Two Former Senior Executives of ArthroCare Corp. Arrested in $400 Million Securities Fraud Scheme

WASHINGTON—Two former senior executives of Austin, Texas-based ArthroCare Corp., a publicly traded medical device company, were arrested this morning in Morristown, New Jersey and Orange County, California for their alleged roles in a scheme to defraud the company’s shareholders and members of the investing public by falsely inflating ArthroCare’s earnings by tens of millions of dollars, announced Assistant Attorney General Lanny A. Breuer of the Department of Justice’s Criminal Division and U.S. Attorney Robert Pitman for the Western District of Texas. The department said that the loss to the company’s shareholders and the investing public was more than $400 million.

A 16-count indictment was unsealed today in the U.S. District Court for the Western District of Texas against John Raffle, the former senior vice president of strategic business units of ArthroCare and David Applegate, the former senior vice president in charge of ArthroCare’s spine division. Raffle was arrested in Morristown and Applegate was arrested in Orange County.

The indictment, which was originally returned on August 21, 2012, charges Raffle and Applegate 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 unsealed today alleges that these senior corporate executives participated in a scheme to artificially inflate their company’s stock prices, cheating shareholders and the investing public out of hundreds of millions of dollars,” said Assistant Attorney General Breuer. “The Criminal Division will continue to vigorously pursue those who defraud American investors.”

According to the indictment, between in or about December 2005 through in or about December 2008, Raffle, Applegate, and other senior executives and employees of ArthroCare allegedly inflated falsely ArthroCare’s sales and revenue through a series of end-of-quarter transactions involving several of ArthroCare’s distributors. According to court documents, Raffle and Applegate determined the type and amount of product to be shipped to distributors based on ArthroCare’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 worth of ArthroCare’s 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 shipped product to DiscoCare that far exceeded DiscoCare’s needs at Raffle and Applegate’s direction.

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.

According to the indictment, in the third quarter of 2007, 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 under the Son of DRS program because ArthroCare acquired DiscoCare before any payments came due. The indictment alleges that, between August and November 2007, 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.

According to court documents, between December 2005 and December 2008, ArthroCare’s shareholders held more than 25 million shares of ArthroCare stock. On July 21, 2008, after ArthroCare announced publicly that it 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. The drop in ArthroCare’s share price caused an immediate loss in shareholder value of more than $400 million.

Upon conviction, Raffle and Applegate face a maximum prison sentence of five years for the conspiracy charge and 20 years for each count of mail and wire fraud. Raffle and Applegate also face a maximum sentence of 25 years in prison for each securities fraud count.

An indictment is merely a charge, and the defendants are presumed innocent until proven guilty.

The case is being prosecuted by Assistant Chief Benjamin D. Singer and Trial Attorney Henry P. Van Dyck of the Criminal Division’s Fraud Section. This case was investigated by the FBI’s Austin Resident Agency.