Centro case – the central messages

The Centro case is about errors in the financial statements of the Centro Group, for the year ended 30 June 2007.  The directors did not detect the errors, because they did not check the financial statements - they relied on management and the auditors to get them right.

The errors that the directors failed to pick up were:

  • Current liabilities were wrongly classified as non-current: $1.5 billion for Centro Properties, and $0.5 billion for Centro Retail. The Court found that the directors knew that the relevant liabilities were payable in less than 12 months.

  • Centro Properties had given guarantees for short-term liabilities of associated companies (totalling over $2 billion) between balance date and reporting date.  These guarantees were not disclosed as post-balance date events.

These errors in the financial statements took on greater significance in late 2007 and early 2008, as the global financial crisis deepened and Centro experienced difficulty in refinancing short term debt.  By the end of February 2008 Centro had been forced to issue a series of announcements to ASX disclosing its financial difficulties, correcting the errors in the 2007 accounts - and by doing so, exposing the errors in high relief.

ASIC brought a civil penalty action against the directors, for breach of:

  • their duties of care and diligence: Corporations Act sections 180 and 601FD; and

  • their duties to take all reasonable steps to comply or secure compliance with the financial reporting provisions of the Corporations Act: section 344.

On 27 June 2011, the Federal Court (Justice Middleton) delivered judgment on liability.  Justice Middleton held that the directors had breached both duties.  Penalties have yet to be determined.

There are two key messages in the case, for company directors and their advisers.

  1. Directors are the last line of defence on financial reporting – really

    The financial reporting provisions of the Corporations Act provide a regime of checks and balances.  In this regime, directors' specific obligations form the last line of defence.  Directors do have a real obligation to focus on the accounts, and take reasonable steps to satisfy themselves that the accounts are correct.  This function cannot be delegated to others.

    This regime of checks and balances makes good economic sense.  The financial statements are a portrait of the company, painted as at the balance date for the benefit of shareholders and investors.  It's important that the portrait should be accurate.  Directors are responsible for the governance of the company and they are supposed to keep informed about the company's business.  It's logical that before the company presents its annual financial portrait to shareholders and the market, directors should be obliged to check it and make sure it aligns with reality as they know it.

    In this sense, directors are the last line of defence against errors in the financial statements.  This analogy is useful, because it makes it plain that the role of directors in checking financial statements can't be delegated to the in-house accountants, senior management and auditors who form the earlier lines of defence.  It has never been acceptable for the last line of defence to go off duty, because they left it to the earlier lines of defence to stop anything dangerous getting through.

  2. Information overload is no excuse - directors must take control

    The Centro Group structure was very complex: two 'stapled security' structures, each with a listed public company and a listed property trust, and various associated entities.  This meant that the process of preparing annual accounts for the Group was very complex and imposed a heavy workload and tight time pressures on all involved - including the directors.

    The directors submitted to the Federal Court that they could not reasonably be expected to scrutinise and cross-check all of the detailed information that came to them in Board papers, to pick up on discrepancies between the real financial position of the Group and the position presented in the accounts.

    In dismissing this argument, Justice Middleton said it was up to the directors to control the volume and quality of information that came to them.  If more time was needed, they should have asked for more time.  The volume and complexity of information could not be an excuse for failing to properly read and understand the financial statements.

After Centro, how should directors approach financial statements?

The Centro case says directors do have a duty to focus on financial statements, read them and check them.   The evidence showed that the Centro directors did not even try to do this - they relied entirely on the integrity of the draft statements provided to them by management.  Therefore, the case does not deal in any detail with the standard that directors have to achieve, if they do make a genuine effort to do their duty.

Directors would be entitled to react to the Centro case with alarm if it obliged them to read, financial statements with the eyes of an expert.  It does not.  The requirement outlined by Justice Middleton was 'the financial literacy to understand basic accounting conventions, and proper diligence in reading the financial statements'.

Practical recommendations for in-house counsel, in advising senior management

First, as a result of the Centro case directors are likely to put pressure on management for early delivery of draft financial statements.  In-house counsel should warn management that they will be expected to provide draft financial statements to the Audit Committee and Board with enough time to review them.  If the corporate structure is complex (generating multiple sets of accounts), directors will need even more time.  In a post-Centro world, presenting draft financial statements at the last minute and pushing directors up against a reporting deadline may prove to be a terminal event for members of the senior management team.

Second, in-house counsel should make sure that the CEO and CFO are aware of and complying with their obligation to provide the declaration required by section 295A of the Corporations Act.  This declaration is required to say that financial records have been properly maintained and that the financial statements give a true and fair view and comply with accounting standards.  Since this is a legal requirement, focusing on it may seem to be emphasising the obvious – but the declaration was not provided in the Centro case.

Third, encourage senior management to review the way they present information to the Board.  If senior management don’t take the initiative on this, it’s likely that the directors will.  It was emphasised in the Centro case that Boards must take responsibility for the quality of information coming to them.  Board papers and presentations should be giving the directors a clear picture of what's going on in the company, without information overload.  The Centro case is really saying that directors must have their own picture of the company, understand the picture being presented by the financial statements, and make sure there's no difference between the two pictures.

Understanding the implications for directors

In addition to the three practical issues raised above, there are some other messages that directors are likely to take away from the Centro case.  It’s useful for in-house counsel to understand these.

First, there will be a renewed emphasis on getting an appropriate skill mix on the Board.  It’s in the interests of directors to make sure they have at least one 'financial terrier' on the Board - a director who has real financial expertise and can be relied on to bring that expertise to bear on a thorough review of the financial statements.  He or she will normally be able to do this review as part of the Audit Committee process, before the draft financial statements come to the full Board.

Second, directors won’t be able to leave it all to the financial terrier, or rely on the section 295A declaration from the CEO and CFO.  The key message of the Centro case is that all directors are expected to read the financial statements, notes and directors' report for themselves – and  read them carefully, checking to see if there is anything there that doesn't align with what the individual director knows about the company.  After Centro, there are likely to be more questions on the financial statements, coming from both the Audit Committee and the Board.  This will put pressure on the in-house accounting function to make sure the quality of presentation in the financial statements meets the directors’ post-Centro expectations.

Third, you may find that some directors are not confident about their ability to understand the basic accounting concepts in the financial statements.  The only safe option for directors in this position is to take an appropriate course to improve their skills.  Courses are available from the Australian Institute of Company Directors and other providers.

Remember the 'two pictures' analogy.  To provide proper support for the Board, management must put directors in a position to form an accurate picture of the company, understand the picture presented by the financial statements, and make sure the two pictures match.

For more information, please contact partner Leigh Warnick on (08) 9288 6771 / leigh.warnick@lavanlegal.com.au or partner Tony Chong on (08) 9288 6843 / tony.chong@lavanlegal.com.au.