Why did CITIC Pacific's board wait 6 weeks before telling investors that it had a huge exposure to exotic foreign exchange forward contracts? What does this say about the quality of its board, and the independent directors on its audit committee who, according to a separate statement by the Chairman, found time to complete an investigation of the incident even before the incident was announced?

CITIC Pacific's time bomb
20 October 2008

It turns out that little old ladies buying minibonds aren't the only ones to have been taken in by structured financial products. Hang Seng Index member (for now) CITIC Pacific Ltd (CP, 0267.HK) stunned the market this evening with the extremely late announcement that they are sitting on realised and unrealised losses of HK$15.5bn (US$1.99bn), due to foreign exchange exposures the Company was aware of six weeks ago (although the losses have grown) but had failed to tell investors until now.

The losses involve exotic foreign exchange forward contracts such as "dual currency target redemption forward contracts", where they get a limited upside (due to a knock-out clause) and an unlimited downside, being required to take the weaker of the Australian dollar and Euro. Another series of "AUD target redemption forward contracts" involves receiving up to AUD9.05bn in monthly instalments up to October 2010. The counterparty bank(s) for these contracts have not been disclosed, and CP did not say when the contracts were entered into. They should tell investors how long this time-bomb was ticking. If the exposure pre-dates the interim report for 30-Jun-08 or even the audited annual report for 31-Dec-07 then it raises additional questions. On this, the two reports said (p120 of the annual report):

"The functional currency and future cash flow for Group's Australian Iron Ore Mining project is denominated in USD. Substantial portion of the project infrastructure / pre-completion operating expenditure is projected to be denominated in non-USD currencies. Foreign exchange forward contracts and structured forward instruments are employed to hedge or minimise the non-USD currency exposure."

There was no sensitivity analysis to FX movements in the annual report. In the interim report (p10) it adds:

"As at 30 June 2008, outstanding foreign exchange forward contracts and structured forward instruments amounted to HK$3.9 billion (31 December 2007: HK$3.5 billion)"

CP says it became aware of the situation on 7-Sep-08 (a Sunday). Since then, the shares have fallen 41.7% while the HSI has fallen 23.1%. At yesterday's suspension price of $14.52, the company was valued at HK$31.84bn, so the loss is almost half of its market value. Net tangible assets were $55.2bn, so the loss is about 28% of that.

It cannot have taken 6 weeks to understand the basic financial parameters of the contracts the company had signed and the magnitude of money at risk, even if detailed valuations of options embedded in the derivatives were not available, and even if the amount of losses was a moving target as the Australian Dollar and Euro slumped against the US dollar. The board should have disclosed what they knew, when they knew it.

It is mind-boggling that the board could sit on this information for so long. CP's Managing Director, Henry Fan Hung-ling (Mr Fan), is also a member of Hong Kong's cabinet and a Government-appointed director of Hong Kong Exchanges and Clearing Ltd (HKEx, 0388.HK), which owns the Stock Exchange of Hong Kong Ltd (SEHK), which regulates listed companies. He also chairs the Mandatory Provident Fund Schemes Authority, which regulates retirement savings schemes, and the SFC's Takeovers and Mergers Panel (of which your editor is a member). Another Executive Director of CP, Vernon Moore, who has today been appointed Finance Director, was a member of the Listing Committee for several years until 16-May-03 and is a member of the new Financial Reporting Council (which investigates problems with financial reporting) and the Securities and Futures Appeals Tribunal.  Surely they and their fellow directors are aware of Listing Rule 13.09 which requires prompt disclosure of price-sensitive information.

CP Chairman Larry Yung Chi-kin (Mr Yung) also digs the company deeper into the regulatory hole - outside of the official announcement, he has put out his own statement in a press release, which provides further information that should have been contained in the announcement filed with SEHK.

In the statement, he discloses that "after senior management discovered the problem last month, a special board meeting was held to discuss the issue, and the Audit committee was authorised to begin an independent investigation", which has already concluded. It says something about the quality of the INEDs that they did not require the company to immediately announce the situation before embarking on their investigation as to how it arose. You don't wait for the investigator's report before disclosing a plane crash.

There was no mention of the audit committee or its investigation in the Announcement. The press release also contains a summary of the audit committee's findings. It alleges:

Incidentally, the biographies in the annual report call Mr Chang a Deputy Managing Director, not Finance Director, while Mr Chau was called an Executive Director, not Financial Controller. When were these titles and responsibilities assumed? What you will see in the annual report under "senior management" (the next layer below the board) is that Ms Frances Yung Ming-fong is "Director, Group Finance" - but apparently, not Group Finance Director. Did she know what was going on, or is her title misleading? She's the Chairman's daughter.

Apart from apportioning blame which was not allocated in the announcement, Mr Yung's statement also reveals that CP's auditor, PricewaterhouseCoopers, has been "invited...to study ways to improve the Group's internal control. Their recommendations have been accepted in full and will be implemented".

So CP had time to do all of this while still keeping investors in the dark. It's shocking. The credit rating agencies will probably need to put the company's rating under review for downgrade. CP says PRC state-owned CITIC Group, which owns 29% of CP, has "indicated its full support as always to the Company" and "has agreed to coordinate to arrange a standby loan facility of USD1.5 billion". It remains to be seen whether the loan can actually be arranged. And what does "full support" mean - is CITIC Group going to guarantee CP's borrowings?

This episode has revealed deeply defective internal controls at a member of Hong Kong's blue-chip index, as well as disregard for the need and obligation to promptly inform investors of price-sensitive information. Investors should attach a discount for this, as should credit ratings agencies.

© Webb-site.com, 2008

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