Directors - Is Your Financial Literacy Good Enough?

The obligations on directors and officers to exercise due care, skill and diligence in the performance of their duties lies at the heart of the regulatory scheme of corporate governance.  Indeed over the past two decades there have been a number of decisions in Australia where the courts have assessed and commented on the adequacy of the conduct and decision making of directors and officers.  Of the most notable of these decisions was Australian Securities and Investments Commission v Healey (2011) 196 FCR 291 (the Centro case), which established the principle that it is part of a director’s duty to acquire a degree of financial literacy, including a knowledge of accounting practices and accounting standards, so that they are able to review financial statements and monitor the progress of the company.

By way of summary, his Honour, Justice Middleton held that:

1. There is a core, irreducible requirement of directors to be involved in the management of the company and to take all reasonable steps to be in a position to guide and monitor the company.
2. Whether a director has taken “all reasonable steps” will depend on the circumstances of the case and will differ depending upon the company, the complexity of the company’s business, the internal reporting procedures within the company and the nature of the task the director is obliged to undertake.
3. The standard of “all reasonable steps” is determined objectively by reference to the particular circumstances of the case. It requires, at a minimum, that directors take a diligent and intelligent interest in the information either available to them or which they might appropriately demand from the executives or other employees and agents of the company.
4. All directors must carefully read, understand and focus upon the contents of financial reports, consider whether the financial statements are consistent with his or her knowledge of the company’s financial position, consider the statutory requirements, apply the knowledge he or she has of the affairs of the company, and if necessary, make further inquiries if matters revealed in the financial statements call for such inquiries.
5. The objective duty of competence requires that the directors have the ability to read and understand financial statements. A director must, at least, understand the terminology used in the financial statements and understand that financial statements.
6. Directors are entitled to seek assistance in carrying out their responsibilities, and may rely on others to assist them in fulfilling a requirement even where it is one directly imposed upon them by the Act. It is reasonable for the directors to delegate various tasks to others, such as the preparation of books and accounts and the carrying on of the day-to-day affairs of the company. To a degree, the directors can rely upon the processes they have put in place. … However, this does not discharge the entire obligation upon the directors. A further step is required for all reasonable steps to have been taken. This involves the directors taking upon themselves the responsibility of reading and understanding the financial statements.

More recently the Federal Court handed down its decision in Australian Securities and Investments Commission v Godfrey [2017] FCA 1569 with the judgment providing a cautionary tale for directors that they must ensure they have sufficient financial literacy, and should not rely solely on management or external auditors to ensure that their company meets its financial reporting requirements.

In Godfrey, the plaintiff, the Australian Securities and Investments Commission (ASIC), alleged that Mr Godfrey had contravened section 344 of the Corporations Act 2001 (Cth) (the Act) which provides that a director of a company contravenes that section if they fail to take all reasonable steps to comply with, or secure compliance with, Pt 2M.3 which deals with financial reporting.

The defendant, Patrick John Godfrey (Mr Godfrey), was the managing director of Banksia Securities Ltd (BSL). BSL’s business involved raising money from the public through the issue of debentures, and loaning the funds raised to third party borrowers for property investment and development. BSL’s main asset was its loan portfolio.  In his position at BSL, Godfrey had primary responsibility for making recommendations to the board about bad or doubtful debts. He therefore had a key role to play in ensuring that the company complied with Part 2M.3 of the Act.

The alleged conduct resulting in contraventions of the Act by Godfrey concerned inadequate provisioning for bad and doubtful debts. ASIC sought declarations of the contraventions, the payment of a pecuniary penalty, and an order disqualifying Godfrey from managing corporations.

Both ASIC and the court accepted that there was no dishonesty on the part of Godfrey in the way in which he carried out his responsibilities as managing director.  Rather the breach of the Act arose because Godfrey did not realise that BSL’s policies for determining impairment of loans were not appropriate and not consistent with AASB 139. This stemmed from Godfrey’s lack of understanding and an inadequate knowledge of the relevant financial matters.

As a result of such lack of understanding and inadequate knowledge, Godfrey failed to ensure that BSL’s policies relating to the assessment of impaired loans were consistent with the relevant accounting standard (AASB 139), resulting in significant misstatements in the financial reports prepared by BSL in the relevant period.

The penalty applied to Mr Godfrey was disqualification from managing corporations for a period of five years, and a pecuniary penalty of $25,000.

Lessons to be learnt from Centro, ASIC v Godfrey and related cases

Directors have an objective duty of skill, competence and diligence in discharging their financial responsibilities which requires a degree of financial literacy and familiarity with accounting standards relevant to the circumstances.  While directors are entitled to seek assistance in carrying out their responsibilities, they should be cautious to rely solely on management or external auditors to ensure the company meets its financial reporting requirements, and they properly discharge their duties.