Lawsuit challenging Arthrocare business model and Arthrocare Executive Has Been Referred to Florida’s State Attorney’s Office For Determination of Criminal Charges.

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Could this be the final straw in the “Discocare Model”?

Just last week in the 17th Judicial Court in Broward County Florida a, judge made a determination in a contempt hearing that implicates Arthrocare executive and former Discocare director Michael Denker.

June 12 Court Doc (PDF)

This was a contempt hearing for Mr. Denker amongst others for not answering a deposition in the Islam personal injury case.  This case directly challenged the “Discocare model” as shown here:

http://citronresearch.com/wp-content/uploads/2008/04/new_problems_at_arthrocare.pdf

On June 12, the court record states:

Attorney statement:

“We were before Your Honor on a status conference, I kind of described the difficulties that we were having in getting discovery including some people that we subpoenaed that did not show.  Michael Denker is one of those people.”

Judge’s reply:

“I’m going to refer this to the State Attorney’s Office.  I don’t think its really — at this moment I’m going to defer on the indirect criminal contempt.  I’m going to send it up to the State Attorney’s Office determine whether criminal charges should be filed against him.”

Why would Mr. Denker go through such lengths to avoid a deposition?  Why would Arthrocare allow Denker to even go in front of a judge for contempt?  What are they hiding?  Maybe the answer can be found in the incriminating nature of the first deposition that showed the “all too comfy” relationship between Arthrocare and Discocare. 

http://citronresearch.com/wp-content/uploads/2007/12/denkerdepo.pdf

It is unclear if judge intended his referral to extend to the all defendants; Citron will continue to follow this part of the story.  Does Arthrocare and its shareholders take comfort in state prosecutor looking at this case?  Especially, because the Florida Department of Insurance has recently made an issue of patient brokering and fraudulent billing.

Michael Denker’s employment- Is this the Rosetta Stone?

Citron has previously documented the involvement in Discocare of Michael Denker, the former sales manager of Arthrocare’s spine unit, who was hired to run Discocare.  In the recent deposition of former Arthrocare employee Jackie Brown on May 14, 2008, she stated that Denker never left active involvement at Arthrocare.  .  This is in direct contradiction to his own words from his own his earlier deposition.

 Jacqueline Brown Deposition (PDF)

Here are the key lines:

Q-Then was it your understanding when you talked to Mr. Denker that he was an Arthrocare employee?

A-Yes.

Q- Do you know whether or not he was a DiscoCare employee?

A- I don’t know what his role was.  I didn’t figure that out while I worked there.  I know he participated with Discocare but he was an Arthrocare employee.

If Ms. Brown’s testimony is true, the implications for Arthrocare are devastating.  Not only would Denker be guilty of perjury (in addition to contempt), but this information could render every Arthrocare transaction with Discocare as related party – and subject to extra disclosure and restatement.  It also calls into question if we can trust Arthrocare and their transactions with their other billing company DRS.  Both of these companies present a potential restatement of financials for the past year.

It is precisely this vulnerability that led Williams Capital (which used to rate Arthrocare a “buy”) to downgrade it again last week, this time from “hold” to “sell”.

It all comes back to the numbers.

Even if you believe that Arthrocare and Discocare happened to share the same fax # pre-acquisition by fluke, you cannot deny the potential restatements if either the auditor or the company discloses that Discocare was a related party.  The company wants us to believe that the NASDAQ inquiry cleared this up, yet they never disclosed what the nature of that inquiry was; therefore we have no clarity as to what was disclosed.  With the medical device industry making a move towards more disclosure, Citron finds it disturbing that Arthrocare is violently moving in the opposite direction.  The headline risk surrounding Arthrocare seems to be growing every day.

Weakening Spine

Meanwhile, in another blow to the “Discocare model”, in a case last week Nikhol and Geroge Primm v. Specialty Appliance Mechanics, Inc., Case No. 07-215CA pending in Martin County, Florida the plaintiff sought $1,500,000 and was awarded only $23,000.

The reason these cases are so important is not only for the future viability of the Discocare model and growth in Arthrocare’s spine business, but more importantly every case lost is $7,500 that will not be recovered by Arthrocare/Discocare, as well as a beacon to insurance companies that many of these cases are seriously flawed and can be effectively defended in court. 

So even if you believe that Discocare and Arthrocare were separate entities pre acquisition, there has to be concern about the future viability of its “model” to deliver growing profitability.

Conclusion

Citron continues to see ominous signs confirming its original diagnosis – that Arthrocare’s revenue growth was and is alarmingly dependent on a shady reimbursement scheme, replete with deception and disreputable characters.  This has led management down a road of sacrificing credibility for short-term financial performance.