Anil Hargovan
The need for directors to be aware of the business fundamentals, to have a questioning mind and to maintain familiarity with the financial status of the company is nothing new to the law on directors duties– such expectations were well established prior to the Centro decision. However, when such expectations are marshalled and directed to the directors reporting obligations, they begin to bite.
It is now clear it is getting much harder to get people to sit on boards. This may be a hurdle for the government’s plan to increase the diversity of boards.
In September 2007 Centro directors failed to detect an error that led to more than $2 billion of short-term debt being classed as long-term debt. ASIC has now obtained a judgment that calls for proper diligence when directors are reading financial statements.
I feel the message for directors is clear – namely, reading of the financial statements is not to be a passive exercise, nor will skim reading suffice. Going through the motions will not be tolerated. Scrutiny and the understanding of content is required. This necessitates financial literacy skills.
The need for financial literacy has been well established by case law. However I believe the Centro decision elevates the financial literacy requirement in a robust manner.
On the facts of this case it was held that the apparent errors in the financial statements were not complicated. This is a judgment call which potentially gives rise to uncertainty.
What may appear to be uncomplicated to a judge, with the benefit of expert evidence, may appear to be complicated to a director, particularly given the push towards board diversity by the ASX recommendations on good corporate governance practices.
We are entering unchartered territory here, especially not knowing to what extent should directors be familiar with accounting standards. The mapping of the boundaries, between complicated and uncomplicated items in financial statements, will be reliant on future case law in this area. Until then, directors will have to live with this uncertainty which is unsettling and unsatisfactory.
The sting in the judgment lies with the finding that being surrounded by financial experts, or having an Audit Committee, is helpful but not necessarily a panacea for the discharge of the directors reporting obligations. The Centro decision sends out a strong message for directors to take their financial reporting obligations personally and seriously. The approval of the company’s financial reports is a personal and fundamental responsibility of each director as emphasised by the judge which is a recurring theme in this case.
In the future the big issue from this decision is do we want to hand the responsibility to experts to free up the directors to focus on other matters like leadership in business skills and strategy or do we want to turn directors into accountants?
This is a policy debate raised squarely by the Centro decision which rejects the notion that compliance obligation for financial reporting lies exclusively with financial accountants. Centro decision suggests that the time is ripe to revisit policy issues on the role of a company director to provide greater clarity and certainty on the demands expected of this profession. Herein lies the danger – the Corporations Act says that anyone over the age of 18 can be appointed a director but then, with limited exceptions, remains largely silent on the performance expectations of directors. A reading of the Corporations Act gives little indication of the true challenges and skills set required to successful discharge the responsibilities of office of director.
The Centro decision is also a wake up call for legislators to address and focus upon the current lack of direction and guidance in the Corporation Act, such as the need for financial literacy, which has simply failed to keep pace with judicial developments in this area of law.
In considering this, I also think there is a dramatic implications for boards in Australia.
Company directors may be understandably concerned by the ramifications of the judgement which has the potential to undermine the movement towards more diversity of boards. The encouraging signs and momentum in attracting board diversity, currently at a record high, (Women comprised 25% of all new appointments to ASX 200 boards in 2010, compared to only 5% in 2009 and 8% in 2007 and 2008: AICD Figures) which may well be arrested as a consequence of the Centro decision.
Should the Prime Minister deliver on her threat to legislate to lift the representation of woman on boards, the policy outcome will be a potential disaster unless remediated/accompanied by lessons in financial literacy for all such appointees to the board.
Associate Professor Anil Hargovan is at the Australian School of Taxation & Business Law at the Australian School of Business