Centro and now Freedom Foods – the first companies that come to mind in a litany of accounting scandals that happened under the noses of their boards and have taken the corporate scalps of more than a few chairman and sent their companies spiraling into insolvency.

In the last few days, Freedom Foods has announced net asset write-downs and restatements of $590m plunging shareholders’ funds to a deficiency of $58.4m and requiring a massive capital raise that will see a new major shareholder on the register.

One of the directors of Freedom is one of my former partners and he is an extremely smart and financially literate individual and would not knowingly have permitted this to have occurred – but what obligation was he under to quite literally go down into the warehouse and check inventory dates?

Statute

Section 286 of the Corporations Act requires a company to maintain proper books and records while Section 344 Corporation Act imposes a direct penalty on directors if the company fails to adhere to its financial and audit obligations.

At all times the directors remain under the requirement to act with the due care and diligence that a reasonable person would exercise in the circumstances, section 180 of the Corporations Act.

Centro

In 2011 after Centro Justice Middleton set out a statement of principles for directors:

  • Each director sits at the apex of the company by management, it is not sufficient to rely on another director;
  • Each director must read and understand the accounts;
  • Each director must understand the fundamentals of the business and therefore the areas of risk; and
  • Each director is expected to have some financial knowledge.

The outcome in Centro was that the court found that the directors had knowledge of the issues of the company and could not rely on management or auditor sign-offs. This duty cannot be delegated.

Penalties

In 2019 the Federal Government amended the Corporations Act 2001 (Cth) and Australian Securities and Investments Commission (ASIC) Act. The new penalties underscore the substantial obligations under the law on directors and officers.

  • For an individual, maximum civil penalties increase from $200,000 to the greater of $1.05 million or three times the benefit gained (or loss avoided) from the breach.
  • For corporations, maximum civil penalties increase from $1m to the greater of $10.5m, or three times the benefit gained (or loss avoided, or 10 per cent of annual turnover with a cap set at $525m.
  • Courts can make ‘relinquishment orders’ that aims to recover the financial benefit from corporate misconduct. (Note this can included where directors benefited from share trading)

Maximum prison terms increase from five years to 15 years for serious criminal offenses such as:

  • Recklessly or dishonestly breaching directors’ and officers’ duties (s184).
  • Dishonestly failing to comply with financial and audit obligations (s344(2)).
  • Intentionally or recklessly breaching the duties of officers or employees of the responsible entity of a registered scheme (ss601FD, 601FE).
  • Knowingly or recklessly providing defective disclosure documents or statements (ss952D, 952F, 1021D).

Aggressive Accounting 

In the course of 12 months, the company released some 120 new products onto the market which should have been the first red flag to directors on a number of levels, while the aggressive capitalisation of expenses should have been another. 

While there might not be a direct breach of accounting standards the director’s care of Centro should have had a sharpened eye as to what was being capitalised.

The court in Mayfair 101 and its director James Malwhinney are reviewing the aggressive capitalisation of expenses even down to office flowers.

The conflict between the duty of management to improve the profitability of the company for shareholders and the obligations of the directors to ensure that appropriate governance and risk structures are in place.

If there hadn’t been a whistleblower contacting ASIC in 2019 would the company and its auditors have addressed the aggressive accounting policies or could the board have remained blissfully unaware?

Outcomes

Spend time understanding the basics of the business you are a director of, and have a list of critical issues that impact the business and where necessary spend some time with the CFO and ask the difficult questions, even if it will be uncomfortable for the board.

In the Freedom Food scenario, I don’t think we have heard the end, especially where we are reading in the papers that data was being withheld from the auditors.