BECG Case - 2

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ChinaAviationOil'sCollapse:Singaporenc.'sChallenges

'Theirbusinesss thejet fuelbusiness...they shouldhaveconcentratedon that.1- OngEngTong,an independentilconsultant'Thereis a saying,if a companyloses $50 million, it's the company's problem. But if it loses $500 million,it's thesystem'sproblem."2

- A Singaporeoiltrader

OnNovember7th2004,SouthAfrica's StandardBank,threatened to open insolvencyproceedingsagainstSingapore-basedhinaAviationOil(CAO),unlessthecompanyrepaid$14millionitowedbeforeDecember9th2004.3Whatmadehisnewsbizarrewasthefactthattheaviationfuel importingunitof Chinesestate-ownedenterpriseChinaAviationilHoldingCompany,CAO,whichwaslistedontheSingaporeExchangehadseenitsprofitsgrowbymorethanthreeimesheprofitssinceits listingin2001,andthe companywas votedthe "mosttransparent"companylistedinSingapore,tsshareswererankedamonghebluechipindices.WhatwasunknowntotheinvestorswasthefactthatCAOhadost$550millionnspeculativeoil trading,leavingitbankrupt.ThiswasthesecondmajorderivativescandalattheSingaporexchange.hefirstonewas thecollapseof UK'sBaringsBankin 1995.ThederivativesscandalraisedconsiderableoncernnthecreditabilityofSingapore,whichhadthe reputationofbeing,Asia'sbest-regulatedinancialcentre,lsowerehequestionsaboutcorporatetransparencyamongChinesecompaniesand the roleof independentdirectors.AOhadmanagedabailoutplan,butitwasSingapore,whichwaspayiogthepricefor itsrolein thescandal.ChinaAviationOil'sCollapseChinastheworld'secondargestconsumerofjet aviationuels,andaccordingoanestimateby InternationalEnergy

Agency,etaviationuelimportsaccountor abouta thirdof China'stotalconsumption,whichisabout230,000barrelsperday,4hinaviationOilCorpLtd,establishedn1993,isamultinationalnvestmentandoil infrastructureompanywithitsheadquartersnSingaporendisthesoleimporterofjet aviationfuelin China.ItismajorlyownedbyChinaAviationOilHoldingompanyCAOHC)Exhibit1),a state-ownedenterprise(SOE)thatenjoys100%monopolyn thesupplyofjet

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earnings,tbeganradingnfuturesorpurelyspeculativeeasons.CAO'smanagingirectorandChiefExecutiveOfficer,ChenJiulinChen)wasresponsibleorthespeculativeradingattheSingaporexchange.nearly2004,Chenspeculatedthattheoilpricewouldbearound$38perbarrel,nthefourthquarteroftheyear.Hewasexpectingheoilpricesofall.ButinOctober004,oilpriceswentskyward.Withoilpricesover$55perbarrel,thadwellpassedChen'sexpectedriceandhelostthebet(Exhibit).Accordingothecontract,CAOhadopaythebanksandfinancialsnstitutionsheearnestmoney,whichwas$5000oronedollarriseinoilpriceperbarrel.

Havingexhaustedtsownresourcesopayforthemargincall,it turnedoitsparentcompanyorfunds.CAOHCent$108millionoCAO.Thisamountwasraisedbyselling15%ofitsstakenCAO,whicheducedheparentcompany'sharefrom75%o60%.Accordingomediaeports,CAOHCapproachedeutscheBankorhelpinsellinghestakehroughablockrade.nsuchadeal,aninvestmentankpurchaseslargeblockofsharesromanissuer thecompanyrabigshareholder andresellshesharesatadiscountoasmallcadreofprofessionalnvestors.AccordingoSingaporeregulations,eutscheankwasnotrequiredoperformextensiveuediligencenthecompanyndrestrictedtselfoashortsetofquestionsbouttsfinancialecordsandwhetherherewereanyissueshatcouldhaveamaterialadverseimpactonthebusinessor itsfinancialcondition.OnreceivingafavourableesponseDeutscheBanksubmittedheregulatoryilingwiththeexchange.Finally,DeutscheBankoffered145millionCAOsharesatS$1.35each,with14%discountothemarketprice.Byindustrymeasures,hedealwasasuccess.Withtheparentcompany'selp,CAOmanagedosettleewofthedeals.But,bylateNovember,AOhadreceivedpaymentdemandsormarginpaymentsandsettlementf derivativesradesfromJ Aron,Mitsui&CoEnergyRisk

Management,arclaysCapital,SouthAfrica'sStandardBank,SumitomoMitsuiBankingCorporation,ortisBankandAustralia'sMacquarieankotalling247.5millionExhibit).6Unableosecuremorefunds,Chenmadetknownothepublichathiscompanyadcollapsedwith$550millionnderivativeosses.CAOSingapore'stockpriceellsteadily-losing39%beforeradingwassuspendednNovember6111004.Chenwasarrestedorhisinvolvementnthecollapse.Assetsbeingnsufficientoservicehedebt,creditorseganexpectingarentcompanyoprovideadditionalesourcestofinancehedebt.Withpressuremountingromitscreditorsorpaymentsandtoavoidbankruptcy,CAOputupareorganizationlan.AccordingotheplanCAOHCwouldconvertpartofa$118millionoantoCAOntoequityandinvestadditional50million.SingaporetatenvestmentgencyTemasekoldingsIe.Ltd.wouldnvestanother50million.Buttheinvestmentouldnotproceedunlesshecreditorsacceptherepaymentlan,Le.CAOwouldrepayatotalof$220millionoitscreditors,fwhichtwouldpay$100millionmmediatelyndtheremaining120millionwouldbepaidoveraperiodofeightyears.MichaelColeman,managingirectorofSingapore-asedAislingAnalyticsPte,said,"It'snotacompellingase,yougottowaiteightyears.Youarenotgettingbackenoughupfrontomaketworthwaiting."7Creditorswouldhavetowriteoff60%ofthemoneyheyloaned.OfficialsromtheSin,gapore-basedverseasChineseBankingCorp.,oneofthecreditors,aid,"Theproposedchemeofarrangementsagoodstartingpointforfurthernegotiations

betweenllthecreditorsndCAO."8CAOalsoappointedonsultanteloitte&Toucheoactasitsfinancialadviser.Eventhoughhecompanyadmanagedbailout,itfacedegalandcriminalawsuitsnSingapore.

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.ChinaAviationOil'sCollapse:Singaporenc.'sChallenges

CriticsayhatheCAOscandaladbroughtntospotlightheshortcomingsnthecity-state'sinancialiberalizationprocess.hiswasnotthefirstcorporatecandalohappenattheSingaporeExchange.InNovember004,hreeemployeesromheGovernmentfSingaporenvestmentorp,whichmanagesingapore'soreigneserves,wereinedfornsiderradingnJapanesehares.nApril2004,aformerinancemanagerwithAsiaPacificBreweriesasailedor42yearsorcheatingermanndJapanesebanksof $71million.n2001,Singapore-listedsiaPulpandPaper,anIndonesianoodndpulpconglomerate,efaultedndebtsotalling13.9billion.1OhemostnfamousfallthescandalswashecollapseftheUK'sBaringsBankn1995afterit lost$1.2billiononderivatesradingby'roguerader'11NickLeeson(Box 1).

Box1Collapseof BaringsBank

'Wewerealldrivenomakeprofits,profits,andmoreprofits..."saysNickLeeson(Leeson)inhisautobiographyRogueTrader,eesonadshakenhefinancialworld in 1995whenhesingle-handedlybroughtdownoneof theoldestandreverederchantanksnUK.TheBaringsBankwasbankruptbecauseofunauthorizedradinglosses.LeesonadworkedrieflyorMorganStanleybeforeoiningBarings.Atbothfirms,heworkedinoperations,butshortlyafterOiningarings,ewastransferredotheJakarta,whereheeamedanameforhimselfbyhishardwork.So,in 1993,whenaringsecuritiesSingapore)imitedBSS),purchasedaseatfortradingnfuturesontheSingaporentemationalMonetaryxchangeSIMEX today'sSingaporeExchange)heBarings'managementpromotedhimasthegeneralmanagerfBaringsuturesSingapore).eesonwasBarings'starSingaporerader,bringingsubstantialprofitsfromtheSIMEXndhadmademorethan1Om- about10%ofBarings'totalprofitfor 1993.Hehimselfhadeameda bonusof130,000nhissalaryof50,000.Hispositionuthorizedimtodotwotypesoftransactions.TransactinguturesandoptionsordersforclientsorforotherfirmswithinheBaringsrganization,ndarbitragingpricedifferencesbetweenNikkeifutures(Nikkei225)tradedontheSIMEXndJapan'sOsakaExchange.Leesonexecuteda tradingstrategyknownasa "straddle,"withtheobjectiveofmakingprofitysellingputandcalloptionsonthesameunderlyinginancialnstrument.Astraddlewillgenerallyproducepositiveamingshenmarketsarestablebutcanresultin largelossesifmarketsarevolatile.LeesonookmassiveisksonBarings'inancesbecausetherewerehugefinancialincentives.Thelargertheprofitsthe

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ASingaporeoiltradersaid,"SomeonentheSingaporegovernmentwassleeping.LossesofthismagnitudesuggestheSGX(SingaporeExchange)andMAS(MonetaryAuthorityofSingapore)failedto enforcecorporategovernance.TheentireSGXtradingsystemandtheMAS'ssupervisoryoleneedtobeexamined."12oattractforeigncompanieso listtheirsharesontheSingaporeExchange,heexchangehadeasedmanyrulesandregulations,Theexchangehadswitchedtssystemof listingfromamerit-basedsystemtoonerelyingoncorporatedisclosurethatputsmoreonusontheinvestortoadopta 'buyerbeware'attitude.EswaranRamasamy,irectorforenergyinformationproviderPlatts,said,"(Theexchange)hastobefaultedfornotsayinganythingaboutit (CAO).SGXbeingtheexchangeshouldbewaryofallthesethings...toputitbluntly,theyhavenotdonetheirjOb,"13Butthe factremainedthatCAOmadelossesonoil swaps,whicharenotregulatedbytheexchange.

ButCAOhadviolatedmajorlaws.Accordingothe"Noticeon furtherstreamliningandstandardizinguturesmarket",issuedbytheStateCouncilonAugust1st1998,enterpriseswithoverseasfuturespermitcanonlybe allowedtoengageinhedgetransactionsandtheyarenotallowedoengagenspeculativeransactions.CAOnotonlyindulgednspeculationbutitsthevolumeoftransactionslsoexceededhetotalofspottradingimit.Itstartedspeculatingwith2millionbarrelsnitiallyandthenumberhadreached52millionbarrelsbythetimethescandalookplace.Ithadexhaustedts$5minternalrading imitsbackin2003,butkeptdoublingupitsspeculativebids,in anattempttomakegoodthedeficitandtoldnobodyaboutitsmountingossesforoverayear.Ithadalsomisrepresentedtsfinancialstatements.AccordingothefinancialstatementhetotalassetsofCAOinJune2004was$515millionandtheassets-liabilitiesatiowas73%.Thelong-termaccountreceivablewas$141million,whichwas equalto theaccountpayable.Judgingfromthe account,therewasnoproblemwiththebusinessoperations.Butactuallyhefirmsufferedpotentialossesof$3.58billioninoilfuturestradingandthiswasnotshowninitsfinancialstatement.CAO'scorporategovemanceandriskmanagementpolicieshadfailedandregulatoryauthoritieshadfailedinidentifyingheflaws.It alsohadposedcredibilityquestionforotherChinesecompanies.Chinesecompanieshadenjoyeda highertradingfrequencyamonglocalinvestorsthanotherstocksbut afterthe scandal,investorstookcautiousapproach.

ThecollapseofCAOhadraisedquestionsonthestandardsofcorporategovemancenChinesefirmsandhighlightedtheflawsthatareoftenoverlookedin thegeneralenthusiasmaboutthe country'semergenceasa globaltradingandeconomicpower.AmajorityoftheChinesecompanieswerestate-ownedenterprisescontrolledbyentrepreneursorfamilymemberswhohadlittleexperiencenlookingafterminorityshareholdersandonlyapartialunderstandingfconceptssuchasboardindependence,ndependentauditingof resultsandtheneedforproperriskcontrol.Limiteddisclosureandlackoftransparencyndealingshadcompoundedtheproblemof compliance.ThereweremediareportsthatthecorporategovernanceofChineseirms,listedinSingaporeespeciallywasworsethanthoselistedinothercountries.MakYuenTeen,co-directoroftheCorporateGovernanceCentreattheNationalUniversityofSingapore,arguesfora returntostricterrulesbySingaporeExchangeto avoida raceto thebottom,since"smallerexchangeslikeSingafdoremaybea fourthor fifthchoiceforChinesecompanieshatcannotgetto theUSorHongKong."14

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partnerfSingapore,wnedheparentcompany.BobBroadfoot,hemanagingdirectorof thePoliticalandEconomicRiskConsultancyPERC)nHongKong,saidthatthelatestscandalshouldnotnecessarilyamishthe reputationofSingaporefinancialuthorities,heSingaporeExchangeappearedobedoingthings"bythebook"inmanaginghescandal,hroughmeasuresuchasthePriceWaterhouseCoopersuditandensuringthatthe companyfileda courtaffidavit."[Corporate]governancesnotdefinedbynothavinganyviolationsatall; it is definedbyhowthey[financialauthorities]managethoseviolations,"16Thendependentirectorsandlawsgoverningcorporatetransparencywerealso subjectsof criticism.Failurein

dischargingheirdutieshadwipedoutCAO'sshareholderequityworth$143.4milliontherebyleavingthesharesofmorethan,000nvestorsfthecompanyvirtuallyworthless,7AlsoinquestionwastheroleofCEOs whetherheyshouldaimforheobjectivefprofitmaximizationtowhichtheircompensationslinked,orworkintheinterestoftheshareholdersandaimforwealthmaximization.Expertsoiced,WithSingaporemakinggreatstridesin corporategovernance,companiesshouldno longerbe

permittedoengagenactivitieshatflyunderthesupervisoryadar."18heSingaporeExchangeacedpressuretodefenditsaggressiveooingfforeigncompaniesooffertheirshareshere,AnotherseriousssuewastheregulatoryreatmentofdenvativesradingwhichwasalsotherootcauseofBarings'downfall.Therewereopinionsthatthecity-stateshouldreviewitscorporatendsecurityawsandtightenhelistingrulesfortheforeigncompanies.ButPrimeMinisterLeewasof theviewthathecity-state'sorporateegulationsarein linewiththebestpracticesinotherjurisdictions.Hesaid,"Iwouldnot,asaknee-Jerkesponseveryimesomethinggoeswrong...say'tightenherules'.Thiswasouroldattitude..,thinkhat'snotpossible,19

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Public

llIli,.

GreaterChinaTravelIndustry(Singapore)PteLtd

(2)

CompaniaLogisticadeHidrocarburos(CLH)

Exhibit 1CorporateStructureof CAD

ChinaAviationOilHoldingCompany(1)

':fllill

ShuidongOilStorageTankFarm(Shuidong)

ShanghaiPudongIntemationalAirport

AviationOilSupplyCompany(Pudong)

SouthChinaBluf'skyAviationOilCo

Ltd (Bluesky)

'l/llill

ChinaAviationOilSupplyCompany.l

therAFSCs

15AFSCs

ChinaAviationOilHoldingCompany"CAOHC'1,state-ownednterprisen thePRC,ownsapproximately75%of theenlargedsharecapitalofourCompany.ccording10theprovisionsofthelawofthePeople'sRepublicofChinaonIndustrialEnterprisesOwnedbytheWholePeople,CAOHC'sssetsareownedbythe

1)

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Exhibit2NewYorkMercantileExchangeNymex)OilFuturesContractor2004

6555

)45CQ~35

25Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec2004

Source:awyer,Nick':4wrong-way bet'~ http://db.riskwaters.com, January 2005

Exhibit3CAD's PaymentDemandsasofNovember2!1'2004

I Company Dateof demand Amount(US$) Details>-IBarc/aysCapital October29 26,461,650 Settlementof threederivativestransactions>-IMitsui&CoEnergyRisk November 70,331,400 Unwindingf50%volumeofeightManagement derivativesontractsIJAron&Company November6 12,397,805 Settlementfsixswapandoptions(Singapore) transactions

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Exhibit4MainCreditorsof TroubledCAOandTheirinvestments

Source:"FACTBOX-MainreditorsoftroubledCAOSingapore",www.reuters.com.anuary24111005

'S.No Creditors Amountn$,million1. ChinaAviationOilHoldingCo 118.02. SatyaCapitalLtd. 51.7,3. StandardBankLondonLtd.: 34.1,4. SumitomoMitsuiBankingCorp. 26.1,5. Industrial&CommercialankofChina(Shanqhairanch) 26.1,6. ChinaEverbrightBank 26.1,7. BankofCommunicationsSingapore) 25.9,8. BPSinqaporePte.Ltd 23.3,9. ChinaMerchantsBankCo.Ltd. 19.3,10. BarclaysBankPic. 18.5,11. BeijingCityCommercialank 17.412. ChinaOil(HK)Corp.Ltd. 16.4,13. SingaporePetroleumCo.Ltd. 15.4,14. GlencorenternationalG 15.0,15. Oversea-ChineseankingCorp.Ltd. 15.0,16. SKEnerqyAsiaPte.Ltd. 14.3,17. SocieteGenerale 13.8,18. NorddeutscheandesbankGironzentrale 13.019. ShanqhaiPudongDevelopmentank 13.0,20. ItochuPetroleumCo.(S)Pte.Ltd 12.421. BankofCommunicationsShanghai) 10.622. UnitedOverseasBankLtd.(Singapore) 9.7,23. Industrial&CommercialankofChina,Macau, 9.724. JAron&Co. 7.725. MacquarieBankLtd. 6.1