UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





FORM 10-K





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

For the fiscal year ended December 31, 2010


OR





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

For the transition period from  to


COMMISSION FILE NO: 001-32569





AMERICAN ORIENTAL BIOENGINEERING, INC.


(Exact name of registrant as specified in its charter)




NEVADA
84-0605867(State or other jurisdiction ofincorporation or organization)
(I.R.S. EmployerIdentification No.)





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


Beijing, 100176, People’s Republic of China


(Address of principal executive offices) (Zip Code)





86-10-5982-2039


(Registrant’s telephone number, including area code)








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





Common Stock, Par Value $0.001 Per Share
New York Stock Exchange(Title of Class)
(Name of exchange on which registered)





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


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


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


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


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


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


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




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




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


The aggregate market value of the voting stock held on June 30, 2010 by non-affiliates of the registrant was $154,793,767 based on the closing price of $2.52 per share as reported on the New York Stock Exchange on June 30, 2010, the last business day of the registrant’s most recently completed second fiscal quarter (calculated by excluding all shares held by executive officers, directors and holders known to the registrant of five percent or more of the voting power of the registrant’s common stock, without conceding that such persons are “affiliates” of the registrant for purposes of the federal securities laws).


On March 11, 2011, 78,598,604 shares of the registrant’s Common Stock, $0.001 par value and 1,000,000 shares of the registrant’s Class A Preferred Stock, $0.001 par value were outstanding.




DOCUMENTS INCORPORATED BY REFERENCE




None.








TABLE OF CONTENTS





PagePART I
3ITEM 1.
Busines
3ITEM 1A.
Risk Factors
18ITEM 1B.
Unresolved Staff Comments
27ITEM 2.
Properties
27ITEM 3.
Legal Proceedings
28ITEM 4.
(Removed and Reserved)
28PART II
28ITEM 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
28ITEM 6.
Selected Financial Data
30ITEM 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
32ITEM 7A.
Quantitative and Qualitative Disclosures About Market Risk
43ITEM 8.
Financial Statements and Supplementary Data
44ITEM 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
44ITEM 9A.
Controls and Procedures
44ITEM 9B.
Other Information
47PART III
47ITEM 10.
Directors, Executive Officers and Corporate Governance
47ITEM 11.
Executive Compensation
53ITEM 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
61ITEM 13.
Certain Relationships and Related Transactions, and Director Independence
61ITEM 14.
Principal Accounting Fees and Services
62PART IV
64ITEM 15.
Exhibits, Financial Statement Schedules
64Schedule II — Valuation and Qualifying Accounts
65Exhibit Index
66Signatures
69Reports of Independent Registered Public Accounting Firms on Financial Statement Schedule
F-2





1





SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS





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





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





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





2





PART I.





ITEM 1.
BUSINESS


Overview





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





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





Year Ended December 31,2010


2009


2008Revenue from pharmaceutical products

$
250,131,594


$
244,168,159


$
224,904,348Revenue from nutraceutical products


41,020,289



39,125,655



34,266,739Total manufacturing revenue


291,151,883



283,293,814



259,171,087Distribution revenue


14,792,202



12,856,966



5,471,971Total revenues

$
305,944,085


$
296,150,780


$
264,643,058





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





We currently market over 140 pharmaceutical products in China. Two flagship prescription pharmaceutical products currently marketed in China are Shuanghuanglian Lyophilized Injection Powder, or SHL Injection Powder, and Cease Enuresis Soft Gel, or CE Gel. SHL Injection Power is an anti-viral injection effective in treating respiratory infections, bronchitis and tonsillitis, and CE Gel is indicated to alleviate bedwetting. We market our SHL Injection Powder through our brand name SHJ, and our CE Gel through Harbin Three Happiness Bioengineering Co., Ltd, or Three Happiness, which are both well-recognized brand names in China. These products are detailed to physicians at hospitals and clinics through the efforts of our sales force and through educational physician conferences and seminars.





Over-the-counter pharmaceutical products are similar to our prescription pharmaceutical products in that they are approved by the SFDA, but are sold over-the-counter direct to consumers in pharmacies and other retail outlets. Our over-the-counter pharmaceutical products include Jinji Series, Cease Enuresis Patch, and CE Patch, and Boke Series. Jinji Series is a line of products approved for the treatment of various women’s health indications including endometritis, annexitis, pelvic inflammation, premenstrual and menopausal symptoms. CE Patch is a product indicated to alleviate bedwetting and for the treatment of incontinence. Boke Series is a line of nasal products indicated to alleviate sinus infections and nasal congestions. Our Jinji line of products, our CE Patch and our Boke Series are proprietary branded products and have leading market positions in the over-the-counter segments in which they compete and are marketed through our extensive direct-to-consumer advertising campaign. We highlight the quality and benefits of these products through television, newspaper and print advertisements.





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





In October 2008, through the acquisition of Nuo Hua Investment Company Ltd. (“Nuo Hua”), distribution of pharmaceutical products became part of our businesses. Nuo Hua is a holding company with a subsidiary and affiliated company that maintain a significant presence in pharmaceutical wholesale and retail distribution in China. We now distribute more than 13,000 pharmaceutical products.





We own and operate five manufacturing facilities through which we manufacture all of our products. Each facility is Good Manufacturing Practices, or GMP, International Organization for Standardization, or ISO, and Export Product certified.




3




Industry Background and Market Opportunities





The Chinese pharmaceutical and nutraceutical markets are highly fragmented, comprising a large number of small enterprises. We believe that this fragmentation provides opportunities for better managed and more financially sound companies to gain market share by using comparatively strong technical, manufacturing and marketing abilities.





Meanwhile, market conditions continue to be influenced by the evolution of Chinese government healthcare policy. “Opinions of the State Council on Deepening the Reform of the Medical and Health Care System,” issued by The State Council of the People’s Republic of China (“the State Council”) in April 2009, signaled the formal commencement of a major public health initiative by the Chinese government. The goal of this new policy is to provide access to basic medical care for every person in China by 2020.





Subsequent government policy statements related to this reform, including “Opinions on Formulation and Implementation of Essential Drugs List”, and China’s National Medical Insurance Catalog are set to exert considerable, generally positive influence on the Chinese pharmaceutical industry and its future development. For example, as stated above, a major component of these reforms is an effort to extend basic medical insurance coverage to a larger portion of the Chinese population.





Notwithstanding positive factors identified above, we believe an increased dispensing of drugs on the Essential Drugs List (“EDL”) and on National Medical Insurance Catalog (“NIC”) will bring pressure on the pricing of all generic drugs, whether branded or not.  This trend has put a significant squeeze on the profit margins of those manufacturers who make such products, and such negative impacts will only start stabilizing when the price differentiation among the generic drugs, EDL drugs, and NIC drugs are minimized.





Moreover, China’s regulatory agencies have introduced a series of new regulations to control the standards and quality of manufacture and distribution in the pharmaceutical industry. These new regulations require companies to obtain government recognized manufacturing and distribution licenses, GMP and good sales practice certificates, and have resulted in the elimination of many small or poorly managed companies. We believe that this new legislation will precipitate consolidation opportunities and a generally more favorable competitive environment.





Pharmaceutical Market





According to the statistics of China’s National Development and Reform Commission, the pharmaceutical industry in China was approximately $181 billion in 2010. China is expected to become the world’s third largest pharmaceutical market by 2011, which includes western medicine and TCM. This growth is being driven by several factors including improving standards of living and an increase in disposable income fueled by the growing economy, the aging population, the increasing participation in the State Basic Medical Insurance System and the increase in government spending on public healthcare. In January 2009, the Chinese government approved a healthcare reform plan and has budgeted for RMB 850 billion, or $124 billion, in a three year program to make medical services and products more affordable and accessible to the whole population.





Traditional Chinese Medicine Market





The traditional Chinese medicine, or TCM market for pharmaceutical products in China was approximately $40 billion in 2010, accounting for about 22% of all expenditures on medicine within the China. TCM, mostly made of botanical plants, has thousands of years of history and is well accepted in China. The traditional formulations, mostly in large dosage of bitter tasting soups, is being upgraded into more convenient formulations, such as tablets, gels, injectables, etc. for improved convenience and sometimes, for improved efficacy.





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





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





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





●
China’s longstanding preference for TCM remedies;





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





●
existence of well-recognized brands supported by a long history;





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





●
lower pricing as compared to western medicine.





4




Nutraceutical Market





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





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





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





Financial Information about Industry Segments





Since October 2008, we have two operating segments based on our major lines of businesses: manufacturing and distribution. For additional information please refer to Note 20 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2010.





Our Strengths





We believe we have the following competitive strengths that could enable us to capitalize on the large, fragmented and growing market for our pharmaceutical and nutraceutical products.





●
Fully Integrated Platform for Sustainable Growth. We are a vertically integrated pharmaceutical and nutraceutical company with our own development, manufacturing, commercialization and distribution capabilities for the prescription pharmaceutical, over-the-counter pharmaceutical and nutraceutical markets. Our nationally recognized branded products are distributed to all provinces, including rural areas and major cities in China. We believe these capabilities can be leveraged to provide substantial organic growth across all of our product categories and can serve as a platform for integrating additional acquisitions.





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





●
Well-Recognized Brand Names That Can be Leveraged for Additional Growth. We have nationally recognized brand names in China, including, Jinji, SHJ, Boke and Three Happiness. We believe these brand names will allow continued sales growth for our existing products and can be leveraged further with product line extensions and by establishing brand families for related products. For instance, our Jinji product line enjoys particularly strong brand recognition in the women’s health market. We believe we can significantly capitalize on this strength for future product introductions to treat other women’s health indications and as we expand into other therapeutic categories.





●
Demonstrated Ability to Identify and Integrate Acquisitions. We have completed and integrated seven acquisitions from year 2004 to year 2008, each of which has contributed to our revenue and earnings growth. These acquisitions also added value to our brands, enhanced our products development capabilities, expanded our distribution networks and broadened our products offering. Our disciplined approach to acquisitions is based on well-defined criteria and is supported by multi-disciplinary team dedicated to these business development activities, which we believe positions us well to participate in further consolidation in our industries.





●
Experienced and Results-Oriented Management Team. Major members of our senior management team have worked together for over 17 years and have contributed significantly to the growth of our business. Our management team has extensive experience with the People’s Republic of China, or PRC, government and the market for pharmaceutical and nutraceutical products. Our management team encourages a strong corporate culture, which we believe contributes to our overall results.




5




●
Centralized R&D function to generate robust pipeline of new products.In addition to a portfolio of prescription and over-the-counter pharmaceutical products that are approved by SFDA, but have not been commercially launched, we are also building a centralized R&D function to generate pipeline of new products. We believe that as a company with our own proprietary technology and patented products we will be more competitive and can command a higher margin for our products.





Our Strategy





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





●
Cultivating AOBO as a Unified Mega Brand in Its Own Right, Fusing the Synergy among Our Nationally Established Individual Brands, such as, Jinji, Boke, CE, etc.Our vision is to create a unified mega brand for AOBO so that we can leverage on the establishment of all individual brands of ours to boost our chance of winning in the government sponsored competitive tendering processes for EDL products as well as those on the national insurance catalogs.  We believe a reasonably priced product with a brand name will be more appealing to consumers, patients, and doctors.





●
Promoting Our Existing Brands to Maintain National Recognition. We intend to support and grow the existing recognition and reputation of our brands and to maintain our branded pricing strategy through continued sales and marketing efforts. To achieve this goal, we plan to:





●
detail the efficacy and safety profile of our established prescription pharmaceutical products to physicians at hospitals and clinics in all provinces in China through the efforts of our sales force and through educational physician conferences and seminars; and





●
expand our extensive direct-to-consumer advertising campaign highlighting the quality and benefits of our fast growing over-the-counter pharmaceutical products through television, newspaper and print advertisements.





●
Developing and Introducing Additional Products to Expand or Strengthen Our Existing Portfolio. We plan to focus our research and development capabilities towards expanding our existing portfolio of approved products. We have over 400 prescription and over-the-counter pharmaceutical products in our portfolio that are currently approved but have not been commercially launched. In addition, we intend to conduct clinical trials for new modernized products and product line extensions for our existing products. We plan to introduce other proprietary products to leverage our branded market leadership position, particularly in the therapeutic areas we already have an establishment to develop product line extensions for our existing products and areas such as cancer and cardiovascular disease.





●
Expanding Our Distribution Network For Further Market Penetration. We intend to expand our reach beyond the current distribution points in China to drive additional growth of our existing and future products. We currently contract with over 320 distributors in China and plan to expand upon these relationships to target new markets. In addition, we plan to continue to broaden our marketing efforts outside of major cities in China and increase our market penetration in cities and rural areas where we already have a presence.








We also intend to expand our presence beyond China to international markets. We plan to work with other international pharmaceutical companies in cross selling of our products.





●
Acquiring Complementary Products Lines, Technologies, Distribution Networks and Companies. We intend to selectively pursue strategic acquisition opportunities that we believe would grow our customer base, expand our product lines and distribution network, enhance our manufacturing and technical expertise or otherwise complement our business or further our strategic goals. Pursuing additional acquisitions is a significant component of our growth strategy.





Research and Development





We believe science, technology and innovation represent a significant part of our business. We spent $15.3 million in 2010 or 5% of the total revenues, compared to $7.9 million in 2009 and $1.5 million in 2008. The costs of Company-sponsored research activities relating to the development of new products, improvement of existing products, and technical support of products.





We believe that, investment in R&D and innovation could help us to meet new product launch target and improve sustainable long term growth. In 2009, we established new and advanced R&D center in Beijing. As of December 31, 2010, we had more than 130 special talents in multiple research and development centers in both China and the U.S., including top talented people with maser and doctor degrees. Our research and development facility in New Jersey coordinates our global research and development efforts, leveraging the core competencies of each of our centers. Since 2008, we have launched over 27 new products, achieved over $46 million revenues, or 19% of our total revenue from pharmaceutical products in 2010.




6




Our research and development efforts fall into three categories, namely, the near term, intermediate term, and long term. In the near term we focus on the development, by which we mean our interest will remain in innovations in life cycle management and technology upgrade on existing products, so that safety and efficacy can be improved, or, new indications can be developed for the treatment of additional diseases. We may also in license some drug product candidates at late stage development for further development, so that the time to potential commercialization may be drastically reduced.  The goal is to launch more competitive products with a relatively short timeframe. For our long term efforts, we plan to enter major therapeutic areas, such as cancer and cardiovascular diseases.





We remain focused on overall operation’s profitability and maintaining control of working capital. We establish collaborative projects across traditional boundaries, to share experience and goals. Our risk-sharing partners including but not limited to universities, labs, or other pharmaceutical companies. In this way, we believe that we can significantly reduce the time and resources that would be otherwise required.





We have made and expect to continue making substantial efforts in research and development activities. We believe that our emphasis on research and development investment is the most important core competency that we have to achieve our historic growth and maintain growth possibilities going forward.





Our Products





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





We currently manufacture and sell over 140 products. The following table summarizes our principal marketed pharmaceutical and nutraceutical products that comprised the majority of our revenue in the year of 2010.





Product

Distribution

Point

Indication

Insurance coveragePharmaceutical ProductsShuanghuanglian Lyophilized Injection Powder

Rx

Respiratory infections, bronchitis and tonsillitis

National Insurance CatalogCease Enuresis Soft Gel

Rx

Bedwetting

NoneCease Enuresis Patch

OTC

Bedwetting and incontinence

NoneJinji Capsule

Rx&OTC

Endometritis, annexitis and pelvic inflammations

National Insurance CatalogJinji Yimucao

OTC

Premenstrual syndrome, or PMS, and other PMS and menopause-related symptoms

Essential Drug ListBoke Nasal Spray

OTC

Nasal congestion and sinus infection

National Insurance CatalogNutraceutical ProductsSoy Peptide Series

OTC

Nutritional products for overall health and well-being

None





7





Prescription Pharmaceutical Products





Shuanghuanglian Lyophilized Injection Powder





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





Our SHL Injection Powder was commercially launched in China in 1997 by HSPL, which we acquired in 2004. We detail the safety and efficacy of this product to physicians in hospitals and clinics primarily in rural China. We believe that injectables are of higher quality and offer better bioavailability and efficacy than oral formulations. We are one of the two companies approved by the Ministry of Health to manufacture and commercialize SHL injection powder. This product is manufactured at our Heilongjiang Songhuajiang Pharmaceutical, or HSPL, facility in Harbin.





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





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





Cease Enuresis Soft Gel





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





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





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





Over-the-Counter Pharmaceutical Products





Cease Enuresis Patch





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





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





8





Jinji Capsule





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





Our Jinji Capsule was commercially launched approximately 30 years ago in China by GLP, which we acquired in April 2006. With its long history, the Jinji brand name is well-recognized in the women’s health market in China. We promote our Jinji Capsule through direct-to-consumer advertising, including an extensive television commercial campaign. These commercials are televised nationally in China. We believe that these advertisements continue to strengthen our brand loyalty, a major driver of the historical popularity of the drug. This product is manufactured at our Guangxi Lingfeng Pharmaceutical Co., or GLP, facility in Hezhou in the Guangxi Province in Southwestern China.




Phase 3 clinical trials for Jinji Capsule were conducted on 421 female patients at Wuzhou City People’s Hospital, Wuzhou City Workers’ Hospital and Hezhou TCM Hospital. These trials demonstrated safety and efficacy in accordance with SFDA requirements.





Jinji Yimucao





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





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





Boke Nasal Spray





Our Boke nasal spray is an over-the-counter pharmaceutical product approved and marketed for the treatment of sinus congestion from common cold, stuffy nose, chronic rhinitis, allergic rhinitis and nasosinusitis. The spray is marketed under the product name of Ditong Biyanshui Penwuji (“Ditong”). Ditong is approved by the SFDA in China and marketed as a branded drug. This product consists of a combination of many parts of TCM plants, including roots, vines, flowers and stems. Treatment dosage is three to four times a day and two sprays into each nostril.





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





Principal Nutraceutical Products





Soy Peptide Series





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





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





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Product Pipeline





We have our own research, development and laboratory facilities and retain our own professional research and development team. We have also entered into joint research and development agreements with outside research institutes in China and in the United States. We have a portfolio of approved prescription and over-the-counter pharmaceutical products that have not been commercially launched. We continue to strengthen our research and development efforts through the establishment of our research facility in Beijing and had retained a number of highly respected talents in the industry. We intend to continue introducing new modernized products to leverage our branded market leadership position, and to develop line extensions for our existing products.




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





Marketing and Sales





We focus our marketing efforts on establishing business relationships and growing our brand recognition.In 2010,  we manufactured and marketed more than 140 products. In 2010, we made special efforts on our prescription and generic products’ market based on the changing pharmaceutical environment and we penetrated major cities and rural areas, including hospitals, clinics, pharmacies and retail stores.Our investments in marketing and TV advertising have generated a positive effect on sales. While marketing and promotional expenses for newly-launched products have impacted our short-term profitability, this is in line with our strategy of investing in new products we feel have good potential for growth in the future.





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





We maintain approximately 100 regional representative offices throughout China and employ approximately 2,100 sales and marketing professionals in major cities and extensive rural areas Through their regular meetings with physicians and hospital administrators, the organization of academic seminars and conferences, and assisting with clinical trials, our salespeople can effectively communicate the therapeutic benefits of our products to physicians and hospital administrators. Specifically, our senior personnel in the prescription sales force typically interact with the heads of a hospital administration and the persons in charge of the relevant departments to seek the inclusion of our products in the hospital’s formulary. Our middle-level and junior personnel typically meet with individual physicians to promote the therapeutic value and other features of our products.





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


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





Distributors and Customers





We sell part of our products to third-party distributors who resell these products to hospitals and retail pharmacies. In addition, these distributors also handle distribution logistics, warehousing and transportation.As of December 31, 2010, our national distribution network consisted of more than 570 distributors covering major cities and extensive rural areas in China.The breadth of our distribution channel allows us to target distribution points comprising hospitals, clinics, pharmacies and retail stores.





We make selections based on factors such as sales experience, knowledge of the products, contacts in the hospital and communities, reputation and market coverage.We do not enter into exclusive distribution agreements with these third party distributors.





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


The distribution industry in China is fragmented with over 10,000 distributors. Due to the number of distributors, we do not rely on any one distributor for our distribution needs. We estimate that our top 10 distributors account for only approximately 13% of our total sales.





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In October 2008, through the acquisition of Nuo Hua, distribution of pharmaceutical products became part of our business. Through Nuo Hua’s subsidiary and affiliated company, we now distribute more than 13,000 pharmaceutical products through an extensive sales network covering major urban and rural areas in China.





Manufacturing





We employ a vertically integrated operating model that enables us to efficiently develop, manufacture and market quality products at competitive prices. Our manufactories work closely with research and development team to optimize manufacturing processes and develop commercially viable products. In addition, our manufactories incorporate regular feedback from our sales and marketing personnel, enabling us to timely and cost-effectively introduce products tailored to end-user needs. Furthermore, our manufacturing operations, which are based primarily in China, provide us with a distinct competitive advantage in the markets by enabling us to leverage low-cost technical expertise, labor, raw materials, and facilities. As part of our overall strategy to lower production costs through our vertically integrated operating model, we have made substantial investments in our in-house manufacturing infrastructure to complement our research and development, product design activities, capacity improvement, and efficiency enhancement.





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





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





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





The details of our facilities are as follows:





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





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





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





●
CCXA. Our CCXA facility is located in ChangChun, the capital of Jilin Province in northeast China. It is approximately1,357,220 square feet and manufactures a variety of generic pharmaceutical products.





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





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





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Raw Materials





Our production facilities are located in China certain regions, which allow us to maintain close relationships with suppliers of medicinal herbs, to have lower transportation costs and they give us the option of farming our own medicinal herbs, which we believe is a competitive advantage. Historically, we have not had difficulty obtaining raw materials from suppliers. Currently, we rely on numerous suppliers to deliver our required raw materials.




The increase in raw materials cost should be viewed against the macro economic conditions in China. Industry research indicates that TCM raw materials price will continue to increase. The impact of such inflation will vary depending on different products that require different TCM raw materials. We continue to take different approach to reduce the risk of over reliance on certain raw materials, including entering arrangements with numerous suppliers in China to hedge against the risk of short supply due to irregularities in seasonal temperatures. We have started to invest in the plantation of certain key raw materials of our products. We believe it is important to control the upper chain of the raw material supply in order to have steady quality, rational price and sufficient quantity raw materials in the future.





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





Intellectual Property





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





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





To a large extent, we rely on such State Protection law to protect our intellectual property rights with respect to some of our products. As of March 11, 2011, we owned a total of 48 patents and the number of patents in the process of application is 33; and have registered a total of 266 trademarks and the number of trademarks in the process of application is 10.





The Company has the following invention patents related to material products:





Application No./Patent No.
Product Covered
Purpose
Expiration Date00103392.1
Soybean Peptides
the equipment and method of producing small molecular peptides from protein separated from soybean
3/01/2020200410043925.0
SHL
the production method of  injection powder
10/11/2024200510055523.7
Jinji Capsule
a drug for treatment of pelvic inflammatory disease and its production method
3/16/2025200510010531.X
CE Gel
a method for quality control of the production of WenGuanGuoZiRen cream
11/11/2025200610009619.4
CE Patch
a method for the extraction of effective portion of WenGuanGuoZiRen
1/12/2026144459.0
CE Patch
the extraction of WenGuanGuoZiRen, its method of extraction and usage
1/12/2026





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





Application No.
Purpose
Expiration Date200630157478.1
packaging box for CE Patch
12/4/2016200630157477.7
packaging box for CE Capsule
12/4/2016200630157479.6
packaging box for SHL Injection Powder
12/4/2016200730145294.8
packaging box for Jinji Yimucao
4/30/2017200830113220.0
packing box for Ditong rhinitis Spray
9/05/2018





Competition





We believe that we are well positioned to compete in the fast-developing Chinese pharmaceutical and nutraceutical market with our strong brand, diverse product portfolio, research and development capabilities, established sales and marketing network and favorable cost structure. We believe that competition and leadership in our industry are based on managerial and technological expertise, and the ability to identify and exploit commercially viable products. Other factors affecting our competitive position include time to market, patent position, product efficacy, safety, convenience, reliability, availability and pricing.





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





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





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





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





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





There are relatively well capitalized and established players in the pharmaceutical distribution business, such as Sinopharm, Jointtown, just to name a few, which have built an intensive nationwide network while our distribution business is relatively regionally strong.





Environmental Matters





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





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





Employees





We had 4,295 employees as of December 31, 2010. Approximately 1,484 of these employees are principally engaged in manufacturing and services activities, 2,114 in sales and marketing, 134 in research and development and 563 in management and administration. We continue to monitor our headcount and may add additional employees for sales and marketing, research and development, customer service and manufacturing and assembly as our business grows. In general, we consider our relationship with our employees to be good.





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Insurance





We currently carry insurance policies which are customary for enterprises in China providing for total coverage of approximately $75.01 million. We have property coverage of approximately $57.21 million, motor vehicle coverage of approximately $1.32 million and employee health and accident coverage of approximately $5.53 million. We also maintain Director and Officer Insurance coverage of $11 million. We paid aggregate insurance premiums of $351,269 in 2010.





Our History





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





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





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





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





Regulations of Our Industry





Regulations Relating to the Pharmaceutical Industry





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





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





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





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Provisional National Production Standard.In connection with the SFDA’s approval of a new medicine, the SFDA will normally direct the manufacturer to produce the medicine according to a provisional national production standard, or a provisional standard. A provisional standard is valid for two years, during which the SFDA closely monitors the production process and quality consistency of the medicine to develop a national final production standard for the medicine, or a final standard. Three months before the expiration of the two-year period, the manufacturer is required to apply to the SFDA to convert the provisional standard to a final standard. Upon approval, the SFDA will publish the final standard for the production of this medicine. In practice, the approval for conversion to a final standard is a time-consuming process. However, during the SFDA’s review period, the manufacturer may continue to produce the medicine according to the provisional standard.





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





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





Pharmaceutical Product Manufacturing





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





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





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





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





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





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





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





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





Reimbursement under the National Medical Insurance Program. The Ministry of Labor and Social Security, together with other government authorities, determines which medicines are to be included in or removed from the national medicine catalog for the National Medical Insurance Program, and under which tier a medicine should fall, both of which affect the amounts reimbursable to program participants for their purchases of those medicines. These determinations are based on a number of factors, including price and efficacy. A National Medical Insurance Program participant can be reimbursed for the full cost of a Tier 1 medicine and 80 to 90% of the cost of a Tier 2 medicine. Although it is designated as a national program, the implementation of the National Medical Insurance Program is delegated to various provincial governments, each of which has established its own medicine catalog. A provincial government must include all Tier 1 medicines listed in the national medicine catalog in its provincial medicine catalog, but may use its discretion based on its own selection criteria to add other medicines to, or exclude Tier 2 medicines listed in the national medicine catalog from, its provincial medicine catalog, so long as the combined numbers of the medicines added and excluded do not exceed 15% of the number of the Tier 2 medicines listed in the national catalog. In addition, provincial governments may use their discretion to upgrade a nationally classified Tier 2 medicine to Tier 1 in their provincial medicine catalogs, but may not downgrade a nationally classified Tier 1 medicine to Tier 2. The total amount of reimbursement for the cost of prescription and over-the-counter medicines, in addition to other medical expenses, for an individual program participant in a calendar year is capped at the amount in that participant’s individual account. The amount in a participant’s account varies, depending upon the amount of contributions from the participant and his or her employer. Generally, program participants who are from relatively wealthier eastern parts of China and relatively wealthier metropolitan centers have greater amounts in their individual accounts than those from less developed provinces.





Regulation Relating to the Nutraceutical Industry





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





Registration of Health Products





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





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





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





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





Permits and Licenses for manufacturing of Health Foods





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





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





Compliance with GMP





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





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





Label of Health Food





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





Other Regulations





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





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




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





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





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





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





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





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





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





Available Information





We make available free of charge on or through our internet website,www.bioaobo.com, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to those reports, if any, filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission. We also make available free of charge on our internet website,www.bioaobo.com, our Amended and Restated Code of Ethics, Amended and Restated Nominating and Corporate Governance Committee Charter, Second Amended and Restated Compensation Committee Charter and Charter of the Audit Committee. The information contained on our website is not intended to be incorporated into this Annual Report on Form 10-K.


ITEM 1A.
RISK FACTORS





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





Risks Related to Our Business and Industry





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





Our top six products, which comprise Shuanghuanglian Lyophilized Injection Powder, or SHL Injection Powder, CE Gel, Jinji Capsule, Jinji Yimucao, Soybean Peptide Tablets and Boke Nose Spray, constituted approximately 59% of our total revenues in 2010 and 67% of our total revenues in 2009. We expect that these six products will continue to account for a majority of our sales in the near future. Because of our dependence on a few products, any disruption in, or compromise of, our manufacturing operations, sales operations or distribution channels, relating to any of these products could result in our failure to meet shipping and delivery deadlines or meet quality standards, which in turn could result in the cancellation of purchase orders, refusal to accept deliveries or a reduction in purchase prices, any of which could have a material adverse effect on our financial condition and results of operations.





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





Consumer spending is generally affected by a number of factors, including general economic conditions, the level of unemployment, inflation, interest rates, energy costs, gasoline prices and consumer confidence generally, all of which are beyond our control. Consumer purchases of discretionary items tend to decline during recessionary periods, when disposable income is lower, and may impact sales of our products. In addition, sudden disruptions in business conditions as a result of a terrorist attack, retaliation and the threat of further attacks or retaliation, war, adverse weather conditions and climate changes or other natural disasters, pandemic situations or large scale power outages can have a short or, sometimes, long-term impact on consumer spending. A downturn in the economy in China, including any recession or a sudden disruption of business conditions in those economies, could adversely affect our business, financial condition, and results of operation.





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





We compete with other companies, many of whom are developing, or can be expected to develop, products similar to ours. Some of our competitors are more established than we are, have greater brand recognition of products that compete with ours, have more financial, technical, marketing and other resources than we presently possess and a larger customer base. These competitors may be able to respond more quickly to new or changing opportunities and customer requirements and may be able to undertake more extensive promotional activities, offer more attractive terms to customers or adopt more aggressive pricing policies. Our commercial opportunity will be reduced or eliminated if our competitors develop and commercialize products that are safer, more effective, have fewer side effects, are less expensive or have more attractive product characteristics than our current products or products that we may develop in the future. We cannot assure you that we will be able to compete effectively with current or future competitors or that the competitive pressures we face will not harm our business.





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





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





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





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





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





Even if we complete one or more strategic transactions, we may be unable to integrate or coordinate successfully the personnel and operations of a business. Integration of acquired business operations could disrupt our business by diverting management away from day-to-day operations. The difficulties of integration may be increased by the necessity of coordinating geographically dispersed organizations, integrating personnel with disparate business backgrounds and combining different corporate cultures. We also may not be able to maintain key employees or customers of an acquired business or realize cost efficiencies or synergies or other benefits we anticipated when selecting our acquisition candidates. In addition, we may incur non-recurring severance expenses, restructuring charges and change of control payments and may need to record write-downs from future impairments of intangible assets, which could reduce our future reported earnings. At times, acquisition candidates may have liabilities or adverse operating issues that we fail to discover through due diligence prior to the acquisition.





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





We may face difficulties in implementing our organic growth strategy.





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




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





In order to maximize potential growth in our current and potential markets, we believe that we must expand our manufacturing and marketing operations. To this end, we are and expect to continue to increase our employee headcount which will place a strain on our management and on our operational, accounting, and information systems. Our need to manage our operations and growth effectively requires us to continue to expend funds to improve our financial controls, operating procedures, management information systems, reporting systems and procedures to manage our increased operations. If we are unable to implement improvements to our management information and control systems successfully in an efficient or timely manner, or if we encounter deficiencies in our existing systems and controls, then management may receive inadequate information to manage our day-to-day operations. We will also need to effectively train, motivate and manage our employees. Our failure to manage our growth could disrupt our operations and ultimately prevent us from generating the revenues we expect.





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





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





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





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





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





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





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





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





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





●
decreased demand for our products;





●
adverse publicity resulting in injury to our reputation;





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●
product liability claims and significant litigation costs;





●
substantial monetary awards to or costly settlements with consumers;





●
product recalls;





●
loss of revenues; or





●
the inability to commercialize future products.





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





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





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





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





We may incur significant costs associated with our public company reporting requirements, costs associated with applicable corporate governance requirements, including requirements under the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley, and other rules implemented by the Securities and Exchange Commission and the New York Stock Exchange, or NYSE. We expect all of these applicable rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly. We also expect that these applicable rules and regulations may make it more difficult and more expensive for us to obtain director and officer liability insurance and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. As a result, it may be more difficult for us to attract and retain qualified individuals to serve on our Board of Directors, on committees of our Board of Directors or as executive officers.





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





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





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





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





Risks Related to Inflation in Raw Materials





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





Risks Related to China





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





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





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





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





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





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





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





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





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





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





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





Accordingly, government actions in the future, including any decision not to continue to support recent economic reforms and to return to a more centrally planned economy or regional or local variations in the implementation of economic policies, could have a significant effect on economic conditions in China or particular regions thereof, and could require us to divest ourselves of any interest we then hold in Chinese properties or joint ventures.





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





The PRC legal system is a civil law system. Unlike the common law system, the civil law system is based on written statutes in which decided legal cases have little value as precedents. In 1979, the PRC government began to promulgate a comprehensive system of laws and has since introduced many laws and regulations to provide general guidance on economic and business practices in China and to regulate foreign investment. Progress has been made in the promulgation of laws and regulations dealing with economic matters such as corporate organization and governance, foreign investment, commerce, taxation and trade. The promulgation of new laws, changes of existing laws and the abrogation of local regulations by national laws could have a negative impact on our business and business prospects. In addition, as these laws, regulations and legal requirements are relatively recent, their interpretation and enforcement involve significant uncertainty.





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





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





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





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





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





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





Between 1994 and 2004, the exchange rate for RMB against the U.S. dollar remained relatively stable, most of the time in the region of approximately RMB8.28 to US$1.00. However, in 2005, the Chinese government announced that it would begin pegging the exchange rate of the RMB against a number of currencies, rather than just the U.S. dollar. As our operations are primarily in China, any significant revaluation of the RMB may materially and adversely affect our cash flows, revenues, financial condition and the value of our common stock. For example, to the extent that we need to convert U.S. dollars into RMB for our operations, appreciation of this currency against the U.S. dollar could have a material adverse effect on our business, financial condition, results of operations and the value of our common stock. Conversely, if we decide to convert our Renminbi into U.S. dollars for the purpose of declaring dividends on our common stock or for other business purposes and the U.S. dollar appreciates against the RMB, the U.S. dollar equivalent of our earnings from our subsidiaries in China would be reduced.





Future inflation in China may inhibit our ability to conduct business in China.





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





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





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





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





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





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





We are subject to many general regulations governing business entities and their behavior in China and in other jurisdictions in which we have operations. In particular, we are subject to laws and regulations covering food, dietary supplements and pharmaceutical products. Such regulations typically deal with licensing, approvals and permits. Any change in product licensing may make our products more or less available on the market. Such changes may have a positive or negative impact on the sale of our products and may directly impact the associated costs in compliance and our operational and financial viability. Such regulatory environment also covers any existing or potential trade barriers in the form of import tariffs and taxes that may make it difficult for us to import our products to certain countries and regions, such as Japan, South Korea and Hong Kong, which would limit our international expansion.





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





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





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





There have been recent incidents reported in the Chinese media of a significant number of patients experiencing severe adverse health consequences following their use of pharmaceutical products manufactured by certain pharmaceutical companies in China. A number of patients have become ill and a number of fatalities have been reported. For example, several deaths were caused by drugs sold by the Second Pharmaceutical Factory of Qiqihaer, a Chinese drug manufacturer, in May 2006. Concerns over the safety of pharmaceutical products manufactured in China could have an adverse effect on the sale of such products, including products manufactured by us. If in the future we become involved in incidents of the type described above, such problems could severely and adversely impact our product sales and reputation.





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





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





Risks Related to Our Common Stock





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





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




25




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





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





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





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





●
changes in laws or regulations applicable to our products;





●
period to period fluctuations in our operating results;





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





●
changes in financial estimates or recommendations by securities analysts;





●
conditions or trends in our industry;





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





●
developments in domestic and international governmental policy or regulations;





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





●
additions or departures of key personnel;





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





●
additional sales of our common stock by us; and





●
sales and distributions of our common stock by our shareholders.





In the past, shareholders have often instituted securities class action litigation after periods of volatility in the market price of a company’s securities. If a shareholder files a securities class action suit against us, we would incur substantial legal fees and our management’s attention and resources would be diverted from operating our business in order to respond to the litigation.





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





Our officers, directors and holders of more than five percent of our outstanding shares of common stock, together control approximately 46.0% of the voting power of our stock, of which approximately 39% is controlled by Tony Liu, our Chairman and Chief Executive Officer. In particular, Mr. Liu owns 1,000,000 shares of Series A preferred stock, which shares by their terms have aggregate voting power equal to 25.0% of the combined voting power of our common and preferred stock. Moreover, this voting power cannot be diluted or reduced by the issuance of additional shares of common stock, meaning that the holder or holders of our Series A preferred stock will always possess 25.0% of the aggregate voting power of our common and preferred stock. As a result, Mr. Liu, or these shareholders acting together, will be able to exert a significant degree of influence over our management and over matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions. In addition, this concentration of ownership may delay or prevent a change in control of our company and might affect the market price of our common stock, even when a change may be in the best interests of all shareholders. In addition, the interests of our officers, directors and principal shareholders may not always coincide with our interests or the interests of other shareholders and, accordingly, these control persons could cause us to enter into transactions or agreements that we would not otherwise consider.





26





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





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





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





We may never pay any dividends to our shareholders.





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





ITEM 1B.
UNRESOLVED STAFF COMMENTS





None.





ITEM 2.
PROPERTIES





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





Subsidiary

Facilities

Size of Land

Land Use Right

ExpiresThree Happiness

GMP Manufacturing, warehouse and office

1,532,775 sq. feet

2055-2056HSPL

GMP Manufacturing, warehouse and office

532,339 sq. feet

2055GLP

GMP Manufacturing, warehouse and office

1,875,287 sq. feet

2045-2059CCXA

GMP Manufacturing, warehouse and office

1,357,220 sq. feet

2052-2058BOKE

GMP Manufacturing, warehouse and office

174,280 sq. feet

2052





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





In addition to the above, we own a 2,637 square feet office in Hong Kong. We lease approximately 100 sales representative offices throughout China and we lease offices in Shenzhen and New Jersey. All leases are for a term of one year and are renewable.




27


ITEM 3.
LEGAL PROCEEDINGS


We are not involved in any litigation that we believe could have a material adverse effect on our financial position or results of operations. There is no action, suit, proceeding, inquiry or investigation before or by any court, public board, government agency, self-regulatory organization or body pending or, to the knowledge of our executive officers or any of our subsidiaries, threatened against or affecting our company, our common stock, any of our subsidiaries or of our companies or our Company’s subsidiaries’ officers or directors in their capacities as such, in which an adverse decision could have a material adverse effect.





ITEM 4.
REMOVED AND RESERVED





PART II





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





Our common stock has been listed for trading on the New York Stock Exchange, or NYSE, under the ticker symbol “AOB” since December 18, 2006. The following table shows the high and low closing sales price for our common stock reported by the NYSE from January 1, 2009 to March 11, 2011.





Year

Period

High


Low2009

First Quarter

$
7.39


$
3.30Second Quarter

$
5.45


$
3.88Third Quarter

$
6.24


$
4.62Fourth Quarter

$
4.76


$
3.772010

First Quarter

$
4.83


$
4.03Second Quarter

$
4.24


$
2.52Third Quarter

$
2.61


$
2.17Fourth Quarter

$
2.99


$
2.182011

First Quarter (January 1 – March 11)

$
2.56


$
2.24





Stockholders and Dividends





As of March 11, 2011, there were approximately 200 record holders of our common stock.





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





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





Issuances of Unregistered Securities





On December 7, 2010, the Company issued 8,466 shares of common stock to a consultant for advisory services rendered in 2010 and to be rendered in 2011. The issuance of the foregoing shares was exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended.





28





Equity Compensation Plan Information





The following table sets forth aggregate information regarding our equity compensation plans in effect as of December 31, 2010:





Number of

securities to be

issued upon

exercise of

outstanding options,

warrants

and rights


Weighted-average

exercise price of

outstanding

options, warrants

and rights


Number of

securities

remaining

available for

future issuance

under equity

compensation

plans (excluding

securities reflected

in column (a))Plan category

(a)


(b)


(c)Equity compensation plans approved by security holders (1)


2,947,281


$
7.81



2,052,719Equity compensation plans not approved by security holders


-0-



-0-



-0-Total


2,947,281


$
7.81



2,052,719





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








Stock Price Performance Graph





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




COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*


Among American Oriental Bioengineering, the NYSE Composite Index


and a Peer Group










COMPARISON OF CUMULATIVE TOTAL RETURN OF ONE OR MORE


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





YEAR ENDINGCOMPANY/INDEX/MARKET

12/31/2005


12/29/2006


12/31/2007


12/31/2008


12/31/2009


12/31/2010American Oriental Bioengineering


100.00



264.63



251.25



153.97



105.44



54.42NYSE Market Index


100.00



120.47



131.15



79.67



102.20



115.88Peer Group


100.00



115.87



120.90



98.88



112.21



115.67





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





29





Equity Repurchases





In connection with the private placement pursuant to Section 4(2) of the Securities Act of $115,000,000 principal amount of 5% Convertible Senior Notes due 2015 (the “Notes”) at a purchase price of $1,000 per Note to several “qualified institutional buyers,” as defined in Rule 144A under the Securities Act, the Company purchase shares of its common stock in the approximate value of $30.0 million.





Issuer Purchases of Equity Securities





Period

Total Number

of Shares

of Common Stock

Purchased


Average Price Paid

per Share of

Common Stock


Total Number

of Shares of

Common Stock

Purchased as

Part of Publicly

Announced Plans


Maximum Number

(or Approximate

Dollar Value) of

Common Stock

that May Yet

Be Purchased

Under the Plans

or Programs7/15/2008


3,712,700


$
8.08



3,712,700


$
45,000,000




ITEM 6.
SELECTED FINANCIAL DATA


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





The selected financial information for each of the three years ended December 31, 2010, 2009 and 2008 has been derived from, and should be read in conjunction with, the audited consolidated financial statements and other financial information presented elsewhere herein. The selected financial information for the year ended December 31, 2007 and 2006 has been derived from the Company’s Annual Report on Form 10-K for the year ended December 31, 2007 and are not included herein. Capitalized terms are as defined and described in the consolidated financial statements or elsewhere herein.





The selected financial information for the year ended December 31, 2008 reflects the acquisition of Nuo Hua on October 18, 2008 and the acquisition of GHK on October 20, 2008. The selected financial information for the year ended December 31, 2007 reflects the acquisition of CCXA on September 6, 2007 and the acquisition of Boke on October 18, 2007. The selected financial information for the year ended December 31, 2006 reflects the acquisition of the GLP effective in May 2006 and the acquisition of HQPL effective in July 2006.





30





Five Year Financial Summary





Year Ended December 31,2010


2009


2008


2007


2006Statement of Operations Data:Revenues

$
305,944,085


$
296,150,780


$
264,643,058


$
160,482,383


$
110,182,092Cost of sales


148,186,531



129,367,775



91,031,274



49,364,486



38,318,223GROSS PROFIT


157,757,554



166,783,005



173,611,784



111,117,897



71,863,869Selling, general and administrative expenses


66,439,702



62,164,936



57,849,286



33,631,194



18,580,864Advertising costs


38,920,905



31,896,992



34,102,538



22,865,903



15,174,125Research and development costs


15,365,131



7,922,357



1,528,991



870,219



742,705Depreciation and amortization


6,662,237



6,038,625



4,383,215



1,989,425



988,488Purchased in-process research and development


—



—



12,255,248



—



—INCOME FROM OPERATIONS


30,369,579



58,760,095



63,492,506



51,761,156



36,377,687Equity in earnings (loss) from unconsolidated entities


384,991



2,075,139



(1,132,986
)


23,711



(3,811)Interest (expense) income, net


(5,900,055)



(5,746,382
)


(2,571,015
)


617,524



574,172Other expense, net


(204,736)



(569,661
)


(65,843
)


(525,065
)


(329,987
)INCOME BEFORE INCOME TAX


24,649,779



54,519,191



59,722,662



51,877,326



36,618,061Income tax


8,336,366



13,216,986



12,635,472



8,011,248



7,416,915NET INCOME


16,313,413



41,302,205



47,087,190



43,866,078



29,201,146Net loss(income) attributable to non-controlling interest


27,937



118,945



(27,575)



—



—NET INCOME ATTRIBUTABLE TO CONTROLLING INTEREST

$
16,341,350


$
41,421,150


$
47,059,615


$
43,866,078


$
29,201,146EARNINGS PER COMMON SHAREBasic

$
0.22


$
0.56


$
0.62


$
0.63


$
0.47Diluted

$
0.22


$
0.53


$
0.61


$
0.61


$
0.46WEIGHTED AVERAGE COMMON SHARES OUTSTANDINGBasic


74,810,016



74,612,602



76,504,035



69,870,775



62,679,996Diluted


75,724,826



89,286,621



82,254,185



71,364,244



62,913,961





December 31,2010


2009


2008


2007


2006Balance Sheet Data:Cash and cash equivalents

$
94,568,520


$
91,126,486


$
68,060,769


$
166,410,075


$
87,784,419Working capital


162,175,191



130,943,266



87,082,705



180,536,568



92,252,071Total assets


611,544,992



576,481,765



528,675,732



358,351,088



188,468,241Total debt (including current maturities of debt)


7,698,529



11,188,433



8,003,328



9,927,270



10,681,493Total Shareholders’ equity

$
430,395,508


$
394,522,604


$
348,944,446


$
313,778,571


$
156,095,725





Year Ended December 312010


2009


2008


2007


2006Cash Flow Data:Net cash provided by operating activities

$
8,033,253


$
19,658,632


$
74,809,867


$
45,364,532


$
29,093,464Net cash (used in) provided by investing activities


(6,162,785)



1,153,358



(257,374,093
)


(69,845,702
)


(26,386,564
)Net cash (used in) provided by financing activities

$
(3,870,079)


$
1,806,991


$
78,372,423


$
96,833,706


$
26,158,514





31




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


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





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





PRELIMINARY NOTE REGARDING FORWARD-LOOKING STATEMENTS





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





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





CRITICAL ACCOUNTING POLICIES AND ESTIMATES





This section should be read together with the Summary of Significant Accounting Policies included as Note 3 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2010.





Estimates affecting accounts and notes receivable and inventories





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





At December 31, 2010, the Company provided a $687,879 reserve against accounts and notes receivable. Management’s estimate of the appropriate reserve on accounts and notes receivable at December 31, 2010 was based on the aged nature of these accounts and notes receivable. In making its judgment, management assessed its customers’ ability to continue to pay their outstanding invoices on a timely basis, and whether their financial position might deteriorate significantly in the future, which would result in their inability to pay their debts to the Company.





At December 31, 2010, the Company provided an allowance against its inventories amounting to $22,734. Management determination of this allowance was based on potential impairments to the current carrying value of the inventories due to potential obsolescence of aged inventories. In making its estimate, management considered the probable demand for our products in the future and historical trends in the turnover of our inventories.





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





Policy affecting recognition of revenue





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





1.
Persuasive evidence of an arrangement exists;


2.
Delivery has occurred or services have been rendered;


3.
The seller’s price to the buyer is fixed or determinable; and


4.
Collectability is reasonably assured.





32




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





Goodwill





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





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




We conducted an impairment test as of December 31, 2010 and no impairment loss was identified. We will continue to closely monitor the projections for our reporting units and the economic conditions of the product end-markets. Any significant change in market conditions and estimates or judgments could give rise to impairment in the period that the change becomes known.





Share-based Compensation





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





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





Accounting for Income Taxes and Uncertain Income Tax Positions





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





On January 1, 2007, we adopted FASB ASC 740-10, “Accounting for uncertainty in Income Taxes”. FASB ASC 740-10 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The amount recognized is measured as the largest amount of the benefit that is more likely than not to be realized upon ultimate settlement. Our adoption of FAS ASC 740-10 did not result in any adjustment to the opening balance of our retained earnings as of January 1, 2007. As of and for the year ended December 31, 2010, the Company recorded an unrecognized tax benefit of approximately $5,050,157, which is mainly related to non-trade intercompany transactions, fixed assets and intangible assets.





Our accounting policy for interest and/or penalties related to an uncertain position, if any when required, is classified as part of other expenses.  The Company recorded $398,395 interest and a penalty of $440,000 as of December 31, 2010.





33





RECENT ACCOUNTING PRONOUNCEMENTS





In January 2010, the FASB issued Accounting Standards Update 2010-06 (ASU 2010-06), “Fair Value Measurements and Disclosures (Topic 820)”: Improving Disclosures about Fair Value Measurements.  This amendment to ASC Topic 820 has improved disclosures about fair value measurements on the basis of input received from the users of financial statements.  This is effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements.  Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years.  Early adoption is permitted.  The provisions of ASU 2010-06 are not expected to have a material effect on the financial position, results of operations or cash flows of the Company.





In February 2010, the FASB issued Accounting Standards Update 2010-09 (ASU 2010-09), "Subsequent Events (Topic 855)."  The amendments remove the requirements for an SEC filer to disclose a date, in both issued and revised financial statements, through which subsequent events have been reviewed.  Revised financial statements include financial statements revised as a result of either correction of an error or retrospective application of U.S. GAAP.  ASU 2010-09 is effective for interim or annual financial periods ending after June 15, 2010.  The provisions of ASU 2010-09 did not have a material effect on the financial position, results of operations or cash flows of the Company.





In February 2010, the FASB issued Accounting Standards Update 2010-10 (ASU 2010-10), "Consolidation (Topic 810)."  The amendments to the consolidation requirements of ASC Topic 810 resulting from the issuance of Statement 167 are deferred for a reporting entity's interest in an entity (1) that has all the attributes of an investment company or (2) for which it is industry practice to apply measurement principles for financial reporting purposes that are consistent with those followed by investment companies.  An entity that qualifies for the deferral will continue to be assessed under the overall guidance on the consolidation of variable interest entities in ASC Subtopic 810-10 (before the Statement 167 amendments) or other applicable consolidation guidance, such as the guidance for the consolidation of partnerships in ASC Subtopic 810-20.  The deferral is primarily the result of differing consolidation conclusions reached by the International Accounting Standards Board ("IASB") for certain investment funds when compared with the conclusions reached under Statement 167.  The deferral is effective as of the beginning of a reporting entity's first annual period that begins after November 15, 2009, and for interim periods within that first annual reporting period, which coincides with the effective date of Statement 167.  Early application is not permitted.  The provisions of ASU 2010-10 are effective for the Company beginning in 2010. The adoption of ASU 2010-10 did not have a material impact on the financial position, results of operations or cash flows of the Company.





In March 2010, the FASB issued Accounting Standards Update 2010-11 (ASU 2010-11), "Derivative and Hedging (Topic 815)."  All entities that enter into contracts containing an embedded credit derivative feature related to the transfer of credit risk that is not only in the form of subordination of one financial instrument to another will be affected by the amendments in ASU 2010-11 because the amendments clarify that the embedded credit derivative scope exception in paragraph 815-15-15-8 through 15-9 does not apply to such contracts.  ASU 2010-11 is effective at the beginning of the reporting entity's first fiscal quarter beginning after June 15, 2010.  The provisions of ASU 2010-11 did not have a material effect on the financial position, results of operations or cash flows of the Company.





In April 2010, the FASB issued Accounting Standards Update 2010-13 (ASU 2010-13), "Compensation—Stock Compensation (Topic 718)." ASU 2010-13 provides amendments to ASC Topic 718 to clarify that an employee share-based payment award with an exercise price denominated in the currency of a market in which a substantial portion of the entity’s equity securities trades should not be considered to contain a condition that is not a market, performance, or service condition. Therefore, an entity would not classify such an award as a liability if it otherwise qualifies as equity. The amendments in ASU 2010-13 are effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. The provision of ASU 2010-13 are not expected to have a material effect on the financial position, results of operations or cash flows of the Company.





In December 2010, the FASB issued an Accounting Standards Update 2010-28(“ASU 2010-28”), “Intangibles—Goodwill and Other (Topic 350)”.  ASU 2010-28 amends ASC Topic 350.  ASU 2010-28 clarifies the requirement to test for impairment of goodwill.  ASC Topic 350 requires that goodwill be tested for impairment if the carrying amount of a reporting unit exceeds its fair value.  Under ASU 2010-28, when the carrying amount of a reporting unit is zero or negative an entity must assume that it is more likely than not that a goodwill impairment exists, perform an additional test to determine whether goodwill has been impaired and calculate the amount of that impairment.  The modifications to ASC Topic 350 resulting from the issuance of ASU 2010-28 are effective for fiscal years beginning after December 15, 2010 and interim periods within those years. Early adoption is not permitted.  The provisions of ASU 2010-28 are not expected to have a material effect on the financial position, results of operations or cash flows of the Company.





34





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





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





Year Ended December 31,


Year Ended December 31,2010


2009


2010


2009Revenues

$
305,944,085


$
296,150,780



100%



100%Cost of sales


148,186,531



129,367,775



48



44GROSS PROFIT


157,757,554



166,783,005



52



56Selling, general and administrative expenses


66,439,702



62,164,936



22



21Advertising costs


38,920,905



31,896,992



13



11Research and development costs


15,365,131



7,922,357



5



3Depreciation and amortization


6,662,237



6,038,625



2



2Total operating expenses


127,387,975



108,022,910



42



37INCOME FROM OPERATIONS


30,369,579



58,760,095



10



19Equity in earnings from unconsolidated entities


384,991



2,075,139



—



1Interest expense, net


(5,900,055)



(5,746,382
)


2



2Other expense, net


(204,736)



(569,661
)


—



—INCOME BEFORE INCOME TAX


24,649,779



54,519,191



8



18Income tax


8,336,366



13,216,986



3



4NET INCOME


16,313,413



41,302,205



5



14Net loss attributable to non-controlling interest


27,937



118,945



—



—NET INCOME ATTRIBUTABLE TO CONTROLLING INTEREST EARNINGS PER COMMON SHARE

$
16,341,350


$
41,421,150



5%



14%Basic

$
0.22


$
0.56Diluted

$
0.22


$
0.53





Revenues





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





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





Year Ended December 31,


Increase/


Increase/2010


2009


(Decrease)


(Decrease)Revenue from pharmaceutical products

$
250,131,594


$
244,168,159


$
5,963,435



2%Revenue from nutraceutical products


41,020,289



39,125,655



1,894,634



5%Total manufacturing revenue


291,151,883



283,293,814



7,858,069



3%Distribution revenue


14,792,202



12,856,966



1,935,236



15%Total revenues

$
305,944,085


$
296,150,780


$
9,793,305



3%





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





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





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





35





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





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





Cost of Sales and Gross Profit





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





Year Ended December 31,


Increase/


Increase/2010


2009


(Decrease)


(Decrease)Pharmaceutical products

$
113,090,019


$
99,522,407


$
13,567,612



14%Nutraceutical products


20,756,967



17,439,581



3,317,386



19%Total manufacturing cost


133,846,986



116,961,988



16,884,998



14%Distribution cost


14,339,545



12,405,787



1,933,758



16%Total cost

$
148,186,531


$
129,367,775


$
18,818,756



15%





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





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





Selling, General and Administrative Expenses





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





Year Ended December 31,


Increase/


Increase/2010


2009


(Decrease)


(Decrease)Promotional materials and fees

$
23,507,944


$
26,729,235


$
(3,221,291)



(12)%Payroll


12,820,709



10,193,585



2,627,124



26%Shipping


5,682,503



5,024,799



657,704



13%Trips and traveling


4,236,108



3,704,674



531,434



14%Professional fees


3,483,684



3,551,625



(67,941)



(2)%Staff welfare and insurance


3,012,736



1,397,123



1,615,613



116%Stock based compensation


3,124,188



2,718,771



405,417



15%Miscellaneous


10,571,830



8,845,124



1,726,706



20%TOTAL

$
66,439,702


$
62,164,936


$
4,274,766



7%





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





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





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







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





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





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




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




36







Advertising Costs





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





We increased advertising costs to create a unified mega brand for AOB so that we can leverage on the establishment of all our individual brands to boost chances of winning in the government sponsored competitive tendering processes for China's essential drug list products as well as those in the national insurance catalogs.





We also increased advertising costs in connection with promoting our new launched products in 2009 and 2010. We believe a reasonably priced product with a brand name will be more appealing to consumers, patients and doctors.





Research and Development Costs





Research and development costs increased by $7,442,774, or 94%, from $7,922,357 in 2009 to $15,365,131 in 2010. Expressed as a percentage of revenue, research and development cost was 5% for 2010, compared to 3% for 2009.





The increase in research and development costs reflected our continuing effort in research and development activities. Our research and development activities consist of near term, middle term and long term stages which contribute to both our current and future business strategies. Our key research and development programs during 2010 include the improvement of SHL Lyophilized Injection Powder, Cease Enuresis Soft Gel, Jinji series products and some acquired projects from GuangXi HuiKe Pharmaceutical Research and Development Co., Ltd., or GHK.We believe we have proven research and development capabilities and a robust pipeline with promising market potential. With stringent quality assurance programs in place at our manufacturing facilities, we believe we are on track with our capacity expansion initiatives in advance of the commercialization of our pipeline products. The majority of our research and development expenditures are on pharmaceutical products.





Depreciation and Amortization





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





Equity in Earnings from Unconsolidated Entities





Equity in earnings (loss) from unconsolidated entities decreased from a gain of $2,075,139 in 2009 to a gain of $384,991 in 2010. For additional information, see “Item 8. Financial Statements and Supplementary Data — Note 11. Investments in and advances to unconsolidated entities.”





Interest Expense, Net





Net interest expense was $5,900,055 for 2010, compared to net interest expense of $5,746,382 for 2009. The increase in net interest expense was mainly due to the decrease in interest expense capitalized as construction in progress. For additional information, see “Item 8. Financial Statements and Supplementary Data — Note 8. Construction in progress”




Income Tax





The decrease in the income tax expense was mainly due to the decline of income before income taxes. The Company’s effective tax rate for 2010 was 34%, which is an increase of 10% from 2009. The increase in the effective tax rate is mainly due to a decrease in profits before tax relative to permanent differences, unrecognized tax benefits and a change in valuation allowance. For additional information, see “Item 8. Financial Statements and Supplementary Data — Note 22. Taxes”





37





RESULTS OF OPERATIONS – YEAR ENDED DECEMBER 31, 2009 AS COMPARED TO YEAR ENDED DECEMBER 31, 2008





The following table sets forth the amounts and the percentage relationship to revenues of certain items in our consolidated statements of income for the years ended December 31, 2009 and 2008:





Year Ended December 31,


Year Ended December 31,2009


2008


2009


2008Revenues

$
296,150,780


$
264,643,058



100%



100%Cost of sales


129,367,775



91,031,274



44



34GROSS PROFIT


166,783,005



173,611,784



56



66Selling, general and administrative expenses


62,164,936



57,849,286



21



22Advertising costs


31,896,992



34,102,538



11



13Research and development costs


7,922,357



1,528,991



3



1Depreciation and amortization


6,038,625



4,383,215



2



2Purchased in-process research and development


-



12,255,248



—



5Total operating expenses


108,022,910



110,119,278



37



43INCOME FROM OPERATIONS


58,760,095



63,492,506



19



23Equity in earnings (loss) from unconsolidated entities


2,075,139



(1,132,986
)


1



—Interest expense, net


(5,746,382
)


(2,571,015
)


2



1Other expense, net


(569,661
)


(65,843
)


—



—INCOME BEFORE INCOME TAX


54,519,191



59,722,662



18



22Income tax


13,216,986



12,635,472



4



5NET INCOME


41,302,205



47,087,190



14



17Net loss (income) attributable to non-controlling interest


118,945



(27,575
)


—



—NET INCOME ATTRIBUTABLE TO CONTROLLING INTEREST EARNINGS PER COMMON SHARE

$
41,421,150


$
47,059,615



14%



17%Basic

$
0.56


$
0.62Diluted

$
0.53


$
0.61





Revenues





Revenues in 2009 were $296,150,780, an increase of $31,507,722, or 12% compared to revenues for 2008.





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





Year Ended December 31,


Increase/


Increase/2009


2008


(Decrease)


(Decrease)Revenue from pharmaceutical products

$
244,168,159


$
224,904,348


$
19,263,811



9%Revenue from nutraceutical products


39,125,655



34,266,739



4,858,916



14%Total manufacturing revenue


283,293,814



259,171,087



24,122,727



9%Distribution revenue


12,856,966



5,471,971



7,384,995



135%Total revenues

$
296,150,780


$
264,643,058


$
31,507,722



12%





Sales of our pharmaceutical products increased by $19,263,811, or 9%, as compared to the year of 2008 primarily due to the following factors:





●
the sales of our prescription pharmaceutical products increased from $87,423,056 in 2008 to $115,785,594 in 2009, or a 32% increase. This is primarily due to the increase in sales of our prescription formulated Jinji capsule, BOKE and CCXA prescription pharmaceutical products despite the decrease in sales of our SHL products. The overall increase in sales was supported by our continuous marketing efforts, increase in new products offering, as well as expanding coverage to the previously unaddressed rural market; Our newly launched products, such as YuYeQingHuo Capsules which treat throat inflammation, have offset some of the negative impact from the healthcare reform;




38




●
the sales of our OTC pharmaceutical products decreased from $137,481,292 to $128,382,565, or 7% decrease. This was attributable to the decrease in the sales of our Jinji Yimucao, which is a product included the China’s essential drug list. Our distributors reduced their order in anticipating a decrease in average selling price when the government auctions begin in the fourth quarter. The decrease was partially offset by the increase in sales of our Boke and CCXA products as a result of improved recognition of our product. We expect the sales of our OTC products will resume once the selling price is stabilized. We continue to introduce new products to diversify our product portfolio and reduce concentration risks. Our newly launched products, such as Shedanchan beiye which treat inflammation and cough, have offset some of the negative impact from the healthcare reform; and





Sales from our nutraceutical products increased from $34,266,739 in 2008 to $39,125,655 in 2009, representing a growth of 14%. This increase was mainly attributed to new beverage products launched in 2009.





The Company recorded $12,856,966 distribution revenue from Nuo Hua's majority owned subsidiary in 2009. The Company has recorded $5,471,971 in 2008 since the investment in Nuo Hua in October, 2008.





Cost of Sales and Gross Profit





Cost of sales was $129,367,775 in 2009, compared to $91,031,274 in 2008. Cost of sales in 2009 and 2008 by segments and product categories were as follows:





Year Ended December 31,


Increase/


Increase/2009


2008


(Decrease)


(Decrease)Pharmaceutical products

$
99,522,407


$
72,244,010


$
27,278,397



38%Nutraceutical products


17,439,581



13,543,450



3,896,131



29%Total manufacturing cost


116,961,988



85,787,460



31,174,528



36%Distribution cost


12,405,787



5,243,814



7,161,973



137%Total cost

$
129,367,775


$
91,031,274


$
38,336,501



42%





The cost of sales of pharmaceutical and nutraceutical products increased by 38% and 29%, respectively, in 2009 compared to 2008. These increases are attributed to our increase in sales.





Gross profit decreased by $6,828,779, or 4%, for 2009 over 2008. These decreases are attributed to our increase in distribution sales and the increase in production cost. The Company recorded $12,405,787 distribution cost from Nuo Hua's majority owned subsidiary in 2009. The Company has recorded $5,243,814 in 2008 since the investment in Nuo Hua in October, 2008. Gross profit as a percentage of net revenues decreased from 66% in prior year to 56% in 2009 due to a greater proportion of CCXA in 2009 compared to 2008. Further, the purchase prices of certain raw materials increased the cost of sales and lower margin distribution business from Nuo Hua also contributed to lower gross profit.





Selling, General and Administrative Expenses





Selling, general and administrative expenses, increased from $57,849,286 in 2008 to $62,164,936 in 2009, representing a 7% increase. The details of our sales and marketing expenses were as follows:





Year Ended December 31,


Increase/


Increase/2009


2008


(Decrease)


(Decrease)Promotional materials and fees

$
26,729,235


$
26,607,944


$
121,291



0%Payroll


10,193,585



9,381,157



812,428



9%Shipping


5,024,799



3,501,453



1,523,346



44%Trips and traveling


3,704,674



3,443,662



261,012



8%Professional fees


3,551,625



2,755,215



796,410



29%Staff welfare and insurance


1,397,123



1,268,535



128,588



10%Stock based compensation


2,718,771



2,277,503



441,268



19%Miscellaneous


8,845,124



8,613,817



231,307



3%TOTAL

$
62,164,936


$
57,849,286


$
4,315,650



7%





The increase in selling, general and administrative expenses in 2009 compared to 2008 was primarily due to the following factors:





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





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




39







●
the increase of professional fees primarily due to the increase of accounting related professional fees. Accounting related professional fees increased by approximate $0.8 million, as compared to 2008, due primarily to the increase in audit fees relating to our increased number of subsidiaries being audited; and additional accrual of audit fee to our new auditors;





●
stock compensation expense increased due to our additional amortization cost of new stock options and restricted common stock issued to the executives and the senior management in 2009; and





Advertising Costs





We focus our marketing efforts on establishing business relationships and growing our brand recognition.Our investments in marketing and TV advertising have generated a positive effect on sales. While marketing and promotional expenses for newly-launched products have impacted our short-term profitability, this is in line with our strategy of investing in new products we feel have exceptional potential for growth in the future.





Advertising costs decreased by $2,205,546, from $34,102,538 in 2008 to $31,896,992 in 2009.  Advertising costs as a percentage of revenue decreased from 13% in 2008 to 11% in 2009. As the general advertising cost of media in the PRC continues to increase, we decreased media advertising activities but increased other promotional activities and direct sales efforts to support the continuous growth of our revenue efficiently.





Research and Development Costs





We believe science, technology and innovation represent a significant part of our business. We believe that our emphasis on research and development investment is the most important core competency that we have to achieve our historic growth and maintain growth possibilities going forward.




Research and development costs consist of salary and benefit costs, fees paid to clinical research organizations, supplies and facility costs. Research and development costs increased by $6,393,366, or 418%, from $1,528,991 in 2008 to $7,922,357 in 2009. Expressed as a percentage of revenue, research and development cost was 3% for 2009, compared to 1% for 2008.





The increase in research and development costs reflected our effort in R&D activities including the set up of the centralized R&D centre in Beijing, China in 2009 as well as the acquisition of GuangXi HuiKe Research and Development Co., Ltd. (“GHK”) in late 2008. Our key research and development programs include the improvement of SHL Lyophilized Injection Powder, Cease Enuresis Soft Gel, Jinji Yimucao, and some acquired projects from GHK. The majority of research and development expenditures are on pharmaceutical products.





Depreciation and Amortization





Depreciation and amortization expenses increased by $1,655,410, or 38%, in 2009 as compared to 2008. This increase was primarily due to the depreciation and amortization charges of the facilities and lands acquired during the second half of 2008.





Purchased in-process research and development





We did not incur any IPR&D expense in 2009. Acquisition-related in-process research and development charge of $12,255,248 in 2008 was related to the acquisition of GuangXi HuiKe Pharmaceutical Research and Development Co., Ltd. (“GHK”). On the date of acquisition, GHK was working on at least seven in progress R&D projects. The Company intended to continue and invest in all the projects leading to either obtaining production licenses for new products or proprietary technology patents of future economic value. We estimated fair value of the IPR&D and recognized them as acquired intangible assets apart from goodwill. However, according to US GAAP applicable at the time of the acquisition, the IPR&D project that have no alternative future use was charged to expense at the acquisition date. The acquired IPR&D charge was a non-recurring expense deducted from operating income.





Interest Expense, Net





Net interest expense was $5,746,382 for 2009, compared to net interest expense of $2,571,015 for 2008. The increase was mainly related to the convertible notes issued in July 2008.





Income Tax





Income tax expense for 2009 was $13,216,986, compared to $12,635,472 for 2008. The Company’s effective tax rate for 2009 was 24% which is an increase of 3% from prior year. The increase is mainly due to the accrual of unrecognized tax benefits.





40





FINANCIAL POSITION, LIQUIDITY AND CAPITAL RESOURCES





Cash





Our cash position at December 31, 2010 was $94,568,520, representing an increase of $3,442,034, or 4%, compared with our cash position of $91,126,486 at December 31, 2009. The increase was mainly attributable to the increase of operating activities of $ 8,033,253 and partially offset by the investing and financing activities of $6,162,785 and $3,870,079.





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





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





Working Capital





We maintain a significant level of working capital. Our working capital increased by $31,231,925 to $162,175,191 at December 31, 2010, as compared to $130,943,266 at December 31, 2009, primarily due to an increase in net accounts and notes receivable by $23,094,465, an increase in cashand cash equivalents by $3,442,034, an increase in net inventories by $2,649,875, and a decrease in current liabilities by $2,897,259.





Cash Flow





2010 Compared to 2009





Operating Activities





Cash flows from operations during 2010 amounted to $8,033,253, representing a decrease of $11,625,379 compared with cash flows from operations of $19,658,632 for 2009. The decrease in net cash provided by operating activities was primarily attributable to the decrease in net income of $24,988,792, changes in operating assets and liabilities which aggregated to a net cash outflow of $24,562,862, a decrease by $10,373,566 from a net cash outflow of $34,936,428 during 2009. As reflected in our cash flows, the changes included:





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





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




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





Investing Activities





Our net cash used in investing activities amounted to $6,162,785 during 2010, compared to net cash provided by investing activities of $1,153,358 in 2009. The changes in net cash used in investing activities were primarily attributable to the return of a refundable deposit of $6,397,106 in 2009 for due diligence, partially offset by expansion of our manufacturing, research & development facilities and continuing commitments to quality assurance.





Financing Activities





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





2009 Compared to 2008





Cash flows from operations in 2009 amounted to $19,658,632, representing a decrease of approximately 74% compared with cash flows from operations of $74,809,867 in 2008. The decreased in net cash provided by operating activities was primarily attributable to:





●
the decrease in our net income by 12% to $41,302,205 in 2009, compared with net income of $47,087,190 in last year; and





●
a non-cash purchased in-process research and development expenses of $12,255,248 was recorded in 2008 which increased the net cash provided by operating activities in 2008.




41




During 2009, changes in operating assets and liabilities aggregated to a net cash outflow of $34,936,428, decrease by $35,546,489 from a net cash inflow of $610,061 during 2008. As reflected in our cash flow, the changes including:





●
cash outflow from accounts and notes receivable amounted to $20,111,898 primarily affected by the increase of our sales revenue, especially during the fourth quarter which is the industry’s peak season;





●
cash outflow from advances to suppliers and prepaid expenses amounted to $18,152,003 primarily attributed to advances payment in purchasing certain raw materials in preparing for a potential increase of future purchase prices;





●
cash outflows from accounts payable amounted to $4,790,744 primarily attributed to the timing of payments to vendors in the ordinary course of business; and





●
cash inflows from inventories amounted to $3,153,553 mainly due to the utilization of inventories which affected by the increase of our sales revenue, especially during the fourth quarter.





Our cash flows provided by investing activities amounted to $1,153,358 during 2009, compared to cash used in investing activities of $257,374,093 in 2008. The Changes in net cash provided by investing activities was primarily attributable to:





●
no acquisition in 2009 compared to the acquisitions of Nuo Hua and GHK in 2008;





●
capital expenditures of $5,098,717 in 2009 compared to $172,682,150 in 2008; and





●
we received $6,397,106 for refundable deposit for potential investment compared to cash outflow of $2,917,734 in 2008.





Our cash flows provided by financing activities was $1,806,991 in 2009, compared to cash inflow of $78,372,423 in 2008. The change was primarily attributable to:





●
we received net proceeds of $110 million from the issuance of our convertible notes and paid $29,998,616 for our prepaid forward stock repurchase contract in 2008; we did not do any issuance of our convertible notes in 2009;





●
we received $10,682,945 from bank loans in 2009 compared to $9,480,315 in 2008; and





●
we repaid $8,875,954 of bank loans in 2009 compared to $11,467,826 in 2008.





Off -balance Sheet Arrangements





We do not have any off -balance sheet arrangements as of December 31, 2010.





Contractual Obligations





The following table summarizes the Company's estimated contractual obligations as of December 31, 2010:





Payments due by periodTotal


Less than 1

year


1-3 years


3-5 years


More than 5

yearsCapital expenditure  commitments


14,785,039



5,913,022



8,872,017



—



—Advertising commitments


7,028,963



7,028,963



—



—



—R&D commitments


2,602,544



2,202,235



400,309



—



—Long-term loan


741,271



61,405



127,506



134,038



418,322Convertible notes*


141,114,583



5,750,000



11,500,000



11,500,000



112,364,583Total


166,272,400



20,955,625



20,899,832



11,634,038



112,782,905





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





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





42





ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





Issuance of Common Stock





See Part II, Item 5 for issuance of unregistered shares of common stock during 2010.





Inflation





Inflation has not had a material impact on our business.





Currency Exchange Fluctuations





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





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





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





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





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





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





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





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





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




43




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





We recognized a foreign currency translation adjustment of $16.1 million and $1.4 million as of December 31, 2010 and 2009, respectively. The balance sheet amounts with the exception of equity at December 31, 2010 were translated at 6.6118 RMB to $1.00 USD as compared to 6.8372 RMB at December 31, 2009. The equity accounts were stated at their historical rate. The average translation rates applied to the income and cash flow statement amounts for 2010 and 2009 were 6.7245 RMB and 6.8457 RMB to $1.00 USD, respectively. We do not hedge our exposure to foreign exchange risk; as such, we may in the future experience economic loss as a result of any foreign currency exchange rate fluctuations.





ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA





The information required by ITEM 8 appears after the signature page to this report.


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


On August 7, 2009, the Audit Committee of the Board of Directors of AOB approved the engagement of Ernst & Young Hua Ming (“EY”) as the Company’s independent registered public accounting firm for the year ended December 31, 2009. On August 10, 2009, the Board of Directors of AOB terminated the engagement of Weinberg & Company, P.A. (“Weinberg”) as the independent registered public accounting firm of the Company, effective August 10, 2009.





During the years ended December 31, 2006, 2007 and 2008 and through August 10, 2009, there were no disagreements with Weinberg on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreements, if not resolved to the satisfaction of Weinberg, would have caused Weinberg to make reference to the subject matter of the disagreements in its reports on the consolidated financial statements for such years.





The reports of Weinberg on the Company’s consolidated financial statements for the years ended December 31, 2006, 2007 and 2008 did not contain an adverse opinion or a disclaimer of an opinion, and were not qualified or modified as to uncertainty, audit scope or accounting principles.





During the years ended December 31, 2006, 2007 and 2008 and through August 10, 2009, there were no reportable events (as defined in Item 304(a)(1)(v) of Regulation S-K).





ITEM 9A.
CONTROLS AND PROCEDURES





(a) Evaluation of Disclosure Controls and Procedures





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





Although the management of our Company, including the Chief Executive Officer and the Chief Financial Officer, believes that our disclosure controls and internal controls currently provide reasonable assurance that our desired control objectives have been met, management does not expect that our disclosure controls or internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our Company have been detected. These inherent limitations 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 the controls. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.




44




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





The management of AOB is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:





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





2. Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorization of our management and directors; and





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





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





Under the supervision and with the participation of the Chief Executive Officer and Chief Financial Officer, management conducted an evaluation of the effectiveness of its internal control over financial reporting as of December 31, 2010. The framework on which such evaluation was based is contained in the report entitled “Internal Control — Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO Report”).





Based on that evaluation and the criteria set forth in the COSO Report, management concluded that its internal control over financial reporting was effective as of December 31, 2010.





Our independent registered public accounting firm, Ernst & Young Hua Ming, who also audited our consolidated financial statements, independently assessed the effectiveness of our internal control over financial reporting as of December 31, 2010, as stated in their report which is included in this Annual Report.




45





Report of Independent Registered Public Accounting Firm





The Board of Directors and Shareholders of


American Oriental Bioengineering, Inc.





We have audited American Oriental Bioengineering, Inc.’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). American Oriental Bioengineering, Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.





We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.





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





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





In our opinion, American Oriental Bioengineering, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on the COSO criteria.





We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of American Oriental Bioengineering, Inc. as of December 31, 2010 and 2009, and the related consolidated statements of income and comprehensive income, changes in shareholders’ equity, and cash flows for each of the two years in the period ended December 31, 2010 of American Oriental Bioengineering, Inc. and our report dated March 15, 2011 expressed an unqualified opinion thereon.










/s/ Ernst & Young Hua Ming


Shanghai, People’s Republic of China


March 15, 2011




46





(c) Changes in Internal Control over Financial Reporting





There was no change in our internal control over financial reporting that occurred during the fourth fiscal quarter of the fiscal year covered by this Annual Report on Form 10-K that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.





ITEM 9B.
OTHER INFORMATION





Not applicable.





PART III





ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE





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





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





Name

Age

Position

Date Of Initial

AppointmentTony Liu

58

Chief Executive Officer and Chairman of the Board

December 18, 2001Jun Min

52

Vice President and Director

May 8, 2002Yanchun Li

42

Chief Financial Officer, Secretary and Director

May 8, 2002Binsheng Li

47

Chief Accounting Officer and Director

May 8, 2002Cosimo J. Patti (1)(2)(3)

61

Independent Director

September 27, 2004Xianmin Wang (2)(3)

68

Independent Director

January 1, 2005Eileen Brody (1)(2)(3)

49

Independent Director

June 22, 2005Lawrence S. Wizel (1)(2)(3)

67

Independent Director

August 21, 2006Baiqing Zhang (3)

58

Independent Director

December 15, 2006Xiaopeng Xu

62

Chief Operations Officer

March 11, 2010Yang Yang

43

Chief Marketing Officer

April 10, 2010





(1)
Serves as a member of the Audit Committee.


(2)
Serves as a member of the Compensation Committee.


(3)
Serves as a member of the Nominating and Corporate Governance Committee.





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





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





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




47




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





Binsheng Liis one of our partner founders and has served as our Chief Accounting Officer and as a member of our Board of Directors since 2002. Mr. Li began his career at Three-Happiness Bioengineering, Co. Ltd. in 1994 in the accounting department. Mr. Li is in charge of all financial management and accounting work for the Company. Mr. Li graduated from DalianFinancial School in 1986 with a major in Finance and Economics.





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





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





Eileen Brodyhas served on our Board of Directors since 2005. Since August 2005, Ms. Brody has been President of Dawson-Forte Cashmere, an apparel trading company. Since June 2007 Ms. Brody has been a member of the Board of Directors of Fuqi International, Inc. (NASDAQ:FUQI), a company specializing in designing, developing, promoting, and selling a range of precious metal jewelry products in the Chinese luxury goods market. From 1997 to 2004, she was Vice President of Merchandising and Planning for Carter’s Retail division of The William Carter Company. From 1992 to 1997, she held various management positions for Melville Corporation, a multi-billion dollar retailer. From 1983 to 1990, Ms. Brody worked for KPMG Peat Marwick as a Senior Manager. Ms. Brody is a Certified Public Accountant. Ms. Brody contributes to our Board of Directors her overall business experience managing companies doing business throughout China, her financial expertise and auditing background. She received her Undergraduate and MBA degrees from Pace University and a second MBA from the Harvard Graduate School of Business.





Lawrence S. Wizelhas served on our Board of Directors since 2006. Prior to joining our Board of Directors, he served as Deputy Professional Practice Director at Deloitte Touche USA LLP, or Deloitte, in Deloitte’s New York office. Mr. Wizel began his career at Deloitte in 1965 and was a partner from 1980 until he retired in June 2006. Mr. Wizel was responsible for serving a diverse client base of publicly held and private companies in a variety of capacities including, SEC filings, initial public offerings, mergers and acquisition transactions and periodic reporting. Since September 2006, Mr. Wizel has been a member of the Board of Directors of 3SBio Inc. (NASDAQ:SSRX), a biotechnology company focused on researching, developing, manufacturing and marketing biopharmaceutical products primarily in China. Since August 2007, Mr. Wizel has been a member of the Board of Directors of Puda Coal, Inc. (NYSE AMEX:PUDA), a supplier of metallurgical coking coal to the industrial sector in China. Since June 2010, Mr. Wizel has been a member of the Board of Directors of Sunity Online Entertainment Limited, a developer and host of online games. Mr. Wizel contributes to our Board of Directors his financial expertise and 12 years of experience of managing and working with companies whose operations are based in China. He received his BA in 1965 in accounting from Michigan State University and is a Certified Public Accountant.





48




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





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





Yang Yanghas served as Chief Marketing Officer and Managing Director of Guangxi Lingfeng Pharmaceutical Co., Ltd, a wholly owned subsidiary of the Company since April 2010. Prior to his above appointment, he was the general manager of marketing for the Territory of China since January 2009. Before joining the Company, Mr. Yang worked in various senior management capacities for Sunflower Pharmaceutical Group, including its Chief Marketing Officer, Marketing General Manager, Sales Manager, etc. from 1998 to 2008 mainly responsible for branding strategies, and branding image, integrated media advertising. Sunflower Weikangling, and Sunflower Liver Booster are two well-known products in China representing Mr. Yang’s master pieces of marketing, which were even quoted in marketing text books.  Mr. Yang received a bachelor’s degree from Chengdu University of Traditional Chinese Medicines in 1995.





Legal Proceedings





None of our directors and officers has been involved in any of the legal proceedings specified in Item 401(f) of Regulation S-K in the past 10 years.





BOARD LEADERSHIP STRUCTURE





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





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





BOARD’S ROLE IN RISK OVERSIGHT





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




49




CORPORATE GOVERNANCE





Board of Directors





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





Board Committees





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





Compensation Committee





The Compensation Committee was established on January 15, 2005.  The members of the Compensation Committee during 2010 were Cosimo J. Patti, Xianmin Wang, Lawrence S. Wizel and Eileen Brody. Ms. Brody served as the Chairperson of the Compensation Committee. Each of these members is considered “independent” under Section 303A.02 of the listing standards of the New York Stock Exchange, as determined by our Board of Directors. The Compensation Committee operates under a written charter. The Second Amended and Restated Compensation Committee Charter can be found on our website atwww.bioaobo.comand can be made available in print free of charge to any shareholder who requests it.





The Compensation Committee assists the Board of Directors in determining the compensation of our Chief Executive Officer and makes recommendations to the Board of Directors with respect to the compensation of the Chief Financial Officer, other executive officers of the Company and the independent directors. The Compensation Committee administers our 2006 equity incentive plan, under the direction of the Board of Directors.  The Compensation Committee held two meetings during 2010.





Nominating and Corporate Governance Committee





The Nominating and Corporate Governance Committee was established on January 15, 2005. The purpose of the Nominating and Corporate Governance Committee is to assist the Board of Directors in identifying qualified individuals to become members of the Board of Directors, in determining the composition of the Board of Directors and in monitoring the process to assess the effectiveness of the Board of Directors. The Nominating and Corporate Governance Committee held one meeting during 2010.





The members of the Nominating and Corporate Governance Committee during 2010 were Cosimo J. Patti, Eileen Brody, Baiqing Zhang, Lawrence S. Wizel and Xianmin Wang. Mr. Wang served as the Chairperson of the Nominating and Corporate Governance Committee. Each of the above-listed Nominating and Corporate Governance Committee members is considered “independent” under Section 303A.02 of the listing standards of the New York Stock Exchange, as determined by our Board of Directors.





There have been no changes to the procedures by which the stockholders of the Company may recommend nominees to the Board of Directors since the filing of the Company’s Definitive Proxy Statement on October 22, 2010 for its Annual Meeting of Stockholders, which was held on December 8, 2010. The Nominating and Corporate Governance Committee operates under a written charter.  The Amended and Restated Nominating and Corporate Governance Committee Charter can be found on our website atwww.bioaobo.comand can be made available in print free of charge to any shareholder who requests it.




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





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





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





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





50




Binsheng Li: Mr. Li is one of our partner founders and he contributes to our Board of Directors his skills in accounting and financial management.  Mr. Li accumulated his knowledge and experience through his education and business practice.





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





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





Eileen Bridget Brody: Ms. Brody contributes to the Board of Directors of AOB her overall business experience managing companies doing business throughout China, her financial expertise and auditing background.





Lawrence S. Wizel: Mr. Wizel contributes to the Board of Directors of AOB his financial expertise and 12 years of experience of managing and working with companies whose operations are based in China.





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





Audit Committee





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





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


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





The Audit Committee met four times during 2010.  Pursuant to its charter, the Audit Committee meets at least quarterly with the Company’s internal auditors. The Company does not limit the number of audit committees of other companies on which its Audit Committee members can serve.





The members of the Audit Committee during 2010 were Cosimo Patti, Xianmin Wang, Eileen Brody and Lawrence S. Wizel. Mr. Wizel served as the Chairperson of the Audit Committee. Each of these members is considered “independent” under Section 303A.02 of the listing standards of New York Stock Exchange, as determined by our Board of Directors. The Audit Committee performs each of its responsibilities as outlined in its charter.





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




51





REPORT OF THE AUDIT COMMITTEE (1)





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





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





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





Based upon the reports, review and discussions described in this report, and subject to the limitations on the role and responsibilities of the Audit Committee referred to above and in the Charter, the Audit Committee recommended to the Board that the audited financial statements as of and for the year ended December 31, 2010 be included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, as filed with the Securities and Exchange Commission.





THE AUDIT COMMITTEE





Lawrence S. Wizel (Chairman)


Eileen Brody


Cosimo Patti





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





EXECUTIVE SESSIONS





Under the NYSE Rules, our non-management directors are required to hold regular executive sessions. The chairperson of the executive session will rotate at each session so that each non-management director shall have an opportunity to serve as chairperson. Interested parties may communicate directly with the presiding director of the executive session or with the non-management directors as a group, by directing such written communication to Mr. Larry S. Wizel at c/o American Oriental Bioengineering, Inc., 15 Exchange Place, Suite 500, Jersey City, NJ 07302.





PROCESS FOR SENDING COMMUNICATIONS TO THE BOARD OF DIRECTORS





The Board of Directors maintains a process for stockholders to communicate with the Board of Directors. Stockholders wishing to communicate with the Board of Directors or any individual director (including the director who presides at executive sessions of non-management or independent directors or with those directors as a group) must mail a communication addressed to the Secretary of the Company, c/o American Oriental Bioengineering, Inc., 15 Exchange Place, Suite 500, Jersey City, NJ 07302.  Any such communication must state the number of shares of Common Stock beneficially owned by the stockholder making the communication. All of such communications will be forwarded to the full Board of Directors or to any individual director or directors to whom communication is directed unless the communication is clearly of a marketing nature or is inappropriate, in which case we have the authority to discard the communication or take appropriate legal action regarding the communication.




52




CODE OF ETHICS





We adopted a code of ethics that applies to our directors, officers and employees, including our Chief Executive Officer and Chief Financial Officer, and other persons who perform similar functions. A written copy of the code can be found on our website atwww.bioaobo.comand can be made available in print to any shareholder upon request at no charge by writing to our Secretary, c/o American Oriental Bioengineering, Inc., 15 Exchange Place, Suite 500, Jersey City, NJ 07302.  Our Amended and Restated Code of Ethics is intended to be a codification of the business and ethical principles which guide us, deter wrongdoing, promote honest and ethical conduct, avoid conflicts of interest, and foster full, fair, accurate, timely and understandable disclosures, compliance with applicable governmental laws, rules and regulations, the prompt internal reporting of violations and accountability for adherence to this code.





CHIEF EXECUTIVE OFFICER CERTIFICATIONS





In connection with our listing on the New York Stock Exchange, Mr. Tony Liu, our Chief Executive Officer, submitted an Annual CEO Certification, without qualification, to the New York Stock Exchange certifying that he is not aware of any violation by the Company of New York Stock Exchange corporate governance listing standards during 2010. Mr. Liu has executed a Certification pursuant to Rule 13a-14(a) of the Securities Exchange Act and a Certification pursuant to 18 U.S.C. 1350, which are filed as Exhibits 31.1 and 32, respectively, to this Annual Report on Form 10-K.





SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE





Section 16(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), requires the executive officers and directors of the Company and every person who is directly or indirectly the beneficial owner of more than 10% of any class of security of the Company to file reports of ownership and changes in ownership with the Securities and Exchange Commission.  Such persons also are required to furnish our company with copies of all Section 16(a) forms they file.  Based solely on our review of copies of such forms received by us, we believe that during the fiscal year 2010, all of the executive officers and directors of the Company and every person who is directly or indirectly the beneficial owner of more than 10% of any class of security of the Company complied with the filing requirements of Section 16(a) of the Exchange Act, except as disclosed in the following table:





Name

Number of Reports Not Filed Timely

Number of Transactions Not Reported TimelyYang Yang

2

1Xiaoliang Wang

2

1








ITEM 11.
EXECUTIVE COMPENSATION





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





Compensation Objectives





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





Process for Determining Compensation for Executives





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





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





53





Elements of Compensation





Base Salary. Base salaries for the named executive officers are set forth in their respective employment agreements. Periodically, however, the Compensation Committee considers proposals from the Company’s management to approve increases to the base salaries for named executive officers other than our CEO. When considering whether to approve these adjustments, the Compensation Committee takes into account a number of factors, including:




●
the Company’s performance;


●
the individual’s current and historical performance and contribution to the Company; and
 ●
the individual’s role and unique skills.
 Base salaries are reviewed annually, and may be increased to align salaries with market levels after taking into account the subjective evaluation described previously. The Company did not benchmark the compensation paid to its executives for 2010 and the Compensation Committee did not take into account compensation data and benchmarks for comparable positions and companies. On April 8, 2010, the Compensation Committee met and reviewed the compensation package for each executive and determined, after taking into account the capital requirements of the business and the then current economic situation, that the salary base compensation for the executives which were carried over from 2008 to 2009 (with one slight adjustment), continued to be competitive and, therefore, no salary increase for the year ended December 31, 2010 was warranted.





Annual Cash Incentive Bonuses. The Company has a cash incentive bonus program for NEOs. The cash bonus is determined by the Company’s compensation committee and is performance based.  The program is designed to promote executive decision making and achievement that supports the realization of key overall Company financial goals. For the year 2010, the participants in the Company’s cash incentives program consisted of each of the Company’s five NEOs except Xiaopeng Xu.





In 2010, executives had target bonus opportunities ranging from 0% to 100% of base salary earnings, depending on position level and responsibility, with larger bonus opportunities provided to those with greater responsibility. The Compensation Committee establishes the guidelines under which the plan is administered, including financial performance goals and payout schedules.





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





The program provides payouts based on different levels of achievement:





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





1.
The revenues for 2010 increase no less than 10% compared with 2009, or equal or above US$325.77 million.


2.
The operating income margin for 2010 is higher than 2009, or above 19.84%.





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





1.
If the revenue for 2010 increases less than 10% compared with 2009, or less than US$325.77 million, no bonus will be earned.


2.
If the revenue for 2010 increases more than 10% compared with 2009, or equal to or more than US$325.77 million, 100% bonus will be earned.


3.
Additional RMB 500,000 (US$73,149) will be added to the bonus pool if the revenues for 2010 increase above 11%, and will be paid on the following condition:


(1)
The revenues for 2010 increase between 11% and 20%, 120% bonus payout;


(2)
The revenues for 2010 increase between 21% and 30%, 140% bonus payout;


(3)
The revenues for 2010 increase between 31% and 50%, 160% bonus payout;


(4)
The revenues for 2010 increase between 51% and 70%, 180% bonus payout;


(5)
Maximum: the revenues for 2010 increase above 71%, 200% bonus payout.





Since the Company did not meet its performance target for 2010, no cash bonuses will be paid for this period.





54





Equity Incentive Compensation. We believe that long-term performance is achieved through an ownership culture participated in by our executive officers through the use of stock-based awards. Currently, we do not maintain any incentive compensation plans based on pre-defined performance criteria. The Compensation Committee has the general authority, however, to award equity incentive compensation, i.e. stock options and restricted stock awards to our executive officers in such amounts and on such terms as the committee determines in its sole discretion. The Compensation Committee does not have a determined formula for determining the number of options available to be granted. The Compensation Committee will review each executive’s individual performance and his or her contribution to our strategic goals periodically. With the exception of stock options and restricted stock awards automatically granted at the end of each fiscal quarter in accordance with the terms of the employment agreement with our executive officers, our Compensation Committee grants equity incentive compensation at times when we do not have material non-public information to avoid timing issues and the appearance that such awards are made based on any such information.





The Compensation Committee carefully monitors our executive compensation programs. Although it has been our general objective to provide our NEOs with total annual compensation near the median of the range of salaries for executives in similar positions with similar responsibilities at comparable companies, we have also balanced this goal with the overall global market conditions and performance of the Company and to that end did not increase levels of compensation during 2010.





The respective total aggregate equity based compensation granted to each of our executive officers for the current fiscal year is the same as the aggregate value of the equity based compensation for the year ended December 31, 2009. In 2010, the equity compensation described below consisted of restricted shares to each executive. The Compensation Committee determined that it would be more prudent and attractive to executives, in light of the freezing of salaries for the 2010 fiscal year, that the Company issue to the executives restricted shares having the same aggregate equity compensation value as for the year ended December 31, 2009. With the issuance of restricted shares instead of stock options, a greater amount of shares would continue to be available under the Company’s Stock Option Plan. At the time of the award, because of the significant volatility in the marketplace and in particular the Company’s stock price, the Black Scholes calculation abnormally increased the stock option value beyond the normal inherent value thus issuing all stock options to executives would have been potentially less attractive.





Risk Analysis of Our Compensation Plans





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





55





Summary Compensation Table





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





Name and Principal Position

Year

Salary

($) (1)

Bonus

($) (2)

Stock

Awards

($) (3)

Option

Awards

($) (3)

All Other

Compensation

($)

Total

($)Tony Liu,

2010


200,000


—


538,000


—


—


738,000CEO and Chairman

2009


200,000


—


377,541


160,459


—


738,0002008


200,000


40,267


—


538,000


—


778,267Yanchun Li,

2010


160,000


—


475,200


—


—


635,200CFO, Director

2009


160,000


—


333,472


141,728


—


635,2002008


160,000


30,201


—


475,200


—


665,401Jun Min,

2010


120,000


—


356,400


—


—


476,400VP, Director

2009


120,000


—


250,104


106,296


—


476,4002008


120,000


30,201


—


356,400


—


506,601Binsheng Li,

2010


80,000


—


293,600


—


—


373,600Chief Accounting officer, Director

2009


80,000


—


206,034


87,566


—


373,6002008


80,000


20,134


—


293,600


—


393,734Yang Yang,

2010


146,297


—


146,297


—


—


292,594Chief Marketing Officer(4)

2009


—


—


—


—


—


—2008


—


—


—


—


—


—Xiaopeng Xu,

2010


51,204


—


51,204


—


—


102,408Chief Operating Officer(5)

2009


—


—


—


—


—


—2008


—


—


—


—


—


—Wilfred Chow,

2010


—


—


—


—


186,400


186,400Former SVP of Finance (6)

2009


190,000


—


229,472


97,528


—


517,0002008


190,000


40,267


—


327,000


—


557,267





(1)
The amounts reported in this column represent base salaries paid to each of the named executive officers for 2010 as provided for in their respective employment agreements.


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


(3)
Stock and option awards amounts shown in this table represent the grant date fair value computed in accordance with FASB ASC 718.


(4)
On April 8, 2010, the Board of Directors of the Company approved the appointment of Mr. Yang Yang as Chief Marketing Officer of the Company.  Mr. Yang Yang’s compensation was paid to or received in Chinese Yuan Renminbi (RMB), for which the Company used an exchange rate of RMB 6.8354 to US $1 to convert the RMB amount to US dollar amount, which rate is the interbank exchange rate on the Board Approve date.


(5)
On March 10, 2010, the Board of Directors of the Company approved the appointment of Mr. Xiaopeng Xu as Chief Operating Officer of the Company. Mr. Xiaopeng Xu’s compensation was paid to or received in Chinese Yuan Renminbi (RMB), for which the Company used an exchange rate of RMB 6.8354 to US $1 to convert the RMB amount to US dollar amount, which rate is the interbank exchange rate on the Board Approve date.


(6)
On March 11, 2010, Mr. Wilfred Chow’s resignation from his position as Senior Vice President of Finance of the Company was officially approved by the Board at its audit committee meeting. Upon Mr. Chow’s departure from the Company, the monetary value of all shares of AOB’s Common Stock and options to purchase shares of AOB’s Common Stock previously granted to Mr. Chow was $186,400, which amount was exchanged for a total of 44,916 shares of AOB’s Common Stock, as calculated based upon an agreed price of $4.15 per share.





56




EmployeeEquity Incentive Plan





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





As of December 31, 2010, the Company granted an aggregate of 2,947,281 option and restricted stock under the 2006 Plan. For the year ended December 31, 2010, 448,361 restricted stocks were granted to the executive officers. In 2010, the Company granted the following options to the NEO’s pursuant to the 2006 Plan:





2010 Grants of Plan-Based Awards Table





Name

Grant

Date

Estimated Future

Payouts Under

Equity Incentive

Plan Awards

(Target) (#)(1)

Exercise or

Base Price

of Option

Awards

($ /Sh) (2)

Closing

Price on

Grant

Date

($ /Sh)

Grant Date

Fair Value

Of Stock

Awards

($/Sh)

Grant Date

Fair Value

of Option

Awards

($ /Sh)Tony Liu

4/8/10

129,638

—

4.15

538,000

—Yanchun Li

4/8/10

114,506

—

4.15

475,200

—Jun Min

4/8/10

85,880

—

4.15

356,400

—Binsheng Li

4/8/10

70,747

—

4.15

293,600

—Yang Yang

4/8/10

35,252

—

4.15

146,297

—Xiaopeng Xu

4/8/10

12,338

—

4.15

51,204

—





(1)
Represents the number of shares and stock options granted in 2009 under the Company’s 2006 Plan. These shares and stock options vest and become exercisable ratably in five equal annual installments beginning one year after the grant date.


(2)
Represents the exercise price for the stock options granted, which was closing price on the date of the grant.





Employment Agreements





On April 8, 2010, we entered into employment agreements with Tony Liu, our Chairman and Chief Executive Officer, Yanchun Li, our Chief Financial Officer, Jun Min, our Vice President, and Binsheng Li, our Chief Accounting Officer, all of whom are also directors of the Company. On April 8, 2010, we entered into employment agreement with Yang Yang, our Chief Marketing Officer.





Tony Liu’s employment agreement has a term of one year, effective as of April 10, 2010, and provides for an annual base salary of $200,000, subject to subsequent annual review by the Company’s Compensation Committee. The term of his agreement shall be automatically renewed for another year, unless a written notice is given by either party of an intention not to renew the agreement no later than 90 days prior to the expiration of the term. The agreement also provides for grant of a stock award of 129,638 shares.  The stock are awarded under the Company’s 2006 Equity Incentive Plan and will vest ratably over a five year period, subject to Mr. Liu’s continued employment with the Company on each vesting date. Mr. Liu is also entitled to an annual performance based bonus of up to US$40,000 based upon the Company’s performance. Such amount may be increased if the Company exceeds certain net income targets for the year, or may be decreased if the net income targets are not met. We can terminate Mr. Liu’s employment with cause or without cause pursuant to a decision by our Board of Directors. In the event Mr. Liu’s employment is terminated without cause, he will be eligible to receive monthly payments at his then applicable monthly base salary for the rest of his term from the date of termination of the employment.





Lily Li’s employment agreement has a term of one year, effective as of April 10, 2010, and provides for an annual base salary of $160,000, subject to subsequent annual review by the Company’s Compensation Committee. The term of her agreement shall be automatically renewed for another year, unless a written notice is given by either party of an intention not to renew the agreement no later than 90 days prior to the expiration of the term. The agreement also provides for grant of a stock award of 114,506 shares.  The stock are awarded under the Company’s 2006 Equity Incentive Plan and will vest ratably over a five year period, subject to Ms. Li’s continued employment with the Company on each vesting date. Ms. Li is also entitled to an annual performance based bonus of up to US$30,000 based upon the Company’s performance and such amount may be increased if the Company exceeds certain net income targets for the year, or may be decreased if the net income targets are not met. We can terminate Ms. Li’s employment with cause or without cause pursuant to a decision by our Board of Directors. In the event Ms. Li’s employment is terminated without cause, she will be eligible to receive monthly payments at her then applicable monthly base salary for the rest of her term from the date of termination of her employment.





57




Jun Min’s employment agreement has a term of one year, effective as of April 10, 2010, and provides for an annual base salary of $120,000, subject to subsequent annual review by our Board of Directors. The term of his agreement shall be automatically renewed for another year, unless a written notice is given by either party of an intention not to renew the agreement no later than 90 days prior to the expiration of the term. The agreement also provides for grant of a stock award of 85,880  shares. The stock are awarded under the Company’s 2006 Equity Incentive Plan and will vest ratably over a five year period, subject to Mr. Min’s continued employment with the Company on each vesting date. Mr. Min is also entitled to an annual performance based bonus of up to US$30,000 based upon the Company’s performance and such amount may be increased if the Company exceeds certain net income targets for the year, or may be decreased if the net income targets are not met. We can terminate Mr. Min’s employment with cause or without cause pursuant to a decision by our Chief Executive Officer. In the event Mr. Min’s employment is terminated without cause, he will be eligible to receive monthly payments at his then applicable monthly base salary for the rest of his term from the date of termination of the employment.





Binsheng Li’s employment agreement has a term of one year, effective as of April 10, 2010, and provides for an annual base salary of $80,000, subject to subsequent annual review by our Board of Directors. The term of his agreement shall be automatically renewed for another year, unless a written notice is given by either party of an intention not to renew the agreement no later than 90 days prior to the expiration of the term. The agreement also provides for grant of a stock award of 70,747 shares. The stock are awarded under the Company’s 2006 Equity Incentive Plan and will vest ratably over a five year period, subject to Mr. Li’s continued employment with the Company on each vesting date. Mr. Li is also entitled to an annual performance based bonus of up to US$20,000 based upon the Company’s performance and such amount may be increased if the Company exceeds certain net income targets for the year, or may be decreased if the net income targets are not met. We can terminate Mr. Li’s employment with cause or without cause pursuant to a decision by our Chief Executive Officer. In the event Mr. Li’s employment is terminated without cause, he will be eligible to receive monthly payments at his then applicable monthly base salary for the rest of his term from the date of termination of the employment.





Yang Yang’s employment agreement has a term of one year, effective as of April 8, 2010, and provides for an annual base salary of RMB 1,000,000(equal to US$146,297), subject to subsequent annual review by our Board of Directors. The term of his agreement shall be automatically renewed for another year, unless a written notice is given by either party of an intention not to renew the agreement no later than 90 days prior to the expiration of the term. The agreement also provides for grant of a stock award of 35,252 shares. The stock are awarded under the Company’s 2006 Equity Incentive Plan and will vest ratably over a five year period, subject to Mr. Yang’s continued employment with the Company on each vesting date. Mr. Yang is also entitled to an annual performance based bonus of up to RMB 500,000 (US$73,149) based upon the Company’s performance and such amount may be increased if the Company exceeds certain net income targets for the year, or may be decreased if the net income targets are not met. We can terminate Mr. Yang’s employment with cause or without cause pursuant to a decision by our Chief Executive Officer. In the event Mr. Yang’s employment is terminated without cause, he will be eligible to receive monthly payments at his then applicable monthly base salary for the rest of his term from the date of termination of the employment.





Since July 2009, Mr. Xu was employed by the Company as General Manager of AOB manufacturing. and Mr. Xu will perform his current services pursuant to the employment agreement entered into with the Company on July 15, 2009.  Such agreement may be terminated by the Company or Mr. Xu with or without cause.  Mr. Xu will be paid an annual salary of RMB 350,000 (equal to $51,127) and is eligible to participate in the Company’s stock and bonus plans.





Potential Payments upon Termination or Change in Control





Assuming the employment of our named executive officers were to be terminated without cause or for good reason, as of December 31, 2010, the following individuals would have been entitled to payments in the amounts set forth opposite to their name in the below table through April 10, 2011:





Cash PaymentsTony Liu

$
66,667Yanchun Li


53,333JunMin


40,000Binsheng Li


26,667Yang Yang


48,766Xiaopeng Xu


17,068





58





2010 Outstanding Equity Awards at Year-end





Option Awards

Stock AwardsNumber of

Securities

Underlying

Unexercised

Options

(#)

Number of

Securities

Underlying

Unexercised

Options

(#)

Equity

Incentive

Plan Awards:

Number of

Securities

Underlying





Number of

Shares or

Market Value of

Shares orName

Exercisable

Unexercisable

Unexercised

Unearned

Options

(#)

Option

Exercise

Price

($)

Option

Expiration

Date

Units of

Stock That

Have Not

Vested (#)

Units of

Stock That

Have Not

Vested ($)Tony Liu

120,000

80,000

200,000

10.74

4/20/2017Tony Liu

44,740

67,110

111,850

8.35

4/20/2018Tony Liu

12,156

48,624

60,780

4.01

4/10/2019

75,320

302,033Tony Liu











129,638

538,000Yanchun Li

96,000

64,000

160,000

10.74

4/20/2017Yanchun Li

39,518

59,276

98,794

8.35

4/20/2018Yanchun Li

10,737

42,948

53,685

4.01

4/10/2019

66,528

266,777Yanchun Li











114,506

475,200Jun Min

72,000

48,000

120,000

10.74

4/20/2017Jun Min

29,638

44,458

74,096

8.35

4/20/2018Jun Min

8,053

32,211

40,264

4.01

4/10/2019

49,896

200,083Jun Min











85,880

356,400Binsheng Li

48,000

32,000

80,000

10.74

4/20/2017Binsheng Li

24,416

36,624

61,040

8.35

4/20/2018Binsheng Li

6,634

26,535

33,169

4.01

4/10/2019

41,104

164,827Binsheng Li











70,747

293,600Yang Yang











29,190

117,050Yang Yang











35,252

146,297Xiaopeng Xu











12,338

51,204





Option Exercises and Stock Vested During 2010





Option AwardsNumber of

Shares Acquired

on Exercise (#)


Value Realized on

Exercise ($)Tony Liu


—



—Yanchun Li


—



—Jun Min


—



—Binsheng Li


—



—Yang Yang


—



—





Compensation of Independent Directors for 2010





The annual retainer is paid to the independent directors in monthly installments in arrears. An independent director is entitled to receive each year shares of Common Stock with an aggregate value range from $65,000 to $73,000 per annum, calculated based on the average closing price per share for the five (5) trading days preceding and including the date of grant. The equity award to independent directors is awarded at the beginning of each year for service rendered for the preceding year. The Company allows each independent director to elect to take stock awards instead of cash compensation. The Company reimburses its independent directors for reasonable travel expenses to attend Board and Committee meetings.




59




The following table sets forth all compensation paid or to be paid by AOB, as well as certain other compensation paid or accrued, for each of the independent directors for 2010.





Name

Fees Earned or

Paid in Cash

($)

Stock Awards

($) (4)

Option Awards

($) (4)

Non-Equity

Incentive Plan

Compensation

($)

Change in

Pension

Value and

Nonqualified

Deferred

Compensation

Earnings ($)

All Other

Compensation

($)

Total

($)Cosimo J. Patti

50,000


65,000
(1)
—


—


—


—


115,000Xianmin Wang

50,000


65,000
(1)
—


—


—


—


115,000Eileen Brody

50,000


70,000
(2)
—


—


—


—


120,000Lawrence S Wizel

50,000


73,000
(3)
—


—


—


—


123,000Baiqing Zhang

50,000


65,000
(1)
—


—


—


—


115,000





(1)
15,845 shares of common stock to be issued were outstanding for each of the independent directors as of January 1, 2011.


(2)
19,913 shares of common stock to be issued were outstanding as of January 1, 2011.


(3)
17,795 shares of common stock to be issued were outstanding as of January 1, 2011


(4)
For awards of stock and option, the aggregate grant date fair value computed in accordance with FASB ASC 718





COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION





Members of our Compensation Committee of the Board of Directors during 2010 were Ms. Brody and Messrs. Patti, Wizel and Wang. No member of our Compensation Committee was, or has been, an officer or employee of the Company or any of our subsidiaries. No member of the Compensation Committee has a relationship that would constitute an interlocking relationship with executive officers or directors of the Company or another entity.





COMPENSATION COMMITTEE REPORT (1)





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





THE COMPENSATION COMMITTEE





Eileen Brody (Chair)


Cosimo J.Patti


Xianmin Wang


Lawrence S. Wizel





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





60





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





The following table sets forth certain information regarding beneficial ownership of common stock as of March 11, 2011 by each person known to us to own beneficially more than 5% of our common stock, each of our directors, each of our named executive officers; and all executive officers and directors as a group.





Title of Class

Name and Addressof Beneficial Owner (1)

Amount and Nature of

Beneficial Ownership (2)


Percent of

Class (3)Series A Preferred Stock

Tony Liu


1,000,000
(4)

100.00%Common Stock

Tony Liu


14,617,900
(5)

18.60%Common Stock

Yanchun Li


989,098
(6)

1.26%Common Stock

Jun Min


1,078,531
(7)

1.37%Common Stock

Binsheng Li


417,047
(8)

*Common Stock

Cosimo J. Patti


40,842
(9)

*Common Stock

Xianmin Wang


63,264
(10)

*Common Stock

Eileen Brody


105,033
(11)

*Common Stock

Lawrence S. Wizel


45,945
(12)

*Common Stock

Baiqing Zhang


40,948
(13)

*Common Stock

Yang Yang


7,279


*Total Ownership of Common Stock by All Directors and Officers as a Group


17,405,932
(14)

22.15%Common Stock

Wellington Management Company, LLP


4,593,068
(15)

5.84%





(1)
Unless otherwise indicated, the address for all named executive officers, directors and shareholders is c/o American Oriental Bioengineering, Inc., 1 Liangshuihe First Ave, Beijing E-Town Economic and Technology Development Area, E-Town, Beijing, 100176, People’s Republic of China.


(2)
The amount of beneficial ownership includes the number of shares of Common Stock and/or Series A Preferred Stock, plus, in the case of each of the executive officers and directors and all officers and directors as a group, all shares issuable upon the exercise of the options held by them, which were exercisable as of March 11, 2011 or within 60 days thereafter. Pursuant to Rule 13d-3 under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”) and the rules promulgated by the SEC, every person who has or shares the power to vote or to dispose of shares of common stock are deemed to be the “beneficial owner” of all the shares of common stock over which any such sole or shared power exists.


(3)
Based upon 78,598,604 shares outstanding as of March 11, 2011.


(4)
Through his Common Stock and Series A Preferred Stock ownership, currently, Mr. Liu has voting power equal to approximately 38.88% of our voting securities.


(5)
Includes 251,422 shares of common stock issuable upon exercise of options.


(6)
Includes 208,750 shares of common stock issuable upon exercise of options.


(7)
Includes 156,563 shares of common stock issuable upon exercise of options.


(8)
Includes 113,892 shares of common stock issuable upon exercise of options.


(9)
Includes 15,845 shares of common stock issuable for services rendered in 2010.


(10)
Includes 15,845 shares of common stock issuable for services rendered in 2010.


(11)
Includes 19,913 shares of common stock issuable for services rendered in 2010.


(12)
Includes 17,795 shares of common stock issuable for services rendered in 2010.


(13)
Includes 15,845 shares of common stock issuable for services rendered in 2010.


(14)
Includes 2,919 shares of Common Stock owned by Xiaoliang Wang, our President of Research and Development.


(15)
Wellington Management Company, LLP, in its capacity as investment adviser, may be deemed to beneficially own 4,593,068 shares of the Issuer which are held of record by clients of Wellington Management Company, LLP.  These securities are owned of record by clients of Wellington Management Company, LLP. Those clients have the right to receive, or the power to direct the receipt of, dividends from, or the proceeds from the sale of, such securities.  The business address of Wellington Management Company, LLP is 280 Congress Street, Boston, MA 02210. The foregoing information was derived from a Schedule 13G filed with the SEC on February 14, 2011.





Changes in Control





None.





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





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





61





Director Independence





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





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





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





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





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





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





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





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


ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES





On August 7, 2009, the Audit Committee of the Board of Directors of the Company approved the engagement of Ernst & Young Hua Ming as the Company’s independent registered public accounting firm for the year ending December 31, 2010.  On August 10, 2009, the Board of Directors of the Company terminated the engagement of Weinberg & Company, P.A. as the independent registered public accounting firm of the Company, effective immediately.





Audit Fees





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





2010:
$1,680,000
Ernst & Young Hua Ming.2010:
$0
Weinberg & Company, P.A.2009:
$1,467,000
Ernst & Young Hua Ming.2009:
$376,293
Weinberg & Company, P.A.





62





Audit Related Fees





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





2010:
$0
Ernst & Young Hua Ming.2010:
$32,775
Weinberg & Company, P.A.2009:
$0
Ernst & Young Hua Ming.2009:
$0
Weinberg & Company, P.A.





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





Tax Fees





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





2010:
$266,942
Ernst & Young Hua Ming.2009:
$7,000
Weinberg & Company, P.A.





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





All Other Fees





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





2010:
$0
Ernst & Young Hua Ming.2009:
$27,222
Weinberg & Company, P.A.





Audit Committee Approval





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





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





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





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




63




The Audit Committee will not grant approval for:





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





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





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





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





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





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





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





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





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





PART IV





ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES




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





1. Financial Statements





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





2. Financial Statement Schedules





Schedule II — Valuation and Qualifying Accounts





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





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


●
2006 Equity Incentive Plan
 ●
Employment Agreement, dated April 8, 2010, by and between American Oriental Bioengineering, Inc. and Tony Liu
 ●
Employment Agreement, dated April 8, 2010, by and between American Oriental Bioengineering, Inc. and Yanchun Li
 ●
Employment Agreement, dated April 8, 2010, by and between American Oriental Bioengineering, Inc. and Jun Min
 ●
Employment Agreement, dated April 8, 2010, by and between American Oriental Bioengineering, Inc. and Binsheng Li
 ●
Employment Agreement, dated April 8, 2010, by and between American Oriental Bioengineering, Inc. and Yang Yang
 ●
Executive Employment Agreement dated as of July 15, 2009 between the Company and Xiaopeng Xu


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





(c) Not applicable.





64




AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


SCHEDULE II — VALUATION AND QUALIFYING ACCOUNTS


Fiscal Years Ended December 31, 2010, 2009 and 2008








Description
Balance at

December

31, 2007
Additions
Deductions
Balance at

December

31, 2008
Additions
Deductions
Balance at

December

31, 2009
Additions
Deductions
Balance at

December

31, 2010(1)

Charged

to costs and expenses
(2)

Charged

to other accounts


(1)

Charged

to costs

and

expenses
(2)

Charged

to other accounts


(1)

Charged to costs and expenses
(2) Charged to other accountsAllowance for doubtful accounts
$302,270


$75,940
$226,330
$296,567


$522,897
$164,982


$687,879Allowance for inventories
$237,427


$69,998
$167,429


$131,587
$35,842


$13,108
$22,734






65





EXHIBIT INDEX





Reg. S-K

Exhibit Table

Item No.

Description

of Exhibit2.1

Purchase Agreement, dated as of September 8, 2004, between American Oriental Bioengineering, Inc., the Government of Heilongjiang Province of China and Heilongjiang Songhuajiang Pharmaceutical Limited (incorporated by reference from the Report on Form 8-K, Commission File No. 000-29785, filed with the Commission on September 14, 2004).2.2

Acquisition Agreement, dated September 6, 2007, by and between American Oriental Bioengineering, Inc. and Renson Holdings Limited for the purchase of all of the outstanding capital stock of Changchun Xinan Pharmaceutical Group Company Limited (incorporated by reference from the Report on Form 10-Q, Commission File No. 001-32569, filed with the Commission on November 5, 2007).2.3

Acquisition Agreement, dated October 18, 2007, by and between American Oriental Bioengineering, Inc. and Renson Holdings Limited for the purchase of all of the outstanding capital stock of Guangxi Boke Pharmaceutical Limited (incorporated by reference from the Report on Form 10-Q, Commission File No. 001-32569, filed with the Commission on November 5, 2007).3.1(a)

Amendment and Restatement of Articles of Incorporation of American Oriental Bioengineering, Inc. (incorporated by reference from the Registration Statement on Form SB-2 Commission File No. 333-124133, filed with the Commission on April 18, 2005).3.1(b)

Certificate of Amendment to Amendment and Restatement of Articles of Incorporation of American Oriental Bioengineering, Inc. (incorporated by reference from the Registration Statement on Form S-3 Commission File No. 333-131229, filed with the Commission on January 23, 2006).3.2

Amended and Restated Bylaws of American Oriental Bioengineering, Inc. (incorporated by reference from the Report on Form 10-Q, Commission File No. 001-32569, filed with the Commission on August 11, 2008).4.1

Form of Warrant (incorporated by reference from the Current Report on Form 8-K, Commission File No. 001-32569, filed with the Commission on December 1, 2005).4.2

American Oriental Bioengineering, Inc. 2003 Stock Option Plan (incorporated by reference from the Report on Form 10-KSB, Commission File No. 000-29785, filed with the Commission on April 15, 2004).4.3

Indenture, dated as of July 15, 2008, by and between Wells Fargo Bank, National Association, as Trustee and American Oriental Bioengineering, Inc. (incorporated by reference from the Current Report on Form 8-K, Commission File No. 001-32569, filed with the Commission on July 15, 2008).4.4

Registration Rights Agreement, dated as of July 15, 2008, by and among the investors specified therein and American Oriental Bioengineering, Inc. (incorporated by reference from the Current Report on Form 8-K, Commission File No. 001-32569, filed with the Commission on July 15, 2008).4.5

2006 Equity Incentive Plan (incorporated by reference to the Proxy Statement on Schedule 14A, filed with the Commission on October 17, 2006).10.1

Stock and Warrant Purchase Agreement, dated as of November 28, 2005, by and among American Oriental Bioengineering, Inc. and the signatory purchasers named therein (incorporated by reference from the Current Report on Form 8-K, Commission File No. 001-32569, filed with the Commission on December 1, 2005).10.2

Form of Registration Rights Agreement by and among American Oriental Bioengineering, Inc. and the signatories thereto (incorporated by reference from the Current Report on Form 8-K, Commission File No. 001-32569, filed with the Commission on December 1, 2005).10.3

Purchase Agreement, dated September 8, 2004, by and between American Oriental Bioengineering, Inc. and the Government of Heilongjiang Province of China and Heilongjiang Songhuajiang Pharmaceutical Limited (incorporated by reference from the Current Report on Form 8-K, Commission File No. 000-29785, filed with the Commission on September 14, 2004).10.4

Purchase Agreement, dated as of August 18, 2002, by and between American Oriental Bioengineering, Inc. and Tony Liu (incorporated by reference from the Schedule 14C Commission File No. 000-29785, filed with the Commission on October 15, 2002).





66




10.5

Subscription Agreement, dated as of November 23, 2004, between American Oriental Bioengineering, Inc. and the Subscribers (incorporated by reference from the Registration Statement on Form SB-2, Commission File No. 333-124133, filed with the Commission on April 18, 2005).10.6(a)

Consulting Agreement, dated June 28, 2004, by and between American Oriental Bioengineering, Inc. and Bai Chao (incorporated by reference from the Registration Statement on Form S-8, Commission File No. 333-117276, filed with the Commission on July 9, 2004).10.6(b)

Consulting Agreement, dated June 28, 2004, by and between American Oriental Bioengineering, Inc. and Kou Yumin (incorporated by reference from the Registration Statement on Form S-8, Commission File No. 333-117276, filed with the Commission on July 9, 2004).10.6(c)

Consulting Agreement, dated June 28, 2004, by and between American Oriental Bioengineering, Inc. and Xiangli Men (incorporated by reference from the Registration Statement on Form S-8 Commission File No. 333-117276, filed with the Commission on July 9, 2004).10.6(d)

Consulting Agreement, dated June 28, 2004, by and between American Oriental Bioengineering, Inc. and Linda Welsh (incorporated by reference from the Registration Statement on Form S-8 Commission File No. 333-117276, filed with the Commission on July 9, 2004).10.6(e)

Consulting Agreement, dated June 28, 2004, by and between American Oriental Bioengineering, Inc. and Dr. Jie Zhu (incorporated by reference from the Registration Statement on Form S-8 Commission File No. 333-117276, filed with the Commission on July 9, 2004).10.6(f)

Consulting Agreement, dated June 28, 2004, by and between American Oriental Bioengineering, Inc. and Brian Corday (incorporated by reference from the Registration Statement on Form S-8 Commission File No. 333-117276, filed with the Commission on July 9, 2004).10.6(g)

Consulting Agreement, dated October 1, 2003, by and between American Oriental Bioengineering, Inc. and Haishan Wang (incorporated by reference from the Registration Statement on Form S-8 Commission File No. 333-109832, filed with the Commission on October 10, 2003).10.6(h)

Consulting Agreement, dated October 1, 2003, by and between American Oriental Bioengineering, Inc. and Xiangli Men (incorporated by reference from the Registration Statement on Form S-8 Commission File No. 333-109832, filed with the Commission on October 10, 2003).10.6(i)

Consulting Agreement, dated October 1, 2003, by and between American Oriental Bioengineering, Inc. and Lau Chak Wong (incorporated by reference from the Registration Statement on Form S-8 Commission File No. 333-109832, filed with the Commission on October 10, 2003).10.7(a)

Independent Director Agreement, dated July 1, 2006, by and between American Oriental Bioengineering, Inc. and Cosimo J. Patti (incorporated by reference to the Quarterly Report on Form 10-Q, filed with the Commission on August 14, 2006).10.7(b)

Independent Director Agreement, dated July 1, 2006, by and between American Oriental Bioengineering, Inc. and Xianmin Wang (incorporated by reference to the Quarterly Report on Form 10-Q, filed with the Commission on August 14, 2006).10.7(c)

Independent Director Agreement, dated July 1, 2006, by and between American Oriental Bioengineering, Inc. and Eileen B. Brody (incorporated by reference to the Quarterly Report on Form 10-Q, filed with the Commission on August 14, 2006).10.7(d)

Independent Director Agreement, dated August 21, 2006, by and between American Oriental Bioengineering, Inc. and Lawrence S. Wizel, (incorporated by reference to the Annual Report on Form 10-K, filed with the Commission on March 13, 2007).10.7(e)

Independent Director Agreement, dated December 15, 2006, by and between American Oriental Bioengineering, Inc. and Baiqing Zhang, (incorporated by reference to the Annual Report on Form 10-K, filed with the Commission on March 13, 2007).10.8

Securities Purchase Agreement, dated as of July 9, 2008, by and among the investors specified therein and American Oriental Bioengineering, Inc. (incorporated by reference from the Current Report on Form 8-K, Commission File No. 001-32569, filed with the Commission on July 15, 2008).





67




10.9

Form of Prepaid Forward Share Repurchase Contract Confirmation, dated as of July 15, 2009 (incorporated by reference from the Current Report on Form 8-K, Commission File No. 001-32569, filed with the Commission on July 15, 2008).10.10(a)

Employment Agreement, dated April 8, 2010, by and between American Oriental Bioengineering, Inc. and Tony Liu, filed herewith.10.10(b)

Employment Agreement, dated April 8, 2010, by and between American Oriental Bioengineering, Inc. and Yanchun Li, filed herewith.





10.10(c)

Employment Agreement, dated April 8, 2010, by and between American Oriental Bioengineering, Inc. and Jun Min, filed herewith.10.10(d)

Employment Agreement, dated April 8, 2010, by and between American Oriental Bioengineering, Inc. and Binsheng Li, filed herewith.10.10(e)

Employment Agreement, dated April 8, 2010, by and between American Oriental Bioengineering, Inc. and Yang Yang, filed herewith.10.11

Stock Award and Non-Qualified Stock Option Grant Agreement (incorporated by reference to the Annual Report on Form 10-K, filed with the Commission on March 15, 2010).10.12

Executive Employment Agreement dated as of July 15, 2009 between the Company and Xiaopeng Xu (incorporated by reference from the Current Report on Form 8-K, filed with the Commission on March 17, 2011).14

Amended and Restated Code of Ethics of American Oriental Bioengineering, Inc., dated November 9, 2006, (incorporated by reference to the Annual Report on Form 10-K, filed with the Commission on March 13, 2007).21

Subsidiaries of the Registrant, (incorporated by reference to the Annual Report on Form 10-K, filed with the Commission on March 15, 2009).23.1

Consent of Ernst & Young Hua Ming, an independent registered public accounting firm.23.2

Consent of Weinberg and Company, P.A., an independent registered public accounting firm.31.1

Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith.31.2

Certification of Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith.32

Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. 1350 (Section 906 of the Sarbanes-Oxley Act of 2002), filed herewith.





68





SIGNATURES





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







AMERICAN ORIENTAL BIOENGINEERING, INC.Date: March 15, 2011
By:
/s/ Tony LiuTony LiuChief Executive Officer and Chairman of the Board of Directors (Principal Executive Officer)





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





SIGNATURE

TITLE

DATE/s/ Tony Liu

Chief Executive Officer and Chairman of the Board of Directors

March 15, 2011Tony Liu

(Principal Executive Officer)/s/ Yanchun Li

Chief Financial Officer, Secretary and Director

March 15, 2011Yanchun Li

(Principal Financial Officer)/s/ Jun Min

Vice President and Director

March 15, 2011Jun Min/s/ Binsheng Li

Chief Accounting Officer and Director

March 15, 2011Binsheng Li

(Principal Accounting Officer)/s/ Cosimo J. Patti

Independent Director

March 15, 2011Cosimo J. Patti/s/ Xianmin Wang

Independent Director

March 15, 2011Xianmin Wang/s/ Eileen Brody

Independent Director

March 15, 2011Eileen Brody/s/ Lawrence S. Wizel

Independent Director

March 15, 2011Lawrence S. Wizel/s/ Baiqing Zhang

Independent Director

March 15, 2011Baiqing Zhang





69




AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES





TABLE OF CONTENTS





PAGE
2-3
REPORTS OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMSPAGE
4-5
CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 2010 AND 2009PAGE
6
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME FOR THE YEARS ENDED DECEMBER 31, 2010, 2009 AND 2008PAGE
7
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY FOR THE YEARS ENDED DECEMBER 31, 2010, 2009 AND 2008PAGE
8
CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2010, 2009 AND 2008PAGE
9-33
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2010, 2009 AND 2008





F-1





Report of Independent Registered Public Accounting Firm





The Board of Directors and Shareholders of


American Oriental Bioengineering, Inc.





We have audited the accompanying consolidated balance sheets of American Oriental Bioengineering, Inc. as of December 31, 2010 and 2009, and the related consolidated statements of income and comprehensive income, changes in shareholders’ equity, and cash flows for each of the two years in the period ended December 31, 2010. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.





We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Oriental Bioengineering, Inc. at December 31, 2010 and 2009, and the consolidated results of its operation and its cash flow for each of the two years in the period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.




We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), American Oriental Bioengineering, Inc.’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 15, 2011 expressed an unqualified opinion thereon.














/s/ Ernst & Young Hua Ming


Shanghai, The People’s Republic of China


March 15, 2011




F-2





Report of Independent Registered Public Accounting Firm





To the Board of Directors and Shareholders of


American Oriental Bioengineering, Inc.:





We have audited the accompanying consolidated statements of income and comprehensive income, changes in shareholders’ equity and cash flows of American Oriental Bioengineering, Inc. and Subsidiaries (the “Company”) for the year ended December 31, 2008.  Our audit also included the financial statement schedule on page 65 for the year ended December 31, 2008. We have also audited the Company’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organization of the Treadway Commission.  As described in Management’s Report on Internal Control over Financial Reporting, management excluded from its assessment the internal control over financial reporting at Nuo Hua Investment Company Ltd., which was acquired October 18, 2008, and Guangxi HuiKe Pharmaceutical Research and Development Co., ltd., which was acquired October 20, 2008, and whose combined financial statements constitute 11% and 10% of net and total assets, respectively, and 2% of revenues and (25%) of net income of the consolidated financial statements as of and for the year ended December 31, 2008. Accordingly, our audit did not include the internal control over financial reporting at Nuo Hua Investment Company Ltd. and GuangXi HuiKe Pharmaceutical Research and Development Co., Ltd. The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these consolidated financial statements and the financial statement schedule and an opinion on the Company’s internal control over financial reporting based on our audit.





We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. An audit of the consolidated financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation.  Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk.  Our audit also included performing such other procedures as we considered necessary in the circumstances.  We believe that our audit provides a reasonable basis for our opinion.





A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive an principal financial officers, or persons performing similar functions, and effected by the company’s Board of Directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with  generally accepted accounting principles and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.





Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be detected on a timely basis.   Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.





In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of American Oriental Bioengineering, Inc. and Subsidiaries for the year ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America.  Also, in our opinion, the related financial statement schedule for the year ended December 31, 2008, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.





Weinberg & Company, P.A.


Boca Raton, Florida


February 27, 2009




F-3





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


CONSOLIDATED BALANCE SHEETS




ASSETS





DECEMBER 31,2010


2009CURRENT ASSETSCash and cash equivalents

$
94,568,520


$
91,126,486Restricted cash


537,297



3,298,379Accounts and notes receivable, net


80,598,919



57,504,454Inventories, net


12,665,586



10,015,711Advances to suppliers and prepaid expenses


14,246,144



13,901,180Deferred tax assets


649,503



824,451Other current assets


2,986,005



1,246,647Total Current Assets


206,251,974



177,917,308LONG-TERM ASSETSProperty, plant and equipment, net


109,547,616



95,468,265Land use rights, net


155,433,311



153,604,196Other long term assets


8,167,880



7,909,086Construction in progress


22,516,044



28,975,386Other intangible assets, net


14,889,127



18,695,554Goodwill


33,164,121



33,164,121Investments in and advances to equity investments


59,068,491



57,325,887Deferred tax assets


147,024



134,268Unamortized financing cost


2,359,404



3,287,694Total Long-Term Assets


405,293,018



398,564,457TOTAL ASSETS

$
611,544,992


$
576,481,765





See accompanying notes to the consolidated financial statements




F-4
 
 
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 CONSOLIDATED BALANCE SHEETS
  LIABILITIES AND SHAREHOLDERS’ EQUITY





DECEMBER 31,2010


2009CURRENT LIABILITIESAccounts payable

$
10,716,686


$
7,497,143Notes payable


537,297



3,392,575Other payables and accrued expenses


18,039,557



22,320,757Taxes payable


1,237,169



947,338Short-term bank loans


6,957,258



10,384,368Current portion of long-term bank loans


61,405



60,108Other liabilities


6,284,107



2,199,280Deferred tax liabilities


243,304



172,473Total Current Liabilities


44,076,783



46,974,042LONG-TERM LIABILITIESLong-term bank loans, net of current portion


679,866



743,957Deferred tax liabilities


15,837,479



15,961,465Unrecognized tax benefits


5,050,157



2,746,561Convertible notes


115,000,000



115,000,000Total Long-Term Liabilities


136,567,502



134,451,983TOTAL LIABILITIES


180,644,285



181,426,025COMMITMENTS AND CONTINGENCIESEQUITYSHAREHOLDERS’ EQUITYPreferred stock, $0.001 par value; 2,000,000 shares authorized; 1,000,000 shares issued and outstanding at December 31, 2010 and December 31, 2009, respectively


1,000



1,000Common stock, $0.001 par value; 150,000,000 shares authorized; 78,598,604 and 78,321,439 shares issued and outstanding at December 31, 2010 and December 31, 2009, respectively


78,598



78,321Common stock to be issued


350,500



388,000Prepaid forward repurchase contract


(29,998,616)



(29,998,616
)Additional paid-in capital


203,322,671



199,829,921Retained earnings (the restricted portion of retained earnings is $26,471,124 and $23,757,901 at December 31, 2010 and December 31, 2009, respectively)


207,515,104



191,173,754Accumulated other comprehensive income


49,126,251



33,050,224Total Shareholders’ Equity


430,395,508



394,522,604Non-controlling Interest


505,199



533,136TOTAL EQUITY


430,900,707



395,055,740TOTAL LIABILITIES AND EQUITY

$
611,544,992


$
576,481,765





See accompanying notes to the consolidated financial statements




F-5





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME





YEARS ENDED DECEMBER 31,2010


2009


2008Revenues

$
305,944,085


$
296,150,780


$
264,643,058Cost of sales


148,186,531



129,367,775



91,031,274GROSS PROFIT


157,757,554



166,783,005



173,611,784Selling, general and administrative expenses


66,439,702



62,164,936



57,849,286Advertising costs


38,920,905



31,896,992



34,102,538Research and development costs


15,365,131



7,922,357



1,528,991Depreciation and amortization expenses


6,662,237



6,038,625



4,383,215Purchased in-process research and development expenses


—



—



12,255,248Total operating expenses


127,387,975



108,022,910



110,119,278INCOME FROM OPERATIONS


30,369,579



58,760,095



63,492,506Equity in earnings (losses) from unconsolidated entities


384,991



2,075,139



(1,132,986)Interest expense, net


(5,900,055)



(5,746,382)



(2,571,015)Other expenses, net


(204,736)



(569,661)



(65,843)INCOME BEFORE INCOME TAX


24,649,779



54,519,191



59,722,662Income tax


8,336,366



13,216,986



12,635,472NET INCOME


16,313,413



41,302,205



47,087,190Net loss (income) attributable to non-controlling interest


27,937



118,945



(27,575)NET INCOME ATTRIBUTABLE TO CONTROLLING INTEREST


16,341,350



41,421,150



47,059,615OTHER COMPREHENSIVE INCOMEForeign currency translation gain


16,076,027



1,362,038



15,767,870OTHER COMPREHENSIVE INCOME


16,076,027



1,362,038



15,767,870COMPREHENSIVE INCOME

$
32,417,377


$
42,783,188


$
62,827,485EARNINGS PER COMMON SHAREBasic

$
0.22


$
0.56


$
0.62Diluted

$
0.22


$
0.53


$
0.61WEIGHTED AVERAGE COMMON SHARES OUTSTANDINGBasic


74,810,016



74,612,602



76,504,035Diluted


75,724,826



89,286,621



82,254,185





See accompanying notes to the consolidated financial statements




F-6


AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY





Total American Oriental Bioengineering, Inc. Shareholders’ EquityPreferred Stock



Common StockShares


Stated

Value



Shares


Par

Value


Stock To

Be Issued


Prepaid

forward

Repurchase

Contract


Additional

Paid-in

Capital


Retained

Earnings


Accumulated

Other

Compre-hensive

Income


Non-controlling

Interest

Total

EquityBALANCE AT DECEMBER 31, 2007


1,000,000


$
1,000



77,991,935


$
77,992


$
1,611,333


$
—


$
193,474,941


$
102,692,989


$
15,920,316


$
—

$
313,778,571Common stock issued for director services


—



—



26,581



26



(285,333
)


—



285,307



—



—



—


—Common stock to be issued for director services


—



—



—



—



376,335



—



—



—



—



—


376,335Common stock issued for consulting services


—



—



26,748



27



—



—



259,973



—



—



—


260,000Stock-based compensation to employees


—



—



—



—



—



—



1,700,671



—



—



—


1,700,671Prepaid forward repurchase contract


—



—



—



—



—



(29,998,616
)


—



—



—



—


(29,998,616)Exercise of warrants


—



—



204,000



204



(1,326,000
)


—



1,325,796



—



—



—


—Acquisition of non-controlling interest


—



—



—



—



—



—



—



—



—



624,506


624,506Foreign currency translation


—



—



—



—



—



—



—



—



15,767,870






15,767,870Net income


—



—



—



—



—



—



—



47,059,615



—



27,575


47,087,190BALANCE AT DECEMBER 31, 2008


1,000,000


$
1,000



78,249,264


$
78,249


$
376,335


$
(29,998,616
)

$
197,046,688


$
149,752,604


$
31,688,186



652,081

$
349,596,527Common stock issued for director services


—



—



42,471



42



(376,335
)


—



376,293



—



—



—


—Common stock to be issued for director services


—



—



—



—



388,000



—



—



—



—



—


388,000Common stock issued for consulting services


—



—



29,704



30



—



—



160,770



—



—



—


160,800Stock-based compensation to employees


—



—



—



—



—



—



2,246,170



—



—



—


2,246,170Foreign currency translation


—



—



—



—



—



—



—



—



1,362,038



—


1,362,038Net income / (loss)


—



—



—



—



—



—



—



41,421,150



—



(118,945)


41, 302,205BALANCE AT DECEMBER 31, 2009


1,000,000


$
1,000



78,321,439


$
78,321


$
388,000


$
(29,998,616
)

$
199,829,921


$
191,173,754


$
33,050,224



533,136

$
395,055,740Common stock issued for director services


—



—



80,375



80



(388,000
)


—



387,920



—



—



—


—Common stock to be issued for director services


—



—



—



—



350,500



—



—



—



—



—


350,500Common stock issued for consulting services


—



—



93,462



94



—



—



418,923



—



—



—


419,017Stock-based compensation to employees


—



—



—



—



—



—



2,686,010



—



—



—


2,686,010Exercise of common stock awards to employees


—



—



103,328



103



—



—



(103)



—



—



—


—Foreign currency translation


—



—



—



—



—



—



—



—



16,076,027



—


16,076,027Net income / (loss)


—



—



—



—



—



—



—



16,341,350



—



(27,937)


16,313,413BALANCE AT DECEMBER 31, 2010


1,000,000


$
1,000



78,598,604


$
78,598


$
350,500


$
(29,998,616
)

$
203,322,671


$
207,515,104


$
49,126,251


$
505,199

$
430,900,707




See accompanying notes to the consolidated financial statements


F-7





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


CONSOLIDATED STATEMENTS OF CASH FLOWS





YEARS ENDED DECEMBER 31,2010


2009


2008CASH FLOWS FROM OPERATING ACTIVITIES:Net income

$
16,313,413


$
41,302,205


$
47,087,190Adjustments to reconcile net income to net cash provided by operating activities:Depreciation and amortization


12,704,743



12,439,088



9,919,809Amortization of deferred issuance cost


928,289



928,289



425,466Loss on disposal of property, plant and equipment


89,760



15,039



29,890Stock-based consulting expenses


168,092



164,600



268,500Purchased in-process research and development


—



—



12,255,248Provision for (reversal of) doubtful accounts and slow moving inventories


142,836



164,980



(200,683)Deferred taxes


(402,537)



(978,175
)


1,205,733Stock-based compensation expenses


2,686,010



2,246,173



1,700,671Equity in (earnings) losses from unconsolidated entities


(384,991)



(2,075,139)



1,131,647Independent director stock compensation


350,500



388,000



376,335Changes in operating assets and liabilities, net of effects of acquisitions:(Increase) decrease in:Accounts and notes receivable


(23,247,668)



(20,111,898)



(14,542,181)Inventories


(2,639,009)



3,153,553



745,267Advances to suppliers and prepaid expenses


(320,239)



(18,152,003
)


939,249Other current assets


(1,685,995)



(480,066
)


1,185,707Increase (decrease) in:Accounts payable


2,016,701



(4,790,744
)


4,854,620Other payables and accrued expenses


(5,365,288)



2,224,217



11,927,197Taxes payable


289,831



526,668



(2,427,886)Other liabilities


4,085,209



(52,716
)


(2,071,912
)Unrecognized tax benefits


2,303,596



2,746,561



—Net cash provided by operating activities


8,033,253



19,658,632



74,809,867CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of property, plant and equipment


(1,025,842)



(1,117,992
)


(48,561,170
)Purchases of construction in progress


(5,037,826)



(2,861,461
)


(24,574,369
)Purchase of land use rights and other intangible assets


(18,032)



(1,119,264
)


(99,546,611)Purchases of subsidiaries, net of cash acquired


—



—



(53,055,492
)Refundable deposit


—



6,397,106



(2,917,734)Deposit for long-term assets


(27,502)



—



(6,347,174
)Investments in and advances to equity investments


(53,838)



(238,795
)


(22,379,659)Proceeds from disposal of property, plant and equipment


255



93,764



8,116Net cash (used in) provided by investing activities


(6,162,785)



1,153,358



(257,374,093)
 CASH FLOWS FROM FINANCING ACTIVITIES:Proceeds from bank loans


6,764,562



10,682,945



9,480,315Repayment of bank loans


(10,634,641)



(8,875,954)



(11,467,826)Net proceeds from convertible notes






—



110,358,550Prepaid forward repurchase contract






—



(29,998,616
)Net cash (used in) provided by financing activities


(3,870,079)



1,806,991



78,372,423Effect of exchange rate changes on cash and cash equivalents


5,441,645



446,736



5,842,497NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS


3,442,034



23,065,717



(98,349,306)Cash and cash equivalents, beginning of year


91,126,486



68,060,769



166,410,075CASH AND CASH EQUIVALENTS, END OF YEAR

$
94,568,520


$
91,126,486


$
68,060,769
 SUPPLEMENTARY CASH FLOW INFORMATIONNon-cash transactions:Conversion of promissory note to investment in equity investments


—



4,759,612



—Cash paid during the period for:Interest paid

$
6,252,963


$
6,236,504


$
778,013Income taxes paid

$
6,658,671


$
11,401,681


$
14,909,132





See accompanying notes to the consolidated financial statements




F-8




AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE 1 - PRINCIPAL ACTIVITIES AND ORGANIZATION





American Oriental Bioengineering, Inc. (“AOB”) is a fully integrated pharmaceutical company dedicated to improving health through the development, manufacture, commercialization and distribution of a broad range of pharmaceutical and healthcare products in China. AOB and its subsidiaries are collectively referred to herein as the “Company,” “we,” “us,” “our” and “ourselves,” unless the context indicates otherwise. The following list contains the particulars of its operating subsidiaries and major affiliate companies:





Name of Subsidiary

Principal activities

Acquired

Percentage of

ownership

December 31,

2010Harbin Three Happiness Bioengineering Co., Ltd. (“Three Happiness”)

Manufacture and commercialize a broad range of branded pharmaceutical and nutraceutical products

Dec 2001

100%Heilongjiang Songhuajiang Pharmaceutical Co., Ltd. (“HSPL”)

Manufacture and commercialize an anti-viral injection powder, a prescription pharmaceutical product

Sept 2004

100%Guangxi Lingfeng Pharmaceutical Co., Ltd. (“GLP”)

Manufacture and commercialize a series of pharmaceutical products that focus on women’s health

Apr 2006

100%Heilongjiang Qitai Pharmaceutical Co., Ltd. (“HQPL”)

Wholesale of pharmaceutical and nutraceutical products

Jul 2006

100%Changchun Xinan Pharmaceutical Co., Ltd. (“CCXA”)

Manufacture and distribute a broad range of generic pharmaceutical products

Sept 2007

100%Guangxi Boke Pharmaceutical Co., Ltd. (“Boke”)

Manufacture and commercialize pharmaceutical products that alleviate nasal congestion and provide sinus relief

Oct 2007

100%Shen zhen Nuo Hua Trading Co., Ltd. (“Nuo Hua”)

Wholesale and retail of pharmaceutical and nutraceutical products

Oct 2008

100%GuangXi HuiKe Research and Development Co., Ltd. (“GHK”)

Pharmaceutical research and products development

Oct 2008

100%Aoxing Pharmaceutical Company, Inc. (“AXN”)

Manufacture and commercialize pain management pharmaceutical products

Apr 2008

36.1%





NOTE 2 - BASIS OF PRESENTATION





Basis of Consolidation





The consolidated financial statements include the financial statements of American Oriental Bioengineering, Inc. and its subsidiaries. All significant inter-company balances and transactions between the Company and its subsidiaries are eliminated upon consolidation. Results of acquired subsidiaries are consolidated from the date on which control is transferred to the Company and are no longer consolidated from the date that control ceases.





Use of Estimates





The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. Significant estimates reflected in the consolidated financial statements include, but are not limited to, the recoverability of the carrying amount and estimated useful lives of long-lived assets, allowance for accounts receivable, realizable values for inventories, valuation allowance of deferred tax assets, purchase price allocation of its acquisitions, valuation of derivative financial instruments, and share-based compensation expenses. Changes in facts and circumstances may result in revised estimates. Actual results could differ from these estimates.




F-9
 
 
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





Foreign Currency





The accompanying consolidated financial statements are presented in United States dollars (“US$”). The functional currency of the Company is US$, while that of the Company’ subsidiaries operating in the PRC is Renminbi (“RMB”), as determined based on the criteria of Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ ASC”) 830 “Foreign Currency Matters”.





Assets and liabilities of non-U.S. subsidiaries are translated into U.S. dollars at the noon buying rate certified by the Federal Reserve Bank of New York on December 31, 2010. Income and expense items are translated at average exchange rates prevailing during the period. The resulting translation adjustments are recorded as a component of shareholders’ equity. Gains and losses from foreign currency transactions are included in net income.





2010


2009


2008Year end RMB : US$ exchange rate


6.6118



6.8372



6.8542Average yearly RMB : US$ exchange rate


6.7245



6.8457



7.0842





The RMB is not freely convertible into foreign currency and all foreign exchange transactions must take place through authorized institutions. No representation is made that the RMB amounts could have been, or could be, converted into US$ at the rates used in translation.





NOTE 3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





Revenue Recognition





Revenues represent the invoiced value of goods sold and are recognized upon the shipment of goods to customers. The product sales price stated in the sales contract or purchase order is final and not subject to adjustment. Revenues are recognized pursuant to FASB ASC 605 “Revenue Recognition”, when all of the following criteria are met:





●
Persuasive evidence of an arrangement exists,





●
Delivery has occurred or services have been rendered,





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





●
Collectability is reasonably assured.





Revenue is recognized net of all value-added taxes imposed by governmental authorities and collected from customers concurrent with revenue-producing transactions.





For the year ended December 31, 2008 and 2009, the Company offered sales rebates to its major customers based on collections made during the year, provided that the customers make payments prior to certain days after year end. The rebates are calculated based on different percentages depending on settlement methods, which include settling by cash or notes receivable. Customers are entitled to either cash rebates or receiving additional free inventories based on predetermined prices. In accordance with FASB ASC 605, the Company accounted for estimated cash settlement as sales discount, and estimated free inventories as cost of sales, upon recognition of revenue. Such estimation is based on maximum exposure the Company potentially will offer in rebates, and subsequently true up at year end. No sales rebates were offered by the Company to its customers for the year ended December 31, 2010.





Cost of Sales





Cost of sales includes direct and indirect production costs, as well as freight in and handling costs for products sold.





Selling, General and Administrative Expenses





Selling, general and administrative (SG&A) expenses include salaries, benefits and other staff-related costs associated with sales and marketing, finance and other administrative personnel; facilities and overhead costs; legal expenses and other general and administrative costs. SG&A expenses also include the costs of selling merchandise, including preparing the merchandise for sale, such as picking, packing, warehousing and order charges. All shipping and handling are expensed as incurred and outbound freight is not billed to customers.





F-10




AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





Advertising Costs





The Company expenses advertising costs as incurred. Point of sale materials are accounted for as inventories and are charged to expense as utilized.





Research and Development Costs





Research and development costs are expensed as incurred.





FASB ASC 805 “Business combinations” requires the recognition of tangible and intangible assets that result from or are to be used in research and development activities as assets, irrespective of whether the acquired assets have an alternative future use. Acquired In-Progress Research & Development (IPR&D) assets are required to be measured at their acquisition-date fair value. Uncertainty about the outcome of an individual project does not affect the recognition of an IPR&D asset, but is reflected in its fair value.





Comprehensive Income





Comprehensive income is defined to include all changes in equity except those resulting from investments by owners and distributions to owners. Among other disclosures, items that are required to be recognized under current accounting standards as components of comprehensive income are required to be reported in a financial statement that is presented with the same prominence as other financial statements. The Company’s comprehensive income includes net income and foreign currency translation adjustments.





Stock-Based Compensation





Stock-based compensation includes 1) stock options and common stock awards granted to employees and directors for services, and are accounted for under FASB ASC 718 “Compensation - Stock Compensation”, and 2) common stock awards granted to consultants which are accounted for under FASB ASC 505-50 “Equity – Equity-Based Payments to Non-Employees”.





All grants of common stock awards and stock options to employees and directors are recognized in the financial statements based on their grant date fair values. The Company has elected to recognize compensation expense using the straight-line method for all common stock awards and stock options granted with service conditions that have a graded vesting schedule, with a corresponding charge to additional paid-in capital.





Common stock awards are granted to directors for services provided. The vested portions of common stock awards granted but not yet issued are recorded in Common Stock to be Issued until issuance.





Common stock awards issued to consultants represent common stock granted to non-employees in exchange for services at fair value. The measurement dates for such awards are set at dates that the contracts are entered into as the awards are non-forfeitable and vest immediately. The measurement date fair value is then recognized over the service period as if the Company has paid cash for such service. The Company does not have significant grants to consultants for any of the period presented.





The Company estimates fair value of common stock awards based on the number of shares granted and the quoted price of the Company’s common stock on the date of grant.





The fair value of stock options is estimated using the Black-Scholes model. The Company’s expected volatility assumption


is based on the historical volatility of the Company’s stock. The expected life assumption is presumed to be the mid-point between the vesting date and the end of the contractual term, as is permitted for “plain vanilla” employee stock options. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant.





FASB ASC 718 requires forfeitures to be estimated at the time of grant and revised, if necessary, in the subsequent period if actual forfeitures differ from initial estimates. Forfeiture rate is estimated based on historical and future expectation of employee turnover rate and are adjusted to reflect future change in circumstances and facts, if any. Share-based compensation expense is recorded net of estimated forfeitures such that expense was recorded only for those stock options and common stock awards that are expected to vest.




F-11




AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





Income Taxes





The Company accounts for income taxes following the liability method pursuant to FASB ASC 740 “Income Taxes”.  Under this method, deferred tax assets and liabilities are determined based on the difference between the financial reporting and tax bases of assets and liabilities using enacted tax rates that will be in effect in the period in which the differences are expected to reverse. The Company records a valuation allowance to offset deferred tax assets if, based on the weight of available evidence, it is more-likely-than-not that some portion, or all, of the deferred tax assets will not be realized.  The effect on deferred taxes of a change in tax rate is recognized in income in the period that includes the enactment date.





The Company accounts for uncertainty in income taxes in accordance with FASB ASC 740-10 “Income Taxes-Overall”. The Company has elected to classify interest and penalties related to an uncertain position, if and when required, as part of interest expenses and other expenses, respectively, in the consolidated statements of income and comprehensive income.





Value-Added Tax (“VAT”)





Enterprises or individuals, who sell commodities, engage in repair and maintenance or import or export goods in the PRC are subject to a value-added tax in accordance with the PRC laws. The value-added tax’s standard rate is 17% of the gross sales price and the Company records its revenue net of VAT. A credit is available whereby VAT paid on the purchases of semi-finished products or raw materials used in the production of the Company’s finished products can be used to offset the VAT due on the sales of the finished products.





Segment Reporting





The Company has two operating segments based on its major lines of businesses: manufacturing and distribution. Each operating segment derives its revenues from the sale of products or services, respectively and each is the responsibility of a group of senior management of the Company who has knowledge of product and service specific operational risks and opportunities. The Company’s chief operating decision maker reviews and evaluates separate sets of financial information for decisions regarding resources allocation and performance assessments.





Cash and Cash Equivalents





Cash and cash equivalents consist of cash on hand and bank deposits with original maturities of three months or less, which are unrestricted as to withdrawal and use.





Restricted Cash





Restricted cash represents amounts held by a bank as security for bank acceptance notes and therefore is not available for the Company’s use. The restriction on cash is expected to be released within the next twelve months.





Accounts and Notes Receivable





Accounts and notes receivable are carried at net realizable value. An allowance for doubtful accounts is recorded in the period when loss is probable based on an assessment of specific evidence indicating troubled collection, historical experience, accounts aging and other factors. A receivable is written off after all collection effort has ceased.





Financing Costs





Financing costs represent the incurred costs directly attributable to the issuance of the convertible notes. These costs, presented as non-current assets, are deferred and amortized ratably using the effective interest method from the debt issuance date over the earliest redemption date of the convertible notes. If the notes are converted prior to the debt maturity date, the unamortized financing costs will be transferred to equity immediately upon occurrence of such an event.





Inventories





Inventories are stated at the lower of cost or market value. Cost is determined by the weighted average method. Costs of raw materials and consumables and packaging materials are based on purchase costs while costs of work-in-progress and finished goods comprise direct materials, direct labor and an allocation of manufacturing overhead costs.





F-12





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





Recurring agricultural costs include costs relating to irrigation, fertilizing, seedling, utility, farming wages and other ongoing crop and land maintenance activities. Recurring agricultural costs are capitalized as inventory and cease to be accumulated when the crops have reached maturity and ready to be harvested.  Any recurring agricultural costs incurred subsequent to the crops reaching maturity are expensed as incurred. Non recurring agricultural costs, primarily comprising soil improvements and other long-term crop growing costs that benefit multiple harvests, are deferred and amortized over the estimated production period.





Fair Value of Financial Instruments





FASB ASC 820 “Fair Value Measurements and Disclosures” establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. The hierarchy prioritizes the inputs into three levels based on the extent to which inputs used in measuring fair value are observable in the market.





These tiers include:





●
Level 1 - defined as observable inputs such as quoted prices in active markets;





●
Level 2 - defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and





●
Level 3 - defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.





The carrying amounts of financial assets and liabilities, such as cash and cash equivalents, accounts and notes receivable, short-term bank loans, accounts payable, notes payable and other payables, approximate their fair values because of the short maturity of these instruments. The carrying values of long-term loans approximate their fair values due to the fact that the interest rates on these loans are reset each year based on prevailing market interest rates. The convertible notes are initially recognized based on residual proceeds after allocation to the derivative financial liabilities, if any, at fair value and subsequently carried at amortized cost using the effective interest rate method, with any accrued and unpaid interest included under other payables and accrued expenses.





Construction in Progress





Construction in progress represents direct costs of construction or acquisition, interest and design fees incurred. Capitalization of these costs ceases and the construction in progress is transferred to property, plant and equipment when substantially all the activities necessary to prepare the assets for their intended use are completed. No depreciation is provided until it is completed and ready for intended use.





The Company accounts for interest capitalization in accordance with FASB ASC 835 "Interest".  Interest costs are capitalized if they are incurred during the acquisition, construction or production of a qualifying asset and such costs could have been avoided if expenditures for the assets have not been made.  Capitalization of interest costs commences when the activities to prepare the asset are in progress and expenditures and borrowing costs are being incurred. Interest costs are capitalized until the assets are ready for their intended use.





Land Use Rights





According to the PRC laws, the government owns all the land in the PRC. Companies or individuals are authorized to possess and use the land only through land use rights granted by the PRC government. Land use rights are being amortized using the straight-line method over the lease term ranging from 40 to 50 years.





F-13





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





Property, Plant and Equipment





Property, plant and equipment are carried at cost less accumulated depreciation. Depreciation is provided over their estimated useful lives, using the straight-line method. Estimated useful lives of the property, plant and equipment are as follows:





Buildings
40 yearsMachinery and equipment
10 yearsMotor vehicles
5 yearsOffice equipment
5 yearsOther equipment
5 yearsLeasehold improvements
Shorter of 10 years or the lease term





The cost and related accumulated depreciation of assets sold or otherwise retired are eliminated from the accounts and any gain or loss is included in the statement of income. The cost of maintenance and repairs is charged to the statement of income as incurred, whereas significant renewals and betterments are capitalized.





Other Intangible Assets





Other intangible assets include product licenses, trademarks, patents and proprietary technologies, which are stated at acquisition cost less accumulated amortization. Amortization expense is recognized using the straight-line method over the estimated useful life. Proprietary technologies are recorded as an intangible asset only if regulatory approval from the Chinese State Food and Drug Administration, or SFDA, has been obtained and for which the re-registration of the proprietary technologies with the SFDA by the Company in its name is determined to be reasonably assured or perfunctory. The amortization of such intangible assets will not commence until the technology has been re-registered with the SFDA and hence ready for its intended use.  The cost of the product licenses are amortized over their licensed period of 2 to 12 years; the cost of trademarks are amortized over their registered period of 2 to 10 years; the cost of patents are amortized over their protection period of 7 to 20 years and the cost of proprietary technologies is amortized over its protection period of 10 years. The weighted-average  amortization period of product licenses, trademarks, patents and proprietary technologies are 7.56 years, 6.40 years, 12.85 years and 9.42 years, respectively.





Goodwill





Goodwill and other intangible assets are accounted for in accordance with the provisions of FASB ASC 805 and FASB ASC 350 “Intangibles - Goodwill and Other”. Under FASB ASC 805, goodwill is measured as the excess of a over b below:





a.
The aggregate of the following:





1.
The consideration transferred measured in accordance ASC 805, which generally requires acquisition-date fair value.


2.
The fair value of any non-controlling interest in the acquiree.


3.
In a business combination achieved in stages, the acquisition-date fair value of the acquirer’s previously held equity interest in the acquiree.





b.
The net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed measured in accordance with FASB ASC 805.





Other intangible assets are separately recognized from goodwill if the benefit of the intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed, rented, or exchanged, regardless of an intent to do so.





Under FASB ASC 350, goodwill, including any goodwill included in the carrying value of investments accounted for using the equity method of accounting, and certain other intangible assets deemed to have indefinite useful lives are not amortized.





F-14





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





Impairment





The annual evaluation of impairment of goodwill involves comparing the current fair value of each of the Company’s reporting units to their recorded value, including goodwill. The Company utilizes a two-step method to perform a goodwill impairment review in the fourth quarter of each fiscal year or when facts and circumstances indicate goodwill may be impaired. In the first step, the Company determines the fair value of the reporting unit using expected future discounted cash flows and estimated terminal values. If the net book value of the reporting unit exceeds the fair value, the Company would then perform the second step of the impairment test which requires allocation of the reporting unit’s fair value of all of its assets and liabilities in a manner similar to a purchase price allocation, with any residual fair value being allocated to goodwill. The implied fair value of the goodwill is then compared to the carrying value to determine impairment, if any.





Finite-lived intangible assets are amortized over their respective useful lives and, along with other long-lived assets, are evaluated for impairment periodically whenever events or changes in circumstances indicate that their related carrying amounts may not be recoverable in accordance with FASB ASC 360, “Property, Plant and Equipment”.





In evaluating long-lived assets for recoverability, including finite-lived intangibles and property and equipment, the Company uses its best estimate of future cash flows expected to result from the use of the asset and eventual disposition in accordance with FASB ASC 360-10-15. To the extent that estimated future, undiscounted cash inflows attributable to the asset, less estimated future, undiscounted cash outflows, are less than the carrying amount, an impairment loss is recognized in an amount equal to the difference between the carrying value of such asset and its fair value. Assets to be disposed of and for which there is a committed plan of disposal, whether through sale or abandonment, are reported at the lower of carrying value or fair value less costs to sell.





No impairment loss is subsequently reversed even if facts and circumstances indicate recovery. There was no impairment loss recognized for the years presented.





Investments





The Company applies FASB ASC 323 “Investments—Equity Method and Joint Ventures” in accounting for its equity investments. Under FASB ASC 323, the equity method of accounting is used for investments in entities in which the Company has the ability to exercise significant influence but does not own a majority equity interest or otherwise control. The cost method is used for investments over which the Company does not have the ability to exercise significant influence or control.





The Company monitors its investments for other-than-temporary impairment by considering factors including, but not limited to, current economic and market conditions, the operating performance of the investee companies including current earnings trends and other company-specific information. Any balance of equity method goodwill is not tested for impairment under the provisions of FASB ASC 350. Instead, equity method goodwill is tested for impairment together with the related investment as they are not separable.





Economic and Political Risks





The Company’s operations are conducted in the PRC. Accordingly, the Company’s business, financial condition and results of operations may be influenced by the political, economic and legal environment in the PRC, and by the general state of the PRC economy.





The Company’s operations in the PRC are subject to special considerations and significant risks not typically associated with companies in North America and Western Europe. These include risks associated with, among others, the political, economic and legal environment and foreign currency exchange. The Company’s results may be adversely affected by changes in the political and social conditions in the PRC, and by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion, remittances abroad, rates and methods of taxation and price controls, among other things.





The Company’s products are subject to price control by the PRC government. The maximum prices of the products are published by the PRC price administration authorities from time to time. Any changes in product pricing announced by the PRC price administration authorities affect future sales transactions.




F-15





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





Recently Issued Accounting Standards





In January 2010, the FASB issued Accounting Standards Update 2010-06 (ASU 2010-06), “Fair Value Measurements and Disclosures (Topic 820)”: Improving Disclosures about Fair Value Measurements.  This amendment to ASC Topic 820 has improved disclosures about fair value measurements on the basis of input received from the users of financial statements.  This is effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements.  Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years.  Early adoption is permitted.  The provisions of ASU 2010-06 are not expected to have a material effect on the financial position, results of operations or cash flows of the Company.





In February 2010, the FASB issued Accounting Standards Update 2010-09 (ASU 2010-09), "Subsequent Events (Topic 855)."  The amendments remove the requirements for an SEC filer to disclose a date, in both issued and revised financial statements, through which subsequent events have been reviewed.  Revised financial statements include financial statements revised as a result of either correction of an error or retrospective application of U.S. GAAP.  ASU 2010-09 is effective for interim or annual financial periods ending after June 15, 2010.  The provisions of ASU 2010-09 did not have a material effect on the financial position, results of operations or cash flows of the Company.





In February 2010, the FASB issued Accounting Standards Update 2010-10 (ASU 2010-10), "Consolidation (Topic 810)."  The amendments to the consolidation requirements of ASC Topic 810 resulting from the issuance of Statement 167 are deferred for a reporting entity's interest in an entity (1) that has all the attributes of an investment company or (2) for which it is industry practice to apply measurement principles for financial reporting purposes that are consistent with those followed by investment companies.  An entity that qualifies for the deferral will continue to be assessed under the overall guidance on the consolidation of variable interest entities in ASC Subtopic 810-10 (before the Statement 167 amendments) or other applicable consolidation guidance, such as the guidance for the consolidation of partnerships in ASC Subtopic 810-20.  The deferral is primarily the result of differing consolidation conclusions reached by the International Accounting Standards Board ("IASB") for certain investment funds when compared with the conclusions reached under Statement 167.  The deferral is effective as of the beginning of a reporting entity's first annual period that begins after November 15, 2009, and for interim periods within that first annual reporting period, which coincides with the effective date of Statement 167.  Early application is not permitted.  The provisions of ASU 2010-10 are effective for the Company beginning in 2010. The adoption of ASU 2010-10 did not have a material impact on the financial position, results of operations or cash flows of the Company.





In March 2010, the FASB issued Accounting Standards Update 2010-11 (ASU 2010-11), "Derivative and Hedging (Topic 815)."  All entities that enter into contracts containing an embedded credit derivative feature related to the transfer of credit risk that is not only in the form of subordination of one financial instrument to another will be affected by the amendments in ASU 2010-11 because the amendments clarify that the embedded credit derivative scope exception in paragraph 815-15-15-8 through 15-9 does not apply to such contracts.  ASU 2010-11 is effective at the beginning of the reporting entity's first fiscal quarter beginning after June 15, 2010.  The provisions of ASU 2010-11 did not have a material effect on the financial position, results of operations or cash flows of the Company.





In April 2010, the FASB issued Accounting Standards Update 2010-13 (ASU 2010-13), "Compensation—Stock Compensation (Topic 718)." ASU 2010-13 provides amendments to ASC Topic 718 to clarify that an employee share-based payment award with an exercise price denominated in the currency of a market in which a substantial portion of the entity’s equity securities trades should not be considered to contain a condition that is not a market, performance, or service condition. Therefore, an entity would not classify such an award as a liability if it otherwise qualifies as equity. The amendments in ASU 2010-13 are effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. The provision of ASU 2010-13 are not expected to have a material effect on the financial position, results of operations or cash flows of the Company.





In December 2010, the FASB issued an Accounting Standards Update 2010-28(“ASU 2010-28”), “Intangibles—Goodwill and Other (Topic 350)”.  ASU 2010-28 amends ASC Topic 350.  ASU 2010-28 clarifies the requirement to test for impairment of goodwill.  ASC Topic 350 requires that goodwill be tested for impairment if the carrying amount of a reporting unit exceeds its fair value.  Under ASU 2010-28, when the carrying amount of a reporting unit is zero or negative an entity must assume that it is more likely than not that a goodwill impairment exists, perform an additional test to determine whether goodwill has been impaired and calculate the amount of that impairment.  The modifications to ASC Topic 350 resulting from the issuance of ASU 2010-28 are effective for fiscal years beginning after December 15, 2010 and interim periods within those years. Early adoption is not permitted.  The provisions of ASU 2010-28 are not expected to have a material effect on the financial position, results of operations or cash flows of the Company.





F-16





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE 4 - ACCOUNTS AND NOTES RECEIVABLE





Accounts and notes receivable is net of provision for doubtful debts. Provision for doubtful debt activity is as follows:





December 31,2010


2009Beginning balance

$
522,897


$
226,330Provision for doubtful debts


164,982



296,567Reversal


-



-Written off


-



-Ending balance

$
687,879


$
522,897





NOTE 5 - INVENTORIES





Inventories are summarized as follows:





December 31,2010


2009Raw materials

$
6,902,658


$
4,599,700Work in process


2,274,499



2,407,927Finished goods


3,511,163



3,043,926Total inventories


12,688,320



10,051,553Less: provision against slow-moving inventories


(22,734)



(35,842
)Inventories, net

$
12,665,586


$
10,015,711





As of December 31, 2010 and 2009, raw materials included capitalized agricultural costs of $190,697 and nil, respectively.





NOTE 6 - ADVANCES TO SUPPLIERS AND PREPAID EXPENSES





December 31,2010


2009Advance to suppliers

$
12,292,689


$
11,876,655Prepaid expenses


1,953,455



2,024,525Advances to suppliers and prepaid expenses

$
14,246,144


$
13,901,180





Advances to suppliers mainly represent interest-free cash deposits paid to suppliers for future purchases of raw materials. Prepaid expenses mainly relate to the prepaid research and development expenses to external contractors for research on new knowledge and product development. The prepayment is amortized over the contract period of the research and development contracts.





NOTE 7 - LAND USE RIGHTS





Land use rights consist of the following:





December 31,2010


2009Cost of land use rights

$
165,625,682


$
160,165,545Less: Accumulated amortization


(10,192,371)



(6,561,349
)Land use rights, net

$
155,433,311


$
153,604,196





As of December 31, 2010 and 2009, the net book value of land use rights pledged as collateral was $20,729,293 and $48,101,071, respectively. See Note 15.





Amortization expense for the years ended December 31, 2010, 2009 and 2008 was $3,329,633, $3,239,304 and $1,357,929, respectively.




F-17





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





Amortization expense for the next five years and thereafter is as follows:




2011

$
(3,385,222)2012

$
(3,385,222)2013

$
(3,385,222)2014

$
(3,385,222)2015

$
(3,385,222)Thereafter

$
(138,507,201)Total

$
(155,433,311)





NOTE 8 - CONSTRUCTION IN PROGRESS





Construction in progress as of December 31, 2010 and 2009 was $22,516,044 and $28,975,386, respectively. Construction in progress represents the construction for production lines and buildings. The Company capitalizes interest as a component of construction in progress in accordance with ASC 835. Total interest costs incurred for the years ended December 31, 2010, 2009 and 2008 amounted to $7,582,137, $7,168,444 and 3,879,759, respectively.





Total interest costs capitalized as part of construction in progress for the years ended December 31, 2010, 2009 and 2008 amounted to $1,330,488, $816,392 and nil, respectively. Capitalized interest included in construction in progress was $1,640,632 and $816,392 as of December 31, 2010 and 2009, respectively.





NOTE 9 - PROPERTY, PLANT AND EQUIPMENT





Property, plant and equipment consist of the following:





December 31,2010


2009At cost:Buildings

$
104,865,498


$
91,565,622Machinery and equipment


23,512,674



21,016,658Motor vehicles


1,568,813



1,535,238Office equipment


2,529,352



2,157,528Other equipment


3,996,164



610,945136,472,501



116,885,991Less : Accumulated depreciationBuildings


(9,278,438)



(6,600,971
)Machinery and equipment


(14,438,180)



(12,483,002
)Motor vehicles


(1,331,806)



(1,130,968
)Office equipment


(1,458,772)



(1,037,234
)Other equipment


(417,689)



(165,551
)(26,924,885)



(21,417,726
)Property, plant and equipment, net

$
109,547,616


$
95,468,265





As of December 31, 2010 and 2009, the net book value of property, plant and equipment pledged as collateral for bank loans was $6,243,893 and $13,615,710, respectively. See Note 15.





Depreciation expense for the years ended December 31, 2010, 2009 and 2008 was $5,014,924, $4,142,651 and $3,396,747, respectively.




F-18





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE 10 - OTHER INTANGIBLE ASSETS





Other intangible assets are summarized as follows:





December 31,2010


2009At cost:Product licenses

$
16,053,679


$
15,524,443Trademarks


10,945,759



10,584,914Patents


4,972,016



4,808,103Proprietary technology


291,990



282,364Software


94,488



73,82232,357,932



31,273,646Less: Accumulated amortizationProduct licenses

$
(8,891,025)


$
(6,396,185
)Trademarks


(6,009,283)



(4,168,125
)Patents


(2,448,111)



(1,935,171
)Proprietary technology


(100,775)



(67,468
)Software


(19,611)



(11,143
)(17,468,805)



(12,578,092
)Other intangible assets, net

$
14,889,127


$
18,695,554





Amortization expense for the years ended December 31, 2010, 2009 and 2008 was $4,354,074, $5,049,117 and $5,165,133, respectively.





Amortization expense for the next five years and thereafter is as follows:





2011

$
(3,508,922)2012


(3,508,922)2013


(3,508,922)2014


(1,688,771)2015


(1,153,568)Thereafter


(1,520,022)Total

$
(14,889,127)





NOTE 11 - INVESTMENTS IN AND ADVANCES TO EQUITY INVESTMENTS





Long-term investments and advances include our equity investment in Aoxing Pharmaceutical Company, Inc. (“AXN”), Nuo Hua Affiliate and Hezhou Jinji Color Printing Co., Ltd. (“Jinji”). AXN is a PRC-based pharmaceutical company, listed on the NYSE AMEX, specializing in the research, development, manufacture and distribution of narcotic and pain-management products in the PRC. Nuo Hua Affiliate maintains a presence in pharmaceutical wholesale and retail distribution in the PRC. Jinji is a color printing company focusing on the printing of external packaging materials. Long-term investments are accounted for using the equity accounting method.





As of December 31, 2010, the Company owns a 36.1% equity interest in AXN through an initial $18 million direct investment of its common stock in April 2008 and a subsequent conversion of a promissory note into additional common stock in August 2009. The promissory note represents an advance of RMB30 million to AXN in May 2008. Upon conversion, the balance of such advance was reclassified to investment. The Company owns a 30% equity interest in Nuo Hua Affiliate through the acquisition of Nuo Hua in October 2008 and the Company owns a 40% equity interest in Jinji through the acquisition of GLP in April 2006. The cost of investments in excess of the estimate of the underlying equity in net assets at the time of the investments was goodwill of $1,369,799.





F-19





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





The following table summarizes the changes in investments in and advances to equity investments as of and for the years ended December 31, 2010, 2009 and 2008.


AXN

Nuo Hua Affiliate

Jinji

TotalAt December 31, 2008Cost of investments:
$
18,000,000

$
32,999,023

$
86,067

$
51,085,090Share of equity income (loss):

(1,580,344)


773,415


42,303


(764,626)Advances:

4,520,209


—


122,391


4,642,600Long-term investments and advances:

20,939,865


33,772,438


250,761


54,963,064Add (subtract) during the year ended December 31, 2009Cost of investments:

4,759,612


—


—


4,759,612Share of equity income (loss):

(328,900)


2,401,186


2,853


2,075,139Advances:

(4,516,909)


—


(41,332)


(4,558,241)Foreign currency translation gain

—


85,989


324


86,313At December 31, 2009Cost of investments:

22,759,612


32,999,023


86,067


55,844,702Share of equity income (loss):

(1,909,244)


3,260,590


45,480


1,396,826Advances:

3,300


—


81,059


84,359Long-term investments and advances:
$
20,853,668

$
36,259,613

$
212,606

$
57,325,887Add (subtract) during the year ended December 31, 2010Cost of investments:

—


—


—


—Share of equity income (loss):

(1,947,002)


2,331,440


553


384,991Advances:

(3,300)


—


58,195


54,895Foreign currency translation gain

—


1,298,203


4,515


1,302,718At December 31, 2010Cost of investments:

22,759,612


32,999,023


86,067


55,844,702Share of equity income (loss):

(3,856,246)


6,890,233


50,548


3,084,535Advances:

—


—


139,254


139,254Long-term investments and advances:
$
18,903,366

$
39,889,256

$
275,869

$
59,068,491





The advances to AXN and Jinji were unsecured, non-interest-bearing and repayable on demand.





As of December 31, 2010 and 2009, the value based on quoted market price and the carrying amount of the investment in AXN is as follows:




December 31,2010


2009Investment in AXN based on quoted market price

$
46,841,875


$
33,578,405Carrying amount of investment in AXN

$
18,903,366


$
20,850,368





NOTE 12 - OTHER LONG-TERM ASSETS





December 31,2010


2009Payment for long-term supply contract

$
7,724,069


$
7,469,432Deposits for long-term assets


443,811



439,654Other long-term assets

$
8,167,880


$
7,909,086




F-20





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





Payment for long-term supply contract represents a payment for a long-term supply contract entered into with a third party on October 17, 2009 to secure the supply of Xanthoceras Sorbifolia Bge (“XSB”), a major raw material of a subsidiary of the Company. The Company expects such supply to start from year four of the contract as XSB is a fruit from certain plant which requires a three-year period to mature. The contract expires after 10 years while the Company is entitled to renewal with terms to be negotiated. Under the contract, the Company is entitled to a supply price at fair value when delivered. The payment will be amortized to inventory upon delivery of the raw material. The Company assesses the impairment of the payment as of each balance date. As of December 31, 2010 and 2009, no impairment was recognized.





Deposits for long term assets are refundable deposits to acquire land use rights located in the PRC. The long-lived assets to be acquired will be for use in the expansion of some of the Company's current manufacturing facilities and are not intended for resale by the Company. The deposits will be reclassified to the respective accounts under long-lived assets upon the transfers of legal title.





NOTE 13 - OTHER PAYABLES AND ACCRUED EXPENSES





The components of other payables and accrued expenses are as follows:





December 31,2010


2009Other taxes payable

$
295,702


$
616Other payables


9,378,014



10,152,627Accrued expenses


8,365,841



12,167,514Other payables and accrued expenses

$
18,039,557


$
22,320,757





Other payables balance mainly represent VAT-output for manufacturing subsidiaries.





Accrued expenses mainly represent promotional fee, interest expenses accrued on convertible notes and other banks loans and accrued advertisement expenses.





NOTE 14 - OTHER LIABILITIES





December 31,2010


2009Due to employees

$
2,803,189


$
784,249Advances from customers


2,194,450



400,260Other current liabilities


1,286,468



1,014,771Other liabilities

$
6,284,107


$
2,199,280





Due to employees mainly represent deposits collected from our salesman to encourage receivables collection.





Advances from customers mainly represent cash received for goods not yet delivered to customer.





NOTE 15 - DEBT





Short-term bank loans are obtained from local banks. All of the short-term bank loans are repayable within one year and are secured by property, plant and equipment and land use rights owned by the Company. See Notes 7 and 9.





F-21





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





Short-term loans are summarized as follows:





No.

Due Date

Interest Rate

Per Annum


December 31,

20101.

March 5, 2011


5.310~5.560
%

$
756,2242.

April 14, 2011


5.310
%


1,512,4463.

May 21, 2011


5.310~5.560
%


756,2244.

May 31, 2011


5.310~5.560
%


756,2245.

June 5, 2011


5.310~5.560
%


453,7346.

June 13, 2011


5.310~5.560
%


453,7347.

July 20, 2011


5.310
%


756,2248.

July 20, 2011


5.310
%


756,2249.

September 27, 2011


5.310~5.560
%


756,224$
6,957,258No.

Due Date

Interest Rate

Per Annum


December 31,

20091.

March 25,2010


5.31
%

$
731,2942.

April 23, 2010


5.31
%


1,462,5873.

May 13, 2010


5.31
%


731,2944.

May 27, 2010


5.31
%


731,2945.

June 12, 2010


5.31
%


877,5516.

September 2, 2010


6.11
%


731,2947.

September 23, 2010


6.11
%


731,2948.

July 20, 2010


5.31
%


1,462,5869.

August 6, 2010


5.84
%


2,193,88010.

October 29, 2010


5.31
%


731,294$
10,384,368





Long-term loans include a mortgage loan that bears interest on daily balances at 2.50% per annum below HSBC HKD best lending rate and is repayable over 15 years. Long-term loans are summarized as follows:





December 31,

2010


December 31,

2009Loan from HSBC, due December 31, 2021 and secured by the office in CNT Tower

$
741,271


$
804,065Total long-term loans


741,271



804,065Less: current portion of long-term loans


61,405



60,108Long-term portion

$
679,866


$
743,957





The repayment schedule is as follows:





No.

Due Date

Interest Rate

Per Annum


December 31,

20101.

December 31, 2011


2.50
%

$
61,405Current portion of long-term loans






61,4052.

December 31, 2012


2.50
%


62,9563.

December 31, 2013


2.50
%


64,5504.

December 31, 2014


2.50
%


66,1825.

December 31, 2015


2.50
%


67,856Thereafter


2.50
%


418,322Long-term portion






679,866$
741,271





F-22





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





The unused lines of credit for short-term financing and the weighted average interest rate on short-term borrowings outstanding are as follows:





Years Ended December 31,2010


2009


2008Unused lines of credit

$
—


$
—


$
—





Years Ended December 31,2010


2009


2008Weighted average interest rate

$
5.40%


$
6.25%


$
7.26%





Interest expense for all outstanding debt excluding the convertible notes was $505,425, $1,418,444, and $1,244,411 for the years ended December 31, 2010, 2009 and 2008, respectively.





NOTE 16 - CONVERTIBLE NOTES





On July 15, 2008, the Company closed a private offering and issued $115 million aggregate principal amount of 5.00% Convertible Senior Notes due 2015 (the “Notes”). The Notes were sold to qualified institutional buyers in a private placement exempt from the registration requirements of the Securities Act of 1933, as amended. The net proceeds from the sale of the Notes were $110,474,993, after deducting the placement agents’ commission and offering expenses payable by the Company.





The following is a brief summary of certain terms of this offering.





●
Total offering is $115,000,000 aggregate principal amount of 5.00% Convertible Senior Notes due on July 15, 2015.





●
Interest at 5.00% per year, payable semiannually in arrears in cash.





●
The Notes are convertible, at the option of the holder, at any time prior to the close of business on the second business day preceding the maturity date based on an initial conversion rate of 107.6195 shares per $1,000 principal amount of Notes, which represents an initial conversion price of $9.29 per share.





●
The conversion rate is subject to certain adjustments. In particular, holders who convert their Notes in connection with certain events of fundamental changes, as defined pursuant to the convertible notes agreement, may be entitled to a make whole premium in the form of additional shares of our common stock.





●
The initial conversion rate may also be adjusted on January 15, 2009 if the volume weighted average price (“VWAP”) of common stock for each of the 30 consecutive trading days ended on January 15, 2009 is less than $8.08 per share. In such an event, the conversion rate will be increased as a one-time conversion price adjustment such that the conversion price as adjusted would represent the greater of (1) 115.0% of such arithmetic average of the daily VWAP and (2) $8.08.





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





●
If a fundamental change event occurs, holders will have the right to require the Company to repurchase for cash all or any portion of their notes. The fundamental change purchase price will be 100% of the principal amount of the Notes to be purchased plus accrued and unpaid interest, if any, up to, but excluding, the fundamental change repurchase date.





●
The Notes are unsecured, unsubordinated obligations and rank equal in right of payment to all of the Company’s existing and future unsecured and unsubordinated indebtedness. The Notes will be effectively subordinated to all of the Company’s existing and future secured indebtedness.





Notes issuance costs incurred by the Company that were directly attributable to the issuance of the Notes were deferred and are charged to the consolidated statements of income and comprehensive income using the effective interest rate method over the term of the Notes.





F-23





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





The Company has determined that the conversion feature embedded in the Notes is not required to be bifurcated and accounted for as a derivative pursuant to FASB ASC 815 “Derivatives and Hedging”, since the embedded conversion feature is indexed to the Company’s own stock and would be classified in shareholders’ equity if it was a free-standing instrument. The holder’s put rights qualify as an embedded derivative, but bifurcation of such is not required since it is considered to have economic characteristic and risks that are clearly and closely related to those of the debt host.





On the date of issuance of the Notes, no portion of the proceeds was attributable to the beneficial conversion feature (“BCF”) since the conversion price of the Notes exceeded the market price of the Company’s common stock. Furthermore, no contingent BCF exists from the one time conversion rate adjustment based on VWAP, as the adjustment is subject to a floor of $8.08, which equals market price of the Company’s common stock on the issuance date of the Notes.





The VWAP of the Company’s common stock for each of the 30 consecutive trading days ending on January 15, 2009 was $6.02 per share and as such, the initial conversion price of $9.29 per share was adjusted to $8.08 on January 15, 2009.





The effective interest rate on the convertible notes for the years ended December 31, 2010, 2009 and 2008 was 5.945%.





The amount of interest cost recognized for the years ended December 31, 2010, 2009 and 2008 was $5,750,000, $5,750,000 and $2,635,417, respectively.





NOTE 17 - PREPAID FORWARD SHARES REPURCHASE TRANSACTION





In connection with the offering of the Notes, the Company entered into a prepaid forward repurchase contract with an affiliate of the lead placement agent (“Merrill affiliate”). Pursuant to the prepaid forward repurchase contract, the Company paid approximately $30 million to the Merrill affiliate to fund the purchase of 3.7 million shares of common stock for settlement at or about maturity of the Notes, which will occur on July 15, 2015. The forward shares purchase transaction was also intended to reduce the potential dilution of common stock that would result from the conversion of the Notes into shares of common stock.





The $30 million cost of the forward stock repurchase transaction qualifies as an equity transaction and was separately presented under shareholders’ equity in the balance sheet without subsequent recognition of changes in fair value. The prepaid forward repurchase contract contains an embedded equity forward derivative that is contingently cash settleable based on certain events.  The contingent cash settlement feature was bifurcated from the prepaid forward repurchase contract but its value was insignificant for any of the years presented.





The Company is potentially subject to significant concentration of credit risk with respect to the prepaid forward repurchase contract. The fact that the Merrill affiliate has merged with Bank of America reduced the bankruptcy and default risk. The Company will closely monitor the third depositary and may request early settlement of the contract prior to the maturity of the Notes.





NOTE 18 - SHAREHOLDERS’ EQUITY





Preferred Stock





The Company has 1,000,000 shares of Series A preferred stock (“Series A”) issued and outstanding. Pursuant to the terms of the Series A, the holder holds aggregate voting power equal to 25% of the combined voting power of common stock and preferred stock. The percentage of voting power represented by the Series A cannot be diluted by the issuance of additional shares of common stock. The Series A has a liquidation preference equal to its initial issue price that will be paid to the holders of the Series A upon liquidation, dissolution or winding up and prior to any distributions being made to holders of common stock. The series A does not participate in profits and dividends with common stock.





Common Stock





Stock-Based Compensation





At the Annual Shareholders’ Meeting held on October 21, 2006, the shareholders of the Company approved the stock incentive plan (the “2006 Plan”), which allows the Company’s Board of Directors, at its discretion, to offer stock options and common stock awards to employees, directors and consultants of the Company.





F-24





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





The Company has reserved 5,000,000 shares of common stock for issuance upon the exercise of stock options and common stock awards granted under the 2006 Plan. The term of the options granted under the 2006 Plan should be no more than 10 years from the grant date. Options will be granted with an exercise price not less than the fair market value of a share of common stock on the date of the grant.





Common Stock Awards issued to consultants and employee directors





Common stock awards are issued to consultants as partial payment in connection with the consulting services rendered or to be rendered, or to directors as compensation for participating in the Company’s board meetings. Number of shares granted and expenses recognized were insignificant during the years presented.





In connection with common stocks awards described above, the Company recorded “Common stock to be issued” for vested but yet to be issued shares. Number of shares to be issued was insignificant during the years presented.





Stock Options and Common Stock Awards issued to employees





Stock options and common stock awards granted to employees vest over a five year service period using a graded vesting schedule of 20% per fully completed year (based on each subsequent one-year anniversary of the date of grant). Compensation expense for all stock options and common stock awards granted is recognized over the grantee’s respective requisite service period.





Stock options





The Company calculated the estimated fair value of the options of the grant date using the Black-Scholes Option Pricing Model with the following assumptions:





Grant Date

April 10,

2009


November 25,

2008


April 9,

2008


August 20,

2007


April 20,

2007Risk-free interest rate


2.33%



2.41%



2.93%



4.45%



4.59%Expected term


6.5



6.5



6.5



6.5



6.5Expected volatility


65.70%



64.81%



56.89%



71.71%



74.69%Expected dividend yield


0.00%



0.00%



0.00%



0.00%



0.00%Fair value of share option


2.64



3.34



4.81



5.87



7.44





The model requires the input of subjective assumptions including the expected stock price volatility and the expected dividend yield. The Company uses historical experience of employee turnover and future expectation to estimate forfeiture rate. For expected volatilities, the Company has made reference to historical volatilities of the Company’s stock. The risk-free interest rate for periods within the contractual life of the option is based on the U.S. Treasury Bills yield in effect at the time of grant.





The Company recorded $1,898,552, $1,922,769 and $1,700,670 compensation cost for years ended December 31, 2010, 2009 and 2008, respectively, with corresponding credits to additional paid-in capital. Compensation cost of all stock option awards are recorded in selling, general and administrative expenses. The total fair value of the options granted to employees at the respective grant dates was $9,492,751, of which the unrecognized portion of $3,636,176 is expected to be recognized following the straight-line method over the remaining weighted average vesting period of 2.2 years as of December 31, 2010.





The expected forfeiture rate of the stock options granted as of December 31, 2010 is 0%.




F-25




AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





The following table summarizes the stock option activities of the Company:





Activity


Weighted Average

Exercise PriceOutstanding as of January 1, 2009


1,697,763


$
8.68Granted


338,440


$
4.01Exercised


—


$
—Cancelled/Forfeited


—


$
—Outstanding as of January 1, 2010


2,036,203


$
7.91Granted


—


$
—Exercised


—


$
—Cancelled/Forfeited


(204,925)


$
8.73Outstanding as of December 31, 2010


1,831,278


$
7.81Vested and expected to vest as of December 31, 2010


1,831,278





The following table summarizes information about stock options outstanding as of December 31, 2010:





Options Outstanding

Options ExercisableRange of Exercise Prices


Number of

Shares


Weighted

Average

Exercise

Price

Weighted Average

Remaining

Contractual Life

(in years)

Number of

Shares


Weighted

Average

Exercise

Price$8.54 - 10.74



869,500


$
9.96

6.45


521,700


$
9.96$4.95 - 8.35



660,280


$
6.73

7.61


264,112


$
6.73$4.01



301,498


$
4.01

8.33


60,299


$
4.011,831,278








846,111





Options granted have no intrinsic value at grant date and at the date of these financial statements as the exercise price of all vested and unvested options was higher than the market price.





The weighted average fair value per share of the 1,831,278 options issued under the Company’s 2006 Plan is $5.18 per share. As of December 31, 2010, the Company has 846,111 outstanding vested stock options, with an exercise price above the average market price.





Common Stock Awards





On April 10, 2009 and April 8, 2010, the Compensation Committee of the Board of Directors of the Company approved the grant of common stock awards to the Company’s executive officer and certain senior management members. Common stocks awards granted vest over a five-year service period. Compensation expense is recognized for the fair value of common stocks on the grant date on a straight-line basis over five years, the requisite service period of the awards.  The number of shares granted and the grant date market price of the Company’s common stock determines the fair value of the common stocks awards under the 2006 Plan.





The expected forfeiture rate of the common stock awards granted as of December 31, 2010 is 0%.





F-26
 
 
 AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





The following is a summary of the status of the Company’s common stock awards for the year ended December 31, 2010:





Number of

Common Stocks


Weighted

Average Grant

Date Fair ValueNon-vested common stocks at beginning of year


573,867


$
4.01Granted


599,361


$
4.15Forfeited


(57,225)



4.01Vested


(103,328)



4.01Non-vested common stocks at December 31, 2010


1,012,675


$
4.09Expected to vest as of December 31, 2010


1,012,675





The Company recorded selling, general and administrative expenses of $787,458, $323,401 and nil in connection with such awards for the years ended December 31, 2010, 2009 and 2008, respectively.





The total fair value of the common stock awards granted as of the respective grant date was $$4,559,083, of which the unrecognized portion of $3,460,873 is expected to be recognized following the straight-line method over the remaining weighted average vesting period of 3.8 years as of December 31, 2010.





Statutory Reserves





In accordance with the PRC Regulations on Enterprises with Foreign Investment, an enterprise established in the PRC with foreign investment is required to provide for certain statutory reserves, namely (i) General Reserve Fund, (ii) Enterprise Expansion Fund and (iii) Staff Welfare and Bonus Fund, which are appropriated from net profit as reported in the enterprise’s PRC statutory accounts. A wholly-owned foreign enterprise (“WOFE”) is required to allocate at least 10% of its annual after-tax profit to the General Reserve Fund until the balance of such fund has reached 50% of its respective registered capital.  A non- wholly-owned foreign invested enterprise is permitted to provide for the above allocation at the discretion of its Board of Directors. Appropriations to the Enterprise Expansion Fund and Staff Welfare and Bonus Fund are at the discretion of the Board of Directors for all foreign invested enterprises. The aforementioned reserves can only be used for specific purposes and are not distributable as cash dividends.





As a result, $26,471,124 and $23,757,901 have been appropriated to accumulated statutory reserves, which were included in retained earnings, by the Company’s PRC subsidiaries as of December 31, 2010 and 2009, respectively.





NOTE 19 - COMMITMENTS AND CONTINGENCIES





As of December 31, 2010, the Company had entered into capital commitments for the manufacturing facilities under construction in the People’s Republic of China. The capital commitments were $5,913,022 within one year and $8,872,017 after one year but within five years. In addition, the Company had advertisement contract commitments of $7,028,963 for the next 12 months as well as R&D commitments of $2,202,235 within one year and $400,309 after one year but within five years.





Effective from January 1, 2007, the Company adopted the guidance for accounting for uncertainty in income taxes as provided under FASB ASC 740-10, which prescribes a more-likely-than-not threshold for financial statement recognition and measurement of a tax position taken in the tax return. As of December 31, 2010, the Company has recorded an unrecognized tax benefit of $5,050,157.





As of December 31, 2010, the Company has no significant litigation claims. Also, the Company does not have significant operating-lease commitments as of December 31, 2010.





F-27





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE 20 - SEGMENT REPORTING





For the years ended December 31, 2010, 2009 and 2008 the Company’s segments are as follows:





Year Ended December 31,2010


2009


2008Manufacturing SegmentRevenue from pharmaceutical products

$
250,131,594


$
244,168,159


$
224,904,348Revenue from nutraceutical products


41,020,289



39,125,655



34,266,739Total manufacturing revenue


291,151,883



283,293,814



259,171,087Total manufacturing costs


133,846,985



116,961,988



85,787,460Depreciation and amortization expense


4,973,682



4,562,045



4,173,964Selling, general and administrative expenses, Research and development costs and Advertising costs


111,025,660



92,591,166



99,002,180Operating income of manufacturing segment


33,426,593



56,635,139


$
57,766,126
 Distribution SegmentDistribution revenue

$
14,792,202


$
12,856,966


$
5,471,971Equity in earnings (loss) from unconsolidated entities


2,331,440



2,401,186



441,403Operating income of distribution segment


1,765,353



2,054,253



501,818Reconciliation to Consolidated Net Income Attributable to Controlling Interest:Total net operating income, as defined, for reportable segments


35,191,946



58,689,392



58,267,944Unallocated


(18,850,596)



(17,268,242)



(11,208,329)Consolidated Net Income Attributable to Controlling Interest

$
16,341,350


$
41,421,150


$
47,059,615





All operating revenues comprise amounts received from external third party customers.





As of December 31, 2010 and 2009, total assets of the manufacturing and distribution segments are as follows:





December 31,2010


2009Manufacturing

$
427,354,827


$
383,755,187Distribution


56,260,366



54,348,079Corporate


127,929,799



138,378,499Total assets

$
611,544,992


$
576,481,765





As of both December 31, 2010 and 2009, goodwill of the manufacturing and distribution segments was $27,817,108 and $5,347,013, respectively.





For the years ended December 31, 2010, 2009 and 2008, capital expenditures of the manufacturing and distribution segments are as follows:





Year Ended December 31,2010


2009


2008Manufacturing

$
6,252,696


$
4,810,168


$
67,707,425Distribution


18,530



692



12,168Corporate


883,428



287,857



104,962,557Total capital expenditure

$
7,154,654


$
5,098,717


$
172,682,150





All of the Company’s operations are located in the PRC.




F-28




AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE 21 - EARNINGS PER SHARE





Basic earnings per share is computed by dividing net income attributable to controlling interest by the weighted average number of common shares outstanding, excluding common shares to be delivered under a prepaid forward repurchase contract (3,712,700 shares) during the year. Diluted earnings per share is computed by dividing net income attributable to controlling interest as adjusted for the effect of dilutive potential common shares, if any, by the weighted average number of common shares and dilutive potential common shares outstanding during the year. The potential common stocks are stock options, common stock awards and convertible notes.





The following is a reconciliation of the numerator and denominator used in the calculation of basic and diluted earnings per share available to common shareholders.





Years Ended December 31,2010


2009


2008EPS Numerator:Net income attributable to controlling interest

$
16,341,350


$
41,421,150


$
47,059,615Interest expense on convertible securities, net of taxes


—



5,750,000



2,635,417Amortization of financing costs, net of taxes


—



928,288



425,466Less: capitalization of interest on convertible securities


—



(816,392
)


—Net income, as adjusted

$
16,341,350


$
47,283,046


$
50,120,498EPS Denominator:Weighted average common shares outstanding – Basic


74,810,016



74,612,602



76,504,035Effect of dilutive instruments:Stock options


—



—



—Convertible notes


—



14,232,673



5,749,763Common stock awards to be issued


914,810



441,346



—Warrants


—



—



387Weighted average common shares outstanding – Diluted


75,724,826



89,286,621



82,254,185





EPS - Basic

$
0.22


$
0.56


$
0.62EPS - Diluted

$
0.22


$
0.53


$
0.61





The calculation of weighted average common shares outstanding for the diluted earnings per share calculation excludes consideration of stock options for the years ended December 31, 2010, 2009 and 2008, because the exercise of these options would not have been dilutive for those years due to the fact that the exercise prices were greater than the weighted average market price of the Company’s common stock for each year.





As more fully discussed in Note 16, the Company had certain convertible notes outstanding during the years presented. The aggregate number of shares of common stock that could be issued in the future to settle these notes is deemed outstanding for the purposes of the calculation of diluted earnings per share. This approach, referred to as the if-converted method, requires that such shares be deemed outstanding regardless of whether the notes are then contractually convertible into the Company’s common stock. For this if-converted calculation, the interest expense and issuance costs (net of tax) attributable to these notes are added back to net income attributable to controlling interest, reflecting the assumption that the notes have been converted.  The calculation of diluted earnings per share excludes the convertible notes for the year ended December 31, 2010 because conversion of the convertible notes under the if-converted method would have been anti-dilutive.





F-29





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE 22 - INCOME TAX





(a) Corporate Income Tax (“CIT”)





The Company has not recorded a provision for U.S. federal income tax for the years ended December 31, 2010, 2009 and 2008 due to the cumulative tax net operating loss in the United States.





On March 16, 2007, the National People’s Congress of China approved the new Corporate Income Tax Law of the PRC (“New CIT Law”), which is effective from January 1, 2008.





Under the New CIT Law, the statutory corporate income tax rate applicable to most companies is 25% instead of the old tax rate of 33%. The New CIT Law also provides tax concession to certain industries and locations. GLP, BOKE, Three Happiness, HSPL and CCXA were granted certification of High and New Technology Enterprise (“HNTE”) status to enjoy a tax rate of 15% from 2008 to 2010. The HNTE status is renewable three years after certificate issuance and needs to be reapplied three years after certificate renewal via an application and approval process which will be initiated prior to the expiring of the HNTE certification. However, in practice, the renewable procedure is not clear as to whether it is possible to be completed prior to the expiring of the current certification. At the current stage, management does not believe it is more-likely-than-not that these entities will qualify for the HNTE status upon renewal; as a result, the Company applied 25% corporate income tax rate on deferred taxes for GLP, BOKE, Three Happiness, HSPL and CCXA as of December 31, 2010. The tax rate applicable to HQPL, Nuo Hua and GHK is 25%.





In accordance with the New CIT Law, enterprises established under the laws of foreign countries or regions and whose “place of effective management” is located within the PRC territory are considered PRC resident enterprises and subject to the PRC income tax at the rate of 25% on worldwide income. The definition of “place of effective management" refers to an establishment that exercises, in substance, overall management and control over the production and business, personnel, accounting, properties, etc. of an enterprise. As of December 31, 2010, no detailed interpretation or guidance has been issued to define “place of effective management”. Furthermore, as of December 31, 2010, the administrative practice associated with interpreting and applying the concept of “place of effective management” is unclear. If the Company’s non-PRC incorporated entities are deemed PRC tax residents, such entities would be subject to PRC tax under the New CIT Law. The Company has analyzed the applicability of this law as of December 31, 2010, and the Company has not accrued for PRC tax on such basis. The Company will continue to monitor changes in the interpretation or guidance of this law.





The New CIT Law also imposes a 10% withholding income tax, subject to reduction based on tax treaty where applicable, for dividends distributed by a foreign invested enterprise to its immediate holding company outside China. Such dividends were exempted from PRC tax under the previous income tax law and regulations. The foreign invested enterprise will be subject to the withholding tax starting from January 1, 2008.





Income before income taxes and non-controlling interest:





Years Ended December 31,2010


2009


2008Non-PRC

$
(16,551,812)


$
(15,282,854
)

$
(11,817,032
)PRC


41,201,591



69,802,045



71,539,694Total

$
24,649,779


$
54,519,191


$
59,722,662





The provisions for income taxes for the years ended December 31, 2010, 2009 and 2008 are summarized as follows:





Years Ended December 31,2010


2009


2008Current

$
8,738,903


$
14,234,251


$
12,469,511Deferred


(402,537)



(1,017,265)



165,961Total

$
8,336,366


$
13,216,986


$
12,635,472





F-30





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





The reconciliation of tax computed by applying the statutory income tax rate applicable to the PRC operations to income tax expenses is as follows:





Years Ended December 31,2010


2009


2008Income tax computed at the PRC statutory tax rate at 25% for years 2008, 2009 and 2010


6,162,446



13,629,798



14,930,666Preferential tax rate


(4,569,785)



(7,051,457
)


(8,424,544
)Tax rate differences


(1,953,086)



(1,247,652
)


(1,011,709)Deferred tax impact


(1,593,025)



871,749



—Provision-to-return adjustment


48,207



291,938



—Changes in the valuation allowance


9,313,496



6,055,491



4,159,595Permanent differences:Write-off IPR&D expenses






—



3,063,812Tax exempted income


(588,354)



(659,581
)


(110,351)Other permanent differences


1,516,467



1,326,700



28,003Total

$
8,336,366


$
13,216,986


$
12,635,472





The tax effects of temporary differences that give rise to the Company’s net deferred tax liabilities as of December 31, 2010 and 2009 are as follows:





Year Ended December 31,2010


2009Deferred tax assetsCurrentBad debts

$
96,334


$
93,158Other costs


190,536



590,405Unrecorded expenses


362,633



140,888Stock-based compensation expenses


427,707



—Valuation allowance


(427,707)



—Total current deferred tax assets


649,503



824,451Non-currentAmortization


147,024



134,268Unrealized equity losses of unconsolidated entity


1,576,211



—Stock-based compensation expenses


2,382,712



—Tax loss carried forward


19,344,451



14,861,967Valuation allowance


(23,303,374)



(14,861,967
)Total non-current deferred tax assets


147,024



134,268Total deferred tax assets

$
796,527


$
958,719Deferred tax liabilitiesCurrentOver accrual of welfare

$
(171,293)


$
(115,074
)Other


(72,011)



(57,399
)Total current deferred tax liabilities


(243,304)



(172,473
)Non-currentAmortization


(443,775)



(360,452
)Depreciation


(354,451)



(222,815
)GLP acquisition


(6,426,982)



(6,295,276
)CCXA acquisition


(4,557,169)



(4,716,197
)Boke acquisition


(4,055,102)



(4,366,725
)Total non-current deferred tax liabilities


(15,837,479)



(15,961,465
)Total deferred tax liabilities


(16,080,783)



(16,133,938
)Net deferred tax liabilities

$
(15,284,256)


$
(15,175,219
)





F-31





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





As of December 31, 2010, the Company intends to permanently reinvest the undistributed earnings from its foreign subsidiaries to fund future operations. The amount of unrecognized deferred tax liabilities for temporary differences related to investments in foreign subsidiaries is not determined because such a determination is not practicable.





In assessing the realizability of deferred tax assets, the Company has considered whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. The Company records a valuation allowance to reduce deferred tax assets to a net amount that management believes is more-likely-than-not realizable based on the weight of all available evidence. As of December 31, 2010, the Company recorded a full valuation allowance against the deferred tax assets of those subsidiaries that are in a cumulative loss position.




As of December 31, 2010, the Company had net operating tax losses carried forward of $57,691,437, which includes $40,421,621, $10,436,288 and $6,833,528 in the US, PRC, and Hong Kong, respectively. Those losses carried forward in the US expire between years 2025 and 2031 and in the PRC expire between years 2013 and 2016. Loss incurred in Hong Kong is carried forward indefinitely.





(b) FASB ASC 740-10 Implementation





The Company’s adoption of FASB ASC 740-10 did not result in any adjustment to the opening balance of the Company’s retained earnings as of January 1, 2008 nor did it have any impact on the Company’s financial statements for the year ended December 31, 2008. The Company has elected to classify interest and/or penalties related to an uncertain position, if and when required, as part of other expenses in the consolidated statements of income and comprehensive income.





For the year ended December 31, 2010, the Company had an unrecognized tax benefit of $5,679,036 which is mainly related to tax positions associated with non-trade intercompany transactions, fixed assets, intangible assets, stock-based compensation expenses and unrealized equity losses. The Company recorded a penalty of $398,395 and $440,000 for the years ended December 31, 2010 and 2009, respectively, related to its uncertain tax positions. It is possible that the amount accrued will change in the next 12 months; however, an estimate of the range of the possible change cannot be made at this time. $5,050,157 of the unrecognized tax benefits, if ultimately recognized will impact the effective tax rate. Reconciliation of accrued unrecognized tax benefits excluding the penalty is as follows:





December 31,2010


2009Beginning balance

$
2,306,561


$
-Increases related to prior year positions


1,513,198



762,992Increases related to current year positions


1,859,277



1,543,569Ending balance

$
5,679,036


$
2,306,561





The Company has various open tax years between 2005 and 2010 in its significant operating jurisdictions.





NOTE 23 - EMPLOYEE DEFINED CONTRIBUTION PLAN





Full time employees of the Company’s subsidiaries in the PRC participate in a government-mandated defined contribution plan pursuant to which certain pension benefits, medical care, unemployment insurance, employee housing fund and other welfare benefits are provided to employees. Chinese labor regulations require that the PRC subsidiaries of the Company make contributions to the government for these benefits based on 41% of the employees’ salaries. The Company’s PRC subsidiaries have no legal obligation for the benefits beyond the contributions made. The total amounts for such employee benefits, which were expensed as incurred, were $3,582,934, $978,178 and $781,191 for the years ended December 31, 2010, 2009 and 2008, respectively and are included in selling, general and administrative expenses.





NOTE 24 - SUBSEQUENT EVENTS





There were no significant subsequent events occurred after December 31, 2010.





F-32





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE 25 - SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)





Quarters EndedMarch 31


June 30


September 30


December 31Year Ended December 31, 2010REVENUES

$
53,749,768


$
77,296,212


$
91,533,044


$
83,365,061GROSS PROFIT

$
28,236,721


$
39,840,352


$
47,282,198


$
42,398,283NET INCOME

$
3,117,777


$
5,117,734


$
5,323,144


$
2,754,758Basic net income per common share

$
0.04


$
0.07


$
0.07


$
0.04Diluted net income per common share

$
0.04


$
0.07


$
0.07


$
0.04Year Ended December 31, 2009REVENUES

$
46,077,190


$
71,222,037


$
78,818,666


$
100,032,887GROSS PROFIT

$
28,416,852


$
41,627,114


$
44,131,161


$
52,607,878NET INCOME

$
7,155,060


$
12,446,270


$
10,027,846


$
11,673,029Basic net income per common share

$
0.10


$
0.17


$
0.13


$
0.16Diluted net income per common share

$
0.10


$
0.16


$
0.13


$
0.14










F-33