[ This is a low-liquidity idea, please skip if this is an issue ]

China-Biotics, Inc.

Have you ever seen a stock decline 36% during a two-week period in which a single investor accumulated 50% of the float? This is what has purportedly happened in the case of China-Biotics (Nasdaq:CHBT) from May 12, 2011 through May 27, 2011. While this piece of information standing taken at face value would be extremely puzzling, the skeptic’s interpretation makes a lot of sense: I believe this is not a real transaction, and in fact that the CEO sold his entire stake of 9 million shares (approximately $80 million at the average market price during this period) through intermediaries.

I propose shorting CHBT via put options. CHBT is another Chinese reverse merger company that is clearly a fraud. I believe that this trade offers 2.5:1 upside:downside with a 75% chance of success.

Fake Revenues, Fake Stores, Fake Customers

In its SEC filings, CHBT claimed 2009 revenue of USD 71 million, while in its Chinese (SAIC) filings, its 2009 revenue was a mere USD 500k. Much has been said about the SAICs, but history has proven them to be extremely accurate and I view them as the best measure of the "degree of fraud". By this measure, CHBT is nearly 100% fraudulent.

In August 2010, Citron Research questioned the existence of the company’s retail outlets. CHBT responded with a list of addresses. Citron and Kerrisdale Capital then took pictures at these addresses to prove that the retail outlets were nonexistent. In its 10-Q for the quarter ended September 30, the company claimed to have suddenly closed 95 (out of 103 total) retail outlets in the month of September. At the same time, they reported an increase in revenues and met guidance.

A major Chinese publication, First Financial Daily, interviewed three major Chinese dairy manufacturers and all of them denied having a relationship with CHBT. CHBT claims to sell products to Bright Dairy, but that company has stated that they do not know CHBT. It is unlikely that CHBT has any substantial bulk customers. The same article indicated that CHBT’s business in supermarkets is not only much smaller than represented, but actually declining, based on the reporter’s channel checks.

Timing the Short - Auditors

There is much more evidence but suffice to say that the fraud case is very clear. The only question here is timing the short.

Luckily, I believe it is extremely likely that BDO HK, the company’s auditing firm, will resign before the June 15^th 10-K deadline. BDO HK and BDO China have not “covered themselves in glory” this year. They signed 10-Ks for BORN, CMFO, GFRE, HOGS, ONP, and ZSTN in March 2011. Despite this embarrassing performance, I believe that BDO will, in the end, act rationally. BDO is one of the largest auditors in the world outside the big 4, and faces substantial legal and reputational risk. Also, the environment has changed significantly since March. The space is now under a microscope by the SEC and the mainstream media. CHBT is such a blatant fraud, that a clean opinion would be difficult to justify.

16 Chinese stocks are currently halted, not including those that were later delisted. Especially important, Deloitte resigned CCME and LFT; E&Y resigned CAGC; and KPMG resigned CBEH, even after signing for CBEH and YONG in March. I believe that BDO will follow the lead of the big 4 here. BDO China did resign the NIV account on May 14, 2011, which I take as a sign that the tide has finally turned. (note: NIV is under SEC investigation)

I have learned that BDO HK will not be taking any new RTO clients going forward, and I suspect that they will be looking to distance themselves from their existing business. They've publicly acknowledged that the status quo is unsustainable, so why would they continue to sign off, especially on a fraud as blatant as CHBT? That just seems like it would be asking for a lawsuit. One piece of disconfirmatory evidence is that BDO is continuing to audit ONP, another RTO fraud. So, while I think a resignation here is likely, it’s not definite.

Timing the Short - Management

I don’t get to a 75% chance of resignation based on an analysis of BDO’s incentives alone. I also would like to look at what management is doing here.

Which brings me back to the strange case of Richard Azar, who (according to SEC filings) purchased 4 million shares of CHBT, or approximately half of the reported float, since May 12. This story is full of holes, some of which were reported in Rick Pearson’s article on thestreet.com.

http://www.thestreet.com/story/11127326/1/china-stocks-who-is-richard-azar.html?cm_ven=RSSFeed

It seems clear to me that a stock does not drop by 36% when someone purchases 50% of the float. Rather, a stock would drop massively if someone SELLS 50% of the float. I believe that is exactly what is happening here. I can’t prove the exact mechanics, but it could look something like this: CHBT’s Chairman sold shares to Azar at a large discount to market, which Azar promptly hedged by selling shares short in another account or purchasing puts. This is hypothetical but extremely likely based on a filing from two days ago.

On May 31, 2011, CHBT’s CEO filed a Form 4/A disclosing that the he no longer owns 4 million shares which he had previously owned through his wife. The amendment also deletes a disclosure of 5 million shares direct ownership. If accurate, this means the CEO sold his entire stake of 9 million shares, or 41% of the shares outstanding.

January 19 original Form 4:

May 31 amended Form 4:

Management went to significant lengths to bury the stock sales and disclosure. In conjunction with the Form 4/A releases, they released an 8-K indicating that options were being repriced. If not read carefully, the Form 4/As could just look like an amendment to disclose the options repricing. They also, it appears, engineered a sham transaction with Richard Azar to create the appearance of a massive buyer.

Management is dumping shares. And the reason is that they also believe that BDO will resign. They are spending time covering up a stock sale instead of trying to fool BDO. Assuming the filing is accurate, the CEO is out and no longer has much incentive to try to fool BDO.

Execution

If BDO resigns, Nasdaq will halt the stock before June options expiration. You can then exercise and hold a short position to be closed when the stock reopens much lower (I would estimate around $2-$3).

The June put options are likely to be a good bet. I was able to purchase June $5s this morning at $0.80 and June $6s at $1.20. The November options would also work—by November, the stock price will have had a few months to absorb the news, and offer some (not much) downside protection if BDO doesn’t resign.

For those who find this to be too much excitement, the 2013 Jan $5 puts have been offered in recent days in the mid $2s, though liquidity is intermittent. The odds of this fraudulent company surviving 2 audit cycles is roughly zero, given that the SEC’s response to the Chinese reverse merger scandal is likely to include assurance measures tied to FY11 audit.

Disclaimer: The author and contributors to this report are short CHBT. We may increase or reduce our short position in the future without disclosure. This report is provided for informational purposes only, and does not constitute investment advice. Investing in securities involves a high degree of risk, and should only be undertaken by (or with the advice of) investment professionals.