Alert – Finding a balance? The penalty judgment in Centro

2 September 2011

The finding of breach

As reported in our previous Alert, Justice Middleton determined in ASIC v Healey & Ors [2011] FCA 717 (liability judgment) that seven directors of Centro had breached their duty of care and diligence, and their duty to take all reasonable steps to ensure compliance with the financial reporting requirements, by signing off on financial statements that failed to disclose significant matters as required by the law and the accounting standards. Mr Nenna, the former CFO, had admitted each of the substantive breaches alleged against him, and it was not necessary for him to be represented at the trial.

Regarding CNP, the disclosure failures were that:

  • approximately $1.5 billion of short term liabilities were wrongly classified as non-current liabilities, and
  • guarantees of material short term liabilities of an associated company given after the balance date were not disclosed.

Regarding CER, the disclosure failure was that the 2007 annual report wrongly classified approximately $600m of short-term liabilities as non-current liabilities.

ASIC's submissions on penalty

ASIC asked for disqualification for 3 years and a pecuniary penalty of $100,000 for each of Mr Scott (CEO at the relevant time) and Mr Nenna, and for disqualifications of 6 to 18 months, with pecuniary penalties of $30,000 to $60,000 for the non-executive directors.

The defendants' submissions on penalty

Mr Nenna submitted that the appropriate penalty for him was up to two years' disqualification from managing corporations, subject to an exception to allow him to continue as director of his family's self managed superannuation fund. The CEO and all of the non-executive directors asked to be exonerated from their contraventions.

The outcome

Justice Middleton stated that the court attempted to achieve a balance between recognising the seriousness of the contraventions, and taking into account the relevant circumstances, the overall conduct of the defendants, and the impact that the penalties imposed would have upon the defendants.  He said that achieving this balance 'is in the public interest' and that the imposition of greater penalties 'would not bring about a greater benefit for society or the corporate world, and would otherwise be unfair and inappropriate' (at [6]). (All references to paragraphs are to the penalty judgment unless otherwise indicated).

Justice Middleton emphasised the central role of general deterrence in his deliberation, and took into account the widespread debate in the director community, and the wider business community, following the 27 June 2011 liability judgment, in determining the directors' punishment. 

The court determined that the non-executive directors should not be exonerated under section 1317S or section 1318, but should not receive punishment other than declarations of contravention.  No distinction was drawn, as to penalties, between the directors who had served on Centro's Board Audit and Risk Management Committee (BARMC) and those who had not.

The court determined that Mr Scott should be neither exonerated nor disqualified, and made a declaration of contravention in addition to imposing a low range pecuniary penalty of $30,000. Although Mr Scott's contravention was as a director, his special position as CEO required the court to take a different approach to punishment ([211]-[212]). Justice Middleton noted that there was evidence in support of Mr Scott's work ethic ([198]), his business success until mid-2007 ([199]), and his otherwise exemplary track record ([201]ff).  He also noted the toll that the liability judgment had taken on Mr Scott's reputation and prospects of obtaining comparable future employment.

Mr Nenna received a declaration of contravention and was disqualified from managing corporations for two years.  Justice Middleton found that Mr Nenna was an honest person, that the impact of the litigation upon him had been profound, and that there was nothing about his conduct that might indicate a propensity to act in a similar way in the future ([215]-[222]).

The court ordered the defendants to pay ASIC's costs.

The non-executive directors

Justice Middleton decided that the non-executive directors should not be exonerated under section 1317S or section 1318, and that it was necessary to make declarations of contravention against them, principally because of the seriousness of the contraventions, having regard to the principles of general deterrence ([132]-[133]).  But he thought it unnecessary to impose disqualification or pecuniary penalties on them, having regard to a number of mitigating circumstances. The declarations of contravention are very detailed and take up almost half the judgment.

Seriousness of the contraventions

Three matters are mentioned in the judgment ([134]-[142]).

The first relates to the serious nature of the breaches of duty. In light of what the directors knew, they neither could nor should have certified the truth and fairness of the financial statements in the absence of disclosure of the significant matters, if they had been conscious of what their duty required of them.

If the directors had understood and applied their minds to the financial statements and recognised the task's importance, each of them would have questioned each of the matters not disclosed. In the process of reviewing the financial statements and directors' reports, the directors needed to enquire further into the matters the documents revealed. Justice Middleton held that the fact that they did not do so demonstrated a failure by each of them to understand and appreciate the requirements of their duty.

His Honour acknowledged that although the directors undoubtedly misunderstood their duties, the circumstances in which they found themselves in this position were unusual.  Whilst they did not obtain legal advice as to the specific duties, they did retain and rely on a range of professional people and organisations in carrying out their responsibilities placed upon them as directors. 

The court found, however, that each director did not go far enough. As Middleton J explained in the liability judgment, the task confronting the directors required critical and detailed attention, and the directors could not place their faith in 'sole reliance on others, no matter how confident or trustworthy they may appear to be' (liability judgment, [174]).  

Secondly, the sums of money that were misclassified as non-current liabilities, and the monetary impact of the post-balance date events not disclosed, was large, material and significant (at [138]).

The third aspect of seriousness related to market integrity.  The information not disclosed was a matter of significance to the market's assessment of the risk facing CNP and CER. A reasonable person would expect the information that was not disclosed to have a material effect on the price or value of the Centro securities. This material information was withheld from the market for at least 3 months, from 18 September to 17 December 2007.

Interestingly, Justice Middleton cited with approval the observations by Finkelstein J in ASIC v Fortescue Metals Group Ltd [2011] FCAFC 19.  Disagreeing with observations by Keane CJ (with whom Emmett J agreed) to the effect that ASIC's proceeding against Fortescue and Mr Forrest may not have been 'worth the candle' as no investors suffered loss, Justice Finkelstein spoke persuasively about the importance of laws directed to ensuring there is 'a fully informed and therefore efficient market for listed securities' (at [232]).

The position of the directors – mitigating circumstances

Justice Middleton held that banning the directors (including Mr Scott) from acting as directors would have been inappropriate having regard to the circumstances of the contraventions and their past and future contribution to the corporate world. However, in the case of Mr Scott, a pecuniary penalty was necessary in addition to declarations of contravention in order to act as a general deterrent in the case of a chief executive officer [102].

The circumstances which he took into account were the following.

Personal qualities and conduct

Justice Middleton repeatedly referred to the directors as 'intelligent, experienced and conscientious people' (at [169]), an expression he had used in the liability judgment.  He noted that each director had a hitherto unblemished history.  Supporting character evidence indicated that the non-executive directors 'are men of the highest calibre…who still have a valuable contribution to make to the financial world' ([180]-[185]).  The directors made no personal gain from their contraventions, or any flagrant breach, impropriety or deceptiveness ([183]).

Proper governance procedures

Justice Middleton noted that in approving the relevant accounts, the directors had conformed to a set of well-established corporate governance practices and relied on expert accounting advice in following those practices. Also, the non-executive directors had relied on the operation of a number of 'safety nets' designed to ensure that the accounts presented to the Board were true and correct ([304], liability judgment).

The corporate governance practices of the Centro board conformed to the recommendations in the ASX Corporate Governance Council Principles and Recommendations, in particular:

  • the board having a majority of independent directors
  • there being a separation between the roles of chairman and CEO, and
  • the establishment of an audit committee chaired by an independent director other than the chairman of the board, with a formal charter relating to its roles and responsibilities complying with the AICD/Institute of Internal Auditors Australia and Auditing and Assurance Standards Board publication Audit committees: a guide to good practice.

The BARMC and other board members operated under a set of practices and procedures which accorded with good practice generally.  All of the Board's corporate governance practices and procedures were followed in the process of approval of the financial statements, and one of the key features of the board's corporate governance practices and procedures in relation to financial reporting was that there were a number of safety nets designed to ensure that the accounts presented to the Board for approval were correct.

Justice Middleton concluded that the safety nets failed through no fault of the non-executive directors, who had ' reasonably expected that accounts produced by the accounting staff of the Centro Group would comply with the AIFRS and that, if they did not for any reason comply, PwC or Centro's accounting staff would identify the error' (at [174]).

Post-contravention conduct

Once the errors were identified and the issue of potential misclassification came to the attention of the Board, the directors quickly took steps to determine how the error came about. His Honour inferred that if the non-executive directors had been informed of the error, they would not have approved the accounts until the matter had been thoroughly investigated. 

Contraventions did not cause Centro's refinancing difficulties

The directors acted promptly, openly and responsibly when refinancing difficulties emerged in December 2007 and when the possible classification errors were identified early in 2008 ([176], [181]).  His Honour found that the evidence did not point to any connection between the directors' contraventions with respect to the financial statements and Centro's refinancing difficulties and overall decline.  But the contraventions contributed to the market not having information that would have been relevant to making decisions regarding investment in Centro securities in the period from September to December 2007 [178].

Isolated circumstances

The directors' actions were not indicative of a wider lack of appreciation of the significance and demands of their role, and were isolated in the circumstances of the proceeding ([177], [185]).

Publicity of liability judgment

Justice Middleton considered that the widespread publicity following the liability judgment was a factor in determining appropriate punishment: 'against such a backdrop of widespread public analysis and associated embarrassment and reputational damage for each of the directors, the need for the imposition of a disqualification order or pecuniary penalty for reasons of general deterrence is much less than it would otherwise be' ([177]).

Contrition

The directors acted in good faith believing that they were discharging their duties properly.  To the extent that they failed to do so they took responsibility for their actions and expressed their regrets. While he thought that some of the directors could have gone further in the way they expressed their remorse, the judge took into account that each director still faces litigation in a pending class action. Each director took his role and responsibility extremely seriously ([180]).

General deterrence

In light of the matters listed above, Justice Middleton concluded that declarations of contravention would be sufficient to satisfy the requirement for general deterrence, and disqualification orders were ‘unnecessary and excessive’ ([188]). Declarations of contravention would have a significant adverse impact, particularly in light of the reputational damage already inflicted upon the directors. The effect that this reputational damage had and would continue to have on the directors 'cannot be underestimated' ([188]).

Some comments

The orders in the Centro penalty case stand in contrast with the outcomes in some other recent cases. For example, the penalty orders made by Justice Gzell in the James Hardie case against the non-executive directors were disqualifications for five years and fines of $30,000 (the orders were set aside by the Court of Appeal, but not for reasons relating to the appropriateness of the penalties).

Care must be taken in drawing inferences from a comparison of one penalty case with another. Justice Middleton correctly emphasised the importance of careful factual analysis in the setting of penalties, and said that the guidance that can be obtained from other decisions is limited ([103]).

Nevertheless in some respects Justice Middleton's approach seems to be different from the approach taken by some other judges, admittedly in quite different factual circumstances. For example, in ASIC v Vizard (2005) 54 ACSR 394; [2005] FCA 137 at [39]-[40], Justice Finkelstein referred to the damage to the defendant's reputation, and observed that 'while shaming is a form of punishment, it is not a substitute for the formal expression by society through its courts that the offender has committed a wrong', and that 'formal retribution is a necessary element in imposing a proper punishment because it ensures that punishment is just and appropriate to the circumstances'. There is room for debate whether 'formal retribution' is satisfied simply by a declaration of contravention.

It may appear odd, in light of the liability judgment, that the court took into account the reliance that the directors placed on the finance team and auditors for the purpose of fixing appropriate penalties.  Again the explanation is factual.  In the detailed circumstances of this case, the directors breached their duty by accepting the draft financial statements that were presented to them by others, without applying their knowledge of the true position derived from board papers and hence asking appropriate questions. But it was relevant to penalty that they had reasonably expected that financial statements produced by the accounting staff would comply with accounting standards and that any problems would be identified by those staff or the auditors.

Author(s) Robert Austin, Carolyn Reynolds