ArthroCare: The Distributor Bought With the Seller’s Money

The ArthroCare securities fraud scheme used distributor inventory to inflate reported sales and caused more than $750 million in investor losses, according to the Justice Department’s account of the criminal case. Executives chose shipments to meet Wall Street forecasts, then reported the devices as sales while they sat with distributors. For someone inside sales, distribution or finance, the revealing details were the promises that went with the boxes: extra time to pay, cash commissions and permission to send products back.

ArthroCare was a publicly traded medical-device manufacturer based in Austin, Texas. Its surgical products included SpineWands, used to treat patients with spinal injuries. The company’s relationship with DiscoCare, a distributor supplied only by ArthroCare, became central to how sales reached the financial statements.

ArthroCare Channel Stuffing Started With the Revenue Target

ArthroCare channel stuffing worked backward from the revenue the company wanted to report. According to the criminal trial evidence described by the Justice Department, executives determined the type and quantity of devices to ship from the amount needed to meet analyst forecasts. They parked inventory at distributors near quarter-end and counted the shipments as sales in quarterly and annual filings. The criminal case described a scheme running from 2005 through 2009.

The Securities and Exchange Commission’s February 2011 order concerning ArthroCare described the same pressure inside the spine business. The agency said employees initiated large orders to fill revenue shortfalls even though DiscoCare had excess inventory and little prospect of selling it within a reasonable time. It described payment terms that let DiscoCare wait until it had sufficient funds, and weaknesses in sales controls that allowed personnel to withhold critical information from accounting staff.

The manufacturer needed a number before the quarter closed. The distributor supplied the place to put the devices.

DiscoCare’s Payment Terms Kept Unsold Inventory Moving

DiscoCare’s capacity to sell and pay for the devices mattered as much as the shipping record. In its 2012 civil complaint seeking repayment of executive compensation, the agency alleged that the distributor had close operational ties to ArthroCare. Former ArthroCare employees helped run it, some remained on ArthroCare’s payroll and benefits, and the businesses shared office space.

According to that complaint, health insurers’ reimbursement restrictions had slowed SpineWand sales to hospitals and other health care facilities. DiscoCare grew out of an arrangement in which treatment for accident victims would be paid from later settlements with liability insurers. That made collections dependent on when those settlements arrived. The complaint alleged that collections took longer than expected, leaving DiscoCare unable to pay even for its initial stocking order. ArthroCare nevertheless sought another order and offered expanded territory in exchange.

At ArthroCare, the complaint alleged, the terms kept changing to support the desired revenue. Under a revised DiscoCare agreement, the price varied with the source of payment, and revenue was supposed to wait until the underlying surgery had occurred. Near year-end, sales executives persuaded accounting personnel to record additional sales on assurances that the procedures would happen the following quarter. On the agency’s account, the financial statements were getting ahead of the surgeries.

Returns Could Move Revenue Into Another Quarter

The Securities and Exchange Commission alleged that ArthroCare also used returns to move revenue out of a quarter that had done too well. Its complaint said that, the day before the second quarter of 2006 ended, sales executives asked DiscoCare for a $500,000 order despite its existing oversupply. The day after the quarter closed, an executive realized the order was unnecessary to meet the target and decided to move half into the following quarter.

The problem, according to the agency’s order, was that exceeding analysts’ expectations could cause them to set the next quarter’s estimates too high. ArthroCare requested a return to manage that expectation.

The complaint alleged that the executive instructed DiscoCare to request a return authorization, then gave accounting staff a false account of its timing. He said the return had been agreed before quarter-end and the paperwork had merely been delayed. When the outside auditor asked, he said distributors had ordered the wrong products or quantities. In the complaint’s account, the internal reason was the revenue target. The explanation given to the people checking the books was a customer mistake.

A Stocking Letter Written by the Seller

The complaint alleged that ArthroCare manufactured apparent customer demand by writing the customer’s request itself. It described a spine sales executive ghostwriting a letter for DiscoCare in March 2007, saying it needed safety stock to supply surgeons promptly. According to the complaint, DiscoCare already held excess inventory, but ArthroCare used the letter to support recognizing another shipment as immediate revenue.

The agency alleged that, near the end of the next quarter, sales executives wanted approximately $2.1 million in shipments to meet analyst expectations, while DiscoCare had only $900,000 in approved cases expected to be completed before quarter-end. The executives allegedly hid the smaller figure from accounting staff.

Fees Made the Sales Look Bigger

The Securities and Exchange Commission’s order described how ArthroCare’s distributor payments changed the appearance of its sales. According to the agency, commissions tied to sales volume were labeled service fees, letting ArthroCare record the full selling price as revenue and treat the payment back to the distributor as an expense. The complaint alleged that this change inflated revenue by $4.5 million.

According to the complaint, an executive preferred to explain the fee calculation verbally or in a nonbinding side letter. When an accountant questioned a calculation, the executive told sales staff to adjust or round the payment amount to avoid detection.

The complaint alleged that an unnamed distributor other than DiscoCare bought with ArthroCare’s own money. The agency alleged that ArthroCare kept demanding larger orders while knowing the distributor could not pay, and promised orally that payment was due only on products resold. According to the complaint, this distributor paid ArthroCare only from the quarterly marketing fees ArthroCare paid it based on the amount of product ordered. The complaint put the result this way:

A similar concealment appeared in the Securities and Exchange Commission’s accounting-fraud allegations against Lucent Technologies. The agency alleged that executives promised distributors extra rights, including returns when sales to end customers failed to materialize, and withheld those promises from finance staff. In both accounts, people booking revenue were missing terms that changed the sale.

Buying the Distributor Hid the Unpaid Balance

DiscoCare’s unpaid balance eventually became a disclosure problem of its own. The complaint alleged that the amount owed had reached $13 million, or 19% of ArthroCare’s total customer receivables. It was hurting the measure analysts used to track how quickly customers paid. Recognizing a potential loss on that balance would also hurt earnings.

ArthroCare acquired DiscoCare effective December 31, 2007. According to the complaint, bringing the distributor inside the company would eliminate the receivable from the combined balance sheet while leaving earlier sales in the income statement. The complaint also alleged that executives approved another shipment before the acquisition and asked DiscoCare to delay selling those wands until afterward, allowing ArthroCare to book revenue on the same devices again.

The Justice Department’s account of the criminal trial separately said the chief executive caused the acquisition to conceal the nature and financial significance of the DiscoCare relationship from investors. The acquisition became part of the concealment.

The Financial Statements Had to Be Rewritten

ArthroCare restated its financial statements after an internal review. The agency’s complaint put the overstatement of 2007 revenue at $39.5 million and the overstatement of that year’s net income at $42.7 million. Moving shipments and payments between accounting categories had changed what investors understood about both sales and earnings.

The agency’s order recorded tighter revenue controls and standard customer contracts with approval requirements for changes.

The Justice Department’s account of the criminal trial also described the chief executive’s false testimony to the Securities and Exchange Commission about ArthroCare’s relationship with DiscoCare.

What Evidence Is Needed to Prove Fraud?

We work with you to determine what your information can establish. In ArthroCare’s case, purchase orders and fee schedules left out the promises that changed the sale. The complaint described oral payment assurances, a stocking request written by the seller and information kept from accounting staff.

A distributor employee may know who promised payment could wait. A sales employee may know why a return was requested or who drafted a customer’s letter. A finance employee may have seen the revenue target beside the unpaid balance. We connect those accounts to the company’s reported results and work out with you what supports a whistleblower case.

When Device Sales Reach Medicare Bills

The complaint traced DiscoCare’s business model to health insurers’ reimbursement restrictions. ArthroCare’s securities case concerned how the company reported sales from that model to investors. If the devices you know about were also billed to Medicare, we examine the provider’s bill and the manufacturer’s instructions with you. A whistleblower case under the False Claims Act can pay 15% to 30% of what the government recovers. We work with you to identify which payments and representations your information concerns.

You Know What the Distributor Was Promised

If the orders or payment promises you know about also connect to Medicare bills, tell our whistleblower experts what happened inside the sale. We build your strongest False Claims Act whistleblower case with you, bring in medical-device fraud whistleblower lawyers who understand the sales and billing connection, and stay alongside you through the process.