In re ARTHROCARE CORPORATION SECURITIES LITIGATION.

726 F.Supp.2d 696

In re ARTHROCARE CORPORATION SECURITIES LITIGATION.

Case No. A-08-CA-574-SS.

United States District Court, W.D. Texas,Austin Division.

July 20, 2010.

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Jeffrey A. Klafter, Klafter Olsen & Lesser LLP, Rye Brook, NY, John F. Harnes, Meryl W. Roper, James M. Wilson, Jr., Martin D. Chitwood, Robert W. Killorin, Ze'Eva Kushner Banks, Chitwood Harley Harnes, LLP, Atlanta, GA, Kurt B. Olsen, Klafter Olsen & Lesser, LLP, Washington, DC, Matthew R. Pearson, Gravely & Pearson, LLP, San Antonio, TX, Tom Alan Cunningham, Cunningham Darlow LLP, Houston, TX, for Plaintiff.

Wilens, Douglas, Elizabeth A. Shonson, Jack Reise, Michael L. Greenwald, Stephen R. Astley, Robbins Geller Rudman & Dowd LLP, Boca Raton, FL, Joe Kendall, Kendall Law Group, LLP, Dallas, TX, for Intervenor Plaintiff.

Courtney Thornton Stewart, George Barton Butts, Jennifer A. Lloyd, DLA Piper LLP (US), Austin, TX, Noah A. Katsell, Robert W. Brownlie, DLA Piper LLP (US), San Diego, CA, Eric J. Ball, Jay L. Pomerantz, Tyler A. Baker, III, Fenwick & West LLP, Mountain View, CA, David W. Klaudt, Jason S. Lewis, Jeffrey M. Benton, Locke Lord Bissell & Liddell, LLP, Dallas, TX, for Defendants.

Jeffrey A. Klafter, Klafter Olsen & Lesser LLP, Rye Brook, NY, Kurt B. Olsen, Klafter Olsen & Lesser, LLP, Washington, DC, Matthew R. Pearson, Gravely & Pearson, LLP, San Antonio, TX, for Movant.

ORDER

SAM SPARKS, District Judge.

BE IT REMEMBERED on June 18, 2010, the Court held a hearing in the above-styled cause, and the parties appeared through counsel. Pending before the Court were Defendant ArthroCare Corporation's (“ArthroCare”) Motion to Dismiss [# 166] and the appendix thereto [# 167], Lead Plaintiff DeKalb County Pension Fund's (“Plaintiff”) response [# 186], and ArthroCare's reply [# 194]; Defendant David Applegate's (“Applegate”) Motion to Dismiss [# 168], Plaintiff's memorandum in opposition [# 184], and Applegate's reply [# 193]; Defendant John T. Raffle's (“Raffle”) Motion to Dismiss [# 170], Plaintiff's memorandum in opposition [# 182], and Raffle's reply [# 198]; Defendant Michael Baker's (“Baker”) Motion to Dismiss [# 172], Plaintiff's response thereto [# 188], and Baker's reply [# 196]; Defendant Michael Gluk's (“Gluk”) Motion to Dismiss [# 169], Plaintiff's response thereto [# 180], and Gluk's reply [# 195]; Defendant PriceWaterhouseCooper's (“PwC”) Motion to Dismiss [# 171], Plaintiff's response thereto [# 190], and PwC's reply [# 192]; and Plaintiff's Motion for Leave to File a Sur-Reply to Baker's Motion to Dismiss [# 200]. Because there has been no response to Plaintiff's Motion for Leave to File a Sur-Reply to Baker's Motion to Dismiss [# 200], the Court assumes it is unopposed and hereby GRANTS the motion. Thereafter, considering all the foregoing documents, the case file as a whole, the applicable law, and the arguments of counsel at the hearing, the Court enters the following opinion and orders.

Background ¹

I. General Allegations

This is a consolidated securities class action suit against ArthroCare, an Austin-based public company that develops, manufactures, and markets minimally invasive surgical products. Also named as defendants are various former executives of ArthroCare-Michael Baker, Michael Gluk, John Raffle, and David Applegate ² -and ArthroCare's auditor, PwC. The case arises from ArthroCare's November 18, 2009 restatement (the “Restatement”), in which it restated its earnings from 2004 through the first quarter of 2008, and made numerous admissions of wrongdoing and lack of internal controls. CCAC [# 139] at ¶ 8. The Court appointed Plaintiff as lead plaintiff in this case on December 9, 2008. See Dec. 10, 2008 Order [# 99].

Plaintiff brings suit on behalf of all persons or entities who purchased common stock in ArthroCare between May 10, 2005 and February 18, 2009 (the “Class Period”). CCAC at ¶ 1. Plaintiff alleges ArthroCare and the Individual Defendants made public statements during the Class period-including statements to investors during earnings conference calls, in press releases, and in filings with the Securities and Exchange Commission (“SEC”)-that were materially false and misleading with respect to the true nature of ArthroCare's affairs, and failed to disclose a number of fraudulent and improper practices within the company (of which the Individual Defendants were aware). Id. at ¶ 2. Therefore, Plaintiff seeks to hold ArthroCare and the Individual Defendants liable for violations of § 10(b) of the Securities and Exchange Act and Rule 10b-5 promulgated thereunder. Id. at ¶¶ 546-57. Plaintiff also alleges the Control Person Defendants had direct control over the activities or public statements of ArthroCare and participated in the improper activities and fraudulent statements in question, and are therefore liable as “control persons” under § 20(a) of the Securities and Exchange Act. Id. at ¶¶ 3; 570-74. Finally, Plaintiff alleges PwC's statements accompanying several of ArthroCare's public filings during the Class Period were materially false and misleading, and PwC was either aware of this or severely reckless in not being aware, and is therefore liable under § 10(b) of the Securities and Exchange Act and Rule 10b-5. Id. at ¶¶ 4; 558-69.

II. Improper Practices

The principal fraudulent and improper practices complained of by Plaintiff can be divided into two main areas: (a) insurance billing and healthcare compliance, and (b) accounting and internal controls.

A. Insurance and Healthcare Compliance

i. DiscoCare

ArthroCare has three core business units: Sports Medicine, Ear Nose Throat, and Spine. Id. at ¶ 28. In 2000, ArthroCare's Spine division began manufacturing and marketing “Spine Wands”: surgical devices that use ArthroCare's patented technology to remove disc tissue in herniated discs (a procedure that is commonly referred to as a “PDD,” or Percutaneous Disc Decompression). Id. at ¶¶ 29-30. In or around 2004, insurance companies became reluctant to reimburse for PDD procedures because they questioned the effectiveness of the procedure and generally characterized it as experimental, and thus non-reimbursable. Id. at ¶ 32. These reimbursement issues concerned physicians, and Spine Wand sales flattened in 2004 and 2005. Id. at ¶ 39.

However, in 2005 ArthroCare became aware of a promising solution to the reimbursement problem, which had been developed by Palm Beach Lakes Surgery Center (“PBLSC”), ArthroCare's largest customer for Spine Wands. PBLSC had begun pursuing reimbursement for Spine Wands not through healthcare insurance companies, but through liability claims to casualty insurers. Specifically, PBLSC had developed a network of personal injury lawyers willing to refer their clients to PBLSC for PDD procedures; in turn, PBLSC would receive a “Letter of Protection” (“LOP”) from the law firm, which promised payment upon settlement of the personal injury claim. Id. at ¶ 40.

PBLSC would perform the PDD and then provide medical records and billing information to the lawyers, who would use it in a settlement demand letter to the casualty insurer. Id.

ArthroCare began to employ this business model to boost sales of Spine Wands. Id. at ¶ 41. In late 2005, DiscoCare, Inc. (“DiscoCare”) was formed as a distributor exclusively for ArthroCare Spine Wands. Id. at ¶ 41. DiscoCare was substantially intertwined with PBLSC and ArthroCare-for instance, Dr. Jonathon Cutler, a partner and physician at PBLSC, was the owner of DiscoCare; ArthroCare's Florida subsidiary (DRS) shared a fax number with DiscoCare (which ArthroCare executives later claimed was a “mistake” on the DiscoCare website); DiscoCare's functional address was the same as PBLSC's; and Denker, a former sales executive of ArthroCare in the Spine division, was the “Director” of DiscoCare and ran its daily operations. Id. at ¶ 42. However, ArthroCare officially referred to DiscoCare as a “third party biller” for Spine Wands, and claimed it was a wholly separate entity from ArthroCare. Id. at ¶ 42.

The relationship between DiscoCare, ArthroCare, PBLSC, and personal injury lawyers became known as the “DiscoCare Model.” Id. at ¶ 43. The model essentially worked as follows: physicians or surgical centers certified to perform PDDs would enter into relationships with personal injury lawyers whereby the lawyers would refer their personal injury clients to the physician and provide the physician with an LOP. Id. In turn, the physician would perform the PDD using Spine Wands from DiscoCare, which they got in exchange for the LOP (in lieu of paying for the Wand themselves). Once the physician performed the PDD procedure, the physician would provide medical records and bills to the lawyers to use in a settlement demand letter to the casualty insurer. Once the insurer settled, the lawyers, the physician, ArthroCare, and DiscoCare would be paid out of the settlement proceeds. Id. By using the DiscoCare Model, ArthroCare was able to vastly increase the number of physicians and facilities using Spine Wands. Id. at ¶ 46.

One of the keys to the DiscoCare Model was grossly inflated prices. First, DiscoCare/ArthroCare grossly inflated the price of the Spine Wands sold through the DiscoCare Model: specifically, ArthroCare received $7,500 for a Spine Wand used in the DiscoCare Model versus a maximum of $1,400 for the same Spine Wand used in traditional PDD procedures. Id. at ¶ 56. ArthroCare also apparently realized that if the physicians changed the CPT codes for the PDD procedure, they could vastly increase their charges for the procedure itself. ³ Id. at ¶ 48. Thus, under the DiscoCare Model, ArthroCare advised physicians to use CPT code 63056, which corresponds to an “open microdiscectomy”-a far more invasive and complicated procedure than a PDD procedure. ⁴ Id. at ¶ 51. This practice is referred to as “upcoding.” Because the microdiscectomy is...