SHANGHAI (Reuters) - As a flood of unregulated cash swirls through the Chinese economy, Beijing has been taking aim at the trust companies whose unrestrained lending practices are worrying regulators.

FILE PHOTO: The company logo of China Cinda Asset Management Co Ltd is displayed at a news conference on the company's annual results in Hong Kong, China March 30, 2016. REUTERS/Bobby Yip/File Photo

The trusts, at the heart of a vast shadow banking industry, are being pressured to step up compliance and background checks, and are being pushed towards greater transparency.

But the fast-growing 20 trillion yuan ($3 trillion) industry, whose lending operations are cloaked behind opaque structures, will be tough to rein in, according to employees at some trusts.

A regulatory sanction against one trust, Shanghai International Trust, and a legal case against another, National Trust, offer rare insights into the industry, and reveals just how hard it will be to police it.

Shanghai Trust was fined 200,000 yuan for selling a product that violated leverage rules, according to a regulator’s notice in January. Regulators provided no further details about the case. Under these rules, property developers are only allowed to borrow up to three times their existing net assets.

According to two people with direct knowledge of the case, an unknown sum was loaned by China Construction Bank 601939.SS through Shanghai Trust to Cinda Asset Management Company. Cinda then invested the cash.

One of the sources said Cinda used the cash to acquire land, a sector rife with speculation that regulators have singled out as a “risky” destination for trust company loans. The source provided no further details.

Shanghai Trust, Cinda, CCB and the China Banking Regulatory Commission (CBRC) declined to comment for this story.

STEEL LOANS

The case against National Trust, which had revenue of 655 million yuan in 2016, involves wealth management products linked to the steel industry.

The trust was sued in June this year by eight investors who allege it misrepresented the risks involved in products it sold them and failed to adequately assess the guarantor’s creditworthiness.

The trust skirted restrictions on loans to the steel industry by using the products to raise money to lend to a subsidiary of Bohai Steel Group, according to Tang Chunlin, a lawyer at Yingke Law Firm, who is representing the investors.

The plaintiffs invested different sums in the wealth management products, which National Trust promised would deliver an annual return of over 9 percent. National Trust lent the money collected to a Bohai subsidiary, Tianjin Iron and Steel Group Co, according to documents reviewed by Reuters.

Bohai Steel Group, which is undergoing a state-financed restructuring, has liabilities of around 192 billion yuan.

National Trust has now defaulted on the product, according to Tang and Gongyu Zhou, one of the eight investors, because Tianjin Iron and Steel is unable to pay back its loan.The products were also illegally sold via third-party non-financial institutions, Tang and Zhou said.

Zhou said he invested one million yuan in the product over two years from 2015 through 360caifu.com, an online finance platform.

Bohai Steel Group, Tianjin Iron and Steel and 360caifu.com did not respond to requests for comment. National Trust declined to comment.

STRUCTURAL CONCERNS

One of the biggest challenges facing regulators is that many trusts employ a baffling array of structures, and funnel money through complex webs of beneficiaries, which makes untangling transactions extremely difficult.

Nine people working at trusts, including the two with knowledge of the Shanghai Trust case, said such complex structures were often deliberately used to sidestep lending restrictions on banks and borrowers.

“Really, only the project manager knows exactly how the money flows,” said a senior employee at one trust firm. The source and others at the trust firms could not be named because they were not allowed to speak to the public.

INSURANCE LINK

The practices of the trusts, and the speed at which the industry is growing, have made them a target for Beijing as it tries to keep a lid on risky lending, cool overheated markets and control corporate debt.

In April, Deng Zhiyi, head of the CBRC’s trust department, warned of “severe risks” from funds flowing into the real estate, coal and steel sectors through trusts.

The industry is now roughly a tenth the size of China’s commercial banking sector.

While the companies are overseen by the CBRC, they are not held to the same standards as banks. For example, they do not have to meet the same capital adequacy standards.

However, the regulator set out in detail in April certain structures that the trusts should not use, such as money-pooling schemes and structuring products to avoid restrictions on leverage.

That was “a signal for financial institutions that from a legal and enforcement perspective, we are entering a stricter period,” said Armstrong Chen, financial compliance partner at King & Wood Mallesons.

Trust firms will also have to start registering the details of their products, identifying the ultimate borrower of funds, this year, said Chen, who is in regular contact with the regulators.

Chen said the requirement would improve transparency, but people at trust firms say it will still be difficult to detect the use of the under-the-table agreements typical of the industry.

The Shanghai Trust case also reflected the tougher line being taken by regulators. The fine would have been negligible for the state-owned company, one of the largest trusts with a total of 3.89 billion yuan in revenue at the end of 2016.

But according to three different sources with direct knowledge, Shanghai Trust was also barred from selling products to insurers for three years, a blow to a company that had made considerable sums selling products to the sector in recent years. One insurer invested as much as 10 billion yuan in just one of its property projects, according to one of the sources.

COMPLIANCE EFFORTS

Some of the trusts are already responding to the government pressure.

Anxin Trust 600816.SS is increasing the number of onsite visits by staff and has doubled its compliance team, said a person with direct knowledge of the company's activities. The trust is also looking at less risky deals – in healthcare, for example, rather than the more volatile property sector.

A spokesman for Anxin said managing risk was a priority for the trust.

China Industrial International Trust is requiring staff to include photos of site visits to prevent them from faking trips.

Documents have to be signed by all participants face-to-face, said a person with direct knowledge of the company’s operations. The company declined to comment.

Despite these changes, the government’s job managing the trusts keeps growing. In the first half of this year, trust loans increased by 1.31 trillion yuan, which compared with 279.2 billion in the period last year, according to central bank figures.

That growth will be a challenge for the regulator, which is already facing staff shortages as it struggles to keep up with a broader official crackdown on financial risk.

The trusts see more boom times ahead.

“The demand for trust loans is increasing,” an internal report at a large trust firm in May said. “In the past, state-owned-enterprises would not consider such loans, but are now considering them,” said the report, adding that the trend started in March.

A source made the report available to Reuters on the condition the name of the company was not disclosed.