Hounding honest directors will only benefit corporate cowboys

SOME things in life are certain. One of them is the schadenfreude when board directors are slotted by a judge for breaching their statutory duties of care and diligence.

Regulators rejoice at their wisely targeted prosecution. Shareholders cheer that someone is held to account for falling share prices. And the community rarely looks beyond the simplistic picture of privileged, middle-aged men being brought down a notch.

A more thoughtful reaction might be to ask where this will end? If we keep feeling smug about pinging directors, we might find good directors departing, leaving less qualified corporate cowboys to take their seats. When that happens, shareholders, employees, suppliers and creditors will suffer.

Last week's decision by the Federal Court, which found that six non-executive directors and two executives at Centro failed in their duties when they approved financial accounts in 2007, has been hailed as a firm but fair raising of the liability bar. Justice John Middleton found that the directors failed to take all reasonable steps to ensure compliance with financial reporting obligations under the Corporations Act 2001 when they approved consolidated financial statements for Centro companies, which incorrectly classified $1.5 billion in debt as non-current liabilities that should have been classified as current liabilities and did not disclose $US1.75bn in guarantees entered into post balance date. It sounds fair enough at face value. We should expect directors to have a certain level of financial literacy. They should be able to spot red flag issues. And there are plenty of directors who don't have what one judge has called this "core, irreducible requirement of skill".

But consider the facts more closely. Middleton said the Centro directors "are intelligent, experienced and conscientious people".

There was no suggestion of dishonesty. In other words, these are not rogue directors. Middleton also found that neither management nor Centro's highly paid auditors, PricewaterhouseCoopers, realised the errors in the financial statements. And that raises the very real question of whether other directors on other boards would have acted in the same fashion, relying on the expertise of external auditors when signing off on the financial accounts?

You see where this is going. Former NSW Supreme Court judge Robert Austin calls it the "expectation gap": the gap between what the community expects from non-executive directors and what these directors can do in the real world of modern corporate life. Middleton sided with the community's expectations when he described directors as being "at the apex of the structure of direction and management of a company". In the real world it is much less clear whether it is reasonable for directors to be familiar with every detail, financial or otherwise, to properly manage a corporation to avoid liability and prosecution.

That said, there is a cosy directors' club and much can be said against it. The aim of some directors is to enjoy a cushy transition between full-time work and retirement. Their eye is always on securing the next directorship. Hence, they don't raise searching questions of management and they never rock the chairman's boat.

But there are many more conscientious people who join boards, looking for stimulating, part-time work. And that's the key. This is part-time work. Non-executive directors do not run companies. Their role is not operational. Management does that.

And yet the law increasingly assumes an operational role from these directors and attaches liability accordingly. The best directors understand the business, have a vision about strategy, keep management on their toes, know enough about the corporate world to appoint the right chief executive (the board's most important role) and aren't fooled by management. The Centro decision means directors will spend less time doing strategy work and more time ticking compliance boxes to avoid prosecutions and class actions.

Austin has suggested the best way to more closely align reality with community expectations (and the law that follows those expectations) is to make clearer the content of directors' responsibilities. He suggests amending company constitutions to clarify that directors do not manage companies by delegation to executives or otherwise. A company constitution should reflect a more realistic role where a director guides and monitors management, leaving directors to do precisely that.

You can imagine the indignation at such a change. Shareholder associations and class action lawyers will scream about rich men at the big end of town trying to escape liability. And that explains why, to date, nothing much has happened with Austin's sensible suggestions.

But here's a prediction. Expectations about non-executive directors may change when women start feeling the heat of prosecutions. Sure, women only account for 11 per cent of top 100 board seats. But as The Australian's John Durie reported, women account for 21 per cent of all directors who sit on three boards, compared with 9.8 per cent of men. And more than 29 per cent of directors with two seats are women compared with 22 per cent of men. So with increasing numbers of women filling multiple board seats, we will soon see more women the subject of Australian Securities & Investments Commission prosecutions for breaches of directors' duties.

While no one has sympathy for a board filled with middle-aged, white males, there will be plenty of sympathy when members of the protected species -- women -- start to question the increasingly unrealistic burdens on directors.

And maybe we can expect to see more of these kinds of prosecutions given that women often tend to come to boards from outside the executive ranks of corporate life. Don't shoot the messenger but some have suggested career paths such as accounting, law, management consultancy and so on, though highly skilled, are more prone to produce directors who can be more easily snowed by management.

For all the populist tilting to "get" directors every time something goes wrong at a company, if good directors vacate the board space, companies, shareholders and the broader community of stakeholders will suffer. Blue chip companies will continue to attract the talented directors. Increased burdens will simply further concentrate the ranks of the directors' club, keeping all the good directors on a merry-go-round of blue chip boards.

But who will want to join a mid-cap or small-cap company, let alone a company in trouble? Companies that most need bright, tough directors will miss out. Think about that next time you smile at the downfall of an honest director.