ITEM 1A. RISK
FACTORS
In addition to the other information
in this Form 10-Q, readers should carefully consider the following important factors. These factors, among others, in some cases
have affected, and in the future could affect, our financial condition and results of operations and could cause our future results
to differ materially from those expressed or implied in any forward-looking statements that appear in this on Form 10-Q or that
we have made or will make elsewhere.
Risks Related to Our Business and Our
Industry
There is substantial doubt about our ability to continue
as a going concern.
Our independent public accounting firm has
issued an opinion on our audited consolidated financial statements for the year ended December 31, 2011 that states that the consolidated
financial statements were prepared assuming we will continue as a going concern, and further states that we have incurred significant
losses from operations for the year ended December 31, 2011 and has a working capital deficiency. As noted in the opinion, those
conditions raise substantial doubt about our ability to continue as a going concern. Our plans concerning these matters are discussed
in Note 5 to the accompanying unaudited consolidated financial statements to this quarterly report on Form 10-Q. Our future is
dependent on our ability to fund continuing operations through new financing from related parties and equity financing arrangements
successfully or otherwise address these matters. If we fail to do so for any reason, we would, in all likelihood, experience severe
liquidity problems and may have to curtail our operations. If we curtail our operations, we may be placed into bankruptcy or undergo
liquidation, the result of which will adversely affect the value of our common stock.
If we fail to maintain effective internal
control over financial reporting, we may not be able to accurately report our financial results. We can provide no assurance
that we will at all time in the future be able to report that our internal control is effective.
Our management has concluded that our internal
controls over financial reporting were effective as of September 30, 2012. See “Item 4. Controls and Procedures.” If,
in the future, we fail to comply with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 or report significant deficiencies,
we might be subject to regulatory sanction and investors may lose confidence in our financial statements.
Our limited operating history makes it difficult to evaluate
our business and prospects.
We were incorporated on December 30, 2009
in the State of Nevada. We have not yet launched three MMORPGs, all of which were under development. Our limited operating history
may not provide a meaningful basis for investors to evaluate our business and prospects. Our business strategy has not been proven
over time and we cannot be certain that we will be able to successfully operate our online game business.
You should also consider additional risks
and uncertainties that may be experienced by early stage companies operating in a rapidly developing and evolving industry. Some
of these risks and uncertainties relate to our ability to:
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develop new MMORPGs that are appealing to game players and meet our expected timetable for launches of new games;
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raise our brand recognition and game player loyalty; and
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successfully adapt to an evolving business model.
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We may not be successful in addressing
the risks listed above, which may materially and adversely affect our business prospects.
Our business, financial condition and results of operations,
as well as our ability to obtain financing, may be adversely affected by the downturn in the global or Chinese economy.
The global financial markets have experienced
significant disruptions since 2008 and the effect of the crisis has persisted through 2009 and 2010, and to a lesser extent in
2011. China’s economy has also faced challenges. To the extent that there have been improvements in some areas, it is uncertain
whether such recovery is sustainable. The online game industry is particularly sensitive to economic downturns, and the macroeconomic
environment in China may affect our business and prospects. A prolonged slowdown in China’s economy may lead to a reduced
level of online game purchasing activities, which could materially and adversely affect our business, financial condition and results
of operations.
Moreover, a slowdown in the global or
China’s economy or the recurrence of any financial disruptions may have a material and adverse impact on financings available
to us. The weakness in the economy could erode investors’ confidence, which constitutes the basis of the credit markets.
The recent financial turmoil affecting the financial markets and banking system may significantly restrict our ability to obtain
financing in the capital markets or from financial institutions on commercially reasonable terms, or at all. Although we are uncertain
about the extent to which the recent global financial and economic crisis and slowdown of China’s economy may impact our
business in the short term and long term, there is a risk that our business, results of operations and prospects will be materially
and adversely affected by any ongoing global economic downturn or slowdown in China’s economy.
We may not be successful in operating and improving our games
to satisfy the changing demands of game players.
We expect to depend on purchase and continual
consumption of virtual items by our game players to generate revenues, which in turn depends on the continued attractiveness of
our games to the game players and their satisfactory game-playing experience. We also expect to improve our games through regular
updates as well as periodic major enhancements using expansion packs. However, we cannot assure you that our efforts will be effective
in eliminating program errors associated with our games, satisfying game player demands, or retaining the continued attractiveness
of our games. For example, we may fail to provide game updates and expansion packs in a timely manner due to technologies, resources
or other factors, and to timely respond and/or resolve complaints from our game players. Our failure to address these issues could
adversely affect the game-playing experience of our game players, damage the reputation of our games, shorten the lifespan of our
games, and eventually result in the loss of game players and a decrease in our revenues.
We may fail to launch games according to our timetable, and
our games may not be commercially successful.
We have three games in the pipeline,
Three Kingdoms Online, UU World, and 108 Warriors. The game 108 Warriors was officially launched on August 23, 2012. We will
not generate any revenue from a game until it is launched. However, we cannot assure you that we will be able to meet our
timetable for our game launches. A number of factors, including technical difficulties, lack of sufficient game development
personnel and other resources could result in delayed launching of our games. In addition, we cannot assure you that our
games will be as well received in the market. There are many factors that may adversely affect the popularity of our games.
For example, we may fail to anticipate and adapt to future technical trends, new business models and changed game player
preferences and requirements, or fail to effectively plan and organize marketing and promotion activities. If the new games
we introduce are not commercially successful, we may not be able to recover our product development costs, which can be
significant.
Our business may not succeed in a highly competitive market.
Competition in the online game market
in China is becoming increasingly intense. According to Securities Asia Estimates, the current Chinese online games market is dominated
by eight operators with a total market share of 76%. Tencent, Shanda, and NetEase are the top 3 online game companies in China
with combined market share of 50%. Six of the top Chinese online games operators are listed in the US, and three are listed on
the Hong Kong Stock Exchange.
The top online games operators have already
begun strengthening their product offering platform and disengaging themselves from dependence on one single product. In this aim,
they have achieved notable success, which is evident from the attractive games they currently have in their portfolio. At the same
time, most of them have started to develop multiple games targeted at different market segments, and also put more emphasis on
promoting a few competitive products to keep ahead of the market and achieve maximum profits. With their diversified portfolio
of games, the top online games operators have been able to maximize interest from potential users and consequently maximize their
revenue streams. Because competition is becoming fiercer in the online games industry, only developers who have core competency
in R&D, operations and distribution can expand in a sustainable way, most of which focus on MMORPGs. Moreover, there are many
venture-backed private companies focusing on online game development, and MMORPG development in particular, further intensifying
the competition. Recently, many of our competitors have been aggressively hiring talent for game development, increasing spending
on marketing for games and bidding for licenses of games. Increased competition in the online game market may make it difficult
for us to retain our existing employees and attract new employees, and to sustain our growth rate. Furthermore, we also face intense
competition for cost-effective marketing resources for online games, such as online game-related websites, which could drive up
our marketing costs and decrease the effectiveness of our marketing campaigns.
We generate all of our revenues under the item-based revenue
model, which may present risks related to consumer preferences and regulatory restrictions.
We operate our games under the item-based
revenue model. Under this revenue model, our game players are free to play the games for an unlimited amount of time, but are charged
for the purchases of certain virtual items such as performance-enhancing clothing, equipment and accessories that enhance the game-playing
experience. The item-based revenue model requires us to design games that not only attract game players to spend more time playing,
but also encourages them to purchase virtual items. The sale of virtual items requires us to track closely consumer tastes and
preferences, especially as to in-game consumption patterns. If we fail to design virtual items so as to incentivize game players
to purchase them, we may not be able to effectively translate our game player base and their playing time into revenues. Although
the item-based revenue model is currently a prevalent revenue model for MMORPGs in China, it does not have a long history of proven
commercial application. In addition, the item-based revenue model may cause additional concerns with PRC regulators who have been
implementing regulations designed to reduce the amount of time that Chinese youths spend on online games and intended to limit
the total amount of virtual currency issued by online game operators and the amount of purchase by individual game player. A revenue
model that does not charge for time may be viewed by the PRC regulators as inconsistent with this goal. We cannot assure you that
the item-based revenue model will continue to be commercially successful, or that we will not in the future need to change our
revenue model to a new revenue model. Any change in revenue model could result in disruption of our game operations and decrease
in the number of our game players.
We rely on data recorded
in our billing systems for revenue recognition and tracking of game players’ consumption patterns of virtual items
Our game operations revenues are collected
through the sale of our prepaid game cards or online direct sale of game points. However, we do not recognize revenues when our
prepaid game card or game points are sold. Rather, our revenues are recognized when the virtual items purchased by our game players
are consumed. For instant and limited consumption virtual items, including those with a predetermined expiration time, revenues
are recognized as they are consumed or expired, and for perpetual virtual items, revenues are recognized over their estimated lives.
We rely on our billing systems to capture the purchase and consumption of the virtual items by our game players. If our billing
systems fail to accurately record the purchase and consumption information of the virtual items, we may not be able to accurately
recognize our revenues. In addition, various factors affect the estimated lives of perpetual virtual items, such as the average
period that game players typically play our games and other game player behavior patterns, the acceptance and popularity of expansion
packs, promotional events launched and market conditions, and we rely on our billing systems to capture such historical game player
behavior patterns and other information. If such information is not accurately recorded, or if we do not have sufficient information
due to our short operating history, we will not be able to accurately estimate the lives of the perpetual virtual items, which
will also affect our ability to accurately recognize our revenues from such perpetual virtual items. Therefore, if our billing
systems were damaged by system failure, network interruption, or virus infection, or attacked by a hacker, the integrity of data
would be compromised, which could materially and adversely affect our revenue recognition and the completeness and accuracy of
our recognized revenues, resulting in possible restatement of our financial statements and loss of investors’ confidence
in us.
In addition, we rely on our billing systems
to record game player purchase and consumption patterns, based on which we improve our existing virtual items and design new virtual
items. For example, we intend to increase development efforts on the number and variety of virtual items that our game players
like to purchase, and we may also adjust prices accordingly. If our billing systems fail to record data accurately, our ability
to improve existing virtual items or design new virtual items that are appealing to our game players may be adversely affected,
which could in turn materially and adversely affect our revenues.
We have a dedicated team that analyzes
pricing trends and determines the pricing of our virtual items. Our pricing team maintains a database that tracks each sale and
the sale price for each virtual item. The database also tracks user behavior after the launch of each of our virtual items. We
use this data-tracking to help us determine discounts or premiums for our current virtual items based on the demand for such virtual
items and to forecast expected demand, and thus price, for similar virtual items. Our pricing team determines the price of each
virtual item before its introduction, based primarily on its analysis of the database and demand for comparable virtual items.
We may change the pricing of certain virtual items based on their consumption pattern.
Rapid technological changes may increase our game development
costs.
The online game industry is evolving rapidly,
so we need to anticipate new technologies and evaluate their possible market acceptance. In addition, government authorities or
industry organizations may adopt new standards that apply to game development. Any new technologies and new standards may require
increases in expenditures for MMORPG development and operations, and we will need to adapt our business to cope with the changes
and support these new services to be successful. If we fall behind in adopting new technologies or standards, our existing games
may lose popularity, and our newly developed games may not be well received in the marketplace. As a result, our business prospects
and results of operations could be materially and adversely affected.
Our business may be materially harmed if our MMORPGs are
not featured in a sufficient number of Internet cafes in China.
A substantial number of game players access
our games through Internet cafes in China. Due to limited hardware capacity, Internet cafes generally feature a limited number
of games on their computers. We thus compete with a growing number of other online game operators to ensure that our games are
featured on these computers. We take steps to ensure that our games are featured in a sufficient number of Internet cafes, including
maintaining good relationships with Internet cafe operators, requiring our distributors to maintain a sales presence in a large
number of Internet cafes, conducting periodical promotional activities in select Internet cafes, and other general sales and marketing
efforts. If we fail to maintain good relationships with Internet cafe operators, or if we and/or our distributors fail to successfully
persuade Internet cafes to feature our MMORPGs, our revenues may be materially and adversely affected.
We may be exposed to infringement or misappropriation claims
by third parties, which, if determined adversely to us, could subject us to significant liabilities and other costs.
Our success depends largely on our ability
to use and develop our technology and know-how without infringing the intellectual property rights of third parties. We cannot
assure you that third parties will not assert intellectual property claims against us. We are subject to additional risks if entities
licensing to us intellectual property, including, for example, game source codes, do not have adequate rights in any such licensed
materials. The validity and scope of claims relating to the intellectual property of game development and technology involve complex
scientific, legal and factual questions and analysis and, therefore, tend to be uncertain. If third parties assert copyright or
patent infringement or violation of other intellectual property rights against us, we have to defend ourselves in litigation or
administrative proceedings, which can be both costly and time consuming and may significantly divert the efforts and resources
of our technical and management personnel. An adverse determination in any such litigation or proceedings to which we may become
a party could subject us to significant liability to third parties, require us to seek licenses from third parties, to pay ongoing
royalties, or to redesign our games or subject us to injunctions prohibiting the development and operation of our games.
Unauthorized use of our intellectual
property by third parties, and the expenses incurred in protecting our intellectual property rights, may adversely affect our business.
We regard our
copyrights, trademarks, service marks, trade secrets and other intellectual property as critical to our success. Unauthorized use
of the intellectual property used in our business, whether owned by us or licensed to us, may adversely affect our business and
reputation.
We rely on copyright,
trademark, trade secret and other intellectual property law, as well as non-competition, confidentiality and license agreements
with our employees, licensors, business partners and others to protect our intellectual property rights. Our employees are generally
required to sign agreements acknowledging that all inventions, trade secrets, works of authorship, developments and other processes
generated by them on our behalf are our property, and assigning to us any ownership rights that they may claim in those works.
Despite our precautions, third parties may obtain and use intellectual property that we own or license without our consent. Unauthorized
use of our intellectual property by third parties, and the expenses incurred in protecting our intellectual property rights may
materially and adversely affect our business.
For instance,
pirate game servers illegally operate unauthorized copies of our online games and enable players to play those games without purchasing
prepaid cards for our online games. Despite our efforts to shut down pirate game servers, we believe that a significant number
of pirate game servers continue to operate unauthorized copies of our online games. If pirate game servers continue to operate
any of our online games, our business, financial condition and results of operations may be materially and adversely affected.
The validity,
enforceability and scope of protection of intellectual property in online game industry are uncertain and still evolving. In particular,
the laws and enforcement procedures in the PRC are uncertain and do not protect intellectual property rights in this area to the
same extent as do the laws and enforcement procedures in the United States and other developed countries. Policing unauthorized
use of intellectual properties is difficult and expensive. Any steps we have taken to prevent the misappropriation of our intellectual
properties may be inadequate. Moreover, litigation may be necessary in the future to enforce our intellectual property rights.
Future litigation could result in substantial costs and diversion of our resources, and could disrupt our business, as well as
have a material adverse effect on our financial condition and results of operations.
We may fail to maintain a stable and efficient physical distribution
network for our prepaid game cards.
Online payment systems in China are in
a developmental stage and are not as widely available to or accepted by consumers in China as they are in the United States. We
rely heavily on a physical distribution network composed of third-party distributors to cover a network of retail outlets across
China for the sales of our prepaid game cards to our game players. We sell prepaid game cards in virtual and physical form to a
range of regional third-party distributors, who in turn sub-distribute them to numerous retail outlets across China. As a result,
our revenues could be adversely affected by the under-performance of our distributors, such as the failure to meet minimum sales
or penetration targets or the failure to establish an extensive retail network.
We could be liable for breaches of security of our and third-parties’
online payment platforms, and sales made through those channels might have a negative impact on our revenues.
We expect to sell a substantial portion
of our virtual prepaid game cards through other third-party online payment platforms. We also expect to rely on our own website
to directly sell our virtual prepaid game cards and game points to our game players. In all these online transactions, secured
transmission of confidential information, such as customers’ credit card numbers and expiration dates, personal information
and billing addresses, over public networks is essential to maintain consumer confidence. As a result, the associated online crime
will likely increase as well. We cannot assure you that our current security measures and those of the third parties with whom
we transact business are adequate. We must be prepared to increase our security measures and efforts so that our game players have
confidence in the reliability of the online payment systems that we use, which will require additional costs and expenses and may
still not be completely safe. In addition, we do not have control over the security measures of our third-party online payment
vendors. Security breaches of the online payment systems that we use could expose us to litigation and possible liability for failing
to secure confidential customer information and could harm our reputation, ability to attract customers and ability to encourage
customers to purchase virtual items.
We are dependent upon our existing management, our key development
personnel and qualified technical personnel, and our business may be severely disrupted if we lose their services.
Our future success depends substantially
on the continued services of our executive officers and our key development personnel, such as our Chairman, Zhilian Chen, Chief
Executive Officer, and Mingyang Li and our Chief Operating Officer. If one or more of our executive officers and key development
personnel were unable or unwilling to continue in their present positions, we might not be able to replace them easily or at all.
In addition, if any of our executive officers or key employees joins a competitor or forms a competing company, we may lose know-how,
key professionals and staff members as well as suppliers. These executive officers and key employees could develop and operate
games that could compete with and take game players away from our existing and future games. Each of our executive officers and
key personnel has entered into an employment agreement with us, which contains non-competition provisions. However, if any dispute
arises between our executive officers, key employees and us, these non-competition provisions may not be enforceable in China.
If any of these were to happen, our competitive position and business prospects may be materially and adversely affected.
We have limited insurance coverage.
The insurance industry in China is still
in the early stages of development. Insurance companies in China offer limited insurance products. We have determined that the
risks of disruption or liability from our business, the loss or damage to our property, including our facilities, equipment and
office furniture, the cost of insuring for these risks, and the difficulties associated with acquiring such insurance on commercially
reasonable terms make it impractical for us to have such insurance. As a result, we do not have any business liability, disruption,
litigation or property insurance coverage for our operations in China except for insurance on some company owned vehicles. Any
uninsured occurrence of loss or damage to property, or litigation or business disruption may result in the incurrence of substantial
costs and the diversion of resources, which could have an adverse effect on our operating results.
There are uncertainties regarding the future growth of the
online game industry in China.
The online game industry, from which we
derive all of our revenues, is a relatively new and evolving industry. The growth of the online game industry and the level of
demand and market acceptance of our games are subject to a high degree of uncertainty. Our future operating results will depend
on numerous factors affecting the online game industry, many of which are beyond our control, including:
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the growth of personal computer, Internet and broadband users and penetration in China and other markets in which we offer our games, and the rate of any such growth;
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whether the online game industry, particularly in China and the rest of the Asia-Pacific region, continues to grow and the rate of any such growth;
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general economic conditions in China, particularly economic conditions adversely affecting discretionary consumer spending, such as the slowdown in China’s economic growth partly caused by the recent global crisis in the financial services and credit markets;
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the availability and popularity of other forms of entertainment, particularly games of console systems, which are already popular in developed countries and may gain popularity in China; and
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changes in consumer demographics and public tastes and preferences.
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There is no assurance that online games,
in particular MMORPGs, will continue to be popular in China or elsewhere. A decline in the popularity of online games in general,
or the MMORPGs that we operate, will likely adversely affect our business and prospects.
The successful operation of our business and implementation
of our growth strategies, including our ability to accommodate additional game players in the future, depend upon the performance
and reliability of the Internet infrastructure and fixed telecommunications networks in China.
Although private Internet service providers
currently exist in China, almost all access to the Internet is maintained through state-owned telecommunications operators under
the administrative control and regulatory supervision of the Ministry of Industry and Information Technology, or MIIT (formerly
the Ministry of Information Industry). We rely on this infrastructure to provide data communications capacity primarily through
local telecommunications lines. Although the government has announced plans to develop aggressively the national information infrastructure,
we cannot assure you that this infrastructure will be developed as planned or at all. In addition, we will have no access to alternative
networks and services, on a timely basis if at all, in the event of any infrastructure disruption or failure. The Internet infrastructure
in China may not support the demands necessary for the continued growth in Internet usage.
The limited use of personal computers in China and the relatively
high cost of Internet access in relation to per capita gross domestic product may limit the development of the Internet in China
and impede our growth.
The penetration rate for personal computers
in China is significantly lower than it is in the United States and other developed countries. Furthermore, the cost of Internet
access is still relatively high as compared to other developed countries. The limited use of personal computers in China and the
relatively high cost of Internet access may limit the growth of our business. In addition, there may be increases in Internet access
fees or telecommunication fees in China. If that happens, the number of our game players may decrease and the growth of our game
player base may be materially impacted.
Risks Related to Our Structure and Restrictions
If the PRC government determines that the agreements that
establish the VIE structure for operating our business does not comply with PRC government restrictions on foreign investment in
the online game industry, we could face severe penalties.
Various regulations in China currently
restrict or prevent foreign-invested entities from engaging in telecommunication services, including operating online games. Because
of these restrictions, our online game operations in the PRC are conducted through our VIE, Beijing Sntaro Technology Co., Ltd.,
a PRC company (“Beijing Sntaro”) that has 100% ownership interest in Beijing Sntaro Freeland Network Co. Ltd., a PRC
Company, through a series of contractual arrangements. For details of these contractual arrangements, see our Annual Report on
Form 10-K filed with the SEC on March 29, 2012.
A circular issued by MIIT in July 2006,
or the MIIT circular, reiterated the regulations on foreign investment in telecommunications businesses. Under this circular, a
domestic company that holds a license for the provision of Internet information service, or an ICP license, or a license to conduct
any value-added telecommunications business in China, is prohibited from leasing, transferring or selling the license to foreign
investors in any form, and from providing any assistance, including providing resources, sites or facilities, to foreign investors
to conduct value-added telecommunications businesses illegally in China. Furthermore, the relevant trademarks and domain names
that are used in the value-added telecommunications business must be owned by the local ICP license holder. The circular further
requires each ICP license holder to have the necessary facilities for its approved business operations and to maintain such facilities
in the regions covered by its license. In addition, all value-added telecommunications service providers are required to maintain
network and information security in accordance with the standards set forth under relevant PRC regulations.
On September 28, 2009, the General Administration
of Press and Publications, or the GAPP, the National Copyright Administration (“NCA”), and National Office of Combating
Pornography and Illegal Publications (“NOCPIP”) jointly published the “Stipulations on ‘Three Provisions’
” of the State Council and the Relevant Interpretations of the State Commission Office for Public Sector Reform and the Further
Strengthening of the Administration of Pre-examination and Approval of Online games and the Examination and Approval of Imported
Online games (Xin Chu Lian [2009] No. 13), or Circular 13. Circular 13 restates the general principle espoused in recently promulgated
regulations that foreign investment is not permitted in online game operating businesses in China. According to Circular 13, foreign
investors are prohibited from participating in online game operating businesses via wholly owned, equity joint venture or cooperative
joint venture investments in China, and from controlling and participating in such businesses directly or indirectly through contractual
or technical support arrangements. In the event of a violation of these provisions, GAPP shall, in conjunction with the relevant
government authorities of the PRC, investigate and handle the same in accordance with the law. In serious cases, the relevant licenses
and registrations shall be revoked. However, due to the lack of a detailed interpretation of Circular 13, it is not yet clear how
it will be implemented. Moreover, Circular 13 was issued solely by GAPP, NCA and NOCPIP, instead of being jointly issued by the
publication administration authorities and other government authorities which are in charge of the related business operations,
like the Ministry of Commerce, or the MOFCOM, and the MIIT, and the scope, implementation and enforcement of Circular 13 from the
views of the above mentioned other authorities remain uncertain.
In the opinion of Han Kun Law Offices,
our PRC legal counsel, subject to the interpretation and implementation of the MIIT Circular and Circular 13, the ownership structure
of Ningbo Sntaro and Beijing Sntaro and our contractual arrangements with Beijing Sntaro and its shareholders comply with all existing
PRC laws, rules and regulations. However, in the opinion of our PRC legal counsel, there are substantial uncertainties regarding
the interpretation and application of current or future PRC laws and regulations and there may be changes and other developments
in the PRC laws and regulations or their interpretations. Accordingly, we cannot assure you that Chinese government authorities
will ultimately take a view that is consistent with the opinion of our PRC legal counsel.
If our past or current ownership structures,
contractual arrangements and businesses is found to be in violation of any existing or future PRC laws or regulations, including
the MIIT Circular and Circular 13, the relevant supervisory authorities would have broad discretion in dealing with such violations,
including, but not limited to: revoking our business and operating licenses; levying fines; confiscating our income or the income
of Beijing Sntaro; shutting down our servers or blocking our website; imposing conditions or requirements with which we may not
be able to comply; requiring us to restructure the relevant ownership structure, operations or contractual arrangements; restricting
or prohibiting our use of the proceeds from our public offering to finance our business and operations in China; and taking other
regulatory or enforcement actions that could be harmful to our business. Any of these actions could cause significant disruption
to our business operations.
Ningbo Sntaro’s contractual arrangements with Beijing
Sntaro and its shareholders may not be as effective in providing control over Beijing Sntaro as direct ownership of Beijing Sntaro
and the shareholders of Beijing Sntaro may have potential conflicts of interest with us.
We have no ownership interest in Beijing
Sntaro and we conduct substantially all of our operations and expect to generate substantially all of our revenues through contractual
arrangements that our subsidiary, Beijing Sntaro, had entered into with Beijing Sntaro and its shareholders, and such contractual
arrangements are designed to provide us with effective control over Beijing Sntaro. See our Annual Report on Form 10-K filed with
the SEC on March 29, 2012 for a description of these contractual arrangements. We depend on Beijing Sntaro to hold and maintain
certain licenses necessary for our game business. Beijing Sntaro also owns all of the necessary intellectual property, facilities
and other assets relating to the operation of our games, and employs personnel for our game operations and distribution.
If we had direct ownership of Beijing
Sntaro, we would be able to exercise our rights as a shareholder to effect changes in the board of directors of Beijing Sntaro,
which in turn could effect changes, subject to any applicable fiduciary obligations, at the management level. Due to our VIE structure,
we have to rely on contractual rights to effect control and management of Beijing Sntaro, which exposes us to the risk of potential
breach of contract by the shareholders of Beijing Sntaro.
The shareholders of Beijing Sntaro may
breach, or cause Beijing Sntaro to breach, the contracts for a number of reasons. For example, their interests as shareholders
of Beijing Sntaro and the interests of our company may conflict and we may fail to resolve such conflicts; the shareholders may
believe that breaching the contracts will lead to greater economic benefit for them; or the shareholders may otherwise act in bad
faith. If any of the foregoing were to happen, we may have to rely on legal or arbitral proceedings to enforce our contractual
rights, including specific performance or injunctive relief, and claiming damages. Such arbitral and legal proceedings may cost
us substantial financial and other resources, and result in disruption of our business, and we cannot assure you that the outcome
will be in our favor.
In addition, as all of these contractual
arrangements are governed by PRC law and provide for the resolution of disputes through either arbitration or litigation in the
PRC, they would be interpreted in accordance with PRC law and any disputes would be resolved in accordance with PRC legal procedures.
The legal environment in the PRC is not as developed as in other jurisdictions, such as the United States. As a result, uncertainties
in the PRC legal system could further limit our ability to enforce these contractual arrangements. Furthermore, these contracts
may not be enforceable in China if PRC government authorities or courts take a view that such contracts contravene PRC laws and
regulations or are otherwise not enforceable for public policy reasons. In the event we are unable to enforce these contractual
arrangements, we may not be able to exert effective control over Beijing Sntaro, and our ability to conduct our business may be
materially and adversely affected.
Contractual arrangements between Ningbo Sntaro and Beijing
Sntaro may be subject to scrutiny by the PRC tax authorities and a finding that we owe additional taxes or are ineligible for our
tax exemption, or both, could substantially increase our taxes owed, and reduce our net income.
Under PRC law, arrangements and transactions
among related parties may be subject to audit or challenge by the PRC tax authorities. If the contractual arrangements between
Ningbo Sntaro and Beijing Sntaro are found not to be on an arm’s-length basis, or to result in an unreasonable reduction
in tax under PRC law, the PRC tax authorities have the authority to disallow our tax savings, adjust the profits and losses of
our respective PRC entities and assess late payment interest and penalties.
If any of our PRC operating entities incurs
debt on its own behalf in the future, the instruments governing the debt may restrict their ability to pay dividends or make other
distributions to us. In addition, the PRC tax authorities may require us to adjust our taxable income under the contractual arrangements
with the PRC operating entities we currently have in place in a manner that would materially and adversely affect the PRC operating
entities’ ability to pay dividends and other distributions to us. Furthermore, relevant PRC laws and regulations permit payments
of dividends by the PRC operating entities only out of their retained earnings, if any, determined in accordance with PRC accounting
standards and regulations. Under PRC laws and regulations, each of the PRC operating entities is also required to set aside a portion
of its net income each year to fund specific reserve funds. These reserves are not distributable as cash dividends. In addition,
subject to certain cumulative limits, the statutory general reserve fund requires annual appropriations of 10% of after-tax income
to be set aside prior to payment of dividends. As a result of these PRC laws and regulations, the PRC operating entities are restricted
in their ability to transfer a portion of their net assets to us whether in the form of dividends, loans or advances. Any limitation
on the ability of the PRC operating entities to pay dividends to us could materially and adversely limit our ability to grow, make
investments or acquisitions that could be beneficial to our businesses, pay dividends, or otherwise fund and conduct our business.
The laws and regulations governing the online game industry
in China are evolving and subject to future changes. We may fail to obtain or maintain all applicable permits and approvals.
The online game industry in China is highly
regulated by the PRC government. Various regulatory authorities of the PRC central government, such as the State Council, the MIIT,
GAPP, the Ministry of Culture and the Ministry of Public Security, are empowered to issue and implement regulations governing various
aspects of the online game industry.
We are required to obtain applicable permits
or approvals from different regulatory authorities in order to operate our online game business. For example, as an online game
operator in China, we must obtain an Online Cultural Operating Permit from the Ministry of Culture and an Internet publishing license
from GAPP in order to distribute games through the Internet. If we fail to maintain any of our permits or approvals or to apply
for permits and approvals on a timely basis, we may be subject to various penalties, including fines and the discontinuation or
restriction of our operations.
As the online game industry is at an early
stage of development in China, new laws and regulations may be adopted from time to time to require additional licenses and permits
other than those we currently have, and address new issues that arise. In addition, substantial uncertainties exist regarding the
interpretation and implementation of current and any future PRC laws and regulations applicable to the online game industry. We
cannot assure you that we will be able to obtain timely, or at all, required licenses or any other new license required in the
future. We cannot assure you that we will not be found in violation of any current PRC laws or regulations should their interpretations
change, or that we will not be found in violation of any future PRC laws or regulations.
Risks Related to Doing Business in China
Changes in China’s economic, political or social conditions
or government policies could have a material adverse effect on our business and operations.
Substantially all of our assets and operations
are located in China. Accordingly, our business, financial condition, results of operations and prospects may be influenced to
a significant degree by political, economic and social conditions in China generally and by continued economic growth in China
as a whole.
The Chinese economy differs from the economies
of most developed countries in many respects, including the level of government involvement, level of development, growth rate,
control of foreign exchange and allocation of resources. Although the Chinese government has implemented measures emphasizing the
utilization of market forces for economic reform, the reduction of state ownership of productive assets, and the establishment
of improved corporate governance in business enterprises, a substantial portion of productive assets in China is still owned by
the government. In addition, the Chinese government continues to play a significant role in regulating industry development by
imposing industrial policies. The Chinese government also exercises significant control over China’s economic growth through
allocating resources, controlling payment of foreign currency-denominated obligations, setting monetary policy, and providing preferential
treatment to particular industries or companies.
While the Chinese economy has experienced
significant growth over the past decades, growth has been uneven, both geographically and among various sectors of the economy.
The Chinese government has implemented various measures to encourage economic growth and guide the allocation of resources. Some
of these measures may benefit the overall Chinese economy, but may 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.
In addition, in the past the Chinese government has implemented certain measures, including interest rate increases, to control
the pace of economic growth. These measures may cause decreased economic activity in China, which may adversely affect our business
and operating results.
Uncertainties with respect to the Chinese legal system could
have a material adverse effect on us.
We conduct substantially all of our operations
through Ningbo Sntaro and Beijing Sntaro, companies established in the PRC. Ningbo Sntaro is generally subject to laws and regulations
applicable to foreign investment in China and, in particular, laws applicable to wholly foreign-owned enterprises. The PRC legal
system is a civil law system based on written statutes. Prior court decisions may be cited for reference but have limited precedential
value. Since 1979, PRC legislation and regulations have significantly enhanced the protections afforded to various forms of foreign
investments in China. However, since these laws and regulations are relatively new and the PRC legal system continues to rapidly
evolve, the interpretations of many laws, regulations and rules are not always uniform and enforcement of these laws, regulations
and rules involves uncertainties. We cannot predict the effect of future developments in the PRC legal system, including the promulgation
of new laws, changes to existing laws or the interpretation or enforcement thereof, the preemption of local regulations by national
laws, or the overturn of local government’s decisions by the higher level government. These uncertainties may limit legal
protections available to us. In addition, any litigation in China may be protracted and result in substantial costs and diversion
of resources and management attention.
We must comply with the Foreign Corrupt Practices Act.
We are required to comply with the United
States Foreign Corrupt Practices Act, which prohibits U.S. companies from engaging in bribery or other prohibited payments to foreign
officials for the purpose of obtaining or retaining business. Foreign companies, including some of our competitors, are not subject
to these prohibitions. Corruption, extortion, bribery, pay-offs, theft and other fraudulent practices occur from time-to-time in
mainland China. If our competitors engage in these practices, they may receive preferential treatment from personnel of some companies,
giving our competitors an advantage in securing business or from government officials who might give them priority in obtaining
new licenses, which would put us at a disadvantage. Although we inform our personnel that such practices are illegal, we cannot
assure you that our employees or other agents will not engage in such conduct for which we might be held responsible. If our employees
or other agents are found to have engaged in such practices, we could suffer severe penalties.
Changes in foreign exchange regulations in the PRC may affect
our ability to pay dividends in foreign currency or conduct other foreign exchange business.
The Renminbi is not a freely convertible
currency, and the restrictions on currency exchanges may limit our ability to use revenues generated in Renminbi to fund our business
activities outside the PRC or to make dividends or other payments in United States dollars. The PRC government strictly regulates
conversion of Renminbi into foreign currencies. Over the years, foreign exchange regulations in the PRC have significantly reduced
the government’s control over routine foreign exchange transactions under current accounts. In the PRC, the State Administration
for Foreign Exchange, or the SAFE, regulates the conversion of the Renminbi into foreign currencies. Pursuant to applicable PRC
laws and regulations, foreign invested enterprises incorporated in the PRC are required to apply for “Foreign Exchange Registration
Certificates.” Currently, conversion within the scope of the “current account” (e.g. remittance of
foreign currencies for payment of dividends, etc.) can be effected without requiring the approval of SAFE. However, conversion
of currency in the “capital account” (e.g. for capital items such as direct investments, loans, securities, etc.) still
requires the approval of SAFE.
PRC regulations relating to mergers and acquisitions of domestic
enterprises by foreign investors may increase the administrative burden we face and create regulatory uncertainties.
On August 8, 2006, the Ministry of Commerce
(the “MOC”), joined by the China Securities Regulatory Commission (the “CSRC”), State-owned Assets Supervision
and Administration Commission of the State Council (the “SASAC”), the State Administration of Taxation (the “SAT”),
the State Administration of Industry and Commerce (the “SAIC”), and SAFE, jointly promulgated a rule entitled the Provisions
Regarding Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (the “M&A Rules”), which took effect
as of September 8, 2006. This new regulation, among other things, has certain provisions that require special purpose vehicles,
or SPVs, formed for the purpose of acquiring PRC domestic companies and controlled by PRC individuals, to obtain the approval of
the CSRC prior to publicly listing their securities on an overseas stock market. However, the new regulation does not expressly
provide that approval from the CSRC is required for the offshore listing of the SPV which acquires, directly or indirectly, equity
interest or shares of domestic PRC entities held by domestic companies or individuals by cash payment, nor does it expressly provide
that approval from CSRC is not required for the offshore listing of a SPV which has fully completed its acquisition of equity interest
of domestic PRC equity prior to September 8, 2006. On September 21, 2006, the CSRC published on its official website a notice specifying
the documents and materials that are required to be submitted for obtaining CSRC approval.
It is not clear whether the provisions
in the new regulation regarding the offshore listing and trading of the securities of a SPV applies to an offshore company such
as us which owns controlling contractual interest in the PRC operating entities. We believe that the M&A Rules and the CSRC
approval are not required in the context of the share exchange we consummated in October 2010 because (i) such share exchange is
a purely foreign related transaction governed by foreign laws, not subject to the jurisdiction of PRC laws and regulations; (ii)
we are not a SPV formed or controlled by PRC companies or PRC individuals; and (iii) we are owned or substantively controlled by
foreigners. However, we cannot be certain that the relevant PRC government agencies, including the CSRC, would reach the
same conclusion, and we still cannot rule out the possibility that CSRC may deem that the share exchange circumvented the new M&A
rules, the PRC Securities Law and other rules and notices.
If the CSRC or another PRC regulatory agency
subsequently determines that the CSRC’s approval is required for the share exchange, we may face sanctions by the CSRC or
another PRC regulatory agency. If this happens, these regulatory agencies may impose fines and penalties on our operations in the
PRC, limit our operating privileges in the PRC, delay or restrict the repatriation of the proceeds from this offering into the
PRC, restrict or prohibit payment or remittance of dividends to us or take other actions that could have a material adverse effect
on our business, financial condition, results of operations, reputation and prospects, as well as the trading price of our shares.
The CSRC or other PRC regulatory agencies may also take actions requiring us, or making it advisable for us, to delay or cancel
the transaction.
The M&A Rules, along with foreign exchange
regulations discussed in the above subsection, will be interpreted or implemented by the relevant government authorities in connection
with our future offshore financings or acquisitions, and we cannot predict how they will affect our acquisition strategy. For example,
our operating companies’ ability to remit dividends to us, or to engage in foreign-currency-denominated borrowings, may be
conditioned upon compliance with the SAFE registration requirements by such Chinese domestic residents, over whom we may have no
control. In addition, such Chinese domestic residents may be unable to complete the necessary approval and registration procedures
required by the SAFE regulations. Such uncertainties may restrict our ability to implement our acquisition strategy and adversely
affect our business and prospects.
Currency fluctuations and restrictions on currency exchange
may adversely affect our business, including limiting our ability to convert Chinese Renminbi into foreign currencies and, if Chinese
Renminbi were to decline in value, reducing our revenue in U.S. dollar terms.
Our reporting currency is the U.S. dollar
and our operations in China use the local currency as their functional currencies. Substantially all of our revenue and expenses
are in Chinese Renminbi. We are subject to the effects of exchange rate fluctuations with respect to any of these currencies. For
example, the value of the Renminbi depends to a large extent on Chinese government policies and China’s domestic and international
economic and political developments, as well as supply and demand in the local market. Since 1994, the official exchange rate for
the conversion of Renminbi to the U.S. dollar had generally been stable and the Renminbi had appreciated slightly against the U.S.
dollar. However, on July 21, 2005, the Chinese government changed its policy of pegging the value of Chinese Renminbi to the U.S.
dollar. Under the new policy, Chinese Renminbi may fluctuate within a narrow and managed band against a basket of certain foreign
currencies. As a result of this policy change, Chinese Renminbi continually appreciated approximately 2.6% against the U.S. dollar
in 2005, 3.2% in 2006, 6.4% in 2007, 6.3% in 2008, 0.2% in 2009, 3.3% in 2010 and 3.7% in 2011. It is possible that the Chinese
government could adopt a more flexible currency policy, which could result in more significant fluctuation of Chinese Renminbi
against the U.S. dollar. We can offer no assurance that Chinese Renminbi will be stable against the U.S. dollar or any other foreign
currency.
The income statements of our operations
are translated into U.S. dollars at the average exchange rates in each applicable period. To the extent the U.S. dollar strengthens
against foreign currencies, the translation of these foreign currencies denominated transactions results in reduced revenue, operating
expenses and net income for our international operations. Similarly, to the extent the U.S. dollar weakens against foreign currencies,
the translation of these foreign currency denominated transactions results in increased revenue, operating expenses and net income
for our international operations. We are also exposed to foreign exchange rate fluctuations as we convert the financial statements
of our foreign operating subsidiary and VIEs into U.S. dollars in consolidation. If there is a change in foreign currency exchange
rates, the conversion of the foreign subsidiary and VIEs’ financial statements into U.S. dollars will lead to a translation
gain or loss which is recorded as a component of other comprehensive income. In addition, we have certain assets and liabilities
that are denominated in currencies other than the relevant entity’s functional currency. Changes in the functional currency
value of these assets and liabilities create fluctuations that will lead to a transaction gain or loss. We have not entered
into agreements or purchased instruments to hedge our exchange rate risks, although we may do so in the future. The availability
and effectiveness of any hedging transaction may be limited and we may not be able to successfully hedge our exchange rate risks.
Although Chinese governmental policies
were introduced in 1996 to allow the convertibility of Chinese Renminbi into foreign currency for current account items, conversion
of Chinese Renminbi into foreign exchange for capital items, such as foreign direct investment, loans or securities, requires the
approval of the State Administration of Foreign Exchange, or SAFE, which is under the authority of the People’s Bank of China.
These approvals, however, do not guarantee the availability of foreign currency conversion. We cannot be sure that we will be able
to obtain all required conversion approvals for our operations or those Chinese regulatory authorities will not impose greater
restrictions on the convertibility of Chinese Renminbi in the future. Because a significant amount of our future revenue may be
in the form of Chinese Renminbi, our inability to obtain the requisite approvals or any future restrictions on currency exchanges
could limit our ability to utilize revenue generated in Chinese Renminbi to fund our business activities outside of China, or to
repay foreign currency obligations, including our debt obligations, which would have a material adverse effect on our financial
condition and results of operations.
Future inflation in China may inhibit our activity to conduct
business in China.
In recent years, the Chinese economy has
experienced periods of rapid expansion and high rates of inflation. These factors have led to the adoption by Chinese government,
from time to time, of various corrective measures designed to restrict the availability of credit or regulate growth and contain
inflation. High inflation may in the future cause Chinese government to impose controls on credit and/or prices, or to take
other action, which could inhibit economic activity in China, and thereby harm the market for our products.
We may have difficulty establishing adequate management,
legal and financial controls in the PRC.
We may have difficulty in hiring and retaining
a sufficient number of qualified employees to work in the PRC. As a result of these factors, we may experience difficulty
in establishing management, legal and financial controls, collecting financial data and preparing financial statements, books of
account and corporate records and instituting business practices that meet Western standards. We may have difficulty establishing
adequate management, legal and financial controls in the PRC.
You may experience difficulties in effecting service of legal
process, enforcing foreign judgments or bringing original actions in China based on United States or other foreign laws against
us and our management.
We conduct substantially all of our operations
in China and substantially all of our assets are located in China. In addition, some of our directors and executive officers reside
within China. As a result, it may not be possible to effect service of process within the United States or elsewhere outside China
upon some of our directors and senior executive officers, including with respect to matters arising under U.S. federal securities
laws or applicable state securities laws. It would also be difficult for investors to bring an original lawsuit against us or our
directors or executive officers before a Chinese court based on U.S. federal securities laws or otherwise. Moreover, China does
not have treaties with the United States or many other countries providing for the reciprocal recognition and enforcement of judgment
of courts.
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 holders of our securities.
Under the new Enterprise Income Tax Law
(or EIT Law), an enterprise established outside of China with its “de facto management body” in China is considered
a “resident enterprise,” meaning that it can be treated the same as a Chinese enterprise for enterprise income tax
purposes. The implementing rules of the new EIT Law defines “de facto management body” as an organization that exercises
“substantial and overall management and control over the production and operations, personnel, accounting, and properties”
of an enterprise. Currently no interpretation or application of the new EIT Law and its implementing rules is available, therefore
it is unclear how tax authorities will determine tax residency based on the facts of each case.
If the PRC tax authorities determine that
China Net is a “resident enterprise” for PRC enterprise income tax purposes, a number of unfavorable PRC tax consequences
could follow. First, we will be subject to enterprise income tax at a rate of 25% on our worldwide income as well as PRC enterprise
income tax reporting obligations. This would mean that income such as interest on offering proceeds and other 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 by our PRC subsidiary 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, a 10% withholding tax will be imposed on dividends we pay to our non-PRC
shareholders.
Our PRC operating companies are obligated to withhold and
pay PRC individual income tax in respect of the salaries and other income received by their employees who are subject to PRC individual
income tax. If they fail to withhold or pay such individual income tax in accordance with applicable PRC regulations, they may
be subject to certain sanctions and other penalties, which could have a material adverse impact on our business.
Under PRC laws, Ningbo Sntaro and the our
other PRC operating entities will be obligated to withhold and pay individual income tax in respect of the salaries and other income
received by their employees who are subject to PRC individual income tax. Such companies may be subject to certain sanctions and
other liabilities under PRC laws in case of failure to withhold and pay individual income taxes for its employees in accordance
with the applicable laws.
In addition, the SAT has issued several
circulars concerning employee stock options. Under these circulars, employees working in the PRC (which could include both PRC
employees and expatriate employees subject to PRC individual income tax) are required to pay PRC individual income tax in respect
of their income derived from exercising or otherwise disposing of their stock options. Our PRC entities will be obligated to file
documents related to employee stock options with relevant tax authorities and withhold and pay individual income taxes for those
employees who exercise their stock options. While tax authorities may advise us that our policy is compliant, they may change their
policy, and we could be subject to sanctions.
Because Chinese laws will govern almost all of our business’
material agreements, we may not be able to enforce our rights within the PRC or elsewhere, which could result in a significant
loss of business, business opportunities or capital.
Unlike common law systems, the Chinese legal
system is a system in which decided legal cases have little precedential value. Although legislation in the PRC over the past 30
years has significantly improved the protection afforded to various forms of foreign investment and contractual arrangements in
the PRC, these laws, regulations and legal requirements are relatively new. Due to the limited volume of published judicial decisions,
their non-binding nature, the short history since their enactments, the discrete understanding of the judges or government agencies
of the same legal provision, inconsistent professional abilities of the judicators, and the inclination to protect local interest
in the court rooms, interpretation and enforcement of PRC laws and regulations involve uncertainties, which could limit the legal
protection available to us, and foreign investors, including you. The inability to enforce or obtain a remedy under any of our
future agreements could result in a significant loss of business, business opportunities or capital and could have a material adverse
impact on our business, prospects, financial condition, and results of operations. In addition, the PRC legal system is based in
part on government policies and internal rules (some of which are not published on a timely basis or at all) that may have a retroactive
effect. As a result, we may not be aware of our violation of these policies and rules until a period of time after the violation.
In addition, any litigation in the PRC, regardless of outcome, may be protracted and result in substantial costs and diversion
of resources and management attention.
We face risks related to health epidemics and other natural
disasters.
Our business could be adversely affected
by the effects of avian flu, SARS or other epidemics or outbreaks. China reported a number of cases of SARS in 2003, which resulted
in the closure by the PRC government of many businesses in May and June of 2003 to prevent the transmission of SARS. In recent
years, there have been reports of occurrences of avian flu in various parts of China, including a few confirmed human cases and
deaths. Any prolonged recurrence of avian flu, SARS or other adverse public health developments in China may have a material adverse
effect on our business operations. These could include illness and loss of our management and key employees, as well as temporary
closure of our offices and related other businesses, such as server operations, upon which we rely. Such loss of management and
key employees or closures would severely disrupt our business operations. We have not adopted any written preventive measures or
contingency plans to combat any future outbreak of avian flu, SARS or any other epidemic. In addition, other major natural disasters
may also adversely affect our business by, for example, causing disruptions of the Internet network or otherwise affecting access
to our games.
Risks Related to our Securities
Insiders have substantial control over us, and they could
delay or prevent a change in our corporate control even if our other stockholders wanted it to occur.
Our executive officers, directors, and principal
stockholders hold approximately 54% of our outstanding common stock. Accordingly, these stockholders are able to exert substantial
influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate
transactions. This could delay or prevent an outside party from acquiring or merging with us even if our other stockholders
wanted it to occur.
There may not be sufficient liquidity in the market for our
securities in order for investors to sell their securities.
There is currently only a limited public
market for our Common Stock and there can be no assurance that a trading market will develop further or be maintained in the future.
As of November 12, 2012, the closing trade price of our Common Stock was $0.32 per share. As of November 12, 2012,
we had approximately 383 shareholders of record of our Common Stock, not including shares held in street name. In
addition, during the past two years our Common Stock has had a trading range with a low price of $0.1253 per share and a high price
of $5.35 per share.
The market price of our Common Stock may be volatile.
The market price of our Common Stock has
been and will likely continue to be highly volatile, as is the stock market in general. Some of the factors that may materially
affect the market price of our Common Stock are beyond our control, such as changes in financial estimates by industry and securities
analysts, conditions or trends in the industry in which we operate or sales of our common stock. These factors may materially adversely
affect the market price of our Common Stock, regardless of our performance. In addition, the public stock markets have experienced
extreme price and trading volume volatility particularly for companies whose primary operations are located in the PRC. This volatility
has significantly affected the market prices of securities of many companies for reasons frequently unrelated to the operating
performance of the specific companies. These broad market fluctuations may adversely affect the market price of our Common Stock.
Our officers and directors have limited experience in public
company reporting, which could impact our ability to satisfy public company filing requirements and increase our securities compliance
costs.
Our officers and directors have limited
experience as officers and directors of a publicly traded company, or in complying with the regulatory requirements applicable
to a public company. As a result, we could have difficulty satisfying the regulatory requirements applicable to public companies,
which could adversely affect the market for our common stock. Although our local financial and accounting team is well trained
and has increased their technical expertise in US GAAP and other public company filing requirements during last year and through
the quarter ended September 30, 2012, we continue to rely upon outside experts to advise us on matters relating to public company
reporting and US GAAP. However, we believe that this role will be assumed by our local financial and accounting team as our next
step of our remediation plan in the future.
Because the Company became public by means of a reverse merger,
it may not be able to attract the attention of major brokerage firms.
Additional risks may exist since the Company
became public through a “reverse merger.” Securities analysts of major brokerage firms may not provide coverage
of the Company since there is little incentive to brokerage firms to recommend the purchase of its Common Stock. No assurance
can be given that brokerage firms will want to conduct any secondary offerings on behalf of the Company in the future.
We may need additional capital and may sell additional securities
or other equity securities or incur indebtedness, which could result in additional dilution to our shareholders or increase our
debt service obligations.
We may require additional cash resources
due to changed business conditions or other future developments, including any investments or acquisitions we may decide to pursue.
If our cash resources are insufficient to satisfy our cash requirements, we may seek to sell additional equity or debt securities
or obtain a credit facility. The sale of additional equity securities or equity-linked debt securities could result in additional
dilution to our shareholders. The incurrence of indebtedness would result in increased debt service obligations and could result
in operating and financing covenants that would restrict our operations. We cannot assure you that financing will be available
in amounts or on terms acceptable to us, if at all.
We have not paid dividends in the past and do not expect
to pay dividends in the future, and any return on investment may be limited to the value of our stock.
We have never paid any cash dividends on
our common stock and do not anticipate paying any cash dividends on our common stock in the foreseeable future and any return on
investment may be limited to the value of our stock. We plan to retain any future earning to finance growth.
Techniques employed by manipulative short sellers in Chinese
small cap stocks may drive down the market price of our common stock.
Short selling is the practice of selling
securities that the seller does not own but rather has, supposedly, borrowed from a third party with the intention of buying identical
securities back at a later date to return to the lender. The short seller hopes to profit from a decline in the value of the securities
between the sale of the borrowed securities and the purchase of the replacement shares, as the short seller expects to
pay less in that purchase than it received in the sale. As it is therefore in the short seller’s best interests
for the price of the stock to decline, many short sellers (sometime known as “disclosed shorts”) publish, or arrange
for the publication of, negative opinions regarding the relevant issuer and its business prospects in order to create negative
market momentum and generate profits for themselves after selling a stock short. While traditionally these disclosed shorts
were limited in their ability to access mainstream business media or to otherwise create negative market rumors, the rise of the
Internet and technological advancements regarding document creation, videotaping and publication by weblog (“blogging”)
have allowed many disclosed shorts to publicly attack a company’s credibility, strategy and veracity by means of so-called
research reports that mimic the type of investment analysis performed by large Wall Street firm and independent research analysts.
These short attacks have, in the past, led to selling of shares in the market, on occasion in large scale and broad base.
Issuers with business operations based in China and who have limited trading volumes and are susceptible to higher volatility levels
than U.S. domestic large-cap stocks can be particularly vulnerable to such short attacks.
These short seller publications are not
regulated by any governmental, self-regulatory organization or other official authority in the U.S., are not subject to the certification
requirements imposed by the Securities and Exchange Commission in Regulation AC (Regulation Analyst Certification) and, accordingly,
the opinions they express may be based on distortions of actual facts or, in some cases, fabrications of facts. In light
of the limited risks involved in publishing such information, and the enormous profit that can be made from running just one successful
short attack, unless the short sellers become subject to significant penalties, it is more likely than not that disclosed shorts
will continue to issue such reports.
While we intend to strongly defend our public
filings against any such short seller attacks, oftentimes we are constrained, either by principles of freedom of speech, applicable
state law (often called “Anti-SLAPP statutes”), or issues of commercial confidentiality, in the manner in which we
can proceed against the relevant short seller. You should be aware that in light of the relative freedom to operate that
such persons enjoy – oftentimes blogging from outside the U.S. with little or no assets or identity requirements –
should we be targeted for such an attack, our stock will likely suffer from a temporary, or possibly long term, decline in market
price should the rumors created not be dismissed by market participants.
Our Common Stock is considered “penny stock.”
The SEC has adopted regulations which generally
define “penny stock” to be an equity security that has a market price of less than $5.00 per share, subject to specific
exemptions. The market price of our common stock is currently less than $5.00 per share and therefore may be a “penny
stock.” Brokers and dealers effecting transactions in “penny stock” must disclose certain information
concerning the transaction, obtain a written agreement from the purchaser and determine that the purchaser is reasonably suitable
to purchase the securities. These rules may restrict the ability of brokers or dealers to sell the common stock and may affect
your ability to sell shares.
The market for penny stocks has experienced numerous frauds
and abuses which could adversely impact investors in our stock.
OTCBB securities are frequent targets of
fraud or market manipulation, both because of their generally low prices and because OTCBB reporting requirements are less stringent
than those of the stock exchanges or NASDAQ.
Patterns of fraud and abuse include:
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Control of the market for the security by one or a few broker-dealers that are often related to the promoter or issuer;
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Manipulation of prices through prearranged matching of purchases and sales and false and misleading press releases;
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“Boiler room" practices involving high pressure sales tactics and unrealistic price projections by inexperienced sales persons;
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Excessive and undisclosed bid-ask differentials and markups by selling broker-dealers; and
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Wholesale dumping of the same securities by promoters and broker-dealers after prices have been manipulated to a desired level, along with the inevitable collapse of those prices with consequent investor losses.
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Our management is aware of the abuses that have occurred historically
in the penny stock market.