(Bloomberg) -- It sounds straight out of Le Carre: “The Enigma Network.”
But suddenly that phrase is sending shock waves across Hong Kong equities, in an unexpected culmination of one man’s campaign to train a spotlight on the market’s darkest corners.
His name is David Webb -- and if investors ignored him until now, they’re paying the price.
Six weeks ago, Webb, a former director of the Hong Kong stock exchange, issued a report titled “The Enigma Network: 50 stocks not to own.” His argument: the companies were entwined in a complex web of cross-shareholdings that had pushed their valuations to unsustainable levels.
On Tuesday, seemingly without warning, many of those small-cap shares abruptly plummeted, some by more than 90 percent. The turmoil once again underscored how the Hong Kong Stock Exchange and its sibling, the Growth Enterprise Market, have become a breeding ground of wild volatility. The phenomenon has raised red flags for the city’s regulators, who have warned small-caps can be black boxes and, at times, subject to manipulation.
Webb, an activist investor who’s been a vocal critic of the Hong Kong exchange since he quit the board in 2008, called on authorities to do more to protect investors.
“What this really points to is the ongoing problems with our legal and regulatory system for listed companies,” he said in an interview on Tuesday.
Hong Kong’s Securities and Futures Commission said it couldn’t comment on whether it’s pursuing any investigations. But the regulator noted that Tuesday’s biggest decliners tended to have characteristics conducive to extreme volatility and market misconduct: multiple relationships between different companies and listed brokerage firms, high shareholding concentrations, low volume and small public floats.
Hong Kong Exchanges & Clearing Ltd., which proposed sweeping changes to its small-cap market earlier this month to revive confidence in the venue, said it couldn’t explain Tuesday’s moves.
While the stocks highlighted by Webb barely budged when he released his report in May, they accounted for all but three of Tuesday’s 20 biggest losers in Hong Kong.
Among the decliners were China Jicheng Holdings Ltd. and GreaterChina Professional Services Ltd., which both fell more than 90 percent. Even as traders struggled to nail down a trigger for the moves, many pointed to links between the companies and Lerado Financial Group Co., a brokerage that’s under regulatory investigation. Lerado had previously disclosed an investment in China Jicheng and had an underwriting role on a GreaterChina share placement in 2015.
Lerado said it sold 1.48 billion shares of China Jicheng on Tuesday at an average price of HK$0.0169 per share, according to a statement to the Hong Kong stock exchange. China Jicheng ended the day at HK$0.016.
Thirty-eight of the 50 stocks flagged by Webb fell on Wednesday. The S&P/HKEX GEM Index dropped 0.8 percent at the close, following Tuesday’s 9.6 percent rout.
Webb also has a history with Lerado. The activist was named as a substantial shareholder as far back as the company’s 2008 interim report and has been one of the firm’s biggest critics. Lerado has made a series of “highly questionable transactions” that diluted net-asset value per share, Webb wrote in March 2016, calling on the SFC and the stock exchange to require more disclosure from the company.
The SFC suspended trading in Lerado’s shares from June 6, saying a company circular dated Oct. 26, 2015, included “materially false, incomplete or misleading information.”
In that 2015 document, Lerado outlined plans to raise money for the margin lending business of its unit Black Marble, and said that Black Marble was planning to underwrite a placement for GreaterChina Professional and an open offer for China Investment & Finance Group Ltd. China Investment fell as much as 94 percent Tuesday, before paring its loss to 50 percent.
Calls to Lerado and GreaterChina Professional weren’t answered. The person who answered the phone at China Jicheng said they weren’t aware of the share price decline and couldn’t comment. China Investment didn’t immediately respond to a request for comment.
Whatever the catalyst for the selloff, investors can’t say they weren’t warned. As Webb flagged six weeks ago and reiterated on Tuesday: “A lot of the stocks were very overvalued.”