Arthrocare puts itself up for sale

(Fortune) -- Embattled surgical device maker Arthrocare announced yesterday that it is seeking an end-run around its bitter battle with short-sellers and has hired a major investment bank to explore "strategic alternatives," including a possible sale of the company.

The retention of Goldman Sachs (GS, Fortune 500) capped a madcap two weeks of contradictory pronouncements for Arthrocare. Last Tuesday, the company said it was seeking to buy back an additional $75 million in stock, after using almost $60 million in debt to complete a buy-back in December. The week before, Arthrocare's chief executive Mike Baker acknowledged that first quarter earnings were going to be lower than expected because of an inventory backlog at its controversial subsidiary, DiscoCare.

Arthrocare's outside spokeswoman told Fortune that none of its executives would be available to comment on the apparent contradiction between management's generally bullish statements and the board's sudden desire to explore all available options for maximizing shareholder value.

Unlike other high-profile situations whereby activist or otherwise disgruntled shareholders complain about stock-price valuation or alleged managerial problems, none of Arthrocare's shareholders appear to have initiated the move. News of a possible sale sent Arthrocare (ARTC) up $3 a share to $43. The stock was at $44.01 in mid-day trading.

The fast-growing Austin, Tx.-based Arthrocare is an unlikely lightning rod for criticism from some of the largest hedge funds on Wall Street, where bets against the company's stock have pushed the short interest to an unheard of 54%.

The earnings quality analysis unit of Gradient Analytics has issued a series of increasingly sharp criticisms about the quality of Arthocare's accounting statements; the highly-followed research boutique has assigned the company a grade of "F" for, among other reasons, the growing likelihood of a major earnings restatement. But most short sellers - who have an interest in the share price going down - hone in on the company's relationship with hone in on the company's relationship with West Palm Beach-based DiscoCare and Arthrocare. In brief, some short sellers argue that DiscoCare - a billing services provider purchased by the company on December 31 - has helped Arthrocare generate sales for its high-margin, rapidly-growing spinal product unit by prompting physicians to assign improper insurance reimbursement codes.

Arthrocare has always sharply denied these charges. Arthrocare's 10-K filed last Friday noted that the Nasdaq stock exchange - where the company's shares are traded - has requested information regarding DiscoCare; the company did not explain what Nasdaq has requested.

Specifically, short sellers question DiscoCare's close working relationship with personal injury lawyers and a small group of orthopedic surgeons who perform a minimally invasive spinal procedure known as percutaneous disc decompression (PDD) with Arthrocare products.

According to trial testimony that Fortune obtained, many of these physicians do PDD's under attorney letters of protection, whereby their fees and charges are applied against pending plaintiff insurance settlements in worker's compensation or auto accident lawsuits.

Arthrocare has labored mightily to drum up interest and awareness of its spinal products among personal injury lawyers and orthopedists, according to documents obtained by Fortune. In one instance, the company sought to hire several law school graduates to help market the company to personal injury lawyers. In another, both Arthrocare and DiscoCare sales staff openly discussed attempting to persuade physicians of the merits of billing PDD type surgeries under a code that is traditionally used for open spinal surgery.

Arthocare would not comment on these practices; in the past it has denied that either it or Discocare has ever improperly instructed doctors. If the company is going to successfully sell itself, however, it's going to have to face up to the fact that increasingly pointed questions about its accounting and its role with DiscoCare are not going away anytime soon.