Banking on the financial literacy of directors: is it a breach of duty when the numbers don’t add up?

One of the issues that directors of companies regularly face is the extent to which they can rely on their employees or external advisors in fulfilling their role. This is particularly so when it comes to financial decision making. A director may try to wash their hands of the consequences of a decision by saying that they relied upon advice external or employee specialists. 

The Federal Court of Australia has recently continued the emerging trend of demanding more from directors in fulfilling their duties: that is, they are expected to have a sufficient level of financial literacy by virtue of their office.

The core irreducible duty

Directors of companies have a host of duties that arise out of the operation of the Corporations Act 2001 (Cth) (the Act). This includes a duty of care and diligence, which was described by Spigelman CJ in the NSW Court of Appeal decision of Deputy Commissioner of Taxation v Clark to include a “core, irreducible requirement of involvement in the management of the company”. Furthermore, directors have a duty to ensuring that the company complies with its obligations with respect to financial reporting.

In the now infamous case 2011 case of ASIC v Healey, the directors of the Centro group companies were found to have breached their duties by failing to pick up on an error in classifying a significant amount of short-term liabilities as non-current liabilities in the companies’ financial reports. In that case, Middleton J stated that whilst directors are entitled to rely upon others, they must keep themselves informed, monitor the corporate affairs, and be familiar with the financial position of the company.

His Honour went on to say that a director “cannot substitute reliance upon the advice of management for their own attention and examination of an important matter that falls specifically within [their] responsibilities” and that “the objective duty of competence requires that the directors have the ability to read and understand financial statements”. Indeed, his Honour concluded that so important is a director’s duty to examine financial statements is they must have some familiarity and understanding of the reports and the terminology therein.

The upshot of Healey is that directors are not only required to have “the financial literacy to understand basic accounting conventions and proper diligence in reading the financial statements”, but also have knowledge of the actual affairs of the company based on the documents of the company and the discussions of the board. That knowledge then must be applied in approving the financial documents of the company.

Trouble with Banksia blooms

The Federal Court of Australia recently faced similar issues in the case of ASIC v Godfrey (2017) 123 ACSR 478.

Patrick Godfrey was the managing director of Banksia Securities Ltd (Banksia). Banksia’s business involved issuing public debentures, then using the funds raised as loans to third parties for the purposes of property development. In 2011 and 2012 Mr Godfrey was a signatory on a number of financial reports. Those financial reports significantly misstated the level of bad or doubtful debts that Banksia was entitled to, and were not prepared in accordance with the relevant accounting standards. This had the result of substantially overstating the amount of shareholder capital available to Banksia.

ASIC investigated, and ultimately Mr Godfrey agreed to cooperate with the regulatory body. ASIC and Mr Godfrey went to the Court with an agreed set of facts and proposed orders. Those orders included:

  1. declarations that Mr Godfrey had breached his duties under the Act in ensuring that Banksia complied with its financial reporting obligations;
  2. that Mr Godfrey be disqualified from managing a corporation for five years; and
  3. a pecuniary penalty of $25,000.

The question for Moshinsky J of the Federal Court was whether these orders were suitable.

The requirement of financial literacy

His Honour considered another of factors in determining that the orders were appropriate, including the severity of the breaches, the fact that Mr Godfrey otherwise had good character, that Mr Godfrey had cooperated with ASIC, and that the offences were not committed dishonestly.

The court considered the fact that Mr Godfrey was the person primarily responsible for reporting to the board as to bad or doubtful debts. In discharging this responsibility, he did not act dishonestly but failed to ensure that the requisite accounting standards concerning these debts were followed.

Moshinksy J stated at [46]:

It is established that it is part of the duty of a director to acquire a degree of financial literacy so as to equip him or her for the task of reviewing financial statements in the discharge of the responsibility to monitor the progress of the company. The acquisition of the requisite degree of financial literacy is the first step that a director of [Banksia] sought reasonably to have taken to ensure compliance with [the Act].”

His Honour concluded that, in this case, obtaining an understanding of how to properly account for receivable loans was a step that Mr Godfrey could have reasonably taken, but he failed to do so.

Implications

From the cases of Healey and Godfrey we can glean that directors are required to maintain a degree of financial literacy. The extent of that financial literacy will depend on the facts and circumstances of the case.

In Healey it was a simple as being able to read and understand financial documents so to be able to distinguish that an error had occurred in the classification of liabilities. In Godfrey, by virtue of his responsibilities, the Court reasonably expected him to be able to ensure that the appropriate accounting standards were followed for bad or doubtful debts.

What is critical is that the idea that directors can blindly rely on employees or external specialists is being eroded away: they have a core, irreducible duty to be active in the management of the company, including its financial reporting.

Contributors

Luke Dominish Lawyer