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The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.



) -- I recently put out a few feelers by phone, email and on message boards to get arguments to refute the fraud allegations against

China Biotics

( CHBT). I even made it known that the title of the article I would write would be titled "CHBT: Refuting the Fraud Allegations." So far, I have received zero responses. This is in sharp contrast to when I questioned

China MediaExpress

( CCME) and was flooded with responses by investors ardently defending the company. It seems that the only reason people continue to buy or hold shares of CHBT rest on the assumption that recent purchases by a Trinidadian investor bode well for the company's upcoming audit.

Point #1: Many companies (,, do have some legitimate business, yet even a very small amount of accounting fraud leads to an auditor resignation, halting of the stock and subsequent delisting.

Point #2: Even when fraud allegations are "old news," this does not make them any less true. Allegations about

Longtop Financial

( LFT) were well over a year old before the stock was eventually halted. CFO Derek Palaschuk repeatedly dismissed the validity of the allegations based on the fact that they were "old news."

Point #3: The standard procedure for preparing quarterly financials is largely perfunctory and consists only of compiling numbers provided by management. So far I have never seen an auditor resign due to fraud during a 10Q audit. This is a severe problem with PCAOB procedures, and if the procedures had tougher requirements, fraud would be uncovered sooner, most likely during the quarterly audits rather than just at year-end.

If it is possible that there is even a very small amount of fraud at CHBT, then the stock will not receive a clean audit from BDO and it will be delisted. Period. All investors will be stuck holding a pink sheet stock priced at around $1 (Trinidadians included). Again, it only takes a little fraud, not a lot. So the big question is: "Will BDO find evidence of fraud?"

I am still short shares of CHBT but if any logical arguments could be found to change my mind, I would be more than happy to reverse my position. So far I have seen none. While the large purchases by the Trinidadian are supporting the share price in the short term, the only thing that really matters is whether BDO will sign off on the company's 10K, due out in a short number of trading days. Based on all of the facts I have seen, I continue to believe that a sign off on the 10K is impossible. If BDO does resign, the stock would still be halted and delisted, leaving investors with an 80%-90% loss from current levels. This is true regardless of whether the Trinidadian holds $5 million or $50 million. Everyone loses.

The reasons I think BDO is unlikely to sign off are that the discrepancies at CHBT are major, not minor, and they are so public that they cannot be missed in a 10K audit.

BDO's first task: Confirm that the stores existed. The primary basis for the allegations was that the 111 stores that CHBT claimed to have did not exist. Immediately following allegations of fraud, CHBT disclosed that it abruptly closed 95 of those 111 stores. However, the number of employees only decreased by 66, from 513 to 447. Here are the





This implies less than one employee per store. It also makes very little sense that when CHBT had 111 retail outlets that the total number of CHBT employees was only 513. For a manufacturer, there should be a large number of management, sales, administrative and production staff in addition to the staff at the 111 stores.

After the store closures were announced, several individuals attempted to identify the locations where the stores were previously located and discovered that the addresses listed were not for retail space, but were often residential or office buildings with no retail space. Here's a

brief presentation

. Following the fraud allegations, CHBT abruptly removed the list of retail addresses from its Web site.

For BDO, a quick in-person check of the addresses in Shanghai would be easy and require very little time. If it turns out that these locations were never, in fact, retail locations at all, then that alone would amount to material deception by management and would be sufficient to justify BDO resigning, just as Deloitte resigned from CCME.PK and LFT. Based on photographic evidence, this would appear to be a certainty.

BDO's second task: Confirm customer revenue. BDO can easily contact the major customers of CHBT to conduct an independent verification. This is not typically done during a 10Q audit. For FY2010, CHBT claims that Beijing DBN Technology accounted for 13% of revenue. Yet when contacted by China Economic Review (which does not have any position in the stock), the probiotics manager (Kong Xiaoyan) said that this was not the case.

The same goes for Bright Dairy, which says it has not used any of CHBT's products (according to board secretary Zhu Jianyi, who responded in writing). The same goes for Holiland and Relax XinQiao which, in fact, no longer even produce probiotics products at all. In an older version of CHBT's investor presentation, there was a slide that listed Holiland, DBN, LiJia and YueJia as major customers. Following the publication of the fraud analysis,

this slide

was abruptly deleted.

Despite store closures and no major customers, CHBT reported that revenue for the December quarter rose by 40% to $32 million. Revenue for the past nine months is reported at $81 million.

The question I ask is not "if" BDO resigns, but rather "when." In looking at past precedents, it is clear that the announcements of auditor resignations come as late as possible and right before the expected release of annual results. With CCME.PK, the resignation came exactly one trading day before earnings were due. Many investors I spoke with had taken great comfort from the notion that Deloitte had already been working on CCME.PK's audit for three months and had not come forward to raise any issues. More than one long investor took a liking to the phrase "silence is golden."

I believe that last week's early resignation of Deloitte from LFT will start to serve as a precedent and that auditors will resign from questionable companies earlier on in the process. However, there are only a short few trading days left until CHBT needs to release its 10K, so it is difficult to predict anything related to timing.

Again, if anyone has any logical arguments to refute the fraud allegations, I would be happy to post them in an article titled "CHBT: Refuting the Fraud Allegations."

Disclosure: The author is short CHBT. The author can be reached for comments at

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

Rick Pearson is a Beijing-based private investor focusing on U.S.-listed China small-cap stocks. Until 2005, Pearson was a director at Deutsche Bank, spending nine years in equity capital markets in New York, Hong Kong and London. Previously, he spent time working in venture capital in Beijing. Mr. Pearson graduated magna cum laude with a degree in finance from the University of Southern California and studied Mandarin for six years. He has frequently lived, worked and traveled in China since 1992.