China Biotics' Fraud Casting Doubt on All Chinese RTOs

by: Ian Bezek

China-Biotics (OTC:CHBT) appears to have committed malicious accounting fraud to intentionally fool its auditor, BDO Limited, according to the company's partly hilarious but mostly disturbing 8-K filed Thursday. China-Biotics' auditor resigned, and issued one of the more shocking resignation letters I've ever read. Among the highlights, BDO claims that China-Biotics committed "illegal acts" including document forgery and an elaborate scheme in which BDO's auditors were directed to a "suspected fake website" when BDO attempted to verify China-Biotics' cash balance with the company's bank. BDO also states that, among other things, China-Biotics forged sales documents and mis-stated interest income.

The fallout from BDO's letter has been fast. China-Biotics' CFO has already resigned, and the NASDAQ is already moving to remove the company from its exchange; shares are likely to be delisted July 5th. While China-Biotics has long been a suspected fraud, it is surprising just how far China-Biotics was willing to go in support of its faked numbers.

In particular, it is amazing that China-Biotics would go to the trouble of making a fake bank website for BDO's auditors to visit. That is the sort of shamelessly fraudulent act one associates with Nigerian money-wiring scams rather than NASDAQ-listed companies. If China-Biotics was willing to go this far -- and it was able to fool a respected auditor such as BDO for a time, what other similar bank account related frauds will be discovered? While we've known for months now that fraud ran deep across the sector, this level of sophisticated deception must make us probe even more deeply into companies that claim high cash balances.

China-Biotics claimed to have $132 million in cash, or nearly $6/share in cash, (more than 150% of the company's market value before it was halted.) This supposed cash formed the core of bull's hopes for the stock. As one can see in this bullish piece on China-Biotics, the number one reason to be excited about the stock was because the company was going to launch a dividend.

The illusion of a large cash balance allows companies to announce dividends, share buybacks, and other sorts of things to goose the share price and scare off short sellers. With this arsenal of tools to boost share prices -- all built off the facade of a strong cash position -- a fraudulent enterprise can remain listed and continue misappropriating resources far longer than would otherwise be possible. It's hard to believe China-Biotics is the only cockroach; now that the light has been shone on bank balance-related fraud, auditors will look for and find other companies employing similar techniques.

If cash balances truly are being faked in such clever and elaborate schemes across the Chinese RTO space, things are about to get much much worse for investors in these stocks. Here is a partial list of Chinese RTO companies that share the same red flag -- having a very high reported cash balance compared with their market cap -- as China-Biotics:

Company Ticker Reported Cash Market Cap
Advanced Battery (OTCPK:ABAT) $86 million $84 million
A-Power Energy (NASDAQ:APWR) $168 million $81 million
China Education Alliance (CEU) $68 million $30 million
China Mass Media (NYSE:CMM) $112 million $35 million
Duoyuan Global Water (DGW) $157 million $95 million
SkyPeople Fruit Juice (SPU) $66 million $67 million
Yuhe International (NASDAQ:YUII) $42 million $25 million
ZST Digital Networks (NASDAQ:ZSTN) $40 million $31 million

It's also worth watching the shares of other companies that BDO Limited audits. BDO Limited is starting to have a fairly poor track record in China. One former client, China Expert Technology now trades for less than a penny, and other BDO Limited companies have been embroiled in controversy. BDO Limited's client list includes SkyPeople Fruit Juice (SPU), Oriental Paper (NYSEMKT:ONP), and Gulf Resources (GFRE). Since China-Biotics was able to fool BDO Limited for quite awhile, one must wonder if BDO Limited is dropping the ball in any of these other audits as well.

Writing after the ChinaMedia Express scandal, I wondered if things could get worse for the Chinese RTO space. Clearly things could, and did still get worse. And now, with solid evidence that companies have figured out how to fake cash balances (and even create entire fake bank websites) to a point where they can fool Top 10 auditors like BDO Limited, it's hard to avoid the conclusion that the sector is heading for full-on collapse.

I can't imagine why an investor would want to own shares in any of these companies at this juncture. If you can't even trust companies' cash balances, how can you possibly make informed investments? My advice, unless you are a sophisticated speculator with money to burn, is to stay far away from Chinese RTOs until there is far more transparency in the sector.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.