages concerning CER's debt that were buried deep in a 1,180-page board pack provided months earlier in a different context. Justice Middleton disagreed with the directors, observing that if there was an information overload, it could have been prevented by the directors.

His Honour concluded that the directors should have detected the apparent errors in the financial statements and made relevant enquiries of management and the auditors. They did not, and as a result, they breached sections 180 and 344.

The New Zealand Context

The Centro decision is particularly interesting given the recent unsuccessful prosecution of the directors of carpetmaker Feltex Carpets Ltd for breach of section 36A of the Financial Reporting Act: Ministry of Economic Development v Feeney (Feltex) (DC, CRI-2008-004-029199, 2 Aug 2010).

As with Centro, Feltex had mistakenly failed to classify a liability as current, in breach of the applicable financial reporting standard. However, Judge Jan Doogue accepted the Feltex directors' defence that they had taken all reasonable and proper steps to ensure compliance with the reporting standards, and found the directors not guilty. Because Feltex turned on an affirmative defence that the directors needed to prove on the balance of probabilities, the standard of proof was the same as Centro, although the onus was on the directors rather than the regulator.

Although the issues in both cases initially appear very similar, there are three important factual differences. First, the Centro directors had the contents of the applicable reporting standard spelt out in one of the notes to the financial statements. The Feltex directors did not. Second, the Feltex directors mistakenly applied the old financial reporting standards based on incorrect advice from the company's auditors that there was no relevant change under the new standards. The Centro directors did not.

And third, all the Centro directors needed to know was that the companies had liabilities maturing in the next 12 months. To pick up the mistake in the Feltex accounts, by contrast, the Feltex directors needed to know that a breach of covenant in a facility agreement means that the liability is current, even if the maturity date is otherwise more than 12 months away and even if there are reasonable grounds to believe that the bank does not intend to take any action on the breach.

Given these key factual differences, it is not surprising that the courts reached different conclusions based on the different facts in each case.

Centro has already been cited in New Zealand, in the criminal prosecution of the directors of Nathans Finance NZ Ltd under section 58 of the Securities Act 1978: R v Moses (CRI 2009-004-1388, 8 July 2011) at [85]. Justice Heath also said at [80] that directors need to have "more than a basic understanding of accounting principles", although this discussion is arguably limited to finance company directors.

Takeaway for Directors

Directors reading the Feltex decision may assume that they can rely exclusively on the advice of management and auditors in ensuring compliance with applicable reporting standards. However, Centro suggests that this may not always be true. Although directors are entitled to rely on others, directors must also make sure that they exercise their own independent judgment in carefully reviewing and understanding the financial statements (including all notes to those statements).

Directors should also ensure that they have a least a basic knowledge of conventional accounting practice and concepts. Of course, what one person considers to be a simple accounting concept may be highly technical to another. The courts in Centro and Feltex have begun to draw this line, but it is a distinction that will likely continue to be contentious. At the very least, directors should make sure that they read and understand the accounting concepts explained in the notes to the accounts.

Directors also need to balance the need for sufficient information from management with what the directors in Centro described as "information overload" from the board papers. Boards should make sure that they receive sufficient information, but that they are not overburdened with material – a balance likely to be difficult to achieve in practice.

Directors must then make sure they carefully and diligently review all of the information provided to them. Justice Middleton was critical of the Centro directors for failing to carefully review the annexures to the operational reports contained in the board papers. To the extent that directors do not require this level of information, then this material should be excised from the board papers.

Finally, directors need to make enquiries of management and the auditors if there is anything in the financial statements that they do not understand or that is not consistent with the knowledge that they have or should have as directors.