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Conventional wisdom tells us that insider selling should not necessarily be viewed as a red flag by investors. Insiders can have many reasons to sell other than lack of confidence in their company. Maybe they are buying a house or have other personal financial commitments for which they need the money. But what if 3 separate company insiders including the CFO, COO and a board director/former COO sell millions worth in stock on 17 different occasions within a single quarter while the company itself withholds material information from shareholders. Shouldn’t investors then view this as a major red flag? This is exactly what happened with China Agritech (OTCPK:CAGC) during the period between reporting results for the first quarter and second quarter of 2010.

CAGC filed its 10-Q for the first quarter of 2010 on May 10, 2010. In it, they reported significantly improved operating income figures compared with the same quarter in 2009, $4,261,866 vs. $1,979,297. The stock responded well to the news, rising from a close of $13.55 on May 7, the Friday before the report, to an intra-day high of $16.97 on May 13, representing a 25% gain in 3 trading sessions. The problem for shareholders is that the numbers reported by CAGC were totally misleading because they neglected to report $3,257,410 in stock-based compensation that occurred during the period. This stock-based compensation expense was instead reported on August 16 as an adjustment in the 10-Q for the second quarter of 2010, buried as Note 18 to the financial statements:

On January 12, 2010, the Company awarded an aggregate of 326,600 shares (as adjusted for the 2-for-1 forward stock split on February 1, 2010) consisting of 158,620 shares of restricted common stock and 167,980 shares of unrestricted common stock to certain directors and officers in consideration for services rendered, with varying vesting periods among different grantees in accordance with the terms of the agreements entered into by the Company and the grantees. The shares of common stock were valued by using the closing share price of $17.61 per share at approximately $5,751,426 and amortized over the vesting period. The Company omitted to record the stock compensation expense of $3,257,410 for three months ended March 31, 2010.

CAGC did not actually earn $4.2 million in operating income during the first quarter, they earned just over $1 million, representing an almost 50% decrease in operating income compared to 2009 vs. the over 100% increase that they had initially reported.

What makes this omission all the more questionable is that beginning on May 13, three days after the glowing Q1 report, and ending on August 9, one week before filing the amendment in the Q2 report, insiders sold CAGC stock on 17 separate occasions representing 200,000 shares. Insiders granting themselves $3.2 million worth in free shares classifies as material information. If it had properly reported, perhaps the price that insiders could sell at wouldn't have been as high. Regardless, not reporting it in Q1 and selling before filing the Q2 10-Q should definitely be considered as withholding material information. To add insult to injury, the company was not only misleading existing investors in CAGC’s stock, but was misleading all the new investors who had just participated in the April 29 equity financing, as well as their largest investor, CAGP IV GENERAL PARTNER, L.P. who contributed $10 million to company coffers by exercising warrants on June 23, 2010, prior to the filing of the adjustment.

Examining the stock-based compensation itself, a significant amount of the stock is unrestricted stock. This is a compensation scheme that gives an incentive for insiders to sell vs. increasing shareholder value. This type of compensation arrangement will be familiar to anyone who has examined past Chinese stock frauds China Energy Savings Technology (Delisted, formerly CESV), Eternal Technologies Group (OTC:ETLT), China Continental Inc. (Delisted, formerly CHCL), and CAGC’s CFO Yau Sing (Gareth) Tang’s own former outfit, the now defunct China Cable and Communications (CCCI.PK). With incentive stock options, insiders don't make money unless the stock goes up. In the case of China Agritech, the insiders are poised to do extremely well regardless of future share price trends. CAGC did also award insiders 781,000 options in the second quarter.

In conclusion, China Agritech’s reporting omission of stock-based compensation expense in the first quarter of 2010 represents the withholding of material information by company insiders and is extremely suspicious considering both the nature of the awards and the insider sales that took place in the period between the filing of Q1 and the post-award amendment filed in Q2. This represents yet another instance in which CAGC management has acted in a corrupt manner and should be considered carefully by any current or prospective investors in CAGC stock.

Disclosure: Short CAGC

Source: China Agritech: Did Management Withhold Material Information While Simultaneously Selling Stock?