ITEM 1. BUSINESS
Overview
We are a China-based, vertically integrated pharmaceutical company dedicated to improving health through the development, manufacture and commercialization of a broad range of pharmaceutical and healthcare products. A majority of our current products are manufactured using plant based materials. Our business is comprised of prescription pharmaceutical products, over-the-counter pharmaceutical products and nutraceutical products. Our pharmaceutical products were approved by the Chinese State Food and Drug Administration, or SFDA, based on demonstrated safety and efficacy before they were permitted for sale in China. We sell our pharmaceutical products primarily to hospitals, clinics, pharmacies and retail outlets in all provinces, including rural areas and major cities in China, through the efforts of our sales and marketing professionals. We leverage our relationship with distributors to distribute our products to both urban and rural areas of China. We intend to use our established business as a platform for continued growth both organically and through strategic acquisitions.
The following table represents the manufacturing revenues realized from the sale of our pharmaceutical and nutraceutical products, as well as our distribution revenue from our distribution business for the periods indicated:
The global economic challenges and uncertainties impacted our business in 2011 and 2012. These challenges and uncertainties have negatively affected consumers’ demands for both pharmaceutical and nutraceutical products, which contributed to the overall decline in sales during 2011 and 2012 as compared with 2009 and 2010.
In addition to the ongoing economic challenges and uncertainties, our business was negatively impacted by incidents such as the toxic drug capsules incident in 2012. Incidents like that shook the pharmaceutical industry, resulting in a decline in market demand for capsules-related products. Although we are not directly involved in the scandal and we have been inspected and passed the safety requirement, our sales in pharmaceutical and nutraceutical products have been impacted significantly due to the loss of confidence of consumers and substantial decline in market demand. This decline was offset by the acquisition of Liaoning North Medicated Herbs Pharmaceutical Co., Ltd. in December 2011, which contributed an increase in distribution revenue in 2012.
Each of our pharmaceutical products has certain medicinal functions and has demonstrated safety and efficacy in accordance with SFDA requirements for the treatment of at least one or more therapeutic indications. A majority of our pharmaceutical products are based on non-synthetic medicinal compounds that are extracted from various parts of one or more plants. We apply modern production techniques to traditional Chinese medicine, or TCM to produce a variety of pharmaceutical products in different formulations, such as tablets, capsules and powders.
We currently market 109 pharmaceutical products in China. Two flagship prescription pharmaceutical products currently marketed in China are Shuanghuanglian Lyophilized Injection Powder, or SHL Injection Powder, and Cease Enuresis Soft Gel, or CE Gel. SHL Injection Power is an anti-viral injection effective in treating respiratory infections, bronchitis and tonsillitis, and CE Gel is indicated to alleviate bedwetting. We market our SHL Injection Powder through our brand name SHL, and our CE Gel through Harbin Three Happiness Bioengineering Co., Ltd, or Three Happiness. These products are detailed to physicians at hospitals and clinics through the efforts of our sales force and through educational physician conferences and seminars.
Over-the-counter pharmaceutical products are similar to our prescription pharmaceutical products in that they need approval from the SFDA prior to sales and marketing. They are sold over-the-counter in pharmacies and other retail outlets. Our products in this category include Jinji Series, Cease Enuresis Patch, or CE Patch, and Boke Series. Jinji Series is a line of products approved for the treatment of various women’s health indications including endometritis, annexitis, pelvic inflammation, premenstrual and menopausal symptoms. CE Patch is a product indicated to alleviate bedwetting and for the treatment of incontinence. Boke Series is a line of nasal products indicated to alleviate sinus infections and nasal congestions.
Nutraceutical products are intended for the overall well-being. We market several nutraceutical products in China, including our soybean peptide based drinks, tablets, powder and instant coffee. We promote our nutraceutical products through TV and print advertising campaigns in magazines and newspapers, and distribute these products to supermarkets, fitness centers, healthcare specialty stores and other retail outlets in China.
We own and operate five manufacturing facilities through which we manufacture all of our products. Each facility is current in its certified standing of Good Manufacturing Practices, or GMP, and International Organization for Standardization, or ISO, and has clearance for export from Chinese authorities.
Industry Background and Market Opportunities
The Chinese pharmaceutical and nutraceutical markets are highly fragmented, consisting of a large number of small enterprises. We believe that such fragmentation provides opportunities for consolidation and acquisitions. However, the cost for consolidation has been going up in recent years as more acquirers step into the arena, including well capitalized international pharmaceutical giants, such as Bayer and Novartis, among others. Intensified competition among an increased number of acquirers makes accretive acquisitions more and more difficult.
A factor that has an obvious impact on all pharmaceutical manufacturers in China is the fast paced evolving Chinese government healthcare policies. “Opinions of the State Council on Deepening the Reform of the Medical and Health Care System,” issued by The State Council of the People’s Republic of China (“the State Council”) in April 2009, signaled the formal commencement of a major public health initiative by the Chinese government. The goal of this new policy is to provide access to basic medical care for every person in China by 2020.
In the practice of the above said healthcare reform, we witnessed increased dispensing of drugs on the Essential Drugs List (“EDL”) and of products covered by the National Medical Insurance Catalog (“NIC”). This nationwide trend has exerted a continuous and powerful pressure on the pricing of all generic drugs, whether branded or not, resulting in a significant shrinkage of the profit margins of those manufacturers who make such products.
The pricing pressure on EDL or NIC products will have a positive long term impact on China if such pricing pressure can force out inefficiently run manufacturers into bankruptcies. However, the healthcare reform will risk tarnishing the benefits it has brought to the nation if the practice of relentlessly seeking low priced products actually forces quality manufacturers out of the bidding and will leave room for inferior quality products to win the bidding
Pharmaceutical Market
According to the statistics of China’s National Development and Reform Commission, the pharmaceutical industry in China was approximately $181 billion in 2010. China became the world’s second largest pharmaceutical market after the US in 2012, which includes western medicine and TCM. In January 2009, the Chinese government approved a healthcare reform plan and has budgeted for RMB 850 billion, or $124 billion, in a three year program to make medical services and products more affordable and accessible to the whole population. Although there is tremendous upside for the pharmaceutical market in China, it is volatile and full of uncertainties, challenges and fierce competition that could affect our future performance. Incidents such as the toxic drug capsules incident in 2012 exemplify the vulnerability of the market on which our performance depends.
Traditional Chinese Medicine Market
The traditional Chinese medicine or TCM market for pharmaceutical products in China was approximately $40 billion in 2010, accounting for about 22% of all expenditures on medicine within the China. TCM, mostly made of botanical plants, has thousands of years of history and is well accepted in China. The traditional formulations, mostly in large dosage of bitter tasting soups, is being upgraded into more convenient formulations, such as tablets, gels, injectables, etc. for improved convenience and sometimes, for improved efficacy.
The government of China is committed to supporting and promoting the development of modernized TCM, as evidenced by the government formulating an industry development plan for the modernized TCM sector and adding more modernized TCMs to the national medicine catalog of the National Medical Insurance Program. Additionally, the State Administration of Traditional Chinese Medicine, a national government agency, formulates TCM industry policies for the development of TCM and provides research grants for TCM research and development.
The Chinese Ministry of Health ("MOH") published its EDL at the new edition of 2012 with 317 drugs on the list, among which 203 are TCM. We have 74 of our TCM products included in the EDL.
We believe that TCM will remain as mainstream medicines in China and will continue to grow as a result of:
·The Chinese continued preference for TCM remedies with its roots deeply cultivated in five thousand years of history;
·government support for modernized TCM as a key component of increasing quality of healthcare;
·the rapidly growing over-the-counter market, in which TCM makes up more than half; and
·lower pricing as compared to western medicine.
Nutraceutical Market
The Chinese nutraceutical market is a multibillion dollar market and continues to grow. The nutraceutical products are typically ingested in the form of a pill, capsule, tablet or in liquid form. The main channels for distributing nutraceutical products, including health foods, in China are supermarkets and retail outlets.
The nutraceutical market in China has been growing rapidly over the past decade, which is driven primarily by the increase in per capita income as well as the increase in awareness of the importance of maintaining one’s health. However, a series of food safety scandals and economy challenges have had an adverse effect on the nutraceutical market in 2012 and negatively affected our business in this sector.
Some nutraceuticals may be registered as health foods in China and are subject to approval by the SFDA. Health foods are generally defined as products that are suitable for a specific group of people and that are able to adjust body functions while not aiming at curing a disease. These substances, however, only need to demonstrate safety rather than meet clinical endpoints for efficacy. The SFDA has a list of 27 approved health and beauty benefits that health foods may claim on their packaging or in advertisements. These direct-to-consumer advertisements typically highlight one or more of the approved benefits while focusing on some trend for healthy living.
Financial Information about Industry Segments
Since October 2008, we have two operating segments based on our major lines of businesses: manufacturing and distribution. For additional information please refer to Note 20 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2012.
Our Strengths
We believe we have the following strengths, the potential of which when materialized will give us an edge in competition in the market.
·Diverse Product Categories That Provide Operating Flexibility. Our business consists of three product categories including prescription pharmaceutical products, over-the-counter pharmaceutical products and nutraceutical products. Our pharmaceutical products target different therapeutic areas including women’s health, nasal, bedwetting and anti-viral. Each of these competes in a market segment with differentiated regulatory, economic and general market characteristics. We believe this diversification reduces our dependence on any one market segment and enables us to adapt to evolving market conditions in China in order to optimize our business operations in a long run.
·Well-Recognized Brand Names That Can be Leveraged for Competition with Our Competitors. We have nationally recognized brand names in China, including, Jinji, SHL, Boke and Three Happiness. We believe these brand names provide us with valuable resources for our products to compete in the market. It can also be leveraged further with product line extensions and by establishing brand families for related products. For instance, our Jinji product line enjoys brand recognition in the women’s health market. We believe we can significantly capitalize on this strength for future product introductions to treat other women’s health indications or even when we expand into other therapeutic categories.
Our Strategy
Given the ongoing economic challenges and uncertainties of the markets in which we operate, our objective is to stabilize our business and regain profit in our operation through development, manufacture and commercialization of pharmaceutical products. We intend to achieve this objective by:
·Cultivating AOBO as a Unified Mega Brand in Its Own Right, Fusing the Synergy among Our Nationally Established Individual Brands, such as, Jinji, Boke, CE, etc. Our vision is to create a unified mega brand for AOBO so that we can leverage on the brand equity we have already established to boost the credibility and the acceptance of our other products, including the image of those products that are part of the government sponsored tendering processes for EDL as well as those in the national insurance catalogs. We believe a reasonably priced product with a brand name will be more appealing to consumers, patients, and doctors.
·Promoting Products through Education. We intend to support and increase the sales of our products by education, such as informational seminars to cultivate an educated audience for our branded products. We will detail the efficacy and safety profile of our established prescription pharmaceutical products to physicians at hospitals and clinics in all provinces in China through the efforts of our sales force and through educational physician conferences and seminars. We will expand our extensive direct-to-consumer advertising campaign highlighting the quality and benefits of our fast growing over-the-counter pharmaceutical products through television, newspaper and print advertisements.
·Developing and Introducing Additional Products to Expand or Strengthen Our Existing Portfolio. We plan to focus our research and development capabilities towards expanding our existing portfolio of approved products. We have over 170 prescription and over-the-counter pharmaceutical products in our portfolio that are currently approved but have not been commercially launched. In addition, we are conducting clinical trials for new modernized products. These products, if and when successful are expected to break into new markets, or will broaden our patient acceptance because of increased credibility. We have recently cut back on research and development costs due to liquidity concerns, so new product development will likely not be as aggressive as in recent periods.
Research and Development
We believe science, technology and innovation, when managed appropriately, will be a critical success factor in our business. Although there was uncertainties in the pharmaceutical market in 2012, we continued to commit substantial resources to research and development and spent $6.2 million, or 4% of total revenues in 2012, compared to $12.7 million 6% of total revenues in 2011. We have recently cut back on research and development costs due to liquidity concerns, so new product development will likely not be as aggressive as in recent periods.
Our research and development efforts fall into three categories, namely, the near term, intermediate term, and long term. In the near term we focus on the development, by which we mean our interest will remain in innovations in life cycle management and technology upgrade on existing products, so that safety and efficacy can be improved, or, new indications can be developed for the treatment of additional diseases.
We may also license some drug product candidates at late stage development for further development, so that the time to potential commercialization may be drastically reduced. The goal is to launch more competitive products with a relatively short timeframe. For our long term efforts, we plan to enter major therapeutic areas, such as cancer and cardiovascular diseases.
We remain focused on our overall operation’s profitability and maintaining control of working capital. We establish collaborative projects mostly inside China, but also have some collaborative development with professional labs in the USA. Leveraging on the resources outside the Company, we believe we can significantly reduce the time and resources that would be otherwise required. We have made and expect to continue making substantial efforts in research and development activities.
Our Products
Our manufacturing business consists of three main product categories, including prescription pharmaceutical products, over-the-counter pharmaceutical products and nutraceutical products. The majority of our pharmaceutical products are based on non-synthetic medicinal compounds that are extracted from different parts, such as leaves and roots, of one or more plants. All of our pharmaceutical products have demonstrated safety and efficacy in clinical trials sufficient to obtain approval by the SFDA. Nutraceutical products, also frequently referred to as functional foods, functional beverages, dietary supplements or general nutritional supplements, are intended to promote overall health and well-being. Our nutraceutical products are generally considered general nutritional supplements and are not subject to regulatory approval by the SFDA.
We currently manufacture and sell 109 products. The following table summarizes our principal marketed pharmaceutical and nutraceutical products that comprised the majority of our revenue in the year of 2012.
Prescription Pharmaceutical Products
Shuanghuanglian Lyophilized Injection Powder
Our SHL Injection Powder is a prescription pharmaceutical product approved and marketed for the treatment of flu symptoms, including high fever, cough and sore throat, as well as upper respiratory infections, mild pneumonia and tonsillitis. Our SHL Injection Powder, marketed under the brand name SHL, is one of the only two formulations of SHL approved by the SFDA for intravenous injections. The approved dosage for our SHL Injection Powder is 60 mg for every kilogram of a patient’s body weight. In practice, a medical doctor will decide exactly how much SHL injection powder to use for each patient. This product consists of two plant based ingredients isolated from flowers and leaves.
Our SHL Injection Powder was commercially launched in China in 1997 by HSPL, which we acquired in 2004. We detail the safety and efficacy of this product to physicians in hospitals and clinics primarily in rural China. We believe that injectables are of higher quality and offer better bioavailability and efficacy than oral formulations.
We are one of the two companies approved by the Ministry of Health to manufacture and commercialize SHL injection powder. This product is manufactured at our Heilongjiang Songhuajiang Pharmaceutical, or HSPL, facility in Harbin.
Phase 3 clinical trials for SHL Injection Powder were conducted on 489 patients at Harbin University of Medical Sciences First Affiliated Hospital, Heilongjiang TCM Research Institute and Harbin TCM Hospital. These trials demonstrated safety and efficacy in accordance with SFDA requirements.
Product safety and side effects are always a concern with TCM injection pharmaceutical products. Our SHL injection powder has not been subject to any liability claims. While we continue to conduct research to upgrade and improve the safety of the products, in 2010, HSPL where our SHL products are made had one short notice inspection by the GMP Expert Group from China SFDA, and three inspections by the provincial or municipal drug administration bureaus. We successfully passed each of the inspections.
Cease Enuresis Soft Gel
Our CE Gel is a prescription pharmaceutical product approved and marketed to alleviate bedwetting. This product consists of a formulation that is isolated from the seed of a plant. Our CE Gel is the only SFDA approved Category 1 new pharmaceutical product for this indication. Category 1 approval provides a product with 12 year protection from other companies replicating the product and can be granted when the product is considered to be the first product for a specific indication.
Our CE Gel was commercially launched in China in April 2004. We detail the clinical benefits of this product to physicians in hospitals and clinics throughout China. As prescription medications cannot be commercially advertised in China, we rely on physicians to recommend the use of our CE Gel to patients. The Cease Enuresis brand name, however, is well recognized by many patients as our CE Patch is an over-the-counter pharmaceutical product that we promote through direct-to-consumer advertising. This product is manufactured at our Three Happiness facility in Harbin.
Phase 3 clinical trials for CE Gel were conducted on 437 patients at Beijing Children’s Hospital, China University of Medical Sciences No. 2 Clinical Hospital, Liaoning TCM Institute Affiliated Hospital and Liaoning TCM Research Institute. These trials demonstrated safety and efficacy in accordance with SFDA requirements.
Over-the-Counter Pharmaceutical Products
Cease Enuresis Patch
Our CE Patch is an over-the-counter pharmaceutical product approved and marketed for the treatment of bedwetting and incontinence. Our CE Patch is formulated for delivery by a patch and can be used in combination with our CE Gel. This product consists of the same plant based ingredients as our CE Gel. Our CE Patch was commercially launched in China in 2005. We promote our CE Patch through direct-to-consumer advertising on television and in print media in China. This product is manufactured at our Three Happiness facility.
Our CE Patch was approved by the Food and Drug Administration Bureau of the Heilongjiang Province, under the medical device regulatory pathway.
Jinji Capsule
Our Jinji Capsule is both a prescription and over-the-counter pharmaceutical product approved and marketed for the treatment of endometritis, annexitis and pelvic inflammations. This is our company’s proprietary product that has a well recognized brand name. This product consists of a combination of many parts of TCM plants, including roots, vines, flowers and stems. We source the majority of our raw materials for our Jinji product line from the Guangxi province, which we believe has a unique natural environment to cultivate high quality plants. We believe the combination of these quality ingredients, our manufacturing processes and our well-recognized brand name position our Jinji products well to compete in the marketplace. A course of treatment requires a dose of four capsules taken three times a day.
Our Jinji Capsule was commercially launched approximately 30 years ago in China by GLP, which we acquired in April 2006. With its long history, the Jinji brand name is well-recognized in the women’s health market in China. We promote our Jinji Capsule through direct-to-consumer advertising, including an extensive television commercial campaign. These commercials are televised nationally in China. We believe that these advertisements continue to strengthen our brand loyalty, a major driver of the historical popularity of the drug. This product is manufactured at our Guangxi Lingfeng Pharmaceutical Co., or GLP, facility in Hezhou in the Guangxi Province in Southwestern China. Phase 3 clinical trials for Jinji Capsule were conducted on 421 female patients at Wuzhou City People’s Hospital, Wuzhou City Workers’ Hospital and Hezhou TCM Hospital. These trials demonstrated safety and efficacy in accordance with SFDA requirements.
Jinji Yimucao
Our Jinji Yimucao is an over-the-counter pharmaceutical product approved and marketed for the treatment of premenstrual syndrome, or PMS, and other PMS and menopause-related symptoms. Jinji Yimucao is approved by the SFDA in China and marketed as a branded generic drug. This product consists of a combination of many parts of TCM plants, including roots, vines, flowers and stems. We source the majority of our raw materials for our Jinji product line from the Guangxi province, which we believe has a unique natural environment to cultivate high quality plants. We believe the combination of these quality ingredients, our manufacturing processes and our well-recognized brand name position our product well to compete in the marketplace. Each treatment requires a dose of two packets of powder for oral suspension taken two times a day.
In early 2007 we commercially launched JinjiYimucao. We own this product as a result of the acquisition of GLP, which we completed in April 2006. We promote Jinji Yimucao through direct-to-consumer advertising, including an extensive television commercial campaign. We believe that these advertisements continue to strengthen our brand loyalty, a major driver of the historical popularity of the drug. This product is manufactured at our GLP facility in Hezhou.
Boke Nasal Spray
Our Boke nasal spray is an over-the-counter pharmaceutical product approved and marketed for the treatment of sinus congestion from common cold, stuffy nose, chronic rhinitis, allergic rhinitis and nasosinusitis. The spray is marketed under the product name of DitongBiyanshuiPenwuji (“Ditong”). Ditong is approved by the SFDA in China and marketed as a branded drug. This product consists of a combination of many parts of TCM plants, including roots, vines, flowers and stems. Treatment dosage is three to four times a day and two sprays into each nostril.
Ditong was commercially launched by Boke in China approximately 10 years ago. We own this product as a result of the acquisition of Boke, which we completed in October 2007. We promote Boke nasal spray through direct-to-consumer advertising, including an extensive television commercial campaign. We believe that these advertisements continue to strengthen our brand loyalty, a major driver of the historical popularity of the drug. This product is manufactured at our Boke facility in Nanning.
Principal Nutraceutical Products
Soy Peptide Series
Our Soy Peptide Series is our primary line of nutraceutical products, all of which are available in supermarkets, fitness centers, specialty nutraceutical stores and other retail outlets. These products include tablets, powders, drinks and instant coffee that are non-genetically modified and derived from soybeans through a biochemical process involving decomposition, conversion and synthesis of soybean protein. They are used as food and beverage supplements and are easily digested, increase metabolism and can replenish body strength. The benefit of our peptide formulation compared with the soybean itself is that our formulation is more readily absorbable by the human body. We manufacture these products at our Three Happiness facility in Harbin.
Our Soy Peptide Series was commercially launched in China in 2002. We do not have any exclusivity under Chinese law for these products but we own trademarks and market all of our nutraceutical products through print advertising campaigns. While the nutraceutical market is highly fragmented with many competitors, we believe that our product branding and multiple forms for delivery of the peptide will continue to support additional growth.
Product Pipeline
We have our own research, development and laboratory facilities in China and a lab in USA, all of which are run by our own professional research and development team. We have also entered into joint research and development agreements with outside research institutes in China and in the United States. We intend to continue introducing new modernized products to leverage our branded market leadership position, and to develop line extensions for our existing products.
We are also exploring opportunities for acquisitions that may complement our existing product lines and leverage our significant sales and distribution capabilities.
Marketing and Sales
We focus our marketing efforts on establishing business relationships and growing our brand recognition. In 2012, we manufactured and marketed 109 products. In 2012, we made special efforts in our prescription and generic products’ market based on the changing pharmaceutical environment and we penetrated major cities and rural areas, including hospitals, clinics, pharmacies and retail stores. We continue to invest in marketing and TV advertisements. While marketing and promotional expenses for newly-launched products have impacted our short-term profitability, this is in line with our strategy of investing in new products we expect to have potential for growth in the future.
Our marketing division is responsible for designing our overall marketing strategy, managing our brand, conducting market research and surveys, liaising with various levels of regulatory authorities and government institutions and providing training to our sales force. Our marketing division also ensures that our brand is associated with high quality products and responsive service, our customer support and sales team work with each member within our sales channel, including hospitals, clinics, and distributors in a wide range of areas to help them become more effective.
We maintain approximately 100 regional representative offices throughout China and employ approximately 1,600 sales and marketing professionals in major cities and extensive rural areas. Through regular meetings with physicians and hospital administrators, the organization of academic seminars and conferences, and assisting with clinical trials, our salespeople can effectively communicate the therapeutic benefits of our products to physicians and hospital administrators. Specifically, our senior personnel in the prescription sales force typically interact with the heads of a hospital administration and the persons in charge of the relevant departments to seek the inclusion of our products in the hospital’s formulary. Our middle-level and junior personnel typically meet with individual physicians to promote the therapeutic value and other features of our products.
Our sales people are assigned to a number of retail pharmacies in a designated region, where they work with pharmacy salespeople to conduct in- store promotions and other forms of direct marketing to consumers and also educate pharmacy salespeople on our products. They also organize free community healthcare activities, collect consumer opinions on our products and our promotional and advertising activities, and relay these consumer opinions to our marketing strategy division. This valuable feedback allows us to tailor our promotional and advertising activities to fit different consumer profiles and different localities.
By working closely with our distributors, our customer support and sales team are able to provide us valuable insights into the operations of each local distributor, which help us, ensure that each distributor is able to operate effectively for our growth.
Distributors and Customers
We sell part of our products to third-party distributors who resell these products to hospitals and retail pharmacies. In addition, these distributors also handle distribution logistics, warehousing and transportation. As of December 31, 2012, our national distribution network consisted of more than 320 distributors covering major cities and extensive rural areas in China. The breadth of our distribution channel allows us to target distribution points comprising hospitals, clinics, pharmacies and retail stores.
We make selections based on factors such as sales experience, knowledge of the products, contacts in the hospital and communities, reputation and market coverage. We do not enter into exclusive distribution agreements with these third party distributors.
We actively manage our distribution network and we review our distribution agreements on an annual basis to specify designated distribution points, the location and method for delivery of our products to certain distribution points and targets for annual sales volume and receivable collections.
The distribution industry in China is fragmented with over 10,000 distributors. Due to the number of distributors, we do not rely on any one distributor for our distribution needs. We estimate that our top 10 distributors account for only approximately 17% of our total sales.
Since October 2008, through the acquisition of NuoHua, distribution of pharmaceutical products became part of our business and we now distribute pharmaceutical products throughout the Liaoning and Jilin province in China.
Manufacturing
We employ a vertically integrated operating model in order to enable us to develop, manufacture and market quality products at competitive prices. Our factories work closely with our research and development team to optimize manufacturing processes and develop commercially viable products. In addition, our factories incorporate regular feedback from our sales and marketing personnel, in order to timely and cost-effectively introduce products tailored to end-user needs.
Furthermore, most of our manufacturing operations, which are based in China, have easy access to transportation, often provide us with the convenience of low-cost operations, sufficient labor pool and close proximity to sources of some raw materials. As part of our overall strategy to lower production costs through our vertically integrated operating model, we have made substantial investments in our in-house manufacturing infrastructure to complement our research and development, product design activities, capacity improvement, and efficiency enhancement.
We have five manufacturing facilities in China dedicated exclusively to the manufacture of our products. Each facility is GMP certified. We have fully integrated manufacturing support systems including quality assurance, quality control and regulatory compliance.
Our quality assurance team devotes significant attention to quality control for designing, manufacturing and testing our products, and is also responsible for ensuring that we are in compliance with all applicable national and local regulations and standards, as well as our internal policies. On February 12, 2011, SFDA promulgated the more stringent new GMP guidelines. The new standards are aimed at improving drug production management and controlling risks in the production process and introduce internationally-recognized quality control mechanisms. The latest update to GMP standard has greatly raised the bar for quality control, documentation, and overall manufacturing processes, thus causing an increase of cost in manufacturing and decrease of profit margins.
However, from a long term perspective, we believe the upgraded GMP standards will ensure better quality in the pharmaceutical products that are sold in China’s pharmaceutical markets. The new regulations apply to new manufacturing facilities effective from March 1, 2011 and the industry has a five year phase-in period to bring existing facilities in line with the revisions.
The details of our facilities are as follows:
·Three Happiness. Our Three Happiness facility is located in Harbin, the capital of Heilongjiang Province in northeast China. It is approximately 1,532,775 square feet and manufactures both pharmaceutical and nutraceutical products. The Three Happiness facility consists of one pharmaceutical and one nutraceutical manufacturing plant, including a dedicated building for soybean peptide products.
·HSPL. Our HSPL facility is also located in Harbin. It is approximately 532,339 square feet and manufactures our SHL Injection Powder.
·GLP. Our GLP facility is located in He Zhou, in the Guang Xi Province in southwest China. It is approximately 1,875,287 square feet and manufactures our Jinji series of women’s health products.
·CCXA. Our CCXA facility is located in ChangChun, the capital of Jilin Province in northeast China. It is approximately 1,357,220 square feet and manufactures a variety of generic pharmaceutical products.
·Boke. Our Boke facility is located in NanNing, the capital of Guang Xi Province in southwest China. It is approximately 174,280 square feet and manufactures our Boke series of nasal products.
We have land use rights to the land on which our manufacturing facilities are located that are granted and allocated to us by the government. According to Chinese laws, the government owns all the land in China and companies or individuals are authorized to use the land only through land use rights granted or allocated by, or leased from, the PRC government.
Raw Materials
Our production facilities are located in certain regions of China, usually with easy transportation access to some of the raw materials we use in manufacturing our products. We also have some farm land where medicinal herbs are grown and harvested for us, which we believe is a cost saving measure when the harvest is ready for our products. Historically, we have not had difficulty obtaining the quantity of raw materials we need from suppliers, although the general trend of price increases continue.
The increase in raw materials cost should be viewed against the macro economic conditions in China. Industry research indicates that TCM raw materials price will continue to increase. The impact of such inflation will vary depending on different products that require different TCM raw materials, even though a few TCM raw materials have seen a small percentage of price decline. We continue to take multiple approaches to reduce the risk of over reliance on certain raw materials, including entering arrangements with suppliers in China to hedge against the risk of short supply due to weather induced irregularities.
To mitigate the impact of the increasing cost and supply of raw materials, the Company entered into long-term supply contracts with various third parties to grow Millettia and Xanthoceras Sorbifolia Bge (“XSB”), which are the Company’s major raw materials. Through these supply contracts, the Company believes that it will stabilize the supply of its major material in a long run and reduce the risk of increasing cost in future periods.
As such, in 2009 and 2010, the Company’s GLP subsidiary entered into long-term supply contracts with various third parties to grow Millettia and XSB, a major raw material of the Company, on behalf of the Company through leasing land use rights and production arrangements. Under these contracts, the Company bears the costs in relation to Millettia cultivation and in return is entitled to a supply price at fair value discounted at a pre- determined rate when delivered. The purchase commitment is unconditional and the Millettia is not expected to be harvest until after 2018 and XSB is not expected to be harvest until after 2014. The Company expects the initial supply of Millettia to occur between year nine and year eleven of the contract period as Millettia is a stem from a certain plant which requires an eight to ten-year period to mature. XSB requires a three-year period to mature and the Company expects the initial supply from year four. The contracts for Millettia expire after 30 years and the contract for XBS expire after 10 years. All contracts entitle the Company to renew with terms to be negotiated.
We have our own quality control system, and devote significant attention to quality control for the raw material extraction, product production, manufacturing, and commercialization. In particular, we have established a quality control system in accordance with SFDA regulations.
Intellectual Property
We regard our packaging designs, service marks, trademarks, trade secrets, patents and similar intellectual property as part of our core competence that is critical to our success. We rely on patent, trademark and trade secret law, as well as confidentiality agreements with certain of our employees, distributors and others to protect our intellectual property rights.
There are three types of patents under the PRC patent law. The first type, an external design patent, refers to a new design of a product’s shape, pattern or a combination of shape and pattern and the combination of a product’s color and its shape and pattern, where such a design is aesthetically appealing and suitable for industrial application. The second type of patent is called an invention patent and the third type of patent is referred to as a new model or utility patent. Invention patents and utility patents are similar in that both of them relate to scientific or technological inventions. A utility patent, compared to an invention patent, requires a lower level of creativity and covers a narrower scope. In addition, an invention patent can be a new technology introduced in respect of an existing product, method or their improvements, while a utility patent is restricted to a product’s shape, constitutions or a combination of these two. Invention patents are valid for 20 years, whereas utility patents and external design patents are each valid for
10 years.
To a large extent, we rely on such State Protection law to protect our intellectual property rights with respect to some of our products. As of December 31, 2012, we owned a total of 53 patents and the number of patents in the process of application is 37; and have registered a total of 272 trademarks and the number of trademarks in the process of application is 51.The Company has the following invention patents related to material products:
Application No./Patent No. Product Covered Purpose Expiration Date
00103392.1 Soybean Peptides the equipment and method of producing small molecular peptides from protein separated from soybean 3/01/2020
200410043925.0 SHL the production method of injection powder 10/11/2024
200510055523.7 Jinji Capsule a drug for treatment of pelvic inflammatory disease and its production method 3/16/2025
200510010531.X CE Gel a method for quality control of the production of WenGuanGuoZiRen cream 11/11/2025
200610009619.4 CE Patch a method for the extraction of effective portion of WenGuanGuoZiRen 1/12/2026
144459.0 CE Patch the extraction of WenGuanGuoZiRen, its method of extraction and usage 1/12/2026
In addition, the Company has the following external design patents for packaging designs related to our key products:
Application No. Purpose Expiration Date
200630157478.1 packaging box for CE Patch 12/4/2016
200630157477.7 packaging box for CE Capsule 12/4/2016
200630157479.6 packaging box for SHL Injection Powder 12/4/2016
200730145294.8 packaging box for JinjiYimucao 4/30/2017
200830113220.0 packing box for Ditong rhinitis Spray 9/05/2018
For the years ended December 31, 2012, 2011, and 2010, the Company conducted annual impairment tests to determine if recorded amounts for these assets all active, being used in production of products or would be utilized in future production. The assessment also included an evaluation of the ongoing cash flows from these assets. In performing such analysis as of December 31, 2011, the Company identified certain product licenses, trademarks and patents that would no longer be used due to change in product lines, customer acceptance or expiration of the underlying right. As such, the Company determined that $6,928,064 of such items had been impaired or abandoned during the year ended December 31, 2011. No such charges were recorded in 2012. The Company believes the remaining licenses, trademarks, and patents still have value and will continue to be used in ongoing operations.
Competition
We believe that competition and leadership in our industry are based on managerial and technological expertise, and the ability to identify and exploit commercially viable products in a long run. Other factors affecting our competitive position include time to market, patent position, product efficacy, safety, convenience, reliability, availability and pricing.
Our SHL Injection Powder primarily competes with a similar injection powder product produced by Harbin Pharmaceutical Group. Our marketing strategy with respect to this product is broader than our competitor by focusing on rural markets as well as major cities and continues to maintain high products quality. We believe this strategy has been successful for us against our competition.
Our CE Gel competes with several other products having similar functionality. Some of these products include the Jianpizhiyi Tablet produced by Shangdong Zhiling Pharmaceutical Company, Yeniaoying produced by Tianjin Zhongxin Company, Shengjiyiniaokang produced by Shanxi Dingxing Healthcare Scientific Limited and Suoquan Pill produced by Jilin Tianguang Pharmaceutical Limited. Despite the similar products in the market, we believe our CE Gel is the leading product, as currently it is the only SFDA approved first grade medicine for bedwetting.
Our Jinji Capsule competes with Huahong Pill produced by Huahong Pharmaceutical Group and Qianjin Pill produced by Qianjin Pharmaceutical Group.
Our Boke nasal spray competes with Dezhong Biyankang produced by Guangdong Foshan Dezhong Pharmaceutical Co., Ltd; Zhonglian Rhinitis Tablets produced by Wuhan Zhonglian Pharmaceutical Co., Ltd; and Qianbai Rhinitis Tablet produced by Guangzhou Qixing Pharmaceutical Co., Ltd.
Our Soy Peptide Series competes with Leneng Peptide Powder, produced by Leneng Bioengineering Company and Soybean Protein Peptide, produced by Harbin High and New Technology Company Limited.
Environmental Matters
We are subject to evolving regulations under laws and regulations administered by governmental authorities at the national, provincial and city levels, some of which are, or may be, applicable to our business. Our hospital customers are also subject to a wide variety of laws and regulations that could affect the nature and scope of their relationships with us.
We must comply with numerous additional state and local laws relating to matters such as safe working conditions, manufacturing practices, environmental protection and fire hazard control. We may be required to incur significant costs to comply with these laws and regulations in the future. Unanticipated changes in existing regulatory requirements or adoption of new requirements could have a material adverse effect on our business, financial condition and results of operations.
Employees
We had 3,719 employees as of December 31, 2012. 1,182 of these employees are principally engaged in manufacturing and services activities, 1,752 in sales and marketing, 115 in research and development and 670 in management and administration. We continue to monitor our headcount and may add additional employees for sales and marketing, research and development, customer service and manufacturing and assembly as our business grows. In general, we consider our relationship with our employees to be good.
Insurance
We currently carry insurance policies which are customary for enterprises providing for total coverage of approximately $42 million. We have property coverage of approximately $16.6 million, motor vehicle coverage of approximately $0.9 million, employee health and accident coverage of approximately $24.12 million and material damage insurance coverage of $0.4 million . We paid aggregate insurance premiums of $86,848 in 2012.
Our History
Three Happiness had been conducting business in China since 1994. In June 2002, through a share exchange with the stockholders of Three Happiness, Three Happiness became our wholly-owned subsidiary and continued its business operations in China. Prior to the share exchange we did not have any business operations. At the time of the share exchange we changed our name to American Oriental Bioengineering, Inc.
In February 2003, we acquired the rights to a soybean protein peptide biochemical engineering project, which provided us with the rights to manufacture and commercialize our Soy Peptide Series of nutraceutical products. Also, since the share exchange in 2002, we acquired seven companies in China. In November 2004, we acquired HSPL, which manufactures and commercializes our SHL Injection Powder. In April 2006, we acquired GLP, which manufactures and commercializes our Jinji series. In July 2006, we acquired HQPL, a pharmaceutical distributor that owns a license to distribute pharmaceutical products in China. In August 2007, we acquired CCXA, which manufactures and commercializes a board range of generic pharmaceutical products. In October 2007, we acquired BOKE, which manufactures and commercializes our Boke series of nasal products. In October 2008, we acquired NuoHua, a pharmaceutical wholesale and retail distribution company, and Guang Xi Hui Ke Pharmaceutical Research and Development Co., Ltd. (“GHK”), a company engaged in pharmaceutical research and product development leading to SFDA approval to expedient product launches in China.
On July 18, 2005, our common stock commenced trading on the American Stock Exchange, or AMEX, under the ticker symbol “AOB.” On November 14, 2005, our common stock commenced trading on the Archipelago Exchange, or ArcaEx, a facility of the Pacific Exchange.
On December 18, 2006, we voluntary elected to delist our common stock from the AMEX and ArcaEx. Our common stock commenced trading on the New York Stock Exchange under the ticker symbol “AOB” on the same day.
On March 16, 2012, concurrent with the Company’s 8-K announcing audit committee investigation into matters identified by the auditor Ernst & Young Hua Ming, the Company’s stock was suspended in trading by NYSE. On April 16, 2012, the New York Stock Exchange (“NYSE”) filed a form of 25NSE with SEC to announce official delisting the Company’s common stock. As a result of the delisting the Company’s common stock started to be quoted on the Pink Sheet on May 29, 2012.
Regulations of Our Industry --the Pharmaceutical Industry
The pharmaceutical industry in China, including the TCM sector, is highly regulated. The primary regulatory authority is the SFDA, including its provincial and local branches. As a developer, producer and distributor of medicinal products, we are subject to regulation and oversight by the SFDA and its provincial and local branches. The Law of the PRC on the Administration of Pharmaceuticals provides the basic legal framework for the administration of the production and sale of pharmaceuticals in China and covers the manufacturing, distributing, packaging, pricing and advertising of pharmaceutical products. Its implementing regulations set forth detailed rules with respect to the administration of pharmaceuticals in China. We are also subject to other PRC laws and regulations that are applicable to business operators, manufacturers and distributors in general.
Registration and Approval of Medicine. A medicine must be registered and approved by the SFDA before it can be manufactured. The registration and approval process requires the manufacturer to submit to the SFDA a registration application containing detailed information concerning the efficacy and quality of the medicine and the manufacturing process and the production facilities the manufacturer expects to use. To obtain the SFDA registration and approval necessary for commencing production, the manufacturer is also required to conduct pre-clinical trials, apply to the SFDA for permission to conduct clinical trials, and, after clinical trials are completed, file clinical data with the SFDA for approval. Our pharmaceutical products are approved by the SFDA and are being sold both as prescription and over-the-counter medicines.
New Medicine. If a medicine is approved by the SFDA as a new medicine, the SFDA will issue a new medicine certificate to the manufacturer and impose a monitoring period which shall be calculated starting from the day of approval for manufacturing of the new medicine and may not exceed five years. The length of the monitoring period is specified in the new medicine certificate. During the monitoring period, the SFDA will monitor the safety of the new medicine, and will neither accept new medicine certificate applications for an identical medicine by another pharmaceutical company, nor approve the production or import of an identical medicine by other pharmaceutical companies. For new medicines approved prior to September 2002, the monitoring period could be longer than five years. As a result of these regulations, the holder of a new medicine certificate effectively has the exclusive right to manufacture the new medicine during the monitoring period.
Provisional National Production Standard. In connection with the SFDA’s approval of a new medicine, the SFDA will normally direct the manufacturer to produce the medicine according to a provisional national production standard, or a provisional standard. A provisional standard is valid for two years, during which the SFDA closely monitors the production process and quality consistency of the medicine to develop a national final production standard for the medicine, or a final standard.
Three months before the expiration of the two-year period, the manufacturer is required to apply to the SFDA to convert the provisional standard to a final standard. Upon approval, the SFDA will publish the final standard for the production of this medicine. In practice, the approval for conversion to a final standard is a time-consuming process. However, during the SFDA’s review period, the manufacturer may continue to produce the medicine according to the provisional standard.
Transitional Period. Prior to the latter of (1) the expiration of a new medicine’s monitoring period or (2) the date when the SFDA grants a final standard for a new medicine after the expiration of the provisional standard, the SFDA will not accept applications for an identical medicine nor will it approve the production of an identical medicine by other pharmaceutical companies. Accordingly, the manufacturer will continue to have an exclusive production right for the new medicine during this transitional period.
Continuing SFDA Regulation. Pharmaceutical manufacturers in China are subject to continuing regulation by the SFDA. If the labeling or manufacturing process of an approved medicine is significantly modified, a new pre-market approval or pre-market approval supplement will be required by the SFDA. A pharmaceutical manufacturer is subject to periodic inspection and safety monitoring by the SFDA to determine compliance with regulatory requirements. The SFDA has a variety of enforcement actions available to enforce its regulations and rules, including fines and injunctions, recall or seizure of products, the imposition of operating restrictions, partial suspension or complete shutdown of production and criminal prosecution.
Pharmaceutical Product Manufacturing
Permits and Licenses for Pharmaceutical Manufacturers. A pharmaceutical manufacturer must obtain a pharmaceutical manufacturing permit from the SFDA’s relevant provincial branch. This permit is valid for five years and is renewable upon its expiration. Each of our manufacturing facilities has a pharmaceutical manufacturing permit. We do not anticipate any difficulty in renewing our pharmaceutical manufacturing permits upon expiration.
Good Manufacturing Practice. A pharmaceutical manufacturer must meet Good Manufacturing Practice standards, or GMP standards, for each of its production facilities in China in respect of each form of pharmaceutical products it produces. GMP standards include staff qualifications, production premises and facilities, equipment, raw materials, environmental hygiene, production management, quality control and customer complaint administration. If a manufacturer meets the GMP standards, the SFDA will issue to the manufacturer a Good Manufacturing Practice certificate, or a GMP certificate, with a five-year validity period. However, for a newly established pharmaceutical manufacturer that meets the GMP standards, the SFDA will issue a GMP certificate with only a one-year validity period. We have obtained a GMP certificate for all of our production facilities covering all of the products that we produce.
On February 12, 2011, SFDA promulgated the more stringent new GMP guidelines. The new standards are aimed at improving drug production management and controlling risks in the production process and introduce internationally-recognized quality control mechanisms. The latest update to GMP standard has greatly raised the bar for quality control, documentation, and overall manufacturing processes.
Pharmaceutical Distribution. A distributor of pharmaceutical products in China must obtain a pharmaceutical distribution permit from the relevant provincial or local SFDA branches. The distribution permit is granted if the relevant SFDA provincial branch receives satisfactory inspection results of the distributor’s facilities, warehouse, hygiene environment, quality control systems, personnel and equipment. A pharmaceutical distribution permit is valid for five years.
Restrictions on Foreign Ownership of Pharmaceutical Wholesale and Retail Businesses in China. Chinese regulations on foreign investment currently permit foreign companies to establish or invest in wholly foreign-owned companies or joint ventures that engage in wholesale or retail sales of pharmaceuticals in China. For retail sales, these regulations restrict the number and size of retail pharmacy outlets that a foreign investor may establish. Retail pharmacy chains with more than 30 outlets that sell a variety of branded pharmaceutical products sourced from different suppliers are limited to less than 50.0% foreign ownership unless the outlets are owned by a third party and operated under a foreign franchise.
Good Supply Practice Standards. The SFDA applies Good Supply Practice standards, or GSP standards, to all pharmaceutical wholesale and retail distributors to ensure the quality of distribution in China. The currently applicable GSP standards require pharmaceutical distributors to implement controls on the distribution of medicine, including standards regarding staff qualifications, distribution premises, warehouses, inspection equipment and facilities, management and quality control. A certificate for GSP standards, or GSP certificate, is valid for five years, except for a newly established pharmaceutical distribution company, for which the GSP certificate is valid for only one year.
Price Controls. The retail prices of prescription and over-the-counter medicines that are included on essential drug list (the “EDL”) and in the national medicine catalog are subject to price controls administered by the Price Control Office under the National Development and Reform Commission, or the NDRC, and provincial price control authorities, either in the form of fixed prices or price ceilings. The controls over the retail price of a medicine effectively set the limits for the wholesale price of that medicine. From time to time, the NDRC publishes and updates a national list of medicines that are subject to price control. Fixed prices and price ceilings on medicines are determined based on profit margins that the NDRC deems reasonable, the type and quality of the medicine, its production costs, the prices of substitute medicines and the extent of the manufacturer’s compliance with the applicable GMP standards. The NDRC directly regulates the price of some of the medicines on the list, and delegates the power to provincial price control authorities to regulate the remainder on the list. For those medicines under the authority of provincial price control authorities, each provincial price control authority regulates medicines manufactured by manufacturers registered in that province. Provincial price control authorities have the discretion to authorize price adjustments based on the local conditions and the level of local economic development. Only the manufacturer of a medicine may apply for an increase in the retail price of the medicine and it must apply either to the NDRC, if the price of the medicine is nationally regulated, or to the provincial price control authorities in the province where it is registered, if the price of the medicine is provincially regulated. For a provincially regulated medicine, when provincial price control authorities approve an application, they will file the new approved price with the NDRC for confirmation and thereafter the newly approved price will become binding and enforceable across China.
The controversial Anhui Model, while its pros and cons are still subject to debate, as we interpret it from what we have observed, has created a tendency of government tendering process favoring low cost at the expense of quality at least in some provinces, including Anhui. The prevalence of this tendency has forced out some well-established manufacturers, such as The Buchang Group, (see report on November 1, 2011 from www.meinet.com.cn) from participation in bidding, as the winning bid demands a price below cost. Also in above cited report, Yu Mingde, the president of China Pharmaceutical Enterprise Management Society, was reportedly said that “Tong Ren Tang was forced out of bidding in certain regions” because of below cost pricing.”Facing the challenges between the profit margin squeeze and revenue growth, we have adopted and will continue to adopt a stance that gives more priority to profitability. Notwithstanding our effort, we cannot assure you of profitable operations if the Anhui Model continues its abusive practice in the government tendering process.
Tendering Requirement for Hospital Purchases of Medicines. Provincial and municipal government agencies such as provincial or municipal health departments also operate a mandatory tendering process for purchases by state-owned hospitals of a medicine included in provincial medicine catalogs. These government agencies organize a tendering process once every year in their province or city and typically invite manufacturers of provincial catalog medicines that are on the hospitals’ formularies and are in demand by these hospitals to participate in the tendering process. A government-approved committee consisting of physicians, experts and officials is delegated by these government agencies the power to review bids and select one or more medicines for the treatment of a particular medical condition. The selection is based on a number of factors, including bid price, quality and manufacturer’s reputation and service. The bidding price of a winning medicine will become the price required for purchases of that medicine by all state-owned hospitals in that province or city. The tendering requirement was first introduced in 2001 and has since been implemented across China. We understand that the level of present implementation of the tendering requirement varies among different provinces in China.
Reimbursement under the National Medical Insurance Program. The Ministry of Labor and Social Security, together with other government authorities, determines which medicines are to be included in or removed from the national medicine catalog for the National Medical Insurance Program, and under which tier a medicine should fall, both of which affect the amounts reimbursable to program participants for their purchases of those medicines. These determinations are based on a number of factors, including price and efficacy. A National Medical Insurance Program participant can be reimbursed for the full cost of a Tier 1 medicine and 80 to 90% of the cost of a Tier 2 medicine.
Although it is designated as a national program, the implementation of the National Medical Insurance Program is delegated to various provincial governments, each of which has established its own medicine catalog. A provincial government must include all Tier 1 medicines listed in the national medicine catalog in its provincial medicine catalog, but may use its discretion based on its own selection criteria to add other medicines to, or exclude Tier 2 medicines listed in the national medicine catalog from, its provincial medicine catalog, so long as the combined numbers of the medicines added and excluded do not exceed 15% of the number of the Tier 2 medicines listed in the national catalog. In addition, provincial governments may use their discretion to upgrade a nationally classified Tier 2 medicine to Tier 1 in their provincial medicine catalogs, but may not downgrade a nationally classified Tier 1 medicine to Tier 2. The total amount of reimbursement for the cost of prescription and over-the-counter medicines, in addition to other medical expenses, for an individual program participant in a calendar year is capped at the amount in that participant’s individual account. The amount in a participant’s account varies, depending upon the amount of contributions from the participant and his or her employer. Generally, program participants who are from relatively wealthier eastern parts of China and relatively wealthier metropolitan centers have greater amounts in their individual accounts than those from less developed provinces.
Regulation Relating to the Nutraceutical Industry
Some nutraceuticals produced in China can be labeled as health food, which means the product is aimed at a specific group of people and is able to adjust bodily function but is not aimed at curing disease. Health foods are required to be approved by the SFDA and are subject to its regulation. We currently have only one product approved as a health food by the SFDA.
Registration of Health Products
The approval of nutraceuticals as health products requires (i) an applicant to perform product research prior to submitting an application for registration of health food; (ii) an applicant to submit the sample and relevant product research materials to the examination institute appointed by the SFDA for required trial and examination; and (iii) the issuance of a report by the examination institute.
Provincial food and drug authorities review the product research materials and sample and, if found satisfactory, the food and drug authorities at the provincial level conduct site inspections and sample examinations and thereafter submit their opinion along with the application materials to the SFDA, and in the meantime, send inspection notice together with the sample to be examined to the appointed examination institute. The examination institute conducts examinations and inspections and submits its report to the SFDA. If all the regulatory requirements are satisfied, the SFDA will grant an Approval Certificate of Homemade Health Food to the applicant. The Approval Certificate of Health Food is effective for a period of five years.
Any changes to the items stated in the Approval Certificate of Health Food as well as its appendices must be approved by the SFDA. However, pursuant to the Administration Rules for Registration of Health Food (Trial), the product name, raw materials, manufacturing process, usage methods and other items stated in the Approval Certificate of Health Food, which may affect the safety and function of the health food, shall not be altered.
In the case of transfer of technology of the registered health products to be manufactured in PRC, the transferee shall apply for new approval certificate of homemade health food in accordance with the relevant provisions of the Administration Rules for Registration of Health Food (Trial).
Permits and Licenses for Manufacturing of Health Foods
Those enterprises engaging in manufacturing and operation of health food business must also comply with the PRC Food Hygiene Law and the Administration Rules of Food Hygiene Permit. Under the PRC Food Hygiene Law, enterprises engaging in manufacturing and operation of food products in PRC are required to obtain Hygiene Permit from the relevant PRC hygiene administrative authorities. In order to manufacture health food in the PRC, the manufacturing enterprise shall apply to the hygiene administration authorities at the provincial level for approval. If it is qualified, the hygiene administrative authorities at the provincial level will issue a Hygiene Permit with the approved health food specified. Each Hygiene Permit issued to a food manufacturing enterprise is effective for a period of four years. The enterprise is required to apply for renewal of such permit within sixty days prior to its expiry.
Manufacturing enterprise of health food shall organize its manufacture in accordance with the approval and shall not change the ingredient, manufacturing process, quality standard, name of the products, label, illustration and so on. The manufacturing procedures and conditions shall be in compliance with hygiene requirements that are applicable to the food manufacturing enterprise.
Compliance with GMP
Pursuant to the Notice of Circulating the Examination Methods and Assessment Guidelines of Good Manufacturing Practices of Health Food promulgated by the MOH, the Hygiene Permit shall only be issued to those enterprises in compliance with the GMP upon examination of the hygiene administrative authorities at the provincial level. For those enterprises failing to meet the GMP, the Hygiene Permit will be revoked.
On February 12, 2011, SFDA promulgated the more stringent new GMP guidelines. The new standards are aimed at improving drug production management and controlling risks in the production process and introduce internationally-recognized quality control mechanisms. The latest update to GMP standard has greatly raised the bar for quality control, documentation, and overall manufacturing processes.
Label of Health Food
The Regulation for Label of Health Food as promulgated by the MOH provides for requirements of the label of health food. According to this regulation, the name, function, functional ingredient, applicable scope and file number of approval of the health food labeled shall be consistent with those corresponding items stated in the Approval Certificate of Health Food issued by the hygiene administrative authorities at the provincial level.
Other Regulations
In addition to the regulations relating to pharmaceutical industry in China, our operating subsidiaries are also subject to the regulations applicable to a foreign invested enterprise, or FIE, in China.
Foreign Currency Exchange. Pursuant to the Foreign Currency Administration Rules promulgated in 1996 and amended in 1997 and various regulations issued by State Administration of Foreign Exchange, or the SAFE, and other relevant PRC government authorities, the Renminbi is freely convertible only to the extent of current account items, such as trade-related receipts and payments, interests and dividends. Capital account items, such as direct equity investments, loans and repatriation of investment, require the prior approval from the SAFE or its local counterpart for conversion of Renminbi into a foreign currency, such as U.S. dollars, and remittance of the foreign currency outside the PRC. Payments for transactions that take place within the PRC must be made in Renminbi. Unless otherwise approved, PRC companies other than FIEs must convert foreign currency payments they receive from abroad into Renminbi. On the other hand, FIEs may retain foreign exchange in accounts with designated foreign exchange banks, subject to a cap set by the SAFE or its local counterpart.
Dividend Distribution. The principal regulations governing dividend distributions by wholly foreign-owned enterprises and Sino-foreign equity joint ventures include:
·Wholly Foreign-Owned Enterprise Law (1986), as amended;
·Wholly Foreign-Owned Enterprise Law Implementing Rules (1990), as amended;
·Sino-Foreign Equity Joint Venture Enterprise Law (1979), as amended;
·Sino-Foreign Equity Joint Venture Enterprise Law Implementing Rules (1983), as amended; and
·Regulations on the Administration of Foreign Exchange Settlement, Sale and Payment.
Under these regulations, wholly foreign-owned enterprises and Sino-foreign equity joint ventures in the PRC may pay dividends only out of their accumulated profits, if any, determined in accordance with PRC accounting standards and regulations. Additionally, these foreign-invested enterprises are required to set aside certain amounts of their accumulated profits each year, if any, to fund certain reserve funds. These reserves are not distributable as cash dividends.
Available Information
We make available free of charge on or through our internet website, www.bioaobo.com, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to those reports, if any, filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission.
We also make available free of charge on our internet website, www.bioaobo.com, our Amended and Restated Code of Ethics, Amended and Restated Nominating and Corporate Governance Committee Charter, Second Amended and Restated Compensation Committee Charter and Charter of the Audit Committee. The information contained on our website is not intended to be incorporated into this Annual Report on Form 10-K.
ITEM 1A.
ITEM 1A. RISK FACTORS
Our business, financial condition, operating results and prospects are subject to the risks listed below. Additional risks and uncertainties not presently foreseeable to us, when materialized, may also impair our business operations. If any of the following risks actually occurs, our business, financial condition or operating results could be materially adversely affected. In such case, the trading price of our common stock could decline, and our shareholders may lose all or part of their investment in the shares of our common stock.
Risks Related to Our Business and Industry
Our auditors have included a going concern assumption in their opinion. We have sustained substantial decreases in our revenues and increases in our net loss in our last two fiscal years. We have also experienced substantial decreases in our cash balances and working capital during that timeframe.
We have incurred substantial operating losses in our past two fiscal years, and may continue to incur losses. For the year ended December 31, 2012, we recorded a loss from operations of $86,331,001 and utilized cash in operations of $46,453,319. As of December 31, 2012, we had a working capital deficit of $10,763,083. In addition, we were in default of $49,161,000 of our convertible notes due July 15, 2015. If the holders of the notes declare the notes due and payable, we presently do not have the ability to pay these notes. As a result, our independent registered public accounting firm, in their report on the Company’s 2012 consolidated financial statements, has raised substantial doubt about our ability to continue as a going concern.
To meet our capital needs, we are considering multiple alternatives, including, but not limited to, additional debt financing and credit lines, delaying capital spending for future periods, and/or operating cost reductions. We believe we can utilize our properties and land use rights located in Beijing, China to secure such financing. However, we do not have commitments for such funds, and no assurance can be given that the financing will be available or, if available, that it will be on terms that are satisfactory to us. Even if we are able to obtain additional financing, it may contain undue restrictions on its operations, in the case of debt financing or cause substantial dilution to shareholders, in case or equity financing.
If we are unable to raise additional funds, we may be required to cease all operations and close our company, in which case our stockholders will suffer a total loss on their investment. If we do raise additional funds by issuing equity securities, further dilution to stockholders will result, and new investors could have rights superior to current shareholders. Any additional funding that we obtain in a financing is likely to reduce the percentage ownership of the company held by our existing security holders. The amount of this dilution may be substantially increased if the trading price of our common stock has declined at the time of any financing from its current levels.
We are in default of outstanding convertible notes
On July 15, 2008 the Company issued $115,000,000 of its 5% senior convertible notes (the “Notes”). The net proceeds from the sale of the Notes were $110,358,550. During the years ended December 31, 2012 and 2011, the Company repurchased a total of $59,339,000 and $6,500,000, respectively, in principal amount of the Notes for cash consideration of $18,478,888 and $3,160,004, respectively, leaving an aggregate of $49,161,000 in principal amount outstanding as of December 31, 2012.
This liability of the Company is in default, which was caused by the delisting of the Company’s common stock by the NYSE as described in Form 25NSE filed on April 16, 2012 by NYSE; and by the non-payment of the interest due on July 15, 2012. On April 8, 2013, four of the holders of the Notes filed a action claiming a default under the Notes, which allegedly resulted in an acceleration of the maturity of the Notes. The Plaintiffs had previously commenced a similar action in federal court in New Jersey, but that action was withdrawn and the present action was interposed. The action seeks payment of $20,378,608 plus prejudgment interest and other fees and costs. An adverse judgment related to this proceeding would have a material adverse affect on our liquidity.
A majority of our sales revenue is derived from six of our products and a disruption in, or a compromise of, our manufacturing or sales operations, or distribution channels related to any of these six products could materially and adversely affect our financial condition and results of operations.
Our top six products, namely, Shuanghuanglian Lyophilized Injection Powder, or SHL Injection Powder, CE Gel, Jinji Capsule, Jinji Yimucao, Soybean Peptide Tablets and Boke Nose Spray, constituted approximately 45% of our total revenues in 2012 and 63% of our total revenues in 2011. We expect that these six products will continue to account for a majority of our sales in the near future. Because of our dependence on a few products, any disruption in, or compromise of, our manufacturing operations, sales operations or distribution channels, relating to any of these products could result in our failure to meet shipping and delivery deadlines or meet quality standards, which in turn could result in the cancellation of purchase orders, refusal to accept deliveries or a reduction in purchase prices, any of which could have a material adverse effect on our financial condition and results of operations.
We have been named as a defendant in securities class action and shareholder derivative lawsuits, and in an action claiming we defaulted under the Notes, which could result in substantial damages and may divert management's time and attention from our business
We and certain of our officers and directors are named as defendants in a purported securities class action lawsuit, and in two shareholder derivative lawsuits, each described in more detail in "Item 3. Legal Proceedings." In addition a complaint has been filed against us by certain holders claiming default under the Notes. These lawsuits and any other related lawsuits are subject to inherent uncertainties, and the actual costs to be incurred relating to these lawsuits will depend upon many unknown factors. The outcome of the litigation is necessarily uncertain, and we could be forced to expend significant resources in the defense of these suits, and we may not prevail. Monitoring and defending against legal actions is time-consuming for our management and detracts from our ability to fully focus our internal resources on our business activities. In addition, we may incur substantial legal fees and costs in connection with the litigation. We are not currently able to estimate the possible cost to us from these matters, and we cannot be certain how long it may take to resolve the litigation or the possible amount of any damages that we may be required to pay. We have not established any reserves for any potential liability relating to these lawsuits. It is possible that we could, in the future, incur judgments or enter into settlements of claims for monetary damages. A decision adverse to our interests on these actions could result in the payment of substantial damages and could have a material adverse effect on our cash flow, results of operations, financial position and stock price.
A general economic downturn, a recession in China or sudden disruption in business conditions may affect consumer purchases of discretionary items, including pharmaceutical and nutraceutical products, which could adversely affect our business.
Consumer spending is generally affected by a number of factors, including general economic conditions, the level of unemployment, inflation, interest rates, energy costs, gasoline prices and consumer confidence generally, all of which are beyond our control. Consumer purchases of discretionary items tend to decline during recessionary periods, when disposable income is lower, and may impact sales of our products.
In addition, sudden disruptions in business conditions as a result of a terrorist attack, retaliation and the threat of further attacks or retaliation, war, adverse weather conditions and climate changes or other natural disasters, pandemic situations or large scale power outages can have a short or, sometimes, long-term impact on consumer spending. A downturn in the economy in China, including any recession or a sudden disruption of business conditions in those economies, could adversely affect our business, financial condition, and results of operation.
Intense competition from existing and new companies may adversely affect our revenues and profitability.
We compete with other companies, many of whom are developing, or can be expected to develop, products similar to ours. Some of our competitors are more established than we are, have greater brand recognition of products that compete with ours, have more financial, technical, marketing and other resources than we presently possess and a larger customer base. These competitors may be able to respond more quickly to new or changing opportunities and customer requirements and may be able to undertake more extensive promotional activities, offer more attractive terms to customers or adopt more aggressive pricing policies. Our commercial opportunity will be reduced or eliminated if our competitors develop and commercialize products that are safer, more effective, have fewer side effects, are less expensive or have more attractive product characteristics than our current products or products that we may develop in the future. We cannot assure you that we will be able to compete effectively with current or future competitors or that the competitive pressures we face will not harm our business.
We have witnessed pricing pressure on EDL drugs, and those covered by NIC. The lower priced EDL drugs and NIC drugs may lure away customers or patients that may otherwise buy more expensive branded drugs. If this trend becomes wide spread, it could curtail the scale of our manufacture and finally lead to a decline in sales growth and profit margin.
We depend on our key management personnel and the loss of their services could adversely affect our business.
Our success depends in part on our continued ability to attract, retain and motivate highly qualified management. We place substantial reliance upon the efforts and abilities of our executive officers, including Tony Liu, Yanchun Li, and Jun Min. The loss of services of any of these individuals or one or more other members of our senior management could delay or prevent the successful execution of our business objectives and could have a material adverse effect on our operations.
Replacing key employees may be difficult and costly and may take an extended period of time because of the limited number of individuals in our industry with the breadth of skills and experience required to develop and commercialize products successfully. We do not maintain “key person” insurance policies on the lives of these individuals or the lives of any of our other employees. We have entered into employment agreements with these individuals. We may need to hire additional personnel as we expand our commercial activities. We may not be able to attract or retain qualified management on acceptable terms in the future due to the intense competition for qualified personnel in our industry. If we are not able to attract and retain the necessary personnel to accomplish our business objectives, we may experience constraints that will impede these objectives.
We may face difficulties in implementing our organic growth strategy.
Many obstacles to entering new markets exist, such as the costs associated with entering new markets, recruiting and retaining adequate numbers of effective sales and marketing personnel, developing and implementing effective marketing efforts abroad, establishing and maintaining the appropriate regulatory compliance and maintaining attractive foreign exchange ratios. However, there is no assurance that we will be successful in implementing our strategies or that our strategies, even if implemented, will lead to the successful achievement of our objectives. Our business plan and growth strategy is based on currently prevailing circumstances and the assumption that certain circumstances will or will not occur, as well as the inherent risks and uncertainties involved in various stages of development. We cannot, therefore, assure you that we will be able to successfully overcome such difficulties and continue to grow our business.
If we fail to manage our growth and current operations, we may not achieve future growth or our expected revenues.
In order to maximize growth in our current and potential markets, we believe that expanding our manufacturing and marketing operations is key. However, due to the ongoing economic challenges, we expect to stabilize or even decrease our employee headcount for cost control, which will place a strain on our management and on our operational, accounting, and information systems when necessary. Our need to manage our operations and growth effectively requires us to continue to expend funds to improve our financial controls, operating procedures, management information systems, reporting systems and procedures to manage our increased operations.
If we are unable to implement improvements to our management information and control systems successfully in an efficient or timely manner, or if we encounter deficiencies in our existing systems and controls, then management may receive inadequate information to manage our day-to-day operations. We will also need to effectively train, motivate and manage our employees. Our failure to manage our growth could disrupt our operations and ultimately prevent us from generating the revenues we expect.
We operate in a highly regulated industry and our business may be significantly affected by the changes in government policies that are not favorable to the pharmaceuticals industry
The pharmaceutical industry is highly regulated in the China and there have been several reforms in the healthcare policies in the recent years, including the price control polices on the retail prices of prescription and over-the-counter medicines as well as the National Medical Insurance Program. Such policies might not be favorable to our business and our revenue might be significantly affected by further changes in the future.
We may have difficulty defending our intellectual property rights from infringement which may undermine our competitive position.
We regard our service marks, trademarks, trade secrets, patents and similar intellectual property as critical to our success. We rely on trademark, patent and trade secret law, as well as confidentiality agreements to protect our proprietary rights. Certain of our products have received trademark and patent protection in China and Hong Kong. No assurance can be given that such patents and licenses will not be challenged, invalidated, infringed or circumvented, or that such intellectual property rights will provide a competitive advantage to us. Our trade secrets may otherwise become known or be independently discovered by our competitors. Policing the unauthorized use of proprietary technology can be difficult and expensive. Also, litigation may be necessary to enforce our intellectual property rights, protect our trade secrets or determine the validity and scope of the proprietary rights of others. The outcome of such potential litigation may not be in our favor and any success in litigation may not be able to adequately protect our rights. Such litigation may be costly and divert management attention away from our business. An adverse determination in any such litigation would impair our intellectual property rights and may harm our business, prospects and reputation. Enforcement of judgments in China and Hong Kong is uncertain and even if we are successful in such litigation it may not provide us with an effective remedy. In addition, we have no insurance coverage against litigation costs and would have to bear all costs arising from such litigation to the extent we are unable to recover them from other parties. The occurrence of any of the foregoing could have a material adverse effect on our business, financial condition and results of operations. In addition, there can be no assurance that we will be able to obtain licenses from third-parties that we may need to conduct our business or that such licenses can be obtained at a reasonable cost.
In addition, third parties may file infringement claims against us asserting that we are infringing on their patents or trademarks. In the event that such claims are filed, regardless of the merit of such a claim, we may incur substantial costs and diversion of management as a result of our involvement in such proceedings.
We currently sell our products mainly in China. China will remain our primary market for the foreseeable future. If we expand into additional countries, our risk of intellectual property infringement may be heightened. Laws and enforcement mechanisms in other countries may not protect proprietary rights to the same extent as China and Hong Kong. To date, no trademark or patent filings have been made other than in China and Hong Kong.
The measures we take to protect our proprietary rights may be inadequate, and we cannot give you any assurance that our competitors will not independently develop formulations and processes that are substantially equivalent or superior to our own or copy our products.
If we cannot procure our raw materials from our current sources we may be forced to seek alternative sources of supply, which may disrupt our operations or may result in the supply of lesser quality products.
The loss of any of our primary supply sources, or delays, disruptions or other difficulties in procuring these raw materials from our primary supply sources could have a material adverse effect on our business and results of operations. Additionally, due to the nature of the raw materials, mainly plants, the supply of these raw materials can be adversely affected by any material change in the climatic or environmental conditions in China, which may, in turn, result in increased costs to purchase these raw materials. If we are required to procure alternative sources of supply, our ability to maintain high quality products, lower costs and to provide our products to customers when needed could be impaired, and as a result we could lose business and our results of operations could be materially and adversely affected.
We do not have product liability insurance and we could be exposed to substantial liability.
We face an inherent business risk of exposure to product liability claims in the event that the use of our products is alleged to have resulted in adverse side effects. Adverse side effects, marketing or manufacturing problems pertaining to any of our products could result in:
· decreased demand for our products;
· adverse publicity resulting in injury to our reputation;
· product liability claims and significant litigation costs;
· substantial monetary awards to or costly settlements with consumers;
· product recalls;
· loss of revenues; or
· the inability to commercialize future products.
These risks will exist for those products in clinical development and with respect to those products that have received regulatory approval for commercial sale or any product we may acquire. To date, we have not experienced any product liability claims. However, that does not mean that we will not have any such claims with respect to our products in the future. We do not carry product liability insurance. The lack of product liability insurance exposes us to risks associated with potential product liability claims, which can be significant.
Our property and equipment insurance does not cover the full value of our property and equipment, which leaves us with exposure in the event of loss or damage to our properties.
We currently carry insurance policies with property coverage of approximately $16.6 million, and motor vehicle coverage of approximately $0.9 million, which is substantially less that the carrying value of these assets. In the event of material loss or damage to our assets, our insurance policies would only cover a portion of the replacement value. Additionally, except for property and automobile insurance, we do not have other insurance such as business liability or disruption insurance coverage for our operations in the PRC.
Our international operations require us to comply with a number of U.S. and international regulations.
We need to comply with a number of international regulations in countries outside of the United States. In addition, we must comply with the Foreign Corrupt Practices Act, or FCPA, which prohibits U.S. companies or their agents and employees from providing anything of value to a foreign official for the purposes of influencing any act or decision of these individuals in their official capacity to help obtain or retain business, direct business to any person or corporate entity or obtain any unfair advantage. Any failure by us to adopt appropriate compliance procedures and ensure that our employees and agents comply with the FCPA and applicable laws and regulations in foreign jurisdictions could result in substantial penalties or restrictions on our ability to conduct business in certain foreign jurisdictions. The U.S. Department of The Treasury’s Office of Foreign Asset Control, or OFAC, administers and enforces economic and trade sanctions against targeted foreign countries, entities and individuals based on U.S. foreign policy and national security goals. As a result, we are restricted from entering into transactions with certain targeted foreign countries, entities and individuals except as permitted by OFAC which may reduce our future growth.
We may incur significant costs to ensure compliance with U.S. corporate governance and accounting requirements.
We may incur significant costs associated with our public company reporting requirements, costs associated with applicable corporate governance requirements, including requirements under the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley, and other rules implemented by the Securities and Exchange Commission. We expect all of these applicable rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly. We also expect that these applicable rules and regulations may make it more difficult and more expensive for us to obtain director and officer liability insurance and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage.
As a result, it may be more difficult for us to attract and retain qualified individuals to serve on our Board of Directors, on committees of our Board of Directors or as executive officers.
We were late in filing tax returns and information reports as required under U.S. laws, and may ultimately be held liable for significant taxes, interest and penalties.
We were late in filing our (1) U.S. federal income tax returns for our taxable years ended December 31, 2012 and 2011, including, without limitation, information returns on Internal Revenue Service ("IRS") Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, and (2) information reports for the years ended December 31, 2012 and 2011, concerning our interests in foreign bank accounts on TD F 90-22.1, Report of Foreign Bank and Financial Accounts ("FBARs"). Late filings of the IRS Forms 5471 subjects us to civil penalties of $10,000 for each of our 22 foreign subsidiaries with respect to each of the taxable years at issue (for an aggregate of $250,000). In addition, we are subject to civil penalties for the untimely filing of the FBARs of at least $10,000 for each of our 5 foreign bank accounts over the tow year period at issue (for an aggregate of $50,000). Although we do not believe that our failure to timely file the FBARs was "willful," if the IRS were to prove that our failure to file an FBAR was "willful," we ultimately could be held liable for a civil penalty for each such failure equal to the greater of $100,000 or 50% of the balance in the unreported foreign bank account. During the years at issue, our total foreign bank account balances have been as high as about $ 7 million. We have provided an accrual for what we believe would be the potential liabilities for the untimely filing of the IRS Forms 5471 and the FBARs in our financial statements for our year ended December 31, 2012. However, as indicated above, these potential liabilities could be substantially greater than the amounts we have accrued.
In addition, because we did not generate any income in the United States or otherwise have any U.S. taxable income, we do not believe that we owe U.S. federal income taxes for the taxable years ended December 30, 2012 and 2011 or in respect to any transactions that we or any of our subsidiaries may have engaged in through our financial year end December 31, 2012. However, there can be no assurance that the IRS will agree with this position, and therefore we ultimately could be held liable for U.S. federal income taxes, interest and penalties.
We may incur significant costs to ensure compliance with environment protection requirements.
We are subject to PRC laws and regulations concerning the discharge of waste water, gaseous waste and solid waste during our manufacturing processes. We are required to establish and maintain facilities to dispose of waste and report the volume of waste to the relevant government authorities, which conduct scheduled or unscheduled inspections of our facilities and treatment of such discharge. We may not at all times comply fully with environmental regulations. Any violation of these regulations may result in substantial fines, criminal sanctions, revocations of operating permits, shutdown of our facilities and obligation to take corrective measures. Our cost of complying with current and future environmental protection laws and regulations and our liabilities which may potentially arise from the discharge of effluent water and solid waste may materially adversely affect our business, financial condition and results of operations. The government may take steps towards the adoption of more stringent environmental regulations. Due to the possibility of unanticipated regulatory or other developments, the amount and timing of future environmental expenditures may vary substantially from those currently anticipated. If there is any unanticipated change in the environmental regulations, we may need to incur substantial capital expenditures to install, replace, upgrade or supplement our pollution control equipment or make operational changes to limit any adverse impact or potential adverse impact on the environment in order to comply with new environmental protection laws and regulations. If such costs become prohibitively expensive, we may be forced to cease certain aspects of our business operations.
Risks Related to Inflation in Raw Materials
We purchase raw materials from third parties to manufacture our products, including prescription and OTC pharmaceutical products, and nutraceutical products as well. Recent industry research shows there is an uptrend in the price of raw materials. Such an inflation trend, if continues at double digits, or even triple digits in some cases, may have a negative impact on our profitability.
Risks Related to China
Compliance with the new Good Manufacturing Practice standards promulgated by the SFDA could have a material adverse effect on our business operations, financial condition and results of operations.
On February 12, 2011, SFDA promulgated the more stringent new Good Manufacturing Practice standards, or GMP standards. The new standards are aimed at improving drug production management and controlling risks in the production process and introduce internationally- recognized quality control mechanisms. The latest update to GMP standards has greatly raised the bar for quality control, documentation, and overall manufacturing processes. The new regulations apply to new manufacturing facilities effective from March 1, 2011 and the industry has a five-year grace period to bring existing facilities in line with the revisions.
A pharmaceutical manufacturer must meet GMP guidelines for each of its production facilities in China in respect of each form of pharmaceutical products it produces. GMP standards include staff qualifications, production premises and facilities, equipment, raw materials, environmental hygiene, production management, quality control and customer complaint administration. If a manufacturer meets the GMP standards, the SFDA will issue to the manufacturer a Good Manufacturing Practice certificate, or a GMP certificate, with a five-year validity period. However, for a newly established pharmaceutical manufacturer that meets the GMP standards, the SFDA will issue a GMP certificate with only a one-year validity period. We have obtained a GMP certificate for all of our production facilities covering all of the products that we produce.
We have five manufacturing facilities in China dedicated exclusively to the manufacture of our products. Each facility is GMP certified. We have fully integrated manufacturing support systems including quality assurance, quality control and regulatory compliance. We have developed our own independent quality control systems in accordance with SFDA regulations. Our quality assurance team devotes significant attention to quality control for designing, manufacturing and testing our products, and is also responsible for ensuring that we are in compliance with all applicable national and local regulations and standards, as well as our internal policies. Our senior management team is also actively involved in setting quality assurance policies and managing internal and external quality performance. These support systems enable us to maintain high standards of quality for our products and deliver reliable products to our customers on a timely basis.
Even though, from a long term perspective, we believe the upgraded GMP standards will ensure better qualities in the pharmaceutical products that are sold in China’s pharmaceutical markets, in the short run compliance with the new GMP standards could have a material adverse effect on our business operations, financial condition and results of operations with the significant increase for such compliance.
There could be changes in government regulations toward the pharmaceutical and nutraceutical industries that may adversely affect our business.
The manufacture and sale of pharmaceutical products in China is heavily regulated by many state, provincial and local authorities. These regulations significantly increase the difficulty and costs involved in obtaining and maintaining regulatory approvals for marketing new and existing products. Our future growth and profitability depend to a large extent on our ability to obtain regulatory approvals. Additionally, the law could change so as to prohibit the use of certain pharmaceuticals. If one of our products becomes prohibited, this change would cease the manufacture of that product. The China National Development and Reform Commission, or CNDRC, has recently implemented price adjustments on many marketed pharmaceutical products. We have no control over such governmental policies, which may impact the pricing and profitability of our products.
The State Food and Drug Administration of China requires pharmaceutical manufacturers to obtain Good Manufacturing Practices, or GMP, certifications. We have received our GMP certifications. However, should we fail to receive or maintain the GMP certifications in the future, we would no longer be able to manufacture pharmaceuticals in China, and our businesses would be materially and adversely affected.
Moreover, the laws and regulations regarding acquisitions in the pharmaceutical industry in China may change, which could significantly impact our ability to grow through acquisitions.
Certain political and economic considerations relating to China could adversely affect our company.
China is transitioning from a planned economy to a market economy. While the PRC government has pursued economic reforms since its adoption of the open-door policy in 1978, a large portion of the Chinese economy is still operating under five-year plans and annual state plans. Through these plans and other economic measures, such as control on foreign exchange, taxation and restrictions on foreign participation in the domestic market of various industries, the PRC government exerts considerable direct and indirect influence on the economy. Many of the economic reforms carried out by the PRC government are unprecedented or experimental, and are expected to be refined and improved. Other political, economic and social factors can also lead to further readjustment of such reforms. This refining and readjustment process may not necessarily have a positive effect on our operations or future business development. Our operating results may be adversely affected by changes in China’s economic and social conditions as well as by changes in the policies of the PRC government, such as changes in laws and regulations, or the official interpretation thereof, which may be introduced to control inflation, changes in the interest rate or method of taxation, and the imposition of additional restrictions on currency conversion.
Accordingly, government actions in the future, including any decision not to continue to support recent economic reforms and to return to a more centrally planned economy or regional or local variations in the implementation of economic policies, could have a significant effect on economic conditions in China or particular regions thereof, and could require us to divest ourselves of any interest we then hold in Chinese properties or joint ventures.
The recent nature and uncertain application of many PRC laws applicable to us create an uncertain environment for business operations and they could have a negative effect on us.
The PRC legal system is a civil law system. Unlike the common law system, the civil law system is based on written statutes in which decided legal cases have little value as precedents. In 1979, the PRC government began to promulgate a comprehensive system of laws and has since introduced many laws and regulations to provide general guidance on economic and business practices in China and to regulate foreign investment. Progress has been made in the promulgation of laws and regulations dealing with economic matters such as corporate organization and governance, foreign investment, commerce, taxation and trade.
The promulgation of new laws, changes of existing laws and the abrogation of local regulations by national laws could have a negative impact on our business and business prospects. In addition, as these laws, regulations and legal requirements are relatively recent, their interpretation and enforcement involve significant uncertainty.
Currency conversion and exchange rate volatility could adversely affect our financial condition and the value of our common stock.
The PRC government imposes control over the conversion of Renminbi, or RMB, into foreign currencies. Under the current unified floating exchange rate system, the People’s Bank of China publishes an exchange rate, which we refer to as the PBOC exchange rate, based on the previous day’s dealings in the inter-bank foreign exchange market. Financial institutions authorized to deal in foreign currency may enter into foreign exchange transactions at exchange rates within an authorized range above or below the PBOC exchange rate according to market conditions.
Pursuant to the Foreign Exchange Control Regulations of the PRC issued by the State Council which came into effect on April 1, 1996, and the Regulations on the Administration of Foreign Exchange Settlement, Sale and Payment of the PRC which came into effect on July 1, 1996, regarding foreign exchange control, conversion of RMB into foreign exchange by Foreign Investment Enterprises, or FIEs, for use on current account items, including the distribution of dividends and profits to foreign investors, is permissible. FIEs are permitted to convert their after-tax dividends and profits to foreign exchange and remit such foreign exchange to their foreign exchange bank accounts in China. Conversion of RMB into foreign currencies for capital account items, including direct investment, loans, and security investment, is still under certain restrictions, and prior approval from the SAFE or its relevant branches must be sought. On January 14, 1997, the State Council amended the Foreign Exchange Control Regulations and added, among other things, an important provision, which provides that the PRC government shall not impose restrictions on recurring international payments and transfers under current account items.
Enterprises in China, including FIEs, which require foreign exchange for transactions relating to current account items, if within a certain limited amount may, without approval of the State Administration of Foreign Exchange, or SAFE, effect payment from their foreign exchange account or convert and pay at the designated foreign exchange banks by providing valid receipts and proofs.
Our wholly owned subsidiaries, Three Happiness, HSPL, GLP, HQPL, CCXA, BOKE, NuoHua and GHK are FIEs to which the Foreign Exchange Control Regulations are applicable. There can be no assurance that we will be able to obtain sufficient foreign exchange to pay dividends or satisfy other foreign exchange requirements in the future.
Between 1994 and 2004, the exchange rate for RMB against the U.S. dollar remained relatively stable, most of the time in the region of approximately RMB8.28 to US$1.00. However, in 2005, the Chinese government announced that it would begin pegging the exchange rate of the RMB against a number of currencies, rather than just the U.S. dollar. As our operations are primarily in China, any significant revaluation of the RMB may materially and adversely affect our cash flows, revenues, financial condition and the value of our common stock.
For example, to the extent that we need to convert U.S. dollars into RMB for our operations, appreciation of this currency against the U.S. dollar could have a material adverse effect on our business, financial condition, results of operations and the value of our common stock. Conversely, if we decide to convert our Renminbi into U.S. dollars for the purpose of declaring dividends on our common stock or for other business purposes and the U.S. dollar appreciates against the RMB, the U.S. dollar equivalent of our earnings from our subsidiaries in China would be reduced.
Future inflation in China may inhibit our ability to conduct business in China.
In recent years, the Chinese economy has experienced periods of rapid expansion and high rates of inflation. During the past ten years, the rate of inflation in China has been as high as 20.7% and as low as 2.2%. These factors have led to the adoption by the PRC government, from time to time, of various corrective measures designed to restrict the availability of credit or regulate growth and contain inflation. While inflation has been more moderate since 1995, high inflation may in the future cause the PRC government to impose controls on credit or prices, or to take other action, which could inhibit economic activity in China, and thereby harm the market for our products.
It may be difficult to effect service of process and enforcement of legal judgments upon us and our officers and certain of our directors because they reside outside the United States.
As our operations are presently based in China and our officers and certain of our directors reside in China, service of process on us and our officers and certain directors may be difficult to effect within the United States. Also, our main assets are located in China and any judgment obtained in the United States against us may not be enforceable outside the United States.
Any future outbreak of avian influenza, or the Asian bird flu, or any other epidemic in China could have a material adverse effect on our business operations, financial condition and results of operations.
Since mid-December 2003, a growing number of Asian countries have reported outbreaks of highly pathogenic avian influenza in chickens and ducks. Since all of our operations are in China, an outbreak of the Asian Bird Flu in China in the future may disrupt our business operations and have a material adverse effect on our financial condition and results of operations. For example, a new outbreak of Asian Bird Flu, or any other epidemic, may reduce the level of economic activity in affected areas, which may lead to a reduction in our revenue if our clients cancel existing contracts or defer future expenditures. In addition, health or other government regulations may require temporary closure of our offices, or the offices of our customers or partners, which will severely disrupt our business operations and have a material adverse effect on our financial condition and results of operations.
Our business may be affected by unexpected changes in regulatory requirements in the jurisdictions in which we operate.
We are subject to many general regulations governing business entities and their behavior in China and in other jurisdictions in which we have operations. In particular, we are subject to laws and regulations covering food, dietary supplements and pharmaceutical products. Such regulations typically deal with licensing, approvals and permits. Any change in product licensing may make our products more or less available on the market. Such changes may have a positive or negative impact on the sale of our products and may directly impact the associated costs in compliance and our operational and financial viability. Such regulatory environment also covers any existing or potential trade barriers in the form of import tariffs and taxes that may make it difficult for us to import our products to certain countries and regions, such as Japan, South Korea and Hong Kong, which would limit our international expansion.
Most of our assets are located in China, any dividends or proceeds from liquidation are subject to the approval of the relevant Chinese government agencies.
Our assets are predominantly located inside China. Under the laws governing FIEs in China, dividend distribution and liquidation are allowed but subject to special procedures under the relevant laws and rules. Any dividend payment will be subject to the decision of the Board of Directors and subject to foreign exchange rules governing such repatriation. Any liquidation is subject to both the relevant government agency’s approval and supervision as well the foreign exchange control. This may generate additional risk for our investors in case of dividend payment or liquidation.
There have been recent incidents in which patients have experienced severe adverse reactions following the use of pharmaceutical products manufactured in China and the poison capsule scandal.
There have been recent incidents reported in the Chinese media of a significant number of patients experiencing severe adverse health consequences following their use of pharmaceutical products manufactured by certain pharmaceutical companies in China. A number of patients have become ill and a number of fatalities have been reported. In addition, there have been incidents reported in China of the poison capsule scandal in 2012, which have shaken the pharmaceutical industry and negatively impacted the market demand. In April 2012, the outbreak of poison capsule scandal was resulted with several capsules recall from a handful of pharmaceutical companies. Although our products were not directly related to the poison capsule scandal and we passed safety inspection, the scandal significantly impacted the pharmaceutical industry as a whole, which shook consumers’ confidence and resulted in a significant decrease in market demand. Our sales are vulnerable to the decrease in the overall market demand, for which our sales may be significantly affected in the future period.
Concerns over the safety of pharmaceutical products manufactured in China could have an adverse effect on the sale of such products, including products manufactured by us. If in the future we become involved in incidents of the type described above, such problems could severely and adversely impact our product sales and reputation.
Anti-corruption measures taken by the government to correct corruptive practices in the pharmaceutical industry could adversely affect our sales and reputation.
The government has recently taken anti-corruption measures to correct corrupt practices. In the pharmaceutical industry, such practices include, among others, acceptance of kickbacks, bribery or other illegal gains or benefits by the hospitals and medical practitioners from pharmaceutical distributors in connection with the prescription of a certain drug. Substantially all of our sales to our ultimate customers are conducted through third- party distributors. We have no control over our third-party distributors, who may engage in corrupt practices to promote our products. While we maintain strict anti-corruption policies applicable to our internal sales force and third-party distributors, these policies may not be effective. If any of our third-party distributors engage in such practices and the government takes enforcement action, our products may be seized and our own practices and involvement in the distributors’ practices may be investigated. If this occurs, our sales and reputation may be materially and adversely affected.
Risks Related to Our Common Stock
Our common stock price may be extremely volatile, and you may not be able to resell your shares at or above the price you paid for the stock.
Our common stock price has experienced large fluctuations. In addition, the trading prices of stocks for companies in our industry in general have experienced extreme price fluctuations in recent years. Any negative change in the public’s perception of the prospects of companies in our industry could depress our stock price regardless of our results of operations. Other broad market and industry factors may decrease the trading price of our common stock, regardless of our performance. Market fluctuations, as well as general political and economic conditions such as terrorism, military conflict, recession or interest rate or currency rate fluctuations, may also decrease the trading price of our common stock. In addition, our stock price could be subject to wide fluctuations in response to various factors, including:
·changes in laws or regulations applicable to our products;
·period to period fluctuations in our operating results;
·announcements of new technological innovations or new products by us or our competitors;
·changes in financial estimates or recommendations by securities analysts;
·conditions or trends in our industry;
·changes in the market valuations of other companies in our industry;
·developments in domestic and international governmental policy or regulations;
·announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments;
·additions or departures of key personnel;
·disputes or other developments relating to proprietary rights, including patents, litigation matters and our ability to obtain patent protection for our technologies;
·additional sales of our common stock by us; and
·sales and distributions of our common stock by our shareholders.
The decrease in our common stock price might negatively affect the support and confident from our business partners, governmental agencies and employees.
In recent periods, especially starting from the second half of 2011, financial scandals and market crises have been focused on and negatively impacted most China based companies that are listed in the US capital markets. We were adversely impacted during this crisis which resulted in a significant decrease in our stock price and market capital. The decrease of our common stock price and the negative news may significantly affect our business relationship with our partners, governmental agencies and our management teams, which would ultimately affect their support to our company.
Some of our existing shareholders can exert control over us and may not make decisions that are in the best interest of all the shareholders.
Our officers, directors and holders of more than five percent of our outstanding shares of common stock, together control approximately 39.0% of the voting power of our stock, of which approximately 36.5% is controlled by Tony Liu, our Chairman and Chief Executive Officer. In particular, Mr. Liu owns 1,000,000 shares of Series A preferred stock, which shares by their terms have aggregate voting power equal to 25.0% of the combined voting power of our common and preferred stock. Moreover, this voting power cannot be diluted or reduced by the issuance of additional shares of common stock, meaning that the holder or holders of our Series A preferred stock will always possess 25.0% of the aggregate voting power of our common and preferred stock. As a result, Mr. Liu, or these shareholders acting together, will be able to exert a significant degree of influence over our management and over matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions. In addition, this concentration of ownership may delay or prevent a change in control of our company and might affect the market price of our common stock, even when a change may be in the best interests of all shareholders. In addition, the interests of our officers, directors and principal shareholders may not always coincide with our interests or the interests of other shareholders and, accordingly, these control persons could cause us to enter into transactions or agreements that we would not otherwise consider.
Provisions of the Nevada Revised Statutes may discourage a change of control.
We are incorporated in Nevada. Certain provisions of the Nevada Revised Statutes, or NRS, could delay or make more difficult a change of control transaction or other business combination that may be beneficial to shareholders. We are subject to Nevada’s “Combinations With Interested Shareholders” statutes (NRS Sections 78.411 through 78.444), which provide that specified persons who, together with affiliates and associates, own, or within three years did own, 10% or more of the outstanding voting stock of a Nevada corporation with at least 200 shareholders cannot engage in specified business combinations with the corporation for a period of three years after the date on which the person became an interested shareholder, unless the combination or the transaction by which the person first became an interested shareholder is approved by the corporation’s Board of Directors before the person first became an interested shareholder.
Nevada’s “Acquisition of Controlling Interest” statutes (NRS Sections 78.378-78.3793) apply only to Nevada Corporations with at least 200 shareholders, including at least 100 shareholders of record who are Nevada residents, and which conduct business directly or indirectly in Nevada. As of the date of this prospectus, we do not believe we have 100 shareholders of record who are residents of Nevada, although there can be no assurance that in the future the “Acquisition of Controlling Interest” statutes will not apply to us. The “Acquisition of Controlling Interest” statutes provide that persons who acquire a “controlling interest”, as defined in NRS Section 78.3785, in a company may only be given full voting rights in their shares if such rights are conferred by the disinterested shareholders of the company at an annual or special meeting. However, any disinterested shareholder that does not vote in favor of granting such voting rights is entitled to demand that the company pay fair value for their shares, if the acquiring person has acquired at least a majority of all of the voting power of the company. As such, persons acquiring a controlling interest may not be able to vote their shares.
We may never pay any dividends to our shareholders.
We have not paid any cash dividends on shares of our common stock. We currently intend to retain all available funds and future earnings, if any, to support our operations and finance the growth and development of our business. Our Board of Directors does not intend to distribute dividends in the foreseeable future. The declaration, payment and amount of any future dividends, if any, will be made at the discretion of the Board of Directors, and will depend upon, among other things, the results of our operations, cash flows and financial condition, operating and capital requirements, and other factors the Board of Directors considers relevant. There is no assurance that future dividends will be paid, and if dividends are paid, there is no assurance with respect to the amount of any such dividend.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
We did not receive any material comments from the SEC staff more than 180 days before the end of 2012 regarding our periodic or current reports that remained unresolved at the date hereof.
ITEM 2.
ITEM 2. PROPERTIES
According to Chinese law, the government owns all the land in China and companies or individuals are authorized to use the land only through land use rights granted by the Chinese government. Our principal facilities are located at each of our manufacturing subsidiaries summarized as follow:
We also invested and purchased land and properties in Beijing Economic-Technological Development Area during 2008. The size of land is 551,713 sq. feet with land use right expiring in year 2054. We utilize the facilities as our multi-functional headquarters for purposes including administration, research and development, convention and training.
During 2011, we acquired a TCM raw material trading center in Northeast China approved by the China’s SFDA and a building from the purchase of Liaoning Baicao. The sizes of the buildingsare141,771 sq. feet and 9,881 sq. feet, respectively.
In addition to the above, we own a 2,637 square feet office in Hong Kong and 63,942 square feet office in Harbin. We lease approximately 100 sales representative offices throughout China and we lease offices in Shenzhen and New Jersey. All leases are for a term of one year and are renewable.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On June 23, 2010, Haining Zhang asserted breach of contract, fraudulent dealing, and breach of fiduciary duty claims against the Company and its Chief Executive Officer, Shu Jun Liu (together "Defendants"). Zhang's claims arose out of an alleged 2003 investment banking advisory and consultant agreement, whereby Zhang allegedly arranged for the Company to receive an equity line of credit and was allegedly given the exclusive right to arrange financing transactions for the Company for a period of one year. Zhang sought damages for allegedly unpaid financing commission and advisory compensation in the amount of $2,410,000, plus interest and expenses. On September 12, 2011, the District Court granted a motion by Defendants to dismiss Zhang's claims as either barred by the applicable statute of limitations or as failing to state a claim. Zhang filed a notice of appeal on October 11, 2011. On April 23, 2013, the Second Circuit Court of Appeals affirmed the District Court’s dismissal of Zhang’s claims. Although Zhang has 90 days from the date of the Second Circuit’s decision in which to seek an appeal to the United States Supreme Court, we do not believe the Supreme Court would hear an appeal of Zhang’s case.
On June 22, 2012, a putative class action complaint was filed by Kevin McGee against American Oriental Bioengineering Inc, Eileen Brody, Binsheng Li, Yangchun Li, Tony Liu, Cosimo Patti, Xianmin Wang, and Lawrence Wizel alleging violations of Section 10b of the Securities Exchange Act of 1934 and liability pursuant to Section 20(a) thereunder. The gravamen of the complaint, as subsequently amended (see below) centers on the accounting treatment of the sale of an interest held by the Company’s subsidiary, Nuo Hua Investment Company Limited and the Company’s Restatement filed on November 14, 2011. Several motions were filed for appointment as lead plaintiff, and on October 16, 2012, the Court appointed lead plaintiff, consolidated the cases, and ordered that a consolidated complaint be filed, which occurred on November 19, 2012. The served defendants (AOB, Brody, Wizel and Patti) moved to dismiss the consolidated complaint, and on March 25, 2013 those motions were granted with leave to amend. On April 15, 2013, Plaintiffs filed a Second Amended Complaint, which the served Defendants moved to dismiss on May 15, 2013. In the interim, the Court granted Plaintiffs’ motion for leave to serve most of the remaining Defendants by alternative means, and on May 15, 2013, the parties entered into a stipulation consenting to the filing of a Third Amended Complaint (“TAC,” setting forth no new paragraphs), deeming the TAC served on all defendants, deeming the motion to dismiss the Second Amended Complaint interposed against the TAC, and reserving all rights of the un-served Defendants.
On October 1, 2012, Peter Barbato filed a shareholder derivative Complaint against Tony Liu, Yanchun Li, Binsheng Li, Lawrence Wizel, Cosimo Patti, Xianmin Wang, Eileen Brody, Jun Min, and Baiqing Zhang (collectively, “Defendants”), and the Company as a nominal Defendant. The Complaint asserts causes of action for Breach of Fiduciary Duty and Unjust Enrichment. These claims similarly arise out of alleged accounting errors that were made in the Company’s financial statements for the periods between the third quarters ending September 30, 2009 and September 30, 2011, which were filed with the SEC. The alleged accounting errors were related to the Company’s sale of an interest held by the Company’s subsidiary, Nuo Hua Investment Company Limited, and were disclosed in the Company’s Restatement filed on November 14, 2011. The Complaint also alleges that its claims arise out of alleged inconsistencies that the Company’s then auditor, Ernst and Young, discovered throughout the course of the Company’s audit for the year ending 2011. The Parties have agreed that Defendants need not respond to the complaint until motions to dismiss the class action Complaint filed against the Company in the Central District of California are resolved.
On December 6, 2012, David Bravetti filed a shareholder derivative Complaint against Tony Liu, Yanchun Li, Binsheng Li, Jun Min, Lawrence Wizel, Cosimo Patti, Xianmin Wang, Baiqing Zhang, Eileen Brody (collectively, “Defendants”). Because the complaint sets forth a shareholder derivative claim, the Company is named as a nominal Defendant, although no relief is sought for the Company and any relief obtained from the Defendants would inure to the benefit of the Company. The Complaint asserts causes of action for breach of fiduciary duty, waste of corporate assets, and unjust enrichment. Bravetti’s claims arose out of alleged accounting errors that were made in the Company’s financial statements for the periods between the third quarters ending September 30, 2009 and September 30, 2011, which financial statements were included in filings made with the SEC. The alleged accounting errors were related to the Company’s sale of an interest held by the Company’s subsidiary, Nuo Hua Investment Company Limited and were disclosed in the Company’s Restatement filed on November 14, 2011. The Complaint also alleges that its claims arise out of alleged inconsistencies that the Company’s then auditor, Ernst and Young Hua Ming, discovered throughout the course of the Company’s audit for the year ending 2011. Although the Complaint claims that jurisdiction is proper in federal court in New Jersey because of diversity of citizenship, according to the Complaint, Bravetti is a New Jersey citizen, as is one of the Defendants. The Company did not file a responsive pleading to Bravetti’s Complaint, and subsequent to seeking and obtaining a default against the Company, Bravetti agreed to dismiss his claim and file elsewhere. Subsequently, however, Bravetti “corrected” his complaint now to claim to be a Florida citizen. On March 26, 2013, Bravetti undertook to provide Defendants proof of his citizenship. That proof has been provided, and Defendants have not come to a conclusion whether it was sufficient.
On April 8, 2013, four of the holders of the Company’s 5% senior convertible notes issued July 15, 2008 (the “Notes”) filed this action claiming a default under the Notes, which allegedly resulted in an acceleration of the maturity of the Notes. The Plaintiffs had previously commenced a similar action in federal court in New Jersey, but that action was withdrawn and the present action was interposed. The action seeks payment of $20,378,608.33 plus prejudgment interest and other fees and costs. The Company has been served with the complaint, and Plaintiffs agreed to extend the Company’s time to answer. When that time passed on June 3, 2013, Plaintiffs refused to grant additional time and have now made a motion seeking entry of a default. The Company filed its answer on June 5, 2013.
There are no known other legal proceedings against the Company.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock was listed for trading on the New York Stock Exchange, or NYSE, under the ticker symbol “AOB” from December 18, 2006 until May 29, 2012. On April 16, 2012, The NYSE filed a form of 25NSE with SEC to announce official delisting the Company’s common stock. Prior to that delisting, the Company made an effort to regain its compliance of the listing requirements, including a 1 for 2 reverse split of the common stock, in order to raise the stock price above the minimum maintenance price stipulated by NYSE.
On March 16, 2012 concurrent with the Company’s 8-K announcing audit committee investigation into matters identified by the then auditor Ernst & Young Hua Ming, the Company’s stock was suspended in trading by NYSE. The suspension remained in force until the official delisting on May 29, 2012. As a result the Company’s common stock commenced quotation on the Pink Sheet on May 29, 2012.
The following table shows the high and low closing sales price for our common stock reported by the NYSE from January 1, 2011 to until May 10, 2013.
* The above prices reflect a 2 for 1 reverse stock split of our issued and outstanding shares of common stock effected on February 24, 2012.
Stockholders and Dividends
As of April 30, 2013, there were approximately 393 record holders of our common stock.
Under current PRC regulations, wholly foreign-owned enterprises and Sino-foreign equity joint ventures in the PRC may pay dividends only out of their accumulated profits, if any, determined in accordance with PRC accounting standards and regulations. Additionally, these foreign-invested enterprises are required to set aside certain amounts of their accumulated profits each year, if any, to fund certain reserve funds. These reserves are not distributable as cash dividends.
We have not paid any cash dividends on shares of our common stock and do not plan to do so in the near future. We currently plan to retain future earnings to fund the development and growth of our business. Any future determination related to our dividend policy will be made at the discretion of our Board of Directors.
Issuances of Unregistered Securities
None.
Equity Compensation Plan Information
The following table sets forth aggregate information regarding our equity compensation plans in effect as of December 31, 2012. All shares are issuable pursuant to the Company’s 2006 Equity Incentive Plan (the “2006 Plan”), which was approved by the Company’s shareholders.
Equity Repurchases
On March 20, 2011, the Board of Directors authorized the Company to repurchase up to $20 million of the Company’s outstanding common stock over the next two years in the open market, in privately negotiated transactions, block trades and accelerated stock repurchase transactions or otherwise, as determined by the Company and funded from available working capital. The timing and extent of any purchases depend upon the trading price of the Company’s common stock, general business and market conditions and other investment opportunities. The Company entered into a share buyback program and engaged a financial institution to act as a broker on behalf of the Company to repurchase common stock based on a predetermined quantity and price range (“Share Buyback Program”).
Any common stock repurchased by the Company became part of its treasury stock which will be shown as a separate item in the consolidated statements of changes in shareholders’ equity. The treasury stock may be retired or used by the Company to finance or execute acquisitions or other arrangements.
During the year ended December 31, 2012, the Company made the following stock repurchases:
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth our selected consolidated financial data. You should read this information together with our consolidated financial statements and the related notes to those statements included in this report, and “Item 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that are based on management’s current expectations, estimates and projections about our business and operations. Our actual results may differ materially from those currently anticipated and expressed in such forward- looking statements. See “Forward-Looking Statements.”
As used in this report, the terms “Company”, “we”, “our”, “us” and “AOB” refer to American Oriental Bioengineering, Inc., a Nevada corporation.
PRELIMINARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
This Annual Report contains forward-looking statements within the meaning of the federal securities laws. These include statements about our expectations, beliefs, intentions or strategies for the future, which we indicate by words or phrases such as “anticipate,” “expect,” “intend,” “plan,” “will,” “we believe,” “AOB believes,” “management believes” and similar language. The forward-looking statements are based on the current expectations of AOB and are subject to certain risks, uncertainties and assumptions, including those set forth in the discussion under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this report. Actual results may differ materially from results anticipated in these forward-looking statements. We base the forward-looking statements on information currently available to us, and we assume no obligation to update them.
Investors are also advised to refer to the information in our previous filings with the Securities and Exchange Commission (SEC), especially on Forms 10-K, 10-Q, and 8-K, in which we discuss in more detail various important factors that could cause actual results to differ from expected or historic results. It is not possible to foresee or identify all such factors. As such, investors should not consider any list of such factors to be an exhaustive statement of all risks and uncertainties or potentially inaccurate assumptions.
BUSINESS OVERVIEW
The global economic challenges and uncertainties impacted our business in 2011 and 2012. These challenges and uncertainties had negatively affected consumers’ demands for both pharmaceutical and nutraceutical products, which contributed to the overall decline in sales of our manufacturing segments.
In addition, the establishment of price controls over prescription and over-the-counter medicines negatively impacted our business. There were two price adjustments by the Price Control Office in 2011 and 2012 respectively that lowered certain prices of prescription and over-the-counter medicines. As a result, we lost our ability to compete effectively due to the pricing adjustments, particularly when we entered the state-owned hospitals’ purchase of medicine tendering process. As a result, sales in our manufacturing segments fell sharply.
The continuous increase in cost of raw material also impacted our business as the gross profit declined during 2011 and 2012.
In addition to the ongoing economic challenges and uncertainties, our business was negatively impacted by the toxic drug capsules incident in 2012. Incidents like that shook the pharmaceutical industry and resulted in a decline in market demand. Although we were not directly involved in the scandal and our facilities were inspected and passed the safety requirements, our subsequent sales have been impacted significantly due to the loss of confidence of consumers in pharmaceutical products and huge decline in market demand. All these challenges, uncertainties and incidents may continue to have an adverse impact on our future performance.
We are taking actions to mitigate the impact of these economic conditions, including: 1) focus on our well-recognized brand names, including AOBO and our Jinji products; 2) diversify our products through products line extension; and 3) develop and introduce new products.
To mitigate the impact of the increasing cost and supply of the raw material needed for our products, we entered into long-term supply contracts with various third parties to grow Millettia and Xanthoceras Sorbifolia Bge (“XSB”), which are our major raw materials. We bear the cultivation cost for these raw materials, including leasing the land use rights. In return, we are entitled to purchase the raw material at a pre-determined discounted price. Through these supply contracts, we believe that we can stabilize the supply of our major raw materials in the long run and reduce the risk of increasing costs in future periods. We will continue to leverage our resources to improve our margin as well as stabilize our cost and supply of raw material.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
This section should be read together with the Summary of Significant Accounting Policies included as Note 3 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2012.
Estimates affecting accounts receivable, inventories, property, plant and equipment and intangible assets,
The preparation of our consolidated financial statements requires management to make estimates and assumptions that affect our reporting of assets and liabilities (and contingent assets and liabilities). These estimates are particularly significant where they affect the recoverability of the carrying amount and estimated useful lives of long-lived assets and goodwill, allowance for accounts receivable, and realizable values for inventories.
At December 31, 2012, we provided a reserve of $18,134,912 against accounts receivable. Our estimate of the appropriate reserve on accounts receivable at December 31, 2012 was based on the aged nature of these accounts receivable. In making its judgment, we assessed our customers’ ability to continue to pay their outstanding invoices on a timely basis, and whether their financial position might deteriorate significantly in the future, which would result in their inability to pay their debts to the Company.
At December 31, 2012, we provided an allowance against inventories amounting to $47,281. Our determination of this allowance was based on potential impairments to the current carrying value of the inventories due to potential obsolescence of aged inventories. In making this estimate, we considered the probable demand for our products in the future and historical trends in the turnover of our inventories.
During the years ended December 31, 2012, 2011 and 2010, we recognized impairment losses on property, plant and equipment in the amount of $12,577,507, $733,688, and nil respectively. We estimated that the fair value of the Company’s property, plant and equipment using the future cash flow expected to be generated and determined the difference between the carrying value and carrying value as an impairment loss.
During the years ended December 31, 2012, 2011 and 2010, we recognized impairment losses of acquired intangible assets amounting to nil, $6,928,064, and nil, respectively. We performed an impairment of our intellectual properties in patent by comparing fair values based on a discounted cash flows model to the carrying values. We determined that the carrying value exceeded the fair value and an impairment loss was provided.
During the years ended December 31, 2012, 2011 and 2010, we recognized impairment losses of land use rights amounting to $10,255,550, nil, and nil, respectively. We determined that the carrying value of these assets exceeded the fair value and an impairment loss was provided.
During the years ended December 31, 2012, 2011 and 2010, we recognized impairment losses of capitalized agricultural costs amounting to $8,525,587, nil, and nil, respectively. We determined that the carrying value of these assets exceeded the fair value and an impairment loss was provided.
While we currently believe that there is little likelihood that actual results will differ materially from these current estimates, if customer demand for our products continues to decrease significantly in the near future, or if the financial condition of our customers deteriorates in the near future, we could realize significant write downs for slow-moving inventories or uncollectible accounts receivable and notes receivable.
Policy affecting recognition of revenue
Among the most important accounting policies affecting our consolidated financial statements is our policy of recognizing revenue in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 605 “Revenue Recognition”. Under this policy, all of the following criteria must be met in order for us to recognize revenue:
1. Persuasive evidence of an arrangement exists;
2. Delivery has occurred or services have been rendered;
3. The seller’s price to the buyer is fixed or determinable; and
4. Collectability is reasonably assured.
The majority of the Company’s revenue results from sales contracts with distributors and revenue is recorded upon the shipment of goods. Management conducts credit background checks for new customers as a means to reduce the subjectivity of assuring collectability.
Goodwill
We account for goodwill in accordance with the provisions of FASB ASC 350 “Intangible - Goodwill and Other”. We conduct an impairment test on an annual basis and, in addition, if we notice any indication of impairment, we conduct such test immediately.
The application of the impairment test requires judgment, including the identification of reporting units, assignments of assets and liabilities to reporting units and the determination of the fair value of each reporting unit. Fair value is primarily determined by computing the future discounted cash flows expected to be generated by the reporting unit that are believed to be reasonable under current and forecasted circumstances, the results of which form the basis for making judgments about carrying values of the reported net assets of our reporting units.
During the year ended December 31, 2011, we considered the on-going decline in our stock price and the significant reduction in revenues as impairment indicators and conducted a goodwill impairment assessment at the subsidiary level. Based on the first step of the goodwill impairment test, the fair value of certain reporting units did not exceed the net book value. We performed additional impairment analysis and determined that all goodwill was impaired, and a goodwill impairment loss was recognized for the entire amount as of December 31, 2011.
Investment in equity method investment
We account for our equity investment in accordance with FASB ASC 323, “Investments-Equity Method and Joint Ventures”. Under FASB ASC 323, the equity method of accounting is used for investments in entities in which we have the ability to exercise significant influence but do not own a majority equity interest or otherwise control. Under the equity method, we initially record our investment at cost and adjust the carrying amount of the investment to recognize our proportionate share of each equity investee’s net income or loss into consolidated statements of income after the date of acquisition.
We monitor our investments for other-than-temporary impairment by considering factors including, but not limited to, current economic and market conditions, the operating performance of the investee companies including current earnings trends and other company-specific information. We perform an impairment assessment by comparing fair value of the investment to readily available market information, or if not available, to discounted cash flow models.
Share-based Compensation
The Company periodically issues stock options and warrants to employees and non-employees in non-capital raising transactions for services and for financing costs. The Company accounts for stock option and warrant grants issued and vesting to employees based on the authoritative guidance provided by the FASB whereas the value of the award is measured on the date of grant and recognized over the vesting period. The Company accounts for stock option and warrant grants issued and vesting to non-employees in accordance with the authoritative guidance of the FASB whereas the value of the stock compensation is based upon the measurement date as determined at either a) the date at which a performance commitment is reached, or b) at the date at which the necessary performance to earn the equity instruments is complete. Non-employee stock-based compensation charges generally are amortized over the vesting period on a straight-line basis. In certain circumstances where there are no future performance requirements by the non-employee, option grants are immediately vested and the total stock-based compensation charge is recorded in the period of the measurement date.
The fair value of the Company’s common stock option grant is estimated using the Black-Scholes-Merton option pricing model, which uses certain assumptions related to risk-free interest rates, expected volatility, expected life of the common stock options, and future dividends. Compensation expense is recorded based upon the value derived from the Black-Scholes-Merton option pricing model, and based on actual experience. The assumptions used in the Black-Scholes-Merton option pricing model could materially affect compensation expense recorded in future periods.
Accounting for Income Taxes
The Company uses an asset and liability approach for financial accounting and reporting for income taxes that allows recognition and measurement of deferred tax assets based upon the likelihood of realization of tax benefits in future years. Under the asset and liability approach, deferred taxes are provided for the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance is provided for deferred tax assets if it is more likely than not these items will either expire before the Company is able to realize their benefits, or that future deductibility is uncertain. We account for uncertainty in income taxes in accordance with FASB ASC 740-10 which prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. The Company’s policy is to recognize interest and/or penalties related to income tax matters in income tax expense.
Newly Adopted Accounting Pronouncements
In July 2012, FASB issued ASU No. 2012-02, “Intangibles - Goodwill and Other”. This update presents an entity with the option to first to assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform the quantitative impairment test in accordance with Subtopic 350-30, “Intangibles - Goodwill and Other - General Intangibles Other than Goodwill”. The more-likely-than-not threshold is defined as having a likelihood of more than fifty percent. ASU No. 2012-02 will be effective for annual and impairment tests performed for fiscal years beginning after 15 September 2012, with early adoption permitted. The Company does not expect the adoption of this update will have a material effect on its consolidated financial statements.
In February 2013, the FASB issued ASU No. 2013-02, “Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” The new guidance requires entities to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income unless the amounts are not reclassified in their entirety to net income. For amounts that are not required to be reclassified in their entirety to net income in the same reporting period, entities are required to cross-reference other disclosures that provide additional detail about those amounts. The new guidance is effective prospectively for all interim and annual periods beginning after December 15, 2012, with early adoption permitted. The Company does not expect the adoption of this update will have a material effect on its consolidated financial statements.
Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the Securities Exchange Commission (the "SEC") did not or are not believed by management to have a material impact on the Company's present or future consolidated financial statements.
FINANCIAL STATEMENT PRESENTATION
RESULTS OF OPERATIONS - YEAR ENDED DECEMBER 31, 2012 AS COMPARED TO YEAR ENDED DECEMBER 31, 2011
The following table sets forth the amounts and the percentage relationship to revenues of certain items in our consolidated statements of income for the years ended December 31, 2012 and 2011:
Revenues
Revenues for 2012 were $145,099,627, a decrease of $67,590,761, or 32% compared to revenues for 2011.
We classify our revenues into two segments: manufacturing revenue and distribution revenue. The manufacturing revenue comprises revenue from pharmaceutical and nutraceutical products. Revenues by segments and product categories were as follows:
In 2012, revenue decreased by $67,590,761, or 32%, as compared to 2011.
Our pharmaceutical products decreased from $159,024,681 for 2011 to $92,028,563 for 2012, or a 42% decrease. The decrease was primarily due to the following factors:
·Rapidly evolving Chinese government healthcare policies have a material impact on the entire pharmaceutical industry in China. In April 2009, the State Council issued “Opinions of the State Council on Deepening the Reform of the Medical and Health Care System,” a major public health initiative, the goal of which is to provide access to basic medical care for every person in China by 2020. In the implementation of this plan, we witnessed increased dispensing of drugs that were listed on the government-published essential drug list, and of products covered by the National Medical Insurance Catalog. This nationwide trend has exerted a continuous and powerful downward pressure on the pricing of all generic drugs, whether branded or not, resulting in a significant shrinkage of profit margins for manufacturers of these products. Our profit margins from our manufacturing segment decreased from 51% in 2011 to 41% in 2012, principally as a result of this pricing pressure.
·Negative publicity surrounding the discovery of toxic substances in drug capsules in China resulted in an overall decline in demand in the pharmaceutical market in 2012. Although we were not directly involved in the scandal and we have passed safety inspections, our sales have been impacted significantly due to the widespread loss of confidence by consumers in pharmaceutical products.
·Because of the actual and potential size of the Chinese pharmaceutical market, we face intense competition from companies that manufacture products similar to ours, which has had a negative impact on our revenues. Many these manufacturers are more established than we are, have greater brand recognition of products that compete with ours, have more financial, technical, marketing and other resources than we presently possess, and have a larger customer base. These competitors are often able to respond more quickly to new or changing opportunities and customer requirements, and are able to undertake more extensive promotional activities, offer more attractive terms to customers, or adopt more aggressive pricing policies.
·Because traditional Chinese medicine injection products are not covered under the new essential drug list, sales of SHL powder, one of our two flagship products, declined materially in 2012.
·Revenue in connection with our nutraceutical products decreased from $37,757,118 for 2011 to $6,478,928 for 2012, an 83% decrease. Revenues were adversely affected by the food safety and drug problem in 2012. The decrease was mainly due to the decrease in sales from our Soy Peptide tablets and Soy Peptide drinks.
Distribution revenue increased by $30,683,547 or 193%, to $46,592,136, primarily as a result of the recognition of a full year of revenue in 2012 for Liaoning Baicao, which was acquired at the end of 2011. Sales from our Yushuntang subsidiary were $14,396,974 in 2012, as compared to $15,914,134 in 2011. Due to the sale of 6% interest in Yushuntang in December 2012 which resulted in the deconsolidation of this subsidiary, no further revenue will be recognized in our consolidated statement of operations for Yushuntang in 2013 and thereafter.
Cost of Sales and Gross Profit
Cost of sales was $100,741,813 in 2012, compared to $112,939,705 in 2011. Cost of sales by segments and product categories were as follows:
The decrease in cost of sales is due to the decrease of product sales, and a manufacturing cost decrease from $97,843,799 for 2011 to $57,674,443 for 2012,or a 41% decrease. With the merger of Liaoning Baicao, distribution sales and costs increased to offset the decrease in manufacturing costs. This was offset by an increase in cost of distribution revenue of $27,971,464 or 185% from NuoHua's majority owned subsidiaries due to an increase of distribution revenue.
Gross profit decreased by $55,392,869 or 56% for 2012 compared to the 2011. Gross profit as a percentage of revenues decreased from 47% in 2011 to 31% in 2012 mainly due to the decrease of sales prices and the increase in the purchase price of raw materials also attributed to the decrease of gross profit.
Selling, General and Administrative Expenses
Selling, general and administrative expenses, decreased slightly from $51,351,940 in 2011 to $49,725,528 in 2012, representing a 3% decrease. The details of our sales and marketing expenses were as follows:
The decreases in promotional fees and travel expenses resulted from the initial implementation of our cost reduction measures in 2012, as further discussed in the “Liquidity” section.
The decrease in shipping costs was primarily due to the reduction in sales volume of our products.
Increased professional fees resulted primarily from costs associated with the audit committee’s internal investigation related to our prior auditors’ resignation and the cost of re-auditing the prior year financial statements, which were conducted in 2012.
Stock based compensation decreased as a result of fewer directors receiving stock based compensation in 2012, as well the completion of amortization of previously-issued consultant shares and employee stock options.
Advertising Costs
Advertising costs increased by $14,114,098, or 95%, from $14,910,983 in 2011 to $29,025,081. Advertising costs as a percentage of revenue increased from 7% for 2011 to 22% for 2012.
We continued to invest in advertising to create a unified megabrand for AOBO so that we can leverage on the establishment of all our individual brands to increase brand awareness and market shares.
Research and Development Costs
Research and development costs decreased by $6,412,065 from $12,658,085 in 2011 to $6,246,020 in 2012. Expressed as a percentage of revenue, research and development costs were 4% and 6% for 2012 and 2011, respectively. The decrease was due primarily to spending cutbacks resulting from liquidity concerns.
Our research and development activities consist of near term, middle term and long term stages which contribute to both our current and future business strategies. Our key research and development programs include the improvement of our existing products such as SHL Lyophilized Injection Powder, Cease Enuresis Soft Gel and Jinji series products and development of new products. The majority of our research and development expenditures are on pharmaceutical products.
Depreciation and Amortization
Depreciation and amortization expenses decreased by $248,741, or 5%, in 2012 as compared to 2011. This was mainly due to the recognized impairment of acquired intangible assets in 2011.
Provision for doubtful accounts
Provision for doubtful accounts decreased from a charge of $15,624,998 in 2011 to $7,087,232 in 2012. The change was mainly due to the market conditions at the time the 2011 and 2012 results were prepared, which we assessed might significantly deteriorate our customers’ ability to continue to pay their outstanding invoices on a timely basis.
Impairment of acquired intangible assets
Impairment of acquired intangible assets was nil in 2012 and $6,928,064 in 2011. This was mainly due to our change in the estimates of the fair value of our intellectual properties in patent, where the expected future cash flow generated from these patents would significantly decrease. We estimated that the fair value of our intangible assets exceeds the carrying value as of December 31, 2011 and an impairment loss of $6,928,064 was recognized in 2011.
Impairment of goodwill
Impairment of goodwill was nil in 2012 and $33,164,121 in 2011. With the decrease in sales in 2011 and the negative changes in the pharmaceutical market with governmental influence over the retail price of prescription and OTC medicines, we expected that there would be a continuous decline in sales subsequently and the future cash flows expected to be generated by the reporting units were significantly decreased. The continuous increase in cost, including retail price of raw material and labor cost also affected our estimation for cash flow generated in future period. As a result, we impaired the recorded goodwill as of December 31, 2011 from $33,164,121 as of December 31, 2010. No impairment charges were recognized in 2012.
Impairment of capitalized agricultural costs
Impairment of capitalized agricultural costs was $8,525,587 in 2012 and nil in 2011. The 2012 charge was due to the impairment of capitalized agricultural costs in relation to Millettia and XSB cultivation at our 3H and GLP subsidiaries. Our estimated future cash flows from these products was affected by a downward trend in the sales of these products.
Impairment of property, plant and equipment
Impairment of property, plant and equipment was $12,577,507 in 2012 and $733,688 in 2011. The 2012 charge was due to the impairment of production assets at our 3H, HSPL, and CCXA subsidiaries. The 2011 charge was mainly due to the fair value estimation of assets in our Three Happiness subsidiary, where one of the production lines was no longer expected to generate significant cash flow in the future.
Impairment of land use rights
During 2012, we recognized a charge to impair land use rights whose fair value was less than carrying value in the amount of $10,255,550.
Impairment of equity method investment - AXN
Impairment of equity method investment -AXN was $11,937,037 in 2011, compared to nil in 2012. In 2011, the Company considered AXN’s declining stock price, as well as other information found in the public filings of AXN, and various internet articles and websites, as indications that the decline in the value of AXN was other than temporary and accordingly performed an asset impairment test at December 31, 2011. Such factors as AXN’s write off of its Goodwill and a “going concern” paragraph in its most recent audit report were two of the factors. The Company considered the market value of the publically traded stock of AXN, as well as adjusting the carrying value of the investment for the step up in value of the net assets and goodwill recognized upon the original investment, as indicators of the current value of the investment. After considering these methodologies the Company estimated the value of its equity investment in AXN to be $5,708,329, and recognized an impairment of $11,937,037 in the equity investment for the year ending December 31, 2011. No impairment was recognized in 2012, as the carrying value of the investment exceeded the fair value at December 31, 2012.
Gain on extinguishment of convertible notes
During 2011, the Company repurchased a total $6,500,000 in principal amount of our convertible Notes for $3,160,004. A gain of debt extinguishment of $3,242,389 was recognized representing the difference between the net carrying value of the notes repurchased and the repurchase price. During 2012, the Company repurchased a total $59,339,000 in principal amount of our convertible Notes for $18,478,888. A gain of debt extinguishment of $40,413,555 was recognized representing the difference between the net carrying value of the notes repurchased and the repurchase price. For additional information, see “Item 1. Financial Statements - Note 15. Convertible Notes”.
Equity in Earnings (Losses) from Equity Method Investments
Equity in earnings(losses) from equity method investments decreased from a loss of $1,254,973 in 2011 to a loss of $2,813,235 in 2012. The increased loss was mainly due to the recognition of the share of equity losses from investment in AXN, as well as a loss from our share of Yushuntang’s loss in 2012.
The Company considered AXN’s declining stock price, as well as other information found in the public filings of AXN, and various internet articles and websites, as indications that the decline in the value of AXN was other than temporary and accordingly performed an asset impairment test at December 31, 2011. Such factors as AXN’s write off of its Goodwill and a “going concern” paragraph in its most recent audit report were two of the factors. The Company considered the market value of the publicly traded stock of AXN, as well as adjusting the carrying value of the investment for the step up in value of the net assets and goodwill recognized upon the original investment, as indicators of the current value of the investment. After considering these methodologies the Company estimated the value of its equity investment in AXN to be $5,708,329, and recognized an impairment of $11,937,037 in the equity investment for the year ending December 31, 2011. No impairment was recognized in 2012, as the carrying value of the investment exceeded the fair value at December 31, 2012.
Loss of deconsolidation and impairment of advances
The Company had previously consolidated the financial statements of Yushuntang as a 55% majority owned subsidiary from its acquisition in September 2008 until December 2012. Effective December 31, 2012, the Company sold 6% of its interest in Yushuntang and reduced its ownership to 49% so the Company no longer had a controlling financial interest. Since the Company’s ownership decreased below 50% in December 2012, this entity no longer qualifies for consolidation and is treated as a long term investment using the equity method subsequent to the sale date. As of December 31, 2012, In accordance with FASB ASC 810-10-40, “Deconsolidation of a Subsidiary or Derecognition of a Group of Assets” the Company deconsolidated it majority ownership interest and recognized a non-cash net gain of $891,540 on the transaction. The gain on deconsolidation was reduced by $4,206,253 which represented amounts due to the Company from Yushuntang now considered uncollectible based on the status of Yushuntang as follows:
The Company’s retained investment of 49% of Yushuntang was valued at $232,896 using a value based on the sale price of the 6% interest sold in December 2012. The Company does not have a continuing involvement in the operations of Yushuntang subsequent to the sale outside of its ownership stake, the buyer of the 6% interest was not a related party. At December 31, 2012, Yushuntang is considered a related party subsequent to the sale, based on the Company’s material equity stake.
For the year ended December 31, 2012, Yushuntang reported revenues of $14,396,974, gross profit of $992,833, loss from operations of $59,049, and net loss of $27,482, which are included in the accompanying consolidated statement of operations. For the year ended December 31, 2011, Yushuntang reported revenues of $15,914,134, gross profit of $827,738, loss from operations of $3,076,447, and net loss of $2,282,234, which are included in the accompanying consolidated statement of operations. At December 31, 2012, net assets of Yushuntang that were deconsolidated included cash of $171,167, accounts receivable of $4,850,673, inventories of $3,083,123, deferred tax assets and other assets of $1,047,004, accounts payable and accrued expenses of 6,092,669, and payable to the Company of $4,206,253.
Interest Expense, Net
Net interest expense was $5,834,698 in 2012, compared to net interest expense of $6,610,001 for 2011. The decrease was mainly due to lower average balances of convertible notes resulting from early retirements in 2012.
Income Tax
The Company’s effective tax rate for 2012 was 4%, compared to1% in 2011. For additional information, see “Item 1. Financial Statements - Note 21 - Income Tax”.
RESULTS OF OPERATIONS - YEAR ENDED DECEMBER 31, 2011 AS COMPARED TO YEAR ENDED DECEMBER 31, 2010
The following table sets forth the amounts and the percentage relationship to revenues of certain items in our consolidated statements of income for the years ended December 31, 2011 and 2010:
Revenues
Revenues for 2011 were $212,690,388, a decrease of $93,253,697, or 30% compared to revenues for 2010.
We classify our revenues into two segments: manufacturing revenue and distribution revenue. The manufacturing revenue comprises revenue from pharmaceutical and nutraceutical products. Revenues by segments and product categories were as follows:
Revenue in connection with our pharmaceutical products decreased by $91,106,913, or 36%, as compared to 2010 primarily due to the following factors:
·sales from our prescription pharmaceutical products decreased from $129,218,968 for 2010 to $98,463,901 for 2011, or a 24% decrease. The decrease was primarily due to the decrease in sales from SHL powder and CCXA’s generic pharmaceutical products and partially offset by the increase in sales from our prescription formulated Jinji capsule; and
·sales from our OTC pharmaceutical products decreased from $120,912,626 for 2010 to $60,560,780 for 2011, or a 50% decrease. This was mainly due to the decreased sales volume of GLP’s generic OTC drugs, which was affected by the downturn of the economic climate in the pharmaceutical industry. Our revenue from OTC drugs in 2010 was partly due to the positive effect from our TV advertisements. In 2011, we decreased our advertisement cost to around $14 million or 61% of 2010 and the TV advertisements were not as effective as in 2010. The decrease in retail price of our OTC drugs in 2011 affected by the price control policy and impacted the profit margin of our distributors, which leaded to a loss of motivation from them to sale our products and resulted with a decline of sales of our OTC drugs.
·The recent price control over the prescription and OTC medicines affect our sales volume in 2011 where our products lost the ability to compete effectively with our competitors and resulted with a significant decrease in sales when comparing to 2010.
We decreased the manufacturing of certain generic drugs since the TCM raw material price for these drugs has continued to increase during this year. Accordingly, we shifted the products mix toward higher-margin products from lower margin products to minimize the impact from the increased cost of certain raw materials and the continuing government price cut on certain products.
Revenue in connection with our nutraceutical products decreased by $3,263,171 or 8% compared to 2010. The decrease was mainly due to the decrease in sales from our Soy Peptide tablets and partially offset by the increase in sales from our Soy Peptide drinks which we launched commercially in late 2009. We decreased the advertising for certain old nutraceutical products and focused on new products to achieve optimum efficiency while maintaining strict advertising cost control.
The distribution revenue from NuoHua's majority owned subsidiary increased by $1,116,387 or 8%, to $15,908,589. This increase was mainly attributed to NuoHua's expanding market coverage.
Cost of Sales and Gross Profit
Cost of sales was $112,939,705 in 2011, compared to $148,186,531 in 2010. Cost of sales by segments and product categories were as follows:
Gross profit decreased by $58,006,871 or 37% for 2011 compared to the 2010. Gross profit as a percentage of revenues decreased from 52% in 2010 to 47% in 2011 mainly due to the new levied urban construction and maintenance tax and educational surcharge. The decrease of sales and continuously increase of the purchase price of raw materials also attributed to the decrease of gross profit.
From December of 2010, the urban construction and maintenance tax and educational surcharge were levied on foreign investment enterprises and foreign enterprises that previously enjoyed the exemption. We recognized the urban construction and maintenance tax and educational surcharge in cost of sales. As a result of the regulation change, our gross margin for 2011 was affected by approximately 2%.
We continued our efforts to manage the margin pressure although the increased purchase prices of certain raw materials increased the cost of sales.
Selling, General and Administrative Expenses
Selling, general and administrative expenses, decreased from $66,439,702 in 2010 to $51,351,940 in 2011, representing a 23% decrease. The details of our sales and marketing expenses were as follows:
The decrease in selling, general and administrative expenses for 2011 compared to 2010 was primarily due to the following factors:
·the decrease of promotional materials and fees by $12,218,851, or 52%, as compared to 2010. This was primarily due to the reduction of our promotional activities in relation to SHL powder and generic prescription and OTC drugs;
·the decrease of shipping costs by $1,995,544, or 35%, as compared to 2010. This was primarily due to the reduction of sales volume of our products; and
·the decrease in selling, general and administrative expenses was partially offset by the increase of staff welfare and insurance expenses by $820,434, which was mainly due to the increase of our staff welfare and insurance coverage and level as required by Chinese labor law.
Advertising Costs
Advertising costs decreased by $24,009,922, or 62%, from $38,920,905 in 2010 to $14,910,983 in 2011. Advertising costs as a percentage of revenue decreased from 13% for 2010 to 7% for 2011.
We decreased the advertising costs related to some of our OTC generic drugs in 2011. We continued to invest in advertising to create a unified megabrand for AOBO so that we can leverage on the establishment of all our individual brands to increase brand awareness and market shares.
Research and Development Costs
Research and development costs decreased by $2,707,046 from $15,365,131 for 2010 to $12,658,085 in 2011. Expressed as a percentage of revenue, research and development costs were 6% and 5% for 2011 and 2010, respectively.
Our research and development activities consist of near term, middle term and long term stages which contribute to both our current and future business strategies. Our key research and development programs include the improvement of our existing products and development of new products such as SHL Lyophilized Injection Powder, Cease Enuresis Soft Gel and Jinji series products. The majority of our research and development expenditures are on pharmaceutical products.
Depreciation and Amortization
Depreciation and amortization expenses increased by $832,814, or 13%, in 2011 as compared to 2010. This was mainly due to the increase of the property, plant and equipment during the second half of 2011.
Provision for doubtful accounts
Provision for doubtful accounts increased to $15,624,998 in 2011 from nil in 2010. The increase was mainly due to the current market condition, which we assessed might significantly deteriorate our customers’ ability to continue to pay their outstanding invoices on a timely basis.
Impairment of acquired intangible assets
Impairment of acquired intangible assets increased from nil in 2010 to $6,928,064 in 2011. This was mainly due to our changes of estimates of the fair value of our intellectual properties in patent, which the expected future cash flow generated from these patents would significantly decrease. We estimated that the fair value of our intangible assets exceeds the carrying value as of December 31, 2011 and an impairment loss of $6,928,064 was recognized in 2011.
Impairment of goodwill
Impairment of goodwill increased from nil in 2010 to $33,164,121 in 2011. With the recent decrease in sales in 2011 and the negative changes in the pharmaceutical market with governmental influence over the retail price of prescription and OTC medicines, we expected that there would be a continuous decline in sales subsequently and the future cash flows expected to be generated by the reporting units were significantly decreased. The continuous increase in cost, including retail price of raw material and labor cost also affected our estimation for cash flow generated in future period. As a result, we impaired the recorded goodwill as of December 31, 2011 from $33,164,121 as of December 31, 2010.
Impairment of property, plant and equipment
Impairment of property, plant and equipment increased from nil in 2010 to $733,688 in 2011. The decrease was mainly due to the fair value estimation of assets in our Three Happiness subsidiary, where one of the production lines was no longer expected to generate significant cash flow in the future. We impaired the assets with $733,688 impairment loss in 2011.
Impairment of equity method investment - AXN
Impairment of equity method investment -AXN was $11,937,037 in 2011, compared to nil in 2010. The Company considered AXN’s declining stock price, as well as other information found in the public filings of AXN, and various internet articles and websites, as indications that the decline in the value of AXN was other than temporary and accordingly performed an asset impairment test at December 31, 2011. Such factors as AXN’s write off of its Goodwill and a “going concern” paragraph in its most recent audit report were two of the factors. The Company considered the market value of the publically traded stock of AXN, as well as adjusting the carrying value of the investment for the step up in value of the net assets and goodwill recognized upon the original investment, as indicators of the current value of the investment. After considering these methodologies the Company estimated the value of its equity investment in AXN to be $5,708,329, and recognized an impairment of $11,937,037 in the equity investment for the year ending December 31, 2011.
Gain on extinguishment of convertible notes
During 2011, the Company repurchased a total $6,500,000 in principal amount of our convertible Notes for $3,160,004. A gain of debt extinguishment of $3,242,389 was recognized representing the difference between the net carrying value of the notes repurchased and the repurchase price. For additional information, see “Item 1. Financial Statements - Note 15. Debt”.
Equity in Earnings (Losses) from Equity Method Investments
Equity in earnings(losses) from equity method investments decreased from a gain of $213,177 in 2010 to a loss of $1,254,973 in 2011. The increased loss was mainly due to the recognition of the share of equity losses from investment in AXN. On October 18, 2010, the NuoHua Affiliate was disposed to an unrelated third party; as a result, the Company was no longer entitled to recognize its equity earnings from the NuoHua Affiliate.
Interest Expense, Net
Net interest expense was $6,610,001 for 2011 compared to net interest expense of $5,900,055 for 2010. The increase was mainly due to the increase proceeds from short-term loans in 2011 as compared to 2010.
Income Tax
The Company’s effective tax rate for 2011 was 1%, compared to 40% in 2010. For additional information, see “Item 1. Financial Statements - Note 22. Income Tax”.
FINANCIAL POSITION, LIQUIDITY AND CAPITAL RESOURCES
Cash
Our cash position at December 31, 2012 was $7,097,098, representing a decrease of $45,530,830, or 87%, compared with our cash position of $52,627,928 at December 31, 2011. The decrease was mainly attributable to approximately $46.5 million cash used in operating activities, as well as $15.5 million used for financing activities, principally from the repurchase convertible notes in the amount of $18.5 million. These amounts were offset by $15.2 million cash provided by investing activities, primarily from the receipt of notes receivable in the amount of $27.8 million and proceeds from the 2011 sale of the NuoHua affiliate of $18.3 million, offset by purchases of property and equipment of $18.8 million.
We manage our cash based on thorough consideration of our corporate strategy as well as macroeconomic considerations. Factors we take into account when managing our cash include interest income, foreign currency fluctuation as well as the flexibility in executing our acquisition strategy.
Liquidity
For the year ended December 31, 2012, we recorded a loss from operations of $86,331,001 and utilized cash in operations of $46,453,319. As of December 31, 2012, we had a working capital deficit of $10,763,083. In addition, we were in default of $49,161,000 of our convertible notes due July 15, 2015. If the holders of the notes declare the notes due and payable, we presently do not have the ability to pay these notes. These factors, among others, raise substantial doubt about our ability to continue as a going concern. Our ability to continue as a going concern is dependent upon our ability to return to profitability or to develop additional sources of financing or capital. Our financial statements do not include any adjustments that might result from the outcome of these uncertainties.
Historically, our main source of cash was through the sales of our products, Common Stock sales and debt financing. However, due to the decrease in sales, our ability to meet contractual obligations and payables depends on our ability to implement cost reductions effectively and obtain additional financing. We believe that the ongoing economic challenges and uncertainties in 2012 will continue to negatively impact our business in 2013. Thus, we expect that for 2013 we will continue to generate losses from operations, and our operating cash flows will not be sufficient to cover operating expense; therefore, we expect to continue to incur net losses.
To meet our capital needs, we are considering multiple alternatives, including, but not limited to, additional debt financing and credit lines, delaying capital spending for future periods, and/or operating cost reductions. We believe we can utilize our properties and land use rights located in Beijing, China to secure such financing. No assurance can be given that the financing will be available or, if available, that it will be on terms that are satisfactory to us. Even if we are able to obtain additional financing, it may contain undue restrictions on our operations, in the case of debt financing or cause substantial dilution to shareholders, in case or equity financing.
We have implemented a cost reduction plan that includes decreasing our overhead, research and development, and advertising costs, which we estimate will save us 10% to 15% overall compared to 2012. We do not believe that this initiative will jeopardize our current operations or future growth plans materially. We also plan to delay our capital spending and additional expansion to future periods, including investments in construction in progress.
Our plan to delay our capital spending to future periods includes renegotiating the terms of our capital expenditure commitments, and we do not believe such deferrals would cause us material contractual penalties as we believe the contracts can be renegotiated. We have also examined the structural effect of a delay on the buildings and we believe that they could sustain a delay of at least 2-3 years without comprising overall structural integrity. We have also evaluated our current production lines and expect that they will continue to function through their estimated useful lives.
Furthermore, as of December 31, 2012, we had invested in capitalized agricultural cost for $17,443,475. These pre-harvest agriculture costs usually require substantial investment in the early stages, gradually decreasing to maintenance costs during the growing stage. We expect that the cost required for these crops will be around $2.5 million per year. We anticipate that the crops will benefit the Company’s operation in terms of raw material supply for internal use, as well as profit from selling to the market in 2018.
We have also reviewed all of our current material obligations and expect that we could fulfill all of our material commitments, with the exception of construction contracts which we believe can be renegotiated.
We do not plan to further downsize our operations beyond the cost reductions discussed herein, including selling or closing any of our subsidiaries or suspending any ongoing operations.
Total Debt
We have total of $67,642,849 debt as of December 31, 2012, as compared to $116,440,026 as of December 31, 2011. The decrease of $48,797,177 was mainly due to the repayment of $59,339,000 of convertible notes in 2012, offset by increased notes payable.
Convertible notes
On July 15, 2008 the Company issued $115 million of its 5% senior convertible notes. The Notes are in default, which was caused by the delisting of the Company’s common stock by the NYSE as described in Form 25NSE filed on April 16, 2012 by NYSE; and by the non-payment of the semiannual interest payment due on July 15, 2012. The Company also has not paid the semiannual interest payment due January 15, 2013.
On February 19, 2013, the Company received a notice of acceleration under the terms of the Notes issued pursuant to an Indenture, dated as of July 15, 2008, between the Company and Wells Fargo Bank, National Association, as Indenture Trustee (the “Indenture”). The notice was sent by certain holders of the Notes that together hold more than 25% of the aggregate principal amount of the Notes. The notice states that the default is the result of the Company’s failure to (A) pay to the holders under the terms of the Indenture accrued interest due and payable on each of July 16, 2012 and January 15,2013, which failure to pay continued for a period of thirty (30) days after July 16, 2012 and January 15, 2013, respectively, and (B) provide, pursuant to the terms of the Indenture, a notice of the termination of trading and delisting of the Company’s common stock by the New York Stock Exchange. As of March 4, 2013, the aggregate principal amount of the Notes, and unpaid, but accrued interest was $53,010,424. The notice of acceleration resulted in the principal amount of the Senior Convertible Notes plus accrued and all unpaid interest and accrued and unpaid Additional Interest (as defined in the Indenture) on the Notes through February 19, 2013, to become immediately due and payable.
During 2011, the Company repurchased its outstanding 5% senior convertible notes in the aggregate amount of $6,500,000 in three separate transactions at a weighted average price of $0.49 on the dollar through negotiated transactions or a market transaction on the platform of Portal. As a result of said repurchases, the outstanding balance of our convertible notes was reduced from $115,000,000 to $108,500,000.
In 2012, the Company repurchased an additional aggregate amount of $59,339,000 of its outstanding 5%senior convertible notes in multiple negotiated transactions. The weighted average price the Company paid was approximately $0.3114 on the dollar. As a result of the repurchase transactions after 2011, the outstanding balance of our convertible notes as of December 31, 2012 was $49,161,000.
The Company remains opportunistic towards future repurchases. The potential consummation of future repurchase transactions will depend upon, including and not limited to, the availability of funds, the competing priority of funds, timing, price, etc. There is no guarantee there will be any future repurchase transactions. Any future repurchases will result in a reduction in cash available from operations.
Cash Flow
2012 Compared to 2011
Operating Activities
Cash flows used by operations during 2012 amounted to $46,453,319, representing an increase in cash used of $76,409,037 compared with cash flows provided from operations of $29,955,718 for 2011. The increase in net cash used by operating activities was primarily attributable to an increased loss after adjusting for non-cash items of $39,285,073, as compared to adjusted income after adjusting for non-cash items of $17,769,286 in 2011.
Other changes in operating assets and liabilities as reflected in our statement of cash flows included:
·cash outflows from accounts payable amounted to $6,368,230 mainly attributed to the timing of payments in 2012; and
·cash inflow from advances to suppliers and prepaid expenses amounted to $6,242,832, mainly affected by the timing of recognition of prepaid amounts.
Investing Activities
Our net cash provided by investing activities amounted to $15,181,644 in 2012, compared to net cash used in investing activities of $71,948,735 in 2011. As reflected in our statement of cash flows, the changes mainly included:
·collection of notes receivable issued in 2011 in the amount of $27,848,917;
·cash inflow from the collection of receivable from the sale of the NuoHua affiliate in the amount of $18,311,212
·cash outflows for purchases of PPE and CIP of $18,663,399 in 2011 for the expansion and upgrade of our manufacturing facilities to complement capacity improvement and efficiency enhancement.
Financing Activities
Our net cash used in financing activities was $15,485,748 in 2012, compared to cash used of $4,261,856 in 2011.
We repurchased a total $59,339,000 in principal amount of our convertible Notes for $18,478,888 in 2012.
Off -balance Sheet Arrangements
We do not have any off -balance sheet arrangements as of December 31, 2012.
Contractual Obligations
The following table summarizes the Company's estimated contractual obligations as of December 31, 2012:
* Holders of the convertible notes may require the Company to repurchase all or a portion of their notes on July 15, 2013 for cash at a price equal to 100% of the principal amount of the notes to be purchased, plus accrued and unpaid interest, if any, up to, but excluding, the repurchase date.
The Company also has an unconditional purchase commitment in connection with the Millettia long-term supply contracts, which is not expected to be harvested until after 2018. The purchase amount will be based on fair value discounted at a pre-determined rate pursuant to the long-term supply contracts.
In 2009, the Company entered into a long-term supply contract with a third party to secure the supply of XSB, which is a major raw material of the Company. The Company expects such supply to start from year four of the contract, as XSB is a fruit from a certain plant which requires a three-year period to mature. The contract expires after 10 years, while the Company is entitled to renewal with terms to be negotiated. Under the contract, the Company is entitled to a supply price at a discount to market price when delivered
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Issuance of Common Stock
See Part II, Item 5 for issuance of unregistered shares of common stock.
Inflation
Inflation has not had a material impact on our business.
Currency Exchange Fluctuations
The Company's operations are exposed to a variety of global market risks, including the effect of changes in foreign currency exchange rates. These exposures are managed, in part, with the use of a financial derivative. The Company does not use financial derivatives to hedge exposures in the ordinary course of business or for speculative purposes.
We currently conduct substantially all of our operations through our PRC subsidiaries. The functional currency of our PRC subsidiaries is the Chinese RMB. The financial statements of our PRC subsidiaries are translated to U.S. dollars using year-end exchange rates as to assets and liabilities and average exchange rates as to revenues, expenses, and cash flows. Capital accounts are translated at their historical exchange rates when the capital transaction occurred. Translation adjustments resulting from this process are included in accumulated other comprehensive income in the statement of shareholders’ equity. Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred.
As the majority of our assets and substantially all of our revenue, costs and expenses are denominated in RMB, any significant revaluation of the RMB may materially and adversely affect our cash flows, revenues and financial condition. For example, if the RMB depreciates against the U.S. dollar, the value of our RMB revenues, earnings, and assets, as expressed in our U.S. dollar financial statements could decline. In addition, if we decide to convert our RMB into U.S. dollars for the purpose of making payments for business purposes, the U.S. dollar equivalent of the RMB we convert would be reduced. On the other hand, to the extent that we need to convert U.S. dollars we receive from an offering of our securities into RMB for our operations, appreciation of the RMB against the U.S. dollar could reduce the amount of the U.S. dollars available.
The local currencies in the countries in which we sell our products may fluctuate in value in relation to other currencies. Such fluctuations may affect the costs of our products sold and the value of our local currency profits. While we are not conducting any operations in countries other than China at the present time, we may expand to other countries and may then have an increased risk of exposure of our business to currency fluctuation.
The PRC government imposes control over the conversion of RMB, into foreign currencies. Under the current unified floating exchange rate system, the People’s Bank of China publishes an exchange rate, which we refer to as the PBOC exchange rate, based on the previous day’s dealings in the inter-bank foreign exchange market. Financial institutions authorized to deal in foreign currency may enter into foreign exchange transactions at exchange rates within an authorized range above or below the PBOC exchange rate according to market conditions.
Pursuant to the Foreign Exchange Control Regulations of the PRC issued by the State Council which came into effect on April 1, 1996, and the Regulations on the Administration of Foreign Exchange Settlement, Sale and Payment of the PRC which came into effect on July 1, 1996, regarding foreign exchange control, conversion of RMB into foreign exchange by Foreign Investment Enterprises, or FIEs, for use on current account items, including the distribution of dividends and profits to foreign investors, is permissible. FIEs are permitted to convert their after-tax dividends and profits to foreign exchange and remit such foreign exchange to their foreign exchange bank accounts in China. Conversion of RMB into foreign currencies for capital account items, including direct investment, loans, and security investment, is still under certain restrictions. On January 14, 1997, the State Council amended the Foreign Exchange Control Regulations and added, among other things, an important provision, which provides that the PRC government shall not impose restrictions on recurring international payments and transfers under current account items.
Enterprises in China, including FIEs, which require foreign exchange for transactions relating to current account items, if within a certain limited amount may, without approval of the State Administration of Foreign Exchange, or SAFE, effect payment from their foreign exchange account or convert and pay at the designated foreign exchange banks by providing valid receipts and proofs.
Convertibility of foreign exchange in respect of capital account items, such as direct investment and capital contribution, is still subject to certain restrictions, and prior approval from the SAFE or its relevant branches must be sought.
Between 1994 and 2004, the exchange rate for RMB against the U.S. dollar remained relatively stable, most of the time in the region of approximately RMB8.28 to US$1.00. However, in 2005, the Chinese government announced that it would begin pegging the exchange rate of the RMB against a number of currencies, rather than just the U.S. dollar.
Since a significant amount of our future revenues are expected to be denominated in RMB, any existing and future restrictions on currency exchange may limit our ability to utilize revenue generated in China to fund our business activities outside of China, if any, or expenditures denominated in foreign currencies, or our ability to meet our foreign currency obligations, which could have a material adverse effect on our business, financial condition and results of operations. We cannot be certain that the PRC regulatory authorities will not impose more stringent restrictions on the convertibility of RMB with respect to foreign exchange transactions.
We recognized a foreign currency translation adjustment of $4.1 million, $18.7 million and $16.0 million for the years ended December 31, 2012, 2011, and 2010, respectively. The balance sheet amounts with the exception of equity at December 31, 2012 were translated at 6.3161 RMB to $1.00 USD as compared to 6. 3647 RMB at December 31, 2011. The equity accounts were stated at their historical rate.
The average translation rates applied to the income and cash flow statement amounts for 2012, 2011 and 2010 were 6.3198 RMB, 6.4883 RMB, and 6.7245 RMB to $1.00 USD, respectively. We do not hedge our exposure to foreign exchange risk; as such, we may in the future experience economic loss as a result of any foreign currency exchange rate fluctuations.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our independent registered public accounting firm’s report and our consolidated financial statements begin on page.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
On June 15, 2012, the Company dismissed Ernst & Young Hua Ming (“EY”), as its independent registered public accounting firm. The decision to dismiss EY was approved by the Company’s Audit Committee on June 15, 2012. At the time of delivery, EY’s reports on the financial statements of the Company as of and for the years ended December 31, 2010 and 2009 did not contain any adverse opinion or a disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope, or accounting principles. Although there were no disagreements or differences of opinion that should be reported as set forth in Item 304(a)(i)(iv) under Regulation S-K, there were “reportable events”, as defined in Item 304(a)(1)(v) of Regulation S-K, which are set forth below.
During EY’s audit of the Company’s December 31, 2011 financial statements, EY identified inconsistencies, which were communicated to the Audit Committee on March 13, 2012, as a result of which an independent investigation was launched. As of the date of EY’s dismissal, the investigation was not completed, and EY’s concerns over these inconsistencies were not resolved. Consequently, EY concluded that it was unable to rely on management’s representations provided in connection with its audits of the financial statements for the years ended December 2009 and 2010, the effectiveness of the Company’s internal control over financial reporting as of December 31, 2009 and 2010, and its review of the Company’s unaudited interim financial information for the quarters ended September 30, 2009 through September 30, 2011. On June 15, 2012, the Company received a letter from EY in which it withdrew its reports on the financial statements and related internal control over financial reporting for the years ended and as of December 31, 2009 and 2010 and accordingly, its reports issued thereto on March 15, 2010 and 2011 can no longer be relied upon. The inconsistencies EY identified, which were not resolved at the time of its dismissal, and its inability to rely on management’s representations leading to the withdrawal of its reports, constituted reportable events as defined in Item 304(a)(1)(v) of Regulation S-K.
The Company provided EY with a copy of this disclosure on June 15, 2012, providing EY with the opportunity to furnish the Company with a letter addressed to the SEC stating whether the independent accountant agrees with the statements made by the registrant in response to this Item 4.01(a). A copy of the letter, dated June 15, 2012, furnished by EY in response to that request was filed as Exhibit 16.1 to the Current Report on Form 8-K filed with the SEC on June 15,2012.
On June 15, 2012, the Company engaged Weinberg & Company P.A. (“Weinberg”) as its new independent registered public accounting firm. The decision to engage Weinberg as the Company’s new independent registered public accounting firm was approved by the Company’s Audit Committee on June 15, 2012.
During the Company’s two most recent fiscal years ended December 31, 2011 and 2010 and through June 15, 2012, the Company did not consult Weinberg with respect to (i) the application of accounting principles to a specified transaction, either completed or proposed; or (ii) the type of audit opinion that might be rendered on the Company’s consolidated financial statements, and neither a written report nor oral advice was provided to the Company that Weinberg concluded was an important factor considered by the Company in reaching a decision as to the accounting, auditing or financial reporting issue; or (iii) any matter that was the subject of either a disagreement as defined in Item 304(a)(1)(iv) of Regulation S-K or a reportable event as described in Item 304(a)(1)(v) of Regulation S-K.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures
AOB maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in reports filed by AOB under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and form and that such information is accumulated and communicated to AOB’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. Our Chief Executive Officer and Chief Financial Officer evaluated, with the participation of other members of management, the effectiveness of AOB’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)), as of the end of the period covered by this Annual Report on Form 10-K as of December 31, 2012 (the “Evaluation Date”). Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were not effective.
(b) Management’s Report on Internal Control over Financial Reporting
The management of AOB is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:
1. Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets;
2. Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorization of our management and directors; and
3. Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisitions, use or disposition of our assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In connection with the preparation of the annual report of the Company’s 2012 consolidated financial statements, under the supervision and with the participation of the Chief Executive Officer and Chief Financial Officer, management reassessed evaluation of the effectiveness of its internal control over financial reporting as of December 31, 2012. The framework on which such evaluation was based is contained in the report entitled “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO Report”). As a result of that reassessment, management identified two deficiencies as of December 31, 2012 that constituted a material weaknesses and a significant deficiency; accordingly, the Chief Executive Officer and Chief Financial Officer concluded that the Company did not maintain effective internal control over financial reporting as of December 31, 2012.
Description of Material Weakness
A material weakness in internal control over financial reporting is defined as a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis.
Management is continuing its review of the Company’s internal control over financial reporting as it believes the following material weaknesses still exist: (i) a lack of senior management personnel who have the requisite U.S. GAAP experience to prepare financial statements in accordance with U.S. GAAP; (ii) the Company did not maintain an adequate financial reporting organizational structure to support the complexity and operating activities of the Company resulting in a weakness in efficiency and controls related to the financial statement closing process. However, the Company has taken steps described above to remediate these deficiencies.
In response to the material weakness identified above, management, under the supervision of the Chief Executive Officer and Chief Financial Officer, commenced to implement the measures described below to address the material weakness. This remediation effort is both to address the identified material weakness and to enhance the Company’s overall financial control environment. The material weaknesses identified by management have been remediated.
(c) Changes in Internal Control over Financial Reporting
In response to the material weakness identified above, management, under the supervision of the Chief Executive Officer and Chief Financial Officer, commenced to implement the measures describes below to address the material weakness. This remediation effort is intended both to address the identified material weakness and to enhance the Company’s overall financial control environment. During 2012 and 2013, the Company has taken steps to remediate these matters.
Remediation Steps Taken to Address Material Weakness
·Management revised its policies and procedures relating to the identification of significant transactions that will impact its financial accounting and disclosures. This includes the establishment of a Disclosure Committee consisting of the Chief Executive Office, Chief Financial Officer, other accounting and operational management as deemed necessary and the Audit Committee financial expert. The responsibility of the Disclosure Committee is to assist the Company’s financial reporting team in ensuring that the accounting consequences of the Company’s material transaction are captured and reflected in the Company’s financial statements on a timely and accurate manner.
·Management established a reporting threshold for significant and material transactions to those who are responsible for oversight the financial reporting, particularly to the Audit Committee.
·Management established a threshold for significant and material transactions that would require approval from the board of directors.
·Management designed controls to obtain internal certifications from operational management to ensure all important transactions, contracts and agreements have been appropriately disclosed to the Disclosure Committee.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The following table sets forth the names and ages of our current directors and executive officers, their principal offices and positions and the date each such person became a director or executive officer. Executive officers are elected annually by our Board of Directors. Each executive officer holds his office until he resigns, is removed by the Board or his successor is elected and qualified. Directors are elected annually by our shareholders at the annual meeting. Each director holds his or her office until his or her successor is elected and qualified or his or her earlier resignation or removal.
The following persons are the directors and executive officers of the Company:
(1) Serves as a member of the Audit Committee.
(2) Serves as a member of the Compensation Committee.
(3) Serves as a member of the Nominating and Corporate Governance Committee.
(4) Serves as a member of the Disclosure Committee.
There are no family relationships between or among any of the executive officers or directors of the Company. Below are brief descriptions of the backgrounds and experiences of the officers and directors:
TONY LIU - CHIEF EXECUTIVE OFFICER AND CHAIRMAN OF THE BOARD OF DIRECTORS. Tony Liu is the principal founder of our Company and has served as our Chief Executive Officer and the Chairman of our Board of Directors since 2001. He served in the army for over 19 years. After Mr. Liu left the army, he began working for the government in the Heilongjiang province in northeastern China. In addition to serving as a representative to the National People’s Congress in China, with his practical work experience in the Chinese community for many years, Mr. Liu has witnessed and participated in the massive macroeconomic changes for the past thirty years. He has many years of experience in managing the army, government agencies and pharmaceutical companies. Mr. Liu was named the Outstanding Chinese Entrepreneur of the World and he is currently the Vice Chairman of the World Eminence Chinese business Association. Mr. Liu graduated with a major in Communications & Commands from Wuhan Communication College in 1986 and studied Integrated Marketing and Media at the University of Hong Kong in 2004. Mr. Liu studied in the Program of Sustainable Growth of Large Corporations sponsored by the School of Engineering and the School of Business at Stanford University. Mr. Liu passed the dissertation for his Doctor of Business Administration degree in September 2010 at Tarlac State University through a program jointly run by Beijing Normal University and Tarlac State University. This program is accredited by The Philippines Department of Education and China Department of Education.
JUN MIN - VICE PRESIDENT AND DIRECTOR. Jun Min is one of our partner founders and has served as our Vice President and as a member of our Board of Directors since 2002. Mr. Min worked at the Price Checking Department Bureau of Heilongjiang Province from 1987 to 1992. Subsequently, he worked for Three- Happiness Bioengineering, Co. Ltd. from 1994. In November 2008, Mr. Min joined the board of directors of China Aoxing Pharmaceuticals Co., Inc. (OTCBB:CAXG), a specialty pharmaceutical company specializing in research, development, manufacturing and distribution of a variety of narcotics and pain-management products. He has over 20 years of experience in operations management and has an extensive knowledge of the consumer and pharmaceutical products industries in China. Mr. Min received a BA in Business Management from Harbin Broadcast & TV University in 1986.
YANCHUN LI - CHIEF FINANCIAL OFFICER, SECRETARY AND DIRECTOR. Yanchun Li one of our partner founders and has served as Chief Financial Officer since May 2007. Prior to her appointment as Chief Financial Officer, she had been the Acting Chief Financial Officer since May 2002, Chief Operating Officer from October 2003 until March 2010 and Secretary since October 2003 and has worked at the Company and served as a member of the Board of Directors since 2002. Ms. Li has fifteen years of experience in management in the food industry and the pharmaceutical industry in China. In particular, she has extensive experience and innovative insight in marketing, management, brand building, corporate strategy, human resource and financial capital management. Before joining us, Ms. Li worked for China Ruida Food Limited Company and successfully established the Ruida brand as the number one brand in the instant frozen food industry. Ms. Li joined Three-Happiness Bioengineering, Co. Ltd. in 1994 and was in charge of the marketing and sales. Under her leadership, the functional drink of the Three-Happiness brand has reached stunning achievement nationwide across China. The Three-Happiness brand was later awarded the Top Ten Well-known Brands in China. Ms. Li won the China Golden Award in Marketing of Year 2005 and was elected into the Who is Who of Chinese Origin Worldwide. Ms. Li received her BA in English from Beijing University of Industry and Commerce in 1993 and completed the Owner/President Management Program in 2008, an advanced program, at Harvard Business School.
COSIMO J. PATTI - INDEPENDENT DIRECTOR. Cosimo J. Patti has served on our Board of Directors since 2004. Before joining us, Mr. Patti was an arbitrator for the National Association of Securities Dealers and the New York Stock Exchange for 18 years. Since August 1999, Mr. Patti has been the President and Chairman of Technology Integration Group, Inc. In May 2009, Mr. Patti was appointed to the board of directors of China XD Plastics Company Limited (NASDAQ:CXDC), a company engaged in the development, manufacturing, and distribution of modified plastics primarily for use in automotive applications. In June 2007, Mr. Patti joined the board of directors of Advanced Battery Technologies, Inc. (NASDAQ:ABAT), a company engaged in the business of designing, manufacturing and marketing rechargeable polymer lithium-ion batteries. From 2002 to 2004, Mr. Patti was the Senior Director of Applications Planning with iCi/ADP. He was the Director of Strategic Cross-border Business with Cedel Bank from 1996 to 1999, and President and Founder of FSI Advisors Group from 1998 to 2002. Since 1986 Mr. Patti has served as an appointed arbitrator to the New York Stock Exchange and the National Association of Securities Dealers adjudicating cases involving client disputes within government, equity, derivative and fixed income securities trading activities. Mr. Patti contributes to our Board of Directors his forty years of experience successfully managing corporate teams in domestic and international operations, compliance and sales organizations. Mr. Patti attended Brooklyn College from 1968 to 1970.
XIANMIN WANG - INDEPENDENT DIRECTOR. Xianmin Wang has served on our Board of Directors since 2005. He was the Vice Governor of Heilongjiang Province from 1998 to 2003, where he was in charge of Financial and Economic affairs. Mr. Wang was Secretary of Daqing Municipal Party Committee from 1996 to 1998, and Vice Secretary of Harbin Municipal Party Committee from 1991 to 1992. Mr. Wang received a post graduate degree in Philosophy from Renmin University of China in 1964. He also holds a bachelor’s degree in Economics from Northeast Forest University and postgraduate degrees in Philosophy from Heilongjiang University and Renmin University of China.
BAIQING ZHANG - INDEPENDENT DIRECTOR. Baiqing Zhang has served on our Board of Directors since 2006. Mr. Zhang brings to us two decades of experience in the Chinese government’s regulatory and supervisory divisions. From 1997 until Mr. Zhang retired in 2005, Mr. Zhang served as Deputy Director, Division Chief of the Heilongjiang Regulatory Bureau of the China Securities Regulatory Commission, or CSRC, where he managed and imposed regulatory compliance for all Heilongjiang-based securities issuances, as well as supervised securities trading, investment funds and legal affairs. The CSRC is China’s primary regulatory body overseeing the country’s financial markets. Prior to this, he spent ten years as a member of the Discipline Inspection Committee in the Department of Supervision of the Heilongjiang Province, and previously was the Vice Principal of Hebei Institute of Mechanical and Electrical Technology, where he taught college courses. Since 2005, Mr. Zhang has been a consultant in the fields of law and economics, public policy, and business strategy. He also consults and lectures about regulatory issues in the Chinese securities markets, based on his significant experience at the CSRC. Mr. Zhang received a degree in Management of Economics from the Tianjin Normal University and a degree in Accounting from the Heilongjiang Economics Management Academy.
XIAOPENG XU - CHIEF OPERATING OFFICER. Xiaopeng Xu has served as Chief Operating Officer since March, 2010. Since July 2009, Mr. Xu was employed by the Company as general manager of manufacturing. Prior to joining the Company in 2009, Mr. Xu, has served in a number of senior positions in the pharmaceutical industry in China, including the General Manager of China National Pharmaceutical Industry Co., Ltd. from 2005 to 2006, Executive Deputy General Manager of Harbin Pharmaceutical Group Co., Ltd., (Shanghai Stock Exchange: 600664) from 2004 to 2005 and the Factory Director of Harbin Pharmaceutical Group General Industry Co., Ltd. from 1996 to 2004. Currently Mr. Xu also serves in the following capacity for the following entities: Independent Director of Heibei Aoxing Pharmaceutical Co., Inc. since August 2009, Independent Director of Harbin Baida Pharmaceutical Co., Ltd. since 2005, Visiting Professor of Shenyang Pharmaceutical University since 2004, Vice Chairman of China Pharmaceutical Industry Association since 2002, and Vice Chairman of China Anesthetic Association since 2003 (both of the latter associations are industry oriented academic organizations). Mr. Xu graduated from Harbin CCP School in 1985 and completed graduate level programs in CEO courses from Tsinghua University in 2002.
YAN GAO - CHIEF ACCOUNTING OFFICER. Yan Gao has served as Chief Accounting Officer since February 22, 2012. Prior to being appointed as CAO on February 22, 2012, Mr. Gao was an in-house senior accountant for the Company on the financial reporting team, preparing draft reports and responsible for overseeing financial management matters. He joined the Company in 2006 as the Financial Controller for Guangxi Lingfeng Pharmaceutical Ltd., a wholly owned subsidiary of the Company, and served as the General Manager of the Company's Finance Department in 2009, during which he was in charge of financial planning, cash flow management, internal control compliance, business consolidations and reporting. Mr. Gao graduated with a major in Accounting from Heilongjiang College with a professional certificate in 1994.
BOARD LEADERSHIP STRUCTURE
The Board of Directors believes that Tony Liu’s service as both Chairman of the Board and Chief Executive Officer is in the best interest of the Company and its stockholders. Mr. Liu possesses detailed and in-depth knowledge of the issues, opportunities, and challenges facing AOB in the pharmaceutical industry, and is thus best positioned to develop agendas that ensure that the time and attention of our Board of Directors are focused on the most critical matters. His combined role enables decisive leadership, ensures clear accountability, and enhances AOB’s ability to communicate its message and strategy clearly and consistently to AOB’s stockholders, employees and customers.
Each of the directors other than Tony Liu, Jun Min, Yanchun Li is independent (see “Director Independence” below), and the Board of Directors believes that the independent directors provide effective oversight of management. The Board of Directors has not designated a lead director. Our independent directors call and plan their executive sessions collaboratively and, between Board of Directors meetings, communicate with management and one another directly. In the circumstances, the directors believe that formalizing in a lead director functions in which they all participate might detract from rather than enhance performance of their responsibilities as directors.
BOARD’S ROLE IN RISK OVERSIGHT
The Board of Directors as a whole has responsibility for risk oversight, with reviews of certain areas being conducted by the relevant Board of Directors committees. These committees then provide reports to the full Board of Directors. The oversight responsibility of the Board of Directors and its committees is enabled by management reporting processes that are designed to provide visibility to the Board of Directors about the identification, assessment, and management of critical risks. These areas of focus include strategic, operational, financial and reporting, succession and compensation, compliance, and other risks. The Board of Directors and its committees oversee risks associated with their respective areas of responsibility, as summarized below.
CORPORATE GOVERNANCE
Board of Directors
We have six members serving on our Board of Directors. Each board member is nominated for election at our annual meeting to serve until the next annual meeting of shareholders and until their successors are duly elected and qualified.
Board Committees
The Board of Directors has a Compensation Committee, a Nominating and Corporate Governance Committee, a Disclosure Committee and an Audit Committee.
Compensation Committee
The Compensation Committee was established on January 15, 2005. The members of the Compensation Committee were Cosimo J. Patti, Xianmin Wang and Lawrence S. Wizel during 2012. Mr. Wizel served as a member of the compensation committee until May 9, 2012, when he resigned. Each of these members is considered “independent” under Section 303A.02 of the listing standards of the New York Stock Exchange, as determined by our Board of Directors. The Compensation Committee operates under a written charter.
The Second Amended and Restated Compensation Committee Charter can be found on our website at www.bioaobo.com and can be made available in print free of charge to any shareholder who requests it.
The Compensation Committee assists the Board of Directors in determining the compensation of our Chief Executive Officer and makes recommendations to the Board of Directors with respect to the compensation of the Chief Financial Officer, other executive officers of the Company and the independent directors. The Compensation Committee administers our 2006 equity incentive plan, under the direction of the Board of Directors. The Compensation Committee held one meeting during 2012.
Nominating and Corporate Governance Committee
The Nominating and Corporate Governance Committee was established on January 15, 2005. The purpose of the Nominating and Corporate Governance Committee is to assist the Board of Directors in identifying qualified individuals to become members of the Board of Directors, in determining the composition of the Board of Directors and in monitoring the process to assess the effectiveness of the Board of Directors. The Nominating and Corporate Governance Committee held one meeting during 2012.
The members of the Nominating and Corporate Governance Committee during 2012 were Cosimo J. Patti, Baiqing Zhang, Lawrence S. Wizel and Xianmin Wang. Mr. Wang served as the Chairperson of the Nominating and Corporate Governance Committee. Mr. Wizel served as the member of the Nominating and Corporate Governance Committee until May 9, 2012, when he resigned as the independent director. Each of the above-listed Nominating and Corporate Governance Committee members is considered “independent” under Section 303A.02 of the listing standards of the New York Stock Exchange, as determined by our Board of Directors.
There have been no changes to the procedures by which the stockholders of the Company may recommend nominees to the Board of Directors since the filing of the Company’s Definitive Proxy Statement on November 18, 2011 for its Annual Meeting of Stockholders, which was held on December 28, 2011. The Nominating and Corporate Governance Committee operates under a written charter. The Amended and Restated Nominating and Corporate Governance Committee Charter can be found on our website at www.bioaobo.com and can be made available in print free of charge to any shareholder who requests it.
The Nominating and Corporate Governance Committee and the Board believe that the leadership skills and other experiences of its Board members provide AOB with a range of perspectives and judgment necessary to guide AOB’s strategies and monitor their execution.
Tony Liu: Mr. Liu is the principal founder of our Company and he contributes to our Board of Directors his leadership skills and his vision of the direction of the development of the Company’s business in the future. Mr. Liu accumulated his skills and experience over twenty years of business practice, and his continuous learning, including his recent award of a doctoral degree in business administration from Tarlac State University.
Jun Min: Mr. Min is one of our partner founders and he contributes to our Board of Directors his management skills and experience that he accumulated over twenty years while working in the private sector.
Yanchun Li: Ms. Li is one of our partner founders and she contributes to our Board of Directors her strategic thinking, and practical execution of major decisions by the Board of Directors. Ms. Li has won several national awards for excellent business talents in China.
Cosimo J. Patti: Mr. Patti contributes to our Board of Directors his skills and experience that he had accumulated by working for companies such as Lehman Brothers and the New York Stock Exchange.
Xianmin Wang: Mr. Wang contributes to our Board of Directors by leveraging his experience obtained when he worked in the capacity of deputy governor of Heilongjiang Province and the mayor of Daqing City.
Baiqing Zhang: Mr. Zhang contributes to our Board of Directors his overall business experience that he accumulated from his work for the regulatory body of the securities industry in China.
Disclosure Committee
The Disclosure Committee was established on May 21, 2012. The members of the Disclosure Committee are designated by the Chief Executive Officer and/or the Chief Financial Officer. The initial members include the Chief Executive officer, the Chief Financial Officer, the Chief Operating Officer, the Chief Accounting Officer, the Chairman of the Audit Committee, the Vice President and Director, the General Manager of Human Resources, the Vice President of Research and Development, the General Manager of Auditing Center, the Director of Sales, and the General Manager of Public Relation. The Compensation Committee operates under a written charter.
The Disclosure Committee Charter can be found on our website at www.bioaobo.com and can be made available in print free of charge to any shareholder who requests it.
The Disclosure Committee assists the Company and our Chief Executive Officer and Chief Financial Officer in establishing, maintaining, reviewing and evaluating control and other procedures designed to ensure that information required to disclosed by the Company in its publicly filed reports, including, without limitation, reports required to be filed pursuant to the Securities Exchange Act of 1934, as amended is recorded, processed, summarized and reported within the time period(s) specified in applicable rules and forms. The Disclosure Committee holds regular meetings at least one each quarter prior to and in connection with the Company’s release of earnings results and, if applicable, its preparation of financial statements, annual or quarterly filings and proxy and information statement with the SEC.
The initial members of the Disclosure Committee are as follow:
Audit Committee
The Audit Committee operates under a written charter. The Charter of the Audit Committee can be found on our website at www.bioaobo.com and can be made available in print free of charge to any shareholder who requests it.
The Audit Committee’s charter states that the responsibilities of the Audit Committee shall include, among other things:
·reviewing the Audit Committee’s charter;
·reviewing the Company’s annual report to stockholders and reports submitted to the SEC;
·naming the Company’s independent auditors, confirming and reviewing their independence, and approving their fees;
·reviewing the independent auditors’ performance;
·considering the independent auditors’ judgments about the Company’s accounting principles;
·considering and approving major changes to the Company’s auditing and accounting principles;
·establishing reporting systems to the committee by management and the independent auditors regarding management’s significant judgments in preparing financial statements;
·following an audit, reviewing significant difficulties encountered during the audit;
·reviewing significant disagreements among management and the independent auditors in the preparation of the Company’s financial statements;
·reviewing the extent to which improvements in financial or accounting practices approved by the committee have been implemented;
·review with counsel any legal matters that could have a significant impact on the Company’s financial statements; and
·review all Company transactions, in which any related person may have a direct or indirect material interest.
The Audit Committee met four times during 2012. Pursuant to its charter, the Audit Committee meets at least quarterly with the Company’s internal auditors. The Company does not limit the number of audit committees of other companies on which its Audit Committee members can serve.
The members of the Audit Committee during 2012 were Cosimo Patti and Lawrence S. Wizel. Mr. Wizel served as the Chairperson until May 9, 2012 when he resigned as the independent director of the Board of Director. Each of these members is considered “independent” under Section 303A.02 of the listing standards of New York Stock Exchange, as determined by our Board of Directors. The Audit Committee performs each of its responsibilities as outlined in its charter.
Our Board of Directors has determined that we have at least one audit committee financial expert, as defined in the Exchange Act, serving on our Audit Committee. Lawrence S. Wizel was the “audit committee financial expert” and was an independent member of our Board of Directors until May 9, 2012. Mr. Patti is the Chairperson of the Audit Committee, the “audit committee financial expert” and an independent member of our Board of Directors.
REPORT OF THE AUDIT COMMITTEE (1)
The role of the Audit Committee is to assist the Board of Directors in its oversight of the Company’s financial reporting process. The Board of Directors, in its business judgment, has determined that all members of the committee are “independent”. The Audit Committee operates pursuant to a Charter that was approved by the Board. As set forth in the Charter, management of the Company is responsible for the preparation, presentation and integrity of the Company’s financial statements, accounting and financial reporting principles and internal controls and procedures designed to assure compliance with accounting standards and applicable laws and regulations. The independent auditors are responsible for auditing the Company’s financial statements and expressing an opinion as to their conformity with generally accepted accounting principles.
In the performance of the oversight of the Company’s financial reporting process, the Audit Committee has reviewed and discussed the audited financial statements with management, the internal auditors and the independent auditors. The Audit Committee has discussed with the independent auditors the matters required to be discussed by Statement of Auditing Standards No. 61, Communication with Audit Committee, as amended, as adopted by the Public Company Accounting Oversight Board (“PCAOB”) in Rule 3200T.
Finally, the Audit Committee has received written disclosures and the letter from the independent auditors, as required by applicable requirements of the PCAOB regarding the independent accountant’s communications with the Audit Committee concerning independence, and has discussed with the independent accountant the independent accountant’s independence.
Members of the Audit Committee rely without independent verification on the information provided to them and on the representations made by management and the independent accountants. Accordingly, the Audit Committee’s oversight does not provide an independent basis to determine that management has maintained appropriate accounting and financial reporting principles or appropriate internal control and procedures designed to assure compliance with accounting standards and applicable laws and regulations. Furthermore, the Audit Committee’s consideration and discussions referred to above do not assure that the audit of the Company’s financial statements has been carried out in accordance with generally accepted accounting principles or that the Company’s auditors are in fact “independent.”
Based upon the reports, review and discussions described in this report, and subject to the limitations on the role and responsibilities of the Audit Committee referred to above and in the Charter, the Audit Committee recommended to the Board that the audited financial statements as of and for the year ended December 31, 2012 be included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012, as filed with the SEC.
THE AUDIT COMMITTEE
Cosimo Patti (Chairman)
(1)The material in the Audit Committee report is not soliciting material, is not deemed filed with the SEC and is not incorporated by reference in any filing of the Company under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this proxy statement and irrespective of any general incorporation language in such filing.
PROCESS FOR SENDING COMMUNICATIONS TO THE BOARD OF DIRECTORS
	The Board of Directors maintains a process for stockholders to communicate with the Board of Directors. Stockholders wishing to communicate with the Board of Directors or any individual director (including the director who presides at executive sessions of non-management or independent directors or with those directors as a group) must mail a communication addressed to the Secretary of the Company, c/o American Oriental Bioengineering, Inc., 211 Warren Street Suite 219, Newark, NJ 07103. Any such communication must state the number of shares of Common Stock beneficially owned by the stockholder making the communication. All of such communications will be forwarded to the full Board of Directors or to any individual director or directors to whom communication is directed unless the communication is clearly of a marketing nature or is inappropriate, in which case we have the authority to discard the communication or take appropriate legal action regarding the communication.
CODE OF ETHICS
We adopted a code of ethics that applies to our directors, officers and employees, including our Chief Executive Officer and Chief Financial Officer, and other persons who perform similar functions. A written copy of the code can be found on our website at www.bioaobo.com and can be made available in print to any shareholder upon request at no charge by writing to our Secretary, c/o American Oriental Bioengineering, Inc., 211 Warren Street Suite 219, Newark, NJ 07103. Our Amended and Restated Code of Ethics is intended to be a codification of the business and ethical principles which guide us, deter wrongdoing, promote honest and ethical conduct, avoid conflicts of interest, and foster full, fair, accurate, timely and understandable disclosures, compliance with applicable governmental laws, rules and regulations, the prompt internal reporting of violations and accountability for adherence to this code.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
There are no transactions, since January 1, 2011 the beginning of the Company’s last fiscal year, or any currently proposed transactions, in which the Company was or is to be a participant and in which any related person had or will have a direct or indirect material interest. It is the Company’s policy that the Company will not enter into any related party transactions unless the Audit Committee or another independent body of the Board of Directors first reviews and approves the transactions.
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
	Section 16(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), requires the executive officers and directors of the Company and every person who is directly or indirectly the beneficial owner of more than 10% of any class of security of the Company to file reports of ownership and changes in ownership with the SEC. Such persons also are required to furnish our company with copies of all Section 16(a) forms they file. Based solely on our review of copies of such forms received by us, we believe that during the fiscal year 2012, all of the executive officers and directors of the Company and every person who is directly or indirectly the beneficial owner of more than 10% of any class of security of the Company complied with the filing requirements of Section 16(a) of the Exchange Act.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The Company’s executive compensation program for the named executive officers (NEOs) is administered by the Compensation Committee of the Board of Directors.
Compensation Objectives
We believe that the compensation programs for the Company’s NEOs should reflect the Company’s performance and the value created for the Company’s shareholders. In addition, the compensation programs should support the short-term and long-term strategic goals and values of the Company, and should reward individual contributions to the Company’s success. Our compensation plans are consequently designed to link individual rewards with Company’s performance by applying objective, quantitative factors including the Company’s own business performance and general economic factors. We also rely upon subjective, qualitative factors such as technical expertise, leadership and management skills, when structuring executive compensation in a manner consistent with our compensation philosophy.
Process for Determining Compensation for Executives
The Compensation Committee makes independent decisions about all aspects of NEO compensation, and takes into account (i) recommendations from our CEO with respect to the compensation of NEOs other than himself, and (ii) information that our Human Resources department provides regarding compensation data.
The Compensation Committee regularly reviews the design and structure of the Company’s compensation programs to ensure that management’s interests are closely aligned with shareholders’ interests and that the compensation programs are designed to further the Company’s strategic priorities.
Elements of Compensation
Base Salary. Base salaries for the named executive officers are set forth in their respective employment agreements.
However, the Compensation Committee considers proposals from the Company’s management to approve increases to the base salaries for named executive officers other than our CEO. When considering whether to approve these adjustments, the Compensation Committee takes into account a number of factors, including:
·the Company’s performance;
·the individual’s current and historical performance and contribution to the Company; and
·the individual’s role and unique skills.
Base salaries are reviewed annually, and may be increased to align salaries with market levels after taking into account the subjective evaluation described previously. The Company did not benchmark the compensation paid to its executives for 2011 and the Compensation Committee did not take into account compensation data and benchmarks for comparable positions and companies. On April 10, 2011, the Compensation Committee met and reviewed the compensation package for each executive and determined, after taking into account the capital requirements of the business and the then current economic situation, that the salary base compensation for the executives which were carried over from 2008 to 2010 (with one slight adjustment), continued to be competitive and, therefore, no salary increase for the year ended December 31, 2012 was warranted.
Annual Cash Incentive Bonuses. The Company has a cash incentive bonus program for NEOs. The cash bonus is determined by the Company’s compensation committee and is performance based.
The program is designed to promote executive decision making and achievement that supports the realization of key overall Company financial goals. For the year 2012, the participants in the Company’s cash incentives program consisted of each of the Company’s six NEOs.
In 2012, executives had target bonus opportunities ranging from 0% to 100% of base salary earnings, depending on position level and responsibility, with larger bonus opportunities provided to those with greater responsibility. The Compensation Committee establishes the guidelines under which the plan is administered, including financial performance goals and payout schedules.
Equity Incentive Compensation. We believe that long-term performance is achieved through an ownership culture participated in by our executive officers through the use of stock-based awards. Currently, we do not maintain any incentive compensation plans based on pre-defined performance criteria. The Compensation Committee has the general authority, however, to award equity incentive compensation, i.e. stock options and restricted stock awards to our executive officers in such amounts and on such terms as the committee determines in its sole discretion.
The Compensation Committee does not have a determined formula for determining the number of options available to be granted. The Compensation Committee will review each executive’s individual performance and his or her contribution to our strategic goals periodically. With the exception of stock options and restricted stock awards automatically granted at the end of each fiscal quarter in accordance with the terms of the employment agreement with our executive officers, our Compensation Committee grants equity incentive compensation at times when we do not have material non-public information to avoid timing issues and the appearance that such awards are made based on any such information.
The Compensation Committee carefully monitors our executive compensation programs. Although it has been our general objective to provide our NEOs with total annual compensation near the median of the range of salaries for executives in similar positions with similar responsibilities at comparable companies, we have also balanced this goal with the overall global market conditions and performance of the Company and to that end decrease levels of compensation during 2012.
Risk Analysis of Our Compensation Plans
The Compensation Committee has reviewed our compensation policies as generally applicable to our NEOs and believes that our policies do not encourage excessive and unnecessary risk-taking, and that the level of risk that they do encourage is not reasonably likely to have a material adverse effect on the Company. The design of our compensation policies and programs encourage our NEOs to remain focused on both the short-and long-term goals of the Company. For example, while our cash bonus plans measure performance on an annual basis, our equity awards typically vest over a number of years, which we believe encourages our NEOs to focus on sustained stock price appreciation, thus limiting the potential value of excessive risk-taking. The Compensation Committee believes that the balance of long-term equity incentive, short-term cash incentive bonus and base salary appropriately balances both the short and long term performance goals of the Company without encouraging excessive risk related behavior. While the Compensation Committee regularly evaluates its compensation programs, the Compensation Committee believes that its current balance of incentives both adequately compensates its NEOs and does not promote excessive risk taking.
Summary Compensation Table
The following table sets forth all cash compensation paid or to be paid by the Company, as well as certain other compensation paid or accrued, for each of the last three years of our company to each named executive officer.
(1)The amounts reported in this column represent base salaries paid to each of the named executive officers for 2012 as provided for in their respective employment agreements.
(2)The named executive officers did not receive any discretionary bonuses, sign-on bonuses, or other annual bonus payments that are not contingent on the achievement of stipulated performance goals. Cash bonus payments are contingent on achieving pre-established and communicated goals.
(3)Stock and option awards amounts shown in this table represent the grant date fair value computed in accordance with FASB ASC 718.
(4)Other compensation includes reimbursement for business-related travel expenses.
Employee Equity Incentive Plan
In March 2004, our Board of Directors formally adopted a Stock Option Plan (the “2004 Plan”). Under the 2004 Plan, we were authorized to grant non-qualified options to purchase up to 2,900,000 shares of our common stock to our employees, officers, directors and consultants. The 2004 Plan was administered directly by our Compensation Committee. Subject to the provisions of the 2004 Plan, the Compensation Committee determined who would receive stock options, the number of shares of common stock that may be covered by the option grants, the time and manner of exercise of options and exercise prices, as well as any other pertinent terms of the options. The Company replaced the 2004 Plan with a new Equity Incentive Plan that was adopted by the Board and approved by the Shareholders in 2006 (“2006 Plan”). The 2006 Plan provides a maximum of 5,000,000 shares for future grants but the Company is not intended to grant more than 1,000,000 shares in one calendar year. The Company will not grant any additional awards under the 2004 Plan. All Awards starting from 2007 would be granted under the 2006 Plan. Those individuals with awards outstanding under the 2004 Plan will continue to hold such awards in accordance with the terms of their respective grant agreements.
During the year ended December 31, 2012, the Company did not grant any restricted stock or stock options to the NEO’s.
Employment Agreements
On April 10, 2011, we entered into employment agreements with Tony Liu, our Chairman and Chief Executive Officer, Yanchun Li, our Chief Financial Officer, and Jun Min, our Vice President. Tony Liu, Yanchun Li and Jun Min are also directors of the Company.
Tony Liu’s employment agreement has a term of one year, effective as of April 10, 2011, and provides for an annual base salary of $200,000, subject to subsequent annual review by the Company’s Compensation Committee. The term of his agreement shall be automatically renewed for another year, unless a written notice is given by either party of an intention not to renew the agreement no later than 90 days prior to the expiration of the term. The agreement also provides for grant of a stock award of 110,765 shares. The stock are awarded under the Company’s 2006 Equity Incentive Plan and will vest ratably over a five year period, subject to Mr. Liu’s continued employment with the Company on each vesting date. Mr. Liu is also entitled to an annual performance based bonus of up to $40,000 based upon the Company’s performance. Such amount may be increased if the Company exceeds certain net income targets for the year, or may be decreased if the net income targets are not met. We can terminate Mr. Liu’s employment with cause or without cause pursuant to a decision by our Board of Directors. In the event Mr. Liu’s employment is terminated without cause, he will be eligible to receive monthly payments at his then applicable monthly base salary for the rest of his term from the date of termination of the employment.
Lily Li’s employment agreement has a term of one year, effective as of April 10, 2011, and provides for an annual base salary of $160,000, subject to subsequent annual review by the Company’s Compensation Committee. The term of her agreement shall be automatically renewed for another year, unless a written notice is given by either party of an intention not to renew the agreement no later than 90 days prior to the expiration of the term. The agreement also provides for grant of a stock award of 97,836 shares. The stock are awarded under the Company’s 2006 Equity Incentive Plan and will vest ratably over a five year period, subject to Ms. Li’s continued employment with the Company on each vesting date. Ms. Li is also entitled to an annual performance based bonus of up to $30,000 based upon the Company’s performance and such amount may be increased if the Company exceeds certain net income targets for the year, or may be decreased if the net income targets are not met. We can terminate Ms. Li’s employment with cause or without cause pursuant to a decision by our Board of Directors. In the event Ms. Li’s employment is terminated without cause, she will be eligible to receive monthly payments at her then applicable monthly base salary for the rest of her term from the date of termination of her employment.
Jun Min’s employment agreement has a term of one year, effective as of April 10, 2011, and provides for an annual base salary of $120,000, subject to subsequent annual review by our Board of Directors. The term of his agreement shall be automatically renewed for another year, unless a written notice is given by either party of an intention not to renew the agreement no later than 90 days prior to the expiration of the term. The agreement also provides for grant of a stock award of 73,377 shares. The stock are awarded under the Company’s 2006 Equity Incentive Plan and will vest ratably over a five year period, subject to Mr. Min’s continued employment with the Company on each vesting date. Mr. Min is also entitled to an annual performance based bonus of up to $30,000 based upon the Company’s performance and such amount may be increased if the Company exceeds certain net income targets for the year, or may be decreased if the net income targets are not met. We can terminate Mr. Min’s employment with cause or without cause pursuant to a decision by our Chief Executive Officer. In the event Mr. Min’s employment is terminated without cause, he will be eligible to receive monthly payments at his then applicable monthly base salary for the rest of his term from the date of termination of the employment.
Xiaopeng Xu’s employment agreement has a term of one year, effective as of April 10, 2011, and provides for an annual base salary of RMB 500,000(equal to US$76,378), subject to subsequent annual review by our Board of Directors. The term of his agreement shall be automatically renewed for another year, unless a written notice is given by either party of an intention not to renew the agreement no later than 90 days prior to the expiration of the term. The agreement also provides for grant of a stock award of 8,986 shares. The stock are awarded under the Company’s 2006 Equity Incentive Plan and will vest ratably over a five year period, subject to Mr. Xu’s continued employment with the Company on each vesting date. Mr. Xu is also entitled to an annual performance based bonus of up to RMB 300,000 ($45,827) based upon the Company’s performance and such amount may be increased if the Company exceeds certain net income targets for the year, or may be decreased if the net income targets are not met. We can terminate Mr. Xu’s employment with cause or without cause pursuant to a decision by our Chief Executive Officer. In the event Mr. Xu’s employment is terminated without cause, he will be eligible to receive monthly payments at his then applicable monthly base salary for the rest of his term from the date of termination of the employment.
Potential Payments upon Termination or Change in Control
Assuming the employment of our named executive officers were to be terminated without cause or for good reason, as of December 31, 2012, the following individuals would have been entitled to payments in the amounts set forth opposite to their name in the below table through April 10, 2013:
2012 Outstanding Equity Awards at Year-end
Option Exercises and Stock Vested During 2012
Compensation of Independent Directors for 2012
The annual retainer is paid to the independent directors in monthly installments in arrears. An independent director is entitled to receive each year shares of Common Stock with an aggregate value range from $50,000 to $63,000 per annum, calculated based on the average closing price per share for the five (5) trading days preceding and including the date of grant. The equity award to independent directors is awarded at the beginning of each year for service rendered for the preceding year. The Company allows each independent director to elect to take stock awards instead of cash compensation. The Company reimburses its independent directors for reasonable travel expenses to attend Board and Committee meetings.
The following table sets forth all compensation paid or to be paid by AOB, as well as certain other compensation paid or accrued, for each of the independent directors for 2012.
(1)159,473 shares of common stock to be issued were outstanding as of January 1, 2013. Mr. Patti's compensation is comprised of $50,000 director fee, plus $48,000 for services rendered in connection with our financial investigation.
(2)24,829 shares of common stock to be issued were outstanding as of January 1, 2013.
(3)24,829 shares of common stock to be issued were outstanding as of January 1, 2013.
(4)200,578 shares of common stock to be issued were outstanding as of January 1, 2013. Mr. Wizel resigned as Chairman of Audit Committee and independent director on May 9, 2012. Subsequent to his resignation, Mr. Wizel performed financial consulting services and services related to our independent investigation, for which he was compensated $69,083 in 2012.
(5)27,191 shares of common stock to be issued were outstanding as of January 1, 2013. Ms. Brody resigned as an independent director on December 11, 2011. Subsequent to her resignation, Ms. Brody performed financial consulting services and services related to our independent investigation, for which she was compensated $25,000 in 2012.
(6)For awards of stock and option, the aggregate grant date fair value computed in accordance with FASB ASC 718.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
Members of our Compensation Committee of the Board of Directors during 2012 were Messrs. Patti, Wizel and Wang. No member of our Compensation Committee was, or has been, an officer or employee of the Company or any of our subsidiaries. No member of the Compensation Committee has a relationship that would constitute an interlocking relationship with executive officers or directors of the Company or another entity. Mr. Wizel resigned as a member of the Board and from service on all Board Committees as of May 9, 2012.
COMPENSATION COMMITTEE REPORT (1)
The Compensation Committee has reviewed and discussed the discussion and analysis of the Company’s compensation which appears above with management, and, based on such review and discussion, the Compensation Committee recommended to the Company’s Board of Directors that the above disclosure be included in this Annual Report on Form 10-K.
THE COMPENSATION COMMITTEE
Cosimo J. Patti (Chair)
Xianmin Wang
(1)The material in the Compensation Committee report is not soliciting material, is not deemed filed with the SEC and is not incorporated by reference in any filing of the Company under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this Form 10-K and irrespective of any general incorporation language in such filing.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The following table sets forth certain information regarding beneficial ownership of common stock as of May 14, 2013 by each person known to us to own beneficially more than 5% of our common stock, each of our directors, each of our named executive officers; and all executive officers and directors as a group.
* - Denotes less than 1%
(1)Unless otherwise indicated, the address for all named executive officers, directors and shareholders is c/o American Oriental Bioengineering, Inc., 1 Liangshuihe First Ave, Beijing E-Town Economic and Technology Development Area, E-Town, Beijing, 100176, People's Republic of China.
(2)The amount of beneficial ownership includes the number of shares of Common Stock and/or Series A Preferred Stock, plus, in the case of each of the executive officers and directors and all officers and directors as a group, all shares issuable upon the exercise of the options held by them, which were exercisable as of May 14, 2013 or within 60 days thereafter. Pursuant to Rule 13d-3 under the Securities Exchange Act of 1934, as amended, (the "Exchange Act") and the rules promulgated by the SEC, every person who has or shares the power to vote or to dispose of shares of common stock are deemed to be the "beneficial owner" of all the shares of common stock over which any such sole or shared power exists.
(3)Based upon 36,419,706 shares outstanding as of May 14, 2013.
(4)Through his Common Stock and Series A Preferred Stock ownership, currently, Mr. Liu has voting power equal to approximately 36.5% of our voting securities.
(5)Includes 180,237 shares of common stock issuable upon exercise of options.
(6)Includes 150,871 shares of common stock issuable upon exercise of options.
(7)Includes 113,154 shares of common stock issuable upon exercise of options.
Changes in Control
None.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
There were no transactions, since January 1, 2011, the beginning of the Company’s last fiscal year in which the Company was or is to be a participant and in which any related person had or will have a direct or indirect material interest. It is the Company’s policy that the Company will not enter into any related party transactions unless the Audit Committee or another independent body of the Board of Directors first reviews and approves the transactions.
Director Independence
Although we are no longer subject to the listing standards of the NYSE, we continue to maintain a majority of the directors who are independent directors under Section 303A.01 of the listing standard of NYSE. Section 303A.02 of the NYSE listing standards provide that no director can qualify as independent unless the Board affirmatively determines that the director has no material relationship with the listed company. The Board has adopted the following standards in determining whether or not a director has a material relationship with the Company and these standards are:
·No director who is an employee or a former employee of the Company can be independent until three years after termination of such employment.
·No director who is, or in the past three years has been, affiliated with or employed by the Company’s present or former independent auditor can be independent until three years after the end of the affiliation, employment or auditing relationship.
·No director can be independent if he or she is, or in the past three years has been, part of an interlocking directorship in which an executive officer of the Company serves on the compensation committee of another company that employs the director.
·No director can be independent if he or she is receiving, or in the last three years has received, more than $120,000 during any 12-month period in direct compensation from the Company, other than director and committee fees and pension or other forms of deferred compensation for prior service (provided such compensation is not contingent in any way on continued service).
·Directors with immediate family members in the foregoing categories are subject to the same three-year restriction.
·No director can be independent if he or she is a current employee, or an immediate family member is a current executive officer, of a company that has made payments to, or received payments from, AOB for property or services in an amount which, in any of the last three fiscal years, exceeds the greater of $1 million, or 2% of such other company’s consolidated gross revenues.
Based on these independence standards and all of the relevant facts and circumstances, the Board determined that none of the following directors had any material relationship with the Company and, thus, are independent under Section 303A.02 of the listing standards of NYSE: Messrs. Patti, Wang, Wizel and Zhang.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Audit Fees
The aggregate fees for each of the last two fiscal years for professional services rendered by the principal accountant for our audits of our annual financial statements and interim reviews of our financial statements included in our fillings with Securities and Exchange Commission on Form 10-Ks and 10-Qs services that are normally provided by the accountant in connection with statutory and regulatory filings or engagements for those years were approximately:
Audit Related Fees
The aggregate fees in each of the last two years for the assurance and related services provided by the principal accountant that are not reasonably related to the performance of the audit or review of the Company’s financial statements and are not reported under Audit Fees above were approximately:
Tax Fees
The aggregate fees in each of the last two years for the professional services rendered by the principal accountant for tax compliance, tax advice and tax planning were approximately:
All Other Fees
The aggregate fees in each of the last two fiscal years for the products and services provided by the principal accountant, other than the services reported under Audit Fees and Tax Fees above, were approximately:
Audit Committee Approval
In accordance with the SEC’s auditor independence rules, the Audit Committee has established the following policies and procedures by which it approves in advance any audit or permissible non-audit services to be provided to AOB by its independent auditor.
Prior to the engagement of the independent auditor for any fiscal year’s audit, management submits to the Audit Committee for approval lists of recurring audit, audit-related, tax and other services expected to be provided by the auditor during that fiscal year. The Audit Committee adopts pre- approval schedules describing the recurring services that it has pre-approved, and is informed on a timely basis, and in any event by the next scheduled meeting, of any such services rendered by the independent auditor and the related fees.
The fees for any services listed in a pre-approval schedule are budgeted, and the Audit Committee requires the independent auditor and management to report actual fees versus the budget periodically throughout the year. The Audit Committee will require additional pre-approval if circumstances arise where it becomes necessary to engage the independent auditor for additional services above the amount of fees originally pre- approved. Any audit or non-audit service not listed in a pre-approval schedule must be separately pre-approved by the Audit Committee on a case-by- case basis.
Every request to adopt or amend a pre-approval schedule or to provide services that are not listed in a pre-approval schedule must include a statement by the independent auditors as to whether, in their view, the request is consistent with the SEC’s rules on auditor independence.
The Audit Committee will not grant approval for:
·any services prohibited by applicable law or by any rule or regulation of the SEC or other regulatory body applicable to AOB;
·provision by the independent auditor to AOB of strategic consulting services of the type typically provided by management consulting firms; or
·the retention of the independent auditor in connection with a transaction initially recommended by the independent auditor, the tax treatment of which may not be clear under the Internal Revenue Code and related regulations and which it is reasonable to conclude will be subject to audit procedures during an audit of AOB’s financial statements.
Tax services proposed to be provided by the auditor to any director, officer or employee of AOB who is in an accounting role or financial reporting oversight role must be approved by the Audit Committee on a case-by-case basis where such services are to be paid for by AOB, and the Audit Committee will be informed of any services to be provided to such individuals that are not to be paid for by AOB.
In determining whether to grant pre-approval of any non-audit services in the “all other” category, the Audit Committee will consider all relevant facts and circumstances, including the following four basic guidelines:
·whether the service creates a mutual or conflicting interest between the auditor and the Company;
·whether the service places the auditor in the position of auditing his or her own work;
·whether the service results in the auditor acting as management or an employee of the Company; and
·whether the service places the auditor in a position of being an advocate for the Company.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) The following documents are filed as part of this report:
1. Financial Statements
See ITEM 8 of this Annual Report on Form 10-K.
2. Financial Statement Schedules
Schedule II - Valuation and Qualifying Accounts
Schedules other than those listed above are omitted because they are not required or are not applicable.
3. The exhibits referred to below, which include the following managerial contracts or compensatory plans or arrangements:
·2006 Equity Incentive Plan
·Employment Agreement, dated April 10, 2011, by and between American Oriental Bioengineering, Inc. and Tony Liu
·Employment Agreement, dated April 10, 2011, by and between American Oriental Bioengineering, Inc. and Yanchun Li
·Employment Agreement, dated April 10, 2011, by and between American Oriental Bioengineering, Inc. and Jun Min
·Employment Agreement, dated April 10, 2011, by and between American Oriental Bioengineering, Inc. and Xiaopeng Xu
(b) The exhibits listed on the Exhibit Index are filed as part of this report
(c) Not applicable.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
Fiscal Years Ended December 31, 2012, 2011, and 2010
EXHIBIT INDEX
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
AMERICAN ORIENTAL BIOENGINEERING, INC.
Date: June 11, 2013 By: /s/ Tony Liu
Tony Liu
Chief Executive Officer and Chairman of the Board of Directors
(Principal Executive Officer)
Pursuant to the requirements of the Securities and Exchange Act of 1934, this Report has been signed below by the following person on behalf of the Registrant and in the capacities and on the dates indicated.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors
American Oriental Bioengineering, Inc.
We have audited the accompanying consolidated balance sheets of American Oriental Bioengineering, Inc. as of December 31, 2012 and 2011, and the related consolidated statements of operations and comprehensive income (loss), changes in shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2012. Our audits also included the financial statement schedule listed in the Index at Item 15. These consolidated financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company was not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting as of December 31, 2012. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that we considered appropriate in the circumstances, but not for expressing an opinion on the effectiveness of the Company's internal control over financial reporting as of December 31, 2012. Accordingly, we express no such opinion for the year ending December 31, 2012. Our audit as of December 31, 2011 required an audit of the internal controls over financial reporting, and our opinion on those controls is below. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Oriental Bioengineering, Inc. as of December 31, 2012 and 2011, and the results of their consolidated operations and their cash flows for each of the three years in the period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1, the company has suffered recurring losses and utilized significant cash in operations. In addition, at December 31, 2012, the Company had a working capital deficiency and its convertible notes were in default. These matters raise substantial doubt about the Company's ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1 to the consolidated financial statements. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), American Oriental Bioengineering, Inc.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report which expressed an adverse opinion thereon dated January 7, 2013 included in the Company’s December 31, 2011 Form 10-K filed on January 7, 2013.
/s/ WEINBERG & COMPANY, P.A.
WEINBERG & COMPANY, P.A.
Los Angeles, California
June 11, 2013
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
ASSETS
See accompanying notes to the consolidated financial statements.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
LIABILITIES AND EQUITY
See accompanying notes to the consolidated financial statements.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
See accompanying notes to the consolidated financial statements.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
YEARS ENDED DECEMBER 31, 2012, 2011, AND
See accompanying notes to the consolidated financial statements.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(continued)
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
See accompanying notes to the consolidated financial statements.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
NOTE 1 - PRINCIPAL ACTIVITIES AND ORGANIZATION
American Oriental Bioengineering, Inc. (“AOB”) is a fully integrated pharmaceutical company dedicated to improving health through the development, manufacture, commercialization and distribution of a broad range of pharmaceutical and healthcare products in the People’s Republic of China(the “PRC”). AOB and its subsidiaries are collectively referred to herein as the “Company,” “we,” “us,” “our” and “ourselves,” unless the context indicates otherwise. The following list contains the particulars of the Company’s operating subsidiaries and major affiliate companies:
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
NOTE 2 - BASIS OF PRESENTATION
Basis of Consolidation
The consolidated financial statements include the financial statements of American Oriental Bioengineering, Inc. and its wholly owned subsidiaries. Inter-company balances and transactions between the Company and its subsidiaries are eliminated upon consolidation. Results of acquired subsidiaries are consolidated from the date on which control is transferred to the Company and are no longer consolidated from the date that control ceases.
Going Concern
The accompanying consolidated financial statements are prepared under a going concern basis in accordance with US generally accepted accounting principles (“GAAP”) which contemplates the realization of assets and discharge of liabilities and commitments in the normal course of business. For the year ended December 31, 2012, the Company recorded a loss from operations of $86,331,001 and utilized cash in operations of $46,453,319. As of December 31, 2012, the Company had a working capital deficit of $10,763,083. In addition, the Company was in default of $49,161,000 of its convertible notes due July 15, 2015, for which the Company has subsequently received a notice of acceleration of amount due (see Note 23). If the holders of the notes declare the notes due and payable, the Company presently does not have the ability to pay these notes. These factors, among others, raise substantial doubt about the Company’s ability to continue as a going concern. The Company’s ability to continue as a going concern is dependent upon its ability to return to profitability or to develop additional sources of financing or capital. The Company’s financial statements do not include any adjustments that might result from the outcome of these uncertainties.
Historically, the Company’s main source of cash was through the sales of its products, Common Stock sales and debt financing. However, due to the decrease in sales, the Company’s ability to meet contractual obligations and payables depends on its ability to implement cost reductions effectively and obtain additional financing. The Company believes that the ongoing economic challenges and uncertainties in 2012 will continue to negatively impact its business in 2013. Thus, the Company expects that for 2013 it will continue to generate losses from operations, and its operating cash flows will not be sufficient to cover operating expense; therefore, the Company expects to continue to incur net losses.
To meet its capital needs, the Company is considering multiple alternatives, including, but not limited to, additional debt financing and credit lines, delaying capital spending for future periods, and/or operating cost reductions. The Company believes it can utilize its properties and land use rights located in Beijing, China to secure such financing. No assurance can be given that the financing will be available or, if available, that it will be on terms that are satisfactory to the Company. Even if the Company is able to obtain additional financing, it may contain undue restrictions on its operations, in the case of debt financing or cause substantial dilution to shareholders, in case or equity financing.
Reverse Stock Split
The Company filed with the Nevada Secretary of State an Amendment to its Articles of Incorporation. The amendments (i) decreased its authorized common stock from 150,000,000 shares, $0.001 par value to 75,000,000 shares, $0.002 par value; and (ii) effected a reverse split of its common stock in a ratio of one-for-two. The amendment became effective on February 24, 2012. All references in these financial statements to quantities of common stock or per share values have been adjusted to reflect the retroactive effect of the one-for-two reverse stock split.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. Significant estimates reflected in the consolidated financial statements include, but are not limited to, the recoverability of the carrying amount and estimated useful lives of long-lived assets and goodwill, allowance for accounts receivable, realizable values for inventories, valuation allowance of deferred tax assets, purchase price allocation of acquisitions, and valuation of share-based compensation expenses. Changes in facts and circumstances may result in revised estimates. Actual results could differ from these estimates.
Foreign Currency
The accompanying consolidated financial statements are presented in United States dollars (“US$”). The Renminbi (RMB”) is the functional currency of Three Happiness, HSLP, GLP, HQLP, CCXA, Boke, NuoHua, and GHK (the Operating Subsidiaries”) as it is the currency of the PRC, which is the primary economic environment the Operating Subsidiaries operate in and the environment in which the Company primarily generates and expends cash.
Assets and liabilities are translated into U.S. dollars at the noon buying rate certified by the Federal Reserve Bank of New York on December 31, 2012 and 2011. Income and expense items are translated at average exchange rates prevailing during the period. The resulting translation adjustments are recorded as a component of shareholders’ equity. Gains and losses from foreign currency transactions are included in net income.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
NOTE 3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Revenue Recognition
Revenues represent the invoiced value of goods sold and are recognized upon the shipment of goods to customers. The product sales price stated in the sales contract or purchase order is final and not subject to adjustment. Revenues are recognized when all of the following criteria are met:
·Persuasive evidence of an arrangement exists,
·Delivery has occurred or services have been rendered,
·The seller’s price to the buyer is fixed or determinable, and
·Collectability is reasonably assured.
Revenue is recognized net of all value-added taxes imposed by governmental authorities and collected from customers concurrent with revenue-producing transactions.
The Company establishes provisions against revenue for estimated sales returns in the same period that the related revenue is recognized based on historical product returns. For the years ended December 31, 2012, 2011, and 2010, sales returns were $3,389,344, $1,888,544, and nil respectively, and are netted against revenue in the consolidated statements of operations and comprehensive income.
Cost of Sales
Cost of sales includes direct and indirect production costs, as well as freight in and handling costs for products sold.
Selling, General and Administrative Expenses
Selling, general and administrative (“SG&A”) expenses include salaries, benefits and other staff-related costs associated with sales and marketing, finance and other administrative personnel; facilities and overhead costs; legal expenses and other general and administrative costs. SG&A expenses also include the costs of selling merchandise, including preparing the merchandise for sale, such as picking, packing, warehousing and order charges. Shipping and handling costs are expensed as incurred and outbound freight is not billed to customers.
Shipping and handling costs included in selling, general and administrative expenses were $2,144,000, $3,686,959, and 5,682,503 for the years ended December 31, 2012, 2011, and 2010, respectively.
Advertising Costs
The Company expenses advertising costs as incurred. Point of sale materials are accounted for as inventories and are charged to expense as utilized. For the years ended December 31, 2012, 2011, and 2010, advertising costs were $29,025,081, $14,910,983, and $38,920,905, respectively.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
Comprehensive Income
Comprehensive income is defined to include all changes in equity except those resulting from investments by owners and distributions to owners. Among other disclosures, items that are required to be recognized under current accounting standards as components of comprehensive income are required to be reported in a financial statement that is presented with the same prominence as other financial statements. The Company’s comprehensive income includes net income and foreign currency translation adjustments.
Stock-Based Compensation
The Company periodically issues stock options and warrants to employees and non-employees in non-capital raising transactions for services and for financing costs. The Company accounts for stock option and warrant grants issued and vesting to employees based on the authoritative guidance provided by the FASB whereas the value of the award is measured on the date of grant and recognized over the vesting period. The Company accounts for stock option and warrant grants issued and vesting to non-employees in accordance with the authoritative guidance of the FASB whereas the value of the stock compensation is based upon the measurement date as determined at either a) the date at which a performance commitment is reached, or b) at the date at which the necessary performance to earn the equity instruments is complete. Non-employee stock-based compensation charges generally are amortized over the vesting period on a straight-line basis. In certain circumstances where there are no future performance requirements by the non-employee, option grants are immediately vested and the total stock-based compensation charge is recorded in the period of the measurement date.
The fair value of the Company’s common stock option grant is estimated using the Black-Scholes-Merton option pricing model, which uses certain assumptions related to risk-free interest rates, expected volatility, expected life of the common stock options, and future dividends. Compensation expense is recorded based upon the value derived from the Black-Scholes-Merton option pricing model, and based on actual experience. The assumptions used in the Black-Scholes-Merton option pricing model could materially affect compensation expense recorded in future periods.
Income Taxes
The Company uses an asset and liability approach for financial accounting and reporting for income taxes that allows recognition and measurement of deferred tax assets based upon the likelihood of realization of tax benefits in future years. Under the asset and liability approach, deferred taxes are provided for the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance is provided for deferred tax assets if it is more likely than not these items will either expire before the Company is able to realize their benefits, or that future deductibility is uncertain. The Company’s policy is to recognize interest and/or penalties related to income tax matters in income tax expense.
Value-Added Tax (“VAT”)
Enterprises or individuals, who sell commodities, engage in repair and maintenance or import or export goods in the PRC are subject to a value-added tax in accordance with the PRC laws. The value-added tax’s standard rate is 17% of the gross sales price and the Company records its revenue net of VAT. A credit is available whereby VAT paid or borne by the Company can be used to offset the VAT due on the sales of the finished products.
Segment Reporting
The Company has two operating segments based on its major lines of businesses: manufacturing and distribution. Each operating segment derives its revenues from the sale of products or services, respectively and each is the responsibility of a group of senior management of the Company who has knowledge of product and service specific operational risks and opportunities. The Company’s chief operating decision maker reviews and evaluates separate sets of financial information for decisions regarding resources allocation and performance assessments.
Cash and Cash Equivalents
Cash and cash equivalents consist of cash on hand and bank deposits with original maturities of three months or less, which are unrestricted as to withdrawal and use. Substantially all of the Company’s cash accounts are located in banks within the PRC.
Restricted Cash
Restricted cash represents amounts held by a bank as security for bank acceptance notes and therefore is not available for the Company’s use. The restriction on cash is expected to be released within the next twelve months.
Accounts and Notes Receivable
Accounts and notes receivable are carried at net realizable value. An allowance for doubtful accounts is recorded in the period when loss is probable based on an assessment of specific evidence indicating troubled collection, historical experience, accounts aging and other factors. A receivable is written off after all collection effort has ceased.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
Deferred Financing Costs
Deferred financing costs represent the incurred costs directly attributable to the issuance of the convertible notes. These costs, presented as non-current assets, are deferred and amortized ratably using the effective interest method from the debt issuance date over the earliest redemption date of the convertible notes. If the notes are converted prior to the debt maturity date, the unamortized financing costs will be transferred to equity immediately upon occurrence of such an event.
Inventories
Inventories are stated at the lower of cost or market value. Cost is determined by the weighted average method. Costs of raw materials and consumables and packaging materials are based on purchase costs while costs of work-in-progress and finished goods comprise direct materials, direct labor and an allocation of manufacturing overhead costs.
Capitalized agricultural costs include costs relating to irrigation, fertilizing, seedling, utility, farming wages and other ongoing crop and land maintenance activities. Recurring agricultural costs are capitalized and cease to be accumulated when the crops have reached maturity and ready to be harvested. Any recurring agricultural costs incurred subsequent to the crops reaching maturity are expensed as incurred. Non recurring agricultural costs, primarily comprising soil improvements and other long-term crop growing costs that benefit multiple harvests, are deferred and amortized over the estimated production period.
Fair Value of Financial Instruments
FASB ASC 820 “Fair Value Measurements and Disclosures” establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. The hierarchy prioritizes the inputs into three levels based on the extent to which inputs used in measuring fair value are observable in the market.
These tiers include:
·Level 1 - defined as observable inputs such as quoted prices in active markets;
·Level 2 - defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and
·Level 3 - defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions
The carrying amounts of financial assets and liabilities, such as cash and cash equivalents, accounts and notes receivable, short-term bank loans, accounts payable, notes payable and other payables, approximate their fair values because of the short maturity of these instruments. The carrying values of long-term loans approximate their fair values due to the fact that the interest rates on these loans are reset each year based on prevailing market interest rates. The convertible notes are initially recognized based on residual proceeds after allocation to the derivative financial liabilities, if any, at fair value and subsequently carried at amortized cost using the effective interest rate method, with any accrued and unpaid interest included under other payables and accrued expenses.
Land Use Rights
According to the PRC laws, the government owns all the land in the PRC. Companies or individuals are authorized to possess and use the land only through land use rights granted by the PRC government. Land use rights are being amortized using the straight-line method over the related lease terms ranging from 40 to 50 years.
Property, Plant and Equipment
Property, plant and equipment are carried at cost less accumulated depreciation. Depreciation is provided over their estimated useful lives, using the straight-line method. Estimated useful lives of the property, plant and equipment are as follows:
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
The cost and related accumulated depreciation of assets sold or otherwise retired are eliminated from the accounts and any gain or loss is included in the statement of income. The cost of maintenance and repairs is charged to the statement of income as incurred, whereas significant renewals and betterments are capitalized.
Construction in Progress
Construction in progress represents direct costs of construction or acquisition, interest and design fees incurred. Capitalization of these costs ceases and the construction in progress is transferred to property, plant and equipment when substantially all the activities necessary to prepare the assets for their intended use are completed. No depreciation is provided until it is completed and ready for intended use.
The Company accounts for interest capitalization in accordance with FASB ASC 835 "Interest". Interest costs are capitalized if they are incurred during the acquisition, construction or production of a qualifying asset and such costs could have been avoided if expenditures for the assets have not been made. Capitalization of interest costs commences when the activities to prepare the asset are in progress and expenditures and borrowing costs are being incurred. Interest costs are capitalized until the assets are ready for their intended use.
Acquired Intangible Assets
Acquired finite-lived intangible assets include product licenses, trademarks, patents and proprietary technologies, which are stated at acquisition cost less accumulated amortization. Amortization expense is recognized using the straight-line method over the estimated useful life. Proprietary technologies are recorded as an intangible asset only if regulatory approval from the Chinese State Food and Drug Administration, or SFDA, has been obtained and for which the re-registration of the proprietary technologies with the SFDA by the Company in its name is determined to be reasonably assured or perfunctory. The amortization of such intangible assets will not commence until the technology has been re-registered with the SFDA and hence ready for its intended use. The cost of the product licenses are amortized over their licensed period of 2 to 12 years; the cost of trademarks are amortized over their registered period of 2 to 10 years; the cost of patents are amortized over their protection period of 7 to 20 years and the cost of proprietary technologies is amortized over its protection period of 10 years. The weighted-average amortization period of product licenses, trademarks, patents and proprietary technologies are 8.0 years, 6.4 years, 12.8 years and 9.4 years, respectively.
Acquired indefinite-lived intangible assets includes a pharmaceutical trade license. The indefinite-lived intangible asset is not amortized and is tested for impairment annually, or whenever events or changes in circumstances indicate that the carrying value may not be recoverable. If the Company determines that the fair value of the indefinite-lived intangible asset is more than its carrying amount, no further testing is necessary. If, however, the Company determines that it is more likely than not that the fair value of the indefinite-lived intangible asset is less than its carrying amount, we compare the fair value of the indefinite-lived asset with its carrying amount. If the carrying value of an individual indefinite-lived intangible asset exceeds its fair value, the individual asset is written down by an amount equal to such excess.
Goodwill
Goodwill and other intangible assets are accounted for in accordance with the provisions of FASB ASC 805 and FASB ASC 350 “Intangibles - Goodwill and Other”. Under FASB ASC 805, goodwill is measured as the excess of a over b below:
a. The aggregate of the following
1. The consideration transferred measured in accordance ASC 805, which generally requires acquisition-date fair value.
2. The fair value of any non-controlling interest in the acquiree.
3. In a business combination achieved in stages, the acquisition-date fair value of the acquirer’s previously held equity interest in the acquiree.
b. The net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed measured in accordance with FASB ASC 805
Other intangible assets are separately recognized from goodwill if the benefit of the intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed, rented, or exchanged, regardless of an intent to do so.
Under FASB ASC 350, goodwill, including any goodwill included in the carrying value of investments accounted for using the equity method of accounting, and certain other intangible assets deemed to have indefinite useful lives are not amortized.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
Impairment
The annual evaluation of impairment of goodwill involves comparing the current fair value of each of the Company’s reporting units to their recorded value, including goodwill. The Company utilizes a two-step method to perform a goodwill impairment review in the fourth quarter of each fiscal year or when facts and circumstances indicate goodwill may be impaired. In the first step, the Company determines the fair value of the reporting unit using expected future discounted cash flows and estimated terminal values. If the net book value of the reporting unit exceeds the fair value, the Company would then perform the second step of the impairment test which requires allocation of the reporting unit’s fair value of all of its assets and liabilities in a manner similar to a purchase price allocation, with any residual fair value being allocated to goodwill. The implied fair value of the goodwill is then compared to the carrying value to determine impairment, if any.
During the year ended December 31, 2012, no impairment of goodwill was recognized. During the year ended December 31, 2011, the Company considered the on-going decline in its stock price and the significant reduction in revenues as impairment indicators and conducted a goodwill impairment assessment at the subsidiary level. Based on the first step of the goodwill impairment test, the fair value of certain reporting units did not exceed the net book value. Therefore, the Company performed additional procedures and a goodwill impairment loss was recognized (See Note 10).
Finite-lived intangible assets are amortized over their respective useful lives and, along with other long-lived assets, are evaluated for impairment periodically whenever events or changes in circumstances indicate that their related carrying amounts may not be recoverable.
In evaluating long-lived assets for recoverability, including finite-lived intangibles and property and equipment, the Company uses its best estimate of future cash flows expected to result from the use of the asset and eventual disposition in accordance with FASB ASC 360. To the extent that estimated future, undiscounted cash inflows attributable to the asset, less estimated future, undiscounted cash outflows, are less than the carrying amount, an impairment loss is recognized in an amount equal to the difference between the carrying value of such asset and its fair value. Assets to be disposed of and for which there is a committed plan of disposal, whether through sale or abandonment, are reported at the lower of carrying value or fair value less costs to sell.
The Company determined that the long-lived assets associated with the Company’s BOKE, CCXA and 3H manufacturing facilities were not expected to be fully recoverable. For the years ended December 31, 2012 and 2011, the Company recorded an impairment charge of nil and $6,928,064, respectively, for intangible assets held by BOKE and CCXA. For the years ended December 31, 2012, 2011, and 2010, the Company also recorded an impairment charge of $12,577,507, $733,688, and nil, respectively, related to the excess of the carrying value over fair market values for certain property, plant and equipment held by 3H, HSPL, and CCXA, impairment charges of $10,255,550, nil, and nil, respectively, related to the excess of the carrying value over fair market values for land use rights held by 3H and CCXA, and impairment charges of $8,525,587, nil, and nil, respectively, related to the excess of the carrying value over fair market values for capitalized agricultural costs held by 3H and GLP.
Earnings per share
Basic earnings per share is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the year. The diluted earnings per share calculation give effect to all potentially dilutive common shares outstanding during the year. As of December 31, 2012, common stock equivalents were composed of options convertible into 883,639 shares of the Company’s common stock and notes convertible into 6,084,282 shares of the Company’s common stock. For the year ended December 31, 2012, common stock equivalents have been excluded from the calculation of earnings per share as their effect is anti-dilutive.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
The following is a reconciliation of the numerator and denominator used in the calculation of basic and diluted earnings per share available to common shareholders:
Equity method Investments
The equity method of accounting is used for investments in entities in which the Company exercises significant influence but which do not meet the requirements for consolidation. Under the equity method, the Company initially records its investment at cost and adjusts the carrying amount of the investment to recognize the Company’s proportionate share of each equity investee’s net income or loss into consolidated statements of income after the date of acquisition. The Company monitors its equity method investments for other-than-temporary impairment by considering factors including, but not limited to, current economic and market conditions, the operating performance of the investee companies including current earnings trends and other company-specific information. An impairment loss on the equity method investments is recognized when a decline in value is determined to be other-than-temporary (see note 12).
Economic and Political Risks
The Company’s operations are conducted in the PRC. Accordingly, the Company’s business, financial condition and results of operations may be influenced by the political, economic and legal environment in the PRC, and by the general state of the PRC economy.
The Company’s operations in the PRC are subject to special considerations and significant risks not typically associated with companies in North America and Western Europe. These include risks associated with, among others, the political, economic and legal environment and foreign currency exchange. The Company’s results may be adversely affected by changes in the political and social conditions in the PRC, and by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion, remittances abroad, rates and methods of taxation and price controls, among other things.
The Company’s products are subject to price control by the PRC government. The maximum prices of the products are published by the PRC price administration authorities from time to time. Any changes in product pricing announced by the PRC price administration authorities affect future sales transactions.
Newly Adopted Accounting Pronouncements
In July 2012, FASB issued ASU No. 2012-02, “Intangibles - Goodwill and Other”. This update presents an entity with the option to first to assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform the quantitative impairment test in accordance with Subtopic 350-30, “Intangibles - Goodwill and Other - General Intangibles Other than Goodwill”. The more-likely-than-not threshold is defined as having a likelihood of more than fifty percent. ASU No. 2012-02 will be effective for annual and impairment tests performed for fiscal years beginning after 15 September 2012, with early adoption permitted. The Company does not expect the adoption of this update will have a material effect on its consolidated financial statements.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
In February 2013, the FASB issued ASU No. 2013-02, “Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” The new guidance requires entities to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income unless the amounts are not reclassified in their entirety to net income. For amounts that are not required to be reclassified in their entirety to net income in the same reporting period, entities are required to cross-reference other disclosures that provide additional detail about those amounts. The new guidance is effective prospectively for all interim and annual periods beginning after December 15, 2012, with early adoption permitted. The Company does not expect the adoption of this update will have a material effect on its consolidated financial statements.
Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the Securities Exchange Commission (the "SEC") did not or are not believed by management to have a material impact on the Company's present or future consolidated financial statements.
NOTE 4 - CONCENTRATION OF RISKS
Concentration of credit risks
Assets that potentially subject the Company to significant concentration of credit risk primarily consist of cash and cash equivalents, accounts receivable and prepaid forward repurchase contract (Note 16). As of December 31, 2012, substantially all of the Company’s cash and cash equivalents were deposited in financial institutions located in PRC, which management believes are of high credit quality. Accounts receivable are typically unsecured and mainly derived from revenue earned from customers in the PRC, which are exposed to credit risk. The risk is mitigated by credit evaluations the Company performs on its customers and its ongoing monitoring process of outstanding balances. The Company maintains reserves for estimated credit losses, which have generally been within its expectations.
Current vulnerability due to certain other concentrations
The Company’s operations may be adversely affected by significant political, economic and social uncertainties in the PRC. Although the PRC government has been pursuing economic reform policies for more than 30 years, no assurance can be given that the PRC government will continue to pursue such policies or that such policies may not be significantly altered, especially in the event of a change in leadership, social or political disruption or unforeseen circumstances affecting the PRC’s political, economic and social conditions. There is also no guarantee that the PRC government’s pursuit of economic reforms will be consistent or effective.
Currency convertibility risk
The Company transacts the majority of its business in RMB, which is not freely convertible into foreign currencies. On January 1, 1994, the PRC government abolished the dual rate system and introduced a single rate of exchange as quoted daily by the People’s Bank of China (the “PBOC”). However, the unification of the exchange rates does not imply that the RMB may be readily convertible into United States dollars or other foreign currencies. All foreign exchange transactions continue to take place either through the PBOC or other banks authorized to buy and sell foreign currencies at the exchange rates quoted by the PBOC. Approval of foreign currency payments by the PBOC or other institutions requires submitting a payment application form together with suppliers’ invoices, shipping documents and signed contracts. Additionally, the value of the RMB is subject to changes in central government policies and international economic and political developments affecting supply and demand in the PRC foreign exchange trading system market.
NOTE 5 - ACCOUNTS RECEIVABLE
Accounts receivable consist of the following:
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
Provision for doubtful accounts activity is as follows:
Accounts receivable arise from sales to the Company’s customers and are generally due and payable on terms ranging from 30 to 180 days beginning after the invoice date. The Company assessed distributors’ credit history, operation performance, financial position, reputation among peers, etc. to assign credit terms. The company’s management reviews credit term and conditions of the account receivable balance for each distributor on a quarterly basis.
In the year ended December 31, 2011, the Company offered credit extension from 30 to 90 days to certain distributors with long-term business relationships and healthy credit records in order to match new industry practice and stimulate demand in sales. As a result, the Company’s days’ sales in accounts receivable increased to 125 days in 2011 compared to 82 days in 2010. The Company does not have plans to offer any additional credit term extensions in the near future.
During the years ended December 31, 2011 and 2012, the Company reviewed its accounts receivable based on the changing climate in the drug business in China and estimated that significant increases to its allowance was required. The Company estimates that the remaining net receivables will be collected.
NOTE 6 - INVENTORIES
Inventories are summarized as follows:
Capitalized agricultural costs are summarized as follows:
Pre-harvest agricultural costs, including irrigation, fertilization, seeding, laboring, land leasing costs, and other ongoing crop and land maintenance activities, are capitalized as inventory and cease to be accumulated when the crops reach maturity and is ready to be harvested. Land leasing costs incurred prior to harvest are capitalized as they are an essential pre-condition to the cultivation and an inevitable cost component of the total growing cost during the cultivation period. All costs incurred subsequent to the crops reaching maturity will be expensed as incurred. The Company has reflected the capitalized agriculture costs as a long term asset as it does not expect to utilize this asset currently.
To mitigate the impact of the increasing cost and supply of raw materials, the Company entered into long-term supply contracts with various third parties to grow Millettia and Xanthoceras Sorbifolia Bge (“XSB”), which are its principal raw materials in some products. Through these supply contracts, the Company believes that it will stabilize the supply of these critical raw materials in the long run, and reduce the risk of increasing costs in future periods.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
As such, in 2009 and 2010, the Company’s GLP subsidiary entered into long-term supply contracts with various third parties to grow Millettia, a major raw material of the Company, on behalf of the Company through leasing land use rights and production arrangements. Under these contracts, the Company bears the costs in relation to Millettia cultivation and in return entitled to a supply price at a discounted pre-determined rate when delivered. The purchase commitment is unconditional and the Millettia is not expected to be harvested until after 2018. The Company expects the initial supply of Millettia to occur between year nine and year eleven of the contract period as Millettia is a stem from a certain plant which requires an eight to ten-year period to mature. These contracts expire after 30 years but entitle the Company to renew with terms to be negotiated. As of December 31, 2012 and 2011, the Company had capitalized agricultural costs in relation to Millettia cultivation of $17,628,715 and $14,123,280, respectively.
On October 17, 2009, AOB’s subsidiary 3H entered into a long-term supply contract with a third party to secure the supply of XSB, which is a major raw material of the Company. The Company expects such supply to start from year four of the contract, as XSB is a fruit from a certain plant which requires a three-year period to mature. The contract expires after 10 years, while the Company is entitled to renewal with terms to be negotiated. Under the contract, the Company is entitled to a supply price at a discount to market price when delivered. As of December 31, 2012 and 2011, the Company capitalized agricultural costs in relation to XSB cultivation of $8,345,340 and $8,174,777, respectively.
At December 31, 2012, management used its best estimate of the future cash flows expected to result from future market values, yields and costs to harvest, in evaluating its capitalized agricultural costs at 3H and GLP for recoverability. In addition, management considered the Company’s decline in sales in 2012 and other economic challenges which impacted the Company in 2012, in preparing its estimates. Based on these estimates, the Company determined the value of its capitalized agricultural costs to be $17,443,475, and recognized an impairment charge in the amount of $8,525,587 for the year ending December 31, 2012. For the years ended December 31, 2011 and 2010, the Company did not recognize any impairment charges for capitalized agricultural costs.
NOTE 7 - ADVANCES TO SUPPLIERS AND PREPAID EXPENSES
Advances to suppliers mainly represent interest-free cash deposits paid to suppliers for future purchases of raw materials. Prepaid expenses mainly relate to the prepaid research and development expenses to external contractors for research on new knowledge and product development.
NOTE 8 - PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consist of the following:
As of December 31, 2012 and 2011, the net book value of property, plant and equipment pledged as collateral for bank loans was $6,099,734 and $6,249,074, respectively. See Note 14.
Depreciation expense for the years ended December 31, 2012, 2011 and 2010 was $6,776,883, $5,709,259, and $5,014,924, respectively.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
During the years ended December 31, 2012, 2011 and 2010, the Company recorded an impairment charge of $12,577,507, $733,688, and nil, respectively, related to the excess of the carrying value over fair market values for certain property, plant and equipment and construction in progress held by 3H, HSPL, and CCXA.
As of December 31, 2012, the Company had entered into capital commitments for the manufacturing facilities under construction in the People’s Republic of China. The capital commitments were $16,713,767 and all due within one year.
NOTE 9 - LAND USE RIGHTS
Land use rights consist of the following:
As of December 31, 2012 and 2011, the net book value of land use rights pledged as collateral was $20,664,778 and $21,020,381, respectively. See Note 14.
Amortization expense for the years ended December 31, 2012, 2011 and 2010 was $3,564,774, $3,476,589, and $3,329,304, respectively.
During the year ended December 31, 2012, the Company recorded an impairment charge of $10,255,550 related to the excess of the carrying value over fair market values for certain land use rights held by 3H and CCXA.
Amortization expense for the next five years and thereafter is as follows:
NOTE 10 - GOODWILL IMPAIRMENT
The manufacturing and distribution segments are tested for impairment on a regular basis. During the year ended December 31, 2011, due to an increase in competition in the generic drug market in China under the health care reform, as well as the Chinese government’s downward pressure on prices, the operating profits and cash flows for the manufacturing segment were lower than expected. Based on that trend, the earnings forecasts for the next five years were revised. For the year ended December 31, 2011, goodwill impairment losses of $27,817,108 and $5,347,013 were recognized in the manufacturing reporting units and distribution reporting units, respectively. The fair value of those reporting units was estimated using the expected present value of future cash flows expected at that time. As a result of the impairment charges, the balance of goodwill was nil as of both December 31, 2012 and 2011.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
NOTE 11 - ACQUIRED INTANGIBLE ASSETS
Acquired intangible assets are summarized as follows:
Amortization expense for the years ended December 31, 2012, 2011, and 2010 was $1,665,718, $3,283,901, and $4,360,515, respectively.
Amortization expense for the next five years and thereafter is as follows:
Acquired finite-lived intangible assets include product licenses, trademarks, patents and proprietary technologies, which are stated at acquisition cost less accumulated amortization. Amortization expense is recognized using the straight-line method over the estimated useful life.
During 2011, as part of acquisition of Liaoning Baicao (Note 12), the Company also acquired an intangible asset consisting of a pharmaceutical trade license valued at $5,521,077 through the purchase price allocation. The pharmaceutical trade license was originally obtained from a local governmental agency, with an original term from 2009 to 2014, and can be automatically renewed subject to meeting usual and customary conditions of operations. The Company has determined the pharmaceutical trade license is an indefinite-lived intangible asset not subject to amortization but subject to annual impairment testing, or whenever events or changes in circumstances indicate that the carrying value may not be recoverable.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
The Company conducts impairment tests on a regular basis to determine if the carrying values of acquired intangible assets are in excess of the fair value, and that such assets are active, being used in production of products, or are intended to be utilized in future production. The assessment also includes an evaluation of the ongoing cash flows from these assets. No impairment was recognized in 2012. In performing such analysis in 2011, the Company identified certain product licenses, trademarks and patents that were no longer expected to be used due to changes in product lines, customer acceptance, or expiration of the underlying right. As such, the Company recorded an impairment charge against these items in the amount of $6,928,064 during the year ended December 31, 2011. The Company believes the remaining product licenses, patents, trademarks, pharmaceutical trade license, and other intangibles still have value and are used in ongoing operations.
NOTE 12 - INVESTMENTS IN AND ADVANCES TO EQUITY METHOD INVESTMENTS
Long-term investments and advances include the Company’s equity investment in Aoxing Pharmaceutical Company, Inc. (“AXN”), Jilin Yushuntang Pharmaceutical Co., Ltd. (“Yushuntang”), and Hezhou Jinji Color Printing Co., Ltd. (“Jinji”).
AXN is a PRC-based pharmaceutical company, listed on the NYSE AMEX, specializing in the research, development, manufacture and distribution of narcotic and pain-management products in the PRC. Yushuntang is a formerly consolidated subsidiary which the Company controlled 55% from its acquisition in September 2008 until December 2012. Effective December 31, 2012, the Company’s ownership in Yushuntang decreased to 49% and Yushuntang was deconsolidated. Jinji is a color printing company focusing on the printing of external packaging materials. Long-term investments are accounted for using the equity accounting method.
As of December 31, 2012, the Company owns a 33.7% equity interest in AXN, a 49% equity interest in Yushuntang, and a 40% equity interest in Jinji. As of December 31, 2012, 2011 and 2010, the changes in investments in and advances to equity method investments are summarized as follows:
The advances to AXN and Jinji were unsecured, non-interest-bearing and repayable on demand.
As of December 31, 2011, the value of the Company’s investment in AXN based on quoted market price of AXN was $5,708,329, as compared to $46,841,875 as of December 31, 2010. At December 31, 2011, the Company considered AXN’s declining stock price, as well as other information found in the public filings of AXN, and various internet articles and websites, as indicators that the decline in the value of AXN was other than temporary and accordingly performed an asset impairment test. Such factors as AXN’s write off of its Goodwill and a “going concern” paragraph in its most recent audit report were two of the factors. The Company considered the market value of the publicly traded stock of AXN, as well as adjusting the carrying value of the investment for the step up in value of the net assets and goodwill recognized upon the original investment, as indicators of the current value of the investment. After considering these methodologies the Company estimated the value of its equity investment in AXN to be $5,708,329, and recognized an impairment charge in the amount of $11,937,037 in the equity investment for the year ending December 31, 2011. No impairment was recognized in 2012 or 2010 as the fair value of the investment exceeded the carrying value at December 31, 2012 and 2010.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
Deconsolidation and impairment of advances to Yushuntang
The Company had previously consolidated the financial statements of Yushuntang as a 55% majority owned subsidiary from its acquisition in September 2008 until December 2012. Effective December 31, 2012, the Company sold 6% of its interest in Yushuntang for $28,499 and reduced its ownership to 49% so the Company no longer had a controlling financial interest. Since the Company’s ownership decreased below 50% in December 2012, this entity no longer qualifies for consolidation and is treated as a long term investment using the equity method subsequent to the sale date. As of December 31, 2012, in accordance with FASB ASC 810-10-40, “Deconsolidation of a Subsidiary or Derecognition of a Group of Assets” the Company deconsolidated it majority ownership interest and recognized a non-cash net gain of $891,540 on the transaction. The gain on deconsolidation was reduced by $4,206,253 which represented amounts due to the Company from Yushuntang now considered uncollectible based on the status of Yushuntang as follows:
The Company’s retained investment of 49% of Yushuntang was valued at $232,896 using a value based on the sale price of the 6% interest sold in December 2012. The Company does not have a continuing involvement in the operations of Yushuntang subsequent to the sale outside of its ownership stake, the buyer of the 6% interest was not a related party. At December 31, 2012, Yushuntang is considered a related party subsequent to the sale, based on the Company’s material equity stake.
For the year ended December 31, 2012, Yushuntang reported revenues of $14,396,974, gross profit of $992,833, loss from operations of $59,049, and net loss of $27,482, which are included in the accompanying consolidated statement of operations. For the year ended December 31, 2011, Yushuntang reported revenues of $15,914,134, gross profit of $827,738, loss from operations of $3,076,447, and net loss of $2,282,234, which are included in the accompanying consolidated statement of operations. At December 31, 2012, net assets of Yushuntang that were deconsolidated included cash of $171,167, accounts receivable of $4,850,673, inventories of $3,083,123, deferred tax assets and other assets of $1,047,004, accounts payable and accrued expenses of 6,092,669, and payable to the Company of $4,206,253.
Disposal of NuoHua Affiliate and acquisition of Liaoning Baicao
On September 27, 2010, the Company entered into a share transfer agreement with an unrelated third party buyer to transfer an equity interest in NuoHua’s majority owned subsidiary (“NuoHua Affiliate”) for a consideration of RMB 255,000,000 ($38,567,410), including cash of RMB 148,543,200 ($22,466,378) and an equity interest of RMB 106,456,800 ($16,101,032) of another company owned by the third party buyer. The legal transfer of NuoHua Affiliate was completed in October 2010 and the difference between the sales price and the carrying value of the Company’s equity interest in NuoHua Affiliate of $1,083,637 was recognized as a loss on disposal of NuoHua Affiliate during the year ended December 31, 2010. At December 31, 2010, the total consideration of RMB 255,000,000 ($38,567,410) was recognized as receivable for disposal of NuoHua Affiliate.
On October 29, 2011, the equity interest to be transferred to the Company was determined to be 100% of Liaoning Baicao, which distributes pharmaceutical products through its sales network covering major urban and rural areas in Liaoning province in the PRC. On December 28, 2011, the acquisition of Liaoning Baicao was completed.
The receivable to be paid with the equity interest of Liaoning Baicao was RMB 106,456,800 ($16,101,032 plus a translation gain of $600,412, or $16,701,444). The estimated fair value of the tangible and identifiable intangible assets acquired and liabilities assumed of Liaoning Baicao was determined to be RMB 52,534,719 ($8,254,076). The difference of RMB 53,922,081 ($8,447,368) between the receivable balance and the fair value of at the acquisition date was recognized as a loss on receivable for disposal of NuoHua affiliate.
In November 2011, the Company was paid cash consideration of RMB 33,000,000 (approximately $5,180,000). As of December 31, 2011, the Company was due cash consideration from the third party of RMB 115,543,200 ($18,153,754) which was subsequently collected in cash in May, 2012.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
The Company accounted for the acquisition of Liaoning Baicao as a business combination and allocated the purchase price to the tangible and identifiable intangible assets acquired and liabilities assumed based on their estimated fair values as of the acquisition date. The Company engaged an independent third-party valuation firm to assist in the determination of the fair value of the net assets of Liaoning Baicao. As there was only three days from the transfer date of December 28, 2011 to the year end of December 31, 2011, the operating results for three days were not considered in the consolidated financial statements due to the immaterial impact.
The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the acquisition date:
NOTE 13 - ACCRUED EXPENSES AND OTHER PAYABLES
The components of other payables and accrued expenses are as follows:
Other payables balance mainly represent VAT-output for manufacturing subsidiaries.
Accrued expenses mainly represent promotional fee, interest expenses accrued on convertible notes and other banks loans and accrued advertisement expenses.
Due to employees mainly represents commissions payable or expense reimbursements due to the Company’s salesmen.
Advances from customers mainly represent cash received for goods not yet delivered to customer.
NOTE 14 - DEBT
Short-term loans obtained from local banks were $6,807,999 and $6,756,014 as of December 31, 2012 and 2011, respectively. The short-term loans payable are due on various dates through November 15, 2013 (through September 19, 2012 at December 31, 2011), with interest ranging from 6.00% to 6.6% per annum (5.8% to 7.2% at December 31, 2011). At December 31, 2012 and 2011, the short-term loans are secured by property, plant and equipment owned by the Company of $6,099,734 and $6,249,074, respectively, and land use rights owned by the Company of $20,664,778 and $21,020,381, respectively.
The Company has outstanding long-term bank loans of $619,401 and $681,100 at December 31, 2012 and 2011, respectively. The loan payable bears interest at 2.50% per annum, is due December 31, 2021, and is secured by property, plant, and equipment with a net book value of approximately $1.2 million at December 31, 2012.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
The repayment schedule of long-term bank loans is as follows:
NOTE 15 - CONVERTIBLE NOTES
On July 15, 2008 the Company issued $115,000,000 of 5% senior convertible notes (the “Notes”) for net proceeds of $110,358,550. The Notes are in default, which was caused by the delisting of the Company’s common stock by the NYSE as described in Form 25NSE filed on April 16, 2012 by NYSE; and by the non-payment of the semiannual interest payment due on July 15, 2012. The Company also has not paid the semiannual interest payment due January 15, 2013. The Notes were sold to qualified institutional buyers in a private placement exempt from the registration requirements of the Securities Act of 1933, as amended.
The following is a brief summary of certain terms of the Notes issued.
● Total offering was $115,000,000 aggregate principal amount of 5.00% Convertible Senior Notes due on July 15, 2015.
● Interest at 5.00% per year, payable semiannually in arrears in cash.
● The Notes are convertible, at the option of the holder, at any time prior to the close of business on the second business day preceding the maturity date based on an initial conversion rate of 107.6195 shares per $1,000 principal amount of Notes, which represents an initial conversion price of $9.29 per share.
● The conversion rate is subject to certain adjustments. In particular, holders who convert their Notes in connection with certain events of fundamental changes, as defined pursuant to the convertible notes agreement, may be entitled to a make whole premium in the form of additional shares of the Company’s common stock.
● The initial conversion rate may also be adjusted on January 15, 2009 if the volume weighted average price (“VWAP”) of common stock for each of the 30 consecutive trading days ended on January 15, 2009 is less than $8.08 per share. The VWAP of the Company’s common stock for each of the 30 consecutive trading days ending on January 15, 2009 was $6.02 per share and as such, the initial conversion price of $9.29 per share was adjusted to $8.08 on January 15, 2009.
● Holders may require the Company to repurchase all or a portion of their Notes on July 15, 2013 for cash at a price equal to 100% of the principal amount of the notes to be purchased, plus accrued and unpaid interest, if any, up to, but excluding, the repurchase date.
● If a fundamental change event occurs, holders will have the right to require the Company to repurchase for cash all or any portion of their notes. The fundamental change purchase price will be 100% of the principal amount of the Notes to be purchased plus accrued and unpaid interest, if any, up to, but excluding, the fundamental change repurchase date.
● The Notes are unsecured, unsubordinated obligations and rank equal in right of payment to all of the Company’s existing and future unsecured and unsubordinated indebtedness. The Notes will be effectively subordinated to all of the Company’s existing and future secured indebtedness.
Note issuance costs incurred by the Company that were directly attributable to the issuance of the Notes were deferred and are recognized using the effective interest rate method over the term of the Notes. As of December 31, 2012 and 2011, the unamortized portion of the deferred financing fees was $212,724 and $1,347,735, respectively.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
The Company has determined that the conversion feature embedded in the Notes is not required to be bifurcated and accounted for as a derivative since the embedded conversion feature is indexed to the Company’s own stock and would be classified in shareholders’ equity if it was a free-standing instrument. The holder’s put rights qualify as an embedded derivative, but bifurcation of such is not required since it is considered to have economic characteristic and risks that are clearly and closely related to those of the debt host. On the date of issuance of the Notes, no portion of the proceeds was attributable to the beneficial conversion feature (“BCF”) since the conversion price of the Notes exceeded the market price of the Company’s common stock. Furthermore, no contingent BCF exists from the one time conversion rate adjustment based on VWAP, as the adjustment is subject to a floor of $8.08, which equaled the market price of the Company’s common stock on the issuance date of the Notes.
At December 31, 2012, the aggregate principal amount of the Notes outstanding was $49,161,000. During the year ended December 31, 2012, the Company repurchased a total of $59,339,000 of principal amount of the Notes for $18,478,888 cash consideration and expensed $446,557 of related unamortized Notes issue cost resulting in a net gain of $40,413,555.
At December 31, 2011, the aggregate principal amount of the Notes outstanding was $108,500,000. During the year ended December 31, 2011, the Company repurchased a total of $6,500,000 in principal amount of the Notes for $3,160,004 cash consideration and expensed $97,607 of related unamortized Notes issue cost resulting in a net gain of $3,242,389.
The repurchases were recorded as follows:
The effective interest rate on the convertible notes for the years ended December 31, 2012, 2011 and 2010 was 5.95%, 5.13%, and 5.13%, respectively.
The amount of interest expense recognized for the years ended December 31, 2012, 2011 and 2010 was $4,275,767, $5,570,725, and $5,750,000, respectively.
NOTE 16 - PREPAID FORWARD SHARES REPURCHASE TRANSACTION
In connection with the offering of the Notes (see Note 15), the Company entered into a prepaid forward repurchase contract with an affiliate of the lead placement agent (“Merrill Affiliate”). Pursuant to the prepaid forward repurchase contract, the Company paid $29,998,616 to fund the purchase of 1,856,350 shares of common stock for settlement at or about the maturity date of the Notes of July 15, 2015. In August 2012, the Company received 1,856,350 shares from Merrill Affiliate to complete this part of the transaction and the shares were cancelled upon receipt. Of the total carrying value of $29,998,616, the par value of the shares retired of $3,713 was allocated to common stock, and the balance of $29,994,903 was allocated to additional paid-in capital. The Company has no further rights or obligations related to the contract.
The cost of the forward stock repurchase transaction qualified as an equity transaction and was separately presented under shareholders’ equity in the balance sheet without subsequent recognition of changes in fair value. The prepaid forward repurchase contract contained an embedded equity forward derivative that was contingently cash settleable based on certain events but its value was insignificant for any of the years presented.
NOTE 17 - SHAREHOLDERS’ EQUITY
Preferred Stock
The Company has 1,000,000 shares of Series A preferred stock (“Series A”) issued and outstanding. Pursuant to the terms of the Series A, the holder holds aggregate voting power equal to 25% of the combined voting power of common stock and preferred stock. The percentage of voting power represented by the Series A cannot be diluted by the issuance of additional shares of common stock. The Series A has a liquidation preference equal to its initial issue price that will be paid to the holders of the Series A upon liquidation, dissolution or winding up and prior to any distributions being made to holders of common stock. The Series A does not participate in profits and dividends with common stock.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
Common Stock
Stock-Based Compensation
At the Annual Shareholders’ Meeting held on October 21, 2006, the shareholders of the Company approved the stock incentive plan (the “2006 Plan”), which allows the Company’s Board of Directors, at its discretion, to offer stock options and common stock awards to employees, directors and consultants of the Company.
The Company has reserved 5,000,000 shares of common stock for issuance upon the exercise of stock options and common stock awards granted under the 2006 Plan. The term of the options granted under the 2006 Plan should be no more than 10 years from the grant date. Options will be granted with an exercise price not less than the fair market value of a share of common stock on the date of the grant.
Common Stock Awards issued to consultants and employee directors
Common stock awards are issued to consultants as partial payment in connection with the consulting services rendered or to be rendered, or to directors as compensation for participating in the Company’s board meetings. Number of shares granted and expenses recognized were insignificant during the years presented.
In connection with common stocks awards described above, the Company recorded “Common stock to be issued” for vested but yet to be issued shares. Number of shares to be issued was insignificant during the years presented.
Stock Options and Common Stock Awards issued to employees
Stock options and common stock awards granted to employees vest over a five year service period using a graded vesting schedule of 20% per fully completed year (based on each subsequent one-year anniversary of the date of grant). Compensation expense for all stock options and common stock awards granted is recognized over the grantee’s respective requisite service period.
Stock options
The Company calculated the estimated fair value of granted options on the grant date, using the Black-Scholes-Merton Option Pricing Model with the following assumptions:
The model requires the input of subjective assumptions including the expected stock price volatility and the expected dividend yield. The Company uses historical experience of employee turnover and future expectation to estimate forfeiture rate. For expected volatilities, the Company has made reference to historical volatilities of the Company’s stock. The risk-free interest rate for periods within the contractual life of the option is based on the U.S. Treasury Bills yield in effect at the time of grant.
The Company recorded compensation cost in the amount of $1,176,760, $1,898,550, and $1,922,769 for years ended December 31, 2012, 2011 and 2010, respectively, with corresponding credits to additional paid-in capital. Compensation cost of all stock option awards are recorded in selling, general and administrative expenses. The total fair value of the options granted to employees at the respective grant dates was $9,194,987, of which the unrecognized portion of $497,866 is expected to be recognized following the straight-line method over the remaining weighted average vesting period of 0.4 years as of December 31, 2012.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
The expected forfeiture rate of the stock options granted as of December 31, 2012 is 0%. The following table summarizes the stock option activities of the Company:
The following table summarizes information about stock options outstanding as of December 31, 2012:
Options granted have no intrinsic value at grant date and at the date of these financial statements as the exercise price of all vested and unvested options was higher than the market price.
The weighted average fair value per share of the 883,639 options issued under the Company’s 2006 Plan is $10.41 per share. As of December 31, 2012, the Company has 761,331 outstanding vested stock options, with an exercise price above the average market price.
Common Stock Awards
On April 10, 2009, April 8, 2010 and April 10, 2011, the Compensation Committee of the Board of Directors of the Company approved the grant of common stock awards to the Company’s executive officer and certain senior management members. Common stocks awards granted vest over a five-year service period. Compensation expense is recognized for the fair value of common stocks on the grant date on a straight-line basis over five years, the requisite service period of the awards. The number of shares granted and the grant date market price of the Company’s common stock determines the fair value of the common stocks awards under the 2006 Plan.
The expected forfeiture rate of the common stock awards granted as of December 31, 2012 is 7%.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
Following is a summary of the status of the Company’s common stock awards for the year ended December 31, 2012:
The Company recorded selling, general and administrative expenses of $1,422,190, $995,763, and $787,458 in connection with such awards for the years ended December 31, 2012, 2011 and 2010, respectively.
The total fair value of the common stock awards granted as of the respective grant date was $5,666,538, of which the unrecognized portion of $2,433,893 is expected to be recognized following the straight-line method over the remaining weighted average vesting period of 2.42 years as of December 31, 2012.
Independent directors also earn common stock awards on a monthly basis, with grants generally made in the following year for shares earned. Shares earned but not granted are reflected in “Stock to be issued” on the accompanying consolidated balance sheets. During the years ended December 31, 2012, 2011 and 2010, the Company recognized expense related to earned director share-based compensation in the amount of $172,524, $291,333, and $350,500, respectively. During the years ended December 31, 2012, 2011 and 2010, the Company issued a total of 27,700, 42,622 and 40,188 shares of common stock, respectively.
Treasury Stock
On March 20, 2011, the Board of Directors authorized the Company to repurchase up to $20 million of the Company’s outstanding common stock over the next two years in the open market, in privately negotiated transactions, block trades and accelerated stock repurchase transactions or otherwise, as determined by the Company and will be funded from available working capital. The timing and extent of any purchases depend upon the trading price of the Company’s common stock, general business and market conditions and other investment opportunities. The Company entered into a share buyback program and engaged a financial institution to act as a broker on behalf of the Company to repurchase common stock based on a predetermined quantity and price range (“Share Buyback Program”).
Any common stock repurchased by the Company became part of its treasury stock which will be shown as a separate item in the consolidated statements of changes in shareholders’ equity. The treasury stock may be retired or used by the Company to finance or execute acquisitions or other arrangements. During the year ended December 31, 2011, the Company repurchased 224,582 shares of its common stock at a total cost of $799,999 pursuant to this Share Buyback Program. These shares were retired in May 2013. During the year ended December 31, 2012, the Company repurchased and retired 1,003,336 shares of its common stock at a total cost of $1,270,603 pursuant to this Share Buyback Program. The total cost was allocated $1,931 to common stock, being the par value of the shares retired, and the balance of $1,268,672 was allocated to additional paid-in capital.
NOTE 18 - RESTRICTED NET ASSETS
Under PRC laws and regulations, there are restrictions on the Company’s PRC subsidiaries with respect to transferring certain of their net assets to the Company either in the form of dividends, loans, or advances. Amounts restricted included paid-in capital and statutory reserve funds of the Company’s PRC subsidiaries. Such balance as of December 31, 2012 and 2011 are summarized below:
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
NOTE 19 - COMMITMENTS AND CONTINGENCIES
Commitments
As of December 31, 2012, the Company had entered into capital commitments for the manufacturing facilities under construction in the People’s Republic of China. The capital commitments were $16,713,767 within one year. In addition, the Company had R&D commitments of $3,593,785 within one year and $2,734,264 after one year but within five years, and purchase commitments of $2,348,679 within one year and $4,445,264 after one year but within five years.
The Company also has an unconditional purchase commitment in connection with the Millettia long-term supply contracts, which is not expected to be harvested until after 2018 (see Note 6). The purchase amount will be based on fair value discounted at a pre-determined rate pursuant to the long-term supply contracts. At December 31, 2012, the Company had a commitment to pay maintenance fees of approximately $111,000 (RMB 700,000) per year from 2013 to 2019 related to the XSB long-term supply contract.
Legal proceedings
On June 23, 2010, Haining Zhang asserted breach of contract, fraudulent dealing, and breach of fiduciary duty claims against the Company and its Chief Executive Officer, Shu Jun Liu (together “Defendants”). Zhang’s claims arose out of an alleged 2003 investment banking advisory and consultant agreement, whereby Zhang allegedly arranged for the Company to receive an equity line of credit and was allegedly given the exclusive right to arrange financing transactions for the Company for a period of one year. Zhang sought damages for allegedly unpaid financing commission and advisory compensation in the amount of $2,410,000, plus interest and expenses. On September 12, 2011, the District Court granted a motion by Defendants to dismiss Zhang’s claims as either barred by the applicable statute of limitations or as failing to state a claim. Zhang filed a notice of appeal on October 11, 2011. On April 23, 2013, the Second Circuit Court of Appeals affirmed the District Court’s dismissal of Zhang’s claims. Although Zhang has 90 days from the date of the Second Circuit’s decision in which to seek an appeal to the United States Supreme Court, the Company does not believe the Supreme Court would hear an appeal of Zhang’s case.
On June 22, 2012, a putative class action complaint was filed by Kevin McGee against American Oriental Bioengineering Inc, Eileen Brody, Binsheng Li, Yangchun Li, Tony Liu, Cosimo Patti, Xianmin Wang, and Lawrence Wizel alleging violations of Section 10b of the Securities Exchange Act of 1934and liability pursuant to Section 20(a) thereunder. The gravamen of the complaint, as subsequently amended (see below) centers on the accounting treatment of the sale of an interest held by the Company’s subsidiary, Nuo Hua Investment Company Limited and the Company’s Restatement filed on November 14, 2011. Several motions were filed for appointment as lead plaintiff, and on October 16, 2012, the Court appointed lead plaintiff, consolidated the cases, and ordered that a consolidated complaint be filed, which occurred on November 19, 2012. The served defendants (AOB, Brody, Wizel and Patti) moved to dismiss the consolidated complaint, and on March 25, 2013 those motions were granted with leave to amend. On April 15, 2013, Plaintiffs filed a Second Amended Complaint, which the served Defendants moved to dismiss on May 15, 2013. In the interim, the Court granted Plaintiffs’ motion for leave to serve most of the remaining Defendants by alternative means, and on May 15, 2013, the parties entered into a stipulation consenting to the filing of a Third Amended Complaint (“TAC,” setting forth no new paragraphs), deeming the TAC served on all defendants, deeming the motion to dismiss the Second Amended Complaint interposed against the TAC, and reserving all rights of the un-served Defendants.
On October 1, 2012, Peter Barbato filed a shareholder derivative Complaint against Tony Liu, Yanchun Li, Binsheng Li, Lawrence Wizel, Cosimo Patti, Xianmin Wang, Eileen Brody, Jun Min, and Baiqing Zhang (collectively, “Defendants”), and the Company as a nominal Defendant. The Complaint asserts causes of action for Breach of Fiduciary Duty and Unjust Enrichment. These claims similarly arise out of alleged accounting errors that were made in the Company’s financial statements for the periods between the third quarters ending September 30, 2009 and September 30, 2011, which were filed with the SEC. The alleged accounting errors were related to the Company’s sale of an interest held by the Company’s subsidiary, Nuo Hua Investment Company Limited, and were disclosed in the Company’s Restatement filed on November 14, 2011. The Complaint also alleges that its claims arise out of alleged inconsistencies that the Company’s then auditor, Ernst and Young, discovered throughout the course of the Company’s audit for the year ending 2011. The Parties have agreed that Defendants need not respond to the complaint until motions to dismiss the class action Complaint filed against the Company in the Central District of California are resolved.
On December 6, 2012, David Bravetti filed a shareholder derivative Complaint against Tony Liu, Yanchun Li, Binsheng Li, Jun Min, Lawrence Wizel, Cosimo Patti, Xianmin Wang, Baiqing Zhang, Eileen Brody (collectively, “Defendants”). Because the complaint sets forth a shareholder derivative claim, the Company is named as a nominal Defendant, although no relief is sought for the Company and any relief obtained from the Defendants would inure to the benefit of the Company. The Complaint asserts causes of action for breach of fiduciary duty, waste of corporate assets, and unjust enrichment. Bravetti’s claims arose out of alleged accounting errors that were made in the Company’s financial statements for the periods between the third quarters ending September 30, 2009 and September 30, 2011, which financial statements were included in filings made with the SEC. The alleged accounting errors were related to the Company’s sale of an interest held by the Company’s subsidiary, Nuo Hua Investment Company Limited and were disclosed in the Company’s Restatement filed on November 14, 2011. The Complaint also alleges that its claims arise out of alleged inconsistencies that the Company’s then auditor, Ernst and Young Hua Ming, discovered throughout the course of the Company’s audit for the year ending 2011. Although the Complaint claims that jurisdiction is proper in federal court in New Jersey because of diversity of citizenship, according to the Complaint, Bravetti is a New Jersey citizen, as is one of the Defendants. The Company did not file a responsive pleading to Bravetti’s Complaint, and subsequent to seeking and obtaining a default against the Company, Bravetti agreed to dismiss his claim and file elsewhere. Subsequently, however, Bravetti “corrected” his complaint now to claim to be a Florida citizen. On March 26, 2013, Bravetti undertook to provide Defendants proof of his citizenship. That proof has been provided, and Defendants have not come to a conclusion whether it was sufficient.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
On April 8, 2013, four of the holders of the Company’s 5% senior convertible notes issued July 15, 2008 (the “Notes”) filed this action claiming a default under the Notes, which allegedly resulted in an acceleration of the maturity of the Notes. The Plaintiffs had previously commenced a similar action in federal court in New Jersey, but that action was withdrawn and the present action was interposed. The action seeks payment of $20,378,608 plus prejudgment interest and other fees and costs. The Company has been served with the complaint, and Plaintiffs agreed to extend the Company’s time to answer. When that time passed on June 3, 2013, Plaintiffs refused to grant additional time and have now made a motion seeking entry of a default. The Company filed its answer on June 5, 2013.
There are no other known legal proceedings against the Company.
NOTE 20 - SEGMENT REPORTING
For the years ended December 31, 2012 and 2011 the Company’s segments are as follows:
All operating revenues comprise amounts received from external third party customers. All of the Company’s operations are located in the PRC.
As of December 31, 2012 and 2011, total assets of the manufacturing and distribution segments are as follows:
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
For the years ended December 31, 2012 and 2011, capital expenditures of the manufacturing and distribution segments are as follows:
NOTE 21 - INCOME TAX
The Company’s operating subsidiaries have their principal operations in the PRC and are subject to a PRC Enterprise Income Tax (“EIT”) rate of 25% in 2012 and 2011, subject to certain rate reductions. Each of the Company’s subsidiaries in the PRC files separate tax returns. The Company’s subsidiaries Three Happiness, HSPL, GLP,CCXA, and Boke were granted certification as “high and new technology” enterprises from 2008 to 2011 and benefited from a preferential income tax rate of 15% during these periods. Beginning January 1, 2012, the preferential income tax rate of 15% was extended for Three Happiness, HSPL, GLP, CCXA, and Boke until December 31, 2013.
The provisions for income taxes for the years ended December 31, 2012 and 2011 are summarized as follows:
The reconciliation of tax computed by applying the statutory income tax rate applicable to the PRC operations to income tax expenses is as follows:
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
The tax effects of temporary differences that give rise to the Company’s net deferred tax liabilities as of December 31, 2012 and 2011 are as follows:
In assessing the realizability of deferred tax assets, the Company has considered whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. The Company records a valuation allowance to reduce deferred tax assets to a net amount that management believes is more-likely-than-not realizable based on the weight of all available evidence.
The Company has not recorded a provision for U.S. federal income tax for the years ended December 31, 2012 and 2011 due to the cumulative tax net operating losses in the United States. As of December 31, 2012, the Company had net operating tax losses carried forward of approximately $19,000,000, $60,000,000 and $8,000,000 in the US, PRC, and Hong Kong, respectively. Those losses carried forward in the US expire between years 2025 and 2030, and in the PRC expire between years 2015 and 2018. Losses incurred in Hong Kong are carried forward indefinitely. In the PRC and Hong Kong the subsidiaries with loss carryforwards are taxed on a separate return basis and the Company has determined all amounts should have full valuation allowances. At December 31, 2012, the tax benefit of the loss carryforwards has not been recorded and therefore is not presented in the table above.
The Company’s PRC subsidiaries deemed “high technology” enterprises are subject to preferred tax rates (tax holiday). The table below shows the effect of using the higher rates and earnings per share.
Accrued Taxes
Effective January 1, 2007, the Company adopted guidance for accounting for uncertainty in income which prescribes a more-likely-than-not threshold for financial statement recognition and measurement of a tax position taken in the tax return. As of December 31, 2012, the Company has recorded an accrued tax of $11,015,810 mainly related to tax positions associated with deemed interest on non-trade intercompany transactions. The Company recorded a penalty of $693,480 and $663,343 for the years ended December 31, 2012 and 2011, respectively, related to its uncertain tax positions. It is possible that the amount accrued will change in the next 12 months; however, an estimate of the range of the possible change cannot be made at this time. The accrued taxes, if ultimately recognized will impact the effective tax rate.
AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2012, 2011, AND
Reconciliation of accrued taxes excluding the penalty is as follows:
The Company has various open tax years between 2005 and 2010 in its significant operating jurisdictions.
At December 31, 2012, $300,000 is included in taxes payable for the US for what we believe to be the potential liabilities for the untimely filing of IRS Forms 5471 and IRS Report of Foreign Bank and Financial Accounts. However, the potential liabilities could be greater if the IRS were to so determine our failure to file was willful. We believe the likelihood of the IRS considering our failure to file as being willful is remote.
All of the Company’s operations are conducted in the PRC. At December 31, 2012, the Company’s unremitted foreign earnings of its PRC subsidiaries totaled approximately $147 million and the Company held approximately $13.6 million of cash and cash equivalents in the PRC. These unremitted earnings are planned to be reinvested indefinitely into the operations of the Company in the PRC. While repatriation of some cash held in the PRC may be restricted by local PRC laws, most of the Company's foreign cash balances could be repatriated to the United States but, under current U.S. income tax laws, could be subject to U.S. federal income taxes less applicable foreign tax credits. Determination of the amount of unrecognized deferred U.S. income tax liability on the unremitted earnings is not practicable because of the complexities associated with this hypothetical calculation, and as the Company does not plan to repatriate any cash in the PRC to the United States, no deferred tax liability has not been accrued for cash to be repatriated.
NOTE 22 - EMPLOYEE DEFINED CONTRIBUTION PLAN
Full time employees of the Company’s subsidiaries in the PRC participate in a government-mandated defined contribution plan pursuant to which certain pension benefits, medical care, unemployment insurance, employee housing fund and other welfare benefits are provided to employees. Chinese labor regulations require that the PRC subsidiaries of the Company make contributions to the government for these benefits based on 41% of the employees’ salaries. The Company’s PRC subsidiaries have no legal obligation for the benefits beyond the contributions made. The total amounts for such employee benefits, which were expensed as incurred, were $4,841,673 and $5,714,921 for the years ended December 31, 2012 and 2011, respectively and are included in selling, general and administrative expenses.
NOTE 23 - SUBSEQUENT EVENTS
On February 19, 2013, the Company received a notice of acceleration under the terms of the Company’s 5.00% Convertible Senior Notes due 2015 (the “Senior Notes”) issued pursuant to an Indenture, dated as of July 15, 2008, between the Company and Wells Fargo Bank, National Association, as Indenture Trustee (the “Indenture”). The notice was sent by certain holders of the Senior Notes that together hold more than 25% of the aggregate principal amount of the Senior Notes. The notice states that the default is the result of the Company’s failure to (A) pay to the holders under the terms of the Indenture accrued interest due and payable on each of July 16, 2012 and January 15,2013, which failure to pay continued for a period of thirty (30) days after July 16, 2012 and January 15, 2013, respectively, and (B) provide, pursuant to the terms of the Indenture, a notice of the termination of trading and delisting of the Company’s common stock by the New York Stock Exchange. As of March 4, 2013, the aggregate principal amount of the Senior Notes, and unpaid, but accrued interest was $53,010,424. The notice of acceleration resulted in the principal amount of the Senior Convertible Notes plus accrued and all unpaid interest and accrued and unpaid Additional Interest (as defined in the Indenture) on the Notes through February 19, 2013, to become immediately due and payable.