Special Report: " Rats" and " black mouths" gnaw at China stocks

SHANGHAI (Reuters) - Even before China's great stock market bull run of 2006-2007, Wang Jianzhong had become known as China's " god of stocks" for his prescient picks.

Such was his influence at the market's peak that reports by his company, Beijing Shoufang Investment Consulting, republished in dozens of influential newspapers and websites, were themselves often cited as a reason for a particular share price rising.

By late 2006, it was generally expected that whichever companies Wang recommended in his columns would be among the biggest gainers the next trading day in the Shanghai and Shenzhen markets.

Wang knew it as well, and put that knowledge to use.

Between January 2007 and May 2008, Wang bought shares in 38 companies, wrote reports on them, and then unloaded the stocks after his recommendations helped lift their share prices.

It was a lucrative ramping scheme. In 55 separate transactions during that time, Wang earned 125 million yuan ($19.5 million), according to regulators.

The financial sleight of hand has now given him the dubious distinction of being China's first convicted stock market manipulator. He was sentenced in August to seven years in prison and fined 125 million yuan, on top of having illicit earnings of the same amount confiscated.

While his case went hardly noticed in the Western media, Wang is now known as China's most famous " black mouth" -- a Chinese expression for a commentator who manipulates the market by talking up companies in which they have taken stakes.

Wang's case is just one high-profile example of widespread wrongdoing in China's capital markets, according to eight industry insiders interviewed by Reuters. The shady practices not only hurt millions of retail investors but create challenges for the foreign money managers and investment banks that invest their clients' cash in mainland Chinese equities.

Employees of Chinese brokerages, fund managers, and company executives are among those engaged in illicit activities, ranging from falsifying numbers on listing prospectuses to insider trading, the industry sources said.

These disclosures about how the markets are being manipulated follow a Reuters investigation into accounting fraud at Chinese companies listed in North American exchanges.

The accounting scandals exposed a subculture of bookkeeping shenanigans in Chinese finance, underscoring the dark side to the explosive growth of China's nascent financial markets and the risks to investors entering them.

FALSE IPO DATA

One of the most common of the illegal stock trading practices is including false figures for revenue and other data on IPO prospectuses, said one senior manager with a brokerage firm based in eastern China.

" It's just a bunch of bosses meeting up and filling in the forms. 'What kind of price do you want? We'll get you that price,'" said the source, who asked not to be identified for fear of repercussions.

" Often it's because someone's kid is doing a certain business, so if I help him with an IPO now, he might help me with something else down the road."

Another practice involves collusion between company executives and major institutional investors. They get together ahead of a planned secondary share offering, and agree to ensure the company's share price performs well enough to attract demand for the offering.

The investors then dump the shares after the offering when the share price has reached a high enough level. Along the way, commentators help talk up the stock among retail investors amid well-timed releases of positive news on the company, said another industry source, again on condition of anonymity.

" We'll set it up for them. Everyone will get together in a room and work out a schedule," the source said. " We'll know when the stock will reach a certain point, and set a target for when those involved will aim to get out."

The source declined to give names of particular companies affected by such practices for fear of incriminating his firm. But it is not uncommon to see share prices of some listed companies, especially smaller firms listed in the southern boomtown of Shenzhen, experience massive run-ups followed by precipitous falls after a secondary offering.

To be sure, that type of scheme is facilitated by the herd mentality of China's retail investors, who account for some two-thirds of stock market turnover and are known to trade on very short-term horizons based less on fundamentals than on daily rumors about policy support for certain sectors or deals by individual companies.

The sheer amount of effort the China Securities Regulatory Commission (CSRC) has devoted to combating the problem of insider trading is one indication of the extent of the problem.

The CSRC has in the past year published more than half a dozen statements about insider trading on its website, in addition to holding symposiums on the issue, after China's cabinet ordered a crackdown late last year.

The CSRC declined repeated requests for comment. But the regulator said in a statement on its website (http://www.csrc.gov.cn)

this month that it had taken on 83 new cases of market malpractice in the first half of this year, including 45 cases of insider trading.

" In the second half, with changes happening in market conditions and uncertainty in the external environment, illegal activities will take on new forms," CSRC warned in the statement. The regulator said " it will continue to prioritize the crackdown on insider training ... 'rat trading' and illegal information disclosure."

RATS' NESTS

The misuse of private trading accounts by mutual fund managers is a practice, which like that of " black mouths," is common enough to have been given a colorful nickname in Chinese: " rat trading."

The rats are fund managers who buy securities in their own personal trading account ahead of large purchases of the same security by their fund house, hoping to profit from a rise in the share price from their firm's larger transactions.

The CSRC has been especially cracking down on this practice because it is holding back the development of the mutual fund industry. In one illustrative case, the regulator meted out punishment to Huang Lin, former money manager at Franklin Templeton Sealand Fund Management Co in Shanghai.

Using an account in an associate's name, Huang, 32, bought or sold stocks from May 2007 to July 2008 ahead of transactions in the same stocks by the mutual fund he managed, the CSRC said.

Ironically, the 15 illegal transactions, which involved eight stocks, including Ningbo Huaxiang Electronics < 002048.SZ> and Huafa Industrial < 600325.SS> , resulted in a loss for Huang of 54,000 yuan, according to the watchdog, which said it collected evidence from trading and chatroom records.

The regulator barred him from working in the fund industry and fined him 300,000 yuan.

In the mutual fund industry, perhaps more than anywhere else, investor distrust is holding it back. The fund industry's assets under management have fallen steadily, to the point their equity holdings now account for only 19 percent of China's total trade able share capitalization, down from a third in 2007, according to Huatai United Securities.

" I suspect 'rat trading' has been quite rampant in the industry and only a fraction of such malpractices have been caught," said Zhang Haochuan, head of research at fund consultancy Z-Ben Advisors. " This has certainly hurt the industry's growth."

The reluctance of small retail investors to entrust their cash with professional money managers has, in turn, helped perpetuate a speculative investment culture that almost guarantees a volatile market, with amateurs engaged in herd-like day trading.

With distrustful investors avoiding mutual funds, the market is starved of stable long-term stock investments, the type that has helped support more mature markets.

That is at least one reason why China's stocks have not performed in line with record corporate profits and booming economic growth, which has averaged in the double digits for most of the last decade, analysts say.

The Shanghai Composite Index < .SSEC> fell 14 percent in 2010, when it was one of the world's worst performers despite the more than 10 percent growth in the economy. It is down another 14 percent so far this year.

CAUGHT IN OWN TRAP

Sometimes the rats get caught in their own trap.

In one example, real estate executive Qing Shaoqiu bought more than a million shares in the company he chaired, Shanghai Xingye Resources Holdings < 600603.SS> , just hours ahead of a share suspension, betting a merger his company was planning to announce would lead to a jump in share price.

It ended up being scrapped due to adverse market conditions, leading to sharp falls in Xingye's share price. When trading resumed, Qing was stuck with a 2 million yuan loss.

Not only that, last November the CSRC fined Qing, now 40, 200,000 yuan for insider trading, barred him for life from China's capital markets and banned from serving as an executive on any listed company for five years.

Such practices pose huge headaches for the 116 foreign institutions allowed to trade on China's equity and bond markets through the Qualified Foreign Institutional Investor (QFII) program.

Smaller companies can be especially challenging, many of them listed on the small- and medium-sized enterprise board and Nasdaq-style " innovation board" in Shenzhen, bordering Hong Kong. Their share prices are easier to influence by virtue of their smaller size, analysts say.

The CSRC has strict reporting requirements for the more than 2,200 companies listed in Shanghai and Shenzhen, but many analysts question the quality of the data, especially that of the smaller companies.

" You have some pretty creative accounting techniques that Chinese companies often use," said Kent Kedl, managing director of Greater China and North Asia with consultancy Control Risks.

" Some will have one set of books internally, one set of books for the tax authorities, and another one to potentially show investors. It's a pretty common thing."

That makes it essential for foreign investors to have an on-the-ground presence to oversee investment targets, said Ching Shao, chief executive and co-founder of the SMC China Fund in Shanghai.

" You really need to do your own due diligence," she said. " Not only talking to the companies, but going to talk to their competitors, their enemies, their suppliers -- the people who conduct business with them," she said. " That's really the very reliable source."

TOUGHER PENALTIES

Companies have gone to unusual lengths to corner any " rat traders."

" When you come in at 8:30 in the morning, you hand over your mobile phone. Then from the time you walk into your office to the time you sit down at your workstation, you're on camera," one fund industry source said.

" Once you log in, you're getting screen shots of your desktop every three or seven seconds. But what's the reality? Everybody's got three mobile phones because their line is recorded, so they use their mobile phones. And it happens a lot."

The problem is part of a much larger China syndrome. Whether it's food safety or rampant counterfeiting, those who want to cheat or cut corners will usually find a way around any restrictions, because enforcement resources are so woefully inadequate.

Industry participants have called for stiffer penalties for offences, and some point to the increasing trend of criminal penalties, including jail terms such as Wang's, as a sign of progress.

In many ways, the problems with China's markets are growing pains. The stock markets were established just over 20 years ago, and some of the problems of manipulation and insider trading that have cropped up also plagued more developed markets, especially when they were at a similar stage of development.

FAIR PLACE TO GAMBLE

Many retail investors shrug off the inherent disadvantage they face, with so many insiders privy to so much information that they are not. That includes the chronic leaking of important economic data, prompting the statistics agency to crack down on the practice this year.

" This market isn't healthy, it isn't fair, but what can I do?" said Ms. Xu, a 56-year-old retired worker, monitoring the prices of shares she had bought at a brokerage in the eastern city of Hefei, in Anhui province.

" I'm retired, and don't have much else to do. At least this way I can come here every day, have something to do, and the chance of making a little money," she said, surrounded by other retail investors, many of whom passed the time by knitting sweaters and playing cards.

While some individual investors might be resigned toward the market manipulations, the Chinese government itself has much higher expectations, announcing plans to turn Shanghai into a global financial center by 2020.

" Things have actually been improving quite a lot, especially for larger enterprises," said Geng Xiao, an economist who formerly worked for the Hong Kong Securities and Futures Commission and is now director of research for the Fung Global Institute in Hong Kong.

But, he added, regulators need to do more to stamp out insider trading and other market malpractices. They need to provide better oversight, particularly of smaller companies, if they hope to make China's capital markets serve their ultimate function of channeling investment to the most deserving ends.

They will never be able to erase the rambling-gambling nature of China's markets, he said.

" I'm not against it being a casino, because it is in a way," he said. " But it has to be a fair, efficient casino. And then you can use that to diversify risk and allow people to help the real sector."