CITIC Pacific: Foreign Exchange Scandal

CITIC PACIFIC:
Foreign Exchange
Scandal
Case Overview
In February 2008, CITIC Pacific’s (CP) stock price sat at a high of HK$43. But within a
mere 8 months, it plunged by 92 per cent to HK$3.66 after a foreign exchange scandal
which led to a loss of some US$2 billion. This loss was attributed to the unauthorised
betting on foreign exchange derivative contracts that were supposedly hedges against
currency risks. The objective of this case is to allow a discussion of issues such as
board composition, risk management, executive compensation and other corporate
governance practices.

Unauthorised Bets on Foreign Exchange Derivative Contracts

CP’s investment in a Western Australia iron ore mining project involved an estimated
capital commitment of A$1.6 billion and €85 million 1. In addition, annual operating
expenditure of at least A$1 billion for up to 25 years was projected.

CP’s cash projections were denominated in USD, but these expenses were paid in
Australian dollars and Euros, thus exposing CP to fluctuations in foreign exchange
rates. To hedge against these risks, CP entered into contracts to deliver USD in return
for AUD and EUR. These actions were common to mitigate business risks. The unique
problem faced by CP, however, arose from its use of “foreign exchange accumulators”.

Accumulators, including currency target redemption forward contracts and daily accrual
contracts, were employed by CP. Unlike regular derivatives, accumulators have a
unique characteristic: the knock-out clause. The knock-out feature causes the contracts
to expire once CP achieves a stipulated profit from the contracts. While the upside gain
of the hedging instrument was confined, losses could be unlimited, thus resulting in an
asymmetrical payoff.

“This wasn’t a hedge, this was an outright bet,” said David Webb, a well- known
corporate governance activist in Hong Kong. 2 CP’s transactions involved substantial
risks that far exceeded its actual hedging needs. The mining project required only an
initial capital expenditure of A$1.6 billion, yet it entered into contracts for over A$9
billion.3 90 per cent of these hedging contracts were entered into when the Australian
Dollar hit a high of 87 cents against the USD in October 2008. Hence, when the
Australian dollar fell by 20 percent to 70 cents against the USD, a loss of HK$15.5
billion was expected.4
This news alarmed investors, who were unaware of the extent of exposure to these
leveraged Australian Dollar contracts5. It also became clear that the company knew of
the exposure as early as 7 September 2008, six weeks before giving a profit warning.

The profit warning caused a 74.8 per cent plunge in CP’s share price from HK$14.52 to
a record low of HK$3.66, compared with its HK$43 peak in February 2008.

CP’s Board of Directors

CP had 19 directors on the board. The board was led by the Chairman, Larry Yung Chi-
Kin, who is also an executive director. There were 12 executive directors and seven
non-executive directors, four of whom are deemed independent pursuant to the Listing
Rules. Two of the independent directors were brothers.

CP’s board appeared to comprise qualified and competent individuals. Their

competencies and industry expertise indicated that they should be familiar with Hong
Kong’s regulations. Despite this, the board failed to announce CP’s loss immediately,
violating Listing Rule 13.09 that requires prompt disclosure of price-sensitive
information.

Executive Compensation
CP’s compensation strategy was set to cultivate a pay-for-performance culture 7. CP’s
senior management personnel had a substantial portion of cash compensation linked to
performance-based variables to reflect their contribution to the firm’s financial
performance. Yung’s total remuneration was made up of 94 per cent of discretionary
bonuses and share-based payment, while for Managing Director Henry Fan Hung Ling,
it was 95 per cent. On top of his compensation, Yung received an additional HK$569
million in dividends from his 19 per cent stake in CP.

Amalgamation of Ownership and Management

Control of the company rested in the hands of Yung and CP’s major corporate
shareholder, CITIC Group8. This was a situation where the major shareholders held
both ownership and management control over the company.

The failure to separate ownership and management enabled the controllers to benefit
from the asymmetric information. Before the derivative losses occurred, CP’s two
largest individual shareholders frequently raised their stakes in the company. However,
they suddenly stopped these moves in early September9.

The Yung family appeared to be influential in CP’s management, with founder Larry
Yung helming the Chairman position and his son Carl Yung as the Deputy Managing
Director. Before the foreign exchange controversy, Frances Yung, the daughter of Larry
Yung, also occupied a senior management position of Director, Group Finance.
Regulatory Policies in Place
In the profit warning dated 20 October 2008, the Company indicated that it was “aware
of the exposure arising from these contracts on 7 September 2008”10. That the company
needed six weeks to comprehend the financial parameters and risks of its derivatives
contracts was a non- realistically long time. The failure to promptly disclose price-
sensitive information violated Listing Rule 13.09. However, the Hong Kong Stock
Exchange (HKSE) does not have the power to investigate breaches of disclosure
requirements. There are no legal penalties for non-disclosure of price-sensitive
information.11

In an unrelated circular dated 16 September 2008, the directors expressed a view that
there were “no material adverse changes in the company during the year up to 9
September 2008”12. This contradicts the profit warning which indicated the Company
had known of the losses as early as 7 September 2008. This indicates a possible false
and misleading statement, which may subject directors to liability under section 298 of
the Securities and Futures Ordinance.

Failed Internal Controls

The effectiveness of CP’s internal control system is reviewed regularly by the Group
Internal Audit Department. The department also conducts systematic independent
evaluations of all business units and subsidiaries in the Group on a continual basis.
However, internal controls can only provide reasonable, but not absolute, assurance
against any material misstatements or elimination of risks, as seen from the failure of
these controls.

The foreign derivatives contracts were made without proper authorisation and adequate
evaluation of its potential risk exposure. Chang, the Group’s Finance Director, did not
follow CP’s hedging policy: he failed to adhere to standard procedures of obtaining prior
approval of the Chairman before committing to contracts. Furthermore, monitoring
mechanisms failed to serve their purpose. The Group Financial Controller’s purpose as
a check and balance fell through when Group Financial Controller Chau Chi Yin did not
notify the Chairman of any unusual hedging transactions.

Steps Taken Towards Recovery

Management reshuffle
On 8 April 2009, CP announced a top management reshuffle. This involved the
resignations of CP’s founding chairman, Yung, and Managing Director, Fan. The
resignations came at a time of police investigations. In a statement to the Hong Kong
Stock Exchange, CITIC Pacific said “Mr Yung believed that his resignation would be in
the best interests of the company.” Chang Zhenming, the vice chairman and president
of CITIC group, took over as chairman of CP. Zhang Jijing stepped up as the company’s
managing director. By the end of 2009, CP had appointed a new financial controller,
treasurer and several new executives. In addition, CP committed itself to appointing
more independent board directors in the long run. Frances Yung, the Director of Group
Finance, was not forced to leave the company but was instead demoted and took a
salary cut.

Internal control improvements

CP underwent a major restructuring of its financial control teams via the recruitment of
seasoned professionals. They took on roles in identifying, reporting and managing the
Group’s treasury activities and financial risks13.

Accounting firm PricewaterhouseCoopers (PwC) was engaged to review CP’s financial

risk management and company-level corporate controls. Following recommendations
from PwC, the Group Internal Audit expanded its scope of risk-based internal audit
services provided to the Audit Committee. Additionally, CP appointed a consulting firm to
conduct a thorough study and assessment of CP’s finance function.

CP also updated its terms of reference (TOR) of the audit committee. The updated TOR
expanded the committee’s oversight function to include the duty to discuss with
management the company’s internal control systems and the responsibility to ensure that
management has taken the internal control measures into consideration when
implementing policies and programmes.

These efforts aimed at improving internal control and corporate governance seemed to
have done well in restoring investor confidence, as seen from the 19 per cent increase
in share price a day after the management reshuffle was announced. Despite suffering
losses amounting to HK$10billion and incurring a debt of HK$9.38billion15 from its
unauthorised currency trading bets, CP continued to show positive results in 2009.
These are attributable to profits from its steel business, property projects in mainland
China and the progress of its iron ore mine in Australia.

Discussion Questions
1. How has the failure to separate ownership, the board and management impaired the
corporate governance of the company?
2. Discuss how the compensation system may have impacted the risk appetite and
corporate governance of the company.
3. Which do you think played the biggest role in CP’s scandal — weak board oversight,
failed internal control, or a flawed compensation system?
4. Other than those already taken by the company, how else can they improve
corporate governance and internal control?