Directors Must Be Financially Literate

A recent Federal Court decision, ASIC v Godfrey [2017] FCA 1569 (Godfrey), has confirmed that directors must have a certain level of financial literacy, in order to fulfil their duties under the Corporations Act 2001(Cth) (the Act). This decision affirms the landmark Centro case, ASIC v Healey(2011) 196 FCR 291 (Centro). Directors cannot rely solely on internal management or external auditors to fulfil financial reporting requirements.

Key Facts

Mr Patrick Godfrey was managing director of Banksia Securities Limited (BSL). BSL’s main asset was its loan portfolio. Mr Godfrey failed to ensure adequate provision for bad and doubtful debts in BSL’s financial reports for June 2011, December 2011 and June 2012. Four loans had been under-provisioned by around $4 million, resulting in overstated profits for the relevant years. Mr Godfrey was unaware that BSL’s policies for determining loan impairments were not consistent with the relevant accounting standard,AASB 139.

Decision

The Court relied on the key principle from Centro, that directors must have “the financial literacy to understand basic accounting conventions”[1]and exercise “proper diligence in reading the financial statements”. Applying Centro, the Court held that Mr Godfrey should have acquired a greater degree of financial understanding, in order to properly discharge his duty. Mr Godfrey was found to have breached section 344(1) of the Act by failing to take reasonable steps to secure BSL’s compliance with the financial reporting requirements under Part 2M.3 of the Act.

The Court emphasised that Mr Godfrey should have had a better understanding of the relevant financials because he held primary responsibility for making recommendations to the board about bad or doubtful debts. Importantly, Mr Godfrey’s duty could not be “abrogated by reliance on the management of BSL, its internal Audit and Corporate Governance Committee or its external auditors”.

Penalty

Mr Godfrey was disqualified from managing corporations for a five-year period and a pecuniary penalty of $25,000 was imposed. The potential maximum pecuniary penalty was $200,000 for each contravention. The comparatively small amount of $25,000 was imposed because Mr Godfrey had not acted dishonestly, was found to be of good character, and had fully cooperated with ASIC.

Lessons for Directors

The key message from this case is that directors must have sufficient financial literacy to review financial statements, monitor the company’s progress and ensure compliance with relevant accounting standards. Directors must take full responsibility for their duties, especially duties in relation to financial reporting. They cannot merely rely on internal management or external auditors.