On the morning of August 22, 2012, federal agents in Orange County, California and Morristown, New Jersey, arrested John Raffle and David Applegate on 16-count indictments for cheating investors.
Raffle and Applegate were both former senior vice presidents of Austin-based ArthroCare Corporation. Call it Rafflegate.
According to an August 22 U.S. Department of Justice (DOJ) press release, the pair allegedly schemed to defraud the company’s shareholders by falsely inflating ArthroCare’s earnings by tens of millions of dollars. The government says the loss to shareholders was more than $400 million.
Conspiracy, Wire, Mail and Securities Fraud Charges
Both men were charged with one count of conspiracy to commit wire, mail and securities fraud; four counts of wire fraud; eight counts of mail fraud; and three counts of securities fraud. The indictment also seeks forfeiture of assets held by Raffle and Applegate.
The indictment charges that between December 2005 through December 2008, Raffle and Applegate inflated ArthroCare’s sales and revenues through a series of end-of-the quarter transactions involving several of the company’s distributors. We detail some of those transactions below.
“Parking” Devices
According to court documents, Raffle and Applegate determined the type and amount of product to be shipped to distributors based on the company’s need to meet Wall Street analyst forecasts, rather than distributors’ actual orders. Raffle, Applegate and others then allegedly caused ArthroCare to “park” millions of dollars of medical devices at its distributors at the end of each relevant quarter. ArthroCare would then report these shipments as sales in its quarterly and annual filings at the time of the shipment, enabling the company to meet or exceed internal and external earnings forecasts.
According to the indictment, ArthroCare’s distributors agreed to accept shipment of millions of dollars of product in exchange for substantial, upfront cash commissions, extended payment terms and the ability to return product, as well as other special conditions, allowing ArthroCare to inflate falsely its revenue by tens of millions of dollars. ArthroCare did not disclose the conditions of the purported sales to investors.
The indictment further alleges that Raffle, Applegate and others used DiscoCare, a privately owned Delaware corporation, as one of the distributors to cover shortfalls in ArthroCare’s revenue. According to the indictment, ArthroCare, at Raffle and Applegate’s direction, shipped product to DiscoCare that far exceeded DiscoCare’s needs.
$37 Million Phantom Sales
According to court documents, between the fourth quarter of 2005 and the fourth quarter of 2007, ArthroCare reported more than $37 million in revenue in its publicly filed financial statements based on purported sales to DiscoCare. However, during the same time period, DiscoCare’s actual net cash payments to ArthroCare for the products were less than $50, 000. Court documents further allege that, to conceal the fact that DiscoCare owed ArthroCare a substantial amount of money on unused inventory, Raffle and Applegate caused ArthroCare to acquire DiscoCare on December 31, 2007.
In the third quarter of 2007, according to the indictment, Raffle and Applegate began a new program at ArthroCare, called “Son of DRS.” Under the Son of DRS program, ArthroCare allegedly shipped medical devices from its sports division to its customers free of charge and recorded the revenue once DiscoCare had been invoiced for the product. According to court documents, DiscoCare never was required to pay ArthroCare for any of the product DiscoCare purportedly purchased because ArthroCare acquired DiscoCare before any payments came due.
The indictment further alleges that Raffle and Applegate caused ArthroCare to falsely report more than $7 million in revenue in its publicly filed financial statements based on purported sales to DiscoCare under this program.
$400 Million Share Loss
Between December 2005 and December 2008, ArthroCare’s shareholders held more than 25 million shares of company stock. On July 21, 2008, after announcing that the company would be restating its previously reported financial results from the third quarter 2006 through the first quarter 2008 to reflect the results of an internal investigation, the price of ArthroCare shares dropped from $40.03 to $23.21 per share, an immediate loss in shareholder value of more than $400 million.
The arrests of Raffle and Applegate follow an announcement on November 28, 2011 that ArthroCare reached an agreement in principle to settle a private securities class action lawsuit filed by former shareholders. The settlement called for a $74 million settlement fund.
Start of Alleged Conspiracy
According to a June 2011 lawsuit filed by the Securities and Exchange Commission (SEC) against Raffle and Applegate, sales in ArthroCare’s spine unit were stagnant in 2004 because health insurers were beginning to cut reimbursement for the unit’s primary device, the SpineWand.
West Palm Beach skyline. Source: WikimediaThere was one customer however, whose sales increased. That customer, the Palm Beach Lakes Surgery Center (PBLSC), allegedly had a unique arrangement with a local personal injury law firm whereby they would provide wands and treatment to the firm’s clients in return for assignment of rights in subsequent settlements with the liability insurers. PBLSC allegedly invoiced the law firm for the wand and associated medical services, which the law firm then used as part of settlement negotiations with liability and worker’s compensation insurers. When the insurer settled, PBLSC got paid.
This arrangement, according to the SEC complaint, allowed PBLSC to move a high volume of SpineWands while circumventing reimbursement restrictions.
Birth of DiscoCare
The SEC says PBLSC’s founders hoped to replicate this success on a broader scale and, with Applegate’s assistance, founded DiscoCare. DiscoCare then allegedly hired a former top ArthroCare salesman and a number of other former ArthroCare employees to help run the company. Some remained on ArthroCare’s payroll and insurance benefits program. DiscoCare also shared office space with an ArthroCare branch office, which was DiscoCare’s only supplier.
The first distributor agreement between the two companies was executed on December 23, 2005, with an initial stocking order of $975, 000. Because the sale was not contingent upon DiscoCare’s ability to resell the devices or obtain collection, ArthroCare recorded the revenue immediately upon shipment.
Meeting Quarterly Projections
That order was ArthroCare’s largest order of that quarter, by far, and allowed, according to the SEC, ArthroCare to meet is Q4 2005 revenue expectations. Raffle refused requests by ArthroCare finance personnel to check DiscoCare’s background and credit and instead, gave DiscoCare lengthier payment terms than usually afforded to distributors.
Then the next quarter came along and ArthroCare realized it would fall short of Q1 2006 revenue projections. Because collections under DiscoCare’s arrangement with the law firm were taking much longer than expected, the SEC says DiscoCare lacked cash to pay for any future orders, as well as for the initial stocking order which DiscoCare had not yet paid for.
Yet, ArthroCare expanded DiscoCare’s territory and Raffle and Applegate allegedly asked DiscoCare to place another $975, 000 order. DiscoCare agreed and ArthroCare reached its revenue target for Q1 2006.
The day before the end of the following quarter (Q2 2006), Raffle and Applegate asked DiscoCare to place a $500, 000 order. The day after the quarter closed, the SEC alleges that Raffle realized ArthroCare really hadn’t needed the previous order and decided to “move” half of the $500, 000 order to the third quarter.
New DiscoCare Agreement
In November 2006, ArthroCare and DiscoCare executed a new distributor agreement whereby DiscoCare would receive a “monthly service fee.” ArthroCare then credited half of the monthly service fee to pay for DiscoCare’s outstanding receivable balance.
The new agreement, claims the SEC, also changed how ArthroCare recognized revenue from DiscoCare. Originally, ArthroCare recognized sales upon shipment of product to DiscoCare. Under the new arrangement, revenue was recognized only after the surgery had been performed.
Almost immediately, says the SEC, ArthroCare sought to circumvent this new requirement. With less than two weeks left in 2006, Raffle needed to find $2 million in revenue to meet the annual sales target. “As usual, ” said the SEC, “Raffle and Applegate looked to DiscoCare.” But there wasn’t enough time to complete $2 million worth or surgeries by year end. So, the duo convinced ArthroCare accounting personnel to record the sales as 2006 revenue on the assurance that the cases would be completed by the following quarter. They also negotiated a retroactive 10% price increase, increasing the company’s total revenue by 1%.
There are further SEC allegations. We don’t have space to note them all, but you get the picture.
ArthroCare Acquires DiscoCare
During the second half of 2007, the company realized that DiscoCare’s accounts receivable balance had ballooned to $13 million (or 19% of ArthroCare’s total accounts receivable) and the duo wondered if “this may force our hand [with regard to] buying them out early.” So ArthroCare acquired DiscoCare, effective December 31, 2007. The acquisition would eliminate the receivables, but not erase prior sales.
Double Booking
“Raffle and Applegate, however, were not content with this outcome, ” stated the SEC complaint.
Before completion of the acquisition, Raffle and Applegate allegedly approved shipment of $1.5 million in SpineWands to DiscoCare. They then asked DiscoCare to delay selling the wands until after the acquisition was closed. Now ArthroCare could book the same sales twice. They also expensed the marketing fee, allowing, claims the SEC, ArthroCare to inflate revenue by $4.5 million.
Image created by RRY Publications, LLC. Sources: Morguefile and mensaticAs a result, the SEC claims ArthroCare overstated revenue by $19.3 million in 2006, $39.5 million in 2007, and $13.5 million in Q1 2008. They also overstated net income by $4.0 million in 2006, $42.7 million in 2007, and $7.0 million in Q1 2008.
David Applegate has a LinkedIn profile that says he had global profit and loss responsibility for the spine business unit and directly managed marketing, sales and R&D functions.
“In 2004, Spine sales were approximately $13 [million per year] and declining. I repositioned the product line as a highly profitable practice builder for orthopedic spine and neurosurgeons. I focused sales and product development efforts towards surgeons and away from interventional pain physicians. In addition, I implemented an innovative reimbursement model that was highly successful. Subsequently, Spine business unit sales nearly tripled over a three year period to $37 million in 2007 at a standard gross margin of [approximately] 95%, ” states his profile.
The SEC said the duo misled ArthroCare accounting staff and outside auditors about details of some of the DiscoCare arrangements.
In July 2011, the two former company executives settled inventory and sales-manipulation allegations with the SEC without admitting wrong-doing related to manipulation of ArthroCare’s stock.
Raffle agreed to pay $175, 000 of the $2.1 million that a court ruled he was liable for in profits and interest while Applegate agreed to pay $55, 000 of the $728, 224 for which a court ruled that he was liable. Both men reportedly agreed not to work as corporate officers for five years, and to cooperate in any future investigations related to the case.
ArthroCare Pledges Full Cooperation
ArthroCare’s current President and CEO David Fitzgerald has been in his position since 2009.
His office provided us with the following statement for this story: “We are aware of the recent indictment of two former ArthroCare executives. The DOJ investigation concerning the company is still ongoing and indictment of these two former executives does not change that fact. The Company will continue to provide its full cooperation to the DOJ in its ongoing investigation, as we have done since the inception of the investigation.”
Raffle and Applegate could face a maximum prison sentence of five years for the conspiracy charge and 20 years for each count of mail and wire fraud. They also face a maximum sentence of 25 years in prison for each securities fraud count.
