September 10,2009

SOEs May Sue Derivative Transaction Counterparties

By CSC staff, Shanghai

Litigiousness, thy name is not America! (At least not necessarily)

Chinese state-owned enterprises (SOEs) suffering huge losses from fuel hedging transactions are threatening to strike back at their counterparties by taking them to Court.

According to China Business News, a financial adviser for a central firm with such a loss says: "We have ample evidence showing that some of the SOEs participating in fuel hedging transactions have been cheated by foreign investment banks in the process of signing contracts, so those contracts are invalid because of deceit. I believe that these SOEs will have high possibility in winning a suit."

The adviser would disclose neither his name, the name of his company nor the foreign investment bank out of professional secrecy. He and other partners become financial advisers to the firm around the Spring Festival (February), when the enterprise found itself facing big time losses in its hedging transaction.

It has been rumored that SOEs may have been mistreated by foreign investment banks, but there has been no show of fact. The financial advisor said that according to the evidence they have collected, including e-mails, written promotion materials, online communications records, and analysis and valuation on the contract signed by the firm and the foreign investment bank, they can draw two conclusions: there were false statements in the process of signing contracts, and the contracts have no investment value, let alone hedging function.

"For example, you have a tomato, but say it is an orange. And I buy it as an orange because I have not seen oranges. You can say I am stupid, but the sale is a kind of fraud in itself," the financial adviser says. He added that "the contracts signed by some SOEs with foreign investment banks are not hedging contracts, the nature of which having been changed through product structure adjustment, packaging and additional terms by foreign investment banks. We have negotiated with a foreign investment bank, asking them whether the contract is hedging contract, and they are speechless."

"We have learnt that senior managers of these SOEs and their articles of association have no speculative intention in transactions. Then why did they sign contracts with speculative nature? Because they did not know such complex derivatives," the insider said. "Foreign investment banks have rich experience in product design and it is difficult for outsiders to find problems. With their strong marketing and public relations capacity, banks can easily persuade counterparties to sign the contracts."

He continued, "What is more, we have found that these so called hedging contracts do not even have speculative value. Speculation is like buying lottery tickets. Despite the slim chance of winning, you can earn a lot if you win. According to these contracts, if oil prices rise, the costs for SOEs in the spot market will rise, but its earnings from derivatives will be very small. Once oil prices fall, these firms will make double compensation to their counterparties, and the losses may become a bottomless pit."

Air China signed OTC contracts with several foreign investment banks around last October. Crude oil fell from $100/barrel at that time to $40/barrel by the end of last year. The loss of fair value for Air China reached 6.8 billion yuan while Eastern Airlines lost about 6.2 billion.

Recently, loss suffering SOEs sent letters to their counterparties, and they are investigating the issue and reserving recourse rights. On September 7, the State-owned Assets Supervision and Administration Commission said it would pay close attention to the issue and provide assistance because SOEs' move is to use legal means to safeguard legitimate rights and interests.

"At present, some of the enterprises have not yet decided how to solve the problem, and they can choose between prosecution, arbitration and negotiations. I believe we can win if we resort to prosecution," the financial adviser said.

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