A company battles the short-sellers

(Fortune) -- Of all the battles that a modern CEO must wage, there is one over which he or she has almost no control: the battle with short-sellers.

Take, for example, Michael Baker, the CEO of Arthrocare, a mid-sized surgical device company based in Austin, Texas. Founded in 1993, Arthrocare has done admirably in nearly every area traditionally used to judge a company's performance.

In 2006 the company booked $263 million in revenues and has publicly confirmed estimates of around $315 million for last year. Operating income through the nine months ended September 30 was $33.4 million, and is slated to come in above 2006's $42.4 million. Net income, per management, should be around $1.50 per share. He proudly tells Fortune that all three of his company's units - sports medicine; ear, nose and throat; and spinal care - are growing at 20% annual rates.

Under Baker's direction, Arthrocare has aggressively expanded into new markets, away from brutal competition with well-heeled competitors like Johnson & Johnson (JNJ, Fortune 500) and Stryker and into fast-growing areas like minimally invasive spinal procedures. Indeed, the spinal division's push appears to be pure genius. The unit's growth has been impressive - the spinal group now makes up 15% of corporate revenues for the quarter ended September 30, up from the low single digits two years ago.

Yet track the company's stock performance, and you see a different tale. In early November, it was a hair under $61 a share; today, it's below $40, even though every announcement has been positive.

The immediate reason has been that more than a dozen prominent investment firms - from one-man shops like Andrew Left's Citron Research, to those with $20 billion in assets like Och-Ziff Capital Management - have taken a short bet on Arthrocare (and of late been profitably right). The short interest as a percentage of Arthrocare's float stands at a punishing 44.6% - which is far out of whack with an industry average of well below 10%.

The shortseller storm over Arthrocare has become so severe that one of the nation's largest insurers - State Farm - is attempting to use a Florida lawsuit to learn if there is anything peculiar about the business practices of a company that Arthrocare bought.

Why such animus for a company that has a track record of earnings growth and no known regulatory violations?

Short sellers - who by definition have an interest in a stock going down - allege that Arthrocare's fast revenue growth and high margins from its spinal business have come about largely because it had an unusual arrangement with a billing service provider in Florida called DiscoCare. Specifically, they claim that DiscoCare helped physicians exploit - or abuse - insurance loopholes or inefficiencies to get unjustifiably large payments. Arthrocare, while insisting that it has done nothing wrong, did not help itself with these investors by pointedly refusing to answer questions about its relationship to DiscoCare until around New Year's, when it unexpectedly bought the company for $25 million in cash.

This made the short-sellers go nuts. Postings on Andrew Left's Citron Research's Web site used reams of company documents and made the extreme assertion that Anthrocare engage in a "scheme to defraud." In Left's version, DiscoCare coaches doctors to code certain spinal surgical procedures that deploy Arthrocare products in a way that will that vastly increase reimbursements from insurance companies.

For his part, CEO Baker angrily defends his company's relationship to DiscoCare. "We were in the middle of negotiations to buy [DiscoCare] when all of these rumors and weird questions surfaced," he told Fortune. "We looked into them and found nothing, absolutely nothing," adding that he had a team of lawyers and analysts pore over the company and found nothing untoward or wanting. He said that DiscoCare provided an excellent service - helping its clients make more money and save time - and if he hadn't agreed to the deal, his competitors probably would have.

Still, there is some reason to think that the number of these procedures receiving higher reimbursement has risen. Fortune has reviewed Florida health care data showing that the Palm Beach Lakes Surgical Center, for one, greatly expanded in 2006 the number of such procedures reimbursed at the higher level.

If the shortsellers are correct that either Arthrocare (ARTC) or DiscoCare have been instrumental in helping or directing physicians to enter inappropriate insurance codes for the procedures using their instruments, then the company is in a world of hurt. To start with, class action suits are almost assured to spring up. On top of that, auto insurance and workers compensation carriers - who reimburse the doctors who perform the procedures with Arthrocare's products -could cut or cease their payments. And, needless to say, there is the specter of legal or regulatory action. Any or all of these would almost certainly chop the spine unit's sales and margins.

If they're wrong, then the company has lost $700 million in market capitalization for no good reason. And, Baker says, there has been a human cost as well. "My father is sick with cancer and spends a lot of time surfing the Internet and he has to read these lies and innuendos. It's something I won't forget," he told Fortune.

But one thing seems certain: this battle is unlikely to disappear soon. Fortune has reviewed legal documents, buried in an otherwise obscure traffic accident lawsuit in Palm Beach County, Silien vs. ArmChem International, that could pose long-term headaches for Baker and his company.

Steven Woods of Deerfield Beach, Fl.'s Roig, Kasperovich, Tutan & Woods law firm is demanding that Baker and his company turn over all records relating to the DiscoCare acquisition, the "DiscoCare model," company sales practices and claims. They have subpoenaed records of communication between both Arthrocare and DiscoCare and the owners of Palm Beach Lakes Surgical Center, the clinic that has been one of Arthrocare's biggest customers for the past two years, according to Florida healthcare records.

Auto insurance giant State Farm - which insures ArmChem International and has paid out millions of dollars worth of spinal surgery claims over the past several years - has thrown its considerable weight behind the investigation that led to the subpoenas.

Woods, a Roig lawyer, declined to comment on the specifics of the subpoenas or this case. He confirmed that he does work on behalf of State Farm in this case and has in the past worked with the investigative unit of State Farm and other insurance companies to combat fraud. (Insurance companies, of course, have an interest in reducing the amount they pay on claims where possible.)

A spokesman for State Farm told Fortune, "We are aware of Arthrocare and the company's products and procedures. Over the past several years, we have seen a significant increase in the number of times procedures have been performed and are investigating the company accordingly."

"We see this as routine," said Arthrocare's Baker. "We're not a party to this case," adding that the only aspects of the document request that the company was likely to provide - based on probable admissibility criteria - were device sales and pricing material. Asked about State Farm's involvement, he said. "We had not heard that they had any concerns" about his company or their products. "They've never said anything to us." He reiterated that neither Arthrocare nor DiscoCare had ever improperly instructed doctors.

It is possible, of course, that the subpoenas will be dismissed. But even so, the allegations that have dogged Arthrocare are bound to reappear.