You could be forgiven for being a bit shocked about what happened recently in the Centro case ( ASIC v Healy [2011] FCA 717) when not only the board of Centro but all of the financial staff, the CFO, Managing Director and the PWC Audit team missed the fact that about $2 billion dollars of short term debt had been misclassified as long term debt. As most people would have heard by now, the Court found that the directors had breached their duties in failing to pick up a mistake, which according to Middleton J, has come to be known as the “Blind Freddy” proposition (par.251).  There has been a lot of comment about what this means for directors – especially in the context of large, complex companies, who should surely be able to rely on the experts advising them – however, the use of the expression “Blind Freddy” probably puts the result of this case in context.

There are a number of problems emerging in our traditional approach to the role and responsibilities of directors in Australia, a major one being what can realistically be expected of them as companies get larger and larger and more complex. The corporate model that we use and our legal imperatives were, of course, set down in a much simpler corporate environment of the 19 and 20th centuries. Clearly things have changed: not only in the size and complexity of companies and the business environment, but also the level of public participation in the share market and the gap between those ‘owners’ and the people who control the company. Government and regulators thus have a political motivation to demand a level of oversight that it is increasingly doubtful that a board, especially a board of part time directors, can  provide even with the best will in the world.

ASIC v Healy appears to be one of those cases: honest, intelligent, highly ethical directors, who were trying to do the right thing, who appeared to have all of the right systems and processes, and to ask all of the right questions, still got it wrong. It seems to be a tough decision. As the defence said, if the experts in the company get it wrong what hope has the board?!

The line in the judgement that sends a chill through my bones is in paragraph 333 where evidence was given of a discussion at the Board Audit Committee meeting about whether there was sufficient time for review of the financial statements, and the practical consequences if final amendments to the Annual Report did not get finalised that day. At this point, Mr Cougle of PwC, said that “he could give comfort that the auditors had signed off on the full accounts.” The question that every one of us as a director must think about is: how would we respond to that assurance, or more particularly, how would we have responded before this case?

As would be expected, a lot of the case centred around the issue of reliance under section 189 of the Corporations Law (2001). One side argued that directors must, in all reality, be able to rely on the information that came from the experts both in management and the external auditors, while the other saying that this is so, but that there are limits to this power. As is often the case, media and commentators have reviewed the decision in terms of ‘all or nothing’. That is,  there is either a total power to rely on others, or there is none. This would mean, following the case of Centro, that directors everywhere will be forced to trawl through the minutiae of the accounts to second guess the so called experts. However, like life, the answer is much greyer than that! ASIC never suggested that directors were responsible for all errors, only those which were so obvious that ‘blind Freddy’ could have seen them. Or in ASIC’s words:

“We will submit that the court can draw the conclusion [ as to the breach of standards of care and diligence] from the obviousness of the error to any reader of the accounts who had the requisite financial literacy and the knowledge that these directors had of the affairs of the companies, specifically their debts.” (Para 251.)

Middleton J ultimately agreed with this submission, but again and again throughout the judgement, he emphasized that this does not mean that directors should be experts or delve into the minutiae of operations. But that directors do have a real role – “they are not an ornament but an essential component of corporate governance.” (Para 19).

He said:

“All directors must carefully read and understand financial statements before they form the opinions which are to be expressed in the declaration required by Section 295(4). 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 out of a number of responsibilities a director has in carrying out the role and function of a director.” (Para 17)

In summary, I think the judgement draws out some very important issues for directors, a number of which we have been promoting for some time:

  • Where directors are specifically required to sign off on an area of company reporting , such as under Section 295(4) of the Corporations Act ( that there are reasonable grounds to believe that a company would be able to pay its debts as and when they become due, that the accounts comply with the requisite accounting standards, and that the accounts present a true and fair view of the company’s financial circumstances) they cannot merely rely or delegate this to others, but must satisfy themselves that this declaration is correct;
  • The Reliance Provision in Section 189 cannot be used where a director’s personal opinion or individual certification is sought. He or she must apply their own minds and cannot delegate that assessment to somebody else;
  • A director’s role is to bring their ‘accumulated knowledge’ of the business as a whole to the task before them. This is a different perspective from other people in the organisation; it is a directorial perspective which requires the board to stand back and view the whole business, from a strategic or helicopter level;
  • The judgement upheld ASIC’s view that had the directors taken a whole view, they should have noticed the error. Middleton J said:

“A reading of the financial statements by the directors is not merely undertaken for the purposes of correcting typographical or grammatical errors or even immaterial errors of arithmetic. The reading of the financial statements by a director is for a higher and more important purpose: to ensure that the information included therein is accurate. The scrutiny by the directors …involves understanding their content…These are the minimal steps a person in the position of any director would and should take before participating in the approval or adoption of the financial statements and their own director’s reports.”( Para.22)

  • The ‘line in the sand’ on what directors should have seen is the ‘Blind Freddy” proposition. That is something large and obvious that it should have been visible to those “at the top of the governance apex’ because it impacted the whole business, in this case $2 billion of misstated current debt as well as $1.75 billion in guarantees of an associated company;
  • Even with the need for diversity within boards, there is a skill all directors must have which is a level of financial acumen to enable them, personally, to sign off on a provision such as Section 295(4) Corporations Act 2001;
  • Indeed, if a business is becoming too large and complex for the board to truly understand what is going on, then that too is an issue for the board. Is ‘big’ necessarily better? If continued growth is what your business needs, it then is for the board to consider what governance structure is necessary to ensure that the business is still coherent enough to enable the board to fulfil its role and duties?

One of the traps of collective decision making, is how easy it is to sit back and rely on others, especially if they appear to have skills and experience that one doesn’t have. This is a basic human tendency that we see occur even amongst people who have highly developed skills. It serves to show that everything is relative!

We now have the results of the sentencing hearing where Middleton J maintained his path in defining further the fine line between a director’s role and that of his or her advisors within management and beyond. The directors have been found guilty of breaching their duties but no further penalty was considered necessary in the circumstances of this case. This, we believe, is the right outcome. Some might ask (and have) whether it is enough to change behaviours? However, the impact of this case on the individuals involved, and the consequences for their reputations cannot be overstated. As for the rest, the judgement in this case serves as a valuable restatement of the issues and the fault lines that are appearing in our corporate model. More importantly it emphasises the need for all of us, as directors, to understand the business of the company to which we owe our duty of care, and to bring our independent judgement to the issues before us taking into account the ‘Blind Freddy’ proposition before we rely too heavily on others!

For the full case details, open the PDF document.