AOBI American Oriental Bioengineering Inc (CE)

NOTE 17 – SUBSEQUENT EVENTS

On October 1, 2012, Peter Barbato filed a shareholder derivative Complaint against Tony Liu, Yanchun Li, Binsheng Li, Lawrence Wizel, Cosimo Patti, Xianmin Wang, Eileen Brody, Jun Min, and Baiqing Zhang (collectively, “Defendants”), and the Company as a nominal Defendant.  The Complaint asserts causes of action for Breach of Fiduciary Duty and Unjust Enrichment.  These claims similarly arise out of alleged accounting errors that were made the Company’s financial statements for in the periods between the third quarters ending September 30, 2009 and September 30, 2011, which were filed with the SEC.  The alleged accounting errors were related to the Company’s sale of an interest held by the Company’s subsidiary, Nuo Hua Investment Company Limited, and were disclosed in the Company’s Restatement filed on November 14, 2011.  The Complaint also alleges that its claims arise out of alleged inconsistencies that the Company’s then auditor, Ernst and Young Hua Ming, discovered throughout the course of the Company’s audit for the year ending 2011.  The Parties have agreed that Defendants need not respond to the complaint until motions to dismiss the class action Complaint filed against the Company in the Central District of California are resolved.

On December 6, 2012, David Bravetti filed a shareholder derivative Complaint against Tony Liu, Yanchun Li, Binsheng Li, Jun Min, Lawrence Wizel, Cosimo Patti, Xianmin Wang, Baiqing Zhang, Eileen Brody (collectively, “Defendants”). Because the complaint sets forth a shareholder derivative claim, the Company is named as a nominal Defendant, although no relief is sought for the Company and any relief obtained from the Defendants would inure to the benefit of the Company.  The Complaint asserts causes of action for breach of fiduciary duty, waste of corporate assets, and unjust enrichment.  Bravetti’s claims arose out of alleged accounting errors that were made in the Company’s financial statements for the periods between the third quarters ending September 30, 2009 and September 30, 2011, which financial statements were included in filings made with the SEC.  The alleged accounting errors were related to the Company’s sale of an interest held by the Company’s subsidiary, Nuo Hua Investment Company Limited and were disclosed in the Company’s Restatement filed on November 14, 2011.  The Complaint also alleges that its claims arise out of alleged inconsistencies that the Company’s then auditor, Ernst and Young Hua Ming, discovered throughout the course of the Company’s audit for the year ending 2011.  Although the Complaint claims that jurisdiction is proper in federal court in New Jersey because of diversity of citizenship, according to the Complaint, Bravetti is a New Jersey citizen, as is one of the Defendants. The Company did not file a responsive pleading to Bravetti’s Complaint, and subsequent to seeking and obtaining a default against the Company, Bravetti agreed to dismiss his claim and file elsewhere. Subsequently, however, Bravetti “corrected” his complaint now to claim to be a Florida citizen. On March 26, 2013, Bravetti undertook to provide Defendants proof of his citizenship. That proof has been provided, and Defendants have not come to a conclusion whether this was sufficient. 

AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2012 AND 2011

On February 19, 2013, the Company received a notice of acceleration under the terms of the Company’s 5.00% Convertible Senior Notes due 2015 (the “Senior Notes”) issued pursuant to an Indenture, dated as of July 15, 2008, between the Company and Wells Fargo Bank, National Association, as Indenture Trustee (the “Indenture”). The notice was sent by certain holders of the Senior Notes that together hold more than 25% of the aggregate principal amount of the Senior Notes. The notice states that the default is the result of the Company’s failure to (A) pay to the holders under the terms of the Indenture accrued interest due and payable on each of July 16, 2012 and January 15,2013, which failure to pay continued for a period of thirty (30) days after July 16, 2012 and January 15, 2013, respectively, and (B) provide, pursuant to the terms of the Indenture, a notice of the termination of trading and delisting of the Company’s common stock by the New York Stock Exchange. As of March 4, 2013, the aggregate principal amount of the Senior Notes, and unpaid, but accrued interest was $53,010,424. The notice of acceleration resulted in the principal amount of the Senior Convertible Notes plus accrued and all unpaid interest and accrued and unpaid Additional Interest (as defined in the Indenture) on the Notes through February 19, 2013, to become immediately due and payable.

On April 8, 2013, four of the holders of the Company’s 5% senior convertible notes issued July 15, 2008 (the “Notes”) filed this action claiming a default under the Notes, which allegedly resulted in an acceleration of the maturity of the Notes. The Plaintiffs had previously commenced a similar action in federal court in New Jersey, but that action was withdrawn and the present action was interposed. The action seeks payment of $20,378,608 plus prejudgment interest and other fees and costs. The Company has been served with the complaint, and Plaintiffs agreed to extend the Company’s time to answer. When that time passed on June 3, 2013, Plaintiffs refused to grant additional time and have now made a motion seeking entry of a default. The Company filed its answer on June 5, 2013.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the information contained in the condensed consolidated financial statements of the Company and the notes thereto appearing elsewhere herein and in conjunction with the Management’s Discussion and Analysis set forth in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. Readers should carefully review the risk factors disclosed in the Company’s Form 10-K for the year ended December 31, 2011 filed by the Company with the Securities and Exchange Commission (“SEC”).

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 quarterly 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 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

Global economic challenges and uncertainties have impacted our business in 2011, 2012 and the first half of 2013. These challenges and uncertainties have 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. There were two price adjustments by the Price Control Office in 2011 and 2012, respectively 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.

The continuous increase in cost of raw material also impacted our business as gross profit has declined since the end of 2010.

In addition to the ongoing economic challenges and uncertainties, our business was negatively impacted by the toxic drug capsules incident in 2012. Incidents like that shook the pharmaceutical industry and resulted in a decline in market demand. Although we were not directly involved in the scandal and our facilities were inspected and passed the safety requirements, our subsequent sales have been impacted significantly due to the loss of consumer confidence in pharmaceutical products and huge decline in market demand. All of these challenges, uncertainties and incidents may continue to have an adverse impact on our future performance.

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

To mitigate the impact of the increasing cost and supply of the raw material needed for our products, we entered into long-term supply contracts with various third parties to grow Millettia and Xanthoceras Sorbifolia Bge (“XSB”), which are major raw materials. 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 term and reduce the risk of increasing costs in future periods. Subsequent to September 30, 2012, in the fourth quarter of 2012, we recorded an impairment of approximately $8.5 million of our capitalized agricultural costs.

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 Annual Report on Form 10-K for the year ended December 31, 2011 filed with the SEC on January 7, 2013.

Estimates affecting accounts receivable and inventories

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 receivable and inventories.

At September 30, 2012 and December 31, 2011, we provided a reserve of $17,873,220 and $16,354,873, respectively, against accounts receivable. Our estimate of the appropriate reserve on accounts receivable at September 30, 2012 and December 31, 2011 was based on the aged nature of these accounts receivable. In making our 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 September 30, 2012 and December 31, 2011, we provided an allowance against inventories amounting to $317,290 and $624,516, respectively. 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 our estimate, we considered the probable demand for our products in the future and historical trends in the turnover of our inventories.

While we currently believe 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, we could realize significant write downs for slow-moving inventories or uncollectible accounts receivable and notes receivable.

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 our 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, we believe that we can apply the provisions of FASB ASC 605 with minimal subjectivity.

Investment in equity method investment

We account for our equity investment in accordance with 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 do not own a majority equity interest or otherwise control. Under the equity method, we initially record our investment at cost and adjust 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 perform an impairment assessment by comparing fair value of the investment to readily available market information, or if not available, to discounted cash flow models.

Impairment

In evaluating long-lived assets for recoverability, including finite-lived intangibles and property and equipment, we use our best estimate of future cash flows expected to result from the use of the asset and eventual disposition. To the extent that estimated future, undiscounted cash inflows attributable to the asset, less estimated future, undiscounted cash outflows, are less than the carrying amount, an impairment loss is recognized in an amount equal to the difference between the carrying value of such asset and its fair value. Assets to be disposed of and for which there is a committed plan of disposal, whether through sale or abandonment, are reported at the lower of carrying value or fair value less costs to sell.

In evaluating capitalized agriculture costs, we use our best estimate of the future cash flows expected to result from future market values, yields and costs to harvest. To the extent that estimated future cash inflows attributable to the asset, less estimated future, cash outflows, are less than the carrying amount, an impairment loss is recognized in an amount equal to the excess of the carrying value over the estimated fair values of the capitalized agricultural costs.

The Company’s annual impairment testing is performed in the fourth quarter of each year. 

Share-based Compensation

We periodically issue stock options and warrants to employees and non-employees in non-capital raising transactions for services and for financing costs. We account for stock option and warrant grants issued and vesting to employees based on the authoritative guidance provided by the FASB whereas the value of the award is measured on the date of grant and recognized over the vesting period. We account for stock option and warrant grants issued and vesting to non-employees in accordance with the authoritative guidance of the FASB whereas the value of the stock compensation is based upon the measurement date as determined at either a) the date at which a performance commitment is reached, or b) at the date at which the necessary performance to earn the equity instruments is complete. Non-employee stock-based compensation charges generally are amortized over the vesting period on a straight-line basis. In certain circumstances where there are no future performance requirements by the non-employee, option grants are immediately vested and the total stock-based compensation charge is recorded in the period of the measurement date.

The fair value of our common stock option grant is estimated using the Black-Scholes-Merton option pricing model, which uses certain assumptions related to risk-free interest rates, expected volatility, expected life of the common stock options, and future dividends. Compensation expense is recorded based upon the value derived from the Black-Scholes-Merton option pricing model, and based on actual experience. The assumptions used in the Black-Scholes-Merton option pricing model could materially affect compensation expense recorded in future periods.

Accounting for Income Taxes and Uncertain Income Tax Positions

We use an asset and liability approach for financial accounting and reporting for income taxes that allows recognition and measurement of deferred tax assets based upon the likelihood of realization of tax benefits in future years. Under the asset and liability approach, deferred taxes are provided for the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance is provided for deferred tax assets if it is more likely than not these items will either expire before we are able to realize their benefits, or that future deductibility is uncertain. We account for uncertainty in income taxes in accordance with FASB ASC 740-10 which 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. Our policy is to recognize interest and/or penalties related to income tax matters in income tax expense.

Newly Adopted Accounting Pronouncements

In July 2012, FASB issued ASU No. 2012-02, “Intangibles – Goodwill and Other”. This update presents an entity with the option to first to assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform the quantitative impairment test in accordance with Subtopic 350-30, “Intangibles – Goodwill and Other – General Intangibles Other than Goodwill”. The more-likely-than-not threshold is defined as having a likelihood of more than fifty percent. ASU No. 2012-02 will be effective for annual and impairment tests performed for fiscal years beginning after 15 September 2012, with early adoption permitted. The Company does not expect the adoption of this update will have a material effect on its consolidated financial statements.

In January 2013, the FASB issued ASU 2013-01, Balance Sheet (Topic 210): Clarifying Scope of Disclosures Offsetting Assets and Liabilities. This ASU clarifies which instruments and transactions are subject to the offsetting disclosure requirements by ASU 2011-11. This guidance is effective for annual and interim reporting periods beginning January 1, 2013. We do not believe the adoption of this update will have a material effect on our financial position and results of operations.

In February 2013, the FASB issued ASU No. 2013-02, “Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” The new guidance requires entities to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income unless the amounts are not reclassified in their entirety to net income. For amounts that are not required to be reclassified in their entirety to net income in the same reporting period, entities are required to cross-reference other disclosures that provide additional detail about those amounts. The new guidance is effective prospectively for all interim and annual periods beginning after December 15, 2012, with early adoption permitted. The Company does not expect the adoption of this update will have a material effect on its consolidated financial statements.

Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and 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.

RESULTS OF OPERATIONS – THREE MONTHS ENDED SEPTEMBER 30, 2012 AS COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 2011

The following table sets forth the amounts and the percentage relationship to revenues of certain items in our condensed consolidated statements of income for the three months ended September 30, 2012 and 2011:

Revenues

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:

Revenue from our pharmaceutical products decreased from $40,276,279 for three months ended September 30, 2011 to $14,860,925 for the same period of 2012, or a 63% decrease. The decrease was primarily due to the following factors:

Revenue in connection with our nutraceutical products decreased from $8,774,711 in 2011 to $1,587,654 in 2012, an 82% decrease. Revenues were adversely affected by the food safety and drug problem in 2012. The decrease was mainly due to the decrease in sales from our Soy Peptide tablets and Soy Peptide drinks.

Distribution revenue increased by $8,161,268 or 167%, to $13,044,880 for the three months ended September 30, 2012 from $4,883,612 for the same period of 2011, primarily as a result of the acquisition of Liaoning Baicao, which occurred at the end of 2011.

Cost of sales in the manufacturing segment decreased with the corresponding drop in revenues for this segment. Gross profit as a percentage of revenues for the manufacturing segment was 33% in 2012, down from 51% in 2011.

Cost of sales in the distribution segment increased proportionally to the increase in sales from 2011 to 2012, with gross profit as a percentage of revenues also increasing slightly from 7% to 8%.

Selling, General and Administrative Expenses

Selling, general and administrative expenses, decreased from $12,080,424 in the three months ended September 30, 2011 to $12,005,502 in the three months ended September 30, 2012, representing a 1% decrease. The details of our sales and marketing expenses were as follows:

The decrease in promotional fees and travel expenses resulted from fewer marketing and promotional activities carried out during the third quarter of 2012 as compared with the same period of 2011.

The decrease in shipping costs was primarily due to the reduction in sales volume of our products.

Increased professional fees resulted primarily from costs associated with the audit committee’s internal investigation related to our prior auditors’ resignation and the cost of re-auditing the prior year financial statements, which were conducted in 2012.

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

Advertising Costs

Advertising costs increased by $6,420,139, or 217%, from $2,964,877 in the three months ended September 30, 2011 to $9,385,016 in the three months ended September 30, 2012, primarily as a result of more promotional expense by us in an effort to generate additional sales in the highly competitive Chinese pharmaceutical marketplace. Advertising costs as a percentage of revenue increased from 5% in 2011 to 32% in 2012.

Research and Development Costs

Research and development costs decreased by $1,144,318 from $2,825,967 in the three months ended September 30, 2011 to $1,681,649 in the three months ended September 30, 2012, primarily as a result of the initial implementation of our cost reduction measures started in 2012, as further discussed in the “Liquidity” section. Expressed as a percentage of revenue, research and development costs were 6% and 5% in 2012 and 2011, 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.

Depreciation and Amortization

Depreciation and amortization expenses decreased by $1,721, or less than 1%, in the three months ended September 30, 2012 as compared to the same period of 2011.

Provision for reserves and doubtful accounts

Provision for doubtful accounts increased from a recovery of $2,666,829 in the three months ended September 30, 2011 to a charge of $777,947 in the three months ended September 30, 2012, due to continued deterioration of our customers’ ability to continue to pay their outstanding invoices on a timely basis. We evaluate the provision for doubtful accounts on an ongoing basis, based upon 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 us.

Gain on extinguishment of convertible notes

During the three months ended September 30, 2012, we repurchased a total $59,339,000 in principal amount of our convertible Notes for $18,478,888. A gain of debt extinguishment of $40,413,555 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 12. Convertible Notes.”

Equity in Losses from Equity Method Investments

Equity in losses from equity method investments decreased from income of $796,727 in the three months ended September 30, 2011 to $267,470 in the three months ended September 30, 2012. The decreased loss was mainly due to a smaller loss realized by AXN in the three months ended September 30, 2012 as compared to the same period of 2011.

Interest Expense, Net

Net interest expense was $1,423,839 in the three months ended September 30, 2012, compared to $1,802,954 for the three months ended September 30, 2011. The decrease was mainly due to lower interest on convertible notes, as the average balances were lower in 2012 due to the extinguishment of $59,339,000 in face value.

Income Tax

The Company’s effective tax rate for the three months ended September 30, 2012 was 2%, compared to 40% in the three months ended September 30, 2011. The higher effective tax rate in 2011 was mainly due to an increase in valuation allowance change because some of the entities within the group realized a relatively larger accounting loss for 2011 compared to 2010, for which a valuation allowance was fully provided. For additional information, see “Item 1. Financial Statements – Note 16. Income Tax.”

Revenues

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:

Revenue from our pharmaceutical products decreased from $119,969,639 for the nine months ended September 30, 2011 to $44,972,009 for the same period of 2012, or a 63% decrease. The decrease was primarily due to the following factors:

Revenue in connection with our nutraceutical products decreased from $28,110,229 in the nine months ended September 30, 2011 to $4,798,790 in the nine months ended September 30, 2012, an 83% decrease. Revenues were adversely affected by the food safety and drug problem in 2012. The decrease was mainly due to the decrease in sales from our Soy Peptide tablets and Soy Peptide drinks.

Distribution revenue increased by $21,006,222 or 176%, to $32,914,862 for the nine months ended September 30, 2012 from $11,908,640 for the same period of 2011, primarily as a result of the acquisition of Liaoning Baicao, which occurred at the end of 2011.

Cost of sales in the manufacturing segment decreased with the corresponding drop in revenues for this segment. Gross profit as a percentage of revenues for the manufacturing segment was 30% in 2012, down from 51% in 2011.

Cost of sales in the distribution segment increased proportionally to the increase in sales from 2011 to 2012, with gross profit as a percentage of revenues also increasing from 5% to 8%.

Selling, General and Administrative Expenses

Selling, general and administrative expenses, increased from $34,577,769 in the nine months ended September 30, 2011 to $36,047,706 in the nine months ended September 30, 2012, representing a 4% increase. The details of our sales and marketing expenses were as follows:

The decrease in promotional fees resulted from fewer marketing and promotional activities carried out during the first three quarters of 2012 as compared with the same period of 2011.

The decrease in shipping costs was primarily due to the reduction in sales volume of our products.

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

Increased professional fees resulted primarily from costs associated with the audit committee’s internal investigation related to our prior auditors’ resignation and the cost of re-auditing the prior year financial statements, which were conducted in 2012.

Advertising Costs

Advertising costs increased by $13,332,067, or 131%, from $10,185,380 in the nine months ended September 30, 2011 to $23,517,447 in the nine months ended September 30, 2012, primarily as a result of more promotional expense by us in an effort to generate additional sales in the highly competitive Chinese pharmaceutical marketplace. Advertising costs as a percentage of revenue decreased from 6% for 2011 to 28% for 2012.

Research and Development Costs

Research and development costs decreased by $3,674,572 from $8,652,455 in the nine months ended September 30, 2011 to $4,977,883 in the nine months ended September 30, 2012, primarily as a result of the initial implementation of our cost reduction measures started in 2012, as further discussed in the “Liquidity” section. Expressed as a percentage of revenue, research and development costs were 6% and 5% for 2012 and 2011, 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.

Depreciation and Amortization

Depreciation and amortization expenses increased by $102,620, or 2%, in the nine months ended September 30, 2012 as compared to the nine months ended September 30, 2011. This was mainly due to an increase in property and equipment in the final three quarters of 2011, offset by an impairment charge related to acquired intangible assets that was recognized in the fourth quarter of 2011, resulting in lower amortization in 2012.

Provision for reserves and doubtful accounts

Provision for doubtful accounts increased from a recovery of $2,666,829 in the nine months ended September 30, 2011 to a charge of $3,831,195 in the nine months ended September 30, 2012, due to continued deterioration of our customers’ ability to continue to pay their outstanding invoices on a timely basis. We evaluate the provision for doubtful accounts on an ongoing basis, based upon 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 us.

Gain on extinguishment of convertible notes

During the nine months ended September 30, 2012, we repurchased a total $59,339,000 in principal amount of our convertible Notes for $18,478,888. A gain of debt extinguishment of $40,413,555 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 12. Convertible Notes.”

Equity in Losses from Equity Method Investments

Equity in losses from equity method investments decreased from $857,811 in the nine months ended September 30, 2011 to $1,756,517 in the nine months ended September 30, 2012. The increased loss was mainly due to a larger loss realized by AXN in the nine months ended September 30, 2012.

Interest Expense, Net

Net interest expense was $4,975,119 in the nine months ended September 30, 2012, compared to $4,850,651 for the nine months ended September 30, 2011. The increase was mainly due to higher average balances of bank acceptance notes to vendors, offset by lower interest expense on convertible notes due to the repurchase of $59,339,000 in principal during the third quarter of 2012.

Income Tax

The Company’s effective tax rate for the nine months ended September 30, 2012 was 6%, compared to 27% in the nine months ended September 30, 2011. The higher effective tax rate in 2011 was mainly due to an increase in valuation allowance change because some of the entities within the group realized a relatively larger accounting loss for 2011 compared to 2010, for which a valuation allowance was fully provided. For additional information, see “Item 1. Financial Statements – Note 19. Income Tax.”

FINANCIAL POSITION, LIQUIDITY AND CAPITAL RESOURCES

Cash

Our cash position at September 30, 2012 was $26,432,161, representing a decrease of $26,195,767, or 50%, compared with our cash position of $52,627,928 at December 31, 2011. The decrease was mainly attributable to net cash used in operations of $37.1 million in the nine months ended September 30, 2012, due in large part to our lower sales and larger operating losses.

We manage our cash based on thorough consideration of our corporate strategy as well as macroeconomic considerations, and we take into account such factors as interest income and foreign currency fluctuation.

Liquidity

Our financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. For the nine months ended September 30, 2012, we recorded a loss from operations of $56,506,400 and utilized cash in operations of $37,139,732.  As of September 30, 2012, we had working capital of $869,366.  In addition, subsequent to September 30, 2012 we were in default of $49,161,000 of our convertible notes due July 15, 2015. On April 8, 2013, four of the holders of the Notes filed this action claiming a default under the Notes, which allegedly resulted in an acceleration of the maturity of the Notes. The Plaintiffs had previously commenced a similar action in federal court in New Jersey, but that action was withdrawn and the present action was interposed. The action seeks payment of $20,378,608 plus prejudgment interest and other fees and costs. The Company has been served with the complaint, and Plaintiffs agreed to extend the Company’s time to answer. When that time passed on June 3, 2013, Plaintiffs refused to grant additional time and have now made a motion seeking entry of a default. The Company filed its answer on June 5, 2013. We presently do not have the ability to pay these notes. These factors, among others, raise substantial doubt about our ability to continue as a going concern. As a result, our independent registered public accounting firm, in its report on our 2012 financial statements, has raised substantial doubt about our ability to continue as a going concern. The financial statements do not include any adjustments that might be necessary should we be unable to continue as a going concern. Our ability to continue as a going concern is dependent upon our ability to return to profitability or to develop additional sources of financing or capital. No assurances can be given that we will be successful in obtaining additional financing in the future and any future financing that we may obtain may cause significant dilution to existing stockholders.

Historically, our main source of cash was through the sales of our products, common stock sales and debt financing.  However, due to the decrease in sales, our ability to meet contractual obligations and payables depends on our ability to implement cost reductions effectively and obtain additional financing. We believe that the ongoing economic challenges and uncertainties experienced in 2012 and the first quarter of 2013 will continue to negatively impact our business in the remainder 2013.  Thus, we expect that for 2013 we will continue to generate losses from operations, and our operating cash flows will not be sufficient to cover operating expense; therefore, we expect to continue to incur net losses

To meet our capital needs, we are considering multiple alternatives, including, but not limited to, additional debt financing and credit lines, delaying capital spending for future periods, and/or operating cost reductions.   We believe we can utilize our properties and land use rights located in Beijing, China to secure such financing.  No assurance can be given that the financing will be available or, if available, that it will be on terms that are satisfactory to us. Even if we are able to obtain additional financing, it may contain undue restrictions on our operations, in the case of debt financing or cause substantial dilution to shareholders, in case or equity financing.

We have implemented a cost reduction plan that includes decreasing our overhead, research and development, and advertising costs, which we estimate will save us 10% to 15% overall compared to 2012. We do not believe that this initiative will jeopardize our current operations or future growth plans materially. We also plan to delay our capital spending and additional expansion to future periods, including investments in construction in progress.

Our plan to delay our capital spending to future periods includes renegotiating the terms of our capital expenditure commitments, and we do not believe such deferrals would cause us material contractual penalties as we believe the contracts can be renegotiated.  We have also examined the structural effect of a delay on the buildings and we believe that they could sustain a delay of at least 2-3 years without comprising overall structural integrity.   We have also evaluated our current production lines and expect that they will continue to function through their estimated useful lives.  

Furthermore, as of September 30, 2012, we had invested in capitalized agricultural cost for $25,831,222.  These pre-harvest agriculture costs usually require substantial investment in the early stages, gradually decreasing to maintenance costs during the growing stage.  We expect that the cost required for these crops will be around $2.5 million per year.  We anticipate that the crops will benefit our operations in terms of raw material supply for internal use, as well as profit from selling to the market in 2018.  

We have also reviewed all of our current material obligations and expect that we could fulfill all of our material commitments, with the exception of construction contracts which we believe can be renegotiated.

We do not plan to further downsize our operations beyond the cost reductions discussed herein, including selling or closing any of our subsidiaries or suspending any ongoing operations.  

Total Debt

We had total of $67,214,059 in debt as of September 30, 2012, as compared to $116,440,026 as of December 31, 2011. The decrease of $49,225,967 was mainly due to the repurchase of convertible notes with a face value of $59,339,000 during the third quarter of 2012.

Cash Flow

Operating Activities

Cash flows used by operations during the nine months ended September 30, 2012 amounted to $37,139,732, representing an increase in cash used of $57,929,115 compared with cash flows provided by operations of $20,787,291 for nine months ended September 30, 2011. The increase in net cash used by operating activities was primarily attributable to: (i) lower sales and resulting increased losses in 2012 as compared to 2011, and (ii) a large decrease in accounts receivable of $16,554,608 in 2011, with a corresponding decrease of accounts receivable of only $9,251,412 in 2012.

Investing Activities

Our net cash provided by investing activities amounted to $25,807,373 in the nine months ended September 30, 2012, as compared to net cash used in investing activities of $39,616,540 in the nine months ended September 30, 2011. The changes mainly included: (i) the collection of notes receivable in the first three quarters of 2012 in the amount of $24,278,884, (ii) cash inflow from the collection of receivable for the sale of the NuoHua affiliate in the amount of $18,278,815 in 2012, and (iii) deposits made against long term assets in the amount of $30,353,949 in 2011.

Financing Activities

Our net cash provided used in activities was $16,443,390 in the nine months ended September 30, 2012, compared to cash provided by financing activities of $1,956,053 in the nine months ended September 30, 2011. The difference is primarily due to (i) cash used for the purchase of convertible notes in the amount of $18,478,888 in 2012, and (ii) increases in restricted cash of $6,781,052 in 2012 resulting from an increased use of bank acceptance notes which require restricted cash deposits.

Issuance of Common Stock

See Part II, Item 2 for issuance of unregistered shares of common stock.

Inflation

Inflation has not had a material impact on our business.

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.

We recognized a foreign currency translation adjustment of $3.3 million and $16.4 million for the nine months ended September 30, 2012 and 2011, respectively. The balance sheet amounts with the exception of equity at September 30, 2012 were translated at 6.3340 RMB to $1.00 USD as compared to 6.3647 RMB at December 31, 2011. The equity accounts were stated at their historical rate.

The average translation rates applied to the income and cash flow statement amounts for the three months ended September 30, 2012 and 2011 were 6.3313 RMB and 6.4329 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 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK