China Biotics (NASDAQ:CHBT) — What Really Happened Last Week

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C’mon, not anther story on the Chinese RTO market!  Sheesh!

These stories have been flogged to death by the media and anyone who buys these stocks now knows it is a caveat emptor market.  Yet last week the tables turned.  For the first time, mainstream Chinese media started to pick up on the world of fraud that exists in many of the Chinese based companies with US listings….and the first poster child was China Biotics.

On January 16th, an independent Chinese blogger Xia Cao (pen name), produced a post calling into question various aspects of the company’s accounting and tax reporting.

But Xai Cao is no ordinary blogger.  What distinguishes his work is that he teaches at Shanghai National Accounting Institute and has developed quite a reputation for exposing financial fraud in China.  In fact, of the 125 companies the Chinese Securities Regulatory Commission has pressed charges against; Xia Cao was the first to challenge 25 of them – an astonishing 20% of the total number….a number that makes Citron jealous.

Here’s a properly translated version (not a Google Translation) :

CHBT by Influential Chinese Blogger

Then, on January 21st, the story was picked up by the mainstream press, who took the story to another level.  The China Biotics saga was written about by Yicai First Financial Newspaper in China with the headline

“China Biotics suspected of inflating financial performance: the number of branded stores became a myth”

This writer became the first entity to speak to customers, employees, and the company itself on an independent basis.  This is something that no blogger, analyst, or journalist had ever done in the past.  But more importantly, it wasn’t just any newspaper, either.  Yicai’s First Financial is the equivalent of the Wall Street Journal and China’s oldest financial paper. More importantly, it carries the imprimatur of the Chinese Government: http://translate.google.com/translate?hl=en&sl=zh-CN&u=http://www.yicai.com/aboutus/1.html&prev=/search%3Fq%3Dyicai%26hl%3Den%26rls%3Dcom.microsoft:en-us:IE-SearchBox%26rlz%3D1I7GGLL_en%26prmd%3Divns&rurl=translate.google.com&twu=1

(A properly translated version of the Yicai article)

China Biotics Being Suspected for Inflating Financial Performances

It is Citron’s opinion that if an article comparable to this had been published by the Wall Street Journal on a US publicly-traded company, it would be halted for trading.

So What Did the Company Do?

They couldn’t possibly refute the writer’s story, because in China, he is of a very strong reputation.  And to refute the newspaper is to refute a state controlled entity, so they did what they’ve always done – turned in another quarter of “perfect” numbers and raised guidance.

They’ve now constructed a large manufacturing plant….and that is it.  This is the Field of Dreams.  Their stores don’t check out, their “distribution chain” doesn’t check out, and their “major customers” don’t check out.

Investors are left to believe either the company’s statements or to conclude that the company has produced a fictional narrative of its last five years, of an order of magnitude larger than reality.

This peculiar situation forces the auditor to actually perform an audit.

Past, Present, and Future

Anyone with a rational thought can agree that the past of CHBT is murky at best.  Now the Chinese media has given us a fair glimpse of the present of CHBT…your only hope is the future.  Unfortunately, in the publically traded markets you cannot escape your past and if fraudulent, all filings will have to be amended.  Now that is has become mainstream Chinese news, you can be guaranteed that that Chinese based auditors cannot turn a blind eye, especially when Xai Cao questions the cash in the bank, past earnings, and more importantly the taxes owed.

“If you tell the truth, you don’t have to remember anything.” — Mark Twain

It appears to Citron that the company has spun so many lies in the past that it will become impossible to cover them up in the future to an audit or the scrutiny of local media.  One that we find the funniest comes from their last 10Q when they state,

“As of September 30, 2010, we had a total of 447 employees, compared with 415 as of September 30, 2009.”

Yet, this is after they closed the majority of their stores, which employed over 200 people.  This is just one of MANY inconsistencies that riddle their filings.

What is the SEC doing about this?

With no jurisdiction to enforce anything inside China, the SEC’s new Chinese Reverse Merger task force has taken the strategy of looking to US parties playing supporting roles in propping up fraudulent companies trading in the US and operating in China.  Thus, auditors, underwriters, and of course promoters are going to be held accountable for fraudulent misrepresentations made in the US markets.

Conclusion

We are pleased that the mainstream Chinese press has started to cover the RTO market.  The fact that CHBT was the first of the exposes will put additional pressure on the auditor not to turn a blind eye to the blatant misstatements in the reported financials of China Biotics.

Cautious Investing to All.