Ex-Arthrocare exec pleads guilty to stock fraud scheme

Ex-Arthrocare exec pleads guilty to stock fraud scheme

Ex-ArthroCare (NSDQ:ARTC) executive David Applegate pleaded guilty this week to federal charges that he helped run a scheme that eventually defrauded investors in the medical device company of some $400 million.

Applegate, 54, pleaded to 1 count of conspiracy to commit securities, mail & wire fraud and another count of making false statements, for regulatory filings made with the SEC containing faked quarterly and annual sales figures.

Applegate and another ex-ArthroCare exec, John Raffle, were arrested last summer and charged by the U.S. Justice Dept. with wire fraud and making false statements in connection with the alleged scheme to artificially inflate ArthroCare’s share price by rigging its sales figures, according to court documents.

The feds accused Applegate and Raffle of generating false revenue numbers designed to meet internal and external forecasts by dumping inventory, first with a distributor called DiscoCare and eventually via free shipments to end-users. ArthroCare was DiscoCare’s only client until it acquired DiscoCare in December 2007, according to the documents.

"Raffle, Applegate and others inflated falsely ArthroCare’s sales and revenue through a series of end-of-quarter transactions involving DiscoCare. After Raffle and Applegate determined the type and amount of product to be shipped to DiscoCare based on ArthroCare’s need to meet sales forecasts, rather than DiscoCare’s needs for the products, Raffle, Applegate and others caused ArthroCare to ship millions of dollars worth of ArthroCare’s medical devices to DiscoCare at the end of quarters. 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 documents.

From the 4th quarter of 2005 until the 4th quarter of 2007, ArthroCare shipped DiscoCare a total of roughly $37 million worth of products, court documents say, with DiscoCare paying less than $50,000 back to ArthroCare during that time.

But the scheme grew too big to cover using the DiscoCare ruse, so Applegate and Raffle allegedly engineered a buyout of the distributor.

"Because ArthroCare continued to ship to DiscoCare more product than there were patients who were actually undergoing surgery with the product, and because DiscoCare could not receive reimbursement from insurance companies for product that was not used during surgery, DiscoCare’s account receivable with ArthroCare began to grow dramatically. From June 2007 to December 2007, DiscoCare’s account receivable to ArthroCare more than doubled, to over $26 million," the documents allege. "To conceal the fact that DiscoCare owed ArthroCare a substantial amount of money on the unused inventory, Raffle and others, with Applegate’s knowledge, caused ArthroCare to acquire DiscoCare on December 31, 2007."

Raffle then allegedly cooked up another scheme to falsely inflate sales, called "Son of DRS," involving the shipment of medical devices from ArthroCare’s sports division to customers for free. ArthroCare would then invoice DiscoCare and record the shipments as revenue.

"Instead of parking inventory at the DiscoCare warehouse, Raffle and others, with Applegate’s knowledge, caused the inventory to be parked at end-users, while simultaneously invoicing DiscoCare," according to the documents. "DiscoCare did not know that it was being invoiced under the ‘Son of DRS’ program for millions and millions of dollars worth of ArthroCare products, and therefore, could not possibly have purchased the products. Between August and November 2007, Raffle and others, with Applegate’s knowledge, caused ArthroCare to falsely report over $7 million in revenue in its publicly filed financial statements based on purported sales to DiscoCare under this program."

Applegate faces a maximum sentence of 5 years in prison for the conspiracy charge and 20 years for the mail and wire fraud charge.

ArthroCare and the Justice Dept. have until the end of this month to hash out a deal over a criminal probe into the Austin, Texas-based company’s spinal business, having extended the deadline 3 times already. The deal was 1st extended in January and again the following month, until March 30.

ArthroCare president & CEO David Fitzgerald told investors during the J.P. Morgan Healthcare conference in San Francisco early this year that the DOJ could ask for an extension.

"The DOJ criminal investigation that began in December of 2008 is ongoing and we continue to actively cooperate with the investigation," Fitzgerald said at the time. "Although the DoJ has not committed to an end date and may request future tolling agreements, we think it’s possible that the DoJ investigation of the company may complete soon."

ArthroCare launched an internal investigation into the DiscoCare sales in July of 2008 and announced that it would restate previously reported financial earnings for the period from Q3 2006 to Q1 2008. The day that announcement was made, ARTC shares dropped from $40.03 to $23.21 per share, a loss of more than 40%.

Earlier this year ArthroCare lost a $74 million settlement to shareholders in a lawsuit accusing the company, former president & CEO Michael Baker and former senior VP and CFO Michael Gluk of making "public statements that were materially false and misleading" in order to inflate share prices.

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