ArthroCare Securities: Dealings Lead to Potential Lawsuit


. By Gordon Gibb

There is nothing more complicated than the various dealings of a major corporation, the results of which can leave your head spinning. However, the announcement of a class-action lawsuit against ArthroCare Corporation alleging securities fraud appears to suggest that such complexities, and the motivation behind them, can hit investors in the pocketbook.

At issue is the alleged issuance of various false and misleading statements concerning business dealings and financial results that may have served to drive down the value of Arthro stock, which at one point was trading as high as $64.84 until recently, a price suspected as being artificially high due to the alleged machinations of the company. However, that same stock was worth $38.11 as of January 25th of this year once news stories and various reports exposed the alleged wrongdoing, and investors lost ground in the process.

The class action is seeking plaintiffs who may have purchased ArthroCare stock at the artificially inflated price.

ArthroCare designs, develops, manufactures and markets medical devices for use in soft-tissue surgery. In recent months, the company has been taken to task over its relationship with DiscoCare, a company reportedly founded by senior ArthroCare employees that serves as ArthroCare's largest customer in its spine division.

It has been reported that ArthroCare recently acquired DiscoCare for $25 million.

ArthroCare has been accused, among other things, of employing bill-and-hold accounting, a practice that is perfectly legal but reportedly can only be employed if requested by a customer, and only if the customer identifies a legitimate reason, for business purposes, as the basis for that request.

However, given the allegation that DiscoCare is owned by ArthroCare, has the latter as its only vendor and sells only ArthroCare spine wands, transactions between the two could be interpreted as 'related party.'

The allegation is that ArthroCare's reported financial results were materially overstated due to the improper recognition of revenue from transactions involving an ArthroCare 'sales agent,' as well as transactions with a related party. An alleged violation of Generally Accepted Accounting Practices (GAAP) was realized through the recognition of revenue where payment for the shipment of ArthroCare's products was contingent upon the decision of third-party payers to pay for the product or the successful resolution of personal injury lawsuits, and recognizing revenue from bill-and-hold transactions between the Company and its 'sales agent' involving products that were to be paid for, according to the contingent payment arrangement.

It should be noted that a previous drop in ArthroCare stock at the beginning of the decade caused much gnashing of teeth in the investment community, after the company appeared to drag its heals over the implementation of a new accounting rule at the behest of the Securities & Exchange Commission (SEC) that would serve to outlaw the front-loading of licensing and royalty fees from multi-year contracts. The SEC dictated that companies earning licensing fees and royalties where applicable would be required instead to spread those fees over the life of the contract term.

It was reported that ArthroCare was making a habit—perfectly legal at the time—of booking fees all at once, which helped the company double its sales every year since the 1990s. When, in 1999 the company moved into the black, stock prices began to rise and hit a high of $62 in late February of 2000.

Other companies employing the front-loading tactics opted to comply with the new SEC rules sooner than later; given the expectation that stock price would drop over the interim. Among the early movers to compliance, according to Forbes magazine, was Cima Labs, a manufacturer of fast-dissolving tablets serving the drug industry. Thinking it prudent to get the pain over with, the company made the accounting change and saw its stock price drop modestly from $19 to $13 per share after the fact.

However, ArthroCare stalled for almost a year before finally implementing the revision. In so doing, the stock price tumbled from a high of $62 in February of that year, to just $18. While investors were left grumbling, it was reported that ArthroCare CEO Michael Baker triggered a sale of his own shares at the high mark of $62 per share, netting a reported $10.6 million.

In the latest instance, ArthroCare stands accused of artificially inflating the stock price through misrepresentations to $64.84 per share. However, once reports surfaced questioning the accuracy of ArthroCare's reported financial results, and its various business dealings with the identified sales agent and related party, the stock price tumbled, potentially hurting investors in the process.

Investors, who may have purchased ArthroCare stock between August 4, 2006 and January 23rd of this year, might wish to familiarize with the pending class action, filed in the US District Court for the Southern District of Florida, in an effort to recoup losses.