Backroom Deals Rattle a Shenzhen Brokerage

Securities regulators have started pulling back the curtain on insider schemes at Guosen Securities, a Shenzhen-based brokerage that recently ousted an investment banking director after accusing him and his wife of illegal trades.

The investigation and firing of Li Shaowu could affect Guosen's ongoing preparations for an initial public offering, since the probe has turned attention on the firm's unusual organizational structure.

Other major securities firms around the country have circulated internal warnings about the case. And the probe, which the Shenzhen Securities Regulatory Bureau began in mid-June, could expose a dark side of deals involving IPO sponsors, venture capital firms, and various interests holding shares on behalf of listed companies.

The Guosen case dates to 2001, when Li and his wife Qiu Liying began investing in three companies by buying stock. Initial investments totaled less than 1.43 million yuan combined, but eventually the stock was worth about 32 million yuan – a more than 20-fold return.

Through his wife's company and other means, Li apparently bought 60,000 shares in Shenzhen Laibao High-Tech (SZE: 002106) and 65,000 shares in Luoyang Bearing Science & Technology (SZE: 002046). He also invested in a company called SF Diamond, buying 1 million shares, at a time when it was awaiting a regulatory decision on an IPO request.

Guosen was the underwriter for Laibao High-Tech's listing, and Li was a member of the deal's liaison staff. The company launched its IPO in January 2007, and the value of what were officially Qiu's holdings jumped more than 15 times to about 1.9 million yuan.

A recent report in The Economic Observer said Li became president of Guosen's No. 4 Investment Banking Department in late 2004, around the same time that his wife paid 110,300 yuan for 50,000 shares in Laibao High-Tech on behalf of employees at a company subsidiary, Zhejiang Jinlai Coating. Some 60,00 shares were later transferred to Qiu – just before the company went public.

Securities regulations say neither representatives of IPO underwriters nor their spouses may own an issuing company's shares in any way. Violators can be barred from sponsoring a listing or locked out of the stock market entirely.

A Guosen source said these rules are aimed at controlling IPO sponsor representatives, which technically Li was not. But the company did fault Li for violating internal rules and discipline procedures by failing to disclose his wife's holdings, which prompted his dismissal.

Structural Flaws

In addition, Guosen's business structure has raised questions. One brokerage investment banker thinks the case stems from the fact that the company's Guosen Securities Investment Bank is divided into more than 20 departments.

By splitting the investment banking unit into parts "two sponsors can organize a small team" with independent accounting, said a brokerage industry source. And each team can be responsible for its own profits and losses.

The team approach apparently helped Guosen remain flexible so that it could pursue projects quickly. In this way, the firm became a leader for deals on the Shenzhen stock exchange and the Growth Enterprise Market.

On the other hand, because headquarters lets sponsor representatives operate on a loose leash, the system apparently leaves a door open to rent-seeking.

The recently launched Growth Enterprise Market – a board that focuses on technology start-ups – has influenced the environment as well, as brokers and VC firms have drawn close and formed circles of common interest.

One industry insider told Caixin similar rent-seeking cases would be difficult if not impossible to find on China's main stock exchanges, where listings are large, companies are well-developed, and individuals can't afford to get involved with mere small investments.

Some weak companies, to access the capital market as quickly as possible, have hired sponsors who, in turn, bring in VC firms willing to work on listings in exchange for hefty payments. If an IPO launch goes well, everyone is satisfied.

Caixin obtained a signed agreement between a venture capital firm and a "management company" that was supposed to handle project investment, legal issues, listing procedures and business advice. Under the agreement, if the VC firm succeeded in investing in the company and getting it listed, the management company would receive 5 to 10 percent of the investment as an initial consulting fee.

The agreement said if the stock lockup period after a listing was less than two years, and the return on VC investment climbed to 50 percent, up to 25 percent of the return would go to the management company as a consulting fee. If the return exceeded 50 percent, the fee ratio would fall, and if the return exceeded 150 percent, the fee would be 10 percent.

At the same time, the agreement said if the invested company is unable to list within three years, the sponsor would be required to return 40 percent of the initial consulting fee to the VC firm.
 
Shady Deals

In the Li case, another source said, the leader behind the "management company" was a sponsor representative at Guosen's investment banking department. The VC firm was less than two years old years and held investments in 10 companies, including two that had been listed.

In one recent project, the management company received a fee of nearly 10 million yuan from the VC firm. "This fee depends on the negotiations," a source said. "At most, it would be 15 percent."

The source also said the manager of the brokerage's investment banking project and that of the VC firm were classmates.

Guosen announced Li's ouster May 26 in an internal memo. He had worked as president for four of the firm's investment banking departments.

Declining performance inside each of Li's departments came to light during a review conducted between late 2009 and early this year by Guosen's banking department. Company officials who proposed adjusting Li's position discovered problems after talking to employees and examining project risks.

Guosen officials decided to sack Li and cancel his job contract after completing the investigation. They also alerted regulators.

A further investigation found that his wife had falsified her identity in the SF Diamond prospectus. It said that, starting in May 2007, Qiu had served as deputy director of the Shenzhen Municipal Nanfang Hongli Tax Firm. But in fact, she's never even worked for the firm.

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