Rat traders run rampant with insider deals on mainland
Daniel Ren in Shanghai
05 April 2010
The gregarious and helpful manner of the Shanghai analyst vanished shortly after he was tapped to run a multibillion-yuan fund at a Beijing-based asset management company.
As an analyst in the late 1990s he would freely expressed his views about the economy and the market. He was comfortable providing stock tips, claiming he only recommended diamond-in-the-rough stocks that were set to skyrocket.
But the analyst – who requested anonymity because he feared prosecution – became elusive about three years ago, immediately after he was picked to manage a blue-chip fund.
“I don’t want any media to get my name in any of their stories,” he told the South China Morning Post. “I have to play it safe.”
The analyst said he had entered a new world when he took the helm of the fund.
Like many other fund managers, he opened a “rat account”, a secret account, usually opened under the name of a friend or family member, through which he would trade shares using inside information about companies he represented. Also on the side, he traded shares for “clients”, again using inside information, charging them a fee for managing their portfolios.
He earned millions of yuan in annual salary and pocketed millions more in illegal income – the profits from his rat accounts.
“To be honest, fund managers don’t necessarily always make money on their own accounts,” he said. “You must be damn smart and extremely cautious in the circle [the fund industry]. Otherwise, you will fall into the losers’ camp” of those who get caught by regulators.
In addition to his rat accounts, the fund manager and several of his friends at other fund houses and brokerages raised a secret and illegal private fund, managing the portfolio for their friends, relatives and investors, and charging fees.
“There’s no way that you can avoid conflicts of interest in running the mutual funds and the private fund,” he said. “Therefore, we must be tight-lipped. More importantly, we have to make sure that we can make money for the clients whether it is a bull or bear market.”
The fund manager said he became a master of price-rigging.
“Millions of retail investors never come to realise they are wrestling with smart guys like us,” he said. “They can never make money. They have no inside information and no cash, but they still believe the market is a gold mine.”
Rat traders use brokerage accounts of family members or friends to trade shares for themselves, taking advantage of inside information to reap illegal gains.
“Rat trading is quite rampant in the market,” said Chen Jiwu, president of Shanghai Vstone Capital and previously the chief investment officer of Fullgoal Fund Management. “In the mutual fund industry, honestly, it is not easy to find one who doesn’t own a rat account. Keeping tight-lipped is the rule of the game.”
Fund managers on the mainland are highly regarded even though – perhaps because – they profit from insider information and manipulate the market. They are seen as the smartest people in the finance sector and admired for their ability to make money.
More importantly, mainlanders believe fund managers know about the best investment opportunities and can avoid risks. Individual investors think that if they can figure out their strategy or their next move, they, too, can make money.
Front-running is a widely used tactic that can almost guarantee high returns for rat traders.
Before making a decision to use their multibillion-yuan fund to load up on shares of a target stock, fund managers secretly buy up thousands of shares for their rat accounts. When the fund starts to build its position in the stock, the price normally is bid up as the fund purchases millions of shares. The fund manager can then cash out of his rat accounting, taking advantage of the price increase.
“You can’t expect tonnes of money in this game,” said the Shanghai fund manager. “But it is safe.”
When the fund plans to pare its position in a certain stock, the manager first sells the rat account shares.
Another common scheme – variously called “false packaging” or “sham transactions” – involves funds colluding with executives of listed firms to manipulate share prices.
Before Beijing started its share structure reform in 2006, only one-third of the shares on the A-share market were tradable. The rest – held by state-owned parents or local authorities such as provincial-level state-asset regulators – were locked up. Beijing froze the bulk of state shares because it was worried the central government would lose control of the listed firms if the state-owned parents and local authorities dumped the shares.
But the small market capitalisation of tradable shares made it easier for powerful funds to acquire a majority of the freely floated shares, which facilitated price-rigging.
According to a Shanghai-based fund manager with more than 10 years of asset management experience, a fund manager would approach the top executives of a listed company after the fund had accumulated a large number of shares. The manager would pressure the executives to publish false statements about potential asset restructurings or acquisitions – news that normally would attract a rush of retail investors. The resulting buying frenzy from the small investors would drive up share prices, creating an easy exit for the fund.
“We just needed to get to know them, and we could convince them to work with us on the scheme,” the fund manager said. He said most of the targeted “partners” would agree to the scheme after being bribed.
Guangdong Yorkpoint is an example of how fund managers and company executives profited from what essentially was a trap laid for individual investors.
In 2000, four consulting firms colluded with executives of Guangdong Yorkpoint Science & Technology to manipulate the price of the Shenzhen-listed firm.
Guangdong Yorkpoint falsely announced that it would diversify into electric cars and nanotechnology, two high-tech sectors highly popular with retail investors. The stock price quadrupled to over 100 yuan in three months before sinking more than 90 per cent to hit as low as 5.34 yuan. The wild stock price swings attracted the China Securities Regulatory Commission’s attention and it began to probe into the transactions in January 2001. The regulator found the four big corporate investors in Yorkpoint had plotted with company executives to rig the stock price.
In September 2003, a Guangzhou court sentenced Li Hongqing, a former vice-president of Yorkpoint, to 3-1/2 years in prison.
As mutual funds increased in size, the rat accounts held by fund managers swelled.
“The money we made in our own accounts was the bonus we awarded ourselves,” the Shanghai-based fund manager said. “It would be pointless if we took the risks of violating the law, only to benefit the mutual fund without reaping personal benefits.”
On the mainland, a large number of securities analysts also own rat accounts, but they, unlike fund managers, are less highly regarded. Stock market analysts on the mainland had long been likened to weather forecasters since their prediction of the market directions often prove wrong.
Retail investors generally have been unaware of the behind-the-screen activities of analysts and fund managers. They might have suspected many were cheating, but they had little idea how the schemes work. Some retail investors thought they could discover the strategies of the fund managers and analysts by watching the price movements and turnover of a particular stock.
“China’s retail investors aren’t stupid; we knew the powerful funds were rigging the prices against us,” said Davis Zhang, a white-collar retail investor. “But many seasoned small investors like me can see through the tactics and make money.”
Unfortunately, millions of other mainland equity investors also think they have Warren Buffett-like wizardry for investing. But too often they are wrong and simply provide the “liquidity” for analysts and fund managers to profit.
Ye Zhigang helped prove that.
A machinery analyst with Haitong Securities, Ye Zhigang was found late last year by the regulator to have written bullish research reports on certain companies to lure retail investors. Ye allegedly pocketed illegal gains on his own accounts after overstating the earnings potential of certain companies.
A second Shanghai fund manager said Ye was only caught when his ex-girlfriend, who had detailed knowledge of his illegal practices, reported him to the China Securities Regulatory Commission following a bitter break-up with the analyst.
Gu Xiaorong, a researcher at Shanghai Academy of Social Sciences, said that rampant rat trading posed a huge threat to the nation’s stock market because rat traders capitalise on the multibillion-yuan mutual funds raised from small investors to manipulate stocks, which ends up harming small investors.
Those in the industry say the China Securities Regulatory Commission has turned a blind eye to rampant insider trading for nearly two decades.
The CSRC says it has taken time to set up an efficient monitoring system as the market, which was established in 1990, developed.
But, even now, the Shanghai Stock Exchange’s surveillance department has only a dozen employees overseeing questionable trades. “Unless someone reports the guilt of others to the authorities, the regulator won’t take the initiative to spot rat accounts,” a Shanghai exchange official said. “So the rule of the game [among the rat traders] is to keep tight-lipped and low-key.”
The CSRC took its first step toward cracking down on rat traders in 2007 when two notorious fund managers, Tang Jian and Wang Limin, were found to have used affiliated persons’ accounts to trade shares.
But the two rat traders were fined only 500,000 yuan each, as at that time there were no criminal sanctions against insider trading.
Only in March last year did the National People’s Congress amend the criminal law so that rat traders can face up to 10 years in prison.
But to date, only a dozen insider traders have been caught, including Liu Baochun, the director-general of the Nanjing Economic Commission. Liu was taken in by police for questioning after people with direct knowledge of his activities reported to the authorities that he used inside information to buy shares of Jiangsu Gaochun Ceramics.
Liu and his wife, an employee with Nanjing Securities, which acted as financial adviser to loss-making Gaochun Ceramics, used a relative’s brokerage account to buy thousands of shares in the company. Gaochun was supervised by Liu’s commission. The couple took advantage of inside information about a restructuring to pocket gains of several million yuan.
Gaochun stock soared their 10 per cent daily limit for 11 consecutive days when trading resumed on May 22, 2009 after the restructuring.
“It is an open secret that nearly all securities industry employees trade shares via their relatives’ accounts or for affiliated persons,” said West China Securities trader Wei Wei. “Obviously, the regulator faces a dilemma. To entirely clean up the market, the regulator might have to kill the market first.”
Last year, the CSRC waged a national campaign to bust rat traders. In November, it said it had uncovered three fund managers who allegedly had conducted insider trading.
But since then, no other cases have been reported.
According to securities industry employees in Shanghai, the regulator has required companies to intensify their oversight of employees. Company employees are required to file a list of the accounts owned by their relatives. But, so far, the watchdog has not taken further steps to spot questionable trades.
At the end of last year, CSRC chairman Shang Fulin, rather than announcing more cases or issuing strongly worded statements warning rat traders of possible consequences, instead simply told the fund houses to exercise more self-discipline.
“Under any circumstance, fund companies and managers shouldn’t do rat trading,” he told a forum in Beijing. “Protecting fund investors’ interests is the key to future development of the fund industry.”
On the street, that signalled nothing more was likely to happen. Many experts and ordinary investors say the CSRC’s efforts can best be described by the expression “head of a tiger, tail of a snake”. The regulators come roaring in but soon they slither out silently.