The Centro Decision — did it raise the bar for the standard required of directors in considering and approving a company's financial reports?

The recent Federal Court decision of ASIC v Healy[1]reaffirmed the importance of a director's role in preparing and approving a company's financial reports. Although directors may enlist accountants and company management to prepare financial reports, the directors have the ultimate responsibility to review and carefully consider those reports before they are approved and submitted to ASIC.

Jeff Holowaychuk

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The facts

The decision in the ASIC v Healy (Centro Case) relates to a number of errors that were found in the annual financial reports of the Centro Group.

The Centro Group is a retail investment organisation specialising in the ownership, management and development of retail shopping centres.

In 2007, the board meetings of the Centro Group approved financial reports that significantly understated the group's short-term liabilities, being liabilities which are due to be repaid or refinanced within 12 months.

When, some months later, the Centro Group discovered these errors and announced them to the market, ASIC commenced legal proceedings against the Centro Group directors for breaching their duties under the Corporations Act 2001 (Corporations Act).

Director's duties

The Court in the Centro Case was concerned with the obligations imposed on directors under sections 180 and 344 of the Corporations Act. Those duties are as follows:

• directors must exercise their powers and discharge their duties with the degree of care and diligence that a reasonable person would exercise if they were in the shoes of that director; and
• directors must not fail to take all reasonable steps to comply with or secure compliance with Parts 2M.2 and 2M.3 of the Corporations Act, which contain the financial reporting requirements.

In particular, the Court examined how these duties applied to the requirement for directors to include a declaration in company financial reports.

Financial reporting requirement

The Act, in Part 2M.3, requires certain companies to prepare financial reports and directors' reports for each financial year. Companies that must prepare and lodge financial reports with ASIC include:

• all public companies;
• all large proprietary companies; and
• in certain circumstances, small proprietary companies — for example, if the shareholders or ASIC direct the company to prepare a financial report.

A financial report must consist of:

• the company's financial statements for the year;
• the notes to the financial statements; and
• the directors' declaration about the statements and notes.

In relation to the director's declaration — which was key to the Court's decision in the Centro case — the directors must declare:

• that there are reasonable grounds to believe that the company will be able to pay its debts as and when they come due and payable;
• whether the company has included an explicit and unreserved statement of compliance with international financial reporting standards in the notes of the report;
• whether the financial report complies with accounting standards and give a true and fair view of the financial position and performance of the company; and
• if the company is listed, that the chief executive officer or chief financial officer have given the directors a declaration under section 295A of the Corporations Act.

The Court's findings

The Court found that:

• the Centro Group directors failed to carry out their duties with a sufficient degree of care and diligence; and
• that by signing the directors' declaration, which certifies the truth and fairness of the Centro Group's financial reports, the directors breached both of sections 180(1) and 344.

The Court considered that persons in the position of the Centro Group directors knew, or ought to have known, about the company's short-term liabilities. In addition, company directors should have a basic understanding of accounting principles and standards in order to perform their duties. Therefore, had the directors exercised their powers with a sufficient degree of care and diligence — ie by reading the financial reports with a critical eye — then their knowledge of the company's affairs would have exposed the error and caused them to raise the issue with management and advisors.

How does this decision affect company directors more generally?

Although the Centro case relies heavily on its own circumstances, the decision sets some general points about the duties of directors:

• Directors should take reasonable steps to place themselves in a position to guide and monitor the management of the company, becoming familiar with the company's business, activities and financial position.
• Directors should have a basic understanding of accounting practices and standards to assist in critically assessing financial reports.
• Directors are expected to read and understand financial reports, forming their own opinion as to whether the reports provide a true and fair view of the company's financial affairs.
• Directors should be cautious when delegating financial reporting obligations to internal or external advisers. Although some reliance on the work of others to prepare the accounts is permitted, the directors have ultimate responsibility for approving the accounts and cannot pass that responsibility to others.

More information from Maddocks

For more information about financial reporting obligations and directors duties more generally, contact Maddocks on (03) 9288 0555 and ask to speak to a member of the Maddocks Corporate and Commercial Team.

More information from Cleardocs

You can read an Overview of the duties imposed on company directors under the Corporations Act here.

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[1] [2011] FCA 717