Director’s duties – the bar has been raised

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Directors duties and financial statements when put together carry a lot of weight.  The decision of His Honour Middleton J in Australian Securities and Investments Commission v Healey [and others] [2011] FCA 717 (the Centro Case) handed down by the Federal Court on 27 June 2011 held that the defendant directors had breached their director’s duties in failing to discharge their duties of care and diligence. 

If you are a director of a company, especially one in which you are not involved in the day to day management of, this decision is cause for some sober reflection. 

In our assessment the “bar has been raised” by this decision in the expectation that the law places on directors and their duties of care and diligence, especially in their function of representing to the world at large the financial position of the company as disclosed in the publicly available financial statements. 

This judgement (131 pages of it) has particular relevance in relation to the procedure adopted for consideration of the financial statements of the company and the resolution to sign the directors declaration required.   

The following extracts from the judgement indicate the tenor of the judgement (emphasis added). 

14.               A director is an essential component of corporate governance. Each director is placed at the apex of the structure of direction and management of a company. The higher the office that is held by a person, the greater the responsibility that falls upon him or her. The role of a director is significant as their actions may have a profound effect on the community, and not just shareholders, employees and creditors.  

15.               This proceeding involves taking responsibility for documents effectively signed-off by, approved, or adopted by the directors. What is required is that such documents, before they are adopted by the directors, be read, understood and focussed upon by each director with the knowledge each director has or should have by virtue of his or her position as a director. I do not consider this requirement overburdens a director, or as argued before me, would cause the boardrooms of Australia to empty overnight. Directors are generally well remunerated and hold positions of prestige, and the office of director will continue to attract competent, diligence and intelligent people.  

16.               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.  

17.               All directors must carefully read and understand financial statements before they form the opinions which are to be expressed in the declaration required by s 295(4). Such a reading and understanding would require the director to consider whether the financial statements were consistent with his or her own knowledge of the company’s financial position. This accumulated knowledge arises from a number of responsibilities a director has in carrying out the role and function of a director. These include the following: a director should acquire at least a rudimentary understanding of the business of the corporation and become familiar with the fundamentals of the business in which the corporation is engaged; a director should keep informed about the activities of the corporation; whilst not required to have a detailed awareness of day-to-day activities, a director should monitor the corporate affairs and policies; a director should maintain familiarity with the financial status of the corporation by a regular review and understanding of financial statements; a director, whilst not an auditor, should still have a questioning mind.  

18.               A board should be established which enjoys the varied wisdom, experience and expertise of persons drawn from different commercial backgrounds. Even so, a director, whatever his or her background, has a duty greater than that of simply representing a particular field of experience or expertise. A director is not relieved of the duty to pay attention to the company’s affairs which might reasonably be expected to attract inquiry, even outside the area of the director’s expertise.  

19.               The words of Pollock J in the case of Francis v United Jersey Bank (1981) 432 A 2d 814, quoted with approval by Clarke and Sheller JJA in Daniels v Anderson (1995) 37 NSWLR 438, make it clear that more than a mere ‘going through the paces’ is required for directors. As Pollock J noted, a director is not an ornament, but an essential component of corporate governance.  

20.               Nothing I decide in this case should indicate that directors are required to have infinite knowledge or ability. Directors are entitled to delegate to others the preparation of books and accounts and the carrying on of the day-to-day affairs of the company. What each director is expected to do is 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. Such a responsibility arises in this proceeding in adopting and approving the financial statements. Because of their nature and importance, the directors must understand and focus upon the content of financial statements, and if necessary, make further enquiries if matters revealed in these financial statements call for such enquiries.  

21.               No less is required by the objective duty of skill, competence and diligence in the understanding of the financial statements that are to be disclosed to the public as adopted and approved by the directors.  

22.               No one suggests that a director should not personally read and consider the financial statements before that director approves or adopts such financial statements. A reading of the financial statements by the directors is not merely undertaken for the purposes of correcting typographical or grammatical errors or even immaterial errors of arithmetic. The reading of financial statements by a director is for a higher and more important purpose: to ensure, as far as possible and reasonable, that the information included therein is accurate. The scrutiny by the directors of the financial statements involves understanding their content. The director should then bring the information known or available to him or her in the normal discharge of the director’s responsibilities to the task of focussing upon the financial statements. These are the minimal steps a person in the position of any director would and should take before participating in the approval or adoption of the financial statements and their own directors’ reports.  

23.               The omissions in the financial statements the subject of this proceeding were matters that could have been seen as apparent without difficulty upon a focussing by each director, and upon a careful and diligent consideration of the financial statements. As I have said, the directors were intelligent and experienced men in the corporate world. Despite the efforts of the legal representatives for the directors in contending otherwise, the basic concepts and financial literacy required by the directors to be in a position to properly question the apparent errors in the financial statements were not complicated.  

Some immediate ‘good governance’ implication questions

  1. Does your board have the right mix of wisdom, experience and expertise? If not, what steps will you take to seek that?
  2. Do your directors have the ability to read and understand financial statements? If not, what training is going to be organised?
  3. What does a familiarity with the financial status and regular review of the financial statements require? Monthly?
  4. Do your directors have the time and the ‘head space’ to read, understand and enquire into the financial statements? They might be wise, experienced and expert but if they may simply not have the time needed.
  5. Do you ask your co-directors – have you read, understood and enquired into the financial statements?
  6. Do your directors understand that they have the freedom to delay the adoption of the financial statements, ask the hard questions and insist on answers and further specific professional advice if required?
  7. What does monitoring corporate affairs and policies require? Are policy changes reported to the Board and in certain cases not able to be adopted without the approval of the Board?

Company Boards are increasingly asking us to have a ‘half day work-shop’ with their Board to unpack and explain their duties and provide practical advice on applying those duties. The agendas for such a workshop can be tailored for each board and often covers other ‘big ticket’ legal, risk, compliance and tax issues.