CHBT: Chinese Fraud Du Jour?

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 models.

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 year.

    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