China-Biotics Auditor Quits, Alleges 'Illegal Acts'

(Updated from Thursday. Adds detail from BDO Limited's resignation letter.)

NEW YORK (TheStreet) -- The auditor of China-Biotics (CHBT) has resigned amid a series of explosive allegations that suggest the company's management may have committed acts of forgery in an elaborate scheme to report false financial results.

A Shanghai-based maker of probiotic yogurt cultures, China-Biotics revealed the resignation in a disclosure filing with the Securities and Exchange Commission following the closing bell Thursday, making it the latest Chinese company to see its auditor flee after accountants uncovered evidence of potential fraud while examining financial numbers in preparation for an annual report.

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In a resignation letter appended to China-Biotics' filing, BDO Limited, the Hong Kong-based affiliate of the global accounting firm BDO International, said the irregularities it discovered "likely constitute illegal acts."

China-Biotics' U.S.-based representatives at the PR firm Grayling didn't immediately respond to requests for comment.

Among other things, BDO said that its auditors, attempting to review online bank records, were directed by staff of China-Biotics to "access a suspected fake Web site" that supposedly belonged to the bank in question, called the Bank of Communications, where the company kept one of its major cash accounts. BDO also noted irregularities involving interest income and the "chops" that were included on a sales contract. "Chops" in China are used as a kind of seal to verify document authenticity.

BDO Limited also said China-Biotics failed to take "appropriate remedial actions" when the firm's auditors approached management about the irregularities, making it "impossible for BDO Limited to gather evidence to assess whether the Company's accounting records have been falsified and whether there are other issues which could have a material effect on the financial statements of the Company."

In the Thursday filing, China-Biotics said its chief financial officer, Travis Cai, also resigned. A replacement was named: Marie Yang, the "financial manager" of one of China-Biotics' subsidiaries. In her new role, she'll receive $3,000 a month, the company said.

The company received a delisting notice from the Nasdaq Stock Market on Thursday evening. In a press release, China-Biotics said it will "use its best efforts to submit a plan of compliance" to the exchange by the deadline, July 5.

China-Biotics has long been suspected by short-sellers and others of falsifying the information it files with the SEC -- and thus presenting to the American investing public an exaggerated picture of its business.

The company, which went public in the U.S. through the controversial reverse-merger process in 2006, had vigorously defended itself against its accusers. It has become one of the most contentious long-short battleground stocks in a sector full of them. The company had even attracted interest from major U.S. institutional money, including the massive Boston-based fund advisor Wellington Management, which took an 8% stake in China-Biotics.

Trading in the stock has been halted since June 15, when China-Biotics failed to file its 10-K annual report with the SEC before the deadline for companies with fiscal years that end in March.

BDO Limited had served as the company's auditor for the last two audit cycles. This time, though, it refused to certify the 2010 numbers. Its resignation letter was dated June 22.

As reported by TheStreet in December, the SEC has been investigating the possibility of ubiquitous fraud among small-cap Chinese companies since at least last fall. According to people with knowledge of the investigation, the commission's enforcement division had shown interest in individual companies -- including China-Biotics -- as well as the so-called "gatekeepers," the promoters, investment banks, lawyers and auditors that have helped small Chinese companies go public in the U.S. and raise capital here, particularly through reverse mergers.

Along with other many other audit firms that work for Chinese companies with shares listed in the US., BDO Limited has seen its share of criticism. A Web site called BDO Watch was set up months ago by anonymous critics trying to draw attention to the accounting firm's work for China-Biotics. The site carries an open letter to the senior management of BDO International.

One passage on the site reads: "China-Biotics claims to be the dominant probiotics producer in China, with a reported revenue run rate in excess of $110 million and an alleged $130 million cash in the bank ... From a transparency standpoint, however, the company is nearly impenetrable."

As of Dec. 31, the end of its fiscal third quarter, China-Biotics claimed cash and cash equivalents of $132.3 million, according to its quarterly report filed with the SEC.

BDO's resignation letter constituted one of the most detailed descriptions of purported financial fraud by a Chinese company since the scandal erupted in force earlier this year, with the outgoing auditors of companies such as Longtop Financial (LFT), China MediaExpress (CCME), China Electric Motor and China Century Dragon Media making similar allegations of possible wrongdoing.

The reverse merger process -- sometimes called a reverse takeover, or RTO -- has long been criticized as merely a way to skirt the tougher scrutiny given by regulators to companies selling stock through IPOs; just this month, the SEC issued an investor bulletin warning about the heightened risk of fraud among companies that have gone through reverse mergers.

Short-sellers first became interested in China-Biotics as early as 2009, drawn by what they believed to be uncommonly wide profit margins (the company claimed 70% gross margins when it first came public) and the large discrepancies between its financial reports filed with the SEC in the U.S. and those submitted to government authorities in China -- two metrics that have in the past served as warning signs for potential fraud among other Chinese companies.

Last year, private investigators in China hired by short-sellers allegedly discovered that many of the stores China-Biotics claimed to own in and around Shanghai didn't exist. China-Biotics responded by arguing that it had already closed down those stores after a strategic decision to shift to bulk wholesale probiotic sales. Other questions raised by bearish investors involved the true extent of the company's manufacturing capabilities and the validity of its supply arrangements with certain customers. Short-sellers and researchers have also raised questions about the amount of cash that China-Biotics claimed to have on its balance sheet.

Before criticism of China-Biotics (and Chinese small-caps in general) had captured the market's attention, the company's stock climbed above $19 in March 2010, reaching a market cap of more than $400 million. That value has since cratered amid the battle over whether the company has lied about its operations. China Biotics stock closed at $3.46 before Nasdaq's halt.

-- Written by Scott Eden in New York

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