Wednesday, June 29, 2011

Landmark Australian Ruling Calls Directors Essential Component of Corporate Governance

In a landmark corporate governance opinion, the Federal Court of Australia ruled that company directors failed to take all reasonable steps required of them, and acted in the performance of their duties as directors without exercising the degree of care and diligence the law requires of them. Far from a mere technical oversight, said Justice Middleton, the information not disclosed was a matter of significance to the assessment of the risks facing the company. Giving that information to shareholders and, for a listed company, the market, is one of the fundamental purposes of the requirement that financial statements must be prepared and published. The importance of the financial statements is one of the fundamental reasons why the directors are required to approve them and resolve that they give a true and fair view. A director, while not an auditor, should still have a questioning mind, said the Court. More than a mere going through the paces is required for directors, since a director is not an ornament, but an essential component of corporate governance. Australian Securities and Investments Commission v. Healy, [2011] FCA 717, June 27, 2011.

Justice Middleton said that each director is placed at the apex of the structure of direction and management of the company. The Court said that 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, noted the court, and not just shareholders, employees and creditors.

Australian Securities and Investment Commission Chair Greg Medcraft said that the case highlighted the danger of boards uncritically relying on management, or the auditors. Each member of the board must bring and apply their own skills and knowledge when declaring financial statements are true and fair, he said. This is not a responsibility company boards can delegate or merely rubber stamp. It’s not good enough for directors to just be present. Chairman Medcraft also said that there was a minimum standard of boardroom participation that directors must meet. This means the key elements of a company’s financial position are something directors should understand and be able to communicate accurately to the market.

The Commission alleged that the directors failed to discharge their duties with due care and diligence in approving the financial reports and that the directors, and the former chief financial officer, knew that the entities had very significant short-term interest bearing liabilities, and should have known that these liabilities were incorrectly classified in the 2007 financial reports.

The central question in the proceeding was whether the directors were required to apply their own minds to, and carry out a careful review of, the proposed financial statements and the proposed directors report, to determine that the information they contained was consistent with the director's knowledge of the company's affairs, and that they did not omit material matters known to them or material matters that should have been known to them.

The Court noted that the significant matters not disclosed were well known to the directors, or if not well known to them, were matters that should have been well known to them. In the light of the significance of the matters that they knew, they could not have, nor should they have, certified the truth and fairness of the financial statements, and published the annual reports in the absence of the disclosure of those significant matters. If they had understood and applied their minds to the financial statements and recognized the importance of their task, posited the Court, each director would have questioned each of the matters not disclosed. Each director, in reviewing financial statements, needed to inquire further into the matters revealed by those statements.

All directors must carefully read and understand financial statements before they form their opinions, said Justice Middleton, and 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, noted the Court, including acquiring at least a rudimentary understanding of the business of the corporation and becoming familiar with the fundamentals of the business in which the corporation is engaged.

A director should keep informed about the activities of the corporation. While not required to have a detailed awareness of day-to-day activities, said the Court, a director should monitor the corporate affairs and policies, as well as maintaining familiarity with the financial status of the corporation by a regular review and understanding of financial statements.

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