Quotes of the Day

Members of the board of directors of China National Offshore Oil Corp. (CNOOC) had an inkling that something was up the day they gathered in Hong Kong this spring for a regularly scheduled meeting with the firm's top management. Rumors that CNOOC, the third largest oil company in China, might make an audacious bid to buy Unocal, the ninth largest oil company in the U.S., had appeared in the financial press as early as January, although CNOOC never confirmed the stories. Board members also knew that CNOOC, in an effort to boost its ability to fuel China's booming economy, had been scouting more than 100 companies with oil and gas reserves for possible acquisition.

But the subject of buying Unocal had never before been discussed at a board meeting—which meant that when they sat down with CNOOC's CEO Fu Chengyu and other top executives on March 29 in a conference room at the Island Shangri-La in Hong Kong, they were in for a shock. CNOOC, Fu told them, was ready to make a play for the Los Angeles-based oil company. "The ship was about to leave the port, and the [directors] hadn't even known there was a ship," says one adviser to CNOOC with knowledge of the meeting.

In the months since, CNOOC's $18.5 billion bid for Unocal—which threatens to trump a rival $16.5 billion offer by Chevron—has created a storm of opposition in Washington. To CNOOC's surprise and dismay, its bid has become a locus for all the angst some Americans feel about China's rising economy, adding further tension to already strained trade ties between the U.S. and China. The U.S. House of Representatives passed a resolution on June 30 warning that the proposed acquisition poses a threat to national security and urging the Bush Administration to block any deal.

Obscured by the political hysteria is the fact that, according to U.S. Securities and Exchange Commission (SEC) documents seen by TIME, CNOOC, not Chevron, was actually Unocal's first choice as a merger partner. Some beltway politicians would paint CNOOC, which is 70% state-owned, as an arm of a Communist government out to strip the U.S. of vital energy supplies. TIME's reporting on the genesis of CNOOC's Unocal bid—dubbed "Operation Treasure Ship" by the Chinese company's investment bankers—reveals a far more complicated reality. CNOOC is a flagship Chinese firm determined to emerge as a major player in the global oil business, rewarding its shareholders in the process. The Unocal bid was its coming-out party, but at times, for Fu Chengyu & Co., it's been anything but fun. It has, so far, shown top management to be not completely fluent in Western-style corporate governance, or aware of the political backlash its acquisition attempt might spur across the Pacific.

CNOOC is not the typical, lumbering, command-economy-era dinosaur that still plagues corporate China. In early 2001, it sold a 30% stake in the company to the public, and these shares trade freely on the Hong Kong and New York stock exchanges. CNOOC officials take pride in their success at running an outward-looking firm that generally operates without Beijing's direction. The company is overseen by a strong eight-person board that includes four foreigners as nonexecutive, or outside, directors.

In fact, CNOOC's top management may have underestimated just how seriously its outside directors took their role. When it became clear at the meeting in late March that the board had been left mostly in the dark about CNOOC's plans for Unocal, a few outside directors, including former Swiss ambassador to China Erwin Schurtenberger and Goldman Sachs Asia vice chairman Kenneth Courtis, rebelled, forcing Fu to pull back just as Operation Treasure Ship was about to set sail. Ever since, CNOOC has had to play catch-up against Chevron in the fight for Unocal.

The board's revolt in March reflects the growing pains that an ambitious Chinese company is going through even as it tries to present a confident face to the world. Indeed, the issue of what CNOOC's board knew and when remains a touchy subject for Fu as the takeover fight progresses. In an interview with TIME, he declined to say exactly when he told his board of his intentions toward Unocal. But the reason for the board's initial ire is clear: according to SEC documents, as far back as December, Fu had directly discussed the possibility of acquiring Unocal with the California firm's CEO, Charles Williamson. For CNOOC, the potential magnitude of the deal (the companies are of similar size) was breathtaking, and the risks involved—from the debt CNOOC would have to take on to finance an acquisition, to a possible downturn in oil prices—were substantial. That Fu hadn't informed the board of his thinking, or of his conversation with Williamson, infuriated several of its members.

Fu downplays the initial discourse with Williamson, saying he was simply talking with someone his company had done business with in the past, and the topic of a possible merger came up only briefly. But the first time Chevron's CEO, David O'Reilly, spoke to Williamson about a possible merger—just weeks after Fu's conversation with Unocal in December—the Chevron chief was politely rebuffed, according to SEC documents. If Unocal was going to be sold, it appears that CNOOC had already been given first dibs.

O'Reilly, however, was not dissuaded. He wanted to expand Chevron's footprint in Asia. Unocal owns valuable production and distribution facilities and has a stake in oil and gas reserves in Thailand, Indonesia and Burma. On Feb. 7, Williamson told O'Reilly that he had been approached by others—Italy's Eni, a partly state-owned oil and gas company, had also expressed interest at this point—and that Unocal's board would evaluate any and all offers. That's what O'Reilly had wanted to hear: Unocal was now officially in play.

Two weeks later, O'Reilly convened a meeting of Chevron's board, which received a detailed briefing on Unocal. On Feb. 23, the board gave its go-ahead to him to pursue a deal. But in early March, Unocal's board rejected Chevron's initial offer—an all-stock deal worth less than $60 per share. "They wanted some cash on the barrelhead and knew CNOOC would be coming forward with a cash bid," says a banker who advised Unocal.

In less than a month, Fu intended to do just that. But by late March, he still hadn't informed his directors. "He was treating his own board as an afterthought," says one source close to the outside board members. "It was very much the China of 20 years ago in the way the directors were treated initially—where the boss decides and the board just rubber-stamps everything. Why were they treated that way? I don't have a clue."

On March 28, Unocal CEO Williamson again spoke to Chevron's O'Reilly, telling him that he was expecting formal bids from both CNOOC and Eni in the next few days, SEC documents reveal. He also said that if Chevron wanted to get back into the game, it should make an improved offer before Unocal's board reconvened two days later. O'Reilly, again with his board's backing, complied, coming up with an improved all-stock deal.

Now the ball was in CNOOC's court, and Fu, by all accounts, was confident as his board gathered in Hong Kong. He did not see the rebellion coming, says a banker close to CNOOC. Three key outside directors—former Shell Chemicals CEO Evert Henkes, former Swiss ambassador Schurtenberger, and Courtis of Goldman Sachs—all raised pointed questions at the meeting. According to sources with knowledge of the meeting, Schurtenberger—presciently, as it turned out—questioned whether the company was prepared for what was likely to be a hostile U.S. political reaction to the deal. Henkes wondered about the debt load that CNOOC would have to take on to finance the transaction—the firm is seeking to borrow about $16 billion. He asked whether a partner might be brought in to absorb some of the risk. (This was something Haier, a large Chinese appliance company, did, by turning to a U.S. private-equity firm as its partner in making a bid for Maytag last month.)

The meeting was civil—"no one was shouting or pounding the table," says one attendee—but as the questions mounted, it was clear that Fu did not have the board's backing. At least not yet. On April 1 he called Williamson, telling him he needed to do a bit more work with his board but that CNOOC would still make a formal bid in time for another Unocal board meeting the following day. He was mistaken. Schurtenberger, privately, was seething. "For him it was a trust issue," says a friend of his. "Beyond all the questions about strategy or debt, he just couldn't believe the board was being treated in this fashion." (Schurtenberger declined to comment to TIME.)

The directors told Fu that they would not back the bid unless they were given more time to study it. Fu agreed, and had to phone Williamson back on April 2 and climb down, telling the Unocal CEO that CNOOC would not be coming forth with an offer that day after all. "That couldn't have been an easy call to make," says a source close to Fu. "It was like calling off a wedding at the last minute, with all the guests in church."

Even worse, from CNOOC's standpoint, Unocal was now preparing to marry someone else. Williamson had told Chevron's O'Reilly that he needed to sweeten his bid further—and include some cash—in order for Unocal's board to approve it. O'Reilly did so, and with CNOOC suddenly sidelined, Chevron was in the driver's seat. Unocal's board in Los Angeles met into the wee hours on April 3. At 4:30 a.m., O'Reilly and Williamson signed a merger agreement.

Meanwhile, at Courtis' urging, CNOOC's board insisted on hiring an outside investment bank—NM Rothschild & Sons—and an energy consulting firm to do their own independent evaluation of the deal, in the hope that the board and Fu might eventually find some common ground. But Schurtenberger wasn't going to stick around for the results. On April 4, he submitted his resignation from the board in writing, citing health reasons. (He has had prostate cancer for many years.) When Courtis failed to appear on the dais at the annual shareholders' meeting the next month in Hong Kong, it caused a stir. Had he resigned too? The first question to Fu from the small audience of Chinese journalists in attendance was, "Where is director Courtis?" Fu smiled and said, "His plane from London was late, it just got here. He'll be at the board meeting that follows."

The independent reports came in. One source describes their findings as "explanatory for the most part, not strongly endorsing a deal, but not entirely negative, either." Fu put the matter to the board again. Courtis, who had not resigned, was now in a difficult position. Advisers to CNOOC have said he still had reservations about the deal. But his employer, Goldman Sachs, had been hired by CNOOC as its investment adviser and stood to reap a significant reward for its efforts only if the deal went through. When it came time for another board vote, Courtis recused himself. Henkes, critically, did not oppose it, and neither did anyone else on the board.

CNOOC was back in the hunt, with a gold-plated army of advisers behind it. Besides Goldman Sachs and JPMorgan, the company had hired Akin Gump Strauss Hauer & Feld, one of Washington's pre-eminent lobbying firms, as well as the same media consulting company that has worked for George W. Bush's two presidential campaigns. Finally, with his board's backing, Fu on June 22 announced its $18.5 billion all-cash bid for Unocal. "It's the superior offer and I believe we'll prevail," he told TIME in early July. His advisers insist that's not bravado. "He really thinks we're going to win this thing," says one of his bankers.

He may be right. Chevron has not yet countered, so CNOOC's remains the richer bid as Unocal shareholders prepare to vote on Aug. 10. But despite all the high-priced bankers and lobbyists, Fu did not appear to be prepared for what Schurtenberger had discussed at the board meeting in late March: the political firestorm the bid would provoke in the U.S. Fu, CNOOC sources say, was stunned by the June 30 Congressional resolution objecting to the merger. So was the Chinese government. One of Fu's advisers says Beijing, already sparring with Washington over the value of China's currency and U.S. quotas on Chinese-made textile imports, was not expecting a hornet's nest to be stirred up.

In Washington, CNOOC responded last week by trying to kick-start the approval process, asking the Committee on Foreign Investment in the United States (CFIUS), run by the U.S. Treasury Department, to begin its analysis of the bid. The only problem was, CFIUS, an interagency body that reviews mergers between foreign and American companies for potential U.S. national-security risks, gets to work only after a deal is done. It won't move until it is clear that CNOOC is going to win Unocal. Banking sources say Chevron may well wait until shortly before the Aug. 10 Unocal shareholders' meeting before announcing a sweeter bid, hoping to end matters then and there. But Unocal's own investment bankers, Morgan Stanley, appraise Unocal's stock at between $55 and $68.25 per share—not that far from the $67 that CNOOC has already offered. Wall Street already views CNOOC's bid as rich. Increasing it will prompt shareholders to wonder whether it is overpaying.

How much higher might the two companies vying for Unocal go? Fu said in an interview last week that his "board is determined to win this bid," a statement some interpreted as a sign that CNOOC will counter a higher Chevron offer. Unocal last week told CNOOC executives that its board might still be open to a merger with the Chinese company if CNOOC meets certain conditions, including shedding some of Unocal's American assets to appease political opponents worried about the loss of domestic U.S. reserves. Directors Courtis and Henkes have been pushing this idea for months, banking sources say, and Fu himself is considering it.

According to TIME's sources, CNOOC's CEO may also decide to bring in a U.S. partner to help shoulder some of the risk and defuse the anti-Chinese political atmosphere. A spokesman for CNOOC denies that this option is being considered—"we're full steam ahead with our current bid"—but some analysts believe bringing in a partner would have been the wisest course from the start. If it happens, it may also be a signal that in the midst of a historic transpacific takeover bid, CNOOC's management and its board may finally be on the same page.

• Bill Powell | Shanghai
• When CNOOC's CEO set his sights on Unocal, he had no idea of the storm he'd cause in D.C. and his boardroom