UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
x ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE OF 1934
For the fiscal year ended December 31, 2008
o TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE OF 1934
For the transition period from ____ to _____
Commission file number: 001-32581
LOTUS PHARMACEUTICALS, INC. |
(Exact name of registrant as specified in its charter) |
NEVADA | 20-0507918 |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) |
16 Cheng Zhuang Road, Feng Tai District, Beijing 100071, People's Republic of China | n/a |
(Address of principal executive offices) | (Zip Code) |
Registrant's telephone number, including area code: | 86 (10) 63899868 |
Securities registered under Section 12(b) of the Act:
Title of each class | Name of each exchange on which registered |
None | Not applicable |
Securities registered under Section 12(g) of the Act:
Common stock |
(Title of class) |
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. [ ] Yes [√] No
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 [√] No
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 [√] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company:
Large accelerated filer | [ ] | Accelerated filer | [ ] |
Non-accelerated filer (Do not check if smaller reporting company) | [ ] | Smaller reporting company | [√] |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) Yes [ ] No [√]
State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was sold, or the average bid and asked prices of such common equity, as of the last business day of the registrant's most recently completed second fiscal quarter $12,441,550 on June 30, 2008.
Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date. 43,377,932 shares of common stock are issued and outstanding as of March 31, 2009.
DOCUMENTS INCORPORATED BY REFERENCE
List hereunder the following documents if incorporated by reference and the Part of the Form 10-K (e.g., Part I, Part II, etc.) into which the document is incorporated: (1) Any annual report to security holders; (2) Any proxy or information statement; and (3) Any prospectus filed pursuant to Rule 424(b) or (c) under the Securities Act of 1933. The listed documents should be clearly described for identification purposes (e.g., annual report to security holders for fiscal year ended December 24, 1980). None.
LOTUS PHARMACEUTICALS, INC.
FORM 10-K
TABLE OF CONTENTS
Page No. | ||
Part I | ||
Item 1. | Business. | 4 |
Item 1A. | Risk Factors. | 16 |
Item 1B. | Unresolved Staff Comments. | 29 |
Item 2. | Properties. | 29 |
Item 3. | Legal Proceedings. | 30 |
Item 4. | Submission of Matters to a Vote of Security Holders. | 30 |
Part II | ||
Item 5. | Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. | 30 |
Item 6. | Selected Financial Data. | 32 |
Item 7. | Management's Discussion and Analysis of Financial Condition and Results of Operation. | 32 |
Item 7A. | Quantitative and Qualitative Disclosures About Market Risk. | 45 |
Item 8. | Financial Statements and Supplementary Data. | 45 |
Item 9. | Changes In and Disagreements With Accountants on Accounting and Financial Disclosure. | 45 |
Item 9A.(T) | Controls and Procedures. | 45 |
Item 9B. | Other Information. | 47 |
Part III | ||
Item 10. | Directors, Executive Officers and Corporate Governance. | 47 |
Item 11. | Executive Compensation. | 50 |
Item 12. | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. | 52 |
Item 13. | Certain Relationships and Related Transactions, and Director Independence. | 53 |
Item 14. | Principal Accountant Fees and Services. | 54 |
Part IV | ||
Item 15. | Exhibits, Financial Statement Schedules. | 54 |
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CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION
This report contains forward-looking statements. These forward-looking statements are subject to known and unknown risks, uncertainties and other factors which may cause actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. These forward-looking statements were based on various factors and were derived utilizing numerous assumptions and other factors that could cause our actual results to differ materially from those in the forward-looking statements. These factors include, but are not limited to, the risk of doing business in the People's Republic of China ("PRC"), our ability to implement our strategic initiatives, our access to sufficient capital, the effective integration of our subsidiaries in the PRC into a U.S. public company structure, economic, political and market conditions and fluctuations, government and industry regulation, Chinese and global competition, and other factors. Most of these factors are difficult to predict accurately and are generally beyond our control. You should consider the areas of risk described in connection with any forward-looking statements that may be made herein. Readers are cautioned not to place undue reliance on these forward-looking statements and readers should carefully review this report in its entirety, including the risks described in "Item 1A. - Risk Factors". Except for our ongoing obligations to disclose material information under the Federal securities laws, we undertake no obligation to release publicly any revisions to any forward-looking statements, to report events or to report the occurrence of unanticipated events. These forward-looking statements speak only as of the date of this report, and you should not rely on these statements without also considering the risks and uncertainties associated with these statements and our business.
OTHER PERTINENT INFORMATION
We maintain a web site at www.lotuspharma.com. Information on this website is not a part of this annual report.
INDEX OF CERTAIN DEFINED TERMS USED IN THIS REPORT
Unless specifically set forth to the contrary, when used in this report the terms:
• "Lotus," "we," "us," "our," the "Company," and similar terms ref er to Lotus Pharmaceuticals, Inc., a Nevada corporation formerly known as S.E. Asia Trading Company, Inc., and its subsidiary,
• "Lotus International" refers to Lotus Pharmaceutical International, Inc., a Nevada corporation and a subsidiary of Lotus,
• "Lotus Century" refers to Lotus Century Pharmaceutical (Beijing) Technology co., Ltd., a wholly foreign-owned enterprise (WFOE) Chinese company which is a subsidiary of Lotus,
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• "Liang Fang" refers to Beijing Liang Fang Pharmaceutical Co., Ltd., a Chinese limited liability company formed on June 21, 2000 and an affiliate of En Zhe Jia,
• "En Zhe Jia" refers to Beijing En Zhe Jia Shi Pharmaceutical Co., Ltd., a Chinese limited liability company formed on September 17, 1999 and an affiliate of Liang Fang,
• "Lotus East" collectively refers to Liang Fang and En Zhe Jia,
• "Consulting Services Agreements" refers to the Consulting Services Agreements dated September 20, 2006 between Lotus and Lotus East.
• "Operating Agreements" refers to the Operating Agreements dated September 20, 2006 between Lotus, Lotus East and the stockholders of Lotus East,
• "Equity Pledge Agreements" refers to the Equity Pledge Agreements dated September 20, 2006 between Lotus, Lotus East and the stockholders of Lotus East,
• "Option Agreements" refers to the Option Agreements dated September 20, 2006 between Lotus, Lotus East and the stockholders of Lotus East,
• "Proxy Agreements" refers to the Proxy Agreements dated September 20, 2006 between Lotus, Lotus East and the stockholders of Lotus East,
• "Contractual Arrangements" collectively refers to the Consulting Services Agreements, Operating Agreements, Equity Pledge Agreements, Option Agreements and the Proxy Agreements,
• "China" or the "PRC" refers to the People's Republic of China,
• "RMB" refers to the renminbi which is the currency of mainland PRC of which the yuan is the principal currency,
• "2007" generally refers to the fiscal year ended December 31, 2007; and
• "2008" generally refers to the fiscal year ending December 31, 2008.
OVERVIEW
We operate, control and beneficially own the pharmaceutical businesses in China of Lotus East under the terms of the Contractual Arrangements. Other than the Contractual Arrangements with Lotus East, we do not have any business or operations. Pursuant to the Contractual Arrangements we provide business consulting and other general business operation services to Lotus East. Through these Contractual Arrangements, we have the ability to control the daily operations and financial affairs of Lotus East, appoint each of their senior executives and approve all matters requiring stockholder approval. As a result of these Contractual Arrangements, which enable us to control Lotus East, we are considered the primary beneficiary of Lotus East. Accordingly, we consolidate Lotus East's results, assets and liabilities in our financial statements. The creditors of Lotus East, however, do not have recourse to any assets we may have.
PRC law currently places certain limitations on foreign ownership of Chinese companies. To comply with these foreign ownership restrictions, we operate our business in China through the Contractual Arrangements with Lotus East. The contractual relationship among the above companies as follows:
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Notwithstanding that Lotus, Liang Fang and En Zhe Jia are separate legal entities and the legal obligations of the parties are governed by the Contractual Arrangements, there is commonality of control between Lotus and Lotus East as set forth in the following table:
Name | Executive Officer/Director of Lotus | Principal Stockholder of Lotus | Stockholder of Liang Fang | Stockholder of En Zhe Jia |
Dr. Liu Zhong Yi | √ | √ | √ | √ |
Mrs. Song Zhenghong 1 | √ | √ | √ | √ |
Wen Li Xian | √ |
(1) Mrs. Song Zhenghong is the spouse of Dr. Liu Zhong Yi.
Based in Beijing, China, Lotus East is engaged in the production, trade and retailing of pharmaceuticals, focusing on the development of innovative medicines and investing in strategic growth to address various medical needs. Lotus East owns and operates 10 drug stores throughout Beijing, China that sell Western and traditional Chinese medications, lease medical treatment facilities to licensed physicians, and generate revenues from the leasing of retail space to third party vendors and the leasing of advertising locations at its retail stores.
Our principal executive offices are located at 16 Cheng Zhuang Road, Feng Tai District, Beijing 100071 China and our telephone number is 86-10-63899868. Our fiscal year end is December 31.
The Contractual Arrangements are comprised of a series of agreements, including Consulting Services Agreements and Operating Agreements, through which we have the right to advise, consult, manage and operate Lotus East, and collect and own all of their respective net profits. Additionally, under Proxy Agreements, the stockholders of Lotus East have vested their voting control over Lotus East to us. In order to further reinforce our rights to control and operate Lotus East, these companies and their stockholders have granted us, under Option Agreements, the exclusive right and option to acquire all of their equity interests in Lotus East, alternatively, all of the assets of Lotus East. Further the Lotus East stockholders have pledged all of their rights, titles and interests in Lotus East to us under Equity Pledge Agreements.
Under PRC laws, each of Lotus, Lotus International, Liang Fang and En Zhe Jia is an independent legal person and none of them is exposed to liabilities incurred by the other party. Other than pursuant to the Contractual Arrangements, Lotus East does not transfer any other funds generated from their respective operations to us.
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On September 6, 2006, we entered into the following Contractual Arrangements:
Consulting Services Agreements. Pursuant to the exclusive Consulting Services Agreements we have the exclusive right to provide to Lotus East general pharmaceutical business operations services as well as consulting services related to the technological research and development of pharmaceutical products as well as general business operation advice and strategic planning (the "Services"). Under these agreements, we own the intellectual property rights developed or discovered through research and development, in the course of providing the Services, or derived from the provision of the Services. Lotus East is to pay us a quarterly consulting service fees in RMB that is equal to Lotus East's net profits, as defined, for such quarter.
Operating Agreements. Pursuant to the Operating Agreements we provide guidance and instructions on Lotus East's daily operations, financial management and employment issues. The stockholders of Lotus East must designate the candidates recommended by us as their representatives on each of Lotus East's Board of Directors. We have the right to appoint senior executives of Lotus East. In addition, we agreed to guarantee Lotus East's performance under any agreements or arrangements relating to Lotus East's business arrangements with any third party. Lotus East, in return, agreed to pledge its accounts receivable and all of its assets to us. Moreover, Lotus East agreed that without our prior consent, Lotus East would not engage in any transaction that could materially affect the assets, liabilities, rights or operations of Lotus East, including, without limitation, incurrence or assumption of any indebtedness, sale or purchase of any assets or rights, incurrence of any encumbrance on any of its assets or intellectual property rights in favor of a third party or transfer of any agreements relating to its business operation to any third party. The term of these agreements is 10 years from September 6, 2006 and may be extended only upon our written confirmation prior to the expiration of the these agreements, with the extended term to be mutually agreed upon by the parties.
Equity Pledge Agreements. Under the Equity Pledge Agreements, the stockholders of Lotus East pledged all of their equity interests in Lotus East to us to guarantee Lotus East's performance of its obligations under the Consulting Services Agreements. If Lotus East or Lotus East's stockholders breaches its respective contractual obligations, we, as pledgee, will be entitled to certain rights, including the right to sell the pledged equity interests. Lotus East's stockholders also agreed that upon occurrence of any event of default, we will be granted an exclusive, irrevocable power of attorney to take actions in the place and stead of Lotus East's stockholders to carry out the security provisions of the Equity Pledge Agreements and take any action and execute any instrument that we might deem necessary or advisable to accomplish the purposes of The Equity Pledge Agreements. The stockholders of Lotus East agreed not to dispose of the pledged equity interests or take any actions that would prejudice our interest. The Equity Pledge Agreements expire two years after Lotus East's obligations under the Consulting Services Agreements have been fulfilled.
Option Agreements. Under the Option Agreements, the stockholders of Lotus East irrevocably granted us or our designated person exclusive options to purchase, to the extent permitted under PRC law, all or part of the equity interests in Lotus East for the cost of the initial contributions to the registered capital or the minimum amount of consideration permitted by applicable PRC law. We, or our designated person, has sole discretion to decide when to exercise the option, whether in part or in full. The term of these agreements is 10 years from September 6, 2006 and may be extended prior to their expiration by written agreement of the parties.
Proxy Agreements. Pursuant to the Proxy Agreements, Lotus East's stockholders agreed to irrevocably grant a person to be designated by us with the right to exercise Lotus East's stockholders' voting rights and their other rights, including the attendance at and the voting of Lotus East's stockholders' shares at the stockholders' meetings (or by written consent in lieu of such meetings) in accordance with applicable laws and their Articles of Association, including but not limited to the rights to sell or transfer all or any of his equity interests of Lotus East, and appoint and vote for the directors and Chairman as the authorized representative of the stockholders of Lotus East. The term of these Proxy Agreements is 10 years from September 6, 2006 and may be extended prior to their expiration by written agreement of the parties.
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LOTUS EAST
Based in Beijing, China, Liang Fang is engaged in the production, trade and retailing of pharmaceuticals, focusing on the development of innovative medicines and investing in strategic growth to address various medical needs.
Liang Fang owns and operates 10 drug stores throughout Beijing, China that sell Western and traditional Chinese medications, lease medical treatment facilities to licensed physicians, and generate revenues from the leasing of retail space to third party vendors and the leasing of advertising locations at its retail stores. En Zhe Jia is the sole manufacturer for Liang Fang and maintains facilities for the production of medicines, patented Chinese medicine, as well as the research and production of other new medicines.
Lotus East's business is composed of three parts:
· | manufacturing and distribution of pharmaceutical products, including the manufacture of pharmaceutical products for other distributors (OEM manufacturing), |
· | retailing of Western and traditional Chinese medications, and medical treatment equipment through retail locations; and |
· | research and development as outlined below: |
MANUFACTURING AND DISTRIBUTION OF PHARMACEUTICAL PRODUCTS
Lotus East's production enterprise is located in the Chaoyang District of Beijing and covers a floor space of approximately 50,000 square feet. It possesses liquid phase, gas phase, spectrum, and mass spectrum equipment and a
variety of types of purification and distilling equipment, all of which can be used for production and research and development of biochemical medicines, Chinese traditional medicines, chemical compound medicines, antibiotics and other new medicines. As one of the first enterprises to be authenticated by the National China Good Manufacturing Practices (GMP), Lotus East believes it has an advanced automatic pharmacy product line which is GMP authenticated under certificate numbers C0849, C0850, D1645, and G3452. Medicines produced by Lotus East include:
· | material medicine, |
· | troches, |
· | capsules, |
· | granule medicaments; |
· | freeze-dried powder for injections, |
· | injections of small capacities, and |
· | eye drops. |
Different production control zones are used with separated air conditioning system according to different production and control needs. Production and sale of its pharmaceuticals and wholesale distribution of third party manufactured pharmaceuticals is Lotus East's largest and most profitable business and accounts for approximately 88% and 73% of our net revenues in 2008 and 2007, respectively. Under various manufacturing contracts, Lotus East provides contract manufacturing services for several drug companies including the manufacture of product to their specifications.
Currently, Lotus East markets and sells its products only in PRC. Lotus East's principal pharmaceutical manufactured products include:
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Valsartan
In 2000, Lotus East obtained approval from the State Food and Drug Administration (SFDA) of China to sell Valsartan as a raw material and as a capsule (Maixin). Among its best selling products, Valsartan is a drug that treats hypertension or high blood pressure. This product is globally recognized as the ideal anti-high blood pressure medication by the medical industry due to its most stable and longest lasting treatment results and minimum side-effects.
High blood pressure adds to the workload of the heart and arteries. If it continues for a long time, the heart and arteries may not function properly. This can damage the blood vessels of the brain, heart, and kidneys, resulting in a stroke, heart failure, or kidney failure. High blood pressure may also increase the risk of heart attacks. These problems may be less likely to occur if blood pressure is controlled. Valsartan works by blocking a substance in the body that causes blood vessels to tighten. As a result, Valsartan relaxes blood vessels. This lowers blood pressure and increases the supply of blood and oxygen to the heart. Lotus East's goal is to make Valsartan the number one prescribed brand in its class of high blood pressure medications in the PRC.
Lotus East holds current manufacturing rights to produce Valsartan. It estimates that there are currently 10 enterprises producing single regent dosage and fixed-dose combinations of Valsartan in China. The foreign pharmacy Novartis Pharma sells Valsartan under its brand name, Diovan. According to clinical verification, the two products, Maixin and Diovan, have the same clinical effects. Lotus East’s currently holds approximately 20% of the total China market share for Valsartan. Lotus East believes that it will maintain its current market share due to increased brand recognition and continued sales efforts. Lotus East also believes that even if the Chinese government does not take any measures to protect these products, other enterprises still cannot replicate its products in the near future because it takes at least two to three years to replicate any orally taken medicine and China SFDA has not been encouraging for duplicated medicines by limiting the approvals given to the new applications for duplicated medicines. Even if the market does face fiercer competition in the future, Lotus East believes its market will be relatively mature and that its production cost will be lower than those newly approved products. Accordingly, it believes that its sales revenue from Valsartan can stay relatively stable.
Brimonidine Tartrate Eyes Drops
Brimonidine Tartrate is a drug used to constrict adrenaline receptors, an important step in treating glaucoma. Lotus East sells Brimonidine Tartrate eye drops under its brand name "Muxin". The drug was first put into market in the U.S. in 1998 and in August 2004, Lotus East received the rights to manufacture and release the drug in the Chinese market. A fast and obvious curative effect, very few side effects, a very high exponent of cure and high endurement are prime features of the drug. It will produce no harmful effects of reducing blood pressure, resulting in calmness and so on, much like diazepam. The imported product of its kind is Alphagan and is produced by Allergan (Hangzhou) Pharmaceutical Co., Ltd. According to clinical experiments of People's Hospital of Peking University and Tianjin Eye Hospital, Muxin and imported Alphagan have exactly the same curative effect but the side-effects of Muxin are fewer than Alphagan. As a result, Lotus East believes that its product has a stronger competitive advantage.
Lotus East holds manufacturing rights to produce Brimonidine Tartrate through August 2009. Lotus East estimates that other enterprises will not be able to replicate this product until March 2010, as it believes it takes at least 30 months to replicate an eye drop medicine. Currently, Lotus East has minimal competition and believes its market share will increase. However, it does anticipate lowers gross margins profits after 2010.
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Levofloxacin Lactate for Injection
Levofloxacin is a popular anti-bacterial drug for the treatment of mild, moderate, and severe infections caused by susceptible trains of the designated microorganisms in the conditions such as acute maxillary sinusitis, acute bacterial exacerbation of chronic bronchitis, community-acquired pneumonia, complicated and uncomplicated skin and skin structure infections, complicated and uncomplicated urinary tract infections, and acute pyelonephritis. Lotus East received the rights to manufacture and release the drug in the Chinese market in 2005. Lotus East currently sells Levofloxacin Lactate for Injection under its brand name "Junxin". The imported product of its kind is manufactured by Japanese pharmaceutical company, Daiichi Pharmaceutical Co. Levofloxacin is one of most widely use antibiotics in China and Lotus East believes this product will remain competitive through 2011.
Nicergoline for Injection
Nicergoline for Injection is a national medical insurance product. It is an A-receptor blockage nerve system blood-brain medicine with remarkable curative effect. On the cerebral level, it prompts a lowering of vascular resistance, an increase in arterial flow and stimulates the use of oxygen and glucose. Nicergoline also improves blood circulation in the lungs and limbs and has been shown to inhibit blood platelet aggregation. It is used to treat senile dementia, migraines of vascular origin, transient ischemia, platelet hyper-aggregability and macular degeneration. Lotus East received the rights to manufacture this product in 2006 and release the drug in the Chinese market in 2007. The estimated patient base for this product in China is approximately 30,000,000 people and Lotus East believes this product will remain competitive through 2011. Sales decrease in 2008 but we expect future sales will remain stable at the current level as 2008.
Lotus East also acts as a wholesale distributor to distribute various pharmaceutical products manufactured by third party manufacturers. The third party manufactured products are –
Product Name | Type of Distribution Rights |
Octreotide Acetate Injection Solution | Exclusive Distribution Rights |
Recombinant Human Erythropoietin Injection | Exclusive Distribution Rights |
Recombinant Human Granulocyte Colony Stimulating Factor Injection | Exclusive Distribution Rights |
Recombinant Human Interleukin-2 for Injection | Exclusive Distribution Rights |
Cervus and Cucumis Polypeptide Injection | Exclusive Distribution Rights |
Potassium Aspartate and Magnesium Aspartate for Injection | Non-exclusive Distribution Rights |
Deproteinized Calfblood Extractives Injection | Non-exclusive Distribution Rights |
Cefotaxime Sodium For Injection | Non-exclusive Distribution Rights |
Ningxinyishen Koufuye | Non-exclusive Distribution Rights |
In 2008 and 2007, revenues from wholesale distribution of our four principal products (Walsartan, Brimonidine Tartrate Eyes Drops, Levofloxacin Lactate for Injection and Nicergoline for Injection) manufactured by Lotus East were approximately 49% and 28% of Lotus East's total sales revenue, respectively.
With the implementation in China of macro-economic policy and price controls by the Chinese government, the overall profit margin of medicines in the industry shall decrease. However, the rapid increase in the disposable income, government-backed healthcare spending and the number of elderly people in China in recent years have primarily resulted in an increasing spending on prescription and OTC medicines in China.
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As of the date of this report, we cannot estimate the effect of these economic policies and increased spendings in China on our results of operations.
Technology Transfer Agreement
On April 25, 2008 En Ze Jia entered into a Technology Transfer Agreement with Dong Guan Kai Fa Biologicals Medicine LTD ("Dong Guan") pursuant to which Dong Guan agreed to transfer the technology material, new medicine research and rights to the Chinese patent of the anti-asthma new medicine R-BM to En Ze Jia on an exclusive basis in exchange for a transfer technology fee of approximately $6,860,000 (RMB 48 million) to be paid at various intervals. Under the terms of the agreement, En Ze Jia is obligated to:
• | complete the filing with the Chinese State Food and Drug Administration (SFDA) of the medicine's clinical research ratification document, |
• | complete the clinical research, |
• | complete the medicine's trial production, and |
• | providing raw materials and formulation related documentation and apply for the new medicine certification and production approval. |
In addition to the payment of the technology transfer fee, En Ze Jia is responsible for paying all costs associated with its responsibility under the agreement which are presently estimated at $2,286,000 (RMB 16 million). Lotus East intends to use its working capital to fund the project costs.
Dong Guan is responsible for preparing and transferring the clinical research and application documents as well as assisting En Ze Jia in the completing the clinical research and applying for the new medicine certification and production approval documents.
Under the terms of the agreement, the technology transfer fee is to be paid upon the following schedule:
• Approximately $1,429,000 (RMB 10 million) is due by the 15th business day following the receipt of the processing notice of the receipt of the clinical application and all related material from SFDA is received,
• Approximately $1,144,000 (RMB 8 million) is due by the 10th business day after the receipt of the medicine's clinical ratification document,
• Approximately $1,429,000 (RMB 10 million) is due by the 15th business day after the medicine's Phase I clinical study is completed and ratification from the SFDA is obtained, and
• Approximately $2,858,000 (RMB 20 million) is due by the 10th business day after the medicine's Phase II clinical study is completed and ratification from the SFDA is obtained.
En Ze Jia paid Dong Guan a deposit of approximately $2,858,000 (RMB 20 million) which is returned to En Ze Jia with 10 days after the transfer technology fee is paid. In the event Dong Guan should be unable to timely return the deposit, it will pay En Ze Jia a late fee and En Ze Jia is entitled to damages for Dong Guan's failure to timely return the deposit.
In addition to the technology transfer fee, Dong Guan is entitled to annual payments equal to 3% of the product's annual sales in the prior year beginning in following year after the medicine is produced and marketed and continuing until August 2020, the expiration date of the patent. The agreement further requires En Ze Jia to complete various stages of the process in accordance with an established schedule with anticipates the introduction of the product to market during 2014. En Ze Jia, however, anticipates that the product will be launched in 2012 assuming the approval of SFDA can be obtained.
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The intellectual property arising from the agreement will be jointly shared by the parties. In addition, En Ze Jia has guaranteed that both parties must jointly apply for related government grants prior to when the new medicine is marketed. Upon receipt of the government grants En Ze Jia guaranteed that the grant monies will be shared equally by both parties.
The agreement can be terminated by Dong Guan if En Ze Jia should fail to make any of the aforedescribed payments in which event the patent rights would revert to Dong Guan and it is entitled to transfer the project rights to a third party.
RETAIL DRUGSTORES
Lotus East owns and operates 10 drug stores throughout many different districts of Beijing, including:
· | Xin Zhong Tai Drugstore |
· | Long Ren Tang Drugstore |
· | Wan Shou Road Drugstore |
· | He Ping Li Drugstore |
· | Feng Lin Lu Zhou |
· | Youth Lake Drugstore |
· | Capital Airport Drugstore |
· | Young An Zhong Sheng Drugstore |
· | Cheng Zhuang Road Drugstore |
· | Feng Tai Drugstore |
These 10 drug stores all offer in excess of 5,000 types of Western and traditional Chinese medications, and medical treatment equipment. The drug stores attempt to compete according to lower pricing and more efficient distribution and management practices. Lotus East has approximately 300 employees (90 exclusive sales representatives, 65 retail store staff, 60 product marketing specialists including registered pharmacists, 45 administrative staff and 40 factory workers).
Through its retail operations, Lotus East also generates revenue through the leasing of office space to licensed physicians, the lease of store front areas to various merchants, and the lease of advertising space in the retail pharmacies.
DISTRIBUTION METHODS OF THE PRODUCTS OR SERVICES AND LOTUS EAST'S CUSTOMERS
Currently, Lotus East sells drugs through over 70 distribution agents and drug distribution companies in China covering 32 except Tibet, Taiwan, Hong Kong, and Macau in the PRC. Lotus East works with various distribution companies to distribute its products. The demand for new drugs in China is substantial as the drug distribution companies suffer from very low profit margins from the distribution of old generic drugs. Additionally, Lotus East has a network of connections with hospitals in the Inner Mongolia and surrounding areas which provide direct access to hospitals in these areas. Lotus East's drug products are also sold through its retail drug stores.
Lotus East recognizes the importance of branding as well as packaging. All of its products bear a uniform brand but it also brands and packages its products with specialized designs to differentiate the different categories of its products.
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Lotus East conducts promotional marketing activities to publicize and enhance the company's image as well as to reinforce the recognition of its brand name, including:
· | publishing advertisements and articles in national as well as specialized and provincial pharmaceutics and Biotech newspapers and magazines, and in other media, including the Internet; |
· | participation in national meetings, seminars, symposiums, exhibitions for bio-pharmaceutical and other related industries; |
· | organizing cooperative promotional activities with distributors; and |
· | Educational and seminar training sessions to physicians and pharmacists to introduce and explain our drugs. |
· | Establishment of an over the counter department to resell various retail pharmaceutical products to other third party pharmacies |
Excluding customers in its retail operations, Lotus East currently has over 130 customers, including over 30 direct customers in Beijing, Shanghai, Chongqing, GuangDong, Inner Mongolia, Ningxia, Henan, Hubei, LiaoNing, HeiLongjiang, Guangxi, Jiangsu, Hebei, Anhui, Yunnan, Sichuan, Shanxi provinces in the PRC. In 2008, Lotus East spent approximately $181,000 on advertising expenses as compared to approximately $2.6 million in 2007.
AGREEMENT WITH WU LAN CHA BU EMERGENCY HOSPITAL
On October 10, 2006, Lotus East entered into a five-year loan agreement and contract with Wu Lan Cha Bu Emergency Hospital whereby Lotus East agreed to lend to Wu Lan Cha Bu Emergency Hospital approximately $4,377,000 for the construction of a hospital ward in Inner Mongolia, China. In exchange for the loan, Wu Lan Cha Bu Emergency Hospital agreed that Lotus East would be the exclusive provider for all medicines and disposable medical treatment apparatus to it for a period of 20 years. In October 2006, Dr. Liu Zhong Yi, our Chief Executive Officer and the CEO and principal stockholder of Lotus East, loaned these funds to Wu Lan Cha Bu Emergency Hospital on behalf of Lotus East. Accordingly, on October 10, 2006 Lotus East entered into an assignment agreement whereby it assigned all of its rights, obligations, and receipts under the loan agreement to Dr. Liu, except for the rights to revenues from the sale of medical and disposable medical treatment apparatus which will remain with Lotus East. As compensation to Dr. Liu for accepting the assignment under the loan agreement including all of the risks and obligations and for Dr. Liu not accepting the rights to revenues from the sale of medical and disposable medical treatment apparatus which will remain with Lotus East, Lotus East agreed to pay Dr. Liu an aggregate of approximately $1,313,000 to be paid in five equal annual installments of approximately $263,000. On October 2006, we estimated the hospital construction project will be completed by 2009. But there have been delays in this construction project, so, at this moment, we estimated it will not be completed until summer of 2010. Accordingly, it is anticipated that Lotus East will begin generating revenue from the hospital in late 2010.
COMPETITION
Vertically integrated pharmaceutical operations are still at an early stage of development in China due to heavy state involvement in the past and Lotus East believes that the industry is fragmented. Lotus East faces competition from domestic drug research and development companies and drug manufacturing companies which are growing rapidly. Its direct competitors are domestic pharmaceutical companies and new drug research and development institutes that have fairly strong research and development capabilities in new drugs such as Beijing Venture Biopharma Technology Co., Ltd., Fosun Group Co., Ltd., Zhuhai Lizhu and Beijing Nohua . Lotus East also faces competition of foreign companies who have strong proprietary pipeline and strong financial resources. These companies have significantly greater assets than Lotus East and have a larger current market share. Lotus East believes its advantage is its local concentration in research and development, the local distribution network, and lower prices. Lotus East believes that it has good quality and technical manufacturing practices and generally has not experienced any quality control issue. Lotus East attempts to focus more on quality, and establishing long-term good cooperative relations with the Chinese Academy of Medical Sciences and the China Academy of Traditional Chinese Medicine and medicine test organizations. Lotus East believes that it is able to compete as a result of its research and development capability, extensive sales network and lower prices. Other than these competitors, most of Lotus East's other competitors produce only one or two products.
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RAW MATERIALS AND PRINCIPAL SUPPLIERS
Lotus East designs, creates prototypes and manufactures its products at its manufacturing facilities located at Beijing, PRC. Its principal raw materials include Brimonidine Tartrate, Levofloxacin Lactate, Nicergoline and Valsartan. The prices for these raw materials are subject to market forces largely beyond Lotus East's control, including energy costs, organic chemical prices, market demand, and freight costs. The prices for these raw materials have varied significantly in the past and may vary significantly in the future.
Lotus East relies on a combination of trademark, copyright and trade secret protection laws in PRC and other jurisdictions, as well as confidentiality procedures and contractual provisions to protect our intellectual property and its brand. Lotus East intends to apply for patent protection of certain of its special technologies to protect our core technologies. There are no assurances, however, that if such applications are made that the patents will be granted. Lotus East also enters into confidentiality, non-compete and invention assignment agreements with its employees and consultants and nondisclosure agreements with third parties. "Maixing" and "Liang Fang" are its registered trademarks in the PRC.
RESEARCH AND DEVELOPMENT
Lotus East places great emphasis on product research and development and it has established a research and development center. Lotus East's research and development team is comprised of nine individuals who are focused on discovering new drugs as well as developing generic and improved drugs based on existing products already on the market and traditional Chinese medicinal products. Lotus East also contracts third party research and development institutes to conduct various research and development projects on its behalf. From research and development performed during and prior to fiscal 2005, Lotus East has a product pipeline containing approximately seven products in different dosage forms which are ready for commercialization in China for the treatment of diseases. Lotus East expects to receive Chinese SFDA approvals on those products in the near future. Lotus East intends to commercialize or license these drugs during 2008 and 2009. In 2007, Lotus East resumed its new drug research and development effort and started five new research and development projects and those projects are in different development stages. Major projects currently being undertaken at these centers focus on the following:
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Drug Name | Target Treatment | Status (A) |
Calcium Dibutyryl Adensine Monophosphate for Injection | used to cure angina and acute myocardial infarction | Pending final SFDA approval |
Gatifloxacin Lactate for Injection | used for curing acute nasosinusitis, chronic bronchitis, pneumonia, gonorrhea, and rectum infection | Pending final SFDA approval |
Sodium Aescinate for Injection | use for curing hydrocephalus, swelling caused by wounds or surgery operation and for venous return disorder. | Pending final SFDA approval |
Isosorbide Mononitrate-Sustained Release Tablets | used for preventing angina (chest pain) caused by heart disease. | Pending SFDA approval |
Gliclazide-Controlled Release Tablets | Used for control of hyperglycemia in gliclazide responsive diabetes mellitus of stable, mild, non-ketosis prone, maturity onset or adult type | Pending SFDA approval |
Salbutamol Sulfate-Controlled Release Tablets | Used for the relief of bronchospasm in conditions such as asthma and chronic obstructive pulmonary disease | Undergoing clinical studies |
Total Hawthorn Flavonoids-Sustained Release Tablets (TCM, patent product) | Used to control high blood pressure | In development stage |
Doxazosin-Controlled Release Tablets | Used for curing benign prostatic hyperplasia | In development stage |
Nifedipine-Controlled Release Tablets | used for curing hypertension and angina | In development stage |
Lovastatin-Controlled Release tablets | used to hypolipidemic | In development stage |
Simvastatin-Comtrolled Release tablets | used to hypolipidemic | In development stage |
Verapamil Hydrochloride-Controlled Release Tablets | used for curing variant angina and unstable angina | In development stage |
Valsartan-Controlled Release Tablets | Used for curing high blood pressure | In development stage |
(A) Subject to SFDA. Pending Administrative Protection and approval.
GOVERNMENT APPROVAL AND REGULATION
Lotus East's sales market is presently limited to China. Lotus East is subject to the Drug Administration Law of China, which governs the licensing, manufacturing, marketing and distribution of pharmaceutical products in China and sets penalties for violations of the law. Additionally, Lotus East is also subject to various regulations and permit systems by the Chinese government.
The Drug Administration Law of the PRC governs Lotus East and its products. The State Food & Drug Administration of the PRC regulates and implements drug laws. The State FDA has granted Lotus East six government permits for it to produce the following products:
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· | Valsartan Capsules, |
· | the material of Valsartan, |
· | Levofloxacin Lactate for Injection, |
· | the material of Levofloxacin Lactate, |
· | Brimonidine Tartrate Eyes Drops with a density of 0.1, and |
· | Brimonidine Tartrate Eyes Drops with the density of 0.3. |
No enterprise may start production at its facilities until it receives approval from the provincial, autonomous region level, or municipality level SFDA to begin operations. The approval process takes about two years: including local SFDA approval, Local SFDA assessment, State SFDA processing, state SFDA expert valuation, clinical trial, final approval.
Lotus East has the requisite approval and licenses from the Beijing SFDA in order to operate its production facilities.
COMPLIANCE WITH ENVIRONMENTAL LAW
Lotus East complies with the Environmental Protection Law of China and its local regulations. In compliance with PRC environmental regulations, Lotus East spent approximately $0 in 2008 and approximately $170,000 in 2007 on compliance with environmental regulations, principally for waste discharge processing and dust cleaning.
EMPLOYEES
We do not have any employees. As of March 31, 2009, Lotus East has 239 employees, including 199 full time employees and 40 part time employees. All of these employees are all located in the PRC and who receive labor insurance. These employees are organized into a union under the labor laws of China and can bargain collectively with Lotus East. Lotus East believes it maintains good relations with its employees.
Lotus East is required to contribute a portion of its employees' total salaries to the Chinese government's social insurance funds, including medical insurance, unemployment insurance and job injuries insurance, and a housing assistance fund, in accordance with relevant regulations. It expects the amount of its contribution to the government's social insurance funds to increase in the future as it expands its workforce and operations.
CONSULTING ARRANGEMENT WITH CFO ONCALL, INC.
In August 2006, we engaged CFO Oncall, Inc., a U.S. based firm that provides outsourced chief financial officer/controller services to public companies, to assist us assembling our annual and quarterly financial statements, as well as to assist our management in the preparation of our financial statements. Under the terms of the engagement, Mr. Adam Wasserman, a principal of CFO Oncall, Inc., serves as our Chief Financial Officer. We pay this firm on a monthly fixed fee. In 2008 and 2007, we paid CFO Oncall, Inc. $120,000 and $94,200 for its services, respectively.
HISTORY OF OUR COMPANY
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We were incorporated on January 28, 2004 in the State of Nevada as S.E. Asia Trading Company, Inc. to sell jewelry and home accessories.
On September 6, 2006, we entered into a definitive Share Exchange Agreement with Lotus International, whereby we would acquire all of the outstanding common stock of Lotus International in exchange for newly-issued shares of our stock to Lotus International's stockholders. Lotus International was incorporated under the laws the State of Nevada on August 28, 2006 to develop and market pharmaceutical products in China. On September 28, 2006, Lotus International became our wholly-owned subsidiary and Lotus International's stockholders own the majority of our voting stock. The acquisition of Lotus International by us was accounted for as a reverse merger because on a post-merger basis, the former stockholders of Lotus International held a majority of our outstanding common stock on a voting and fully-diluted basis. As a result, Lotus International is deemed to be the acquirer for accounting purposes.
We changed our name to Lotus Pharmaceuticals, Inc. on December 6, 2006.
In May 2007 we formed Lotus Century to engage in the development of innovative medicines, medical technology consulting and outsourcing services, and related training services. As of March 31, 2009, it has not commenced operations.
ITEM 1.A RISK FACTORS
Investing in our securities involves a great deal of risk. You should not invest in our common stock unless you can afford to lose your entire investment. Careful consideration should be made of the following factors as well as other information included in this prospectus before deciding to purchase our common stock. You should pay particular attention to the fact that we conduct all of our operations in China and are governed by a legal and regulatory environment that in some respects differs significantly from the environment that may prevail in other countries. Our business, financial condition or results of operations could be affected materially and adversely by any or all of these risks.
RISKS RELATING TO OUR OVERALL BUSINESS OPERATIONS
THE SERIES A CONVERTIBLE REDEEMABLE PREFERRED STOCK HAS A MANDATORY CONVERSION AND WE MAY NOT HAVE SUFFICIENT FUNDS AVAILABLE TO PAY THE REDEMPTION AMOUNTS.
Under the designations, rights and preferences of the Series A Convertible Redeemable Preferred Stock at the option of the holder for a period of 90 days beginning on February 25, 2010. The redemption price which is equal to $0.87 per share plus any accrued but unpaid dividends, must be paid in cash, in one lump sum within one month from the end of the 90 day period. Assuming that sufficient funds are available to us to pay these redemption amounts, if one or more of the holders of the Series A Convertible Redeemable Preferred Stock should elect redemption of those shares, the payment of the redemption price will materially and adversely impact our liquidity. In addition, as described elsewhere herein, we are dependent on Lotus East to both pay our management fees on a current basis and to repay the amounts we have advanced that company. If for any reason those amounts should not have been tendered and one or more of the Series A Convertible Redeemable Preferred Stock holders should request redemption, it is possible we would not have sufficient funds to pay the redemption amounts.
IN ORDER TO COMPLY WITH PRC LAWS LIMITING FOREIGN OWNERSHIP OF CHINESE COMPANIES, WE CONDUCT OUR PHARMACEUTICAL BUSINESS THROUGH LOTUS EAST BY MEANS OF THE CONTRACTUAL ARRANGEMENTS. WE DO NOT HAVE ANY OPERATIONS OTHER THAN PURSUANT TO THE CONTRACTUAL ARRANGEMENTS WITH LOTUS EAST. THE TERM OF THOSE CONTRACTUAL ARRANGEMENTS IS ONLY FOR 10 YEARS AND THERE ARE NO ASSURANCES THOSE AGREEMENTS WILL BE RENEWED. IF THE PRC GOVERNMENT DETERMINES THAT THE CONTRACTUAL ARRANGEMENTS DO NOT COMPLY WITH APPLICABLE REGULATIONS, OUR BUSINESS COULD BE ADVERSELY AFFECTED AND WE COULD BE FORCED TO CEASE OPERATIONS.
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The PRC government restricts foreign investment in pharmaceutical businesses in China. Lotus East holds the licenses and approvals necessary to operate its pharmaceutical business in China and through the Contractual Arrangements with Lotus East and its stockholders we substantially control Lotus East. Neither Lotus nor Lotus International, however, are engaged in any business or operations other than pursuant to the terms of the various Contractual Arrangements with Lotus East as described elsewhere in this prospectus. As such, we are completely dependent on the Contractual Arrangements. We do not generate any revenues and have no assets. All of Lotus East's assets and operations are located in the PRC. As described in the financial statements included elsewhere in this prospectus, the assets and liabilities at each of December 31, 2008 and 2007 and the results of operations for 2008 and 2007 are those of Lotus East.
We cannot assure you that we will be able to enforce these contracts. If we are unable to enforce any legal rights we may have under these contracts or otherwise, our ability to continue as a going concern is in jeopardy. In addition, the terms of these contracts expire in September 2016 and there are no assurances these agreements will be renewed. If the Contractual Arrangements are not renewed or are significantly modified, unless we have expanded our business and operations, of which there are no assurances, we will in all likelihood be forced to cease our operations.
The Contractual Arrangements are also subject to enforcement under the laws of the PRC. Although we believe we comply with current PRC regulations, we cannot assure you that the PRC government would agree that these operating arrangements comply with PRC licensing, registration or other regulatory requirements, with existing policies or with requirements or policies that may be adopted in the future. If the PRC government determines that we do not comply with applicable law, it could revoke Lotus East's business and operating licenses, require us to discontinue or restrict our operations, restrict our right to collect revenues, require us to restructure our operations, impose additional conditions or requirements with which we may not be able to comply, impose restrictions on our business operations or on our customers, or take other regulatory or enforcement actions against us that could be harmful to our business.
OUR CONTRACTUAL ARRANGEMENTS WITH LOTUS EAST AND THEIR RESPECTIVE STOCKHOLDERS MAY NOT BE AS EFFECTIVE IN PROVIDING CONTROL OVER THESE ENTITIES AS DIRECT OWNERSHIP.
We have no equity ownership interest in Lotus East and rely on the Contractual Arrangements to control and operate such businesses. These Contractual Arrangements may not be as effective in providing control over Lotus East as direct ownership. For example, Lotus East could fail to take actions required for our businesses despite its contractual obligation to do so. If Lotus East fails to perform under the agreements with us, we may have to rely on legal remedies under PRC law, which may not be effective. In addition, we cannot assure you that the Lotus East stockholders would always act in our best interests.
CERTAIN OF OUR EXECUTIVE OFFICERS, DIRECTORS AND PRINCIPAL STOCKHOLDERS ARE ALSO OFFICERS, DIRECTORS AND PRINCIPAL STOCKHOLDERS OF LOTUS EAST. WE ARE NOT RECEIVING THE BENEFIT OF CERTAIN TERMS OF THE CONTRACTUAL ARRANGEMENTS AND THERE ARE NO ASSURANCES THAT THE CONFLICTS OF INTEREST BETWEEN OBLIGATIONS TO OUR COMPANY AND OBLIGATIONS LOTUS EAST WILL BE RESOLVED IN OUR FAVOR.
While pursuant to the Contractual Arrangements we have the ability to control the daily operations and financial affairs of Lotus East, appoint each of their senior executives and approve all matters requiring approval by their respective members, these actions on our behalf are determined by our Board of Directors. Dr. Liu, our CEO, and his wife Mrs. Zhenghong, are members of our Board of Directors and principal stockholders of our company and they are also officers, directors and principal stockholders of Lotus East. Conflicts of interests between their duties to our company and Lotus East may arise. Dr. Lui and Mrs. Zhenghong each have a duty of loyalty and care to us under Nevada law when there are any potential conflicts of interests between our company and Lotus East. We cannot assure you, however, that when conflicts of interest arise, Dr. Liu and or Mrs. Zhenghong will act completely in our interests or that conflicts of interests will be resolved in our favor. In addition, Dr. Liu and/or Mrs. Zhenghong could violate their legal duties by diverting business opportunities from us to others.
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In addition, while the terms of the Contractual Arrangements provide that we are to be paid quarterly service fees equal to the net profit of Lotus East, such payments have not been tendered to us and those funds are being retained by Lotus East to fund their operations. At December 31, 2008 approximately $25 million is due to us by Lotus East which remains unpaid as of the date hereof. Although we have no business and operations other than pursuant to the terms of the Contractual Arrangements, we incur operating expenses related to our public company reporting requirements including legal and accounting fees. There are no assurances that these fees will be paid, or that any other conflicts of interest which may arise between our company and Lotus East related to their obligation to pay the amounts due us will be resolved in our favor.
WE HAVE LENT SUBSTANTIALLY ALL OF THE NET PROCEEDS FROM OUR RECENTLY COMPLETED FINANCINGS TO LOTUS EAST ON AN INTEREST FREE, UNSECURED BASIS. IF THESE AMOUNTS ARE NOT REPAID, OR IF LOTUS EAST DOES NOT BEGIN PAYING THEIR QUARTERLY SERVICE FEES, IT IS POSSIBLE THAT WE WILL NOT HAVE SUFFICIENT CAPITAL TO PAY OUR OPERATING EXPENSES WHICH COULD RESULT IN A REMOVAL OF OUR COMMON STOCK FROM QUOTATION ON THE OTC BULLETIN BOARD.
In 2007, we sold $3,000,000 principal amount 14% secured convertible notes in a private placement and we lent approximately $2 million of those proceeds to Lotus East for working capital. In 2008, we received net proceeds from the sale of shares of our Series A Convertible Redeemable Preferred Stock of approximately $4.6 million. We used approximately $2,576,557 of those proceeds to repay in full all of our outstanding obligations under our 14% secured convertible notes. Of the remaining proceeds, we lent approximately $1,600,000 to Lotus East. These loans are in the form of unsecured, interest free advances for use by Lotus East in their operations including in their research and development activities. We do not have an understanding with Lotus East regarding the repayment of the amounts advanced to that company. If these funds are not repaid, we may not have sufficient capital to pay our operating expenses which could result in our inability to remain current in our reporting obligations under Federal securities laws. If we were unable to remain current in those requirements, our common stock would be removed from quotation on the OTC Bulletin Board and our stockholders would in all likelihood lose their entire investment in our company.
IF WE FAIL TO MAINTAIN THE ADEQUACY OF OUR INTERNAL CONTROLS, OUR ABILITY TO PROVIDE ACCURATE FINANCIAL STATEMENTS AND COMPLY WITH THE REQUIREMENTS OF THE SARBANES-OXLEY ACT OF 2002 COULD BE IMPAIRED, WHICH COULD CAUSE OUR STOCK PRICE TO DECREASE SUBSTANTIALLY.
We have committed limited personnel and resources to the development of the external reporting and compliance obligations that would be required of a public company. Recently, we have taken measures to address and improve our financial reporting and compliance capabilities and we are in the process of instituting changes to satisfy our obligations in connection with joining a public company, when and as such requirements become applicable to us. Prior to taking these measures, we did not believe we had the resources and capabilities to do so. We plan to obtain additional financial and accounting resources to support and enhance our ability to meet the requirements of being a public company. We will need to continue to improve our financial and managerial controls, reporting systems and procedures, and documentation thereof. If our financial and managerial controls, reporting systems or procedures fail, we may not be able to provide accurate financial statements on a timely basis or comply with the Sarbanes-Oxley Act of 2002 as it applies to us. Any failure of our internal controls or our ability to provide accurate financial statements could cause the trading price of our common stock to decrease substantially. We have implemented, or plan to implement, the measures described below under the supervision and guidance of our management to remediate the above control deficiencies and to strengthen our internal controls over financial reporting. Key elements of the remediation effort include, but are not limited to, the following initiatives, which have been implemented, or are in the process of implementation, as of the date of filing of this Annual Report:
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· | We have increased efforts to enforce internal control procedures. We have also reorganized the structure of our China financial department and clarified the responsibilities of each key personnel in order to increase communications and accountability. |
· | We have recruited and will continue to bring in additional qualified financial personnel for the accounting department to further strengthen our China financial reporting function. |
· | We continually review and improve our standardization of our monthly and quarterly data collection, analysis, and reconciliation procedures. To further improve the timeliness of data collection, we are selecting and will install new point of sale systems and enterprise resource planning systems for our wholesale and retail operations. |
· | We plan on significantly increasing the level of communication and interaction among our China management, independent auditors, our directors of the Board, and other external advisors.. |
· | We are in the process of searching for qualified internal control consultants to help us be in compliance with internal control obligations, including Section 404 of the Sarbanes-Oxley Act of 2002. We also plan to dedicate sufficient resources to implement required internal control procedures. |
If our financial and managerial controls, reporting systems or procedures fail, we may not be able to provide accurate financial statements on a timely basis or comply with the Sarbanes-Oxley Act of 2002 as it applies to us. Any failure of our internal controls or our ability to provide accurate financial statements could cause the trading price of our common stock to decrease substantially.
RISKS RELATED TO LOTUS EAST'S OPERATIONS
LOTUS EAST'S SUCCESS DEPENDS ON COLLABORATIVE PARTNERS, LICENSEES AND OTHER THIRD PARTIES OVER WHOM IT HAS LIMITED CONTROL.
Due to the complexity of the process of developing pharmaceuticals, Lotus East's core business depends on arrangements with pharmaceutical institutes, corporate and academic collaborators, licensors, licensees and others for the research, development, clinical testing, technology rights, manufacturing, marketing and commercialization of its products. It has one research collaboration and outsources other business functions. Its license agreements could obligate it to diligently bring potential products to market, make milestone payments and royalties that, in some instances, could be
substantial, and incur the costs of filing and prosecuting patent applications. There are no assurances that Lotus East will be able to establish or maintain collaborations that are important to its business on favorable terms, or at all.
A number of risks arise from its dependence on collaborative agreements with third parties. Product development and commercialization efforts could be adversely affected if any collaborative partner:
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· | terminates or suspends its agreement with Lotus East; |
· | causes delays; |
· | fails to timely develop or manufacture in adequate quantities a substance needed in order to conduct clinical trials; |
· | fails to adequately perform clinical trials; |
· | determines not to develop, manufacture or commercialize a product to which it has rights; or |
· | otherwise fails to meet its contractual obligations. |
Lotus East's collaborative partners could pursue other technologies or develop alternative products that could compete with the products it is developing.
THE PROFITABILITY OF LOTUS EAST'S PRODUCTS WILL DEPEND IN PART ON ITS ABILITY TO PROTECT PROPRIETARY RIGHTS AND OPERATE WITHOUT INFRINGING THE PROPRIETARY RIGHTS OF OTHERS.
The profitability of Lotus East's products will depend in part on its ability to obtain and maintain manufacturing rights and preserve trade secrets, and the period its intellectual property remains protected. Lotus East must also operate without infringing the proprietary rights of third parties and without third parties circumventing its rights. The patent positions of pharmaceutical and biotechnology enterprises, including Lotus East, are uncertain and involve complex legal and factual questions for which important legal principles are largely unresolved. The biotechnology patent situation outside the U.S. is uncertain, is currently undergoing review and revision in many countries, and may not protect Lotus East's intellectual property rights to the same extent as the laws of the U.S. Because patent applications are maintained in secrecy in some cases, Lotus East cannot be certain that it or its licensors are the first creators of inventions described in our pending patent applications or patents or the first to file patent applications for such inventions.
Most of Lotus East's drug products have been approved by the PRC's Food and Drug Administration (SFDA) but have not received patent protection. For instance, Valsartan, one of Lotus East's most profitable products, is produced by other companies in China, including Novartis. If Novartis or any other company were to obtain patent protection for Valsartan in China, or for any of Lotus East's other drug products, it would have a material adverse effect on its revenue.
Other companies may independently develop similar products and design around any patented products Lotus East develops. We cannot assure you that:
· | any of Lotus East's patent applications will result in the issuance of patents; |
· | Lotus East will develop patentable products; |
· | the manufacturing rights Lotus East has been issued will provide it with any competitive advantages; |
· | the patents of others will not impede Lotus East's ability to do business; or |
· | third parties will not be able to circumvent Lotus East's manufacturing rights. |
There are no assurances that Lotus East will be able to meaningfully protect its trade secrets. We cannot assure you that any of Lotus East's existing confidentiality agreements with employees, consultants, advisors or collaborators will provide meaningful protection for its trade secrets, know-how or other proprietary information in the event of any unauthorized use or disclosure. Collaborators, advisors or consultants may dispute the ownership of proprietary rights to Lotus East's products, for example by asserting that they developed the product independently.
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LOTUS EAST MAY ENCOUNTER DIFFICULTIES IN MANUFACTURING ITS PRODUCTS.
Before Lotus East's products can be profitable, they must be produced in commercial quantities in a cost-effective manufacturing process that complies with regulatory requirements, including GMP, production and quality control regulations. If Lotus East cannot arrange for or maintain commercial-scale manufacturing on acceptable terms, or if there are delays or difficulties in the manufacturing process, it may not be able to conduct clinical trials, obtain regulatory approval or meet demand for its products. Production of Lotus East's products could require raw materials which are scarce or which can be obtained only from a limited number of sources. If Lotus East is unable to obtain adequate supplies of such raw materials, the development, regulatory approval and marketing of its products could be delayed.
LOTUS EAST COULD NEED MORE CLINICAL TRIALS OR TAKE MORE TIME TO COMPLETE ITS CLINICAL TRIALS THAN WE HAVE PLANNED.
Clinical trials vary in design by factors including dosage, end points, length, and controls. Lotus East may need to conduct a series of trials to demonstrate the safety and efficacy of its products. The results of these trials may not demonstrate safety or efficacy sufficiently for regulatory authorities to approve Lotus East's products. Further, the actual schedules for its clinical trials could vary dramatically from the forecasted schedules due to factors including changes in trial design, conflicts with the schedules of participating clinicians and clinical institutions, and changes affecting product supplies for clinical trials.
Lotus East relies on collaborators, including academic institutions, governmental agencies and clinical research organizations, to conduct, supervise, monitor and design some or all aspects of clinical trials involving our products. Since these trials depend on governmental participation and funding, Lotus East has less control over their timing and design than trials it sponsors. Delays in or failure to commence or complete any planned clinical trials could delay the ultimate timelines for Lotus East product releases.
LOTUS EAST MAY NOT BE ABLE TO OBTAIN THE REGULATORY APPROVALS OR CLEARANCES THAT ARE NECESSARY TO COMMERCIALIZE ITS PRODUCTS.
The PRC imposes significant statutory and regulatory obligations upon the manufacture and sale of pharmaceutical products. It typically has a lengthy approval process in which it examines pre-clinical and clinical data and the facilities in which the product is manufactured. Regulatory submissions must meet complex criteria to demonstrate the safety and efficacy of the ultimate products. Addressing these criteria requires considerable data collection, verification and analysis. Lotus East may spend time and money preparing regulatory submissions or applications without assurances as to whether they will be approved on a timely basis or at all.
Lotus East's product candidates, some of which are currently in the early stages of development, will require significant additional development and pre-clinical and clinical testing prior to their commercialization. These steps and the process of obtaining required approvals and clearances can be costly and time-consuming. If Lotus East's potential products are not successfully developed, cannot be proven to be safe and effective through clinical trials, or do not receive applicable regulatory approvals and clearances, or if there are delays in the process:
· | the commercialization of Lotus East's products could be adversely affected; |
· | any competitive advantages of the products could be diminished; and |
· | revenues or collaborative milestones from the products could be reduced or delayed. |
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Governmental and regulatory authorities may approve a product candidate for fewer indications or narrower circumstances than requested or may condition approval on the performance of post-marketing studies for a product candidate. Even if a product receives regulatory approval and clearance, it may later exhibit adverse side effects that limit or prevent its widespread use or that force Lotus East to withdraw the product from the market.
Any marketed product and its manufacturer will continue to be subject to strict regulation after approval. Results of post-marketing programs may limit or expand the further marketing of products. Unforeseen problems with an approved product or any violation of regulations could result in restrictions on the product, including its withdrawal from the market and possible civil actions.
In manufacturing Lotus East's products it is required to comply with applicable good manufacturing practices regulations, which include requirements relating to quality control and quality assurance, as well as the maintenance of records and documentation. If Lotus East cannot comply with regulatory requirements, including applicable good manufacturing practice requirements, it may not be allowed to develop or market the product candidates. If Lotus East fails to comply with applicable regulatory requirements at any stage during the regulatory process, it may be subject to sanctions, including fines, product recalls or seizures, injunctions, refusal of regulatory agencies to review pending market approval applications or supplements to approve applications, total or partial suspension of production, civil penalties, withdrawals of previously approved marketing applications and criminal prosecution.
COMPETITORS MAY DEVELOP AND MARKET PHARMACEUTICAL PRODUCTS THAT ARE LESS EXPENSIVE, MORE EFFECTIVE OR SAFER, MAKING LOTUS EAST'S PRODUCTS OBSOLETE OR UNCOMPETITIVE.
Some of Lotus East's competitors and potential competitors have greater product development capabilities and financial, scientific, marketing and human resources than it does. Technological competition from pharmaceutical companies and biotechnology companies is intense and is expected to increase. Other companies have developed technologies that could be the basis for competitive products. Some of these products have an entirely different approach or means of accomplishing the desired curative effect than products Lotus East is developing. Alternative products may be developed that are more effective, work faster and are less costly than its products. Competitors may succeed in developing products earlier than Lotus East, obtaining approvals and clearances for such products more rapidly than it, or developing products that are more effective than those of Lotus East. In addition, other forms of treatment may be competitive with its products. Over time, Lotus East's products may become obsolete or uncompetitive.
LOTUS EAST'S OPERATIONS AND THE USE OF ITS PRODUCTS COULD SUBJECT IT TO DAMAGES RELATING TO INJURIES OR ACCIDENTAL CONTAMINATION.
Lotus East's research and development processes involve the controlled use of hazardous materials. It is subject to central government, provincial and local laws and regulations governing the use, manufacture, storage, handling and disposal of such materials and waste products. The risk of accidental contamination or injury from handling and disposing of such materials cannot be completely eliminated. In the event of an accident involving hazardous materials, Lotus East could be held liable for resulting damages. Lotus East is not insured with respect to this liability. Such liability could exceed its resources.
IF LOTUS EAST WERE SUCCESSFULLY SUED FOR PRODUCT LIABILITY, IT COULD FACE SUBSTANTIAL LIABILITIES THAT MAY EXCEED ITS RESOURCES.
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Lotus East may be held liable if any product it develops, or any product which causes injury or is found unsuitable during product testing, manufacturing, marketing, sale or use. These risks are inherent in the development of pharmaceutical products. Lotus East does not have product liability insurance. If Lotus East choose to obtain product liability insurance but cannot obtain sufficient insurance coverage at an acceptable cost or otherwise protect against potential product liability claims, the commercialization of products that it develops may be prevented or inhibited. If it is sued for any injury caused by its products, Lotus East's liability could exceed its total assets.
LOTUS EAST HAS LIMITED BUSINESS INSURANCE COVERAGE.
The insurance industry in China is still at an early stage of development. Insurance companies in China offer limited business insurance products. Lotus East does not have any business liability or disruption insurance coverage for its operations in China. Any business disruption, litigation or natural disaster may result in our incurring substantial costs and the diversion of its resources.
LOTUS EAST'S SUCCESS DEPENDS ON ATTRACTING AND RETAINING QUALIFIED PERSONNEL.
Lotus East depends on a core management and scientific team. Although most of these personnel are founders and stockholders of Lotus East, there can be no assurance that it can be successful in retaining them. The unavailability
or departure of such key personnel may seriously disrupt and harm its operations, business and the implementation of its business strategy and plans. Lotus East's future success depends in large part on its continued ability to attract and retain other highly qualified scientific, technical and management personnel, as well as personnel with expertise in clinical testing and government regulation. It faces competition for personnel from other companies, universities, public and private research institutions, government entities and other organizations. If Lotus East's recruitment and retention efforts are unsuccessful, its business operations could suffer.
RISKS RELATED TO DOING BUSINESS IN CHINA
BOTH OUR COMPANY AND LOTUS EAST MAY BE ADVERSELY AFFECTED BY COMPLEXITY, UNCERTAINTIES AND CHANGES IN PRC REGULATION OF PHARMACEUTICAL BUSINESS AND COMPANIES, INCLUDING LIMITATIONS ON OUR ABILITY TO OWN KEY ASSETS.
The PRC government regulates the pharmaceutical industry including foreign ownership of, and the licensing and permit requirements pertaining to, companies in the pharmaceutical industry. These laws and regulations are
relatively new and evolving, and their interpretation and enforcement involve significant uncertainty. As a result, in certain circumstances it may be difficult to determine what actions or omissions may be deemed to be a violation
of applicable laws and regulations. Issues, risks and uncertainties relating to PRC government regulation of the pharmaceutical industry include the following:
· | we only have contractual control over Lotus East. We do not own it due to the restriction of foreign investment in Chinese businesses; and |
· | uncertainties relating to the regulation of the pharmaceutical business in China, including evolving licensing practices, means that permits, licenses or operations at our company may be subject to challenge. This may disrupt Lotus East's business, or subject it to sanctions, requirements to increase capital or other conditions or enforcement, or compromise enforceability of related contractual arrangements, or have other harmful effects on it. |
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The interpretation and application of existing PRC laws, regulations and policies and possible new laws, regulations or policies have created substantial uncertainties regarding the legality of existing and future foreign
investments in, and the businesses and activities of, pharmaceutical businesses in China, including our business.
ADVERSE CHANGES IN ECONOMIC AND POLITICAL POLICIES OF THE PRC GOVERNMENT COULD HAVE A MATERIAL ADVERSE EFFECT ON THE OVERALL ECONOMIC GROWTH OF CHINA, WHICH COULD ADVERSELY AFFECT LOTUS EAST'S BUSINESS.
All of Lotus East's business operations are conducted in China. Accordingly, our results of operations, financial condition and prospects are subject to a significant degree to economic, political and legal developments in
China. China's economy differs from the economies of most developed countries in many respects, including with respect to:
· | the amount of government involvement, |
· | level of development, |
· | growth rate, |
· | control of foreign exchange, and |
· | allocation of resources. |
While the PRC economy has experienced significant growth in the past 20 years, growth has been uneven across different regions and among various economic sectors of China. The PRC government has implemented various measures to encourage economic development and guide the allocation of resources. Some of these measures benefit the overall PRC economy, but may also have a negative effect on us. For example, our financial condition and results of operations may be adversely affected by government control over capital investments or changes in tax regulations that are applicable to Lotus East. Since early 2004, the PRC government has implemented certain measures to control the pace of economic growth. Such measures may cause a decrease in the level of economic activity in China, which in turn could adversely affect our results of operations and financial condition.
IF PRC LAW WERE TO PHASE OUT THE PREFERENTIAL TAX BENEFITS CURRENTLY BEING EXTENDED TO FOREIGN INVESTED ENTERPRISES AND "NEW OR HIGH-TECHNOLOGY ENTERPRISES" LOCATED IN A HIGH-TECH ZONE, LOTUS EAST WOULD HAVE TO PAY MORE TAXES, WHICH COULD HAVE A ATERIAL AND ADVERSE EFFECT ON OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Under PRC laws and regulations, a foreign invested enterprise may enjoy preferential tax benefits if it is registered in a high-tech zone and also qualifies as "new or high-technology enterprise". As a foreign invested enterprise as well as a certified "new or high-technology enterprise" located in a high-tech zone in Beijing: Lotus East is registered in the Liangxiang Economic Tech Development Zone and is entitled to an exemption from enterprise income tax until December 12, 2008. If the PRC law were to phase out preferential tax benefits currently granted to "new or high-technology enterprises" and technology consulting services, we would be subject to the standard statutory tax rate, which currently is 25%, and we would be unable to obtain business tax refunds for our provision of technology consulting services. Loss of these preferential tax treatments could have a material and adverse effect on our financial condition and results of operations.
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UNCERTAINTIES WITH RESPECT TO THE PRC LEGAL SYSTEM COULD ADVERSELY AFFECT US.
We conduct our business through the Contractual Arrangements with Lotus East. Our operations in China are governed by PRC laws and regulations. We are generally subject to laws and regulations applicable to foreign investments in China and, in particular, laws applicable to wholly foreign-owned enterprises. The PRC legal system is based on written statutes. Prior court decisions may be cited for reference but have limited precedential value.
Since 1979, PRC legislation and regulations have significantly enhanced the protections afforded to various forms of foreign investments in China. However, China has not developed a fully integrated legal system and recently enacted laws and regulations may not sufficiently cover all aspects of economic activities in China. In particular, because these laws and regulations are relatively new, and because of the limited volume of published decisions and their nonbinding nature, the interpretation and enforcement of these laws and regulations involve uncertainties. In addition, the PRC legal system is based in part on government policies and internal rules (some of which are not published on a timely basis or at all) that may have a retroactive effect. As a result, we may not be aware of our violation of these policies and rules until some time after the violation. In addition, any litigation in China may be protracted and result in substantial costs and diversion of resources and management attention.
YOU MAY EXPERIENCE DIFFICULTIES IN EFFECTING SERVICE OF LEGAL PROCESS, ENFORCING FOREIGN JUDGMENTS OR BRINGING ORIGINAL ACTIONS IN CHINA BASED ON UNITED STATES OR OTHER FOREIGN LAWS AGAINST US OR OUR MANAGEMENT.
All of Lotus East's assets are located outside the United States and all of its current operations are conducted in China. Moreover, the majority of our directors and officers are nationals or residents of China. All or a substantial portion of the assets of these persons are located outside the United States. As a result, it may be difficult for our stockholders to effect service of process within the United States upon these persons. In addition, there is uncertainty as to whether the courts of China would recognize or enforce judgments of U.S. courts obtained against us or such officers and/or directors predicated upon the civil liability provisions of the securities law of the United States or any state thereof, or be competent to hear original actions brought in China against us or such persons predicated upon the securities laws of the United States or any state thereof.
GOVERNMENTAL CONTROL OF CURRENCY CONVERSION MAY ADVERSELY AFFECT OUR COMPANY.
The PRC government imposes controls on the convertibility of RMB into foreign currencies and, in certain cases, the remittance of currency out of China. Lotus East receives all of its revenues in RMB. Under our current structure, our income is restricted to payments under the Contractual Arrangements with Lotus East. Shortages in the availability of foreign currency may restrict the ability of Lotus East to remit sufficient foreign currency to pay the monthly fees due us, or otherwise satisfy their foreign currency denominated obligations. As such, we may not be able to receive all amounts due to us from Lotus East under the Contractual Arrangements. Under existing PRC foreign exchange regulations, payments of current account items, including profit distributions, interest payments and expenditures from trade-related transactions, can be made in foreign currencies without prior approval from the PRC State Administration of Foreign Exchange by complying with certain procedural requirements. However, approval from appropriate government authorities is required where RMB is to be converted into foreign currency and remitted out of China to pay capital expenses such as the repayment of bank loans denominated in foreign currencies.
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The PRC government may also at its discretion restrict access in the future to foreign currencies for current account transactions. If the foreign exchange control system prevents Lotus East from obtaining sufficient foreign currency to satisfy its currency demands, we may not have sufficient funds available to pay our obligations as they become due.
FLUCTUATION IN THE VALUE OF RMB MAY HAVE A MATERIAL ADVERSE EFFECT ON YOUR INVESTMENT.
The value of RMB against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in political and economic conditions. All of Lotus East's financial assets and its revenues and costs are denominated in RMB. We rely entirely on fees paid to us by Lotus East. Any significant fluctuation in value of RMB may materially and adversely affect our cash flows, revenues, earnings and financial position, and the value of the consulting fees payable to us by Lotus East. For example, an appreciation of RMB against the U.S. dollar would make any new RMB denominated investments or expenditures more costly to Lotus East, to the extent that it might need to convert U.S. dollars into RMB for such purposes. An appreciation of RMB against the U.S. dollar would also result in foreign currency translation losses for financial reporting purposes when we translate our U.S. dollar denominated financial assets into RMB, as RMB is our reporting currency.
WE FACE RISKS RELATED TO HEALTH EPIDEMICS AND OTHER OUTBREAKS.
Lotus East's business could be adversely affected by the effects of SARS or another epidemic or outbreak. China reported a number of cases of SARS in April 2004. Any prolonged recurrence of SARS or other adverse public health developments in China may have a material adverse effect on Lotus East's business operations. For instance, health or other government regulations adopted in response may require temporary closure of Lotus East's production facilities or of its offices. Such closures would severely disrupt its business operations and adversely affect our results of operations. Lotus East has not adopted any written preventive measures or contingency plans to combat any future outbreak of SARS or any other epidemic.
RISKS RELATED TO HOLDING OUR SECURITIES
OUR CORPORATE ACTIONS ARE SUBSTANTIALLY CONTROLLED BY OUR MANAGEMENT.
Our executive officers and directors own approximately 62% of our outstanding common stock and approximately 55% of voting control. These stockholders, acting individually or as a group, could exert substantial influence over matters such as electing directors and approving mergers or other business combination transactions. In addition, because of the percentage of ownership and voting concentration in these principal stockholders, elections of our board of directors will generally be within the control of these stockholders. It would be difficult for our stockholders to propose and have approved proposals not supported by management. There can be no assurances that matters voted upon by our officers and directors in their capacity as stockholders will be viewed favorably by all stockholders of our company.
THE ELIMINATION OF MONETARY LIABILITY AGAINST OUR DIRECTORS AND OFFICERS UNDER NEVADA LAW AND THE EXISTENCE OF INDEMNIFICATION RIGHTS TO OUR DIRECTORS AND OFFICERS MAY RESULT IN SUBSTANTIAL EXPENDITURES BY US MAY DISCOURAGE LAWSUITS AGAINST OUR DIRECTORS AND/OR OFFICERS.
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Our articles of incorporation do not contain any specific provisions that eliminate the liability of our directors for monetary damages to our company and stockholders, however we are prepared to give such indemnification to our directors and officers to the extent provided by Nevada law. These indemnification obligations could result in our company incurring substantial expenditures to cover the cost of settlement or damage awards against directors and officers, which we may be unable to recoup. These provisions and resultant costs may also discourage our company from bringing a lawsuit against directors and officers for breaches of their fiduciary duties, and may similarly discourage the filing of derivative litigation by our stockholders against our directors and officers even though such actions, if successful, might otherwise benefit our company and stockholders.
WE MAY HAVE DIFFICULTY ESTABLISHING ADEQUATE MANAGEMENT, LEGAL AND FINANCIAL CONTROLS IN THE PRC.
PRC companies have historically not adopted a Western style of management and financial reporting concepts and practices, which includes strong corporate governance, internal controls and, database, financial and other control systems. As a result, we may experience difficulty in establishing management, legal and financial controls, collecting financial data and preparing financial statements, books of account and corporate records and instituting business practices that meet Western standards. Therefore, we may, in turn, experience difficulties in implementing and maintaining adequate internal controls as required under Section 404 of the Sarbanes-Oxley Act of 2002. Any failure on our part may result in significant deficiencies or material weaknesses in our internal controls which could impact the reliability of our financial statements which could have a materially adverse effect on our business.
THE EXERCISE OF OUTSTANDING WARRANTS, THE ISSUANCE OF SHARES OF OUR COMMON STOCK AS INTEREST ON THE OUTSTANDING NOTES AND THE POSSIBLE CONVERSION OF THOSE OUTSTANDING NOTES WILL BE DILUTIVE TO OUR EXISTING STOCKHOLDERS.
At March 31, 2009, we had 43,377,932 shares of our common stock issued and outstanding and the following securities which are convertible or exercisable into shares of our common stock were outstanding:
· | 5,747,118 shares of our common stock issuable upon the possible conversion of the Series A Convertible Redeemable Preferred Stock; |
· | up to an additional 919,544 shares of our common stock which we may issue the Series A Convertible Redeemable Preferred Stockholders as dividend payments; and |
· | 5,166,999 of our common stock issuable upon the exercise of common stock purchase warrants with an average exercise price of $1.13 per share. |
The issuance of the shares as dividend payment, the exercise of the warrants and/or the conversion of the Series A Convertible Redeemable Preferred Stock may materially adversely affect the market price of our common stock and will have a dilutive effect on our existing stockholders.
CERTAIN OF OUR OUTSTANDING WARRANTS CONTAIN CASHLESS EXERCISE PROVISIONS WHICH MEANS WE WILL NOT RECEIVE ANY CASH PROCEEDS UPON THEIR EXERCISE.
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In February 2007 and February 2008, we issued five year common stock purchase warrants to purchase an aggregate of 4,373,553 shares of our common stock with current exercise prices ranging from $0.87 to $1.20 per share in connection with the sales of our 14% secured convertible notes and the shares of our Series A Convertible Redeemable Preferred Stock. All of these warrants are exercisable on a cashless basis at any time when there is not an effective registration statement covering the shares of our common stock underlying the warrants which means that the holders, rather than paying the exercise price in cash, may surrender a number of warrants equal to the exercise price of the warrants being exercised. The utilization of this cashless exercise feature will deprive us of additional capital which might otherwise be obtained if the warrants did not contain a cashless feature.
WE HAVE NOT VOLUNTARILY IMPLEMENTED VARIOUS CORPORATE GOVERNANCE MEASURES, IN THE ABSENCE OF WHICH, STOCKHOLDERS MAY HAVE MORE LIMITED PROTECTIONS AGAINST INTERESTED DIRECTOR TRANSACTIONS, CONFLICTS OF INTEREST AND SIMILAR MATTERS.
Recent Federal legislation, including the Sarbanes-Oxley Act of 2002, has resulted in the adoption of various corporate governance measures designed to promote the integrity of the corporate management and the securities markets. Some of these measures have been adopted in response to legal requirements. Others have been adopted by companies in response to the requirements of national securities exchanges, such as the NYSE or the NASDAQ Stock Market, on which their securities are listed. Among the corporate governance measures that are required under the rules of national securities exchanges are those that address board of directors' independence, audit committee oversight, and the adoption of a code of ethics. We have not adopted a code of ethics nor have we adopted any of these other corporate governance measures and, since our securities are not yet listed on a national securities exchange, we were not required to do so. We have not adopted corporate governance measures such as an audit or other independent committees of our board of directors. If we expand our board membership in future periods to include additional independent directors, we may seek to establish an audit and other committees of our board of directors. It is possible that if we were to adopt some or all of these corporate governance measures, stockholders would benefit from somewhat greater assurances that internal corporate decisions were being made by disinterested directors and that policies had been implemented to define responsible conduct. For example, in the absence of audit, nominating and compensation committees comprised of at least a majority of independent directors, decisions concerning matters such as compensation packages to our senior officers and recommendations for director nominees may be made by a majority of directors who have an interest in the outcome of the matters being decided. Prospective investors should bear in mind our current lack of corporate governance measures in formulating their investment decisions.
WE MAY BE EXPOSED TO POTENTIAL RISKS RELATING TO OUR INTERNAL CONTROLS OVER FINANCIAL REPORTING AND OUR ABILITY TO HAVE THOSE CONTROLS ATTESTED TO BY OUR INDEPENDENT AUDITORS.
As directed by Section 404 of the Sarbanes-Oxley Act of 2002 ("SOX 404"), the Securities and Exchange Commission adopted rules requiring small business issuers, such as our company, to include a report of management on the company's internal controls over financial reporting in their annual reports for fiscal years ending on or after December 15, 2007. Such report is contained later in this annual report under Item 9A(T) Controls and Procedures. In addition, unless the pending one year delay proposed by the SEC is adopted, for our fiscal year ending December 31, 2009 the independent registered public accounting firm auditing our financial statements must also attest to and report on management's assessment of the effectiveness of our internal controls over financial reporting as well as the operating effectiveness of our internal controls. In the event we are unable to receive a positive attestation from our independent auditors with respect to our internal controls, investors and others may lose confidence in the reliability of our financial statements and our ability to obtain financing as needed could suffer.
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BECAUSE OUR STOCK CURRENTLY TRADES BELOW $5.00 PER SHARE, AND IS QUOTED ON THE OTC BULLETIN BOARD, OUR STOCK IS CONSIDERED A "PENNY STOCK" WHICH CAN ADVERSELY AFFECT ITS LIQUIDITY.
As the trading price of our common stock is less than $5.00 per share, our common stock is considered a "penny stock," and trading in our common stock is subject to the requirements of Rule 15g-9 under the Securities Exchange Act of 1934. Under this rule, broker/dealers who recommend low-priced securities to persons other than established customers and accredited investors must satisfy special sales practice requirements. The broker/dealer must make an individualized written suitability determination for the purchaser and receive the purchaser's written consent prior to the transaction.
SEC regulations also require additional disclosure in connection with any trades involving a "penny stock," including the delivery, prior to any penny stock transaction, of a disclosure schedule explaining the penny stock market and its associated risks. These requirements severely limit the liquidity of securities in the secondary market because few broker or dealers are likely to undertake these compliance activities. In addition to the applicability of the penny stock rules, other risks associated with trading in penny stocks could also be price fluctuations and the lack of a liquid market.
Not applicable to a smaller reporting company.
Our principal executive offices are located Liang Fang's headquarters which are provided to us at no cost.
Lotus East leases all of its office and retail locations. Lease terms are generally one to 20 years, with renewal options. All of its leases provide for a fixed annual rent. Lotus East intends to continue to lease all of its leases.
Lotus East has the following properties leased in Beijing, China:
Property Location (District of Beijing, China) | Area (sq. ft) | Lease Expiration Period | Purpose |
Fengtai District | 4,413 | August 31, 2009 | Liang Fang warehouse |
Fengtai District | 11,345 | December 31, 2009 | Liang Fang headquarters |
Fengtai District | 12,917 | July 3, 2019 | Retail - Xinzhong Taita Pharmacy |
Fengtai District | 2,067 | December 31, 2009 | Retail - Nangong Pharmacy |
Fengtai District | 2,153 | December 31, 2010 | Retail - Chenzhuang Rd. Pharmacy |
Haidian District | 3,660 | December 31, 2009 | Retail - Wanshou Rd. Pharmacy |
Dongcheng District | 2,153 | May 31, 2009 | Retail - Qingnianhu Pharmacy |
Dongcheng District | 807 | Month-to-Month | Retail - Hepingli Pharmacy |
Chaoyang District | 1,550 | December 31, 2011 | Retail - Capital Airport Pharmacy |
Chaoyang District | 2,691 | Month-to-Month (related party) | Retail - Fenglinlvzhou Pharmacy |
Fangshan District | 1,615 | December 31, 2010 | Retail - Yonganzhongshen Pharmacy |
Liujia Village | 2,153 | October 9, 2010 | Retail Pharmacy |
Chaoyan District | 72,118 | Property Owned by Lotus | En Zhe Jia Shi production and manufacturing facility |
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On June 3, 2008 Liang Fang entered into an agreement with Cha You Qian Qi Economy Commission, a governmental agency (“Cha You”) related to the construction of a pharmaceutical plant in Cha You’s Cha Ha Er Industrial Garden District. The new facility, which will be comprised approximately 40,000 square meters situated on 600 MU of land (approximately 400,200 square meters), will be used to expand Liang Fang’s current manufacturing capacity. The new facility, which will manufacture medical injection products, including 0.9% physiological saline injection, hydroxyethyl starch 130/0.4 injection and hydroxyethyl starch 200/0.5 injection, Qiang Yi Ji starch, a medical corn starch commonly known as O-2-hydeoxyethyl starch, dextran and additional pharmaceuticals, will require a total investment of RMB 623.66 million, or approximately $90.99 million. It anticipated that construction will begin on the project in September 2008 and that it will take between 12 to 30 months to complete the facility.
Included in the total cost of the project is land cost of RMB 223.66 million (approximately $32.63 million) which is paid to Cha You. Other components of the project include construction costs of approximately RMB 120 million (approximately $17.51 million), costs associated with the various production lines estimated at RMB 230 million (approximately $33.56 million) and working capital of approximately RMB 50 million (approximately $7.29 million).
Liang Fang intends to use its present working capital together with bank loans and government grants to fund the project. The funds are required to be invested over the next 18 months under a specified schedule ending in December 2010. As of December 31, 2008, Liang Fang has paid about RMB 226.5 million (approximately $33 million) of the total investment. Liang Fang, however, has not secured either the bank loans or government grants and does not have sufficient working capital to complete this project without securing substantial funds from those third party sources.
Under the terms of the agreement, Cha You agreed to abate fees associated with water resources, waste and other relative supplies for a period of 30 years and agreed to ensure that the land use tax to be paid by Liang Fang after it begins normal production will be at the lowest tax rate imposed for five years. Once the project is completed, for a period of eight years the local reserved portion of the imposed corporation income tax will be returned to Liang Fang. Liang Fang is required to commence construction by September 3, 2008. If for any reason Liang Fang should fail to begin construction within 90 days from the date of the agreement, Cha You has the right to restore the land use rights to it and Liang Fang will forfeit any funds invested to date. In addition, Liang Fang is prohibited from changing the land use designation. We commenced the construction in August 2008 and we completed the payment for land use right of RMB 223.66 million (approximately $32.63 million) in February 2009.
We are not a party to any pending legal proceedings.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
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MARKET PRICE OF AND DIVIDENDS ON COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock is quoted on the OTCBB under the symbol LTUS. The reported high and low sales prices for the common stock as reported on the OTCBB are shown below for the periods indicated. The quotations reflect inter-dealer prices, without retail mark-up, markdown or commission, and may not represent actual transactions.
High | Low | |
Fiscal 2007 | ||
First quarter ended March 31, 2007 | $3.50 | $1.50 |
Second quarter ended June 30, 2007 | $3.30 | $1.50 |
Third quarter ended September 30, 2007 | $2.45 | $1.20 |
Fourth quarter ended December 31, 2007 | $1.60 | $0.90 |
Fiscal 2008 | ||
First quarter ended March 31, 2008 | $1.24 | $0.54 |
Second quarter ended June 30, 2008 | $1.30 | $0.59 |
Third quarter ended September 30, 2008 | $0.80 | $0.30 |
Fourth quarter ended December 31, 2008 | $0.44 | $0.16 |
Fiscal 2009 | ||
First quarter ended March 31, 2009 | $0.38 | $0.13 |
On March 31, 2009, the last sale price of our common stock as reported on the OTCBB was $0.30. As of March 31, 2009, there were approximately 63 record owners of our common stock.
DIVIDEND POLICY
We have not paid cash dividends on our common stock since we became public through a reverse merger. We intend to keep future earnings to finance the expansion of our business, and we do not anticipate that any cash dividends will be paid in the foreseeable future. We rely on dividends from Lotus East for our funds and PRC regulations may limit the amount of funds distributed to us from Lotus East, which will affect our ability to declare any dividends. See “Risk Factors - Risks Related to Doing Business in the PRC” – Lotus East re subject to restrictions on paying dividends and making other payments to us” and “Governmental control of currency conversion may affect the value of your investment.”
Our future payment of dividends will depend on our earnings, capital requirements, expansion plans, financial condition and relevant factors that our board of directors may deem relevant. Our retained earnings limits our ability to pay dividends.
Payment of dividends will be within the sole discretion of our Board of Directors, subject to the limitations in the designations, rights and preferences of our Series A Preferred Stock, and will depend, among other factors, upon our earnings, capital requirements and our operating and financial condition.
Pursuant to the designations, rights and preferences of our Series A Preferred Stock each share pays a mandatory dividend at an annual rate of 8.00%, compounded annually, of the sum of
· | $0.87 per share (subject to appropriate adjustment in the event of any stock dividend, stock split, combination or other similar recapitalization affecting such shares), plus |
· | an amount equal to any dividend that has accumulated through such date on a share of Series A Preferred Stock has not paid in full that are payable in respect of such share, whether or not such dividends are declared. |
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Dividend payments are to be made in additional shares of Series A Preferred Stock on February 25 of each year.
The terms of the Series A Preferred Stock prohibit us from declaring or paying dividends on our common stock as long as the Series A Preferred Stock is outstanding.
RECENT SALES OF UNREGISTERED SECURITIES
None.
Not applicable to a smaller reporting company.
Overview
We operate, control and beneficially own the pharmaceutical businesses in China of Lotus East under the terms of the Contractual Arrangements. Other than the Contractual Arrangements with Lotus East, we do not have any business or operations. Pursuant to the Contractual Arrangements we provide business consulting and other general business operation services to Lotus East. Through these Contractual Arrangements, we have the ability to control the daily operations and financial affairs of Lotus East, appoint each of their senior executives and approve all matters requiring stockholder approval. As a result of these Contractual Arrangements, which enable us to control Lotus East, we are considered the primary beneficiary of Lotus East. Accordingly, we consolidate Lotus East's results, assets and liabilities in our financial statements. The creditors of Lotus East, however, do not have recourse to any assets we may have.
PRC law currently places certain limitations on foreign ownership of Chinese companies. To comply with these foreign ownership restrictions, we operate our business in China through the Contractual Arrangements with Lotus East. The contractual relationship among the above companies as follows:
Based in Beijing, China, Lotus East is engaged in the production, trade and retailing of pharmaceuticals, focusing on the development of innovative medicines and investing in strategic growth to address various medical needs. Lotus East owns and operates 10 drug stores throughout Beijing, China that sell Western and traditional Chinese medications, lease medical treatment facilities to licensed physicians, and generate revenues from the leasing of retail space to third party vendors and the leasing of advertising locations at its retail stores.
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When used in this section, and except as may be set forth otherwise, the terms "we," "us," "ours," and similar terms includes Lotus and its subsidiary Lotus International as well as Lotus East.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our discussion and analysis of our financial condition and results of operations are based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses. On an ongoing basis, we evaluate our estimates and judgments, including those related to accrued expenses, fair valuation of stock related to stock-based compensation and income taxes. We based our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
REVENUE RECOGNITION
Product sales are generally recognized when title to the product has transferred to customers in accordance with the terms of the sale. The Company recognizes revenue in accordance with the Securities and Exchange Commission’s (SEC) Staff Accounting Bulletin (SAB) No. 101, “Revenue Recognition in Financial Statements” as amended by SAB No. 104 (together, “SAB 104”), and Statement of Financial Accounting Standards (SFAS) No. 48 “Revenue Recognition When Right of Return Exists.”SAB 104 states that revenue should not be recognized until it is realized or realizable and earned. In general, the Company records revenue when persuasive evidence of an arrangement exists, services have been rendered or product delivery has occurred, the sales price to the customer is fixed or determinable, and collectability is reasonably assured.
SFAS No. 48 states that revenue from sales transactions where the buyer has the right to return the product shall be recognized at the time of sale only if the seller’s price to the buyer is substantially fixed or determinable at the date of sale, the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product, the buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product, the buyer acquiring the product for resale has economic substance apart from that provided by the seller, the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer, and the amount of future returns can be reasonably estimated.
The Company’s net product revenues represent total product revenues less allowances for returns.
PRODUCT RETURNS
The Company accounts for sales returns in accordance with Statements of Financial Accounting Standards (SFAS) No. 48, Revenue Recognition When Right of Return Exists, by establishing an accrual in an amount equal to its estimate of sales recorded for which the related products are expected to be returned. The Company determines the estimate of the sales return accrual primarily based on historical experience regarding sales returns, but also by considering other factors that could impact sales returns. These factors include levels of inventory in the distribution channel, estimated shelf life, product discontinuances, and price changes of competitive products, introductions of generic products and introductions of competitive new products. In general, for wholesale sales, the Company provides credit for product returns that are returned six months prior to and up to six months after the product expiration date. Upon sale, the Company estimates an allowance for future product returns. The Company provides additional reserves for contemporaneous events that were not known and knowable at the time of shipment. In order to reasonably estimate future returns, the Company analyzed both quantitative and qualitative information including, but not limited to, actual return rates, the level of product manufactured by the Company, the level of product in the distribution channel, expected shelf life of the product, current and projected product demand, the introduction of new or generic products that may erode current demand, and general economic and industry wide indicators. The Company also utilizes the guidance provided in SAB 104 in establishing its return estimates.
OTHER REVENUE
Other revenues consist of (i) rental income received for the lease of retail space to various retail merchants; (ii) advertising revenues from the lease of counter space at our retail locations; (iii) rental income from the lease of retail space to licensed medical practitioners; and (iv) revenues received by us for research and development projects. We recognize revenues upon performance of such funded research. We recognize revenues from leasing of space as earned from contracting third parties. Revenues received in advance are reflected as deferred revenue on the accompanying balance sheets. Additionally, we receive income from the sale of developed drug formulas. Income from the sale of drug formulas are recognized upon performance of all of our obligations under the respective sales contract and are included in other income on the accompanying consolidated statement of operations.
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ACCOUNTS RECEIVABLE
Accounts receivable are carried at original invoice amount less an estimate made for doubtful receivables based on a review of all outstanding amounts on a monthly basis. Management judgment and estimates are made in connection with establishing the allowance for doubtful accounts. Specifically, we analyze the aging of accounts receivable balances, historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms. Significant changes in customer concentration or payment terms, deterioration of customer credit-worthiness or weakening in economic trends could have a significant impact on the collectability of receivables and our operating results. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.
INVENTORIES
Inventories are stated at the lower of cost or market with cost determined under the moving average method. Inventory consists of finished capsules, liquids, finished oral suspension powder and other western and traditional Chinese medicines and medical equipment. At least on a quarterly basis, we review our inventory levels and write down inventory that has become obsolete or has a cost basis in excess of its expected net realizable value or is in excess of expected requirements. Inventory levels are evaluated by management relative to product demand, remaining shelf life, future marketing plans and other factors, and reserves for obsolete and slow-moving inventories are recorded for amounts which may not be realizable.
PROPERTY AND EQUIPMENT
Property and equipment are carried at cost. The cost of repairs and maintenance is expensed as incurred; major replacements and improvements are capitalized. When assets are retired or disposed of, the cost and accumulated depreciation are removed from the accounts, and any resulting gains or losses are included in income in the year of disposition. In accordance with Statement of Financial Accounting Standards (SFAS) No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", we examine the possibility of decreases in the value of fixed assets when events or changes in circumstances reflect the fact that their recorded value may not be recoverable.
Depreciation is calculated on a straight-line basis over the estimated useful lives of the assets. The useful lives for property and equipment are as follows:
Buildings and leasehold improvement | 20 to 40 years | |||
Manufacturing equipment | 10 to 15 years | |||
Office equipment and furniture | 5 to 8 years |
INCOME TAXES
Taxes are calculated in accordance with taxation principles currently effective in the United States and PRC. We account for income taxes using the liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income in the period that includes the enactment date. A valuation allowance is provided for the amount of deferred tax assets that, based on available evidence, are not expected to be realized.
RECENT ACCOUNTING PRONOUNCEMENTS
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In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No.115", under which entities will now be permitted to measure many financial instruments and certain other assets and liabilities at fair value on an instrument-by-instrument basis. This Statement is effective as of the beginning of an entity's first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007, provided the entity also elects to apply the provisions of SFAS 157. The adoption of SFAS 159 did not have a material impact on our financial statements.
In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141R, Business Combinations (SFAS 141R) and Statement of Financial Accounting Standards No. 160, Accounting and Reporting of Non-controlling Interests in Consolidated Financial Statements, an amendment of ARB No. 51 (SFAS 160). These two standards must be adopted in conjunction with each other on a prospective basis. The most significant changes to business combination accounting pursuant to SFAS 141R and SFAS 160 are the following: (a) recognize, with certain exceptions, 100 percent of the fair values of assets acquired, liabilities assumed and non-controlling interests in acquisitions of less than a 100 percent controlling interest when the acquisition constitutes a change in control of the acquired entity, (b) acquirers' shares issued in consideration for a business combination will be measured at fair value on the closing date, not the announcement date, (c) recognize contingent consideration arrangements at their acquisition date fair values, with subsequent changes in fair value generally reflected in earnings, (d) the expensing of all transaction costs as incurred and most restructuring costs, (e) recognition of pre-acquisition loss and gain contingencies at their acquisition date fair values, with certain exceptions, (f) capitalization of acquired in-process research and development rather than expense recognition, (g) earn-out arrangements may be required to be re-measured at fair value and (h) recognize changes that result from a business combination transaction in an acquirer's existing income tax valuation allowances and tax uncertainty accruals as adjustments to income tax expense. Should we decide to enter into future business combinations, these new standards will significantly affect our accounting for future business combinations following adoption on January 1, 2009.
In March 2008, the FASB issued SFAS No. 161, "Disclosures about Derivative Instruments and Hedging Activities-- an amendment of FASB Statement No. 133" ("FAS 161"). FAS 161 changes the disclosure requirements for derivative instruments and hedging activities. Entities are required to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under Statement 133 and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity's financial position, financial performance, and cash flows. The guidance in FAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. This Statement encourages, but does not require, comparative disclosures for earlier periods at initial adoption. The adoption of SFAS 161 did not have a material impact on our financial statements.
In May 2008, the Financial Accounting Standards Board (FASB”) issued FASB Staff Position (FSP”) APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement) . FSP APB 14-1 clarifies that convertible debt instruments that may be settled in cash upon either mandatory or optional conversion (including partial cash settlement) are not addressed by paragraph 12 of APB Opinion No. 14, Accounting for Convertible Debt and Debt issued with Stock Purchase Warrants . Additionally, FSP APB 14-1 specifies that issuers of such instruments should separately account for the liability and equity components in a manner that will reflect the entity’s nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods. FSP APB 14-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. We will adopt FSP APB 14-1 beginning in the first quarter of fiscal 2010, and this standard must be applied on a retrospective basis. We are evaluating the impact the adoption of FSP APB 14-1 will have on our consolidated financial position and results of operations.
In May 2008, the FASB issued Statement of Financial Accounting Standards (SFAS”) No. 162, The Hierarchy of Generally Accepted Accounting Principles . This standard is intended to improve financial reporting by identifying a consistent framework, or hierarchy, for selecting accounting principles to be used in preparing financial statements that are presented in conformity with generally accepted accounting principles in the United States for non-governmental entities. SFAS No. 162 is effective 60 days following approval by the U.S. Securities and Exchange Commission (SEC”) of the Public Company Accounting Oversight Board’s amendments to AU Section 411, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles . We do not expect SFAS No. 162 to have a material impact on the preparation of our consolidated financial statements.
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On June 16, 2008, the FASB issued final Staff Position (FSP) No. EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities” to address the question of whether instruments granted in share-based payment transactions are participating securities prior to vesting. The FSP determines that unvested share-based payment awards that contain rights to dividend payments should be included in earnings per share calculations. The guidance will be effective for fiscal years beginning after December 15, 2008. We are currently evaluating the requirements of (FSP) No. EITF 03-6-1.
On October 10, 2008, the FASB issued FSP 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active,” which clarifies the application of SFAS 157 in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP 157-3 became effective on October 10, 2008, and its adoption did not have a material impact on our financial position or results.
In January 2009, the FASB issued FSP EITF 99-20-1, “Amendments to the Impairment Guidance of EITF Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets”. FSP EITF 99-20-1 changes the impairment model included within EITF 99-20 to be more consistent with the impairment model of SFAS No. 115. FSP EITF 99-20-1 achieves this by amending the impairment model in EITF 99-20 to remove its exclusive reliance on “market participant” estimates of future cash flows used in determining fair value. Changing the cash flows used to analyze other-than-temporary impairment from the “market participant” view to a holder’s estimate of whether there has been a “probable” adverse change in estimated cash flows allows companies to apply reasonable judgment in assessing whether an other-than-temporary impairment has occurred. The adoption of FSP EITF 99-20-1 did not have a material impact on our consolidated financial statements.
Results of Operations
Year Ended December 31, 2008 compared to Year Ended December 31, 2007
Total Net Revenues
Total revenues for the year ended December 31, 2008 were $73,803,029 as compared to total revenues of $56,873,115 for the year ended December 31, 2007, an increase of $16,929,914 or approximately 29.77% comparable period in 2007. For the year ended December 31, 2008 and 2007, net revenues consisted of the following:
2008 | 2007 | |||||||
Wholesale | $ | 65,264,281 | $ | 41,651,106 | ||||
Retail | 2,837,257 | 3,471,960 | ||||||
Other revenues | 5,701,491 | 11,750,049 | ||||||
Total net revenues | $ | 73,803,029 | $ | 56,873,115 |
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For the year ended December 31, 2008, wholesale revenues increased by $23,613,175or 56.69%. The significant increase in tangible product revenues is mainly attributed to strong sales in Brimonidine Tartrate Eye Drops and third party manufactured drugs included Recombinant Human Granulocyte Colony, Recombinant Human Interleukin-2 for Injection, Recombinant Human Erythropoietin Injection, Deproteinized Calfblood Extractives Injection, Octreotide Acetate Injection, Cervus and Cucumis and Polypeptide Injection Cefrotaxime Sodium for Injection. The increase in revenue was offset by the decrease in sales in Levofloxacin Lactate for Injection and Valsartan Capsules. The significant increased sales in Brimonidine Tartrate Eye Drops were primarily due to our strong sales effort on promoting this drug. In late 2007, we obtained exclusive distribution rights from a third party Beijing based pharmaceutical company for four drugs: Octreotide Acetate Injection, Recombinant Human Erythropoietin Injection, Recombinant Human Granulocyte Colony-stimulating Factor Injection, and Recombinant Human Interleukin-2 for Injection. In 2008, we obtained exclusive distribution rights for Cervus and Cucumis Polypeptide Injection. Additionally, we also strengthen our relationships with the several large drug manufacturers in 2008. As a result, we experienced a significant increase in our third party manufactured drug sales during the year ended December 31, 2008. As majority of our wholesale products are prescription drugs that are in demand by patients in China, we believe the demand for our wholesale products will not be impacted by the overall softening economy. We expect the sales will continue to have steady growth in our fiscal year of 2009. | ||
For the year ended December 31, 2008, retail revenues decreased by $634,703 or 18.28%. The decrease is primarily attributable to the slowdown in economy growth and the impact from 2008 Olympic held in Beijing. The slowdown in the economy growth resulted in less non-essential health supplements being purchases. The Company also experienced a reduction in the sale of higher priced drugs in 2008. As a result, the Company generated less per store revenue. Additionally, during the 2008 Olympics, the Beijing government restricted the city traffic and limited local roads used by locals. Consequentially, the Company’s retail stores received less visits from its customers. We expect our retail revenue will slightly increase in our fiscal year of 2009. | ||
For the year ended December 31, 2008, other revenues decreased by $6,048,558 or 51.48%. The decrease in other revenues is attributed to the following: |
2008 | 2007 | |||||||
Leasing revenues | $ | 779,346 | $ | 859,288 | ||||
Third-party manufacturing | 4,465,965 | 9,482,572 | ||||||
Advertising revenues | 230 | 601,335 | ||||||
Research and development and lab testing services | 455,950 | 806,854 | ||||||
Total other revenues | $ | 5,701,491 | $ | 11,750,049 |
We sublease certain portion our retail stores and counter spaces to various other vendors and generate leasing revenue. The leasing revenue remained materially consistent with prior year same period. The slight decrease was primarily due to less counter space being leased to third parties due to less demand for our counter spaces during the year ended December 31, 2008. We expect our leasing revenue to remain flat in our fiscal 2009. |
For third-party manufacturing, customers supply the raw materials and we are paid a fee for manufacturing their products. We had less large manufacturing contracts during the year ended December 31, 2008 as the demand for the third-party manufacturing decreased as compared to the same period in 2007. Several of our historical, large third party manufacturing customers have built their own facilities and started manufacturing products on their own in 2008 and we were unable to find new customers to replace them. As a result, our third-party manufacturing revenue decreased. We anticipate the third-party manufacturing revenue will continue to decrease for the fiscal 2009 as we do not expect to have new customers with large third party manufacturing contracts. | ||
A large advertisement contract whereby we receive approximately $50,000 per month for the lease of counter and other space at our retail locations ended in December 2007. Accordingly, our advertising revenues decreased during the year ended December 31, 2008 as compared to the same period in 2007. As the local government tightens the advertising rules and regulations in the pharmaceutical industry, we do not anticipate signing similar advertisement contracts in the near future. | ||
We performed research and development and lab testing projects for various third parties and performed drug testing and analysis. We preformed less R&D testing services and drug testing and analysis work for third parties during the year ended December 31, 2008 as compared to the same period in 2007. Some of our historical customers for these services were able to find other companies that provide similar R&D and lab testing serves at a lower price and decided not to use our services in 2008. We expect the revenue from R&D and lab testing will maintain at its current level with minimal growth in the fiscal year of 2009. |
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Cost of Sales
Cost of sales includes raw materials, packing materials, direct labor, manufacturing costs, which includes allocated portion of overhead expenses such as Labor fee, utilities and depreciation directly related to product production, and related taxes. For the year ended December 31, 2008, cost of sales amounted to $40,440,088 or approximately 54.79% of total net revenues as compared to cost of sales of $33,678,963 or approximately 59.22% of total net revenues for the year ended December 31, 2007. The decrease in cost of sales as a percentage of total net revenue was primarily due to better purchase pricing management and more efficient production cost controls.
Gross Profit
Gross profit for the year ended December 31, 2008 was $33,362,941 or 45.21% of total net revenues, as compared to $23,194,152 or 40.78% of total net revenues for the year ended December 31, 2007. The increase in gross profit was attributable to the decrease in cost of sales as a percentage of revenue. The decrease in cost of sales as a percentage of revenue was primarily contributed to better managed raw material and third party manufactured finished goods purchase prices. Although we recognized higher than average gross profits during the year ended December 31, 2008, there could be no assurance that we will continue to recognize similar gross profit margin in the future.
Operating Expenses
Total operating expenses for the year ended December 31, 2008 were $18,292,997, an increase of $6,407,138 or 53.91% from total operating expenses in the year ended December 31, 2007 of $11,885,859. This increase included the following:
For the year ended December 31, 2008, selling expenses amounted to $14,902,646 as compared to $6,460,206 for the year ended December 31, 2007, an increase of $8,442,440 or 130.68% from the comparable period in fiscal 2007. This increase is primarily attributable to an increase of approximately $5.6 million in commission paid to our sales representatives on sales generated to provide greater incentives; we increased the sales commission percentage in 2008. Additionally, we paid bonuses to our collection personnel of approximately $2.5 million to improve our collections on accounts receivables and cash flows. In order to generate sufficient cash to meet our near term capital commitments such as new manufacture plant construction project and acquiring Chinese Class I drug patent, management adopted a high commission and bonuses policy to incentivize our sales and collection personnel’s performance. As a result, the significant increase in the selling expenses negatively impacted of our net income. Management has modified its sales and collection incentive policy and reduced the sales commission percentage and collection bonuses in 2009 as the Company’s near term capital requirement has been met. Although we currently expect the selling expenses as a percentage of revenue will decrease, we cannot guarantee that we will not reinforce the high sales and collection incentive policy and increase the selling expenses as a percentage of revenue to meet future working capital needs.
For the year ended December 31, 2008, research and development costs amounted to $1,200,194 as compared to $2,411,651 for the year ended December 31, 2007, a decrease of $1,211,457 or 50.23%from the comparable period in 2007. In late 2007, we entered into several research and development agreements with third parties for the design, research and development of designated pharmaceutical projects. We fulfilled these research and development agreements on June 30, 2008. We did not enter into any new research and development agreement in the last half fiscal year of 2008. As a result, expenses related to those research and development projects decreased during the year ended December 31, 2008. As we have a number of new drugs that are either under development or waiting for approval, we do not expect to enter into additional research and development agreements that will incur material research and development costs in the near future.
For the year ended December 31, 2008, general and administrative expenses were $ 2,190,157 as compared to $3,014,002 for the year ended December 31, 2007, a decrease of $823,845 or 27.33% from the comparable period in fiscal 2007. These changes are summarized below:
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For the Year ended December 31, | ||||||||
2008 | 2007 | |||||||
Salaries and related benefits | $ | 1,411,256 | $ | 1,457,501 | ||||
Depreciation | 16,868 | 10,550 | ||||||
Amortization | 151,723 | 140,471 | ||||||
Rent | 210,954 | 242,856 | ||||||
Travel and entertainment | 57,525 | 284,357 | ||||||
Professional fees | 521,519 | 250,472 | ||||||
Bad debt recovery | (575,781 | ) | - | |||||
Other | 396,092 | 627,795 | ||||||
Total | $ | 2,190,157 | $ | 3,014,002 |
The changes in these expenses from the year ended December 31, 2008 as compared to the year ended December 31, 2007 included the following:
· | Salaries and related benefits decreased $46,245 or 3.17% primarily due to a decrease in bonuses paid to administrative personnel. The bonuses paid in 2007 were paid to several key employees and management and determined by meeting various individuals’ as well as overall Company’s operational goals. As we continue our efforts to control corporate spending, starting in 2008, we no longer provided certain benefits that were provided to employees in the 2007 including insurance, car allowances and other fringe benefits. As a result, the salaries and related benefits costs decreased accordingly |
· | Depreciation on our fixed assets increased by $6,318 or approximately 59.89% which is primarily attributable to the purchase of new equipment in 2008. |
· | Amortization of our intangible assets increased by $11,252 or approximately 8.01% which is primarily attributable to the purchase of new intangible asset used in our office in fiscal year of 2008. |
· | Bad debt recovery income increased $575,781 or 100% primarily due to our strong effort on accounts receivable collection. |
· | Rent decreased by $31,902 or approximately 13.14% which primarily reflects our ability to renegotiate a portion of our leases at reduced rent rates on a short term basis. |
· | Travel and entertainment expenses decreased by $226,832 or 79.77% as a result of corporate spending control effort. |
· | Professional fees increased $271,047 or 108.21% due to increase in investor relation professional fees, legal expenses related to February 2008 financing and a stock based compensations paid to a technology consultant for consulting services provided to the Company. |
· | Other general and administrative expenses, which includes utilities, office supplies and training and other office expenses decreased by $231,703 or approximately 36.91% reflecting efforts at reducing non-sales related corporate training and other activities as well as stricter controls on corporate spending. |
Income from Operations
We reported income from operations of $15,069,944 for the year ended December 31, 2008 as compared to income from operations of $11,308,293 for the year ended December 31, 2007, an increase of $3,761,651 or approximately 33.26%.
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Other Expense
For the year ended December 31, 2008, total other expense amounted to $2,279,296 as compared to other expense of $91,165 for the year ended December 31, 2007, an increase of $2,188,131 or 2400.19% from the comparable period in 2007. This change is primarily attributable to:
· | For the year ended December 31, 2008, we do not receive any forgiveness of business and value-added taxes from local government as compared to $2,160,795 forgiveness of business of business and valued-added taxes received from local government for the year ended December 31, 2007. In 2007, the Chinese local government granted Lotus East special tax waivers to exempt and release business and value added taxes. The PRC local government has provided various incentives to local companies in order to encourage economic development. Such incentives include reduced tax rates and other measures. The tax waivers were provided on a non-recurring basis. We do not expect to receive the forgiveness of taxes in 2009. | |
· | For the year ended December 31, 2008, our debt issuance cost amounted to $361,436 as compared to $205,379 for the year ended December 31, 2007, an increase of $156,057 or approximately 75.98%, due to our February 2008 financing. | |
· | For the year ended December 31, 2008, we recorded registration rights penalties of $650 related to the late filing of our registration statement on Form SB-2 as compared to $110,000 for the year ended December 31, 2007, a decrease of $109,350 or 99.41%. | |
· | For the year ended December 31, 2008, interest expense was $1,929,836 as compared to $2,038,735 for the year ended December 31, 2007, a decrease of $108,899 or 5.34% which is primarily attributable to the amortization of debt discount on our 2007 financing which was fully amortized earlier in 2008 and the annual interest rate on our 2007 financing was larger than the annual interest rate on our 2008 financing. |
NET INCOME, OTHER COMPREHENSIVE INCOME AND COMPREHENSIVE INCOME
As a result of these factors, we reported net income of $12,790,648 for the year ended December 31, 2008 as compared to net income of $11,217,128 for the year ended December 31, 2007. This translates to basic and diluted net income per common share of $0.30, $0.27 and $0.27, $0.26 for the year ended December 31, 2008 and 2007, respectively.
During the year ended December 31, 2008, our unrealized gain on foreign currency translation of $2,247,686, an increase of $767,334, or approximately 51.83%, from the same period in 2007. We report in U.S. dollars, but the functional currency of Lotus East is the RMB. Translation adjustments result from the process of translating the local currency financial statements into U.S. dollars, with the average translation rates applied to our income statement of 6.96225 RMB to $1.00 during the year ended December 31, 2008. As a result of this non-cash gain, we reported comprehensive income of $15,038,334 for the year ended December 31, 2008 as compared to $12,697,480 for the same period in 2007.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity is the ability of a company to generate funds to support its current and future operations, satisfy its obligations and otherwise operate on an ongoing basis.
At December 31, 2008, we had a cash balance of $1,278,808. These funds are located in financial institutions located as follows:
China | $ | 1,277,649 | ||
USA | 1,159 | |||
Total | $ | 1,278,808 |
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Our working capital position decreased $20,229,954 to $ 4,422,183 at December 31, 2008 from $24,652,137 at December 31, 2007. This decrease in working capital is primarily attributable to a decrease in cash of approximately $3.28 million, a decrease in accounts receivable net of allowance of approximately $14.30 million, a decrease in prepaid expenses and other assets of approximately $0.89 million, a decrease in convertible debt net of debt discount of approximately $2.56 million, an increase in other receivable-related party of approximately $2.03 million, an increase in inventories net of reserve for obsolete inventory of approximately $0.38 million, an increase in deferred debt issuance costs of approximately $0.37 million, an increase in accounts payable and accrued expenses of approximately $1.41 million, an increase in tax payable of approximately $4.44 million and an increase in due to related parties of approximately of $1.27 million.
At December 31, 2008, our accounts receivable, net of allowance for doubtful accounts, was $6,132,912 as compared to $20,430,827 at December 31, 2007, a decrease of $14,297,915. The decrease was primarily due to our strong collection effort which significantly improved our accounts receivable aging days. We expect our accounts receivable will maintain at the current level; in addition to our continuous collection effort, we have started to provide our customers discounted sales price on our products if they pay for the products within a certain short time period.
At December 31, 2008, we maintained an allowance for doubtful accounts on accounts receivable balances of $0 as compared to $548,083 at December 31, 2007, a decrease of $548,083 reflects our best estimate of probable losses. In determining the allowance for doubtful accounts, our management reviews our accounts receivable aging as well as the facts and circumstances of specific customers which may indicate the collection of specific amounts are at risk. Our terms of sale generally require payment within two to four months, we believe that our terms of sale are customary among our competitors for a company in our size within our industry. As described elsewhere herein, in 2008 we began paying a bonus to certain employees who are involved in the collection of accounts receivable to generate sufficient cash to meet our near term capital commitments such as new manufacture plant construction project and acquiring Chinese Class I drug patent. At December 31, 2008, these bonuses totaled $2.5 million. We also occasionally offer established customers longer payment terms on new products as an incentive to purchase these products, which has served to further increase the average days outstanding for accounts receivable. As the market for these new products is established, we will discontinue offering this sales incentive. Occasionally we will request a customer to prepay an order prior to shipment.
At December 31, 2008, our inventories of raw materials, work in progress, packaging materials, finished goods and reserve for obsolete inventories totaled $3,787,802, an increase of approximately $0.38 million, or 11.06%, from December 31, 2007. Included in this change was an increase of $79,154 in finished goods and an increase of $571,981 in raw materials offset by decreases in packaging materials of $36,867, work in progress of $279,759 and inventories reserve of $42,554 and there is an exchange rate effect in fiscal year of 2008 about reverse for obsolete inventories of $2,855. We expect to maintain slight higher raw materials and finished goods inventory levels to accommodate for anticipated future sales growth and productions.
At December 31, 2008, we have another receivable-related party of $2,027,954 as compared to $0 at December 31, 2007, a increase of $2,027,954. The increase was due to a wire transfer fund from the Company account to our CEO, Zhongyi Liu, personal account in order to form a subsidiary in Inner Mongolia, China. In December 2008, in connection with the new plant facility in Cha Ha Er Industrial Garden District in Inner Mongolia, the Company planned to form a new subsidiary in Inner Mongolia. In preparation for the register capital of the originally planned new entity, on December 25, 2008, the Company transferred $2,027,954 to the Company’s CEO to register for the new entity. The Company subsequently determined forming an Inner Mongolia new entity was not necessary and the money was returned to the Company on January 5, 2009.
At December 31, 2008, we have a prepaid expenses and other assets of $121,274 as compared to $1,009,382 at December 31, 2007, a decrease of $888,108. The decrease was primarily due to the completion of our research and development contracts which were recorded as a prepayment of approximately $1,009,000 in fiscal 2007 and we did not make similar research and development contract prepayments in 2008.
At December 31, 2008, we have a deferred debt cost of $464,411 as compared to $29,340 at December 31, 2007, an increase of $ 435,071. The increase was primarily attributed to the issuance of the series A convertible redeemable preferred stock and warrants to purchase 2,873,553 shares of the company’s common stock. We recorded a total deferred debt cost of $796,133 to be amortized over the term of our purchase agreement.
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At December 31, 2008, we have a deposit on patent of $2,917,919 to acquire a new Chinese Class I anti-asthma medicine drug patent in accordance with a technology transfer agreement the Company entered into in April 2008.
At December 31, 2008, we have an installment on intangible assets of $38,175,134 to acquire the foregoing Chinese Class I drug patent, another drug certificate and intellectual property right- Yipubishan in accordance with a new drug certificate and intellectual property right transfer contract we entered into on December 2, 2008 and land use right in Inner Mongolia. In accordance with the agreement we entered into in June 2008, we recorded an installment on land use right of $32,631,088 for the amounts paid to a local government agency in Cha You to acquire a long-term interest to utilize certain land to construct a new manufacture facility. We did not have these installments at December 31, 2007.
At December 31, 2008, we have a convertible debt, net of debt discount of $0 as compared to $2,561,645 at December 31, 2007, a decrease of $2,561,645. Because we repaid in full all of our outstanding obligations under the 14% Secured Convertible Notes due February 2008.
At December 31, 2008, we have an accounts payable and accrued expenses of $2,170,165 as compared to $764,491 at December 31, 2007, an increase of $1,405,674. The increase was primarily attributed to the increase in payables for construction in progress for our new facility in Inner Mongolia.
At December 31, 2008, we have a taxes payable of $5,015,908 as compared to $572,200 at December 31, 2007. The amounts are related to accrued but unpaid value added taxes and other related taxes for the year ended December 31, 2008. The increase in the taxes payable is primarily due to increase in our revenues and we did not receive any forgiveness of taxes from local government during the year ended December 31, 2008 and the tax payment timing differences.
Our balance sheet at December 31, 2008, also reflects a balance due to related parties of $2,113,914 which was a working capital advances made to us by our president, vice-president and an officer of the Company and a Board member as well as an amount payable of approximately $1,051,450 related to an assignment agreement as discussed elsewhere in this report. These advances are non-interest bearing and are due on demand. We are currently repaying these balances as operating cash become available.
At December 31, 2008, we have a series A convertible redeemable preferred stock of $3,652,341 as compared to $0 at December 31, 2007. The increase is due to our private financing in February 25, 2008.
Our balance sheet at December 31, 2008 also reflects notes payable to related parties of approximately $5 million due on December 30, 2015 which is a working capital loan made to us by the Company’s Chief Executive Officer, two employees of the Company and a Board member. These loans bear a variable annual interest at 80% of current bank rate and are unsecured. During the year ended December 31, 2008, we did not repay any portion of these loan balances.
The changes in asset and liabilities discussed above is based on a comparison of amounts on our balance sheets at December 31, 2008 and December 31, 2007 and does necessarily reflect changes in assets and liabilities reflected on our cash flow statement, which we use the average foreign exchange rate during the period to calculate these changes.
Net cash provided by operating activities for the year ended December 31, 2008 was $37,394,084 as compared to net cash used in operating activities of $850,455 for the year ended December 31, 2007. For the year ended December 31, 2008, net cash provided by operating activities was attributable primarily to a decrease in accounts receivable of $16,001,384, a decrease in prepaid expenses and other current assets of $939,654, an increase in accounts payable and accrued expenses of $1,360,568, an increase in taxes payable of $4,336,947, and the add back of net income of $12,790,648, depreciation and amortization of $634,347, amortization of deferred debt issuance costs of $361,062, amortization of debt discount of $208,355, amortization of discount on convertible redeemable preferred stock of $962,604, amortization of prepaid expense attributable to warrants of $163,338, stock based compensation of $318,551 and warrant repricing of $74,593 offset by a decrease in allowance for doubtful accounts of $575,781, an increase in inventories of $145,910 and a decrease in advances from customers of $36,276. Net cash used in operating activities for the year ended December 31, 2007 was $850,455. For the year ended December 31, 2007, net cash used in operating activities was attributable primarily to our net income of $11,217,128, the add back of depreciation and amortization of $564,607, amortization of deferred debt issuance costs of $205,379, amortization of debt discount of $1,458,484, stock issued for compensation of $ 284,200 and an increase in value-added taxes payable of $608,526 and an increase in unearned revenue of $71,402 offset by an decrease in allowance for doubtful accounts of $2,385,354, a forgiveness of income and value-added taxes of $2,160,795, an increase in accounts receivable of $9,764,076, an increase in inventories of $58,942, an increase of prepaid expenses and other current assets of $714,013 and a decrease in advances from customers of $204,267.
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Net cash used in investing activities for the year ended December 31, 2008 amounted to $41,901,488. For the year ended December 31, 2008, net cash used in investing activities was attributable to the deposit on patent right of $2,872,635, the installments on intangible assets of $ 37,582,678, the purchase of intangible asset of $7,756 and the purchase of property and equipment of $1,438,419. Net cash used in investing activities for the year ended December 31, 2007 was $381,772 and was attributable to the purchase of property and equipment.
Net cash provided by financing activities was $980,937 for the year ended December 31, 2008 and was attributable to the receipt of net proceeds of $5,000,000 from our private financing and proceeds from related party advances of $ 965,986 offset by payments on convertible debt of $2,520,000, debt issuance costs of $468,568 and repayments of related party advances of $1,996,481. Net cash provided by financing activities was $3,472,102 for the year ended December 31, 2007 and was primarily attributable to the receipt of net proceeds of $2,950,000 from our debt financing and the collections from related party advances of $1,061,009 offset by payments on related party advances and notes of $307,381 and the payment of debt issuance costs of $231,526.
We reported a net decrease in cash for the year ended December 31, 2008 of $3,279,149 as compared to a net increase in cash of $2,468,801for the year ended December 31, 2007.
In 2007, we lent approximately $2 million of the net proceeds received from the sale of $3 million principal amount convertible debt to Lotus East, which they used as working capital. These advances are unsecured and interest free. During the first quarter of 2008, we used a portion of the proceeds from the sale of equity to satisfy these notes, lent Lotus East an additional $1.6 million and retained the balance to fund our operating expenses. We have no operations other than the Contractual Arrangements with Lotus East and, accordingly, we are dependent upon the quarterly service fees due us to provide cash to pay our operating expenses. Such payments have not been tendered to us and those funds are being retained by Lotus East to fund their operations. At December 31, 2008, Lotus East owned us approximately $ 23.7 million for such fees and we do not know when such funds will be paid to us. Our CEO is also the CEO and principal shareholder of Lotus East. Accordingly, we are solely reliant upon his judgment to ensure that the funds advanced to Lotus East are repaid to us. If these funds should not be repaid, or if Lotus East should continue to withhold payment of the quarterly service fee due us under the Contractual Arrangement, it is possible that we will not have sufficient funds to pay our operating expenses in future periods.
Other than our existing cash we presently have no other alternative source of working capital. We believe that our working capital may not be sufficient to fund our current operations for the next 12 months unless Lotus East pays us the amounts due to us. Lotus East has historically funded its capital expenditures from their working capital and has advised us that they believe this capital is sufficient for their current needs. Lotus East has unpaid contractual commitments for approximately $62.7 million related to a Technology Transfer Agreement and the construction of the new manufacturing facility. While it intends to fund the costs associated with the Technology Transfer Agreement and a portion of the construction of the new manufacturing facility with its existing working capital, it is dependent upon the continued growth of its operations and prompt payment of outstanding accounts receivables by its customers to ensure that it has sufficient cash for these commitments. In addition, its ability to fully fund the costs associated with the new manufacturing facility is materially dependent upon its ability to secured bank financing and/or government grants. As the banking industry is tightening the credit/lending policy, we expect the bank financing will become more challenging and the time to obtain the bank funding might be longer than expected. Although the Chinese government has recently announced an economic simulation plan, there is no guarantee that we will successfully be awarded the government grant. As it has no firm commitments for either, while its management believes the company will be successful in securing the necessary funding through its increasing revenue, quicker collections on receivables, current discussions with various commercial banks there are no assurances the funding will be available in the amounts or at the time required to meet Liang Fang's commitment. In the event Lotus East is not successful in obtaining the funds it needs for the Technology Transfer Agreement, it is possible that it could default under the terms of the agreement and forfeit any funds paid to date. If Lotus East is not successful in obtaining all of the funding necessary to complete the construction of the new facility, it would lose the approximately $33,813,000 spent to date, including the $32,631,000 for the deposit on the land use rights which is non-refundable.
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However, the ability of Lotus East to raise any significant capital to expand their operations is very limited. We believe that it is in our best long term interests to assist Lotus East in their growth plans. Accordingly, it is likely that we will seek to raise working capital not only for our operating expense but to provide capital to Lotus East for these projects as well as providing working capital necessary for its ongoing operations and obligations. No assurances can be given that we will be successful in obtaining additional capital, or that such capital will be available in terms acceptable to our company, particularly given the current conditions in the capital markets. If we are unable to raise capital as necessary for our operations, and we were no longer able to timely file our reports with the Securities and Exchange Commission, our common stock would be removed from quotation on the OTC Bulletin Board. In this event, the ability of our stockholders to liquidate their investment in our company would be adversely impacted and it is possible that an event of default would occur under various agreements we are a party to with the purchases of our Series A Convertible Redeemable Preferred Stock and common stock purchase warrants.
Contractual Obligations and Off-Balance Sheet Arrangements
Contractual Obligations
We have certain fixed contractual obligations and commitments that include future estimated payments. Changes in our business needs, cancellation provisions, changing interest rates, and other factors may result in actual payments differing from the estimates. We cannot provide certainty regarding the timing and amounts of payments. We have presented below a summary of the most significant assumptions used in our determination of amounts presented in the tables, in order to assist in the review of this information within the context of our consolidated financial position, results of operations, and cash flows. The total of contractual obligations and commitments does not include any payments made by us.
The following tables summarize our contractual obligations as of December 31, 2008, and the effect these obligations are expected to have on our liquidity and cash flows in future periods.
Payments Due by Period | ||||||||||||||||||||
Total | Less than 1 year | 1-3 Years | 3-5 Years | 5 Years + | ||||||||||||||||
Contractual Obligations: | ||||||||||||||||||||
Series A convertible redeemable preferred stock | $ | 5,466,667 | $ | 5,400,000 | $ | 66,667 | $ | - | $ | - | ||||||||||
Related Parties Indebtedness | 6,106,901 | 525,225 | 525,225 | - | 5,056,451 | |||||||||||||||
Patent Purchase Obligations | 4,376,878 | 1,458,959 | 2,917,919 | - | - | |||||||||||||||
Construction Obligations | 58,358,379 | 8,753,757 | 49,604,622 | - | - | |||||||||||||||
Intellectual Rights Purchase Obligations | 4,960,462 | 4,960,462 | - | - | - | |||||||||||||||
Total Contractual Obligations: | $ | 79,269,287 | $ | 21,098,403 | $ | 53,114,433 | $ | - | $ | 5,056,451 |
Off-balance Sheet Arrangements
As of the date of this report, we do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors, however we have agreed to guarantee loans for Lotus East, if required. As of the date of this report, we have not entered into any guarantee arrangements with Lotus East. The term "off-balance sheet arrangement" generally means any transaction, agreement or other contractual arrangement to which an entity unconsolidated with us is a party, under which we have: (i) any obligation arising under a guarantee contract, derivative instrument or variable interest; or (ii) a retained or contingent interest in assets transferred to such entity or similar arrangement that serves as credit, liquidity or market risk support for such assets.
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Not applicable to smaller reporting companies.
Please see our financial statements beginning on page F-1 of this annual report.
None.
Our management does not expect that our disclosure controls or our internal controls over financial reporting will prevent all error and fraud. A control system, no matter how well conceived and operated, can provide only reasonable, but no absolute, assurance that the objectives of a control system are met. Further, any control system reflects limitations on resources, and the benefits of a control system must be considered relative to its costs. These limitations also include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of a control. A design of a control system is also based upon certain assumptions about potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and may not be detected.
Evaluation of Disclosure Controls and Procedures
Disclosure controls and procedures refer to controls and other procedures designed to ensure that information required to be disclosed in the reports we file or submit under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
As required by Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, our management has carried out an evaluation, with the participation and under the supervision of our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 2008. As discussed in more detail below, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures are ineffective as of December 31, 2008, due to material weaknesses that we identified in internal control over financial reporting.
Report of Management on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act. Our management is also required to assess and report on the effectiveness of our internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002 ("Section 404"). Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2008. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control - Integrated Framework. In its assessment of the effectiveness of internal control over financial reporting as of December 31, 2008, our management determined that the material weaknesses below existed. A material weakness is 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 annual or interim financial statements will not be prevented or detected in a timely basis. A significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the company's financial reporting. The following material weaknesses have been identified and included in our management’s assessment as of December 31, 2008:
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1. | We did not maintain effective control over the period-end closing process. Due to the insufficient number of qualified resources, we were unable to timely and accurately complete our work needed to close our books and prepare financial statements in accordance with accounting principles generally accepted in the United States of America. This control deficiency resulted in a significant number of audit adjustments to our 2008 financial statements. In addition, this control deficiency could result in a material misstatement to annual or interim financial statements that would not be prevented or detected. Accordingly, management determined that this control deficiency constitutes a material weakness. |
2. | Multiple material adjustments were made as a result of audit procedures performed, which is a material weakness. Management has concluded that the controls over the period-end financial reporting process were not operating effectively. Specifically, controls were not effective to ensure that significant accounting estimates and other adjustments were appropriately reviewed, analyzed, and monitored on a timely basis. |
3. | Significant capital expenditures were discussed and approved at management meetings at which some directors of the board of directors attended but no formal board approval procedure were followed, which is a significant deficiency. |
Remediation Measures of Material Weaknesses
We have implemented, or plan to implement, the measures described below under the supervision and guidance of our management to remediate the above control deficiencies and to strengthen our internal controls over financial reporting. Key elements of the remediation effort include, but are not limited to, the following initiatives, which have been implemented, or are in the process of implementation, as of the date of filing of this Annual Report:
1. | We have increased efforts to enforce internal control procedures. We have also reorganized the structure of our China financial department and clarified the responsibilities of each key personnel in order to increase communications and accountability. |
2. | We have recruited and will continue to bring in additional qualified financial personnel for the accounting department to further strengthen our China financial reporting function. |
3. | We continually review and improve our standardization of our monthly and quarterly data collection, analysis, and reconciliation procedures. To further improve the timeliness of data collection, we are selecting and will install new point of sale systems and enterprise resource planning systems for our wholesale and retail operations. |
4. | We plan on significantly increasing the level of communication and interaction among our China management, independent auditors, our directors of the Board, and other external advisors.. |
5. | We are in the process of searching for qualified internal control consultants to help us be in compliance with internal control obligations, including Section 404. We also plan to dedicate sufficient resources to implement required internal control procedures. |
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We believe that the foregoing steps will remediate the material weaknesses identified above, and we will continue to monitor the effectiveness of these steps and make any changes that our management deems appropriate. Due to the nature of these material weaknesses in our internal control over financial reporting, there is more than a remote likelihood that misstatements which could be material to our annual or interim financial statements could occur that would not be prevented or detected.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. 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 and procedures may deteriorate.
Auditor Attestation
This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management's report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit us to provide only management's report in this annual report.
Changes in Internal Control over Financial Reporting
Except as described above, there have been no changes in our internal control over financial reporting during our fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B. OTHER INFORMATION.
None.
DIRECTORS AND EXECUTIVE OFFICERS
The following individuals serve as our executive officers and members of our Board of Directors:
Name | Age | Positions held: | ||
Dr. Liu Zhong Yi | 48 | Chief Executive Officer, President, and Chairman of the Board of Directors | ||
Adam Wasserman | 44 | Chief Financial Officer | ||
Dr. Ian Ashley | 39 | Secretary | ||
Ms. Li Ping | 47 | Director | ||
Mr. Liu Jin | 72 | Director | ||
Ms. Xian Xuemei | 39 | Director | ||
Mrs. Song Zhenghong | 42 | Director |
DR. LIU ZHONG YI. Dr. Lui has served as Chairman of the Board and Chief Executive Officer of Lotus since September 2006 and he has also served in those positions at Lotus International since founding that company in August 2006. Dr. Liu is also the Chairman, Deputy Chief Physician and founder of Liang Fang and founder and General Manager of En Zhe Jia Shi.. As a researcher and medical student, Dr. Liu excelled in the development of many new drugs in wide use in China today. While working for the Chinese Government in 1992, he established the Research Center of Space Flight Biological Engineering Technology, and continued his renowned research related to incretion diseases. Four years later, entering the private sector and invigorated by burgeoning capitalism in China, Dr. Liu started his first pharmaceutical company in Beijing. He earned his Master's Degree in Endocrinology from Beijing Xiehe Medical School, after doing his undergraduate studies in Inner Mongolia Medicine College in Inner Mongolia, China He is a majority stockholder in each of Liang Fang and En Zhe Jia and the spouse of Mrs. Song Zhenghong.
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ADAM WASSERMAN. Mr. Wasserman has served as Chief Financial Officer for Lotus since October 2006 under the terms of the consulting agreement with his firm, CFO Oncall, Inc. Mr. Wasserman devotes approximately 20% of his time to our company. Since November 1999, Mr. Wasserman has been CEO of CFO Oncall, Inc., a Weston, Florida based provider of consultant accounting services specializing in financial reporting, budgeting and planning, mergers and acquisitions, audit preparation services, accounting, automated systems, banking relations and internal controls. Mr. Wasserman has also served as the chief financial officer of Transax International Limited since May 2005, Gold Horse International, Inc. since July 2007 and China Wind Systems, Inc. since March 2008. Mr. Wasserman has also served as the chief financial officer of Explorations Group Inc. (January 2002 until December 2005) Colmena Corp. (May 2003 until June 2004) and Genesis Pharmaceuticals Enterprises, Inc. (October 2001 until October 2007), all client companies of CFO Oncall, Inc. From June 1991 to November 1999 he was Senior Audit Manager at American Express Tax and Business Services, in Fort Lauderdale, Florida where his responsibilities included supervising, training and evaluating senior staff members, work paper review, auditing, maintaining positive client relations, preparation of tax returns and preparation of financial statements and the related footnotes. From September 1986 to May 1991, he was employed by Deloitte & Touche, LLP. During his employment, his significant assignments included audits of public (SEC reporting) and private companies, tax preparation and planning, management consulting, systems design, staff instruction, and recruiting. Mr. Wasserman holds a Bachelor of Administration from the State University of New York at Albany. He is a CPA (New York) and a member of The American Institute of Certified Public Accountants and is a director, the treasurer and an executive board member of Gold Coast Venture Capital Association.
DR. IAN ASHLEY. Dr. Ashley has been a member of our Board of Directors since September 2006 and a member of Lotus International's Board of Directors since August 2006. Previously he worked for Merck & Co in 1990 in Research and Development with focus on hypertension and calcium channel blockers. He is ABEM Board Certified in Emergency Medicine after finishing a residency in Emergency Medicine at Loma Linda University Medical Center in Southern California. Since 2002, Dr. Ashley has served as Attending Physician at Providence Hospital in Waco, Texas. Dr. Ashley graduated Summa Cum Laude with degrees in Chemistry and Biochemistry from Oberlin College before graduating from Baylor College of Medicine in Houston, Texas in 1996.
MS. LI PING. Ms. Li has been a member of our Board of Directors since September 2006 and a member of Lotus International's Board of Directors since August 2006. Ms. Li served as salesman and deputy manager of the sales department of Beijing Dongcheng Medicine Wholesale Company from 1984 to 1999. Since 2000, she served as director of Liang Fang and is responsible for medicine and clinic promotions. Ms. Li graduated from the Beijing Medical School, apothecary.
LIU JIN. Mr. Liu has been a member of our Board of Directors since September 2006 and a member of Lotus International's Board of Directors since August 2006. Mr. Liu served as an accountant for the Finance Bureau of Liangcheng County from 1958 to1970 and the as accountant and accountant general for Finance Bureau of Chayouqiqnqi of Inner Mongolia. Since 2000, Mr. Liu has served as a director of Liang Fang and has been responsible for production cost control. Mr. Liu graduated from the Middling Finance School of Wulanchabu City of Inner Mongolia in 1958.
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XIAN XUEMEI. Ms. Xian has been a member of our Board of Directors since December 2006. Ms. Xian served as clinical pharmacist of Chengdu Spaceflight Hospital from 1997 to 2000. Since 2001, she has been working with Liang Fang and is responsible for medical quality inspections. Ms. Xian graduated from the School of Pharmacy, West China University of Medical Sciences with a bachelor's degree in 1996 with excellent academic results.
SONG ZHENGHONG. Mrs. Song has been a member of our Board of Directors since September 2006 and a member of Lotus International's Board of Directors since August 2006. Since 1991, Mrs. Song has been a teacher, assistant teacher and senior teacher at Yungang Second Middle School in Fengtai, Beijing. She is a minority stockholder in each of Liang Fang and En Zhe Jia and the wife of Dr. Liu.
There are no family relationships between any of the executive officers and directors, except as set forth above. Each director is elected at our annual meeting of stockholders and holds office until the next annual meeting of stockholders, or until his successor is elected and qualified.
COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT
Based solely upon a review of Forms 3 and 4 and amendments thereto furnished to us under Rule 16a-3(d) of the Securities Exchange Act during 2008 and Forms 5 and amendments thereto furnished to us with respect to 2008, as well as any written representation from a reporting person that no Form 5 is required, we are not aware that any officer, director or 10% or greater stockholder failed to file on a timely basis, as disclosed in the aforementioned Forms, reports required by Section 16(a) of the Securities Exchange Act during 2008, except as follows:
· | Dr. Liu Zhong Yi did not timely file on one occasion the receipt of 30,000 shares of our common stock issued as compensation for his services as a director, |
· | Dr. Ian Ashley did not timely file on one occasion the receipt of 30,000 shares of our common stock issued as compensation for his services as a director, |
· | Ms. Li Ping did not timely file on one occasion the receipt of 30,000 shares of our common stock issued as compensation for his services as a director, |
· | Mr. Liu Jin did not timely file on one occasion the receipt of 30,000 shares of our common stock issued as compensation for his services as a director, |
· | Ms. Caeli Widger did not timely file on one occasion the receipt of 30,000 shares of our common stock issued as compensation for her services as a director, |
· | Ms. Xian Xuemei did not timely file on one occasion the receipt of 30,000 shares of our common stock issued as compensation for her services as a director, and |
· | Mrs. Song Zhenghong did not timely file on one occasion the receipt of 30,000 shares of our common stock issued as compensation for her services as a director. |
These delinquent reports have not been filed as of the date of this report.
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CODE OF ETHICS
On February 1, 2006 our Board of Directors adopted a Financial Code of Ethics which applies to our Chief Executive Officer, Chief Financial Officer and members of our financial department. We will provide a copy, without charge, to any person desiring a copy of the Financial Code of Ethics, by written request to 16 Cheng Zhuang Road, Feng Tai District, Beijing 100071, People’s Republic of China. Attention: Corporate Secretary. In addition, we have filed a copy of the Financial Code of Ethics with the Securities and Exchange Commission as an exhibit to this report.
COMMITTEES OF THE BOARD OF DIRECTORS
Our Board of Directors has not established any committees, including an Audit Committee, a Compensation Committee or a Nominating Committee, any committee performing a similar function. The functions of those committees are being undertaken by the entire board as a whole.
We do not have a policy regarding the consideration of any director candidates which may be recommended by our stockholders, including the minimum qualifications for director candidates, nor has our Board of Directors established a process for identifying and evaluating director nominees. We have not adopted a policy regarding the handling of any potential recommendation of director candidates by our stockholders, including the procedures to be followed. Our Board has not considered or adopted any of these policies as we have never received a recommendation from any stockholder for any candidate to serve on our Board of Directors. Given our relative size and lack of directors and officers insurance coverage, we do not anticipate that any of our stockholders will make such a recommendation in the near future. While there have been no nominations of additional directors proposed, in the event such a proposal is made, all members of our Board will participate in the consideration of director nominees.
None of our directors is an "audit committee financial expert" within the meaning of Item 401(e) of Regulation S-B. In general, an "audit committee financial expert" is an individual member of the audit committee or Board of Directors who:
· | understands generally accepted accounting principles and financial statements, |
· | is able to assess the general application of such principles in connection with accounting for estimates, accruals and reserves, |
· | has experience preparing, auditing, analyzing or evaluating financial statements comparable to the breadth and complexity to our financial statements, |
· | understands internal controls over financial reporting, and |
· | understands audit committee functions. |
Since the closing of the share exchange with Lotus International, we have relied upon the personal relationships of our CEO to attract individuals to our Board of Directors. While we would prefer that one or more of our directors be an audit committee financial expert, the individuals whom we have been able to attract to our Board do not have the requisite professional backgrounds. It is our intent to expand our Board of Directors during 2009 to include additional independent directors as well as one or more directors who are considered audit committee financial experts. At that time we intent to establish an Audit Committee of our Board of Directors. Our securities are not quoted on an exchange, however, that has requirements that a majority of our Board members be independent and we are not currently otherwise subject to any law, rule or regulation requiring that all or any portion of our Board of Directors include "independent" directors, nor are we required to establish or maintain an Audit Committee or other committee of our Board of Directors.
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The following table summarizes all compensation recorded by us in the last completed fiscal year for our principal executive officer, each other executive officer serving as such whose annual compensation exceeded $100,000, and up to two additional individuals for whom disclosure would have been made in this table but for the fact that the individual was not serving as an executive officer of our company at December 31, 2008. The value attributable to any option awards is computed in accordance with FAS 123R.
SUMMARY COMPENSATION TABLE | |||||||||
Name and principal position (a) | Year (b) | Salary ($) (c) | Bonus ($) (d) | Stock Awards ($) (e) | Option Awards ($) (f) | Non-Equity Incentive Plan Compensation ($) (g) | Nonqualified Deferred Compensation Earnings ($) (h) | All Other Compensation ($) (i) | Total ($) (j) |
Liu Zhong Yi (1) | 2008 2007 | 180,000 150,000 | 0 0 | 0 0 | 0 0 | 0 0 | 0 0 | 0 50,000 | 180,000 200,000 |
Adam Wasserman (2) | 2008 2007 | 50,000 50,000 | 0 0 | 0 0 | 0 0 | 0 0 | 0 0 | 70,000 44,200 | 120,000 94,200 |
(1) Dr. Liu has served as our Chief Executive Officer and President since September 28, 2006. Dr. Liu’s other compensation for 2008 and 2007 was $0 and $50,000, respectively. Dr. Liu’s other compensation includes fees paid for his car allowance and personal expenses. Compensation amounts reflected for Dr. Liu for each of 2007 and 2008 exclude any payments to him for his services as a director or pursuant to the terms of the assignment agreement entered into between Dr. Liu and Lotus East in October 2006 in conjunction with the loan agreement and contract with Wu Lan Cha Bu Emergency Hospital. See Director Compensation below and Item 13. Certain Relationships and Related Transactions, and Director Independence.
(2) Compensation for Adam Wasserman was paid to CFO Oncall, Inc., a company where Mr. Wasserman serves as chief executive officer.
HOW DR. LIU'S COMPENSATION IS DETERMINED
We currently have no employment agreements with any of our executive officers, nor any compensatory plans or arrangements resulting from the resignation, retirement or any other termination of any of our executive officers, from a change-in-control, or from a change in any executive officer's responsibilities following a change-in-control. A portion of compensation paid to Dr. Liu as reflected in the foregoing table is paid by Lotus East. Dr. Liu is the principal owner of the Lotus East companies and the amount of compensation paid to him is within his sole discretion.
OUTSTANDING EQUITY AWARDS AT FISCAL YEAR END
The following table provides information concerning unexercised options, stock that has not vested and equity incentive plan awards for each named executive officer outstanding as of December 31, 2008:
OPTION AWARDS | STOCK AWARDS | ||||||||
Name | Number of securities underlying unexercised options(#) exercisable | Number of securities underlying unexercised options(#) unexercisable | Equity incentive plan awards: Number of securities underlying unexercised unearned options(#) | Option exercise price($) | Option expiration date | Number of shares or units of stock that have not vested (#) | Market value of shares or units of stock that have not vested ($) | Equity incentive plan awards: Number of unearned shares, units or other rights that have not vested (#) | Equity incentive plan awards: Market or payout value of unearned shares, units or other rights that have not vested (#) |
(a) | (b) | (c) | (d) | (e) | (f) | (g) | (h) | (i) | (j) |
Dr. Liu Zhong Yi | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 |
Adam Wasserman | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 |
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DIRECTOR COMPENSATION
The following table provides information concerning the compensation of members of our Board of Directors for each of their services as a director for 2008. The value attributable to any option awards is computed in accordance with
FAS 123R.
Director Compensation | |||||||
Name | Fees earned or paid in cash ($) | Stock awards ($) | Option awards ($) | Non-equity incentive plan compensation ($) | Nonqualified deferred compensation earnings ($) | All other compensation ($) | Total ($) |
(a) | (b) | (c) | (d) | (e) | (f) | (g) | (h) |
Liu Zhong Yi | 0 | 30,000 | 0 | 0 | 0 | 0 | 30,000 |
Dr. Ian Ashley | 0 | 30,000 | 0 | 0 | 0 | 0 | 30,000 |
Li Ping | 0 | 30,000 | 0 | 0 | 0 | 0 | 30,000 |
Liu Jin | 0 | 30,000 | 0 | 0 | 0 | 0 | 30,000 |
Caeli Widger | 0 | 30,000 | 0 | 0 | 0 | 0 | 30,000 |
Xian Xuemei | 0 | 30,000 | 0 | 0 | 0 | 0 | 30,000 |
Song Zhenghong | 0 | 30,000 | 0 | 0 | 0 | 0 | 30,000 |
RELATED STOCKHOLDER MATTERS.
At March 31, 2009 we had 43,377,932 shares of common stock and 5,747,118 shares of Series A Convertible Redeemable Preferred Stock issued and outstanding. Each share of common stock entitles the holder to one vote and each
of the Series A Convertible Redeemable Preferred Stock entitles the holder to a number of votes equal to the number of shares into which the Series A Convertible Redeemable Preferred Stock is then convertible vote at any meeting of our stockholders. Presently, the Series A Convertible Redeemable Preferred Stock is convertible on a one for one basis. The holders of the common stock and the Series A Convertible Redeemable Preferred Stock vote together on all matters submitted to a vote of our stockholders, except that they are not entitled to vote in the election of our directors. The following table sets forth information known to us as of March 31, 2009 relating to the beneficial ownership of shares of our voting securities by:
· | each person who is known by us to be the beneficial owner of more than five percent of our outstanding voting stock; |
· | each director; |
· | each named executive officer; and |
· | all named executive officers and directors as a group. |
Unless otherwise indicated, the business address of each person listed is in care of Boca Corporate Plaza, 16 Cheng Zhuang Road, Feng Tai District Beijing 100071 People's Republic of China. The percentages in the table have been calculated on the basis of treating as outstanding for a particular person, all shares of our common stock outstanding on that date and all shares of our common stock issuable to that holder in the event of exercise of outstanding options, warrants, rights or conversion privileges owned by that person at that date which are exercisable within 60 days of that date. Except as otherwise indicated, the persons listed below have sole voting and investment power with respect to all shares of stock owned by them, except to the extent that power may be shared with a spouse.
52
Amount and Nature of Beneficial Ownership | |||||
Common Stock | Series A Convertible Redeemable Preferred Stock | ||||
Name | # of Shares | % of Class | # of Shares | % of Class | % of Vote |
Dr. Liu Zhong Yi (1) | 19,689,191 | 45.4% | 0 | n/a | 40.1% |
Adam Wasserman (2) | 171,490 | * | 0 | n/a | * |
Dr. Ian Ashley | 34,483 | * | 0 | n/a | * |
Li Ping | 64,483 | * | 0 | n/a | * |
Liu Jin | 64,483 | * | 0 | n/a | * |
Caeli Widger | 34,483 | * | 0 | n/a | * |
Xian Xuemei | 64,483 | * | 0 | n/a | * |
Song Zhenghong | 6,772,483 | 15.6% | 0 | n/a | 13.8% |
All officers and directors as a group (nine persons) (1), | 26,895,579 | 62.0% | 0 | n/a | 54.7% |
* represents less than 1%
(1) Includes 7,500,000 shares of our common stock which are subject to the terms of the Escrow Agreement entered into in February 2008 in conjunction with the sale our Series A Convertible Redeemable Preferred Stock described earlier in this annual report.
(2) Mr. Wasserman's address is 1643 Royal Grove Way, Weston, Florida 33327.
Dr. Liu leases Lotus East a 249 square meter retail space for no charge on a month-to-month basis.
On October 10, 2006, Lotus East entered into a five-year loan agreement and contract with Wu Lan Cha Bu Emergency Hospital whereby Lotus East agreed to lend to Wu Lan Cha Bu Emergency Hospital approximately $4,377,000 for the construction of a hospital ward in Inner Mongolia, China. In exchange for the loan, Wu Lan Cha Bu Emergency Hospital agreed that Lotus East would be the exclusive provider for all medicines and disposable medical treatment apparatus to it for a period of 20 years. In October 2006, Dr. Liu Zhong Yi, our Chief Executive Officer and the CEO and principal stockholder of Lotus East, loaned these funds to Wu Lan Cha Bu Emergency Hospital on behalf of Lotus East. Accordingly, on October 10, 2006 Lotus East entered into an assignment agreement whereby it assigned all of its rights, obligations, and receipts under the loan agreement to Dr. Liu, except for the rights to revenues from the sale of medical and disposable medical treatment apparatus which will remain with Lotus East. As compensation to Dr. Liu for accepting the assignment under the loan agreement including all of the risks and obligations and for Dr. Liu not accepting the rights to revenues from the sale of medical and disposable medical treatment apparatus which will remain with Lotus East, Lotus East agreed to pay Dr. Liu an aggregate of approximately $1,313,000 to be paid in five equal annual installments of approximately $263,000. During 2008 and 2007 Dr. Liu was paid $0 and $ 194,709, respectively, under the terms of this agreement. Dr. Liu agreed to allow the Company deferred the installments in 2008 to ease the burden on Company’s working capital needs. Our financial statements as December 31, 2008 include $26,261 for the 2008 installments which is reflected in current portion of due to related parties in balance sheet.
In 2007, we sold $3,000,000 principal amount 14% secured convertible notes in a private placement and we lent approximately $2 million of those proceeds to Lotus East for working capital. In 2008 we received net proceeds from the sale of shares of our Series A Convertible Redeemable Preferred Stock of approximately $4.6 million. We used approximately $2,576,557 of those proceeds to repay in full all of our outstanding obligations under our 14% secured convertible notes. Of the remaining proceeds, we lent approximately $1,600,000 to Lotus East. These loans are in the form of an unsecured, interest free advances for use by Lotus East in their operations including in their research and development activities. We do not have an understanding with Lotus East regarding the repayment of the amounts advanced to that company.
53
DIRECTOR INDEPENDENCE
Our Board of Directors has determined that directors Dr. Ian Ashley, and Caeli Widger are independent directors within The NASDAQ Stock Market's director independence standards pursuant to Marketplace Rule 4200.
PRINCIPAL ACCOUNTING FEES AND SERVICES. |
The following table sets forth the fees billed by our principal independent accountants for each of our last two fiscal years for the categories of services indicated.
Years Ended December 31, | ||||||||
Category | 2008 | 2007 | ||||||
Audit Fees1 | $ | 77,000 | $ | 75,000 | ||||
Audit Related Fees2 | 22,500 | 17,400 | ||||||
Tax Fees3 | 0 | 0 | ||||||
All Other Fees4 | 0 | 0 | ||||||
Total | $ | 99,500 | $ | 92,400 |
1 | Consists of fees billed for the audit of our annual financial statements, review of our Form 10-K and services that are normally provided by the accountant in connection with year-end statutory and regulatory filings or engagements. |
2 | Consists of fees billed for the review of our quarterly financial statements, review of our forms 10-Q/10-QSB and 8-K and services that are normally provided by the accountant in connection with non year end statutory and regulatory filings on engagements. |
3 | Consists of professional services rendered by a company aligned with our principal accountant for tax compliance, tax advice and tax planning. |
4 | The services provided by our accountants within this category consisted of advice and other services relating to SEC matters, registration statement review, accounting issues and client conferences. |
Our Board of Directors has adopted a procedure for pre-approval of all fees charged by our independent auditors. Under the procedure, the Board approves the engagement letter with respect to audit, tax and review services. Other fees are subject to pre-approval by the Board, or, in the period between meetings, by a designated member of Board. Any such approval by the designated member is disclosed to the entire Board at the next meeting. The audit and tax fees paid to the auditors with respect to fiscal year 2008 were pre-approved by the entire Board of Directors.
54
Exhibit No. | Description |
2.3 | Share Exchange Agreement between S.E. Asia Trading Company, Inc., SEAA Stockholders and Lotus Pharmaceutical International, Inc. and the Lotus Pharmaceutical International, Inc. Stockholders dated September 6, 2006 (1) |
3.1 | Certificate of Amendment effective December 14, 2006 (5) |
3.2 | Charter of S.E. Asia Trading Company, Inc. as filed with the State of Nevada (2) |
3.3 | Bylaws (2) |
3.4 | Certificate of Designation of the Relative Rights and Preferences of the Series A Convertible Redeemable Preferred Stock (8) |
4.1 | Form of Warrant (6) |
4.2 | Form of Series A Convertible Redeemable Preferred Stock Certificate (8) |
10.1 | Equity Pledge Agreement between Lotus Pharmaceutical International, Inc. and Liang Fang Pharmaceutical Co., Ltd. and Liang Fang’s Majority Stockholders dated September 6, 2006 (3) |
10.2 | Operating Agreement between Lotus Pharmaceutical International, Inc., and Liang Fang, Liang Fang’s Majority Stockholders dated September 6, 2006 (3) |
10.3 | Proxy Agreement between Lotus Pharmaceutical International, Inc., Liang Fang, and Liang Fang s Majority Stockholders dated September 6, 2006 (3) |
10.4 | Option Agreement between Lotus Pharmaceutical International, Inc. and Liang Fang, Liang Fang Majority Stockholders dated September 6, 2006 (3) |
10.5 | Equity Pledge Agreement between Lotus Pharmaceutical International, Inc. and En Zhe Jia Shi Pharmaceutical Co., Ltd. and En Zhe Jia Shi’s Majority Stockholders dated September 6, 2006 (3) |
10.6 | Operating Agreement between Lotus Pharmaceutical International, Inc., and En Zhe Jia Shi, En Zhe Jia Shi’s Majority Stockholders dated September 6, 2006 (3) |
10.7 | Proxy Agreement between Lotus Pharmaceutical International, Inc., En Zhe Jia Shi, and En Zhe Jia Shi’s Majority Stockholders dated September 6, 2006 (3) |
10.8 | Option Agreement between Lotus Pharmaceutical International, Inc. and En Zhe Jia Shi, En Zhe Jia Shi’s Majority Stockholders dated September 6, 2006 (3) |
10.9 | Consulting Services Agreement between Lotus Pharmaceutical International, Inc. and Liang Fang Pharmaceutical Co., Ltd. dated September 6, 2006 (3) |
10.10 | Consulting Services Agreement between Lotus Pharmaceutical International, Inc., En Zhe Jia Shi Pharmaceutical Co., Ltd. dated September 6, 2006 (3) |
10.11 | Letter of Resignation by Mr. Thomas Miller to the Board of Directors of S.E. Asia Trading Company (3) |
10.12 | General Partnership Agreement between Genesis Equity Partners, LLC and Liang Fang Pharmaceutical, Ltd. dated March 15, 2006. (3) |
10.13 | Lease Agreement between Beijing Aoshikai Peace Lane Shopping Center and Liang Fang Pharmaceutical Co. Ltd. dated June 1, 2002. (3) |
10.14 | Lease Agreement between Beijing Aoshikai Peace Lane Shopping Center and Liang Fang Pharmaceutical Co. Ltd. dated June 1, 2005. (3) |
10.15 | Lease Agreement between Beijing Fengtai District Retired Officer Management Agency of General Logistics of P.L.A. and Liang Fang Pharmaceutical Co. Ltd. dated September 15, 2003. (3) |
10.16 | Lease Agreement between Beijing Fengtai District 2nd Sanatorium of General Logistics of P.L.A. and Liang Fang Pharmaceutical Co. Ltd. dated April 1, 2003. (3) |
10.17 | Lease Agreement between Beijing Qiji Investment and Management Center and Liang Fang Pharmaceutical Co. Ltd. dated October 10, 2005. (3) |
10.18 | Lease Agreement between Beijing South Palace Marketing Center and Liang Fang Pharmaceutical Co. Ltd. dated January 1, 2006. (3) |
10.19 | Lease Agreement between Beijing Xingfa Food Shop and Liang Fang Pharmaceutical Co. Ltd. dated January 1, 2006. (3) |
10.20 | Lease Agreement between Construction and Repair Agency of Haiying Group and Liang Fang Pharmaceutical Co. Ltd. dated December 31, 2000. (3) |
10.21 | Lease Agreement between Liu Zhongyi and Liang Fang Pharmaceutical Co. Ltd. Dated December 15, 2001. (3) |
10.22 | Lease Agreement between Real Estate Management Agency of General Logistics of P.L.A. and Drugstore (Wanshou Round Branch) of Liang Fang Pharmaceutical Co. Ltd. dated September 1, 2004. (3) |
10.23 | Loan Agreement between Beijing En Ze Jia Shi Pharmaceutical Co., Ltd. and Liu Zhongyi dated December 31, 2005. (3) |
55
10.24 | Loan Agreement between Beijing En Ze Jia Shi Pharmaceutical Co., Ltd. and Ma Zhaozhao dated December 31, 2005. (3) |
10.25 | Loan Agreement between Beijing En Ze Jia Shi Pharmaceutical Co., Ltd. and Song Guo an dated December 31, 2005. (3) |
10.26 | Loan Agreement between Beijing En Ze Jia Shi Pharmaceutical Co., Ltd. and Song Zhenghong dated December 31, 2005. (3) |
10.27 | Loan Agreement between Beijing En Ze Jia Shi Pharmaceutical Co., Ltd. and Zehng Guixin dated December 31, 2005. (3) |
10.28 | Letter Agreement among S.E. Asia Trading Company, Inc., Lynn Management, LLC and Dynacap Holdings Limited LLC dated September 13, 2006. (3) |
10.29 | Bill of Sale between S.E. Asia Trading Company, Inc. and Charles Smith dated September 25, 2006. (3) |
10.30 | Loan Agreement among Beijing Liang Fang Pharmaceutical Co., Ltd. and Wu Lan Cha Bu Emergency Hospital (English version) (7) |
10.31 | Loan Agreement among Beijing Liang Fang Pharmaceutical Co., Ltd. and Wu Lan Cha Bu Emergency Hospital (Chinese version) (7) |
10.32 | Contract among Wu Lan Cha Bu Emergency Hospital Center and Beijing Liang Fang Pharmaceutical Co., Ltd. dated October 10, 2006 (English version) (7) |
10.33 | Contract among Wu Lan Cha Bu Emergency Hospital Center and Beijing Liang Fang Pharmaceutical Co., Ltd. dated October 10, 2006 (Chinese version) (7) |
10.34 | Assignment agreement among Beijing Liang Fang Pharmaceuticals Co., Ltd. and Dr. Liu Zhong Yi dated October 10, 2006 (English version) (7) |
10.35 | Assignment agreement among Beijing Liang Fang Pharmaceuticals Co., Ltd. and Dr. Liu Zhong Yi dated October 10, 2006 (Chinese version) (7) |
10.36 | Convertible Redeemable Preferred Share and Warrant Purchase Agreement dated February 25, 2008 by and among Lotus Pharmaceuticals, Inc., its founders Dr. Liu Zhong Yi and Mrs. Song Zhenghong, and certain accredited investors (6) |
10.37 | Form of Escrow Agreement (6) |
10.38 | Form of Closing Escrow Agreement (6) |
10.39 | English translation of Technology Transfer Agreement dated April 25, 2008 by and between Bei Jing En Ze Jia Shi Pharmaceuticals LTD and Dong Guan Kai Fa Biologicals Medicine LTD (9) |
10.40 | English translation of Agreement dated June 3, 2008 by and between Beijing Liang Fang Pharmaceutical Co., Ltd., a Chinese limited liability company, and Cha You Qian Qi Economy Commission. (10) |
10.41 | Yipubishan New Drug Certificate and Intellectual Property Right Transfer Contract (12) |
14.1 | Lotus Pharmaceuticals, Inc. Code of Business Conduct and Ethics (11) |
21.1 | Subsidiaries of the company (7) |
31.1 | Rule 13a-14(a)/ 15d-14(a) Certification of Chief Executive Officer *** |
31.2 | Rule 13a-14(a)/ 15d-14(a) Certification of Chief Financial Officer * |
32.1 | Section 1350 Certification of Chief Executive Officer * |
32.2 | Section 1350 Certification of Chief Financial Officer * |
(1) | Incorporated by reference from the Current Report on Form 8-K filed on September 7, 2006. |
(2) | Incorporated by reference from the registration statement on Form SB-1, SEC File No. 333-118898, filed on September 10, 2004, as amended. |
(3) | Incorporated by reference from the Current Report on Form 8-K filed on October 5, 2006. |
(4) | Incorporated by reference from the Current Report on Form 8-K filed on November 13, 2006. |
(5) | Incorporated by reference from the Current Report on Form 8-K filed on December 19, 2006. |
(6) | Incorporated by reference from the Current Report on Form 8-K filed on February 26, 2008. |
(7) | Incorporated by reference from the Annual Report on Form 10-KSB for the fiscal year ended December 31, 2006. |
(8) | Incorporated by reference from the Current Report on Form 8-K/A as filed on February 29, 2008. |
(9) | Incorporated by reference from the Current Report on Form 8-K as filed on May 30, 2008. |
(10) | Incorporated by reference from the Current Report on Form 8-K as filed on July 17, 2008. |
(11) | Incorporated by reference from the Current Report on Form S-1 as filed on May 13, 2008. |
(12) | Incorporated by reference from the Current Report on Form 8-K as filed on February 18, 2009. |
56
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated.
LOTUS PHARMACEUTICALS, INC. | |||
April 15, 2009 | By: | /s/ Zhong Yi Liu | |
Zhong Yi Liu, Chief Executive Officer and Director | |||
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated.
Signature | Title | Date | ||
/s/ Liu Zhong Yi | Chief Executive Officer and Director | April 15, 2009 | ||
Liu Zhong Yi | ||||
/s/ Adam Wasserman | Chief Financial Officer, principal accounting officer | April 15, 2009 | ||
Adam Wasserman | ||||
Ian Ashley | Director | April 15, 2009 | ||
Ian Ashley | ||||
/s/ Ms. Li Ping | Director | April 15, 2009 | ||
Ms. Li Ping | ||||
/s/ Mr. Liu Jin | Director | April 15, 2009 | ||
Mr. Liu Jin | ||||
/s/ Ms. Xian Xuemei | Director | April 15, 2009 | ||
Ms. Xian Xuemei | ||||
/s/ Ms. Song Zhenghong | Director | April 15, 2009 | ||
Ms. Song Zhenghong |
57
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2008 and 2007
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2008 and 2007
CONTENTS
Report of Independent Registered Public Accounting Firm | F-2 |
Consolidated Financial Statements: | |
Consolidated Balance Sheets | F-3 |
Consolidated Statements of Operations | F-4 |
Consolidated Statements of Cash Flows | F-5 |
Consolidated Statements of Shareholders’ Equity | F-6 |
Notes to Consolidated Financial Statements | F-7 to F-28 |
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors
Lotus Pharmaceuticals, Inc. and Subsidiaries
Beijing, China
We have audited the accompanying consolidated balance sheets of Lotus Pharmaceuticals, Inc. and Subsidiaries as of December 31, 2008 and 2007 and the related consolidated statements of operations, changes in shareholders' equity, and cash flows for the years ended December 31, 2008 and 2007. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purposes of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining on a test basis, evidence supporting the amount 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 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 financial position of Lotus Pharmaceuticals, Inc. and Subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for the years ended December 31, 2008 and 2007, in conformity with accounting principles generally accepted in the United States of America.
/s/ Sherb & Co., LLP
Certified Public Accountants
New York, New York
March 17, 2009
CONSOLIDATED BALANCE SHEETS |
December 31, | ||||||||
2008 | 2007 | |||||||
ASSETS | ||||||||
CURRENT ASSETS: | ||||||||
Cash | $ | 1,278,808 | $ | 4,557,957 | ||||
Accounts receivable, net of allowance for doubtful accounts | 6,132,912 | 20,430,827 | ||||||
Other receivable | 15,757 | - | ||||||
Other receivable-related party | 2,027,954 | - | ||||||
Inventories, net of reserve for obsolete inventory | 3,787,802 | 3,410,739 | ||||||
Prepaid expenses and other assets | 121,274 | 1,009,382 | ||||||
Deferred debt costs | 398,067 | 29,340 | ||||||
Total Current Assets | 13,762,574 | 29,438,245 | ||||||
PROPERTY AND EQUIPMENT - Net | 7,554,817 | 6,169,966 | ||||||
OTHER ASSETS | ||||||||
Deposit on patent license | 2,917,919 | - | ||||||
Installments on intangible assets | 38,175,134 | - | ||||||
Intangible assets, net of accumulated amortization | 1,231,730 | 1,291,322 | ||||||
Deferred debt costs | 66,344 | - | ||||||
Total Assets | $ | 63,708,518 | $ | 36,899,533 | ||||
LIABILITIES AND SHAREHOLDERS' EQUITY | ||||||||
CURRENT LIABILITIES: | ||||||||
Convertible debt, net of debt discount | $ | - | $ | 2,561,645 | ||||
Accounts payable and accrued expenses | 2,170,165 | 764,491 | ||||||
Taxes Payable | 5,015,908 | 572,200 | ||||||
Advances from customers | - | 34,531 | ||||||
Unearned revenue | 565,629 | 530,063 | ||||||
Due to related parties | 1,588,689 | 323,178 | ||||||
Total Current Liabilities | 9,340,391 | 4,786,108 | ||||||
LONG-TERM LIABILITIES: | ||||||||
Due to related parties | 525,225 | 738,300 | ||||||
Notes payable - related parties | 5,056,451 | 4,738,508 | ||||||
Series A convertible redeemable preferred stock, $.001 par value; 10,000,000 shares | ||||||||
authorized; 5,747,118 and -0- shares issued and outstanding at December 31, 2008 | ||||||||
and 2007, respectively, net | 3,652,341 | - | ||||||
Total Liabilities | 18,574,408 | 10,262,916 | ||||||
SHAREHOLDERS' EQUITY: | ||||||||
Common stock ($.001 par value; 200,000,000 shares authorized; | ||||||||
42,420,239 and 41,794,200 shares issued and outstanding | ||||||||
at December 31, 2008 and 2007, respectively) | 42,420 | 41,794 | ||||||
Additional paid-in capital | 11,554,381 | 8,095,848 | ||||||
Statutory reserves | 3,750,529 | 2,161,505 | ||||||
Retained earnings | 25,557,537 | 14,355,913 | ||||||
Other comprehensive gain - cumulative foreign currency translation adjustment | 4,229,243 | 1,981,557 | ||||||
Total Shareholders' Equity | 45,134,110 | 26,636,617 | ||||||
Total Liabilities and Shareholders' Equity | $ | 63,708,518 | $ | 36,899,533 | ||||
See notes to consolidated financial statements |
F-3
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES |
CONSOLIDATED STATEMENTS OF OPERATIONS |
For the Years Ended | ||||||||
December 31, | ||||||||
2008 | 2007 | |||||||
NET REVENUES: | ||||||||
Wholesale | $ | 65,264,281 | $ | 41,651,106 | ||||
Retail | 2,837,257 | 3,471,960 | ||||||
Other revenues | 5,701,491 | 11,750,049 | ||||||
Total Net Revenues | 73,803,029 | 56,873,115 | ||||||
COST OF SALES | 40,440,088 | 33,678,963 | ||||||
GROSS PROFIT | 33,362,941 | 23,194,152 | ||||||
OPERATING EXPENSES: | ||||||||
Selling expenses | 14,902,646 | 6,460,206 | ||||||
Research and development | 1,200,194 | 2,411,651 | ||||||
General and administrative | 2,190,157 | 3,014,002 | ||||||
Total Operating Expenses | 18,292,997 | 11,885,859 | ||||||
INCOME FROM OPERATIONS | 15,069,944 | 11,308,293 | ||||||
OTHER INCOME (EXPENSE): | ||||||||
Forgiveness of business and value-added taxes | - | 2,160,795 | ||||||
Debt issuance costs | (361,436 | ) | (205,379 | ) | ||||
Registration rights penalty | (650 | ) | (110,000 | ) | ||||
Interest income | 12,626 | 102,154 | ||||||
Interest expense | (1,929,836 | ) | (2,038,735 | ) | ||||
Total Other Income (Expense) | (2,279,296 | ) | (91,165 | ) | ||||
INCOME BEFORE INCOME TAXES | 12,790,648 | 11,217,128 | ||||||
INCOME TAXES | - | - | ||||||
NET INCOME | $ | 12,790,648 | $ | 11,217,128 | ||||
COMPREHENSIVE INCOME: | ||||||||
NET INCOME | 12,790,648 | 11,217,128 | ||||||
OTHER COMPREHENSIVE INCOME: | ||||||||
Unrealized foreign currency translation gain | 2,247,686 | 1,480,352 | ||||||
COMPREHENSIVE INCOME | $ | 15,038,334 | $ | 12,697,480 | ||||
NET INCOME PER COMMON SHARE: | ||||||||
Basic | $ | 0.30 | $ | 0.27 | ||||
Diluted | $ | 0.27 | $ | 0.26 | ||||
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING: | ||||||||
Basic | 42,307,762 | 41,417,434 | ||||||
Diluted | 48,054,880 | 43,861,106 | ||||||
See notes to consolidated financial statements |
F-4
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES |
CONSOLIDATED STATEMENTS OF CASH FLOWS |
For the Years Ended | ||||||||
December 31, | ||||||||
2008 | 2007 | |||||||
CASH FLOWS FROM OPERATING ACTIVITIES: | ||||||||
Net income | $ | 12,790,648 | $ | 11,217,128 | ||||
Adjustments to reconcile net income from operations to net cash | ||||||||
provided by (used in) operating activities: | ||||||||
Depreciation and amortization | 634,347 | 564,607 | ||||||
Amortization of deferred debt issuance costs | 361,062 | 205,379 | ||||||
Interest expense | 1,170,959 | 1,458,484 | ||||||
Amortization of prepaid expense attributable to warrants | 163,338 | - | ||||||
Stock based compensation | 318,551 | 284,200 | ||||||
Warrant repricing | 74,593 | - | ||||||
(Decrease) increase in allowance for doubtful accounts | (575,781 | ) | (2,385,354 | ) | ||||
Forgiveness of income and value-added taxes | - | (2,160,795 | ) | |||||
Changes in assets and liabilities: | ||||||||
Accounts receivable | 16,001,384 | (9,764,076 | ) | |||||
Inventories | (145,910 | ) | (58,942 | ) | ||||
Prepaid expenses and other current assets | 939,654 | (714,013 | ) | |||||
Accounts payable and accrued expenses | 1,360,568 | 27,266 | ||||||
Taxes payable | 4,336,947 | 608,526 | ||||||
Unearned revenue | - | 71,402 | ||||||
Advances from customers | (36,276 | ) | (204,267 | ) | ||||
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES | 37,394,084 | (850,455 | ) | |||||
CASH FLOWS FROM INVESTING ACTIVITIES: | ||||||||
Deposit on patent right | (2,872,635 | ) | - | |||||
Installment on intangible assets | (37,582,678 | ) | - | |||||
Purchase of intangible asset | (7,756 | ) | - | |||||
Purchase of property and equipment | (1,438,419 | ) | (381,772 | ) | ||||
NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES | (41,901,488 | ) | (381,772 | ) | ||||
CASH FLOWS FROM FINANCING ACTIVITIES: | ||||||||
Net proceeds (payments) from convertible debt | (2,520,000 | ) | 2,950,000 | |||||
Proceeds from sale of convertible redeemable peferred stocks | 5,000,000 | - | ||||||
Payment of debt issuance costs | (468,568 | ) | (231,526 | ) | ||||
Proceeds from related party advances | 965,986 | 1,061,009 | ||||||
Repayments of related party advances | (1,996,481 | ) | (816,732 | ) | ||||
Repayments of notes payable - related parties | - | 509,351 | ||||||
NET CASH PROVIDED BY FINANCING ACTIVITIES | 980,937 | 3,472,102 | ||||||
EFFECT OF EXCHANGE RATE ON CASH | 247,318 | 228,926 | ||||||
NET (DECREASE) INCREASE IN CASH | (3,279,149 | ) | 2,468,801 | |||||
CASH - beginning of year | 4,557,957 | 2,089,156 | ||||||
CASH - end of year | $ | 1,278,808 | $ | 4,557,957 | ||||
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: | ||||||||
Cash paid for: | ||||||||
Interest | $ | 103,250 | $ | 477,001 | ||||
Income taxes | $ | - | $ | - | ||||
Non-cash investing and financing activities: | ||||||||
Warrants issued for prepaid financing costs | $ | 327,565 | $ | - | ||||
Warrants issued for consulting | $ | 178,187 | $ | - | ||||
Common stock issued for compensation | $ | 318,551 | $ | - | ||||
Common stock issued for conversion of convertible debt | $ | 250,000 | $ | 230,000 | ||||
Debt discount for grant of warrants and beneficial conversion feature | $ | 2,310,263 | $ | 1,616,839 | ||||
Due from related party offset against note payable-related parties | $ | - | $ | 813,650 | ||||
See notes to consolidated financial statements. |
F-5
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES |
For the Years Ended December 31, 2008 and 2007 |
Common Stock, $.001 Par Value | Additional | Other | Total | |||||||||||||||||||||||||
Number of | Paid-in | Retained | Statutory | Comprehensive | Shareholders' | |||||||||||||||||||||||
Shares | Amount | Capital | Earnings | Reserves | Income | Equity | ||||||||||||||||||||||
Balance, December 31, 2006 | 41,280,000 | 41,280 | 5,965,323 | 4,530,360 | 769,930 | 501,205 | 11,808,098 | |||||||||||||||||||||
Discount on convertible debt | - | - | 1,616,839 | - | - | - | 1,616,839 | |||||||||||||||||||||
Common stock issued for services | 284,200 | 284 | 283,916 | - | - | - | 284,200 | |||||||||||||||||||||
Common stock issued for conversion of convertible debt | 230,000 | 230 | 229,770 | - | - | - | 230,000 | |||||||||||||||||||||
Appropriation to statutory reserve | - | - | - | (1,391,575 | ) | 1,391,575 | - | - | ||||||||||||||||||||
Comprehensive income: | ||||||||||||||||||||||||||||
Net income for the year | - | - | - | 11,217,128 | - | - | 11,217,128 | |||||||||||||||||||||
Foreign currency translation adjustment | - | - | - | - | - | 1,480,352 | 1,480,352 | |||||||||||||||||||||
Total comprehensive income | - | - | - | - | - | - | 12,697,480 | |||||||||||||||||||||
Balance, December 31, 2007 | 41,794,200 | 41,794 | 8,095,848 | 14,355,913 | 2,161,505 | 1,981,557 | 26,636,617 | |||||||||||||||||||||
Issuance of Series A convertible redeemable preferred stock | - | - | 2,637,828 | - | - | - | 2,637,828 | |||||||||||||||||||||
Warrants issued for consulting expense | - | - | 178,187 | - | - | - | 178,187 | |||||||||||||||||||||
Common stock issued for services | 366,962 | 367 | 318,184 | - | - | - | 318,551 | |||||||||||||||||||||
Common stock issued for conversion of convertible debt | 250,000 | 250 | 249,750 | - | - | - | 250,000 | |||||||||||||||||||||
Common stock issued for warrants exercised | 9,077 | 9 | (9 | ) | - | - | - | - | ||||||||||||||||||||
Warrants repricing | - | - | 74,593 | - | - | - | 74,593 | |||||||||||||||||||||
Appropriation to statutory reserve | - | - | - | (1,589,024 | ) | 1,589,024 | - | - | ||||||||||||||||||||
Comprehensive income: | ||||||||||||||||||||||||||||
Net income for the year | - | - | - | 12,790,648 | - | - | 12,790,648 | |||||||||||||||||||||
Foreign currency translation adjustment | - | - | - | - | - | 2,247,686 | 2,247,686 | |||||||||||||||||||||
Total comprehensive income | - | - | - | - | - | - | 15,038,334 | |||||||||||||||||||||
Balance, December 31, 2008 | 42,420,239 | 42,420 | 11,554,381 | 25,557,537 | 3,750,529 | 4,229,243 | 45,134,110 | |||||||||||||||||||||
See notes to consolidated financial statements |
F-6
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization
Lotus Pharmaceuticals, Inc. (“Lotus” or the “Company”), formerly S.E. Asia Trading Company, Inc. (“SEAA”), was incorporated on January 28, 2004 under the laws of the State of Nevada. SEAA operated as a retailer of jewelry, framed art and home accessories. In December 2006, SEAA changed its name to Lotus Pharmaceuticals, Inc.
On September 6, 2006, the Company entered into a definitive Share Exchange Agreement with Lotus Pharmaceutical International, Inc. (“Lotus International”), whereby the Company acquired all of the outstanding common stock of Lotus International in exchange for newly-issued stock of the Company to Lotus International’s shareholders. On September 28, 2006 (the closing date), Lotus International became a wholly-owned subsidiary of the Company and Lotus International’s shareholders became the owners of the majority of the Company’s voting stock. The acquisition of Lotus International by the Company was accounted for as a reverse merger because on a post-merger basis, the former shareholders of Lotus International hold a majority of the outstanding common stock of the Company on a voting and fully-diluted basis. As a result, Lotus International is deemed to be the acquirer for accounting purposes.
Lotus International was incorporated under the laws the State of Nevada on August 28, 2006 to develop and market pharmaceutical products in the People’s Republic of China (“PRC” or “China”). PRC law currently has limits on foreign ownership of certain companies. To comply with these foreign ownership restrictions, Lotus operates its pharmaceutical business in China through Beijing Liang Fang Pharmaceutical Co., Ltd. (“Liang Fang”) and an affiliate of Liang Fang, Beijing En Zhe Jia Shi Pharmaceutical Co., Ltd. (“En Zhe Jia”), both of which are pharmaceutical companies headquartered in the PRC and organized under the laws of the PRC (hereinafter, referred to together as “Lotus East”). Lotus International has contractual arrangements with Lotus East and its shareholders pursuant to which Lotus International will provide technology consulting and other general business operation services to Lotus East. Through these contractual arrangements, Lotus International also has the ability to substantially influence Lotus East’s daily operations and financial affairs, appoint its senior executives and approve all matters requiring shareholder approval. As a result of these contractual arrangements, which enable Lotus International to control Lotus East, Lotus International is considered the primary beneficiary of Lotus East. Accordingly, the consolidated financial statements include the accounts of Lotus Pharmaceuticals, Inc. and its wholly-owned subsidiary, Lotus International and companies under its control (Lotus East).
On September 6, 2006, Lotus International entered into the following contractual arrangements:
Operating Agreement. Pursuant to the operating agreement among Lotus, Lotus East and the shareholders of Lotus East, (collectively “Lotus East’s Shareholders”), Lotus provides guidance and instructions on Lotus East’s daily operations, financial management and employment issues. The shareholders of Lotus East must designate the candidates recommended by Lotus as their representatives on Lotus East’s Board of Directors. Lotus has the right to appoint senior executives of Lotus East. In addition, Lotus agreed to guarantee Lotus East’s performance under any agreements or arrangements relating to Lotus East’s business arrangements with any third party. Lotus East, in return, agreed to pledge its accounts receivable and all of its assets to Lotus. Moreover, Lotus East agreed that without the prior consent of Lotus, Lotus East would not engage in any transaction that could materially affect the assets, liabilities, rights or operations of Lotus East, including, without limitation, incurrence or assumption of any indebtedness, sale or purchase of any assets or rights, incurrence of any encumbrance on any of its assets or intellectual property rights in favor of a third party or transfer of any agreements relating to its business operation to any third party. The term of this agreement is ten (10) years from September 6, 2006 and may be extended only upon Lotus’s written confirmation prior to the expiration of the this agreement, with the extended term to be mutually agreed upon by the parties.
Consulting Services Agreement. Pursuant to the exclusive consulting services agreements between Lotus and Lotus East, Lotus has the exclusive right to provide to Lotus East general pharmaceutical business operations services as well as consulting services related to the technological research and development of pharmaceutical products as well as general business operation advice and strategic planning (the “Services”). Under this agreement, Lotus owns the intellectual property rights developed or discovered through research and development, in the course of providing the Services, or derived from the provision of the Services. Lotus East is required to pay a quarterly consulting service fees in Renminbi (“RMB”), the functional currency of the PRC, to Lotus that is equal to Lotus East’s profits, as defined, for such quarter. To date, no consulting fees have been paid by Lotus East.
Equity Pledge Agreement. Under the equity pledge agreement between the shareholders of Lotus East and Lotus, the shareholders of Lotus East pledged all of their equity interests in Lotus East to Lotus to guarantee Lotus East’s performance of its obligations under the technology consulting agreement. If Lotus East or Lotus East’s Shareholders breaches its respective contractual obligations, Lotus, as pledgee, will be entitled to certain rights, including the right to sell the pledged equity interests. Lotus East’s Shareholders also agreed that upon occurrence of any event of default, Lotus shall be granted an exclusive, irrevocable power of attorney to take actions in the
F-7
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Organization (continued)
place and stead of Lotus East’s Shareholders to carry out the security provisions of the equity pledge agreement and take any action and execute any instrument that Lotus may deem necessary or advisable to accomplish the purposes of the equity pledge agreement. The shareholders of Lotus East agreed not to dispose of the pledged equity interests or take any actions that would prejudice Lotus’ interest. The equity pledge agreement will expire two (2) years after Lotus East’s obligations under the exclusive consulting services agreements have been fulfilled.
Option Agreement. Under the option agreement between the shareholders of Lotus East and Lotus, the shareholders of Lotus East irrevocably granted Lotus or its designated person an exclusive option to purchase, to the extent permitted under PRC law, all or part of the equity interests in Lotus East for the cost of the initial contributions to the registered capital or the minimum amount of consideration permitted by applicable PRC law. Lotus or its designated person has sole discretion to decide when to exercise the option, whether in part or in full. The term of this agreement is 10 years from September 6, 2006 and may be extended prior to its expiration by written agreement of the parties.
Proxy Agreement. Pursuant to the proxy agreement among Lotus and Lotus East’s Shareholders, Lotus East’s Shareholders agreed to irrevocably grant a person to be designated by Lotus with the right to exercise Lotus East’s Shareholders’ voting rights and their other rights, including the attendance at and the voting of Lotus East’s Shareholders’ shares at the shareholders’ meetings (or by written consent in lieu of such meetings) in accordance with applicable laws and its Article of Association, including but not limited to the rights to sell or transfer all or any of his equity interests of Lotus East, and appoint and vote for the directors and Chairman as the authorized representative of the shareholders of Lotus East. The term of this Proxy Agreement is ten (10) years from September 6, 2006 and may be extended prior to its expiration by written agreement of the parties.
Liang Fang is a Chinese limited liability company and was formed under laws of the People’s Republic of China on June 21, 2000. Liang Fang is engaged in the production, trade and retailing of pharmaceuticals. Further, Liang Fang is focused on development of innovative medicines and investing strategic growth to address various medical needs for patients worldwide. Liang Fang’s operations are based in Beijing, China.
As of September 30, 2007, Liang Fang owns and operates 10 drug stores throughout Beijing, China. These drugstores sell Western and traditional Chinese medicines, and medical treatment accessories.
Liang Fang’s affiliate, En Zhe Jia is a Chinese limited liability company and was formed under laws of the People’s Republic of China on September 17, 1999. En Zhe Jia is the sole manufacturer for Liang Fang and maintains facilities for the production of medicines, patented Chinese medicine, as well as the research and production of other new medicines.
As a result of the management agreements between Lotus International and Lotus East, Lotus East was deemed to be the acquirer of Lotus International for accounting purposes. Accordingly, the financial statement data presented are those of Lotus East for all periods prior to the Company’s acquisition of Lotus International on September 28, 2006, and the financial statements of the consolidated companies from the acquisition date forward.
On May 29, 2007, the Company formed a new entity, Lotus Century Pharmaceutical (Beijing) Technology Co., Ltd. (‘‘Lotus Century’’), a wholly foreign-owned enterprise (“WFOE”) organized under the laws of the Peoples’ Republic of China. Lotus Century is a Chinese limited liability company and a wholly-owned subsidiary of Lotus Pharmaceutical International, Inc. Lotus Century intends to be engaged in development of innovative medicines, medical technology consulting and outsourcing services, and related training services.
Basis of presentation
The consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States of America (“US GAAP”). The consolidated statements include the accounts of Lotus Pharmaceuticals, Inc. and its wholly-owned subsidiaries, Lotus and Lotus Century and variable interest entities under its control (Liang Fang and En Zhe Jia). All significant inter-company balances and transactions have been eliminated.
The Company has adopted FASB Interpretation No. 46R "Consolidation of Variable Interest Entities" ("FIN 46R"), an Interpretation of Accounting Research Bulletin No. 51. FIN 46R requires a Variable Interest Entity (VIE) to be consolidated by a company if that company is subject to a majority of the risk of loss for the VIE or is entitled to receive a majority of the VIE's residual returns. VIEs are
F-8
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Basis of presentation (continued)
those entities in which the Company, through contractual arrangements, bears the risks of, and enjoys the rewards normally associated with ownership of the entities, and therefore the Company is the primary beneficiary of these entities. As a VIE, Lotus East’s revenues are included in the Company’s total revenues, its income from operations is consolidated with the Company’s, and the Company’s net income includes all of Lotus East’s net income.
Use of estimates
The preparation of financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect certain reported amounts and disclosures. Accordingly, actual results could differ from those estimates. Significant estimates in 2008 and 2007 include the allowance for doubtful accounts, the allowance for obsolete inventory, the useful life of property and equipment and intangible assets, fair value of warrants and beneficial conversion features related to the convertible notes, fair value of warrants granted and accruals for taxes due.
Fair value of financial instruments
The carrying amounts reported in the balance sheet for cash, accounts receivable, accounts payable and accrued expenses, convertible debt, customer advances, and amounts due from related parties approximate their fair market value based on the short-term maturity of these instruments.
Cash and cash equivalents
For purposes of the consolidated statements of cash flows, the Company considers all highly liquid instruments purchased with a maturity of three months or less and money market accounts to be cash equivalents. The Company maintains cash and cash equivalents with various financial institutions mainly in the PRC and the United States. Balances in the United States are insured up to $250,000 at each bank. Balances at financial institutions or state-owned banks within the PRC are not covered by insurance. Non-performance by these institutions could expose the Company to losses for amounts in excess of insured balances. At December 31, 2008 and 2007, the Company’s China bank balances of approximately $1,3 million and $4.5 million, respectively, are uninsured. The Company has not experienced, nor does it anticipate, non-performance by these institutions.
Accounts receivable
The Company records accounts receivable, net of an allowance for doubtful accounts and sales returns. The Company maintains allowances for doubtful accounts for estimated losses. The Company reviews the accounts receivable on a periodic basis and makes general and specific allowances when there is doubt as to the collectability of individual balances. In evaluating the collectability of individual receivable balances, the Company considers many factors, including the age of the balance, customer’s historical payment history, its current credit-worthiness and current economic trends. The amount of the provision, if any is recognized in the consolidated statement of operations within “General and administrative expenses”. Accounts are written off after exhaustive efforts at collection. The Company policy regarding sales returns is discussed below. The activity in the allowance for doubtful accounts and sales returns accounts for accounts receivable for the years ended December 31, 2008 and 2007 is as follows:
Allowance for doubtful accounts | Allowance for sales returns | Total | ||||||||||
Balance – December 31, 2006 | $ | 539,627 | $ | 2,297,399 | $ | 2,837,026 | ||||||
Additions (Reductions) | (26,617 | ) | (2,354,720 | ) | (2,381,337 | ) | ||||||
Foreign currency translation adjustments | 35,073 | 57,321 | 92,394 | |||||||||
Balance – December 31, 2007 | 548,083 | 0 | 548,083 | |||||||||
Additions (Reductions) | (575,781 | ) | 0 | (575,781 | ) | |||||||
Foreign currency translation adjustments | 27,698 | 0 | 27,698 | |||||||||
Balance—December 31, 2008 | $ | - | $ | - | $ | - |
F-9
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Inventories
Inventories, consisting of raw materials, work-in-process and finished goods related to the Company’s products are stated at the lower of
cost or market utilizing the moving average method. An allowance is established when management determines that certain inventories may not be saleable. If inventory costs exceed expected market value due to obsolescence or quantities in excess of expected demand, the Company will record reserves for the difference between the cost and the market value. These reserves are recorded based on estimates and reflected in cost of sales. The Company recorded an inventory reserve of $0 and $42,554, respectively, for the year ended December 31, 2008 and 2007.
Property and equipment
Property and equipment are carried at cost and are depreciated on a straight-line basis over the estimated useful lives of the assets. The cost of repairs and maintenance is expensed as incurred; major replacements and improvements are capitalized. When assets are retired or disposed of, the cost and accumulated depreciation are removed from the accounts, and any resulting gains or losses are included in income in the year of disposition. In accordance with Statement of Financial Accounting Standards (SFAS) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, the Company examines the possibility of decreases in the value of fixed assets when events or changes in circumstances reflect the fact that their recorded value may not be recoverable.
Impairment of long-lived assets
In accordance with Statement of Financial Accounting Standards (SFAS) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, the Company periodically reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable. The Company recognizes an impairment loss when the sum of expected undiscounted future cash flows is less than the carrying amount of the asset. The amount of impairment is measured as the difference between the asset’s estimated fair value and its book value. The Company did not consider it necessary to record any impairment charges during the year ended December 31, 2008 and 2007.
Income taxes
The Company is governed by the Income Tax Law of the People’s Republic of China and the United States. Income taxes are accounted for under Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes,” which is an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company’s financial statements or tax returns.
Earnings per common share
Basic earnings per share is computed by dividing net earnings by the weighted average number of shares of common stock outstanding during the period. Diluted income per share is computed by dividing net income by the weighted average number of shares of common stock, common stock equivalents and potentially dilutive securities outstanding during each period. Potentially dilutive common shares consist of the common shares issuable upon the conversion of convertible debt (using the if-converted method). The following table presents a reconciliation of basic and diluted earnings per share:
For the Year Ended December 31, | ||||||||
2008 | 2007 | |||||||
Net income for basic and diluted earnings per share | $ | 12,790,648 | $ | 11,217,128 | ||||
Weighted average shares outstanding – basic | 42,307,762 | 41,417,434 | ||||||
Effect of dilutive securities: | ||||||||
Unexercised warrants | — | — | ||||||
Convertible debentures | 5,747,118 | 2,443,672 | ||||||
Weighted average shares outstanding– diluted | 48,054,880 | 43,861,106 | ||||||
Earnings per share – basic | $ | 0.30 | $ | 0.27 | ||||
Earnings per share – diluted | $ | 0.27 | $ | 0.26 |
F-10
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Earnings per common share (continued)
At December 31, 2008 and 2007, a total of 5,166,999 and 1,500,000 outstanding warrants have not been included in the calculation of diluted earnings per shares as the effect would be anti-dilutive. The closing market price of all outstanding warrants of the Company on December 31, 2008 and 2007 was lower than the exercise price of all outstanding warrants. Because of that, the Company assumes that none of the outstanding warrants at that date would have been exercised and therefore none were included in the computation of the diluted earnings per share for the years of 2008 and 2007. Accordingly, the Company has excluded any effect of outstanding warrants as their effect would be anti-dilutive.
Revenue recognition
Product sales
Product sales are generally recognized when title to the product has transferred to customers in accordance with the terms of the sale. The Company recognizes revenue in accordance with the Securities and Exchange Commission’s (SEC) Staff Accounting Bulletin (SAB) No. 101, “ Revenue Recognition in Financial Statements “ as amended by SAB No. 104 (together, “SAB 104”), and Statement of Financial Accounting Standards (SFAS) No. 48 “ Revenue Recognition When Right of Return Exists. “ SAB 104 states that revenue should not be recognized until it is realized or realizable and earned. In general, the Company records revenue when persuasive evidence of an arrangement exists, services have been rendered or product delivery has occurred, the sales price to the customer is fixed or determinable, and collectability is reasonably assured.
SFAS No. 48 states that revenue from sales transactions where the buyer has the right to return the product shall be recognized at the time of sale only if the seller’s price to the buyer is substantially fixed or determinable at the date of sale, the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product, the buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product, the buyer acquiring the product for resale has economic substance apart from that provided by the seller, the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer, and the amount of future returns can be reasonably estimated.
The Company’s net product revenues represent total product revenues less allowances for returns.
Allowance for returns
The Company accounts for sales returns in accordance with Statements of Financial Accounting Standards (SFAS) No. 48, Revenue Recognition When Right of Return Exists, by establishing an accrual in an amount equal to its estimate of sales recorded for which the related products are expected to be returned. The Company determines the estimate of the sales return accrual primarily based on historical experience regarding sales returns, but also by considering other factors that could impact sales returns. These factors include levels of inventory in the distribution channel, estimated shelf life, product discontinuances, and price changes of competitive products, introductions of generic products and introductions of competitive new products. In general, for wholesale sales, the Company provides credit for product returns that are returned six months prior to and up to six months after the product expiration date. Upon sale, the Company estimates an allowance for future product returns. The Company provides additional reserves for contemporaneous events that were not known and knowable at the time of shipment. In order to reasonably estimate future returns, the Company analyzed both quantitative and qualitative information including, but not limited to, actual return rates, the level of product manufactured by the
Company, the level of product in the distribution channel, expected shelf life of the product, current and projected product demand, the introduction of new or generic products that may erode current demand, and general economic and industry wide indicators. The Company also utilizes the guidance provided in SAB 104 in establishing its return estimates. Historically, approximately 49% of our total revenues consist of sales of four principal products and product returns from these principal products, as well as the Company’s other products, have been immaterial. Accordingly, based upon the Company’s experience, it historically does not record a reserve at the time of sale and there have been no accounting entries related to its product return policy which have reduced its gross revenues or had any material impact on its financial statements.
Other revenues
Other revenues consist of (i) leasing revenues received for the lease of retail space to various retail merchants; (ii) advertising revenues from the lease of counter space at the Company’s retail locations; (iii) leasing revenue from the lease of retail space to licensed medical
F-11
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Revenue recognition (continued)
practitioners; (iv) revenues received by the Company for research and development projects and lab testing jobs conducted on behalf of third party companies, and; (v) revenues received for performing third party contract manufacturing projects. In connection with third-party manufacturing, the customer supplies the raw materials and we are paid a fee for manufacturing their product and revenue is recognized at the completion of the manufacturing job. The Company recognizes revenues from leasing of space and advertising revenues as earned from contracting third parties. The Company recognizes revenues upon performance of any research or lab testing jobs. Revenues received in advance are reflected as deferred revenue on the accompanying balance sheet. Additionally, the Company receives income from the sale of developed drug formulas. Income from the sale of drug formulas are recognized upon performance of all of the Company’s obligations under the respective sales contract and are included in other income on the accompanying consolidated statement of operations.
Concentrations of credit risk
Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash and trade accounts receivable. Substantially all of the Company’s cash is maintained with state-owned banks within the People’s Republic of China of which no deposits are covered by insurance. The Company has not experienced any losses in such accounts and believes it is not exposed to any risks on its cash in bank accounts. A significant portion of the Company’s sales are credit sales which are primarily to customers whose ability to pay is dependent upon the industry economics prevailing in these areas; however, concentrations of credit risk with respect to trade accounts receivables is limited due to generally short payment terms. The Company also performs ongoing credit evaluations of its customers to help further reduce credit risk.
Shipping costs
Shipping costs are included in selling expenses and totaled $210,096 and $420,082 for the years ended December 31, 2008 and 2007, respectively.
Advertising
Advertising is expensed as incurred. Advertising expenses were included in selling expenses and amounted to $181,026 and $2,602,997 for the years ended December 31, 2008 and 2007, respectively.
Research and development
Research and development costs are expensed as incurred. These costs primarily consist of cost of material used and salaries paid for the development of the Company's products and fees paid to third parties. For the years of 2008 and 2007, the Company expensed $1,200,194 and $2,411,651 as research and development expense, respectively, and paid for future research and development services in the amount of $0 and $769,742 at December 31, 2008 and December 31, 2007, respectively, which has been included in prepaid expenses on the accompanying balance sheets. The December 31, 2007 prepaid research and development expense has been fully expensed during the year ended December 31, 2008.
Foreign currency translation
The reporting currency of the Company is the U.S. dollar. The functional currency of the Company is the local currency, the Chinese Renminbi (“RMB”). Results of operations and cash flows are translated at average exchange rates during the period, assets and liabilities are translated at the unified exchange rate at the end of the period, and equity is translated at historical exchange rates. 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.
Asset and liability accounts at December 31, 2008 and 2007 were translated at 6.8542 RMB to $1.00 USD and at 7.3141RMB to $1.00 USD, respectively. Equity accounts were stated at their historical rate. The average translation rates applied to income statements for the years ended December 31, 2008 and 2007 were 6.96225 RMB and 7.6172 RMB to $1.00 USD, respectively. In accordance with Statement of Financial Accounting Standards No. 95, "Statement of Cash Flows," cash flows from the Company's operations is calculated based upon the local currencies using the average translation rate. As a result, amounts related to assets and liabilities reported on the statement of cash flows will not necessarily agree with changes in the corresponding balances on the balance sheet.
F-12
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Accumulated other comprehensive income
Accumulated other comprehensive income consisted of unrealized gains on foreign currency translation adjustments from the translation of financial statements from Chinese RMB to US dollars. For the years ended December 31, 2008 and 2007, unrealized foreign currency translation gain was $2,247,686 and $1,480,352, respectively.
Recent Accounting Pronouncements
In February 2007, the FASB issued SFAS No. 159,"The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115", under which entities will now be permitted to measure many financial instruments and certain other assets and liabilities at fair value on an instrument-by-instrument basis. This Statement is effective as of the beginning of an entity's first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007, provided the entity also elects to apply the provisions of SFAS 157. The adoption of this interpretation did not have an impact on the Company’s financial position, results of operations, or cash flows.
In December 2007, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 141R, “Business Combinations” (“FAS 141R”) which replaces FAS No. 141 and establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquire. FAS 141R also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. This Statement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Early adoption of FAS 141R is prohibited. The Company is currently evaluating the impact, if any, of adopting FAS 141R on its financial position and results of operations.
In December 2007, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 160, “Non-controlling Interests in Consolidated Financial Statements” (“FAS 160”) which amends ARB 51 to establish accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. It clarifies that a non-controlling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. In addition to the amendments to ARB 51, this Statement amends FASB Statement No. 128, Earnings per Share; so that earnings-per-share data will continue to be calculated the same way those data were calculated before this Statement was issued. This Statement is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. The Company is currently evaluating the impact, if any, of adopting FAS 160 on its financial position and results of operations.
In March 2008, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 161, "Disclosures about Derivative Instruments and Hedging Activities - an amendment of FASB Statement No. 133" (FAS 161). FAS 161 amends and expands disclosures about derivative instruments and hedging activities. FAS 161 required qualitative disclosures about the objectives and strategies of derivative instruments, quantitative disclosures about the fair value amounts of and gains and losses on derivative instruments, and disclosures of credit-risk-related contingent features in hedging activities. FAS 161 is effective for fiscal years beginning after November 15, 2008 and will be effective for the Company in fiscal year 2010. Early adoption is prohibited; however, presentation and disclosure requirements must be retrospectively applied to comparative financial statements. The Company has not yet determined the effect, if any, that the adoption of this standard will have on its financial position or results of operations.
In April 2008, FASB Staff Position No. 142-3, Determination of the Useful Life of Intangible Assets (“FSP 142-3”) was issued. This standard amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FASB Statement No. 142, Goodwill and Other Intangible Assets. FSP 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Early adoption is prohibited. The Company has not determined the impact on its financial statements of this accounting standard.
In May 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement). FSP APB 14-1
F-13
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Recent Accounting Pronouncements (continued)
clarifies that convertible debt instruments that may be settled in cash upon either mandatory or optional conversion (including partial cash settlement) are not addressed by paragraph 12 of APB Opinion No. 14, Accounting for Convertible Debt and Debt issued with Stock Purchase Warrants . Additionally, FSP APB 14-1 specifies that issuers of such instruments should separately account for the liability and equity components in a manner that will reflect the entity’s nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods. FSP APB 14-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. We will adopt FSP APB 14-1 beginning in the first quarter of fiscal 2010, and this standard must be applied on a retrospective basis. We are evaluating the impact the adoption of FSP APB 14-1 will have on our consolidated financial position and results of operations.
In May 2008, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 162, The Hierarchy of Generally Accepted Accounting Principles. This standard is intended to improve financial reporting by identifying a consistent framework, or hierarchy, for selecting accounting principles to be used in preparing financial statements that are presented in conformity with generally accepted accounting principles in the United States for non-governmental entities. SFAS No. 162 is effective 60 days following approval by the U.S. Securities and Exchange Commission (“SEC”) of the Public Company Accounting Oversight Board’s amendments to AU Section 411, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles. We do not expect SFAS No. 162 to have a material impact on the preparation of our consolidated financial statements.
In May 2008, the FASB issued SFAS No. 163, “Accounting for Financial Guarantee Insurance Contracts – an interpretation of FASB Statement No. 60.” SFAS 163 requires that an insurance enterprise recognize a claim liability prior to an event of default (insured event) when there is evidence that credit deterioration has occurred in an insured financial obligation. This Statement also clarifies how Statement 60 applies to financial guarantee insurance contracts, including the recognition and measurement to be used to account for premium revenue and claim liabilities. Those clarifications will increase comparability in financial reporting of financial guarantee insurance contracts by insurance enterprises. This Statement requires expanded disclosures about financial guarantee insurance contracts. The accounting and disclosure requirements of the Statement will improve the quality of information provided to users of financial statements. SFAS 163 will be effective for financial statements issued for fiscal years beginning after December 15, 2008. The Company does not expect the adoption of SFAS 163 will have a material impact on its financial condition or results of operation.
In June 2008, the FASB ratified EITF 07-5, “Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own Stock”. EITF 07-5 addresses how an entity should evaluate whether an instrument or embedded feature is indexed to its own stock, carrying forward the guidance in EITF 01-6 and superseding EITF 01-6. Other issues addressed in EITF 07-5 include addressing situations where the currency of the linked instrument differs from the host instrument and how to account for market-based employee stock options. EITF 07-5 is effective for fiscal years beginning after December 15, 2008 and early adoption is not permitted. The Company has evaluated this statement and estimated that it is not expected to have an impact on its financial position and results of operations.
On June 16, 2008, the FASB issued Final Staff Position (“FSP”) No. EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities” to address the question of whether instruments granted in share-based payment transactions are participating securities prior to vesting. The FSP determines that unvested share-based payment awards that contain rights to dividend payments should be included in earnings per share calculations. The guidance will be effective for fiscal years beginning after December 15, 2008. The Company does not expect the adoption of EITF 03-6-1 will have a material impact on its financial condition or results of operation.
On October 10, 2008, the FASB issued FSP 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active,” which clarifies the application of SFAS 157 in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP 157-3 became effective on October 10, 2008, and its adoption did not have a material impact on our financial position or results.
F-14
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Recent Accounting Pronouncements (continued)
In January 2009, the FASB issued FSP EITF 99-20-1, “Amendments to the Impairment Guidance of EITF Issue No. 99“Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets”. FSP EITF 99-20-1 changes the impairment model included within EITF 99-20 to be more consistent with the impairment model of SFAS No. 115. FSP EITF 99-20-1 achieves this by amending the impairment model in EITF 99-20 to remove its exclusive reliance on “market participant” estimates of future cash flows used in determining fair value. Changing the cash flows used to analyze other-than-temporary impairment from the “market participant” view to a holder’s estimate of whether there has been a “probable” adverse change in estimated cash flows allows companies to apply reasonable judgment in assessing whether an other-than-temporary impairment has occurred. The adoption of FSP EITF 99-20-1 did not have a material impact on our consolidated financial statements.
Reclassifications
Certain prior period amounts have been reclassified to conform to the current period presentation. These reclassifications have no effect on net income.
NOTE 2 – ACCOUNTS RECEIVABLE
At December 31, 2008 and 2007, accounts receivable consisted of the following:
2008 | 2007 | |||||||
Accounts receivable | $ | 6,132,912 | $ | 20,978,910 | ||||
Less: allowance for sales returns | - | - | ||||||
Less: allowance for doubtful accounts | - | (548,083 | ) | |||||
$ | 6,132,912 | $ | 20,430,827 |
NOTE 3 - INVENTORIES
At December 31, 2008 and 2007, inventories consisted of the following:
2008 | 2007 | |||||||
Raw materials | $ | 2,884,092 | $ | 2,312,111 | ||||
Work in process | - | 279,759 | ||||||
Packaging materials | 16,100 | 52,967 | ||||||
Finished goods | 887,610 | 808,456 | ||||||
3,787,802 | 3,453,293 | |||||||
Less: reserve for obsolete inventory | - | (42,554 | ) | |||||
$ | 3,787,802 | $ | 3 ,410,739 |
NOTE 4 - PROPERTY AND EQUIPMENT
At December 31, 2008 and 2007, property and equipment consist of the following:
Useful Life | 2008 | 2007 | |||||||
Office equipment and furniture | 3-8 Years | $ | 228,673 | $ | 154,488 | ||||
Manufacturing equipment | 10 – 15 Years | 5,585,793 | 5,032,601 | ||||||
Building and building improvements | 20 – 40 Years | 3,136,164 | 2,938,966 | ||||||
Construction in progress | 1,181,757 | — | |||||||
10,132,387 | 8,126,055 | ||||||||
Less: accumulated depreciation | (2,577,570 | ) | (1,956,089 | ) | |||||
$ | 7,554,817 | $ | 6,169,966 |
F-15
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 4 - PROPERTY AND EQUIPMENT (Continued)
For the year ended December 31, 2008, construction in progress amounted to $1,181,757, representing construction for a new manufacturing plant located in Cha Ha Er Industrial Garden District in Inner Mongolia, China. The amount included costs for road, electrical, sewage, heating and water pipes constructions.
For the years ended December 31, 2008 and 2007, depreciation expense amounted to $482,624 and $424,135 of which $480,201 and $413,586 is included in cost of sales, respectively.
NOTE 5 – DEPOSIT AND INSTALLMENT ON INTANGIBLE ASSETS
Deposit and Installments on a Chinese Class I drug patent-Laevo-Bambutero
Pursuant to the technology transfer agreement the Company’ entered into in April 2008 (See note 14), the Company made a deposit to acquire a Chinese Class I drug patent. Accordingly, the Company recorded $2,917,919 as deposit on patent as of December 31, 2008.
Also, the Company has made an installment on the Chinese Class I drug patent to obtain the patent according to the signed contract. Therefore, the Company recorded $2,626,127 as installment on intangible assets as of December 31, 2008. The Company will need to make additional installments of approximately $4,377,000 to obtain the patent.
In addition, we expect to incur approximately $14.5 million expenses related to our Laevo-Bambutero drug that was recently accepted by the Chinese SFDA for clinical trial evaluations in the next 24 to 30 months.
Installment on Yipubishan
The Company has made an installment on the drug Yipubishan in accordance with a new drug certificate and intellectual property right transfer contract the Company entered into on December 2, 2008 (See note 14). Accordingly, the Company recorded $2,917,919 as installment on intangible assets as of December 31, 2008. The Company will need to make additional installments of approximately $4,960,000 to obtain the new drug certificate and intellectual property right.
Installments on land use right
As of December 31, 2008, the Company paid $32,631,088 (RMB 223.66 million) for land use rights to property in the Cha Ha Er Industrial Park ( See note 14), located in Inner Mongolia. The amount has reflected as an installment payments on land use rights on its balance sheet at December 31, 2008. The installment payment is non-refundable in the event the Company decides not to construct the manufacture facility.
NOTE 6 – INTANGIBLE ASSETS
The Company purchased manufacturing rights for two approved drugs. The manufacturing rights issued are in connection with the Company’s products Valsartan and Brimonidine. The manufacturing rights for Valsartan became effective in November 2000 and had a life of 6.5 years, which expired in 2007. The manufacturing rights for Brimonidine became effective on August 27, 2005 and will expire in August 2009.
On October 9, 2006, the Company entered into a five-year loan agreement and a contract with Wu Lan Cha Bu Emergency Hospital (“Wu Lan”), whereby the Company agreed to lend to Wu Lan approximately $4,377,000 for the construction of a hospital ward in Inner Mongolia, China. In exchange for agreeing to lend to Wu Lan the funds, Wu Lan agreed that the Company will be the exclusive provider for all medicines and disposable medical treatment apparatus to Wu Lan for a period of twenty (20) years. In October 2006, the Company’s chief executive officer, Mr. Liu, lent these funds to Wu Lan on behalf of the Company. The Company entered into an assignment agreement whereby the Company assigned all of its rights, obligations, and receipts under the Loan Agreement to Mr. Liu, except for the rights to revenues from the sale of medical and disposable medical treatment apparatus which will remain with the Company. As compensation to Mr. Liu for accepting the assignment under the loan agreement including all of the risks and obligations and for Liu not accepting the rights to revenues from the sale of medical and disposable medical treatment apparatus which will remain with the Company, the Company agreed to pay Mr. Liu an aggregate of approximately $1,313,000 in 5 equal annual installments of approximately $263,000. Accordingly, the Company recorded an intangible asset of approximately $1,313,000 related to exclusive rights to provide all medicines and disposable medical treatment apparatus to Wu Lan for a period of twenty (20) years. The Company will amortize this exclusive right over a term of 20 years.
F-16
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 6 – INTANGIBLE ASSETS (Continued)
At December 31, 2008 and 2007, intangible assets consist of the following:
2008 | 2007 | |||||||
Manufacturing rights | $ | 1,264,334 | $ | 1,187,569 | ||||
Revenue rights | 1,313,064 | 1,230,500 | ||||||
Software | 10,796 | - | ||||||
2,588,194 | 2,418,069 | |||||||
Less: accumulated amortization | (1,356,464 | ) | (1,126,747 | ) | ||||
$ | 1,231,730 | $ | 1,291,322 |
Amortization expense amounted to approximately $151,723 and $140,472 for the year ended December 31, 2008 and 2007.
The projected amortization expense attributed to future periods is as follows:
Year ending December 31: | ||||
2009 | $ | 127,711 | ||
2010 | 68,279 | |||
2011 | 67,355 | |||
2012 | 65,653 | |||
Thereafter | 902,732 | |||
$ | 1,231,730 |
NOTE 7 – RELATED PARTY TRANSACTIONS
Notes payable – related parties
Notes payable - related parties consisted of the following at December 31, 2008 and 2007:
2008 | 2007 | |||||||
Note to Song Guoan, father of Song Zheng Hong, director and spouse of Liu Zhong Yi, due on December 30, 2015 with variable annual interest at 80% of current bank rate (4.75% and 6.26% at December 31, 2008 and 2007, respectively), and unsecured | $ | 761,894 | $ | 1,895,424 | ||||
Note to Zheng Gui Xin, employee, due on December 30, 2015 with with variable annual interest at 80% of current bank rate (4.75% and 6.26% at December 31, 2008 and 2007, respectively), and unsecured | 1,649,354 | 1,545,645 | ||||||
Note to Ma Zhao Zhao, employee, due on December 30, 2015 with variable annual interest at 80% of current bank rate (4.75% and 6.26% at December 31, 2008 and 2007, respectively), and unsecured | 660,562 | 619,027 | ||||||
Note to Liu Zhong Yi, officer and director, due on December 30, 2015 with variable annual interest at 80% of current bank rate (4.75% and 6.26% at December 31, 2008 and 2007, respectively), and unsecured | 1,406,094 | 136,244 | ||||||
Note to Song Zheng Hong, director and spouse of the Company chief executive officer, Liu Zhong Yi, due on December 30, 2015 with variable annual interest at 80% of current bank rate (4.75% and 6.26% at December 31, 2008 and 2007, respectively), and unsecured | 578,547 | 542,168 | ||||||
Total notes payable – related parties, long term | $ | 5,056,451 | $ | 4,738,508 |
F-17
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 7 – RELATED PARTY TRANSACTIONS (Continued)
For the years ended December 31, 2008 and 2007, interest expense related to these related loans amounted to $294,394 and $209,834, respectively.
Due to related parties
Several employees of the Company, from time to time, provided advances to the Company for operating expenses. During the years ended December 31, 2008 and 2007, the Company repaid approximately $0 and $118,919 of these advances, respectively. At December 31, 2008 and 2007, the Company had a payable to these employees amounting to $36,358 and $34,072, respectively. These advances are short-term in nature and non-interest bearing.
The chief executive officer of the Company and his spouse, from time to time, provided advances to the Company for operating expenses. During the years ended December 31, 2008 and 2007, the Company repaid $0 and $561,878 of these advances, respectively. At December 31, 2008 and 2007, the Company had a payable to the chief executive officer and his spouse amounting to $682,178 and $0, respectively. These advances are short-term in nature and non-interest bearing.
On October 9, 2006, the Company entered into a five-year loan agreement and a contract with Wu Lan Cha Bu Emergency Hospital ("Wu Lan"), whereby the Company agreed to lend to Wu Lan approximately $4,377,000 for the construction of a hospital ward in Inner Mongolia, China. In exchange for agreeing to lend to Wu Lan the funds, Wu Lan agreed that the Company will be the exclusive provider for all medicines and disposable medical treatment apparatus to Wu Lan for a period of twenty (20) years. In October 2006, the Company's chief executive officer, Mr. Liu, lent these funds to Wu Lan on behalf of the Company. Accordingly, the Company entered into an assignment agreement whereby the Company assigned all of its rights, obligations, and receipts under the Loan Agreement to Mr. Liu, except for the rights to revenues from the sale of medical and disposable medical treatment apparatus which will remain with the Company. As compensation to Mr. Liu for accepting the assignment under the loan agreement including all of the risks and obligations and for Liu not accepting the rights to revenues from the sale of medical and disposable medical treatment apparatus which will remain with the Company, the Company agreed to pay Mr. Liu an aggregate of approximately $1,313,000 to be paid in 5 equal annual installments of approximately $263,000. Accordingly, the Company recorded an intangible asset of approximately $1,313,000 related to exclusive rights to provide all medicines and disposable medical treatment apparatus to Wu Lan for a period of twenty (20) years and a corresponding related party liability. For the years ended December 31, 2008 and 2007, the Company paid approximately $0 and $195,000 of this related party liability, respectively. At December 31, 2008 and 2007, amounts due under this assignment agreement amounted to $1,031,028 and $966,198 of which $525,225 and $738,300 is included in long-term liabilities and has been included in due to related parties on the accompanying balance sheets, respectively.
At December 31, 2008 and 2007, the Company has recorded accrued interest relating to notes payable - related parties of $364,350 and $61,208, respectively, which have been included in due to related parties on the accompanying balance sheets.
For the year ended December 31, 2008 and 2007, a summary of activities in due to related parties is as follows:
Assignment fee payable | Working capital advances | Accrued interest | Total | |||||||||||||
Balance - December 31, 2006 | $ | 1,093,700 | $ | 695,231 | $ | - | $ | 1,788,931 | ||||||||
Additions | - | - | 58,774 | 58,774 | ||||||||||||
Payments made | (194,709 | ) | (680,797 | ) | - | (875,506 | ) | |||||||||
Foreign currency fluctuations | 67,207 | 19,638 | 2,434 | 89,279 | ||||||||||||
Balance - December 31, 2007 | 966,198 | 34,072 | 61,208 | 1,061,478 | ||||||||||||
Additions | - | 682,179 | 299,036 | 981,215 | ||||||||||||
Payments made | - | - | - | - | ||||||||||||
Foreign currency fluctuations | 64,830 | 2,285 | 4,106 | 71,221 | ||||||||||||
Balance - December 31, 2008 | $ | 1,031,028 | $ | 718,536 | $ | 364,350 | $ | 2,113,914 |
F-18
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 7 – RELATED PARTY TRANSACTIONS (Continued)
Due from related parties
In December 2008, in connection with the new plant facility in Cha Ha Er Industrial Garden District in Inner Mongolia (See Note 14), the Company planned to form a new subsidiary in Inner Mongolia. In preparation for the register capital of the originally planned new entity, on December 25, 2008, the Company transferred $2,027,954 to the Company’s CEO to register for the new entity. The Company subsequently determined forming an Inner Mongolia new entity was not necessary and the money was returned to the Company on January 5, 2009.
NOTE 8 - CONVERTIBLE DEBT
The convertible debenture liability is as follows at December 31, 2007:
Convertible debentures payable | $ | 2,770,000 | ||
Less: unamortized discount on debentures | (208,355) | |||
Convertible debentures, net | $ | 2,561,645 |
In January 2008, the Company issued 250,000 shares of its common stock in connection with the conversion of $250,000 of convertible debt. In February 2008, in connection with a private placement (See Note 10), the remaining $2,520,000 of convertible debt and any unpaid interest was repaid in full. The Company amortized the remaining $208,355 in discount on debentures in the fiscal year ended December 31, 2008. As of December 31, 2008, the balance of the convertible debt is $0.
NOTE 9 - CONVERTIBLE REDEEMABLE PREFERRED STOCKS
On February 25, 2008, the Company entered into a Convertible Redeemable Preferred Share and Warrant Purchase Agreement (the “Purchase Agreement”) by and among the Company, Dr. Liu ZhongYi and Mrs. Song Zhenghong (the “Founders”), and accredited investors (each a “Purchaser” and collectively, the “Purchasers”), pursuant to which the Company sold to the Purchasers 5,747,118 shares of the Company’s series A convertible redeemable preferred stock and warrants to purchase 2,873,553 shares of the Company’s common stock, in a private placement (the “February 2008 Private Placement”) pursuant to Regulation D under the Securities Act of 1933, for the aggregate purchase price of $5 million (the “Transaction”). The transaction closed on February 25, 2008 (the “Closing Date”). Net proceeds, exclusive of expenses of the Transaction, from the sale to the Company were $4.6 million in cash, after the Company paid fees of approximately $469,000 in cash of which $400,000 was paid to Maxim Group, LLC, the placement agent for the Transaction. The Company recorded the approximately $796,000 in fees, of which $327,565 was related to value of the warrants granted to placement agent, as a deferred debt cost and amortized approximately $331,722 of the deferred cost during the year ended December 31, 2008. The Company has presented the convertible redeemable preferred stocks as long term debt due to the mandatory redeemable feature of the preferred stocks.
The Company used $2,576,556 of the net proceeds of the Transaction to repay in full all of its outstanding principal obligations including accrued interest under the 14% Secured Convertible Notes due February 2008 and the Company will use the remainder of the net proceeds for working capital and general corporate purposes.
The Purchase Agreement includes customary representations and warranties by each party thereto. The following is a brief description of the terms and conditions of the Purchase Agreement and the transactions contemplated there under that are material to the Company:
Pursuant to the Purchase Agreement, the Company issued to the Purchasers an aggregate of 5,747,118 shares of the Company’s series A convertible redeemable preferred stock, par value $0.001 per share, at a price equal to $0.87 per share (the “Preferred Shares”). Each of these Preferred Shares may be converted into one share of the Company’s common stock, par value $0.001 per share (as adjusted for stock splits, stock dividends, reclassification and the like). The Preferred Shares pay an 8% dividend annually, which is payable in additional Preferred Shares. Preferred Shares also pay any dividend paid on the common shares on an as converted basis. For a period of 90 days after February 25, 2010, these Preferred Shares may also be redeemed at the option of the Purchasers at the redemption price of $0.87 per share (as adjusted for stock splits, stock dividends, reclassification and the like), and no other capital stock of the Company may be redeemable prior to the Preferred Shares. Holders of Preferred Shares may not convert Preferred Shares to common shares if the conversion would result in the holder beneficially owning more than 4.99% of the Company’s outstanding common shares. That limitation may be waived by a holder of Preferred Shares on not less than 61 days written notice to the Company. In addition, the Company issued to the Purchasers warrants to purchase up to 2,873,553 shares of the Company’s common stock in the aggregate.
F-19
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 9 - CONVERTIBLE REDEEMABLE PREFERRED STOCKS (Continued)
The warrants have an initial exercise price of $1.20 (subject to adjustment pursuant to the terms of the warrants). The warrants are exercisable for a period of five (5) years from the Closing Date. Holders of the warrants may not exercise the warrants if the exercise would result in the holder beneficially owning more than 4.99% of the Company’s outstanding common shares. That limitation may be waived by a holder of the warrants on not less than 61 days written notice to the Company.
Other key provisions of the February 2008 Private Placement:
• | The Preferred Shares vote with the common stock on an as converted basis, except that the Preferred Shares are not entitled to vote for directors. The Company is prohibited from taking certain corporate actions, including, without limitation, issuing securities senior to the Preferred Shares, selling substantially all assets, repurchasing securities and declaring or paying dividends, without the approval of the holders of a majority of the Preferred Shares outstanding. |
• | The Company agreed to undertake to file a registration statement within 60 days following the Closing Date in order to register the maximum number of common stock issuable from conversion of the Preferred Shares and underlying the warrants that is allowable under applicable federal securities regulations. The Company is also obligated to have the registration statement declared effective within 120 days following the Closing Date. If the Company is informed by the SEC that there are no comments to the registration statement, then the registration statement must be effective within five (5) business days thereafter or on the 60th day after the filing date, whichever is sooner. The registration statement must be declared effective by the 120th day after its filing if the SEC has comments. Otherwise, the Company is subject to liquidated damages, equal to 1% of the total conversion price and exercise price for the common stock being registered under the registration statement, for every 30-day period following the date that the registration statement should have been effective, prorated for any period less than 30 days, until either all of common shares registered under the registration statement have been sold or all such common shares may be sold in any three (3) month period pursuant to Rule 144 promulgated under the Securities Act, whichever is earlier. The Company must also pay the liquidated damages if sales cannot be made pursuant to the registration statement for any reason (excepting market conditions). The maximum amount of liquidated damages is $500,000. |
• | The Founders delivered in the aggregate 7,500,000 shares of the Company’s common stock owned by them (the “Escrow Shares”) to an escrow account. Portions of the Escrow Shares are being held in escrow subject to the Company meeting certain earning targets in fiscal years 2007, 2008 and 2009. The target for 2007 was $8.5 million in net income. The target for 2008 is 95% of $13.8 million in net income and the target for 2009 is 95% of $17.5 million in net income, both after eliminating the effect of non-cash charges associated with the Transaction and adjusting for differences in the exchange rate between Chinese Renminbi and US dollars used in the Company’s financial statements and an exchange rate of RMB 7.30 to USD 1.00. These Escrow Shares will be transferred to the Purchasers if the Company does not meet the earning targets, and released back to the Founders if the Company does. Another portion of the Escrow Shares is being held in escrow subject to the Company listing on the NASDAQ Stock Market within 18 months following the Closing Date. These Escrow Shares will be transferred to the Purchasers if the listing is not completed within that time period, and released back to the Founders if it is. In addition, two-thirds of the Escrow Shares are held in escrow to ensure that the Purchasers receive their full redemption payments if they choose to redeem their Preferred Shares. Each Preferred Share may be redeemed for $0.87 per share (adjusted for stock splits, stock dividends, reclassification and the like). If a Purchaser receives less than the full redemption amount for each Preferred Share being redeemed, the Purchaser will receive a number of Escrow Shares to make up the difference, based on the then-current market price of the common shares. Following the end of the redemption period, these Escrow Shares, less those transferred to any Purchasers that redeemed their Preferred Shares, will be released back to the Founders. |
In connection with the issuance of the series A convertible redeemable preferred stock and warrants to purchase 2,873,553 shares of the Company’s common stock, the Company recorded a total debt discount of $ 2,310,263 to be amortized over the term of this Purchase Agreement. For the year ended December 31, 2008, amortization of debt discount amounted to $ 962,604 and has been included in interest expense.
F-20
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 9 - CONVERTIBLE REDEEMABLE PREFERRED STOCKS (Continued)
For the year ended December 31, 2008, the Company evaluated whether or not the series A convertible redeemable preferred stock contain embedded conversion options, which meet the definition of derivatives under SFAS 133 “Accounting for Derivative Instruments and Hedging Activities” and related interpretations. The Company concluded that since the series A convertible redeemable preferred stock had a fixed redemption price of $0.87, the convertible redeemable preferred stock was not a derivative instrument. The Company analyzed this provision under EITF 05-04 and therefore it qualified as equity under EITF 00-19.
The series A convertible redeemable preferred stock is as follows at December 31, 2008:
Series A convertible redeemable preferred stock | $ | 5,000,000 | ||
Less: unamortized discount | (1,347,659) | |||
Series A convertible redeemable preferred stock, net | $ | 3,652,341 |
NOTE 10 – INCOME TAXES
The Company accounts for income taxes under Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"). SFAS 109 requires the recognition of deferred tax assets and liabilities for both the expected impact of differences between the financial statements and the tax basis of assets and liabilities, and for the expected future tax benefit to be derived from tax losses and tax credit carryforwards. SFAS 109 additionally requires the establishment of a valuation allowance to reflect the likelihood of realization of deferred tax assets. Realization of deferred tax assets, including those related to the U.S. net operating loss carryforwards, are dependent upon future earnings, if any, of which the timing and amount are uncertain. Accordingly, the net deferred tax asset related to the U.S. net operating loss carryforward has been fully offset by a valuation allowance. The Company is governed by the Income Tax Law of the People's Republic of China and the United States.
The components of income (loss) before income tax consist of the following:
Year Ended December 31, | ||||||||
2008 | 2007 | |||||||
U.S. Operations | $ | (3,099,592 | ) | $ | (2,801,788 | ) | ||
Chinese Operations | 15,890,240 | 14,018,916 | ||||||
$ | 12,790,648 | $ | 11,217,128 |
Under the Income Tax Laws of PRC, Chinese companies are generally subject to an income tax at an effective rate of 25% on income reported in the statutory financial statements after appropriate tax adjustments. The PRC local government has provided various incentives to companies in order to encourage economic development. Such incentives include reduced tax rates and other measures. Since 2002, the Company has been entitled to an income tax exemption for a six-year period and was exempted from all of its income tax in the 2008 and 2007 period. The estimated tax savings due to the tax exemption for the years ending December 31, 2008 and 2007 amounted to approximately $3,973,000 and $4,600,000, respectively. The net effect on earnings per share if the income tax had been applied would decrease basic earnings per share for December 31, 2008 and 2007 to $0.21 and $0.16, respectively.
Lotus Pharmaceuticals, Inc. was incorporated in the United States and has available net operating losses of $2,258,217 for income tax purposes at December 31, 2008, subject to the Internal Revenue Code Section 382, which places a limitation on the amount of taxable income that can be offset by net operating losses after a change in ownership. The net operating loss carries forwards for United States income taxes, which may be available to reduce future years' taxable income. These carry forwards will expire, if not utilize, through 2028. Management believes that the realization of the benefits from these losses appears uncertain due to the Company's limited operating history and continuing losses for United States income tax purposes. Accordingly, the Company has provided a 100% valuation allowance on the deferred tax asset benefit to reduce the asset to zero. Management will review this valuation allowance periodically and make adjustments as warranted. The valuation allowance at December 31, 2008 and 2007 was approximately $528,000 and $246,000, respectively. The consolidated income is earned overseas and the Company does not intend to repatriate the funds and, in the event of repatriation there will be a tax on the repatriated income.
The table below summarizes the differences between the U.S. statutory federal rate and the Company’s effective tax rate and as follows for years ended December 31, 2008 and 2007:
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LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 10 – INCOME TAXES (Continued)
2008 | 2007 | |||||||
US Statutory rates | 34.0 | % | 34.0% | |||||
US effective rate in excess of China tax rate | (11.1 | %) | (0.4% | ) | ||||
China income tax exemptions | (31.1 | %) | (42.1% | ) | ||||
Non-deductible compensation, debt cost and interest expense attributable to warrants | 4.1 | % | 5.3% | |||||
US valuation allowance | 4.1 | % | 3.2% | |||||
Total provision for income taxes | 0.0 | % | 0.0% |
Deferred tax assets and liabilities are provided for significant income and expense items recognized in different years for tax and financial reporting purposes. Temporary differences, which give rise to a net deferred tax asset is as follows:
2008 | 2007 | |||||||
Tax benefit of net operating loss carryforward | $ | 768,000 | $ | 246,000 | ||||
Valuation allowance | (768,000 | ) | (246,000 | ) | ||||
Net deferred tax asset | $ | - | $ | - |
After consideration of all the evidence, both positive and negative, management has recorded a valuation allowance at December 31, 2008 and 2007, due to the uncertainty of realizing the deferred income tax assets related to the U.S. net operating loss carryforward.
Beginning January 1, 2008, the new PRC Enterprise Income Tax ("EIT") law replaced the existing laws for PRC Domestic Enterprises ("DES") and PRC Foreign Invested Enterprises ("FIEs"). The key changes are:
a. | The new standard PRC EIT rate of 25% replaced the 33% rate currently applicable to both DES and FIEs, except for High Tech companies who pays a reduced rate of 15%; and | |
b. | Companies established before March 16, 2007 will continue to enjoy tax holiday treatment approved by local government for a grace period of the next 5 years or until the tax holiday term is completed, whichever is sooner. |
NOTE 11 – TAXES PAYABLE
Value Added Tax
The Company is subject to value added tax ("VAT") for manufacturing products. The applicable VAT tax rate is 17% for products sold in the PRC. The amount of VAT liability is determined by applying the applicable tax rate to the invoiced amount of goods sold (output VAT) less VAT paid on purchases made with the relevant supporting invoices (input VAT). Under the commercial practice of the PRC, the Company paid value added taxes ("VAT") based on tax invoices issued. The tax invoices may be issued subsequent to the date on which revenue is recognized, and there may be a considerable delay between the date on which the revenue is recognized and the date on which the tax invoice is issued. In the event that the PRC tax authorities dispute the date of which revenue is recognized for tax purposes, the PRC tax office has the right to assess a penalty, which can range from zero to five times the amount of the taxes which are determined to be late or deficient. According to the PRC tax laws, any potential tax penalty payable on late or deficient payments of this tax could be between zero and five times the amount of the late or deficient tax payable, and will be expensed as a period expense if and when a determination has been made by the taxing authorities that a penalty is due. At December 31, 2008 and 2007, the Company accrued $5,015,908 and $572,200, respectively, of unpaid value-added taxes.
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LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 12 -SHAREHOLDERS’ EQUITY
In January 2008, the Company issued 250,000 shares of its common in connection with the conversion of $250,000 of convertible debt.
In April 2008, the Company issued in aggregate 331,668 shares of restricted common stock to the several directors, consultants and officers of the Company for services rendered. The Company valued these common shares at the fair market value on the date of grant at $0.87 per share or $288,551 in total. In connection with issuance of these shares, the Company recorded prepaid stock-based expenses of $288,551. As of December 31, 2008, the recorded stock-based expenses of $288,551 had fully amortized.
In April 2008, in connection with a cashless exercise of 60,000 warrants, the Company issued 9,077 shares of common stock accordingly.
In June 2008, the Company issued 35,294 shares of restricted common stock to a consultant for services rendered to the Company. The Company valued these common shares at the fair market value on the date of the grant at $0.85 per share or $30,000 in total. The Company recorded stock-based compensation expenses of $30,000 for the year ended December 31, 2008 accordingly.
In February 2007, the Company's Board of Directors and its consenting majority stockholders have adopted and approved an amendment to increase the number of the Company's authorized shares of capital stock from 50,000,000 to 210,000,000 total authorized shares of capital stock. The capital stock shall consist of 200,000,000 authorized shares of Common Stock, $0.001 par value per share, and 10,000,000 authorized shares of Preferred Stock, with a par value $0.001 per share.
In May 2007, the Company issued 74,200 shares of common stock to an officer and a director of the Company for services rendered. The shares were issued at the fair values at the date of the grant of $74,200 or $1.00 per share. Accordingly, the Company recorded stock-based compensation of $74,200.
In September 2007, the Company issued 210,000 shares of common stock to seven directors of the Company for services rendered. The shares were issued at the fair values at the date of the grant of $210,000 or $1.00 per share. Accordingly, the Company recorded stock-based compensation of $210,000.
During the three months ended December 2007, the Company issued 230,000 shares of its common in connection with the conversion of $230,000 of convertible debt.
Stock warrants
In January, 2008, the Company granted 250,000 stock warrants to a consulting company at an exercise price of $1.50 per share in connection with a one year contract. The warrants are not vested until January 2009. The Company valued these warrants utilizing the Black-Scholes options pricing model at approximately $0.71 per warrant or $178,187 in total and recorded a prepaid consulting expense of $178,187 for the year ended December 31 2008. Those warrants will expire in January 2012. For the year ended December 31, 2008, the Company recorded amortization expenses of $163,338 related to the consulting contract.
In connection with the preferred share financing (See Note 9), the Company granted 2,873,553 warrants to investors purchase up to 2,873,553 shares of common stock of the Company at an exercise price of $1.21 per share. The Warrants have a term of 5 years after the issue date of February 12, 2007. Additionally, the Company granted 603,446 stock warrants to an investment banking firm at an exercise price of $1.21 per share. The Company valued these warrants utilizing the Black-Scholes options pricing model at approximately $0.54 per warrant or $327,565 in total and recorded a deferred financing costs of $327,565. Those warrants will expire in February 2013. For the year ended December 31, 2008, the Company recorded amortization expenses of $ 136,485 related to the deferred financing costs.
On February 25, 2008, pursuant to a Convertible Redeemable Preferred Share and Warrant Purchase Agreement (See Note 9), the exercise price of the 1,500,000 warrants granted in February 2007 were reduced and repriced to $0.87 per share. As a result of the repricing, the Company recorded an interest expense of $74,593 for the year ended December, 2008.
Stock warrants issued, terminated/forfeited and outstanding during the year ended December 31, 2008 are as follows:
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LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 12 -SHAREHOLDERS’ EQUITY (Continued)
Shares | Average Exercise price per share | Average life (year) | ||||
Warrants outstanding on December 31, 2007 | 1,500,000 | 0.87 | 5.00 | |||
Warrants issued | 3,726,999 | 1.23 | 4.93 | |||
Warrants terminated/forfeited | - | - | - | |||
Warrants exercised | (60,000) | 0.87 | - | |||
Warrants outstanding on December 31, 2008 | 5,166,999 | 1.13 | 4.95 |
In connection with the debt financing , the Company granted 1,500,000 to investors purchase up to 1,500,000 shares of common stock of the Company at an exercise price of $1.50 per share. The Warrants have a term of 5 years after the issue date of February 12, 2007. On February 25, 2008, pursuant to a Convertible Redeemable Preferred Share and Warrant Purchase Agreement, the exercise prices of these warrants were reduced to $1.20 per share.
NOTE 13 - SEGMENT INFORMATION
The following information is presented in accordance with SFAS No. 131, Disclosure about Segments of an Enterprise and Related Information. In the year ended December 31, 2007 and 2006, the Company operated in two reportable business segments - (1) the manufacture and distribution of pharmaceutical products and (2) the retailing of traditional and Chinese medicines and supplies through ten drug stores located in Beijing China and other ancillary revenues generated from retail location such as advertising income, rental income, and examination income. The Company's reportable segments are strategic business units that offer different products. They are managed separately based on the fundamental differences in their operations.
Information with respect to these reportable business segments for the year ended December 31, 2008 and 2007 is as follows:
2008 | Wholesale and third-party manufacturing and examination | Retail Operations | Rent and Advertising | Unallocated | Total | |||||
Net Revenues | $ | 70,186,196 | $ | 2,837,257 | $ | 779,576 | $ | - | $ | 73,803,029 |
Cost of Sales | 37,846,272 | 2,593,816 | - | - | 40,440,088 | |||||
Operating Expenses | - | - | - | 18,292,997 | 18,292,997 | |||||
Other Expense (Income) | - | - | - | 2,279,296 | 2,279,296 | |||||
Income Taxes | - | - | - | - | - | |||||
Net Income | $ | 32,339,924 | $ | 243,442 | $ | 779,576 | $ | (20,572,293) | $ | 12,790,648 |
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LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 13 - SEGMENT INFORMATION (Continued)
2007 | Wholesale and third-party manufacturing and examination | Retail Operations | Rent and Advertising | Unallocated | Total | |||||||||||||||
Net Revenues | $ | 51,940,532 | $ | 3,471,960 | $ | 1,460,623 | $ | - | $ | 56,873,115 | ||||||||||
Cost of Sales | 30,901,395 | 2,777,568 | - | - | 33,678,963 | |||||||||||||||
Operating Expenses | - | - | - | 11,885,859 | 11,885,859 | |||||||||||||||
Other Expense (Income) | - | - | - | 91,165 | 91,165 | |||||||||||||||
Income Taxes | - | - | - | - | - | |||||||||||||||
Net Income | $ | 21,039,137 | $ | 694,392 | $ | 1,460,623 | $ | (11,977,024 | ) | $ | 11,217,128 |
The Company does not allocate selling and general and administrative expenses to its reportable segments, because these activities are managed at a corporate level.
Asset information by reportable segment is not reported to or reviewed by the chief operating decision maker and, therefore, the Company has not disclosed asset information for each reportable segment. Substantially all of the Company’s assets are located in China.
NOTE 14 – COMMITMENTS AND CONTINGENCIES
Operating Leases
The Company leases office and manufacturing space under leases in Beijing, China that expire through July 2019. |
Future minimum rental payments required under these operating leases are as follows:
Year Ending December 31, | ||||
2009 | $ | 251,084 | ||
2010 | 132,917 | |||
2011 | 109,422 | |||
2012 | 109,422 | |||
2013 and thereafter | 702,124 | |||
Total minimum lease payments | $ | 1,304,969 |
For the years ended December 31, 2008 and 2007, rent expense amounted to $210,954 and $242,856, respectively.
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LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 14 – COMMITMENTS AND CONTINGENCIES (Continued)
Technology Transfer Agreement
In April 2008, one of the Company’s affiliates, En Ze Jia, entered into a Technology Transfer Agreement with Dong Guan Kai Fa Biological Medicine LTD (“Dong Guan”) pursuant to which Dong Guan agreed to transfer the technology material, new medicine research and rights to the Chinese patent of the anti-asthma new medicine R-BM to En Ze Jia on an exclusive basis in exchange for a transfer technology fee of approximately $7 million (RMB 48 million) to be paid at various intervals. Under the terms of the agreement, En Ze Jia is obligated to:
• | complete the filing with the Chinese State Food and Drug Administration (SFDA) of the medicine’s clinical research ratification document, | |
• | complete the clinical research, | |
• | complete the medicine’s trial production, and | |
• | provide raw materials and formulation related documentation and apply for the new medicine certification and production approval. |
In addition to the payment of the technology transfer fee, En Ze Jia is responsible for paying all costs associated with its responsibility under the agreement which are presently estimated at $2.3 million (RMB 16 million). Lotus East intends to use its working capital to fund the project costs.
Dong Guan is responsible for preparing and transferring the clinical research and application documents as well as assisting En Ze Jia in the completing the clinical research and applying for the new medicine certification and production approval documents.
Under the terms of the agreement, the technology transfer fee is to be paid upon the following schedule:
• | Approximately $1.46 million (RMB 10 million) is due by the 15th business day following the receipt of the processing notice of the receipt of the clinical application and all related material from SFDA is received, | |
• | Approximately $1.17 million (RMB 8 million) is due by the 10th business day after the receipt of the medicine’s clinical ratification document, | |
• | Approximately $1.46 million (RMB 10 million) is due by the 15th business day after the medicine’s Phase I clinical study is completed and ratification from the SFDA is obtained, and | |
• | Approximately $2.92 million (RMB 20 million) is due by the 10th business day after the medicine’s Phase II clinical study is completed and ratification from the SFDA is obtained. |
En Ze Jia paid Dong Guan a deposit of approximately $2.92 million (RMB 20 million) in April 2008 which is to be returned to En Ze Jia within 10 days after the transfer technology fee is fully paid. In the event Dong Guan should be unable to timely return the deposit, it will pay En Ze Jia a late fee and En Ze Jia is entitled to damages for Dong Guan’s failure to timely return the deposit.
The intellectual property arising from the agreement will be jointly shared by the parties. In addition, En Ze Jia has guaranteed that both parties must jointly apply for related government grants prior to when the new medicine is marketed. Upon receipt of the government grants En Ze Jia guaranteed that the grant monies will be shared equally by both parties. As of December 31, 2008, the Company has not received any government grant. The agreement can be terminated by Dong Guan if En Ze Jia should fail to make any of the aforedescribed payments in which event the patent rights would revert to Dong Guan and it is entitled to transfer the project rights to a third party.
New Manufacturing Facility
In June 2008, one of the Company’s affiliates, Liang Fang, entered into an agreement with Cha You Qian Qi Economy Commission, a governmental agency (“Cha You”) related to the construction of a pharmaceutical plant in Cha You’s Cha Ha Er Industrial Garden
F-26
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 14 – COMMITMENTS AND CONTINGENCIES (Continued)
New Manufacturing Facility (continued)
District in Inner Mongolia. The new facility, which will be comprised approximately 40,000 square meters situated on 600 MU of land (approximately 400,200 square meters), will be used to expand Liang Fang’s current manufacturing capacity. The Company was subsequently granted the right to expand the land use right area to 1,000 MU (approximately 667,000 square meters). The new facility, which will manufacture medical injection products, including 0.9% physiological saline injection, hydroxyethyl starch 130/0.4 injection and hydroxyethyl starch 200/0.5 injection, Qiang Yi Ji starch, a medical corn starch commonly known as O-2-hydeoxyethyl starch, dextran and additional pharmaceuticals, will require a total investment of RMB 623.66 million, or approximately $91 million. The construction began on the project in August 2008 and the Company anticipates that it will take between 12 to 30 months to complete the construction. As of December 31, 2008, the Company has incurred approximately $1.2 million related to this project and the amount has been included as construction in progress in the consolidated financial statements.
Included in the total cost of the project is land cost of approximately $32.6 million (RMB 223.66 million) which was fully paid to Cha You. Other components of the project include construction costs of approximately $17.5 million (RMB 120 million) costs associated with the various production lines estimated at approximately $33.6 million (RMB 230 million) and working capital of approximately $7.3 million (RMB 50 million).
Liang Fang intends to use its present working capital together with bank loans and government grants to fund the project. The funds are required to be invested over the next 18 months under a specified schedule ending in December 2010. As of December 31, 2008, Liang Fang has paid approximately $33 million (approximately RMB 226.5 million) of the total investment. Liang Fang, however, has not secured either the bank loans or government grants and does not have sufficient working capital to complete this project without securing substantial funds from those third party sources.
Under the terms of the agreement, Cha You agreed to abate fees associated with water resources, waste and other relative supplies for a period of 30 years and agreed to ensure that the land use tax to be paid by Liang Fang after it begins normal production will be at the lowest tax rate imposed for five years. Once the project is completed, for a period of eight years the local reserved portion of the imposed corporation income tax will be returned to Liang Fang.
New Drug Certificate and Intellectual Property Right Transfer Contract
On December 2, 2008, the Company entered into a New Drug Certificate and Intellectual Property Right Transfer Contract with Beijing Yipuan Bio-Medical Technology, Co., Ltd. related to the drug Yipubishan (common name Octreotide Acetate Injection). Under the terms of the agreement, the Company agreed to pay Beijing Yipuan Bio-Medical a total of approximately $7.9 million (RMB 54 million) for technology transfer fees. We have paid approximately $2.9 million (RMB 20 million) to Yipuan as of December 31, 2008 and the balance of approximately $5 million (RMB 34 million) is due by May 31, 2009. Liang Fang intends to use its present working capital to fund the commitments under the agreement. Upon payment of these amounts, Liang Fang will own all intellectual property rights associated with the drug.
As part of the sale of Yipubishan, Yipuan is transferring its distribution channels, including sales representatives, to Liang Fang in phases. Most of Yipuan's sales of Yipubishan take place in Jiangxi province, Xi'an and Shanghai. In 2006, Liang Fang started distributing Yipubishan in Anhui and Inner Mongolia. Liang Fang is considering whether to use the distribution channels it is acquiring from Yipuan for some of its own products.
NOTE 15 – OPERATING RISK
(a) Country risk
Currently, the Company’s revenues are primarily derived from the sale of pharmaceutical products to customers in the Peoples Republic of China (PRC). The Company hopes to expand its operations to countries outside the PRC, however, such expansion has not been commenced and there are no assurances that the Company will be able to achieve such an expansion successfully. Therefore, a downturn or stagnation in the economic environment of the PRC could have a material adverse effect on the Company’s financial condition.
F-27
LOTUS PHARMACEUTICALS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 and 2007
NOTE 15 – OPERATING RISK (Continued)
(b) Products risk
In addition to competing with other manufacturers of pharmaceutical product offerings, the Company competes with larger Chinese and International companies who may have greater funds available for expansion, marketing, research and development and the ability to attract more qualified personnel. These Chinese companies may be able to offer products at a lower price. There can be no assurance that the Company will remain competitive.
(c) Political risk
Currently, PRC is in a period of growth and is openly promoting business development in order to bring more business into PRC. Additionally PRC allows a Chinese corporation to be owned by a United States corporation. If the laws or regulations are changed by the PRC government, the Company's ability to operate the PRC subsidiaries could be affected.
NOTE 16 – SUBSEQUENT EVENT
In February 2009, the Company issued 842,308 shares of common stock to Liu Zhongyi (CEO) using a fair value of $0.26 per share for services rendered through December 31, 2008 as the Company’s chief executive officer.
In February 2009, the Company issued 67,308 shares of common stock to Adam Wasserman (CFO) using a fair value of $0.26 per share for services rendered through December 31, 2008 as the Company’s chief financial officer.
In February 2009, the Company issued 48,077 shares of common stock to Mel Rothberg using a fair value of $0.26 per share for director fees from January 1, 2008 to April 15, 2008 and consulting services rendered through November 30, 2008.
F-28