Adopted with permission from Corporate Governance Case Studies Volume Three. Edited by Mak Yuen Teen 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 supposedly hedged 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. Unauthorized 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 million1. 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. 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. 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. This news alarmed investors, who were unaware of the extent of exposure to these leveraged Australian Dollar contracts. 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. 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 percent. On top of his compensation, Yung received an additional HK$569 million in dividends from his 19 per cent stake in CP.