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Fair Trade

A typically opaque investigation can begin with a tip from a Shanghai Stock Exchange official and end with a ten-year jail term for a businessman convicted of insider trading. What happens in between is a carefully guarded secret.

Likewise hidden from the public eye are the job’s inherent dangers.

“We can get rid of a person for 300,000 yuan” was an indirect threat delivered to one securities inspector after he started working on an insider trading tip, according to an inspector who helped investigate the suspicious, Shenzhen-listed cement company.

In a similarly frightful incident, a gang of thugs came close to hurling a whole team of inspectors and auditors from a hotel window for looking into allegations of a falsified financial report.

“More than a dozen people showed up at our hotel room, surrounded us, and said if we didn’t resolve the problem, they’d throw us from the ninth floor,” said one of the threatened inspectors, all of whom survived the ordeal.

Yet beyond the thugs and death threats, deep inside China’s equities supervision system, even greater hazards lurk.

For example, high-level officials have admitted the system is beset by a nationwide shortage of qualified securities inspectors. And inspectors themselves struggle with their tasks because they have neither adequate enforcement power nor even basic judicial support for securities law.

Tracking down a company boss who manipulates earnings statements to benefit from higher stock prices takes time, people, and money. Success often hinges on cooperation between the nation’s securities watchdog, the China Securities Regulatory Commission (CSRC), and a variety of law enforcement agencies, including the Ministry of Public Security and local courts.

Since taking over the CSRC last year, Chairman Guo Shuqing has pledged more resources for the agency. He says he will give his inspection staff more investigative clout as well as better protection. The ultimate goal is to intensify the battle against market abuse and root out stock traders who game the system.

At an awards ceremony for the agency’s best auditors January 6, Guo called for rapid action to protect the nearly 23 trillion yuan securities industry.

“Insider trading, market manipulation, fraudulent listings, and other illegal activities have not only seriously distorted the normal path for investors seeking returns but have also severely harmed investor confidence and critically affected normal market functions,” Guo said.

The system needs strong, “expert” inspectors who are well protected so they can do their jobs, Guo said. He’s also promoting teamwork to support market stability and a policy of “zero tolerance” toward illegal behavior.

Steep Challenge

Climbing a sheer cliff might be easier for Guo. To meet his lofty goals, huge changes will be needed inside the CSRC structure as well as for the securities market’s legal framework.

As an administrative agency, CSRC lacks judicial investigative powers. Its inspection teams can neither legally subpoena nor tap phones for evidence they may need in an investigation.

Underscored by occasional death threats, inspectors as well as low-level CSRC staffers frequently encounter fierce resistance from companies and businesspeople targeted by probes. Moreover, because lying to a securities inspector is not considered perjury in China, squeezing the truth out of a suspect or his contacts can be difficult, if not impossible.

The nation’s securities law says violence or a threat against anyone working for a securities regulator is punishable by no more than three years in prison—a seemingly light sentence for a thug who throws men from windows.

The law gives CSRC seven, quasi-judicial powers, including the right to conduct on-site investigations, request and collect evidence, demand transaction records, and freeze bank accounts. But in practice, inspectors’ hands are often tied by a lack of resources and an inability to coordinate with other agencies.

Caixin learned from regulatory authorities that inter-departmental coordination is difficult for securities inspectors. CSRC inspectors must first seek cooperation from other government agencies if they want to access details from targeted bank accounts, phone records, and other sources of evidence. And there’s no effective mechanism for coordinating with others to get crucial information.

CSRC’s investigation teams were supposed to get bigger teeth after a 2002 reform drive led by then-Premier Zhu Rongji led to a merger of the Ministry of Public Security’s Securities Crime Investigation Department and CSRC’s Second Inspection Bureau. But in 2006, a public security restructuring weakened that department.

The restructuring “led to new challenges for the cooperation between these two sides of law enforcement. Some in the industry saw it as a step backward for enforcing securities law,” said a legal expert familiar with the securities supervision system.

In other ways, CSRC has been allowed to strengthen its headquarters inspection force. In late 2007, for example, the State Council approved reforms for the securities law enforcement system that let CSRC assign a chief inspector to lead its Inspection Bureau and a separate inspection team.

The bureau tracks and oversees basic casework from office desks, while inspection team members conduct their operations quietly, sometimes undercover, in the field.

In addition, CSRC established an independent Administrative Punishment Committee to hear completed case reports and impose disciplinary action, if necessary, such as firings of wayward government officials. The committee can also levy fines.

The committee functions separately from the courts, however, which has the power to try, convict, and sentence serious securities law violators based on CSRC inspections.

Since the most recent inspection enforcement reform, CSRC inspectors have pursued 387 cases. Public security officials and the courts have been handed ninety-two of these cases, including twenty-five last year, twenty-eight in 2010, nineteen in 2009 and twenty in 2008.

Despite progress, the inspection team remains relatively small and the caseload light relative to the size of China’s securities markets. Shares in 931 companies were trading on the Shanghai Stock Exchange at the end of 2011, and more than 480 were listed on the main board in Shenzhen. Shenzhen’s growth board, ChiNext, has around 270 listed companies.

Caixin learned that the CSRC inspection team has only 140 members but is supposed to have 170 on the job. In addition, the commission has embedded nearly 300 inspection and enforcement staffers at various financial institutions around the country.

And the ratio of inspectors in areas with large numbers of listed companies is grossly inadequate. Caixin learned, for example, that local inspection offices in cities such as Shenzhen and Beijing, and provinces such as Zhejiang and Jiangsu, may have fewer than twenty staffers.

Indeed, the nationwide staff of some 500 market overseers with investigative skills represents less one-sixth of CSRC’s total workforce.

Legal Mountains

Even if Guo manages to overcome his agency’s personnel shortages and the barriers to proper coordination with agencies and the judicial system, he faces mountainous challenges to securities law tied to common attitudes, such as cynicism and greed, in the business community, government circles, and courts.

Insider trading “is just buying stock at an inside price,” said a local official who tried to justify his wrongdoing. “The money spent is real. How is that a crime?”

Courts may share this official’s slant on securities rule violations, too. The Kunming Gundu District Court, for example, in December imposed a relatively light 4 million yuan fine on Shanghai-listed Yunnan Green-Land Biological Technology following a CSRC investigation.

Inspectors found company officials had lied on a prospectus, inflating revenues by 547 million yuan. The trick worked, and private investors bought 346 million yuan worth of shares in the initial public offering. CSRC’s investigators said Green-Land also inflated assets and income, forged bank documents and transactions, and tampered with financial data.

The court sentenced the company’s former chairman He Xuekai and former CFO Jiang Kaixi to three years in jail with reprieve. The men were immediately released from custody.

Critics of the securities law’s market manipulation and insider trading clauses have called them impractical. An inside trader is legally defined in China as one who obtained inside company information only through illegal means such as eavesdropping, stealing, spying, or bribery.

Caixin has learned the People’s Supreme Court, China’s highest court, plans to issue a judicial interpretation on insider trading soon. The decision is expected to expand the crime’s definition, set parameters for circumstantial evidence that CSRC inspectors can use in building a case, and make it easier for regulators to gather information and enforce rules.

Tougher penalties designed to deter securities law violators have been urged. For example, the maximum sentence for an insider trading conviction is ten years, while in the United States it’s twenty years.

Despite these and other obstacles to the supervision system, CSRC has in recent years launched an increasing number of serious probes. The caseload was formerly limited to executives of listed companies and local government officials. But then attention turned toward high-profile violators as well.

The former chairman of China’s largest appliance retailer Gome, Huang Guangyu, was convicted for using inside information to benefit from trading stock in Shenzhen-listed Beijing Zhongguancun Science and Technology Co. in 2010. He’s now serving a fourteen-year jail term for additional charges and has already paid a 600 million yuan fine—a record for such a case.

CSRC has likewise come down hard on so-called “rat traders,” known for bleeding public funds. In a typical case, a fund manager with access to stock information secretly controls “rat accounts” for relatives and friends who can cash in and share the money with him.

Regulators issued administrative penalties to a former manager of China International Fund Management, Tang Jian, and a former manager at Southern Fund, Wang Limin. After the law changed in 2009, an ex-manager for Great Wall Fund, Han Gang, was jailed.

“Before 2005, insider trading cases were rare,” said CSRC Inspection Bureau Chief Mao Bihua. “But over the past two years, they’ve risen to half of all cases.”

Indeed, insider trading is a top priority for inspectors as well as new chairman Guo. Forty-eight of the ninety-four cases opened by CSRC inspectors last year involved insider trading.

Meanwhile, the manipulators are trying to stay one step ahead of the regulators, said Ouyang Jiansheng, deputy chief of the CSRC’s inspection team. For example, some stock market abusers have tried to avoid detection by borrowing money from several people through private agreements and then using different individual accounts for transaction, paving the way for phony accounting and making investigations more difficult.

CSRC is also chasing illegal short-selling. A typical case involved a Guangdong province securities broker employee named Xue Shurong and his colleagues who, between 2007 and 2009, opened 112 accounts at forty-four securities brokers using the names of seventy individuals, investigators later learned.

Using these accounts and more than 2 billion yuan, they recommended stocks in their portfolio to analysts at numerous television stations and securities firms, who then passed on these recommendations to TV viewers and clients. Xue’s group quickly sold their shares as soon as public investors started taking the bait.

The CSRC probe determined that the group earned 426 million illegally by trading 552 different company stocks worth a cumulative 57 billion yuan.

Unfortunately, the nation’s securities law does not identify short-selling as illegal market manipulation. Nor are there legal boundaries for determining causal relationships between this type of market game and investor losses.

CSRC sent the Xue case to the public security ministry, thus recommending criminal prosecution. Local police agencies later completed their work on the case. But to date there’s been no legal action, and the now-wealthy market manipulators are apparently free to do it again.

Lu Yuan, Wang Ziwu, and Zheng Fei are Caixin staff reporters.

This article was originally published in the March 19, 2012 edition of Caixin Magazine.

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From the Caixin Editors
Supervising China’s equity investors is not for wimps. Even an inspector working in the shadows can expect death threats and bribe offers. The new chairman of the China Securities Regulatory Commission, Guo Shuqing, says he wants to give his inspectors more power to weed out the bad guys. But the task is daunting, and no one expects companies and investors who play insider trading games to give up easily.
By Lu Yuan, Wang Ziwu, and Zheng Fei