Rio Tinto: a breakdown of trust, not just rule of law

Rio Tinto: a breakdown of trust, not just rule of law

On Monday, a Chinese court sentenced four executives of Australian mining company Rio Tinto to lengthy prison terms for bribery and stealing commercial secrets.

In the eight months since Australian citizen Stern Hu and his Chinese colleagues Wang Yong, Ge Minqiang and Liu Caikui were arrested, we’ve learnt a great deal about the lack of rules not only in China, but also in the global commodities trade. Some of that is China’s fault, but hardly all of it.

Foreign media coverage of the arrests and trial has focused on whether the Chinese authorities pursued this case for political reasons. Early last year, cash-starved Rio Tinto angered China by inviting Aluminum Corp. of China, or Chinalco, to take a $19.5 billion equity stake and then backed out of the deal under a combination of shareholder, government and public pressure. Rio was also driving a tough bargain in iron ore price negotiations with Chinese buyers. Many observers speculated that the four executives were pawns in a high stakes game of tit-for-tat orchestrated from Beijing.

Certainly the timing of the case makes such suspicions inevitable. But the reality is probably more complicated. The Chinese justice system may be manifestly unfair, and once it gains momentum, a guilty verdict is a foregone conclusion. Yet Rio itself put forces in motion that led to four men losing their freedom.

It all started with the boom in the global iron ore market in the early 2000s. That’s when China’s steel industry embarked on a significant expansion of capacity, turning the trade in ore from a buyer’s market to a seller’s market. China’s large state-owned steel makers bought at the benchmark price negotiated by Japanese and Korean mills, while smaller firms had to pay the higher spot price. This created an incentive for arbitrage and corruption, but unfortunately both the Chinese government and the mining companies were slow to take account of this in their internal controls.

As demand soared, the benchmark and market prices for iron ore diverged and the system came under increasing stress. Rio Tinto began to back out of its contracts, for instance by invoking clauses in contracts to hold back 10% of deliveries, which could then be resold at the spot price. Rio’s Hu himself acknowledged the problem. In 2008, after Rio negotiated an 87% price increase, Australian reporter John Garnaut interviewed him: “He said he had no qualms with driving as hard a bargain as he could on price. But he had misgivings about whether Rio Tinto should risk its integrity in China by claiming ‘force majeure’ to wriggle out of long-term contracts to chase higher prices elsewhere. ‘We acted in accordance with the letter of the contracts, but not the spirit,’ he said."

This weakening of the bonds of contract naturally infuriated Chinese steel makers. So when the economic crisis hit at the end of 2008 and demand for iron ore evaporated, it was payback time. Enjoying a buyer’s market, Chinese firms simply walked away from contracts.

The turnabout didn’t last long. Beijing’s fiscal stimulus quickly revived demand for steel by the middle of 2009, and the Australians were able to start raising prices again. Negotiations over new iron ore benchmark prices were particularly acrimonious, given the bad blood created over the past years. And that was the state of play when Hu and his colleagues were arrested on 5 July.

One past participant in the iron-ore business, who insists on anonymity, believes that the investigation was ongoing for many months before the arrests, meaning they were not directly related to the Chinalco fiasco or the ongoing price negotiations. And some dirt was found.

Rio Tinto has severed its relationship with the executives, saying they engaged in “deplorable behaviour", effectively accepting the verdict that they were taking kickbacks from steel makers to arrange preferential access. The bosses in Australia made the mistake of leaving their Chinese executives in place for too long with too little supervision. But the bigger mistake was destroying the trust of the handshake deals made with Chinese partners in the quest for a little extra margin. That is bad practice anywhere, but especially in China.

Chinalco has not held a grudge against Rio for the failed equity deal. The two companies continue to negotiate joint projects in countries such as Mongolia and Guinea. The Chinese government’s own post-mortem report on the affair is relatively kind to Rio and admits that the Chinese side could have handled the deal better. However, the government of Australian Prime Minister Kevin Rudd does not come off so well. The lack of transparency and hostility towards China came as a complete surprise to Beijing.

It was bad luck that around the same time, Xinjiang dissident Rebiya Kadeer was invited to Australia and Canberra issued a defence white paper that singled out China as a potential threat. From Beijing’s perspective, these all suggested that Australia was turning hostile and there was no certainty about the rules for Chinese companies doing business.

Everyone doing business in China should be clear by now on the rules— there is no rule of law. Deals can be done on the basis of mutual trust, which creates some level of certainty. The four Rio Tinto executives may be guilty of corruption, but the real reason they are in prison is because that trust broke down.


Hugo Restall is a member of the WSJ editorial board.

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