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China Agritech: More Related-Party Corruption

|Includes: China Agritech, Inc. (CAGC)
In my first article about related-party transactions at China Agritech, I established that CEO Yu Chang and director/ex-COO Xiao Rong Teng are siphoning money away from the public company CAGC and into their own pockets via significantly above market price related-party leases. However, these leases are not the only transactions in which Mr. Chang and Ms. Teng are using their positions as officers/directors of the public company CAGC in order to enrich themselves at the expense of CAGC shareholders. This article will examine another instance of corrupt self-dealing on the part of Mr. Chang and Ms. Teng, the buyout of their 10% minority interest in one of CAGC's operating subsidiaries, Pacific Dragon.
When CAGC went public via a reverse merger transaction in 2005, CEO Yu Chang and director/ex-COO Xiao Rong Teng did not vend their entire interest of the Harbin-based operating subsidiary, Pacific Dragon, into the public company. They decided to keep 10% of the subsidiary under the ownership of their personal company, Yinlong. Over the years, as CAGC expanded their operations they also created more operating subsidiaries to hold the various new interests of the company. Beijing Agritech was formed for the Beijing operations, Anhui Agritech was formed for the Anhui operations and Xinjiang Agritech was formed for the Xinjiang operations. From the 2009 10-K:
"Corporate Structure
China Agritech, Inc. is a holding company with no operations. We are the parent company to our operating subsidiaries, Pacific Dragon, Anhui Agritech, Beijing Agritech and Xinjiang Agritech, which are located in the PRC.
On June 29, 2006, the Company established a wholly owned subsidiary, Anhui Agritech.
On November 1, 2006, the Company and the stockholders of CAI Investment, Inc (the “CAI stockholders”) entered into an equity transfer agreement whereby the CAI stockholders transferred 100% equity interest in CAI Investment, Inc. (“CAI”) to the Company in exchange for $1,000. CAI holds 100% equity interest in Beijing Agritech.
On December 23, 2008, the Company formed Xinjiang Agritech, a PRC entity. Beijing Agritech and Anhui Agritech hold 75% and 25% of the equity interests, respectively, in Xinjiang Agritech."
Four years after the initial reverse merger, Mr. Chang and Ms. Teng decided that it was time to sell their remaining 10% interest in Pacific Dragon. According to Note 15 of the 2009 10-K:
"On February 12, 2009, Tailong entered into a share purchase agreement with Pacific Dragon and Yinlong and a supplemental purchase agreement among Yinlong, Pacific Dragon, Mr. Yu Chang and Ms. Xiao Rong Teng pursuant to which Tailong agreed to acquire Yinlong’s 10% interest in Pacific Dragon for a cash payment of $1,000,000 and issuance of 1,745,000 shares (as retroactively adjusted the 1-for-4 reverse split on September 8, 2009 and the 2-for-1 forward split on February 1, 2010) of the Company’s common stock in the Company. On the same date, Tailong completed the acquisition and Pacific Dragon has since become a wholly-owned subsidiary of the Company.”
By any measure, the public company China Agritech significantly overpaid Mr. Chang and Ms. Teng for the acquisition of the minority interest, as I shall demonstrate. According to the 2009 Q1 10-Q, the annual production capacity as at the end of 2008 was 13,000 MT of liquid fertilizers, and 100,000 MT of granular fertilizer. Based on CAGC's own press release from 4 months later, we can determine that the production capacities of the Pacific Dragon operation as at February 12, 2009 were as follows:
Harbin (Pacific Dragon) – 5,000 MT of liquid fertilizer
We can see that at the date of the acquisition, the Pacific Dragon portion of CAGC's overall production capacity is 38.5% of liquid fertilizer capacity and 0% of granular capacity. This means that the 10% minority interest in Pacific Dragon represented 3.85% of CAGC's liquid fertilizer production.
Looking at the balance sheet of the Q1 2009 10-Q, we see that at the end of Q1 2009, CAGC had 12,349,808 shares outstanding (adjusted the 1-for-4 reverse split on September 8, 2009 and the 2-for-1 forward split on February 1, 2010).
After the issuance of the new shares to Mr. Chang and Ms. Teng, CAGC had 14,094,808 shares outstanding (split-adjusted). The new shares now represented 12.4% of CAGCs shares outstanding, while the actual acquisition only represented 3.85% of CAGC's liquid fertilizer production and 0% of granular fertilizer production. In addition to the new shares, Mr. Chang and Ms. Teng personally received $1M in cash from the public company CAGC. Even if the Pacific Dragon minority interest had represented 10% of CAGC’s entire production, which it did not, Mr. Chang and Ms. Teng could not justify the price paid.
What should be plain and obvious from all of this is that CAGC grossly overpaid for the acquisition of the 10% interest of Pacific Dragon. CAGC probably overpaid CEO Yu Chang and Director/ex-COO Xiao Rong Teng by about 3-4 times for this acquisition, based on the amount of additional production it received. Perhaps this is why no independent fairness assessment was done on this acquisition. An additional interesting piece of information is that the new shares were issued to Sammi Holdings, an offshore holding company owned by Mr. Chang and Ms. Teng. Why might Mr. Chang and Ms. Teng choose to place these new shares into this entity instead of directly under their own names?
In conclusion, Yu Chang and Xiao Rong Teng clearly used their positions as officers and directors of the public company CAGC in order to pay themselves a grossly inflated price to acquire the 10% minority interest in Pacific Dragon. This represents yet another in a long line of documented instances, based entirely on publicly available information, in which CAGC’s management has acted in an unethical and corrupt manner. Management has proven on numerous occasions that they will seize opportunities to enrich themselves at the expense of common shareholders. This disposition should be carefully considered by all potential and existing CAGC shareholders. 

Disclosure: short CAGC