10-K 1 aob_10k-123111.htm FORM 10-K

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

 

xANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2011

   OR

  

oTRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from              to            

 

COMMISSION FILE NO: 001-32569

 

 

AMERICAN ORIENTAL BIOENGINEERING, INC.

(Exact name of registrant as specified in its charter)

                                                                                                                                                  

   

NEVADA 84-0605867
(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.)

 

1 Liangshuihe First Ave, Beijing E-Town Economic and Technology Development Area, E-Town,

Beijing, 100176, People’s Republic of China

(Address of principal executive offices) (Zip Code)

 

86-10-5982-2039

(Registrant’s telephone number, including area code)

 

 Securities Registered Pursuant to Section 12(b) of the Act:

    

Common Stock, Par Value $0.002 Per Share New York Stock Exchange
(Title of Class) (Name of exchange on which registered)

   

Securities Registered Pursuant to Section 12(g) of the Act: None.

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o  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 Act.   Yes o  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 o

 

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 o

 

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.  o

 

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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer  o Accelerated filer  x
Non-accelerated filer    (Do not check if a smaller reporting company)  o Smaller reporting company  o

 

 
 

 

 

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

 

The aggregate market value of the voting stock held on June 30, 2011 by non-affiliates of the registrant was $67,483,532 based on the closing price of $1.11 per share as reported on the New York Stock Exchange on June 30, 2011, the last business day of the registrant’s most recently completed second fiscal quarter (calculated by excluding all shares held by executive officers, directors and holders known to the registrant of five percent or more of the voting power of the registrant’s common stock, without conceding that such persons are “affiliates” of the registrant for purposes of the federal securities laws).

 

On March 12, 2012, 39,216,196 shares of the registrant’s Common Stock, $0.002 par value and 1,000,000 shares of the registrant’s Class A Preferred Stock, $0.001 par value were outstanding.

 

On December 14, 2012, 36,421,610 shares of the registrant’s Common Stock, $0.002 par value and 1,000,000 shares of the registrant’s Class A Preferred Stock, $0.001 par value were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

None.

 

 

 
 

 

 

 

TABLE OF CONTENTS

 

      Page
PART I 4
       
  ITEM 1. Business 4
  ITEM 1A. Risk Factors 20
  ITEM 1B. Unresolved Staff Comments 30
  ITEM 2. Properties 30
  ITEM 3. Legal Proceedings 30
  ITEM 4. Mine Safety Disclosures 31
   
PART II 31
       
  ITEM 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 31
  ITEM 6. Selected Financial Data 34
  ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 36
  ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk 49
  ITEM 8. Financial Statements and Supplementary Data 51
  ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 51
  ITEM 9A. Controls and Procedures 51
  ITEM 9B. Other Information 51
   
PART III 54
       
  ITEM 10. Directors, Executive Officers and Corporate Governance 54
  ITEM 11. Executive Compensation 61
  ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 69
  ITEM 13. Certain Relationships and Related Transactions, and Director Independence 70
  ITEM 14. Principal Accounting Fees and Services 70
   
PART IV 72
       
  ITEM 15. Exhibits, Financial Statement Schedules 72
    Schedule II – Valuation and Qualifying Accounts 73
    Exhibit Index 74
    Signatures 77
    Reports of Independent Registered Public Accounting Firms on Financial Statement Schedule F-2

 

 

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Explanatory Note: This Annual Report on Form 10-K is being filed with respect to the fiscal year ended December 31, 2011 (the “Relevant Period”). The financial statements and other information included herein is as of and for the year ended December 31, 2011, and does not necessarily reflect or include all changes in the Company’s business, operations or other matters that occurred after the Relevant Period, except where required.

 

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This Annual Report includes forward-looking statements as defined with Section 27A of the Securities Act and Section 21E of the Securities Exchange Act of 1934, as amended. All statements, other than statements of historical fact, are statements that could be deemed forward-looking statements, including, but not limited to, statements regarding our future financial position, business strategy and plans and objectives of management for future operations. When used in this prospectus, the words “believe,” “may,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “expect” and similar expressions are intended to identify forward-looking statements.

 

We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy, short-term and long-term business operations and objectives, and financial needs. These forward-looking statements are subject to certain risks and uncertainties that could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to the risks discussed under the heading “Risk Factors”. Except as required by law, we assume no obligation to update these forward-looking statements publicly or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.

 

In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this Annual Report may not occur and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements. Accordingly, readers are cautioned not to place undue reliance on such forward-looking statements.

   

PART I

 

 ITEM 1. BUSINESS

       

Overview

  

We are a China-based, vertically integrated pharmaceutical company dedicated to improving health through the development, manufacture and commercialization of a broad range of pharmaceutical and healthcare products. A majority of our current products are manufactured using plant based materials. Our business is comprised of prescription pharmaceutical products, over-the-counter pharmaceutical products and nutraceutical products. Our pharmaceutical products were approved by the Chinese State Food and Drug Administration, or SFDA, based on demonstrated safety and efficacy before they are permitted for sale in China. We sell our products primarily to hospitals, clinics, pharmacies and retail outlets in all provinces, including rural areas and major cities in China, through the efforts of our sales and marketing professionals. We leverage our relationship with distributors to distribute our products to both urban and rural areas of China. We intend to use our established business as a platform for continued growth both organically and through strategic acquisitions.

  

The following table represents the manufacturing revenues realized from the sale of our pharmaceutical and nutraceutical products, as well as our distribution revenue from our distribution business for the periods indicated:

 

    Year Ended December 31,  
    2011     2010     2009  
Revenue from pharmaceutical products   $ 159,024,681     $ 250,131,594     $ 244,168,159  
Revenue from nutraceutical products     37,757,118       41,020,289       39,125,655  
Total manufacturing revenue     196,781,799       291,151,883       283,293,814  
Distribution revenue     15,908,589       14,792,202       12,856,966  
Total revenues   $ 212,690,388     $ 305,944,085     $ 296,150,780  

 

Each of our pharmaceutical products has certain medicinal functions and has demonstrated safety and efficacy in accordance with SFDA requirements for the treatment of at least one or more therapeutic indications. A majority of our pharmaceutical products are based on non-synthetic medicinal compounds that are extracted from various parts of one or more plants. We apply modern production techniques to traditional Chinese medicine, or TCM to produce a variety of pharmaceutical products in different formulations, such as tablets, capsules and powders.

  

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We currently market 158 pharmaceutical products in China. Two flagship prescription pharmaceutical products currently marketed in China are Shuanghuanglian Lyophilized Injection Powder, or SHL Injection Powder, and Cease Enuresis Soft Gel, or CE Gel. SHL Injection Power is an anti-viral injection effective in treating respiratory infections, bronchitis and tonsillitis, and CE Gel is indicated to alleviate bedwetting. We market our SHL Injection Powder through our brand name SHL, and our CE Gel through Harbin Three Happiness Bioengineering Co., Ltd, or Three Happiness. These products are detailed to physicians at hospitals and clinics through the efforts of our sales force and through educational physician conferences and seminars.  

 

Over-the-counter pharmaceutical products are similar to our prescription pharmaceutical products in that they need approval from the SFDA prior to sales and marketing. They are sold over-the-counter in pharmacies and other retail outlets. Our products in this category include Jinji Series, Cease Enuresis Patch, or CE Patch, and Boke Series. Jinji Series is a line of products approved for the treatment of various women’s health indications including endometritis, annexitis, pelvic inflammation, premenstrual and menopausal symptoms. CE Patch is a product indicated to alleviate bedwetting and for the treatment of incontinence. Boke Series is a line of nasal products indicated to alleviate sinus infections and nasal congestions.

 

Nutraceutical products are intended for the overall well-being. We market several nutraceutical products in China, including our soybean peptide based drinks, tablets, powder and instant coffee. We promote our nutraceutical products through TV and print advertising campaigns in magazines and newspapers, and distribute these products to supermarkets, fitness centers, healthcare specialty stores and other retail outlets in China.

 

We own and operate five manufacturing facilities through which we manufacture all of our products. Each facility is current in its certified standing of Good Manufacturing Practices, or GMP, and International Organization for Standardization, or ISO, and has clearance for export from Chinese authorities.

   

Industry Background and Market Opportunities

 

The Chinese pharmaceutical and nutraceutical markets are highly fragmented, consisting of a large number of small enterprises. We believe that such fragmentation provides opportunities for consolidation and acquisitions. However, the cost for consolidation has been going up in recent years as more acquirers step into the arena, including well capitalized international pharmaceutical giants, such as Bayer, Novatis, among others. Intensified competition among an increased number of acquirers makes accretive acquisitions more and more difficult.

 

A factor that has an obvious impact on all pharmaceutical manufacturers in China is the fast paced evolving Chinese government healthcare policies. “Opinions of the State Council on Deepening the Reform of the Medical and Health Care System,” issued by The State Council of the People’s Republic of China (“the State Council”) in April 2009, signaled the formal commencement of a major public health initiative by the Chinese government. The goal of this new policy is to provide access to basic medical care for every person in China by 2020.

 

In the practice of the above said healthcare reform, we witnessed increased dispensing of drugs on the Essential Drugs List (“EDL”) and of products covered by the National Medical Insurance Catalog (“NIC”). This nationwide trend has exerted a continuous and powerful pressure on the pricing of all generic drugs, whether branded or not, resulting in a significant shrinkage of the profit margins of those manufacturers who make such products.

 

The pricing pressure on EDL or NIC products will have a positive long term impact on China if such pricing pressure can force out inefficiently run manufacturers into bankruptcies. However, the healthcare reform will risk tarnishing the benefits it has brought to the nation if the practice of relentlessly seeking low priced products actually forces quality manufacturers out of the bidding and will leave room for inferior quality products to win the bidding

 

The global economic challenges and uncertainties impacted our business in 2011. These challenges and uncertainties have negatively affected consumers’ demands for both pharmaceutical and nutraceutical products, which contributed to the overall decline in sales during 2011.

 

In addition to the on going economic challenges and uncertainties, our business was negatively impacted by incidents that occurred subsequently to 2011, including the toxic drug capsules incident in 2012. Incidents like that shook the pharmaceutical industry resulting in a decline in market demand, which could have an adverse impact on our future performance

 

Pharmaceutical Market

 

According to the statistics of China’s National Development and Reform Commission, the pharmaceutical industry in China was approximately $181 billion in 2010. China is expected to become the world’s third largest pharmaceutical market by 2012, which includes western medicine and TCM. This growth is being driven by several factors including improving standards of living and an increase in disposable income fueled by the growing economy, the aging population, the increasing participation in the State Basic Medical Insurance System and the increase in government spending on public healthcare. In January 2009, the Chinese government approved a healthcare reform plan and has budgeted for RMB 850 billion, or $124 billion, in a three year program to make medical services and products more affordable and accessible to the whole population.

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Traditional Chinese Medicine Market

 

The traditional Chinese medicine or TCM market for pharmaceutical products in China was approximately $40 billion in 2010, accounting for about 22% of all expenditures on medicine within the China.

TCM, mostly made of botanical plants, has thousands of years of history and is well accepted in China. The traditional formulations, mostly in large dosage of bitter tasting soups, is being upgraded into more convenient formulations, such as tablets, gels, injectables, etc. for improved convenience and sometimes, for improved efficacy.

 

The government of China is committed to supporting and promoting the development of modernized TCM, as evidenced by the government formulating an industry development plan for the modernized TCM sector and adding more modernized TCMs to the national medicine catalog of the National Medical Insurance Program. Additionally, the State Administration of Traditional Chinese Medicine, a national government agency, formulates TCM industry policies for the development of TCM and provides research grants for TCM research and development.

 

The Chinese Ministry of Health ("MOH") published its EDL at the end of 2009 with 307 drugs on the list, among which 102 are TCM.  We have 61 of our TCM products included in the EDL.  

 

We believe that TCM will remain as mainstream medicines in China and will continue to grow as a result of:

 

The Chinese continued preference for TCM remedies with its roots deeply cultivated in five thousand years of history;

 

government support for modernized TCM as a key component of increasing quality of healthcare;

  

the rapidly growing over-the-counter market, in which TCM makes up more than half; and

 

lower pricing as compared to western medicine.

  

Nutraceutical Market

 

The Chinese nutraceutical market is a multibillion dollar market and continues to grow. The nutraceutical products are typically ingested in the form of a pill, capsule, tablet or in liquid form. The main channels for distributing nutraceutical products, including health foods, in China are supermarkets and retail outlets.

 

The nutraceutical market in China has been growing rapidly over the past decade. This growth is driven primarily by the increase in per capita income as well as the increase in awareness of the importance of maintaining one’s health. The increase in the number of ailing people which is caused by the development of modernized cities also leads to an increased demand in the nutraceutical market.

 

Some nutraceuticals may be registered as health foods in China and are subject to approval by the SFDA. Health foods are generally defined as products that are suitable for a specific group of people and that are able to adjust body functions while not aiming at curing a disease. These substances, however, only need to demonstrate safety rather than meet clinical endpoints for efficacy. The SFDA has a list of 27 approved health and beauty benefits that health foods may claim on their packaging or in advertisements. These direct-to-consumer advertisements typically highlight one or more of the approved benefits while focusing on some trend for healthy living.

 

Financial Information about Industry Segments

 

Since October 2008, we have two operating segments based on our major lines of businesses: manufacturing and distribution. For additional information please refer to Note 21 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2011.

 

Our Strengths

 

We believe we have the following strengths, the potential of which when materialized will give us an edge in competition in the market.

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Diverse Product Categories That Provide Operating Flexibility. Our business consists of three product categories including prescription pharmaceutical products, over-the-counter pharmaceutical products and nutraceutical products. Our pharmaceutical products target different therapeutic areas including women’s health, nasal, bedwetting and anti-viral. Each of these competes in a market segment with differentiated regulatory, economic and general market characteristics. We believe this diversification reduces our dependence on any one market segment and enables us to adapt to evolving market conditions in China in order to optimize our business operations in a long run.

 

Well-Recognized Brand Names That Can be Leveraged for Competition with Our Competitors. We have nationally recognized brand names in China, including, Jinji, SHL, Boke and Three Happiness. We believe these brand names provide us with valuable resources for our products to compete in the market. It can also be leveraged further with product line extensions and by establishing brand families for related products. For instance, our Jinji product line enjoys brand recognition in the women’s health market. We believe we can significantly capitalize on this strength for future product introductions to treat other women’s health indications or even when we expand into other therapeutic categories.

 

Our Strategy

 

Our objective is to become a market leader for the development, manufacture and commercialization of pharmaceutical products. We intend to achieve this objective by:

 

Cultivating AOBO as a Unified Mega Brand in Its Own Right, Fusing the Synergy among Our Nationally Established Individual Brands, such as, Jinji, Boke, CE, etc. Our vision is to create a unified mega brand for AOBO so that we can leverage on the brand equity we have already established to boost the credibility and the acceptance of our other products, including the image of those products that are part of the government sponsored tendering processes for EDL as well as those in the national insurance catalogs.  We believe a reasonably priced product with a brand name will be more appealing to consumers, patients, and doctors.

 

Promoting Products through Education. We intend to support and increase the sales of our products by education, such as informational seminars to cultivate an educated audience for our branded products. We will detail the efficacy and safety profile of our established prescription pharmaceutical products to physicians at hospitals and clinics in all provinces in China through the efforts of our sales force and through educational physician conferences and seminars. We will expand our extensive direct-to-consumer advertising campaign highlighting the quality and benefits of our fast growing over-the-counter pharmaceutical products through television, newspaper and print advertisements.

 

Developing and Introducing Additional Products to Expand or Strengthen Our Existing Portfolio. We plan to focus our research and development capabilities towards expanding our existing portfolio of approved products. We have over 170 prescription and over-the-counter pharmaceutical products in our portfolio that are currently approved but have not been commercially launched. In addition, we are conducting clinical trials for new modernized products. These products, if and when successful are expected to break into new markets, or will broaden our patient acceptance because of increased credibility.

 

Research and Development

  

We believe science, technology and innovation, when managed appropriately, will be a major positive factor for our business growth. We spent $12.7 million in 2011 or 6% of the total revenues, compared to $15.4 million in 2010 and $7.9 million in 2009 on research and development. The costs of the Company-sponsored research activities related to the development of new products, improvement of existing products, and technical support of products.

 

Our research and development efforts fall into three categories, namely, the near term, intermediate term, and long term. In the near term we focus on the development, by which we mean our interest will remain in innovations in life cycle management and technology upgrade on existing products, so that safety and efficacy can be improved, or, new indications can be developed for the treatment of additional diseases.

 

We may also license some drug product candidates at late stage development for further development, so that the time to potential commercialization may be drastically reduced.  The goal is to launch more competitive products with a relatively short timeframe. For our long term efforts, we plan to enter major therapeutic areas, such as cancer and cardiovascular diseases.

 

We remain focused on our overall operation’s profitability and maintaining control of working capital. We establish collaborative projects mostly inside China, but also have some collaborative development with professional labs in the USA. Leveraging on the resources outside the Company, we believe we can significantly reduce the time and resources that would be otherwise required. We have made and expect to continue making substantial efforts in research and development activities.

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Our Products

 

Our manufacturing business consists of three main product categories, including prescription pharmaceutical products, over-the-counter pharmaceutical products and nutraceutical products. The majority of our pharmaceutical products are based on non-synthetic medicinal compounds that are extracted from different parts, such as leaves and roots, of one or more plants. All of our pharmaceutical products have demonstrated safety and efficacy in clinical trials sufficient to obtain approval by the SFDA. Nutraceutical products, also frequently referred to as functional foods, functional beverages, dietary supplements or general nutritional supplements, are intended to promote overall health and well-being. Our nutraceutical products are generally considered general nutritional supplements and are not subject to regulatory approval by the SFDA.  

 

We currently manufacture and sell 158 products. The following table summarizes our principal marketed pharmaceutical and nutraceutical products that comprised the majority of our revenue in the year of 2011.

 

Product  

Distribution

Point

  Indication   Insurance coverage
Pharmaceutical Products            
             
Shuanghuanglian Lyophilized Injection Powder   Rx   Respiratory infections, bronchitis and tonsillitis   National Insurance Catalog
             
Cease Enuresis Soft Gel   Rx   Bedwetting   None
             
Cease Enuresis Patch   OTC   Bedwetting and incontinence   None
             
Jinji Capsule   Rx&OTC   Endometritis, annexitis and pelvic inflammations   National Insurance Catalog
             
Jinji Yimucao   OTC   Premenstrual syndrome, or PMS, and other PMS and menopause-related symptoms   Essential Drug List
             
Boke Nasal Spray   OTC   Nasal congestion and sinus infection   National Insurance Catalog
             
Nutraceutical Products            
             
Soy Peptide Series   OTC   Nutritional products for overall health and well-being   None

  

Prescription Pharmaceutical Products

 

Shuanghuanglian Lyophilized Injection Powder

 

Our SHL Injection Powder is a prescription pharmaceutical product approved and marketed for the treatment of flu symptoms, including high fever, cough and sore throat, as well as upper respiratory infections, mild pneumonia and tonsillitis. Our SHL Injection Powder, marketed under the brand name SHL, is one of the only two formulations of SHL approved by the SFDA for intravenous injections. The approved dosage for our SHL Injection Powder is 60 mg for every kilogram of a patient’s body weight. In practice, a medical doctor will decide exactly how much SHL injection powder to use for each patient. This product consists of two plant based ingredients isolated from flowers and leaves.

 

Our SHL Injection Powder was commercially launched in China in 1997 by HSPL, which we acquired in 2004. We detail the safety and efficacy of this product to physicians in hospitals and clinics primarily in rural China. We believe that injectables are of higher quality and offer better bioavailability and efficacy than oral formulations.

 

We are one of the two companies approved by the Ministry of Health to manufacture and commercialize SHL injection powder. This product is manufactured at our Heilongjiang Songhuajiang Pharmaceutical, or HSPL, facility in Harbin.

 

Phase 3 clinical trials for SHL Injection Powder were conducted on 489 patients at Harbin University of Medical Sciences First Affiliated Hospital, Heilongjiang TCM Research Institute and Harbin TCM Hospital. These trials demonstrated safety and efficacy in accordance with SFDA requirements.

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Product safety and side effects are always a concern with TCM injection pharmaceutical products. Our SHL injection powder has not been subject to any liability claims. While we continue to conduct research to upgrade and improve the safety of the products, in 2010, HSPL where our SHL products are made had one short notice inspection by the GMP Expert Group from China SFDA, and three inspections by the provincial or municipal drug administration bureaus. We have successfully passed each of the inspections.

 

Cease Enuresis Soft Gel

 

Our CE Gel is a prescription pharmaceutical product approved and marketed to alleviate bedwetting. This product consists of a formulation that is isolated from the seed of a plant. Our CE Gel is the only SFDA approved Category 1 new pharmaceutical product for this indication. Category 1 approval provides a product with 12 year protection from other companies replicating the product and can be granted when the product is considered to be the first product for a specific indication.

 

Our CE Gel was commercially launched in China in April 2004. We detail the clinical benefits of this product to physicians in hospitals and clinics throughout China. As prescription medications cannot be commercially advertised in China, we rely on physicians to recommend the use of our CE Gel to patients. The Cease Enuresis brand name, however, is well recognized by many patients as our CE Patch is an over-the-counter pharmaceutical product that we promote through direct-to-consumer advertising. This product is manufactured at our Three Happiness facility in Harbin.

 

Phase 3 clinical trials for CE Gel were conducted on 437 patients at Beijing Children’s Hospital, China University of Medical Sciences No. 2 Clinical Hospital, Liaoning TCM Institute Affiliated Hospital and Liaoning TCM Research Institute. These trials demonstrated safety and efficacy in accordance with SFDA requirements.

 

Over-the-Counter Pharmaceutical Products

 

Cease Enuresis Patch

 

Our CE Patch is an over-the-counter pharmaceutical product approved and marketed for the treatment of bedwetting and incontinence. Our CE Patch is formulated for delivery by a patch and can be used in combination with our CE Gel. This product consists of the same plant based ingredients as our CE Gel. Our CE Patch was commercially launched in China in 2005. We promote our CE Patch through direct-to-consumer advertising on television and in print media in China. This product is manufactured at our Three Happiness facility.

 

Our CE Patch was approved by the Food and Drug Administration Bureau of the Heilongjiang Province, under the medical device regulatory pathway.

 

Jinji Capsule

 

Our Jinji Capsule is both a prescription and over-the-counter pharmaceutical product approved and marketed for the treatment of endometritis, annexitis and pelvic inflammations. This is our company’s proprietary product that has a well recognized brand name. This product consists of a combination of many parts of TCM plants, including roots, vines, flowers and stems. We source the majority of our raw materials for our Jinji product line from the Guangxi province, which we believe has a unique natural environment to cultivate high quality plants. We believe the combination of these quality ingredients, our manufacturing processes and our well-recognized brand name position our Jinji products well to compete in the marketplace. A course of treatment requires a dose of four capsules taken three times a day.

 

Our Jinji Capsule was commercially launched approximately 30 years ago in China by GLP, which we acquired in April 2006. With its long history, the Jinji brand name is well-recognized in the women’s health market in China. We promote our Jinji Capsule through direct-to-consumer advertising, including an extensive television commercial campaign. These commercials are televised nationally in China. We believe that these advertisements continue to strengthen our brand loyalty, a major driver of the historical popularity of the drug. This product is manufactured at our Guangxi Lingfeng Pharmaceutical Co., or GLP, facility in Hezhou in the Guangxi Province in Southwestern China. Phase 3 clinical trials for Jinji Capsule were conducted on 421 female patients at Wuzhou City People’s Hospital, Wuzhou City Workers’ Hospital and Hezhou TCM Hospital. These trials demonstrated safety and efficacy in accordance with SFDA requirements.

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Jinji Yimucao

 

Our Jinji Yimucao is an over-the-counter pharmaceutical product approved and marketed for the treatment of premenstrual syndrome, or PMS, and other PMS and menopause-related symptoms. Jinji Yimucao is approved by the SFDA in China and marketed as a branded generic drug. This product consists of a combination of many parts of TCM plants, including roots, vines, flowers and stems. We source the majority of our raw materials for our Jinji product line from the Guangxi province, which we believe has a unique natural environment to cultivate high quality plants. We believe the combination of these quality ingredients, our manufacturing processes and our well-recognized brand name position our product well to compete in the marketplace. Each treatment requires a dose of two packets of powder for oral suspension taken two times a day.

 

In early 2007 we commercially launched JinjiYimucao. We own this product as a result of the acquisition of GLP, which we completed in April 2006. We promote Jinji Yimucao through direct-to-consumer advertising, including an extensive television commercial campaign. We believe that these advertisements continue to strengthen our brand loyalty, a major driver of the historical popularity of the drug. This product is manufactured at our GLP facility in Hezhou.

 

Boke Nasal Spray

 

Our Boke nasal spray is an over-the-counter pharmaceutical product approved and marketed for the treatment of sinus congestion from common cold, stuffy nose, chronic rhinitis, allergic rhinitis and nasosinusitis. The spray is marketed under the product name of DitongBiyanshuiPenwuji (“Ditong”). Ditong is approved by the SFDA in China and marketed as a branded drug. This product consists of a combination of many parts of TCM plants, including roots, vines, flowers and stems.

Treatment dosage is three to four times a day and two sprays into each nostril.

 

Ditong was commercially launched by Boke in China approximately 10 years ago. We own this product as a result of the acquisition of Boke, which we completed in October 2007. We promote Boke nasal spray through direct-to-consumer advertising, including an extensive television commercial campaign. We believe that these advertisements continue to strengthen our brand loyalty, a major driver of the historical popularity of the drug. This product is manufactured at our Boke facility in Nanning.

 

Principal Nutraceutical Products

 

Soy Peptide Series

 

Our Soy Peptide Series is our primary line of nutraceutical products, all of which are available in supermarkets, fitness centers, specialty nutraceutical stores and other retail outlets. These products include tablets, powders, drinks and instant coffee that are non-genetically modified and derived from soybeans through a biochemical process involving decomposition, conversion and synthesis of soybean protein. They are used as food and beverage supplements and are easily digested, increase metabolism and can replenish body strength. The benefit of our peptide formulation compared with the soybean itself is that our formulation is more readily absorbable by the human body. We manufacture these products at our Three Happiness facility in Harbin.

 

Our Soy Peptide Series was commercially launched in China in 2002. We do not have any exclusivity under Chinese law for these products but we own trademarks and market all of our nutraceutical products through print advertising campaigns. While the nutraceutical market is highly fragmented with many competitors, we believe that our product branding and multiple forms for delivery of the peptide will continue to support additional growth.

 

Product Pipeline

 

We have our own research, development and laboratory facilities in China and a lab in USA, all of which are run by our own professional research and development team. We have also entered into joint research and development agreements with outside research institutes in China and in the United States. We intend to continue introducing new modernized products to leverage our branded market leadership position, and to develop line extensions for our existing products.

   

We are also exploring opportunities for acquisitions that may complement our existing product lines and leverage our significant sales and distribution capabilities.

 

Marketing and Sales

 

We focus our marketing efforts on establishing business relationships and growing our brand recognition. In 2011, we manufactured and marketed 158 products. In 2011, we made special efforts in our prescription and generic products’ market based on the changing pharmaceutical environment and we penetrated major cities and rural areas, including hospitals, clinics, pharmacies and retail stores. We continue to invest in marketing and TV advertisements. While marketing and promotional expenses for newly-launched products have impacted our short-term profitability, this is in line with our strategy of investing in new products we expect to have potential for growth in the future.

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Our marketing division is responsible for designing our overall marketing strategy, managing our brand, conducting market research and surveys, liaising with various levels of regulatory authorities and government institutions and providing training to our sales force.  Our marketing division also ensures that our brand is associated with high quality products and responsive service, our customer support and sales team work with each member within our sales channel, including hospitals, clinics, and distributors in a wide range of areas to help them become more effective.

 

We maintain approximately 100 regional representative offices throughout China and employ approximately 1,600 sales and marketing professionals in major cities and extensive rural areas. Through regular meetings with physicians and hospital administrators, the organization of academic seminars and conferences, and assisting with clinical trials, our salespeople can effectively communicate the therapeutic benefits of our products to physicians and hospital administrators. Specifically, our senior personnel in the prescription sales force typically interact with the heads of a hospital administration and the persons in charge of the relevant departments to seek the inclusion of our products in the hospital’s formulary. Our middle-level and junior personnel typically meet with individual physicians to promote the therapeutic value and other features of our products.

 

Our sales people are assigned to a number of retail pharmacies in a designated region, where they work with pharmacy salespeople to conduct in-store promotions and other forms of direct marketing to consumers and also educate pharmacy salespeople on our products. They also organize free community healthcare activities, collect consumer opinions on our products and our promotional and advertising activities, and relay these consumer opinions to our marketing strategy division. This valuable feedback allows us to tailor our promotional and advertising activities to fit different consumer profiles and different localities.

 

By working closely with our distributors, our customer support and sales team are able to provide us valuable insights into the operations of each local distributor, which help us, ensure that each distributor is able to operate effectively for our growth.

 

Distributors and Customers

 

We sell part of our products to third-party distributors who resell these products to hospitals and retail pharmacies. In addition, these distributors also handle distribution logistics, warehousing and transportation. As of December 31, 2011, our national distribution network consisted of more than 320 distributors covering major cities and extensive rural areas in China. The breadth of our distribution channel allows us to target distribution points comprising hospitals, clinics, pharmacies and retail stores.

 

We make selections based on factors such as sales experience, knowledge of the products, contacts in the hospital and communities, reputation and market coverage.

We do not enter into exclusive distribution agreements with these third party distributors.

 

We actively manage our distribution network and we review our distribution agreements on an annual basis to specify designated distribution points, the location and method for delivery of our products to certain distribution points and targets for annual sales volume and receivable collections.

    

The distribution industry in China is fragmented with over 10,000 distributors. Due to the number of distributors, we do not rely on any one distributor for our distribution needs. We estimate that our top 10 distributors account for only approximately 12% of our total sales.

    

Since October 2008, through the acquisition of NuoHua, distribution of pharmaceutical products became part of our business and we now distribute pharmaceutical products throughout the Liaoning and Jilin province in China.

 

Manufacturing

 

We employ a vertically integrated operating model in order to enable us to develop, manufacture and market quality products at competitive prices. Our factories work closely with our research and development team to optimize manufacturing processes and develop commercially viable products. In addition, our factories incorporate regular feedback from our sales and marketing personnel, in order to timely and cost-effectively introduce products tailored to end-user needs.

 

Furthermore, most of our manufacturing operations, which are based in China, have easy access to transportation, often provide us with the convenience of low-cost operations, sufficient labor pool and close proximity to sources of some raw materials. As part of our overall strategy to lower production costs through our vertically integrated operating model, we have made substantial investments in our in-house manufacturing infrastructure to complement our research and development, product design activities, capacity improvement, and efficiency enhancement.

 

We have five manufacturing facilities in China dedicated exclusively to the manufacture of our products. Each facility is GMP certified. We have fully integrated manufacturing support systems including quality assurance, quality control and regulatory compliance.

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Our quality assurance team devotes significant attention to quality control for designing, manufacturing and testing our products, and is also responsible for ensuring that we are in compliance with all applicable national and local regulations and standards, as well as our internal policies. On February 12, 2011, SFDA promulgated the more stringent new GMP guidelines. The new standards are aimed at improving drug production management and controlling risks in the production process and introduce internationally-recognized quality control mechanisms. The latest update to GMP standard has greatly raised the bar for quality control, documentation, and overall manufacturing processes, thus causing an increase of cost in manufacturing and decrease of profit margins.

 

However, from a long term perspective, we believe the upgraded GMP standards will ensure better quality in the pharmaceutical products that are sold in China’s pharmaceutical markets. The new regulations apply to new manufacturing facilities effective from March 1, 2011 and the industry has a five year phase-in period to bring existing facilities in line with the revisions.

 

The details of our facilities are as follows:

 

Three Happiness. Our Three Happiness facility is located in Harbin, the capital of Heilongjiang Province in northeast China. It is approximately 1,532,775 square feet and manufactures both pharmaceutical and nutraceutical products. The Three Happiness facility consists of one pharmaceutical and one nutraceutical manufacturing plant, including a dedicated building for soybean peptide products.

 

HSPL. Our HSPL facility is also located in Harbin. It is approximately 532,339 square feet and manufactures our SHL Injection Powder.

 

GLP. Our GLP facility is located in He Zhou, in the Guang Xi Province in southwest China. It is approximately 1,875,287 square feet and manufactures our Jinji series of women’s health products.

 

CCXA. Our CCXA facility is located in ChangChun, the capital of Jilin Province in northeast China. It is approximately 1,357,220 square feet and manufactures a variety of generic pharmaceutical products.

 

Boke. Our Boke facility is located in NanNing, the capital of Guang Xi Province in southwest China. It is approximately 174,280 square feet and manufactures our Boke series of nasal products.

 

We have land use rights to the land on which our manufacturing facilities are located that are granted and allocated to us by the government. According to Chinese laws, the government owns all the land in China and companies or individuals are authorized to use the land only through land use rights granted or allocated by, or leased from, the PRC government.

 

Raw Materials

 

Our production facilities are located in certain regions of China, usually with easy transportation access to some of the raw materials we use in manufacturing our products. We also have some farm land where medicinal herbs are grown and harvested for us, which we believe is a cost saving measure when the harvest is ready for our products. Historically, we have not had difficulty obtaining the quantity of raw materials we need from suppliers, although the general trend of price increases continue.

 

The increase in raw materials cost should be viewed against the macro economic conditions in China. Industry research indicates that TCM raw materials price will continue to increase. The impact of such inflation will vary depending on different products that require different TCM raw materials, even though a few TCM raw materials have seen a small percentage of price decline. We continue to take multiple approaches to reduce the risk of over reliance on certain raw materials, including entering arrangements with suppliers in China to hedge against the risk of short supply due to weather induced irregularities. 

 

To mitigate the impact of the increasing cost and supply of raw materials, the Company entered into long-term supply contracts with various third parties to grow Millettia and Xanthoceras Sorbifolia Bge (“XSB”), which are the Company’s major raw materials. Through these supply contracts, the Company believes that it will stabilize the supply of its major material in a long run and reduce the risk of increasing cost in future periods.

 

As such, in 2009 and 2010, the Company’s GLP subsidiary entered into long-term supply contracts with various third parties to grow Millettia and XSB, a major raw material of the Company, on behalf of the Company through leasing land use rights and production arrangements. Under these contracts, the Company bears the costs in relation to Millettia cultivation and in return is entitled to a supply price at fair value discounted at a pre-determined rate when delivered. The purchase commitment is unconditional and the Millettia is not expected to be harvest until after 2018 and XSB is not expected to be harvest until after 2014. The Company expects the initial supply of Millettia to occur between year nine and year eleven of the contract period as Millettia is a stem from a certain plant which requires an eight to ten-year period to mature. XSB requires a three-year period to mature and the Company expects the initial supply from year four. The contracts for Millettia expire after 30 years and the contract for XBS expire after 10 years. All contracts entitle the Company to renew with terms to be negotiated.

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We have our own quality control system, and devote significant attention to quality control for the raw material extraction, product production, manufacturing, and commercialization. In particular, we have established a quality control system in accordance with SFDA regulations.

 

Intellectual Property

 

We regard our packaging designs, service marks, trademarks, trade secrets, patents and similar intellectual property as part of our core competence that is critical to our success. We rely on patent, trademark and trade secret law, as well as confidentiality agreements with certain of our employees, distributors and others to protect our intellectual property rights.

 

There are three types of patents under the PRC patent law. The first type, an external design patent, refers to a new design of a product’s shape, pattern or a combination of shape and pattern and the combination of a product’s color and its shape and pattern, where such a design is aesthetically appealing and suitable for industrial application. The second type of patent is called an invention patent and the third type of patent is referred to as a new model or utility patent. Invention patents and utility patents are similar in that both of them relate to scientific or technological inventions. A utility patent, compared to an invention patent, requires a lower level of creativity and covers a narrower scope. In addition, an invention patent can be a new technology introduced in respect of an existing product, method or their improvements, while a utility patent is restricted to a product’s shape, constitutions or a combination of these two. Invention patents are valid for 20 years, whereas utility patents and external design patents are each valid for 10 years.

 

To a large extent, we rely on such State Protection law to protect our intellectual property rights with respect to some of our products. As of March 12, 2012, we owned a total of 53 patents and the number of patents in the process of application is 37; and have registered a total of 272 trademarks and the number of trademarks in the process of application is 51.The Company has the following invention patents related to material products:

 

Application No./Patent No. Product Covered Purpose Expiration Date
 00103392.1  Soybean Peptides the equipment and method of producing small molecular peptides from protein separated from soybean 3/01/2020
 200410043925.0  SHL the production method of  injection powder 10/11/2024
 200510055523.7  Jinji Capsule a drug for treatment of pelvic inflammatory disease and its production method 3/16/2025
 200510010531.X  CE Gel a method for quality control of the production of WenGuanGuoZiRen cream 11/11/2025
 200610009619.4  CE Patch a method for the extraction of effective portion of WenGuanGuoZiRen 1/12/2026
 144459.0  CE Patch the extraction of WenGuanGuoZiRen, its method of extraction and usage 1/12/2026

  

 In addition, the Company has the following external design patents for packaging designs related to our key products:

 

Application No. Purpose Expiration Date
 200630157478.1  packaging box for CE Patch 12/4/2016
 200630157477.7  packaging box for CE Capsule 12/4/2016
 200630157479.6  packaging box for SHL Injection Powder 12/4/2016
 200730145294.8  packaging box for JinjiYimucao 4/30/2017
 200830113220.0  packing box for Ditong rhinitis Spray 9/05/2018

 

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For the years ended December 31, 2011, 2010 and 2009, the Company conducted annual impairment tests to determine if recorded amounts for these assets all active, being used in production of products or would be utilized in future production. The assessment also included an evaluation of the ongoing cash flows from these assets. In performing such analysis as of December 31, 2011, the Company identified certain product licenses, trademarks and patents that would no longer be used due to change in product lines, customer acceptance or expiration of the underlying right. As such, the Company determined that $6,928,064 of such items had been impaired or abandoned during the year ended December 31, 2011. The Company believes the remaining licenses, trademarks, and patents still have value and will continue to be used in ongoing operations.

 

Competition

 

We believe that competition and leadership in our industry are based on managerial and technological expertise, and the ability to identify and exploit commercially viable products in a long run. Other factors affecting our competitive position include time to market, patent position, product efficacy, safety, convenience, reliability, availability and pricing.

 

Our SHL Injection Powder primarily competes with a similar injection powder product produced by Harbin Pharmaceutical Group. Our marketing strategy with respect to this product is broader than our competitor by focusing on rural markets as well as major cities and continues to maintain high products quality. We believe this strategy has been successful for us against our competition.

 

 Our CE Gel competes with several other products having similar functionality. Some of these products include the Jianpizhiyi Tablet produced by Shangdong Zhiling Pharmaceutical Company, Yeniaoying produced by Tianjin Zhongxin Company, Shengjiyiniaokang produced by Shanxi Dingxing Healthcare Scientific Limited and Suoquan Pill produced by Jilin Tianguang Pharmaceutical Limited. Despite the similar products in the market, we believe our CE Gel is the leading product, as currently it is the only SFDA approved first grade medicine for bedwetting.

 

Our Jinji Capsule competes with Huahong Pill produced by Huahong Pharmaceutical Group and Qianjin Pill produced by Qianjin Pharmaceutical Group.

 

Our Boke nasal spray competes with Dezhong Biyankang produced by Guangdong Foshan Dezhong Pharmaceutical Co., Ltd; Zhonglian Rhinitis Tablets produced by Wuhan Zhonglian Pharmaceutical Co., Ltd; and Qianbai Rhinitis Tablet produced by Guangzhou Qixing Pharmaceutical Co., Ltd.

 

Our Soy Peptide Series competes with Leneng Peptide Powder, produced by Leneng Bioengineering Company and Soybean Protein Peptide, produced by Harbin High and New Technology Company Limited.

  

Environmental Matters

 

We are subject to evolving regulations under laws and regulations administered by governmental authorities at the national, provincial and city levels, some of which are, or may be, applicable to our business. Our hospital customers are also subject to a wide variety of laws and regulations that could affect the nature and scope of their relationships with us.

 

We must comply with numerous additional state and local laws relating to matters such as safe working conditions, manufacturing practices, environmental protection and fire hazard control. We may be required to incur significant costs to comply with these laws and regulations in the future. Unanticipated changes in existing regulatory requirements or adoption of new requirements could have a material adverse effect on our business, financial condition and results of operations.

 

Employees

 

We had 3,789 employees as of December 31, 2011. 1,399 of these employees are principally engaged in manufacturing and services activities, 1,667 in sales and marketing, 121 in research and development and 602 in management and administration. We continue to monitor our headcount and may add additional employees for sales and marketing, research and development, customer service and manufacturing and assembly as our business grows. In general, we consider our relationship with our employees to be good.

 

Insurance

 

We currently carry insurance policies which are customary for enterprises in China providing for total coverage of approximately $41.8 million. We have property coverage of approximately $22.5 million, motor vehicle coverage of approximately $1.1 million and employee health and accident coverage of approximately $3.2 million. We also maintain Director and Officer Insurance coverage of $15 million. We paid aggregate insurance premiums of $491.623 in 2011.

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Our History

 

Three Happiness had been conducting business in China since 1994. In June 2002, through a share exchange with the stockholders of Three Happiness, Three Happiness became our wholly-owned subsidiary and continued its business operations in China. Prior to the share exchange we did not have any business operations. At the time of the share exchange we changed our name to American Oriental Bioengineering, Inc.

 

In February 2003, we acquired the rights to a soybean protein peptide biochemical engineering project, which provided us with the rights to manufacture and commercialize our Soy Peptide Series of nutraceutical products. Also, since the share exchange in 2002, we acquired seven  companies in China. In November 2004, we acquired HSPL, which manufactures and commercializes our SHL Injection Powder. In April 2006, we acquired GLP, which manufactures and commercializes our Jinji series. In July 2006, we acquired HQPL, a pharmaceutical distributor that owns a license to distribute pharmaceutical products in China. In August 2007, we acquired CCXA, which manufactures and commercializes a board range of generic pharmaceutical products. In October 2007, we acquired BOKE, which manufactures and commercializes our Boke series of nasal products. In October 2008, we acquired NuoHua, a pharmaceutical wholesale and retail distribution company, and Guang Xi Hui Ke Pharmaceutical Research and Development Co., Ltd. (“GHK”), a company engaged in pharmaceutical research and product development leading to SFDA approval to expedient product launches in China.

 

On July 18, 2005, our common stock commenced trading on the American Stock Exchange, or AMEX, under the ticker symbol “AOB.” On November 14, 2005, our common stock commenced trading on the Archipelago Exchange, or ArcaEx, a facility of the Pacific Exchange.

 

On December 18, 2006, we voluntary elected to delist our common stock from the AMEX and ArcaEx. Our common stock commenced trading on the New York Stock Exchange under the ticker symbol “AOB” on the same day. 

 

On March 16, 2012, concurrent with the Company’s 8-K announcing audit committee investigation into matters identified by the auditor Ernst & Young Hua Ming, the Company’s stock was suspended in trading by NYSE. On April 16, 2012, the New York Stock Exchange (“NYSE”) filed a form of 25NSE with SEC to announce official delisting the Company’s common stock. As a result of the delisting the Company’s common stock started to be quoted on the Pink Sheet on May 29, 2012.

 

Regulations of Our Industry --the Pharmaceutical Industry

 

The pharmaceutical industry in China, including the TCM sector, is highly regulated. The primary regulatory authority is the SFDA, including its provincial and local branches. As a developer, producer and distributor of medicinal products, we are subject to regulation and oversight by the SFDA and its provincial and local branches. The Law of the PRC on the Administration of Pharmaceuticals provides the basic legal framework for the administration of the production and sale of pharmaceuticals in China and covers the manufacturing, distributing, packaging, pricing and advertising of pharmaceutical products. Its implementing regulations set forth detailed rules with respect to the administration of pharmaceuticals in China. We are also subject to other PRC laws and regulations that are applicable to business operators, manufacturers and distributors in general.

 

Registration and Approval of Medicine. A medicine must be registered and approved by the SFDA before it can be manufactured. The registration and approval process requires the manufacturer to submit to the SFDA a registration application containing detailed information concerning the efficacy and quality of the medicine and the manufacturing process and the production facilities the manufacturer expects to use. To obtain the SFDA registration and approval necessary for commencing production, the manufacturer is also required to conduct pre-clinical trials, apply to the SFDA for permission to conduct clinical trials, and, after clinical trials are completed, file clinical data with the SFDA for approval. Our pharmaceutical products are approved by the SFDA and are being sold both as prescription and over-the-counter medicines.

 

New Medicine. If a medicine is approved by the SFDA as a new medicine, the SFDA will issue a new medicine certificate to the manufacturer and impose a monitoring period which shall be calculated starting from the day of approval for manufacturing of the new medicine and may not exceed five years. The length of the monitoring period is specified in the new medicine certificate. During the monitoring period, the SFDA will monitor the safety of the new medicine, and will neither accept new medicine certificate applications for an identical medicine by another pharmaceutical company, nor approve the production or import of an identical medicine by other pharmaceutical companies. For new medicines approved prior to September 2002, the monitoring period could be longer than five years. As a result of these regulations, the holder of a new medicine certificate effectively has the exclusive right to manufacture the new medicine during the monitoring period.

     

Provisional National Production Standard. In connection with the SFDA’s approval of a new medicine, the SFDA will normally direct the manufacturer to produce the medicine according to a provisional national production standard, or a provisional standard. A provisional standard is valid for two years, during which the SFDA closely monitors the production process and quality consistency of the medicine to develop a national final production standard for the medicine, or a final standard.

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Three months before the expiration of the two-year period, the manufacturer is required to apply to the SFDA to convert the provisional standard to a final standard. Upon approval, the SFDA will publish the final standard for the production of this medicine. In practice, the approval for conversion to a final standard is a time-consuming process. However, during the SFDA’s review period, the manufacturer may continue to produce the medicine according to the provisional standard.

 

Transitional Period. Prior to the latter of (1) the expiration of a new medicine’s monitoring period or (2) the date when the SFDA grants a final standard for a new medicine after the expiration of the provisional standard, the SFDA will not accept applications for an identical medicine nor will it approve the production of an identical medicine by other pharmaceutical companies.

Accordingly, the manufacturer will continue to have an exclusive production right for the new medicine during this transitional period.

 

Continuing SFDA Regulation. Pharmaceutical manufacturers in China are subject to continuing regulation by the SFDA. If the labeling or manufacturing process of an approved medicine is significantly modified, a new pre-market approval or pre-market approval supplement will be required by the SFDA. A pharmaceutical manufacturer is subject to periodic inspection and safety monitoring by the SFDA to determine compliance with regulatory requirements. The SFDA has a variety of enforcement actions available to enforce its regulations and rules, including fines and injunctions, recall or seizure of products, the imposition of operating restrictions, partial suspension or complete shutdown of production and criminal prosecution.

 

Pharmaceutical Product Manufacturing

 

Permits and Licenses for Pharmaceutical Manufacturers. A pharmaceutical manufacturer must obtain a pharmaceutical manufacturing permit from the SFDA’s relevant provincial branch. This permit is valid for five years and is renewable upon its expiration. Each of our manufacturing facilities has a pharmaceutical manufacturing permit. We do not anticipate any difficulty in renewing our pharmaceutical manufacturing permits upon expiration.

 

Good Manufacturing Practice. A pharmaceutical manufacturer must meet Good Manufacturing Practice standards, or GMP standards, for each of its production facilities in China in respect of each form of pharmaceutical products it produces. GMP standards include staff qualifications, production premises and facilities, equipment, raw materials, environmental hygiene, production management, quality control and customer complaint administration. If a manufacturer meets the GMP standards, the SFDA will issue to the manufacturer a Good Manufacturing Practice certificate, or a GMP certificate, with a five-year validity period. However, for a newly established pharmaceutical manufacturer that meets the GMP standards, the SFDA will issue a GMP certificate with only a one-year validity period. We have obtained a GMP certificate for all of our production facilities covering all of the products that we produce.

 

On February 12, 2011, SFDA promulgated the more stringent new GMP guidelines. The new standards are aimed at improving drug production management and controlling risks in the production process and introduce internationally-recognized quality control mechanisms. The latest update to GMP standard has greatly raised the bar for quality control, documentation, and overall manufacturing processes.

 

Pharmaceutical Distribution. A distributor of pharmaceutical products in China must obtain a pharmaceutical distribution permit from the relevant provincial or local SFDA branches. The distribution permit is granted if the relevant SFDA provincial branch receives satisfactory inspection results of the distributor’s facilities, warehouse, hygiene environment, quality control systems, personnel and equipment. A pharmaceutical distribution permit is valid for five years.

 

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Restrictions on Foreign Ownership of Pharmaceutical Wholesale and Retail Businesses in China. Chinese regulations on foreign investment currently permit foreign companies to establish or invest in wholly foreign-owned companies or joint ventures that engage in wholesale or retail sales of pharmaceuticals in China. For retail sales, these regulations restrict the number and size of retail pharmacy outlets that a foreign investor may establish. Retail pharmacy chains with more than 30 outlets that sell a variety of branded pharmaceutical products sourced from different suppliers are limited to less than 50.0% foreign ownership unless the outlets are owned by a third party and operated under a foreign franchise.

 

Good Supply Practice Standards. The SFDA applies Good Supply Practice standards, or GSP standards, to all pharmaceutical wholesale and retail distributors to ensure the quality of distribution in China. The currently applicable GSP standards require pharmaceutical distributors to implement controls on the distribution of medicine, including standards regarding staff qualifications, distribution premises, warehouses, inspection equipment and facilities, management and quality control. A certificate for GSP standards, or GSP certificate, is valid for five years, except for a newly established pharmaceutical distribution company, for which the GSP certificate is valid for only one year.

  

Price Controls. The retail prices of prescription and over-the-counter medicines that are included on essential drug list (the “EDL”) and in the national medicine catalog are subject to price controls administered by the Price Control Office under the National Development and Reform Commission, or the NDRC, and provincial price control authorities, either in the form of fixed prices or price ceilings. The controls over the retail price of a medicine effectively set the limits for the wholesale price of that medicine. From time to time, the NDRC publishes and updates a national list of medicines that are subject to price control. Fixed prices and price ceilings on medicines are determined based on profit margins that the NDRC deems reasonable, the type and quality of the medicine, its production costs, the prices of substitute medicines and the extent of the manufacturer’s compliance with the applicable GMP standards. The NDRC directly regulates the price of some of the medicines on the list, and delegates the power to provincial price control authorities to regulate the remainder on the list. For those medicines under the authority of provincial price control authorities, each provincial price control authority regulates medicines manufactured by manufacturers registered in that province. Provincial price control authorities have the discretion to authorize price adjustments based on the local conditions and the level of local economic development. Only the manufacturer of a medicine may apply for an increase in the retail price of the medicine and it must apply either to the NDRC, if the price of the medicine is nationally regulated, or to the provincial price control authorities in the province where it is registered, if the price of the medicine is provincially regulated.

For a provincially regulated medicine, when provincial price control authorities approve an application, they will file the new approved price with the NDRC for confirmation and thereafter the newly approved price will become binding and enforceable across China.

 

The controversial Anhui Model, while its pros and cons are still subject to debate, as we interpret it from what we have observed, has created a tendency of government tendering process favoring low cost at the expense of quality at least in some provinces, including Anhui. The prevalence of this tendency has forced out some well-established manufacturers, such as The Buchang Group, (see report on November 1, 2011 from www.meinet.com.cn) from participation in bidding, as the winning bid demands a price below cost. Also in above cited report, Yu Mingde, the president of China Pharmaceutical Enterprise Management Society, was reportedly said that “Tong Ren Tang was forced out of bidding in certain regions” because of below cost pricing.”Facing the challenges between the profit margin squeeze and revenue growth, we have adopted and will continue to adopt a stance that gives more priority to profitability. Notwithstanding our effort, we cannot assure you of profitable operations if the Anhui Model contuses its abusive practice in the government tendering process.

 

Tendering Requirement for Hospital Purchases of Medicines. Provincial and municipal government agencies such as provincial or municipal health departments also operate a mandatory tendering process for purchases by state-owned hospitals of a medicine included in provincial medicine catalogs. These government agencies organize a tendering process once every year in their province or city and typically invite manufacturers of provincial catalog medicines that are on the hospitals’ formularies and are in demand by these hospitals to participate in the tendering process. A government-approved committee consisting of physicians, experts and officials is delegated by these government agencies the power to review bids and select one or more medicines for the treatment of a particular medical condition. The selection is based on a number of factors, including bid price, quality and manufacturer’s reputation and service. The bidding price of a winning medicine will become the price required for purchases of that medicine by all state-owned hospitals in that province or city. The tendering requirement was first introduced in 2001 and has since been implemented across China. We understand that the level of present implementation of the tendering requirement varies among different provinces in China. 

 

Reimbursement under the National Medical Insurance Program. The Ministry of Labor and Social Security, together with other government authorities, determines which medicines are to be included in or removed from the national medicine catalog for the National Medical Insurance Program, and under which tier a medicine should fall, both of which affect the amounts reimbursable to program participants for their purchases of those medicines. These determinations are based on a number of factors, including price and efficacy. A National Medical Insurance Program participant can be reimbursed for the full cost of a Tier 1 medicine and 80 to 90% of the cost of a Tier 2 medicine.

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Although it is designated as a national program, the implementation of the National Medical Insurance Program is delegated to various provincial governments, each of which has established its own medicine catalog. A provincial government must include all Tier 1 medicines listed in the national medicine catalog in its provincial medicine catalog, but may use its discretion based on its own selection criteria to add other medicines to, or exclude Tier 2 medicines listed in the national medicine catalog from, its provincial medicine catalog, so long as the combined numbers of the medicines added and excluded do not exceed 15% of the number of the Tier 2 medicines listed in the national catalog. In addition, provincial governments may use their discretion to upgrade a nationally classified Tier 2 medicine to Tier 1 in their provincial medicine catalogs, but may not downgrade a nationally classified Tier 1 medicine to Tier 2. The total amount of reimbursement for the cost of prescription and over-the-counter medicines, in addition to other medical expenses, for an individual program participant in a calendar year is capped at the amount in that participant’s individual account. The amount in a participant’s account varies, depending upon the amount of contributions from the participant and his or her employer. Generally, program participants who are from relatively wealthier eastern parts of China and relatively wealthier metropolitan centers have greater amounts in their individual accounts than those from less developed provinces.

 

Regulation Relating to the Nutraceutical Industry

 

Some nutraceuticals produced in China can be labeled as health food, which means the product is aimed at a specific group of people and is able to adjust bodily function but is not aimed at curing disease. Health foods are required to be approved by the SFDA and are subject to its regulation. We currently have only one product approved as a health food by the SFDA.

 

Registration of Health Products

 

The approval of nutraceuticals as health products requires (i) an applicant to perform product research prior to submitting an application for registration of health food; (ii) an applicant to submit the sample and relevant product research materials to the examination institute appointed by the SFDA for required trial and examination; and (iii) the issuance of a report by the examination institute.    

 

Provincial food and drug authorities review the product research materials and sample and, if found satisfactory, the food and drug authorities at the provincial level conduct site inspections and sample examinations and thereafter submit their opinion along with the application materials to the SFDA, and in the meantime, send inspection notice together with the sample to be examined to the appointed examination institute. The examination institute conducts examinations and inspections and submits its report to the SFDA. If all the regulatory requirements are satisfied, the SFDA will grant an Approval Certificate of Homemade Health Food to the applicant. The Approval Certificate of Health Food is effective for a period of five years.

 

Any changes to the items stated in the Approval Certificate of Health Food as well as its appendices must be approved by the SFDA. However, pursuant to the Administration Rules for Registration of Health Food (Trial), the product name, raw materials, manufacturing process, usage methods and other items stated in the Approval Certificate of Health Food, which may affect the safety and function of the health food, shall not be altered.

 

In the case of transfer of technology of the registered health products to be manufactured in PRC, the transferee shall apply for new approval certificate of homemade health food in accordance with the relevant provisions of the Administration Rules for Registration of Health Food (Trial).

 

Permits and Licenses for Manufacturing of Health Foods

 

Those enterprises engaging in manufacturing and operation of health food business must also comply with the PRC Food Hygiene Law and the Administration Rules of Food Hygiene Permit. Under the PRC Food Hygiene Law, enterprises engaging in manufacturing and operation of food products in PRC are required to obtain Hygiene Permit from the relevant PRC hygiene administrative authorities. In order to manufacture health food in the PRC, the manufacturing enterprise shall apply to the hygiene administration authorities at the provincial level for approval. If it is qualified, the hygiene administrative authorities at the provincial level will issue a Hygiene Permit with the approved health food specified. Each Hygiene Permit issued to a food manufacturing enterprise is effective for a period of four years. The enterprise is required to apply for renewal of such permit within sixty days prior to its expiry.

 

Manufacturing enterprise of health food shall organize its manufacture in accordance with the approval and shall not change the ingredient, manufacturing process, quality standard, name of the products, label, illustration and so on. The manufacturing procedures and conditions shall be in compliance with hygiene requirements that are applicable to the food manufacturing enterprise.

 

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Compliance with GMP

 

Pursuant to the Notice of Circulating the Examination Methods and Assessment Guidelines of Good Manufacturing Practices of Health Food promulgated by the MOH, the Hygiene Permit shall only be issued to those enterprises in compliance with the GMP upon examination of the hygiene administrative authorities at the provincial level. For those enterprises failing to meet the GMP, the Hygiene Permit will be revoked.

 

On February 12, 2011, SFDA promulgated the more stringent new GMP guidelines. The new standards are aimed at improving drug production management and controlling risks in the production process and introduce internationally-recognized quality control mechanisms. The latest update to GMP standard has greatly raised the bar for quality control, documentation, and overall manufacturing processes.

 

Label of Health Food

 

The Regulation for Label of Health Food as promulgated by the MOH provides for requirements of the label of health food. According to this regulation, the name, function, functional ingredient, applicable scope and file number of approval of the health food labeled shall be consistent with those corresponding items stated in the Approval Certificate of Health Food issued by the hygiene administrative authorities at the provincial level.

 

Other Regulations

 

In addition to the regulations relating to pharmaceutical industry in China, our operating subsidiaries are also subject to the regulations applicable to a foreign invested enterprise, or FIE, in China.

 

Foreign Currency Exchange. Pursuant to the Foreign Currency Administration Rules promulgated in 1996 and amended in 1997 and various regulations issued by State Administration of Foreign Exchange, or the SAFE, and other relevant PRC government authorities, the Renminbi is freely convertible only to the extent of current account items, such as trade-related receipts and payments, interests and dividends. Capital account items, such as direct equity investments, loans and repatriation of investment, require the prior approval from the SAFE or its local counterpart for conversion of Renminbi into a foreign currency, such as U.S. dollars, and remittance of the foreign currency outside the PRC. Payments for transactions that take place within the PRC must be made in Renminbi. Unless otherwise approved, PRC companies other than FIEs must convert foreign currency payments they receive from abroad into Renminbi. On the other hand, FIEs may retain foreign exchange in accounts with designated foreign exchange banks, subject to a cap set by the SAFE or its local counterpart.

  

Dividend Distribution. The principal regulations governing dividend distributions by wholly foreign-owned enterprises and Sino-foreign equity joint ventures include:

 

Wholly Foreign-Owned Enterprise Law (1986), as amended;

 

Wholly Foreign-Owned Enterprise Law Implementing Rules (1990), as amended;

 

Sino-Foreign Equity Joint Venture Enterprise Law (1979), as amended;

 

Sino-Foreign Equity Joint Venture Enterprise Law Implementing Rules (1983), as amended; and

 

Regulations on the Administration of Foreign Exchange Settlement, Sale and Payment.

 

Under these regulations, wholly foreign-owned enterprises and Sino-foreign equity joint ventures in the PRC may pay dividends only out of their accumulated profits, if any, determined in accordance with PRC accounting standards and regulations. Additionally, these foreign-invested enterprises are required to set aside certain amounts of their accumulated profits each year, if any, to fund certain reserve funds. These reserves are not distributable as cash dividends.

 

Available Information

 

We make available free of charge on or through our internet website, www.bioaobo.com, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to those reports, if any, filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission.

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We also make available free of charge on our internet website, www.bioaobo.com, our Amended and Restated Code of Ethics, Amended and Restated Nominating and Corporate Governance Committee Charter, Second Amended and Restated Compensation Committee Charter and Charter of the Audit Committee. The information contained on our website is not intended to be incorporated into this Annual Report on Form 10-K.

 

ITEM 1A. RISK FACTORS

   

Our business, financial condition, operating results and prospects are subject to the risks listed below. Additional risks and uncertainties not presently foreseeable to us, when materialized, may also impair our business operations. If any of the following risks actually occurs, our business, financial condition or operating results could be materially adversely affected. In such case, the trading price of our common stock could decline, and our shareholders may lose all or part of their investment in the shares of our common stock.

 

Risks Related to Our Business and Industry

 

A majority of our sales revenue is derived from six of our products and a disruption in, or a compromise of, our manufacturing or sales operations, or distribution channels related to any of these six products could materially and adversely affect our financial condition and results of operations.

 

Our top six products, namely, Shuanghuanglian Lyophilized Injection Powder, or SHL Injection Powder, CE Gel, Jinji Capsule, Jinji Yimucao, Soybean Peptide Tablets and Boke Nose Spray, constituted approximately 63% of our total revenues in 2011 and 59% of our total revenues in 2010. We expect that these six products will continue to account for a majority of our sales in the near future. Because of our dependence on a few products, any disruption in, or compromise of, our manufacturing operations, sales operations or distribution channels, relating to any of these products could result in our failure to meet shipping and delivery deadlines or meet quality standards, which in turn could result in the cancellation of purchase orders, refusal to accept deliveries or a reduction in purchase prices, any of which could have a material adverse effect on our financial condition and results of operations.

 

A general economic downturn, a recession in China or sudden disruption in business conditions may affect consumer purchases of discretionary items, including pharmaceutical and nutraceutical products, which could adversely affect our business.

 

Consumer spending is generally affected by a number of factors, including general economic conditions, the level of unemployment, inflation, interest rates, energy costs, gasoline prices and consumer confidence generally, all of which are beyond our control. Consumer purchases of discretionary items tend to decline during recessionary periods, when disposable income is lower, and may impact sales of our products.

 

In addition, sudden disruptions in business conditions as a result of a terrorist attack, retaliation and the threat of further attacks or retaliation, war, adverse weather conditions and climate changes or other natural disasters, pandemic situations or large scale power outages can have a short or, sometimes, long-term impact on consumer spending. A downturn in the economy in China, including any recession or a sudden disruption of business conditions in those economies, could adversely affect our business, financial condition, and results of operation.

 

Intense competition from existing and new companies may adversely affect our revenues and profitability.

 

We compete with other companies, many of whom are developing, or can be expected to develop, products similar to ours. Some of our competitors are more established than we are, have greater brand recognition of products that compete with ours, have more financial, technical, marketing and other resources than we presently possess and a larger customer base. 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. Our commercial opportunity will be reduced or eliminated if our competitors develop and commercialize products that are safer, more effective, have fewer side effects, are less expensive or have more attractive product characteristics than our current products or products that we may develop in the future. 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.

 

We have witnessed a tendency of pricing pressure on EDL drugs, and those covered by NIC to such an extent as to threaten profitable pricing induced by certain business models, especially the controversial Anhui Model, and the lower priced EDL drugs and NIC drugs may lure away customers or patients that may otherwise buy more expensive branded drugs. If this tendency is wide spread, it can curtail the scale of our manufacture and finally eat into our sales growth and profit margin.

  

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We depend on our key management personnel and the loss of their services could adversely affect our business.

  

Our success depends in part on our continued ability to attract, retain and motivate highly qualified management. We place substantial reliance upon the efforts and abilities of our executive officers, including Tony Liu, Yanchun Li, and Jun Min. The loss of services of any of these individuals or one or more other members of our senior management could delay or prevent the successful execution of our business objectives and could have a material adverse effect on our operations.

  

Replacing key employees may be difficult and costly and may take an extended period of time because of the limited number of individuals in our industry with the breadth of skills and experience required to develop and commercialize products successfully. We do not maintain “key person” insurance policies on the lives of these individuals or the lives of any of our other employees. We have entered into employment agreements with these individuals. We may need to hire additional personnel as we expand our commercial activities. We may not be able to attract or retain qualified management on acceptable terms in the future due to the intense competition for qualified personnel in our industry. If we are not able to attract and retain the necessary personnel to accomplish our business objectives, we may experience constraints that will impede these objectives.

 

We cannot assure you that we will be able to complete acquisitions or successfully integrate new businesses into our own.

 

We intend to pursue opportunities to grow our business by acquiring businesses, products and technologies that are complementary or related to our existing product lines. Successful completion of an acquisition depends on a number of factors that are not entirely within our control, including our ability to negotiate acceptable terms, conclude satisfactory agreements and obtain all necessary regulatory approvals. We may not be able to locate suitable acquisition candidates at prices that we consider appropriate. If we do identify an appropriate acquisition candidate, we may face competition from other companies interested in acquiring the target company that have greater financial and other resources than we have. Acquisitions of businesses, products, technologies or other material operations may require debt financing or additional equity financing, resulting in leverage or dilution of ownership.

 

Even if we complete one or more strategic transactions, we may be unable to integrate or coordinate successfully the personnel and operations of a business. Integration of acquired business operations could disrupt our business by diverting management away from day-to-day operations. The difficulties of integration may be increased by the necessity of coordinating geographically dispersed organizations, integrating personnel with disparate business backgrounds and combining different corporate cultures. We also may not be able to maintain key employees or customers of an acquired business or realize cost efficiencies or synergies or other benefits we anticipated when selecting our acquisition candidates.

 

In addition, we may incur non-recurring severance expenses, restructuring charges and change of control payments and may need to record write-downs from future impairments of intangible assets, which could reduce our future reported earnings. At times, acquisition candidates may have liabilities or adverse operating issues that we fail to discover through due diligence prior to the acquisition.

 

In addition to the above, acquisitions in China, including of state owned businesses, will be required to comply with laws of the PRC, to the extent applicable. There can be no assurance that any proposed acquisition will be able to comply with PRC requirements, rules and/or regulations, or that we will successfully obtain governmental approvals to the extent required, which may be necessary to consummate such acquisitions.

 

We may face difficulties in implementing our organic growth strategy.

  

Many obstacles to entering new markets exist, such as the costs associated with entering new markets, recruiting and retaining adequate numbers of effective sales and marketing personnel, developing and implementing effective marketing efforts abroad, establishing and maintaining the appropriate regulatory compliance and maintaining attractive foreign exchange ratios. However, there is no assurance that we will be successful in implementing our strategies or that our strategies, even if implemented, will lead to the successful achievement of our objectives. Our business plan and growth strategy is based on currently prevailing circumstances and the assumption that certain circumstances will or will not occur, as well as the inherent risks and uncertainties involved in various stages of development. We cannot, therefore, assure you that we will be able to successfully overcome such difficulties and continue to grow our business. 

  

If we fail to manage our growth and current operations, we may not achieve future growth or our expected revenues.

  

In order to maximize potential growth in our current and potential markets, we believe that we must expand our manufacturing and marketing operations. To this end, we expect to continue to increase our employee headcount which will place a strain on our management and on our operational, accounting, and information systems when necessary. Our need to manage our operations and growth effectively requires us to continue to expend funds to improve our financial controls, operating procedures, management information systems, reporting systems and procedures to manage our increased operations.

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If we are unable to implement improvements to our management information and control systems successfully in an efficient or timely manner, or if we encounter deficiencies in our existing systems and controls, then management may receive inadequate information to manage our day-to-day operations. We will also need to effectively train, motivate and manage our employees. Our failure to manage our growth could disrupt our operations and ultimately prevent us from generating the revenues we expect.

 

We operate in a highly regulated industry and our business may be significantly affected by the changes in government policies that do not favorable to the pharmaceuticals industry

 

The pharmaceutical industry is highly regulated in the China and there have been several reforms in the healthcare policies in the recent years, including the price control polices on the retail prices of prescription and over-the-counter medicines as well as the National Medical Insurance Program. Such policies might not be favorable to our business and our revenue might be significantly affected by further changes in the future period.

 

We may have difficulty defending our intellectual property rights from infringement which may undermine our competitive position.

 

We regard our service marks, trademarks, trade secrets, patents and similar intellectual property as critical to our success. We rely on trademark, patent and trade secret law, as well as confidentiality agreements to protect our proprietary rights. Certain of our products have received trademark and patent protection in China and Hong Kong. No assurance can be given that such patents and licenses will not be challenged, invalidated, infringed or circumvented, or that such intellectual property rights will provide a competitive advantage to us. Our trade secrets may otherwise become known or be independently discovered by our competitors. Policing the unauthorized use of proprietary technology can be difficult and expensive. Also, litigation may be necessary to enforce our intellectual property rights, protect our trade secrets or determine the validity and scope of the proprietary rights of others. The outcome of such potential litigation may not be in our favor and any success in litigation may not be able to adequately protect our rights. Such litigation may be costly and divert management attention away from our business. An adverse determination in any such litigation would impair our intellectual property rights and may harm our business, prospects and reputation. Enforcement of judgments in China and Hong Kong is uncertain and even if we are successful in such litigation it may not provide us with an effective remedy. In addition, we have no insurance coverage against litigation costs and would have to bear all costs arising from such litigation to the extent we are unable to recover them from other parties. The occurrence of any of the foregoing could have a material adverse effect on our business, financial condition and results of operations. In addition, there can be no assurance that we will be able to obtain licenses from third-parties that we may need to conduct our business or that such licenses can be obtained at a reasonable cost.

 

In addition, third parties may file infringement claims against us asserting that we are infringing on their patents or trademarks. In the event that such claims are filed, regardless of the merit of such a claim, we may incur substantial costs and diversion of management as a result of our involvement in such proceedings.

 

We currently sell our products mainly in China. China will remain our primary market for the foreseeable future. If we expand into additional countries, our risk of intellectual property infringement may be heightened. Laws and enforcement mechanisms in other countries may not protect proprietary rights to the same extent as China and Hong Kong. To date, no trademark or patent filings have been made other than in China and Hong Kong.

 

The measures we take to protect our proprietary rights may be inadequate, and we cannot give you any assurance that our competitors will not independently develop formulations and processes that are substantially equivalent or superior to our own or copy our products.

 

If we cannot procure our raw materials from our current sources we may be forced to seek alternative sources of supply, which may disrupt our operations or may result in the supply of lesser quality products.

 

The loss of any of our primary supply sources, or delays, disruptions or other difficulties in procuring these raw materials from our primary supply sources could have a material adverse effect on our business and results of operations. Additionally, due to the nature of the raw materials, mainly plants, the supply of these raw materials can be adversely affected by any material change in the climatic or environmental conditions in China, which may, in turn, result in increased costs to purchase these raw materials. If we are required to procure alternative sources of supply, our ability to maintain high quality products, lower costs and to provide our products to customers when needed could be impaired, and as a result we could lose business and our results of operations could be materially and adversely affected.

 

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We do not have product liability insurance and we could be exposed to substantial liability.

 

We face an inherent business risk of exposure to product liability claims in the event that the use of our products is alleged to have resulted in adverse side effects. Adverse side effects, marketing or manufacturing problems pertaining to any of our products could result in:

   

decreased demand for our products;

 

adverse publicity resulting in injury to our reputation;  

   

product liability claims and significant litigation costs;

 

substantial monetary awards to or costly settlements with consumers;

 

product recalls;

 

loss of revenues; or

 

the inability to commercialize future products.

 

These risks will exist for those products in clinical development and with respect to those products that have received regulatory approval for commercial sale or any product we may acquire. To date, we have not experienced any product liability claims. However, that does not mean that we will not have any such claims with respect to our products in the future. We do not carry product liability insurance. The lack of product liability insurance exposes us to risks associated with potential product liability claims, which can be significant.

 

Our international operations require us to comply with a number of U.S. and international regulations.

 

We need to comply with a number of international regulations in countries outside of the United States. In addition, we must comply with the Foreign Corrupt Practices Act, or FCPA, which prohibits U.S. companies or their agents and employees from providing anything of value to a foreign official for the purposes of influencing any act or decision of these individuals in their official capacity to help obtain or retain business, direct business to any person or corporate entity or obtain any unfair advantage. Any failure by us to adopt appropriate compliance procedures and ensure that our employees and agents comply with the FCPA and applicable laws and regulations in foreign jurisdictions could result in substantial penalties or restrictions on our ability to conduct business in certain foreign jurisdictions. The U.S. Department of The Treasury’s Office of Foreign Asset Control, or OFAC, administers and enforces economic and trade sanctions against targeted foreign countries, entities and individuals based on U.S. foreign policy and national security goals. As a result, we are restricted from entering into transactions with certain targeted foreign countries, entities and individuals except as permitted by OFAC which may reduce our future growth.

 

We may incur significant costs to ensure compliance with U.S. corporate governance and accounting requirements.

 

We may incur significant costs associated with our public company reporting requirements, costs associated with applicable corporate governance requirements, including requirements under the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley, and other rules implemented by the Securities and Exchange Commission. We expect all of these applicable rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly. We also expect that these applicable rules and regulations may make it more difficult and more expensive for us to obtain director and officer liability insurance and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage.

 

As a result, it may be more difficult for us to attract and retain qualified individuals to serve on our Board of Directors, on committees of our Board of Directors or as executive officers.

 

As a public company, we are required to comply with Sarbanes-Oxley and the related rules and regulations of the SEC, including expanded disclosure, accelerated reporting requirements and more complex accounting rules. Compliance with Section 404 of Sarbanes-Oxley and other requirements resulted in increased compliance costs and will continue to require additional management resources. We upgraded our finance and accounting systems, procedures and controls and will need to continue to implement additional finance and accounting systems, procedures and controls as we grow to satisfy these reporting requirements. In addition, we may need to hire additional legal and accounting staff with appropriate experience and technical knowledge, and we cannot assure you that if additional staffing is necessary that we will be able to do so in a timely fashion. If we are unable to complete the required annual assessment as to the adequacy of our internal reporting we could incur significant costs to become compliant.

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We continuously evaluate and monitor developments with respect to Section 404 of Sarbanes-Oxley and other applicable rules; however, we cannot predict or estimate the amount of additional costs we may incur or the timing of such costs.

   

We have identified a material weakness in our internal control over financial reporting which could negatively impact our ability to report our results of operations and financial condition accurately.

 

We have identified a deficiency as of December 31, 2011 that constituted a material weakness. We cannot assure you that we will not identify additional control deficiencies that may constitute significant deficiencies or material weaknesses in our control internal controls in the future. As a result, we may be required to implement further remedial measures and to design enhanced processes and controls to address issues identified through future reviews. This could result in significant delays and costs to us and require us to divert substantial resources, including management item, from other activities.

 

Although we remediated the material weakness for 2011, if we fail to maintain the adequacy of our internal controls in the future, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with the Sarbanes-Oxley Act. Moreover, effective internal controls are necessary for us to produce reliable financial reports and are important to help prevent fraud. As a result, any failure to satisfy the requirements of Section 404 on a timely basis 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 common stock.

 

We may incur significant costs to ensure compliance with environment protection requirements.

 

We are subject to PRC laws and regulations concerning the discharge of waste water, gaseous waste and solid waste during our manufacturing processes.  We are required to establish and maintain facilities to dispose of waste and report the volume of waste to the relevant government authorities, which conduct scheduled or unscheduled inspections of our facilities and treatment of such discharge.  We may not at all times comply fully with environmental regulations.  Any violation of these regulations may result in substantial fines, criminal sanctions, revocations of operating permits, shutdown of our facilities and obligation to take corrective measures.  Our cost of complying with current and future environmental protection laws and regulations and our liabilities which may potentially arise from the discharge of effluent water and solid waste may materially adversely affect our business, financial condition and results of operations.  The government may take steps towards the adoption of more stringent environmental regulations.  Due to the possibility of unanticipated regulatory or other developments, the amount and timing of future environmental expenditures may vary substantially from those currently anticipated. If there is any unanticipated change in the environmental regulations, we may need to incur substantial capital expenditures to install, replace, upgrade or supplement our pollution control equipment or make operational changes to limit any adverse impact or potential adverse impact on the environment in order to comply with new environmental protection laws and regulations. If such costs become prohibitively expensive, we may be forced to cease certain aspects of our business operations.

  

Risks Related to Inflation in Raw Materials

  

We purchase raw materials from third parties to manufacture our products, including prescription and OTC pharmaceutical products, and nutraceutical products as well. Recent industry research shows there is an uptrend in the price of raw materials.  Such an inflation trend, if continues at double digits, or even triple digits in some cases, may have a negative impact on our profitability, and we have largely no control over the inflation in the past or in the near future.

Risks Related to China

 

Compliance with the new Good Manufacturing Practice standards promulgated by the SFDA could have a material adverse effect on our business operations, financial condition and results of operations.

 

On February 12, 2011, SFDA promulgated the more stringent new Good Manufacturing Practice standards, or GMP standards. The new standards are aimed at improving drug production management and controlling risks in the production process and introduce internationally-recognized quality control mechanisms. The latest update to GMP standards has greatly raised the bar for quality control, documentation, and overall manufacturing processes. The new regulations apply to new manufacturing facilities effective from March 1, 2011 and the industry has a five-year grace period to bring existing facilities in line with the revisions.

 

A pharmaceutical manufacturer must meet GMP guidelines for each of its production facilities in China in respect of each form of pharmaceutical products it produces. GMP standards include staff qualifications, production premises and facilities, equipment, raw materials, environmental hygiene, production management, quality control and customer complaint administration. If a manufacturer meets the GMP standards, the SFDA will issue to the manufacturer a Good Manufacturing Practice certificate, or a GMP certificate, with a five-year validity period. However, for a newly established pharmaceutical manufacturer that meets the GMP standards, the SFDA will issue a GMP certificate with only a one-year validity period. We have obtained a GMP certificate for all of our production facilities covering all of the products that we produce.

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We have five manufacturing facilities in China dedicated exclusively to the manufacture of our products. Each facility is GMP certified. We have fully integrated manufacturing support systems including quality assurance, quality control and regulatory compliance. We have developed our own independent quality control systems in accordance with SFDA regulations. Our quality assurance team devotes significant attention to quality control for designing, manufacturing and testing our products, and is also responsible for ensuring that we are in compliance with all applicable national and local regulations and standards, as well as our internal policies. Our senior management team is also actively involved in setting quality assurance policies and managing internal and external quality performance. These support systems enable us to maintain high standards of quality for our products and deliver reliable products to our customers on a timely basis.

 

Even though, from a long term perspective, we believe the upgraded GMP standards will ensure better qualities in the pharmaceutical products that are sold in China’s pharmaceutical markets, in the short run compliance with the new GMP standards could have a material adverse effect on our business operations, financial condition and results of operations with the significant increase for such compliance.

 

There could be changes in government regulations toward the pharmaceutical and nutraceutical industries that may adversely affect our business.

 

The manufacture and sale of pharmaceutical products in China is heavily regulated by many state, provincial and local authorities. These regulations significantly increase the difficulty and costs involved in obtaining and maintaining regulatory approvals for marketing new and existing products. Our future growth and profitability depend to a large extent on our ability to obtain regulatory approvals. Additionally, the law could change so as to prohibit the use of certain pharmaceuticals. If one of our products becomes prohibited, this change would cease the manufacture of that product. The China National Development and Reform Commission, or CNDRC, has recently implemented price adjustments on many marketed pharmaceutical products. We have no control over such governmental policies, which may impact the pricing and profitability of our products.

 

The State Food and Drug Administration of China requires pharmaceutical manufacturers to obtain Good Manufacturing Practices, or GMP, certifications. We have received our GMP certifications. However, should we fail to receive or maintain the GMP certifications in the future, we would no longer be able to manufacture pharmaceuticals in China, and our businesses would be materially and adversely affected.

 

Moreover, the laws and regulations regarding acquisitions in the pharmaceutical industry in China may change, which could significantly impact our ability to grow through acquisitions.

 

Certain political and economic considerations relating to China could adversely affect our company.

 

China is transitioning from a planned economy to a market economy. While the PRC government has pursued economic reforms since its adoption of the open-door policy in 1978, a large portion of the Chinese economy is still operating under five-year plans and annual state plans. Through these plans and other economic measures, such as control on foreign exchange, taxation and restrictions on foreign participation in the domestic market of various industries, the PRC government exerts considerable direct and indirect influence on the economy. Many of the economic reforms carried out by the PRC government are unprecedented or experimental, and are expected to be refined and improved. Other political, economic and social factors can also lead to further readjustment of such reforms. This refining and readjustment process may not necessarily have a positive effect on our operations or future business development. Our operating results may be adversely affected by changes in China’s economic and social conditions as well as by changes in the policies of the PRC government, such as changes in laws and regulations, or the official interpretation thereof, which may be introduced to control inflation, changes in the interest rate or method of taxation, and the imposition of additional restrictions on currency conversion.

 

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 or joint ventures.

 

The recent nature and uncertain application of many PRC laws applicable to us create an uncertain environment for business operations and they could have a negative effect on us.

 

The PRC legal system is a civil law system. Unlike the common law system, the civil law system is based on written statutes in which decided legal cases have little value as precedents. In 1979, the PRC government began to promulgate a comprehensive system of laws and has since introduced many laws and regulations to provide general guidance on economic and business practices in China and to regulate foreign investment. Progress has been made in the promulgation of laws and regulations dealing with economic matters such as corporate organization and governance, foreign investment, commerce, taxation and trade.

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The promulgation of new laws, changes of existing laws and the abrogation of local regulations by national laws could have a negative impact on our business and business prospects. In addition, as these laws, regulations and legal requirements are relatively recent, their interpretation and enforcement involve significant uncertainty.

 

Currency conversion and exchange rate volatility could adversely affect our financial condition and the value of our common stock.

 

The PRC government imposes control over the conversion of Renminbi, or RMB, into foreign currencies. Under the current unified floating exchange rate system, the People’s Bank of China publishes an exchange rate, which we refer to as the PBOC exchange rate, based on the previous day’s dealings in the inter-bank foreign exchange market. Financial institutions authorized to deal in foreign currency may enter into foreign exchange transactions at exchange rates within an authorized range above or below the PBOC exchange rate according to market conditions.    

 

Pursuant to the Foreign Exchange Control Regulations of the PRC issued by the State Council which came into effect on April 1, 1996, and the Regulations on the Administration of Foreign Exchange Settlement, Sale and Payment of the PRC which came into effect on July 1, 1996, regarding foreign exchange control, conversion of RMB into foreign exchange by Foreign Investment Enterprises, or FIEs, for use on current account items, including the distribution of dividends and profits to foreign investors, is permissible. FIEs are permitted to convert their after-tax dividends and profits to foreign exchange and remit such foreign exchange to their foreign exchange bank accounts in China. Conversion of RMB into foreign currencies for capital account items, including direct investment, loans, and security investment, is still under certain restrictions, and prior approval from the SAFE or its relevant branches must be sought. On January 14, 1997, the State Council amended the Foreign Exchange Control Regulations and added, among other things, an important provision, which provides that the PRC government shall not impose restrictions on recurring international payments and transfers under current account items.

 

Enterprises in China, including FIEs, which require foreign exchange for transactions relating to current account items, if within a certain limited amount may, without approval of the State Administration of Foreign Exchange, or SAFE, effect payment from their foreign exchange account or convert and pay at the designated foreign exchange banks by providing valid receipts and proofs.

  

Our wholly owned subsidiaries, Three Happiness, HSPL, GLP, HQPL, CCXA, BOKE, NuoHua and GHK are FIEs to which the Foreign Exchange Control Regulations are applicable. There can be no assurance that we will be able to obtain sufficient foreign exchange to pay dividends or satisfy other foreign exchange requirements in the future.

 

Between 1994 and 2004, the exchange rate for RMB against the U.S. dollar remained relatively stable, most of the time in the region of approximately RMB8.28 to US$1.00. However, in 2005, the Chinese government announced that it would begin pegging the exchange rate of the RMB against a number of currencies, rather than just the U.S. dollar. As our operations are primarily in China, any significant revaluation of the RMB may materially and adversely affect our cash flows, revenues, financial condition and the value of our common stock.

 

For example, to the extent that we need to convert U.S. dollars into RMB for our operations, appreciation of this currency against the U.S. dollar could have a material adverse effect on our business, financial condition, results of operations and the value of our common stock. Conversely, if we decide to convert our Renminbi into U.S. dollars for the purpose of declaring dividends on our common stock or for other business purposes and the U.S. dollar appreciates against the RMB, the U.S. dollar equivalent of our earnings from our subsidiaries in China would be reduced.

 

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. 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 the PRC 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 the PRC government to impose controls on credit or prices, or to take other action, which could inhibit economic activity in China, and thereby harm the market for our products.

 

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It may be difficult to effect service of process and enforcement of legal judgments upon us and our officers and certain of our directors because they reside outside the United States.

 

As our operations are presently based in China and our officers and certain of our directors reside in China, service of process on us and our officers and certain directors may be difficult to effect within the United States. Also, our main assets are located in China and any judgment obtained in the United States against us may not be enforceable outside the United States.

 

Any future outbreak of avian influenza, or the Asian bird flu, or any other epidemic in China could have a material adverse effect on our business operations, financial condition and results of operations.

 

Since mid-December 2003, a growing number of Asian countries have reported outbreaks of highly pathogenic avian influenza in chickens and ducks. Since all of our operations are in China, an outbreak of the Asian Bird Flu in China in the future may disrupt our business operations and have a material adverse effect on our financial condition and results of operations. For example, a new outbreak of Asian Bird Flu, or any other epidemic, may reduce the level of economic activity in affected areas, which may lead to a reduction in our revenue if our clients cancel existing contracts or defer future expenditures. In addition, health or other government regulations may require temporary closure of our offices, or the offices of our customers or partners, which will severely disrupt our business operations and have a material adverse effect on our financial condition and results of operations.

 

Our business may be affected by unexpected changes in regulatory requirements in the jurisdictions in which we operate.

 

We are subject to many general regulations governing business entities and their behavior in China and in other jurisdictions 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. Such regulatory environment also covers any existing or potential trade barriers in the form of import tariffs and taxes that may make it difficult for us to import our products to certain countries and regions, such as Japan, South Korea and Hong Kong, which would limit our international expansion.

 

Most of our assets are located in China, any dividends or proceeds from liquidation are subject to the approval of the relevant Chinese government agencies.

 

Our assets are predominantly located inside China. Under the laws governing FIEs in China, dividend distribution and liquidation are allowed but subject to special procedures under the relevant laws and rules. Any dividend payment will be subject to the decision of the Board of Directors and subject to foreign exchange rules governing such repatriation. Any liquidation is subject to both the relevant government agency’s approval and supervision as well the foreign exchange control. This may generate additional risk for our investors in case of dividend payment or liquidation.

 

There have been recent incidents in which patients have experienced severe adverse reactions following the use of pharmaceutical products manufactured in China and the poison capsule scandal.

 

There have been recent incidents reported in the Chinese media of a significant number of patients experiencing severe adverse health consequences following their use of pharmaceutical products manufactured by certain pharmaceutical companies in China. A number of patients have become ill and a number of fatalities have been reported. In addition, there have been incidents reported in China of the poison capsule scandal in 2012, which have shaken the pharmaceutical industry and negatively impact the market demand. In April 2012, the outbreak of poison capsule scandal was resulted with several capsules recall from a handful of pharmaceutical companies. Although our products did not directly related to the poison capsule scandal and we have been inspected and passed for the safety requirement, the scandal created a huge impact to the pharmaceutical industry as a whole, which shaken the consumers’ confident and result with a significant decrease in market demand. Our sales are vulnerable to the decrease in the overall market demand, for which our sales may be significantly affected in the future period.

 

Concerns over the safety of pharmaceutical products manufactured in China could have an adverse effect on the sale of such products, including products manufactured by us. If in the future we become involved in incidents of the type described above, such problems could severely and adversely impact our product sales and reputation.

 

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Anti-corruption measures taken by the government to correct corruptive practices in the pharmaceutical industry could adversely affect our sales and reputation.

 

The government has recently taken anti-corruption measures to correct corrupt practices. In the pharmaceutical industry, such practices include, among others, acceptance of kickbacks, bribery or other illegal gains or benefits by the hospitals and medical practitioners from pharmaceutical distributors in connection with the prescription of a certain drug. Substantially all of our sales to our ultimate customers are conducted through third-party distributors. We have no control over our third-party distributors, who may engage in corrupt practices to promote our products. While we maintain strict anti-corruption policies applicable to our internal sales force and third-party distributors, these policies may not be effective. If any of our third-party distributors engage in such practices and the government takes enforcement action, our products may be seized and our own practices and involvement in the distributors’ practices may be investigated. If this occurs, our sales and reputation may be materially and adversely affected.

 

Risks Related to Our Common Stock

 

Techniques Employed by Manipulative Short Sellers in Chinese Small Cap Stocks May Drive Down the Market Price of Our Common Stock

 

Short selling is the practice of selling securities that the seller does not own but rather has, supposedly, borrowed from a third party with the intention of buying identical securities back at a later date to return to the lender. The short seller hopes to profit from a decline in the value of the securities between the sale of the borrowed securities and the purchase of the replacement shares, as the short seller expects to pay less in that purchase than it received in the sale.   As it is therefore in the short seller’s best interests for the price of the stock to decline, many short sellers (sometime known as “disclosed shorts”) publish, or arrange for the publication of, negative opinions regarding the relevant issuer and its business prospects in order to create negative market momentum and generate profits for themselves after selling a stock short. While traditionally these disclosed shorts were limited in their ability to access mainstream business media or to otherwise create negative market rumors, the rise of the Internet and technological advancements regarding document creation, videotaping and publication by weblog (“blogging”) have allowed many disclosed shorts to publicly attack a company’s credibility, strategy and veracity by means of so-called research reports that mimic the type of investment analysis performed by large Wall Street firm and independent research analysts.  These short attacks have, in the past, led to selling of shares in the market, on occasion in large scale and broad base.  Issuers with business operations based in China and who have limited trading volumes and are susceptible to higher volatility levels than U.S. domestic large-cap stocks, can be particularly vulnerable to such short attacks.

 

These short seller publications are not regulated by any governmental, self-regulatory organization or other official authority in the U.S., are not subject to the certification requirements imposed by the Securities and Exchange Commission in Regulation AC (Regulation Analyst Certification) and, accordingly, the opinions they express may be based on distortions of actual facts or, in some cases, fabrications of facts.  In light of the limited risks involved in publishing such information, and the enormous profit that can be made from running just one successful short attack, unless the short sellers become subject to significant penalties, it is more likely than not that disclosed shorts will continue to issue such reports.

 

While we intend to strongly defend our public filings against any such short seller attacks, oftentimes we are constrained, either by principles of freedom of speech, applicable state law (often called “Anti-SLAPP statutes”), or issues of commercial confidentiality, in the manner in which we can proceed against the relevant short seller.  You should be aware that in light of the relative freedom to operate that such persons enjoy – oftentimes blogging from outside the U.S. with little or no assets or identity requirements – should we be targeted for such an attack, our stock will likely suffer from a temporary, or possibly long term, decline in market price should the rumors created not be dismissed by market participants.

 

Our common stock price may be extremely volatile, and you may not be able to resell your shares at or above the price you paid for the stock.

 

Our common stock price has experienced large fluctuations. In addition, the trading prices of stocks for companies in our industry in general have experienced extreme price fluctuations in recent years. Any negative change in the public’s perception of the prospects of companies in our industry could depress our stock price regardless of our results of operations. Other broad market and industry factors may decrease the trading price of our common stock, regardless of our performance. Market fluctuations, as well as general political and economic conditions such as terrorism, military conflict, recession or interest rate or currency rate fluctuations, may also decrease the trading price of our common stock. In addition, our stock price could be subject to wide fluctuations in response to various factors, including:

 

changes in laws or regulations applicable to our products;

 

period to period fluctuations in our operating results;

 

announcements of new technological innovations or new products by us or our competitors;

 

changes in financial estimates or recommendations by securities analysts;

 

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conditions or trends in our industry;

 

changes in the market valuations of other companies in our industry;

 

developments in domestic and international governmental policy or regulations;

 

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

 

 ● additions or departures of key personnel;

 

disputes or other developments relating to proprietary rights, including patents, litigation matters and our ability to obtain patent protection for our technologies;

 

additional sales of our common stock by us; and

 

sales and distributions of our common stock by our shareholders.

 

In the past, shareholders have often instituted securities class action litigation after periods of volatility in the market price of a company’s securities.

If a shareholder files a securities class action suit against us, we would incur substantial legal fees and our management’s attention and resources would be diverted from operating our business in order to respond to the litigation.

 

The decrease in our common stock price might negatively affect the support and confident from our business partners, governmental agencies and employees.

 

In recent period, especially starting from the second half of 2011, financial scandals and market crisis have been focus and negatively impact most China based companies that are listed in the US capital market. We were adversely impacted during this crisis with a result of significantly decrease in our stock price and market capital as well as delisting from the major stock exchange. The decrease of our common stock price and the negative news may significantly affect our business relationship with our partners, governmental agencies and our management teams, which would ultimately affect their support to our company.

 

Some of our existing shareholders can exert control over us and may not make decisions that are in the best interest of all the shareholders.

 

  Our officers, directors and holders of more than five percent of our outstanding shares of common stock, together control approximately 45.8% of the voting power of our stock, of which approximately 39.1% is controlled by Tony Liu, our Chairman and Chief Executive Officer. In particular, Mr. Liu owns 1,000,000 shares of Series A preferred stock, which shares by their terms have aggregate voting power equal to 25.0% of the combined voting power of our common and preferred stock. Moreover, this voting power cannot be diluted or reduced by the issuance of additional shares of common stock, meaning that the holder or holders of our Series A preferred stock will always possess 25.0% of the aggregate voting power of our common and preferred stock. As a result, Mr. Liu, or these shareholders acting together, will be able to exert a significant degree of influence over our management and over matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions. In addition, this concentration of ownership may delay or prevent a change in control of our company and might affect the market price of our common stock, even when a change may be in the best interests of all shareholders. In addition, the interests of our officers, directors and principal shareholders may not always coincide with our interests or the interests of other shareholders and, accordingly, these control persons could cause us to enter into transactions or agreements that we would not otherwise consider.

 

Provisions of the Nevada Revised Statutes may discourage a change of control.

 

We are incorporated in Nevada. Certain provisions of the Nevada Revised Statutes, or NRS, could delay or make more difficult a change of control transaction or other business combination that may be beneficial to shareholders. We are subject to Nevada’s “Combinations With Interested Shareholders” statutes (NRS Sections 78.411 through 78.444), which provide that specified persons who, together with affiliates and associates, own, or within three years did own, 10% or more of the outstanding voting stock of a Nevada corporation with at least 200 shareholders cannot engage in specified business combinations with the corporation for a period of three years after the date on which the person became an interested shareholder, unless the combination or the transaction by which the person first became an interested shareholder is approved by the corporation’s Board of Directors before the person first became an interested shareholder.

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Nevada’s “Acquisition of Controlling Interest” statutes (NRS Sections 78.378–78.3793) apply only to Nevada Corporations with at least 200 shareholders, including at least 100 shareholders of record who are Nevada residents, and which conduct business directly or indirectly in Nevada. As of the date of this prospectus, we do not believe we have 100 shareholders of record who are residents of Nevada, although there can be no assurance that in the future the “Acquisition of Controlling Interest” statutes will not apply to us. The “Acquisition of Controlling Interest” statutes provide that persons who acquire a “controlling interest”, as defined in NRS Section 78.3785, in a company may only be given full voting rights in their shares if such rights are conferred by the disinterested shareholders of the company at an annual or special meeting. However, any disinterested shareholder that does not vote in favor of granting such voting rights is entitled to demand that the company pay fair value for their shares, if the acquiring person has acquired at least a majority of all of the voting power of the company. As such, persons acquiring a controlling interest may not be able to vote their shares.

 

We may never pay any dividends to our shareholders.

 

We have not paid any cash dividends on shares of our common stock. We currently intend to retain all available funds and future earnings, if any, to support our operations and finance the growth and development of our business. Our Board of Directors does not intend to distribute dividends in the foreseeable future. The declaration, payment and amount of any future dividends, if any, will be made at the discretion of the Board of Directors, and will depend upon, among other things, the results of our operations, cash flows and financial condition, operating and capital requirements, and other factors the Board of Directors considers relevant. There is no assurance that future dividends will be paid, and if dividends are paid, there is no assurance with respect to the amount of any such dividend.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

 

We did not receive any material comments from the SEC staff more than 180 days before the end of 2011 regarding our periodic or current reports that remained unresolved at the date hereof.

 

ITEM 2. PROPERTIES

 

According to Chinese law, the government owns all the land in China and companies or individuals are authorized to use the land only through land use rights granted by the Chinese government. Our principal facilities are located at each of our manufacturing subsidiaries summarized as follow:

    

Subsidiary   Facilities   Size of Land  

Land Use Right

Expires

Three Happiness   GMP Manufacturing, warehouse and office   1,532,775 sq. feet   2055-2056
HSPL   GMP Manufacturing, warehouse and office   532,339 sq. feet   2055
GLP   GMP Manufacturing, warehouse and office   1,875,287 sq. feet   2045-2059
CCXA   GMP Manufacturing, warehouse and office   1,357,220 sq. feet   2052-2058
BOKE   GMP Manufacturing, warehouse and office   174,280 sq. feet   2052

 

We also invested and purchased land and properties in Beijing Economic-Technological Development Area during 2008. The size of land is 551,713 sq. feet with land use right expiring in year 2054. We utilize the facilities as our multi-functional headquarters for purposes including administration, research and development, convention and training.

 

During 2011, we acquired a TCM raw material trading center in Northeast China approved by the China’s SFDA and a building from the purchase of Liaoning Baicao. The sizes of the buildingsare141,771 sq. feet and 9,881 sq. feet, respectively.

 

In addition to the above, we own a 2,637 square feet office in Hong Kong and 63,942 square feet office in Harbin. We lease approximately 100 sales representative offices throughout China and we lease offices in Shenzhen and New Jersey.

All leases are for a term of one year and are renewable.

 

ITEM 3. LEGAL PROCEEDINGS

 

On June 23, 2010, Haining Zhang asserted breach of contract, fraudulent dealing, and breach of fiduciary duty claims against the Company and its Chief Executive Officer, Shu Jun Liu (together "Defendants"). Zhang's claims arose out of an alleged 2003 investment banking advisory and consultant agreement, whereby Zhang allegedly arranged for the Company to receive an equity line of credit and was allegedly given the exclusive right to arrange financing transactions for the Company for a period of one year. Zhang sought damages for allegedly unpaid financing commission and advisory compensation in the amount of $2,410,000, plus interest and expenses. On September 12, 2011, the Court granted a motion by Defendants to dismiss Zhang's claims as either barred by the applicable statute of limitations or as failing to state a claim. Judgment was entered in Defendants' favor on September 15, 2011. On June 6, 2012, the Court denied a motion by Zhang to alter or amend the Court's September 12, 2011 Order dismissing his case. Zhang has since appealed the District Court's dismissal of his claims to the Second Circuit Court of Appeals. Zhang filed his appellate brief on July 16, 2012, and Defendants filed their answering brief on October 17, 2012. Zhang did not file an optional reply brief on his appeal. No date for oral argument has yet been scheduled. Although there is no way to predict with certainty whether the Court of Appeals will overturn or affirm the District Court's dismissal of Zhang's claims, we believe the Court of Appeals is likely to affirm.

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On June 22, 2012, a complaint, 12 cv 5476, was filed in the Federal District Court for the Central District of California by Kevin McGee against the Company and certain of its current and former officers and directors. On July 5, 2012, a second complaint, 12 cv 05789, was filed by Michael Kane against a similar group of defendants. The complaints, brought as putative class actions on behalf of all persons other than the Defendants who purchased the common stock of the Company between September 27, 2010 and June 15, 2012, were virtually identical and were based entirely on supposed "inconsistencies" raised by the Company's then auditors and the subsequent termination of those auditors by the Company. The complaints alleged violations of Sections 10 (b) and 20 (a) of the Exchange Act of 1934 and rules promulgated thereunder. On October 16, 2012, the court granted the motion of Richard Deutner and Rent EDV Dienstleistungs GmbH for appointment as lead Plaintiff and, thereafter, ordered that the amended consolidated complaint be filed no later than November 19, 2012. On that date, Plaintiff filed and served an amended consolidated complaint, which repeated the allegations set forth in the original complaint and added allegations to the effect that the Company's restatement of its financial statements evidenced allegedly knowing and intentional misstatements of material facts in the Company's public filings. The Company and two former and one current director have been served with the amended consolidated complaint. Responses are due December 19, 2012. In accordance with the schedule set by the Court, the served Defendants, including the Company, served and filed a motion seeking dismissal of the amended consolidated complaint in the action. The motion seeks dismissal of all causes of action. The Company denies the allegations. No prediction can be made, however, as to the final outcome of the matter. 

There is no known other legal proceedings against the Company.

 

ITEM 4. MINE SAFETY DISCLOSURES

 

Not applicable.

 

 

PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

Our common stock was listed for trading on the New York Stock Exchange, or NYSE, under the ticker symbol “AOB” from December 18, 2006 until May 29, 2012. On April 16, 2012, The NYSE filed a form of 25NSE with SEC to announce official delisting the Company’s common stock. Prior to that delisting, the Company made an effort to regain its compliance of the listing requirements, including a 1 for 2 reverse split of the common stock, in order to raise the stock price above the minimum maintenance price stipulated by NYSE.

 

On March 16, 2012 concurrent with the Company’s 8-K announcing audit committee investigation into matters identified by the then auditor Ernst & Young Hua Ming, the Company’s stock was suspended in trading by NYSE. The suspension remained in force until the official delisting on May 29, 2012. As a result the Company’s common stock commenced quotation on the Pink Sheet on May 29, 2012.

 

The following table shows the high and low closing sales price for our common stock reported by the NYSE from January 1, 2010 to until May 29, 2012.

 

Year   Period   High ($)     Low ($)  
2010   First Quarter     9.66       8.06  
    Second Quarter     8.48       5.04  
    Third Quarter     5.22       4.34  
    Fourth Quarter     5.98       4.36  
                     
2011   First Quarter     5.12       2.98  
    Second Quarter     3.80       2.12  
    Third Quarter     2.58       1.20  
    Fourth Quarter     1.86       1.00  
                     
2012   First Quarter *     1.86       1.11  
    Second Quarter(April – May 29)     1.53       0.58  

 

* On February 24, 2012, we effected a 2 for 1 reverse stock split of our issued and outstanding shares of common stock.

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Stockholders and Dividends

 

As of March 12, 2012, there were approximately360 record holders of our common stock.

 

Under current PRC regulations, wholly foreign-owned enterprises and Sino-foreign equity joint ventures in the PRC may pay dividends only out of their accumulated profits, if any, determined in accordance with PRC accounting standards and regulations. Additionally, these foreign-invested enterprises are required to set aside certain amounts of their accumulated profits each year, if any, to fund certain reserve funds. These reserves are not distributable as cash dividends.

 

We have not paid any cash dividends on shares of our common stock and do not plan to do so in the near future. We currently plan to retain future earnings to fund the development and growth of our business. Any future determination related to our dividend policy will be made at the discretion of our Board of Directors.

 

Issuances of Unregistered Securities

 

None.

 

Equity Compensation Plan Information

 

The following table sets forth aggregate information regarding our equity compensation plans in effect as of December 31, 2011:

 

   

Number of

 securities to be

 issued upon

 exercise of

outstanding options,

 warrants

 and rights

   

Weighted-average

 exercise price of

 outstanding

options, warrants

 and rights

   

Number of

 securities

 remaining

 available for

 future issuance

 under equity

 compensation

 plans (excluding

securities reflected

 in column (a))

 
Plan category   (a)     (b)     (c)  
Equity compensation plans approved by security holders (1)     1,810,302     $ 15.70       689,698  
Equity compensation plans not approved by security holders     -0-       -0-       -0-  
Total     1,810,302     $ 15.70       689,698  

 

(1)             Includes shares issuable pursuant to the Company’s 2006 Equity Incentive Plan (the “2006 Plan”), which was approved by the Company’s shareholders.

 

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Stock Price Performance Graph

 

The following chart compares the cumulative total shareholder return on the Company’s shares of common stock with the cumulative total shareholder return of (i) the New York Stock Exchange Market Index and (ii) a peer group index consisting of companies reporting under the Standard Industrial Classification Code 2834 (Pharmaceutical Preparations):

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*

Among American Oriental Bioengineering, the NYSE Composite Index and a Peer Group

 

 

 

COMPARISON OF CUMULATIVE TOTAL RETURN OF ONE OR MORE

COMPANIES, PEER GROUPS, INDUSTRY INDEXES AND/OR BROAD MARKETS

 

    YEAR ENDING  
COMPANY/INDEX/MARKET   12/31/2006     12/31/2007     12/31/2008     12/31/2009     12/31/2010     12/31/2011  
American Oriental Bioengineering     100.00        94.94        58.18        39.84        20.56        4.80  
NYSE Market Index     100.00        109.12        66.40        85.37        97.00        93.41  
Peer Group     100.00        96.56        76.75        95.73        100.28        113.81  

 

The material in this chart is not soliciting material, is not deemed filed with the SEC and is not incorporated by reference in any filing of the Company under the Securities Act of 1933, as amended or the Exchange Act, whether made before or after the date of this proxy statement and irrespective of any general incorporation language in such filing.

 

Equity Repurchases

     

On March 20, 2011, the Board of Directors authorized the Company to repurchase up to $20 million of the Company’s outstanding common stock over the next two years in the open market, in privately negotiated transactions, block trades and accelerated stock repurchase transactions or otherwise, as determined by the Company and funded from available working capital. The timing and extent of any purchases depend upon the trading price of the Company’s common stock, general business and market conditions and other investment opportunities. The Company entered into a share buyback program and engaged a financial institution to act as a broker on behalf of the Company to repurchase common stock based on a predetermined quantity and price range (“Share Buyback Program”).

 

Any common stock repurchased by the Company became part of its treasury stock which will be shown as a separate item in the consolidated statements of changes in shareholders’ equity. The treasury stock may be retired or used by the Company to finance or execute acquisitions or other arrangements.

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As of December 31, 2011, the Company had repurchased 224,582 shares of its common stock at a total cost of $799,999 pursuant to this Share Buyback Program.

 

  

Issuer Purchases of Equity Securities

 

Period  

Total Number

of Shares

of Common Stock

Purchased

   

Average Price Paid

per Share of

Common Stock

   

Total Number

of Shares of

Common Stock

Purchased as

Part of Publicly

Announced Plans

   

Maximum Number

(or Approximate Dollar Value) of Common Stock that May Yet

Be Purchased Under the Plans

or Programs

 
October 1 – December 30*     -     $ -       -       -  

_______________

* There were no purchases of equity securities by the Company during the fourth quarter of 2011.

 

ITEM 6. SELECTED FINANCIAL DATA

  

The following table sets forth selected historical financial information as of the dates and for the periods indicated.

 

The following table sets forth our selected consolidated financial data. You should read this information together with our consolidated financial statements and the related notes to those statements included in this report, and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation” of this report. The selected consolidated balance sheet data and statements of operations data in the table below have been derived from our audited consolidated financial statements. Historical results are not necessarily indicative of results to be expected in the future.

 

The selected financial information for the year ended December 31, 2011 reflects the acquisition of Liaoning Baicao on December 28, 2011. The selected financial information for the year ended December 31, 2008 reflects the acquisition of NuoHua on October 18, 2008 and the acquisition of GHK on October 20, 2008. The selected financial information for the year ended December 31, 2007 reflects the acquisition of CCXA on September 6, 2007 and the acquisition of Boke on October 18, 2007.

 

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Five Year Financial Summary

 

   Year Ended December 31, 
   2011   2010   2009   2008   2007 
                     
Statement of Operations Data:                         
Revenues  $212,690,388   $305,944,085   $296,150,780   $264,643,058   $160,482,383 
Cost of sales   112,939,705    148,186,531    129,367,775    91,031,274    49,364,486 
                          
GROSS PROFIT   99,750,683    157,757,554    166,783,005    173,611,784    111,117,897 
Selling, general and administrative expenses   51,351,940    66,439,702    62,164,936    57,849,286    33,631,194 
Advertising costs   14,910,983    38,920,905    31,896,992    34,102,538    22,865,903 
Research and development costs   12,658,085    15,365,131    7,922,357    1,528,991    870,219 
Depreciation and amortization   7,495,051    6,662,237    6,038,625    4,383,215    1,989,425 
Provision for doubtful accounts   15,624,998                 
Impairment of Property, plant and equipment   733,688                 
Impairment of acquired intangible assets   6,928,064                 
Impairment of goodwill   33,164,121                 
Purchased in-process research and development               12,255,248     
(LOSS) INCOME FROM OPERATIONS   (43,116,247)   30,369,579    58,760,095    63,492,506    51,761,156 
                          
Impairment of investment-AXN   (11,937,037)                
Loss on disposal of NuoHua Affiliate   (8,447,368)   (1,083,637)            
Gain on extinguishment of convertible notes   3,242,389                 
Equity in earnings (losses) from equity method investments   (1,254,973)   213,177    2,075,139    (1,132,986)   23,711 
Interest expense, net   (6,610,001)   (5,900,055)   (5,746,382)   (2,571,015)   617,524 
Other income (expenses), net   266,942    (204,736)   (569,661)   (65,843)   (525,065)
(LOSS) INCOME BEFORE INCOME TAX   (67,856,295)   23,394,328    54,519,191    59,722,662    51,877,326 
Provision for income taxes   635,053    9,335,338    13,216,986    12,635,472    8,011,248 
NET (LOSS) INCOME   (68,491,348)   14,058,990    41,302,205    47,087,190    43,866,078 
Net loss(income) attributable to non-controlling interest   1,041,420    27,937    118,945    (27,575)    
NET(LOSS) INCOME ATTRIBUTABLE TO AMERICAN ORIENTAL BIOENGINEERING, INC.  $(67,449,928)  $14,086,927   $41,421,150   $47,059,615   $43,866,078 
(LOSS) EARNINGS PER COMMON SHARE                         
Basic  $(1.80)  $0.38   $1.11   $1.24   $1.26 
Diluted  $(1.80)  $0.37   $1.06   $1.22   $1.22 
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING                         
Basic   37,416,241    37,405,008    37,306,301    38,252,018    34,935,388 
Diluted   37,416,241    37,862,413    44,643,310    41,127,093    35,682,122 

 

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   December 31, 
   2011   2010   2009   2008   2007 
                     
Balance Sheet Data:                         
Cash and cash equivalents  $52,627,928   $94,568,520   $91,126,486   $68,060,769   $166,410,075 
Working capital   36,131,157    200,551,904    130,943,266    87,082,705    180,536,568 
Total assets   564,981,057    610,223,146    576,481,765    528,675,732    358,351,088 
Total debt (including current maturities of debt)   116,440,026    123,235,826    129,581,008    126,266,215    9,999,524 
Total Shareholders’ equity  $381,698,314   $428,068,163   $394,522,604   $348,944,446   $313,778,571 

 

   Year Ended December 31 
   2011   2010   2009   2008   2007 
Cash Flow Data:                         
Net cash provided by operating activities  $29,955,718   $8,211,516   $27,567,718   $74,809,867   $45,364,532 
Net cash (used in) provided by investing activities   (71,948,735)   (6,341,048)   (6,755,728)   (257,374,093)   (69,845,702)
Net cash (used in) provided by financing activities  $(4,261,856)  $(3,870,079)  $1,806,991   $78,372,423   $96,833,706 

 

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this annual report on Form 10-K. This discussion contains forward-looking statements that are based on management’s current expectations, estimates and projections about our business and operations. Our actual results may differ materially from those currently anticipated and expressed in such forward-looking statements. See “Forward-Looking Statements.”

 

As used in this report, the terms “Company”, “we”, “our”, “us” and “AOB” refer to American Oriental Bioengineering, Inc., a Nevada corporation.

 

PRELIMINARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This Annual Report contains forward-looking statements within the meaning of the federal securities laws. These include statements about our expectations, beliefs, intentions or strategies for the future, which we indicate by words or phrases such as “anticipate,” “expect,” “intend,” “plan,” “will,” “we believe,” “AOB believes,” “management believes” and similar language. The forward-looking statements are based on the current expectations of AOB and are subject to certain risks, uncertainties and assumptions, including those set forth in the discussion under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this report. Actual results may differ materially from results anticipated in these forward-looking statements. We base the forward-looking statements on information currently available to us, and we assume no obligation to update them.

 

 Investors are also advised to refer to the information in our previous filings with the Securities and Exchange Commission (SEC), especially on Forms 10-K, 10-Q, and 8-K, in which we discuss in more detail various important factors that could cause actual results to differ from expected or historic results. It is not possible to foresee or identify all such factors. As such, investors should not consider any list of such factors to be an exhaustive statement of all risks and uncertainties or potentially inaccurate assumptions. 

 

BUSINESS OVERVIEW

 

The global economic challenges and uncertainties had shown an impact on our business in 2011. These challenges and uncertainties had negatively affected consumers’ demands for both pharmaceutical and nutraceutical products, which contributed to the overall decline in sales of our manufacturing segments.

 

In addition, the establishment of price controls over prescription and over-the-counter medicines negatively impacted our business in 2011. There were two price adjustments by the Price Control Office in 2011 that lowered certain prices of prescription and over-the-counter medicines. As a result, we lost our ability to compete effectively due to the pricing adjustments, particularly when we entered the state-owned hospitals’ purchase of medicine tendering process. As a result, sales in our manufacturing segments fell sharply.

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The continuous increase in cost of raw material also impacted our business as the gross profit declined during 2011. Although our sales in the nutraceutical products declined during 2011, the cost of sales increased as the price of raw material increased.

 

In addition to the ongoing economic challenges and uncertainties, our business was negatively impacted by incidents that occurred subsequent to 2011, including the toxic drug capsules in 2012. Incidents like the toxic drug capsules incident that occurred shook the pharmaceutical industry and resulted in a decline in market demands. Although we are not directly involved in the scandal and we have been inspected and passed for the safety requirement, our subsequent sales have been impacted significantly due to the loss of confidence from the consumers to the regard of the pharmaceutical products and huge decline in market demand. All these challenges, uncertainties and incidents would have an adverse impact on our future performance.

 

We are taking actions to mitigate the impact of these economic conditions, including: 1) focus on our well-recognized brand names, including AOBO and our Jinji products; 2) diversify our products through products line extension; 3) develop and introduce new products.

 

To mitigate the impact of the increasing cost and supply of the raw material, we entered into long-term supply contracts with various third parties to grow Millettia and Xanthoceras Sorbifolia Bge (“XSB”), which are our major raw material. We bear the cultivation cost for these raw materials, including leasing the land use rights. In return, we are entitled to purchase the raw material at a pre-determined discounted price. Through these supply contracts, we believe that we can stabilize the supply of our major raw materials in the long run and reduce the risk of increasing costs in future periods. We will continue to leverage our resources to improve our margin as well as stabilize our cost and supply of raw material.

 

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

 

This section should be read together with the Summary of Significant Accounting Policies included as Note 3 to the consolidated financial statements included in our amended Annual Report on Form 10-K for the year ended December 31, 2011.

 

Estimates affecting accounts receivable, inventories, property, plant and equipment and intangible assets,

 

The preparation of our consolidated financial statements requires management to make estimates and assumptions that affect our reporting of assets and liabilities (and contingent assets and liabilities). These estimates are particularly significant where they affect the reported net realizable value of the Company’s accounts and notes receivable and inventories.

 

At December 31, 2011, we provided a $15,624,988 of reserve against accounts receivable. Our estimate of the appropriate reserve on accounts receivable at December 31, 2011 was based on the aged nature of these accounts receivable. In making its judgment, we assessed our customers’ ability to continue to pay their outstanding invoices on a timely basis, and whether their financial position might deteriorate significantly in the future, which would result in their inability to pay their debts to the Company.

 

At December 31, 2011, we provided an allowance against its inventories amounting to $624,516. Our determination of this allowance was based on potential impairments to the current carrying value of the inventories due to potential obsolescence of aged inventories. In making its estimate, we considered the probable demand for our products in the future and historical trends in the turnover of our inventories.

 

At December 31, 2011, we provided an impairment loss on property, plant and equipment for the amount of $733,688. We estimated that the fair value of the Company’s property, plant and equipment using the future cash flow expected to be generated and determined the difference between the carrying value and carrying value as an impairment loss.

 

At December 31, 2011, an impairment loss of acquired intangible assets amounting to $6,928,064 was provided. We performed an impairment of our intellectual properties in patent by comparing fair values based on a discounted cash flows model to the carrying values. We determined that the carrying value exceeded the fair value and an impairment loss was provided.

 

While we currently believes that there is little likelihood that actual results will differ materially from these current estimates, if customer demand for our products decreases significantly in the near future, or if the financial condition of our customers deteriorates in the near future, the Company could realize significant write downs for slow-moving inventories or uncollectible accounts receivable and notes receivable.

 

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Policy affecting recognition of revenue

 

Among the most important accounting policies affecting our consolidated financial statements is our policy of recognizing revenue in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 605 “Revenue Recognition”. Under this policy, all of the following criteria must be met in order for us to recognize revenue: 

 

1.Persuasive evidence of an arrangement exists;
2.Delivery has occurred or services have been rendered;
3.The seller’s price to the buyer is fixed or determinable; and
4.Collectability is reasonably assured.

 

The majority of the Company’s revenue results from sales contracts with distributors and revenue is recorded upon the shipment of goods. Management conducts credit background checks for new customers as a means to reduce the subjectivity of assuring collectability. Based on these factors, the Company believes that it can apply the provisions of FASB ASC 605 with minimal subjectivity.

 

Goodwill

 

We account for goodwill in accordance with the provisions of FASB ASC 350 “Intangible – Goodwill and Other”. We conduct an impairment test on an annual basis and, in addition, if we notice any indication of impairment, we conduct such test immediately.

 

The application of the impairment test requires judgment, including the identification of reporting units, assignments of assets and liabilities to reporting units and the determination of the fair value of each reporting unit. Fair value is primarily determined by computing the future discounted cash flows expected to be generated by the reporting unit that are believed to be reasonable under current and forecasted circumstances, the results of which form the basis for making judgments about carrying values of the reported net assets of our reporting units.

   

We conducted an impairment test as of December 31, 2011 and an impairment loss, amounting to $33,164,121 was recorded. We believed that recent decrease in sales in 2011 and the negative changes in the pharmaceutical market with governmental influence over the retail price of prescription and OTC medicines have adversely affect our estimation over the future cash flows expected to be generated by the reporting units. As of December 31, 2011, goodwill is nil after the impairment loss.

 

Investment in equity method investment

 

We account for our equity investment in accordance to FASB ASC 323, “Investments–Equity Method and Joint Ventures”. Under FASB ASC 323, the equity method of accounting is used for investments in entities in which we have the ability to exercise significant influence but does not own a majority equity interest or otherwise control. Under the equity method, we initially records our investment at cost and adjusts the carrying amount of the investment to recognize our proportionate share of each equity investee’s net income or loss into consolidated statements of income after the date of acquisition.

 

We monitor our investments for other-than-temporary impairment by considering factors including, but not limited to, current economic and market conditions, the operating performance of the investee companies including current earnings trends and other company-specific information. We performed an impairment assessment by comparing fair value of the investment based on a discounted cash flows model to the carrying value.

 

The Company considered AXN’s declining stock price, as well as other information found in the public filings of AXN, and various internet articles and websites, as indications that the decline in the value of AXN was other than temporary and accordingly performed an asset impairment test at December 31, 2011. Such factors as AXN’s write off of its Goodwill and a “going concern” paragraph in its most recent audit report were two of the factors. The Company considered the market value of the publically traded stock of AXN, as well as adjusting the carrying value of the investment for the step up in value of the net assets and goodwill recognized upon the original investment, as indicators of the current value of the investment. After considering these methodologies the Company estimated the value of its equity investment in AXN to be $5,708,329, and recognized an impairment of $11,937,037in the equity investment for the year ending December 31, 2011.

 

Share-based Compensation

 

We account for the stock options and common stock awards granted under our 2006 stock incentive plan (the “2006 Plan”) in accordance with FASB ASC 718 “Compensation – Stock Compensation”. In accordance with FASB ASC 718, all grants of share options and common stock awards are recognized in the financial statements based on their grant date fair values. We have elected to recognize compensation expense using the straight-line method for all share options and common stock awards granted with services conditions that have a graded vesting schedule.

 

We have applied the Black-Scholes Option Pricing Model in determining the fair value of the options granted. We estimate expected volatility at the date of grant based on a combination of historical and implied volatilities from comparable publicly listed companies. Forfeiture rate is estimated based on historical forfeiture patterns and adjusted to reflect future changes in circumstances and facts, if any.

 

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Accounting for Income Taxes and Uncertain Income Tax Positions

 

We account for income taxes in accordance with FASB ASC 740, “Accounting for Income Taxes”. We consider many factors when assessing the likelihood of future realization of our deferred tax assets, including our recent cumulative earnings experience by taxing jurisdiction, expectations of future taxable income, the carry-forward periods available to us for tax reporting purposes, and other relevant factors. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.

 

We account for uncertainty in income taxes in accordance with FASB ASC 740-10. FASB ASC 740-10 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return.

 

For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The amount recognized is measured as the largest amount of the benefit that is more likely than not to be realized upon ultimate settlement. As of December 31, 2011, the Company recorded an accrued tax of approximately $8,849,004, which is mainly related to deemed interest income on non-trade intercompany transactions.

 

Our accounting policy for interest and penalties related to an uncertain position, if any when required, is classified as part of interest expenses and other expenses, respectively.

 

Newly Adopted Accounting Pronouncements

 

In May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (ASU) No. 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs”. ASU No. 2011-4 does not require additional fair value measurements and is not intended to establish valuation standards or affect valuation practices outside of financial reporting. The ASU is effective for interim and annual periods beginning after December 15, 2011. The Company will adopt ASU No. 2011-04 effective January 1, 2012 and it is not expected to affect the Company’s results of operations, financial condition or liquidity.

 

In June 2011, the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income”. The ASU eliminates the option to present the components of other comprehensive income as part of the statement of changes in shareholders’ equity, and instead requires consecutive presentation of the statement of net income and other comprehensive income either in a continuous statement of comprehensive income or in two separate but consecutive statements. ASU No. 2011-5 is effective for interim and annual periods beginning after December 15, 2011. The Company will adopt ASU 2011-05 effective January 1, 2012 and it is not expected to affect the Company’s results of operations, financial condition or liquidity.

 

In September 2011, the FASB issued ASU 2011-08, “Testing Goodwill for Impairment”, an update to existing guidance on the assessment of goodwill impairment. This update simplifies the assessment of goodwill for impairment by allowing companies to consider qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount before performing the two step impairment review process. It also amends the examples of events or circumstances that would be considered in a goodwill impairment evaluation. The amendments are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The Company will adopt ASU 2011-08 effective January 1, 2012. We do not believe that the adoption of this new accounting guidance will have a significant effect on our goodwill impairment assessments in the future.

 

In December 2011, the FASB issued ASU No. 2011-11, “Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities.” This ASU requires an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. ASU No. 2011-11 will be applied retrospectively and is effective for annual and interim reporting periods beginning on or after January 1, 2013. The Company does not expect adoption of this standard to have a material impact on its consolidated results of operations, financial condition, or liquidity.

 

Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the Securities Exchange Commission (the "SEC") did not or are not believed by management to have a material impact on the Company's present or future consolidated financial statements.

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FINANCIAL STATEMENT PRESENTATION

 

RESULTS OF OPERATIONS – YEAR ENDED DECEMBER 31, 2011 AS COMPARED TO YEAR ENDED DECEMBER 31, 2010

 

The following table sets forth the amounts and the percentage relationship to revenues of certain items in our consolidated statements of income for the years ended December 31, 2011 and 2010:

 

   Year Ended December 31,   Year Ended December 31, 
   2011   2010   2011   2010 
                 
Revenues  $212,690,388   $305,944,085    100%   100%
Cost of sales   112,939,705    148,186,531    53    48 
 GROSS PROFIT   99,750,683    157,757,554    47    52 
                     
Selling, general and administrative expenses   51,351,940    66,439,702    24    22 
Advertising costs   14,910,983    38,920,905    7    13 
Research and development costs   12,658,085    15,365,131    6    5 
Depreciation and amortization   7,495,051    6,662,237    4    2 
Provision for doubtful accounts   15,624,998        7     
Impairment of property, plant and equipment   733,688             
Impairment of acquired intangible assets   6,928,064        3     
Impairment of goodwill   33,164,121        16     
Total operating expenses   142,866,930    127,387,975    67    42 
                     
INCOME(LOSS)FROM OPERATIONS   (43,116,247)   30,369,579    (20)   10 
                     
Impairment of investment-AXN   (11,937,037)       (6)    
Loss on disposal of Nuo Hua Affiliate   (8,447,368)   (1,083,637)   (4)    
Gain on extinguishment of convertible notes   3,242,389        2     
Equity in earnings (losses) from equity method investments   (1,254,973)   213,177    (1)    
Interest expense, net   (6,610,001)   (5,900,055)   (3)   (2)
Other income (expenses), net   266,942    (204,736)        
(LOSS) INCOME BEFORE INCOME TAX   (67,856,295)   23,394,328    (32)   8 
Provision for income taxes   635,053    9,335,338        3 
NET (LOSS) INCOME   (68,491,348)   14,058,990    (32)   5 
Net loss (income) attributable to non-controlling interest   1,041,420    27,937         
                     
NET (LOSS) INCOME ATTRIBUTABLE TO AMERICAN ORIENTAL BIOENGINEERING, INC.  $(67,449,928)  $14,086,927    (32)%   5%
                     
(LOSS) EARNINGS PER COMMON SHARE                    
Basic  $(1.80)  $0.38           
Diluted  $(1.80)  $0.37           

  

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Revenues

 

Revenues for 2011 were $212,690,388, a decrease of $93,253,697, or 30% compared to revenues for 2010.

 

We classify our revenues into two segments: manufacturing revenue and distribution revenue. The manufacturing revenue comprises revenue from pharmaceutical and nutraceutical products. Revenues by segments and product categories were as follows: 

 

   Year Ended December 31,   Increase/   Increase/ 
   2011   2010   (Decrease)   (Decrease) 
Revenue from pharmaceutical products  $159,024,681   $250,131,594   $(91,106,913)   (36)%
Revenue from nutraceutical products   37,757,118    41,020,289    (3,263,171)   (8)%
Total manufacturing revenue   196,781,799    291,151,883    (94,370,084)   (32)%
Distribution revenue   15,908,589    14,792,202    1,116,387    8%
Total revenues  $212,690,388   $305,944,085   $(93,253,697)   (30)%

 

Revenue in connection with our pharmaceutical products decreased by $91,106,913, or 36%, as compared to 2010 primarily due to the following factors: 

 

·sales from our prescription pharmaceutical products decreased from $129,218,968 for 2010 to $98,463,901 for 2011, or a 24% decrease. The decrease was primarily due to the decrease in sales from SHL powder and CCXA’s generic pharmaceutical products and partially offset by the increase in sales from our prescription formulated Jinji capsule; and 

 

·sales from our OTC pharmaceutical products decreased from $120,912,626 for 2010 to $60,560,780 for 2011, or a 50% decrease. This was mainly due to the decreased sales volume of GLP’s generic OTC drugs, which was affected by the downturn of the economic climate in the pharmaceutical industry. Our revenue from OTC drugs in 2010 was partly due to the positive effect from our TV advertisements. In 2011, we decreased our advertisement cost to around $14 million or 61% of 2010 and the TV advertisements were not as effective as in 2010. The decrease in retail price of our OTC drugs in 2011 affected by the price control policy and impacted the profit margin of our distributors, which leaded to a loss of motivation from them to sale our products and resulted with a decline of sales of our OTC drugs.

 

·The recent price control over the prescription and OTC medicines affect our sales volume in 2011 where our products lost the ability to compete effectively with our competitors and resulted with a significant decrease in sales when comparing to 2010.

 

We decreased the manufacturing of certain generic drugs since the TCM raw material price for these drugs has continued to increase during this year. Accordingly, we shifted the products mix toward higher-margin products from lower margin products to minimize the impact from the increased cost of certain raw materials and the continuing government price cut on certain products.

 

Revenue in connection with our nutraceutical products decreased by $3,263,171 or 8% compared to 2010. The decrease was mainly due to the decrease in sales from our Soy Peptide tablets and partially offset by the increase in sales from our Soy Peptide drinks which we launched commercially in late 2009. We decreased the advertising for certain old nutraceutical products and focused on new products to achieve optimum efficiency while maintaining strict advertising cost control.

 

The distribution revenue from NuoHua's majority owned subsidiary increased by $1,116,387 or 8%, to $15,908,589. This increase was mainly attributed to NuoHua's expanding market coverage.

 

Cost of Sales and Gross Profit

 

Cost of sales was $112,939,705 in 2011, compared to $148,186,531 in 2010. Cost of sales by segments and product categories were as follows:

 

   Year Ended December 31,   Increase/   Increase/ 
   2011   2010   (Decrease)   (Decrease) 
Pharmaceutical products  $76,874,785   $113,090,019   $(36,215,234)   (32)%
Nutraceutical products   20,969,014    20,756,967    212,047    1%
Total manufacturing cost   97,843,799    133,846,986    (36,003,187)   (27)%
Distribution cost   15,095,906    14,339,545    756,361    5%
Total cost  $112,939,705   $148,186,531   $(35,246,826)   (24)%

 

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Gross profit decreased by $58,006,871 or 37% for 2011 compared to the 2010. Gross profit as a percentage of revenues decreased from 52% in 2010 to 47% in 2011 mainly due to the new levied urban construction and maintenance tax and educational surcharge. The decrease of sales and continuously increase of the purchase price of raw materials also attributed to the decrease of gross profit.

 

From December of 2010, the urban construction and maintenance tax and educational surcharge were levied on foreign investment enterprises and foreign enterprises that previously enjoyed the exemption. We recognized the urban construction and maintenance tax and educational surcharge in cost of sales. As a result of the regulation change, our gross margin for 2011 was affected by approximately 2%.

 

We continued our efforts to manage the margin pressure although the increased purchase prices of certain raw materials increased the cost of sales.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses, decreased from $66,439,702 in 2010 to $51,351,940 in 2011, representing a 23% decrease. The details of our sales and marketing expenses were as follows:

 

   Year Ended December 31,   Increase/   Increase/ 
   2011   2010   (Decrease)   (Decrease) 
Promotional materials and fees  $11,289,093   $23,507,944   $(12,218,851)   (52)%
Payroll   12,961,235    12,820,709    140,526    1%
Shipping   3,686,959    5,682,503    (1,995,544)   (35)%
Trips and traveling   4,296,399    4,236,108    60,291    1%
Professional fees   3,060,406    3,483,684    (423,278)   (12)%
Staff welfare and insurance   3,833,170    3,012,736    820,434    27%
Stock based compensation   3,216,714    3,124,188    92,526    3%
Miscellaneous   9,007,964    10,571,830    (1,563,866)   (15)%
TOTAL  $51,351,940   $66,439,702   $(15,087,762)   (23)%

  

The decrease in selling, general and administrative expenses for 2011 compared to 2010 was primarily due to the following factors:

 

the decrease of promotional materials and fees by $12,218,851, or 52%, as compared to 2010. This was primarily due to the reduction of our promotional activities in relation to SHL powder and generic prescription and OTC drugs;

 

the decrease of shipping costs by $1,995,544, or 35%, as compared to 2010. This was primarily due to the reduction of sales volume of our products; and

 

the decrease in selling, general and administrative expenses was partially offset by the increase of staff welfare and insurance expenses by $820,434, which was mainly due to the increase of our staff welfare and insurance coverage and level as required by Chinese labor law.

   

Advertising Costs

 

Advertising costs decreased by $24,009,922, or 62%, from $38,920,905 in 2010 to $14,910,983 in 2011. Advertising costs as a percentage of revenue decreased from 13% for 2010 to 7% for 2011.

  

We decreased the advertising costs related to some of our OTC generic drugs in 2011. We continued to invest in advertising to create a unified megabrand for AOBO so that we can leverage on the establishment of all our individual brands to increase brand awareness and market shares.

 

Research and Development Costs

 

Research and development costs decreased by $2,707,046 from $15,365,131 for 2010 to $12,658,085 in 2011. Expressed as a percentage of revenue, research and development costs were 6% and 5% for 2011 and 2010, respectively.

 

Our research and development activities consist of near term, middle term and long term stages which contribute to both our current and future business strategies. Our key research and development programs include the improvement of our existing products and development of new products such as SHL Lyophilized Injection Powder, Cease Enuresis Soft Gel and Jinji series products. The majority of our research and development expenditures are on pharmaceutical products.

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Depreciation and Amortization

 

Depreciation and amortization expenses increased by $832,814, or 13%, in 2011 as compared to 2010. This was mainly due to the increase of the property, plant and equipment during the second half of 2011.

 

Provision for doubtful accounts

 

Provision for doubtful accounts increased to $15,624,998 in 2011 from nil in 2010. The increase was mainly due to the current market condition, which we assessed might significantly deteriorate our customers’ ability to continue to pay their outstanding invoices on a timely basis.

 

Impairment of acquired intangible assets

 

Impairment of acquired intangible assets increased from nil in 2010 to $6,928,064 in 2011. This was mainly due to our changes of estimates of the fair value of our intellectual properties in patent, which the expected future cash flow generated from these patents would significantly decrease. We estimated that the fair value of our intangible assets exceeds the carrying value as of December 31, 2011 and an impairment loss of $6,928,064 was recognized in 2011.

 

Impairment of goodwill

 

Impairment of goodwill increased from nil in 2010 to $33,164,121 in 2011. With the recent decrease in sales in 2011 and the negative changes in the pharmaceutical market with governmental influence over the retail price of prescription and OTC medicines, we expected that there would be a continuous decline in sales subsequently and the future cash flows expected to be generated by the reporting units were significantly decreased. The continuous increase in cost, including retail price of raw material and labor cost also affected our estimation for cash flow generated in future period. As a result, we impaired the recorded goodwill as of December 31, 2011 from $33,164,121 as of December 31, 2010.

 

Impairment of property, plant and equipment

 

Impairment of property, plant and equipment increased from nil in 2010 to $733,688 in 2011. The decrease was mainly due to the fair value estimation of assets in our Three Happiness subsidiary, where one of the production lines was no longer expected to generate significant cash flow in the future. We impaired the assets with $733,688 impairment loss in 2011.

 

Impairment of equity method investment - AXN

 

Impairment of equity method investment –AXN was $11,937,037 in 2011, compared to nil in 2010. The Company considered AXN’s declining stock price, as well as other information found in the public filings of AXN, and various internet articles and websites, as indications that the decline in the value of AXN was other than temporary and accordingly performed an asset impairment test at December 31, 2011. Such factors as AXN’s write off of its Goodwill and a “going concern” paragraph in its most recent audit report were two of the factors. The Company considered the market value of the publically traded stock of AXN, as well as adjusting the carrying value of the investment for the step up in value of the net assets and goodwill recognized upon the original investment, as indicators of the current value of the investment. After considering these methodologies the Company estimated the value of its equity investment in AXN to be $5,708,329, and recognized an impairment of $11,937,037 in the equity investment for the year ending December 31, 2011.

 

Gain on extinguishment of convertible notes

 

During 2011, the Company repurchased a total $6,500,000 in principal amount of our convertible Notes for $3,160,004. A gain of debt extinguishment of $3,242,389 was recognized representing the difference between the net carrying value of the notes repurchased and the repurchase price. For additional information, see “Item 1. Financial Statements – Note 15. Debt”.

 

Equity in Earnings (Losses) from Equity Method Investments

 

Equity in earnings(losses) from equity method investments decreased from a gain of $213,177 in 2010 to a loss of $1,254,973 in 2011. The increased loss was mainly due to the recognition of the share of equity losses from investment in AXN. On October 18, 2010, the NuoHua Affiliate was disposed to an unrelated third party; as a result, the Company was no longer entitled to recognize its equity earnings from the NuoHua Affiliate.

 

 

Interest Expense, Net

 

Net interest expense was $6,610,001 for 2011 compared to net interest expense of $5,900,055 for 2010. The increase was mainly due to the increase proceeds from short-term loans in 2011 as compared to 2010. 

 

Income Tax

 

The Company’s effective tax rate for 2011 was 1%, compared to 40% in 2010. For additional information, see “Item 1. Financial Statements – Note 22. Income Tax”.

 

43
 

 

RESULTS OF OPERATIONS – YEAR ENDED DECEMBER 31, 2010 AS COMPARED TO YEAR ENDED DECEMBER 31, 2009

 

The following table sets forth the amounts and the percentage relationship to revenues of certain items in our consolidated statements of income for the years ended December 31, 2010 and 2009:

 

   Year Ended December 31,   Year Ended December 31, 
   2010   2009   2010   2009 
                 
Revenues  $305,944,085   $296,150,780    100%   100%
Cost of sales   148,186,531    129,367,775    48    44 
 GROSS PROFIT   157,757,554    166,783,005    52    56 
                     
Selling, general and administrative expenses   66,439,702    62,164,936    22    21 
Advertising costs   38,920,905    31,896,992    13    11 
Research and development costs   15,365,131    7,922,357    5    3 
Depreciation and amortization   6,662,237    6,038,625    2    2 
Total operating expenses   127,387,975    108,022,910    42    36 
                     
INCOME FROM OPERATIONS   30,369,579    58,760,095    10    20 
Equity in earnings from equity method investment   213,177    2,075,139        1 
Loss on disposal of NuoHua Affiliate   (1,083,637)            
Interest expense, net   (5,900,055)   (5,746,382)   (2)   (2)
Other expense, net   (204,736)   (569,661)        
                     
INCOME BEFORE INCOME TAX   23,394,328    54,519,191    8    18 
Provision for income taxes   9,335,338    13,216,986    3    4 
                     
NET INCOME   14,058,990    41,302,205    5    14 
Net loss attributable to non-controlling interest   27,937    118,945         
                     
NET INCOME ATTRIBUTABLE TO AMERICAN ORIENTAL BIOENGINEERING, INC.  $14,086,927   $41,421,150    5%   14%
                     
EARNINGS PER COMMON SHARE                    
Basic  $0.38   $1.11           
Diluted  $0.37   $1.06           

  

Revenues

 

Revenues for 2010 were $305,944,085, an increase of $9,793,305, or 3% compared to revenues for 2009.

 

We classify our revenues in two segments: manufacturing revenue, which comprises sales by our subsidiaries of our pharmaceutical and nutraceutical products, and distribution revenue. Revenues by segments and product categories were as follows:

 

   Year Ended December 31,   Increase/   Increase/ 
   2010   2009   (Decrease)   (Decrease) 
Revenue from pharmaceutical products  $250,131,594   $244,168,159   $5,963,435    2%
Revenue from nutraceutical products   41,020,289    39,125,655    1,894,634    5%
Total manufacturing revenue   291,151,883    283,293,814    7,858,069    3%
Distribution revenue   14,792,202    12,856,966    1,935,236    15%
Total revenues  $305,944,085   $296,150,780   $9,793,305    3%

 

44
 

 

Revenue in connection with our pharmaceutical products increased by $5,963,435, or 2%, as compared to 2009 primarily due to the following factors: 

 

sales from our prescription pharmaceutical products increased from $115,785,594 for 2009 to $129,218,968 for 2010, or a 12% increase. The increase was primarily due to the increase in sales from our prescription formulated Jinji capsule, SHL powder, YYQH capsule and the expansion of CCXA generic pharmaceutical products in the rural market. The overall increase in sales was supported by our continuous marketing efforts, increase in new products offering, as well as expanding coverage in the rural market;

  

sales from our OTC pharmaceutical products decreased from $128,382,565 for 2009 to $120,912,626 for 2010, or a 6% decrease. This was mainly due to the decreased sales volume of GLP’s generic drugs in the fourth quarter of 2010.

   

Revenue in connection with our nutraceutical products increased by $1,894,634, or 5%, to $41,020,289. This increase was mainly attributed to the increased sales of soybean milk as the market expanded.

 

The distribution revenue from NuoHua's majority owned subsidiary increased from $12,856,966 for 2009 to $14,792,202 for 2010, representing an increase of 15%. This increase was mainly attributed to NuoHua's expanding market coverage.

 

Cost of Sales and Gross Profit

 

Cost of sales was $148,186,531 in 2010, compared to $129,367,775 in 2009. Cost of sales in 2010 and 2009 by segments and product categories were as follows:

 

   Year Ended December 31,   Increase/   Increase/ 
   2010   2009   (Decrease)   (Decrease) 
Pharmaceutical products  $113,090,019   $99,522,407   $13,567,612    14%
Nutraceutical products   20,756,967    17,439,581    3,317,386    19%
Total manufacturing cost   133,846,986    116,961,988    16,884,998    14%
Distribution cost   14,339,545    12,405,787    1,933,758    16%
Total cost  $148,186,531   $129,367,775   $18,818,756    15%

 

The cost of sales of pharmaceutical and nutraceutical products increased by 14% and 19%, respectively, in 2010 compared to 2009. These increases were mainly attributed to our increase in sales and the increase in production costs. The increase in distribution costs were in line with our distribution revenue.

 

Gross profit decreased by $9,025,451 or 5% for 2010 compared to 2009. Gross profit as a percentage of revenues decreased from 56% in 2009 to 52% in 2010 due to a greater proportion of generic product sales in the rural market. Further, the increased purchase prices of certain raw materials increased the cost of sales, which also contributed to lower gross margin.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses, increased from $62,164,936 in 2009 to $66,439,702 in 2010, representing a 7% increase. The details of our sales and marketing expenses were as follows:

 

   Year Ended December 31,   Increase/   Increase/ 
   2010   2009   (Decrease)   (Decrease) 
Promotional materials and fees  $23,507,944   $26,729,235   $(3,221,291)   (12)%
Payroll   12,820,709    10,193,585    2,627,124    26%
Shipping   5,682,503    5,024,799    657,704    13%
Trips and traveling   4,236,108    3,704,674    531,434    14%
Professional fees   3,483,684    3,551,625    (67,941)   (2)%
Staff welfare and insurance   3,012,736    1,397,123    1,615,613    116%
Stock based compensation   3,124,188    2,718,771    405,417    15%
Miscellaneous   10,571,830    8,845,124    1,726,706    20%
TOTAL  $66,439,702   $62,164,936   $4,274,766    7%

 

45
 

 

The increase in selling, general and administrative expenses in 2010 compared to 2009 was primarily due to the following factors:

 

the increase of payroll expenses was primarily due to the increase of the average salaries and bonuses for our staff as a result of our business expanding in the rural market as well as the increase in sales volume. In addition, the increased market need for sales people and China’s increased labor costs also contributed to the increase of payroll expenses;

 

the increase of shipping expenses was primarily due to the increase in sales volume and the increase in logistics costs;

     

the increase of trips and traveling expenses was primarily due to the increase in promotional activities of the sales people;

 

the increase of staff welfare and insurance expenses was primarily due to the increase of our staff welfare and insurance coverage and level as required by Chinese labor law;

 

stock compensation expense increased due to our additional amortization cost of restricted common stock issued to the executives and the senior management in 2010; and

  

the increase was partially offset by a decrease of promotional materials and fees by $3,221,291, or 12% in 2010 as compared to 2009. This was primarily due to the change of our promotional activity for promoting our products. The Company reduced its promotional activities during the second half year of 2010 but increased the coverage and frequency of TV and outdoor advertising to support the continuous growth of our revenue.     

   

Advertising Costs

 

Advertising costs increased by $7,023,913, from $31,896,992 in 2009 to $38,920,905 in 2010. Advertising costs as a percentage of revenue increased from 11% in 2009 to 13% in 2010.

 

We increased advertising costs to create a unified mega brand for AOB so that we can leverage on the establishment of all our individual brands to boost chances of winning in the government sponsored competitive tendering processes for China's essential drug list products as well as those in the national insurance catalogs. We also increased advertising costs in connection with promoting our new launched products in 2009 and 2010. We believe a reasonably priced product with a brand name will be more appealing to consumers, patients and doctors.

 

Research and Development Costs

 

Research and development costs increased by $7,442,774 from $7,922,357 in 2009 to $15,365,131 in 2010. Expressed as a percentage of revenue, research and development cost was 5% for 2010, compared to 3% for 2009.

 

The increase in research and development costs reflected our continuing effort in research and development activities. Our research and development activities consist of near term, middle term and long term stages which contribute to both our current and future business strategies. Our key research and development programs during 2010 include the improvement of SHL Lyophilized Injection Powder, Cease Enuresis Soft Gel, Jinji series products and some acquired projects from Guang Xi Hui Ke Pharmaceutical Research and Development Co., Ltd., or GHK.

 

We believe we have proven research and development capabilities and a robust pipeline with promising market potential. With stringent quality assurance programs in place at our manufacturing facilities, we believe we are on track with our capacity expansion initiatives in advance of the commercialization of our pipeline products. The majority of our research and development expenditures are on pharmaceutical products.

 

Depreciation and Amortization

 

Depreciation and amortization expenses increased $623,612, or 10%, in 2010 as compared to 2009. This was mainly due to the increase of the property, plant and equipment and land use rights.

 

Equity in Earnings (Loss) from Equity Method Investments

 

Equity in earnings (loss) from equity method investments decreased from a gain of $2,075,139 in 2009 to a gain of $213,177  in 2010. For additional information, see “Item 1. Financial Statements –Note 13. Investments in and advances to equity method investments.”

 

Interest Expense, Net

 

Net interest expense was $5,900,055 for 2010, compared to net interest expense of $5,746,382 for 2009. The increase in net interest expense was mainly due to the decrease in interest expense capitalized as construction in progress. For additional information, see “Item 1. Financial Statements – Note 9. Property, plant and equipment”

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Income Tax

 

The decrease in the income tax expense was mainly due to the decline of income before income taxes. The Company’s effective tax rate for 2010 was 40% (restated), which is an increase of 16% (restated) from 2009. The increase in the effective tax rate is mainly due to a decrease in profits before tax relative to permanent differences, unrecognized tax benefits and a change in valuation allowance. For additional information, see “Item 1. Financial Statements – Note 22. Income tax” 

 

FINANCIAL POSITION, LIQUIDITY AND CAPITAL RESOURCES

 

Cash

 

Our cash position at December 31, 2011 was $52,627,928, representing a decrease of $41,940,592, or 44%, compared with our cash position of $94,568,520 at December 31, 2010. The decrease was mainly attributable to the decrease of operating activities of $5,941,237 and investing activities of $45,290,646.

 

We currently generate our cash flow through operations. We expect our existing cash and cash flow generated from operations will be sufficient to sustain our working capital, capital expenditures, and milestone payments for the next twelve months. From time to time, we may identify new expansion opportunities for which there will be a need to use cash.

 

We manage our cash based on thorough consideration of our corporate strategy as well as macroeconomic considerations. Factors we take into account when managing our cash include interest income, foreign currency fluctuation as well as the flexibility in executing our acquisition strategy.

 

Working Capital

 

We maintain a significant level of working capital. Our working capital decreased by $164,420,747 to $36,131,157 at December 31, 2011, as compared to $200,551,904 at December 31, 2010. The sharp decrease was mainly due to the convertible notes, in default, amounting to $108,000,000, present in current liabilities as of December 31, 2011 while the convertible notes as of December 31 2010 amounting to $115,000,000 was presented in the long-term liabilities. The decrease of working capital was also due to a decrease in cash and cash equivalents by $41,940,592, a decrease in net accounts receivable by $27,259,060 and receivable for disposal of NuoHua Affiliate by $20,413,656, an increase in accounts payable by $11,368,859 and offset by the increase in notes receivable by $27,705,356, the increase deferred tax assets by $2,576,300 and the increase in other current assets by $2,182,737.

 

Total Debt

 

We have total of $116,440,026 debt as of December 31, 2011, as comparing to $123,235,826 as of December 31, 2010. The decrease of $6,495,800 was mainly due to our increase repayments to the total debt, including the bank loans and convertible notes. We have been keeping current repayments of the loans and we expect to repay the bank loans when they mature.

 

Convertible notes

 

On July 15, 2008 the Company issued $115 million of its 5% senior convertible notes. This liability of the Company is in default, which was caused by the delisting of the Company’s common stock by the NYSE as described in Form 25NSE filed on April 16, 2012 by NYSE; and by the non-payment of the interest due on July 15, 2012.

 

During 2011, the Company repurchased its outstanding 5% senior convertible notes in the aggregate amount of $6,500,000 in three separate transactions at a weighted average price of $0.49 on the dollar through negotiated transactions or a market transaction on the platform of Portal, in each of which the seller approached the Company for the transaction. As a result of said repurchases, the outstanding balance of our convertible notes was reduced from $115,000,000 to $108,500,000.

 

Subsequently, the Company repurchased an additional aggregate amount of $59,339,000 of its outstanding 5%senior convertible notes in multiple negotiated transactions, in each of which each seller approached the Company separately for the transactions. The weighted average price the Company paid was about $0.3114 on the dollar. As a result of the repurchase transactions after 2011, the outstanding balance of our convertible notes as of this filing date is $49,161,000.

 

The Company will remain opportunistic towards future repurchase. The potential consummation of future repurchase transactions will depend upon, including and not limited to, the availability of funds, the competing priority of funds, timing, price, etc. There is no guarantee there will be any future repurchase transactions

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As of December 31, 2011, the convertible notes are $108,500,000, as comparing to $115,000,000 as of December 31, 2010. The decrease was due to our repurchase of a total of $6,500,000 in principal amount during 2011 with a purchase price of $3,160,004. A gain of debt extinguishment of debt, amounting to $3,242,389 was recognized for the year ended December 31, 2011. For additional information, see “Item 1. Financial Statements – Note 16. Convertible notes”.

 

Cash Flow

 

2011 Compared to 2010

 

Operating Activities

 

Cash flows provided by operations during 2011 amounted to $29,955,718, representing an increase of $21,744,202 compared with cash flows from operations of $8,211,516 for 2010. The increase in net cash provided by operating activities was primarily attributable to the increases of $16,118,296, $6,928,064, $33,164,121, $11,937,037 and $35,750,322 in provision for doubtful accounts, impairment of acquired intangible assets, impairment of goodwill, impairment of equity method investment-AXN and changes in operating assets and liabilities respectively, and decrease of $82,550,338 in net income which aggregated to a net cash inflow of $11,985,438, an increase by $21,347,502 from a net cash outflow of $9,362,064 during 2010.

 

As reflected in our cash flows, the changes included:

 

cash inflow from accounts receivable amounted to $ 15,789,486, mainly affected by the timing of collection of our sales revenue during 2011;

 

cash outflows from inventories amounted to $3,003,807 and cash outflows from advances to suppliers amounted to $ 1,706,525 were mainly due to the increased purchases of raw materials for planned inventory buildup; and

 

cash outflows from other payables and accrued expenses amounted to $5,253,142 mainly attributed to the timing of payments in 2011.

    

Investing Activities

 

Our net cash used in investing activities amounted to $71,948,735 in 2011, compared to net cash used in investing activities of $6,341,048 in 2010. As reflected in our cash flows, the changes mainly included:

 

●   cash outflows for the property acquired, which allow us to have the right to establish a TCM raw material trading center in Northeast China approved by the China’s SFDA amounted to $26,503,473. The investment is intended to be integrated with our competitive infrastructure and whole supply chain management, providing foundation for the Company to start a TCM raw material trading business, offering a long term steadier supply of qualified raw materials with manageable costs.

 

●   cash outflows for purchases of PPE and CIP of $36,396,402 in 2011 for the expansion and upgrade of our manufacturing facilities to complement capacity improvement and efficiency enhancement.

 

Financing Activities

 

Our net cash used in financing activities was $4,261,856 in 2011, compared to cash used of $3,870,079 in 2010.

 

We repurchased a total $6,500,000 in principal amount of our convertible Notes for $3,160,005; we also repurchased 449,163 shares of our common stock at a total cost of $799,999 pursuant to the Share Buyback Program.

 

2010 Compared to 2009

 

Operating Activities

 

Cash flows from operations during 2010 amounted to $8,211,516, representing a decrease of $19,534,465 compared with cash flows from operations of $27,567,718 for 2009. The decrease in net cash provided by operating activities was primarily attributable to the decrease in net income of $27,243,215 (restated), changes in operating assets and liabilities which aggregated to a net cash inflow of $3,463,452 (restated), a decrease by $23,779,763 (restated)   from a net cash inflow of $14,274,863 during 2009. As reflected in our cash flows, the changes included:

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cash outflow from accounts and notes receivable amounted to $23,247,668 primarily affected by the increase of our sales revenue;

 

cash outflows from other payables and accrued expenses amounted to $5,365,288 primarily attributed to the timing of payments to the promotion fee accrued in 2010; and

    

 

cash inflows from other liabilities amounted to $4,085,209 mainly due to increase of our advances from customers, especially during the fourth quarter.

 

Investing Activities

 

Our net cash used in investing activities amounted to $6,341,048 during 2010, compared to net cash provided by investing activities of $6,755,728 in 2009. The changes in net cash used in investing activities were primarily attributable to the return of a refundable deposit of $6,397,106 in 2009 for due diligence, and offset by Capitalized agricultural costs by $7,909,086.

 

Financing Activities

 

Our net cash used in financing activities was $3,870,079 in 2010, compared to cash inflow of $1,806,991 in 2009. The increase in net cash used in financing activities was mainly attributable to the increase of net repayment of bank loans.

 

Off -balance Sheet Arrangements

 

We do not have any off -balance sheet arrangements as of December 31, 2011.

 

Contractual Obligations

 

The following table summarizes the Company's estimated contractual obligations as of December 31, 2011:

 

  Payments due by period 
   

Total

    Less than 1 year   1-3 years   

3-5 years

   More than 5 years 
Capital expenditure commitments  $12,424,230   $9,412,305   $3,011,925   $   $ 
Advertising commitments   578,189    578,189              
R&D commitments   5,563,559    3,214,792    2,348,767         
Long-term loan   681,100    63,070    130,971    137,675    349,384 
Convertible notes*   108,500,000    108,500,000             
Total  $127,747,078   $121,768,356   $5,491,663   $137,675   $349,384 

 

* Holders of the convertible notes may require the Company to repurchase all or a portion of their notes on July 15, 2013 for cash at a price equal to 100% of the principal amount of the notes to be purchased, plus accrued and unpaid interest, if any, up to, but excluding, the repurchase date. 

 

The Company also has an unconditional purchase commitment in connection with the Millettia long-term supply contracts, which is not expected to be harvest until after 2018. The purchase amount will be based on fair value discounted at a pre-determined rate pursuant to the long-term supply contracts.

 

We rely largely on operating cash flow to fund our capital expenditure needs. Due to our significant operating cash flow, we believe we have the ability to meet our capital expenditure needs and foresee no delays to planned capital expenditures.

 

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Issuance of Common Stock

 

See Part II, Item 5 for issuance of unregistered shares of common stock.

 

Inflation

 

Inflation has not had a material impact on our business.

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Currency Exchange Fluctuations

 

The Company's operations are exposed to a variety of global market risks, including the effect of changes in foreign currency exchange rates. These exposures are managed, in part, with the use of a financial derivative. The Company does not use financial derivatives to hedge exposures in the ordinary course of business or for speculative purposes. 

 

We currently conduct substantially all of our operations through our PRC subsidiaries. The functional currency of our PRC subsidiaries is the Chinese RMB. The financial statements of our PRC subsidiaries are translated to U.S. dollars using year-end exchange rates as to assets and liabilities and average exchange rates as to revenues, expenses, and cash flows. Capital accounts are translated at their historical exchange rates when the capital transaction occurred. Translation adjustments resulting from this process are included in accumulated other comprehensive income in the statement of shareholders’ equity. Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred.

 

As the majority of our assets and substantially all of our revenue, costs and expenses are denominated in RMB, any significant revaluation of the RMB may materially and adversely affect our cash flows, revenues and financial condition. For example, if the RMB depreciates against the U.S. dollar, the value of our RMB revenues, earnings, and assets, as expressed in our U.S. dollar financial statements could decline. In addition, if we decide to convert our RMB into U.S. dollars for the purpose of making payments for business purposes, the U.S. dollar equivalent of the RMB we convert would be reduced. On the other hand, to the extent that we need to convert U.S. dollars we receive from an offering of our securities into RMB for our operations, appreciation of the RMB against the U.S. dollar could reduce the amount of the U.S. dollars available.

 

The local currencies in the countries in which we sell our products may fluctuate in value in relation to other currencies. Such fluctuations may affect the costs of our products sold and the value of our local currency profits. While we are not conducting any operations in countries other than China at the present time, we may expand to other countries and may then have an increased risk of exposure of our business to currency fluctuation.

 

The PRC government imposes control over the conversion of RMB, into foreign currencies. Under the current unified floating exchange rate system, the People’s Bank of China publishes an exchange rate, which we refer to as the PBOC exchange rate, based on the previous day’s dealings in the inter-bank foreign exchange market. Financial institutions authorized to deal in foreign currency may enter into foreign exchange transactions at exchange rates within an authorized range above or below the PBOC exchange rate according to market conditions.

 

Pursuant to the Foreign Exchange Control Regulations of the PRC issued by the State Council which came into effect on April 1, 1996, and the Regulations on the Administration of Foreign Exchange Settlement, Sale and Payment of the PRC which came into effect on July 1, 1996, regarding foreign exchange control, conversion of RMB into foreign exchange by Foreign Investment Enterprises, or FIEs, for use on current account items, including the distribution of dividends and profits to foreign investors, is permissible. FIEs are permitted to convert their after-tax dividends and profits to foreign exchange and remit such foreign exchange to their foreign exchange bank accounts in China. Conversion of RMB into foreign currencies for capital account items, including direct investment, loans, and security investment, is still under certain restrictions. On January 14, 1997, the State Council amended the Foreign Exchange Control Regulations and added, among other things, an important provision, which provides that the PRC government shall not impose restrictions on recurring international payments and transfers under current account items.

 

Enterprises in China, including FIEs, which require foreign exchange for transactions relating to current account items, if within a certain limited amount may, without approval of the State Administration of Foreign Exchange, or SAFE, effect payment from their foreign exchange account or convert and pay at the designated foreign exchange banks by providing valid receipts and proofs. 

 

Convertibility of foreign exchange in respect of capital account items, such as direct investment and capital contribution, is still subject to certain restrictions, and prior approval from the SAFE or its relevant branches must be sought.

 

 Between 1994 and 2004, the exchange rate for RMB against the U.S. dollar remained relatively stable, most of the time in the region of approximately RMB8.28 to US$1.00. However, in 2005, the Chinese government announced that it would begin pegging the exchange rate of the RMB against a number of currencies, rather than just the U.S. dollar.  

    

Since a significant amount of our future revenues are expected to be denominated in RMB, any existing and future restrictions on currency exchange may limit our ability to utilize revenue generated in China to fund our business activities outside of China, if any, or expenditures denominated in foreign currencies, or our ability to meet our foreign currency obligations, which could have a material adverse effect on our business, financial condition and results of operations. We cannot be certain that the PRC regulatory authorities will not impose more stringent restrictions on the convertibility of RMB with respect to foreign exchange transactions.

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We recognized a foreign currency translation adjustment of $19.5 million and $16.0 million as of December 31, 2011 and 2010, respectively. The balance sheet amounts with the exception of equity at December 31, 2011 were translated at 6.3647 RMB to $1.00 USD as compared to 6.6118 RMB at December 31, 2010. The equity accounts were stated at their historical rate.

 

The average translation rates applied to the income and cash flow statement amounts for 2011 and 2010 were 6.4883 RMB and 6.7245 RMB to $1.00 USD, respectively. We do not hedge our exposure to foreign exchange risk; as such, we may in the future experience economic loss as a result of any foreign currency exchange rate fluctuations.

 

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

Our independent registered public accounting firm’s report and our consolidated financial statements begin on page F-1.

 

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

   

On June 15, 2012, our audit committee has released Ernst & Yong Hua Ming (“EY”) as the Company’s independent auditor, and at the same time has retained Weinberg & Company as its independent auditor.

 

ITEM 9A. CONTROLS AND PROCEDURES

 

(a) Evaluation of Disclosure Controls and Procedures

 

AOB maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in reports filed by AOB under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and form and that such information is accumulated and communicated to AOB’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. Our Chief Executive Officer and Chief Financial Officer evaluated, with the participation of other members of management, the effectiveness of AOB’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)), as of the end of the period covered by this Annual Report on Form 10-K as of December 31, 2011 (the “Evaluation Date”). Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer previously concluded that the Company’s disclosure controls and procedures were effective.

 

(b) Management’s Report on Internal Control over Financial Reporting

 

The management of AOB is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Our 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 and includes those policies and procedures that:

 

1. Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets;

 

2. 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 authorization of our management and directors; and

 

3. Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisitions, use or disposition of our assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In connection with the preparation of the amended annual report and restatement of the Company’s 2011 consolidated financial statements, under the supervision and with the participation of the Chief Executive Officer and Chief Financial Officer, management reassessed evaluation of the effectiveness of its internal control over financial reporting as of December 31, 2011. The framework on which such evaluation was based is contained in the report entitled “Internal Control – Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO Report”). As a result of that reassessment, management identified two deficiencies as of December 31, 2011 that constituted a material weaknesses and a significant deficiency; accordingly, the Chief Executive Officer and Chief Financial Officer concluded that the Company did not maintain effective internal control over financial reporting as of December 31, 2011.

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Description of Material Weakness

 

A material weakness in internal control over financial reporting is defined as a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis.

 

Management identified the following control deficiencies as of December 31, 2011 that constituted material weaknesses:

 

·A design deficiency in the Company’s controls over the responsibility for financial reporting process that could ensure significant transactions to be recorded and disclosed on a timely basis.

 

·The design deficiency resulting from the lack of a threshold for reporting significant transactions to those responsible for oversight of the financial reporting process.

 

Each of these design deficiencies was determined to be a material weakness.

 

In response to the material weakness identified above, management, under the supervision of the Chief Executive Officer and Chief Financial Officer, commenced to implement the measures described below to address the material weakness. This remediation effort is both to address the identified material weakness and to enhance the Company’s overall financial control environment. The material weaknesses identified by management have been remediated.

 

(c) Changes in Internal Control over Financial Reporting

 

In response to the material weakness identified above, management, under the supervision of the Chief Executive Officer and Chief Financial Officer, commenced to implement the measures describes below to address the material weakness. This remediation effort is intended both to address the identified material weakness and to enhance the Company’s overall financial control environment. During 2012, the Company has taken steps to remediate these matters. 

 

Remediation Steps Taken to Address Material Weakness

 

·Management has relieved the Chief Accounting Officer from all accounting and finance responsibilities. The Company’s legal representative for NuoHua Affiliate was terminated in October 2011

 

·Management revised its policies and procedures relating to the identification of significant transactions that will impact its financial accounting and disclosures. This includes the establishment of a Disclosure Committee consisting of the Chief Executive Office, Chief Financial Officer, other accounting and operational management as deemed necessary and the Audit Committee financial expert.  The responsibility of the Disclosure Committee is to assist the Company’s financial reporting team in ensuring that the accounting consequences of the Company’s material transaction are captured and reflected in the Company’s financial statements on a timely and accurate manner. 

 

·Management established a reporting threshold for significant and material transactions to those who are responsible for oversight the financial reporting, particularly to the Audit Committee.

 

·Management established a threshold for significant and material transactions that would require approval from the board of directors.

 

·Management designed controls to obtain internal certifications from operational management to ensure all important transactions, contracts and agreements have been appropriately disclosed to the Disclosure Committee.
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Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Shareholders of

American Oriental Bioengineering, Inc.

 

We have audited American Oriental Bioengineering, Inc.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control–Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). American Oriental Bioengineering, Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.

 

We conducted our audit 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 effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process 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. A company’s internal control over financial reporting is a process 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. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. The following material weaknesses have been identified and included in management’s assessment as of December 31, 2011. The Company did not establish comprehensive Board and Management authority or threshold limits in order to ensure that material and significant transactions are authorized, recorded and accounted for in a timely manner. The Company did not maintain an effective financial reporting structure to account for material and significant agreements and transactions in a complete and timely manner.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of American Oriental Bioengineering, Inc. as of December 31, 2011 and 2010, and the related consolidated statements of operations and comprehensive income (loss), changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2011. These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the consolidated financial statements and financial statement schedule of the Company as of and for the year ended December 31, 2011, and this report does not affect our report dated January 7, 2013, which expressed an unqualified opinion on those financial statements and financial statements schedule.

 

In our opinion, because of the effect of the material weakness identified above on the achievement of the objectives of the control criteria, American Oriental Bioengineering, Inc. has not maintained effective internal control over financial reporting as of December 31, 2011, based on the COSO criteria.

 

 

/s/ WEINBERG & COMPANY, P.A.

Los Angeles, California

January 7, 2013

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ITEM 9B. OTHER INFORMATION

 

Not applicable.

 

PART III

 

ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

 

The following table sets forth the names and ages of our current directors and executive officers, their principal offices and positions and the date each such person became a director or executive officer. Executive officers are elected annually by our Board of Directors. Each executive officer holds his office until he resigns, is removed by the Board or his successor is elected and qualified. Directors are elected annually by our shareholders at the annual meeting. Each director holds his or her office until his or her successor is elected and qualified or his or her earlier resignation or removal.

 

The following persons are the directors and executive officers of the Company:

 

Name   Age   Position  

Date Of Initial

Appointment

Tony Liu (4)   59   Chief Executive Officer and Chairman of the Board   December 18, 2001
Jun Min (4)   53   Vice President and Director   May 8, 2002
Yanchun Li (4)   43   Chief Financial Officer, Secretary and Director   May 8, 2002
Cosimo J. Patti (1)(2)(3)(4)   62   Independent Director   September 27, 2004
Xianmin Wang (2)(3)(4)   69   Independent Director   January 1, 2005
Baiqing Zhang (3)(4)   59   Independent Director   December 15, 2006
Xiaopeng Xu (4)   63   Chief Operations Officer   March 11, 2010
Yan Gao (4)   40   Chief Accounting Officer   February 22, 2012

(1)Serves as a member of the Audit Committee.
(2)Serves as a member of the Compensation Committee.
(3)Serves as a member of the Nominating and Corporate Governance Committee.
(4)Serves as a member of the Disclosure Committee

 

There are no family relationships between or among any of the executive officers or directors of the Company. Below are brief descriptions of the backgrounds and experiences of the officers and directors:

 

TONY LIU - CHIEF EXECUTIVE OFFICER AND CHAIRMAN OF THE BOARD OF DIRECTORS. Tony Liu is the principal founder of our Company and has served as our Chief Executive Officer and the Chairman of our Board of Directors since 2001. He served in the army for over 19 years. After Mr. Liu left the army, he began working for the government in the Heilongjiang province in northeastern China. In addition to serving as a representative to the National People’s Congress in China, with his practical work experience in the Chinese community for many years, Mr. Liu has witnessed and participated in the massive macroeconomic changes for the past thirty years. He has many years of experience in managing the army, government agencies and pharmaceutical companies. Mr. Liu was named the Outstanding Chinese Entrepreneur of the World and he is currently the Vice Chairman of the World Eminence Chinese business Association. Mr. Liu graduated with a major in Communications & Commands from Wuhan Communication College in 1986 and studied Integrated Marketing and Media at the University of Hong Kong in 2004. Mr. Liu studied in the Program of Sustainable Growth of Large Corporations sponsored by the School of Engineering and the School of Business at Stanford University. Mr. Liu passed the dissertation for his Doctor of Business Administration degree in September 2010 at Tarlac State University through a program jointly run by Beijing Normal University and Tarlac State University. This program is accredited by The Philippines Department of Education and China Department of Education. 

 

JUN MIN - VICE PRESIDENT AND DIRECTOR. Jun Min is one of our partner founders and has served as our Vice President and as a member of our Board of Directors since 2002. Mr. Min worked at the Price Checking Department Bureau of Heilongjiang Province from 1987 to 1992. Subsequently, he worked for Three- Happiness Bioengineering, Co. Ltd. from 1994. In November 2008, Mr. Min joined the board of directors of China Aoxing Pharmaceuticals Co., Inc. (OTCBB:CAXG), a specialty pharmaceutical company specializing in research, development, manufacturing and distribution of a variety of narcotics and pain-management products. He has over 20 years of experience in operations management and has an extensive knowledge of the consumer and pharmaceutical products industries in China. Mr. Min received a BA in Business Management from Harbin Broadcast & TV University in 1986.

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 YANCHUN LI - CHIEF FINANCIAL OFFICER, SECRETARY AND DIRECTOR. Yanchun Li one of our partner founders and has served as Chief Financial Officer since May 2007. Prior to her appointment as Chief Financial Officer, she had been the Acting Chief Financial Officer since May 2002, Chief Operating Officer from October 2003 until March 2010 and Secretary since October 2003 and has worked at the Company and served as a member of the Board of Directors since 2002. Ms. Li has fifteen years of experience in management in the food industry and the pharmaceutical industry in China. In particular, she has extensive experience and innovative insight in marketing, management, brand building, corporate strategy, human resource and financial capital management. Before joining us, Ms. Li worked for China Ruida Food Limited Company and successfully established the Ruida brand as the number one brand in the instant frozen food industry. Ms. Li joined Three-Happiness Bioengineering, Co. Ltd. in 1994 and was in charge of the marketing and sales. Under her leadership, the functional drink of the Three-Happiness brand has reached stunning achievement nationwide across China. The Three-Happiness brand was later awarded the Top Ten Well-known Brands in China. Ms. Li won the China Golden Award in Marketing of Year 2005 and was elected into the Who is Who of Chinese Origin Worldwide. Ms. Li received her BA in English from Beijing University of Industry and Commerce in 1993 and completed the Owner/President Management Program in 2008, an advanced program, at Harvard Business School.

  

COSIMO J. PATTI - INDEPENDENT DIRECTOR. Cosimo J. Patti has served on our Board of Directors since 2004. Before joining us, Mr. Patti was an arbitrator for the National Association of Securities Dealers and the New York Stock Exchange for 18 years. Since August 1999, Mr. Patti has been the President and Chairman of Technology Integration Group, Inc. In May 2009, Mr. Patti was appointed to the board of directors of China XD Plastics Company Limited (NASDAQ:CXDC), a company engaged in the development, manufacturing, and distribution of modified plastics primarily for use in automotive applications. In June 2007, Mr. Patti joined the board of directors of Advanced Battery Technologies, Inc. (NASDAQ:ABAT), a company engaged in the business of designing, manufacturing and marketing rechargeable polymer lithium-ion batteries. From 2002 to 2004, Mr. Patti was the Senior Director of Applications Planning with iCi/ADP. He was the Director of Strategic Cross-border Business with Cedel Bank from 1996 to 1999, and President and Founder of FSI Advisors Group from 1998 to 2002. Since 1986 Mr. Patti has served as an appointed arbitrator to the New York Stock Exchange and the National Association of Securities Dealers adjudicating cases involving client disputes within government, equity, derivative and fixed income securities trading activities. Mr. Patti contributes to our Board of Directors his forty years of experience successfully managing corporate teams in domestic and international operations, compliance and sales organizations. Mr. Patti attended Brooklyn College from 1968 to 1970.  

 

XIANMIN WANG - INDEPENDENT DIRECTOR. Xianmin Wang has served on our Board of Directors since 2005. He was the Vice Governor of Heilongjiang Province from 1998 to 2003, where he was in charge of Financial and Economic affairs. Mr. Wang was Secretary of Daqing Municipal Party Committee from 1996 to 1998, and Vice Secretary of Harbin Municipal Party Committee from 1991 to 1992. Mr. Wang received a post graduate degree in Philosophy from Renmin University of China in 1964. He also holds a bachelor’s degree in Economics from Northeast Forest University and postgraduate degrees in Philosophy from Heilongjiang University and Renmin University of China.   

 

BAIQING ZHANG - INDEPENDENT DIRECTOR. Baiqing Zhang has served on our Board of Directors since 2006. Mr. Zhang brings to us two decades of experience in the Chinese government’s regulatory and supervisory divisions. From 1997 until Mr. Zhang retired in 2005, Mr. Zhang served as Deputy Director, Division Chief of the Heilongjiang Regulatory Bureau of the China Securities Regulatory Commission, or CSRC, where he managed and imposed regulatory compliance for all Heilongjiang-based securities issuances, as well as supervised securities trading, investment funds and legal affairs. The CSRC is China’s primary regulatory body overseeing the country’s financial markets. Prior to this, he spent ten years as a member of the Discipline Inspection Committee in the Department of Supervision of the Heilongjiang Province, and previously was the Vice Principal of Hebei Institute of Mechanical and Electrical Technology, where he taught college courses. Since 2005, Mr. Zhang has been a consultant in the fields of law and economics, public policy, and business strategy. He also consults and lectures about regulatory issues in the Chinese securities markets, based on his significant experience at the CSRC. Mr. Zhang received a degree in Management of Economics from the Tianjin Normal University and a degree in Accounting from the Heilongjiang Economics Management Academy.

 

XIAOPENG XU–CHIEF OPERATING OFFICER. Xiaopeng Xu has served as Chief Operating Officer since March, 2010. Since July 2009, Mr. Xu was employed by the Company as general manager of manufacturing. Prior to joining the Company in 2009, Mr. Xu, has served in a number of senior positions in the pharmaceutical industry in China, including the General Manager of China National Pharmaceutical Industry Co., Ltd. from 2005 to 2006, Executive Deputy General Manager of Harbin Pharmaceutical Group Co., Ltd., (Shanghai Stock Exchange: 600664) from 2004 to 2005 and the Factory Director of Harbin Pharmaceutical Group General Industry Co., Ltd. from 1996 to 2004. Currently Mr. Xu also serves in the following capacity for the following entities: Independent Director of Heibei Aoxing Pharmaceutical Co., Inc. since August 2009, Independent Director of  Harbin Baida Pharmaceutical Co., Ltd. since 2005, Visiting Professor of Shenyang Pharmaceutical University since 2004, Vice Chairman of China Pharmaceutical Industry Association since 2002, and Vice Chairman of China Anesthetic Association since 2003 (both of the latter associations are industry oriented academic organizations). Mr. Xu graduated from Harbin CCP School in 1985 and completed graduate level programs in CEO courses from Tsinghua University in 2002.

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YAN GAO–CHIEF ACCOUNTING OFFICER. Yan Gao has served as Chief Accounting Officer since February 22, 2012. Prior to being appointed as CAO on February 22, 2012, Mr. Gao was an in-house senior accountant for the Company on the financial reporting team, preparing draft reports and responsible for overseeing financial management matters. He joined the Company in 2006 as the Financial Controller for Guangxi Lingfeng Pharmaceutical Ltd., a wholly owned subsidiary of the Company, and served as the General Manager of the Company's Finance Department in 2009, during which he was in charge of financial planning, cash flow management, internal control compliance, business consolidations and reporting. Mr. Gao graduated with a major in Accounting from Heilongjiang College with a professional certificate in 1994.

 

Legal Proceedings

 

In 2010 an individual named Haining Zhang sued the Company and certain of its officer(s)for breach of fiduciary duties . The Company and its officer(s) believed the claims were bogus and moved to petition the court to dismiss the case entirely. As of the filing date of this report, the case has not been established by the court.

 

After the reporting period, a complaint in the form of class action litigation was filed in the Federal District Court for the Central District of California by Kevin McGee against the Company and certain of its current and former officers and directors. Similar complaints were brought up by different plaintiff and representative law firms. However due to the identical nature of claims, i.e. alleging the Company in violation of Section 10(b) and 20(a) of the Exchange Act of 1934 and rules promulgated thereunder, the court on October 16, 2012 granted the motion of Richard Deutner and Itent EDV Dienstleistungs GmbH for appointment as lead plaintiff. The Company denies the allegations. No prediction can be made, however, as to the final outcome of the matter.

 

There is no known other legal proceedings against the Company.

 

BOARD LEADERSHIP STRUCTURE

 

The Board of Directors believes that Tony Liu’s service as both Chairman of the Board and Chief Executive Officer is in the best interest of the Company and its stockholders. Mr. Liu possesses detailed and in-depth knowledge of the issues, opportunities, and challenges facing AOB in the pharmaceutical industry, and is thus best positioned to develop agendas that ensure that the time and attention of our Board of Directors are focused on the most critical matters. His combined role enables decisive leadership, ensures clear accountability, and enhances AOB’s ability to communicate its message and strategy clearly and consistently to AOB’s stockholders, employees and customers.

 

Each of the directors other than Tony Liu, Jun Min, Lily Li is independent (see “Director Independence” below), and the Board of Directors believes that the independent directors provide effective oversight of management. The Board of Directors has not designated a lead director. Our independent directors call and plan their executive sessions collaboratively and, between Board of Directors meetings, communicate with management and one another directly.  In the circumstances, the directors believe that formalizing in a lead director functions in which they all participate might detract from rather than enhance performance of their responsibilities as directors.

 

BOARD’S ROLE IN RISK OVERSIGHT

 

The Board of Directors as a whole has responsibility for risk oversight, with reviews of certain areas being conducted by the relevant Board of Directors committees. These committees then provide reports to the full Board of Directors. The oversight responsibility of the Board of Directors and its committees is enabled by management reporting processes that are designed to provide visibility to the Board of Directors about the identification, assessment, and management of critical risks. These areas of focus include strategic, operational, financial and reporting, succession and compensation, compliance, and other risks. The Board of Directors and its committees oversee risks associated with their respective areas of responsibility, as summarized below.

     

CORPORATE GOVERNANCE

 

Board of Directors

 

We have six members serving on our Board of Directors. Each board member is nominated for election at our annual meeting to serve until the next annual meeting of shareholders and until their successors are duly elected and qualified.

 

Board Committees

 

The Board of Directors has a Compensation Committee, a Nominating and Corporate Governance Committee, a Disclosure Committee and an Audit Committee.

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Compensation Committee

 

The Compensation Committee was established on January 15, 2005.  The members of the Compensation Committee during 2011 were Cosimo J. Patti, Xianmin Wang, Lawrence S. Wizel and Eileen Brody. Ms. Brody served as the Chairperson of the Compensation Committee during 2011, until the Annual Meeting of Shareholders on December 28, 2011, when she decided not to stand for re-election to the Board of Directors. Mr. Wizel served as a member of the compensation committee until May 9, 2012, when he resigned. Each of these members is considered “independent” under Section 303A.02 of the listing standards of the New York Stock Exchange, as determined by our Board of Directors. The Compensation Committee operates under a written charter.

 

The Second Amended and Restated Compensation Committee Charter can be found on our website at www.bioaobo.com and can be made available in print free of charge to any shareholder who requests it.

 

The Compensation Committee assists the Board of Directors in determining the compensation of our Chief Executive Officer and makes recommendations to the Board of Directors with respect to the compensation of the Chief Financial Officer, other executive officers of the Company and the independent directors. The Compensation Committee administers our 2006 equity incentive plan, under the direction of the Board of Directors.  The Compensation Committee held two meetings during 2011.

 

Nominating and Corporate Governance Committee

 

The Nominating and Corporate Governance Committee was established on January 15, 2005. The purpose of the Nominating and Corporate Governance Committee is to assist the Board of Directors in identifying qualified individuals to become members of the Board of Directors, in determining the composition of the Board of Directors and in monitoring the process to assess the effectiveness of the Board of Directors. The Nominating and Corporate Governance Committee held one meeting during 2011.

 

The members of the Nominating and Corporate Governance Committee during 2011 were Cosimo J. Patti, Eileen Brody, Baiqing Zhang, Lawrence S. Wizel and Xianmin Wang. Mr. Wang served as the Chairperson of the Nominating and Corporate Governance Committee. Ms. Brody has decided not to stand for re-election to the Board of Directors and accordingly is no longer be a member of the Nominating and Corporate Governance Committee. Mr. Wizel served as the member of the Nominating and Corporate Governance Committee until May 9, 2012, when he resigned as the independent director. Each of the above-listed Nominating and Corporate Governance Committee members is considered “independent” under Section 303A.02 of the listing standards of the New York Stock Exchange, as determined by our Board of Directors. 

 

There have been no changes to the procedures by which the stockholders of the Company may recommend nominees to the Board of Directors since the filing of the Company’s Definitive Proxy Statement on November 18, 2011 for its Annual Meeting of Stockholders, which was held on December 28, 2011. The Nominating and Corporate Governance Committee operates under a written charter.  The Amended and Restated Nominating and Corporate Governance Committee Charter can be found on our website at www.bioaobo.com and can be made available in print free of charge to any shareholder who requests it.

    

The Nominating and Corporate Governance Committee and the Board believe that the leadership skills and other experiences of its Board members provide AOB with a range of perspectives and judgment necessary to guide AOB’s strategies and monitor their execution.

 

Tony Liu: Mr. Liu is the principal founder of our Company and he contributes to our Board of Directors his leadership skills and his vision of the direction of the development of the Company’s business in the future.  Mr. Liu accumulated his skills and experience over twenty years of business practice, and his continuous learning, including his recent award of a doctoral degree in business administration from Tarlac State University.

 

Jun Min: Mr. Min is one of our partner founders and he contributes to our Board of Directors his management skills and experience that he accumulated over twenty years while working in the private sector.

 

Yanchun Li: Ms. Li is one of our partner founders and she contributes to our Board of Directors her strategic thinking, and practical execution of major decisions by the Board of Directors.  Ms. Li has won several national awards for excellent business talents in China.

 

Cosimo J. Patti: Mr. Patti contributes to our Board of Directors his skills and experience that he had accumulated by working for companies such as Lehman Brothers and the New York Stock Exchange.

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Xianmin Wang: Mr. Wang contributes to our Board of Directors by leveraging his experience obtained when he worked in the capacity of deputy governor of Heilongjiang Province and the mayor of Daqing City.

 

Baiqing Zhang: Mr. Zhang contributes to our Board of Directors his overall business experience that he accumulated from his work for the regulatory body of the securities industry in China.

 

Disclosure Committee

 

The Disclosure Committee was established on May 21, 2012.  The members of the Disclosure Committee are designated by the Chief Executive Officer and/or the Chief Financial Officer. The initial members include the Chief Executive officer, the Chief Financial Officer, the Chief Operating Officer, the Chief Accounting Officer, the Chairman of the Audit Committee, the Vice President and Director, the General Manager of Human Resources, the Vice President of Research and Development, the General Manager of Auditing Center, the Director of Sales, and the General Manager of Public Relation. The Compensation Committee operates under a written charter.

 

The Disclosure Committee Charter can be found on our website at www.bioaobo.com and can be made available in print free of charge to any shareholder who requests it.

 

The Disclosure Committee assists the Company and our Chief Executive Officer and Chief Financial Officer in establishing, maintaining, reviewing and evaluating control and other procedures designed to ensure that information required to disclosed by the Company in its publicly filed reports, including, without limitation, reports required to be filed pursuant to the Securities Exchange Act of 1934, as amended is recorded, processed, summarized and reported within the time period(s) specified in applicable rules and forms. The Disclosure Committee holds regular meetings at least one each quarter prior to and in connection with the Company’s release of earnings results and, if applicable, its preparation of financial statements, annual or quarterly filings and proxy and information statement with the Security Exchange Commission.

 

The initial members of the Disclosure Committee are as follow:

 

Name Capacity
   
Lily Li  Chairperson, Chief Financial Officer
Tony Liu Chief Executive Officer
Jun Min Vice President and Director
Cosimo J. Patti   Chairman of the audit committee
Xiaopeng Xu Chief Operating Officer
Yan Gao     Chief Accounting Office
Ziyu Zhou General Manager of Human Resources
Sheng Jiang               Vice President of Research and Development
Jinli Tang                General Manager of Auditing Center
Yongxin Zhou    Director of Sales
Yanhong Liu               General Manager of Public Relations Department

 

 

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Audit Committee

 

The Audit Committee operates under a written charter.  The Charter of the Audit Committee can be found on our website at www.bioaobo.com and can be made available in print free of charge to any shareholder who requests it.

 

 The Audit Committee’s charter states that the responsibilities of the Audit Committee shall include, among other things:

 

  reviewing the Audit Committee’s charter;
     
  reviewing the Company’s annual report to stockholders and reports submitted to the SEC;
     
  naming the Company’s independent auditors, confirming and reviewing their independence, and approving their fees;
     
  reviewing the independent auditors’ performance;
     
  considering the independent auditors’ judgments about the Company’s accounting principles;
     
  considering and approving major changes to the Company’s auditing and accounting principles;
     
  establishing reporting systems to the committee by management and the independent auditors regarding management’s significant judgments in preparing financial statements;
     
  following an audit, reviewing significant difficulties encountered during the audit;
     
  reviewing significant disagreements among management and the independent auditors in the preparation of the Company’s financial statements;
     
  reviewing the extent to which improvements in financial or accounting practices approved by the committee have been implemented;
     
  review with counsel any legal matters that could have a significant impact on the Company’s financial statements; and
     
  review all Company transactions, in which any related person may have a direct or indirect material interest.

   

The Audit Committee met four times during 2011.  Pursuant to its charter, the Audit Committee meets at least quarterly with the Company’s internal auditors.  The Company does not limit the number of audit committees of other companies on which its Audit Committee members can serve.

 

The members of the Audit Committee during 2011 were Cosimo Patti, Eileen Brody and Lawrence S. Wizel. Mr. Wizel served as the Chairperson of the Audit Committee. He served as the Chairperson until May 9, 2012 when he resigned as the independent director of the Board of Director. Ms. Brody has decided not to stand for re-election to the Board of Directors and accordingly is no longer be a member of the Audit Committee. Each of these members is considered “independent” under Section 303A.02 of the listing standards of New York Stock Exchange, as determined by our Board of Directors. The Audit Committee performs each of its responsibilities as outlined in its charter.

 

Our Board of Directors has determined that we have at least one audit committee financial expert, as defined in the Exchange Act, serving on our Audit Committee. Lawrence S. Wizel was the “audit committee financial expert” and was an independent member of our Board of Directors until May 9, 2012. Mr. Patti is the Chairperson of the Audit Committee, the “audit committee financial expert” and an independent member of our Board of Directors.

 

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REPORT OF THE AUDIT COMMITTEE (1)

The role of the Audit Committee is to assist the Board of Directors in its oversight of the Company’s financial reporting process.  The Board of Directors, in its business judgment, has determined that all members of the committee are “independent”. The Audit Committee operates pursuant to a Charter that was approved by the Board. As set forth in the Charter, management of the Company is responsible for the preparation, presentation and integrity of the Company’s financial statements, accounting and financial reporting principles and internal controls and procedures designed to assure compliance with accounting standards and applicable laws and regulations. The independent auditors are responsible for auditing the Company’s financial statements and expressing an opinion as to their conformity with generally accepted accounting principles. 

 

In the performance of the oversight of the Company’s financial reporting process, the Audit Committee has reviewed and discussed the audited financial statements with management, the internal auditors and the independent auditors. The Audit Committee has discussed with the independent auditors the matters required to be discussed by Statement of Auditing Standards No. 61, Communication with Audit Committee, as amended, as adopted by the Public Company Accounting Oversight Board (“PCAOB”) in Rule 3200T.

 

Finally, the Audit Committee has received written disclosures and the letter from the independent auditors, as required by applicable requirements of the PCAOB regarding the independent accountant’s communications with the Audit Committee concerning independence, and has discussed with the independent accountant the independent accountant’s independence. 

 

Members of the Audit Committee rely without independent verification on the information provided to them and on the representations made by management and the independent accountants. Accordingly, the Audit Committee’s oversight does not provide an independent basis to determine that management has maintained appropriate accounting and financial reporting principles or appropriate internal control and procedures designed to assure compliance with accounting standards and applicable laws and regulations. Furthermore, the Audit Committee’s consideration and discussions referred to above do not assure that the audit of the Company’s financial statements has been carried out in accordance with generally accepted accounting principles or that the Company’s auditors are in fact “independent.” 

 

Based upon the reports, review and discussions described in this report, and subject to the limitations on the role and responsibilities of the Audit Committee referred to above and in the Charter, the Audit Committee recommended to the Board that the audited financial statements as of and for the year ended December 31, 2011 be included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, as filed with the SEC.   

 

THE AUDIT COMMITTEE

Cosimo Patti (Chairman)

_____________

 (1) The material in the Audit Committee report is not soliciting material, is not deemed filed with the SEC and is not incorporated by reference in any filing of the Company under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this proxy statement and irrespective of any general incorporation language in such filing.

 

EXECUTIVE SESSIONS

 Under the NYSE Rules, our non-management directors are required to hold regular executive sessions. The chairperson of the executive session will rotate at each session so that each non-management director shall have an opportunity to serve as chairperson. Interested parties may communicate directly with the presiding director of the executive session or with the non-management directors as a group, by directing such written communication to Mr. Larry S. Wizel at c/o American Oriental Bioengineering, Inc., 211 Warren Street Suite 219, Newark, NJ 07103.

PROCESS FOR SENDING COMMUNICATIONS TO THE BOARD OF DIRECTORS

 

The Board of Directors maintains a process for stockholders to communicate with the Board of Directors.  Stockholders wishing to communicate with the Board of Directors or any individual director (including the director who presides at executive sessions of non-management or independent directors or with those directors as a group) must mail a communication addressed to the Secretary of the Company, c/o American Oriental Bioengineering, Inc., 211 Warren Street Suite 219, Newark, NJ 07103.  Any such communication must state the number of shares of Common Stock beneficially owned by the stockholder making the communication.  All of such communications will be forwarded to the full Board of Directors or to any individual director or directors to whom communication is directed unless the communication is clearly of a marketing nature or is inappropriate, in which case we have the authority to discard the communication or take appropriate legal action regarding the communication.

60
 

 

CODE OF ETHICS

 

We adopted a code of ethics that applies to our directors, officers and employees, including our Chief Executive Officer and Chief Financial Officer, and other persons who perform similar functions. A written copy of the code can be found on our website at www.bioaobo.com and can be made available in print to any shareholder upon request at no charge by writing to our Secretary, c/o American Oriental Bioengineering, Inc., 211 Warren Street Suite 219, Newark, NJ 07103.  Our Amended and Restated Code of Ethics is intended to be a codification of the business and ethical principles which guide us, deter wrongdoing, promote honest and ethical conduct, avoid conflicts of interest, and foster full, fair, accurate, timely and understandable disclosures, compliance with applicable governmental laws, rules and regulations, the prompt internal reporting of violations and accountability for adherence to this code.

 

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

 

There are no transactions, since January 1, 2010 the beginning of the Company’s last fiscal year, or any currently proposed transactions, in which the Company was or is to be a participant and in which any related person had or will have a direct or indirect material interest.  It is the Company’s policy that the Company will not enter into any related party transactions unless the Audit Committee or another independent body of the Board of Directors first reviews and approves the transactions.

 

SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

 

Section 16(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), requires the executive officers and directors of the Company and every person who is directly or indirectly the beneficial owner of more than 10% of any class of security of the Company to file reports of ownership and changes in ownership with the SEC.  Such persons also are required to furnish our company with copies of all Section 16(a) forms they file.  Based solely on our review of copies of such forms received by us, we believe that during the fiscal year 2011, all of the executive officers and directors of the Company and every person who is directly or indirectly the beneficial owner of more than 10% of any class of security of the Company complied with the filing requirements of Section 16(a) of the Exchange Act. 

 

Name   Number of Reports
Not Filed Timely
  Number of Transactions
Not Reported Timely
 –    
         

  

ITEM 11. EXECUTIVE COMPENSATION

 

The Company’s executive compensation program for the named executive officers (NEOs) is administered by the Compensation Committee of the Board of Directors. 

 

Compensation Objectives

 

We believe that the compensation programs for the Company’s NEOs should reflect the Company’s performance and the value created for the Company’s shareholders. In addition, the compensation programs should support the short-term and long-term strategic goals and values of the Company, and should reward individual contributions to the Company’s success. Our compensation plans are consequently designed to link individual rewards with Company’s performance by applying objective, quantitative factors including the Company’s own business performance and general economic factors. We also rely upon subjective, qualitative factors such as technical expertise, leadership and management skills, when structuring executive compensation in a manner consistent with our compensation philosophy.

 

Process for Determining Compensation for Executives

 

The Compensation Committee makes independent decisions about all aspects of NEO compensation, and takes into account (i) recommendations from our CEO with respect to the compensation of NEOs other than himself, and (ii) information that our Human Resources department provides regarding compensation data.

 

The Compensation Committee regularly reviews the design and structure of the Company’s compensation programs to ensure that management’s interests are closely aligned with shareholders’ interests and that the compensation programs are designed to further the Company’s strategic priorities.   

 

61
 

 

Elements of Compensation

 

Base Salary. Base salaries for the named executive officers are set forth in their respective employment agreements.

 

However, the Compensation Committee considers proposals from the Company’s management to approve increases to the base salaries for named executive officers other than our CEO. When considering whether to approve these adjustments, the Compensation Committee takes into account a number of factors, including:

   

the Company’s performance;

   

the individual’s current and historical performance and contribution to the Company; and

   

the individual’s role and unique skills.

   

Base salaries are reviewed annually, and may be increased to align salaries with market levels after taking into account the subjective evaluation described previously. The Company did not benchmark the compensation paid to its executives for 2011 and the Compensation Committee did not take into account compensation data and benchmarks for comparable positions and companies. On April 10, 2011, the Compensation Committee met and reviewed the compensation package for each executive and determined, after taking into account the capital requirements of the business and the then current economic situation, that the salary base compensation for the executives which were carried over from 2008 to 2010 (with one slight adjustment), continued to be competitive and, therefore, no salary increase for the year ended December 31, 2011 was warranted.

 

Annual Cash Incentive Bonuses. The Company has a cash incentive bonus program for NEOs. The cash bonus is determined by the Company’s compensation committee and is performance based.  

The program is designed to promote executive decision making and achievement that supports the realization of key overall Company financial goals. For the year 2011, the participants in the Company’s cash incentives program consisted of each of the Company’s six NEOs.

 

In 2011, executives had target bonus opportunities ranging from 0% to 100% of base salary earnings, depending on position level and responsibility, with larger bonus opportunities provided to those with greater responsibility. The Compensation Committee establishes the guidelines under which the plan is administered, including financial performance goals and payout schedules.

 

The goals reflect the Company’s performance using performance measures of revenues and operating income margin.

 

The program provides payouts based on different levels of achievement:

 

The NEOs, excluding Yang Yang, our Chief Marketing Officer, will receive 100% of bonus when either one of the following targets is met:

 

1.The revenues for 2011 increase no less than 5% compared with 2010, or equal or above US$321.2 million.
2.The operating income margin for 2011 is higher than 2010, or above 10%.

 

For Yang Yang, our Chief Marketing Officer, the bonus payout ratio is as follows:

 

1.If the revenue for 2011 increases less than 5% compared with 2010, or less than US$321.2 million, no bonus will be earned.
2.If the revenue for 2011 increases more than 5% compared with 2010, or equal to or more than US$321.2 million, 100% bonus will be earned.
3.Additional RMB 500,000 (US$75,990) will be added to the bonus pool if the revenues for 2011 increase above 6%, and will be paid on the following condition:

 

(1)The revenues for 2011 increase between 6% and 10%, 120% bonus payout;
(2)The revenues for 2011 increase between 11% and 15%, 140% bonus payout;
(3)The revenues for 2011 increase between 16% and 20%, 160% bonus payout;
(4)The revenues for 2011 increase between 21% and 25%, 180% bonus payout;
(5)Maximum: the revenues for 2011 increase above 26%, 200% bonus payout.

 

Since the Company did not meet its performance target for 2011, no cash bonuses will be paid for this period.

 

62
 

 

Equity Incentive Compensation. We believe that long-term performance is achieved through an ownership culture participated in by our executive officers through the use of stock-based awards. Currently, we do not maintain any incentive compensation plans based on pre-defined performance criteria. The Compensation Committee has the general authority, however, to award equity incentive compensation, i.e. stock options and restricted stock awards to our executive officers in such amounts and on such terms as the committee determines in its sole discretion.

 

The Compensation Committee does not have a determined formula for determining the number of options available to be granted. The Compensation Committee will review each executive’s individual performance and his or her contribution to our strategic goals periodically. With the exception of stock options and restricted stock awards automatically granted at the end of each fiscal quarter in accordance with the terms of the employment agreement with our executive officers, our Compensation Committee grants equity incentive compensation at times when we do not have material non-public information to avoid timing issues and the appearance that such awards are made based on any such information.

 

The Compensation Committee carefully monitors our executive compensation programs. Although it has been our general objective to provide our NEOs with total annual compensation near the median of the range of salaries for executives in similar positions with similar responsibilities at comparable companies, we have also balanced this goal with the overall global market conditions and performance of the Company and to that end decrease levels of compensation during 2011.

 

The respective total aggregate equity based compensation granted to each of our executive officers for the current fiscal year is lower than the aggregate value of the equity based compensation for the year ended December 31, 2010. In 2011, the equity compensation described below consisted of restricted shares to each executive. The Compensation Committee determined that it would be more prudent and attractive to executives, in light of the decreasing salaries for the 2011 fiscal year, that the Company issue to the executives restricted shares having the lower aggregate equity compensation value as for the year ended December 31, 2010. With the issuance of restricted shares instead of stock options, a greater amount of shares would continue to be available under the Company’s Stock Option Plan. At the time of the award, because of the significant volatility in the marketplace and in particular the Company’s stock price, the Black Scholes calculation abnormally increased the stock option value beyond the normal inherent value thus issuing all stock options to executives would have been potentially less attractive.

 

Risk Analysis of Our Compensation Plans

 

The Compensation Committee has reviewed our compensation policies as generally applicable to our NEOs and believes that our policies do not encourage excessive and unnecessary risk-taking, and that the level of risk that they do encourage is not reasonably likely to have a material adverse effect on the Company. The design of our compensation policies and programs encourage our NEOs to remain focused on both the short-and long-term goals of the Company. For example, while our cash bonus plans measure performance on an annual basis, our equity awards typically vest over a number of years, which we believe encourages our NEOs to focus on sustained stock price appreciation, thus limiting the potential value of excessive risk-taking. The Compensation Committee believes that the balance of long-term equity incentive, short-term cash incentive bonus and base salary appropriately balances both the short and long term performance goals of the Company without encouraging excessive risk related behavior. While the Compensation Committee regularly evaluates its compensation programs, the Compensation Committee believes that its current balance of incentives both adequately compensates its NEOs and does not promote excessive risk taking.

 

63
 

 

Summary Compensation Table

 

The following table sets forth all cash compensation paid or to be paid by the Company, as well as certain other compensation paid or accrued, for each of the last three years of our company to each named executive officer.

 

Name and Principal Position   Year  

Salary  

($) (1)

 

Bonus

 ($) (2)

 

Stock

Awards

 ($) (3)

 

Option

 Awards

 ($) (3)

 

All Other

Compensation

 ($)

 

Total

 ($)

 
                                           
Tony Liu,    2011     200,000         376,600             576,600  
CEO and Chairman    2010     200,000         538,000             738,000  
     2009     200,000         377,541     160,459         738,000  
                                           
Yanchun Li,    2011     160,000         332,640             492,640  
CFO, Director    2010     160,000         475,200             635,200  
     2009     160,000         333,472     141,728      –     635,200  
                                           
Jun Min,    2011     120,000         249,480             369,480  
VP, Director    2010     120,000         356,400             476,400  
     2009     120,000         250,104     106,296      –     476,400  
                                           
Binsheng Li,    2011     80,000         205,520             285,520  
Former Chief Accounting officer, former Director(4)    2010     80,000         293,600             373,600  
     2009     80,000         206,034     87,566      –     373,600  
                                           
Yang Yang,    2011     152,756         152,756             305,512  
Chief Marketing Officer(5)    2010     146,297         146,297             292,594  
     2009                          
                                           
Xiaopeng Xu,    2011     76,378         76,378             152,756  
Chief Operating Officer(5)    2010     51,204         51,204             102,408  
     2009                          

________

(1)The amounts reported in this column represent base salaries paid to each of the named executive officers for 2011 as provided for in their respective employment agreements.

(2)The named executive officers did not receive any discretionary bonuses, sign-on bonuses, or other annual bonus payments that are not contingent on the achievement of stipulated performance goals. Cash bonus payments are contingent on achieving pre-established and communicated goals.

(3)Stock and option awards amounts shown in this table represent the grant date fair value computed in accordance with FASB ASC 718.
(4)Binsheng Li’s position as the Chief Accounting Officer has been terminated in November, 2011; Binsheng Li has decided not to stand for re-election to the Board of Directors and accordingly he is no longer a director since December 28, 2011.
(5)Yang Yang and Xiaopeng Xu s’ compensation was paid to or received in Chinese Yuan Renminbi (RMB), for which the Company used an exchange rate of US$1.00=RMB6.8354 for 2010, US$1.00=RMB6.5464 for 2011 to convert the RMB amount to US dollar amount, which rate is the interbank exchange rate on the Board Approve date.

 

Employee Equity Incentive Plan

 

In March 2004, our Board of Directors formally adopted a Stock Option Plan (the “2004 Plan”). Under the 2004 Plan, we were authorized to grant non-qualified options to purchase up to 2,900,000 shares of our common stock to our employees, officers, directors and consultants. The 2004 Plan was administered directly by our Compensation Committee. Subject to the provisions of the 2004 Plan, the Compensation Committee determined who would receive stock options, the number of shares of common stock that may be covered by the option grants, the time and manner of exercise of options and exercise prices, as well as any other pertinent terms of the options. The Company replaced the 2004 Plan with a new Equity Incentive Plan that was adopted by the Board and approved by the Shareholders in 2006 (“2006 Plan”). The 2006 Plan provides a maximum of 5,000,000 shares for future grants but the Company is not intended to grant more than 1,000,000 shares in one calendar year. The Company will not grant any additional awards under the 2004 Plan. All Awards starting from 2007 would be granted under the 2006 Plan. Those individuals with awards outstanding under the 2004 Plan will continue to hold such awards in accordance with the terms of their respective grant agreements.

 

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As of December 31, 2011, the Company granted an aggregate of 1,810,302 option and restricted stock under the 2006 Plan. For the year ended December 31, 2011, 351,409 restricted stocks were granted to the executive officers. In 2011, the Company granted the following restricted stock to the NEO’s pursuant to the 2006 Plan:

  

2011 Grants of Plan-Based Awards Table

 

Name  

Grant

 Date

 

Estimated Future

 Payouts Under

 Equity Incentive

 Plan Awards

 (Target) (#)(1)

 

Exercise or

 Base Price

 of Option

 Awards

 ($ /Sh) (2)

 

Closing

 Price on

 Grant

 Date

 ($ /Sh)

 

Grant Date

Fair Value

 Of Stock

Awards

($/Sh)

 

 Grant Date

 Fair Value

 of Option

 Awards

 ($ /Sh)

Tony Liu   4/10/11   110,765     3.40   376,600  
Yanchun Li   4/10/11   97,836     3.40   332,640  
Jun Min   4/10/11   73,377     3.40   249,480  
Binsheng Li   4/10/11   60,447     3.40   205,520  
Yang Yang   4/10/11   44,928     3.40   152,756  
Xiaopeng Xu   4/10/11   8,986     3.40   30,551  

________

(1)Represents the number of shares and stock options granted in 2011 under the Company’s 2006 Plan. These shares and stock options vest and become exercisable ratably in five equal annual installments beginning one year after the grant date.
(2)Represents the exercise price for the stock options granted, which was closing price on the date of the grant.

 

Employment Agreements

 

On April 10, 2011, we entered into employment agreements with Tony Liu, our Chairman and Chief Executive Officer, Yanchun Li, our Chief Financial Officer, Jun Min, our Vice President and Yang Yang, our Chief Marketing Officer. Tony Liu, Yanchun Li and Jun Min are also directors of the Company.

 

Tony Liu’s employment agreement has a term of one year, effective as of April 10, 2011, and provides for an annual base salary of $200,000, subject to subsequent annual review by the Company’s Compensation Committee. The term of his agreement shall be automatically renewed for another year, unless a written notice is given by either party of an intention not to renew the agreement no later than 90 days prior to the expiration of the term. The agreement also provides for grant of a stock award of 110,765 shares.  The stock are awarded under the Company’s 2006 Equity Incentive Plan and will vest ratably over a five year period, subject to Mr. Liu’s continued employment with the Company on each vesting date. Mr. Liu is also entitled to an annual performance based bonus of up to US$40,000 based upon the Company’s performance. Such amount may be increased if the Company exceeds certain net income targets for the year, or may be decreased if the net income targets are not met. We can terminate Mr. Liu’s employment with cause or without cause pursuant to a decision by our Board of Directors. In the event Mr. Liu’s employment is terminated without cause, he will be eligible to receive monthly payments at his then applicable monthly base salary for the rest of his term from the date of termination of the employment.

 

Lily Li’s employment agreement has a term of one year, effective as of April 10, 2011, and provides for an annual base salary of $160,000, subject to subsequent annual review by the Company’s Compensation Committee. The term of her agreement shall be automatically renewed for another year, unless a written notice is given by either party of an intention not to renew the agreement no later than 90 days prior to the expiration of the term. The agreement also provides for grant of a stock award of 97,836 shares.  The stock are awarded under the Company’s 2006 Equity Incentive Plan and will vest ratably over a five year period, subject to Ms. Li’s continued employment with the Company on each vesting date. Ms. Li is also entitled to an annual performance based bonus of up to US$30,000 based upon the Company’s performance and such amount may be increased if the Company exceeds certain net income targets for the year, or may be decreased if the net income targets are not met. We can terminate Ms. Li’s employment with cause or without cause pursuant to a decision by our Board of Directors. In the event Ms. Li’s employment is terminated without cause, she will be eligible to receive monthly payments at her then applicable monthly base salary for the rest of her term from the date of termination of her employment.   

   

Jun Min’s employment agreement has a term of one year, effective as of April 10, 2011, and provides for an annual base salary of $120,000, subject to subsequent annual review by our Board of Directors. The term of his agreement shall be automatically renewed for another year, unless a written notice is given by either party of an intention not to renew the agreement no later than 90 days prior to the expiration of the term. The agreement also provides for grant of a stock award of 73,377  shares. The stock are awarded under the Company’s 2006 Equity Incentive Plan and will vest ratably over a five year period, subject to Mr. Min’s continued employment with the Company on each vesting date. Mr. Min is also entitled to an annual performance based bonus of up to US$30,000 based upon the Company’s performance and such amount may be increased if the Company exceeds certain net income targets for the year, or may be decreased if the net income targets are not met. We can terminate Mr. Min’s employment with cause or without cause pursuant to a decision by our Chief Executive Officer. In the event Mr. Min’s employment is terminated without cause, he will be eligible to receive monthly payments at his then applicable monthly base salary for the rest of his term from the date of termination of the employment.

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Xiaopeng Xu’s employment agreement has a term of one year, effective as of April 10, 2011, and provides for an annual base salary of RMB 500,000(equal to US$76,378), subject to subsequent annual review by our Board of Directors. The term of his agreement shall be automatically renewed for another year, unless a written notice is given by either party of an intention not to renew the agreement no later than 90 days prior to the expiration of the term. The agreement also provides for grant of a stock award of 8,986 shares. The stock are awarded under the Company’s 2006 Equity Incentive Plan and will vest ratably over a five year period, subject to Mr. Xu’s continued employment with the Company on each vesting date. Mr. Xu is also entitled to an annual performance based bonus of up to RMB 300,000 (US$45,827) based upon the Company’s performance and such amount may be increased if the Company exceeds certain net income targets for the year, or may be decreased if the net income targets are not met. We can terminate Mr. Xu’s employment with cause or without cause pursuant to a decision by our Chief Executive Officer. In the event Mr. Xu’s employment is terminated without cause, he will be eligible to receive monthly payments at his then applicable monthly base salary for the rest of his term from the date of termination of the employment.

 

Binsheng Li’s employment agreement has a term of one year, effective as of April 10, 2011, and provides for an annual base salary of $80,000, subject to subsequent annual review by our Board of Directors. The term of his agreement shall be automatically renewed for another year, unless a written notice is given by either party of an intention not to renew the agreement no later than 90 days prior to the expiration of the term. The agreement also provides for grant of a stock award of 60,447 shares. The stock are awarded under the Company’s 2006 Equity Incentive Plan and will vest ratably over a five year period, subject to Mr. Li’s continued employment with the Company on each vesting date. Mr. Li is also entitled to an annual performance based bonus of up to US$20,000 based upon the Company’s performance and such amount may be increased if the Company exceeds certain net income targets for the year, or may be decreased if the net income targets are not met. We can terminate Mr. Li’s employment with cause or without cause pursuant to a decision by our Chief Executive Officer. In the event Mr. Li’s employment is terminated without cause, he will be eligible to receive monthly payments at his then applicable monthly base salary for the rest of his term from the date of termination of the employment.

 

Yang Yang’s employment agreement has a term of one year, effective as of April 10, 2011, and provides for an annual base salary of RMB 1,000,000(equal to US$152,756), subject to subsequent annual review by our Board of Directors. The term of his agreement shall be automatically renewed for another year, unless a written notice is given by either party of an intention not to renew the agreement no later than 90 days prior to the expiration of the term. The agreement also provides for grant of a stock award of 44,928 shares. The stock are awarded under the Company’s 2006 Equity Incentive Plan and will vest ratably over a five year period, subject to Mr. Yang’s continued employment with the Company on each vesting date. Mr. Yang is also entitled to an annual performance based bonus of up to RMB 500,000 (US$76,378) based upon the Company’s performance and such amount may be increased if the Company exceeds certain net income targets for the year, or may be decreased if the net income targets are not met. We can terminate Mr. Yang’s employment with cause or without cause pursuant to a decision by our Chief Executive Officer. In the event Mr. Yang’s employment is terminated without cause, he will be eligible to receive monthly payments at his then applicable monthly base salary for the rest of his term from the date of termination of the employment. Effective February 22, 2012, Mr. Yang ’s resignation from his position as Chief Marketing Officer of the Company was officially accepted by the Board. Mr. Yang resigned in order to pursue other personal interest.

 

Potential Payments upon Termination or Change in Control

 

Assuming the employment of our named executive officers were to be terminated without cause or for good reason, as of December 31, 2011, the following individuals would have been entitled to payments in the amounts set forth opposite to their name in the below table through April 10, 2012:

 

Cash Payments      
Tony Liu   $ 66,667  
Yanchun Li     53,333  
JunMin     40,000  
Xiaopeng Xu     25,459  

    

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2011 Outstanding Equity Awards at Year-end

 

    Option Awards   Stock Awards  
   

Number of

Securities

Underlying

Unexercised

Options

(#)

 

Number of

Securities

Underlying

Unexercised

Options

(#)

 

Equity

Incentive

Plan Awards:

Number of

Securities

Underlying

         

 

Number of

Shares or

 

 

Market Value of

Shares or

 
Name   Exercisable   Unexercisable  

Unexercised

Unearned

Options

(#)

 

Option

 Exercise

 Price

 ($)

 

Option

 Expiration

 Date

 

Units of

Stock That

Have Not

Vested (#)

 

Units of

Stock That

Have Not

Vested ($)

 
Tony Liu   80,000   20,000   100,000   21.48   4/20/2017    –    –  
Tony Liu   33,555   22,370   55,925   16.7   4/20/2018    –    –  
Tony Liu   12,156   18,234   30,390   8.02   4/10/2019   18,830   151,017  
Tony Liu                       51,855   430,398  
Tony Liu                       110,765   376,599  
Yanchun Li   64,000   16,000   80,000   21.48   4/20/2017    –    –  
Yanchun Li   29,638   19,759   49,397   16.70   4/20/2018    –    –  
Yanchun Li   10,737   16,106   26,843   8.02   4/10/2019   16,632   133,389  
Yanchun Li                       45,803   380,161  
Yanchun Li                       57,253   332,640  
Jun Min   48,000   12,000   60,000   21.48   4/20/2017    –    –  
Jun Min   22,229   14,819   37,048   16.70   4/20/2018    –    –  
Jun Min   8,053   12,079   20,132   8.02   4/10/2019   12,474   100,041  
Jun Min                       34,352   285,122  
Jun Min                       73,377   249,480  
Binsheng Li   32,000   8,000   40,000   21.48   4/20/2017    –      
Binsheng Li   18,312   12,208   30,520   16.70   4/20/2018    –      
Binsheng Li   6,634   9,951   16,585   8.02   4/10/2019   10,276   82,414  
Binsheng Li    –    –    –    –    –   28,299   234,882  
Binsheng Li    –    –    –    –    –   60,447   205,520  
Yang Yang      –    –    –    –    –    –  
Yang Yang    –    –    –    –    –    –    –  
Yang Yang    –    –    –    –    –    –    –  
Xiaopeng Xu    –    –    –    –    –   4,935   40,961  
Xiaopeng Xu    –    –    –    –    –   8,986   30,551  

 

Option Exercises and Stock Vested During 2011

 

    Option Awards  
   

Number of

Shares Acquired

on Exercise (#)

   

Value Realized on

Exercise ($)

 
Tony Liu            
Yanchun Li            
Jun Min            
Binsheng Li            

 

Compensation of Independent Directors for 2011

 

The annual retainer is paid to the independent directors in monthly installments in arrears. An independent director is entitled to receive each year shares of Common Stock with an aggregate value range from $50,000 to $63,000 per annum, calculated based on the average closing price per share for the five (5) trading days preceding and including the date of grant. The equity award to independent directors is awarded at the beginning of each year for service rendered for the preceding year. The Company allows each independent director to elect to take stock awards instead of cash compensation. The Company reimburses its independent directors for reasonable travel expenses to attend Board and Committee meetings.

 

The following table sets forth all compensation paid or to be paid by AOB, as well as certain other compensation paid or accrued, for each of the independent directors for 2011.

67
 

  

Name  

Fees Earned or

Paid in Cash

($)

 

Stock Awards

($) (4)

 

Option Awards

($) (4)

 

Non-Equity

Incentive Plan

Compensation

($)

 

Change in

Pension

Value and

Nonqualified

Deferred

Compensation

Earnings ($)

 

All Other

Compensation

($)

 

Total

($)

 
Cosimo J. Patti   50,000     50,000  (1)                 100,000  
Xianmin Wang   50,000     50,000  (1)                  100,000  
Eileen Brody   50,000     55,000  (2)                 105,000  
Lawrence S Wizel   50,000     63,000  (3)                 113,000  
Baiqing Zhang   50,000     50,000  (1)                 100,000  

________

(1)24,829 shares of common stock to be issued were outstanding for each of the independent directors as of January 1, 2012.
(2)27,191 shares of common stock to be issued were outstanding as of January 1, 2012.
(3)30,569 shares of common stock to be issued were outstanding as of January 1, 2012.
(4)For awards of stock and option, the aggregate grant date fair value computed in accordance with FASB ASC 718.

 

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

 

Members of our Compensation Committee of the Board of Directors during 2011were Ms. Brody and Messrs. Patti, Wizel and Wang. No member of our Compensation Committee was, or has been, an officer or employee of the Company or any of our subsidiaries. No member of the Compensation Committee has a relationship that would constitute an interlocking relationship with executive officers or directors of the Company or another entity.

 

COMPENSATION COMMITTEE REPORT (1)

 

The Compensation Committee has reviewed and discussed the discussion and analysis of the Company’s compensation which appears above with management, and, based on such review and discussion, the Compensation Committee recommended to the Company’s Board of Directors that the above disclosure be included in this Annual Report on Form 10-K.

 

THE COMPENSATION COMMITTEE

 

CosimoJ.Patti (Chair)

Xianmin Wang

 

                                                                         

(1)The material in the Compensation Committee report is not soliciting material, is not deemed filed with the SEC and is not incorporated by reference in any filing of the Company under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this Form 10-K and irrespective of any general incorporation language in such filing.
68
 

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

 

The following table sets forth certain information regarding beneficial ownership of common stock as of December 14, 2012 by each person known to us to own beneficially more than 5% of our common stock, each of our directors, each of our named executive officers; and all executive officers and directors as a group.

 

Title of Class   Name and Address of Beneficial Owner (1)  

Amount and Nature of

Beneficial Ownership (2)

   

Percent of 

Class (3)

 
Series A Preferred Stock   Tony Liu     1,000,000  (4)   100.0%  
Common Stock   Tony Liu     7,393,593  (5)   20.3%  
Common Stock   Yanchun Li     545,564  (6)   1.5%  
Common Stock   Jun Min     577,527  (7)   1.6%  
Common Stock   Cosimo J. Patti     20,422     *  
Common Stock   Xianmin Wang     31,633     *  
Common Stock   Baiqing Zhang     20,474     *  
Common Stock   Xiaoliang Wang     2,919     *  
Common Stock   XiaopengXu     1,234     *  
    Total Ownership of Common Stock by All Directors and Officers as a Group     8,593,366     23.6%  

________

(1)Unless otherwise indicated, the address for all named executive officers, directors and shareholders is c/o American Oriental Bioengineering, Inc., 1 Liangshuihe First Ave, Beijing E-Town Economic and Technology Development Area, E-Town, Beijing, 100176, People’s Republic of China.
(2)The amount of beneficial ownership includes the number of shares of Common Stock and/or Series A Preferred Stock, plus, in the case of each of the executive officers and directors and all officers and directors as a group, all shares issuable upon the exercise of the options held by them, which were exercisable as of December 14, 2012 or within 60 days thereafter. Pursuant to Rule 13d-3 under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”) and the rules promulgated by the SEC, every person who has or shares the power to vote or to dispose of shares of common stock are deemed to be the “beneficial owner” of all the shares of common stock over which any such sole or shared power exists.
(3)Based upon 36,421,610 shares outstanding as of December 14, 2012.
(4)Through his Common Stock and Series A Preferred Stock ownership, currently, Mr. Liu has voting power equal to approximately 40.2% of our voting securities.
(5)Includes 162,974 shares of common stock issuable upon exercise of options.
(6)Includes 135,623 shares of common stock issuable upon exercise of options.
(7)Includes 101,718 shares of common stock issuable upon exercise of options.

 

Changes in Control

 

None.

 

69
 

 

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

 

There were no transactions, since January 1, 2010, the beginning of the Company’s last fiscal year in which the Company was or is to be a participant and in which any related person had or will have a direct or indirect material interest. It is the Company’s policy that the Company will not enter into any related party transactions unless the Audit Committee or another independent body of the Board of Directors first reviews and approves the transactions.   

 

Director Independence

 

A majority of the directors must be independent directors under Section 303A.01 of the listing standard of NYSE. Section 303A.02 of the NYSE listing standards provide that no director can qualify as independent unless the Board affirmatively determines that the director has no material relationship with the listed company. The Board has adopted the following standards in determining whether or not a director has a material relationship with the Company and these standards are:

 

No director who is an employee or a former employee of the Company can be independent until three years after termination of such employment.

 

No director who is, or in the past three years has been, affiliated with or employed by the Company’s present or former independent auditor can be independent until three years after the end of the affiliation, employment or auditing relationship.

 

No director can be independent if he or she is, or in the past three years has been, part of an interlocking directorship in which an executive officer of the Company serves on the compensation committee of another company that employs the director.

 

No director can be independent if he or she is receiving, or in the last three years has received, more than $120,000 during any 12-month period in direct compensation from the Company, other than director and committee fees and pension or other forms of deferred compensation for prior service (provided such compensation is not contingent in any way on continued service).

 

Directors with immediate family members in the foregoing categories are subject to the same three-year restriction.

 

No director can be independent if he or she is a current employee, or an immediate family member is a current executive officer, of a company that has made payments to, or received payments from, AOB for property or services in an amount which, in any of the last three fiscal years, exceeds the greater of $1 million, or 2% of such other company’s consolidated gross revenues.

 

Based on these independence standards and all of the relevant facts and circumstances, the Board determined that none of the following directors had any material relationship with the Company and, thus, are independent under Section 303A.02 of the listing standards of NYSE: Ms. Brody, and Messrs. Patti, Wang, Wizel and Zhang. In accordance with New York Stock Exchange rules a majority of our Board of Directors is independent.

 

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

   

Audit Fees

 

The aggregate fees for each of the last two fiscal years for professional services rendered by the principal accountant for our audits of our annual financial statements and interim reviews of our financial statements included in our fillings with Securities and Exchange Commission on Form 10-Ks and 10-Qs services that are normally provided by the accountant in connection with statutory and regulatory filings or engagements for those years were approximately:

 

 

 

 

2011:

$1,900,000 Weinberg & Company, P.A
       
  2011: $ 1,525,000 Ernst & Young Hua Ming.
       
  2010: $1,680,000 Ernst & Young Hua Ming.

 

70
 

 

 

Audit Related Fees

 

The aggregate fees in each of the last two years for the assurance and related services provided by the principal accountant that are not reasonably related to the performance of the audit or review of the Company’s financial statements and are not reported under Audit Fees above were approximately:

 

 

 

 

2011:

$0 Ernst & Young Hua Ming.
       
  2010: $0 Ernst & Young Hua Ming.
       

We incurred these fees in connection with registration statements and financing transactions.

 

Tax Fees

 

The aggregate fees in each of the last two years for the professional services rendered by the principal accountant for tax compliance, tax advice and tax planning were approximately:

 

  2011: $92,474 Ernst & Young Hua Ming.
       
  2010: $266,942 Ernst & Young Hua Ming.

 

We incurred these fees due to the preparation of our tax returns.

 

All Other Fees

 

The aggregate fees in each of the last two fiscal years for the products and services provided by the principal accountant, other than the services reported under Audit Fees and Tax Fees above, were approximately:

 

  2011: $0 Ernst & Young Hua Ming.
       
  2010: $0 Ernst & Young Hua Ming.

 

Audit Committee Approval

 

In accordance with the SEC’s auditor independence rules, the Audit Committee has established the following policies and procedures by which it approves in advance any audit or permissible non-audit services to be provided to AOB by its independent auditor.

 

Prior to the engagement of the independent auditor for any fiscal year’s audit, management submits to the Audit Committee for approval lists of recurring audit, audit-related, tax and other services expected to be provided by the auditor during that fiscal year. The Audit Committee adopts pre-approval schedules describing the recurring services that it has pre-approved, and is informed on a timely basis, and in any event by the next scheduled meeting, of any such services rendered by the independent auditor and the related fees.

  

The fees for any services listed in a pre-approval schedule are budgeted, and the Audit Committee requires the independent auditor and management to report actual fees versus the budget periodically throughout the year. The Audit Committee will require additional pre-approval if circumstances arise where it becomes necessary to engage the independent auditor for additional services above the amount of fees originally pre-approved. Any audit or non-audit service not listed in a pre-approval schedule must be separately pre-approved by the Audit Committee on a case-by-case basis.

 

Every request to adopt or amend a pre-approval schedule or to provide services that are not listed in a pre-approval schedule must include a statement by the independent auditors as to whether, in their view, the request is consistent with the SEC’s rules on auditor independence.   

    

The Audit Committee will not grant approval for:

 

any services prohibited by applicable law or by any rule or regulation of the SEC or other regulatory body applicable to AOB;
71
 

 

 

provision by the independent auditor to AOB of strategic consulting services of the type typically provided by management consulting firms; or

 

the retention of the independent auditor in connection with a transaction initially recommended by the independent auditor, the tax treatment of which may not be clear under the Internal Revenue Code and related regulations and which it is reasonable to conclude will be subject to audit procedures during an audit of AOB’s financial statements.

 

Tax services proposed to be provided by the auditor to any director, officer or employee of AOB who is in an accounting role or financial reporting oversight role must be approved by the Audit Committee on a case-by-case basis where such services are to be paid for by AOB, and the Audit Committee will be informed of any services to be provided to such individuals that are not to be paid for by AOB.

 

In determining whether to grant pre-approval of any non-audit services in the “all other” category, the Audit Committee will consider all relevant facts and circumstances, including the following four basic guidelines:

 

whether the service creates a mutual or conflicting interest between the auditor and the Company;

 

whether the service places the auditor in the position of auditing his or her own work;

 

whether the service results in the auditor acting as management or an employee of the Company; and

 

whether the service places the auditor in a position of being an advocate for the Company.

 

PART IV

 

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

       

(a) The following documents are filed as part of this report:

 

1. Financial Statements

 

See ITEM 8 of this Annual Report on Form 10-K.

 

2. Financial Statement Schedules

 

Schedule II – Valuation and Qualifying Accounts

 

Schedules other than those listed above are omitted because they are not required or are not applicable.

 

3. The exhibits referred to below, which include the following managerial contracts or compensatory plans or arrangements:

  

2006 Equity Incentive Plan
Employment Agreement, dated April 10, 2011, by and between American Oriental Bioengineering, Inc. and Tony Liu
Employment Agreement, dated April 10, 2011, by and between American Oriental Bioengineering, Inc. and Yanchun Li
Employment Agreement, dated April 10, 2011, by and between American Oriental Bioengineering, Inc. and Jun Min
Employment Agreement, dated April 10, 2011, by and between American Oriental Bioengineering, Inc. and Xiaopeng Xu

  

(b) The exhibits listed on the Exhibit Index are filed as part of this report

 

(c) Not applicable.

   

   

72
 

 

AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

SCHEDULE II – VALUATION AND QUALIFYING ACCOUNTS

 Fiscal Years Ended December 31, 2011, 2010 and 2009

 

 

Description

Balance at

December 31, 2008

Additions Deductions

Balance at

December 31, 2009

Additions Deductions

Balance at

December 31, 2010

Additions Deductions

Balance at

December 31, 2011

   

(1)

Charged

to costs and expenses

(2)

Charged

to other accounts

   

(1)

Charged

to costs

and

expenses

(2)

Charged

to other accounts

   

(1)

Charged to
costs and
expenses

(2) Charged to other accounts    
Allowance for doubtful accounts $226,330 $296,567     $522,897 $164,982     $687,879 $ 15,670,248    $(3,254) $ 16,354,873
Allowance for inventories $167,429     $131,587 $35,842     $13,108 $22,734 $ 608,216    $(6,434) $ 624,516

 

    

73
 

EXHIBIT INDEX

 

Reg. S-K

Exhibit Table

Item No.

 

Description

of Exhibit

2.1   Purchase Agreement, dated as of September 8, 2004, between American Oriental Bioengineering, Inc., the Government of Heilongjiang Province of China and Heilongjiang Songhuajiang Pharmaceutical Limited (incorporated by reference from the Report on Form 8-K, Commission File No. 000-29785, filed with the Commission on September 14, 2004).
     
2.2   Acquisition Agreement, dated September 6, 2007, by and between American Oriental Bioengineering, Inc. and Renson Holdings Limited for the purchase of all of the outstanding capital stock of Changchun Xinan Pharmaceutical Group Company Limited (incorporated by reference from the Report on Form 10-Q, Commission File No. 001-32569, filed with the Commission on November 5, 2007).
     
2.3   Acquisition Agreement, dated October 18, 2007, by and between American Oriental Bioengineering, Inc. and Renson Holdings Limited for the purchase of all of the outstanding capital stock of Guangxi Boke Pharmaceutical Limited (incorporated by reference from the Report on Form 10-Q, Commission File No. 001-32569, filed with the Commission on November 5, 2007).
     
3.1(a)   Amendment and Restatement of Articles of Incorporation of American Oriental Bioengineering, Inc. (incorporated by reference from the Registration Statement on Form SB-2 Commission File No. 333-124133, filed with the Commission on April 18, 2005).
     
3.1(b)   Certificate of Amendment to Amendment and Restatement of Articles of Incorporation of American Oriental Bioengineering, Inc. (incorporated by reference from the Registration Statement on Form S-3 Commission File No. 333-131229, filed with the Commission on January 23, 2006).
     
3.2   Amended and Restated Bylaws of American Oriental Bioengineering, Inc. (incorporated by reference from the Report on Form 10-Q, Commission File No. 001-32569, filed with the Commission on August 11, 2008).
     
4.1   Form of Warrant (incorporated by reference from the Current Report on Form 8-K, Commission File No. 001-32569, filed with the Commission on December 1, 2005).
     
4.2   American Oriental Bioengineering, Inc. 2003 Stock Option Plan (incorporated by reference from the Report on Form 10-KSB, Commission File No. 000-29785, filed with the Commission on April 15, 2004).
     
4.3   Indenture, dated as of July 15, 2008, by and between Wells Fargo Bank, National Association, as Trustee and American Oriental Bioengineering, Inc. (incorporated by reference from the Current Report on Form 8-K, Commission File No. 001-32569, filed with the Commission on July 15, 2008).
     
4.4   Registration Rights Agreement, dated as of July 15, 2008, by and among the investors specified therein and American Oriental Bioengineering, Inc. (incorporated by reference from the Current Report on Form 8-K, Commission File No. 001-32569, filed with the Commission on July 15, 2008).
     
4.5   2006 Equity Incentive Plan (incorporated by reference to the Proxy Statement on Schedule 14A, filed with the Commission on October 17, 2006).
     
10.1   Stock and Warrant Purchase Agreement, dated as of November 28, 2005, by and among American Oriental Bioengineering, Inc. and the signatory purchasers named therein (incorporated by reference from the Current Report on Form 8-K, Commission File No. 001-32569, filed with the Commission on December 1, 2005).
     
10.2   Form of Registration Rights Agreement by and among American Oriental Bioengineering, Inc. and the signatories thereto (incorporated by reference from the Current Report on Form 8-K, Commission File No. 001-32569, filed with the Commission on December 1, 2005).
     
10.3   Purchase Agreement, dated September 8, 2004, by and between American Oriental Bioengineering, Inc. and the Government of Heilongjiang Province of China and Heilongjiang Songhuajiang Pharmaceutical Limited (incorporated by reference from the Current Report on Form 8-K, Commission File No. 000-29785, filed with the Commission on September 14, 2004).
     
10.4   Purchase Agreement, dated as of August 18, 2002, by and between American Oriental Bioengineering, Inc. and Tony Liu (incorporated by reference from the Schedule 14C Commission File No. 000-29785, filed with the Commission on October 15, 2002).

   

74
 

 

10.5   Subscription Agreement, dated as of November 23, 2004, between American Oriental Bioengineering, Inc. and the Subscribers (incorporated by reference from the Registration Statement on Form SB-2, Commission File No. 333-124133, filed with the Commission on April 18, 2005).
     
 10.6(a)   Consulting Agreement, dated June 28, 2004, by and between American Oriental Bioengineering, Inc. and Bai Chao (incorporated by reference from the Registration Statement on Form S-8, Commission File No. 333-117276, filed with the Commission on July 9, 2004).
     
10.6(b)   Consulting Agreement, dated June 28, 2004, by and between American Oriental Bioengineering, Inc. and Kou Yumin (incorporated by reference from the Registration Statement on Form S-8, Commission File No. 333-117276, filed with the Commission on July 9, 2004).
     
10.6(c)   Consulting Agreement, dated June 28, 2004, by and between American Oriental Bioengineering, Inc. and Xiangli Men (incorporated by reference from the Registration Statement on Form S-8 Commission File No. 333-117276, filed with the Commission on July 9, 2004).
     
10.6(d)   Consulting Agreement, dated June 28, 2004, by and between American Oriental Bioengineering, Inc. and Linda Welsh (incorporated by reference from the Registration Statement on Form S-8 Commission File No. 333-117276, filed with the Commission on July 9, 2004).
     
10.6(e)   Consulting Agreement, dated June 28, 2004, by and between American Oriental Bioengineering, Inc. and Dr. Jie Zhu (incorporated by reference from the Registration Statement on Form S-8 Commission File No. 333-117276, filed with the Commission on July 9, 2004).
     
10.6(f)   Consulting Agreement, dated June 28, 2004, by and between American Oriental Bioengineering, Inc. and Brian Corday (incorporated by reference from the Registration Statement on Form S-8 Commission File No. 333-117276, filed with the Commission on July 9, 2004).
     
10.6(g)   Consulting Agreement, dated October 1, 2003, by and between American Oriental Bioengineering, Inc. and Haishan Wang (incorporated by reference from the Registration Statement on Form S-8 Commission File No. 333-109832, filed with the Commission on October 10, 2003).
     
10.6(h)   Consulting Agreement, dated October 1, 2003, by and between American Oriental Bioengineering, Inc. and Xiangli Men (incorporated by reference from the Registration Statement on Form S-8 Commission File No. 333-109832, filed with the Commission on October 10, 2003).
     
10.6(i)   Consulting Agreement, dated October 1, 2003, by and between American Oriental Bioengineering, Inc. and Lau Chak Wong (incorporated by reference from the Registration Statement on Form S-8 Commission File No. 333-109832, filed with the Commission on October 10, 2003).
     
10.7(a)   Independent Director Agreement, dated July 1, 2006, by and between American Oriental Bioengineering, Inc. and Cosimo J. Patti (incorporated by reference to the Quarterly Report on Form 10-Q, filed with the Commission on August 14, 2006).
     
10.7(b)   Independent Director Agreement, dated July 1, 2006, by and between American Oriental Bioengineering, Inc. and Xianmin Wang (incorporated by reference to the Quarterly Report on Form 10-Q, filed with the Commission on August 14, 2006).
     
10.7(c)   Independent Director Agreement, dated July 1, 2006, by and between American Oriental Bioengineering, Inc. and Eileen B. Brody (incorporated by reference to the Quarterly Report on Form 10-Q, filed with the Commission on August 14, 2006).
     
10.7(d)   Independent Director Agreement, dated August 21, 2006, by and between American Oriental Bioengineering, Inc. and Lawrence S. Wizel, (incorporated by reference to the Annual Report on Form 10-K, filed with the Commission on March 13, 2007).
     
10.7(e)   Independent Director Agreement, dated December 15, 2006, by and between American Oriental Bioengineering, Inc. and Baiqing Zhang, (incorporated by reference to the Annual Report on Form 10-K, filed with the Commission on March 13, 2007).
     
10.8   Securities Purchase Agreement, dated as of July 9, 2008, by and among the investors specified therein and American Oriental Bioengineering, Inc. (incorporated by reference from the Current Report on Form 8-K, Commission File No. 001-32569, filed with the Commission on July 15, 2008).

 

75
 

 

10.9   Form of Prepaid Forward Share Repurchase Contract Confirmation, dated as of July 15, 2009 (incorporated by reference from the Current Report on Form 8-K, Commission File No. 001-32569, filed with the Commission on July 15, 2008).
     
10.10(a)   Employment Agreement, dated April 8, 2010, by and between American Oriental Bioengineering, Inc. and Tony Liu, filed herewith.
     
10.10(b)   Employment Agreement, dated April 8, 2010, by and between American Oriental Bioengineering, Inc. and Yanchun Li, filed herewith.

 

10.10(c)   Employment Agreement, dated April 8, 2010, by and between American Oriental Bioengineering, Inc. and Jun Min, filed herewith.
     
10.10(d)   Employment Agreement, dated April 8, 2010, by and between American Oriental Bioengineering, Inc. and Binsheng Li, filed herewith.
     
10.10(e)   Employment Agreement, dated April 8, 2010, by and between American Oriental Bioengineering, Inc. and Yang Yang, filed herewith.
     
10.11   Stock Award and Non-Qualified Stock Option Grant Agreement (incorporated by reference to the Annual Report on Form 10-K, filed with the Commission on March 15, 2010).
     
10.12   Executive Employment Agreement dated as of July 15, 2009 between the Company and Xiaopeng Xu (incorporated by reference from the Current Report on Form 8-K, filed with the Commission on March 17, 2011).
     
14   Amended and Restated Code of Ethics of American Oriental Bioengineering, Inc., dated November 9, 2006, (incorporated by reference to the Annual Report on Form 10-K, filed with the Commission on March 13, 2007).
     
21   Subsidiaries of the Registrant, (incorporated by reference to the Annual Report on Form 10-K, filed with the Commission on March 15, 2009).
     
31.1   Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith.
     
31.2   Certification of Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith.
     
32   Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. 1350 (Section 906 of the Sarbanes-Oxley Act of 2002), filed herewith.

 

101.INS XBRL Instance Document, filed herewith
101.SCH Document, XBRL Taxonomy Extension, filed herewith
101.CAL Calculation Linkbase, XBRL Taxonomy Extension Definition, filed herewith
101.DEF Linkbase, XBRL Taxonomy Extension Labels, filed herewith
101.LAB Linkbase, XBRL Taxonomy Extension, filed herewith
101.PRE Presentation Linkbase, filed herewith

  

76
 

 

SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

  

 

  AMERICAN ORIENTAL BIOENGINEERING, INC.  
       
Date: January 7, 2013 By: /s/ Tony Liu  
    Tony Liu  
    Chief Executive Officer and Chairman of the Board of Directors (Principal Executive Officer)  
       

    

Pursuant to the requirements of the Securities and Exchange Act of 1934, this Report has been signed below by the following person on behalf of the Registrant and in the capacities and on the dates indicated.

 

SIGNATURE   TITLE   DATE
         
/s/ Tony Liu   Chief Executive Officer and Chairman of the Board of Directors   January 7, 2013
Tony Liu    (Principal Executive Officer)    
         
         
/s/ Yanchun Li   Chief Financial Officer, Secretary and Director   January 7, 2013
Yanchun Li   (Principal Financial Officer)      
         
         
/s/ Jun Min   Vice President and Director   January 7, 2013
Jun Min        
         
         
/s/ Gao Yan   Chief Accounting Officer   January 7, 2013
Gao Yan    (Principal Accounting Officer)     
         
         
/s/ Cosimo J. Patti   Independent Director   January 7, 2013
Cosimo J. Patti        
         
         
/s/ Xianmin Wang   Independent Director   January 7, 2013
Xianmin Wang        
         
         
/s/ Baiqing Zhang   Independent Director   January 7, 2013
Baiqing Zhang        

    

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AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

 

TABLE OF CONTENTS

 

     
PAGE F-2 - F-3 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
     
PAGE F-4 - F-5 CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 2011 AND 2010
     
PAGE F-6 CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME(LOSS) FOR THE YEARS ENDED DECEMBER 31, 2011, 2010 AND 2009
     
PAGE F-7 CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY FOR THE YEARS ENDED DECEMBER 31, 2011, 2010 AND 2009
     
PAGE F-8 CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2011, 2010 AND 2009
     
PAGE F-9 - F-33 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2011, 2010 AND 2009

 

 

 

   

F-1
 

    

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors

American Oriental Bioengineering, Inc.

 

We have audited the accompanying consolidated balance sheets of American Oriental Bioengineering, Inc. as of December 31, 2011 and 2010, and the related consolidated statements of operations and comprehensive income (loss), changes in shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2011. Our audits also included the financial statement schedule listed in the Index at Item 15. These consolidated financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedule 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 audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Oriental Bioengineering, Inc. as of December 31, 2011 and 2010, and the results of its consolidated operations and its cash flows for each of the three years in the period ended December 31, 2011, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), American Oriental Bioengineering, Inc.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated January 7, 2013 expressed an adverse opinion thereon.

/s/ WEINBERG & COMPANY, P.A.

Los Angeles, California

January 7, 2013

F-2
 

AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

  

ASSETS

 

   DECEMBER 31, 
   2011   2010 
         
CURRENT ASSETS          
Cash and cash equivalents  $52,627,928   $94,568,520 
Restricted cash   264,031    537,297 
Accounts receivable, net of allowance for doubtful accounts of $16,354,873 and $687,879 as of December 31, 2011 and 2010, respectively   53,196,298    80,455,358 
Inventories, net   18,889,930    12,474,889 
Advances to suppliers and prepaid expenses   16,535,191    14,246,144 
Note receivable   27,848,917     
Receivable for disposal of NuoHua Affiliate   18,153,754    38,567,410 
Deferred tax assets   3,225,803    649,503 
Other current assets   5,168,742    3,129,566 
Total Current Assets   195,910,594    244,628,687 
           
LONG-TERM ASSETS          
Property, plant and equipment, net   170,534,450    132,063,660 
Land use rights, net   157,928,152    155,433,311 
Capitalized agricultural costs   22,333,937    8,358,577 
Acquired intangible assets, net   10,728,658    14,889,127 
Goodwill       33,164,121 
Investments in and advances to equity method investments   5,934,422    19,179,235 
Deferred tax assets   263,109    147,024 
Deferred financing costs   1,347,735    2,359,404 
Total Long-Term Assets   369,070,463    365,594,459 
TOTAL ASSETS  $564,981,057   $610,223,146 

 

  

See accompanying notes to the consolidated financial statements

   

F-3
 

     

AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

 

LIABILITIES AND EQUITY

  

   DECEMBER 31, 
   2011   2010 
         
CURRENT LIABILITIES          
Accounts payable  $22,085,545   $10,716,686 
Accrued expenses and other payables   21,201,533    24,323,664 
Taxes payable   580,293    1,237,169 
Convertible notes, in default   108,500,000     
Notes payable   502,912    537,297 
Short-term bank loans   6,756,014    6,957,258 
Current portion of long-term bank loans   63,070    61,405 
Deferred tax liabilities   90,070    243,304 
Total Current Liabilities   159,779,437    44,076,783 
           
LONG-TERM LIABILITIES          
Long-term bank loans, net of current portion   618,030    679,866 
Deferred tax liabilities   14,572,492    15,837,479 
Accrued taxes   8,849,004    6,055,656 
Convertible notes       115,000,000 
Total Long-Term Liabilities   24,039,526    137,573,001 
TOTAL LIABILITIES   183,818,963    181,649,784 
           
COMMITMENTS AND CONTINGENCIES          
           
EQUITY          
SHAREHOLDERS’ EQUITY          
Preferred stock, $0.001 par value; 2,000,000 shares authorized; 1,000,000 shares issued and outstanding at December 31, 2011 and 2010, respectively   1,000    1,000 
Common stock, $0.002 par value; 75,000,000 shares authorized; 39,476,274 shares and 39,299,303 shares issued as of December 31, 2011 and 2010, respectively; 39,251,691 shares and 39,299,303 shares outstanding as of December 31, 2011 and 2010, respectively   78,952    78,598 
Common stock to be issued (132,247 shares and 85,243 shares as of December 31, 2011 and 2010, respectively)   291,333    350,500 
Additional paid-in capital   206,591,730    203,322,671 
Retained earnings   137,810,753    205,260,681 
Less: Treasury stock, at cost (224,582 shares and nil as of December 31, 2011 and 2010, respectively)   (799,999)    
Less: Prepaid forward repurchase contract   (29,998,616)   (29,998,616)
Accumulated other comprehensive income   67,723,161    49,053,329 
Total American Oriental Bioengineering, Inc. Shareholders’ Equity   381,698,314    428,068,163 
Non-controlling interests   (536,220)   505,199 
TOTAL EQUITY   381,162,094    428,573,362 
TOTAL LIABILITIES AND EQUITY  $564,981,057   $610,223,146 

 

 

See accompanying notes to the consolidated financial statements

   

F-4
 

  

AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME

 

   YEARS ENDED DECEMBER 31, 
   2011   2010   2009 
             
Revenues  $212,690,388   $305,944,085   $296,150,780 
Cost of sales   112,939,705    148,186,531    129,367,775 
GROSS PROFIT   99,750,683    157,757,554    166,783,005 
                
Selling, general and administrative expenses   51,351,940    66,439,702    62,164,936 
Advertising costs   14,910,983    38,920,905    31,896,992 
Research and development costs   12,658,085    15,365,131    7,922,357 
Depreciation and amortization expenses   7,495,051    6,662,237    6,038,625 
Provision for doubtful accounts   15,624,998         
Impairment of acquired intangible assets   6,928,064         
Impairment of goodwill   33,164,121         
Impairment of property, plant and equipment   733,688         
Total operating expenses   142,866,930    127,387,975    108,022,910 
                
(LOSS) INCOME FROM OPERATIONS   (43,116,247)   30,369,579    58,760,095 
                
Impairment of equity method investment-AXN   (11,937,037)        
Loss on disposal of NuoHua Affiliate   (8,447,368)   (1,083,637)    
Gain on extinguishment of convertible notes   3,242,389         
Equity in earnings (losses) from equity method investments   (1,254,973)   213,177    2,075,139 
Interest expense, net   (6,610,001)   (5,900,055)   (5,746,382)
Other income (expense), net   266,942    (204,736)   (569,661)
(LOSS) INCOME BEFORE INCOME TAX   (67,856,295)   23,394,328    54,519,191 
Provision for income taxes   635,053    9,335,338    13,216,986 
NET (LOSS) INCOME   (68,491,348)   14,058,990    41,302,205 
Net loss attributable to non-controlling interest   1,041,420    27,937    118,945 
NET (LOSS) INCOME ATTRIBUTABLE TO AMERICAN ORIENTAL BIOENGINEERING, INC.   (67,449,928)   14,086,927    41,421,150 
                
OTHER COMPREHENSIVE INCOME               
Foreign currency translation gain   18,669,832    16,003,105    1,362,038 
                
COMPREHENSIVE (LOSS) INCOME  $(48,780,096)  $30,090,032   $42,783,188 
(LOSS) EARNINGS PER COMMON SHARE               
Basic  $(1.80)  $0.38   $1.11 
Diluted  $(1.80)  $0.37   $1.06 
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING               
Basic   37,416,241    37,405,008    37,306,301 
Diluted   37,416,241    37,862,413    44,643,310 

 

 

See accompanying notes to the consolidated financial statements

F-5
 

 

           

AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

YEARS ENDED DECEMBER 31, 2011 AND 2009 

 

 

 

Total American Oriental Bioengineering, Inc. Shareholders’ Equity

         
 Preferred Stock   Common Stock                                 
   Shares   Stated
Value
   Shares   Par
Value
   Stock To
Be Issued
   Prepaid
forward
 Repurchase
Contract
   Additional
 Paid-in
Capital
   Treasury   Retained
Earnings
   Accumulated
Other
Comprehensive
Income
   Non-
controlling
Interest
   Total
Equity
 
BALANCE AT
JANUARY 1, 2009
   1,000,000   $1,000    39,124,632   $78,249   $376,335   $(29,998,616)  $197,046,688   $   $149,752,604   $31,688,186   $652,081   $349,596,527 
                                                             
Common stock issued for director services           21,236    42    (376,335)       376,293                      
Common stock to be issued for director services                   388,000                             388,000 
Common stock issued for consulting services           14,852    30            160,770                     160,800 
Stock-based compensation to employees                           2,246,170                     2,246,170 
Foreign currency translation                                        1,362,038        1,362,038 
Net income/(loss)                                    41,421,150        (118,945)   41, 302,205 
                                                             
BALANCE AT DECEMBER 31, 2009   1,000,000    1,000    39,160,720    78,321    388,000    (29,998,616)   199,829,921         191,173,754    33,050,224    533,136    395,055,740 

 

(Continued)

F-6
 

 

 

AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

YEARS ENDED DECEMBER 31, 2011 AND 2009

 

 

   Total American Oriental Bioengineering, Inc. Shareholders’ Equity         
   Preferred Stock   Common Stock                                 
   Shares   Stated
Value
   Shares   Par
Value
   Stock To
Be Issued
   Prepaid
forward
 Repurchase
Contract
   Additional
 Paid-in
Capital
   Treasury   Retained
Earnings
   Accumulated
Other
Comprehensive
Income
   Non-
controlling
Interest
   Total
Equity
 
Common stock issued for director services           40,188    80    (388,000)       387,920                      
Common stock to be issued for director services                   350,500                             350,500 
Common stock issued for consulting services           46,731    94            418,923                     419,017 
Stock-based compensation to employees                           2,686,010                     2,686,010 
Exercise of common stock awards to employees           51,664    103            (103)                     
Foreign currency translation                                        16,003,105        16,003,105 
Net income                                    14,086,927        (27,937)   14,058,990 
                                                             
BALANCE AT DECEMBER 31, 2010   1,000,000    1,000    39,299,303    78,598    350,500    (29,998,616)   203,322,671        205,260,681    49,053,329   $505,199    428,573,362 
                                                             

  

(Continued)

F-7
 

 

AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

YEARS ENDED DECEMBER 31, 2011 AND 2009

 

(Continued)

 

   Total American Oriental Bioengineering, Inc. Shareholders’ Equity         
   Preferred Stock   Common Stock                                 
   Shares   Stated
Value
   Shares   Par
Value
   Stock To
Be Issued
   Prepaid
forward
 Repurchase
Contract
   Additional
 Paid-in
Capital
   Treasury   Retained
Earnings