China prohibit speculative derivative trading overseas; and ·

China Aviation Oil Holdings Company (CAOHC), a state-owned
company in Beijing, is the monopoly importer of jet fuel in China. In 1997,
CAOHC posted Chen Jiulin to the new Singapore subsidiary, China Aviation Oil
(CAO), as the Chief Executive Officer (CEO). By 2001, CAO had prepared for its Initial
Public Offering with its prospectus describing its business as oil derivatives
trading. (Fratzscher, 2006)

The Chinese regulators had prepared an elaborate set of
rules:

·        
People’s Bank of China’s (China’s central bank’s)
regulations: limit derivative transactions by state companies outside of China
to hedging;

·        
China Securities Regulatory Commission’s
regulations: prohibit speculative derivative trading overseas; and

·        
State Council’s regulations: prohibit any
over-the-counter (OTC) derivatives trading for state companies overseas. (Somanathan & Nageswaran,
2015)

CAO itself had also invested in risk management systems,
developed elaborate value-at-risk models, and established three internal
controls with senior traders having strict limits, a risk control committee,
and an internal auditing department. It has also won awards for its corporate
governance, with Singapore investors honouring it as “one of the most
transparent listed companies”. Its spectacular collapse with over US$550
million in derivative losses in November 2004 can only compare to the collapse
of Barings in 1995. (Fratzscher, 2006)

CAO disregarded Chinese regulations and engaged in OTC
derivatives trading of oil futures, taking short positions, which were highly
speculative (opposite of hedging), and misrepresenting its financial position
with accounting gimmicks that extended loss-making futures contracts to avoid
reporting incurred losses. (Somanathan & Nageswaran,
2015)

Chen repeatedly bet the price of oil would fall from US$50
per barrel. When it did not, CAOHC covered the mounting losses by selling 15%
of the 75% shares it owned in the Singapore operation on 20th
October 2004 to Deutsche Bank for $120 million, without disclosing the problem.
Consequently, CAO faced penalties for not disclosing the losses until 30th November 2004. (Becker, 2004)

In an affidavit, Chen disclosed that CAOHC was aware of the
losses 10 days before the sale but did not notify its buyers that CAO was
suffering heavy speculative losses. CAOHC had also assured Deutsche Bank of
CAO’s fiscal health before the transaction. Subsequently, Deutsche Bank resold
the block of shares to more than 50 investors, mostly Asian hedge funds, for
US$108 million, resulting in losses of US$12 million for it. (Arnold & Bradsher, 2004)

Chen was held responsible for the losses and was arrested
and charged with 15 offences, including forgery, failure to disclose the
company’s losses, and 10 counts of making false statements. Subsequently, he
was sentenced to four years and three months imprisonment and fined $330,000
for his pivotal role in the near collapse of CAO. (China Daily, 2006)

 

1.      
Problems in the Corporate Governance

1.1.      Failure to Follow Internal Control Policies

There were internal controls implemented at CAO to limit
trading losses. For instance, each trader in the company was capped to a loss
limit of US$200,000 and once exceeded, would automatically notify the CEO and
Risk Management Committee. In addition, each trader’s positions would be
immediately shut down if their losses reached US$500,000. CAO only had six
traders and hence, the maximum losses allowed should have been only US$3
million. (Roseme, 2007) However, Chen
ignored the limits and granted approval, which kept the traders’ positions from
being shut down. By mid-2004, despite mark to market losses of US$30 million,
he increased the bet by buying short-dated options and sold longer-dated
options. (Farhan, 2014) This showed that CAO
did not adhere to the controls since it exceeded its loss limits by US$547
million. (Roseme, 2007)

1.2.     
Inadequate
Risk Management

In 2002, CAO went into options trading, an area of trading
both the Management and Board were unfamiliar with. Previously, CAO dealt only
in derivatives of futures and swaps for both hedging and speculative purposes.
In mid-2003, it started trading in speculative derivative options to boost its
profile in the market. However, it did not properly assess the risks from such
trades, since its existing risk management system was designed for swaps and
futures trading and not for speculation of options derivative trading. (Farhan, 2014) Its “commencement of
speculative options trading in the first quarter of 2003, without putting in
place a proper risk management environment, raised questions on the strength of
its corporate governance.” (PricewaterhouseCoopers,
2004)

1.3.     
Lack
of Supervision

There was an obvious lack of supervision in CAO, given that
the Risk Department did not alert the Board about the serious problems in the
firm and the Audit Committee failed to detect false reporting by the CEO. (Blanco & Mark, 2005) For example, the
Audit Committee did not point out the inappropriateness in using the valuation
and accounting treatments, or mention about the inadequate risk management for
options trading. (PricewaterhouseCoopers,
2004)
Lastly, despite having independent directors, they were not actively involved
in verifying the financial statements and probing into the company’s business. (Lay Hong, 2009) Hence, both the CEO
and Board overrode internal controls by taking elevated risks to avoid
realizing the losses.

1.4.     
Improper
Application of Accounting Principles

CAO’s valuation method did not comply with IAS 39 Financial
Instruments: Recognition and Measurement and FAS 133 Financial Accounting
Standards No. 133, which recognise derivatives at their fair market value. CAO
valued options at intrinsic value and ignored the time value of money. Such
valuation errors were done throughout 2004 and resulted in accounting errors
being present in all quarterly disclosures. (Farhan, 2014) (Refer to Appendix 1: CAO’s Reported and Adjusted
Profits for 2004 (PricewaterhouseCoopers, 2004))

1.5.     
Lack
of Disclosure

CAO did not conduct a full and proper disclosure of its
losses to its shareholders, independent directors, nominee directors, and audit
committee. (Lay Hong, 2009) The executives hid
the losses from the Board and its audit committee and did not report the true
financial situation to its investors throughout 2004. Furthermore, options had
not been recorded on the Balance Sheet since the activity started in 2002.
Lastly, CAO’s non-executive directors who also worked in CAOHC failed to tell
the rest of the Board to stop their speculating activities, as given by an order
from the Chinese government regulators in March 2002. (Prystay, 2005)

2.      
Reason the Fraud Occurs (Using the Fraud
Triangle)

2.1.     
Pressure

The pressure Chen faced was mostly to recoup the losses
incurred during the speculative trading. (Lay Hong, 2009)

Firstly, Chen
might have faced personal pressure. In the year prior to the scandal, Chen had
sat on the boards of several prestigious institutions and earned many
accolades. Furthermore, China’s former Ambassador to Singapore described CAO as
“the cream of overseas Chinese enterprises” and China’s Communist Party
magazine, “Seeking Truth”, had urged Chinese companies to study CAO’s
management to help build “a great renaissance of the Chinese nation”. With such
recognition and trust, Chen would face large pressure living up to the
standards set and creating more profits. Hence, when faced with a loss, he
would be highly pressured to turn them around. Furthermore, he also hoped to
gain the attention of the new generation of government leaders in Beijing and
was already making headway with CAO’s increasing success. Therefore, he would
not want the losses from these trading activities to negatively affect the
impression the leaders have of him. (Pottinger & Prystay, 2004)

Chen also
faced pressure from CAO’s stakeholders. As CAO’s losses mounted, it started
facing difficulties meeting its creditors’ demands. When it inevitably did not
meet the banks’ demands for more collateral, the banks began forcibly closing
some of its positions, turning potential losses into real ones. (Santini &
McDermott, 2004) In November 2004, when it finally released the figures showing
its losses from the trading activities, many questions about the credibility of
CAO and Chen were raised. Therefore, to portray a façade of a thriving company,
Chen felt the need to continue investing in the trades as much as possible,
hoping to recoup the prior losses. (Lay Hong, 2009)

2.2.     
Opportunity

An opportunity that Chen might have
used to his advantage is the ignorance of the relevant guidelines that were in
place by many of CAO’s employees. (Prystay, 2005) In 2002, Ernst & Young designed a formal corporate
multi-layer risk control system with many safeguards. The system should have
prevented such large-scale losses even without the proper risk management
guidelines mentioned prior. However, these controls and safeguards failed at
each level of management. (Yinzhi, 2012) (Refer to Appendix
2: Failure of Risk Control Structure (Yinzhi, 2012))

In addition, there was a large concentration of
power in the hands of Chen, who was both the Managing Director and Chief
Executive Officer of CAO, allowing him to obstruct the free flow of information
to the Board of Directors, which the Board needed, for them to make meaningful
and independent decisions. Chen made use of this opportunity to deliberately
withhold the relevant information from the Board, ensuring their ignorance of
the losses incurred through the botched trading activities. Therefore,
despite the presence of a minimum of three Independent Directors as required by
the Code, there was no active independent third-party which could verify the
financial statements and probe the situation. (Lay Hong, 2009)

2.3.     
 Rationalise

One way Chen could have rationalised his actions was through the profit
he made just prior when CAO first entered speculative trading in the second
half of 2003. (Santini & McDermott, 2004) The profit could have given Chen
the confidence that the strategy he used previously was successful. Therefore,
despite CAO’s losses in the first quarter of 2004, should he continue using the
proven strategy, he could eventually bring in profits. (Pottinger & Prystay, 2004) The prime aim of these actions was
minimally to recoup and avoid realising the losses and create profits for the
company if possible. (Lay
Hong, 2009)

Another rationale which Chen might have used to
explain the scandal was his lack of knowledge of Singapore’s corporate
environment. Having worked only in China before, Chen had never “operated
in an environment where legal constraints were more important than bureaucratic
controls or where shareholder concerns played a significant role in managerial
decision making”. (Kennedy &
Stiglitz, 2013) In China, where CAO’s parent company is based, the natural
action would be to neglect the issue instead of proceeding with the appropriate
actions as required by the laws and regulations. With this mindset, Chen could
have assumed that a similar corporate environment existed in Singapore and his
actions were therefore also acceptable in Singapore. (Yinzhi, 2012)

 

3.      
Principles of Ethics Breached

The Codes of Ethics varies between companies but is usually
coded based on the Principles of Ethics, which includes professional competence
and due care, integrity, professional behaviour, confidentiality, and
objectivity. Be it the Management or the Board of Directors, their actions and
decisions should comply with the principle of ethics. Breaching the principles
can bring a significant impact to the company and its stakeholders. In this
scandal, CAO breached three principles, namely professional competence and due
care, professional behaviour, and integrity. (Ethics Board, 2005)

3.1.     
Professional
Competence and Due Care

Under the Principles of Ethics, professional competence and
due care require all parties within the company to maintain a certain level of
relevant professional knowledge and skill. (Ethics Board, 2005)

In this scandal, CAO went into speculative options trading
with the Management and Board having no knowledge of the financial product.
Instead of designing a risk management system for speculative options
derivative trading, CAO used the existing system designed for swaps and futures
trading. It should have assigned a group of employees to look into the risk
management strategies for this specific type of trading. If there are no
suitable employees to take on the responsibilities, CAO can outsource it to
other Financial Advisory Companies. (Farhan, 2014)

CAO also valued options at intrinsic value and ignored the
time value of money. Due to the lack of relevant knowledge, this led to the
failure of compliance with IAS 39 Financial
Instruments: Recognition and Measurement and FAS 133 Financial Accounting
Standards No. 133, which recognises derivatives at fair market value.
Such valuation errors were done throughout 2004 and resulted in accounting
errors in the financial statements presented to the public. (Farhan, 2014).

The
improper risk management and failure to comply with the accounting regulations
further increased the risk present in CAO and breached the professional
competence and due care under the principles of ethics.

3.2.     
Professional Behaviour

Under the Principles of Ethics, professional behaviour
emphasizes on complying with the relevant laws and regulations and avoiding any
action that discredits the profession. (Ethics Board, 2005)

After making huge losses,
both CAO’s Management and Chen did not disclose a US$550 million trading loss
and deceived Deutsche Bank AG. (China Daily, 2006) They should have notified the public that it was
suffering heavy speculative losses. as required by the Monetary Authority of
Singapore. (The Institute of Singapore
Chartered Accountants, 2017) Thus, there was a breach of insider trading laws for not
disclosing the trading losses at the time of sale.

As with the earlier principle, CAO breached the IAS 39 and FAS 133,
which recognize derivatives at their fair market value. (Farhan, 2014)

Since both Chen and CAO went against the law which is codified, they
have breached the professional behaviour under the Principle of Ethics.

3.3.     
Integrity

Under the Principles of Ethics, integrity emphasizes that
all parties be straightforward and honest in all professional and business
relationships. (Ethics Board, 2005)

As mentioned above, CAO and Chen failed to disclose the
investment losses that the company had made before the selling the shares to
Deutsche Bank for $120 million. According to the bank, they had asked questions
of the parent company before handling the transaction and CAO did not disclose
the issue throughout the whole transaction process. After knowing the losses
that CAO made, Deutsche Bank immediately resold the block of shares for only
$108 million and incurred approximately $12 million of losses (Arnold & Bradsher, 2004). Also, it has also
led to a 23 percent decrease in the company share price (Burton, 2004).

Instead of hiding the loss information, CAO should have
disclosed it to the public for better decision making. CAO’s action has led to
huge losses for Deutsche Bank and breached the integrity principle.