PINX:BOPH Bohai Pharmaceuticals Group Inc Annual Report 10-K Filing - 6/30/2012

Effective Date 6/30/2012

PINX:BOPH Fair Value Estimate
Premium
PINX:BOPH Consider Buying
Premium
PINX:BOPH Consider Selling
Premium
PINX:BOPH Fair Value Uncertainty
Premium
PINX:BOPH Economic Moat
Premium
PINX:BOPH Stewardship
Premium
 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

x

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934.  

 

For the fiscal year ending June 30, 2012

 

OR

 

¨

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934.     

 

For the transition period from ________    to ________.

 

Commission file number 000-53401

 

Bohai Pharmaceuticals Group, Inc.

(Exact name of registrant as specified in its charter)

 

Nevada   98-0697405  

(State or other jurisdiction

of incorporation or organization)

 

(IRS Employer

Identification number)

 
       

c/o Yantai Bohai Pharmaceuticals Group Co. Ltd.

No. 9 Daxin Road, Zhifu District

Yantai, Shandong Province, China

  264000  
(Address of Principal Executive Offices)   (Zip Code)  
             

 +86(535)-685-7928

(Registrant’s Telephone Number, Including Area Code)

 

Securities registered pursuant to Section 12(b) of the Act:

 

None

(Title of Class)

 

Name of each exchange on which registered

 

None

 

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.001 par value per share

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.   Yes   ¨     No   x

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.   Yes ¨     No   x

.

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x No   ¨ .

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  x    No   ¨ .

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer ¨ Accelerated filer  ¨  
Non-accelerated filer  ¨ Smaller reporting company x

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨     No  x

 

The aggregate market value of the voting and non-voting common stock, other than shares held by persons who may be deemed affiliates of the registrant, computed by reference to the closing sales price for the registrant’s Common Stock on December 31, 2011, as reported on the OTC Bulletin Board, was approximately $5,269,020.

 

As of September 28, 2012, there were 17,861,085 outstanding shares of common stock of the registrant, par value $.001 per share.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

None

   

 
 

 

Bohai Pharmaceuticals Group, Inc.

 

Annual Report on Form 10-K for the

Fiscal Year Ended June 30, 2012

 

TABLE OF CONTENTS

 

    Page
     
Cautionary Note Regarding Forward Looking Statements -i-
     
PART I   1
     
Item 1. Business. 1
Item 1A. Risk Factors. 18
Item 1B. Unresolved Staff Comments. 36
Item 2. Description of Properties. 36
Item 3. Legal Proceedings. 36
     
PART II   37
     
Item 5. Market for Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities Market Information. 37
Item 6. Selected Financial Data. 37
Item 7. Management’s Discussion and Analysis or Plan of Operation. 37
Item 7A. Quantitative and Qualitative Disclosures about Market Risk. 48
Item 8. Financial Statements and Supplementary Data. 48
Item 9. Changes In and Disagreements with Accountants On Accounting and Financial Disclosure. 48
Item 9A. Controls and Procedures. 48
Item 9B. Other Information. 49
     
PART III   50
     
Item 10. Directors, Executive Officers, Promoters and Control Persons; Compliance With  Section 16(A) of the Exchange Act. 50
Item 11. Executive Compensation 52
Item 12. Security Ownership of Certain Beneficial Owners and Management 54
Item 13. Certain Relationships and Related Transactions and Director Independence. 54
Item 14. Principal Accountant Fees and Services. 55
     
Part IV   56
     
Item 15. Exhibits 56
     
FINANCIAL STATEMENTS F-1

 

 
 

 

CAUTIONARY NOTE REGARDING FORWARD LOOKING STATEMENTS

 

In addition to historical information, this Annual Report on Form 10-K contains forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.  The forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in such forward-looking statements.  Factors that might cause such a difference include, but are not limited to those discussed in the sections entitled “Business”, “Risk Factors”, and “Management’s Discussion and Analysis or Plan of Operation.”  Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s opinions only as of the date thereof.  We undertake no obligation to revise or publicly release the results of any revision of these forward-looking statements.  Readers should carefully review the risk factors described in this Annual Report and in other documents that we file from time to time with the Securities and Exchange Commission.

 

In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “projects,” “potential,” “proposed,” “intended,” or “continue” or the negative of these terms or other comparable terminology. You should read statements that contain these words carefully, because they discuss our expectations about our future operating results or our future financial condition or state other “forward-looking” information. There may be events in the future that we are not able to accurately predict or control. You should be aware that the occurrence of any of the events described in our risk factors and other disclosures included in this Annual Report could substantially harm our business, results of operations and financial condition, and that upon the occurrence of any of these events, the trading price of our securities could decline.  Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, growth rates, and levels of activity, performance or achievements.  Factors that may cause actual results, our performance or achievements, or industry results, to differ materially from those contemplated by such forward-looking statements include, without limitation:

 

  ¨ our ability to generate or obtain through financing sufficient working capital to (i) fund the acquisition of Yantai Tianzheng (a total of $25.3million is due); (ii) satisfy our obligations under our convertible notes due October 5, 2012 (currently $9,405,000 due) or (iii) otherwise to support our business plans;

 

  ¨ our ability to integrate the business of Yantai Tianzheng and any future acquisitions into our business;

 

  ¨ our ability to expand our product offerings and maintain the quality of our products;

 

  ¨ the availability of government granted rights to exclusively manufacture or co-manufacture our products;

 

  ¨ the availability of national healthcare reimbursement of our products;

 

  ¨ our ability to manage our expanding operations and continue to fill customers’ orders on time;

 

  ¨ our ability to maintain adequate control of our expenses allowing us to realize anticipated revenue growth;

 

  ¨ our ability to maintain or protect our intellectual property;

 

  ¨ our ability to maintain our proprietary technology;

 

  ¨ the impact of government regulation in China and elsewhere, including the support provided by the Chinese government to the Traditional Chinese Medicine and healthcare sectors in China;

  

  ¨ our ability to implement product development, marketing, sales and acquisition strategies and adapt and modify them as needed;

 

  ¨ our implementation of required financial, accounting and disclosure controls and procedures and related corporate governance policies; and

 

  ¨ our ability to anticipate and adapt to changing conditions in the Traditional Chinese Medicine and healthcare industries resulting from changes in government regulations, mergers and acquisitions involving our competitors, technological developments and other significant competitive and market dynamics.

 

Except as required by applicable law, including the securities laws of the United States, we do not intend to update any of the forward-looking statements to conform these statements to actual results. The following discussion should be read in conjunction with our financial statements and the related notes that appear elsewhere in this report.

 

We cannot give any guarantee that these plans, intentions or expectations will be achieved.  All forward-looking statements involve significant risks and uncertainties, and actual results may differ materially from those discussed in the forward-looking statements as a result of various factors, including those factors listed above and described in the “Risk Factors” section of this Annual Report.

 

-i-
 

 

PART I

 

As used throughout this Annual Report, the terms “BOPH,” “Company,” “we,” “us,” or “our” refer to Bohai Pharmaceuticals Group, Inc., a Nevada corporation, together with:

 

(i)           its wholly owned subsidiary, Chance High International Limited, a British Virgin Islands company (“Chance High”);

 

(ii)         Chance High’s wholly owned subsidiary, Yantai Shencaojishi Pharmaceuticals Co., Ltd., a PRC company (“WFOE”);

 

(iii)        Chance High’s wholly owned subsidiary, Yantai Nirui Pharmaceutical Co., Ltd., a PRC company (“WFOE II”);

 

(iv)         the WFOE’s variable interest entity, Yantai Bohai Pharmaceuticals Group Co., Ltd., a PRC company (“Bohai”), which is our initial operating subsidiary; and

 

(v)          WFOE II’s wholly owned subsidiary, Yantai Tianzheng Pharmaceutical Co., Ltd., a PRC company (“Yantai Tianzheng”), which we acquired in August 2011 and is our second operating subsidiary.

 

In this Annual Report, we sometimes refer to BOPH, Chance High, WFOE, WFOE II, Bohai and Yantai Tianzheng collectively as the “Group.”  As used in this Annual Report, “China” or “the PRC” refers to the People’s Republic of China.

 

Item 1.  Business.

 

Overview

 

We are engaged in the production, manufacturing and distribution in China of herbal pharmaceuticals based on traditional Chinese medicine, which we refer to herein as Traditional Chinese Medicine, or TCM.  We are based in the city of Yantai, Shandong Province, China and our operations are exclusively in China.

 

Our medicines address rheumatoid arthritis, viral infections, gynecological diseases, cardio vascular issues and respiratory diseases.  Our initial operating subsidiary Bohai obtained Drug Approval Numbers (or DANs) for 29 varieties of traditional Chinese herbal medicines in 2004, and an additional 14 varieties in December 2010.  Through our acquisition of Yantai Tianzheng in August 2011, we obtained DANs for another 5 varieties in August 2011.  We currently produce 19 varieties of approved traditional Chinese herbal medicines in seven delivery systems: tablets, granules, capsules, formulations, concentrated powder, tincture and medicinal wine.  Of these 19 products, 12 are prescription drugs and 7 are over the counter (or OTC) products.

 

Three of Bohai’s lead products, Tongbi Capsules and Tablets and Lung Nourishing Syrup, are eligible for reimbursement under China’s National Medical Insurance Program (or NRDL), which we believe significantly increases the marketability of these products.  In addition to these lead products, three of our current products and five of our formulas we acquired in 2010 are eligible for NRDL reimbursement.  In addition, one of our current products and four of our newly acquired formulas are currently included on the Chinese government's Essential Drug List (or EDL).  Inclusion on either the EDL or NRDL allows for up to 100% insurance coverage by the Chinese government.   Yantai Tianzheng owns five prescription products approved by the State Food and Drug Administration of China (which we refer to herein as the SFDA) and currently manufactures four of such products.  Among Yantai Tianzheng’s products, Fangfengtongsheng Granule has an exclusive status and is on the EDL and NDRL. Zhengxintai Capsule has renewed its protective status to August 2017and is currently on NDRL.

 

1
 

 

The Chinese government has previously awarded us exclusive rights to manufacture our Tongbi Capsules product.  We share manufacturing rights with one or more manufacturers for our Anti-flu Granules product We held the Certificates of Protected Variety of Traditional Chinese Medicine (Grade Two) (which we refer to herein as the Certificate of Protection) issued by the SFDA for Tongbi Capsules and Shangtongning Tablets, which give us exclusive or near-exclusive rights to manufacture and distribute these two medicines.  The protection periods for both Tongbi Capsules and Shangtongning Tablets expired in September 2009.  We submitted the application to extend such protection period for Tongbi Capsules on March 12, 2009.  The SFDA approved our request and the protection period for Tongbi Capsules has been extended to September 13, 2016.  We have decided to not submit an extension of protection application for Shangtongning Tablets, but will continue to manufacture this product. The affection of no protected status is not going to affect our business significantly. Any producers, who want to produce the drug, need to apply to SFDA and the approval process is very strict and success rate is low.

 

Our strategy is to leverage the “protected” status and national insurance coverage for certain of our pharmaceutical products to aggressively increase market penetration throughout China, the world’s most populous nation.  By utilizing our distribution platform, in addition to utilizing mass media and other marketing methods to build awareness of our brand, we have been able to and will continue to seek to significantly grow our revenues and earnings.  In addition, as evidenced by our acquisition of Yantai Tianzheng, we may seek additional acquisition candidates or undertake other strategic transactions to broaden our product offerings and sales, marketing and manufacturing capabilities.

 

We are focusing a significant portion of our marketing efforts on our Lung Nourishing Syrup and expect to continue this effort over the next several years.  Lung Nourishing Syrup( which we formerly referred to as “Lung Nourishing Cream”), an ingestible liquid product, is one of our most popular products, and its main ingredient, Laiyang Pear, to our knowledge, is not available in other similar pharmaceutical products.  We applied for a patent for Lung Nourishing Syrup with its production method for the treatment of Lung Qi Deficiency Cough and Chronic Bronchitis, which application was approved by the State Intellectual Property Office of the PRC on June 23, 2010.  The patent was awarded for a period of 20 years starting from the day of its application on September 12, 2007. Even the patent is expired, any producers who want to produce the same product, need to get approval from us, as long as we do not approve, no one can manufacture it. This means we are still the exclusive producer of Lung Nourishing Syrup. For these reasons, we believe Lung Nourishing Syrup contains a novel formulation for the treatment of asthma and other common respiratory ailments with an emphasis on the improvement of overall lung function and health.  We believe this represents an exceptional market opportunity.

 

Our business strategy also seeks to capitalize on new government programs established in early 2009 to extend health insurance coverage to previously uncovered Chinese citizens.  The PRC government’s new health care policies are also designed to encourage the use of TCM and its approach to wellness and treatment of disease.  As a result, the government continues to expand the number of TCMs eligible for reimbursement under national medical insurance programs.  This has resulted in medical professionals working in the state-run medical facilities to increasingly prescribe and recommend TCM products of the type we manufacture and market.  The state-run facilities provide the majority of medical care in China.  Three of our lead products, Lung Nourishing Syrup and Tongbi Capsules and Tablets, are eligible for insurance reimbursement coverage, with others expected to follow.  Currently public health officials in China are developing general consumer awareness of increasing problems and concerns with respiratory and lung health caused by pervasive national air pollution.  This nationwide epidemic is an unfortunate by-product of the robust development of China’s expansive manufacturing and industrial activities.  Increased air pollution is a cause and contributory factor to a range of acute respiratory illnesses including chronic conditions such as asthma.  As a result, we intend to significantly increase promotions for our Lung Nourishing Syrup.

 

As of the date of this Annual Report, we have approximately 805 employees operating from 21offices throughout China.  As we are committed to strong sales efforts, approximately 336 of our employees are sales representatives.

 

As is not uncommon for Chinese companies listed in the U.S., we control our Chinese operating subsidiary, Bohai, pursuant to a series of variable interest entity contractual agreements (the “VIE Agreements”), under which we assume management of the business activities of Bohai and have the right to appoint all executives and senior management and the members of the board of directors of Bohai.  Under these arrangements, however, we do not, directly or indirectly, own any shares in Bohai, which are owned by Mr. Qu, our Chairman, President and Chief Executive Officer and two unaffiliated parties.  Please see “Contractual Arrangements with Bohai and its Shareholders” below.

 

We do, however, directly own our Yantai Tianzheng operating subsidiary through WFOE II.

 

2
 

 

Background and Key Events

 

We were incorporated under the laws of the State of Nevada under the name Link Resources Inc. on January 9, 2008.  Our principal office was in Calgary, Alberta, Canada.  Prior to January 5, 2010, we were a public “shell” company in the exploration stage since our formation and had not yet realized any revenues.  We entered into a Mineral Lease Agreement on April 1, 2008 for two mining claims in Pershing County, Nevada, in an area known as the Goldbanks East Prospect.  We terminated the lease on July 7, 2009.

 

Share Exchange with Chance High

 

Pursuant to the Share Exchange Agreement entered into on January 5, 2010 (the “Share Exchange Agreement”), and related share exchange (the “Share Exchange”) by and among us, Chance High, and the shareholders of Chance High (the “Chance High Shareholders”), we acquired Chance High and its indirect, controlled subsidiary Bohai, a Chinese company engaged the production, manufacturing and distribution in China of herbal medicines, including capsules and other products, based on Traditional Chinese Medicine.  The closing of the Share Exchange (the “Closing”) took place on January 5, 2010.  As of the Closing, pursuant to the terms of the Share Exchange Agreement, we acquired all of the outstanding equity securities (the “Chance High Shares”) of Chance High from the Chance High Shareholders, and the Chance High Shareholders transferred and contributed all of their Chance High Shares to us.  In exchange, we issued to Chance High Shareholders an aggregate of 13,162,500 newly issued shares of our common stock.

 

In addition, pursuant to the terms of the Share Exchange Agreement, Anthony Zaradic, our former sole officer and director (“Zaradic”), cancelled a total of 1,500,000 shares of common stock owned by him.  As a further condition of the Share Exchange, effective as of January 5, 2010, Zaradic resigned from all of his positions with our company and Hongwei Qu (“Qu”), the former principal shareholder and Executive Director of Bohai, was appointed as our President, Chief Executive Officer, Interim Chief Financial Officer, Treasurer and Secretary and also, effective January 16, 2010, as our sole director.  In June 2010, Mr. Qu relinquished the positions of Interim Chief Financial Officer, Treasurer and Secretary and we appointed Gene Hsiao as our Chief Financial Officer.  On July 12, 2010, we appointed three independent directors to our board of directors.

 

January 5, 2010 Private Placement and Related Agreements

 

Securities Purchase Agreement.  On January 5, 2010, we entered into a Securities Purchase Agreement (the “Securities Purchase Agreement”) with certain accredited investors (the “Investors”) and Euro Pacific Capital, Inc. (“Euro Pacific”), as representative of the Investors, relating to a private placement by us of 6,000,000 units consisting of Notes and Warrants, which we refer to herein as the private placement.  The consummation of the private placement resulted in gross proceeds to us of $12,000,000 and net proceeds of approximately $9,700,000.  Each unit consisted of a $2.00 principal amount, two year convertible Note and a three year Warrant to purchase one share of our common stock at $2.40 per share, subject to certain conditions.  Euro Pacific acted as the lead placement agent and Chardan Capital Markets, LLC acted as co-placement agent of the private placement.

 

The Notes have been amended several times by agreement with Euro Pacific, as representative of the Investors.

 

On December 31, 2011, we entered into an amendment to the Notes with Euro Pacific which: (i) extended the maturity date of the Notes from January 5, 2012 to April 5, 2012 (such extra three month period, the “Extended Period”); and (ii) increased the interest rate on the Notes to an annual rate of 12% (or 3% for the Extended Period).

 

In order to demonstrate our efforts to repay the Notes, we (through our Chinese subsidiary) and Euro Pacific established an RMB denominated escrow account in China with the Rural Credit Cooperative of Laishan District, Yantai City (the “Escrow Account”) into which we have deposited the remaining outstanding amount of the Notes ($9.4 million, denominated in RMB). We will have no right to dispose of or use the funds held in the Escrow Account except for (i) conversion into US Dollars for the purpose of repayment of the Notes or (ii) releases from such Escrow Account from time to time in amounts equal to the decreases in the outstanding amount of the Notes, either by payments made by us or conversion of the Notes by Note holders.

 

On May 15, 2012, we and Euro Pacific entered into a Second Amendment to the Notes (the “Second Amendment”) to extend the maturity date thereof from April 5, 2012 to October 5, 2012 (such extra six month period, the “Second Extended Period”); and (ii) maintain the interest rate on the Notes at an annual rate of 12% (or 6% for the Second Extended Period).

 

On June 27, 2012, we and Euro Pacific entered into a Third Amendment to the Notes (the “Third Amendment”) to remove the limitations on our ability to incur debt, to incur liens or to make capital expenditures. The purpose of the Third Amendment is to provide us with enhanced flexibility to seek potential sources of financing.

 

The Company is currently working with Euro Pacific as representative of the Investors on a fourth amendment to the Notes which would further extend the maturity date of the Notes from October 5, 2012 to January 5, 2013. As of the date of this Annual Report, no written agreement has been entered into in this regard. The Company is unable to predict whether an agreement will be reached. The non-payment of the loan in the absence of an extension of the maturity date would constitute an event of default under the terms of loan agreement. The Company can not predict what the implications of the non-payment of the loan would be other than the continued difficulty of repaying the loan from escrowed funds due to currency conversion restriction.

  

3
 

 

Registration Rights Agreement.  In connection with the private placement, we entered into Registration Rights Agreements (the “Registration Rights Agreement”) with the Investors which sets forth the rights of the Investors to have the shares of common stock underlying the Notes and Warrants issued in the private placement registered with the Securities and Exchange Commission (“SEC”) for public resale.  We filed such registration statement with the SEC, and registration statement was declared effective by the SEC on August 12, 2010.

 

Securities Escrow Agreement.  Also in connection with the private placement, we entered into a Securities Escrow Agreement (the “Securities Escrow Agreement”) with Euro Pacific, as representative of the Investors, our principal shareholder, Glory Period Limited, a British Virgin Islands company that we refer to herein as Glory Period and which was the majority shareholder of Chance High prior to the Share Exchange, and Escrow, LLC, as escrow agent (the “Escrow Agent”).  Pursuant to the Securities Escrow Agreement, Glory Period has pledged and deposited a stock certificate representing 1 million shares of our common stock (the “Escrow Shares”) into escrow in order to provide security to the Investors in the event of an occurrence of an event of default under the Notes.  Upon the earlier to occur of the full repayment of all amounts due to the Investors under the Notes or the conversion of fifty percent of the principal face value of Notes into shares of common stock, the Investors’ rights in and to the Escrow Shares shall terminate.  Glory Period is controlled by Qu through certain contractual relationships described elsewhere in this Annual Report.

 

Closing Escrow Agreement. Pursuant to a Closing Escrow Agreement (the “Closing Escrow Agreement”) that we entered into in connection with the private placement on December 10, 2009, we placed a total of $240,000 of proceeds from the private placement (the “Holdback Amount”) with the Escrow Agent.  The Holdback Amount represents an amount sufficient to satisfy the payment to the Investors of one quarterly interest payment due on the aggregate principal amount of all Notes issued in the private placement.  If, subject to certain conditions and after applicable notice and cure periods, an event of default is declared by Euro Pacific with respect to our failure to make a quarterly interest payment to Investors, the Escrow Agent shall disburse such portion of the Holdback Amount to the Investors, and we shall be obligated to deposit additional amounts equal to the Holdback Amount with Escrow Agent.  At such time as seventy-five percent of the aggregate shares of common stock underlying the Notes have been issued upon conversion of the Notes, all remaining funds of the Holdback Amount shall promptly be disbursed to us.

 

Corporate Name Change

 

On January 29, 2010, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) pursuant to which we merged with a newly formed, wholly owned subsidiary called Bohai Pharmaceuticals Group, Inc., a Nevada corporation (“Merger Sub” and such merger transaction, the “Merger”).  Upon the consummation of the Merger, the separate existence of Merger Sub ceased and our shareholders became shareholders of the surviving company named Bohai Pharmaceuticals Group, Inc.  As permitted by Chapter 92A.180 of Nevada Revised Statutes, the sole purpose of the Merger was to effect a change of our corporate name.

 

Changes of Our Independent Registered Accounting Firms

 

Effective January 29, 2010, upon the approval of our board of directors, we dismissed John Kinross-Kennedy as our independent registered public accountant and appointed Parker Randall CF (H.K.) CPA Limited (or Parker Randall) as our independent registered public accounting firm.

 

On June 24, 2011, the audit committee of our board of directors approved the dismissal of Parker Randall as our independent registered public accounting firm, effective as of June 28, 2011, and appointed Marcum Bernstein &Pinchuk LLP as our independent registered public accounting firm as of June 24, 2011.

 

Intangible Assets Transfer

 

On December 9, 2010, we entered into an Transfer Agreement of Intangible Assets (the “Transfer Agreement”) with Shandong Daxin Microbiology Pharmaceutical Industry Co., Ltd., a company incorporated in the People’s Republic of China (“Daxin”), pursuant to which Daxin agreed to transfer to us all rights and title in and to 14 Drug Approval Numbers (“DANs”) for 14 traditional Chinese medicines, which DANs were previously issued to Daxin by the Shandong Branch of the SFDA.  The aggregate purchase price is RMB 48 million (approximately US$7,200,000).  As of the date of the execution of the Transfer Agreement, the proposed transfer of the aforementioned 14 DANs has been approved by Shandong SFDA.  Such purchase price has been paid in full.

 

Acquisition of Yantai Tianzheng

 

On August 8, 2011, WFOE II entered into a Share Purchase Agreement (the “SPA”) pursuant to which we acquired, from the three individual holders thereof, one hundred percent (100%) of the outstanding shares of Yantai Tianzheng.  Under the terms of the SPA, WFOE II will purchase such shares from Mr. Jiangbo Chi, Ms. Shulian Wang and Mr. Bohai Yu.  The percentage interests owned by Mr. Chi, Ms. Wang and Mr. Yu in Yantai Tianzheng, are 60%, 30% and 10%, respectively.  The SPA also contained customary representations, warranties and covenants of the parties.  Mr. Chi (the majority shareholder of Yantai Tianzheng) also entered into an agreement related to his employment by Yantai Tianzheng, ownership of his future work products and certain confidentiality and non-compete obligations.

 

4
 

 

 The purchase price to be paid for Yantai Tianzheng is $35,000,000 in the aggregate.  Pursuant to the SPA, the purchase price has been or will be made in the following installments:

 

1.           The first cash payment in the aggregate amount of $ 6,000,000 was paid within 10 calendar days after the execution of the SPA.

 

2.           The second cash payment in the amount of $12,000,000 was payable within 6 months after the execution of the SPA, subject to certain conditions (unless otherwise waived), such as the performance of all “transition period” obligations related to renewal or extension of material operational agreements and employment agreements. As of the date of this Annual Report, we have paid $3,700,000 of the second installment, with the remainder in the amount of 8,300,000 converted into a two-year term loan due on February 8, 2014 pursuant to Section 3.5 of the SPA as described below.

 

3.           The third cash payment of $12,000,000 bewas payable within 1 year after the execution of the SPA, subject to certain conditions (unless otherwise waived), such as amendment or obtainment of certain certificates and license necessary for consummation of the transaction. This third installment was not paid and was converted into a two-year term loan due on August 8, 2014 pursuant to Section 3.5 of the SPA as described below.

 

4.           The fourth cash payment of $5,000,000 will be payable within 18 months after the execution of the SPA, subject to certain conditions.

 

In addition, each installment requires satisfaction of conditions applicable to its prior payment(s), completion of assignment of certain licenses or certificates, and absence of a material adverse change affecting Yantai Tianzheng during the respective installment periods. In the event that WFOE II fails to pay any of the installments when due, such outstanding installment will be automatically converted into a two-year term loan owed by WFOE II to the Shareholders of Yantai Tianzheng, with interest accruing on any unpaid portion of such loan from its due date until such installment is paid in full at the rate of six percent (6%) per annum. As long as such interest payments are made on a timely basis and the outstanding principal of such loan and interest are satisfied in full within 2 years after the applicable installment election date, WFOE II will not be deemed in breach or default under the SPA and will continue to possess full control and legal ownership over Yantai Tianzheng. Furthermore, even in the event of non-payment by WFOE II of any principal or interest under the loans as described above, or in the event of any other breach or default by WFOE II of the SPA, the remedies of the former Yantai Tianzheng Shareholders against WFOE II are limited solely to monetary damages, and in all instances such Shareholders will have no right to reclaim ownership of YantaiTianzhengYantai Tianzheng or demand that WFOE II in any way revert control or legal ownership over the shares of YantaiTianzhengYantai Tianzheng back to such shareholders.

 

The acquisition of Yantai Tianzheng marked a major milestone for our Company.  The acquisition expanded our product lines and allows us to leverage our respective sales and distribution channels. Yantai Tianzheng’s current sales network spans over 14 major provinces as well as over 14 Tier 2 and Tier 3 cities, with products sold in over thousands of hospitals across China. In addition, Yantai Tianzheng brings additional manufacturing capacity which meets GMP standards and allows us to further expand our production.  We consolidated and integrated the two companies’ operations, which provided substantial improvement in the operating efficiency of the combined companies.

 

Intangible Asset Impairment

 

During the fourth quarter of our 2011 fiscal year, we determined that we will no longer manufacture or seek to develop a market for eight of our products due to a change of our business strategy resulting from our acquisition of Yantai Tianzheng.  As a result of this decision, the total cost of these eight products, in the amount of $635,442, was charged to non-cash impairment loss during the 4th quarter of the fiscal year ended June 30, 2011.  Even though we incurred an impairment loss for these eight products, we continue to retain a full ownership of these products and can still manufacture them at any time we deem desirable.

 

5
 

 

Corporate Structure and Related Agreements

 

Our organizational structure as of the date of this Annual Report is summarized below:

 

 

Chance High owns 100% of the issued and outstanding capital stock of the WFOE.  On December 7, 2009, the WFOE entered into a series of variable interest entity contractual agreements (the “VIE Agreements”) with Bohai and its three shareholders, which include Qu (our Chairman, President and Chief Executive Officer, who owns 90% of Bohai’s shares) and two unaffiliated parties.  Pursuant to the VIE Agreements, WFOE does not directly own the equity of our operating subsidiary, but rather effectively assumed management of the business activities of Bohai and has the right to appoint all executives and senior management and the members of the board of directors of Bohai.  The VIE Agreements are comprised of a series of agreements, including a Consulting Services Agreement, Operating Agreement and Proxy Agreement, through which WFOE has the right to advise, consult, manage and operate Bohai for an annual fee in the amount of Bohai’s yearly net profits after tax.  Additionally, Bohai’s Shareholders have pledged their rights, titles and equity interest in Bohai as security for WFOE to collect consulting and services fees provided to Bohai through an Equity Pledge Agreement.  In order to further reinforce WFOE’s rights to control and operate Bohai, Bohai’s shareholders granted WFOE an exclusive right and option to acquire all of their equity interests in Bohai through an Option Agreement.

 

In addition, on December 7, 2009, Mr. Qu entered into a call option agreement (the “Call Option Agreement”) with Joshua Tan (“Tan”), the sole shareholder of Glory Period, a British Virgin Islands company, which was the majority shareholder of Chance High prior to the share exchange.  The Call Option Agreement became effective upon the closing of the Share Exchange.  Under the Call Option Agreement, Tan shall transfer up to 100% shares of Glory Period within the next 3 years to Qu for nominal consideration, which would give Qu indirect ownership of a significant percentage of our common stock.  The Call Option Agreement provides that Tan shall not dispose any of the shares of Glory Period without Qu’s prior written consent .

 

Executive Offices

 

Our headquarters are located at No. 9 Daxin Road, Zhifu District, Yantai, Shandong Province, P.R. China 264000. Our telephone number is +86(535)-685-7928.

 

Overview of Traditional Chinese Medicine

 

In China, Traditional Chinese Medicine is not an alternative form of therapy but is used in the state-run hospitals alongside modern medicine.  For its practitioners and advocates, TCM is a complete medical system that is used to treat disease in all its forms.  TCM is also believed to promote long term wellness and vigor. Many modern-day drugs have been developed from herbal sources.  These include drugs designed to treat asthma and hay fever such as ephedrine; hepatitis remedies from fruits and licorice roots and a number of anticancer agents from trees and shrubs.

 

For the Chinese, however, health is more than just the absence of disease.  Chinese herbal medicine is not only intended to cure but to enhance the capacity for enjoyment, fulfillment and happiness.  Accordingly, there are herbal drugs that are used to invigorate, nourish blood, calm tension and regulate menstruation.

 

The roots of TCM date back thousands of years and include a number of therapeutic approaches.  These include herbal medications, acupuncture, dietary manipulation, massage and others.  Very early works of Chinese medical literature date back as much as 2,500 years while other classics appeared approximately 2,000 years ago during the Han Dynasty.  Medicine in China continued to develop throughout the Middle Ages when emperors commissioned the creation of various scholarly works that compiled and documented hundreds of medicines derived from herbs, animal sources and minerals.  In addition, these works described their therapeutic uses.  In the 1950s, TCM was further modernized and reformed by the PRC government.

 

6
 

 

The emphasis on wellness and the avoidance of disease is considered by some to be a key distinction between TCM and western medical practice which has been seen as more heavily oriented toward the treatment of disease and less toward prevention.  While TCM has remained a substantial part of medical treatment in China and throughout East Asia, recent decades have seen increasing acceptance throughout the United States, Europe and elsewhere.  This growth is, in part, driven by increasingly educated and empowered consumers of medical care who seek organic, natural and alternative approaches to western medical treatments and prescription drugs.  Medical doctors are also accelerating the process of acceptance, as doctors trained in the western tradition in Europe, the United States and elsewhere are integrating TCM and alternative treatments in their everyday practice.  Additionally, a growing number of physicians specifically trained in TCM, acupuncture and other modalities are opening offices in communities in the U.S. and around the world.

 

We believe that the sales of TCM in China reflect the central and still growing role these therapies play in medical care in that nation.  According to Helmut Kaiser Consultancy, in 2005, total sales revenue for Chinese herbal medicine manufactured in China was $13.6 billion which accounted for 25.8% of all medicine manufactured in China.  This segment had total profit of $1.76 billion which accounted for 29% of the total profit of the Chinese drug industry.  In 2006, there were approximately 1,400 Chinese herbal medicine manufacturers with an annual growth rate of 15%, much higher than the comparable period GDP growth.  According to China News, as a result of the increasing wealth of China and an aging population, it is estimated that by 2015, China will be the second largest market in the world£the herbal medicine production value will exceed more than $887 billion.

 

According to a published report by PricewaterhouseCoopers, in 2009 China had more than 7,000 distributors supplying pharmaceuticals to hospitals and pharmacies.  According to such report, most Chinese seeking medical care go directly to the hospitals where more than 80% of the medicines used throughout China are prescribed.  Only recently have chain drug stores begun to appear allowing drugs to be obtained in many areas without a visit to a hospital.

 

 

Our Products

 

Overview

 

Through our operating subsidiary Bohai, we obtained Drug Approval Numbers for 29 varieties of traditional Chinese herbal medicines in 2004 and an additional 14 varieties in December 2010 through a product acquisition and currently produce 15 TCM pharmaceutical products.  Through our Yantai Tianzheng operating subsidiary, we hold 5 additional varieties of traditional Chinese herbal medicines, of which we currently produce four.  Of our 19 products in production, 12 are prescription drugs and 7 are OTC products.  All of our products are derived from herbal and organic sources.

 

The following is a list of the approved pharmaceutical products that we are producing with their intended uses:

 

Lung Nourishing Syrup.  Lung Nourishing Syrup is designed to moisten the lung and relieve coughs and can be used to treat weak lung and chest tightness, poor chronic cough, shortness of spontaneous breath and chronic bronchitis.

 

Tongbi Capsules.  This product is designed to promote blood circulation and relieve swelling and pain, and can be used to treat cold resistance, liver and kidney deficiency, arthralgia syndrome and rheumatoid arthritis.

 

Tongbi Tablets.  Tongbi Tablets are designed to regulate and fortify the blood promote blood circulation and relieve swelling pain and can be used to treat alpine resistance, liver and kidney deficiency, including rheumatoid arthritis.

 

Shangtongning Tablets.  This product is designed to alleviate pain and can be used to treat bruises.

 

Zhuangyuanshenhailong Medicinal Wine.  This liquid product is designed to promote kidney function and can be used to treat the weakness waist and knee fatigue, insomnia and forgetfulness.

 

Danqi Tablet.  This product is designed to improve blood circulation and can be used to treat blood stasis, cardio-thoracic pain, dizziness and headache, and menstrual pain.

 

Fukangning Tablet.  This product is designed to improve blood circulation and can be used to treat blood stasis, cardio-thoracic pain, dizziness, headache and menstrual pain.

 

BazhenYimu Cream.  This product is designed for menstruation conditioning and can be used to treat dizziness, palpitation, fatigue, weakness and other menstrual symptoms and can also be used to ease menstrual flow.

 

7
 

 

HuoxueShujin Ting.  This product is designed to promote blood circulation and relieve blood congestion, and can be used to treat pain in the waist and leg, numbness in the feet and hands and arthritis.

 

Anti-flu Granules.  This product is designed to detoxify the body, and can be used to treat cold caused by exogenous wind-heat with symptoms such as fever, headache, stuffy nose, sneezing, pharyngodynia, generalized weakness and soreness.

 

Compound Manshanhong Syrup. This product is designed to relieve cough due to throat irritation and to prevent asthma symptoms.

 

Sanqi Shang Tablets.  This product is designed to promote blood circulation and relieve blood congestion, numbness, pain or bruises in the body due to arthritis, acute or chronic sprain or neuralgia.

 

Stomach Nourishing Tablets. This product is designed to relieve heartburn, sour stomach, acid indigestion and stomach upset caused by chronic superficial gastritis.

 

YangxueAnshen Tablets. This product is designed to improve blood circulation and to treat dizziness, palpitation, fatigue, weakness and other menstrual symptoms.

 

ShujinHuoxue Tablets. This product is designed to promote blood circulation and relieve blood congestion, and can be used to treat symptoms related to back pain, muscle paralysis, muscle spasm and acute or chronic sprain.

 

Fangfengtongsheng Granule. This product is used to treat fever, headache, constipation, measles and eczema.

 

Zhengxintai Capsule.  This product is used to improve kidney function and treat coronary artery disease and angina.

 

Tongmai Granule.  This product is used to treat ischemic heart and cerebrovascular diseases, arteriosclerosis and cerebral thrombosis

 

Bezoar Antipyrotic Tablet.  This product is used to heat detoxification eliminate heat from the body, swelling and pain.

 

Of our 19 products currently in production, 12 (Tongbi Tablets, Tongbi Capsules, Shangtongning Tablets, Danqi Tablets, HuoxueShunjin Ting, Compound Manshanhong Syrup, Sanqi Shang Tablets, ShujinHuoxue Tablets, Tongmai Granule, Fangfengtongsheng Granule and Zhengxintai Capsule) are available only through prescription.

 

In addition to the 19 medicines currently in production, we hold the rights to produce 29 other herb-based pharmaceutical formulations.  We anticipate that we will commence the manufacturing and distribution for these additional products if and when appropriate business conditions develop.

 

Product Types

 

Bohai has five production lines for the manufacturing of medicines in five forms, including tablets, granules, capsules, syrup, and medicinal wine.  Our current production capacity is approximately:

 

 

  ¨ 13.5 billion tablets and 3.7 billion capsules;

 

  ¨ 30 million bags granules;

 

  ¨ 20 million bottles/units of concentrated decoctions;

 

  ¨ 15 million bottles/units of syrup;

 

  ¨ 1 million bottles/units of tinctures; and

 

  ¨ 1 million bottles/units medical wine.

 

8
 

 

We believe that during the fiscal year ended June 30, 2012, on average, we operated at approximately 50 % of our production capacity and we believe we are currently operating at approximately 60 % of capacity.  Yantai Tianzheng has annual production capacity of 4 billion tablets, 8 billion capsules and 6.4 billion bags of granules respectively and operated on average at 35 % of its production capacity for the period ended June 30, 2012.

 

One of our pharmaceutical products has been granted “protected” status by the PRC government, a marketplace classification used by the government to regulate both production and distribution of traditional and herbal medicines in addition to the product formula right itself.  These “protected” medicines are not patented in the traditional commercial sense but are essentially proprietary.  The protection refers, in part, to standardizations of formulae which require that medicines of the same name have the same type and proportion of ingredients.  The “protected” designation grants us exclusive manufacturing and distribution rights within China over certain protected products or with up to six manufacturers in other cases.

 

We have the exclusive rights to manufacture Tongbi Capsules and we share manufacturing rights with one or more manufacturers for Shangtongning Tablets and Anti-flu Granules.  The exclusive rights usually have a term of seven years and can be extended for another seven year period after the initial seven year period elapses.  The protection periods for both Tongbi Capsules and Shangtongning Tablets expired in September 2009 and we have filed an application for extending the protection period on March 12, 2009 for Tongbi Capsules. SFDA approved our request to extend the protection period for Tongbi Capsules to September 13, 2016. We have decided not to submit extension application of Shangtongning Tablets, because the SFDA shall not approve Certificate of Protection for Shangtongning Tablets or any other products that are currently produced by more than three manufacturers in China according to applicable Chinese SFDA regulations. 

 

During fiscal 2013, we expect to increase marketing and advertising of Tongbi Capsules and Tablets, which are formulated to treat various forms of arthritis.  Sales of our Tongbi medicines are expected to grow in fiscal 2013 due to its protective status and strong demands of drug consumption resulting from health insurance reform in China. In addition to the Tongbi medicines and the Lung Nourishing Syrup, other substantial contributors to our revenues include its Shangtongning Tablets which are also expected to grow in fiscal 2013 due to strong demands of drug consumption resulting from health insurance reform in China and our marketing efforts.  Sales of our OTC product BazhenYimu Cream, used to strengthen the immune system, the enhancement of physical strength and conditioning, are also projected to grow in fiscal 2013 due to strong demands of drug consumption resulting from health insurance reform in China.  As our Tongbi Capsule has been included in the EDL for Shangdong Province, we will focus our marketing efforts in the rural hospitals in other provinces such as Guangdong and Jiangsu during fiscal 2013.

 

We will continue to promote four products being sold by Yantai Tianzheng under its current marketing strategy combined with our existing national sales efforts.  In particular, we expect that sales from Yantai Tianzheng’s top two products (Fangfengtongsheng Granule and Zhengxintai Capsule) will continue to grow in 2013 due to their exclusive status and/or NDRL status.

 

We price our medicines well under government-mandated caps and at a premium to most competitors because we use high quality raw materials and rely on strict quality control and management to produce high quality finished products.  We therefore believe, subject to applicable clinical analysis, that the purity, potency and effectiveness of our ingredients are superior to similar products in the Chinese marketplace.  As Chinese pharmaceutical regulatory authorities continue to tighten drug regulations to improve Chinese drug quality and safety standards, future entry into the pharmaceutical industry has become an increasing challenge.

 

Overview of the Chinese Market

 

The People’s Republic of China is undergoing the world’s most important and powerful economic transformation.  This transformation includes the confluence of its ancient culture with modern trends in business, technology and finance.  As a result, Chinese operating companies are capitalizing on unmatched growth opportunities in this evolving and growing marketplace.  Although average income is approximately one-tenth that of developed western nations, business growth and market reform-driven policies have given the country’s 1.37 billion citizens more purchasing power than ever.

 

According to a report published in Newsweek, total consumer spending in China reached $1.7 trillion in 2007, compared with $12 trillion in the U.S.  In its China Consumer Survey published in January 2010, Credit Suisse found that household income in China of the bottom 20% of those surveyed rose by 50% since 2004, while the top 10% had grown 255% to around RMB 34,000 per month.  Credit Suisse expects China’s share of global consumption to increase from 5.2% at US$1.72 trillion in 2009 to 23.1% at US$15.94 trillion in 2020, overtaking the U.S. as the largest consumer market in the world.   Further, research on Chinese consumers by management consulting firm McKinsey classifies two million households out of a population of 1.3 billion as “wealthy,” based on fairly modest annual earnings of more than $30,000.  An enormous middle class is rising, however, numbering some 70 million urban households, but these still earn $5,000-$10,000 a year.  China’s National Bureau of Statistics, based on a random survey of 65,000 urban households in China, found that the average (annual) disposable income of urban residents in the first half of 2009 was U.S. $1,300, an increase of 9.8% compared to the same period last year.  When price factors are deducted, this is equivalent to a real increase of 11.2%.  The average consumption expenditure amount of urban residents in the first half of 2009 was U.S. $876, an increase of 8.9% compared to the same period last year. When price factors are deducted, this is equal to a real increase of 10.3%.  

 

9
 

 

TCM Industry Drivers

 

We believe that demographic, governmental and related factors in the China will be favorable to growth and expansion of our business.

 

Growing Prosperity of the Chinese People.  The increased spending power of China’s population continues to be reflected in the increased consumption of health products and medical services between 2007 and 2010.  According to Euromonitor data, spending by Chinese people on these goods and services will increase from $100 billion in 2007 to $145 billion in 2010.  According to the Southern Medicine Economic Institute of the SFDA, sales of TCM increased 20% in 2010 as compared to 2009 in selected hospitals in the cities of Beijing, Guangzhou, Nanjing, Chongqing, Chengdu, Xi'an, Harbin, Shenyang, and Zhengzhou.  Overall sales of TCM in such hospitals increased at an annual rate of more than 20% during the past three years.

 

Population and Aging

 

  ¨ The total population of China was 1.37 billion at the end of 2011, according to official government estimates.

 

  ¨ Due to improved healthcare, the elderly population of China is growing.

 

  ¨ The health/medical costs associated with care for elderly in China are approximately five (5x) times that of younger people.

 

  ¨ China had 170 million elderly people in 2007 but will have an expected 230 million elderly by 2015 according to “Consumer Lifestyles in China: Consumer Trends, China’s Grey Population,” by Euromonitor, 2009.

 

  ¨ The proportion of the China’s population aged 65 and over will rise from just 10% of the overall population in 1995 to 22% by 2030, according to the World Bank.

 

  ¨ From 1995 to 2030 it is estimated that the ratio of working-age people to pensioners will decrease from 9.7:1 to 4.2:1.  China’s national estimates vary slightly from World Bank figures, but still show in increase in the proportion of the population over 65 years from 7% in 2000 to 9.4% in 2007, according to China Country Profile 2009, The Economist Intelligence Unit Ltd.

 

Government Policies in Health Care and TCM.  In April of 2009 the PRC government implemented a new national medical and health plan.  Among other features, this new plan extended national medical insurance coverage to China’s rural areas, where the bulk of the population resides.  This expanded coverage will eventually encompass virtually all of China’s 1.37 billion citizens, greatly expanding the market for TCM pharmaceuticals, as well as other health care products and services.   This has led to massive potential for increased sales growth for Bohai and other providers of TCM pharmaceutical products.

 

According to Reuters, by 2011, the PRC government’s health care investment will reach $1400 billion , compared with $96 billion for 2008. 

 

Government Support of Traditional Chinese Medicine.  Among its public health initiatives, the Chinese government officially supports use of TCM to enhance wellness and to treat chronic and acute diseases. The government has also commenced a program to evaluate TCM and herbal-based pharmaceuticals for coverage and reimbursement under national medical insurance.  In 2002, TCM was declared a “national strategic industry” in the government’s “Development Outline of Traditional Chinese Medicine Modernization (2002 – 2010).”

 

 Decreased Competition.  According to the Information Office of the State Council of the PRC, prior to 2009, there were approximately 6,000 Chinese pharmaceutical manufacturers.  That number is being significantly reduced through both marketplace attrition and direct government involvement, decreasing competition and increasing potential sales opportunities for the surviving companies.  Other companies are expected to fail through lack of size and innovative and aggressive management.  According to a 2009 report published by KMPG, of the approximately 4,500 pharmaceutical companies in China, the majority are small players with limited local market reach, and rapid consolidation between medium and large players in the sector is anticipated since the Chinese government has been encouraging industry consolidation with an effort to improve the Good Manufacturing Practice (GMP) standard, enforce GMP certification and to better control the pricing of drugs.

 

10
 

 

Growth Strategy

 

Our strategic initiatives for the foreseeable future are designed to aggressively capitalize on the health and wellness needs of increasingly wealthy and empowered consumer class in China.  In particular, we are seeking to capitalize on the government policies that extended medical insurance in 2009 to hundreds of millions of Chinese citizens living in rural areas, representing a vast untapped market of potential consumers who previously lacked access to national medical insurance.  As part of its reforms to expand and improve public health and medical care, the PRC government is promoting the use of herbal-based TCM and expanding insurance coverage to 100% of an increasing number of medicines.

 

Our strategic initiatives include the following:

 

Grow Hospital Presence.  We have targeted over 500 hospitals in 100 locations throughout China for direct marketing of Bohai products.  As part of this initiative, our sales team will expand its marketing activities to educate hospital personnel about our product lines and train hospital employees in the preventative and curative qualities of these products.  The initial focus will capitalize on the best known and most popular of our products, such as Tongbi capsules and Shangtongning tablets, using these as door-openers for our other medicines.

 

The average marketing cost to “open” each hospital to our products is $1,500.  For our base Bohai business, we are currently targeting the following provinces and the number of hospitals in such provinces indicted below:

 

Cities    Number of Hospitals 
Zhejiang   50 
Jiangsu   30 
Anhui   30 
Shandong   50 
Sichuan   30 
Hunan   30 
Fujian   120 
Shanghai   40 
Hubei   20 
Guangdong   80 
Chongqing   20 

 

Build Awareness of the Lung Nourishing Syrup.  We allocated a significant portion of the proceeds from our January 2010 private placement for brand-building and continue to dedicate resources to these efforts.  We will continue to primarily target consumers through television and print advertising to expand awareness of the uses and effectiveness of our Lung Nourishing Syrup.  Our advertising targets smokers and workers with occupational diseases as well as city dwellers exposed to smog. 

 

There is no budgeted TV ad spending for Lung Nourishing Syrup in our fiscal year 2013. By the end of our fiscal year 2012, we added more than 300 level 2 hospitals and more than 20 new drug store chains to our national network of retail locations in China currently selling our Lung Nourishing Syrup.  As a result, we now sell Lung Nourishing Syrup in more than 1,900 level 2 hospitals and more than 56 drug store chains across China.

 

Expand to Rural Areas.  We expect to execute a comprehensive marketing campaign targeting 160 rural counties as a result of the national government’s emphasis on expansion of healthcare and health insurance into the country’s rural areas.  We plan on starting our rural marketing in Guangdong, Jiangsu, shanghai and Hubei.  Our sales team will market its products to pharmacies, hospitals, physicians, herbal medicine experts, media outlets and other opinion leaders in these rural areas.  The main purpose is to be listed in the New Rural Cooperative Medical Directory which is farmer-friendly and assists these rural dwellers with reimbursement of medical expenses.

 

Generally, the marketing cost of this professional relationship-building with each rural county is $3,000. Total estimated marketing costs in the New Rural Cooperative Medical Directory could be in excess of $1,000,000. We plan to continue our efforts in hiring additional sale people under our current strategy as national health reform continue to focus in the rural areas.  All of these sales and marketing initiatives will involve both OTC and prescribed products.

 

Develop Our Product Lines and Product Awareness.  Brand awareness marketing will include the promotion and introduction to new markets of the current popular Bohai products such as Tongbi Tablets, Lung Nourishing Syrup, Fangfengtongsheng Granule, and  Zhengxintai Capsule.  As part of our increase in sales and marketing staff, we plan to have special trainers and presenters who can conduct promotional events and seminars to increase awareness of our products.

 

11
 

 

Seek Acquisitions of Complimentary Companies or Assets.  We believe that there may be TCM companies (such as Yantai Tianzheng) or assets in China that would be complimentary with our current product offerings and which could fit well with our sales and marketing platform.  We may seek to acquire such assets or other companies as a means to grow our revenue and profitability.

 

Competitive Advantages

 

We believe there are several key factors that will continue to differentiate us from our competition in the PRC:

 

 

  ¨ “Protected” Status of Key Bohai Product.  One of our lead products (Tongbi Capsules) currently enjoys exclusive protected status by the PRC government.  We have submitted an application for extending the protection period for this product.  This status regulates competition, granting us exclusive or near-exclusive rights to manufacture and sell the protected products. SFDA approved our request to extend the protection period for Tongbi Capsules to September 13, 2016. We submitted to the SFDA our request for renewal of the protected status for Zhengxintai Capsule on February 26, 2010, and such protection period has been extended to August 2017. We are in the process of applying for protected status for Fangfengtongsheng Granule, and such application was received by SFDA on June 30, 2010.

 

  ¨ Patent Granted for Lead Product.  We have received a patent in the PRC for our Lung Nourishing Syrup with its production method for the treatment of Lung Qi Deficiency Cough and Chronic Bronchitis. The patent was awarded for a period of 20 years starting from the day of its application on September 12, 2007.  For these reasons, we believe Lung Nourishing Syrup contains a novel formulation for the treatment of asthma and other common respiratory ailments with an emphasis on the improvement of overall lung function and health.  We believe this represents an exceptional market opportunity.

 

  ¨ Insurance Coverage for Lead Bohai Products.  Five  of our lead products, Lung Nourishing Syrup,  Tongbi Capsules and Tablets, Fangfengtongsheng Granule and Zhengxintai Capsule, are listed in the Catalogue Eligible for Medicine Reimbursement as of November 30, 2009.  This means that these medicines are eligible for reimbursement under the national health insurance.  We will seek to have additional (approximately 2-3) products listed in the catalogue.

 

  ¨ Low Development Costs.  We enjoy relatively low research and development (including acquisition) costs for our TCM products compared with western pharmaceuticals as our products are derived from recognized formulas.

 

  ¨ Effective Sales Force.  We maintain a highly trained sales force of approximately 354 people as of the date of this Annual Report.

 

The principal raw materials used for the production of our distributed products are honey, laiyang pear paste, Sichuan fritillaria, pangolin, and Chinese angelica. Raw materials, as well as packaging materials, are sourced from various independent suppliers in the PRC. We have no long term agreements with our suppliers, and purchase raw materials on a purchase order basis. We try to maintain relationships with at least two vendors for each major raw material in order to ensure a reliable supply of raw materials at reasonable prices. We believe there is ample supply in the market for the foreseeable future of the ingredients for our products.

 

Our principal suppliers include Anhui Dechang Pharmaceutical Tablet Co., Ltd., Shandong Yantai Medicine Purchasing and Supply Station, Anguo Jinkangdi Chinese Herbal Medicine Co., Ltd., and Yantai Yingli Trading Co., Ltd.  In the fiscal year ended June 30, 2012, two suppliers each accounted for 13.2% and 16.2% of our purchases of raw materials, and currently one supplier accounts for over 15 % of our purchases of raw materials. Approximately 45% of the raw material is purchased from Anhui Dechang Pharmaceutical Tablet Co., Ltd., Shandong Yantai Medicine Purchasing and Supply Station, Anguo Jinkangdi Chinese Herbal Medicine Co., Ltd and Yantai Yingli Trading Co., Ltd.

 

Yantai Tianzheng’s major suppliers are Anhui Dechange Pharmaceutical Tablet Co., Ltd., Shandong Yantai Medical Materials Purchasing and Supply Station and Dalian Ronghua Color Print Packaging Co., Ltd. Approximately 50% of the raw material used by Yantai Tianzheng was purchased from Shandong Yantai Medicine Purchasing and Supply Station and Anhui Dechang Pharmaceutical.

 

12
 

 

Research and Development

 

We currently have limited resources to devote to and limited capabilities to conduct the development of new products and as such research and development activities are not presently material to our business.  We have only one full-time employee who is engaged in research and development, so we are mainly dependent on a third-party, Yantai Tianzheng Medicine Research and Development Co., Ltd., to perform research and development for us.  We currently have two products, namely Forsythia Capsule and Fern Injection, under research and development in association with Yantai Tianzheng Medicine Research and Development Co., Ltd.  

 

We, like other TCM manufacturers, enjoy relatively low research and development expenses as most TCM medicines are based on standardized formulas.  In 2008, SFDA promulgated a notice of registration of Chinese traditional medicine providing that TCM composed of classic prescriptions will be exempted from pharmacological and toxicological tests and studies.  The notice defined classic prescription and classic TCM formulas as those herbal remedies recorded in ancient Chinese medicine books from Qing Dynasty or earlier which are currently widely used.  According to such notice, the production and manufacturing of TCM products are subject to non-clinical safety studies only and exempted from pharmacological and toxicological tests and studies.  Thus, TCM products are entitled to obtain faster SFDA approval.  As such, we enjoy relatively low research and development expenses because most of our products are based on classic TCM formulas that are covered by this notice.

 

The research and development process includes qualitative research, preparation for production and other miscellaneous costs.  We intend to introduce one new product by 2014 which is currently identified as a Shujin Pain Relief soft capsule.  The total cost to develop this product is not expected to exceed $1,500,000.  We may also seek to acquire new products through acquisitions of other TCM companies in the future.

 

Manufacturing

 

Although TCM is thousands of years old, we believe that our product manufacturing and procedures are the most modern and up-to-date available.  We employ rigorous standards for product quality control and safety.  The manufacturing facility owned by us is conducted in the city of Yantai in Shandong Province in a state-of-the-art 18,000 square-meter facility that meets or exceeds the latest Good Manufacturing and Quality Management Practice standards (referred to in China as “GMP”).

 

Yantai Tianzheng owns a manufacturing facility with a total area of 10,908.83 square meters (approximately 117,000 square feet) that also meets or exceeds the latest GMP.

 

GMP standards are the government’s benchmark for pharmaceutical manufacturers in China and must be met for the manufacturer to be eligible to market domestically or enter world markets.  On March 31, 2009, we completed a GMP review which included examination of 225 items including development technology, production, quality assurance, quality control, material handling and engineering.  As a result of that review, we were been re-certified for a new five-year period.

 

Through stringent application of GMP standards, the PRC government has reduced the number of marginal medicine manufacturers by one-third, from 6,000 to 4,000.  The new GMP standards established in 2011 could potentially eliminate additional 500 medicine manufacturers.  It is expected that TCM and pharmaceutical companies such as ours that have received full GMP approval by the government will enjoy the competitive benefits of their strict adherence to quality control, safety, health and manufacturing standards.

 

Our advanced and mechanized facilities utilize controlled, clean-room procedures with sophisticated water filtration and materials processing systems.  The manufacturing staff consists of approximately 405 production employees and approximately 19 quality control inspectors as of June 30, 2012.  We believe that we operated at approximately 60% of our manufacturing capacity during as of June 30, 2012.

 

In February 2010, we acquired land use right for a parcel of land totaling 333,335 square meters in YantaiCity which we may use to expand our manufacturing capability.

 

Marketing, Sales and Distribution

 

Bohai’s products are sold either by prescription through hospitals or Over the Counter (OTC) through hospitals, local pharmacies and retail drug store chains. Sales and distribution are managed and executed by approximately 336 sales representatives located in 21 offices throughout China as of June 30, 2012. These employees are trained in all details of each product and are encouraged to develop strong ties with physicians, hospitals and pharmacies in their local areas.

 

13
 

 

Our distribution and marketing initiatives for the next several years will be focused on achieving the following goals:

 

Expand hospital presence.  We intend to further develop business in over 500 hospitals in provinces we already serve including Shandong, Zhejiang, Jiangsu, Anhui, Sichuan, Hubei and other provinces.  We believe that we will generate additional revenue from the newly developed hospitals in those provinces.  During the fiscal year ended June 30, 2012, we added more than 300level 2 hospitals and more than 20 new drug store chains to its national network of retail locations in China currently selling our Lung Nourishing Syrup. As a result, we now sells Lung Nourishing Syrup in approximately 1,900 level 2 hospitals and 56 drug store chains across China.   Currently, we sell our products to more than 16,000 hospitals, medical centers and 66 drug stores in more than 21 provinces and special districts in China.

 

Expand distribution to the rural market.  We believe that the Chinese government’s expansion in 2009 of national medical insurance reimbursement coverage to the rural population provides us with new and largely untapped markets.  Some of our products, namely Lung Nourishing Syrup, Tongbi Capsules and Tongbi Tablets, have been listed in government’s New National Medical Insurance Catalogue in Shandong and Anhui Province as of November 30, 2009, and we expect to gain a competitive advantage in these newly accessible rural markets.  With the addition of more than 6,500 level 2 hospitals medical centers and 30 drug store chains to our national distribution network during the fiscal year ended June 30, 2012, we expect considerable growth in our sales in the rural market.

 

Expand prescription medicine sales organization.  A key element of our growth strategy is increased outreach to physicians.  These outreach programs will focus on the eight current pharmaceutical products of ours that are available by prescription only and will typically take place at state-run hospitals where virtually all Chinese citizens obtain their medical care.  Our educational training programs will be designed to inform doctors of the range of our pharmaceutical products including diseases or health/wellness concerns targeted and proper usage of the medicines. 

 

Expand OTC team to drive market share.  Our management intends to accelerate and expand sales of our OTC medicines through promotion and advertising targeting consumers.  The marketing programs will principally utilize television, print advertising and news releases.

 

Acquisition of Yantai Tianzheng. Part of our ongoing marketing strategy is to consolidate Yantai Tianzheng’s sales team and distribution network with our own.  Together, we sell 19 products to more than 16,000 hospitals medical centers and 66 drug stores in China by working with more than 100 distributors and 300 plus sale people.  The consolidation process for the two companies has been completed by the end of this fiscal year.

 

Competition

 

China’s domestic pharmaceutical industry is highly competitive, with hundreds of companies vying to reach consumers through more than 100,000 pharmacies.  In some categories in which we compete there are many other companies offering the same competitive products.  The market continues to attract new entrants because the per capita medicine consumption in China is still low, compared to developed countries, and that shows promise for substantial growth.

 

Competitive factors primarily include price and quality. We believe that we are able to effectively compete in our market segment in China based upon the quality of our product, given our new GMP certified manufacturing facility and our reputation in the market place.

 

 Many of our current and potential competitors have significantly longer operating histories and significantly greater managerial, financial, marketing, technical and other competitive resources, as well as greater name recognition, than we do. These competitors may be able to respond more quickly to new or changing opportunities and customer requirements and may be able to undertake more extensive promotional activities, offer more attractive terms to customers or adopt more aggressive pricing policies. We cannot assure you that we will be able to compete effectively with current or future competitors or that the competitive pressures we face will not harm our business.

 

Intellectual Property

 

We market our products under the trademark “Xian Ge” which is registered with the PRC Trademark Bureau under the State Administration for Industry and Commerce.  Currently, another company is licensed to utilize our registered trademark “Xian Ge”.  We have also received a patent in the PRC for our Lung Nourishing Syrup with its production method for the treatment of Lung Qi Deficiency Cough and Chronic Bronchitis.

 

14
 

 

Government Regulation

 

We are subject to many general regulations governing business entities and their behavior in China and in any other jurisdiction in which we have operations. In particular, we are subject to laws and regulations covering food, dietary supplements and pharmaceutical products.  Such regulations typically deal with licensing, approvals and permits.  Any change in product licensing may make our products more or less available on the market.  Such changes may have a positive or negative impact on the sale of our products and may directly impact the associated costs in compliance and our operational and financial viability.

 

Our only sales market is presently in China.  We are subject to the Pharmaceutical Administrative Law, which governs the licensing, manufacturing, marketing and distribution of pharmaceutical products in China and sets penalties for violations of the law.  We are also subject to the Food Sanitation Law, which provides for the food sanitation standards to be followed.

 

Under SFDA guidelines for licensing of pharmaceutical products, all pharmaceutical manufacturers must obtain and maintain GMP Certificate.  We hold a GMP Certificate (No. Lu K0587), which was issued by Shandong Branch of SFDA on June 18, 2009 and a GMP Certificate (No. Lu L0763), which was issued by Shandong Branch of SFDA on November 15, 2010 for Yantai Tianzheng.  Because our manufacturing facility has obtained the National GMP Certificate, we are authorized to produce products in seven modes which are tablets, capsules, granules, syrup, concentrated decoctions, tincture and medical wine.  Such certificate expires on June 14, 2014 for us and on November 14, 2014 for Yantai Tianzheng  and we will seek to renew the certificate before its expiration date.

 

We hold a Permit for the Production of Medicine (Lu Zb20050330) issued by Shandong Branch of SFDA on January 1, 2006 which allows us to engage in the production of tablets, capsules, granules, syrup, concentrated decoctions, tincture (for oral use) and medical wine.  Such permit expires on December 31, 2010 and was renewed through December 31, 2015.  Yantai Tianzheng  holds a Permit for the Production of Medicine (Lu 20100140) issued by Shandong Branch of SFDA on January 1, 2011 which allows Tianzheng  to engage in the production of tablets, capsules, and granules.  Such permit expires on December 31, 2015.

 

The Permit for the Production of Medicine and GMP certificates are each valid for a term of five years and must be renewed before their expiration.

 

We obtained a Drug Approval Number for each of our products in 2004. The valid terms of such Drug Approval Numbers have been extended through September 2015.

 

The governmental approval process in China’s newly developed health product is as follows: a product sample is sent to a clinical testing agent designated by the Ministry of Health, which conducts extensive clinical testing and examinations to verify if the product has the specified functions as stated by the company producing the product.  A report will be issued by the clinical testing agent confirming or negating such functions. It generally takes approximately six months to one year for the report to be issued.  This report then has to be submitted to a provincial Health Management Commission for approval. A letter of approval issued by such commission will then be submitted to the Ministry of Health for the issuance of a certificate that authorizes the sales and marketing of the product in China. The whole process generally takes one and a half to two years.

 

Because our subsidiaries WFOE I  and WFOE II are wholly foreign owned enterprises, we are subject to the law on foreign investment enterprises in China, and the foreign company provisions of the Company Law of China, which governs the conduct of our operating subsidiary and its officers and directors. Additionally, we are also subject to varying degrees of regulations and permit system by the Chinese government.

 

Currently we have not developed a market in U.S. so we believe we are not subject to any of regulations by the U.S. Food and Drug Administration.

 

Environment Regulation

 

As of the date of this Annual Report, we believe we are in compliance with the Environmental Protection Law of the PRC, as well as applicable local regulations (including the City of Yantai, where both Bohai and Yantai Tianzheng are located).  In addition to compliance with PRC laws and local regulations, we consistently undertake active efforts to ensure the environmental sustainability of our operations.  Because the manufacturing of herb and plant-based products does not generally cause significant damage or pollution to the environment, the cost of complying with applicable environmental laws is not material.  In the event we fail to comply with applicable laws, we may be subject to penalties.

 

15
 

 

Properties

 

Our corporate headquarters is located at No. 9 Daxin Road, Zhifu District, Yantai, Shandong Province, China. Under the current PRC laws, land is owned by the state, and parcels of land in rural areas which is known as collective land is owned by the rural collective economic organization. “Land use rights” are granted to an individual or entity after payment of a land use right fee is made to the applicable state or rural collective economic organization. Land use rights allow the holder of the right to use the land for a specified long-term period. We have a land use right, expiring in 2047, for a total of approximately 30,637 square meters of land, on which we maintain our manufacturing facility. We currently have not obtained a land use right certificate for a piece of land located in Xingfu Twelve Village of Zhifu District with the area of 11,222 square meters, on which we maintain our corporate headquarters. In the process of the planning of Yantai City, the usage of the aforesaid land use right has been changed from “industrial use” to “commercial use” and therefore, the approval process for the land use right certificates on five relevant parcels of land including the land occupied by us is suspended until the completion of the planning. We cannot assure you that we will eventually obtain the land use right certificate for this land. If we are asked by the local government to relocate our facility, we believe costs associate with relocation and other related expenses will be reimbursed by the local government.

 

On February 22, 2010, we entered into a land-use right purchase agreement with Shandong Yantai Bureau of Land and Resources, pursuant to which we acquired the land use right for a parcel of land totaling 333,335 square meters for RMB 97,500,000 (approximately $14,480,284).  As of March 31, 2011, this purchase price was paid in full.

 

Yantai Tianzheng owns a land use right for a total area of 32,884 square meters at its current headquarters located at 9 Tengen Road, Laishan District, Yantai, China 264003. Its manufacturing facility has a total area of 10,908.83 square meters (approximately 117,422 square feet) that also meets or exceeds the latest GMP.

 

Employees

 

Substantially all of our employees are located in China.  As of the date of this Annual Report, we have approximately 805 employees, including approximately 336 sales representatives, operating from 21 offices throughout China.  There are no collective bargaining contracts covering any of our employees.  We believe our relationship with our employees is satisfactory.

 

 We are required to contribute a portion of our employees’ total salaries to the Chinese government’s social insurance funds, including medical insurance, unemployment insurance and job injuries insurance, and a housing assistance fund, in accordance with relevant regulations.  In the last three years, we contributed approximately $82,586, $113,575, and $$326,117 for the fiscal years ended June 30, 2010, 2011 and 2012, respectively.  We expect the amount of contribution to the government’s social insurance funds to increase in the future as we expand our workforce and operations.

 

January 2010 Share Exchange and Private Placement Transaction

 

We were originally incorporated under the laws of the State of Nevada under the name Link Resources Inc. on January 9, 2008.  Our principal office was in Calgary, Alberta, Canada.  Prior to January 5, 2010, we were a public “shell” company in the exploration stage since our formation and had not yet realized any revenues.  We entered into a Mineral Lease Agreement on April 1, 2008 for two mining claims in Pershing County, Nevada, in an area known as the Goldbanks East Prospect.  We terminated the lease on July 7, 2009.

 

Share Exchange with Chance High

 

Pursuant to the Share Exchange Agreement entered into on January 5, 2010, we acquired Chance High and its indirect controlled subsidiary, Bohai, a Chinese company engaged the production, manufacturing and distribution in China of herbal medicines, including capsules and other products, based on Traditional Chinese Medicine.  On January 5, 2010, pursuant to the terms of the Share Exchange Agreement, we acquired all of the Chance High Shares of Chance High from the Chance High Shareholders, and the Chance High Shareholders transferred and contributed all of their Chance High Shares to us.  In exchange, we issued to Chance High Shareholders an aggregate of 13,162,500 newly issued shares of our common stock.

 

In addition, pursuant to the terms of the Share Exchange Agreement, Zaradic, our former sole officer and director, cancelled a total of 1,500,000 shares of common stock owned by him.  As a further condition of the Share Exchange, effective as of January 5, 2010, Zaradic resigned from all of his positions with our company and Qu, the former principal shareholder and Executive Director of Bohai, was appointed as our President, Chief Executive Officer, Interim Chief Financial Officer, Treasurer and Secretary and also, effective January 16, 2010, as our sole director.  In June 2010, Mr. Qu relinquished the positions of Interim Chief Financial Officer, Treasurer and Secretary and we appointed Gene Hsiao as our Chief Financial Officer.  On July 12, 2010, we appointed three independent directors to our board of directors.

 

Private Placement and Related Agreements

 

Securities Purchase Agreement.  On January 5, 2010, we entered into the Securities Purchase with the Investors and Euro Pacific, as representative of the Investors, relating to a private placement by us of 6,000,000 units consisting of Notes and Warrants.  The consummation of the private placement resulted in gross proceeds to us of $12,000,000 and net proceeds of approximately $9,700,000.  Each unit consisted of a $2.00 principal amount, two year convertible Note and a three year Warrant to purchase one share of our common stock at $2.40 per share, subject to certain conditions.  Euro Pacific acted as the lead placement agent and Chardan Capital Markets, LLC acted as co-placement agent of the private placement.

 

16
 

 

Pursuant to the Securities Purchase Agreement, we have agreed that we shall: 

 

(a)           Within six (6) months of the closing of the private placement, appoint individuals constituting a majority of “independent” directors (as defined under the Nasdaq Marketplace rules) to the our board of directors, with one such director being designated by Euro Pacific, and with at least two of such directors being fluent in English. 

 

(b)           Within six (6) months of the closing of the private placement, enter into a 24 month agreement with a new Chief Financial Officer who is reasonably satisfactory to Euro Pacific and who is proficient in: (i) U.S. generally accepted accounting principals; (ii) transactions similar to the ones contemplated by Securities Purchase Agreement; and (iii) U.S. public company listings and the related filing and compliance requirements.  As of the date of this Annual Report, we have fulfilled this agreement.

 

(c)           Within three (3) months of the closing of the private placement, enter into a 12 month agreement with an investor and public relations firm, the Trilogy Capital Group, and that is reasonably satisfactory to Euro Pacific.  We have fulfilled this agreement when we entered into a one year agreement with Triolgy Capital Partner (which agreement expired at the end of 2010).

 

Registration Rights Agreement.  In connection with the private placement, we entered into the Registration Rights Agreement with the Investors which set forth the rights of the Investors to have the shares of common stock underlying the Notes and Warrants issued in the private placement registered with the SEC for public resale.  We filed such registration statement with the SEC, and such registration statement was declared effective by the SEC on August 12, 2010.

 

Pursuant to the Registration Rights Agreement, we agreed to file a registration statement on Form S-1 (“Registration Statement”) by March 5, 2010 (which agreement was fulfilled) and use our commercially reasonable best efforts to have the Registration Statement declared effective by the SEC within 160 days after the required filing deadline to register 100% of the common stock underlying: (i) the Notes, (ii) the Warrants and the Private Placement Warrants, and (iii) any capital stock of the Company issued or issuable, with respect to the registered shares of common stock as a result of any stock split, stock dividend, recapitalization, exchange or similar event or otherwise, without regard to any limitations on exercises of the Warrants.

 

The Registration Rights Agreement provides that if we fail to file, obtain and maintain effectiveness of Registration Statement due to “filing failure” or “maintenance failure” (each as defined in the Registration Rights Agreement), we shall pay to Investors, distributed pro rata, equal to one percent (1%) of the aggregate purchase price paid for the Notes and Warrants (the “Registration Delay Payments”), provided that in no event shall the aggregate amount of Registration Delay Payments exceed, in the aggregate, six percent (6%) of such aggregate purchase price, or $720,000.

 

Securities Escrow Agreement.  Also in connection with the private placement, we entered into the Securities Escrow Agreement with Euro Pacific, as representative of the Investors, our principal shareholder, Glory Period, and the Escrow Agent.  Pursuant to the Securities Escrow Agreement, Glory Period has pledged and deposited a stock certificate representing 1 million shares of our common stock (the “Escrow Shares”) into escrow in order to provide security to the Investors in the event of an occurrence of an event of default under the Notes.  Upon the earlier to occur of the full repayment of all amounts due to the Investors under the Notes or the conversion of fifty percent of the principal face value of Notes into shares of common stock, the Investors’ rights in and to the Escrow Shares shall terminate.  Glory Period is controlled by Qu through certain contractual relationships described elsewhere in this Annual Report.

 

Closing Escrow Agreement. Pursuant to the Closing Escrow Agreement that we entered into in connection with the private placement on December 10, 2009, we placed a total of $240,000 of proceeds from the private placement (the “Holdback Amount”) with the Escrow Agent.  The Holdback Amount represents an amount sufficient to satisfy the payment to the Investors of one quarterly interest payment due on the aggregate principal amount of all Notes issued in the private placement.  If, subject to certain conditions and after applicable notice and cure periods, an event of default is declared by Euro Pacific with respect to our failure to make a quarterly interest payment to Investors, the Escrow Agent shall disburse such portion of the Holdback Amount to the Investors, and we shall be obligated to deposit additional amounts equal to the Holdback Amount with Escrow Agent.  At such time as seventy-five percent of the aggregate shares of common stock underlying the Notes have been issued upon conversion of the Notes, all remaining funds of the Holdback Amount shall promptly be disbursed to us.

 

Certain Rights of Euro Pacific.  From and after the closing of the private placement, we have agreed with Euro Pacific that if we decide to engage any placement agent, underwriter or investment bank on a fee basis in connection with any private placement of our securities or our affiliates and executive officers (a “Subsequent Offering”) for a period of twelve (12) months from the date of the closing of the private placement, we shall give prompt written notice of such an event to Euro Pacific, and Euro Pacific shall be entitled to a 5 day right of first refusal, beginning on the day Euro Pacific receives such written notice from us of such Subsequent Offering, to act as agent or manager for such private placement.  In addition, Euro Pacific shall be entitled 10.0% of the gross proceeds received by us with respect to any equity or equity-linked financing transactions consummated within twelve (12) months from the closing of the private placement with any investor introduced to is by Euro Pacific.

 

17
 

 

Contractual Arrangements with Bohai and its Shareholders

 

On January 9, 2008, our Company was incorporated under the laws of the State of Nevada under the name Link Resources Inc. On July 2, 2009, we established our wholly owned subsidiary, Chance High International Limited., in Hong Kong. Other than the Company equity interest in Chance High, the Company does not own any assets or conduct any operations. On November 23, 2009, Chance High established one wholly owned subsidiary, YantaiShencaojishi Pharmaceuticals Co., Ltd. (“WFOE” or “Shencaojishi”) in Yantai, Shandong Province of PRC. Other than Shencaojishi, Chance High does not own any assets or conduct any operations. Shencaojishi was formed to operate YantaiBohai Pharmaceuticals Group, Inc. (the “Domestic Company” or “YantaiBohai”) by contract.

 

On December 7, 2009, the WFOE entered into a series of variable interest entity contractual agreements (the “VIE Agreements”) with Bohai and its three shareholders, including Mr. HongweiQu, Jianwei Wang and Lu Liang (the “Bohai Shareholders”).  Pursuant to the VIE Agreements, WFOE effectively assumed management of the business activities of Bohai and has the right to appoint all executives and senior management and the members of the board of directors of Bohai.  The VIE Agreements are comprised of a series of agreements, including a Consulting Services Agreement, Operating Agreement and Proxy Agreement, through which WFOE has the right to advise, consult, manage and operate Bohai for an annual fee in the amount of Bohai’s yearly net profits after tax.  Additionally, Bohai’s Shareholders have pledged their rights, titles and equity interest in Bohai as security for WFOE to collect consulting and services fees provided to Bohai through an Equity Pledge Agreement.  In order to further reinforce WFOE’s rights to control and operate Bohai, Bohai’s Shareholders granted WFOE an exclusive right and option to acquire all of their equity interests in Bohai through an Option Agreement.  Accordingly, we have consolidated Bohai’s historical financial results in our financial statements as a variable interest entity pursuant to U.S. GAAP following the date of the agreements and combined such results prior to the date of the agreements.

 

We have been advised by PRC legal counsel AllBright Law Offices, in an opinion dated December 31, 2009, that: (1) our inner-PRC shareholding structure complies with PRC laws and regulations; (2) the contractual arrangements between the WFOE, Chance High, Bohai and Bohai’s Shareholders are valid and binding on all parties to these arrangements and do not violate relevant PRC laws or regulations; (3) the each of the WFOE and Bohai has the requisite corporate power to own, lease and operate its properties, to enter into contracts and to conduct its business and (4) each of the WFOE and Bohai is qualified to do business in the respective jurisdiction of its establishment.

 

Equity Interest Pledge Agreement. The WFOE and Bohai Shareholders have entered into Equity Interest Pledge Agreements, pursuant to which each Bohai Shareholder has pledged all of his shares of Bohai to the WFOE in order to guarantee cash-flow payments under the applicable Consulting Services Agreement. The Equity Pledge Agreement further entitles the WFOE to collect dividends from Bohai during the term of the pledge.

 

Consulting Service Agreement.Bohai and the WFOE has entered into a Consulting Services Agreement, which provides that the WFOE will be the exclusive provider of technology services to Bohai and Bohai will pay all of its net income based on the quarterly financial statements to the WFOE for such services.  Any such payment from the WFOE to the Company would need to comply with applicable Chinese laws affecting payments from Chinese companies to non-Chinese companies.  See “Risk Factors – Risks Associated With Doing Business in China.”

 

Operating Agreement. Pursuant to the operating agreement among the WFOE, Bohai and each of Bohai Shareholder, the WFOE provides guidance and instructions on Bohai’s daily operations and financial affairs. The Bohai Shareholders must designate the candidates recommended by the WFOE as their representatives on their respective boards of directors. The WFOE has the right to appoint senior executives of Bohai. In addition, the WFOE agrees to guarantee Bohai’s performance under any agreements or arrangements relating to Bohai’s business arrangements with any third party. Bohai, in return, agrees to pledge its accounts receivable and all of its assets to the WFOE. Moreover, Bohai agrees that without the prior consent of the WFOE, Bohai will not engage in any transactions that could materially affect its assets, liabilities, rights or operations, including, without limitation, incurrence or assumption of any indebtedness, sale or purchase of any assets or rights, incurrence of any encumbrance on any of its assets or intellectual property rights in favor of a third party or transfer of any agreements relating to its business operation to any third party.

 

Item 1A. Risk Factors.

 

RISK FACTORS

 

You should carefully consider the risks described below as well as other information provided to you in this Annual Report, including information in the section of this document entitled “Cautionary Note Regarding Forward Looking Statements.”  Our business, operations and financial condition are subject to various significant risks.  Some of these risks are described below and you should take these risks into account in making a decision to invest in our securities.  If any of the following risks actually occurs, we may not be able to conduct our business as currently planned and our business, financial condition or results of operations could be seriously harmed.  In that case, the market price of our common stock could decline and you could lose all or part of your investment in our securities.

 

18
 

 

Risks Related to Our Business

 

Our limited operating history may not serve as an adequate basis to judge our future prospects and results of operations.

 

Our limited operating history in the traditional Chinese herbal medicines industry may not provide a meaningful basis for evaluating our business.  Bohai entered into its current line of business in September 2004 Although Bohai’s revenues have grown rapidly since its inception, we cannot guarantee that we will maintain revenue growth or profitability or that we will not incur net losses in the future.  We will continue to encounter risks and difficulties that companies at a similar stage of development frequently experience, including the potential failure to:

 

  ¨ obtain sufficient working capital to support our expansion;

 

  ¨ maintain or protect our intellectual property;

 

  ¨ maintain our proprietary technology;

 

  ¨ expand our product offerings and maintain the quality of our products;

 

  ¨ manage our expanding operations and continue to fill customers’ orders on time;

 

  ¨ maintain adequate control of our expenses allowing us to realize anticipated revenue growth;

 

  ¨ implement our product development, marketing, sales and acquisition strategies and adapt and modify them as needed;

 

  ¨ integrate any future acquisitions; and

 

  ¨ anticipate and adapt to changing conditions in the Chinese herbal medicines industry resulting from changes in government regulations, mergers and acquisitions involving our competitors, technological developments and other significant competitive and market dynamics.

 

If we are unable to address any or all of the foregoing risks, our business may be materially and adversely affected.

 

We will likely need to raise additional funds in the future to pay or debts and grow our business, which funds may not be available on acceptable terms or at all.

 

We believe that our cash on hand, together with cash generated from our operations, will be sufficient to fund our projected operations for at least the next 12 months.  It is likely however that in the future we will require substantial funds in order to:

 

  ¨ pay down the principal and interest on our convertible notes, as amended, which are due October 5, 2012, the principal amount of which is $9,405,000 as of the date of this Annual Report;

 

  ¨ fund our remaining obligations under our Yantai Tianzheng acquisition, which amounts to $25,300,000as of the date of this Annual Report;

 

19
 

 

  ¨ fund ongoing operating expenses;

 

  ¨ fund our plans to continue the development of our  manufacturing, marketing and sales capabilities; and

 

  ¨ consider and fund strategic acquisitions in the fragmented TCM market in China; and

 

  ¨ cover public company costs.

 

Without enough funds, we may not be able to meet these goals.  We may seek additional funding through public or private financing or through collaborative arrangements with strategic partners. However, as with many Chinese companies and given difficult market conditions generally, we have found it difficult to raise outside funding.

 

You should also be aware that in the future:

 

  ¨ We cannot be certain that additional capital will be available on favorable terms, if at all;

 

  ¨ Any available additional financing may not be adequate to meet our goals; and

 

  ¨ Any equity financing would result in dilution to our shareholders.

 

If we cannot raise additional funds when needed, or on acceptable terms, we may not be able to effectively execute our growth strategy, take advantage of future opportunities, or respond to competitive pressures or unanticipated requirements.  In addition, we may be required to scale back or discontinue our production and development program, or obtain funds through strategic alliances that may require us to relinquish certain rights.

 

We have significant payments that we are required to make in connection with our acquisition of Yantai Tianzheng.

 

On August 8, 2011, through WFOE II, our wholly owned subsidiary and a company formed under the laws of China, we entered into a Share Purchase Agreement (the “SPA”) pursuant to which WFOE II acquired, from the three individual holders thereof, one hundred percent (100%) of the outstanding equity interests (the “Shares”) in Yantai Tianzheng.

 

Pursuant to the SPA, the purchase price to be paid by WFOE II for the Shares is $35,000,000 in the aggregate.  Pursuant to the SPA, the purchase price is payable in cash in four installments within 18 months after the execution of the SPA.  As of the date of this Annual Report, we have paid the initial installment of $6,000,000.  The remaining three installments will be due within 6 months, 12 months, and 18 months after the execution of the SPA in the amount of $12 million, $12 million, and $5 million, respectively. In the event that YantanNirui fails to pay any of the installments when due (such date, the “Conversion Date”), such outstanding installment will be automatically converted into a two-year term loan owed by WFOE II to the Shareholders (a “Conversion Loan”), with interest accruing on any unpaid portion of such Conversion Loan from its due date until such installment is paid in full at the rate of six percent (6%) per annum.  As long as such interest payments are made on a timely basis and the outstanding principal of such Conversion Loan and interest are satisfied in full within 2 years after the Conversion Date, WFOE II will not be deemed in breach or default under the SPA and will continue to possess full control and legal ownership over the Shares.  Furthermore, in the event of non-payment by WFOE II of any principal or interest under the loans as described above, or in the event of any other breach or default by WFOE II of the SPA, the Tianzheng Shareholders remedies against Yantai Nirui are limited solely to monetary damages, and in all instances the Shareholders will have no right to reclaim ownership of the Shares or demand that WFOE II in any way revert control or legal ownership over the Shares back to the Shareholders. As of the date of this Annual Report, we have paid $9,700,000 of the purchase price, and portion of the second installment and the third installment in the aggregate amount of $20,300,000 was converted into Conversion Loans due on February 8, 2014 and August 8, 2014, respectively. The last installment of $5 million is currently outstanding and due on February 8, 2013.

 

We currently believe that we will generate sufficient cash flow from operations and have access to the capital funding (either through debt or equity issuances) necessary to meet our payment requirements under the SPA and the Conversion Loan.  However, there is a significant risk that we may not generate sufficient cash flow from operations or otherwise have access to financing on favorable terms, or at all. Failure to make the last installment payment and the Conversion Loan payments when due would result in an event of default with respect to such obligations and could result in substantial monetary damages and would likely materially disrupt our Yantai Tianzheng business, which could cause a material deterioration in our financial condition or operating results.

 

We have significant payment obligations under the Notes due October 5, 2012, and we continue to face difficulties in converting our cash on hand from RMB to US Dollars in order to make payment under the Notes. Any non-payment of the Notes when due in the absence of an extension of the maturity date would constitute event of default under the Notes, and our financial condition may be adversely affected.

 

As of the date of this Report, we have outstanding Notes in the aggregate amount of approximately $9,405,000, all of which are due October 5, 2012.  We had previously established an RMB denominated escrow account in China and deposited into such escrow account the remaining outstanding amount of the Notes. As of the date of this Report, the escrow account remains in place and we continue to work on converting RMB to Dollars in order to make payments under the Notes.  However, we expect that we will not be able to accomplish this by October 5, 2012, the conclusion date of the Second Extended Period, and we expect to enter into an amendment to the Note to further extend its maturity date. We will continue to work with Euro Pacific on this matter and will continue our efforts in order to meet our obligations to the Note holders. However, there is no assurance that an amendment will be entered into before the due date, and any non-payment of the Notes when due would constitute an event of default under the Notes. In such event, we might be subject to, among other things, non-payment claims of the Noteholders, and our financial condition may be adversely affected.

 

20
 

 

We have not yet developed comprehensive independent corporate governance.

 

Although we have formed audit, compensation, or nominating committees of our board of directors, we are inexperienced in formal U.S. corporate governance procedures.  A lack of functioning independent controls over our corporate affairs may result in potential or actual conflicts of interest between Mr. Qu and our shareholders.  We presently have no policy to resolve such conflicts.  The absence of customary standards of corporate governance may leave our shareholders without protections against interested director transactions, conflicts of interest, if any, and similar matters and any potential investors may be reluctant to provide us with funds necessary to expand our operations.

 

We have been heavily dependent on sales of certain key products.

 

Five of the Company’s products, namely Tongbi Capsules, Tongbi Tablets, Lung Nourishing Syrup, Zhengxintai Capsules and Fangfengtongsheng Tablets represented approximately 22.8%, 9.1%, 16.6%, 10.6% and 18.3%, respectively, of total sales as of June 30, 2012. We expect that a significant portion of our future revenue will continue to be derived from sales of these four products.  If one or more of these products were to become subject to a problem such as loss of Certificates of Protected Variety of Traditional Chinese Medicine, unexpected side effects, regulatory proceedings, publicity adversely affecting user confidence or pressure from competing products, or if a new, more effective treatment should be introduced, the negative impact on our revenues could be significant.  We held the Certificates of Protected Variety of Traditional Chinese Medicine (Grade Two) issued by State Food and Drug Administration of China (“SFDA”) for Tongbi Capsules and Shangtongning Tablets which gave exclusive or near-exclusive rights to manufacture and distribute these two medicines.  These certificates expired in September 2009, and the SFDA approved our request to extend the protection period for Tongbi Capsules to September 13, 2016. Fangfengtongsheng granule is in the process of applying for protection status and its application for protected status was received by SFDA on June 30, 2010. Zhengxintai renewed its protected status in January 2012 and will expire on August 9, 2017. We cannot assure you that we will be granted or will be able to renew the Certificate of Protected Variety of Traditional Chinese Medicine in the future and our failure to obtain such protection, or the loss of such protection, will have a material adverse effect on our revenues.  If we are unable to obtain or maintain such approvals, these products can be manufactured and sold by other pharmaceutical manufacturers in China once the relevant protection periods lapse, which would increase our competition and potentially have an adverse effect on our sales.

 

We may not be able to adequately protect our intellectual property, which could cause us to be less competitive and negatively impact our business.

 

We regard our trademarks, trade secrets, patents and similar intellectual property as critical to our success.  We hold the trademark “Xian Ge” registered with the PRC Trademark Bureau under the State Administration for Industry and Commerce with a valid term effective through February 23, 2013.  We have received a patent in the PRC for Lung Nourishing Syrup with its production method for the treatment of Lung-qi Deficiency Cough and Chronic Bronchitis.  If we are unable to obtain or maintain registered intellectual property protections for our proprietary products or methods, these products or methods could be infringed upon, which could materially adversely affect our business.

 

We rely on trademark, patent and trade secret law, as well as confidentiality agreement with certain of our employees to protect our proprietary rights.  For senior managers, we include a standard confidentiality clause into the employment agreement to prevent them from disclosing the formula or processing procedure to outside parties. No assurance can be given that our intellectual property will not be challenged, invalidated, infringed or circumvented, or that our intellectual property rights will provide competitive advantages to us.  Any material impairment of our intellectual property rights could have a material adverse effect on our business.

 

The availability of counterfeit versions of our products could adversely affect our sales volume, revenue and profitability and brand value.

 

The availability of sales of counterfeits of our products in China could adversely impact our sales and potentially damage the value and reputation of our brands.  For example, we discovered evidence of a counterfeit Tongbi Capsule sold in China which we believe infringes on our intellectual property rights in 2010. We have addressed this situation with applicable PRC authorities and do not believe it will adversely affect our company, but similar situations may arise in the future which could adversely impact our sales, profitability and brand value.  We are in the process of applying a patent for Tongbi Capsule, but no assurances can be given that such patent will be granted.  Additionally, consumers who mistake counterfeit Tongbi Capsules or counterfeits of our other products for our products may attribute quality and efficacy deficiencies in the counterfeit product to our brands and discontinue purchasing our brands, which would have an adverse effect on our sales and profitability.

 

21
 

 

We face competition in the pharmaceutical market in the PRC and such competition could cause our sales revenue and profits to decline.

 

According to SFDA in China, there were approximately 5,071 pharmaceutical manufacturing companies in the PRC as of the end of June 2004, of which approximately 3,237 manufacturers obtained certificates of Good Manufacturing Practices Certification (“GMP”).  After GMP certification became a mandatory requirement on July 1, 2004, approximately 1,834 pharmaceutical manufacturers were forced to cease production.  Only the 3,237 pharmaceutical manufacturers with GMP certifications may continue their manufacturing operations.  As of the end of 2010, there were 19,000 enterprises manufacturing medicines and formulation in China.  The certificates, permits, and licenses required for pharmaceutical operation in the PRC create a potentially significant barrier for new competitors seeking entrance into the market.  Despite these obstacles, we face competitors that will attempt to create, or are already marketing, products in the PRC that are similar to ours.  Many of our current and potential competitors have significantly longer operating histories and significantly greater managerial, financial, marketing, technical and other competitive resources, as well as greater name recognition, than we do.  These competitors may be able to respond more quickly to new or changing opportunities and customer requirements and may be able to undertake more extensive promotional activities, offer more attractive terms to customers or adopt more aggressive pricing policies.  We cannot assure you that we will be able to compete effectively with current or future competitors or that the competitive pressures we face will not harm our business.

 

Our business depends and will depend substantially on the continuing efforts of our present and future executive officers, and our business may be severely disrupted if we lose, are unable to obtain or unable to replace their services.

 

Our future prospects depend substantially on the continued services of our President, Chief Executive Officer, and Chairman of the Board, Mr. Qu.  We have no employment agreement with Mr. Qu and do not maintain key man life insurance on Mr. Qu’s life.  We also have other corporate officers and key employees, and if Mr. Qu or one or more of our future executive officers or key employees are unable or unwilling to continue in their positions, we may not be able to replace them readily, if at all.  Therefore, our business may be severely disrupted, and we may incur additional expenses to recruit and retain new officers.  In addition, if any of our executives joins a competitor or forms a competing company, we may lose some of our customers.

 

Our business and growth will suffer if we are unable to hire and retain key personnel that are in high demand.

 

Our future performance depends on our ability to attract and retain highly skilled chemists, pharmaceutical engineers, technical, marketing and sales personnel, especially qualified personnel for our operations in China.  Qualified individuals are in high demand in China, and there are insufficient experienced personnel to fill the demand.  Therefore, we may not be able to attract or retain the personnel we need to succeed.  Our business development would be hindered if we lost the services of some key personnel.

 

Our business is highly dependent on continually developing or acquiring new and advanced products, technologies, and processes and failure to do so may cause us to lose our competitiveness in the pharmaceutical industry and may cause our profits to decline.

 

To remain competitive in the pharmaceutical industry, it is important to continually develop new and advanced products, technologies and processes.  There is no assurance that our competitors’ new products, technologies and processes will not render our company’s existing products obsolete or non-competitive.  Our company’s competitiveness in the pharmaceutical market therefore relies upon our ability to enhance our current products, introduce new products, and develop and implement new technologies and processes.  Our company’s failure to technologically evolve and/or develop new or enhanced products may cause us to lose our competitiveness in the pharmaceutical industry and may cause our profits to decline.  It is likely that our efforts to grow our products lines will be focused on acquisitions of such products from third parties.  There are many risks attendant to the acquisition of assets or companies, including availability, pricing, competition and, if acquisitions are consummate, integration.  If we are unable to so acquire and integrate new products, our revenue and profitability may suffer.

 

Our research and development may be costly and/or untimely, and there are no assurances that our research and development will either be successful or completed within the anticipated timeframe, if ever at all.

 

We do not presently rely on research and development activities as our business is focused on expanding sales of our existing products.  However, in the future, the research and development of new products may play an important role for our company.  Development of new products requires significant research, development and clinical testing efforts, and we currently have limited resources to devote to and limited capabilities to conduct the development of new products.  We have only one full-time employee who is engaged in research and development, so we mainly dependent on a third-party, Yantai Tianzheng Medicine Research and Development Co., Ltd., to perform the limited amount of research and development that we undertake.  If research and development activities become more important for us, and if we or third parties that we retain are unable to perform research and development successfully, our business and results of operations could be negatively impacted. There was no research and development expenses occurred for the year ended of June 30, 2012.

 

22
 

 

The commercial performance of our products depends upon the degree of market acceptance among the medical community and failure to attain market acceptance among the medical community may have an adverse impact on our operations and profitability.

 

The commercial performance of our products depends upon the degree of market acceptance among the medical community, such as hospitals and physicians.  Even if our products are approved by SFDA, and even if our products are eligible for reimbursement under Chinese national medical insurance programs, there is no assurance that physicians will prescribe or recommend our products to patients.  Furthermore, a product’s prevalence and use at hospitals may be contingent upon our relationship with the medical community.  The acceptance of our products among the medical community may depend upon several factors, including but not limited to, the product’s acceptance by physicians and patients as a safe and effective treatment, cost effectiveness, potential advantages over alternative treatments, and the prevalence and severity of side effects.  Failure to attain market acceptance among the medical community may have an adverse impact on our operations and profitability.

 

We may not be able to obtain the regulatory approvals or clearances that are necessary to commercialize our products.

 

The PRC and other countries impose significant statutory and regulatory obligations upon the manufacture and sale of pharmaceutical products.  Each regulatory authority typically has a lengthy approval process in which it examines pre-clinical and clinical data and the facilities in which the product is manufactured.  Regulatory submissions must meet complex criteria to demonstrate the safety and efficacy of the ultimate products. Addressing these criteria requires considerable data collection, verification and analysis. We may spend time and money preparing regulatory submissions or applications without assurances as to whether they will be approved on a timely basis or at all.

 

Our product candidates, some of which are currently in the early stages of development, will require significant additional development and pre-clinical and clinical testing prior to their commercialization. These steps and the process of obtaining required approvals and clearances can be costly and time-consuming. If our potential products are not successfully developed, cannot be proven to be safe and effective through clinical trials, or do not receive applicable regulatory approvals and clearances, or if there are delays in the process:

 

  ¨ the commercialization of our products could be adversely affected;

 

  ¨ any competitive advantages of the products could be diminished; and

 

  ¨ revenue or collaborative milestones from the products could be reduced or delayed.

 

Governmental and regulatory authorities may approve a product candidate for fewer indications or narrower circumstances than requested or may condition approval on the performance of post-marketing studies for a product candidate. Even if a product receives regulatory approval and clearance, it may later exhibit adverse side effects that limit or prevent its widespread use or that would force us to withdraw the product from the market.

 

Any marketed product and its manufacturer will continue to be subject to strict regulation after approval. Results of post-marketing programs may limit or expand the further marketing of products. Unforeseen problems with an approved product or any violation of regulations could result in restrictions on the product, including its withdrawal from the market and possible civil actions.

 

In manufacturing our products we will be required to comply with applicable good manufacturing practices regulations, which include requirements relating to quality control and quality assurance, as well as the maintenance of records and documentation. If we cannot comply with regulatory requirements, including applicable good manufacturing practice requirements, we may not be allowed to develop or market the product candidates. If we or our manufacturers fail to comply with applicable regulatory requirements at any stage during the regulatory process, we may be subject to sanctions, including fines, product recalls or seizures, injunctions, refusal of regulatory agencies to review pending market approval applications or supplements to approve applications, total or partial suspension of production, civil penalties, withdrawals of previously approved marketing applications and criminal prosecution.

 

Our current and future products may have inadvertent and/or harmful side effects which would expose us to the risks of litigation and a loss of revenue.

 

All medicines have certain side effects.  Although all of our medicines sold on market have passed proper testing and are approved by SFDA, the products may still inadvertently adverse effects on the health of the consumers. If such side effect is identified after marketing and sale of the products, the products may be required to be withdrawn from the market, or have a change in labeling. If a product liability claim is brought against us, it may, regardless of merit or eventual outcome, result in damage to our reputation, breach of contracts with consumers, decreased demand for our products, costly litigation and loss of revenue.

 

23
 

 

Natural disasters, weather conditions and other environmental factors affect our raw material supply, and a reduction in the quality or quantity of our herb supplies may have material adverse consequences on our financial results.

 

Our business may be adversely affected by weather and environmental factors beyond our control, such as natural disasters and adverse weather conditions.  The production of our products depends on the availability of raw materials, a significant portion of which are herbs.  These herbs tend to be very sensitive crops, which can be readily damaged by harsh weather, by disease, and by pests.  If our suppliers’ crops are destroyed by drought, flood, storm, blight, or the other woes of farming, we will not be able to meet the demands of our customers, which will have a material adverse effect on our business and financial condition and results.  

 

Our certificates, permits, and license are subject to governmental control and renewal, and the failure to obtain renewal would cause all or part of our operation to be suspended and have a material adverse effect on our financial condition.

 

We are subject to various PRC laws and regulations pertaining to the pharmaceutical industry.  We have obtained certain certificates, permits, and licenses required for the operation of a pharmaceutical enterprise and the manufacturing and distribution of pharmaceutical products in the PRC.  Some of the permits and license have expired or are about to expire.  We hold a Permit for the Production of Medicine (Lu Zb20050330) issued by Shandong Branch of SFDA on January 1, 2006 which allows us to engage in the production of tablets, capsules, granules, syrup, concentrated decoctions, tincture (for oral use) and medical wine.  Such permit, as renewed, expires on December 31, 2015.  We also hold a GMP Certificate (No. Lu K0587) issued by Shandong Branch of SFDA on June 18, 2009, the scope of inspection of which is tablets, capsules, granules, syrup, concentrated decoctions, tincture and medical wine.  Such certificate expires on June, 17, 2014.  The Permit for the Production of Medicine and GMP certificates are each valid for a term of five years and must be renewed before their expiration.  We hold a Drug Approval Number (“DAN”) for each of our products.  Our license to produce medical wine, as renewed, has a term valid through December 31, 2015.

 

During the application or renewal process for our licenses and permits, we will be evaluated and re-evaluated by the appropriate governmental authorities and must comply with the prevailing standards and regulations, which may change from time to time.  In the event that we are not able to obtain or renew the certificates, permits and licenses, all or part of our operations may be suspended by the government, which would have a material adverse effect on our business and financial condition.  Furthermore, if escalating compliance costs associated with governmental standards and regulations restrict or prohibit any part of our operations, it may adversely affect our results of operations and profitability.

 

We held the Certificates of Protected Variety of Traditional Chinese Medicine (Grade Two) (the “Certificate of Protection”) issued by SFDA for two of our products, Tongbi Capsules and Shangtongning Tablets. The protection periods for both Tongbi Capsules and Shangtongning Tablets expired in September 2009.  We submitted application to extend the protection period for Tongbi Capsules to extend such protection period on March 12, 2009 and such protection period was extended till September 13, 2016.  We have decided not to submit extension application of Shangtongning Tablets, because the SFDA will not approve a Certificate of Protection for Shangtongning Tablets or any other products that are currently produced by more than three manufacturers in China according to applicable Chinese SFDA regulations.  Fangfengtongsheng granule is in the process of applying for protection status and its application for protected status was received by SFDA on June 30, 2010. Zhengxintai capsule renewed its protected status in January 2012 and will expire on August 9, 2017. The loss of the Certificate of Protection for our product Shangtongning Tablets, may grant other manufactures the right to produce similar products, which would result in the loss of competitive advantage and could adversely impact our sales results.

 

Our failure to fully comply with PRC labor laws, including laws relating to social insurance, may expose us to potential liability and increased costs.

 

Companies operating in China must comply with a variety of labor laws, including certain pension, health insurance, unemployment insurance and other welfare-oriented payment obligations.  Our failure to comply with these laws could have a material adverse effect on our business.  For example, we are currently paying social insurance for our 289 full-time employees.  We also currently have approximately 336 sales representatives that we believe we are not required to pay social insurance for as these sales representatives are not legally employees of ours, but are rather independent contractors. We have not paid social insurance for 516 of our full-time employees whose personal identification files cannot be transferred to us since they are not registered residents in Yantai, Shandong Province, and as an alternative we have paid these employees compensation included in their monthly salary with an amount equals to the amount of monthly social insurance that we are required to pay and the employees could pay the social insurance by themselves.  We believe these employees have been covered by social insurance and we are not required to make any contributions to the government in addition to the amount we have paid to these employees.  However, our interpretation of these requirements may be wrong, and the PRC regulatory authorities may not take the same view as we do on this subject.  If the PRC regulatory authorities take the view that we are required to pay social insurance for our independent contractors or other employees, our failure to make previous payments may be in violation of applicable PRC labor laws and we cannot assure you that PRC governmental authorities will not impose penalties on us for failure to comply.  In addition, in the event that any current or former employee files a complaint with the PRC government, we may be subject to making up the social insurance payment obligations as well as paying administrative fines.  The total cost of these payments and any related fines or penalties could be very significant and could have a material adverse effect on our working capital.

 

24
 

 

In addition, the new PRC Labor Contract Law took effect January 1, 2008 and governs standard terms and conditions for employment, including termination and lay-off rights, contract requirements, compensation levels and consultation with labor unions, among other topics.  In addition, the law limits non-competition agreements with senior management and other employees who have access to confidential information to two years and imposes restrictions or geographical limits.  This new labor contract law will increase our labor costs, which could adversely impact our results of operations.

 

We are subject to PRC government price control of drugs which may limit our profitability and even cause us to stop manufacturing certain products.

 

The State Development and Reform Commission of the PRC (“SDRC”) and the price administration bureaus of the relevant provinces of the PRC in which the pharmaceutical products are manufactured are responsible for the retail price control over our pharmaceutical products.  The SDRC sets the price ceilings for certain pharmaceutical products in the PRC. All of our products except those under the protection periods are subject to such price controls as of the date of this Annual Report and we prices our medicines well under government-mandated caps. There is no assurance that whether our other products will remain unaffected by the price control.  Where our products are subject to a price ceiling, we will need to adjust the product price to meet the requirement and to accommodate for the pricing of competitors in the competition for market shares.  The price ceilings set by the SDRC may limit our profitability, and in some instances, such as where the price ceiling is below production costs, may cause us to stop manufacturing certain products which may adversely affect our results of operations.

 

Because we may not be able to obtain business insurance in the PRC, we may not be protected from risks that are customarily covered by insurance in the United States.

 

Business insurance is not readily available in the PRC.  To the extent that we suffer a loss of a type which would normally be covered by insurance in the United States, such as product liability and general liability insurance, we would incur significant expenses in both defending any action and in paying any claims that result from a settlement or judgment.  We have not obtained fire, casualty and theft insurance, and there is no insurance coverage for our raw materials, goods and merchandise, furniture and buildings in China.  Any losses incurred by us will have to be borne by us without any assistance, and we may not have sufficient capital to cover material damage to, or the loss of, our production facility due to fire, severe weather, flood or other cause, and such damage or loss would have a material adverse effect on our financial condition, business and prospects.

 

We may be subject to product liability claims, for which we have no insurance.

 

We may produce products which inadvertently have an adverse pharmaceutical effect on the health of individuals.  Existing laws and regulations in China do not require us to maintain third party liability insurance to cover product liability claims.  However, if a product liability claim is brought against us, it may, regardless of merit or eventual outcome, result in damage to our reputation, breach of contracts with our customers, decreased demand for our products, costly litigations, product recalls, loss of revenue, and our inability to commercialize some products.

 

Our indemnification obligations could adversely affect our business, financial condition and results of operations.

 

Our governing documents require us to indemnify our current and former directors, officers, employees and agents against most actions of a civil, criminal, administrative or investigative nature.  Generally, we are required to advance indemnification expenses prior to any final adjudication of an individual’s culpability.  The expense of indemnifying our current and former directors, officers and employees and agents in their defense or related expenses as a result of any actions related to the internal investigation and financial restatement may be significant and in excess of any insurance coverage we may have.  As such, there is a risk that our indemnification obligations could divert needed financial resources and may adversely affect our business, financial condition and results of operations.

 

 Potential environmental liability could have a material adverse effect on our operations and financial condition.

 

As a manufacturer, we are subject to various Chinese environmental laws and regulations on air emission, waste water discharge, solid wastes and noise.  We are in the process of applying for Pollution Discharge Permit, other than that we believe that our operations are in substantial compliance with current environmental laws and regulations. We cannot assure you that we may not be able to comply with these regulations at all times as the Chinese environmental legal regime is evolving and becoming more stringent.  Therefore, if the Chinese government imposes more stringent regulations in future, we may have to incur additional and potentially substantial costs and expenses in order to comply with new regulations, which may negatively affect our results of operations.  Furthermore, no assurance can be given that all potential environmental liabilities have been identified or properly quantified or that any prior owner, operator, or tenant has not created an environmental condition unknown to us.  If we fail to comply with any of the present or future environmental regulations in any material aspects, we may suffer from negative publicity and be subject to claims for damages that may require us to pay substantial fines or have our operations suspended or even be forced to cease operations.

 

25
 

 

Risks Relating to the Our Corporate Structure

 

Our corporate structure, in particular the VIE Agreements, are subject to significant risks, as set forth in the following risk factors.

 

The PRC government may determine that the VIE Agreements which we utilize to control our operating subsidiary Bohai are not in compliance with applicable PRC laws, rules and regulations and that they are therefore unenforceable.

 

In the PRC it is widely understood that foreign invested enterprises are forbidden or restricted to engage in certain businesses or industries which are sensitive to the economy.  As we intend to centralize our management and operation in the PRC without being restricted to conduct certain business activities which are important for our current or future business but are restricted or might be restricted in the future, we believe our VIE Agreements will be essential for our business operation.  In order for WFOE to manage and operate our business through Bohai in the PRC, the VIE Agreements were entered into under which almost all the business activities of Bohai are managed and operated by WFOE and almost all economic benefits and risks arising from the business of Bohai are transferred to WFOE.

 

There are risks involved with the operation of Bohai under the VIE Agreements.  We have been advised by PRC legal counsel that if the PRC government determines the VIE Agreement used to control the operating company to be unenforceable as they circumvent the PRC restrictions relating to foreign investment restrictions, the relevant regulatory authorities would have broad discretion in dealing with such breach, including:

 

  ¨ imposing economic penalties;

 

  ¨ discontinuing or restricting the operations of WFOE or Bohai;

 

  ¨ imposing conditions or requirements in respect of the VIE Agreements with which WFOE may not be able to comply;

 

  ¨ requiring us to restructure the relevant ownership structure or operations;

 

  ¨ taking other regulatory or enforcement actions that could adversely affect our business; and

 

  ¨ revoking the business license and/or the licenses or certificates of WFOE, and/or voiding the VIE Agreements.

 

Any of these actions could have a material adverse impact on our business, financial condition and results of operations.

 

We depend upon the VIE Agreements in conducting our production, manufacturing and distribution of traditional Chinese herbal medicines in the PRC, which may not be as effective as direct ownership.

 

We conduct our production, manufacturing and distribution of traditional Chinese herbal medicines in the PRC and generate the revenues from our Bohai business through the VIE Agreements.  The VIE Agreements may not be as effective in providing us with control over Bohai as direct ownership.  The VIE Agreements are governed by PRC laws and provide for the resolution of disputes through arbitration proceedings pursuant to PRC laws.  Accordingly, the VIE Agreements will be interpreted in accordance with PRC laws.  If Bohai or its Shareholders fail to perform the obligations under the VIE Agreements, we may have to rely on legal remedies under PRC laws, including seeking specific performance or injunctive relief, and claiming damages, and there is a risk that we may be unable to obtain these remedies.  The legal environment in China is not as developed as in other jurisdictions.  As a result, uncertainties in the PRC legal system could limit our ability to enforce the VIE Agreements.

 

 The pricing arrangement under the VIE Agreements may be challenged by the PRC tax authorities.

 

We could face adverse tax consequences if the PRC tax authorities determine that the VIE Agreements were not entered into based on arm’s length negotiations.  If the PRC tax authorities determine that the VIE Agreements were not entered into on an arm’s length basis, they may adjust the income and expenses of our company for PRC tax purposes which could result in higher tax liability.

 

26
 

 

We rely on the approval certificates and business license held by Bohai and any deterioration of the relationship between WFOE and Bohai could materially and adversely affect the overall business operation of our company.

 

Pursuant to the VIE Agreements, our production, manufacturing and distribution of traditional Chinese herbal medicines in China is undertaken on the basis of the approvals, certificates and business license as well as other requisite licenses held by Bohai.  There is no assurance that Bohai will be able to renew its licenses or certificates when their terms expire with substantially similar terms as the ones they currently hold.

 

Further, our relationship with Bohai is governed by the VIE Agreements, which are intended to provide us, through our indirect ownership of WFOE, with effective control over the business operations of Bohai.  However, the VIE Agreements may not be effective in providing control over the applications for and maintenance of the licenses required for our business operations.  Bohai could violate the VIE Agreements, go bankrupt, suffer from difficulties in its business or otherwise become unable to perform its obligations under the VIE Agreements and, as a result, our operations, reputation, business and stock price could be severely harmed.

 

If WFOE exercises the purchase options over Bohai’s equity pursuant to the VIE Agreements, the payment of purchase prices could materially and adversely affect the financial position of our company.

 

Under the VIE Agreements, WFOE holds an option to purchase all or a portion of the equity of Bohai at a price, pro rata in case of not all, based on the capital paid in by the Bohai Shareholders (namely, $2.94 million or RMB 20 million ).  In the case that applicable PRC laws and regulations require an appraisal of the equity interest or provide other restriction on the purchase price, the purchase price shall be the lowest price permitted under the applicable PRC laws and regulations. As Bohai is already a contractually controlled affiliate to our company, WFOE’s purchase of Bohai’s equity would not bring immediate benefits to our company and the exercise of the option and payment of the purchase prices could adversely affect the financial position of our company.

 

Risks Associated With Doing Business in China

 

There are substantial risks associated with doing business in China, some of which are addressed in the following risk factors.

 

The Chinese government exerts substantial influence over the manner in which we must conduct our business activities.

 

We are dependent on our relationship with the local government in the province in which we operate our business.  The Chinese government has exercised and continues to exercise substantial control over virtually every sector of the Chinese economy through regulation and state ownership.  Our ability to operate in China may be harmed by changes in its laws and regulations, including those relating to the “protected” status of our products, the coverage of national health insurance for our products, taxation, environmental regulations, land use rights, property and other matters.  The central or local governments of in the PRC jurisdictions may impose new, stricter regulations or interpretations of existing regulations that would require additional expenditures and efforts on our part to ensure our compliance with such regulations or interpretations.  Accordingly, government actions in the future, including any decision not to continue to support recent economic reforms and to return to a more centrally planned economy or regional or local variations in the implementation of economic policies, could have a significant effect on economic conditions in China or particular regions thereof, and could require us to divest ourselves of any interest we then hold in Chinese properties.

 

Future inflation in China may inhibit our ability to conduct business in China. In recent years, the Chinese economy has experienced periods of rapid expansion and high rates of inflation.  Rapid economic growth can lead to growth in the money supply and rising inflation.  If prices for our products rise at a rate that is insufficient to compensate for the rise in the costs of supplies, it may have an adverse effect on profitability.  These factors have led to the adoption by Chinese government, from time to time, of various corrective measures designed to restrict the availability of credit or regulate growth and contain inflation.  High inflation may in the future cause Chinese government to impose controls on credit and/or prices, or to take other action, which could inhibit economic activity in China, and thereby harm the market for our products.

 

Our operations and assets in China are subject to significant political and economic uncertainties and we may lose all of our assets and operations if the Chinese government alters its policies to further restrict foreign participation in business operating in the PRC.

 

Changes in PRC laws and regulations, or their interpretation, or the imposition of confiscatory taxation, restrictions on currency conversion, imports and sources of supply, devaluations of currency or the nationalization or other expropriation of private enterprises could have a material adverse effect on our business, results of operations and financial condition.  Under its current leadership, the Chinese government has been pursuing economic reform policies that encourage private economic activities and greater economic decentralization.  There is no assurance, however, that the Chinese government will continue to pursue these policies, or that it will not significantly alter these policies from time to time without notice.  We may lose all of our assets and operations if the Chinese government alters its policies to further restrict foreign participation in business operating in the PRC.

 

27
 

 

We derive all of our sales in China and a slowdown or other adverse developments in the PRC economy may materially and adversely affect our customers, demand for our products and our business.

 

All of our sales are generated in China.  We anticipate that sales of our products in China will continue to represent all of our total sales in the near future.  Although the PRC economy has grown significantly in recent years, we cannot assure you that such growth will continue.  The industry which we are involved in the PRC is relatively new and growing, but we do not know how sensitive we are to a slowdown in economic growth or other adverse changes in the PRC economy which may affect demand for our products.  In addition, the Chinese government also exercises significant control over Chinese economic growth through the allocation of resources, controlling payment of foreign currency-denominated obligations, setting monetary policy and providing preferential treatment to particular industries or companies.  Efforts by the Chinese government to slow the pace of growth of the Chinese economy could result in reduced demand for our products.  A slowdown in overall economic growth, an economic downturn or recession or other adverse economic developments in the PRC may materially reduce the demand for our products and materially and adversely affect our business.

 

Currency fluctuations and restrictions on currency exchange may adversely affect our business, including limiting our ability to convert Chinese Renminbi into foreign currencies and, if Chinese Renminbi were to decline in value, reducing our revenue in U.S. dollar terms.

 

Our reporting currency is the U.S. dollar and our operations in China use their local currency as their functional currencies.  Substantially all of our revenue and expenses are in the Chinese currency, the Renminbi.  We are subject to the effects of exchange rate fluctuations with respect to any of these currencies.  For example, the value of the Renminbi depends to a large extent on Chinese government policies and China’s domestic and international economic and political developments, as well as supply and demand in the local market.  Since 1994, the official exchange rate for the conversion of the Renminbi to the U.S. dollar had generally been stable and the Renminbi had appreciated slightly against the U.S. dollar.  In July 2005, the Chinese government changed its policy of pegging the value of the Renminbi to the U.S. dollar.  Under this policy, which was halted in 2008 due to the worldwide financial crisis, the Renminbi was permitted to fluctuate within a narrow and managed band against a basket of certain foreign currencies.  In June 2010, the Chinese government announced its intention to again allow the Renminbi to fluctuate within the 2005 parameters.  It is possible that the Chinese government could adopt an even more flexible currency policy, which could result in more significant fluctuation of Renminbi against the U.S. dollar, or it could adopt a more restrictive policy.  We can offer no assurance that the Renminbi will be stable against the U.S. dollar or any other foreign currency.  

 

Our financial statements are translated into U.S. dollars at the average exchange rates in each applicable period.  To the extent the U.S. dollar strengthens against foreign currencies, the translation of these foreign currencies denominated transactions results in reduced revenue, operating expenses and net income for our international operations.  Similarly, to the extent the U.S. dollar weakens against foreign currencies, the translation of these foreign currency denominated transactions results in increased revenue, operating expenses and net income for our international operations.  We are also exposed to foreign exchange rate fluctuations as we convert the financial statements of our foreign consolidated subsidiaries into U.S. dollars in consolidation.  If there is a change in foreign currency exchange rates, the conversion of the foreign consolidated subsidiaries’ financial statements into U.S. dollars will lead to a translation gain or loss which is recorded as a component of other comprehensive income.  In addition, we have certain assets and liabilities that are denominated in currencies other than the relevant entity’s functional currency.  Changes in the functional currency value of these assets and liabilities create fluctuations that will lead to a transaction gain or loss.  We have not entered into agreements or purchased instruments to hedge our exchange rate risks, although we may do so in the future.  The availability and effectiveness of any hedging transaction may be limited and we may not be able to hedge our exchange rate risks.

 

The State Administration of Foreign Exchange (“SAFE”) restrictions on currency exchange may limit our ability to receive and use our sales revenue effectively and to pay dividends, and the restrictions may cause a delay in payment of interest or principal on the Notes.

 

On August 29, 2008, SAFE promulgated Circular 142, a notice regulating the conversion by a foreign-invested company of foreign currency denominated capital into Renminbi and restricting the use of such converted Renminbi. SAFE promulgated Circular 45 on November 16, 2011 in order to clarify the application of Circular 142. Under Circular 142 and Circular 45, a foreign-invested company can only use Renminbi converted from foreign currency denominated capital for purposes within its business scope, as approved by the applicable governmental authorities. In addition, Circular 142 and Circular 45 provide that a foreign-invested company may not use such converted Renminbi for equity investments in the PRC unless its business license specifically includes equity investments within its business scope.

 

All of our sales revenue and expenses are denominated in the Chinese currency, Renminbi.  Under PRC law, the Renminbi is currently convertible under the “current account,” which includes dividends and trade and service-related foreign exchange transactions, but not under the “capital account,” which includes foreign direct investment and loans. Currently, our PRC operating subsidiary, Bohai, may purchase foreign currencies for settlement of current account transactions, including payments of dividends to us, without the approval of SAFE, by complying with certain procedural requirements.  However, the relevant PRC government authorities may limit or eliminate our ability to purchase foreign currencies in the future.  Since a significant amount of our future revenue will be denominated in Renminbi, any existing and future restrictions on currency exchange may limit our ability to utilize revenue generated in Renminbi to fund our business activities outside China that are denominated in foreign currencies.

 

28
 

 

All of our income is derived from the consulting fees we receive from Bohai through the VIE Agreements.  SAFE restrictions may delay the payment of dividends, since we have to comply with certain procedural requirement and we may experience difficulties in completing the administrative procedures necessary to obtain and remit foreign currency for the payment of dividends from the profits of WFOE, and it thus may delay our payment of interest to the Notes holders.

 

Foreign exchange transactions by PRC operating subsidiaries under the capital account continue to be subject to significant foreign exchange controls and require the approval of or need to register with PRC government authorities, including SAFE.  If we borrow foreign currency through loans from us or other foreign lenders, these loans must be registered with SAFE, and if we finance our company by means of additional capital contributions, these capital contributions must be approved by certain government authorities, including the Ministry of Commerce, or their respective local counterparts.  These limitations could affect our ability to obtain foreign exchange through debt or equity financing. In particular, on April 3, 2012, we entered into an amendment to the Notes to extend the maturity date of the Notes from April 5 to October 5, 2012, because we faced (and continue to face) difficulties in converting our cash on hand from RMB to US Dollars and in turn remitting such amount outside China for purpose of the Note payments. We cannot assure you that this issue will not continue in the future.

 

The PRC government also may at its discretion restrict access in the future to foreign currencies for current account transactions.  If the foreign exchange control system prevents us from obtaining foreign currency, we may be unable to pay the interest and principal on the Notes, pay dividends or meet obligations that may be incurred in the future that require payment in foreign currency.

 

The PRC State Administration of Foreign Exchange restrictions on the use of offshore holding companies in mergers and acquisitions in China may create regulatory uncertainties that could restrict or limit our ability to operate.

 

In November 2005, SAFE issued a public notice, known as Circular 75, concerning foreign exchange registrations that are required in order to use of offshore holding companies in mergers and acquisitions in China.  The public notice provides that if an offshore company controlled by PRC residents intends to acquire a PRC company, such acquisition will be subject to registration with the relevant foreign exchange authorities.  The public notice also suggested that registration with the relevant foreign exchange authorities is required for any sale or transfer by the PRC residents of shares in an offshore holding company that owns an onshore company.  PRC residents must each submit a registration form to the local SAFE branch with respect to their ownership interests in the offshore company, and must also file an amendment to such registration if the offshore company experiences material events, such as changes in the share capital, share transfer, mergers and acquisitions, spin-off transactions or use of assets in China to guarantee offshore obligations.

 

Internal implementing guidelines issued by SAFE, which became public in June 2007 (known as Notice 106), expanded the reach of Circular 75 by: (i) purporting to cover the establishment or acquisition of control by PRC residents of offshore entities which merely acquire “control” over domestic companies or assets, even in the absence of legal ownership; (ii) adding requirements relating to the source of the PRC resident’s funds used to establish or acquire the offshore entity; (iii) covering the use of existing offshore entities for offshore financings; (iv) purporting to cover situations in which an offshore special purpose vehicle, or SPV, establishes a new subsidiary in China or acquires an unrelated company or unrelated assets in China; and (v) making the domestic affiliate of the SPV responsible for the accuracy of certain documents which must be filed in connection with any such registration, notably, the business plan which describes the overseas financing and the use of proceeds.  Amendments to registrations made under Circular 75 are required in connection with any increase or decrease of capital, transfer of shares, mergers and acquisitions, equity investment or creation of any security interest in any assets located in China to guarantee offshore obligations, and Notice 106 makes the offshore SPV jointly responsible for these filings.  In the case of an SPV which was established, and which acquired a related domestic company or assets, before the implementation date of Circular 75, as applied by SAFE in accordance with Notice 106, may result in fines and other penalties under PRC laws for evasion of applicable foreign exchange restrictions.  Any such failure could also result in the SPV’s affiliates being impeded or prevented from distributing their profits and the proceeds from any reduction in capital, share transfer or liquidation to the SPV, or from engaging in other transfers of funds into or out of China.

 

The PRC regulatory authorities may take the view that our acquisition of indirect ownership and controlling interest in Bohai through VIE arrangements shall be subject to SAFE approval and registration. Any adverse action taken against us by PRC regulatory authorities could significantly and negatively impact our operations and the trading market for our common stock.

 

29
 

 

PRC regulations and potential registration requirements relating to acquisitions of PRC companies by foreign entities may create regulatory uncertainties that could restrict or limit our ability to operate.  Similarly, our failure to obtain the prior approval of PRC authorities for our January 2010 private placement and the listing and trading of our common stock could have a material adverse effect on our business, operating results, reputation and trading price of our common stock.

 

On August 8, 2006, the PRC Ministry of Commerce (“MOC”), joined by the State-owned Assets Supervision and Administration Commission of the State Council, the State Administration of Taxation, the State Administration for Industry and Commerce, the China Securities Regulatory Commission (“CSRC”) and SAFE, released a substantially amended version of the Provisions for Foreign Investors to Merge with or Acquire Domestic Enterprises (the “Revised M&A Regulations”), which took effect September 8, 2006.  These new rules significantly revised China’s regulatory framework governing onshore-to-offshore restructurings and foreign acquisitions of domestic enterprises.  These new rules signify greater PRC government attention to cross-border merger, acquisition and other investment activities, by confirming MOC as a key regulator for issues related to mergers and acquisitions in China and requiring MOC approval of a broad range of merger, acquisition and investment transactions.  Further, the new rules establish reporting requirements for acquisition of control by foreigners of companies in key industries, and reinforce the ability of the Chinese government to monitor and prohibit foreign control transactions in key industries.

 

Among other things, the revised M&A Regulations include new provisions that purport to require that an offshore SPV, formed for listing purposes and controlled directly or indirectly by PRC companies or individuals must obtain the approval of the CSRC prior to the listing and trading of such SPV’s securities on an overseas stock exchange.  On September 21, 2006, the CSRC published on its official website procedures specifying documents and materials required to be submitted to it by SPVs seeking CSRC approval of their overseas listings.  However, the application of this PRC regulation remains unclear with no consensus currently existing among the leading PRC law firms regarding the scope and applicability of the CSRC approval requirement.

 

Our principal shareholder, Glory Period, is 100% owned by Joshua Tan, a Singapore citizen.  As of the date of this Annual Report, Glory Period holds approximately 50% of our outstanding common stock.  Mr. Tan and Mr. Qu (the principal founder of Bohai and our Chairman, President and Chief Executive Officer) entered into the Call Option Agreement on December 7, 2009 by which Mr. Qu has an option to acquire all the issued and outstanding shares of Glory Period within three years for nominal consideration.  Chance High, as the wholly owned subsidiary of our company, formed WFOE on November 23, 2009 and WFOE obtained effective and substantial control over Bohai further through executing the VIE Agreements on December 7, 2009 by and among WFOE, Bohai and the three Shareholders of Bohai (including Mr. Qu).  The PRC regulatory authorities may take the view that entry into the VIE Agreements by WFOE and Bohai resulting in Mr. Qu, a PRC resident becoming the majority owner and effective controlling party of our company which acquired 100% indirect ownership of Bohai.  The PRC regulatory authorities may also take the view that the relevant parties should fully disclose to SAFE or MOC of the overall restructuring arrangements, the existence of the Share Exchange and related VIE Agreements.  If the PRC regulatory authorities take the view that the Share Exchange and VIE arrangement constitutes a reverse ,merger or round-trip investment under the M&A Regulations, we cannot assure you we may be able to obtain the approval required from the national offices of MOC.

 

If the PRC regulatory authorities take the view that the Share Exchange and the VIE Agreements constitutes a reverse merger acquisition or round-trip investment without the approval of the national offices of MOC, they could invalidate the Share Exchange and VIE Agreements.  Additionally, the PRC regulatory authorities may take the view that any public offering plan of us will require the prior approval of CSRC.  If we cannot obtain MOC or CSRC approval in case we are required to do so, our business and financial performance will be materially adversely affected.  We may also face regulatory actions or other sanctions from the MOC or other PRC regulatory agencies.  These regulatory agencies may impose fines and penalties on our operations in the PRC, limit our operating privileges in the PRC, delay or restrict the repatriation of the proceeds from the Private Placement into the PRC, or take other actions that could have a material adverse effect on our business, financial condition, results of operations, reputation and prospects, as well as the trading price of our common stock.

 

Also, if later the CSRC requires that we obtain its approval, we may be unable to obtain a waiver of the CSRC approval requirements, if and when procedures are established to obtain such a waiver. Any uncertainties and/or negative publicity regarding this CSRC approval requirement could have a material adverse effect on the trading price of our common stock.  Furthermore, published news reports in China recently indicated that the CSRC may have curtailed or suspended overseas listings for Chinese private companies. These news reports have created further uncertainty regarding the approach that the CSRC and other PRC regulators may take with respect to transactions that we have engaged in our may in the future engage in.  Any adverse action taken against us by PRC regulatory authorities could significantly and negatively impact our operations and the trading market for our common stock.

 

Because our assets are located outside of the United States and half of our directors, including our Chairman, and the majority of our officers reside outside of the United States, it may be difficult for you to enforce your rights based on the United States federal securities laws against us and these persons in the United States or to enforce judgments of United States courts against us or him in the PRC.

 

Our Chairman of the Board and principal executive officer, Mr. Qu, resides outside of the United States in China.  In addition, another of our directors and a majority of our officers are also located in China.  Furthermore, our operating subsidiary is located in the PRC and all of its assets are located outside of the United States.  China does not have a treaty with United States providing for the reciprocal recognition and enforcement of judgments of courts.  It may therefore be difficult for investors in the United States to enforce their legal rights based on the civil liability provisions of the United States federal securities laws against us in the courts of either the United States or the PRC and, even if civil judgments are obtained in courts of the United States, to enforce such judgments in the PRC courts.  Further, it is unclear if extradition treaties now in effect between the United States and the PRC would permit effective enforcement against us or our officers and directors of criminal penalties, under the United States federal securities laws or otherwise.

 

30
 

 

We may have limited legal recourse under PRC laws if disputes arise under our contracts with third parties.

 

The Chinese government has enacted some laws and regulations dealing with matters such as corporate organization and governance, foreign investment, commerce, taxation and trade.  However, their experience in implementing, interpreting and enforcing these laws and regulations is limited, and our ability to enforce commercial claims or to resolve commercial disputes is unpredictable.  If our new business ventures are unsuccessful, or other adverse circumstances arise from these transactions, we face the risk that the parties to these ventures may seek ways to terminate the transactions, or, may hinder or prevent us from accessing important information regarding the financial and business operations of these acquired companies.  The resolution of these matters may be subject to the exercise of considerable discretion by agencies of the Chinese government, and forces unrelated to the legal merits of a particular matter or dispute may influence their determination. Any rights we may have to specific performance, or to seek an injunction under PRC laws, in either of these cases, are severely limited, and without a means of recourse by virtue of the Chinese legal system, we may be unable to prevent these situations from occurring.  The occurrence of any such events could have a material adverse effect on our business, financial condition and results of operations.  Although legislation in China over the past 30 years has significantly improved the protection afforded to various forms of foreign investment and contractual arrangements in China, these laws, regulations and legal requirements are relatively new and their interpretation and enforcement involve uncertainties, which could limit the legal protection available to us, and foreign investors, including you.  The inability to enforce or obtain a remedy under any of our future agreements could result in a significant loss of business, business opportunities or capital and could have a material adverse impact on our operations.

 

We must comply with the Foreign Corrupt Practices Act.

 

We are required to comply with the United States Foreign Corrupt Practices Act, which prohibits U.S. companies from engaging in bribery or other prohibited payments to foreign officials for the purpose of obtaining or retaining business.  Foreign companies, including some of our competitors, are not subject to these prohibitions.  Corruption, extortion, bribery, pay-offs, theft and other fraudulent practices occur from time-to-time in mainland China.  If our competitors engage in these practices, they may receive preferential treatment from personnel of some companies, giving our competitors an advantage in securing business or from government officials who might give them priority in obtaining new licenses, which would put us at a disadvantage.  We have not established formal policies or procedures for prohibiting or monitoring this conduct, and we can not assure you that our employees or other agents will not engage in such conduct for which we might be held responsible.  If our employees or other agents are found to have engaged in such practices, we could suffer severe penalties.

 

If we make equity compensation grants to persons who are PRC citizens, they may be required to register with SAFE.  We may also face regulatory uncertainties that could restrict our ability to adopt equity compensation plans for our directors and employees and other parties under PRC laws.

 

On April 6, 2007, SAFE issued the “Operating Procedures for Administration of Domestic Individuals Participating in the Employee Stock Ownership Plan or Stock Option Plan of An Overseas Listed Company, also known as “Circular 78.”  It is not clear whether Circular 78 covers all forms of equity compensation plans or only those which provide for the granting of stock options. For any plans which are so covered and are adopted by a non-PRC listed company, such as our company, after April 6, 2007, Circular 78 requires all participants who are PRC citizens to register with and obtain approvals from SAFE prior to their participation in the plan.  In addition, Circular 78 also requires PRC citizens to register with SAFE and make the necessary applications and filings if they participated in an overseas listed company’s covered equity compensation plan prior to April 6, 2007.  We believe that the registration and approval requirements contemplated in Circular 78 will be burdensome and time consuming.

 

 In the future, we may adopt an equity incentive plan and make numerous stock option grants under the plan to our officers, directors and employees, some of whom are PRC citizens and may be required to register with SAFE.  If it is determined that any of our equity compensation plans are subject to Circular 78, failure to comply with such provisions may subject us and participants of our equity incentive plan who are PRC citizens to fines and legal sanctions and prevent us from being able to grant equity compensation to our PRC employees. In that case, our ability to compensate our employees and directors through equity compensation would be hindered and our business operations may be adversely affected.

 

31
 

 

Due to various restrictions under PRC laws on the distribution of dividends by our PRC operating companies, we may not be able to pay dividends to our shareholders.

 

The Wholly-Foreign Owned Enterprise Law (1986), as amended and the Wholly-Foreign Owned Enterprise Law Implementing Rules (1990), as amended and the Company Law of the PRC (2006) contain the principal regulations governing dividend distributions by wholly foreign owned enterprises. Under these regulations, wholly foreign owned enterprises, such as WFOE, may pay dividends only out of their accumulated profits, if any, determined in accordance with PRC accounting standards and regulations. Additionally, WFOE is required to set aside a certain amount of their accumulated profits each year, if any, to fund certain reserve funds.  These reserves are not distributable as cash dividends except in the event of liquidation and cannot be used for working capital purposes.   

 

Furthermore, if our consolidated subsidiaries in China incur debt on their own in the future, the instruments governing the debt may restrict its ability to pay dividends or make other payments. If we or our consolidated subsidiaries are unable to receive all of the revenues from our operations due to these contractual or dividend arrangements, we may be unable to pay dividends on our common stock.

 

We may have difficulty establishing adequate management, governance, legal and financial controls in the PRC.

 

The PRC historically has been deficient in western style management, governance and financial reporting concepts and practices, as well as in modern banking, and other control systems.  Our current management has little experience with western style management, governance and financial reporting concepts and practices, and we may have difficulty in hiring and retaining a sufficient number of qualified employees to work in the PRC.  As a result of these factors, and especially given that we expect to be a publicly listed company in U.S. and subject to regulation as such, we may experience difficulty in establishing management, governance legal and financial controls, collecting financial data and preparing financial statements, books of account and corporate records and instituting business practices that meet western standards.  We may have difficulty establishing adequate management, governance, legal and financial controls in the PRC.  Therefore, we may, in turn, experience difficulties in implementing and maintaining adequate internal controls as required under Section 404 of the Sarbanes-Oxley Act of 2002 and other applicable laws, rules and regulations.  This may result in significant deficiencies or material weaknesses in our internal controls which could impact the reliability of our financial statements and prevent us from complying with SEC rules and regulations and the requirements of the Sarbanes-Oxley Act of 2002.  Any such deficiencies, weaknesses or lack of compliance could have a materially adverse effect on our business and the public announcement of such deficiencies could adversely impact our stock price.

 

It may be difficult to protect and enforce our intellectual property rights under PRC laws.

 

Intellectual property rights in China are still developing, and there are uncertainties involved in the protection and the enforcement of such rights.  We will need to pay special attention to protecting our intellectual property and trade secrets.  Failure to do so could lead to the loss of a competitive advantage that could not be compensated by our damages award. 

 

If our land use rights are revoked, we would have no operational capabilities.

 

Under Chinese law land is owned by the state or rural collective economic organizations. The state issues to tenants the rights to use property.  Use rights can be revoked and the tenants forced to vacate at any time when redevelopment of the land is in the public interest.  The public interest rationale is interpreted quite broadly and the process of land appropriation may be less than transparent.  Through our operating subsidiary Bohai, we rely on these land use rights as the cornerstone of our operations for both our manufacturing facility and our corporate headquarters.  The loss of such rights would have a material adverse effect on our company as we would be required to relocate our facilities and obtain new land use rights, and there is a risk that we would not be able to accomplish such a relocation with reasonable cost or at all.

 

In addition, we currently do not maintain a land use right certificate for a piece of land located in Xingfu Twelve Village of Zhifu District with the area of 11,222 square meters, on which we have built our corporate headquarters.  In the process of the planning of Yantai City, the usage of this land use right has been changed from “industrial use” to “commercial use” and therefore, the process for the land use right certificate on five relevant parcels of land including the land occupied by Bohai is suspended until the completion of the planning. We can not assure you that we will eventually obtain the land use right certificate for this land with reasonable cost.

 

The disclosures in our reports and other filings with the SEC and our other public pronouncements are not subject to the scrutiny of any regulatory bodies in the PRC. 

 

We are regulated by the SEC and our reports and other filings with the SEC are subject to SEC review in accordance with the rules and regulations promulgated by the SEC under the Securities Act and the Exchange Act. Our SEC reports and other disclosure and public pronouncements are not subject to the review or scrutiny of any PRC regulatory authority. For example, the disclosure in our SEC reports and other filings are not subject to the review by China Securities Regulatory Commission, a PRC regulator that is tasked with oversight of the capital markets in China. Accordingly, you should review our SEC reports, filings and our other public pronouncements with the understanding that no local regulator has done any review of our company, our SEC reports, other filings or any of our other public pronouncements.

 

32
 

 

Risks Related to Our Common Stock

 

If we become directly subject to the recent scrutiny, criticism and negative publicity involving U.S.-listed Chinese companies, we may have to expend significant resources to investigate and resolve the matter which could harm our business operations, stock price and reputation and could result in a loss of your investment in our stock, especially if such matter cannot be addressed and resolved favorably.

 

Recently, U.S. public companies that have substantially all of their operations in China, particularly companies like ours which have completed so-called reverse merger transactions, have been the subject of intense scrutiny, criticism and negative publicity by investors, financial commentators and regulatory agencies, such as the SEC. Much of the scrutiny, criticism and negative publicity has centered around financial and accounting irregularities and mistakes, a lack of effective internal controls over financial accounting, inadequate corporate governance policies or a lack of adherence thereto and, in many cases, allegations of fraud. As a result of the scrutiny, criticism and negative publicity, the publicly traded stock of many U.S. listed Chinese companies has sharply decreased in value and, in some cases, has become virtually worthless. Many of these companies are now subject to shareholder lawsuits and SEC enforcement actions and are conducting internal and external investigations into the allegations.

 

It is not clear what effect this sector-wide scrutiny, criticism and negative publicity will have on our company, our business and our stock price, although we believe our stock price and investor following have suffered and may continue to suffer as a result of the scrutiny of Chinese companies like ours. If we become the subject of any unfavorable allegations, whether such allegations are proven to be true or untrue, we will have to expend significant resources to investigate such allegations and/or defend our company. This situation will be costly and time consuming and distract our management from growing our company. If such allegations are not proven to be groundless, our company and business operations will be severely and your investment in our stock could be rendered worthless.

  

The registration statement covering the shares of common stock underlying the Notes and Warrants may not remain effective, which could impact the liquidity of our common stock.

 

Under the terms of our January 2010 Registration Rights Agreement, we are obligated to include the shares of common stock underlying the Notes and Warrants in an effective registration statement.  From time to time, including following the filing of this Annual Report, it will be necessary for us to file post-effective amendments to the registration statement when subsequent events so require.  We intend to use our best efforts to keep the registration statement current, but we may not be able to do so.  If the registration statement is not current in the future, we will incur penalties and investors’ ability to sell the shares of common stock underlying the Notes and Warrants will be limited, which would have a material adverse effect on the liquidity of our common stock.

 

There is currently an extremely limited trading market for our common stock, and the limited public trading market that may develop in the future may cause extreme volatility in our stock price.

 

Although our common stock is listed for quotation on the OTCQB, operated by OTC Markets Group, Inc., there has been only limited trading in our stock.  Trading in our common stock may not fully evolve for a variety of reasons, and even if a market for our stock develops, it may continue to be limited.  Even if a market for our common stock does develop, there is a risk that a meaningful, consistent and liquid trading market may not develop.  Moreover, stocks with limited trading markets have historically experienced extreme price and volume fluctuations and have particularly affected the market prices of many smaller companies like us.  Our common stock is thus expected to be subject to significant volatility when and if meaningful trading commences.  In addition, sales of substantial amounts of our common stock, or the perception that such sales might occur, could adversely affect prevailing market prices of our common stock.

 

All of the foregoing risks are particularly true of our company as we are based in China and recently US-listed Chinese companies (especially those that obtained a US listing via a “reverse merger” transaction as we did) have come under significant scrutiny by US regulators and investors.  This scrutiny and related disfavor for companies like ours has had and may in the future a negative impact on our public stock price

 

An active and visible trading market for our common stock may not develop.

 

We cannot predict whether an active market for our common stock will develop in the future.  In the absence of an active trading market:

 

  Investors may have difficulty buying and selling or obtaining market quotations;

 

  Market visibility for our common stock may be limited; and

 

33
 

 

  A lack of visibility for our common stock may have a depressive effect on the market price for our common stock.

 

The OTCQB is unorganized, inter-dealers, over-the-counter markets that provides significantly less liquidity than NASDAQ or the NYSE AMEX.  No assurances can be given that we will ever obtain a listing for our securities on a senior exchange.  The trading price of our common stock is therefore expected to be subject to significant fluctuations in response to variations in quarterly operating results, changes in analysts’ earnings estimates, announcements of innovations by us or our competitors, general conditions in the industry in which we operate and other factors.  These fluctuations, as well as general economic and market conditions, may have a material or adverse effect on the market price of our common stock.

 

The market price for our stock may be volatile.

 

The market price for our stock may be volatile and subject to wide fluctuations due to factors such as:

 

  the perception of US investors and regulators of US-listed Chinese companies;

 

  actual or anticipated fluctuations in our quarterly operating results;

 

  changes in financial estimates by securities research analysts;

 

  conditions in pharmaceutical markets;

 

  changes in the economic performance or market valuations of other pharmaceutical companies;

 

  announcements by us or our competitors of new products, acquisitions, strategic partnerships, joint ventures or capital commitments;

 

    addition or departure of key personnel;

 

  fluctuations of exchange rates between RMB and the U.S. dollar;

 

  intellectual property or other litigation; and

 

  general economic or political conditions in China.

 

In addition, the securities market has from time to time experienced significant price and volume fluctuations that are not related to the operating performance of particular companies.  These market fluctuations may also materially and adversely affect the market price of our stock.

 

The accounting treatment for our convertible securities is complex and subject to judgments concerning the valuation of embedded derivative rights within the applicable securities.  Fluctuations in the valuation of these rights could cause us to take charges to our earnings and make our financial results unpredictable.

 

Our Notes and Warrants issued in January 2010 contain, or may be deemed to contain from time to time, embedded derivative rights in accordance with GAAP.  These derivative rights, or similar rights in convertible securities we may issue in the future, need to be, or may need to be, separately valued as of the end of each accounting period in accordance with GAAP.  Changes in the valuations of these rights, the valuation methodology or the assumptions on which the valuations are based could cause us to take charges to our earnings, which would adversely impact our results of operations.  Moreover, the methodologies, assumptions and related interpretations of accounting or regulatory authorities associated with these embedded derivatives are complex and in some cases uncertain, which could cause our accounting for these derivatives, and as a result, our financial results, to fluctuate.  There is a risk that questions could arise from investors or regulatory authorities concerning the appropriate accounting treatment of these instruments, which could require us to restate previous financial statements, which in turn could adversely impact our results of operations, our reputation and our public stock price.

 

34
 

 

Shares eligible for future sale may adversely affect the market price of our common stock, as the future sale of a substantial amount of outstanding stock in the public marketplace could reduce the price of our common stock.

 

Pursuant to the terms of the Registration Rights Agreement and Securities Purchase Agreement, we agreed to file a registration statement with the SEC to register the common stock underlying the Notes, Warrants and Placement Agent Warrants for public resale.  All of such shares may be freely sold and transferred following conversion or exercise of the Notes and Warrants if such registration statement remains effective.  Additionally, concurrently with the closing of the Private Placement, we engaged in a Share Exchange, and following the Share Exchange, the former shareholders of Chance High (other than Glory Period) may be eligible to sell all or some of their shares of common stock by means of ordinary brokerage transactions in the open market pursuant to such registration statement or SEC Rule 144, subject to certain limitations.  In general, pursuant to Rule 144, a shareholder (or shareholders whose shares are aggregated) who has satisfied an one-year holding period may, under certain circumstances, sell within any three-month period a number of securities which does not exceed the greater of 1% of the then outstanding shares of common stock or the average weekly trading volume of the class during the four calendar weeks prior to such sale.  As of the date of this annual report, 1% of our issued and outstanding shares of common stock equal approximately 17,861,085 shares. Rule 144 also permits, under certain circumstances, the sale of securities, without any limitations, by a non-affiliate that has satisfied a one-year holding period.  Any substantial sale of common stock pursuant to any resale prospectus or Rule 144 may have an adverse effect on the market price of our common stock by creating an excessive supply.

 

Our controlling shareholder may exercise significant influence over us.

 

Our controlling shareholder, Glory Period Limited, owns approximately 50% of our outstanding common stock as of the closing of the Share Exchange.  Tan is the sole shareholder of Glory Period and Qu is the sole director of Glory Period.  Either Tan or Qu has a controlling influence in determining the outcome of any corporate transaction or other matters submitted to our shareholders for approval, including mergers, consolidations and the sale of all or substantially all of our assets, election of directors, and other significant corporate actions.  Tan and Qu may also have the power to prevent or cause a change in control.  In addition, without the consent of Tan and Qu, we could be prevented from entering into transactions that could be beneficial to us.  As Qu serves as our principal executive officer and Tan has provided consulting services to Bohai in the past, the interests of Tan and Qu may differ from the interests of our other shareholders, which could create conflicts of interest and the potential for approval of actions which may not be in the best interests of all of our shareholders.

 

Compliance with complex and changing regulation of corporate governance and public disclosure, and our management’s inexperience with such regulations, will result in additional expenses and creates a risk of non-compliance.

 

Changing laws, regulations and standards relating to corporate governance and public legal and accounting disclosure, including the Sarbanes-Oxley Act of 2002 and related SEC regulations, have created uncertainty for public companies and significantly increased the costs and risks associated with accessing the public markets and public reporting.  Our management team will need to invest significant management time and financial resources to comply with both existing and evolving standards for public companies, which will lead to increased general and administrative expenses and a diversion of management time and attention from revenue generating activities to compliance activities.  In addition, our management located in the PRC has little experience with compliance with U.S. laws (including securities laws).  This inexperience may cause us to fall out of compliance with applicable regulatory requirements, which could lead to restatements of our financial statements, breaches of covenants in our investor agreements, regulatory enforcement actions against us and a negative impact on our stock price and our business generally.

 

The challenges we have with properly complying with applicable disclosure and accounting regulations were evidenced when we were required to restate our financial statements for the period ended March 31, 2010 to account for the embedded derivative liabilities associated with Notes and Warrants.  There is a risk that we will face similar challenges in the future.

 

If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results or prevent fraud.

 

We are subject to reporting obligations under the U.S. securities laws.  The SEC, as required by Section 404 of the Sarbanes-Oxley Act of 2002, adopted rules requiring every public company to include a management report on such company’s internal controls over financial reporting in its annual report, which contains management’s assessment of the effectiveness of our internal controls over financial reporting.  In addition, we may be required to have an independent registered public accounting firm attest to and report on management’s assessment of the effectiveness of our internal controls over financial reporting.  Our management may conclude that our internal controls over our financial reporting are not effective.  Moreover, even if our management concludes that our internal controls over financial reporting are effective, our independent registered public accounting firm may still decline to attest to our management’s assessment or may issue a report that is qualified if it is not satisfied with our controls or the level at which our controls are documented, designed, operated or reviewed, or if it interprets the relevant requirements differently from us.  Our reporting obligations as a public company will place a significant strain on our management, operational and financial resources and systems for the foreseeable future.  Effective internal controls, particularly those related to revenue recognition, are necessary for us to produce reliable financial reports and are important to prevent fraud.  As a result, our failure to achieve and maintain effective internal controls over financial reporting could result in the loss of investor confidence in the reliability of our financial statements, which in turn could harm our business and negatively impact the trading price of our stock.  Furthermore, we anticipate that we will incur considerable costs and use significant management time and other resources in an effort to comply with Section 404 and other requirements of the Sarbanes-Oxley Act.

 

35
 

 

Our common stock may be considered a “penny stock,” and thereby be subject to additional sale and trading regulations that may make it more difficult to sell.

 

Our common stock, which is currently quoted for trading on OTCQB, may be considered to be a “penny stock” if it does not qualify for one of the exemptions from the definition of “penny stock” under Section 3a51-1 of the Exchange Act, as amended.  Our common stock may be a “penny stock” if it meets one or more of the following conditions: (i) the stock trades at a price less than $5 per share; (ii) it is NOT traded on a “recognized” national exchange; (iii) it is not quoted on the Nasdaq Capital Market, or even if so, has a price less than $5 per share; or (iv) is issued by a company that has been in business less than three years with net tangible assets less than $5 million.  The principal result or effect of being designated a “penny stock” is that securities broker-dealers participating in sales of our common stock will be subject to the “penny stock” regulations set forth in Rules 15-2 through 15g-9 promulgated under the Exchange Act.  For example, Rule 15g-2 requires broker-dealers dealing in penny stocks to provide potential investors with a document disclosing the risks of penny stocks and to obtain a manually signed and dated written receipt of the document at least two business days before effecting any transaction in a penny stock for the investor’s account.  Moreover, Rule 15g-9 requires broker-dealers in penny stocks to approve the account of any investor for transactions in such stocks before selling any penny stock to that investor.  This procedure requires the broker-dealer to: (i) obtain from the investor information concerning his or her financial situation, investment experience and investment objectives; (ii) reasonably determine, based on that information, that transactions in penny stocks are suitable for the investor and that the investor has sufficient knowledge and experience as to be reasonably capable of evaluating the risks of penny stock transactions; (iii) provide the investor with a written statement setting forth the basis on which the broker-dealer made the determination in (ii) above; and (iv) receive a signed and dated copy of such statement from the investor, confirming that it accurately reflects the investor’s financial situation, investment experience and investment objectives.  Compliance with these requirements may make it more difficult and time consuming for holders of our common stock to resell their shares to third parties or to otherwise dispose of them in the market or otherwise.

 

We do not foresee paying cash dividends in the foreseeable future and, as a result, our investors’ sole source of gain, if any, will depend on capital appreciation, if any.

 

We do not plan to declare or pay any cash dividends on our shares of common stock in the foreseeable future and currently intend to retain any future earnings for funding growth. As a result, investors should not rely on an investment in our securities if they require the investment to produce dividend income. Capital appreciation, if any, of our shares may be investors’ sole source of gain for the foreseeable future. Moreover, investors may not be able to resell their common stock at or above the price they paid for them.

 

Item 1B.  Unresolved Staff Comments.

 

None.

 

Item 2. Description of Properties.

 

Our corporate headquarters is located at No. 9 Daxin Road, Zhifu District, Yantai, Shandong Province, China.  Under the current PRC laws, land is owned by the state, and parcels of land in rural areas which is known as collective land is owned by the rural collective economic organization.  “Land use rights” are granted to an individual or entity after payment of a land use right fee is made to the applicable state or rural collective economic organization. Land use rights allow the holder of the right to use the land for a specified long-term period.  We have a land use right, expiring in 2047, for a total of approximately 30,637 square meters of land, on which we maintain our manufacturing facility.  We currently have not obtained a land use right certificate for a piece of land located in Xingfu Twelve Village of Zhifu District with the area of 11,222 square meters, on which we maintain our corporate headquarters.  In the process of the planning of Yantai City, the usage of the aforesaid land use right has been changed from “industrial use” to “commercial use” and therefore, the approval process for the land use right certificate on the land for our corporate headquarters has been suspended until the completion of the planning.  We can not assure you that we will eventually obtain the land use right certificate for this land.

 

On February 22, 2010, we entered into a land-use right purchase agreement with Shandong Yantai Bureau of Land and Resources, pursuant to which we acquired the land use right for a parcel of land totaling 333,335 square meters for RMB 97,500,000 (approximately $14,320,100).  As of March 31, 2011, this purchase price was paid in full.

 

On August 8, 2011, we acquired Yantai Tianzheng, pursuant to which we acquired the land use right for a parcel of land totaling 32,883.6 including a manufacture facility of 10,908.83 square meters (approximately 117,421.668 square feet).

 

Item 3. Legal Proceedings.

 

We are not a party to any current or pending legal proceedings that, if decided adversely to us, would have a material adverse effect upon our business, results of operations, or financial condition, and we are not aware of any threatened or contemplated proceeding by any governmental authority against us.  To our knowledge, we are not a party to any threatened civil or criminal action or investigation. 

 

36
 

 

PART II

 

Item 5.   Market for Common Equity Related Shareholder Matters and Issuer Purchases of Equity Securities Market Information.

 

Our common stock was listed for quotation on the OTCBB and the OTCQB under the symbol “BOPH.” From January 9, 2008 until February 8, 2010, our common stock was listed for quotation on the OTCBB under the symbol “LINK”.  Starting July 24, 2012, our common stock is listed for quotation on the OTCQB only. The following tables set forth, for the calendar quarter indicated, the quarterly high and low sales price for our common stock as reported on the OTCBB/OTCQB.  Trading in the common stock in the over-the-counter market has been limited and sporadic and the quotations set forth below are not necessarily indicative of actual market conditions.  Further, the quotations merely reflect the prices at which transactions were proposed, and do not necessarily represent actual transactions.

 

   High   Low 
2012 by Quarter          
July 1, 2011 - September 30, 2011  $1.00    0.75 
October 1, 2011 - December 31, 2011  $0.89    0.36 
January, 2012 - March 31, 2012  $0.48    0.20 
April 1, 2012 – June 30, 2012  $0.55    0.27 
           
2011 by Quarter          
July 1, 2010 - September 30, 2010  $2.40   $1.26 
October 1, 2010 - December 31, 2010  $2.30   $1.70 
January, 2011 - March 31, 2011  $2.20   $1.65 
April 1, 2011 – June 30, 2011  $1.70   $0.95 

 

Holders

 

As of September 28, 2011, there were 17,861,085 shares of our common stock outstanding held by approximately 65 shareholders of record.  The number of our shareholders of record excludes any estimate by us of the number of beneficial owners of shares held in street name, the accuracy of which cannot be guaranteed.

 

Dividend Policy

 

We have not paid any cash dividends on our common stock to date, and we have no intention of paying cash dividends in the foreseeable future. Whether we will declare and pay dividends in the future will be determined by our board of directors at their discretion, subject to certain limitations imposed under Delaware corporate law. In addition, our ability to pay dividends may be affected by the foreign exchange controls in China. The timing, amount and form of dividends, if any, will depend on, among other things, our results of operations, financial condition, cash requirements and other factors deemed relevant by our board of directors.

 

Recent Sales of Unregistered Securities

 

None.

 

Item 6.  Selected Financial Data.

 

We are a “smaller reporting company” as defined by Regulation S-K and as such, are not required to provide the information contained in this item pursuant to Regulation S-K.

 

Item 7.  Management’s Discussion and Analysis or Plan of Operation.

 

The following discussion and analysis of financial condition and results of operations relates to the operations and financial condition reported in our audited consolidated financial statements for the twelve months ended June 30, 2012 and 2011, and should be read in conjunction with such financial statements and related notes included in this Annual Report. Those statements in the following discussion that are not historical in nature should be considered to be forward looking statements that are inherently uncertain. Actual results and the timing of the events may differ materially from those contained in these forward looking statements due to a number of factors, including those discussed in the “Cautionary Note on Forward Looking Statements” set forth elsewhere in this Annual Report.

 

37
 

 

Overview

 

We are engaged in the production, manufacturing and distribution in China of herbal pharmaceuticals based on traditional Chinese medicine, which we refer to herein as Traditional Chinese Medicine, or TCM. We are based in the city of Yantai, Shandong Province, China and our operations are exclusively in China.

 

Our medicines address rheumatoid arthritis, viral infections, gynecological diseases, cardio vascular issues and respiratory diseases. Our initial operating subsidiary Bohai obtained Drug Approval Numbers (or DANs) for 29 varieties of traditional Chinese herbal medicines in 2004, an additional 14 varieties in December 2010. Through our acquisition of Yantai Tianzheng in August 2011, we obtained DANs for another 5 varieties in August 2011. We currently produce 19 varieties of approved traditional Chinese herbal medicines in seven delivery systems: tablets, granules, capsules, formulations, concentrated powder, tincture and medicinal wine. Of these 19 products, 12 are prescription drugs and 7 are over the counter (or OTC) products.

 

Three of Bohai’s lead products, Tongbi Capsules and Tablets and Lung Nourishing Syrup, are eligible for reimbursement under China’s National Medical Insurance Program (or NRDL), which we believe significantly increases the marketability of these products. In addition to these lead products, three of our current products and five of our formulas we acquired in 2010 are eligible for NRDL reimbursement. In addition, one of our current products and four of our newly acquired formulas are currently included on the Chinese government's Essential Drug List (or EDL). Inclusion on either the EDL or NRDL allows for up to 100% insurance coverage by the Chinese government. Yantai Tianzheng owns five prescription products approved by the State Food and Drug Administration of China (which we refer to herein as the SFDA) and currently manufactures four of such products. Among Yantai Tianzheng’s products, Fangfengtongsheng Granule has an exclusive status and is on the EDL and NDRL, and Zhengxintai Capsule has renewed its protective status to August 2017 and is currently under the NDRL.

 

Prior to January 5, 2010, we were a public “shell” company operating under the name “Link Resources, Inc.” On January 5, 2010, we consummated a share exchange transaction (the “Share Exchange”) pursuant to which we acquired Chance High, the indirect parent company of Bohai, our principal operating subsidiary, which is a Chinese variable interest entity that we (through a Chinese wholly-owned foreign enterprise subsidiary) control through certain contractual arrangements. On August 8, 2011, WFOE II, a PRC company and a newly formed subsidiary of Chance High, entered into a Share Purchase Agreement pursuant to which we acquired, from the three individual holders thereof, one hundred percent (100%) of the outstanding shares of Yantai Tianzheng, which became our second operating subsidiary effective as of July 1, 2011.   

 

Use of Non-GAAP Financial Measures

 

We make reference to Non-GAAP financial measures in portions of this “Management’s Discussion of Financial Condition and Results of Operations”. Management believes that investors may find it useful to review our financial results that exclude certain non-cash income and expense, namely the aggregate change in the fair value of our warrants, amortization of the beneficial conversion features in our convertible notes and the effective interest charges on our convertible notes, stock-based compensation, and deferred income tax expenses as shown in the chart below in the aggregate net amount of $9,465,207 and $(2,234,879) income/(expenses) for the twelve months ended June 30, 2012 and 2011, respectively.

 

38
 

 

Management believes that these Non-GAAP financial measures are useful to investors in that they provide supplemental information to intend to enhance our investors’ understanding of the underlying business trends and operating performance of our Company. We use these Non-GAAP financial measures to evaluate operating performance.  However, Non-GAAP financial measures should not be considered as either a substitute or alternative measurement of net income or any other performance measures derived in accordance with GAAP.

 

The following is a summary of reconciliations of such Non-GAAP financial measures to the most directly comparable GAAP financial measures for the fiscal years ended June 30, 2012 and 2011:

 

   Twelve Months Ended 
   June 30, 
           Increase 
   2012   2011   (Decrease) 
Net income available to Common shareholders -GAAP  $9,648,025   $14,004,875   $(4,356,850)
Add Back (Subtract):               
Change in fair value of warrants   273,369(a)   (4,544,061)(a)   4,817,430 
Amortization of beneficial conversion features on convertible notes converted   9,317,897(a)   1,029,487(a)   8,288,410 
Change in Option and Equity Based Compensation   44,000(b)   209,527(b)   (165,527)
Deferred income tax expenses - indefinite intangible assets   (170,059)(c)   1,070,168(c)   (1,240,227)
Adjusted net income available to Common shareholders -non-GAAP  $19,113,232   $11,769,996   $7,343,236 
Net income margins -non-GAAP   13.91%   14.47%   (0.56)%
Basic earning per share – GAAP  $0.54   $0.81   $(0.27)
Add back (Subtract):               
Change in fair value of warrants   0.02(a)   (0.26)(a)   0.28 
Amortization of beneficial conversion features on convertible notes converted   0.52(a)   0.06(a)   0.46
Change in Option and Equity Based Compensation   0.00(b)   0.01(b)   (0.01)
Deferred tax expenses  - indefinite intangible assets   (0.01)(c)   0.06(c)   (0.07)
Adjusted basic earning per share non-GAAP  $1.07   $0.68   $0.39 
                
Diluted earning per share-GAAP  $0.54   $0.75   $(0.21)
Add back (Subtract):               
Change in fair value of warrants   0.02(a)   (0.20)(a)   0.22 
Amortization of beneficial conversion features on convertible notes converted   0.52(a)   0.05(a)   0.47 
Change in Option and Equity Based Compensation   0.00(b)   0.01(b)   (0.01)
Deferred tax expenses  - indefinite intangible assets   (0.01)(c)   0.05(c)   (0.06)
Adjusted diluted earning per share non-GAAP  $1.07   $0.66   $0.41 
                
Weighted average number of shares               
Basic   17,861,085    17,198,917      
Diluted   17,861,085    22,423,917      

 

(a) We adopted the provisions of FASB accounting standard, ASC 815, which provides standards with respect to determine whether an instrument (or embedded feature) is indexed to an entity’s own stock (See note 14).  As a result of these measurements, we recognized non-cash credits of $(273,369) and $4,544,061 for the twelve months ended June 30, 2012 and 2011, respectively, from changes in fair value for investor and agent warrants and non-cash charges of $9,317,897 and $1,029,487 for the twelve months ended June 30, 2012 and 2011, respectively, for unamortized beneficial conversion features on convertible notes converted.

 

(b) We adopted stock-based compensation expense pursuant to FASB’s accounting standard regarding stock compensation which requires us to measure compensation cost for consultants and stock-based employee compensation plans at fair value at the grant date and recognize the expense over the employee's requisite service period. Under ASC Topic 718, our expected volatility assumption is based on the historical volatility of Company’s stock or the expected volatility of similar entities. The expected life assumption is primarily based on historical exercise patterns and employee post-vesting termination behavior. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant. For the twelve months ended June 30, 2012 and 2011, we recognized $44,000 and $182,500 of restricted stock as compensation expense. For the twelve months ended June 30, 2012 and 2011, we recognized $0 and $27,027, respectably as compensation expenses for our stock option plan.

 

39
 

 

(c) We adopted the provisions of FASB accounting standard, ASC 350, which provides standards with respect to the deferred tax liability for indefinite intangible assets and FASB accounting standard, ASC 360, which provides standards with respect to accounting for the impairment or disposal of long-lived assets.  As a result of these measurements, we recognized net non-cash deferred tax charges of $(170,059) and $434,726 for the twelve months ended June 30, 2012 and 2011, respectively, from deferred tax expenses and impairment losses of $0 and $635,442 for the twelve months ended June 30, 2012 and 2011, respectively.

 

Principal Factors Affecting Our Financial Performance

 

We believe that the following factors will continue to affect our financial performance:

 

Sales of Key Products

 

Our top selling products as a percentage of total net revenue consist of the following:

  

   For the twelve months ended 
   June 30, 
   2012   2011 
Lung Nourishing Syrup   16.6%   26.2%
Tongbi Capsules   22.8%   27.4%
Tongbi Tablets   9.1%   14.4%
Zhengxintai Capsule   10.6%   -%
Fangfengtongsheng Granule   18.3%   -%
Other Products   22.6%   32.0%
Total Sales   100%   100%

  

We expect that a significant portion of our future revenue will continue to be derived from sales of our top five products.

 

We held the Certificates of Protected Variety of Traditional Chinese Medicine (Grade Two) issued by the SFDA for Tongbi Capsules and Anti-flu Granules which gave the Company exclusive or near-exclusive rights to manufacture and distribute these two medicines. Tongbi Capsules’ certificates expired in September 2009. We filed an application for extending the protection period on March 12, 2009 and received certification extension until September 13, 2016. Lung Nourishing Syrup received a patent with duration of 20 years from the State Intellectual Property Office of the PRC and the patent will expire on September 12, 2027.

 

Price Control of Drugs by PRC Government and SDRC

 

The State Development and Reform Commission of the PRC (“SDRC”) and the price administration bureaus of the relevant provinces of the PRC in which the pharmaceutical products are manufactured are responsible for the retail price control over our pharmaceutical products. The SDRC sets the price ceilings for certain pharmaceutical products in the PRC. All of our products except those under the protection periods are subject to such price controls and could affect our future revenue growth. However, due to the direct support of TCM by the Chinese government, China’s immense market, and our protected drugs, we are optimistic regarding our continuous growth potential for TCM in China.

 

Financial Highlights

 

  £ Net revenues for the twelve months ended June 30, 2012 increased 68.9% to $137.4 million compared to the same period in 2011.

 

  o 68% of net revenues was from Bohai and 32% was from Yantai Tianzheng this fiscal year compared to the last fiscal year.

  

  o Sales were mostly derived from our lead products, Lung Nourishing Syrup, Tongbi Capsules, Tongbi Tablets, Fangfengtongsheng Granule, and Zhengxintai Capsules, which together represented over 77.4% of our total net revenues for the twelve months ended June 30, 2012, respectively.

 

  o 78% of net revenue was derived from sales of prescription products and 22% was from Over-the-Counter products for the twelve months ended June 30, 2012.

 

40
 

 

  £ Non-GAAP net income for the twelve months ended June 30, 2012 increased 62.4% to $19.1 million compared to the same period in 2011. The difference was mainly due to increased net income offset by net increase in change in fair value of warrants of $4.8 million in the twelve months ended June 30, 2012 compared to the same period in last year and change in Amortization of beneficial conversion features on convertible notes converted of $8.3 million in the twelve months ended June 30,2012 compared to the same period in last year. (See above Use of Non-GAAP Financial Measures). GAAP net income for the twelve months ended June 30, 2012 decreased 31.1% to $9.6 million compared to the same period in 2011.

 

  o Income from operations increased 55.4% to $28.4 million this fiscal year compared to the last fiscal year. 

 

  o Net income margin decreased from 17.2% for the twelve months ended June 30, 2011 to 7.0% for the twelve months ended June 30, 2012. The decrease was mainly due to the net increase in certain non-cash activities such as effective interest charges  from convertible notes and deferred income tax expenses as well as increase in selling related expenses.

 

  o Included in the net income this fiscal year ended June 30, 2012 were a non-cash charge in deferred income tax expenses of $0.8 million, and a non-cash credit of $0.3 million in changes in fair value of warrants.

 

  £ Basic and diluted earnings per share were $0.54 and $0.54 for the twelve months ended June 30, 2012.

 

  o Non-GAAP Diluted earnings per share increased 62.1% to $1.07 for the twelve months ended June 30, 2012 compared to the same period in 2011.

 

  o Non-GAAP Basic earnings per share increased 57.4% to $1.07 for the twelve months ended June 30, 2012 compared to the same period in 2011.

  

  £ Including restricted cash, our total cash balance was $27.8 million as of June 30, 2012 and cash flow from operating activities was $20.6 million for the twelve months ended June 30, 2012.

 

  o Total cash and cash equivalents increased by $5.0 million for the twelve months ended June 30, 2012 compared to June 30, 2011.

 

  o Major cash payment activities for the twelve months ended June 30, 2012 included $3.1 million for the repayment of short term bank loans and $9.7 million paid for acquisition.

   

Operating Results

 

Comparison of the twelve months ended June 30, 2012 and 2011

 

The following table sets forth key components of our results of operations for the twelve months ended June 30, 2012 and 2011, in US dollars:

 

   For The Twelve Months Ended 
   June 30, 
               Percentage 
   2012   2011   Difference   Increase 
                 
Net revenues  $137,372,492   $81,328,555   $56,043,937    68.9%
                     
Cost of revenue   (33,532,900)   (17,293,680)   (16,239,220)   93.9%
                     
Gross profit   103,839,592    64,034,875    39,804,717    62.2%
                     
Operating expenses   (75,468,125)   (45,779,010)   (29,689,115)   64.9%
                     
Income from operations   28,371,467    18,255,865    10,115,602    55.4%
                     
Total other income (expenses)   (11,408,560)   514,028    (11,922,588)   (2,319.4)%
                     
Income before provision for income taxes   16,962,907    18,769,893    (1,806,986)   (9.6)%
                     
Provision for income taxes   (7,314,882)   (4,765,018)   (2,549,864)   53.5%
                     
Net income  $9,648,025   $14,004,875   $(4,356,850)   (31.1)%

 

41
 

 

The following table sets forth key components as a percentage of net revenue for the twelve months ended June 30, 2012 and 2011:

 

   For The Twelve Months Ended 
   June 30, 
   2012   2011 
         
Net revenues   100.0%   100.0%
           
Cost of sales   (24.4)%   (21.3)%
           
Gross profit   75.6%   78.7%
           
Selling, general, and administrative expenses   (54.9)%   (56.3)%
           
Income from operations   20.7%   22.4%
           
Total other income(expenses)   (8.3)%   0.6%
           
Income before provision for income taxes   12.3%   23.1%
           
Provision for income taxes   (5.3)%   (5.9)%
           
Net income   7.0%   17.2%

 

Net Revenues

 

Net revenues are comprised of sales of 19 traditional Chinese medicines in China during the twelve months ended June 30, 2012 (we currently sell 19 medicines following our acquisition of Yantai Tianzheng on August 8, 2011). Net revenues for the twelve months ended June 30, 2012 increased by $56,043,937, or 68.9%, to $137,372,492 as compared to $81,328,555 for the twelve months ended June 30, 2011. Net revenues were $93,167,083 and $44,205,409 for Bohai and Yantai Tianzheng, respectively, for the twelve months ended June 30, 2012. The increase in Bohai’s revenue was primarily due to a net increase in revenues of 17.7% from our four lead products in Bohai: Lung Nourishing Syrup, Tongbi Capsules, Tongbi Tablets, and Shantongning Tablets, which together accounted for over 82.1% of our total net revenues for Bohai. All of our lead products are listed for coverage and reimbursement under national medical insurance program starting in December 2009. The sale of our prescription drug products for the twelve months ended June 30, 2012 represented 77.5% of total net revenue compared to 60.7% for the same period in last year. The increase in prescription sales was primary due to increases in sales volume from our two prescription drugs, Tongbi Capsules and Tongbi Tablets as well as prescription product sales from Yantai Tianzheng. Yantai Tianzheng was acquired on July 1, 2011.

 

Cost of Revenues

 

Cost of revenues is comprised of raw material costs, labor cost, overhead costs associated with the manufacturing processes and related expenses which are directly attributable to our revenues. Our cost of revenues for the twelve months ended June 30, 2012 was $33,532,900 as compared to $17,293,680 for the twelve months ended June 30, 2011, representing an increase of $16,239,220, or 93.9%. Cost of revenues were $20,269,019 and $13,263,881 for Bohai and Yantai Tianzheng, respectively, for the twelve months ended June 30, 2012.  The increase in overall cost of revenue was also due to cost of revenues of approximately $8.7 million from Yantai Tianzheng which was acquired on July 1, 2011. The increase in cost of revenues was also attributable to an increase in total cost of raw material, labor, and overhead as a result of an increase in overall sales from Bohai for the twelve months ended June 30, 2012 and attributable to increased unit cost mainly caused by increase raw material cost compared to the same period in last year.

 

Gross Profit

 

Gross profit represents the difference between net revenues and cost of revenues. We achieved gross profit of $103,839,592 for the twelve months ended June 30, 2012, compared to $64,034,875 for the same period in 2011, representing an increase of $39,804,717, or 62.2%, over the same periods in 2011. The increase of the gross profit is due to gross profit from Tianzheng, which was acquired on July 1, 2011, as well as due to increased revenues from Bohai.

 

42
 

 

Our overall gross profit margins as a percentage of net revenues decreased by approximately 3.1% from 78.7% to 75.6% the twelve months ended June 30, 2012 compared to the same period in 2011. The decrease of the gross profit margin is because of increased raw material cost for the twelve months ended June 30, 2012 compared to the same period last year. Meanwhile, the Company also makes the effort to improve the cost control to avoid negative inflation effect.

 

Operating Expenses

 

Our operating expenses increased by $29,689,115 to $75,468,125, for the twelve months ended June 30, 2012 compared to $45,779,010 for the same fiscal period in 2011. The overall increase in operating expenses was related to increased depreciation and amortization expenses, services supporting an overall increase in sales activities and new product promotions as well as increased activities arising from our acquisition of Yantai Tianzheng. Operating expenses amounted to $25,537,188 from Yantai Tianzheng for the twelve months ended June 30, 2012. The percentage of operating expenses to net revenues was 54.9% and 56.3% for the twelve months ended June 30, 2012 and 2011, respectively, representing a decrease of 1.4% as a percentage of net revenues.

 

Total Other Income (Expenses)

 

Total other income (expenses) are comprised of interest income (expenses), changes in fair value of derivative instruments, other income (expenses), and amortization of deferred financing fees. Total other expenses were $11,408,560 for the twelve months ended June 30, 2012 compared to total other income of $514,028 for the period ended June 30, 2011, an increase of total other expenses of $11,922,588. The increase in total other expenses were principally due to a net increase of $7,096,584 for interest expenses and a net increase in non-cash gain in fair value of warrants for $4,817,430 for convertible notes in connection with our private placement on January 5, 2010. The effective interest expense for convertible notes is calculated using a constant effective interest rate, applied to the carrying value of the notes each month. As the carrying value increases, so does the interest expense. On December 31, 2011, the Company entered into an amendment to the Notes with Euro Pacific as representative of the Investors (the “Amendment”) which: (i) extended the maturity date of the Notes from January 5, 2012 to April 5, 2012 (such extra three month period, the “Extended Period”); and (ii) increased the interest rate on the Notes to an annual rate of 12% (or 3% for the Extended Period). On May 14, 2011, the Company entered into an amendment to the Notes with Euro Pacific as representative of the Investors (the “Second Amendment”) which: (i) extended the maturity date of the Notes from April 5, 2012 to October 5, 2012 (such extra six month period, the “Second Extended Period”); and (ii) remained the interest rate on the Notes at an annual rate of 12% (or 6% for the Second Extended Period). As of June 30, 2012, there were 5,225,000 shares of the Company’s Common Stock issuable upon conversion of the outstanding convertible notes. (See Note 14).

  

Provision for Income Tax

 

Our provisions for income taxes for the twelve months ended June 30, 2012 and 2011 were $7,314,882 and $4,765,018, an increase of $2,549,864, or 53.5%, from this fiscal quarter to date over the same period last year. The increase in provision for income tax was principally due to an increase in taxable income under the PRC law from Bohai as well as income tax provision from Yantai Tianzheng (see Note 20 to the accompanying audited consolidated financial statements).

 

Net Income

 

We had a net income of $9,648,025 for the twelve months ended June 30, 2012, as compared to net income of $14,004,875 for the twelve months ended June 30, 2011, a decrease in net income of $4,356,850, or 31.1%. This translates into basic net income per common share of $0.54 and $0.81 and diluted net income per common share of $0.54 and $0.75, for the twelve months ended June 30, 2012 and 2011, respectively. The decrease in net income was primarily attributable to an increase in total gross profit of $41,062,431 offset by an increase in operating expenses of $30,946,829, an increase in total other expenses of $11,922,588 resulting from mostly effective interest charges and change in fair value of derivative liabilities, and an increase in the tax provision of $2,549,864 this fiscal year compared to the same period in prior year.

 

Net income margin was 7.0% for the twelve months ended June 30, 2012 compared to 17.2% for the same period last year, a decrease of 59.2%. The decrease in net income margin for the twelve months ended June 30, 2012 over the same period in the previous fiscal year was principally due to a net increase in certain non-cash related activities such as amortization of beneficial conversion features on convertible notes converted and change in fair value of warrants for a total of $13,105,840, as well as a non-cash net decrease in deferred tax expense of $1,240,227. If we excluded such net gains, the net income margin would be 13.9% this fiscal year.

 

We had Non-GAAP net income of $19,113,232 for the twelve months ended June 30, 2012, as compared to Non-GAAP net income of $11,769,996 for the twelve months ended June 30, 2011, an increase in Non-GAAP net income of $7,343,236, or 62.4%. This translates into basic Non-GAAP net income per common share of $1.07 and $0.68, and Non-GAAP diluted net income per common share of $1.07 and $0.66, for the twelve months ended June 30, 2012 and 2011, respectively (See Use of Non-GAAP Financial Measures above).

 

43
 

 

Total other income included a non-cash charge in effective interest expenses of $9,317,897 for the twelve months ended June 30, 2012 compared to $1,029,487 for the same period in 2011.

 

Total other income included a non-cash charge for the twelve months ended June 30, 2012 and 2011 also comprised of a non-cash debit expense for fair value of warrants of $273,369 and income of $4,544,061, respectively.

 

Liquidity and Capital Resources

 

Liquidity is the ability of a company to generate adequate amounts of cash to meet its needs for cash. As of June 30, 2012, we had cash and cash equivalents of $18,386,288 and restricted cash of $9,449,905, substantially almost all of which is located in financial institutions in China. The following table provides detailed information about our net cash flow for financial statement periods presented in this report: 

 

Summary of Cash Flow Statements

 

   For the twelve months ended 
   June 30, 
   2012   2011 
Net cash provided by operating activities  $20,607,540   $10,958,943 
Net cash used in investing activities   (9,824,114)   (14,492,630)
Net cash used in financing activities   (6,144,836)   (1,131,618)
Effect of foreign currency translation on cash and cash equivalents   403,272    860,649 
Net increase (decrease) in cash and cash equivalent  $5,041,862   $(3,804,656)

 

On January 5, 2010, pursuant to a Securities Purchase Agreement with 128 accredited investors, we sold 6,000,000 units for aggregate gross proceeds of $12,000,000, each unit consisting of an 8% senior convertible promissory note in the principal amount of $2.0, or the Notes, and one common stock purchase warrant, or the Warrants. The Notes bear interest at 8% per annum, payable quarterly in arrears on the last day of each of our fiscal quarters. No principal payments are required until maturity of the Notes on January 5, 2012. Each Note, plus all accrued but unpaid interest thereon, is convertible, in whole but not in part, at any time at the option of the holder, into shares of the Company’s common stock at a conversion price of $2.00 per share, subject to adjustment as set forth in the Note. If the convertible note holders did not convert their notes by their maturity date (January 5, 2012), we will need to redeem those convertible notes at $2.0 per each note. As of June 30, 2012, there were 5,225,000 shares of the Company’s Common Stock issuable upon conversion of the outstanding convertible notes. (See Note 14 to the accompanying financial statements).

 

Effective as of June 30, 2010, we entered into an Amendment and Agreement (the “A&A”) with the representative of the investors pursuant to which we agreed to make certain amendments to the Notes and the Warrants.  Pursuant to the A&A, the anti-dilution protection provisions in the Notes and the Warrants were eliminated and a provision specifically precluding net cash settlement by the Company of the Notes and the Warrants was added. In return, and subject to certain non-financing exceptions, we agreed not to issue any new equity securities at a price per share below $2.20 until the earlier of (i) January 5, 2013 or (ii) the date on which, collectively with any prior conversions or exercises of Notes and Warrants, 75% of the principal face value of the Notes in the aggregate has been converted into shares of Company common stock and Warrants representing, in the aggregate, 75% of the aggregate shares of the Company’s common stock underlying the Warrants have been exercised. On March 30, 2011, we entered into a Termination Agreement pursuant to which we and the representative of the investors agreed to terminate the A&A because, after further study, we concluded that the original purpose of the A&A (to mitigate the impact of certain non-cash embedded derivative liabilities associated with the Notes, Warrants and certain placement agent warrants) would not be achieved. Therefore, we determined and agreed with the representative of the investors to terminate the A&A and to thereby restore the Notes, Warrants and such placement agent warrants to their original terms.

 

On December 31, 2011, we entered into an amendment to the Notes with Euro Pacific as representative of the Investors (the “Amendment”) which: (i) extended the maturity date of the Notes from January 5, 2012 to April 5, 2012 (such extra three month period, the “Extended Period”); and (ii) increased the interest rate on the Notes to an annual rate of 12% (or 3% for the Extended Period). 

 

On May 14, 2012, we entered into an amendment to the Notes with Euro Pacific as representative of the Investors (the “Second Amendment”) which: (i) extended the maturity date of the Notes from April 5, 2012 to October 5, 2012 (such extra six month period, the “Second Extended Period”); and (ii) remained the interest rate on the Notes to an annual rate of 12% (or 6% for the Extended Period). 

 

See “Comparison of Years ended June 30, 2012 and 2011 – Cash Position” and “Obligations under Material Contracts” below for further discussion of our liquidity needs.

   

44
 

 

In addition, as part of the contemplated Second Amendment, we established an RMB denominated escrow account in China and to deposit into such escrow account the remaining outstanding amount of the Notes, which we have no right to dispose of or use except for: (i) conversion into US Dollars for the purpose of repayment of the Notes or (ii) releases from such Escrow Account from time to time in amounts equal to the decreases in the outstanding amount of the Notes, either by payments made by us or conversion of the Notes by Note holders.

 

On May 8, 2012, a Three Parties Fund Escrow Agreement (“Escrow Agreement”) was entered into among Yantai Shencaojishi Pharmaceuticals Co., Ltd., our wholly-owned subsidiary (“YantaiShencaojishi”), Euro Pacific and Rural Credit Cooperative of Laishan District, Yantai City (the “Bank”). Pursuant to the Escrow Agreement, an RMB-denominated escrow account (the “Escrow Account”) was established with Bank and RMB 59 million (approximately $10.45 million) was deposited by YantaiShencaojishi into the Escrow Account. On May 9, 2012, a Supplemental Agreement to the Escrow Agreement with details of the Escrow Account was entered into by us, Euro Pacific and the Bank. The Escrow Agreement provides that the Escrow Account will be managed by both us and Euro Pacific and that withdrawal of cash from the Escrow Account cannot be done without prior written consent from both us and Euro Pacific.

 

As of the date of Report on Form 10-K, a repayment of approximately $414,000 was paid on the Notes (calculated based on an annual rate of 12% as discussed above) and a repayment of principal of $631,000 was paid after June 30, 2012. As of the date of this Report, the Escrow Account remains in place and we continue to work on converting RMB to Dollars in order to make payments under the Notes. However, we expect that we will not be able to accomplish this by the conclusion of the Second Extended Period. We will continue to work with Euro Pacific on this matter and will continue our efforts in order to meet our obligations to the Note holders.

 

The Company is currently working with Euro Pacific as representative of the Investors on a fourth amendment to the Notes which would further extend the maturity date of the Notes from October 5, 2012 to January 5, 2013. As of the date of this Annual Report, no written agreement has been entered into in this regard. The Company is unable to predict whether an agreement will be reached. The non-payment of the loan in the absence of an extension of the maturity date would constitute an event of default under the terms of loan agreement. The Company can not predict what the implications of the non-payment of the loan would be other than the continued difficulty of repaying the loan from escrowed funds due to currency conversion restriction.

 

Comparison of years ended June 30, 2012 and 2011

 

Net Cash Provided by Operating Activities

 

Net cash provided by operating activities totaled $20,607,540 for the twelve months ended June 30, 2012 as compared to net cash provided by operating activities of $10,958,943 for the twelve months ended June 30, 2011. The increase in net cash provided by operating activities, for the twelve months ended June 30, 2012 compared to the same period 2011, was primarily due to an increase of $8.3 million in the effective interest on convertible notes, increased $4.8 million in change in fair value of warrants, increased depreciation and amortization of $3.8 million, increased income taxes payable of $0.9 million, and increased accrued liabilities of $1.9 million, offset by decreased net income of $4.4 million, increased accounts receivable of $1.5 million, and decreased accretion of beneficial conversion feature of $1.0 million. We expect our cash flow from operating activities to maintain a positive flow due to our acquisition of Yantai Tianzheng and our continuous cash flow management.

 

Net Cash Used In Investing Activities

 

Net cash used in investing activities was $9,824,114 for the twelve months ended June 30, 2012 and $14,492,630 for the twelve months ended June 30, 2011. The net decrease in cash used in investing activities was due to a cash payment of approximately $9.7 million for our Yantai Tianzheng acquisition this fiscal year, offset by a cash receipt of $1.4 million from Yantai Tianzheng’s acquisition, decreased purchase of leased land use rights of $7.1 million, and decreased purchase of formulas of $7.2 million.

 

The Company is unable to predict whether an agreement will be reached. The non-payment of the loan in the absence of an extension of the maturity date would constitute an event of default under the terms of the note agreement. The Company can not predict what implications of the non-payment would be other than the continued difficulty of repaying the loan from escrowed funds due to currency restrictions.

 

Net Cash Used In Financing Activities

 

Net cash used in financing activities totaled $6,144,836 for the twelve months ended June 30, 2012 as compared to net cash used in financing activities of $1,131,618 for the same period in 2011. The reason for the increase in cash used in financing activities was due to increased net restricted cash of $9.0 million, repayment of $414,000 convertible notes payable, $1.9 million less cash received from sales of common stock, and decreased payments of $1.5 million for short-term bank loans, offset by a cash receipt of $6.3 million from an equity shareholder, Mr. Qu (our Chairman and CEO).  Mr. Qu made a permanent equity capital contribution of approximately $6.3 million (RMB 40,000,000) into Bohai on August 3, 2011to support its future capital needs.

 

Cash Position

 

As of June 30, 2012, we had cash of $18,386,288 as compared to $13,344,426 as of June 30, 2011, an increase of $5,041,862. This increase was due primarily to a capital contribution from an equity holder (our Chairman Mr. Qu) of $6.3 million, and cash receipt of $1.4 million from our acquisition of Yantai Tianzheng, a decrease in cash from purchase of leased land use rights of $7.1 million, and purchase of formulas of $7.2 million offset by a cash payment of approximately $9.7 million for the Yantai Tianzheng acquisition, cash payments for the purchase of property, plant, equipment of $0.9 million, decreased restricted cash of $9.0 million, , and cash payments of $3.1 million for short term bank loans.

 

45
 

 

We believe that we can meet our liquidity and capital requirements for our ongoing operations from our currently available working capital and maintain our operations at our current levels. 

  

However, during the current fiscal year and thereafter, we will be required to fund two significant obligations (as well as others described under “Obligations under Material Contracts” below):

  

  (i) the completion of the acquisition of Yantai Tianzheng ($5,000,000 million is due within 12 months as of June 30, 2012.  The installment balances can be turned into bank loans with a two-years term at 6% annual interest rate); and

 

  (ii) the repayment our convertible promissory notes due October 5, 2012 ($10.04 million due as of June 30, 2012).

 

As such, we will be required to raise substantial additional capital to fund these obligations, either through the issuance of debt or equity securities, bank loans or other methods. Readers are cautioned that additional funding, capital or loans may be unavailable to us on favorable terms, if at all.  If adequate funds are not available, we would likely have to renegotiate the terms of these obligations, which we may be unable to do on favorable terms. We may thus be required to agree to unfavorable terms which could have a material adverse effect on us, our financial condition and our results of operations and beyond.  Moreover, to the extent that additional capital is raised through the sale of equity or convertible debt securities, the issuance of such securities would result in ownership and potentially economic dilution to existing shareholders.

 

In addition, if we are faced with worldwide financial and credit crises as occurred in 2008 and 2009 and very recently in 2011, it may make the future cost of raising funds through the debt or equity markets more expensive or make financial markets unavailable to us at times when we require additional financings.

 

Critical Accounting Policies and Estimates

 

As discussed in Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, of our Annual Report on Form 10-K for the fiscal year ended June 30, 2012, we consider our use of estimates, accounts receivable, revenue recognition, inventories, property plant and equipment, and income taxes to be the most critical accounting policies in understanding the judgments that are involved in preparing our audited consolidated financial statements. There have been no significant changes to these estimates in the twelve months ended June 30, 2012.

 

Recent Accounting Pronouncements Adopted

 

See Note 3 to the consolidated financial statements included in Item 1, Financial Information, of this Annual Report on Form 10-K.

 

Recent Accounting Pronouncements Not Yet Adopted

 

See Note 3 to the audited consolidated financial statements included in Item 1, Financial Information, of this Annual Report on Form 10-K.

 

Obligations under Material Contracts

 

The following table summarizes our contractual obligations as of June 30, 2012, and the effect these obligations are expected to have on our liquidity and cash flows in future periods.

  

    Payments Due by Period   
          Less than      1-3      4-5       
    Total      1 year      Years      years     Years+   
Contractual Obligations:                                        
Convertible notes   $ 10,036,000     $ 10,036,000     $ -     $ -     $ -  
                                         
Construction In Process     463,234        463,234        -       -       -  
                                         
Yantai Tianzheng acquisition     25,300,000       5,000,000       20,300,000       -       -  
                                         
Contract Research and Development Arrangement     1,040,170                               1,040,170  
                      -       -        
Total Contractual Obligations:   $ 36,839,404     $ 15,499,234     $ 20,300,000     $ -     $ 1,040,170  

 

46
 

 

Other than discussed above, there are no other foreseeable material commitments or contingencies as of June 30, 2012.

 

Off-Balance Sheet Arrangements

 

We did not engage in any “off-balance sheet arrangements” (as that term is defined in Item 303(a)(4)(ii) of Regulation S-K) during the twelve months ended June 30, 2012. We have not entered into any financial guarantees or other commitments to guarantee the payment obligations of any third parties. We have not entered into any derivative contracts that are indexed to our shares and classified as shareholder’s equity or that are not reflected in our audited consolidated financial statements. Furthermore, we do not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity. We do not have any variable interest in any unconsolidated entity that provides financing, liquidity, market risk, or credit support to us or engages in leasing, hedging, or research and development services with us.

 

Currency Exchange Risk

 

Our reporting currency is the U.S. dollar and our operations in China use their local currency as their functional currencies. Substantially all of our revenue and expenses are in the Chinese currency, the Renminbi. We are subject to the effects of exchange rate fluctuations with respect to any of these currencies.  For example, the value of the Renminbi depends to a large extent on Chinese government policies and China’s domestic and international economic and political developments, as well as supply and demand in the local market.  Since 1994, the official exchange rate for the conversion of the Renminbi to the U.S. dollar had generally been stable and the Renminbi had appreciated slightly against the U.S. dollar.  In July 2005, the Chinese government changed its policy of pegging the value of the Renminbi to the U.S. dollar.  Under this policy, which was halted in 2008 due to the worldwide financial crisis, the Renminbi was permitted to fluctuate within a narrow and managed band against a basket of certain foreign currencies.  In June 2010, the Chinese government announced its intention to again allow the Renminbi to fluctuate within the 2005 parameters.  It is possible that the Chinese government could adopt an even more flexible currency policy, which could result in more significant fluctuation of Renminbi against the U.S. dollar, or it could adopt a more restrictive policy. We can offer no assurance that the Renminbi will be stable against the U.S. dollar or any other foreign currency. 

    

Our consolidated financial statements are translated into U.S. dollars at the average exchange rates in each applicable period.  To the extent the U.S. dollar strengthens against foreign currencies, the translation of these foreign currencies denominated transactions results in reduced revenue, operating expenses and net income for our international operations.  Similarly, to the extent the U.S. dollar weakens against foreign currencies, the translation of these foreign currency denominated transactions results in increased revenue, operating expenses and net income for our international operations.  We are also exposed to foreign exchange rate fluctuations as we convert the financial statements of our foreign consolidated subsidiaries into U.S. dollars in consolidation.  If there is a change in foreign currency exchange rates, the conversion of the foreign consolidated subsidiaries’ financial statements into U.S. dollars will lead to a translation gain or loss which is recorded as a component of other comprehensive income.  In addition, we have certain assets and liabilities that are denominated in currencies other than the relevant entity’s functional currency. Changes in the functional currency value of these assets and liabilities create fluctuations that will lead to a transaction gain or loss.  We have not entered into agreements or purchased instruments to hedge our exchange rate risks, although we may do so in the future.  The availability and effectiveness of any hedging transaction may be limited and we may not be able to hedge our exchange rate risks. Most of our transactions are settled in Renminbi and U.S. dollars. We are not exposed to significant foreign currency risk.  

 

Credit Risk

 

Our potential credit risk is mainly attributable to our debtors and bank balances.  In respect of debtors, we have policies in place to ensure that it will only accept customers from countries which are politically stable and customers with an appropriate credit history.  In addition, all the bank balances were made with financial institutions with high-credit quality.  Thus, we are not considered to be subject to significant credit risk.

 

Interest Rate Risk

 

Our interest rate risk is primarily attributable to our short-term borrowings, loan to a third party and loan to equity holders.  Our borrowings carry interest at fixed rate.  Our management has not used any interest rate swaps to hedge our exposure to interest rate risk.

 

Inflation

 

In recent years, the Chinese economy has experienced periods of rapid expansion and high rates of inflation. During the past ten years, the rate of inflation in China has been as high as 20.7% and as low as -2.2%. These factors have led to the adoption by Chinese government, from time to time, of various corrective measures designed to restrict the availability of credit or regulate growth and contain inflation. While inflation has been more moderate since 1995, high inflation may in the future cause Chinese government to impose controls on credit and/or prices, or to take other action, which could inhibit economic activity in China, and thereby harm the market for our products.

 

47
 

 

Item 7A.  Quantitative and Qualitative Disclosures about Market Risk.

 

We are a “smaller reporting company” as defined by Regulation S-K and as such, are not required to provide the information contained in this item pursuant to Regulation S-K.

 

Item 8.  Financial Statements and Supplementary Data.

 

Our Consolidated Financial Statements and Notes thereto and the report of Marcum Bernstein Pinchuk LLP, our independent registered public accounting firm, are set forth on pages F-1 through F-[28]  of this Annual Report.

 

Item 9.  Changes In and Disagreements with Accountants On Accounting and Financial Disclosure.

 

None.

 

Item 9A.  Controls and Procedures.

 

Evaluation of Disclosure Controls and Procedures

 

The Company’s management is responsible for establishing and maintaining a system of disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) that is designed to ensure that information required to be disclosed by the Company in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to the issuer’s management, including its principal executive officer or officers and principal financial officer or officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

 

48
 

 

As of the end of the period covered by this Annual Report, our President and Chief Executive and Principal Accounting Officer (the “Certifying Officer”), conducted an evaluation of our disclosure controls and procedures. Based on this evaluation, the Certifying Officer has concluded that our disclosure controls and procedures were, due to certain factors, not effective to ensure that material information is recorded, processed, summarized and reported by our management on a timely basis in order to comply with our disclosure obligations under the Exchange Act and the rules and regulations promulgated thereunder.

 

Our management is also responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

 

Our internal control over financial reporting includes those policies and procedures that:

 

  Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company;
     
  Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of the Company’s management and directors; and
     
  Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.

 

As of June 30, 2012 we carried out an assessment of the effectiveness of our internal control over financial reporting based on the framework in “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation, our management concluded that our internal control over financial reporting was not effective as of June 30, 2012. Management has specifically observed that our accounting systems and current staffing resources in our finance department are currently insufficient to support the complexity of our financial reporting requirements. We currently do not have any staff members in our accounting and finance department who have experience or specialized training in preparing financial statements in the form and format required by the SEC. We have also experienced difficulty in applying complex accounting and financial reporting disclosure rules as required under various aspects of GAAP and SEC reporting regulations including those relating to accounting for business combinations, intangible assets, derivatives and income taxes. Our former Chief Financial Officer, which was based in the United States, resigned from his position with the Company during the quarter ended September 30, 2011. Subsequent thereto, we have engaged the service of an outside financial reporting specialist to assist with the preparation of our financial statements and quarterly and annual report; however, we have not hired a replacement for our CFO position at this time.

 

We have instituted certain procedures to mitigate our internal control risks. Our Chief Executive Officer and our Controller based in China review and approve substantially all of our major transactions to ensure the completeness and fair presentation of our financial statements. We have, when needed, hired outside experts to assist us with implementing complex accounting principles. Management and the Board of Directors believe that the Company must allocate additional human and financial resources to address these matters.

 

Changes in Internal Control over Financial Reporting

 

Subject to the foregoing disclosure, there were no changes in our internal control over financial reporting during our fiscal year ended June 30, 2012 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

Limitations on the Effectiveness of Internal Controls

 

Readers are cautioned that our management does not expect that our disclosure controls and procedures or our internal control over financial reporting will necessarily prevent all fraud and material error. An internal control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any control design will succeed in achieving its stated goals under all potential future conditions. Over time, control may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.

  

Item 9B.  Other Information.

 

None.

 

49
 

 

PART III

 

Item 10.   Directors, Executive Officers, Promoters and Control Persons; Compliance With Section 16(A) of the Exchange Act.

 

The following table sets forth the name, age, and position of our directors, our executive officers and key employees as of the date of this Annual Report.  Executive officers are elected annually by our board of directors.  Each executive officer or key employee holds his office until he resigns, is removed by the board of directors, or his successor is elected and qualified, subject to applicable employment agreements.  We have a classified board of directors under which each of our directors is designated as a part of one of three separate classes, with the directors in one class being elected annually by our shareholders at our annual meeting of shareholders for a term of three years.  Each director holds his office until his successor is elected and qualified or his earlier resignation or removal.  As used below, the term “Bohai” means YantaiBohai Pharmaceuticals Group Co., Ltd., a PRC company and our operating subsidiary.

 

Name   Age   Position/Director Class
Hongwei Qu   37   President, Chief Executive Officer and Chairman of the Board of Directors (Class 1)
Ning Tang   52   Vice President – Operations
Hongbin Shan   43   Vice President – Sales and Marketing
Chunhong Jiang   47   Secretary and Treasurer
Chengde Wang   64   Director (Class 1)
Thomas Tan   50   Director (Class 2)

 

Hongwei Qu.  Mr. Qu became our President, Chief Executive Officer, Interim Chief Financial Officer, Treasurer and Secretary as of January 5, 2010, and, became the sole director and Chairman of the our board of directors effective as of January 16, 2010 upon filing of Schedule 14(f) with the SEC on January 6, 2010 in compliance with Section 14(f) of the Exchange Act.  Mr. Qu relinquished the positions of Interim Chief Financial Officer, Secretary and Treasurer in June 2010.  From 2001 to May 2007, Mr. Qu was the founder and principal officer of YantaiHangwei Medical Trading Co., a PRC company engaged in the wholesale of drugs and medical products and retail of medical devices. In May 2007, Mr. Qu took principal responsibilities for the acquisition of Bohai.  From May 2007 until present, Mr. Qu has served as the General Manger and Executive Director of Boha. Mr. Qu has significant experience in the medical and pharmaceutical sectors in China.  Mr. Qu graduated from Shandong Economic University with a bachelor degree.

 

Ning Tang was appointed as Bohai’s Vice President — Operations in November 2007 and our Vice President – Operations in June 2010.  Mr. Tang has over 25 years of experience in management of pharmaceuticals companies in China.  Prior to his appointment with Bohai, Mr. Tang served as General Manager for YantaiXiangyu Environmental Protection Equipment Co., Ltd. from 2004 to 2007, where he was responsible for all affairs of corporate operations in China.  He served as Vice President of YantaiRongchang Pharmaceuticals Co., Ltd. from 1998 to 2004, where he managed the departments of operation, administration, manufacturing and product quality.  From 1986 to 1998, he served as Deputy Director for Yantai TCM Pharmaceuticals Corporation, where he was responsible for production, product quality, purchase, research and development and sales.  He received his B.S. degree in international trade and business from Shandong Economic University.

 

Hongbin Shan was appointed as Bohai’s General Manager of Sales in May 2010 and as the Vice President – Sales and Marketing as of June 2010.  Mr. Shan has over 10 years of experience in sales, marketing and management.  Prior to his appointment with us, from 1994 to 2010, Mr. Shan served as General Manager for the Qingdao Branch, Shandong Province of Shandong Green Leaf Pharmaceutical Co., Ltd. and manager of the Su-Min Region (including Jiangsu, Fujian, Hubei, Jiangxi and Anhui provinces) where he was responsible for all affairs of marketing and sales.  He also served in the capacity of Assistant Director of the Oncology Division, responsible for the national market of Shandong Green Leaf’s tumor line.  He received his B.S. degree from YantaiUniversity and educational certificate from the senior MBA program of Tsinghua University.

 

Chunhong Jiang was appointed as Bohai’s General Manager of Finance, Secretary and Treasurer in May 2007 and as our Secretary and Treasurer in June 2010.  Ms. Jiang has over 20 years of experience in corporate finance, accounting and management.  Prior to her appointment with Bohai, Ms. Jiang served as Financial Manager for YantaiFurao Trading Group from 2004 to 2007.  She served as Financial Manager and department director for Yantai Garment Company, a subsidiary of China Garment Group from 1994 to 2003, where she was responsible for overall accounting and financial reporting functions. She served as statistician, accountant and financial chief for Yantai Hardware Factory from 1987 to 1993, where she managed the overall statistics, accounting and financial reporting functions.  She graduated from Shandong Economic University.

 

50
 

 

Chengde Wang became an independent director of our Company on July 12, 2010.  Mr. Wang has served as the director medical doctor and Ph.D./MD advisor of Beijing Shuntiande Chinese Medicine Hospital since October 2005, where he is responsible for managing medical practice and research projects.  Prior to joining Beijing Shuntiande Chinese Medicine Hospital, Mr. Wang worked at GuangAnmen Hospital under China Academy of Chinese Medical Science and was the professor and the chief physician in the Beijing University of Chinese Medicine.  Mr. Wang is an expert in Traditional Chinese Medicine and has been honored by the P.R.C. State Council.  He is a member of National Committee of The Chinese People’s Political Consultative Conference, a director of Cooperation Center of State Administration of Traditional Chinese Medicine with Taiwan, Hong Kong and Macao, director and Secretary-General of the Center of Traditional Chinese Medicine Society and expert of review committee of National Essential Drugs Association.  Mr. Wang graduated from Beijing University of Chinese Medicine.

 

Thomas Tan became an independent director of our Company on September 6, 2011. Mr. Tan has over 15 years of experience in corporate finance and management in the United States. In the last 3 years, he has served as the Managing Director of Capital Markets Group at Euro Pacific Capital, Inc., responsible for leading private placements for US listed Chinese companies and Canadian listed mining companies.  In addition, Mr. Tan has focused on the precious metals and mining sectors since 2004, becoming, at the time, a popular independent blogger, writer and contributor for many financial and precious metal websites.  Many of Mr. Tan’s articles were published and treated as Editor’s Picks by Seeking Alpha.  Before joining Euro Pacific in 2008, from 1998 to 2008, Mr. Tan served in various corporate finance positions at Pfizer, Inc. in the financial planning and analysis area, supporting research and development, legal and manufacturing functions.  In 1997, he worked briefly as a banker for the Capital Markets Group at Cargill, Inc.  Mr. Tan holds an MBA in Finance from the Fuqua School of Business at Duke University and has held the Chartered Financial Analyst (CFA) designation since 2004.

   

Audit, Nominating, Compensation Committees and Director Independence

 

Our board of directors is comprised of a majority of “independent” directors (as defined under the Nasdaq Marketplace rules).

 

As part of obligations under the Securities Purchase Agreement in connection with our January 2010 private placement, one of our directors is designated by Euro Pacific Capital, the lead placement agent for such private placement.  Thomas Tan is the director designated by Euro Pacific Capital.

 

Effectively February 2, 2011, the Board established three committees of the Board: an Audit Committee, Nominating and Corporate Governance Committee and Compensation Committee.  In addition, the Board appointed the following directors to serve on such committees, as indicated below;

 

Audit Committee   Members: Thomas Tan
     

Nominating and Corporate

Governance Committee

 

Chairman: Thomas Tan

Members: Chengde Wang

     
Compensation Committee  

Chairman: Thomas Tan

Members: Chengde Wang

 

The Board of Directors has determined that Mr. Tan qualifies as an “audit committee financial expert” as defined by applicable SEC rules.

 

Communication with our Directors

 

Shareholders or other interested parties may communicate with our directors by sending mail to Mr. Hongwei Qu, c/o YantaiBohai Pharmaceuticals Group Co. Ltd., No.9 Daxin Road, Zhifu District, Yantai, Shandong Province, China 264000.

 

Board of Directors’ Meetings

 

During our fiscal year ended June 30, 2012, we did not hold any meetings of the board of directors, although our board of directors did act by unanimous written consent.

 

51
 

 

Section 16(a) Beneficial Ownership Reporting Compliance

 

Section 16(a) of the Securities Exchange Act of 1934, as amended, requires our officers, directors and persons who beneficially own more than 10% of a registered class of our equity securities (“ten percent shareholders”) to file reports of ownership and changes in ownership with the SEC. Officers, directors and ten percent shareholders are charged by the SEC regulations to furnish us with copies of all Section 16(a) forms they file. 

  

Based solely upon a review of copies of Section 16(a) reports and representations received by us from reporting persons, and without conducting any independent investigation of our own, in fiscal year ended on June 30, 2010, our officers, directors and ten percent shareholders are in compliance with Section 16(a).

 

Item 11. Executive Compensation

 

The following table sets forth all compensation received during the last two fiscal years by our Chief Executive Officer, Chief Financial Officer and each of the other most highly compensated executive officers whose total compensation exceeds $100,000 in such fiscal years.  These officers are referred to as the Named Executive Officers in this Annual Report.

 

All the executive officers were paid in RMB and the amounts reported in this table have been converted from Renminbi to U.S. dollars based on the June 30, 2012 conversion rate of RMB 6.3519 to $1.00.

 

SUMMARY COMPENSATION TABLE  
Name and Principal 
Position
  Fiscal
Year
  Salary
($)
    Bonus
($)
    Stock
Awards
($)
    Option
Awards
($)
    Non-Equity
Incentive Plan
Compensation
($)
    Change in
Pension Value
and
Nonqualified
Deferred
Compensation
Earnings
($)
    All Other
Compensation
($)
    Total
($)
 
Hongwei Qu     2012   $ 36,211                                                       36,211  
Chief Executive Officer     2011   $ 36,211       -       -       -       -       -       -     $ 36,211  
                                                                     
Gene Hsiao*     2012   $                                                            
Chief Financial Officer     2011   $ 120,000             $ 95,000       -       -       -       -     $ 215,000  

 

*Effective December 31, 2011, Mr. Hsiao resigned from his position as CFO of the Company.

 

Employment Agreements

 

We presently do not have any employment agreements or other compensation arrangements with Mr. Qu.

  

Director Compensation  
Name (a)  

Fees

Earned

or Paid

in Cash

($)(1)

   

Stock

Awards

($)

   

Option

Awards

($)

   

Non-Equity

Incentive Plan

Compensation

($)

   

Non-Qualified

Deferred

Compensation

Earnings

($)

   

All Other

Compensation

($)

    Total ($)  
Hongwei Qu     -       -       -       -       -       -       -  
Chengde Wang     -       -        -       -       -       -       -  
Adam Wasserman*     -       -       -       -       -       -     $    
Gene Hsiao**     -       -        -       -       -       -          

*         Mr. Wasserman resigned from our board of directors on February 19, 2012.

**       Mr. Hsiao resigned from our board of directors on December 31, 2011.

 

Hongwei Qu is paid in his capacity as executive officer of our Company and he does not receive any additional compensation for his service as director.

 

Gene Hsiao was paid in his capacity as chief financial officer of our Company and he does not receive any additional compensation for his service as director.

 

52
 

 

On January 11, 2010, Dr. Chengde Wang entered into such agreements with the Company, which became effective on July 12, 2010 with his appointments to the Company’s board of directors and the Company’s execution thereof.  On September 6, 2011, Thomas Tan entered into an independent director and indemnification agreement with the Company and it is effective as of such date.  The form of independent director and indemnification agreements are filed as Exhibit 10.1 to our Current Report on Form 8-K, dated July 13, 2010 (the “Independent Director Agreement”).

 

Pursuant to the Independent Director Agreements:

 

(i)           each independent director will be retained as a director of the Company until the director or the Company terminates the agreement upon thirty (30) days prior written notice, with or without cause;

 

(ii)           Mr. Tan receives a $20,000 annual director’s fee and a five year non-qualified option to purchase 6,000 shares of restricted common stock of the Company at a price equal to $2.00 per share with cashless exercise feature; and

 

(iii)         Dr. Wang receives a $22,000 annual director’s fee.

 

The Independent Director Agreement also contains standard confidentiality provisions and provides that the Company shall indemnify the directors to the fullest extent permitted by law against personal liability for actions taken in the performance of their duties to the Company.

 

53
 

 

Item 12.  Security Ownership of Certain Beneficial Owners and Management

 

The table sets forth below certain information regarding the beneficial ownership of our common stock as of the date of this Annual Report, based on 17,861,085 aggregate shares of common stock outstanding as of such date, by: (i) each person who is known by us to own beneficially more than 5% of our outstanding common stock with the address of each such person, (ii) each of our present directors and officers, and (iii) all officers and directors as a group. Beneficial ownership is determined in accordance with SEC rules and generally includes voting or investment power with respect to securities. Unless otherwise indicated, the shareholders listed in the table have sole voting and investment power with respect to the shares indicated. Unless otherwise noted, the principal address of each of the shareholders, directors and officers listed below is No. 9 Daxin Road, Zhifu District, Yantai, Shandong Province, China. All share ownership figures include shares of our Common Stock issuable upon securities convertible or exchangeable into shares of our Common Stock within sixty (60) days of the date of this Annual Report, which are deemed outstanding and beneficially owned by such person for purposes of computing his or her percentage ownership, but not for purposes of computing the percentage ownership of any other person.

 

Name of Beneficial Owner  Shares of Common
Stock Owned
   Percent of Class
Beneficially Owned (1)
 
Glory Period Limited (2)(3)(4)   8,942,471    50.18%
Hongwei Qu (4)   8,942,471    50.18%
Chengde Wang (5)   -    - 
Thomas Tan (6)   -    - 
All Executive Officers and Directors as a group   8,982,471    50.40%

 

(1) Based on 17,861,085 shares of common stock issued and outstanding as of June 30, 2012.

 

(2) Joshua Tan is the sole shareholder of Glory Period, but pursuant to a Call Option Agreement, he has no right to sell any shares without prior written consent by Hongwei Qu.

 

(3) Hongwei Qu is the executive director of Glory Period.

 

(4) On December 7, 2009, Mr. Qu, who is a PRC citizen, entered into the Call Option Agreement with Mr. Tan, a Singapore passport holder and the sole shareholder of Glory Period.  Under the Call Option Agreement, Mr. Qu shall have right and option to acquire up to 100% shares of Glory Period for nominal consideration within the next 3 years.  The Call Option Agreement also provides that Mr. Tan shall not dispose any of the shares of Glory Period without Mr. Qu’s consent.

 

(5) Dr, Wang is a director of our company.

 

(6) Mr. Tan is a director of the Company. Pursuant to his independent directors agreement with us, Mr. Chan is expected to receive, effective September 6, 2011, and provided he is still serving with our Company, a five year non-qualified option to purchase 20,000 shares  of restricted common stock of the Company at a price equal to $2.00 per share with cashless exercise feature

 

Item 13. Certain Relationships and Related Transactions and Director Independence.

 

Chance High owns 100% of the issued and outstanding capital stock of WFOE, a wholly foreign owned enterprise incorporated under the laws of the PRC.  On December 7, 2009, WFOE entered into the VIE Agreements with Bohai, a company incorporated under the laws of the PRC, and its three shareholders which include Mr. Qu (our President and Chief Executive Officer, who owns 90% of Bohai’s shares) and two unaffiliated parties.  Pursuant to the VIE Agreements, WFOE does not directly own the equity of our operating subsidiary, but rather assumed management of the business activities of Bohai and has the right to appoint all executives and senior management and the members of the board of directors of Bohai.  The VIE Agreements are comprised of a series of agreements, including a Consulting Services Agreement, Operating Agreement, Proxy Agreement, Equity Pledge Agreement, and Option Agreement, through which WFOE has the right to advise, consult, manage and operate Bohai for an annual fee in the amount of Bohai’s yearly net profits after tax.  Additionally, Bohai’s shareholders have pledged their rights, titles and equity interest in Bohai as security for WFOE to collect consulting and services fees provided to Bohai through an Equity Pledge Agreement. In order to further reinforce WFOE’s rights to control and operate Bohai, Bohai’s shareholders have granted WFOE the exclusive right and option to acquire all of their equity interests in Bohai through an Option Agreement.

 

54
 

 

Through WFOE, Chance High operates and controls Bohai through the VIE Agreements. WFOE used the contractual arrangements to acquire control of Bohai, instead of using a complete acquisition of Bohai’s assets or equity to make Bohai a wholly-owned subsidiary of WFOE because: (i) PRC laws governing share exchanges with foreign entities, which became effective on September 8, 2006, make the consequences of such acquisitions uncertain and (ii) other than by share exchange transactions, PRC laws require Bohai to be acquired for cash and WFOE was not able to raise sufficient funds to pay the full appraised value for Bohai’s assets or shares as required under PRC laws.

 

Slow Walk Arrangements

 

On December 7, 2009, Mr. Qu, who is a PRC citizen, entered into the Call Option Agreement with Joshua Tan, a Singapore passport holder and the sole shareholder of Glory Period.  Under the Call Option Agreement, Mr. Qu shall have right and option to acquire up to 100% shares of Glory Period for nominal consideration within the next 3 years.  The Call Option Agreement also provides that Mr. Tan shall not dispose any of the shares of Glory Period without Mr. Qu’s consent.

 

Other

 

Other than employment and the foregoing arrangements, none of the following persons has any direct or indirect material interest in any transaction to which we are a party since our incorporation or in any proposed transaction to which we are proposed to be a party: (i) any of Bohai’s directors or officers; (ii) any person who beneficially owns, directly or indirectly, shares carrying more than 10% of the voting rights attached to our common stock; or any relative or spouse of any of the foregoing persons, or any relative of such spouse, who has the same house as such person or who is a director or officer of any parent or subsidiary of our company.

 

Review, Approval or Ratification of Related Party Transactions

 

Our board of directors is responsible for reviewing all “Related Person Transactions” as defined by Item 404 of Regulation S-K of the rules promulgated by the SEC.  Directors and executive officers are responsible for bringing a potential Related Person Transaction to the attention of our Board.

 

In reviewing a related person transaction, our board of directors will, after reviewing all material information regarding the transaction, take into account, among other factors it deems appropriate, whether the transaction is on terms no less favorable than terms generally available to an unaffiliated third party under the same or similar circumstances and the extent of the related person’s interest in the transaction.

 

Item 14.  Principal Accountant Fees and Services.

 

The following table sets forth fees billed to us by our independent registered public accounting firms Marcum Bernstein &Pinchuk, LLP, during the fiscal years ended June 30, 2012 and June 30, 2011, respectfully for: (i) services rendered for the audit of our annual financial statements and the review of our quarterly financial statements; (ii) services by our independent registered public accounting firms that are reasonably related to the performance of the audit or review of our financial statements and that are not reported as audit fees; (iii) services rendered in connection with tax compliance, tax advice and tax planning; and (iv) all other fees for services rendered.

 

   June 2012   June 2011 
Audit Fees  $130,500   $93,000 
Audit Related Fees   3,073    664 
Tax Fees   3,000    3,000 
All Other Fees        - 
 TOTAL  $136,573   $96,664 

 

55
 

 

Part IV

 

Item 15.  Exhibits

 

Exhibit

No.

  Description
2.1   Share Exchange Agreement, dated January 5, 2010, by and among the Company, Chance High and Shareholders of Chance High (1)
3.1   Articles of Incorporation of the Company (2)
3.2   Bylaws of the Company (3)
3.3   Certificate of Amendment to Articles of Incorporation (4)
3.4   Articles of Merger and Agreement and Plan of Merger as filed with the Secretary of State of Nevada on January 29, 2010 (5)
4.1   Form of Note issued to the Investors in the Private Placement, dated January 5, 2010 (1)
4.2   Form of Warrant issued to the Investors in the Private Placement, dated January 5, 2010 (1)
4.3   Form of Placement Agent Warrant issued to affiliates of Euro Pacific Capital, Inc. and to Chardan Capital Markets, LLC, dated January 5, 2010 (1)
5.1   Opinion of Ellenoff Grossman &Schole LLP*
10.1   Securities Purchase Agreement, dated January 5, 2010, by and among the Company, the Investors in the Private Placement and Euro Pacific Capital, Inc. as representative of the Investors (1)
10.2   Registration Rights Agreement, dated January 5, 2010, by and among the Company and the Investors in the Private Placement (1)
10.3   Securities Escrow Agreement, dated January 5, 2010, by and among the Company, Euro Pacific Capital, Inc., as representative of the Investors, Glory Period Limited and Escrow, LLC, as escrow agent (1)
10.4   Closing Escrow Agreement, dated December 10, 2009, by and among the Company, Euro Pacific Capital, Inc., as representative of the Investors, and Escrow, LLC, as escrow agent (1)
10.5   Form of Independent Director Agreement and Indemnify Agreement (6)
10.6   Unofficial English Translation of the Intangible Assets Transfer Agreement, dated December 9, 2010, by and between the Company and Shandong Daxin Microbiology Pharmaceutical Industry Co., Ltd. (7)
10.7   Form of Subscription Agreement for the Company’s Regulation S financing (8)
10.8   Termination Agreement dated and entered into effective for all purposes as of March 30, 2011, by and between the Company and Euro Pacific Capital, Inc., as investor representative. (9)
10.9   Unofficial English Translation of Share Purchase Agreement, dated as of August 8, 2011 among WFOE II, Mr. Jiangbo Chi, Ms. Shulian Wang and Mr. Bohai Yu. (10)
21.1   Subsidiaries of the Registrant +
31.1   Certification of Registrant’s Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934. +
31.2   Certification of Registrant’s Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934. +
32.1   Certification of Registrant’s Chief Executive Officer pursuant to Rule 13a-14(b)/15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350. +
32.2   Certification of Registrant’s Chief Financial Officer pursuant to Rule 13a-14(b)/15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350. +
99.1   Unofficial English translation of Consulting Services Agreement, dated December 7, 2009, between Bohai and the WFOE (1)
99.2   Unofficial English translation of Operating Agreement, dated December 7, 2009, by and among Bohai, its Shareholders and the WFOE (1)
99.3   Unofficial English translation of Voting Rights Proxy Agreement, dated December 7, 2009, by and among Bohai, its Shareholders and the WFOE (1)
99.4   Unofficial English translation of Equity Pledge Agreement, dated December 7, 2009, by and among Bohai, its Shareholders and the WFOE (1)
99.5   Unofficial English translation of Option Agreement, dated December 7, 2009, by and among Bohai, its Shareholders and the WFOE (1)
99.6   Unofficial English translation of Call Option Agreement dated December 7, 2009 (1)
99.7   Opinion of AllBright Law Offices, dated December 31, 2009, with respect to certain PRC matters (11)

 

*   Previously filed
+   Filed herewith
(1)   Incorporated by reference to the Company’s Current Report of Form 8-K, filed on January 11, 2010.
     
(2)   Incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement of Form S-1 (File Number 333-153102), filed on August 20, 2008.

 

(3)   Incorporated by reference to Exhibit 3.2 to the Company’s Registration Statement of Form S-1 (File Number 333-153102), filed on August 20, 2008.
     
(4)   Incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on December 17, 2009.
     
(5)   Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on December 17, 2009.
     
(6)   Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on July 13, 2010.
     
(7)   Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K, filed on February 4, 2010.
     
(8)   Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K, filed on January 25, 2011.
     
(9)   Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K, filed on April 1, 2011.
     
(10)   Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K, filed on August 10, 2011.
     
(11)   Incorporated by reference to Exhibit 99.7 to the Company’s Registration Statement on Form S-1, filed on June 1, 2010.

 

56
 

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM 

 

To the Audit Committee of the Board of Directors and Shareholders

Of Bohai Pharmaceuticals Group, Inc.

 

We have audited the accompanying consolidated balance sheets of Bohai Pharmaceuticals Group, Inc. and Subsidiaries (the “Company”) as of June 30, 2012 and 2011 and the related consolidated statements of income and comprehensive income, stockholders’ equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audit provides a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Bohai Pharmaceuticals Group, Inc and Subsidiaries as of June 30, 2012 and 2011 and the consolidated results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.

 

/s/ Marcum Bernstein & Pinchuk LLP  
   
New York, New York  
September 28, 2012  

 

 
 

 

BOHAI PHARMACEUTICALS GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

 

   June 30,   June 30, 
   2012   2011 
ASSETS          
Current assets:          
Cash  $18,386,288   $13,344,426 
Restricted cash   9,449,905    11,043 
Accounts receivable   29,670,552    15,891,642 
Inventories   3,795,915    1,511,021 
Prepaid expenses and other current assets   879,696    1,060,138 
           
Total current assets   62,182,356    31,818,270 
           
 Non - current assets:          
Property, plant and equipment, net   11,681,272    5,214,962 
Prepayment for property, plant and equipment   594,508    - 
Intangible assets - pharmaceutical formulas   24,345,353    25,019,377 
Long term prepayments - land use right, net   18,739,297    17,577,271 
Other intangible assets, net   22,763,094    - 
Goodwill   5,092,139    - 
Debt issue costs, net   -    485,039 
Total Non - current assets   83,215,663    48,296,649 
           
TOTAL ASSETS  $145,398,019   $80,114,919 
           
LIABILITIES AND STOCKHOLDERS’ EQUITY          
           
Current liabilities:          
Convertible notes, net of discount of $0 and $9,317,897 as of June 30, 2012 and June 30, 2011, respectively  $10,036,000   $1,132,103 
Accounts payable   3,334,101    1,291,907 
Accrued expenses   8,478,054    4,312,333 
Income taxes payable   2,338,825    721,771 
Short-term borrowings   -    920,554 
Acquisition purchase price payable - current portion   5,000,000    - 
Derivative liabilities - investor and agent warrants   1,211,236    937,867 
Due to Related Party   36,002    11,980 
           
Total current liabilities   30,434,218    9,328,515 
           
Non - current liabilities:          
Acquisition purchase price payable - non-current portion   20,300,000    - 
Deferred tax liability   8,161,269    2,878,397 
Total Non - current liabilities   28,461,269    2,878,397 
           
TOTAL LIABILITIES   58,895,487    12,206,912 
           
COMMITMENTS, CONTINGENCIES, AND OTHER MATTERS          
           
STOCKHOLDERS' EQUITY          
Common stock , $0.001 par value, 150,000,000 shares authorized, 17,861,085 shares issued and  outstanding as of June 30, 2012 and June 30, 2011, respectively   17,861    17,861 
Additional paid-in capital   24,615,353    18,345,574 
Accumulated other comprehensive income   6,236,076    3,559,355 
Statutory reserves   2,201,817    2,201,817 
Retained earnings   53,431,425    43,783,400 
           
Total stockholders’ equity   86,502,532    67,908,007 
           
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY  $145,398,019   $80,114,919 

 

See accompanying notes to the consolidated financial statements

 

F-1
 

 

BOHAI PHARMACEUTICALS GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

 

   For the years ended June 30 
   2012   2011 
         
Net revenues  $137,372,492   $81,328,555 
           
Cost of revenues   33,532,900    17,293,680 
           
Gross profit   103,839,592    64,034,875 
           
Operating expenses:          
Selling, general and administrative   72,889,809    45,550,137 
Depreciation and amortization   2,578,316    228,873 
           
Total Operating expenses   75,468,125    45,779,010 
           
Income from operations   28,371,467    18,255,865 
           
Other income (expenses):          
Interest income   69,308    52,102 
Interest expense   (11,194,301)   (4,097,717)
Other (expenses) income, net   (10,198)   15,582 
Change in fair value of derivative liabilities   (273,369)   4,544,061 
           
Total other income (expenses)   (11,408,560)   514,028 
           
Income before provision for income taxes   16,962,907    18,769,893 
           
Provision for income taxes   (7,314,882)   (4,765,018)
           
Net income  $9,648,025   $14,004,875 
           
Comprehensive income:          
Net income   9,648,025    14,004,875 
Other comprehensive income          
Unrealized foreign currency translation gain   2,676,721    3,098,785 
Comprehensive income :  $12,324,746   $17,103,660 
           
Net income per common share          
           
Basic  $0.54   $0.81 
Diluted  $0.54   $0.75 
           
Weighted average common shares outstanding          
           
Basic   17,861,085    17,198,917 
Diluted   17,861,085    22,423,917 

 

See accompanying notes to the consolidated financial statements

 

F-2
 

 

BOHAI PHARMACEUTICALS GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

FOR THE YEARS ENDED JUNE 30, 2012 AND 2011

 

   Common stock    Additional   Accumulated
other
         Total 
   Shares
outstanding
   Amount   paid-in
capital
   comprehensive
income
   Statutory
reserves
   Retained
Earnings
   Stockholders’
Equity
 
                                    
Balance at June 30, 2010  16,500,000   $16,500   $15,317,621   $460,570   $2,201,817   $29,778,525   $47,775,033 
                                    
Stock based compensation   85,000    85    182,415    -    -    -    182,500 
Option based compensation   -    -    27,028    -    -    -    27,028 
Conversion of convertible notes   527,703    528    948,304    -    -    -    948,832 
Issuance of common stock   748,382    748    1,870,207    -    -    -    1,870,955 
Foreign currency translation difference   -    -    -    3,098,785    -    -    3,098,785 
Net income for the year   -    -    -    -    -    14,004,875    14,004,875 
                                    
Balance at June 30, 2011   17,861,085    17,861    18,345,574    3,559,355    2,201,817    43,783,400    67,908,007 
                                    
Capital contribution from stockholder   -    -    6,225,779    -    -    -    6,225,779 
Stock based compensation   -    -    44,000    -    -    -    44,000 
Foreign currency translation adjustment   -    -    -    2,676,721    -    -    2,676,721 
Net income   -    -    -    -    -    9,648,025    9,648,025 
                                    
Balance at June 30, 2012  17,861,085   $17,861   $24,615,353   $6,236,076   $2,201,817   $53,431,425   $86,502,532 

 

See accompanying notes to the consolidated financial statements

 

F-3
 

 

BOHAI PHARMACEUTICALS GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

   For the Years Ended 
   June 30, 
   2012   2011 
         
Cash flows from operating activities:          
           
Net income  $9,648,025   $14,004,875 
Adjustments to reconcile net income to net cash provided by operating activities:          
           
Depreciation and amortization   4,330,595    538,105 
Bad debt expense   -    26,737 
Gain (loss) on disposal of property, plant and equipment   (1,414)   67,048 
Impairment loss on intangible assets – pharmaceutical formulas   -    635,442 
           
Amortization of debt issue costs   485,039    971,004 
Non-cash interest-convertible notes   9,317,897    2,062,688 
Change in fair value of warrants   273,369    (4,544,061)
Stock based compensation   44,000    209,527 
Deferred income taxes   (170,059)   434,726 
           
Changes in operating assets and liabilities:          
Accounts receivable   (6,309,216)   (4,831,672)
Inventories   (900,652)   (704,725)
Prepaid expenses and other current assets   416,173    454,382 
Accounts payable   (428,745)   498,030 
Accrued liabilities   3,054,618    1,152,389 
           
Income taxes payable   847,910    (15,552)
           
Net cash provided by operating activities   20,607,540    10,958,943 
           
Cash flows used in investing activities:          
Purchases of property, plant and equipment   (914,448)   (88,152)
Proceeds from disposal of property, plant and equipment   26,764    4,526 
Land use rights payments   -    (7,166,782)
Purchase of drug formulas   -    (7,242,222)
Property, plant and equipment deposits   (594,508)   - 
Cash received in acquisition of business   1,358,078    - 
Cash paid for acquisition of business   (9,700,000)   - 
           
Net cash used in investing activities   (9,824,114)   (14,492,630)
           
Cash flows from financing activities:          
Proceeds from short term borrowings   -    897,734 
Repayment of short term borrowings   (3,062,076)   (4,518,845)
Borrowing from related party   23,879    53,562 
Repayment of convertible notes   (414,000)   - 
Capital contribution from shareholder   6,297,328    - 
Proceeds from issuance of common stock   -    1,870,955 
Deposit of restricted cash-convertible note escrow deposit   (10,044,756)   (34,046)
Release of restricted cash- convertible note escrow deposit   1,054,789    599,022 
           
Net cash flows used in financing activities   (6,144,836)   (1,131,618)
           
Effect of foreign currency translation on cash and cash equivalents   403,272    860,649 
           
Net increase (decrease) in cash and cash equivalents   5,041,862    (3,804,656)
           
Cash and cash equivalents at beginning of year   13,344,426    17,149,082 
           
Cash and cash equivalents at end of year  $18,386,288   $13,344,426 
           
Cash paid during the period for:          
Interest  $868,875   $1,045,013 
Income taxes  $6,697,654   $4,345,845 
           
Supplemental cash flow information          
           
Non-cash investing and financing activities:          
Common stock issued upon conversion of convertible notes and accrued interest  $-   $948,832 
           
Acquisition liability  $25,300,000   $- 

 

See accompanying notes to the consolidated financial statements

 

F-4
 

 

BOHAI PHARMACEUTICALS GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED JUNE 30, 2012 AND 2011

 

1.

ORGANIZATION AND PRINCIPAL ACTIVITIES 

 

Bohai Pharmaceuticals Group, Inc. (“BPGI”) was incorporated under the laws of the State of Nevada on January 9, 2008 under the name of Link Resources, Inc. Prior to January 5, 2010, BPGI was a public “shell” company. BPGI became a public operating company on January 5, 2010 pursuant to a Share Exchange Transaction completed on January 5, 2010.

 

BPGI is engaged in the production, manufacturing and distribution of herbal pharmaceuticals based on traditional Chinese medicine (“TCM”) in the People’s Republic of China (“China” or the “PRC”) through the following two operating subsidiaries:

 

(i)  YantaiBohai Pharmaceuticals Group Co., Ltd., (“Bohai”) a PRC company and the Company’s original operating subsidiary BPGI controls Bohai through a variable interest entity arrangement (“VIE”) described below; and

 

(ii)  Yantai Tianzheng Pharmaceuticals Company, Ltd., a PRC company (“Yantai Tianzheng”) which BPGI acquired in August 2011 (with an effective date of July 1, 2011) through a newly formed PRC wholly-foreign owned enterprise subsidiary, YantaiNirui Pharmaceuticals, Ltd. (“WFOE II”).

 

BPGI owns 100% of Chance High International Limited, a British Virgin Islands company (“Chance High”). Chance High owns 100% of the issued and outstanding shares of capital stock of a Chinese wholly-foreign owned enterprise known as YantaiShencaojishi Pharmaceuticals Co., Ltd. (the “WFOE”). On December 7, 2009 (prior to the date of the Share Exchange Transaction), the WFOE entered into a series of variable interest entity contractual agreements (the “VIE Agreements”) with Bohai and its three shareholders, including Mr. Hongwei Qu, the Company’s current Chairman and Chief Executive Officer (“Mr. Qu”). Mr. Qu currently owns 96.7% of the outstanding equity interests of Bohai and two other shareholders who collectively own the remaining 3.3% of Bohai.

 

The VIE Agreements include (i) a Consulting Services Agreement, (ii) an Operating Agreement, and (iii) a Proxy Agreement, through which the WFOE has the right to advise, consult, manage and operate Bohai for an annual fee equal to all of Bohai’s yearly net profits after tax.  Pursuant to these agreements, the WFOE indirectly owns but has 100% managerial and economic control of the business activities of Bohai including the right to appoint all executives and senior management and members of the board of directors of Bohai.  Additionally, Bohai’s shareholders pledged their rights, titles and equity interest in Bohai as security for the WFOE to collect consulting and services fees provided to Bohai pursuant to an equity pledge agreement. In order to further reinforce the WFOE’s rights to control and operate Bohai, Bohai’s shareholders granted the WFOE an exclusive right and option to acquire all of their equity interests in Bohai through an option agreement. The VIE Agreements have perpetual terms unless otherwise determined by PRC law, and can (particularly in the case of the Consulting Services Agreement (which is the principal VIE Agreement) be terminated by the parties under certain circumstances, including material breach, the termination of Bohai’s business or a liquidation of Bohai. The WFOE (which is controlled indirectly by BPGI through Chance High) can also terminate the Consulting Services Agreement at will.

 

BPGI, its wholly owned subsidiary Chance High, WFOE, WFOE II, Bohai and Yantai Tianzheng are referred to herein collectively and as a consolidated basis as the “Company” or “we”, “us” or “our” or similar terminology. Mr. Qu currently serves the Company’s Chairman, Chief Executive Officer and President. As used herein, the term “Common Stock” means the common stock of BPGI, $0.001 par value per share.

 

BPGI is headquartered and maintains its principal operations in the city of Yantai, Shandong Province, China, and conducts business operations exclusively in the PRC.

 

2. LIQUIDITY AND FINANCIAL CONDITION

 

The Company’s net income amounted to $9,648,025 for the year ended June 30, 2012. The Company’s cash flows from operations amounted to approximately $20,607,540 for the year ended June 30, 2012. The Company had working capital of approximately $31,748,138 as of June 30, 2012, including a $10,036,000 convertible note obligation, which pursuant to an amendment thereto is set to mature on October 5, 2012 (see below and Note 14) but excluding a $1,211,236 derivative liability for the fair value of warrants that are not expected to result in a cash settlement. The Company has historically financed its operations principally from cash flows generated from operating activities and external financing raised in private placement transactions completed concurrently with and subsequent to the consummation of the Share Exchange.

 

F-5
 

 

As described further in Note 4, the Company completed its acquisition of Yantai Tianzheng on August 8, 2011 (the “Execution Date”), with an effective control date of July 1, 2011, for aggregate purchase consideration of US$35,000,000.The purchase price was originally payable in four installments in the equivalent of Chinese Renminbi, the functional currency of the PRC (“RMB”) including $6,000,000 paid prior to the tenth calendar day after the Execution Date of the acquisition; $12,000,000 was due to be paid on or before the sixth month anniversary of the Execution Date; $12,000,000 is due to be paid on or before the 12 month anniversary of the Execution Date; and the remaining $5,000,000 is due to be paid on or before the 18 month anniversary of the Execution Date. As described in Note 4, the Company has the ability to convert each of the remaining payments that are due into two year term loans bearing interest at 6% per annum. The Company has paid $9,700,000 and deferred $8,300,000 as of June 30, 2012. As of June 30, 2012, the amount of outstanding payments was $25,300,000, of which $20,300,000 originally due at installments dates that occurred through July 1, 2012 were converted into two year term loans bearing interest at 6% per annum and $5,000,000 is due as scheduled on July 1, 2013. Yantai Tianzheng is a TCM manufacturer of principally for prescription medicines based in Yantai, Shandong Province, China, and conducts business operations exclusively in the PRC.

 

The Company has expanded its existing product lines and has additional production capacity through its acquisition of YantaiTianzheng. The company expects to gain the benefits of the economies of scale that management believes could be realized by combining and streamlining the cost structures of the historical Bohai and the acquired Yantai Tianzheng business. On June 8, 2010, YantaiHuanghai Construction Co. signed an agreement with Yantai Tianzheng to perform certain portions of a factory construction located at the premises of Yantai Tianzheng. The total contract price is approximately $3.07 million (RMB 19.5 million) and the construction is estimated to be completed by the end of December 2012. The remaining commitment of the contract was approximately $1.24 million (RMB 7.9 million) as of June 30, 2012.

 

In August 2011, Mr. Qu made a permanent equity capital contribution of $6,225,779 (RMB 40,000,000) into Bohai to support the Company’s future capital needs.

 

Management believes, based on the Company’s historical ability to fund operations using internally generated cash flow and the progress made towards expanding the business through the Yantai Tianzheng acquisition, that the Company’s currently available cash and funds it expects to generate from operations will enable it to operate the business and satisfy short term obligations through at least July 1, 2013.

 

Notwithstanding, the Company still has substantial obligations described below and there is no assurance that unforeseen circumstances would not have a material adverse effect on the Company’s financial condition.

 

As described above, the Company has ongoing obligations with respect to the Yantai Tianzheng acquisition, whether or not the intended benefits of the acquisition are realized. The Company is also required to repay the remaining $10,036,000 balance due on the Company’s convertible notes on the amended contractual maturity date of October 5, 2012 (the “Notes”). On December 31, 2011, the Company entered into an amendment to the Notes with Euro Pacific as representative of the Note holders (the “Amendment”) which: (i) extended the maturity date of the Notes from January 5, 2012 to April 5, 2012 (such extra three months period, the “Extended Period”); and (ii) increased the interest rate on the Notes to an annual rate of 12% (or 3% for the Extended Period). On May 14, 2012, the Company entered into a second amendment to the Notes with Euro Pacific as representative of the Note holders (the “Second Amendment”) which: (i) extended the maturity date of the Notes from April 5, 2012 to October 5, 2012 (such extra six months period, the “Second Extended Period”); and (ii) remained the interest rate on the Notes at an annual rate of 12% (or 6% for the Second Extended Period). The Company has been unable to convert a sufficient number of RMBs into US dollars due to certain currency restrictions in China. As a result, the Company deposited an amount of funds in RMBs into an escrow account to secure the repayment of this obligation as further described in Note 14. The Company believes it has sufficient liquidity to repay the convertible notes and fund the ongoing operational needs of the business. The non-payment of the loan in the absence of an extension of the maturity date would constitute an event of default under the terms of loan agreement. The Company can not predict what the implications of the non-payment of the loan would be other than the continued difficulty of repaying the loan from escrowed funds due to currency conversion restriction. The non-payment of the note could have a material adverse effect on the Company should the note holders declare an event of default.

 

The Company will require significant additional capital in order to fund these obligations and execute its longer term business plan. If the Company is unable to generate sufficient operating cash flows or raise additional capital, or encounters unforeseen circumstances that place constraints on its capital resources, management will be required to take various measures to conserve liquidity. Such measures could include, but not necessarily be limited to, curtailing the Company’s business development activities, suspending the pursuit of one or more elements of its business plan, and controlling overhead expenses.  There is a material risk, and management cannot provide any assurances, that the Company will raise additional capital if needed.  The Company has not received any commitments for new financing, and cannot provide any assurance that new financing will be available to the Company on acceptable terms, if at all. The failure of the Company to fund its obligations when needed would have a material adverse effect on its business and results of operations.

 

3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Principles of Consolidation

 

The accompanying consolidated financial statements include the accounts of BPGI, its wholly-owned subsidiary Chance High, WFOE, WOFE, Bohai and Yantai Tianzheng. All significant intercompany accounts and transactions have been eliminated in consolidation.

 

The Company, in determining whether it is required to consolidate investee businesses, considers both the voting and variable interest models of consolidation as required under applicable GAAP.  We adopted FAS Accounting Standards Codification (“ASC”) 810-10-15-14 and also ASC 810-10-05-8, which requires that a Variable Interest Entity (“VIE”) to be consolidated by a company if that company is entitled to receive a majority of the VIE’s residual returns and has the direct ability to make decisions on all operating activities of the VIE. We control Bohai through the series of VIE Agreements described in Note 1.

 

F-6
 

 

Under the Operating Agreement entered into between WFOE and Bohai, the WFOE has the direct ability to make decisions on all the operating activities and exercise all voting rights of Bohai. Under the Consulting Services Agreement entered into between WFOE and Bohai, Bohai agreed to pay all of its net income to WFOE quarterly as a consulting fee. Accordingly, WFOE has the right to receive the expected residual returns of Bohai.  As such, the Company is the primary beneficiary of and maintains a controlling managerial and financial interest in, Bohai in accordance with ASC 810-10-15-14. Accordingly, Bohai’s financial position and results of operations are consolidated with those of the Company for all periods presented.

 

We initially measured the assets, liabilities, and non-controlling interests of Bohai at their carrying amounts as of the date of the acquisition. We have subsequently accounted for the assets, liabilities, and non-controlling interest of Bohai as if it was consolidated based on voting interests.  The usual accounting rules for which the VIE operates are applied as they would to a consolidated subsidiary as follows:

 

·Carrying amounts of the VIE are consolidated into the financial statements of the Company as the primary beneficiary, or Primary Beneficiary (“PB”); and

 

·Inter-company transactions and balances, such as revenues and costs, receivables and payables between or among the PB and the VIE(s) are eliminated in their entirety.

 

The carrying amount and classification of Yantai Bohai’s assets and liabilities included in the Consolidated Balance Sheets are as follows:

 

      June 30, 
    June 30, 2012   2011 
         
Total current assets*  $51,470,381   $32,711,620 
Total assets*   99,899,826    80,523,230 
Total current liabilities**   11,689,137    18,674,129 
Total liabilities**  $15,277,230   $21,552,525 

 

*           Includes intercompany accounts in the amounts of $20,338,295 and $1,896,933 in current assets as of June 30, 2012 and June 30, 2011, respectively, that were eliminated in consolidation.

 

**         Includes intercompany accounts in the amounts of $2,490,528 and $11,660,222 in current liabilities as of June 30, 2012 and June 30, 2011, respectively that were eliminated in consolidation.

 

Business Combinations

 

The Company uses the acquisition method of accounting for business combinations which requires that the assets acquired and liabilities assumed be recorded at the date of the acquisition at their respective fair values. Assets acquired and liabilities assumed in a business combination that arise from contingencies are recognized at fair value if fair value can reasonably be estimated. If the acquisition date fair value of an asset acquired or liability assumed that arises from a contingency cannot be determined, the asset or liability is recognized if probable and reasonably estimable; if these criteria are not met, no asset or liability is recognized. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Any excess of the purchase price (consideration transferred) over the estimated fair values of net assets acquired is recorded as goodwill. Transaction costs and costs to restructure the acquired company are expensed as incurred. The operating results of acquired business are reflected in the acquirer’s consolidated financial statements and results of operations after the date of the acquisition.

 

Reclassifications

 

Certain amounts in the June 30, 2011 consolidated financial statement have been reclassified to conform to the June 30, 2012 presentation.

 

Business Segments

 

The Company’s operates its business through a single reporting segment.

 

F-7
 

 

Use of Estimates

 

The preparation of the audited consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Management makes these estimates using the best information available at the time the estimates are made; however, actual results could differ materially from those results.

  

Significant estimates and assumptions include allocating purchase consideration issued in business combinations, valuing equity securities and derivative financial instruments issued in financing transactions and in share-based payment arrangements, accounts receivable reserves, inventory reserves, deferred tax reserves estimating the useful lives of long-lived assets and evaluating the carrying amounts of intangible assets including conducting impairment tests. Certain estimates, including accounts receivable and inventory reserves and the carrying amounts of intangible assets (including present value of future cash flow estimates for the Company’s pharmaceutical formulas) could be affected by external conditions including those unique to the Company’s industry and general economic conditions. It is reasonably possible that these external factors could have an effect on management’s estimates that could cause actual results to differ from management’s estimates.

 

Company management re-evaluates accounting estimates at least quarterly based on these conditions and records adjustments, when necessary.

 

Cash and Cash Equivalents

 

We consider all highly liquid investments purchased with original maturities of three months or less to be cash equivalents. We maintain bank accounts in the PRC and a checking account in the United States of America that principally consist of demand deposits. We also have restricted cash accounts in the United States that include funds designated for interest payments due to convertible note holders and for use in investor relations programs pursuant to a securities purchase agreement.

 

Restricted Cash

 

The Company is required by its convertible note holders to maintain deposits in escrow accounts to fund the convertible notes principal and interest payments. Escrow account balances amounted to $9,449,905 and $11,043 as of June 30, 2012 and 2011, respectively. As of June 30, 2012, the Company had one escrow account in China amounting $9,343,870 and one escrow account in US amounting $106,035. As of June 30, 2011, the Company only had one escrow account in US.

 

Accounts Receivable

 

Accounts receivable consists of amounts due from customers. We extend unsecured credit to our customers in the ordinary course of business but mitigate the associated risks by performing credit checks and actively pursuing past due accounts. An allowance for doubtful accounts is established and determined based on management’s assessment of known requirements, aging of receivables, payment history, the customer’s current credit worthiness and the economic environment. As of June 30, 2012 and 2011, no allowance for doubtful accounts was deemed necessary based on management’s assessment.

 

Inventories

 

Inventories are valued at the lower of cost, determined using the weighted average method, or market. Finished goods inventories include the costs of raw materials, direct labor and overhead associated with the manufacturing process. In assessing the ultimate realization of inventories, management makes judgments as to future demand requirements compared to current or committed inventory levels.  Our reserve requirements generally increase/decrease due to management’s projected demand requirements, market conditions and product life cycle changes. As of June 30, 2012 and 2011, management does not believe that any inventory reserves are necessary.

 

Property, Plant and Equipment

 

Property, plant and equipment are carried at cost and are depreciated on a straight-line basis over the estimated useful lives of the assets which range from 5 to 10 years for office equipment, machinery, and vehicles and 30 to 40 years for buildings. The cost of repairs and maintenance is charged to expense as incurred; major replacements and improvements are capitalized.  When assets are retired or disposed of, the cost and accumulated depreciation are removed from the accounts, and any resulting gains or losses are included in income in the year of disposition. We examine the possibility of impairment in the value of fixed assets when events or changes in circumstances reflect the fact that their recorded value may not be recoverable.

 

F-8
 

 

Common Stock Purchase Warrants and Other Derivative Financial Instruments

 

The Company accounts for the issuance of common stock purchase warrants issued as free standing financial instruments in accordance with the applicable provisions ASC 810 “Derivatives and Hedging Activities.” Based on this guidance, the Company classifies as equity any contracts that (i) require physical settlement or net-share settlement or (ii) gives the Company a choice of net-cash settlement or settlement in its own shares (physical settlement or net-share settlement). The Company classifies as assets or liabilities any contracts that require net-cash settlement (including a requirement to net cash settle the contract if an event occurs and if that event is outside the control of the Company) or (ii) gives the counterparty a choice of net-cash settlement or settlement in shares (physical settlement or net-share settlement). The Company assesses classification of its freestanding derivatives at each reporting date to determine whether a change in classification between assets and liabilities is required. The Company determined that its freestanding derivatives, which principally consist of warrants to purchase common stock required classification as liability instruments at June 30, 2012 and 2011 due to the existence of non-standard anti-dilution privileges that caused the warrants to not be indexed to the Company’s own stock.

 

Fair Value Measurements and Fair Value of Financial Instruments

 

We adopted the guidance of ASC 820 for fair value measurements, which clarifies the definition of fair value, prescribes methods for measuring fair value, and establishes a fair value hierarchy to classify the inputs used in measuring fair value as follows:

 

Level 1 - Inputs are unadjusted quoted prices in active markets for identical assets or liabilities available at the measurement date.

 

Level 2 - Inputs are unadjusted quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, inputs other then quoted prices that are observable, and inputs derived from or corroborated by observable market data.

 

Level 3 - Inputs are unobservable inputs which reflect the reporting entity’s own assumptions on what assumptions the market participants would use in pricing the asset or liability based on the best available information.

 

The carrying amounts reported in the audited consolidated balance sheets for cash, accounts receivable, other receivables, short-term borrowings, accounts payable and accrued expenses, customer advances, and amounts due from related parties approximate their fair market value based on the short-term maturity of these instruments.

 

ASC 825-10 “ Financial Instruments, ” allows entities to voluntarily choose to measure certain financial assets and liabilities at fair value (fair value option). The fair value option may be elected on an instrument-by-instrument basis and is irrevocable, unless a new election date occurs. If the fair value option is elected for an instrument, unrealized gains and losses for that instrument should be reported in earnings at each subsequent reporting date. We use Level 3 inputs to value the Company’s derivative liabilities.

 

The following table reflects gains and losses for the years ended June 30, 2012 and 2011 for common stock purchase warrants classified and liabilities categorized as a Level 3 financial instrument.

   

Liabilities:    
     
Balance of warrant liabilities as of June 30, 2010  $5,481,928 
Change in the fair value of warrant liabilities   (4,544,061)
Balance of warrant liabilities as of June 30, 2011   937,867 
Change in the fair value of warrant liabilities   273,369 
Balance of warrant liabilities as of June 30, 2012  $1,211,236 

 

Estimating the fair value of derivative financial instruments requires the development of significant and subjective estimates that may, and are likely to, change over the duration of the instrument with related changes in internal and external market factors. The assumptions used to value the Company’s derivatives, which had a direct effect on the fair values described above are more fully described in Note 14. In addition, valuation techniques are sensitive to changes in the trading market price of the Common Stock estimated volatility and interest rate changes and other variables or market conditions not within the Company’s control that can significantly affect management’s estimates of fair value and changes in fair value. Because derivative financial instruments are initially and subsequently carried at fair value, the Company’s net income may include significant charges or credits as these estimates and assumptions change.

 

Foreign Currency Translation

 

The Company’s reporting currency is the U.S. dollar. The functional currency of the Company’s operating business based in the PRC is the RMB. For the Company’s subsidiaries and affiliates whose functional currencies are the RMB, results of operations and cash flows are translated at average exchange rates during the period, assets and liabilities are translated at the exchange rate in effect as of the end of the period, and stockholders equity is translated at historical exchange rates. Translation adjustments resulting from the process of translating the functional currency financial statements into U.S. dollars are included in comprehensive income. 

 

F-9
 

 

Exchange gains or losses arising from foreign currency transactions are included in the determination of net income for the respective periods. All of the Company’s revenue transactions are transacted in the functional currency. The Company has not entered into any material transactions that are either originated, or are to be settled, in currencies other than the RMB. Accordingly, transaction gains or losses have not had, and are not expected to have a material effect on the Company’s results of operations.

 

Period end exchange rates used to translate assets and liabilities and average exchange rates used to translate results of operations in each of the reporting periods are as follows:

 

   June 30, 2012   June 30, 2011 
Period end US$: RMB exchange rate   6.3143    6.4635 
Average periodic US$: RMB exchange rate   6.3519    6.6278 

 

The RMB is not freely convertible into any other currencies. In addition, all foreign exchange transactions in the PRC must be conducted through authorized institutions. Accordingly, management cannot provide any assurance that the RMB underlying the consolidated financial statement amounts could have been, or could be, converted into US dollars at the exchange rates used to translate the functional currency into the reporting currency.

  

Revenue Recognition

 

Revenue represents the invoiced value of goods sold recognized upon the delivery of goods to distributors. Pursuant to the guidance of ASC Topic 605 and ASC Topic 36, revenue is recognized when all of the following criteria are met:

 

Persuasive evidence of an arrangement exists;

Delivery has occurred or services have been rendered;

The seller’s price to the buyer is fixed or determinable; and

Collectability is reasonably assured.

 

We account for sales returns by establishing an accrual in an amount equal to management’s estimate of sales recorded for which the related products are expected to be returned. We determine the estimate of the sales return accrual primarily based on the Company’s historical experience regarding sales returns, but also by considering other factors that could impact sales returns. These factors include levels of inventory in the distribution channel, estimated shelf life, product discontinuances, and price changes of competitive products, introductions of generic products and introductions of competitive new products. For the years ended June 30, 2012 and 2011, the Company’s sales returns rate were insignificant. Accordingly, provision for sales returns is considered necessary.

 

Cost of Revenue

 

Cost of revenue consists primarily of raw material costs, labor cost, overhead costs associated with the manufacturing process and related expenses which are directly attributable to our revenues.

 

Stock-based Compensation

 

Stock based compensation is accounted for based on the requirements of the Share-Based Payment topic of ASC 718 which requires recognition in the consolidated financial statements of the cost of employee and director services received in exchange for an award of equity instruments over the employee or director’s requisite service period (presumptively, the vesting period). The FASB Accounting Standards Codification also requires measurement of the cost of employee and director services received in exchange for an award based on the grant-date fair value of the award.

 

Pursuant to ASC Topic 505-50, for share-based payments to consultants and other third-parties, compensation expense is determined at the “measurement date.” The expense is recognized over the vesting period of the award. Until the measurement date is reached, the total amount of compensation expense remains uncertain. We record compensation expense based on the fair value of the award at the reporting date. The awards to consultants and other third-parties are then revalued, or the total compensation is recalculated based on the then current fair value, at each subsequent reporting date.

 

Research and Development Costs

 

Research and development costs are charged to expense as incurred and included in operating expenses. We have only one full-time employee who is engaged in research and development, so the Company is mainly dependent on a third-party, Yantai Tianzheng Medicine Research and Development Co., Ltd., to perform the limited amount of research and development that the Company undertakes. Research and development costs amounted to $0 and $497,903 for the years ended June 30, 2012 and 2011, respectively.

 

F-10
 

 

Shipping costs

 

Shipping costs are included in selling, general and administrative expense. Shipping costs amounted to $1,303,710 and $832,401 for the years ended June 30, 2012 and 2011, respectively.

 

Advertising and Promotion

 

Advertising and promotion costs are charged to expense as incurred. Advertising and promotion expenses included in selling, general and administrative expenses amounted to $9,901,082 and $14,822,116 for the years ended June 30, 2012 and 2011, respectively.

 

Income Taxes

 

We are governed by the PRC’s Income Tax Laws and the Internal Revenue Code of the United States. Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement and income tax base of assets and liabilities and operating loss and tax credit carry-forwards. Deferred tax assets are reduced by a valuation allowance to the extent that management concludes it is more likely than not that the benefit of such tax assets will not be realized in future periods. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the periods that include the enactment date.

 

We account for certain tax positions based upon authoritative guidance that prescribes a recognition threshold and measurement processes for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  The guidance also provides direction on recognition, classification, interest and penalties, accounting in interim periods and related disclosure.

 

Our policy is to classify assessments, if any, for tax related to interest as interest expense and penalties as general and administrative expense.

 

Earnings per Share

 

We report earnings per share in accordance with ASC Topic 260, “Earnings Per Share”. Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed by dividing net income by the weighted average number of shares of common stock, common stock equivalents and potentially dilutive securities outstanding during the period. Common equivalent shares are excluded from the computation of diluted shares in periods for which they have an anti-dilutive effect. Diluted shares underlying stock options and common stock purchase warrants are included in the determination of diluted earnings per share using the treasury stock method.  Diluted shares underlying convertible debt obligations are included in the determination of diluted loss per share using the “if converted” method (Note 16).

 

Recent Accounting Pronouncements

 

In May 2011, the FASB issued ASU No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS. The amendments change the wording used to describe the requirements in U.S. GAAP for measuring fair value and for disclosing information about the fair value measurements. The amendments include the following:

 

£Those that clarify the intent of the Company’s Board of Directors regarding the application of existing fair value measurement and disclosure requirements.

 

£Those that change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements.

 

The amendments in this Update are to be applied prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011.  Early application by public entities is not permitted.  

 

F-11
 

 

The Company is currently evaluating the impact of this standard and do not expect its adoption have a material impact on the Company’s audited consolidated financial statements.

 

In June 2011, the FASB issued ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. Under the amendments, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The presentation option under current GAAP to present the components of other comprehensive income as part of the statement of changes in shareholders’ equity has been eliminated.

 

The amendments in this Update should be applied retrospectively. For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Early adoption is permitted. The Company already complies with this presentation.

 

In September 2011, the FASB issued guidance on testing goodwill for impairment (ASU 2011-8). The new guidance provides an entity the option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity determines that this is the case, it is required to perform the currently prescribed two-step goodwill impairment test to identify potential goodwill impairment and measure the amount of goodwill impairment loss to be recognized for that reporting unit (if any). If an entity determines that the fair value of a reporting unit is less than its carrying amount, the two-step goodwill impairment test is not required. The Company adopted this guidance effective July 1, 2012.

 

In December 2011, the FASB issued guidance on offsetting (netting) assets and liabilities. Entities are required to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. The new guidance is effective for annual periods beginning after January 1, 2013. Accordingly the Company will adopt this guidance effective July 1, 2013. The Company does not expect this guidance to have a material effect on its consolidated financial statements.   

 

4. BUSINESS ACQUISITION

 

On August 8, 2011, the Company, through WFOE II, a newly formed limited liability company formed under the laws of the PRC and wholly owned by Chance High (the Company’s wholly-owned subsidiary), signed a share transfer agreement with the shareholders of Yantai Tianzheng to acquire 100% of Yantai Tianzheng’s equity interests for total purchase consideration of US$35,000,000 (paid in its RMB equivalent), payable in four installments: US$6,000,000 was paid on or before the calendar day of the Execution Date of the acquisition; $12,000,000 was due to be paid on or before February 8, 2012 the sixth month anniversary of the Execution Date; $12,000,000 is due to be paid on or before August 8, 2012 the 12 month anniversary of the Execution Date; and the remaining $5,000,000 is due to be paid on or before February 8, 2013 the 18 month anniversary of the Execution Date.

 

In the event that the Company fails to pay either a portion or entire amount of any of the installments when due, such outstanding amount will be automatically converted into a two-year term loan, with interest accruing on any unpaid portion of such loan from its due date until such installment is paid in full at the rate of six percent (6%) per annum. As of June 30, 2012, $9,700,000 was paid, and the balance due amounts to $25,300,000. Interest expense of $195,107 was accrued on $8,300,000 payments converted to a two year term loan and will continue to accrue at the rate of six percent (6%) per annum until the loan is paid in full (with interest). As of June 30, 2012, $20,300,000 of installment payments due through July 1, 2012 were converted to two year term loans with interest at 6% per annum and the remaining $5,000,000 installment that has not been converted is due on January 1, 2013 and is therefore classified as a current liability in the accompanying consolidated balance sheet.

 

The Company acquired Yantai Tianzheng to expand its TCM product lines and cross leverage the Bohai’s and Yantai Tianzheng’s sales markets, which include hospitals and retail drug stores.  In addition, Yantai Tianzheng has excess manufacturing capacity that will allow Bohai to further expand production.  Bohai is currently consolidating and integrating the two companies' operations, which management believes creates the potential for significant improvements in the operating efficiency of the combined business.

  

The Company accounted for its acquisitions of Yantai Tianzheng using the acquisition method of accounting. Accordingly, the results of operations for the year ended June 30, 2012, include the revenues and expenses of the acquired businesses since the effective control date of acquisition on July 1, 2011, which is the date the Company assumed control of Yantai Tianzheng pursuant to the terms of the Share Transfer agreement between WFOE II and the shareholders of Yantai Tianzheng.

 

The fair value of the purchase consideration issued to the sellers of Yantai Tianzheng was allocated to fair value of the net tangible assets acquired, with the resulting excess allocated to separately identifiable intangibles including customer relationships and pharmaceutical formulas with finite lives and the remainder recorded as goodwill.

 

Goodwill recognized from the transactions mainly represented the expected operational synergies upon acquisition of the subsidiary and intangibles not qualifying for separate recognition. Goodwill is nondeductible for income tax purposes in the tax jurisdiction of the acquired business.

 

F-12
 

 

The purchase price was allocated as follows*:

 

Purchase Consideration:     
Cash paid to sellers immediately following the closing  $6,000,000 
Acquisition installment obligation payable to sellers   29,000,000 
Less cash acquired   (1,358,078)
Net purchase consideration   33,641,922 
      
Tangible assets acquired:     
Restricted cash   386,787 
Accounts receivable   6,893,730 
Other receivable and advance to suppliers   208,240 
Inventories   1,312,170 
Property, plant and equipment   5,078, 026 
Construction in progress   1,073,180 
Long term prepayments - land use rights   1,394,291 
Accounts payable   (2,386,576)
Other payable and accrued expenses   (1,081,425)
Income taxes payable   (729,796)
Advance from customers   (170,186)
Short-term borrowings   (2,088,652)
Deferred tax liabilities   (5,261,605)
Net tangible assets acquired   4,628,184 
      
Purchase consideration in excess of fair value of net tangible assets   29,013,738 
      
Allocated to:     
Customer relationships   14,151,156 
Drug product formulas (non-prescription)   9,887,987 
Goodwill   4,974,595 
   $- 

  

The purchase price allocation was based, in part, on management’s knowledge of Yantai Tianzheng’s business and the results of a third party appraisal commissioned by management.  Amounts presented above were translated into US dollars using the exchange rate in effect at the date of the acquisition, which was 6.4635.

  

Yantai Tianzheng’s results of operations are consolidated with the Company effective July 1, 2011. The following table presents the unaudited pro-forma financial results, as if the acquisition of Yantai Tianzheng had been completed as of July 1, 2010.

 

   Year Ended 
   June 30, 2011 
Net Sales  $126,934,504 
Net income  $21,090,583 
Earnings per share- basic  $1.23 
Earnings per share- diluted  $1.07 

 

The unaudited pro-forma results of operations are presented for information purposes only. The unaudited pro-forma results of operations are not intended to present actual results that would have been attained had the acquisition been completed as of July 1, 2010 or to project potential operating results as of any future date or for any future periods.

 

5. INVENTORIES

 

Inventories consist of the following:

 

   June 30,   June 30, 
   2012   2011 
         
Raw materials  $2,079,480   $739,363 
Work in progress   882,005    423,202 
Finished goods   834,430    348,456 
Total inventories  $3,795,915   $1,511,021 

 

F-13
 

 

6. PREPAID EXPENSES AND OTHER CURRENT ASSETS

 

Prepaid expenses and other currents assets consist of the following:

 

  June 30,   June 30, 
   2012   2011 
Prepaid advertising and promotion     $935,275 
Other receivables   862,727    106,626 
Other miscellaneous deposits and prepayments   16,969    18,237 
Total Prepaid expenses and other current assets  $879,696   $1,060,138 

 

7. PROPERTY, PLANT AND EQUIPMENT, NET

 

Property, plant and equipment consist of the following:

 

   June 30,   June 30, 
   2012   2011 
         
Buildings  $8,928,545   $5,122,557 
Plant equipment   2,490,764    1,348,819 
Office equipment   208,539    107,520 
Motor vehicles   285,610    258,720 
Total   11,913,458    6,837,616 
           
Less: accumulated depreciation   (2,188,340)   (1,622,654)
Construction in progress   1,956,154    - 
           
Total Property, plant and equipment, net  $11,681,272   $5,214,962 

 

Depreciation expense for property, plant and equipment for the years ended June 30, 2012 and 2011 amounted to $563,214 and $366,338, respectively.

 

On June 8, 2010, YantaiHuanghai Construction Co. signed an agreement with Yantai Tianzheng to perform certain portions of a factory construction located at the premises of Yantai Tianzheng. The total contract price is approximately $3.07 million (RMB 19.5 million) and the construction is estimated to be completed by the end of December 2012. The remaining commitment of the contract was approximately $1.24 million (RMB 7.9 million) as of June 30, 2012.

 

8. INDEFINITE LIVED INTANGIBLE ASSETS – PHARMACEUTICAL FORMULAS

 

The Company purchased, and currently owns exclusive rights to, a series of pharmaceutical formulas that were approved by the State Food and Drug Administration of China (“SFDA”). The intellectual property underlying these formulas can be renewed every 5 years without limitation for a nominal fee and are subject to certain protections under PRC drug regulations for an indefinite period of time. These regulations mitigate competition and the ability of other suppliers to replicate the Company’s products or produce comparable substitutes. These intangible assets are measured initially at cost not subject to amortization and are tested for impairment annually or in interim reporting periods if events or changes in circumstances indicate that the carrying amounts of these intangible asset might not be recoverable.

 

F-14
 

 

Pharmaceutical formulas with indefinite lives consist of the following:

  

   June 30, 
   2012   2011 
         
Pharmaceutical formulas, without amortization, at cost  $24,345,353   $25,019,377 

 

On December 9, 2010, we entered into an Intangible Assets Transfer Agreement with Shandong Daxin Microbiology Pharmaceutical Industry Co., Ltd. (“Daxin”), an unrelated party, pursuant to which Daxin transferred to us all rights and title for 14 State Food and Drug Administration previously approved traditional Chinese medicine formulas. The aggregate purchase price which amounted to approximately $7,186,100 (RMB 48,000,000), was paid during the quarter ended March 31, 2011. The 14 formulas consist of two new product categories, powder and pellet formulations. Additionally, 4 of the 14 formulas are included in the Chinese government’s Essential Drug List (“EDL”) and an additional 5 medicines are included in the National Drug Reimbursement List (“NDRL”).

 

The Company’s active products that are currently generating revenues were derived from formulas that have an aggregate carrying amount of $16,439,373. Product formulas representing a substantial majority of the remaining carrying amount were purchased in December 2010. The Company is currently evaluating new product candidates to be derived from these formulas that it would market in future periods. In addition, drug product formulas are transferrable in the PRC and as such could be sold to approved purchasers as an alternative means of recovery.

 

During the fourth quarter of our 2011 fiscal year, we determinate that we will no longer manufacture or seek to develop markets for 8 specific product formulas due to a change in our business strategy. Accordingly we recorded a $635,442 impairment charge during the fourth quarter of our fiscal year ended June 30, 2011. There are no further impairment charges the year ended June 30, 2012.

 

9. LONG TERM PREPAYMENTS - LAND USE RIGHTS, NET

 

   June 30, 
   2012   2011 
         
Land use rights, at cost  $20,240,623   $17,999,002 
Less: Accumulated amortization   (1,501,326)   (421,731)
Intangible assets – land use rights, net  $18,739,297   $17,577,271 

 

There is no private ownership of land in PRC. All land is owned by the government, which grants land use rights for specified periods of time. Amortization expense of land use rights amounted to $676,515 and $171,767 for the years ended June 30, 2012 and 2011, respectively. Amortization is calculated over a period of 50 years. Amortization of land use rights for fiscal years ending subsequent to June 30, 2012 is as follows:

 

   Amortization 
2013  $676,515 
2014   676,515 
2015   676,515 
2016   676,515 
2017   676,515 
Thereafter   15,356,722 
Total  $18,739,297 

 

F-15
 

 

10. OTHER INTANGIBLE ASSETS, NET

 

Other Intangible assets, net includes customer relationships and certain non-prescription drug product formulas that are sold over the counter. The Company acquired these assets in its business combination with YantaiTianzheng (Note 4). Customer relationships are amortized on a straight line basis over periods of 5 and 8 years. Pharmaceutical formulas are amortized on a straight line basis over periods of 8 years.

 

Other intangible assets – net at June 30, 2012 is as follow:

  

   Customer Relationships   Drug Formulas   Total 
Cost  $14,485,533   $11,386,833   $25,872,366 
                
Accumulated Amortization   (1,844,068)   (1,265,204)   (3,109,272)
                
Net carrying amount  $12,641,465   $10,121,629   $22,763,094 

 

Amortization expense for fiscal years ending subsequent to June 30, 2012 is as follows:

 

    Amortization  
2013   $ 3,090,866  
2014      3,090,866  
2015     3,090,866  
2016     3,090,866  
2017     3,090,866  
Thereafter     7,308,764  
Total   $ 22,763,094  

 

11. DEBT ISSUE COSTS

 

We incurred total placement fees of $2,152,454 in connection with our private placement of Convertible Notes (see Note 14) that occurred on January 5, 2010. The placement fees are being amortized on a straight line basis over the two year expected life of the Convertible Notes, starting on the date of closing, January 5, 2010.

 

   June 30, 
   2012   2011 
         
Beginning balance  $485,039   $1,562,617 
Transferred to equity on conversion   -    (106,574)
Amortization   (485,039)   (971,004)
Ending balance  $-   $485,039 

  

12. ACCRUED EXPENSES

 

Accrued expense consists of the following:

 

   June 30,   June 30, 
   2012   2011 
         
Accrued expense to sales personnel  $3,778,996   $2,605,375 
Other taxes payable   1,879,334    1,056,691 
Other accrued expense   2,073,741    389,123 
Accrued payroll and welfare   357,975    261,144 
Accrued advertising expense   388,008    - 
Total  $8,478,054   $4,312,333 

  

F-16
 

  

13. SHORT-TERM BORROWINGS

 

The Company has short-term loan facilities from financial institutions in the PRC. Short-term borrowings as of June 30, 2012 and June 30, 2011 consist of the following:

 

Loan from     Annual   June 30,   June 30, 
financial institution  Loan period  interest rate   2012   2011 
                
YantaiLaishan Rural Credit Union  September 21, 2010 to September 20, 2011   9.03%   -    618,860 
YantaiLaishan Rural Credit Union  September 21, 2010 to September 20, 2011   6.90%   -    301,694 
Total short-term borrowings          $-   $920,554 

 

Interest expense for short-term borrowings for the years ended June 30, 2012 and 2011 amounted to $19,943 and $187,446, respectively.

 

14. CONVERTIBLE PROMISSORY NOTES AND WARRANTS

 

On January 5, 2010, pursuant to a Securities Purchase Agreement (the “Securities Purchase Agreement”) with 128 accredited investors (the “Investors”), BPGI sold 6,000,000 units for aggregate gross proceeds of $12,000,000, each unit consisting of an 8% senior convertible promissory note in the principal amount of $2 and one Common Stock purchase warrant (collectively, the “Investor Warrants”). By agreement with the Investors, each investor received: (i) A single Note representing the aggregate number of Notes purchased by them as part of the units (each, a “Note” and collectively, the “Notes”) and (ii) a single Investor Warrant representing the aggregate number of Investor Warrants purchased by them as part of the units. The majority of this debt is guaranteed by third-parties and our CEO, Mr. Qu, and a portion is secured by our inventories and fixed assets.

 

The Notes bear interest at 8% per annum, payable quarterly in arrears on the last day of each fiscal quarter of the Company. Principal is due on January 5, 2012 according to the original agreement. Each Note, plus all accrued but unpaid interest thereon, is convertible, in whole but not in part, at any time at the option of the holder, into shares of Common Stock at a conversion price of $2.00 per share, subject to adjustment as set forth in the Note. The Notes issued have face amounts that range from $43,200 to $500,000.

 

The conversion price of the Notes is subject to standard anti-dilution adjustments for stock splits and similar events. In addition, if we issue or sell any additional shares of Common Stock or instruments convertible or exchangeable for Common Stock at a price per share less than the conversion price then in effect or without consideration, then the conversion price upon each such issuance will be adjusted to that price determined by multiplying the conversion price then in effect by a fraction: (1) the numerator of which is the sum of (x) the number of shares of Common Stock outstanding immediately prior to the issuance of such additional shares of Common Stock plus (y) the number of shares of Common Stock which the aggregate consideration for the total number of such additional shares of Common Stock so issued would purchase at a price per share equal to the conversion price then in effect, and (2) the denominator of which is the number of shares of Common Stock outstanding immediately after the issuance of such additional shares of Common Stock. Notwithstanding any provision of the Note to the contrary, no adjustment will cause the conversion price to be less than $1.00, as adjusted for any stock dividend, stock split, stock combination, reclassification or similar transaction.

 

The Notes contain certain events of default, including non-payment of interest or principal when due, bankruptcy, failure to maintain a listing of the Common Stock or to make required filings on a timely basis. No premium is payable by us if an event of default occurs. However, upon an Event of Default, and provided no more than 50% of the aggregate face amount of the Notes have been converted, the Investors holding Notes have the right to receive a portion, based on their pro-rata participation in the transaction, of 1,000,000 shares of our Common Stock that have been placed in escrow by our principal shareholder. The shares in escrow will be returned to our principal shareholder when 50% of the aggregate face amount of the Notes has been converted or, if later, when the Notes are repaid.

 

Effective as of June 30, 2010, the Company entered into an Amendment and Agreement (the “A&A”) with Euro Pacific Capital, Inc., as representative of the Investors (the “Investor Representative”), pursuant to which the Company and the Investors agreed to make certain amendments to the Notes and the Warrants.  Pursuant to the A&A, the anti-dilution protection provisions in the Notes and the Warrants were eliminated and a provision specifically precluding net cash settlement by us of the Notes and the Warrants was added.  In return, and subject to certain non-financing exceptions, we agreed not to issue any new equity securities at a price per share below $2.20 until the earlier of (i) January 5, 2013 or (ii) the date on which, collectively with any prior conversions or exercises of Notes and Warrants, 75% of the principal face value of the Notes in the aggregate has been converted into shares of Common Stock and Warrants representing, in the aggregate, 75% of the aggregate shares of Common Stock underlying the Warrants have been exercised. The A&A did not change the Company’s accounting for the Notes and the Warrants described below.

 

On and effective as of March 30, 2011, the Company entered into a Termination Agreement (the "Termination Agreement") with the Investor Representative pursuant to which the Company and the Investor Representative agreed to terminate the A&A. As a result of the Termination Agreement, the A&A and each of its provisions were terminated. The Termination Agreement was entered into because, after further study, the Company concluded that the original purpose of the A&A (to mitigate the impact of certain non-cash embedded derivative liabilities associated with the Notes, Warrants and Agent Warrants) would not be achieved. Therefore, the Company determined and agreed with the Investor Representative to terminate the A&A and to thereby restore the Notes, Warrants and Agent Warrants to their original terms.

 

F-17
 

 

The Notes contain certain events of default, including non-payment of interest or principal when due, bankruptcy, failure to maintain a listing of the Common Stock or to make required filings on a timely basis. No premium is payable by us if an event of default occurs. However, upon an Event of Default, and provided no more than 50% of the aggregate face amount of the Notes have been converted, the Investors holding Notes have the right to receive a portion, based on their pro-rata participation in the transaction, of 1,000,000 shares of our Common Stock that have been placed in escrow by our principal shareholder. The shares in escrow will be returned to our principal shareholder when 50% of the aggregate face amount of the Notes has been converted or, if later, when the Notes are repaid.

 

The Investor Warrants expire on January 5, 2013 and may be exercised by the holder at any time to purchase one share of Common Stock at an exercise price of $2.40 per share (subject to adjustment as set forth in the Investor Warrants). The exercise price of the Investor Warrants is subject to adjustment in the same manner as the conversion price of the Notes described above, except that the exercise price will not be adjusted to less than $1.20, as adjusted for any stock dividend, stock split, stock combination, reclassification or similar transaction. The Investor Warrants may only be exercised for cash and do not permit the holder to perform a cashless exercise.

 

In connection with the sale of the units, the Company paid its placement agents a cash fee of $1,200,000. In addition, the placement agents received warrants (the “Placement Agent Warrants” and, together with the Investor Warrants, the “Warrants”) to purchase 600,000 shares of Common Stock, which Placement Agent Warrants are substantially identical to the Investor Warrants, except that, pursuant to separate lock-up agreements executed by the holders of the Placement Agent Warrants, the Placement Agent Warrants are not exercisable until the six month anniversary of the later of: (i) the date of effectiveness of the registration statement registering the resale of the Common Stock underlying the Notes and Warrants or (ii) the date of commencement of sales in connection with such registration statement.

 

In addition to the placement agent fee, the Company paid $370,000 of legal and other expenses. As required by the Securities Purchase Agreement, $500,000 of the proceeds from the sale of the units were placed in escrow to pay investor relations expenses to be incurred by the Company and $240,000, equivalent to one quarter’s interest expense on the Notes, was also placed in escrow. The interest escrow will be released to the Company at such time as 75% of all shares underlying the Notes have been issued upon conversion of Notes. After payment of the placement agent fees and other expenses and the amounts required to be placed in escrow, the Company received net proceeds of $9,690,000. At June 30, 2011 and 2010, $11,043 and $576,019, respectively, remained in escrow and is included in restricted cash.

 

The Company also entered into a Registration Rights Agreement with the Investors. It agreed to file, no later than March 6, 2010, a registration statement to register the shares underlying the Notes and the Warrants and to have such registration statement effective no later than August 13, 2010. The required registration statement was filed on March 2, 2010 and became effective on August 12, 2010. Accordingly, the Company no registration delay payments were incurred.

 

On December 31, 2011, the Company’s Chinese operating subsidiary was unable to convert a sufficient number of RMB’s needed to repay the notes on their contractual maturity date of January 5, 2012. As a result, the Company entered into an amendment to the Notes with Euro Pacific as representative of the Investors which: (i) extended the maturity date of the Notes from January 5, 2012 to April 5, 2012 (such extra three month period, the “Extended Period”); and (ii) increased the interest rate on the Notes to an annual rate of 12% (or 3% for the Extended Period). The Company and Euro Pacific negotiated a second amendment to the Notes to further extend the maturity date thereof. See Note 2. 

 

On May 8, 2012, a Three Parties Fund Escrow Agreement (“Escrow Agreement”) was entered into among Yantai Shencaojishi Pharmaceuticals Co., Ltd., the wholly-owned subsidiary of the Company (“Yantai Shencaojishi”), Euro Pacific and Rural Credit Cooperative of Laishan District, Yantai City (the “Bank”). Pursuant to the Escrow Agreement, an RMB-denominated escrow account (the “Escrow Account”) was established with Bank and RMB 59 million (approximately $10.45 million) was deposited by Yantai Shencaojishi into the Escrow Account. On May 9, 2012, a Supplemental Agreement to the Escrow Agreement with details of the Escrow Account was entered into by the Company, Euro Pacific and the Bank. The Escrow Agreement provides that the Escrow Account will be managed by both the Company and Euro Pacific and that withdrawal of cash from the Escrow Account cannot be done without prior written consent from both the Company and Euro Pacific.

 

On May 14, 2012, the Company entered into another amendment (the “Second Amendment”) to the Notes with Euro Pacific. The Company repaid a portion of amounts due under its two-year 8% convertible notes, as amended, in the amount of approximately $314,000, which is equivalent to the amount of the first quarter 2012 interest payment on the Notes (calculated based on an annual rate of 12% as currently provided for in the Notes). The Company repaid an additional amount of approximately $100,000 on June 28, 2012 and $631,000 on July 3, 2012. In addition, the maturity date of the notes was extended from April 5, 2012 to October 5, 2012 (such extra six month period, the “Second Extended Period”); and (ii) the interest rate on the Notes remains at an annual rate of 12% (or 6% for the Second Extended Period). ($731,000 has been paid July 5, 2012).

 

F-18
 

 

On June 27, 2012, we and Euro Pacific entered into a Third Amendment to the Notes (the “Third Amendment”) to remove the limitations on our ability to incur debt, to incur liens or to make capital expenditures. The purpose of the Third Amendment is to provide us with enhanced flexibility to seek potential sources of financing.

 

The Company is currently working with Euro Pacific as representative of the Investors on a fourth amendment to the Notes which would further extend the maturity date of the Notes from October 5, 2012 to January 5, 2013. As of the date of this Annual Report, no written agreement has been entered into in this regard. The Company is unable to predict whether an agreement will be reached. The non-payment of the loan in the absence of an extension of the maturity date would constitute an event of default under the terms of loan agreement. The Company can not predict what the implications of the non-payment of the loan would be other than the continued difficulty of repaying the loan from escrowed funds due to currency conversion restriction. The non-payment of the note could have a material adverse effect on the Company should the note holders declare an event of default.

 

Valuation

 

At the time the Notes and Warrants were issued, there had not been any market activity for the Common Stock. Accordingly, determining the fair value of the Common Stock required us to make complex and subjective judgments. We estimated the value of our enterprise as of January 5, 2010 based on a review of the enterprise value derived from the use of market and income valuation approaches. We also reviewed an asset-based approach to assess whether the result of such an approach was consistent with the value derived from the market and income valuation approaches. The market approach was based on the market price to earnings multiple for companies considered by management to be comparable to us. The income approach was based on applying discount rates to estimated future net income. The estimated enterprise value was then allocated to our existing outstanding Common Stock, the Notes and the Warrants using the Binomial option pricing method. The option pricing method was based on the two year period to maturity of the Notes and the three year period to expiration of the Warrants, risk-free interest rates commensurate with those periods and the expected volatility used was based on a review of the historical volatility of companies considered by management to be comparable to us.

 

Based on the allocation of the estimated enterprise value, we estimated the fair value of the Common Stock at $2.28 per share, as of January 5, 2010. The Investor Warrants and the Placement Agent Warrants were valued at $5,824,538 and $582,454, respectively, based on the estimated fair value of the Common Stock of $2.28, a term equal to the remaining life of the Warrants, an expected dividend yield of 0%, a risk-free interest rate of 1.57% based on constant maturity rates published by the U.S. Federal Reserve applicable to the remaining life of the Warrants and estimated volatility of 65%, based on a review of the historical volatility of companies considered by management to be comparable to us.  As noted above, prior to the June 30, 2010 Amendment described above, the Warrants contained a down-round anti-dilution protection feature. As of January 5, 2010, the value of this feature was not considered to be material and no adjustment was made for it in the estimated fair value of the Warrants.

 

Accounting for Convertible Notes

 

At January 5, 2010, June 30, 2011 and June 30, 2012, the conversion options embedded in the Notes are not derivative instruments as defined in FASB ASC 815-10-15-83 because the Notes do not permit or require net settlement, there is no market mechanism outside the contracts that permits net settlement and the shares to be received on conversion of the Notes are not readily convertible to cash. At the time the Notes were issued, there had not been any market activity for the Common Stock.  Although market trading activity for our Common Stock has developed, the Notes can be exercised only in whole but not in part and through June 30, 2011 and continuing, there has been insufficient trading volume to permit the shares to be received on conversion of each Note to be readily sold in the market, thus precluding the shares to be received by the holder of each Note from being readily convertible to cash.

 

In future periods, whether or not the embedded conversion option in each Note is considered to be a derivative instrument will depend on whether or not the aggregate number of shares to be received on exercise of each of the Notes, which Notes can be exercised only in whole but not in part, could be readily sold in the market without significantly affecting the market price of the Common Stock, thus permitting the shares received by the holder of each Note to be readily convertible to cash. At each reporting date, the Company will re- evaluate each Note, based on the level of activity in the market for the Common Stock at that time, to determine whether or not the embedded conversion option in each Note is a derivative instrument. Depending on the trading volume for the Common Stock that develops in the future and the face amount of each Note, the embedded conversion option may be considered a derivative instrument for some Notes but not for others and its status as a derivative instrument may vary from period to period.

 

FASB ASC 815-10-15-74 provides that a contract which would otherwise meet the definition of a derivative instrument but that is both (a) indexed to a company’s own stock and (b) classified in shareholders’ equity in the statement of financial position would not be considered a derivative financial instrument. FASB ASC 815-40-15 and 815-40-25 provide guidance for determining whether those two criteria are met. Because the Company’s functional currency is the Renminbi, but the Notes are denominated in U.S. Dollars, FASB ASC 815-40-15-71 provides that the embedded conversion options are not considered to be indexed only to our Common Stock. Furthermore, prior to the June 30, 2010 Amendment described above, the criteria that the instruments be indexed only to the Common Stock was also not met because the conversion price of the Notes would be reduced if we issued securities at a lower exercise or conversion price.

  

Because the requirement that the instruments be indexed only to the Common Stock is not met, the exemption in FASB ASC 815-10-15-74 will not be available and we will account for the embedded conversion options in the Notes as derivative instrument liabilities, if and when the shares to be issued on conversion are considered to be readily convertible to cash.

 

F-19
 

 

Derivative financial instruments are initially measured at their fair value. For derivative financial instruments that are accounted for as liabilities, the derivative instrument is initially recorded at its fair value and is then re-valued at each reporting date, with changes in the fair value reported as charges or credits to income. If and when the embedded conversion option in any of the Notes first qualifies as a derivative instrument, the fair value at that time of the embedded derivative instrument will be re-classified and separately recognized and subsequently marked-to-market each reporting period, as long as the embedded conversion option continues to qualify as a derivative instrument. If the embedded conversion option ceases to be a derivative instrument, it will be marked-to-market as of the date of re-classification but thereafter will no longer be marked-to-market.

 

Warrants

 

The Investor Warrants expire on January 5, 2013 and may be exercised by the holder at any time to purchase one share of Common Stock at an exercise price of $2.40 per share (subject to adjustment as set forth in the Investor Warrants). The exercise price of the Investor Warrants is subject to adjustment in the same manner as the conversion price of the Notes described above, except that the exercise price will not be adjusted to less than $1.20, as adjusted for any stock dividend, stock split, stock combination, reclassification or similar transaction. The Investor Warrants may only be exercised for cash and do not permit the holder to perform a cashless exercise.

 

In connection with the sale of the units, BPGI paid the placement agents a cash fee of $1,200,000. In addition, the placement agents received warrants (the “Placement Agent Warrants” and, together with the Investor Warrants, the “Warrants”) to purchase 600,000 shares of Common Stock, which Placement Agent Warrants are substantially identical to the Investor Warrants.

 

At January 5, 2010, the Investor Warrants were valued at $5,824,538. At June 30, 2011, the Investor Warrants were re-valued at $852,607, using a binomial model, based on the closing market price on that date of $1.05, a term equal to the remaining life of the Warrants which is 1.52 years, an expected dividend yield of 0%, a risk-free interest rate of 0.33%, based on constant maturity rates published by the U.S. Federal Reserve applicable to the remaining life of the Warrants and estimated volatility of 55%, based on a review of the historical volatility of companies considered by management to be comparable to the Company. The effect of the down-round anti-dilution protection was not considered to be material and no adjustment was made for it in the estimated fair value of the Investor Warrants. At June 30, 2012, the fair values of the Investor Warrants amounted $1,101,123, using a binomial model, based on the closing market price on that date of $0.51, a term equal to the remaining life of the Warrants which is 0.52 year, an expected dividend yield of 0%, a risk-free interest rate of 0.16%, based on constant maturity rates published by the U.S. Federal Reserve applicable to the remaining life of the Warrants and estimated volatility of 130%, based on a review of the historical volatility of companies considered by management to be comparable to the Company. The effect of the down-round anti-dilution protection was not considered to be material and no adjustment was made for it in the estimated fair value of the Investor Warrants and the Placement Agent Warrants.

 

The Placement Agent Warrants were initially valued at $582,454. The cost of these instruments, together with the cash fees paid to the placement agents and the other fees and expenses paid by us, as described above, in the aggregate amount of $2,152,454, have been deferred and are being amortized on a straight-line basis over the two year period to maturity of the Notes. At June 30, 2011, the Placement Agent Warrants were re-valued at $85,260, based on the closing market price on that date of $1.05, a term equal to the remaining life of the Warrants which is 1.52 years, an expected dividend yield of 0%, a risk-free interest rate of 0.33% and estimated volatility of 55%. The effect of the down-round anti-dilution protection was not considered to be material and no adjustment was made for it in the estimated fair value of the Placement Agent Warrants. At June 30, 2012, the Placement Agent Warrants were re-valued at $110,112, based on the closing market price on that date of $0.51, a term equal to the remaining life of the Warrants which is 0.52 year, an expected dividend yield of 0%, a risk-free interest rate of 0.16% and estimated volatility of 130%. The effect of the down-round anti-dilution protection was not considered to be material and no adjustment was made for it in the estimated fair value of the Placement Agent Warrants.

 

The aggregate change in fair value of the Investor and Placement Agent Warrants for the years ended June 30, 2012 and 2011 of $(273,369) and $4,544,061, respectively, has been recorded as a component of other income (expense), respectively, on the audited consolidated statements of income.

 

The following table summarizes the weighted average remaining contractual life and exercise price of all of our outstanding warrants.

 

Warrants Outstanding  
        Number              
        Outstanding     Weighted     Weighted Average  
    Number   Currently     Average     Exercise Price of  
    Outstanding   Exercisable     Remaining     Warrants  
Exercise   at    at     Contractual Life     currently  
Price    June 30, 2012   June 30, 2012     (Year)     exercisable  
                       
$ 2.40   6,600,000   6,600,000     0.52     $ 2.40  

 

F-20
 

 

Convertible Notes

 

The Convertible Notes were initially recorded at a discounted carrying amount of zero as a result of having allocated a portion of the proceeds to (i) the fair value of the warrants, which were recorded as liabilities stated at fair value, and (ii) a beneficial conversion feature that was not bifurcated as a free standing derivative at the time of issuance or at subsequent reporting dates based on periodic classification assessments. Accretion of the note discount amounted to $8,997,898 and $1,033,201 for the years ended June 30, 2012 and 2011, respectively. Accretion of the discount was recorded as a component of interest expense in the accompanying statements of income and comprehensive income. Contractual interest expense amounted to $0 and $1,029,487 for the years ended June 30, 2011 and 2012, respectively. There is an aggregate of 5,018,000 shares of Common Stock issuable under all remaining convertible notes as of June 30, 2012.

 

Convertible notes, net of unamortized original issuance discounts are as follows:

 

   June 30, 
   2012   2011 
         
Convertible notes payable, at full principal value  $10,036,000   $10,450,000 
Less: unamortized beneficial conversion feature and warrants discount on convertible notes   -    (9,317,897)
Convertible notes, net  $10,036,000   $1,132,103 

 

Escrowed Shares

 

As of January 5, 2010 and at June 30, 2012 and 2011, the Company’s principal shareholder, Mr. Qu, is obligated to deliver 1,000,000 shares of Common Stock to the Investors if certain Events of Default occur (as defined in the Notes).

 

15.COMMITMENTS, CONTINGENCIES AND OTHER MATTERS

 

(a)Contract Research and Development Arrangement

 

On May 2009, the Company entered into a contract with Yantai Tianzheng Medicine Research and Development Co. to perform research and development on two new pharmaceutical products, namely Fern Injection and Forsythia Capsule. The total contract price is approximately $2,345,509 (RMB 15,000,000). Yantai Tianzheng Medicine Research and Development Co. is committed to complete all research work required for the clinical trial within 3 years. As of June 30, 2012, the Company has paid $1,305,339 (RMB 8,300,000) with respective to the contract. The remaining payment will be made over the remaining of the contract as the services are rendered. The Company has extended the contract with Yantai Tianzheng Medicine Research and Development Co. to May 10, 2017 to allow more time to complete the development process due to changes in government regulatory requirements. Research and development costs associated with this contract amounted to $0 and $497,903 for the years ended June 30, 2012 and 2011, respectively.

 

(b)Supplier Concentrations

 

We have the following concentrations of business with each supplier constituting greater than 10% of the Company’s purchases of raw materials or other supplies:

 

 June 30,  
  2012       2011  
Shandong Yantai Medicine Procurement and Supply Station   13.2 %     14.6 %
Anhui Dechang Pharmaceutical Co. Ltd.   16.2 %     * %

 

* Constitutes less than 10% of the Company’s purchases.

 

We had a commitment to purchase certain raw materials totaling $3,930,135 as of June 30, 2012 that was fulfilled upon the delivery of the goods in July 2012.

 

We have short term raw material purchase obligations with unrelated parties in the amount of $2,986,618 (RMB 18,990,408) that were fulfilled in October 2011.

 

F-21
 

 

(c)Sales Product Concentrations

 

Five of the Company’s products, namely Tongbi Capsules, Tongbi Tablets, Lung Nourishing Syrup, Zhengxintai Capsules and Fangfengtongsheng Tablets represented approximately 22.8%, 9.1%, 16.6%, 10.6% and 18.3%, respectively, of total sales for the years ended June 30, 2012.

 

Four of the Company’s products, namely Tongbi Capsules, Tongbi Tablets, Lung Nourishing Syrup and Shangtongning Tablets represented approximately 27.4%, 14.4%, 26.2% and 8.7%, respectively, of total sales for the year ended June 30, 2011.

 

(d)Economic and Political Risks

 

The Company’s operations are conducted solely in the PRC. There are significant risks associated with doing business in the PRC, which include, among others, political, economic, legal and foreign currency exchange risks. The Company’s results may be adversely affected by changes in political and social conditions in the PRC, and by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion, remittances abroad, and rates and methods of taxation, among other things.

 

(e)Concentrations of Credit Risk

 

Financial instruments which potentially subject us to concentrations of credit risk consist principally of cash and trade accounts receivable. Substantially all of the Company’s cash is deposited in state-owned banks within the PRC, and no deposits are covered by insurance. We have not experienced any losses in such accounts and believe that the Company’s loss exposure is insignificant due to the fact that banks in the PRC are state owned and are generally high credit quality financial institutions. A significant portion of the Company’s sales are credit sales which are made primarily to customers whose ability to pay is dependent upon the industry economics prevailing in these areas. We continually monitor the credit worthiness of the Company’s customers in an effort to reduce credit risk.

   

At June 30, 2012 and June 30, 2011, the Company’s cash balances by geographic area were as follows:

 

   June 30, 
   2012   2011 
Country:                    
United States  $23,406    0.13%  $198,521    1%
China   18,362,882    99.87%   13,145,905    99%
Total cash and cash equivalents  $18,386,288    100%  $13,344,426    100%

 

(f)Certificate of land use right

 

The Company’s corporate headquarters is located at No. 9 Daxin Road, Zhifu District, Yantai, Shandong Province in China. Under the current PRC laws, land is owned by the state, and parcels of land in rural areas which are known as collective land are owned by the rural collective economic organization. “Land use rights” are granted to an individual or entity after payment of a land use right fee is made to the applicable state or rural collective economic organization. Land use rights allow the holder of the right to use the land for a specified long-term period. We have a land use right, expiring in 2047, for a total of approximately 30,637 square meters of land, on which the Company maintains its manufacturing facility. The Company has not obtained a land use right certificate for a piece of land located in Xingfu Twelve Village of Zhifu District with the area of 11,222 square meters, on which the Company maintains its corporate headquarters. In the process of the planning of Yantai City, the usage of the aforesaid land use right has been changed from “industrial use” to “commercial use” and therefore, the approval process for the land use right certificates on five relevant parcels of land including the land occupied by us is suspended until the completion of the planning. We cannot provide any assurance that the Company will eventually obtain the land use right certificate for this land. If the Company is asked by the local government to relocate the Company’s facility, management believes that estimated relocation and other costs will be reimbursed by the local government. The Company does not believe that a requirement to relocate operations would have a material adverse effect on the business.

 

(g)Business insurance

 

Business insurance is not readily available in the PRC. To the extent that the Company suffers a loss of a type which would normally be covered by insurance in the United States, such as product liability and general liability insurance, the Company would incur significant expenses in both defending any action and in paying any claims that could result from a settlement or judgment.

 

F-22
 

 

16.NET INCOME PER SHARE

 

Basic earnings per share is computed on the basis of the weighted average number of shares of Common Stock outstanding during the period. Diluted earnings per share is computed on the basis of the weighted average number of shares of Common Stock plus the effect of potentially dilutive common shares outstanding during the period using the if-converted method for the convertible debt and equity securities and the treasury stock method for stock options and common stock purchase warrants. The following table sets forth the computation of basic and diluted net income per common share:

  

   Year ended   Year ended 
   June 30, 2012   June 30, 2011 
         
Net income available to common stockholders-basic  $9,648,025   $14,004,875 
Effective interest on convertible notes and amortization of debt issue costs        2,860,206 
Net income available for common shareholders – diluted  $9,648,025   $16,865,081 

 

   Year ended   Year ended 
   June 30, 2012   June 30, 2011 
Weighted average number of common shares outstanding - basic   17,861,085    17,198,917 
Options   -    - 
    -    - 
Common shares issuable upon conversion of Convertible Debt   -    5,225,000 
Weighted average number of common shares outstanding - diluted   17,861,085    22,423,917 
           
Earnings per share:          
Basic  $0.54   $0.81 
Diluted  $0.54   $0.75 

 

Warrants to purchase 6,600,000 shares of Common Stock and stock options to purchase 32,000 shares of Common Stock were outstanding as of June 30, 2012 and 2011 but both 6,600,000 shares of Common Stock and 32,000 shares of options were excluded from the computation of diluted earnings per share where applicable as the exercise prices of these securities exceeded the average stock prices for the years ended June 30, 2012 and 2011. Further, we excluded 5,018,000 shares issuable upon conversion of the convertible notes from the computation of diluted EPS in 2012 as the effect of these shares are also antidilutive.

 

17.STOCK OPTIONS

 

On May 2, 2011, the Company granted stock options to a director for the purchase of 6,000 shares of our Common Stock at an exercise price of $2.00 per share. The options vested immediately and expire five years from the date of issuance. These options have been valued at $3,184. The Company uses a binomial option pricing model to calculate the grant date fair value of the options, with the following assumptions: no dividend yield, expected volatility of 55%, risk free interest rate of 0.3%, expected term of 5 years.

 

The following table summarizes the weighted average remaining contractual life and exercise price of our outstanding options as of June 30, 2012:

 

Options Outstanding  
Number  
        Outstanding     Weighted     Weighted Average  
    Number   Currently     Average     Exercise Price of  
    Outstanding   Exercisable     Remaining     Options  
Exercise   at   at     Contractual Life     currently  
Price   June 30, 2012   June 30, 2012      (Years)     exercisable  
                       
$ 2.00   32,000     32,000       3.39     $ 2.00  

 

The Company accounts for share-based payments in accordance with ASC 718. Accordingly, it expenses the fair value of awards granted to the directors. Total compensation expense related to the stock options for the years ended June 30, 2012 and 2011 was $0 and $27,027, respectively and was recorded as general and administrative expense.

  

F-23
 

 

 A summary of our stock option activity as of June 30, 2012, and changes during the twelve months ended June 30, 2012 is presented in the following table:

 

           Exercise Price 
   Option   Vested   per Common 
   Shares   Shares   Stock Range 
Balance, June 30, 2010   -    -   $- 
                
Granted or vested during the year ended June 30, 2011   32,000    32,000   $2.00 
                
Exercised during the year ended June 30, 2011   -    -   $- 
                
Expired during the year ended June 30, 2011   -    -   $- 
                
Balance, June 30, 2011   32,000    32,000   $2.00 
                
Granted or vested during the year ended June 30, 2012   -    -   $- 
                
Exercised during the year ended June 30, 2012   -    -   $- 
                
Expired during the year ended June 30, 2012   -    -   $- 
                
Balance, June 30, 2012   32,000    32,000   $2.00 

 

18.STOCKHOLDERSEQUITY

 

Authorized Capital

 

The Company is authorized to issue 150 million shares of Common Stock, par value $0.001 per share. Holders of its Common Stock are entitled to one vote for each share held of record on each matter submitted to a vote of shareholders.

 

Issuance of Common Stock

 

On January 21, 2011, the Company closed a financing transaction in which it sold an aggregate of 748,382 shares of Common Stock to a total of 42 individual investors domiciled in the PRC at $2.50 per share, for total gross proceeds of $1,870,955.

 

Notes with an aggregate face amount of $1,050,000 and accrual interest of $5,406 were converted into 527,703 shares of Common Stock during the year ended June 30, 2011.

 

Restricted Stock Awards

 

On June 4, 2010, we granted 120,000 shares of Restricted Common Stock to our Chief Financial Officer for three years of service. The Restricted Common Stock vests in three equal annual installments over the related service period. We issued 40,000 shares of Restricted Common Stock with an aggregate fair value of $95,000 under this agreement during the year ended June 30, 2011. The Company recorded $44,000 and $182,500 stock compensation expenses for this accrued during the years ended June 30, 2012 and 2011, respectively. There were no shares issued for the year ended June 30, 2012. Our Chief Financial Officer resigned on December 31, 2011.

 

On October 13, 2010, we granted stock options to two directors for the purchase of 26,000 shares of our Common Stock at an exercise price of $2.00 per share. The options vested immediately and expire five years from the date of issuance.

 

These options have been valued at $23,844. We use a binomial option pricing model to calculate the grant date fair value of the options, with the following assumptions: no dividend yield, expected volatility of 70%, risk free interest rate of 0.3%, expected term of 2.5 years.

 

On May 2, 2011, we granted stock options to a director for the purchase of 6,000 shares of our Common Stock at an exercise price of $2.00 per share.  The options vested immediately and expire five years from the date of issuance. These options have been valued at $3,184. We use a binomial option pricing model to calculate the grant date fair value of the options, with the following assumptions: no dividend yield, expected volatility of 55%, risk free interest rate of 0.3%, expected term of 5 years.

 

The following table summarizes the weighted average remaining contractual life and exercise price of our outstanding options as of June 30, 2012:

 

F-24
 

 

Options Outstanding  
Number  
        Outstanding     Weighted     Weighted Average  
    Number   Currently     Average     Exercise Price of  
    Outstanding   Exercisable     Remaining     Warrants  
Exercise   at   at     Contractual Life     currently  
Price   June 30, 2012   June 30, 2012      (Years)     exercisable  
                       
$ 2.00   32,000     32,000       3.39     $ 2.00  

 

We account for share-based payments in accordance with ASC 718. Accordingly, we expense the fair value of awards granted to the directors. Total compensation expense related to the stock options for the years ended June 30, 2012 and 2011 was $0 and $27,028, respectively and was recorded as general and administrative expense.

 

Statutory Reserves

 

According to the laws and regulations in the PRC, we are required to provide for certain statutory funds, namely, reserve fund by an appropriation from net profit after taxes but before dividend distribution based on the local statutory financial statements of the PRC company prepared in accordance with the accounting principles and relevant financial regulations.

 

In the PRC, we are required to allocate at least 10% of our net profit to the reserve fund until the balance of such fund has reached 50% of its registered capital. Appropriation of enterprise expansion fund are determined at the discretion of it directors. We had satisfied statutory reserve requirement by the first quarter of the fiscal year 2010, no further allocation to the statutory reserve is required.

 

The reserve fund can only be used, upon approval by the relevant authority, to offset accumulated losses or increase capital.

 

19.

OPERATING EXPENSE 

 

For the years ended June 30, 2012 and 2011, operating expenses consisted of the following:

 

   Year ended   Year ended 
   June 30,2012   June 30,2011 
         
Travel and accommodation  $18,401,199   $9,421,895 
Advertising and promotion   9,901,082    14,822,116 
Audit fees and expenses   520,261    197,348 
Commission   11,440,588    3,861,379 
Conference