What areas of law are pertinent to this case study ? Describe what the identified areas of

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What areas of law are pertinent to this case study? Describe what the identified areas of law cover, and explain how they are relevant to the issues raised in the case study. (9 marks) (Question requires a review of the content from Module 9 - The nature of law and sources of law)

RIO TINTO: A CANARY IN THE COAL MINE

Case overviewI

This is the abridged version of a case prepared by Alwyn Thu Naung Zaw, Andy Chang Guang Hao, Bernardus Christianto and Brent Thu Nyi Zaw under the supervision of Professor Mak Yuen Teen. The case was developed from published sources solely for class discussion and is not intended to serve as illustrations of effective or ineffective management or governance. The interpretations and perspectives in this case are not necessarily those of the organisations named in the case, or any of their directors or employees. This abridged version was edited by Isabella Ow under the supervision of Professor Mak Yuen Teen.

After a costly major acquisition in 2007 which resulted in a huge impairment, Rio Tinto made the US$3.7 billion acquisition of Rio Tinto Coal Mozambique (RTCM) in 2011. Subsequently, Rio Tinto wrote off US$2.86 billion in impairment charges for the RTCM acquisition in February 2013, before finally selling the Mozambique coal assets for US$50 million in 2014. This was followed by the resignation of its Chief Executive Officer (CEO) and Chief Financial Officer (CFO). The U.S. Securities and Exchange Commission (SEC) later charged Rio Tinto, its ex-CEO and ex-CFO, with fraud in October 2017. The charges relate to the failure to promptly disclose the nature and extent of unfavourable developments in the valuation of RTCM to the board of directors, the Audit Committee and investors. The objective of this case is to allow a discussion of issues such as the role of the board and external regulatory bodies; conflict of interests; due diligence in acquisitions; competencies of the board and management; and the importance of timely and objective disclosures. 376

Mining giant Rio Tinto

Founded in 1873, Rio Tinto is one of the world's largest mining corporations.1 Its core business is to find, mine and process mineral resources. The Rio Tinto Group consists of Rio Tinto plc and Rio Tinto Limited - the former is registered in England and Wales, while the latter is registered in Australia. Despite its dual company structure, both business entities are managed together, with them sharing the same board of directors. Rio Tinto is listed on three stock exchanges - the New York Stock Exchange, the London Stock Exchange and the Australian Stock Exchange.2

Tom Albanese was Rio Tinto's CEO, having been appointed in May 2007.3 He was a member of the board of directors.4 Prior to this, he had been an executive within Rio Tinto, having worked his way up the organisational ladder over 13 years.5

Albanese's right-hand man was CFO Guy Elliott. Elliott was appointed Finance Director in 2002,6 and had experience in marketing, operations management and strategy. He was one of the few FTSE 100 CFOs who was neither a qualified accountant nor had any background in finance.7 Elliott had been a member of the board since 2002.8 Since 2010, he had also been a non-executive director of Royal Dutch Shell plc, and was the Chairman of its Audit Committee since May 2011.9

Bad judgement or bad timing?

Just a few months into his job, Albanese got into a bidding war for the acquisition of Canadian mining company and aluminium manufacturer Alcan Inc (Alcan).10 Eventually, Rio Tinto bought Alcan for US$38.1 billion, which included a hefty 65% premium. In a Wall Street Journal interview, Dick Evans, former CEO of Alcan, said that the Alcan acquisition was the "worst decision ever, the largest metals and mining transaction in the history of the world at the high point in the commodity cycle".11

Shareholders approved the Alcan acquisition as it was a period when commodity markets were booming. However, after the acquisition, China made its entrance into the aluminium industry and flooded the market with low-cost aluminium, and aluminium prices subsequently fell. The global financial crisis that followed soon after sent commodity prices crashing further.12377

As a result of the series of negative external factors, Rio Tinto took some US$29 billion in impairment on Alcan.13 From then on, the stakes were high for Albanese, as another costly acquisition mistake could mean a loss of reputation.14

Once bitten, not shy

Four years later, in April 2011, Rio Tinto acquired RTCM - a coal business in Mozambique - from Australian mining company Riversdale Mining, for US$3.7 billion.15 This transaction represented the second large-scale acquisition under Albanese's leadership at Rio Tinto. At that time, the acquisition seemed to be in line with senior management's strategy of finding undervalued assets and turning them around.16 It was speculated that the acquisition went ahead in part to restore market confidence in Albanese's deal-making capabilities following the disastrous Alcan acquisition.17

Post-acquisition, Rio Tinto had expected to mine, transport and sell over 40 million tonnes of coal annually by moving the coal down the Zambezi River to a port on the Indian Ocean.18 Unfortunately, in October that same year, Rio Tinto realised that its barging assumptions were not realistic, with the value of the acquired assets estimated to be approximately US$2.1 billion.19 More bad news came when the Mozambique government rejected Rio Tinto's proposal to use the Zambezi River for coal transportation in December 2011, citing environmental concerns.20 By the end of 2011, Rio Tinto realised that it was only able to transport and sell five percent of the coal originally assumed.21

In January 2013, Rio Tinto announced a US$14 billion write-down, which mainly related to Alcan and the Mozambique coal assets.22 A further write-off of US$470 million was recognised for the Mozambique coal assets in February 201423 before Rio Tinto eventually sold them for US$50 million in August 2014, washing its hands off the bad mistake.24378

Albanese stepped down as CEO in January 2013,25 before Elliott followed suit three months later.26 Australian Sam Walsh, who previously headed Rio Tinto's iron ore operations, then took over the CEO position. Walsh managed to cut operating costs by US$2 billion, reducing exploration and development costs by US$1 billion and reducing capital expenditure from US$17.5 billion to US$13 billion in the financial year 2013.27 During his three-year term, Walsh steered Rio Tinto back on track and left the company in "reasonably good shape"28 for his successor, Jean-Sebastien Jacques.

Compensation structure

The compensation structures of both top executives consisted of four components - base salary, short-term incentive plan (STIP), long-term incentive plan (LTIP), and "others".29,30 While the STIP focuses on the achievement of annual performance goals based on certain key performance indicators, the LTIP incentivises executives to meet long-term strategic goals and encourages retention of the executive team.31

During the saga, the amount of compensation derived from the STIP was inherently tied to impartment charges that the Group took. In 2011, Albanese and Elliott voluntarily chose to forgo being considered for the STIP due to the impairment charges for the Alcan acquisition,32 and in the following year, Elliott's STIP was revoked after the Remuneration Committee took the RTCM impairment charges into consideration.33

In Rio Tinto's 2012 Annual Report issued on 6 March 2013, the Remuneration Committee stated that it undertook a wide-ranging review of its LTIP arrangements and implemented changes. The LTIP was simplified by reducing the number of performance share plans (PSP) from two to one. An additional performance metric - Earnings Before Interest and Tax (EBIT) margin - was also added to measure the long-term performance of Rio Tinto. The vesting and performance period for PSP awards were also increased by a year to five years. 379

In addition, malus and clawback provisions were introduced to give the Remuneration Committee the authority to reduce or cancel LTIP under certain circumstances. PSP awards will be reduced or cancelled "in the event of gross misconduct, a materially adverse error in the Company's or a product group's financial statements, or exceptional events that have a materially detrimental impact on the value of any Group company".34 A clawback, which recovers the value of shares vested under the PSP, will occur when there is a "deliberate misconduct by a participant which has a material impact on the value of reputation of a Group company".35

Is anyone listening?

The Audit Committee

In financial year 2011, Rio Tinto's Audit Committee consisted of Ann Godbehere as its Chairman, as well as Michael Fitzpatrick, Lord Kerr, Paul Tellier, and Vivienne Cox.36 They shared many years of relevant work experience in energy giants such as BP plc and Royal Dutch Shell plc, and possessed financial and accounting backgrounds.37 In its 2011 Annual Report, Rio Tinto had disclosed that one of the tasks that the Audit Committee engaged in during the year was to "focus on impairment, acquisitions and the Annual Report."38

External auditors

PricewaterhouseCoopers (PwC) has been the external auditors of Rio Tinto since 1995. In its 2011 Annual Report, Rio Tinto disclosed that "PwC has followed the requirements of the Sarbanes-Oxley and APB Ethical Standards and rotated the audit partner at least every five years".39

The 'whistleblower'

In August 2012, Rio Tinto's former head of technology and innovation, Preston Chiaro, together with his team, conducted an in-house review of the RTCM acquisition, before concluding that the Mozambique assets' value ranged from negative US$300 million to US$4.9 billion.40 Chiaro then communicated the adverse findings to Elliott via a phone call in November 2012. Elliott responded that he would raise the valuation issues at the Audit Committee meeting.41380

Unfortunately, Elliott neither disclosed the negative valuation findings to the Audit Committee nor took any action to address the issues flagged out by the technology and innovation division. As a result, Chiaro bypassed the chain of command and went directly to Chairman Jan du Plessis to voice his concerns in December 2012. Upon hearing the shocking findings, du Plessis launched an investigation, resulting in a heavy impairment of the Mozambique assets.42

Uh oh, was it fraud?

"They tried to save their own careers at the expense of investors by hiding the truth,"

- U.S. SEC, October 201743

On 17 October 2017, fraud charges relating to inaccurate disclosures on the value of RTCM were brought against Rio Tinto, Albanese, and Elliott by the SEC. The SEC alleged that Rio Tinto "failed to follow accounting standards and company policies to accurately value and record" the Mozambique assets. Further, Albanese and Elliott were accused of delaying disclosure of the adverse valuation to Rio Tinto's board of directors, Audit Committee, independent auditors, and investors in order to save their own careers.44

The SEC also alleged that Rio Tinto used materially misleading statements and omissions concerning RTCM's valuation to raise a total of US$5.5 billion from investors through U.S. debt offerings. Furthermore, of the total amount raised, approximately US$3 billion was obtained in an offering that was launched immediately after Albanese and Elliott learnt of RTCM's negative US$680 million valuation.45

There were critics who questioned the nature of the SEC's allegations and claims made against Rio Tinto, Albanese and Elliott. They said they found it curious that the SEC had moved beyond the facts of the case by stating what it believed to be the motives of Albanese and Elliott in committing the alleged fraud.46,47381

Others join the action

Apart from the SEC, other authorities in the United Kingdom and Australia have also taken action against Rio Tinto. In October 2017, the United Kingdom's Financial Conduct Authority (FCA) found Rio Tinto guilty of breaching the FCA's Disclosure and Transparency Rules by not carrying out an impairment test and failing to recognise an impairment loss on the value of its Mozambique assets when it released its 2012 interim results on 8 August 2012. In a statement issued, the FCA said that Rio Tinto's decision not to carry out an impairment test on the assets despite the dismal internal financial modelling results "demonstrated a serious lack of judgement". As a result, Rio Tinto paid a 27.4 million fine.48,49

The mining giant also faced charges by the Australian Securities and Investments Commission (ASIC).50 The ASIC's investigation, launched in March 2018, had initially focused on the disclosures in the March 2012 annual report about the extent of coal resources in Mozambique. The case evolved over the following few months, and in May 2018, the ASIC alleged that Rio Tinto had engaged in "misleading and deceptive conduct". Albanese and Elliott were also accused of breaching the Corporations Act.51

Lessons learnt?

As the legal battles with the authorities waged on, Rio Tinto strongly defended itself against the accusations and charges, denying that it had withheld information from shareholders.52 Regardless of the eventual outcome, the reputational damage on Rio Tinto, Albanese and Elliott has been done. The Rio Tinto case is a reminder to companies and executives alike on the importance of making timely disclosures as well as the importance of corporate governance.