*

Zhongzhi units engaged in potentially illegal practices

before

Chinese shadow bank's collapse, records show

*

Practices involved guaranteeing returns; using new

investor

funds to pay returns on existing wealth management products

*

Chinese regulators had prohibited capital pool business

and

guaranteeing of returns to prevent financial instability

*

Zhongzhi and relevant units did not respond to Reuters

queries

about such practices

SHANGHAI/BEIJING/HONG KONG, Sept 11 (Reuters) - Zhongzhi

Enterprise Group, a former leader of China's shadow banking

sector that declared insolvency last year, used aggressive and

potentially illegal sales practices to sustain its operations as

it lurched toward collapse, according to records reviewed by

Reuters and eight people with direct knowledge of the matter.

China's years-long property boom had propelled

Beijing-headquartered Zhongzhi to the top of the country's $18

trillion asset-management industry and made it a key player in a

shadow banking sector the size of the French economy. Asset

managers such as Zhongzhi sell wealth-management products to

investors. The proceeds are then channeled by licensed trust

firms like its Zhongrong unit to developers and other companies

that cannot tap bank funding directly because of poor

creditworthiness or other reasons.

Previously unreported details show that about a year before

its financial troubles burst into the open, Zhongzhi units were

paying returns to existing investors in wealth-management

products by using funds from new investors, and promising

individual investors lucrative returns that belied the group's

exposure to a deepening property crisis.

China's trust firms are known as shadow banks because they

operate outside many of the rules that govern commercial

lenders. But China's top banking regulator in 2018 specified

that financial institutions including shadow banks and asset

managers should not set up capital pools, to prevent them from

using money from new sales to cover returns on existing

wealth-management products, nor should they guarantee returns on

wealth-management products.

Zhongzhi appears to have violated both those requirements,

two lawyers said after reviewing Reuters' findings at the

request of the news agency. The lawyers added that such

wrongdoing can result in fines and prison sentences of up to 10

years.

"The core of its suspected illegal action is raising money

from investors through its licensed financial institutions to

fund the group's business operations and expansion," said Zhang

Guanghui, an attorney at Guangdong Suijia Law Firm.

Zhongzhi and its units identified in this story did not

respond to detailed requests for comment about the practices

outlined by Reuters.

Chinese officials were similarly tight-lipped. China's

ministries of public security and justice, which oversee the

Beijing police and prosecutors, respectively, did not respond to

queries about the cases against people connected to the shadow

bank. China's National Financial Regulatory Administration and

central bank also did not respond to requests for comment about

Zhongzhi units' practices.

The liquidity crisis at Zhongzhi became public when trust unit

Zhongrong missed payments on dozens of products in the third

quarter of 2023, fueling investor protests and worries that

China's property meltdown was spilling over into its $66

trillion financial industry.

Eventually, Zhongzhi told investors in November 2023 that it was

insolvent with up to $64 billion in liabilities. The group filed

for bankruptcy liquidation in January, while Beijing police

probed its business practices. In March, Beijing police said on

WeChat that wealth-management firms under Zhongzhi should

cooperate with police and return any illegal income.

In August, Beijing prosecutors said they had charged 49

suspects related to Zhongzhi on suspicion of illegally absorbing

public deposits, without providing details.

Public deposits flowed into Zhongzhi's shadow bank operation

via the funds the investors placed in the wealth-management

products that Zhongzhi's licensed financial units were selling.

Reuters couldn't determine the specific deposits or units to

which the prosecutors were referring.

Interviews with current and former Zhongzhi group staff and

investors, as well as records reviewed by Reuters, shed new

light on how its units' possibly illegal practices exposed

middle-class savers to damaging consequences of China's property

bust, despite regulators' efforts to rein in the shadow banking

sector's excesses.

The eight sources spoke to Reuters on the condition of

anonymity, citing fear of official retribution.

RAGS TO RICHES

Zhongzhi was founded in 1995 by Xie Zhikun, a rags-to-riches

tycoon who started with timber and real-estate businesses before

expanding into financial services.

In its heyday, Zhongzhi cashed in on China's booming

property market. It raised funds by selling wealth products to

retail investors while trust arm Zhongrong charged developers

like Country Garden ( CTRYF ) an interest rate of over 12% on one-year

loans, according to four Zhongrong investment banking documents

dated 2017, which Reuters reviewed. While this wasn't uncommon

for shadow banks, the benchmark bank lending rate was around 4%.

As business soared, Xie rubbed shoulders with developer

magnates, including China Evergrande Group ( EGRNF ) chief Hui Ka Yan and

Country Garden ( CTRYF ) head Yang Guoqiang, according to three current

and former staff. Both developers have since defaulted on debt

repayments and property builds; Evergrande is going through a

court-ordered liquidation process, and Country Garden ( CTRYF ) is facing

the prospect of one. Neither responded to requests for comment

about their ties to Zhongzhi.

Zhongzhi staff raked in sky-high bonuses as the property

boom turbocharged both growth and demand for high-yielding

wealth products, said one current and two former Zhongrong

staff. Xie gave vast sums to Fudan University, his alma mater,

and held summer getaways for top-performing staff, where he

would recite poetry, two of these people said. The university

did not respond to questions about the unspecified donations.

Meanwhile, salespeople in Zhongzhi units were touting the

group's connections with local governments and its trust unit's

backing by state-owned Jingwei Textile Machinery Co., its

largest shareholder, according to two investors and now-deleted

state media reports. Jingwei did not respond to a request for

comment about the nature of its involvement with Zhongzhi.

Xie died in 2021, aged 61, after a heart attack. That year

also marked the beginning of the property sector's liquidity

crisis as Chinese regulators cracked down on developers'

debt-fueled construction to curb spillover risk to the broader

financial sector.

In July that year, one Zhongzhi unit's sales pitch for a

wealth-management product masked the growing strain.

"This is a fixed-return product," a Hang Tang Wealth

salesperson wrote to investors in a WeChat group in July 2022,

according to a screengrab of the exchange reviewed by Reuters.

The salesperson guaranteed a minimum 6.2% return on a

three-month wealth management product on investments exceeding 1

million yuan, or about $140,000, outstripping the 1.5% on local

bank deposits.

The Zhongzhi unit "assumes the full, unconditional and

irrevocable obligation" for timely repayment to investors, the

salesperson said, giving three thumbs-up emoji.

Zhongzhi salespeople's tactics and claims pulled in

thousands of investors. But as developers across the country

started to suffer cash flow issues, they defaulted on loans they

owed to Zhongrong, the licensed trust unit. In turn, Zhongrong

defaulted on sums owed to investors.

As difficulties mounted, Zhongrong board secretary Wang

Qiang briefed dozens of angry investors at the company's Beijing

headquarters in August 2023. Wang told them that funds from some

Zhongrong wealth-management products had been invested in

projects that were no longer generating returns, and that the

company was consequently struggling to pay redemptions,

according to a recording of the meeting reviewed by Reuters, as

well as four current and former Zhongzhi employees and two

investors.

"There must have been no returns from the products," Wang

said. "With no returns, what can we use to repay investors?

Either issue new products or rely on the remaining cash." But by

July 28 that year, the cash had run out, he added.

Pressed by an investor on whether Zhongrong had engaged in

capital pool business, which the regulations prohibit, Wang

acknowledged: "Some of the products have characteristics of

capital pools."

Zhongzhi had increasingly employed such practice starting

around early 2022, as developers defaulted on loans and its

coffers ran dry, said one current and three former Zhongzhi unit

employees. The effect, they said, was to conceal Zhongzhi's

deteriorating position.

Wang could not be reached for comment through Zhongrong.

AFTER THE FALL

Zhongzhi's collapse to a large extent was precipitated by

its outsized loan exposure to cash-starved developers, many of

which had turned to shadow banks to borrow as Beijing's

crackdown had cut them off from main street lenders, according

to three current and former employees.

Zhongrong's real-estate investment exposure accounted for

10.7% of its total assets under management as of the end of

2022, higher than the industry average of 5.8%, according to

Citigroup. Zhongrong provided a near-identical figure in its

annual 2022 financial statement.

The bankruptcy proceedings are likely to take a long time.

On June 28, a Beijing court said Zhongzhi's bankruptcy

administrator had applied for "substantial consolidation" and

liquidation of the company and 247 affiliated firms. The

administrator, Beijing Dacheng Law Offices, did not respond to

Reuters questions about the process.

Some Zhongzhi investors told Reuters they have lost hope of

getting their money back.

Wang, a 51-year-old who owns a tech company in Shenzhen,

thought she was "playing safe" when she invested 1 million yuan

in a four-year term product of a Zhongzhi unit, Zhonghai

Shengrong.

The investment contract Wang signed in May 2020, which

Reuters reviewed, said the expected rate of return was 11%,

compared with a benchmark three-year bank deposit rate of 2.75%.

Funds raised from the product would go to the unit's "working

capital", the document showed.

But several months before Wang's returns on maturity were

due, Zhongzhi declared insolvency.

"It turned out I was caught in the landslide," she said.

($1 = 7.0850 Chinese yuan renminbi)