CHBT: Chinese Fraud Du Jour?

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Not even a full hour of trading can pass anymore without a fresh Chinese fraud getting exposed. Today's plunge target: China Biotics.

From BDOWatch:

Jeremy Newman, CEO of BDO International
Holger Otte, Chair of Policy Board
Albert Au, Chairman and CEO of BDO Limited, HK

Your website states that the scope of audit at BDO extends “far
beyond number crunching”. BDO’s audit service claims to add value by
looking at the facts behind the numbers. The US capital markets are now
waiting to see if indeed BDO will give meaning to its words.

The US stock market is in turmoil over the chaos caused by a raft of
publicly traded Chinese operating companies reverse merged into US shell
corporations, which are increasingly beset by serious disclosure
issues. Many of these companies are posting some of the most astounding
financial results ever seen in public filings, but are riddled with
inconsistencies and/or utter lack of transparency in their business

A prominent example is the $200 million market cap company
China-Biotics (NASDAQ:CHBT), an audit client of BDO Limited HK.
China-Biotics claims to be the dominant probiotics producer in China,
with a reported revenue run rate in excess of $110 million and an
alleged $130 million cash in the bank.

From a transparency standpoint, however, the company is nearly
impenetrable. There are gross inconsistencies between its financial and
tax filings in China and its SEC financial disclosures in the US. It
raised capital by asserting that it had built and opened over one
hundred branded retail outlets for which it claimed “a six month return
of capital”. But when allegations arose that the stores were
non-existent, the company immediately responded by claiming to have
recently shut them down. However, the company maintained the same
employee count, gross revenue, and net margins throughout the purported
opening and closing of over one hundred retail stores.

Over the course of eight years, China-Biotics has been involved in a
stunning 76 lawsuits, many of which were never disclosed. Certain
documents from these cases raise critical questions and red flags about
the company.

The company’s financial credibility is inextricably linked to the
faith the market places in the rigorousness of the auditing process. For
the sake of the integrity of the US capital markets, you are implored
to carefully consider SAS 99, the Consideration of Fraud in a Financial
Statement Audit. This statement requires the auditor to gather
information necessary to identify risks of material misstatement,
consider fraud risk factors, and evaluate at the completion of the audit
whether the accumulated results of auditing procedures and other
observations affect the assessment.

In particular, a degree of professional skepticism is required to
protect the shareholders and the investing public on whose behalf you
are engaged. SAS 99 specifically requires pro-active “brainstorming” to
identify areas where the entity’s financial statements might be
susceptible to material misstatement due to fraud.

We wish to draw your attention to the following warning signs as you begin risk assessment for your audit of China-Biotics:

  1. Significant questions surround the sources of China-Biotics’
    revenue. For the quarter ended December 31st, China-Biotics claimed
    total sales of 32 million USD. For the nine months ended December 31st,
    the net sales was 81 million USD. Approximately 58% of revenue came from
    retail sales and 42% came from bulk additives.

    Major inconsistencies exist in China-Biotics’ reported numbers.
    The company met each quarter’s revenue growth targets despite claiming
    to have closed over 90% of its retail locations within the last year.

    According to a news article published in China by First
    Financial Daily News, Yicai, China-Biotics’ operation is significantly
    smaller than it claims to be. The author of the report contacted
    marketing personnel at Danisco, the largest probiotics producer in
    China. The Danisco marketing representative stated that he did not see
    how CHBT could conceivably sell over 80 million USD of probiotics per

    The author of the report also spoke with various supermarkets in
    Shanghai and was informed that they either never carried China-Biotics’
    products or ceased carrying them due to slow sales. Tesco specifically
    stated it had ceased to carry China-Biotics’ products due to slow sales
    and took small delivery only recently.

    On the bulk additives side, no disclosure of China-Biotics’
    major customers has been able to withstand independent verification. The
    Yicai journalist interviewed three major dairy manufacturers in China
    and all of them denied having an ongoing relationship with CHBT. CHBT
    recently announced that it started selling its products to Bright Dairy,
    but Bright Dairy representatives previously stated that they internally
    manufacture the probiotics used in their products and do not know CHBT.

    The evidence indicates that China-Biotics’ reported revenue
    numbers for both its retail/wholesale operation and its bulk additives
    operation are significantly overstated. This provides a basis for a
    thorough SAS 99 inquiry.

  1. Many stock frauds, for example the S-Chip and P-Chip scandals
    and the recent auditor resignation of Deloitte at China MediaExpress,
    revolve around falsified cash balances as a basis for fabricating prior
    years’ profitability. One common method is to “show cash” in accounts
    that is not the company’s own cash, but is in effect “borrowed”. Money
    is deposited into the company’s accounts utilizing a variety of
    undisclosed contingent liability arrangements either with the bank or
    undisclosed third parties.

    As a further concern, China-Biotics’ large reported free cash
    balances earn only .2%, far less than the income that would customarily
    be available to such a cash-rich entity. In 2005, China-Biotics was
    ordered by a Chinese court to pay an advertising company a little over
    $100,000 USD for services received. China-Biotics pleaded for an
    extension of time citing financial difficulty and insufficienct working
    capital. Yet, in the company’s 10-K filed in 2006, the Company claimed
    to have a cash balance of over $20 million USD

    Given the historic lack of transparency in China-Biotics’
    disclosures, thorough verification of its cash balances would be a
    foundation stone of a credible audit.

    Below is a link to the 2005 case document in which China-Biotics was unable to pay a small claim:

  1. China-Biotics disclosed the U.S. class action lawsuits filed
    against the company, but it never disclosed the numerous lawsuits filed
    against the company in China, where its operation is based. CHBT was
    involved in a total of 76 lawsuits from 2002-2010 , with a significant
    portion of these claims being filed in Chinese courts.

    These lawsuits are material indications of the company’s historical operation and are required to be disclosed.

  1. China-Biotics has always maintained that it operated over 100
    retail outlets in Shanghai prior to closing them down during the quarter
    ended September 30th, 2010. However, numerous interviews with current
    employees suggest that reality differs significantly from company
    statements. Specifically, store employees at CHBT’s existing retail
    outlets were quoted in a Chinese financial publication as stating that
    there are only six retail outlets in Shanghai. After China-Biotics
    posted a listing of its retail stores, extensive independent research
    was conducted to verify the legitimacy of these locations. No trace of
    an operational or recently closed retail store could be found at over
    95% of the locations listed.

  1. China-Biotics recently distributed a press release stating that
    it had expanded the categories of probiotics strains supplied to Bright
    Dairy. Yet according to the author of the Yicai report, Bright Dairy
    claims to have no ongoing business relationship with China-Biotics.
    Critical disclosures about CHBT’s largest customers for bulk-additives
    purchases, their concentration of business, and verification of major
    transactions being conducted at arms-length terms, are an absolute
    requirement of your audit.

  1. 1. The differences between China-Biotics SAIC and SEC filings,
    both of which are audited, can only be described as “grossly discrepant”
    with regard to any measure of revenue, assets and liabilities. More
    importantly, SAIC documents are audited by a local audit firm.
    Therefore, the company is deceiving at least one auditor.

    Original and translated SAIC fling:

    Any discrepancies between SAIC, SAT filings and SEC filings for
    China-Biotics should be considered material issues of your audit and
    should be reconciled. Verification of taxes actually paid to government
    authorities should be a basic reference point of your audit.

  1. China-Biotics has reserved a potential tax liability for which
    it would be obligated to pay over 50 million USD of VAT to local tax
    authorities. Over a span of six and a half years, CHBT owed taxes on 60%
    of total taxes payable. This accounting treatment is highly unusual and
    lacks transparency.

    BDO can provide a great service to the capital markets by
    delivering a full and fair audit, guided by its obligation to bring to
    the task a full measure of “professional skepticism” as mandated by SAS
    99. The market is counting on this to include an extensive independent
    review of the Company’s cash balances, including determination of any
    potential undisclosed liabilities, a full disclosure of outstanding
    taxation and historical litigation risks, as well as independent
    verification of revenue concentration issues from its largest customers.

Thank you in advance for representing the interests of investors.

Copies To:

Jeremy Newman, CEO of BDO International
Holger Otte, Chair of Policy Board
Albert Au, Chairman and CEO of BDO Limited, HK
Clement Chan, Managing Partner
Johnson Kong, Managing Partner
Jennifer Yip, Head of Assurance
Lesley Yeung, Deputy Head of Assurance
Hong Ng, Deputy Head of Assurance
Ringo Chiu, Deputy Head of Assurance

h/t Neal