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SPECIAL REPORT-How China's biggest bank became ensnared in a sprawling money laundering probe

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MADRID, July 31 (Reuters) - A few minutes before 8 p.m. on Aug. 8, 2012, two Chinese living in Spain - a banker and her client - held a blunt phone conversation.

Wang Jing was a senior officer at the Madrid branch of the state-controlled Industrial and Commercial Bank of China. The client, Xu Kai, was an alleged top figure in an international money laundering group that was suspected of using the bank to transfer illegal income to China. The network was allegedly using multiple accounts in the name of Chinese residents of Spain, in some cases without their permission, to make the transfers. But there had been a hitch.

Earlier that day, banker Wang said, a woman had come to the branch to complain that transfers were being made from her account without her knowledge. Wang chided Xu, telling her to make sure that account holders used in the scheme were on board.

"You have to look out for yourself and make sure these people are obedient," Wang warned. More complaints would lead to "problems" for the bank, Wang added.

In fact, the bank already had problems. Big problems. Spanish police were listening.

Wang's warning to Xu is documented in confidential court filings that include wiretap transcripts from a series of police investigations starting in 2009 into Chinese organized crime in Spain. The Spanish authorities have said publicly they suspect these groups siphoned up to 1.2 billion euros ($1.4 billion) out of Spain to China between 2009 and the end of 2012.

The wiretaps and findings from police investigations ultimately led Spanish investigators to the front door of the Industrial and Commercial Bank of China, or ICBC - the world's biggest bank by assets. On the morning of Feb. 17 last year, dozens of police officers burst into the bank's Madrid branch and arrested Wang Jing and four other senior managers. Two more executives were arrested after the raid.

In a statement released in May last year, Spanish prosecutors said the giant Chinese state-run lender was a conduit for laundering tens of millions of euros in illegal funds from tax fraud and smuggling by "Chinese criminal organizations." The sums laundered were so large, the prosecutors said, that "the damage to the socio-economic order and the national economy is clear."

But beyond news of the arrests and a summary of allegations in the statement, little information has been revealed about the case.

Now, thousands of pages of confidential case submissions reviewed by Reuters, and interviews with investigators and former ICBC employees, provide the first detailed account of the alleged racket and show that the probe reaches high into the state-run bank's European operation. The investigation has so alarmed Beijing that China's top official in Madrid has publicly pressured Spanish officials to conclude the inquiry, warning that failure to do so would harm economic relations.

FORGED DOCUMENTS

At the core of the ICBC case is the relationship between the bank and a group of clients from Spain's thriving Chinese business community. These clients are alleged to have accumulated mountains of cash, much of it from avoiding duty and tax on the sale of consumer goods imported from China. They could not spend it or bank it in Spain without raising suspicion, so they opted to send it to bank accounts in their homeland.

The wiretap transcripts show how ICBC allegedly helped them do it: Bankers accepted forged documents to conceal the source of the funds, failed to report suspicious transactions and even tipped off the smuggling groups ahead of inspections at the bank, police say in the court filings.

Law enforcement officials in Spain are preparing to expand their probe, Reuters has been told. Prosecutors plan to ask the judge in charge of the case to summon ICBC's Luxembourg-based European administrative board for questioning for the first time, according to two Spanish officials involved in the investigation. The Luxembourg unit of ICBC holds the lender's European Union bank license and is responsible for supervising the Madrid branch.

A spokesman for ICBC in Europe, Sun Feng, said the case file was sealed by the court so the bank could not comment on it. ICBC, he added, was a "law-abiding company" and had cooperated with Spanish authorities.

"ICBC Spain Branch has been insisting on operating within the law and regulations, and has continuously strengthened the internal control of anti-money laundering," Sun said in a written response to questions for this article. "ICBC Spain Branch has always been actively cooperating with the judicial authority to conduct the investigation."

Reuters spoke to five of the arrested ICBC employees by phone and sent questions to all seven and their lawyers. All but Wang Jing, who commented very briefly, declined to discuss the case.

"Inside the bank, I am the lowest-level employee," said Wang Jing, who declined to discuss the wiretap transcript of her phone conversation with Xu Kai. Wang referred all questions to ICBC. Xu Kai, who was arrested and released on bail in late 2012, fled to China. She couldn't be reached for comment.

POLICE SURVEILLANCE

The court filings and wiretap transcripts reviewed by Reuters indicate that within eight months of ICBC opening for business in Madrid in January 2011, its staff there were soliciting money transfer business from people under police surveillance. Money transfers to China soon accounted for an estimated 95 percent of the Madrid branch's business, according to a Spanish judicial official.

The wiretap transcripts document ICBC managers in at least 30 conversations with six leaders of Chinese networks in Spain, who police believe were seeking new avenues to launder money. These included conversations in which ICBC staff discussed how to avoid detection when moving money to China. On occasion, the staff warned of transfers that might attract unwanted attention.

After listening in on the Aug. 8, 2012, phone conversation where Wang Jing warned Xu Kai, the police concluded from a series of wiretap conversations that Wang, "from her privileged position as an ICBC employee, was not only aware of the activities carried out" by suspected money launderers, but also was "actively collaborating" with them. The police pointed in their report to the advice she gives Xu on "how the transfers must be made and how she must control the people working for her."

The wiretap transcripts also document conversations between suspected Chinese money launderers in Spain and ICBC employees in China.

Officials involved in the investigation spoke to Reuters on condition of anonymity because the probe is ongoing and Spain's High Court has imposed secrecy orders on the proceedings.

Between 2011 and 2013, the officials said, ICBC's Madrid branch transferred about 225 million euros to China, most of it for suspected criminal networks. These networks also sent funds via money transfer firms in Spain and by smuggling large amounts of cash by road to other European countries from where it was transferred to China.

On the strength of the wiretaps, money transfer records and other evidence, police last year arrested the seven ICBC executives in Madrid, including branch manager Liu Wei and the general manager of ICBC's European division, Liu Gang. Authorities accused the bank of laundering money for several criminal networks in Spain, and seeking to conceal this role.

The seven employees who are suspects in the money laundering case are out on bail. They have had their passports confiscated and are awaiting further legal proceedings in Spain, according to a spokesman for the High Court.

BANKING LICENSE

For now, none of the suspects have been formally charged. Under Spanish law, a person is named as a suspect under investigation for a particular offense - and can be detained for up to four years - until an investigating judge decides whether to press charges.

If convicted for money laundering, the bankers could be jailed for up to six years. If the bank is found to be complicit, it could lead to a hefty fine. In the event of a trial, the bank would have to endure a public airing of its alleged links with suspected criminal networks in Spain and China.

But the bigger danger for the state-run ICBC is that its European banking license could be withdrawn. ICBC is concerned the investigation could affect its European headquarters in Luxembourg, people with direct knowledge of the case told Reuters. This includes the risk that Luxembourg's financial supervisor could ask the European Central Bank to withdraw ICBC's banking license if the supervisor believes there is sufficient evidence the bank failed to comply with mandatory anti-money laundering provisions, these people said.

ICBC is a flagship in China's quest to become a global banking giant. At the direction of the ruling Communist Party, it and other Chinese state-run banks have aggressively expanded into offshore markets.

For ICBC and the other giants, the money-laundering accusations could stymie their expansion plans. In Italy, state-controlled Bank of China was fined this year for involvement in a separate money-laundering case. The bank said it had strengthened its internal checks and that the settling of the case did "not imply any admission of guilt."

For European countries, meanwhile, the investigations pose the risk of diplomatic conflict with Beijing that could affect business relations with the world's second-biggest economy. A spokesman for the Spanish Civil Guard's serious crime unit said police were working with authorities "in many other countries," without elaborating.

OPERATION SHADOW

In the police raid last year on the ICBC branch, dubbed Operation Shadow, officers swarmed through the lemon-colored building on Paseo de Recoletos, a wide, tree-lined boulevard in central Madrid, filled with art galleries, museums and palaces. All staff were ordered not to touch their phones or computers, former ICBC employees said.

In the summary of accusations against ICBC released last May, Spain's anti-corruption and organized crime prosecutor's office said the alleged criminals carried thousands of euros in cash at a time into the bank's Madrid branch, stuffed in rucksacks and boxes.

ICBC divided the funds being transferred to China between multiple accounts to ensure they didn't exceed the 50,000-euro limit above which it would have had to declare to authorities, according to the summary. The bank, it added, failed to report any suspicious transactions as required under Spanish law regarding 78 of its clients. Detention and bail rulings for some of these customers show that they were already under investigation for suspected involvement in a range of crimes, including money laundering, tax fraud, bribery, extortion, forgery and smuggling.

According to the confidential court filings, police allege members of these suspected criminal organisations used fake documents such as falsified passports to open accounts at ICBC's Madrid branch. ICBC employees are suspected of accepting falsified invoices to justify the origin of money transferred to China, police say in the filings.

If the suspects from the bank and the alleged smuggling networks go on trial, it is possible some might deny they participated in the bugged conversations. They might also dispute the conclusions authorities drew from the wiretaps.

DIPLOMATIC FALLOUT

The ICBC arrests ignited a behind-the-scenes diplomatic spat in the spring of 2016, according to senior Spanish officials.

China was particularly incensed by the high profile raid on the Madrid branch and reports in local media linking the arrests with the "Chinese mafia," according to Javier Serra Guevara, who was Spain's chief commercial attache in Beijing at the time of the raid. "We tried to explain to the (Chinese) that Spain's government does not control the media," said Serra Guevara.

After the raid, the Chinese Foreign Ministry announced it had asked Spain to protect the "rights and interests" of Chinese companies and citizens.

China's ambassador to Spain was more pointed at an investment conference this March. "More than a year has passed since the case arose," Lv Fan said in Madrid. "This has undermined the confidence of Chinese business people and investment here and also that of the Chinese government. A prompt solution would help this confidence to return and for the cooperation between both countries to return to normality."

The Chinese embassy didn't respond to questions from Reuters.

Spain's former foreign minister, Jose Manuel Garcia-Margallo, denied there had been a diplomatic crisis with China over the case. "There was no pressure and we would not have tolerated it," he said. "The media attention has moved on, end of story," he added, abruptly ending the interview.

Spain has been home to a thriving Chinese community for decades. Established residents and an influx of new immigrants, many from Qingtian County in China's Zhejiang Province, found that the global financial crisis provided an ideal opportunity to expand. Their goods were cheap and Spanish businesses were floundering.

Chinese manufactured goods flooded Spain. Imports from China increased from 4.7 billion euros in 2000 to 18.9 billion in 2010, according to the Spanish economy ministry.

OPERATION EMPEROR

One sign of this expansion was the emergence of a sprawling industrial park called Cobo Calleja on the southern outskirts of Madrid. The hub became one of the biggest trading centers for Chinese goods in Europe. The dense complex of warehouses and wholesale outlets sells a vast array of products in bulk from lipstick to industrial compressors, ballet shoes, party hats, saucepans and national flags.

Many of the importers only declared a fraction of the value of each container, knowing that tax and customs people couldn't possibly inspect all the containers arriving in Europe, according to a senior Spanish tax official. However, once the importers sold the undeclared goods, they needed to hide the proceeds from the Spanish tax authorities.

So, the Spanish tax official alleges, the trader networks became crime gangs as they systematically engaged in tax evasion, smuggling and money laundering to hide their funds and get them out of the country to China.

The transcripts of bugged conversations are explicit about smuggling. In one phone call, Zhou Jianjun, a man police suspect to be a leader of a money-laundering network in Spain, discusses illicit merchandise-trading with an associate named in the court filings as a suspected crime boss in China. "If Colombia is known for drugs, African countries for conflict, well, China is known for smuggling," Zhou says.

Zhou was arrested in October 2012 and later released on bail. His lawyer said her client didn't want to talk to Reuters about the case.

A little over two months after her bugged conversation with banker Wang Jing in August 2012, Xu Kai was arrested as part of an investigation code-named Operation Emperor, a sweeping crackdown on Chinese organized crime. Xu's husband, Wang Feng, was also arrested. Police found 34,530 euros in cash when they raided the couple's home, according to a police report on the raid.

SECRET CODES

Most of the intercepted calls involving ICBC staff were with Xu Kai and Wang Feng. The husband and wife led a group "dedicated to the massive transfer of money to China," according to warrants for their arrests. In conversations with bank staff, police say in the court filings, the couple used secret codes. Money was referred to as "merchandise" and a sum of 10,000 euros was called a "unit."

Xu and Wang fled Spain after being released on bail in November 2012, investigators say. International warrants have been issued for their arrest. They face allegations of money laundering, tax fraud, forgery and belonging to a criminal organization.

Reuters was unable to contact Xu and Wang, whom the Spanish authorities say are back in China. A former lawyer for Wang said he had no contact details for him.

The former Madrid branch head and current general manager of ICBC's European division, Liu Gang, was arrested two days after the 2016 raid on the bank when he flew to Madrid from Luxembourg to assist his subordinates, investigators told Reuters. In 2012, Liu had been named one of the 10 most influential Chinese business executives in Spain by the country's leading business daily.

Liu, who was released on bail in April last year, did not respond to questions sent to him and his lawyers.

Contacted by phone, Madrid branch manager Liu Wei said he was busy in a meeting and hung up.

The court filings show that ICBC's management in Spain knew the police were conducting an investigation more than three years before the 2016 raid. As part of Operation Emperor, Spain's High Court authorized police in November 2012 to investigate the bank in connection with evidence collected in the wiretaps.

MONEY TRANSFERS

Judge Fernando Andreu ordered ICBC to immediately freeze all financial assets linked to the people under investigation, cancel all pending transfers and provide information on these clients to investigators.

ICBC complied with parts of the order, the court filings show. It promptly wound down the money transfer services it provided the groups, investigators and former ICBC employees said.

But prosecutors said in the summary of allegations released in May last year that ICBC had failed to comply with court orders requesting information about clients under suspicion. They also said the bank had deliberately obstructed the investigation by supplying misleading information about its clients, their invoices and the accounts under investigation.

After prosecutors aired the allegations, ICBC Europe's chairman, Chen Fei, said in a statement to the media that there had been no trial or verdict in the case, so "no references should be made to the bank's guilt."

Well before ICBC came under suspicion, the smuggling groups were already allegedly using other financial institutions to launder undeclared cash.

Spain's financial intelligence unit, Sepblac, said it detected unusually high amounts flowing to China in 2009, mainly through money transfer companies. The unit sanctioned two money transfer firms for wiring hundreds of millions of euros to China without following proper authentication procedures, according to Sepblac reports.

In blocking the money transfer firms, a former Sepblac official said the agency had unwittingly diverted the networks to ICBC. "We were directing all that activity to the only place it could get out ICBC," he said.

'ASSUMING A RISK'

ICBC's Madrid branch opened for business in the depths of Spain's financial crisis in January 2011. At the opening, then ICBC global chairman Jiang Jianqing, an alternate member of the Communist Party's powerful Central Committee, hosted a banquet in Madrid. Local officials hailed the investment as a demonstration of confidence in Spain.

Three former ICBC staffers in Spain told Reuters the branch was chaotic when it opened. Many of the staffers were unprepared for conducting business in a foreign country, they said, unable to perform basic risk assessments or read a balance sheet. Money laundering controls were lax, they said.

One former employee quit out of frustration over what they said was the lack of attention paid by the branch's leadership to preventing money laundering. The ex-employee said the bank's business was especially vulnerable because clients almost all Chinese primarily used cash. The person's bosses had said that they couldn't demand an "exhaustive statement" from their Chinese clients about the origin of the funds because the Chinese worked in a different way from Europeans and were not used to that.

The failure to adhere to these standard banking practices unnerved some staff. "I felt that I was assuming a risk and did not have the support of the branch's leadership to adequately do my job," said the former employee.

As ICBC staff were moving into their new branch, suspected Chinese criminal groups in Spain were looking for new avenues to launder money, according to the wiretap transcripts and Spanish financial security officials.

Members of these suspected crime networks expressed confidence they could navigate any obstacle to moving cash. In a bugged conversation in September 2011, an unidentified employee at an ICBC branch in China tells Yang Yongjun, a suspected member of one of the crime networks, that new internal bank rules meant money transfers had to be accompanied by customs documents.

"Everything can be bought with money," Yang says. "There won't be any problem with the documents."

Reuters was unable to contact Yang, who was in China when the Spanish authorities issued a warrant for his arrest on suspicion of tax fraud and money laundering in October 2012.

CASH IN THE GAS TANK

Police allege the smugglers used multiple channels to move their money. In late 2011, Spanish police staking out the home of Zhang Jianren, a Chinese businessman in Madrid, watched as a gray Volkswagen Golf Plus with Italian license plates pulled up and parked inside the garage, according to a report filed by police investigators. Months earlier, they had spotted the same car at this address.

This time, a surveillance camera secretly installed by police inside the garage showed the Golf's driver, his passenger and the businessman spend more than 40 minutes taking objects from a pair of trolley suitcases and loading them into the back of the car, the report said. When the Golf drove out, two policemen followed on the R-5 motorway out of Madrid. At a tollgate about 20 kilometers (12 miles) southwest of the city, they pulled the car over.

A quick search of the two occupants, brothers Zhan Fengyuan and Zhan Jing, produced 2,770 euros in cash, according to the report. The brothers, both born in China's Zhejiang Province and holding Italian identity papers, refused to answer questions about the cash, saying only that they were on their way to Portugal.

But there were signs that the vehicle had been tampered with. The Golf had been modified to allow access to the gas tank from under the back seats. After more than three hours searching the vehicle, police recovered another 1,254,020 euros in cash wrapped in plastic bags floating in the tank.

A lawyer in Spain who represented the brothers until 2015 said no criminal charges had been brought against them. A warrant was issued in 2012 for the arrest of Zhang Jianren but he was already in China. Reuters was unable to contact him.

Intercepted conversations between members of the suspected criminal networks suggest that ICBC was more accommodating than local banks after Spain tightened money laundering rules in 2010.

"The Spanish banks aren't processing the transfers when we bring them the invoices, but ICBC processes them whenever we do business with them," Zhou Jianjun, the senior figure in one network monitored by police, told an associate in a call on April 22, 2012.

"I meet with people from ICBC whenever I want to," replied Liu Cong, the associate. Liu was arrested on suspicion of money laundering and tax fraud, and released on bail in late 2012. He did not respond to questions sent by Reuters to his home outside Madrid.

Still, the ICBC staff appeared anxious about attracting attention from Spanish authorities. In one call on May 18, 2012, Madrid banker Wang Jing warned Xu Kai's husband Wang Feng about an inspection at the branch the following week. Wang Jing said she was letting ICBC's clients know they would have to freeze all transfers to China until after the inspection, according to wiretap transcripts.

Toward the end of 2015, just a few months ahead of the raid, concern inside ICBC was high, two former employees told Reuters. Around that time, they said, ICBC's general management in Spain ordered Wang Jing to go through all client records and transactions from the Madrid and Barcelona branches to "clean them" and fix any irregularities. Wang, they said, worked from 8.30 a.m. to 10 p.m. every day for several weeks collecting and sorting the files. (Reporting by Angus Berwick and David Lague. Additional reporting by Giselda Vagnoni in Rome. Edited by Peter Hirschberg.)