Anil Hargovan

The Federal Court has not imposed extra penalties on six non-executive directors involved in the Centro court case, saying their convictions for breaching the Corporations Act are penalty enough.

My first impression suggests that Justice Middleton in the Centro case appears to have taken one step forward (in the liability decision which set the bar on directors performance standards in reading accounts dauntingly high) and two steps back (in the penalty decision handed down yesterday which did not go far enough in sanctioning oversight failure).

The tone of the penalty decision appears to be less caustic and more forgiving of the directors failure to exercise care and diligence.

The failure to throw the book at the directors in the penalty decision  has polarised the corporate community, attracted controversy and seen a vituperative reaction from sections of the media.

The penalty decision elevates shame and reputational loss as strong determinants of general deterrence but will not appease those baying for blood following significant oversight by the directors in the accounts involving billions of dollars.

The penalty decision boosts the directors shame and reputational loss as an effective deterrence tool.  Such sanctions will only be effective, however, for those directors who put a premium on their reputations.

Media reaction to the penalty decision would suggest that the penalties handed down were largely meaningless. It is important to remember that the judge refused to exonerate or grant forgiveness for breaches of the Corporation Act and did issue court declarations of breach of law which puts a stain of the cv of the directors and, more ominously, offers no comfort to the company and its directors facing class action by the shareholders.

In the refusal to grant forgiveness and the confirmation of breaches of law, the penalty decision has laid a stronger foundation and boosts the prospects of  shareholder success in the class action against the company. Herein lies the potential for a greater penalty afforded by this decision.  Perhaps the judge had one eye on the potential impact of the class action and tempered the penalty decision in light thereof.

Anil Hargovan is an Associate Professor at the Australian School of Taxation & Business Law at the ustralian School of Business.

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