UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
 
FORM 10-K
 
þ
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
   
For the fiscal year ended
December 31, 2012
 
 
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 Number:
000-53155

VLOV INC .
(Exact name of issuer as specified in its charter)

Nevada
 
20-8658254
(State or other jurisdiction of incorporation or
organization)
 
(I.R.S.  employer identification number)
     
5F, No. 151 Taidong Road
Xiamen Guanyin Shan International Business Center
Siming District, Xiamen City
Fujian Province 361008
People’s Republic of China
 
 
 
 
 
361008
(Address of principal executive offices)
 
(Zip Code)

Registrant’s telephone number, including area code
+86 (592) 2345999

Securities registered pursuant to Section 12(b) of the Act:

Title of each class
 
Name of each exchange on which registered
     

Securities registered pursuant to section 12(g) of the Act:
 
Common stock, par value $0.00001 per share
(Title of class)

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

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  þ

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  þ 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  þ No  o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) 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. Yes  o No  þ
 
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 (Check one):
 
 
Large Accelerated Filer    o
Accelerated Filer                       o
 
Non-accelerated filer       o
Smaller reporting company      þ
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes  o No  þ
 
As of June 30, 2012, the aggregate market value of the voting stock held by non-affiliates of the registrant was approximately $11.6 million, based on a closing price of $9.03 per share of common stock as reported on the Over-the-Counter Bulletin Board on such date.

As of April 10, 2013, the registrant had 2,637,753 shares of common stock outstanding.
 


 
 
 
 
 
TABLE OF CONTENTS
TO ANNUAL REPORT ON FORM 10-K
FOR YEAR ENDED DECEMBER 31, 2012
 
   
Page
PART I
   
Item 1.
Business
4
Item 1A.
Risk Factors
16
Item 1B.
Unresolved Staff Comments
30
Item 2.
Properties
30
Item 3.
Legal Proceedings
31
Item 4. 
Mine Safety Disclosures
31
     
PART II
   
Item 5.
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
31
Item 6.
Selected Financial Data
32
Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operation
32
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
39
Item 8.
Financial Statements and Supplementary Data
39
Item 9.
Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
41
Item 9A
Controls and Procedures
41
Item 9B.
Other Information
42
     
PART III
   
Item 10.
Directors, Executive Officers and Corporate Governance
43
Item 11.
Executive Compensation
47
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
49
Item 13.
Certain Relationships and Related Transactions, and Director Independence
50
Item 14.
Principal Accounting Fees and Services
51
     
PART IV
   
Item 15. 
Exhibits, Financial Statement Schedules 
51
     
Signatures
  53

 
 

 
 
Forward Looking Statements
 
This Form 10-K and other reports filed by the registrant from time to time with the Securities and Exchange Commission (collectively the “Filings”) contain or may contain forward looking statements and information that are based upon beliefs of, and information currently available to, the registrant’s management as well as estimates and assumptions made by the registrant’s management.  When used in the filings the words “anticipate,” “believe,” “estimate,” “expect,” “future,” “intend,” “plan” or the negative of these terms and similar expressions as they relate to the registrant or the registrant’s management identify forward looking statements.  Such statements reflect the current view of the registrant with respect to future events and are subject to risks, uncertainties, assumptions and other factors (including the risks contained in the section of this report entitled “Risk Factors”) relating to the registrant’s industry, the registrant’s operations and results of operations and any businesses that may be acquired by the registrant.  Should one or more of these risks or uncertainties materialize, or should the underlying assumptions prove incorrect, actual results may differ significantly from those anticipated, believed, estimated, expected, intended or planned.
 
Although the registrant believes that the expectations reflected in the forward looking statements are reasonable, the registrant cannot guarantee future results, levels of activity, performance or achievements.  Except as required by applicable law, including the securities laws of the United States, the registrant does not intend to update any of the forward-looking statements to conform these statements to actual results.  The following discussion should be read in conjunction with the registrant’s financial statements and the related notes thereto included in this report.
 
In this Form 10-K, references to “we,” “our,” “us,” “VLOV” or the “Company” refer collectively to VLOV Inc. and its subsidiaries, variable interest entity and affiliated companies.
   
Other Pertinent Information
 
All share and per share information in this Form 10-K give effect to the 1-for-2.5 reverse split of our common stock  effected on December 9, 2011, and the 1-for-3 reverse split of our common stock effected on September 24, 2012.

 
3

 

PART I

ITEM 1. 
BUSINESS.

Overview

We design, market and distribute apparel and related products targeted at 20-45 years old men under the “VLOV” brand.  We currently carry two product lines: (1) Esquire and (2) Richard Wu.
 
We primarily sell our products to our independent distributors, each of whom is granted rights to market and sell our products in a defined market or territory.  Our distributors sell our products at points of sale, or POS, that they establish within their territories and operate either directly or through third-party retail operators, including counters, concessions, store-in-stores and stand-alone stores.  To better showcase our brand, however, we acquired the retail network of our Fujian distributor in June 2011 to operate the stores on our own.  As of December 31, 2012, all of our products were sold at POS throughout China, including 404 that our distributors operate and 17 that we operate directly (“company stores”).  In January 2013, one of our distributors also began selling our apparel in New York City.  See “ Our Distribution Channel and Customers ” below.
 
Our goal is to provide stylish, fashion-forward clothing, to our target customers.  As such, we maintain and exercise control over advertising and marketing activities from our headquarters in Fujian Province, China, where we set the tone for integrity, consistency and direction of the VLOV brand image.  Additionally, we set guidelines for our distributors as to how our products are to be advertised and displayed.

All our manufacturing activities are carried out by third-party manufacturers.  After we design and create samples, they are presented to our distributors at our biannual previews for their selection and purchase based on what they believe will sell most effectively in their POS.  After our distributors place their purchase orders with us, the manufacturers make and deliver the products to our distributors.

During 2010, all of our business operations were carried out by Jinjiang Yinglin Jinduren Fashion Limited (“Yinglin Jinduren”), which we control through contractual arrangements between Yinglin Jinduren and our wholly-owned subsidiary Dong Rong Capital Investment Limited (“HK Dong Rong”).  We completed the transfer of all sales contracts and design, marketing, sales and purchasing-related assets from Yinglin Jinduren to our wholly-owned subsidiary Dong Rong (China) Co., Ltd. (“China Dong Rong”) in the first quarter of 2011, and all of our business activities are currently conducted by China Dong Rong.

As Yinglin Jinduren has had no operations since early 2011, we may dissolve, and exit from the contractual arrangements with, it sometime in the future.  Until then, we will continue to operate our business through China Dong Rong (as we currently do) while continuing to control Yinglin Jinduren through the contractual arrangements.
 
History and Corporate Structure

We were incorporated in Nevada on October 30, 2006, originally under the name “Sino Charter, Inc.,” with a principal business objective to provide internet-based flight charter booking for East Asia.  Prior to share exchange transaction with Peng Xiang Peng Fei Investments Limited (“PXPF”) described below, we were a public reporting “shell company,” as defined in Rule 12b-2 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).
 
On August 1, 2008, MMH Group, LLC (“MMH”) entered into a stock purchase agreement with Bradley Miller, who had been our sole director and officer since our incorporation date, to acquire from him 13,334 shares of our common stock.  The transaction closed on August 4, 2008, and concurrently with the closing, MMH sold 3,200 shares to Ancora Greater China Fund, L.P. (“Ancora”), and 7,467 shares to Pope Investments II, LLC (“Pope”), leaving MMH with 2,667 shares.  MMH is owned by Matthew Hayden, who replaced Mr. Miller as our sole director and officer until the share exchange transaction with PXPF described below.

On January 12, 2009, we effected a 1-for-100 reverse split of our common stock by filing a Certificate of Amendment to Articles of Incorporation with the Nevada Secretary of State.

On February 12, 2009, we entered into a securities purchase agreement with MMH, Ancora and Pope, pursuant to which we sold 13,707 shares of our common stock to MMH, 16,448 shares to Ancora and 38,379 shares to Pope.  On February 13, 2009, we sold an additional 108,600 shares of our common stock to four purchasers.

 
4

 
 
On February 13, 2009 (the “Closing Date”), we entered into a share exchange agreement (the “Exchange Agreement”) with PXPF and its shareholders who, immediately prior to the closing of the transactions contemplated by the Exchange Agreement (the “Share Exchange”), collectively held 100% of PXPF’s issued and outstanding share capital (the “BVI Shareholders”).  On the Closing Date, we issued 1,941,334 shares of common stock to the BVI Shareholders in exchange for all of their equity interests in PXPF.  The BVI Shareholders became our controlling shareholders, PXPF became our wholly-owned subsidiary, and we acquired the business and operations of PXPF.  Immediately prior to the Share Exchange, we had 193,923 shares of common stock outstanding, including 16,374 shares held by MMH, as well as 19,648 shares held by Ancora and 45,846 shares held by Pope.  Immediately after the Share Exchange, we had 2,135,256 shares of common stock outstanding.  In connection with the Share Exchange, we changed our name from “Sino Charter, Inc.” to “VLOV Inc.” on March 4, 2009, to better reflect our business operations.

The Share Exchange was accounted for as a reverse merger (recapitalization) with PXPF deemed to be the accounting acquirer, and us as the legal acquirer.  Accordingly, the financial information presented in our financial statements is the historical financial information of PXPF, as adjusted to give effect to the change in the share capital as a result of the reverse merger (recapitalization).  The basis of the assets, liabilities and retained earnings of PXPF, the accounting acquirer, have been carried over in the recapitalization.
 
In November 2009, we raised approximately $8 million through a private placement of our series A convertible preferred stock and common stock purchase warrants.  In December 2009, we raised an additional $1.87 million through a private placement of our common stock and common stock purchase warrants.  The registration statement for the securities sold in these transactions was declared effective on March 30, 2011, although we were required to have the registration effective by May 16, 2010.  As such, we have accrued $987,000 in estimated liquidated damages to the investors in these two transactions, which we plan to pay as soon as practically possible.  All of the warrants issued in these transactions expired in the fourth quarter of 2012.
 
On December 9, 2011, we effected a 1-for-2.5 reverse stock split of our issued and outstanding common stock and a proportional reduction of our authorized shares of common stock, by filing a Certificate of Change Pursuant to Nevada Revised Statutes 78.209 with the Nevada Secretary of State on November 16, 2011. 

On September 24, 2012, we effected a 1-for-3 reverse stock split of our issued and outstanding common stock and a proportional reduction of our authorized shares of common stock, by filing a Certificate of Change Pursuant to Nevada Revised Statutes 78.209 with the Nevada Secretary of State on September 13, 2012.   

Unless otherwise indicated, all share and share price information regarding our common stock in this report takes into account the three stock splits described above.

Peng Xiang Peng Fei Investments, Limited

PXPF was incorporated in the British Virgin Islands on April 30, 2008. PXPF was formed by the owners of Yinglin Jinduren as a special purpose vehicle for raising capital outside of the PRC.  Other than holding 100% of the equity interests in HK Dong Rong, PXPF has no operations of its own.

Dong Rong Capital Investment Limited

HK Dong Rong was incorporated on January 5, 2005 originally under the name Korea Jinduren (International) Dress Limited (“Korea Jinduren”).  The company was set up by the owners of Yinglin Jinduren as a special purpose vehicle for raising capital outside of the PRC, and changed its name to HK Dong Rong on April 27, 2009.  HK Dong Rong is wholly-owned by PXPF.  Other than activities arising from its contractual arrangements with Yinglin Jinduren and holding 100% of the equity interests in China Dong Rong, HK Dong Rong has no other operations of its own.

On June 11, 2008, HK Dong Rong entered into a bridge loan and financing agreement (“Bridge Loan Agreement”) with Pope, Ancora (with Pope, collectively the “Bridge Loan Investors”) and MMH.  Under the Bridge Loan Agreement, MMH and the Bridge Loan Investors agreed to provide a U.S. public shell company suitable for the Share Exchange, and the Bridge Loan Investors also agreed to loan Korea Jinduren the sum of $550,000 (the “Bridge Loan”) for payment of professional fees and expenses incurred in connection with the Share Exchange.  The Bridge Loan Investors and MMH would collectively receive shares of common stock equal to 4% of our post-Share Exchange total outstanding and issued common stock.  Additionally, the Bridge Loan Investors would be repaid the Bridge Loan and collectively receive shares of our common stock equal to 1% of our post-Share Exchange total issued and outstanding common stock (the “Bridge Loan Shares”) on or after October 1, 2009 and only upon the completion of a financing.  23,267 shares of common stock were issued at the closing of the Share Exchange as the Bridge Loan Shares.  Both the Bridge Loan and the Bridge Loan Shares were placed in a third-party escrow account, and payments were made from such account as fees and expenses were incurred, and the Bridge Loan Shares held in escrow until their release to the Bridge Loan Investors was required.  On October 28, 2009, the entire amount of the Bridge Loan paid out for fees and expenses was repaid, and the balance of the Bridge Loan remaining in escrow, if any, returned to the Bridge Loan Investors.  The Bridge Loan Shares were released to the Bridge Loan Investors on December 28, 2009 and on March 15, 2010.

 
5

 
 
Dong Rong (China) Co., Ltd.

On November 19, 2009, China Dong Rong was established as the wholly-owned subsidiary of HK Dong Rong, with registered capital of $8 million, all of which has been funded.  China Dong Rong is deemed to be a wholly foreign owned enterprise, or WFOE, under applicable PRC law.  Under applicable PRC regulations, China Dong Rong is required to set aside at least 10% of its annual after-tax net profit, if any, to fund government-mandated statutory reserves until the balance of such reserves reaches $4 million, or 50% of its registered capital.  The funds in the statutory reserves can only be used for certain purposes, such as to increase its registered capital or to eliminate its future losses as determined under PRC generally acceptable accounting principles.  At December 31, 2012 and 2011, the statutory reserves amounted to RMB 20.1 million ($3.2 million) and nil, respectively, and China Dong Rong’s total accumulated net income distributable to us was $30.7 million and $14.5 million, respectively, which amounts are reflected as retained earnings on our consolidated balance sheets as of such dates included elsewhere in this report.  All of our design, marketing, sales and purchasing activities are presently carried out by China Dong Rong.  See “ Transfer of Business Operations to China Dong Rong ” below.
 
Jinjiang Yinglin Jinduren Fashion Limited

Yinglin Jinduren was organized in the PRC on January 19, 2002, and is owned by Qingqing Wu, our Chairman and Chief Executive Officer (“CEO”), and his brother Zhifan Wu (collectively the “Owners”).  Like China Dong Rong, Yinglin Jinduren has statutory reserves requirement (RMB 5 million based on its registered capital of RMB 10 million), which is fully funded.

Prior to January 1, 2011, all of our business operations were carried out by Yinglin Jinduren, to which neither we, PXPF nor HK Dong Rong own any equity interests.   Instead, we control Yinglin Jinduren through contractual arrangements that HK Dong Rong entered into with Yinglin Jinduren and the Owners.  See “ Contractual Arrangements with Yinglin Jinduren and its Owners ” below.  Through such contractual arrangements, we have substantially the same control of and rights to Yinglin Jinduren that we would have had through actual ownership of its equity interests.  Through these contractual arrangements, we provide consulting and other general business operation services to Yinglin Jinduren, and also have the ability to substantially influence its daily operations and financial affairs, since we are able to appoint its senior executives and approve all matters requiring approval of the equity owners.  As a result of these contractual arrangements, we are able to control Yinglin Jinduren and to receive, through a service fee earned by HK Dong Rong, all of the net income of Yinglin Jinduren, although we have generally allowed such amounts to be retained by Yinglin Jinduren to support its operations.  At December 31, 2012 and 2011, Yinglin Jinduren’s total accumulated net income distributable to us was $26.2 million and $26.2 million, respectively, which amounts are reflected as retained earnings on our consolidated balance sheets as of such dates included elsewhere in this report.  Our contractual agreements are silent as to the sharing of losses in the event that Yinglin Jinduren incurs losses in any period.  As a result, in the event Yinglin Jinduren incurs losses, we would expect to absorb such losses through our inability to collect the accumulated net income due to us.
 
As of the date of this report, Yinglin Jinduren has no operations as all of our design, marketing, sales and purchasing activities are being carried out by China Dong Rong.  See “ Transfer of Business Operations to China Dong Rong ” below.

Contractual Arrangements with Yinglin Jinduren and its Owners

Our relationships with Yinglin Jinduren and the Owners are governed by a series of contractual arrangements, as we (including our subsidiaries) do not own any equity interests in Yinglin Jinduren.  In the opinion of Allbright Law Offices, our PRC counsel, rendered in connection with the Share Exchange: (a) PXPF, HK Dong Rong and Yinglin Jinduren are each duly established and validly existing under the laws of its place of establishment, and has the requisite corporate power to conduct its business; (b) the contractual arrangements constitute valid and binding obligations of the parties of such agreements; (c) the contractual arrangements and the rights and obligations of the parties thereto are enforceable and valid in accordance with the laws of the PRC; (d) no approval from or filing with any PRC governmental body is required in connection with the entry and performance of the contractual arrangements; and (e) under Chinese laws, HK Dong Rong and Yinglin Jinduren are each an independent legal entity and neither of them is exposed to liabilities incurred by the other party.  The foregoing opinion, which also describes the corporate history of each of PXPF, HK Dong Rong and Yinglin Jinduren immediately prior to the Share Exchange, is based on documents provided by PXPF and search results from the PRC Companies Registry, the genuineness, completeness, accuracy and validity of which are assumed by Allbright Law Offices, and is limited to interpretation of all such documents based on PRC laws and regulations which Allbright Law Offices believed were applicable at the time the opinion was rendered.
 
 
6

 
 
On December 28, 2005, HK Dong Rong entered into the following contractual arrangements with Yinglin Jinduren and the Owners:

Consulting Services Agreement .  Pursuant to the exclusive consulting services agreement between HK Dong Rong and Yinglin Jinduren, HK Dong Rong has the exclusive right to provide to Yinglin Jinduren general consulting services relating to the management and operations of Yinglin Jinduren’s apparel business (the “Services”).  Additionally, HK Dong Rong owns any intellectual property rights developed through the Services provided to Yinglin Jinduren.  During the term of this agreement, Yinglin Jinduren’s operational incomes are deposited into a bank account designated by HK Dong Rong.  Yinglin Jinduren is obligated to pay a quarterly consulting service fee in Renminbi (“RMB”) to HK Dong Rong that is equal to all of Yinglin Jinduren’s net income for such quarter, based on a financial report certified by Yinglin Jinduren’s chief financial officer and delivered to HK Dong Rong within 45 days after the end of such quarter.  In addition to such quarterly reports, Yinglin Jinduren is also obligated to report its monthly financial results and business conditions to HK Dong Rong, as well as provide its annual audited accounts within 90 days of the fiscal year end.  Yinglin Jinduren is also obligated to maintain accurate books and records of its business activities and transactions, and to make all such information available to HK Dong Rong.  In the event of a breach by Yinglin Jinduren of the foregoing or other obligations under this agreement, HK Dong Rong is entitled to all remedies under PRC law, including recovery of direct and indirect losses as well as legal fees.  The consulting services agreement is in effect unless and until terminated by written notice of either party in the event that: (a) the other party causes a material breach of this agreement, provided that if the breach does not relate to a financial obligation of the breaching party, that party may attempt to remedy the breach within 14 days following the receipt of the written notice; (b) the other party becomes bankrupt, insolvent, is the subject of proceedings or arrangements for liquidation or dissolution, ceases to carry on business, or becomes unable to pay its debts as they become due; (c) HK Dong Rong terminates its operations; (d) Yinglin Jinduren’s business license or any other license or approval for its business operations is terminated, cancelled or revoked; or (e) circumstances arise which would materially and adversely affect the performance or the objectives of the consulting services agreement.  Additionally, HK Dong Rong may terminate the consulting services agreement without cause.  Any dispute arising from this agreement that the parties cannot resolve must be submitted for arbitration before the China International Economic and Trade Arbitration Commission.
 
We have generally allowed Yinglin Jinduren to retain its net income in the PRC in order to support its operations.  Additionally, Yinglin Jinduren was allowed to declare dividends, which dividends were declared and paid to the Owners prior to the Share Exchange.   Thus, immediately prior to the Share Exchange, Yinglin Jinduren declared and paid the equivalent of $5,131,000 in RMB as dividends to Mr. Wu and his brother.  However, Yinglin Jinduren has not declared or paid any dividend since the Share Exchange and will not do so in the future.
 
Operating Agreement .  Pursuant to the operating agreement among HK Dong Rong, Yinglin Jinduren and the Owners, HK Dong Rong provides guidance and instructions on Yinglin Jinduren’s daily operations, financial management and employment issues.  The Owners must designate the candidates recommended by HK Dong Rong as their representatives on Yinglin Jinduren’s board of directors.  HK Dong Rong has the right to appoint senior executives of Yinglin Jinduren.  In addition, HK Dong Rong has the right, but not the obligation, to guarantee the performance of Yinglin Jinduren under any agreements or arrangements relating to Yinglin Jinduren’s business arrangements with any third party.  Yinglin Jinduren, in return, agrees to pledge its accounts receivable and all of its assets to HK Dong Rong.  Moreover, Yinglin Jinduren agrees that without the prior consent of HK Dong Rong, Yinglin Jinduren will not engage in any transactions that could materially affect the assets, liabilities, rights or operations of Yinglin Jinduren, including, without limitation, incurrence or assumption of any indebtedness, sale or purchase of any assets or rights, incurrence of any encumbrance on any of its assets or intellectual property rights in favor of a third party or transfer of any agreements relating to its business operation to any third party.  The term of this agreement is the maximum period of time permitted by law unless sooner terminated by any other agreements reached by all parties or upon a 30-day written notice from HK Dong Rong.  The term may be extended only upon HK Dong Rong’s written confirmation prior to the expiration of the agreement, with the extended term to be mutually agreed upon by the parties.  We have been advised by our PRC counsel that there is no current PRC regulation mandating the maximum length of term permissible for such agreement.

Equity Pledge Agreement .   Under the equity pledge agreement between the Owners and HK Dong Rong, the Owners pledged all of their equity interests in Yinglin Jinduren to HK Dong Rong to guarantee Yinglin Jinduren’s performance of its obligations under the consulting services agreement.  If Yinglin Jinduren or the Owners breach their respective contractual obligations, HK Dong Rong, as pledgee, will be entitled to certain rights, including, but not limited to, the right to vote with, control and sell the pledged equity interests.  The Owners also agreed that upon occurrence of any event of default, HK Dong Rong shall be granted an exclusive, irrevocable power of attorney to take actions in the place and instead of the Owners to carry out the security provisions of the equity pledge agreement, and take any action and execute any instrument as required by HK Dong Rong to accomplish the purposes of the equity pledge agreement.  The Owners agreed not to dispose of the pledged equity interests or take any actions that would prejudice HK Dong Rong’s interest.  The equity pledge agreement will expire two years from the fulfillment of Yinglin Jinduren’s obligations under the consulting services agreement.  HK Dong Rong’s security interests over the pledged equity interests have not been registered with the local State Administration for Industry and Commerce (“SAIC”), as it is unclear whether registration is required under China’s Property Rights Law that became effective on October 1, 2007.  See “ Risk Factors – Risks Related to Our Corporate Structure –If the Chinese government determines that the contractual arrangements through which we control Yinglin Jinduren do not comply with applicable regulations, we could be subject to severe penalties.
 
 
7

 
 
Option Agreement .   Under the option agreement between the Owners and HK Dong Rong, the Owners irrevocably granted HK Dong Rong an exclusive option to purchase, to the extent permitted under Chinese law, all or part of the equity interests in Yinglin Jinduren for the cost of the Owners’ initial contributions to Yinglin Jinduren’s registered capital or the minimum amount of consideration permitted by applicable Chinese law.  HK Dong Rong (or its designee) has sole discretion to decide when to exercise the option, whether in part or in full.  The term of this agreement is ten years from January 1, 2006 and may be extended prior to its expiration by written agreement of the parties.

Proxy Agreement .  Pursuant to the proxy agreement between HK Dong Rong and the Owners, the Owners agreed to irrevocably grant a designee of HK Dong Rong with the right to exercise the Owners’ voting and other rights, including the rights to attend and vote at shareholders’ meetings (or by written consent in lieu of such meetings) in accordance with applicable laws and Yinglin Jinduren’s governing charters comprising of its Articles of Association (the “Articles”).  Under the Articles, shareholders have the power to (a) approve the company’s business, budget, accounting, profit distribution and loss allocation plans, (b) appoint or remove the company’s senior executives and determine their compensations, (c) increase or decrease the company’s registered capital, (d) approve the issuance of debt obligations, (e) approve the company’s merger, division, dissolution or liquidation, and (f) amend the Articles.  Additionally, a shareholder holding at least one tenth of the company’s total voting rights may call for a shareholders’ meeting.  The proxy agreement may not be terminated without the unanimous consent of all parties, except that HK Dong Rong may terminate the proxy agreement with or without cause upon 30-day written notice to the Owners.
 
As a result of these contractual arrangements among HK Dong Rong, Yinglin Jinduren and the Owners, we have the ability to effectively control Yinglin Jinduren’s daily operations and financial affairs, appoint senior executives and decide on all matters requiring approval of the Owners.  In other words, while Mr. Wu and his brother continue to own 100% Yinglin Jinduren’s equity interests, they have given us all of their rights as the Owners through these contractual arrangements.  Accordingly, we are considered the primary beneficiary of Yinglin Jinduren and Yinglin Jinduren is deemed our variable interest entity (“VIE”).
 
However, control based on these contractual arrangements may ultimately not be as effective as direct ownership of Yinglin Jinduren, as we will need to enforce our rights through quasi-judicial proceeding in the event Yinglin Jinduren fails to perform its contractual obligations.  In the event the outcome of such proceeding is unfavorable to us, we may effectively lose control over Yinglin Jinduren.  See “ Risk Factors – Risks Related to Our Corporate Structure – Our contractual arrangements with Yinglin Jinduren and its owners as well as our ability to enforce our rights thereunder may not be as effective in providing control over Yinglin Jinduren as direct ownership. ”   As of April 10, 2013, Mr. Wu owned approximately 48.5% of our issued and outstanding common stock.  As such, we believe that our interests are aligned with those of Yinglin Jinduren and the Owners.  However, we cannot give assurance that such interests will always be aligned, or that we can effectively control Yinglin Jinduren if and when such interests are no longer aligned.  See “Risk Factors - Risks Related to Our Corporate Structure – Certain management members of Yinglin Jinduren have potential conflicts of interest with us, which may adversely affect our business and your ability for recourse.”
 
Transfer of Business Operations to China Dong Rong

Prior to January 1, 2011, all of our business operations were conducted by Yinglin Jinduren.  To provide us with greater control over our business operations, however, we transferred them to China Dong Rong, including (a) all sales contracts, (b) all design, marketing, sales and purchasing-related assets, and (c) all trademarks.  The transfers of design, marketing, sales and purchasing-related assets, which had a net book value of approximately $27,000, as well as sales contracts, were completed in the first quarter of 2011.  As a result, all of our business operations are now carried out by China Dong Rong.  As Yinglin Jinduren has had no operations since early 2011, we may dissolve, and terminate the contractual arrangements with, it sometime in the future.  Until then, however, we operate our business through China Dong Rong while continuing to control Yinglin Jinduren through the contractual arrangements.
 
As we have been outsourcing 100% of our manufacturing to third-party manufacturers since the third quarter of 2010 (see “ Our Suppliers and Manufacturers ” below), all manufacturing related assets were sold in lieu of transferring them to China Dong Rong.  During the first quarter of 2011, we sold equipment with net book value of $146,000 on December 31, 2010, to an unrelated party for approximately $155,000. We also entered into an agreement with the same party to sell the building that houses the equipment and the related land use right, with combined net book value of $1,021,000 on December 31, 2010, for approximately $989,000.  The buyer deposited 60% of the purchase price in accordance with the agreement, and the balance was received on March 31, 2011.  We also obtained a third-party appraisal of approximately $1,051,000 for the building and the land use right.  All proceeds from the sales of the manufacturing assets were transferred to China Dong Rong.  We registered the transfer of the building’s ownership certificate and the land use right certificate with the local authority.
 
 
8

 
 
Our Current Corporate Structure

The following diagram illustrates our current corporate structure:


(1)  
Through the Share Exchange, we became the parent company of PXPF.  Our management includes: Mr. Qingqing Wu as Chairman and CEO, Mr. Bennet P. Tchaikovsky as Chief Financial Officer (“CFO”), and Dr. Jianwei Shen, Mr. Yuzhen Wu, Ms. Ying Zhang and Mr. Jianhui Wang as members of the board of directors.  As of April 10, 2013, Mr. Qingqing Wu, Mr. Tchaikovsky and Ms. Zhang owned or had beneficial interests in 1,279,533 shares, 36,103 shares and 5,336 shares of our issued and outstanding common stock, respectively; Dr. Shen, Mr. Yuzhan Wu, and Mr. Wang do not own any shares.

(2)  
PXPF was formed by the owners of Yinglin Jinduren as a special purpose vehicle for raising capital outside of the PRC.  The management of PXPF is comprised of Mr. Qingqing Wu as its sole Director.  We are the sole shareholder of PXPF.

(3)  
HK Dong Rong was formed by the owners of Yinglin Jinduren as a special purpose vehicle for raising capital outside of the PRC.  The management of HK Dong Rong is comprised of Mr. Qingqing Wu as Chairman and Mr. Lileng Lin as Director.  PXPF is the sole shareholder.

(4)  
HK Dong Rong controls Yinglin Jinduren through contractual arrangements designed to mimic equity ownership of Yinglin Jinduren by HK Dong Rong, including a consulting services agreement, operating agreement, equity pledge agreement, option agreement, and proxy agreement.

(5)  
The management of Yinglin Jinduren is comprised of Mr. Qingqing Wu as Chairman and Executive Director, and Mr. Zhifan Wu as Executive Director.  Messrs. Wu and Wu, who are brothers, hold 65.91% and 34.09% of the ownership interests of Yinglin Jinduren, respectively.   Yinglin Jinduren currently has no operations.

(6)  
The management of China Dong Rong is comprised of Mr. Qingqing Wu as Executive Director.  As of the date of this report, all of our design, marketing, sales and purchasing activities are carried out by China Dong Rong.  HK Dong Rong is the sole shareholder of China Dong Rong.
 
 
9

 
 
Should we dissolve Yinglin Jinduren, our corporate structure would be as follows: 
 

Such structure would have (or already has) the following effects on us:

We have actual ownership interests over the entity that conducts all of our business operations (China Dong Rong).

The potential conflicts of interest with Yinglin Jinduren’s management, as discussed in “ Risk Factors – Risks Related to Our Corporate Structure – Certain management members of Yinglin Jinduren have potential conflicts of interest with us, which may adversely affect our business and your ability for recourse” would no longer exist because we would have exited from the contractual arrangements with Yinglin Jinduren.

The risks related to our current corporate structure as they relate to the contractual arrangements that are discussed under “ Risks Related to Our Corporate Structure ” including the applicable risks and limitations on our holding company’s ability to receive distributions from the Yinglin Jinduren would no longer apply because we would have exited from the contractual arrangements with Yinglin Jinduren.  As discussed more fully below under the risk factor with the title starting with “ We conduct our business through Yinglin Jinduren by means of contractual arrangements…”, the security interests on the equity interests of Yinglin Jinduren as granted under the equity pledge agreement have not been registered with the local SAIC.  After exiting the contractual arrangements, such security interests would no longer exist thus eliminating the need for such registration.

Since the transfer of our design, marketing, sales and purchasing activities from Yinglin Jinduren to China Dong Rong does not involve any foreign currency exchange transaction, such transfer has no effect on us and our management in regards to regulations of the State Administration of Foreign Exchange (“SAFE”).

 
10

 
 
Our Distribution Channel and Customers

We primarily sell our products to our independent distributors, each of whom is granted rights to market and sell our products in a defined market or territory through a distribution agreement.  During 2012, we had distribution agreements with the following distributors, who collectively accounted for approximately 95.1% of our total sales:
 
Distributors
 
Geographical
location
 
2012 Sales
(RMB thousands)
   
2012 Sales
(US$ thousands)*
   
% of total sales made to distributors
 
C-002 of Mingzhu 100 Market
 
Zhejiang
   
112,889
     
17,886
     
19.9
%
Xinshiji Apparel City
 
Beijing
   
96,035
     
15,216
     
16.9
%
Jinyang Commerce Co., Ltd.
 
Hubei
   
84,931
     
13,457
     
15.0
%
Jingduren Store, Tianqiao District, Jinan
 
Shandong
   
80,116
     
12,694
     
14.1
%
Shenyang City Hangweiqi Clothing Co., Ltd.
 
Liaoning
   
37,466
     
5,936
     
6.6
%
Yunfang Jingduren Store
 
Yunnan
   
29,749
     
4,713
     
5.3
%
Shanghai Sendun Trading Limited Company
 
Shanghai
   
29,045
     
4,602
     
5.1
%
Clothwork Apparel, Wanma Plaza
 
Jiangxi
   
27,791
     
4,403
     
4.9
%
Nachun Li
 
Guangxi
   
23,119
     
3,663
     
4.1
%
Yinji Fuchun Apparel
 
Henan
   
20,408
     
3,233
     
3.6
%
Jiaming Tang
 
Sichuan
   
14,763
     
2,339
     
2.6
%
Jinduren Store in Duocai Xintiandi
 
Shaanxi
   
10,943
     
1,734
     
1.9
%
TOTAL DISTRIBUTOR SALES
   
567,255
     
89,876
     
100.0
%
__________
* Based on an average exchange rate of USD $1.00 to RMB 6.31 for the year ended December 31, 2012, as quoted on www.oanda.com .

Each distributor operates a network of retail stores within its territory directly or through third-party operators.  These retail locations, also known as points of sales (“POS”), include counters, concessions, stand-alone stores and store-in-stores. During 2012, all of the POS were located in China, including those of the Shanghai-based distributor that we added during the year.
 
In January 2013, a VLOV distributor began selling our apparel at Trinity Place Department Store’s flagship location at 61 Broadway in New York City.  We authorized this venture because we believe that its success will further enhance our brand image and recognition in and out of China.  As we are unfamiliar with the New York market, the distributor is responsible for store design and marketing; the distributor, however, will require our authorization to open additional POS.  Pending the outcome of this venture, we currently have no plans to appoint additional distributors in the United States.
 
We believe that the distributor model has enabled us to grow by leveraging their regional retail expertise and economies of scale.  We provide retail policies and guidelines, training, advertising and marketing support as well as advertising subsidies to assist our distributors in the management and expansion of their retail distribution networks.  To achieve brand consistency, we have established management and operational guidelines for all our distributors to follow.  These guidelines include, but are not limited to, inventory control, sales and pricing procedures, product and window display requirements and customer service standards.  Although our distributorship agreements do not require our distributors to share POS sales information, our distributorship agreements require all POS to be our exclusive POS, and our sales and marketing staff travel throughout China to monitor and advise our distributors.  Distributors that maintain at least a three-year good standing relationship with us enjoy 120 days of credit while new distributors usually pay us upon our receipt of their orders.  There was no provision for bad debt during the last three years.
 
We aim to provide stylish, fashion-forward clothing to our target customer, and pride ourselves on our brand image and our ability to convey a successful and exclusive lifestyle brand.   Our goal is for our distributors to move towards operating stand-alone stores and store-in-stores as we believe that this will further enhance our brand value amongst our target consumer base.  Given the ever-increasing scale of our marketing efforts, our distributors have been cooperative in shifting away from counters and concessions in favor of stand-along stores and store-in-stores.
  
Each year, we hold two sales previews – typically in April/May and in November– to showcase new designs for all of our product lines to our distributors.  At each sales preview, the distributors place orders for products based on designs that they believe will appeal to their specific geographical markets, and the products are manufactured and delivered to the distributors accordingly.  We then monitor and oversee their operations of their POS through our marketing and sales team.   Our marketing and sales team advises and works closely with our distributors on renovating and updating their POS as and when necessary to achieve maximum performance and to enable them to expand their sales distribution network.  Upon achieving performance targets, distributors may become eligible for advertising rebates from us pursuant to our distribution agreements.  We also have other marketing activities, such as showing at the Mercedes-Benz Fashion Week in New York City.
 
We do not dictate what our distributors should carry at their POS.  Rather, we create sample products, and they select those that they believe will best sell at their POS.  We believe that this process substantially decreases the likelihood of product returns.

While we do not require our distributors to have any minimum number of years of relevant experience, we assess a candidate’s suitability based on, but not limited to, the following:

the relevant experience in the management and operation of casual wear retail stores;
the ability to develop and operate a network of retail stores in its designated sales region;
the perceived ability to meet our sales targets;
the ability to maintain and enhance our brand image;
the suitability of its store location and size; and
overall creditworthiness.

 
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We believe that we can leverage our solid reputation into opportunities to work with potentially desirable distributors, and referrals from existing distributors have been and continue to be a fruitful source of candidates.  We identify suitable distributors and enter into distributorship agreements generally for a term of up to 12 months, renewable on a yearly basis if certain criteria are met.  We allow our distributors to use authorized third-party retail store operators to operate their POS, provided that they first obtain our written approval.  We have contractual relationships only with our distributors and not with each POS.  We require our distributors to implement, monitor, comply with and enforce our sales and marketing guidelines at their POS.  We do not make any payment, give other sales incentives, or pay any fee to our distributors.  Our distributors do not pay us any fee other than for their purchase of our products.

We generally assist our distributors with transferring or exchanging their unsold inventories with our other distributors in order to control their inventory levels, and at the end of each season, we may also allow our distributors to sell their remaining inventories at discounted pricing.  As a result, we have historically had minimal returns from our distributors.

In addition to our distributors, we sell our products directly to consumers at company stores, all currently in Fujian.  In June 2011, we acquired 13 store locations (including 2 stand-alone stores and 11 store-in-stores) from our Fujian distributor to operate as company stores in order to facilitate the promotion of our brand and brand image, offer our distributors a working store model, and benefit from higher retail margin.  Since then, we have added 12 locations, including a flagship store, and closed 8 other locations.  Sales from company stores amounted to approximately $4.67 million (RMB 29.49 million) in 2012, or approximately 4.9% of our total sales.
 
A geographical breakdown of VLOV POS as of December 31, 2012, is as follows:
 
Province /City:
 
Number of POS
 
Zhejiang
   
66
 
Beijing
   
53
 
Hubei
   
40
 
Shandong
   
54
 
Liaoning
   
37
 
Yunnan
   
25
 
Shanghai
   
10
 
Jiangxi
   
27
 
Guangxi
   
27
 
Sichuan
   
22
 
Henan
   
25
 
Shaanxi
   
18
 
Fujian (company stores)
   
17
 
TOTAL
   
421
 
 
Our Sales and Marketing

In addition to our ability to design and produce trendy and high quality apparel, the strength of the VLOV brand is largely dependent on the skill of our sales and marketing team to promote our products to our target consumers.  The team currently has 60 members.  Our sales and marketing director is in charge of four departments: sales, marketing, strategic planning and logistics.
 
We actively market our brand.  Our print advertisements regularly appear in local newspapers and fashion magazines, outdoor venues such as mass transit stations, exterior bus panels and billboards, and indoor venues such as in-mall kiosks.  We also run television and radio advertisements, and look to promote our brand through product placement in film and television and sporting events.  We also have sales and marketing guidelines for all our distributors to follow at their POS, which include pricing and sale procedures, store layout, product and window display requirements and customer service standards.

Our advertising expenses were approximately $5.76 million and $5.97 million for 2011 and 2012, respectively, representing 41% and 34% of our operating expenses for these periods, respectively.

Our Suppliers and Manufacturers

As part of our overall sourcing strategy, we have been outsourcing all of our manufacturing to independent third-party OEM manufacturers since the third quarter of 2010, and we disposed all of our manufacturing-related assets in the first quarter of 2011.  See “ Transfer of Business Operations to China Dong Rong ” above.  We believe that outsourcing allows us to maximize production flexibility while managing capital expenditures and costs of maintaining what would otherwise be a massive workforce.

We currently work with 17 manufacturers.  We do not execute agreements with them since there are many well-qualified manufacturers to choose from and any of them can be readily replaced.  However, we have established good working relationships with all of the manufacturers that we work with and do not expect to replace any of them.  Prior to entering into a relationship with a manufacturer, we review and assess their product quality thoroughly.    

 
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We typically place orders with our manufacturers when we receive orders from our distributors or when directed by our sales department for the company stores.  We select and identify raw materials (including fabric, fasteners, thread, buttons, labels and specialty fabrics) directly from local suppliers, which our manufacturers purchase according to our manufacturing and design specifications.  We do not have agreements with the suppliers.  We generally agree to pay our manufacturers within 30-60 days after they dispatch finished goods to our distributors and/or warehouse.  To date, we have not experienced any significant difficulty in sourcing either qualified OEM manufacturers or the raw materials that they need to make our products.
 
For the year ended December 31, 2012, three manufacturers each accounted for 10% or more of our total purchases: Guangsu (Fujian) Apparel Trading Company, Xiamen Xindongmao Apparel Manufacturing Co., Ltd., and Xiamen Donghuida Apparel Manufacturing Co., Ltd., which accounted for 22%, 20% and 19% of our total purchases, respectively.  

Quality Control

We are committed to designing and creating high quality garments.  We require our OEM manufacturers to comply with our manufacturing standards and specifications, and do not allow them to sub-contract our production orders without our prior written consent.  We are actively involved throughout the entire manufacturing process to ensure quality control, including:

evaluating suppliers to make sure their raw materials meet our standards;
inspecting fabrics for flammability, durability, chemical content, static properties, color retention and various other properties;
inspecting  prototypes of each product prior to initial cutting;
routinely performing continuous on-site inspections;
subjecting finished products to testing; and
conducting final inspection of finished products prior to shipment to ensure that they meet our rigorous quality standards and our specifications.  

Our policies and arrangements allow us to return defective products back to the relevant manufacturers.

In addition, we work closely with, and evaluate, our distributors to further ensure that our products meet with their expectations.  Due to our strict quality control and testing measures, we have not undergone any product recalls, and have not received any significant requests from our distributors to return finished goods.  Product returns have not resulted in material operating expenses historically.
 
Logistics and Inventory

Our OEM manufacturers send finished products directly to our distributors and/or warehouse after final quality inspection.  We are only responsible for shipping costs pertaining to our warehouse and company stores.  To date, our shipping costs have been nominal.
 
Competition
 
The fashion apparel industry is quite competitive in China, including brand names and companies of all sizes, both within China and elsewhere in the world, many of which have greater financial and manufacturing resources than us.  Some of our local competitors include Zuoan and Cabbeen.  International brands such as Hugo Boss and Jack & Jones also compete in the same space as us.  Nevertheless, we have been in the industry since 2004 and believe that we have earned a reputation for producing high fashion and high quality products at competitive prices, and for excellent customer service.

We believe that our chief competitive strength is our in-depth and thorough understanding of our targeted customer groups in China.  Our CEO, who leads our design team, won China Fashion Week’s ”Top Ten Fashion Designer Award” in 2010 and 2011.  We were the only China-based designer to participate in the Spring/Summer 2012 and 2013 Mercedes-Benz New York Fashion Week.  Under Mr. Wu’s leadership, and with inputs from our distributors, our design team formulates new design concepts by analyzing information on global and local fashion trends and market research.  We create prototypes that are initially reviewed by our distributors and marketing team for input and further refined based on evaluations carried out by marketing personnel before showcasing the final designs at our sales fairs.
 
Intellectual Properties and Licenses

We presently have 19 trademarks under China Dong Rong that are registered with the Trademark Office of the State Administration of Industry and Commerce of the PRC (the “PRC Trademark Office”).  These trademarks are issued for a period of 10 years.

 
13

 
 
Additionally, we have trademark license contracts with our CEO, pursuant to which he has irrevocably and perpetually granted us, for no consideration, the right to use four trademarks currently registered in his name with the PRC Trademark Office. To date, we have not used these trademarks.

Our trademark and other intellectual property rights are important to our success and competitive position.  We believe that we take all necessary precautions to protect our intellectual property.  Aside from registering our trademarks with the PRC Trademark Office, our sales and marketing team also diligently conducts market research and patrols VLOV POS and other marketplaces to ensure that our intellectual property are not being violated.  In the event of any infringement upon our intellectual property rights, we will pursue all available legal rights and remedies.

Governmental Regulations

Fabric Safety

We are required to comply with regulations governing fabric safety on the national, provincial and local levels.  Since discontinuing our manufacturing activities in the third quarter of 2010, we have been carrying out quality assurance from our Xiamen headquarters.  Staff members routinely inspect the facilities of our OEM manufacturers to verify certain characteristics of the materials being used for our products, including flammability, durability, chemical content, static properties and color retention.   In addition, we work closely with our distributors to ensure the quality and safety of our products.
 
Enterprise Taxation

Pursuant to the PRC Enterprise Income Tax Law (the “New Tax Law”) passed by the Tenth National People's Congress on 16 March 2007, the new PRC income tax rates for domestic and foreign enterprises are unified at 25% effective January 1, 2008.  The enactment of the New Tax Law is not expected to have any significant financial effect on the amounts accrued in the balance sheet in respect of taxation payable and deferred taxation.

Value Added Tax

The Provisional Regulations of the People’s Republic of China Concerning Value Added Tax promulgated by the State Council came into effect on January 1, 1994, and was amended effective January 1, 2009.  Under these regulations, as amended, and the Implementing Rules of the Provisional Regulations of the People’s Republic of China Concerning Value Added Tax, value added tax is imposed on goods sold in or imported into the PRC and on processing, repair and replacement services provided within the PRC.

Value added tax payable in the PRC is charged on an aggregated basis at a rate of 13 or 17% (depending on the type of goods involved) on the full price collected for the goods sold or, in the case of taxable services provided, at a rate of 17% on the charges for the taxable services provided but excluding, in respect of both goods and services, any amount paid in respect of value added tax included in the price or charges, and less any deductible value added tax already paid by the taxpayer on purchases of goods and service in the same financial year.

Environmental Protection Regulations

In accordance with the Environmental Protection Law of the PRC adopted by the Standing Committee of the NPC on 26th December, 1989, the bureau of environmental protection of the State Council sets the national guidelines for the discharge of pollutants.  The provincial and municipal governments of provinces, autonomous regions and municipalities may also set their own guidelines for the discharge of pollutants within their own provinces or districts in the event that the national guidelines are inadequate.

A company or enterprise which causes environmental pollution and discharges other polluting materials which endanger the public is required to implement environmental protection methods and procedures into its business operations.  This may be achieved by setting up a system of accountability within the company’s business structure for environmental protection; adopting effective procedures to prevent environmental hazards such as waste gases, water and residues, dust powder, radioactive materials and noise arising from production, construction and other activities from polluting and endangering the environment.  The environmental protection system and procedures should be implemented simultaneously with the commencement of and during the operation of construction, production and other activities undertaken by the company.  Any company or enterprise which discharges environmental pollutants should report and register such discharge with relevant bureaus of environmental protection and pay any fines imposed for the discharge.  A fee may also be imposed on the company for the cost of any work required to restore the environment to its original state.  Companies which have caused severe pollution to the environment are required to restore the environment or remedy the effects of the pollution within a prescribed time limit.

If a company fails to report and/or register the environmental pollution caused by it, it will receive a warning or be penalized.  Companies which fail to restore the environment or remedy the effects of the pollution within the prescribed time will be penalized or have their business licenses terminated.  Companies or enterprises which have polluted and endangered the environment must bear the responsibility for remedying the danger and effects of the pollution, as well as to compensate any losses or damages suffered as a result of such environmental pollution.
 
 
14

 
 
Based on the present nature of our operations, we do not believe that environmental laws and the cost of compliance with those laws have or will have a material impact on us or our operations.

Foreign Exchange Controls
 
Pursuant to the Foreign Currency Administration Rules promulgated in 1996, as amended and various regulations issued by the State Administration of Foreign Exchange (“SAFE”), and other relevant PRC government authorities, RMB is convertible without prior approval from SAFE only to the extent of current account items, such as trade-related receipts and payments, interest and dividends and after complying with certain procedural requirements.  Capital account items, such as direct equity investments, loans and repatriation of investments, require the prior approval from the SAFE or its local counterpart for conversion of RMB 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 RMB.  Foreign-invested enterprises may retain foreign exchange in accounts with designated foreign exchange banks subject to limitations set by the SAFE or its local counterpart.  Unless otherwise approved, domestic enterprises must convert all of their foreign currency receipts into RMB.

Pursuant to the SAFE’s Notice on Relevant Issues Concerning Foreign Exchange Control on Domestic Residents’ Corporate Financing and Roundtrip Investment Through Offshore Special Purpose Vehicles, or Circular No. 75, issued on October 21, 2005, (i) a PRC citizen residing in the PRC, or PRC resident, shall register with the local branch of the SAFE before it establishes or controls an overseas special purpose vehicle, or overseas SPV, for the purpose of overseas equity financing (including convertible debts financing); (ii) when a PRC resident contributes the assets of or its equity interests in a domestic enterprise into an overseas SPV, or engages in overseas financing after contributing assets or equity interests to an overseas SPV, such PRC resident shall register his or her interest in the overseas SPV and the change thereof with the local branch of the SAFE; and (iii) when the overseas SPV undergoes a material event outside of China, such as change in share capital or merger and acquisition, the PRC resident shall, within 30 days from the occurrence of such event, register such change with the local branch of the SAFE.  On May 29, 2007, the SAFE issued relevant guidance to its local branches for the implementation of Circular No. 75.  This guidance standardizes more specific and stringent supervision on the registration requirement relating to Circular No. 75 and further requires PRC residents holding any equity interests or options in SPVs to register with the SAFE.  Failure to comply with such registration requirement may result in liability under PRC laws for evasion of applicable foreign exchange restrictions.

Although our CEO who is also our principal shareholder resides in the PRC, he is a foreign national.  As such, he has not registered with the local branch of the SAFE under Circular No. 75.  
 
Seasonality

Chinese consumers’ spending behaviors are typically affected by seasonal shopping patterns within the year.  Sales have generally been higher before the Chinese New Year holiday in early spring, the Labor Day holiday in early May, the summer months and the National Day holiday in early October.  These seasonal fluctuations have resulted in higher sales in the first and second quarters and lower sales in the third and fourth quarters of each year.  
 
The mix of product sales, however, may vary considerably from time to time as a result of changes in seasonal and geographic demand for particular products.  In addition, unexpected and abnormal changes in climate may affect sales of products that are timed for release during a particular season. 
 
Fluctuations in our sales may also result from a number of other factors including:

the timing of our competitors’ launch of new products;
consumer acceptance of our new and existing products;
changes in the overall clothing industry growth rates;
economic and demographic conditions that affect consumer spending and retail sales;
the mix of products ordered by our distributors;
the timing of the placement and delivery of distributor orders; and
variation in the expenditure necessary to support our business.

As a result, we believe that comparisons of our operating results between any interim periods may not be meaningful and that these comparisons may not be an accurate indicator of our future performance.

 
15

 
 
Employees

The following table sets forth the number of our employees for each of our areas of operations and as a percentage of our total workforce as of December 31, 2012:

   
Number of
employees
   
% of
employees
 
Sales & marketing and quality assurance
   
60
     
35
%
Purchasing
   
3
     
2
%
Finance
   
13
     
8
%
Management & administration
   
16
     
9
%
Research & development
   
11
     
6
%
Company stores
   
68
     
40
  TOTAL
   
171
     
100
%

We believe we are in full compliance with Chinese labor laws and regulations and are committed to providing safe and comfortable working conditions for our employees.

Labor Costs .  Because garment manufacturing is a labor-intensive business, we outsource all of our manufacturing to OEM manufacturers.  We rely on in-house skilled labor and talents to design, develop and sell our products.  Generally, we offer one to three months of training to new employees to better understand our brands and improve their relevant skills during the training period.  Management expects that our access to reasonably priced and competent labor force will continue into the foreseeable future.
 
Working Conditions and Employee Benefits .  We believe in the importance of maintaining our social responsibilities, and we are committed to providing employees with a safe, clean, comfortable working environment.  Our employees also are entitled to time off during public holidays.   We believe we are in full compliance with our obligations to provide pension benefits to our employees, as mandated by the PRC government, and offer reasonable wages, life insurance and medical insurance to our employees.  In addition, we frequently monitor working conditions at our OEM manufacturers to ensure their compliance with Chinese labor laws and regulations.  

Compliance with Environmental Laws

Based on the present nature of our operations, we do not believe that environmental laws and the cost of compliance with those laws have or will have a material impact on us or our operations.

Principal Executive Office

Our principal executive office is located at 5F, No. 151 Taidong Road, Xiamen Guanyin Shan International Business Center, Siming District, Xiamen City, Fujian Province 361008, China.  Our main telephone number is +86-0592-2345999, and fax number is +86-0592-2345777.

ITEM 1A.
RISK FACTORS

RISK FACTORS

The reader should carefully consider the risks described below together with all of the other information included in this report.  The statements contained in or incorporated into this report that are not historic facts are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those set forth in or implied by forward-looking statements.  If any of the following risks actually occurs, our business, financial condition or results of operations could be harmed.   In that case, the trading price of our common stock could decline, and an investor in our securities may lose all or part of their investment.

Risks Relating to Our Industry

Our sales are influenced by general economic cycles.  A prolonged period of depressed consumer spending would have a material adverse effect on our profitability.

Apparel is a cyclical industry that is dependent upon the overall level of consumer spending.  The global economy is currently experiencing a downturn.  Purchases of trendy apparel and accessories tend to decline in periods of uncertainty regarding future economic prospects, when consumer spending, particularly on discretionary items, and disposable income decline.  Many factors affect the level of consumer spending in the apparel industries, including, among others: prevailing economic conditions, levels of employment, salaries and wage rates, energy costs, interest rates, the availability of consumer credit, taxation and consumer confidence in future economic conditions.  During periods of economic uncertainty, we may not be able to maintain or increase our sales to existing customers, make sales to new customers, maintain sales levels at our existing POS, or maintain or improve our margins from operations as a percentage of net sales.  Our customers anticipate and respond to adverse changes in economic conditions and uncertainty by reducing inventories and canceling orders.  A prolonged period of depressed consumer spending would have a material adverse effect on our profitability.

 
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We compete with companies with significantly greater resources than ours, and if we are unable to compete effectively with these companies, our market share may decline and our business could be harmed.

We face intense competition in the apparel industry from other established companies both in China and other countries.  A number of our competitors may have significantly greater financial, technological, manufacturing, sales, marketing and distribution resources than we do.  Their greater capabilities in these areas may enable them to better withstand periodic downturns in the apparel industry, compete more effectively on the basis of price and production, better adapt to changes in consumer preferences or retail requirements, devote greater resources to the marketing and sale of their products, and more quickly develop new products.  In addition, new companies may enter the markets in which we compete, further increasing competition in the industry.  As a result, we may not be able to compete successfully with them if we cannot continue enhancing our marketing and management strategies, quality and value or responding appropriately to consumer needs.

We believe that our ability to compete successfully depends on a number of factors, including the style and quality of our products and the strength of our brand name, as well as many factors beyond our control.  We may not be able to compete successfully in the future, and increased competition may result in price reductions, reduced profit margins, loss of market share and an inability to generate cash flows that are sufficient to maintain or expand our development and marketing of new products, which would adversely impact the trading price of our common stock.

The worldwide apparel industry is subject to ongoing pricing pressure.

The apparel market is characterized by low barriers to entry for both suppliers and marketers, global sourcing through suppliers located throughout the world, trade liberalization, continuing movement of product sourcing to lower cost countries, ongoing emergence of new competitors with widely varying strategies and resources, and an increasing focus on apparel in the mass merchant channel of distribution.  These factors contribute to ongoing pricing pressure throughout the supply chain.  This pressure has and may continue to:

require us to reduce wholesale prices on existing products;
result in reduced gross margins across our product lines; and
increase pressure on us to further reduce our production costs and our operating expenses.

Any of these factors could adversely affect our business and financial condition.

Fluctuation in the price, availability and quality of raw materials could increase our cost of goods and decrease our profitability.

We outsource all of our manufacturing needs to, and purchase finished goods from, OEM manufacturers, who supply their own raw materials.   We may also import specialty fabrics to meet specific customer requirements.  The prices we charge for our products are dependent in part on the market price for raw materials used to produce them.  The price, availability and quality of the raw materials for our products may fluctuate substantially, depending on a variety of factors, including demand, supply conditions, transportation costs, government regulation, economic climates and other unpredictable factors.  Any raw material price increases could increase our cost of sales and decrease our profitability unless we are able to pass higher prices on to our customers.
 
For the year ended December 31, 2012, 3 suppliers collectively accounted for 60.9% of our total purchases of finished products.  For the year ended December 31, 2011, 2 suppliers collectively accounted for 25.3% of our total purchases of finished products.  We do not have any long-term written agreements with any of our suppliers and do not anticipate entering into any such agreements in the near future.  We do not believe that the loss of any of these suppliers would have a material adverse effect on our ability to obtain finished goods essential to our business because we believe we can locate other suppliers in a timely manner.
  
Risks Relating to Our Business

Our limited operating history makes it difficult to evaluate our future prospects and results of operations.

We have a limited operating history.  Yinglin Jinduren commenced business in 2004, and we recently commenced retail operations with the acquisition of our Fujian distributor’s stores in June 2011.   Our limited operating history makes it difficult to predict our operating results and we may experience significant fluctuations in our operating results.  Accordingly, you should consider our future prospects in light of the risks and uncertainties experienced by early stage companies in evolving industries such as the apparel industry in China.  Some of these risks and uncertainties relate to our ability to:
 
maintain our market position;
 
 
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attract additional customers and increase spending per customer;
respond to competitive market conditions;
increase awareness of our brands and continue to develop customer loyalty;
respond to changes in our regulatory environment;
maintain effective control of our costs and expenses;
raise sufficient capital to sustain and expand our business; and
attract, retain and motivate qualified personnel.

If we are unsuccessful in addressing any of these risks and uncertainties, our business may be materially and adversely affected.

We may be unable to sustain our past growth or manage our future growth, which may have a material adverse effect on our future operating results.

We have experienced rapid growth since our inception, and have increased our net sales from $4.7 million in 2004 to $94.5 million in 2012.  We anticipate that our future growth rate will depend upon various factors, including the strength of our brand image, the market success of our current and future products, the success of our growth strategies, competitive conditions and our ability to manage our future growth.  Future growth may place a significant strain on our management and operations.  As we continue to grow our operations, our operational, administrative, financial and legal procedures and controls will need to be expanded.  As a result, we may need to train and manage an increasing number of employees, which could distract our management team from our business.  Our future success will depend substantially on the ability of our management team to manage our anticipated growth. If we are unable to anticipate or manage our growth effectively, our future operating results could be adversely affected.
    
We must attract more consumers within our targeted profile to our brands.

Our current products are weighted towards Chinese male consumers 20 to 45 years of age.  If we are not successful in attracting consumers within our demographic profile for our brand, our results of operation and our ability to grow will be adversely affected. 

Our continued operations depend on current fashion trends.  If our designs and products do not continue to be fashionable, or if we are unable to maintain our brand image, our business could be adversely affected.

Our success depends in large part on our ability to develop, market and deliver innovative and stylish products that are consistent and build on our brand image at a pace and intensity competitive with our competition.  The novelty and the design of our apparel are critical to our success and competitive position, and the inability to continue to develop and offer unique products to our customers, and to maintain our brand image, could harm our business.  We cannot be certain that trendy apparel and related accessories will continue to be fashionable.  Should the trend steer away from apparel and related accessories such as ours, our sales could decrease and our business could be adversely affected.  Even if we react appropriately to changes in consumer preferences, consumers may consider our brand image to be outdated or associate our brands with styles that are no longer popular.  In the past, many apparel companies have experienced periods of rapid growth in revenues and earnings followed by periods of declining sales and losses.  Our business may be similarly affected in the future.  In addition, our future designs and plans to expand our product offerings may not be successful, and any unsuccessful designs or product offerings could adversely affect our business.

We depend mainly on our distributors for our sales.  A significant adverse change in our relationship with a distributor or in a distributor’s performance or financial position could harm our business and financial condition.

We primarily sell our products to our distributors who, in turn, sell them at the POS that they operate.  We depend on our distributors’ regional retail experience and economies of scale.  We may not be able to expand the geographical coverage of our existing distributors, or be able to engage new distributors who have strong network and retail experience, which may substantially impair our sales targets.  We rely on our distributors in the management and expansion of their retail sales networks.  Even though we provide retail policies and guidelines, training, advertising and marketing support, our distributors might not carry out our visions and satisfy the needs of our business.  Our sales to distributors also may not correlate directly to the demand for our products by end customers.  If our distributors mismanage and do not effectively expand our retail network, our business and our reputation can be adversely affected.

Presently we have distribution agreements with 12 distributors.  For the year ended December 31, 2011, four of our distributors each accounted for 10% or more of our total net sales, or 51.9% of our total net sales in the aggregate. For the year ended December 31, 2012, four of our distributors each accounted for 10% or more of our total net sales, or 62.7% of our total net sales in the aggregate.  We do not believe that there is any material risk of loss of any of these distributors during the next 12 months.  We believe that we could replace any of these distributors within 12 months, such that the loss of a distributor would not have a material adverse effect on our financial condition in the long term.  None of our affiliates are officers, directors, or material shareholders of any of these distributors.

 
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A decision by a major distributor, whether motivated by competitive considerations, strategic shifts, financial requirements or difficulties, economic conditions or otherwise, to decrease its purchases from us or to change its manner of doing business with us, could adversely affect our business and financial condition.  We sell to certain distributors on open account with 120 day payment terms, but these arrangements are not always possible.  Such evaluation focuses on the distributor’s payment history and ability, and takes into account such distributor’s specific operational history, background and other relevant information as well as the economic and market environment in which the distributor operates.  Thus, we have historically avoided credit exposure due to the financial instability of our distributors; however, while management believes that we will continue to be able to do so, there is no assurance that we will always be able to do so.  In addition, although we have long-standing relationships, we do not have long-term contracts with any of our distributors.  We identify suitable distributors and enter into distributorship agreements, generally for a term of up to 12 months, renewable on a year-to-year basis upon satisfying certain criteria.
 
Our quarterly revenues and operating results fluctuate as a result of a variety of factors, including seasonal fluctuations in demand for denim and related apparel, and accessories delivery date delays, timing of new POS openings.

Our quarterly revenues and operating results have varied significantly in the past and can be expected to fluctuate in the future due to a number of factors, many of which are beyond our control.  For example, sales of our products have historically been somewhat seasonal in nature with the strongest sales generally occurring during the Chinese New Year holiday in early spring, Labor Day holiday in early May, summer months, and National Day holiday in early October.  Delays in scheduling or delivery of products by our distributors could negatively impact our net sales and results of operations for any given quarter.  The timing of new POS openings by our distributors and the amount of revenue contributed by such new POS could also impact our net sales and results of operations for any given quarter.  As a result of these specific and other general factors, our operating results will likely vary from quarter to quarter and the results for any particular quarter may not be necessarily indicative of results for the full year.  Any shortfall in revenues or net income from levels expected by securities analysts and investors could cause a decrease in the trading price of our common stock.

Our business could be harmed if we fail to maintain proper inventory levels.

We place orders with our OEM manufacturers for our products when we receive all of our customers’ orders.  We do this to minimize purchasing costs, the time necessary to fill customer orders and the risk of non-delivery.  We also maintain an inventory of certain products that we anticipate will be in greater demand.  However, we may be unable to sell the products we have ordered in advance from manufacturers or that we have in our inventory.  Inventory levels in excess of customer demand may result in inventory write-downs, and the sale of excess inventory at discounted prices could significantly impair our brand image and have a material adverse effect on our operating results and financial condition.  Conversely, if we underestimate consumer demand for our products or if our manufacturers fail to supply the quality products that we require at the time we need them, we may experience inventory shortages.  Inventory shortages might delay shipments to customers, negatively impact retailer and distributor relationships, and diminish brand loyalty.

We rely on outsourcing for all of our manufacturing needs.  Our inability to secure production sources meeting our quality, cost, working conditions and other requirements, or failures by our contractors to perform, could harm our sales, service levels and reputation.

We source all of our products from independent OEM manufacturers who supply their own raw materials.  As a result, we must locate and secure production capacity.  We depend on these manufacturers to maintain adequate financial resources, secure a sufficient supply of raw materials, and maintain sufficient development and manufacturing capacity in an environment characterized by continuing cost pressure and demands for product innovation and speed-to-market. In addition, we do not have material long-term contracts with any of our OEM manufacturers, who generally may unilaterally terminate their relationship with us at any time. 
 
 
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Our dependence on OEM manufacturing could subject us to difficulty in obtaining timely delivery of products of acceptable quality.  A manufacturer's failure to timely deliver products or to meet our quality standards could cause us to miss the delivery date requirements of our distributors. In addition, any interference with our or our distributors’ ability to receive delivery from those manufacturers, such as conditions at ports or issues that otherwise affect transportation and warehousing providers, could cause delayed delivery of products.  Additionally, if we experience a significant increase in demand, or if we need to replace any of the manufacturers that we currently use, we may have to expand our third-party manufacturing capacity.  We cannot be assured that this capacity will be available to us, or that if available it will be available on terms that are acceptable to us.  Failing to make timely deliveries may cause our distributors to cancel orders, refuse to accept deliveries, impose non-compliance charges through invoice deductions or other charge-backs, demand reduced prices or reduce future orders, any of which could harm our sales and margins.
 
Our success depends on the continued protection of our trademark and other proprietary intellectual property rights.

Our trademark and other intellectual property rights are important to our success and competitive position, and the loss of or inability to enforce trademark and other proprietary intellectual property rights could harm our business.  We devote substantial resources to the establishment and protection of our trademark and other proprietary intellectual property rights in China.  Our efforts to establish and protect our trademark and other proprietary intellectual property rights may not be adequate to prevent imitation or counterfeiting of our products by others or to prevent others from seeking to block sales of our products.  Unauthorized copying of our products or unauthorized use of our trademarks or other proprietary rights may not only erode sales of our products but may also cause significant damage to our brand names and our ability to effectively represent ourselves to our customers.

The loss of our chief executive officer or other key management personnel would have an adverse impact on our future development and could impair our ability to succeed.

Our performance is substantially dependent upon the expertise of our chief executive officer, Mr. Qingqing Wu, and other key management personnel.   Mr. Wu spends all of his working time on our Company's business, including as our Chief Designer.  It may be difficult to find qualified individuals to replace Mr. Wu or other key management personnel if we were to lose any one or more of them.  The loss of Mr. Wu or any of our key management personnel could have a material adverse effect on our business, development, financial condition, and operating results.  Furthermore, most members of our design team are not currently under contract.
 
We must successfully maintain and/or upgrade our information technology systems.

We rely on various information technology systems to manage our operations, and we regularly evaluate these systems against our current and expected requirements.  Although we have no current plans to implement modifications or upgrades to our systems, we will eventually be required to make changes to legacy systems and acquire new systems with new functionality.  We are considering additional investments in updating our current system to help us improve our internal control system and to meet compliance requirements under Section 404.  We are also continuing to develop and update our internal information systems on a timely basis to meet our business expansion needs.  Any information technology system disruptions, if not anticipated and appropriately mitigated, could have an adverse effect on our business and operations.
 
Business interruptions could adversely affect our business.

Our operations and the operations of our suppliers and distributors are vulnerable to interruption by fire, earthquake, hurricanes, power loss, telecommunications failure and other events beyond our control.  In the event of a major natural disaster, we could experience business interruptions, destruction of facilities and loss of life.  In the event that a material business interruption occurs that affects us or our suppliers or distributors, deliveries could be delayed and our business and financial results could be harmed.
 
Our ability to attract customers to the company stores depends heavily on the store locations, and any decrease in customer traffic could cause our net sales to be less than expected.
 
Sales at company stores are dependent, to a significant degree, upon the volume of traffic surrounding the store locations.  A reduction in consumer traffic or our inability to obtain or maintain favorable store locations could have a material adverse effect on us.
 
Our company store growth strategy depends upon our ability to successfully open and operate new stores each year in a timely and cost-effective manner without affecting the success of our existing store base.
 
Our strategy to grow our retail business depends partly on continuing to open new company stores for the foreseeable future.  Our future operating results will depend largely upon our ability to find a sufficient number of suitable locations that will allow us to successfully open and operate new stores each year in a timely and cost-effective manner.  Our ability to successfully open and operate new stores depends on many factors including, among others, our ability to:
 
identify desirable store locations;
negotiate acceptable lease terms, including desirable tenant allowances;
 
 
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maintain out-of-pocket, build-out costs in line with our store economic model, including through leveraging landlords' reimbursements for a portion of our construction expenses, as well as managing these costs at reasonable levels;
hire, train and retain a growing workforce of store managers, sales associates and other personnel;
successfully integrate new stores into our existing control structure and operations, including our information technology systems;
sufficient capitalization to build out retail store locations; and
efficiently managing our OEM manufacturers to meet the needs of a growing retail network.

If we continue to expand our retail operation, we may face risks associated with market saturation of our merchandise.  Also, if we expand into new geographic areas, we will need to successfully identify and satisfy the fashion preferences of our target customers in these areas.  In addition, we will need to address competitive, merchandising, marketing, distribution and other challenges encountered in connection with any expansion.

Finally, we cannot assure you that any newly opened stores will be received as well as, or achieve net sales or profitability levels comparable to those of, our existing stores in our estimated time periods, or at all.  If our stores fail to achieve, or are unable to sustain, acceptable net sales and profitability levels, our business overall may be materially harmed and we may incur significant costs associated with closing or relocating stores.  If we fail to successfully open and operate new stores and execute our growth plans, the price of our common stock could decline.

We are subject to risks associated with leasing substantial amounts of space, including future increases in occupancy costs.

We do not own any real estate.  Instead, the company stores and our corporate headquarters and warehouse are all leased.
  
Our ability to effectively obtain new leases to open new company stores depends on the availability of locations that meets our criteria for traffic, square meters, lease economics, demographics, and other factors, including our ability to negotiate terms that meet our financial targets.  We also must be able to effectively renew our existing store leases.  Failure to secure adequate new locations or successfully modify existing locations, or effectively manage the profitability of our company stores, could have a material adverse effect on our retail operations.
 
Of our 17 operating leases, 11 do not have fixed rental payments.  Instead, the landlord takes a negotiated percentage of the gross sales amount.   In order for us to obtain such a lease, especially at higher-end locations, we need to continually maintain and further enhance our brand image.  If we are unable to generate sufficient revenues from these locations, our landlords may choose not to renew our leases.
 
Additionally, the current economic environment may make it difficult to determine the fair market rent of retail real estate properties within Fujian.  This could impact the quality of our decisions to exercise lease options at previously negotiated rents and the quality of our decisions to renew expiring leases at negotiated rents.  Any adverse effect on the quality of these decisions could impact our ability to retain real estate locations adequate to meet our targets or efficiently manage the profitability of our existing stores and could have a material adverse effect on our results of operations.

Our substantial occupancy costs could have significant negative consequences, which include:

requiring that a substantial portion of our available cash be applied to pay our rental obligations, thus reducing cash available for other purposes;
increasing our vulnerability to general adverse economic and industry conditions; and
limiting our flexibility in planning for, or reacting to changes in, our business or in the industry in which we compete.

We depend on cash flow from operations to pay our lease expenses and to fulfill our other cash needs.  If our retail business does not generate sufficient cash flow from operating activities to fund these expenses and needs and sufficient funds are not otherwise available to us, we may not be able to service our lease expenses, grow our retail business, respond to competitive challenges or fund our other liquidity and capital needs, which would harm our overall business.  If an existing or future store is not profitable, and we decide to close it, we may nonetheless be committed to perform our obligations under the applicable lease including, among other things, paying rent for the balance of the lease term.  In addition, if we are not able to enter into new leases or renew existing leases on terms acceptable to us, this could have an adverse effect on our results of operations.

 
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Risks Related to Our Corporate Structure

If the Chinese government determines that the contractual arrangements through which we control Yinglin Jinduren do not comply with applicable regulations, we could be subject to severe penalties.

There are uncertainties regarding the interpretation and application of PRC laws, rules and regulations, including but not limited to the laws, rules and regulations governing the validity and enforcement of the contractual arrangements between HK Dong Rong and Yinglin Jinduren.  Although we have been advised by our PRC counsel, that based on their understanding of the current PRC laws, rules and regulations, the contractual arrangements with Yinglin Jinduren and its owners, as well our ability to enforce our rights thereunder comply with all applicable PRC laws, rules and regulations, and do not violate, breach, contravene or otherwise conflict with any applicable PRC laws, rules or regulations, we cannot assure you that the PRC regulatory authorities will not determine that our corporate structure and contractual arrangements violate PRC laws, rules or regulations.  If the PRC regulatory authorities determine that our contractual arrangements are in violation of applicable PRC laws, rules or regulations, such contractual arrangements may become invalid or unenforceable.  In addition, new PRC laws, rules and regulations may be introduced from time to time to impose additional requirements that may be applicable to our contractual arrangements.  For example, the PRC Property Rights Law that became effective on October 1, 2007 requires companies to register security interests on equity interests granted under equity pledge agreements with the local State Administration for Industry and Commerce (“SAIC”).  However, it is unclear whether or not we are required to register the security interests under the Property Rights Law because HK Dong Rong entered into the equity pledge agreement with Yinglin Jinduren in 2005, prior to the October 1, 2007 enactment of the Property Rights Law.  This law does not state that it is applicable to transactions prior to its 2007 enactment date and the security interests granted under the equity pledge agreement have not been registered.  Because such registration has not been completed, there is a risk that HK Dong Rong may not be able to enforce its rights under the equity pledge agreement.  In the event Yinglin Jinduren’s equity owners, our CEO Mr. Wu and his brother Mr. Zhifan Wu (collectively the “Owners”), fail to perform their contractual obligations under the equity pledge agreement, HK Dong Rong, as pledgee, becomes entitled to exercise its rights under the equity pledge agreement including the right to vote with, control and sell the pledged equity interests.  If a dispute arises between us and the Owners, and the  Owners breach their obligations under the equity pledge agreement by selling the equity ownership of Yinglin Jinduren to a third party without our consent, HK Dong Rong may not be able to enforce such rights and claim a superior security interest over the pledged equity interests as against a bona fide purchaser of such equity interests because HK Dong Rong’s security interests in the pledged equity interests were not registered with the local SAIC.  If Yinglin Jinduren is sold to a bona fide purchaser and we are unable to enforce the security interests granted under the equity pledge agreement to prevent the completion of such sale, then there is a potential risk that Yinglin Jinduren’s bona fide purchaser may, in turn, refuse to perform all of Yinglin Jinduren’s obligations to us under the contractual arrangements including Yinglin Jinduren’s obligation to pay us fees equal to Yinglin Jinduren’s net income.  Such refusal would sever our ability to continue receiving payments from Yinglin Jinduren, and we would no longer be able to consolidate Yinglin Jinduren’s results, assets and liabilities in the our financial statements.

The Chinese government has broad discretion in dealing with violations of laws and regulations, including levying fines, revoking business and other licenses and requiring actions necessary for compliance.  In particular, licenses and permits issued or granted to us by relevant governmental bodies may be revoked at a later time by higher regulatory bodies.  We cannot predict the effect of the interpretation of existing or new Chinese laws or regulations on our businesses.  We cannot assure you that our current ownership and operating structure would not be found in violation of any current or future Chinese laws or regulations.  As a result, we may be subject to sanctions, including fines, and could be required to restructure our operations or cease to provide certain services.  Any of these or similar actions could significantly disrupt our business operations or restrict us from conducting a substantial portion of our business operations, which could materially and adversely affect our business, financial condition and results of operations.
 
If we, HK Dong Rong or Yinglin Jinduren are determined to be in violation of any existing or future PRC laws, rules or regulations or fail to obtain or maintain any of the required governmental permits or approvals, the relevant PRC regulatory authorities would have broad discretion in dealing with such violations, including:

revoking the business and operating licenses of Yinglin Jinduren and/or voiding the contractual arrangements;
discontinuing or restricting the operations of Yinglin Jinduren;
imposing conditions or requirements with which we or HK Dong Rong or Yinglin Jinduren may not be able to comply;
requiring us to restructure the relevant ownership structure or operations; or
imposing fines or other forms of economic penalties.

Our contractual arrangements with Yinglin Jinduren and its owners as well as our ability to enforce our rights thereunder may not be as effective in providing control over Yinglin Jinduren as direct ownership.

We have no equity ownership interest in Yinglin Jinduren, and rely on contractual arrangements to control the company.  We cannot assure you that the owners of Yinglin Jinduren will always act in our best interests, and these contractual arrangements may not be as effective in providing control over the company as direct ownership.  For example, Yinglin Jinduren could fail to take actions required for our business despite its contractual obligation to do so.  If Yinglin Jinduren fails to perform under its agreements with us, we are required by the terms of these agreements to enforce our rights by arbitration before The China International Economic and Trade Arbitration Commission (CIETAC).  To initiate such proceeding, we must first prepare and submit an arbitration request to CIETAC for its acceptance.  Once accepted, CIETAC will form an arbitration tribunal to hear the matter, set a hearing date and notify Yinglin Jinduren of the proceeding.  Yinglin Jinduren will have 45 days from the receipt of such notice to prepare its statement of defense.  While we have been advised by our PRC counsel that current CIETAC rules requires a decision to be rendered within six months from the selection of the arbitration tribunal, the passage of any prolong period of time without resolution may disrupt and negatively affect our business operations.  Further, we must borne half of CIETAC’s fees in addition to our own expenses incurred to prepare for such proceeding, which fees may become prohibitively expensive as the arbitration must take place in Shanghai and be conducted in Chinese.  As we are also contractually bound by CIETAC’s decision, in the event such decision is unfavorable to us, we may effectively lose our control over Yinglin Jinduren. 

 
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As the contractual arrangements are governed by PRC law, we would be required to rely on PRC law to enforce our rights and remedies under them; PRC law may not provide us with the same rights and remedies as are available in contractual disputes governed by the law of other jurisdictions.
 
Our contractual arrangements with Yinglin Jinduren are governed by the PRC law and provide for the resolution of disputes through arbitral proceedings pursuant to PRC law.  If Yinglin Jinduren or its shareholders fail to perform the obligations under the contractual arrangements, we would be required to resort to legal remedies available under PRC law, including seeking specific performance or injunctive relief, or claiming damages.  We cannot be sure that such remedies would provide us with effective means of causing Yinglin Jinduren to meet its obligations, or recovering any losses or damages as a result of non-performance.  Further, the legal environment in China is not as developed as in other jurisdictions.  Uncertainties in the application of various laws, rules, regulations or policies in PRC legal system could limit our ability to enforce the contractual arrangements and protect our interests.

Our contractual arrangements with Yinglin Jinduren and the payment arrangement thereunder may be challenged by the PRC tax authorities and may result in adverse tax consequences to us.
 
We could face adverse tax consequences if the PRC tax authorities determine that the contractual arrangements were not entered into based on arm’s length negotiations.  For example, PRC tax authorities may adjust the Company’s and/or Yinglin Jinduren’s income and expenses for PRC tax purposes in the form of a transfer pricing adjustment.  A transfer pricing adjustment could result in a reduction, for Chinese tax purposes, of adjustments recorded by Yinglin Jinduren, which could adversely affect us by increasing Yinglin Jinduren’s tax liability without reducing the Company’s tax liability, which could further result in late payment fees and other penalties to Yinglin Jinduren for underpaid taxes.

Certain management members of Yinglin Jinduren have potential conflicts of interest with us, which may adversely affect our business and your ability for recourse.

Our chairman and CEO Mr. Qingqing Wu is also the chairman of Yinglin Jinduren and owns 49.1% of its equity ownership interests.  Conflicts of interests between his duties to our company and Yinglin Jinduren may arise.  As our chairman and CEO, Mr. WU has a duty of loyalty and care to us under U.S. and Hong Kong law when there are any potential conflicts of interests between our company and Yinglin Jinduren.  We cannot assure you, however, that when conflicts of interest arise, he will act completely in our interests or that conflicts of interests will be resolved in our favor.  For example, he may determine that it is in Yinglin Jinduren’s interests to sever the contractual arrangements with HK Dong Rong, irrespective of the effect such action may have on us.  In addition, he could violate his legal duties by diverting business opportunities from us to others, thereby reducing the amount of payment that Yinglin Jinduren is obligated to remit to us under the consulting services agreement.
 
In the event that you believe that your rights have been infringed under the securities laws or otherwise as a result of any one of the circumstances described above, it may be difficult or impossible for you to bring an action against Yinglin Jinduren or Mr. Wu, who resides within China.   Even if you are successful in bringing an action, the laws of China may render you unable to enforce a judgment against the assets of Yinglin Jinduren and its management.

Risks Related to Doing Business in China

Because our assets are located overseas, shareholders may not receive distributions that they would otherwise be entitled to if we were declared bankrupt or insolvent.

All of our assets are located in the PRC.  Because our assets are located overseas, our assets may be outside of the jurisdiction of U.S. courts to administer if we are the subject of an insolvency or bankruptcy proceeding.  As a result, if we declared bankruptcy or insolvency, our shareholders may not receive the distributions on liquidation that they would otherwise be entitled to if our assets were to be located within the U.S., under U.S. bankruptcy law.

Adverse changes in economic and political policies of the PRC government could have a material adverse effect on the overall economic growth of China, which could adversely affect our business.

All of our business operations are currently conducted in the PRC, under the jurisdiction of the PRC government.  Accordingly, our results of operations, financial condition and prospects are subject to a significant degree to economic, political and legal developments in China.  China’s economy differs from the economies of most developed countries in many respects, including with respect to the amount of government involvement, level of development, growth rate, and control of foreign exchange and allocation of resources.  While the PRC economy has experienced significant growth in the past 20 years, growth has been uneven across different regions and among various economic sectors of China.  The PRC government has implemented various measures to encourage economic development and guide the allocation of resources.  Some of these measures benefit the overall PRC economy, but may also have a negative effect on us.  For example, our financial condition and results of operations may be adversely affected by government control over capital investments or changes in tax regulations that are applicable to us.  Since early 2004, the PRC government has implemented certain measures to control the pace of economic growth.  Such measures may cause a decrease in the level of economic activity in China, which in turn could adversely affect our results of operations and financial condition.
 
 
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Because we may not be able to obtain business insurance in the PRC, we may not be protected from risks that are customarily covered by insurance in the United States.

Business insurance is not readily available in the PRC. To the extent that we suffer a loss of a type which would normally be covered by insurance in the United States, such as product liability and general liability insurance, we would incur significant expenses in both defending any action and in paying any claims that result from a settlement or judgment.
 
Unprecedented rapid economic growth in China may increase our costs of doing business, and may negatively impact our profit margins and/or profitability.

Our business depends in part upon the availability of relatively low-cost labor and materials.  Rising wages in China may increase our overall costs of production.  In addition, rising raw material costs, due to strong demand and greater scarcity, may increase our overall costs of production.  If we are not able to pass these costs on to our customers in the form of higher prices, our profit margins and/or profitability could decline.

You may face difficulties in protecting your interests, and your ability to protect your rights through the U.S. federal courts may be limited, because our subsidiaries are incorporated in non-U.S. jurisdictions, we conduct substantially all of our operations in China, and except for our CFO all of our officers and directors reside outside the United States.

Although we are incorporated in Nevada, we conduct substantially all of our operations in China.  Other than our CFO, all of our officers and directors reside outside the United States and some or all of the assets of those persons are located outside of the United States.  As a result, it may be difficult or impossible for you to bring an action against us or against these individuals in China in the event that you believe that your rights have been infringed under the securities laws or otherwise.  Even if you are successful in bringing an action of this kind, the laws of the PRC may render you unable to enforce a judgment against our assets or the assets of our directors and officers.

As a result of all of the above, our public shareholders may have more difficulty in protecting their interests through actions against our management, directors or major shareholders than would shareholders of a corporation doing business entirely within the United States.

The relative lack of public company experience of our management team may put us at a competitive disadvantage.

Our management team in China lacks public company experience, which could impair our ability to comply with legal and regulatory requirements such as those imposed by Sarbanes-Oxley Act of 2002.  Other than our CFO, the individuals who now constitute our senior management have never had responsibility for managing a publicly traded company.  Such responsibilities include complying with federal securities laws and making required disclosures on a timely basis.  Our senior management may not be able to implement programs and policies in an effective and timely manner that adequately responds to such increased legal, regulatory compliance and reporting requirements.  Our failure to comply with all applicable requirements could lead to the imposition of fines and penalties and distract our management from attending to the growth of our business.

Governmental control of currency conversion may affect the value of your investment.

The Chinese government imposes controls on the convertibility of RMB into foreign currencies and, in certain cases, the remittance of currency out of China.  We receive substantially all of our revenues in RMB.  Shortages in the availability of foreign currency may restrict the ability of our Chinese subsidiary and our affiliated entity to remit sufficient foreign currency to pay dividends or other payments to us, or otherwise satisfy their foreign currency denominated obligations.  Under existing Chinese foreign exchange regulations, payments of current account items, including profit distributions, interest payments and expenditures from trade-related transactions, can be made in foreign currencies without prior approval from the SAFE by complying with certain procedural requirements.  However, approval from appropriate government authorities is required where RMB is to be converted into foreign currency and remitted out of China to pay capital expenses such as the repayment of bank loans denominated in foreign currencies.  The Chinese government may also at its discretion restrict access in the future to foreign currencies for current account transactions.  If the foreign exchange control system prevents us from obtaining sufficient foreign currency to satisfy our currency demands, we may not be able to pay dividends in foreign currencies to our stockholders.

 
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Fluctuation in the value of RMB may have a material adverse effect on your investment.

The value of RMB against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in political and economic conditions.  Our revenues and costs are mostly denominated in RMB, as well as a significant portion of our financial assets.  Any significant fluctuation in the value of RMB may materially and adversely affect our cash flows, revenues, earnings and financial position, and the value of, and any dividends payable on, our stock in U.S. dollars.  For example, an appreciation of RMB against the U.S. dollar would make any new RMB denominated investments or expenditures more costly to us, to the extent that we need to convert U.S. dollars into RMB for such purposes.  An appreciation of RMB against the U.S. dollar would also result in foreign currency translation gains for financial reporting purposes when we translate our RMB denominated financial assets into U.S. dollar, as U.S. dollar is our reporting currency.
 
We face risks related to health epidemics and other outbreaks.

Our business could be adversely affected by the effects of an epidemic outbreak, such as the SARS epidemic in April 2003.  Any prolonged recurrence of such adverse public health developments in China may have a material adverse effect on our business operations.  For instance, health or other government regulations adopted in response may require temporary closure of our stores or offices.  Such closures would severely disrupt our business operations and adversely affect our results of operations.  We have not adopted any written preventive measures or contingency plans to combat any future outbreak of SARS or any other epidemic.

If relations between the United States and China worsen, investors may be unwilling to hold or buy our stock and our stock price may decrease.

At various times during recent years, the United States and China have had significant disagreements over political and economic issues. Controversies may arise in the future between these two countries.  Any political or trade controversies between the United States and China, whether or not directly related to our business, could reduce the price of our common stock.

We may be exposed to liabilities under the Foreign Corrupt Practices Act and Chinese anti-corruption laws, and any determination that we violated these laws could have a material adverse effect on our business.
 
We are subject to the Foreign Corrupt Practice Act, or FCPA, and other laws that prohibit improper payments or offers of payments to foreign governments and their officials and political parties by U.S.  persons and issuers as defined by the statute, for the purpose of obtaining or retaining business.  We have agreements with third parties and make all our sales in China.  The PRC also strictly prohibits bribery of government officials.  Our activities in China create the risk of unauthorized payments or offers of payments by the employees, consultants, sales agents or distributors of our company and its affiliate, even though they may not always be subject to our control.  It is our policy to implement safeguards to discourage these practices by our employees, and we currently have no policy to comply specifically with the FCPA.  Our existing safeguards and any future improvements may prove to be less than effective, and the employees, consultants, sales agents or distributors of our company and its affiliate may engage in conduct for which we might be held responsible.  Violations of the FCPA or Chinese anti-corruption laws may result in severe criminal or civil sanctions, and we may be subject to other liabilities, which could negatively affect our business, operating results and financial condition.  In addition, the U.S. government may seek to hold our company liable for successor liability FCPA violations committed by companies in which we invest or that we acquire.

Failure to comply with PRC regulations relating to the establishment of offshore special purpose companies by PRC residents may subject our PRC resident shareholders to personal liability, limit our ability to acquire PRC companies or to inject capital into our PRC subsidiary and affiliate, limit their ability to distribute profits to us or otherwise materially adversely affect us.
 
In October 2005, the State Administration of Foreign Exchange (“SAFE”) issued the Notice on Relevant Issues in the Foreign Exchange Control over Financing and Return Investment Through Special Purpose Companies by Residents Inside China (“Circular 75”), which required PRC residents to register with the competent local SAFE branch before establishing or acquiring control over an offshore special purpose company (“SPV”) for the purpose of engaging in an equity financing outside of China on the strength of domestic PRC assets originally held by those residents.  Internal implementing guidelines issued by SAFE, which became public in June 2007 (“Notice 106”), expanded the reach of Circular 75 by (1) purporting to cover the establishment or acquisition of control by PRC residents of offshore entities which merely acquire “control” over domestic companies or assets, even in the absence of legal ownership; (2) adding requirements relating to the source of the PRC resident’s funds used to establish or acquire the offshore entity; covering the use of existing offshore entities for offshore financings; (3) purporting to cover situations in which an offshore SPV establishes a new subsidiary in China or acquires an unrelated company or unrelated assets in China; and (4) making the domestic affiliate of the SPV responsible for the accuracy of certain documents which must be filed in connection with any such registration, notably, the business plan which describes the overseas financing and the use of proceeds.  Amendments to registrations made under Circular 75 are required in connection with any increase or decrease of capital, transfer of shares, mergers and acquisitions, equity investment or creation of any security interest in any assets located in China to guarantee offshore obligations, and Notice 106 makes the offshore SPV jointly responsible for these filings.  In the case of an SPV which was established, and which acquired a related domestic company or assets, before the implementation date of Circular 75, a retroactive SAFE registration was required to have been completed before March 31, 2006; this date was subsequently extended indefinitely by Notice 106, which also required that the registrant establish that all foreign exchange transactions undertaken by the SPV and its affiliates were in compliance with applicable laws and regulations.  Failure to comply with the requirements of Circular 75, as applied by SAFE in accordance with Notice 106, may result in fines and other penalties under PRC laws for evasion of applicable foreign exchange restrictions.  Any such failure could also result in the SPV’s affiliates being impeded or prevented from distributing their profits and the proceeds from any reduction in capital, share transfer or liquidation to the SPV, or from engaging in other transfers of funds into or out of China.

 
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We have advised our shareholders who are PRC residents, as defined in Circular 75, to register with the relevant branch of SAFE, as currently required, in connection with their equity interests in us and our acquisitions of equity interests in our PRC subsidiary.  However, we cannot provide any assurances that their existing registrations have fully complied with, and they have made all necessary amendments to their registration to fully comply with, all applicable registrations or approvals required by Circular 75.  Moreover, because of uncertainty over how Circular 75 will be interpreted and implemented, and how or whether SAFE will apply it to us, we cannot predict how it will affect our business operations or future strategies.  For example, our present and prospective PRC subsidiaries’ ability to conduct foreign exchange activities, such as the remittance of dividends and foreign currency-denominated borrowings, may be subject to compliance with Circular 75 by our PRC resident beneficial holders.  In addition, such PRC residents may not always be able to complete the necessary registration procedures required by Circular 75.  We also have little control over either our present or prospective direct or indirect shareholders or the outcome of such registration procedures.  A failure by our PRC resident beneficial holders or future PRC resident shareholders to comply with Circular 75, if SAFE requires it, could subject these PRC resident beneficial holders to fines or legal sanctions, restrict our overseas or cross-border investment activities, limit our subsidiaries’ ability to make distributions or pay dividends or affect our ownership structure, which could adversely affect our business and prospects.

Although Mr. Qingqing Wu, our principal shareholder, resides in the PRC, he is a foreign national.  As such, he has not registered with the local branch of the SAFE under Circular No. 75.  However, we cannot provide any assurance that SAFE may nevertheless require Mr. Wu to comply with such registration requirement.  Should SAFE make such determination, failure to comply could subject us to fines or sanctions imposed by the PRC government, which may adversely affect our business.

Under the New EIT Law, we may be classified as a “resident enterprise” of China.  Such classification will likely result in unfavorable tax consequences to us and our non-PRC shareholders.

On March 16, 2007, the National People’s Congress of China passed a new Enterprise Income Tax Law, or the New EIT Law, and on December 6, 2007, the State Council of China passed the Implementing Rules for the New EIT Law, or the Implementing Rules, which took effect on January 1, 2008.  Under the New EIT Law, an enterprise established outside of China with “de facto management bodies” within China is considered a “resident enterprise,” meaning that it can be treated in a manner similar to a Chinese enterprise for enterprise income tax purposes.  The Implementing Rules define de facto management as “substantial and overall management and control over the production and operations, personnel, accounting, and properties” of the enterprise.

On April 22, 2009, the State Administration of Taxation issued the Notice Concerning Relevant Issues Regarding Cognizance of Chinese Investment Controlled Enterprises Incorporated Offshore as Resident Enterprises pursuant to Criteria of de facto Management Bodies (the “Notice”) further interpreting the application of the New EIT Law and its implementation with respect to non-Chinese enterprise or group controlled offshore entities.  Pursuant to the Notice, an enterprise incorporated in an offshore jurisdiction and controlled by a Chinese enterprise or group will be classified as a “non-domestically incorporated resident enterprise” if (i) its senior management in charge of daily operation reside or perform their duties mainly in China; (ii) its financial or personnel decisions are made or approved by bodies or persons in China; (iii) its substantial properties, accounting books, corporate chops, board and shareholder minutes are kept in China; and (iv) half of the directors with voting rights or senior management often resident in China.  Such resident enterprise would be subject to an enterprise income tax rate of 25% on its worldwide income and must pay a withholding tax at a rate of 10% when paying dividends to its non-PRC shareholders.  However, it remains unclear as to whether the Notice is applicable to an offshore enterprise incorporated by a Chinese natural person.  Nor are detailed measures on imposition of tax from non-domestically incorporated resident enterprises available.  Therefore, it is unclear how tax authorities will determine tax residency based on the facts of each case.
 
Yet, as our case substantially meets the foregoing criteria, there is a likelihood that we are deemed to be a resident enterprise by Chinese tax authorities.  If the PRC tax authorities determine that we are a “resident enterprise” for PRC enterprise income tax purposes, a number of unfavorable PRC tax consequences could follow.  First, we may be subject to the enterprise income tax at a rate of 25% on our worldwide taxable income as well as PRC enterprise income tax reporting obligations.  In our case, this would mean that income such as interest on financing proceeds and non-China source income would be subject to PRC enterprise income tax at a rate of 25%.  Second, although, under the New EIT Law and its implementing rules, dividends paid to us from our PRC subsidiaries would qualify as “tax-exempt income,” we cannot guarantee that such dividends will not be subject to a 10% withholding tax, as the PRC foreign exchange control authorities, which enforce the withholding tax, have not yet issued guidance with respect to the processing of outbound remittances to entities that are treated as resident enterprises for PRC enterprise income tax purposes.  Finally, it is possible that future guidance issued with respect to the new “resident enterprise” classification could result in a situation in which a 10% withholding tax is imposed on dividends we pay to our non-PRC shareholders and with respect to gains derived by our non-PRC shareholders from transferring our shares.  We are actively monitoring the possibility of “resident enterprise” treatment and are evaluating appropriate organizational changes to avoid this treatment, to the extent possible.
 
 
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If we were treated as a “resident enterprise” by PRC tax authorities, we would be subject to taxation in both the U.S. and China, and our PRC tax may not be creditable against our U.S. tax.

If we make equity compensation grants to persons who are PRC citizens, they may be required to register with the SAFE. We may also face regulatory uncertainties that could restrict our ability to adopt an equity compensation plan for our directors and employees and other parties under PRC law.
 
On April 6, 2007, SAFE issued the “Operating Procedures for Administration of Domestic Individuals Participating in the Employee Stock Ownership Plan or Stock Option Plan of An Overseas Listed Company (“Circular 78”).  It is not clear whether Circular 78 covers all forms of equity compensation plans or only those which provide for the granting of stock options.  For any plans that are so covered and are adopted by a non-PRC listed company after April 6, 2007, Circular 78 requires all participants who are PRC citizens to register with and obtain approvals from SAFE prior to their participation in the plan.  In addition, Circular 78 also requires PRC citizens to register with SAFE and make the necessary applications and filings if they participated in an overseas listed company’s covered equity compensation plan prior to April 6, 2007. We intend to adopt an equity compensation plan in the future and make option grants to our officers and directors, most of whom are PRC citizens. Circular 78 may require our officers and directors who receive option grants and are PRC citizens to register with SAFE.  We believe that the registration and approval requirements contemplated in Circular 78 will be burdensome and time consuming.  If it is determined that any of our equity compensation plans are subject to Circular 78, failure to comply with such provisions may subject us and participants of any equity incentive plan who are PRC citizens to fines and legal sanctions and prevent us from being able to grant equity compensation to our PRC employees.  In that case, our ability to compensate our employees and directors through equity compensation would be hindered and our business operations may be adversely affected.
 
The audit report included in this filing are prepared by auditors who are not inspected by the Public Company Accounting Oversight Board and, as such, you may not have the benefits of such inspection.
 
Our independent registered public accounting firm that issues the audit report on our 2012 consolidated financial statements included in our Annual Report filed with the U.S. Securities and Exchange Commission, as auditors of companies that are traded publicly in the United States and a firm registered with the U.S. Public Company Accounting Oversight Board (United States) (“the “PCAOB”), is required by the laws of the United States to undergo regular inspections by the PCAOB to assess its compliance with the laws of the United States and professional standards. Because we have substantial operations within the Peoples' Republic of China and the PCAOB is currently unable to conduct inspections of the work of our auditors as it relates to those operations without the approval of the Chinese authorities, our auditor is not currently inspected fully by the PCAOB. Inspections of other firms that the PCAOB has conducted outside China have identified deficiencies in those firms’ audit procedures and quality control procedures, which may be addressed as part of the inspection process to improve future audit quality. This lack of PCAOB inspections in China prevents the PCAOB from regularly evaluating our auditor's audits and its quality control procedures. As a result, investors may be deprived of the benefits of PCAOB inspections. The inability of the PCAOB to conduct full inspections of auditors in China makes it more difficult to evaluate the effectiveness of our auditor’s audit procedures or quality control procedures as compared to auditors outside of China that are subject to PCAOB inspections. Investors may lose confidence in our reported financial information and procedures and the quality of our financial statements.

Risks Related to an Investment in Our Securities

Our common stock has limited liquidity.

Our common stock is traded on the Over-the-Counter Bulletin Board.  It is thinly traded compared to larger more widely known companies in the same industry.  Thinly traded common stock can be more volatile than stock trading in an active public market.  We cannot predict the extent to which an active public market for our common stock will develop or be sustained. 

Our stock is categorized as a penny stock.  Trading of our stock may be restricted by the SEC’s penny stock regulations which may limit a shareholder’s ability to buy and sell our stock.

Our stock is categorized as a penny stock.  The SEC has adopted Rule 15g-9 which generally defines “penny stock” to be any equity security that has a market price (as defined) less than $5.00 per share or an exercise price of less than $5.00 per share, subject to certain exceptions.  Our securities are covered by the penny stock rules, which impose additional sales practice requirements on broker-dealers who sell to persons other than established customers and accredited investors.  The penny stock rules require a broker-dealer, prior to a transaction in a penny stock not otherwise exempt from the rules, to deliver a standardized risk disclosure document in a form prepared by the SEC which provides information about penny stocks and the nature and level of risks in the penny stock market.  The broker-dealer also must provide the customer with current bid and offer quotations for the penny stock, the compensation of the broker-dealer and its salesperson in the transaction and monthly account statements showing the market value of each penny stock held in the customer’s account.  The bid and offer quotations, and the broker-dealer and salesperson compensation information, must be given to the customer orally or in writing prior to effecting the transaction and must be given to the customer in writing before or with the customer’s confirmation.  In addition, the penny stock rules require that prior to a transaction in a penny stock not otherwise exempt from these rules; the broker-dealer must make a special written determination that the penny stock is a suitable investment for the purchaser and receive the purchaser’s written agreement to the transaction.  These disclosure requirements may have the effect of reducing the level of trading activity in the secondary market for the stock that is subject to these penny stock rules.  Consequently, these penny stock rules may affect the ability of broker-dealers to trade our securities.  We believe that the penny stock rules discourage investor interest in and limit the marketability of our common stock.
 
 
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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 the PRC and who have limited trading volumes and are susceptible to higher volatility levels than U.S. domestic large-cap stocks, can be particularly vulnerable to such short attacks.

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

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

In addition to the “penny stock” rules described above, the Financial Industry Regulatory Authority (“FINRA”) has adopted rules that require that in recommending an investment to a customer, a broker-dealer must have reasonable grounds for believing that the investment is suitable for that customer.  Prior to recommending speculative low priced securities to their non-institutional customers, broker-dealers must make reasonable efforts to obtain information about the customer’s financial status, tax status, investment objectives and other information. Under interpretations of these rules, FINRA believes that there is a high probability that speculative low priced securities will not be suitable for at least some customers.  The FINRA requirements make it more difficult for broker-dealers to recommend that their customers buy our common stock, which may limit your ability to buy and sell our stock and have an adverse effect on the market for our shares.
 
We expect to experience volatility in our stock price, which could negatively affect shareholders’ investments.

The market price for shares of our common stock may be volatile and may fluctuate based upon a number of factors, including, without limitation, business performance, news announcements or changes in general market conditions.  Other factors, in addition to the those risks included in this section, that may have a significant impact on the market price of our common stock include, but are not limited to:

receipt of substantial orders or order cancellations of products;
quality deficiencies in services or products;
 
 
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international developments, such as technology mandates, political developments or changes in economic policies;
changes in recommendations of securities analysts;
shortfalls in our backlog, revenues or earnings in any given period relative to the levels expected by securities analysts or projected by us;
government regulations, including stock option accounting and tax regulations;
energy blackouts;
acts of terrorism and war;
widespread illness;
proprietary rights or product or patent litigation;
strategic transactions, such as acquisitions and divestitures;
rumors or allegations regarding our financial disclosures or practices; or
earthquakes or other natural disasters concentrated in Fujian, China where a significant portion of our operations are based.

In the past, securities class action litigation has often been brought against a company following periods of volatility in the market price of its securities.  Due to changes in the market price of our common stock, we may be the target of securities litigation in the future.  Securities litigation could result in substantial costs and divert management’s attention and resources.
 
We do not anticipate that cash dividends will be paid in the foreseeable future.

We do not anticipate paying cash dividends on our common stock in the foreseeable future and we may not have sufficient funds legally available to pay dividends.  Even if the funds are legally available for distribution, we may nevertheless decide not to pay any dividends.  We presently intend to retain all earnings for our operations.

Our common shares are not currently traded at high volume, and you may be unable to sell at or near ask prices or at all if you need to sell or liquidate a substantial number of shares at one time.

We cannot predict the extent to which an active public market for our common stock will develop or be sustained.  Our common shares are currently traded, but currently with low volume, based on quotations on the “Over-the-Counter Bulletin Board”, meaning that the number of persons interested in purchasing our common shares at or near bid prices at any given time may be relatively small or non-existent.  This situation is attributable to a number of factors, including the fact that we are a small company which is still relatively unknown to stock analysts, stock brokers, institutional investors and others in the investment community that generate or influence sales volume, and that even if we came to the attention of such persons, they tend to be risk-averse and would be reluctant to follow an unproven company such as ours or purchase or recommend the purchase of our shares until such time as we became more seasoned and viable.  As a consequence, there may be periods of several days or more when trading activity in our shares is minimal or non-existent, as compared to a seasoned issuer which has a large and steady volume of trading activity that will generally support continuous sales without an adverse effect on share price.  We cannot give you any assurance that a broader or more active public trading market for our common stock will develop or be sustained, or that trading levels will be sustained.
 
Shareholders should be aware that, according to SEC Release No. 34-29093, the market for “penny stocks” has suffered in recent years from patterns of fraud and abuse.  Such patterns include (1) control of the market for the security by one or a few broker-dealers that are often related to the promoter or issuer; (2) manipulation of prices through prearranged matching of purchases and sales and false and misleading press releases; (3) boiler room practices involving high-pressure sales tactics and unrealistic price projections by inexperienced sales persons; (4) excessive and undisclosed bid-ask differential and markups by selling broker-dealers; and (5) the wholesale dumping of the same securities by promoters and broker-dealers after prices have been manipulated to a desired level, along with the resulting inevitable collapse of those prices and with consequent investor losses.  Our management is aware of the abuses that have occurred historically in the penny stock market.  Although we do not expect to be in a position to dictate the behavior of the market or of broker-dealers who participate in the market, management will strive within the confines of practical limitations to prevent the described patterns from being established with respect to our securities. The occurrence of these patterns or practices could increase the future volatility of our share price.
 
Our corporate actions are substantially controlled by our principal shareholders and their affiliated entities.
 
As of April 10, 2013, our principal shareholders, including our officers and directors and their affiliated entities, collectively owned approximately 50.0% of our outstanding shares of common stock.  These shareholders, acting individually or as a group, could exert substantial influence over matters such as electing directors and approving mergers or other business combination transactions.  In addition, because of the percentage of ownership and voting concentration in these principal shareholders and their affiliated entities, elections of our board of directors will generally be within the control of these shareholders and their affiliated entities.  While all of our shareholders are entitled to vote on matters submitted to our shareholders for approval, the concentration of shares and voting control presently lies with these principal shareholders and their affiliated entities.  As such, it would be difficult for shareholders to propose and have approved proposals not supported by management.  There can be no assurances that matters voted upon by our officers and directors in their capacity as shareholders will be viewed favorably by all of our shareholders.
 
 
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The elimination of monetary liability against our directors, officers and employees under Nevada law and the existence of indemnification rights to our directors, officers and employees may result in substantial expenditures by our company and may discourage lawsuits against our directors, officers and employees.

Our Articles of Incorporation, as amended, contain a provision permitting us to eliminate the liability of our directors for monetary damages to our company and shareholders to the extent provided by Nevada law.  We may also have contractual indemnification obligations under our employment agreements with our officers.  The foregoing indemnification obligations could result in our company incurring substantial expenditures to cover the cost of settlement or damage awards against directors and officers, which we may be unable to recoup.  These provisions and resultant costs may also discourage our company from bringing a lawsuit against directors and officers for breaches of their fiduciary duties, and may similarly discourage the filing of derivative litigation by our shareholders against our directors and officers even though such actions, if successful, might otherwise benefit our company and shareholders.
 
Our risk management and internal control systems may not be effective and have deficiencies or material weaknesses.

We are a public company in the United States subject to the Sarbanes-Oxley Act of 2002, as amended (the “Sarbanes-Oxley Act”). The SEC, as required under Section 404 of the Sarbanes-Oxley Act (“Section 404”), has adopted rules requiring public companies to include in their annual reports a management report on the effectiveness of these companies’ internal control over financial reporting.

Our management has concluded that under the rules of Section 404, our internal control over financial reporting was not effective as of December 31, 2012. A material weakness is a deficiency, or a combination of deficiencies, in internal control such that there is a reasonable possibility that a material misstatement of our company’s financial statements will not be prevented, or detected and corrected on a timely basis. A significant deficiency is a deficiency, or combination of deficiencies, in internal control that is less severe than a material weakness, yet important enough to merit attention by those charged with governance. The material weakness we identified is our lack of sufficient qualified accounting personnel with appropriate understanding of U.S. GAAP and SEC reporting requirements commensurate with our financial reporting requirements, which resulted in a number of internal control deficiencies that were identified as being significant.  Also, as a small company, we do not have sufficient internal control personnel to set up adequate review functions at each reporting level.

We are in the process of implementing measures to resolve the material weakness and improve our internal and disclosure controls. However, we may not be able to successfully implement the remedial measures. The implementation of our remedial initiatives may not fully address the material weakness and significant deficiencies in our internal control over financial reporting. In addition, the process of designing and implementing an effective financial reporting system is a continuous effort that requires us to anticipate and react to changes in our business and economic and regulatory environments and to expend significant resources to maintain a financial reporting system that is adequate in satisfying our reporting obligations. We also expect to incur additional compensation expenses in connection with hiring additional accounting and internal control personnel.

As a result, our business and financial condition, results of operations and prospects, as well as the trading price of our ordinary shares may be materially and adversely affected. Ineffective internal control over financial reporting could also expose us to increased risk of fraud or misuse of corporate assets, In turn, that could subject us to potential delisting from the stock exchange on which our ordinary shares are listed, regulatory investigations or civil or criminal sanctions.
 
We will continue to incur increased costs as a result of being a public company.

As a public company, we incur significant legal, accounting and other expenses that we did not incur as a private company prior to the Share Exchange.  We will incur costs associated with our public company reporting requirements.  We will incur costs associated with corporate governance requirements, as well as rules implemented upon our auditors by the Public Company Accounting Oversight Board for reverse-merger Chinese companies, the SEC and the FINRA.  We expect these rules and regulations to significantly increase directly and/or indirectly our legal and financial compliance costs and to make some activities more time-consuming and costly.  If we are able to upgrade to a senior exchange such as the NASDAQ Capital Market, we will incur listing fees as well as other costs to comply with the exchange requirements

We also expect these new rules and regulations as well as the current litigation that has been filed against other reverse merger U.S. listed Chinese-based companies 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 or as executive officers.  We are currently evaluating and monitoring developments with respect to these new rules, and we cannot predict or estimate the amount of additional costs we may incur or the timing of such costs.

ITEM 1B.
UNRESOLVED STAFF COMMENTS

Not applicable.

ITEM 2.
PROPERTIES

We are headquartered in, and operate from, Fujian, China.  Our current operating facilities are as follows:
 
 
Description
 
Location
 
Principal activities
 
Size
(square meters)
 
Lease expiration date
Principal executive office (1)
 
5F., No. 151 Taidong Road, Xiamen Guanyin Shan International Business Center, Siming District, Xiamen City, Fujian 361008
 
Design, marketing, 
sales and purchasing
 
1,447
 
 December 31, 2016
                 
Warehouse (2)
 
Shuangli Industrial Park, Xian hov, Huli District, Xiamen City, Fujian
 
Warehousing
 
1,570
 
February 29, 2016
                 
Company stores (3)
 
Various locations
 
Retail stores
 
Range from 46 to 296
 
Various

(1)  
We are leasing our principal executive office under a property lease agreement.  Rent was $119,000 and $74,000 for 2012 and 2011, respectively. We believe that our principal executive office is well maintained, in good operating condition and sufficient for our current business operations.
 
 
30

 
 
(2)  
We are leasing the Xiamen warehouse under a property lease agreement.  Rent was $42,000 and $41,000 for 2012 and 2011, respectively.  We believe that our warehouse is well maintained, in good operating condition and sufficient for our needs.
(3)  
As of the date of this report, we have entered into 17 operating leases in connection with the company stores.  See Note 18 of the footnotes to our audited financial statements included elsewhere in this report.
 
ITEM 3.
LEGAL PROCEEDINGS

We are not currently involved in any material legal proceedings, and we are not aware of any material legal proceedings pending or threatened against us.  We are also not aware of any material legal proceedings involving any of our directors, officers, or affiliates or any owner of record or beneficially of more than 5% of any class of our voting securities.

ITEM 4.
MINE SAFETY DISCLOSURES

Not applicable.

PART II

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

Market Information

On April 2, 2008, our shares of common stock commenced trading on the Over-The-Counter Bulletin Board (the “OTCBB”) under the symbol “SNOH.”  On January 16, 2009, in connection with a 1-for-100 reverse split of our issued and outstanding common shares, our symbol changed to “SICI.”  On March 20, 2009, in connection with our name change that went effective March 20, 2009, our symbol changed to “VLOV.”  On December 9, 2011, we effected a 1-for 2.5 reverse stock split of our issued and outstanding common shares and a proportional reduction of our authorized common shares.  On September 24, 2012, we effected a 1-for 3 reverse stock split of our issued and outstanding common shares and a proportional reduction of our authorized common shares.
 
The following table sets forth the high and low bid information for our common stock for each quarter within our last two fiscal years and interim periods, as reported by the OTCQB.  The bid prices reflect inter-dealer quotations, do not include retail markups, markdowns, or commissions, and do not necessarily reflect actual transactions. 
 
     
Low
     
High
 
2013
               
Quarter ended June 30, 2013*
 
$
3.75
   
$
4.76
 
Quarter ended March 31, 2013
 
$
2.90
   
$
4.50
 
                 
2012
               
Quarter ended December 31, 2012
 
$
2.13
   
$
5.50
 
Quarter ended September 30, 2012
   
5.10
     
9.06
 
Quarter ended June 30, 2012
   
8.46
     
12.03
 
Quarter ended March 31, 2012
   
9.03
     
14.25
 
                 
2011
               
Quarter ended December 31, 2011
 
$
6.39
   
$
16.50
 
Quarter ended September 30, 2011
   
9.15
     
14.19
 
Quarter ended June 30, 2011
   
10.14
     
18.75
 
Quarter ended March 31, 2011
   
10.50
     
15.75
 
 
* Through April 10, 2013.
 
31

 
 
The last reported closing sales price for shares of our common stock was $3.90 per share on the OTCQB on April 8, 2013.
 
Holders

As of April 10, 2013, we had 53 stockholders of record of our common stock based upon the stockholder list provided by our transfer agent.
 
Transfer Agent
  
Our transfer agent is Transfer Online, Inc., whose address is 317 SW Alder Street, Portland, Oregon 97204, and whose telephone number is (503) 227-2950.
 
Dividends
 
We have never paid cash dividends on our common stock.  We intend to keep future earnings, if any, to finance the expansion of our business, and we do not anticipate that any cash dividends will be paid in the foreseeable future.  Our future payment of dividends will depend on our earnings, capital requirements, expansion plans, financial condition and other relevant factors that our board of directors may deem relevant.

Recent Sales of Unregistered Securities

ITEM 6.
SELECTED FINANCIAL DATA

Not applicable.

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

The following discussion and analysis of our results of operations and financial condition for the fiscal years ended December 31, 2012 and 2011 should be read in conjunction with our financial statements and the notes to those financial statements that are included elsewhere in this annual report.  Our discussion includes forward-looking statements based upon current expectations that involve risks and uncertainties, such as our plans, objectives, expectations and intentions. Actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including those set forth under the “Risk Factors,” “Cautionary Notice Regarding Forward-Looking Statements” and “Description of Business” sections and elsewhere in this report.  We use words such as “anticipate,” “estimate,” “plan,” “project,” “continuing,” “ongoing,” “expect,” “believe,” “intend,” “may,” “will,” “should,” “could,” “predict,” and similar expressions to identify forward-looking statements.    Although we believe the expectations expressed in these forward-looking statements are based on reasonable assumptions within the bounds of our knowledge of our business, our actual results could differ materially from those discussed in these statements.  Factors that could contribute to such differences include, but are not limited to, those discussed in the “Risk Factors” section of this report.  We undertake no obligation to update publicly any forward-looking statements for any reason even if new information becomes available or other events occur in the future.

Overview

We design, market and distribute apparel and related products targeted at 20-45 years old men under the “VLOV” brand.  We currently carry two product lines: (1) Esquire and (2) Richard Wu.
 
We primarily sell our products to our independent distributors, each of whom is granted rights to market and sell our products in a defined market or territory.  Our distributors sell our products at points of sale, or POS, that they establish within their territories and operate either directly or through third-party retail operators, including counters, concessions, store-in-stores and stand-alone stores.  To better showcase our brand, however, we acquired the retail network of our Fujian distributor in June 2011 to operate the stores on our own.  As of December 31, 2012, our products were sold at 421 POS throughout China, including 404 that our distributors operate and 17 that we operate directly (“company stores”).
 
During 2010, all of our business operations were carried out by Yinglin Jinduren, which we control through contractual arrangements between Yinglin Jinduren and our wholly-owned subsidiary HK Dong Rong.  We completed the transfer of all sales contracts and design, marketing, sales and purchasing-related assets from Yinglin Jinduren to our wholly-owned subsidiary China Dong Rong in the first quarter of 2011, and all of our business activities are currently conducted by China Dong Rong.
 
32

 
 
As Yinglin Jinduren has had no operations since early 2011, we may dissolve, and exit from the contractual arrangements with, it sometime in the future.  Until then, we will continue to operate our business through China Dong Rong (as we currently do) while continuing to control Yinglin Jinduren through the contractual arrangements.
 
Critical Accounting Policies

Our management’s discussion and analysis of our financial condition and results of operations are based on our audited consolidated financial statements included with this report that have been prepared in accordance with accounting principles generally accepted in the United States.  The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported net sales and expenses during the reporting periods.  On an ongoing basis, we evaluate our estimates and assumptions.  We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions.

Our significant accounting policies are described in Note 1 to our audited consolidated financial statements.  Our critical accounting policies are those where we have made the most difficult, subjective or complex judgments in making estimates, and/or where these estimates can significantly impact our financial results under different assumptions and conditions.  Our critical accounting policies are:

Basis of presentation and consolidation

As discussed above and in Note 1 to our consolidated financial statements accompanying this report, we transferred our operations from Yinglin Jinduren to China Dong Rong during the first quarter of 2011.  Previously, our operations were conducted by Yinglin Jinduren, in which the equity interests are held by our CEO and his brother.  Through contractual arrangements, we control the daily operations of Yinglin Jinduren, as well as all matters requiring shareholder approval.  We received a fee equal to Yinglin Jinduren’s net income and, in the event it were to incur losses, would be expected to absorb those losses through our inability to collect the accumulated net income due to us.  As a result, we are considered to be the primary beneficiary of Yinglin Jinduren’s operations and accordingly consolidated its assets, liabilities and results of operations in our consolidated financial statements.  All of our operations are now conducted by China Dong Rong.

Revenue Recognition

Sales of goods - distributors

Products for our distributors are manufactured based on their orders.  We are responsible for product design, product specification, pricing to the customer, the choice of OEM manufacturers, product quality and credit risk associated with the customer receivable.  As such, we act as a principal, not as an agent, and record revenues on a gross basis.
 
We recognize revenue when (a) the price to the customer is fixed or determinable, (b) persuasive evidence of an arrangement exists, (c) delivery has occurred and (d) collectability of the resulting receivable is reasonably assured.  Revenue from the sales of goods is recognized on the transfer of significant risks and rewards of ownership, which generally coincides with the time when the goods are delivered and title has passed to the customer.  Revenue excludes value-added tax and is stated after deduction of trade discounts and allowances.
 
We only accept returns within three days of purchase and for quality reasons.  We have not yet had the experience to estimate and provide for such returns at the time of sale, and returns have been minimal to date.
 
 In addition, we do not have any obsolete stock arrangements with our distributors. Therefore, we do not have any arrangements with distributors to accept returns of out-of season stock.

Sales of goods - retail
 
In July 2011, we began operating company stores.  Revenue from retail sales is recognized at each point of sale.  During the years ended December 31, 2012 and 2011, such sales accounted for 4.9% and 3.8% of our total revenue, respectively.  
 
 
33

 
 
Our retail revenue is net of value-added tax (“VAT”) collected on behalf of PRC tax authorities in respect of the sale of merchandise.  VAT collected from customers, net of VAT paid for purchases, is recorded as a liability in the accompanying consolidated balance sheets until it is paid to the relevant PRC tax authorities.

Retail sales returns within seven days of purchase are accepted only for quality reasons.  We have not yet had the experience to estimate and provide for such returns at the time of sale, and returns have been minimal to date.

Accounts receivable

Accounts receivable, which are unsecured, are stated at the amount we expect to collect.  We continuously monitor collections and payments from our customers (our distributors) and maintain a provision for estimated credit losses based upon historical experience and any specific customer collection issues that have been identified.  Historically, our credit losses have not been significant and within our expectations.  However, we cannot guarantee that we will continue to experience the same credit loss rates that have been experienced in the past.

Our accounts receivable aging was as follows for the periods below (amounts in thousands):
 
   
December 31,
 
From date of invoice to customer:
 
2012
   
2011
 
0-30 days
 
$
10,974
   
$
15,314
 
31-60 days
   
9,304
     
10,531
 
61-90 days
   
11,617
     
8,421
 
91-120 days
   
4,104
     
1,313
 
121 days and above
   
7,993
     
-
 
Allowance for doubtful accounts
   
-
     
-
 
Total accounts receivable
 
$
43,992
   
$
35,579
 
 
On average, we collect our receivables within 150 days.  Our ability to collect is attributed to the steps that we take prior to extending credit to our distributors as discussed above.  If we are having difficulty collecting from a distributor, we take the following steps: cease existing shipments to the distributor, visit the distributor to request payment on past due invoice, and if necessary, take legal recourse.  If all of these steps are unsuccessful, management would then determine whether or not the receivable should be reserved or written off.  Of $43,992 in receivables as of December 31, 2012, $23,676 was collected as of March 25, 2013. As of April 10, 2013, there were no accounts receivable aged over 120 days at December 31, 2012 that had not been collected. As of December 31, 2012 and 2011, there was no allowance for uncollectible accounts receivable.
 
Goodwill

As a result of acquiring the retail stores of our Fujian distributor in June 2011, we began operating company stores selling our products.  As our purchase price exceeded the net of the amounts assigned to assets acquired and liabilities assumed, the excess value was recognized as goodwill.

In September 2011, the Financial Accounting Standards Board issued an authoritative pronouncement related to testing goodwill for impairment. The guidance permits us to first assess qualitative factors to determine whether it is “more likely than not” that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test.  We adopted this pronouncement as of the first quarter of 2012.  If it is more likely than not that the fair value of a reporting unit is less than its carrying amount, goodwill is then tested following a two-step process.  The first step compares the fair value of each reporting unit to its carrying amount, including goodwill.  If the fair value of each reporting unit exceeds its carrying amount, goodwill is not considered to be impaired and the second step will not be required.  If the carrying amount of a reporting unit exceeds its fair value, the second step compares the implied fair value of goodwill to the carrying value of a reporting unit’s goodwill.  The implied fair value of goodwill is determined in a manner similar to accounting for a business combination with the allocation of the assessed fair value determined in the first step to the assets and liabilities of the reporting unit.  The excess of the fair value of the reporting unit over the amounts assigned to the assets and liabilities is the implied fair value of goodwill.  An impairment loss is recognized for any excess in the carrying value of goodwill over the implied fair value of goodwill.
 
We have performed an assessment and determined that there was no indication of impairment to goodwill during the years ended December 31, 2012 and 2011.

 
34

 
 
Income Taxes

We are subject to income taxes, primarily in the PRC.  We believe we have adequately provided for all taxes due but amounts asserted by tax authorities could be greater or less than the amounts we have accrued.  We are not aware of any PRC corporate income tax matters through December 31, 2012, and do not anticipate adjustments as a result of any tax audits within the next twelve months.

Derivative instruments

In connection with the sale of debt or equity instruments, we may sell warrants to purchase our common stock.  In certain circumstances, these warrants may be classified as derivative liabilities, rather than as equity.  Additionally, the debt or equity instruments may contain embedded derivative instruments, such as conversion options, which in certain circumstances may be required to be bifurcated from the associated host instrument and accounted for separately as a derivative instrument liability.

The identification of, and accounting for, derivative instruments is not only complex, but can, along with the assumptions used to value them, significantly affect our financial statements.  Our derivative instrument liabilities are re-valued at the end of each reporting period, with changes in the fair value of the derivative liability recorded as charges or credits to income in the period in which the changes occur.  

At December 31, 2012, the warrants that we issued in connection with private placement of our series A convertible preferred stock and common stock in 2009 had expired and were therefore no longer carried as a derivative liability.  Prior to their expiration, we had determined the fair value of these instruments using a binomial option pricing model.  The model requires the use of a number of assumptions, including our expected dividend yield and the expected volatility of our common stock price over the life of the instruments.  Because of the limited trading history for our common stock, we had estimated the future volatility of our common stock price based on the historical experience of other entities deemed comparable to us.  

Foreign Currency Translation

Our functional currency is the Chinese currency, Renminbi (“RMB”), which we translate into U.S. Dollars (“$”) in our financial statements.  Accordingly, all assets and liabilities are translated at the exchange rates prevailing at the balance sheet dates, all income and expenditure items are translated at the average rates for each of the periods and equity accounts, except for retained earnings, are translated at the rate at the transaction date.  Retained earnings reflect the cumulative net income (loss) translated at the average rates for the respective periods since inception, less dividends translated at the rate at the transaction date.
 
RMB is not a fully convertible currency.  All foreign exchange transactions involving RMB must take place either through the People's Bank of China (the “PBOC”) or other institutions authorized to buy and sell foreign exchange.  The exchange rates adopted for the foreign exchange transactions are the rates of exchange quoted by www.oanda.com, which are determined largely by supply and demand.  The rates of exchange quoted by www.oanda.com on December 31, 2012 and December 31, 2011 were $1.00 to RMB 6.31 and RMB 6.36, respectively.  The average translation rates of $1.00 to RMB 6.31 and RMB 6.46 were applied to the income statement accounts for the years ended December 31, 2012 and 2011, respectively.

Translation adjustments are recorded as other comprehensive income in the consolidated statement of stockholders equity and comprehensive income and as a separate component of stockholders equity.

Commencing from July 21, 2005, China adopted a managed floating exchange rate regime based on market demand and supply with reference to a basket of currencies.  Since then, the PBOC administers and regulates the exchange rate of $ against RMB taking into account the demand and supply of RMB, as well as domestic and foreign economic and financial conditions.

Results of Operations
 
  
  
Year ended December 31,
  
  
  
2012
   
2011
  
  
  
(Amounts in thousands, in U.S. Dollars, except for percentages)
  
Net Sales
 
$
94,547
     
100.0
%
 
$
88,826
     
100.0
%
Gross Profit
 
$
42,057
     
44.5
%
 
$
38,762
     
43.6
%
Operating Expenses
 
$
17,914
     
18.9
%
 
$
21,085
     
23.7
%
Income From Operations
 
$
24,143
     
25.5
%
 
$
17,677
     
19.9
%
Other (Expenses) / Income
 
$
762
     
0.8
%
 
$
706
     
0.8
%
Income Tax Expense
 
$
7,027
     
7.4
%
 
$
4,455
     
5.0
%
Net Income
 
$
17,878
     
18.9
%
 
$
13,928
     
15.7
%

Net Sales (amounts in thousands, in U.S. Dollars, except for percentages)

Net sales were $94,547 for 2012 as compared with $88,826 for 2011, an increase of $5,721 or 6.4%.  Net sales for 2012 and 2011 were primarily generated from the sales of our apparels to our distributors, who retailed them at their POS throughout northern, central and southern China.  The higher net sales during 2012 were primarily attributable to increased sales to our distributors in Beijing, Shandong, Hubei and Shanghai, that was offset by lower sales to our distributors in Liaoning, Jiangxi and Yunnan.
 
35

 
 
Our apparels are targeted toward middle to upper class Chinese men from the ages of 20 to 45, who we believe tend to be brand conscious.  We have been allocating additional resources to Shanghai, Beijing, Zhejiang, Shandong and Hubei, where the standard of living is generally higher and consumers are generally more brand conscious and receptive to our upscale products.  Such efforts yielded increased sales in these regions during 2012.  On the other hand, sales in less-affluent regions declined during the same periods as customers there were less receptive.
 
We strive to continue creating more upscale products and educating and working closely with our distributors to best showcase our products, such as through higher-end stand-alone stores and store-in-stores which we believe strengthen the image and exclusivity of our brand among our target demographic.  While our upscale strategy has impacted our revenue growth during 2012, we believe that this will drive our margins and profitability in the long-term.
 
The following table sets forth the geographical breakdown of our total sales revenue for the periods indicated:
 
   
Years ended December 31,
       
   
2012
   
2011
       
   
(Amounts in thousands, in U.S. Dollars, except for percentages)
       
  
 
$
   
% of total
sales revenue
   
$
   
% of total
sales revenue
   
Growth (decline)
in 2012
compared
with 2011
 
Zhejiang
 
$
17,886
     
18.9
%
 
$
16,330
     
18.4
%
   
9.5
%
Beijing
 
$
15,216
     
16.1
%
 
$
8,072
     
9.1
%
   
88.5
%
Hubei
 
$
13,457
     
14.2
%
 
$
10,054
     
11.3
%
   
33.9
%
Shandong
 
$
12,694
     
13.4
%
 
$
9,757
     
11.0
%
   
30.1
%
Liaoning
 
$
5,936
     
6.3
%
 
$
9,941
     
11.2
%
   
(40.3
)%
Yunnan
 
$
4,713
     
5.0
%
 
$
6,242
     
7.0
%
   
(24.5
)%
Shanghai
 
$
4,602
     
4.9
%
 
$
-
     
-
%
   
100
%
Jiangxi
 
$
4,403
     
4.7
%
 
$
6,789
     
7.6
%
   
(35.2
)%
Guangxi
 
$
3,663
     
3.9
%
 
$
5,185
     
5.8
%
   
(29.4
)%
Henan
 
$
3,233
     
3.4
%
 
$
3,741
     
4.2
%
   
(13.6
)%
Sichuan
 
$
2,339
     
2.5
%
 
$
3,036
     
3.4
%
   
(23.0
)%
Shanxi
 
$
1,734
     
1.8
%
 
$
3,927
     
4.4
%
   
(55.8
)%
Fujian (prior distributor)
 
$
-
     
-
%
 
$
2,423
     
2.7
%
   
(100
)%
Fujian (company stores)
 
$
4,671
     
4.9
%
 
$
3,329
     
3.8
%
   
40.3
%
Total Net Sales
 
$
94,547
     
100.0
%
 
$
88,826
     
100.0
%
   
6.4
%
 
 
36

 
 
Cost of Sales and Gross Profit Margin (amounts in thousands, in U.S. Dollars, except for percentages)
 
The following table sets forth our total net sales, cost of sales, gross profit and gross margin of the geographic market segments for the periods indicated.
 
   
Years ended December 31,
 
   
2012
   
2011
 
         
Cost of
   
Gross
   
Gross
         
Cost of
   
Gross
   
Gross
 
   
Net sales
   
sales
   
profit
   
margin
   
Net sales
   
sales
   
profit
   
margin
 
   
(Amounts in thousands, in U.S. Dollars, except for percentages)
 
Zhejiang
 
$
17,886
   
$
 10,121
   
$
 7,765
     
 43.4
%
 
$
16,330
   
$
9,252
   
$
7,078
     
43.3
%
Beijing
 
$
15,216
   
$
 8,546
   
$
 6,670
     
 43.8
%
 
$
8,072
   
$
4,673
   
$
3,399
     
42.1
%
Hubei
 
$
13,457
   
$
 7,790
   
$
 5,667
     
 42.1
%
 
$
10,054
   
$
5,774
   
$
4,280
     
42.6
%
Shandong
 
$
12,694
   
$
 7,135
   
$
 5,559
     
 43.8
%
 
$
9,757
   
$
5,605
   
$
4,152
     
42.6
%
Liaoning
 
$
5,936
   
$
 3,407
   
$
 2,529
     
 42.6
%
 
$
9,941
   
$
5,495
   
$
4,446
     
44.7
%
Yunnan
 
$
4,713
   
$
 2,706
   
$
 2,007
     
 42.6
%
 
$
6,242
   
$
3,616
   
$
2,626
     
42.1
%
Shanghai
 
$
4,602
   
$
2,352
   
$
2,250
     
48.9
%
   
-
     
-
     
-
     
-
 
Jiangxi
 
$
4,403
   
$
 2,522
   
$
 1,881
     
 42.7
%
 
$
6,789
   
$
3,951
   
$
2,838
     
41.8
%
Guangxi
 
$
3,663
   
$
 2,091
   
$
 1,572
     
 42.9
%
 
$
5,185
   
$
3,020
   
$
2,165
     
41.8
%
Henan
 
$
3,233
   
$
 1,871
   
$
 1,362
     
 42.1
%
 
$
3,741
   
$
2,192
   
$
1,549
     
41.4
%
Sichuan
 
$
2,339
   
$
1,328
   
$
1,011
     
43.2
%
 
$
3,036
   
$
1,793
   
$
1,243
     
40.9
%
Shanxi
 
$
1,734
   
$
 985
   
$
 749
     
 43.2
%
 
$
3,927
   
$
2,310
   
$
1,617
     
41.2
%
Fujian (prior distributor)
 
$
-
   
$
-
   
$
-
     
-
%
 
$
2,423
   
$
1,443
   
$
980
     
40.5
%
Fujian (company stores)
 
$
4,671
   
$
1,636
   
$
3,035
     
65.0
%
 
$
3,329
   
$
940
   
$
2,389
     
71.8
%
Total
 
$
94,547
   
$
52,490
   
$
42,057
     
44.5
%
 
$
88,826
   
$
50,064
   
$
38,762
     
43.6
%
 
Total cost of sales for 2012 increased by 4.8% from a year ago primarily due to increased sales.  Our cost of sales as a percentage of net sales was 55.5% and 56.4% for 2012 and 2011, respectively.  Gross margin as a percentage of net sales increased from 43.6% to 44.5% period over period due to our focus on selling higher margin products at higher price points.

Selling, General and Administrative Expenses (amounts in thousands, in U.S. Dollars, except for percentages)
  
  
Years ended December 31,
  
  
  
2012
   
2011
  
  
  
$
   
% of total
net sales
   
$
   
% of total
 net sales
  
  
  
(Amounts in thousands, in U.S. Dollars, except for percentages)
  
Gross Profit
 
$
42,057
     
44.5
%
 
$
38,762
     
43.6
%
Operating Expenses:
                               
Selling Expenses
   
11,645
     
12.3
%
   
15,619
     
17.6
%
General and Administrative Expenses
   
6,269
     
6.6
%
   
5,466
     
6.1
%
Total
   
17,914
     
19.0
%
   
21,085
     
23.7
%
Income from Operations
   
24,143
     
25.5
%
   
17,677
     
19.9
%
 
Selling expenses for 2012 decreased by 25.4% to $11,645 as compared to selling expenses of $15,619 in 2011.  The decrease was mainly due to higher one-time costs incurred during 2011 such as logo development and presenting at the New York Fashion Week in September 2011.  We expect that our selling expenses will increase slightly during 2013; however, if we were to expand our distribution network, open additional stores, or present at other international fashion weeks during 2013, our selling expenses could increase significantly.
 
General and administrative expenses increased by 14.7% from $5,466 for 2011 to $6,269 for 2012.  The higher general and administrative expenses for 2012 resulted from slightly higher research and development costs as well as losses relating to the disposal of leasehold improvements.  We expect that such expenses will increase as a percentage of total revenue and in absolute dollars as we continue to penetrate potential new markets and expand our operations.
 
Change in Fair Value of Derivative Liability (amounts in thousands, in U.S. Dollars, except for percentages)
 
We issued common stock purchase warrants to investors in our equity financings completed in October, November and December 2009, all of which expired during the fourth quarter of 2012.   Prior to their expirations, these warrants were accounted for at fair value as derivative instruments and are marked-to-market each period, with changes in the fair value charged or credited to income each period which did not impact cash flow as these are non-cash charges and credits. During 2012 and 2011, we recorded gains of $673 and $639 in their fair value, respectively.
  
 
37

 
 
Interest Income (amounts in thousands, in U.S. Dollars, except for percentages)

Interest income for 2012 amounted to $89, compared to $75 for 2011.
 
Interest Expense (amounts in thousands, in U.S. Dollars, except for percentages)

Interest expense for 2012 amounted to $0, compared to $8 for 2011.
   
Income Tax Expenses (amounts in thousands, in U.S. Dollars, except for percentages)

Income tax expense for 2012 and 2011 amounted to $7,027 and $4,455, respectively.   The higher income tax for 2012 is attributable to higher operating income and an under-provision of income tax of $1,056 that represents a change in our estimate of the 2011 income tax provision.  Certain expenses incurred during 2011 that we believed were deductible were later deemed non-deductible by the tax bureau subsequent to filing our 2011 Form 10-K on April 12, 2012.  Therefore, a provision was made for the additional income tax expense during 2012.
  
Liquidity and Capital Resources

The following summarizes our cash flows (amounts in thousands, in U.S. Dollars, except for percentages) :

   
Year ended December 31,
   
2012
   
2011
 
Net cash provided by operating activities
 
$
12,894
   
$
6,758
 
Net cash used in investing activities
 
$
(423
 
$
(4,830
)
Net cash (used in)  provided by financing activities
 
$
(397)
   
$
382
 
 
Net cash provided by operating activities in 2012 was $12,894 as compared with $6,758 in 2011.  This increase of $6,136 was mainly attributable to increased net income as well as a slowdown in the growth of accounts receivable year over year, offset by a decrease in accounts payable during 2012.  
 
Net cash used in investing activities was $423 in 2012, compared with $4,830 in 2011.  The decrease of $4,407 was a result of $6,684 for the acquisition of our Fujian distributor’s retail network and $2,301 for build-outs of company stores in 2011, partially offset by the maturity of a 2010 time deposit for $3,020 that was redeemed in 2011, and $1,193 from the sales of property, plant and equipment in 2011.

Net cash used in financing activities was $397 in 2012, from repaying advances from our CEO, as compared with net cash provided by financing activities of $382 in 2011, as a result of advances from our CEO offset by repayments of short-term debt.
 
As of December 31, 2012, we had cash and cash equivalents of $26,923, total current assets of $74,568 and total current liabilities of $12,330.   Included in total current liabilities is $987 of registration liquidated penalties in connection with our equity financings in the fourth quarter of 2009, which we plan to pay as soon as it is practicable to do so.    
 
Contractual Obligations and Off-Balance Sheet Arrangements

Contractual Obligations

Company leases :

For our administrative purposes, we have certain fixed contractual obligations and commitments that include future estimated payments.  Changes in our business needs, cancellation provisions, changing interest rates, and other factors may result in actual payments differing from the estimates.  We cannot provide certainty regarding the timing and amounts of payments.

Store leases :

Of the 17 company stores that we operated as of December 31, 2012, 6 have leases that require fixed rental payments.  The remaining 11 leases have rental payments based on store revenue with no minimum rental payment due, and are thus not included in the table below.  Rental expense for such leases is recorded as sales are made.

The following tables summarize our contractual obligations as of December 31, 2012, and the effect that these obligations are expected to have on our liquidity and cash flows in future periods (amounts in thousands):

   
Future
minimum
payments -
corporate
   
Future
minimum
payments-
company stores
   
Total Future
minimum
payments
 
Year ending December 31,
                 
2013
  $ 137     $ 326     $ 463  
2014
    137       127       264  
2015
    143       -       143  
2016
    151       -       151  
                         
    $ 568     $ 453     $ 1,021  

 
38

 
 
Operating lease amounts include minimum lease payments under our non-cancelable operating leases for office facilities, as well as limited computer and office equipment that we utilize under certain lease arrangements.

Off-Balance Sheet Arrangements

Under the operating agreement between our subsidiary HK Dong Rong and our variable interest entity Yinglin Jinduren, it was agreed that, if any guarantee for the performance of Yinglin Jinduren for any contract or loan was required, HK Dong Rong would agree to provide such guarantee.  To date, no such guarantees have been provided.  We have not entered into any other financial guarantees or other commitments to guarantee the payment obligations of any third parties.  We do not use off-balance sheet derivative financial instruments to hedge or partially hedge interest rate exposure nor do we maintain any other off-balance sheet arrangements for the purpose of credit enhancement, hedging transactions, or other financial or investment purposes.  We have not entered into any derivative contracts that are indexed to our shares and classified as shareholder’s equity or that are not reflected in our consolidated financial statements.  Furthermore, we do not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity.  We do not have any variable interest in any unconsolidated entity that provides financing, liquidity, market risk or credit support to us or engages in leasing, hedging or research and development services with us.

ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable.

ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
Our audited financial statements for the fiscal years ended December 31, 2012 and 2011, together with the reports of the independent certified public accounting firm thereon and the notes thereto, are presented beginning at page F-1.
 
 
39

 
 
VLOV INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Contents
 
Report of Independent Registered Public Accounting Firm – Crowe Horwath (HK) CPA Limited
   
F-1(a)
 
Report of Independent Registered Public Accounting Firm – Crowe Horwath LLP
   
F-1(b)
 
Consolidated Balance Sheets
   
F-2
 
Consolidated Statements of Comprehensive Income
   
F-3
 
Consolidated Statements of Stockholders’ Equity
   
F-4
 
Consolidated Statements of Cash Flows
   
F-5
 
Notes to Consolidated Financial Statements
   
F-6
 
 
 
40

 
 
Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders
VLOV Inc.

We have audited the accompanying consolidated balance sheet of VLOV Inc. (the “Company”) as of December 31, 2012 and the related consolidated statements of comprehensive income, stockholders' equity and cash flows for the year then ended.  These consolidated financial statements are the responsibility of the Company's management.  Our responsibility is to express an opinion on these consolidated financial statements based on our 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.  The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting.  Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting.  Accordingly, we express no such opinion.  An audit includes examining, on a test basis, evidence supporting the 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 audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2012, and the results of its operations and its cash flows for the year then ended in conformity with U.S. generally accepted accounting principles.

/s/ Crowe Horwath (HK) CPA Limited
Hong Kong, China
April 16, 2013

 
F-1(a)

 

Report of Independent Registered Public Accounting Firm
 
To the Board of Directors and Stockholders
VLOV Inc.
 
We have audited the accompanying consolidated balance sheet of VLOV Inc. (the “Company”) as of December 31, 2011, and the related consolidated statements of comprehensive income, stockholders' equity, and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements 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. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the 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 audit provides a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2011, and the results of its operations and its cash flows for the year then ended, in conformity with U.S. generally accepted accounting principles.
 
/s/ Crowe Horwath, LLP
 Indianapolis, Indiana
April 12, 2012 except for the effects of the reverse stock split described in Note 12, as to which the date is April 16, 2013
 
 
F-1(b)

 
 
VLOV INC.
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, in U.S. Dollars)

   
December 31,
2012
   
December 31,
2011
 
             
ASSETS
           
Current Assets:
           
Cash and cash equivalents
 
$
26,923
   
$
14,725
 
Accounts and other receivables
   
44,388
     
36,233
 
Trade deposits
   
872
     
3,482
 
Inventories
   
1,712
     
1,880
 
Prepaid expenses
   
673
     
85
 
Total current assets
   
74,568
     
56,405
 
Property, plant and equipment, net
   
1,121
     
2,197
 
Goodwill
   
5,260
     
5,219
 
TOTAL ASSETS
 
$
80,949
   
$
63,821
 
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current Liabilities:
               
Accounts payable
 
$
5,855
   
$
7,173
 
Accrued expenses and other payables
   
1,758
     
1,967
 
Amounts due to directors/officers
   
812
     
1,216
 
Derivative liability - common stock warrants
   
-
     
673
 
Taxes payable
   
3,905
     
3,002
 
Total current liabilities
   
12,330
     
14,031
 
                 
Commitments and Contingencies
               
Stockholders’ Equity:
               
Common stock, $0.00001 par value, 13,333,334 shares authorized, 2,603,481 and 2,528,914 shares issued and outstanding as of December 31, 2012 and December 31, 2011, respectively
   
1
     
1
 
Preferred stock, $0.00001 par value, 100,000,000 shares authorized, 394,478 and 632,853 shares issued and outstanding as of December 31, 2012 and December 31, 2011, respectively (liquidation preference $1,128,207 and $1,809,960)
   
561
     
900
 
Additional paid-in capital
   
10,575
     
9,718
 
Statutory reserve
   
4,100
     
913
 
Retained earnings
   
49,778
     
35,087
 
Accumulated other comprehensive income
   
3,604
     
3,171
 
Total stockholders' equity
   
68,619
     
49,790
 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
 
$
80,949
   
$
63,821
 

See accompanying notes to consolidated financial statements
 
 
F-2

 
 
VLOV INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Amounts in thousands, in U.S. Dollars- except for share and per share data)
 
   
Year Ended December 31,
 
   
2012
   
2011
 
             
Net sales
 
$
94,547
   
$
88,826
 
Cost of sales
   
52,490
     
50,064
 
Gross profit
   
42,057
     
38,762
 
                 
Operating expenses:
               
Selling expenses
   
11,645
     
15,619
 
General and administrative expenses
   
6,269
     
5,466
 
     
17,914
     
21,085
 
                 
Income from operations
   
24,143
     
17,677
 
                 
Other income (expenses):
               
Change in fair value of derivative liability
   
673
     
639
 
Interest income
   
89
     
75 
 
Interest expense
   
-
     
(8
)
     
762
     
706
 
                 
Income before provision for income taxes
   
24,905
     
18,383
 
Provision for income taxes
   
7,027
     
4,455
 
                 
Net income
   
17,878
     
13,928
 
                 
Other comprehensive income:
               
Foreign currency translation adjustment
   
433
     
1,616
 
                 
Comprehensive income
 
$
18,311
   
$
15,544
 
                 
Allocation of net income for calculating basic earnings per share:
               
Net income attributable to common shareholders
   
17,524
     
13,478
 
Net income attributable to preferred shareholders
   
354
     
450
 
Net income
 
$
17,878
   
$
13,928
 
                 
Basic earnings per share- common
 
$
6.83
   
$
5.42
 
                 
Diluted earnings per share
 
$
6.78
   
$
5.36
 
                 
Weighted average number of common shares and participating preferred shares outstanding:
               
                 
Basic
   
2,565,394
     
2,487,099
 
                 
Diluted
   
2,635,123
     
2,600,897
 
 
See accompanying notes to consolidated financial statements
 
 
F-3

 
 
VLOV INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(Amounts in thousands, in U.S. Dollars – except for share and per share data)

   
 
Common stock
   
Preferred stock
   
Additional
paid-in
   
Statutory
   
Accumulated
other
comprehensive
   
Retained
   
Total
 
   
Shares
   
Amount
   
Shares
   
Amount
   
capital
   
reserve
   
income
   
earnings
   
equity
 
                                                       
Balance at January 1, 2011
   
2,459,223
   
1
     
1,048,759
   
$
1,492
   
$
8,873
   
$
913
   
$
1,555
   
$
21,159
   
$
33,993