10-K 1 artc201310-k.htm 10-K ARTC 2013 10-K
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT
PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2013
Commission File Number: 001-34607
ARTHROCARE CORPORATION
(Exact name of registrant as specified in its charter)
Delaware
State or other jurisdiction of
Incorporation or organization
 
94-3180312
(I.R.S. Employer
Identification No.)
 
 
 
7000 West William Cannon, Austin, TX 78735
(Address of principal executive offices and zip code)
(512) 391-3900
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: Common Stock, $0.001 Par Value
Securities registered pursuant to Section 12 (g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨    No ý
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨    No ý
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý    No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý    No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ý
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.

Large accelerated filer ý
 
Accelerated filer ¨
 
Non-accelerated filer ¨
 (Do not check if a
smaller reporting company)
 
Smaller reporting company ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨    No ý
As of June 30, 2013, the aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was approximately $975,265,320 (based upon the closing sales price of such stock as reported by NASDAQ on such date).
As of January 31, 2014, the number of outstanding shares of the Registrant's Common Stock was 28,567,064.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Exchange Act of 1934, as amended, in connection with our annual meeting of stockholders, scheduled to be held on or before June 22, 2014 are incorporated by reference into Part III of this Annual Report.


ARTHROCARE CORPORATION
FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS



ADDITIONAL INFORMATION

"ArthroCare," "we," "us," "our," and "Company" refer to ArthroCare® Corporation, unless the context otherwise requires.
In this Annual Report on Form 10-K, references to and statements regarding North America refer to the United States, or U.S., Canada and Mexico, references to U.S. dollars, USD or $ are to United States Dollars, and references to the euro or € are to the legal currency of the European Union, or EU.
Throughout this Annual Report on Form 10-K we incorporate by reference certain information from other documents filed with the Securities and Exchange Commission, or the SEC. Please refer to such information at www.sec.gov.
This Annual Report on Form 10-K contains forward-looking statements. In "Part I—Item 1A—Risk Factors," we discuss some of the risk factors that could cause our actual results to differ materially from those provided in the forward-looking statements.
PART I
ITEM 1.    BUSINESS
Recent Developments
On February 3, 2014, the Company announced the entry into an Agreement and Plan of Merger (the "Merger Agreement") with Smith & Nephew, Inc. ("Parent"), Rosebud Acquisition Corporation, a wholly owned subsidiary of Parent ("Merger Subsidiary"), and Smith & Nephew plc ("Parent Holdco"), pursuant to which the Company agreed to be acquired by Parent and become a wholly-owned subsidiary of Parent (the "Merger"). At the effective time of the Merger, each issued and outstanding share of common stock of the Company (other than common shares held by the Company or its subsidiaries, Parent or its subsidiaries, Merger Subsidiary or a stockholder who properly demands appraisal of such common shares under Delaware law) will be converted into a right to receive $48.25 per share in cash (the "Merger Consideration").
 
At the effective time of the Merger, each equity award with respect to shares of common stock of the Company that is outstanding immediately prior to the Merger will be canceled in consideration of a cash payment to the holder of the award (subject to reduction for withholding taxes). In the case of a stock option or stock appreciation award, the holder will receive an amount equal to $48.25 less the applicable exercise price per share, multiplied by the number of shares covered by the award. In the case of a restricted stock award, the holder will receive an amount equal to $48.25 multiplied by the number of shares covered by the award. In the case of a performance award, the holder will receive an amount equal to $48.25 multiplied by the number of shares covered by the award that are earned based on performance through the last business day of the completed fiscal quarter that immediately precedes the effective time of the Merger (but in no event less than one-third of the target number of shares covered by the award). Each of the Company and Parent made customary representations, warranties and covenants in the Merger Agreement, including, among others, covenants by the Company to conduct its business in the ordinary course during the interim period between the execution of the Merger Agreement and the consummation of the Merger.
 
The completion of the Merger is subject to customary conditions, including approval by the Company’s stockholders, the absence of any material adverse effect on the Company’s business and receiving antitrust approvals (including under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended). The Company has also agreed, subject to certain exceptions, not to enter into discussions concerning, or provide confidential information in connection with, any alternative transaction. In addition, each of the parties have agreed to use their reasonable best efforts to cause the Merger to be consummated. Subject to certain exceptions, the Merger Agreement also requires the Company to call and hold a stockholders’ meeting and for the Company’s Board of Directors (the "Board") to recommend that the Company’s stockholders adopt the Merger Agreement. Prior to adoption of the Merger Agreement by the Company’s stockholders, the Board may in certain circumstances change its recommendation that the Company’s stockholders adopt the Merger Agreement, subject to complying with certain notice and other specified conditions set forth in the Merger Agreement, including giving Parent the opportunity to propose changes to the Merger Agreement.
 
The Merger Agreement may be terminated under certain circumstances by the Company, prior to the adoption of the Merger Agreement by the Company’s stockholders, including in the event that the Company receives an unsolicited alternative acquisition proposal that the Company concludes, after following certain procedures, is a Superior Proposal (as defined in the

3

Merger Agreement).  If the Company receives a Superior Proposal, Parent must be given the opportunity to match the Superior Proposal. In addition, Parent may terminate the Merger Agreement under certain circumstances, including if the Board changes its recommendation that stockholders adopt the Merger Agreement, if after a request from Parent the Board fails to reaffirm its recommendation of the Merger following an alternative acquisition proposal or if there is a material breach of the Company’s obligations relating to non-solicitation of an alternative acquisition proposal or the procedures to be followed following receipt of an unsolicited alternative acquisition proposal. Upon termination of the Merger Agreement under certain circumstances, the Company may be required to pay Parent a termination fee equal to $54.9 million.
Overview
We are a medical device company that develops, manufactures and markets surgical products, many of which are based on our minimally invasive patented Coblation® technology. We seek to capitalize on market opportunities across several medical specialties, improve many existing soft-tissue surgical procedures and enable new minimally invasive procedures. Our innovative technologies improve the lives of individuals as diverse as world class athletes suffering from torn rotator cuffs to the millions of citizens suffering from chronic sinusitis and children suffering from tonsillitis. We incorporated in California in 1993 and reincorporated in Delaware in 1995.
Our objective is to expand on our position as a leading global provider of minimally invasive surgical products. We seek to differentiate ourselves in this competitive market by providing our patients and user-physicians with improved treatment options. To accomplish this objective, we are focused on a business strategy featuring the following key elements:
•
expanding our product offering to address large and rapidly growing domestic and international markets;
•
improving selected established medical procedures by replacing current technologies with our technologies;
•
continuing to improve sales and cash flow through a combination of direct sales representatives, independent sales agents and distributors;
•
augmenting our current business with complementary and compatible acquisitions that allow us to capitalize on emerging and existing business opportunities and strengthen our distribution capability; and
•
establishing strategic partnerships to develop new products or further commercialize our technologies and products.
Business Overview
Our business consists of two core product areas: Sports Medicine and Ear Nose and Throat, or ENT. We also manufacture and sell products based on our technology designed for other procedures. Our Sports Medicine, ENT and Other products are marketed and sold through two principal geographic distribution channels: Americas (North and South America) and International (all other geographies).
Many of our key products are based on our patented Coblation technology. The term Coblation means “controlled ablation.” Coblation uses bipolar radiofrequency energy within a conductive medium in the joint (such as saline) to generate a precisely focused plasma field to remove and shape soft tissue. When the plasma is formed and applied to the targeted area, tissue is ablated through a chemical process, as highly charged radicals within the plasma break down molecules within the tissue. The efficiency of the plasma energy is the primary factor that distinguishes our Coblation technology from traditional monopolar devices and other bipolar radiofrequency surgical tools.
Traditional monopolar devices drive electrical energy into the treatment site, through the patient's body, exiting via a grounding pad placed on the patient away from the surgical site. Monopolar probes use heat as the mechanism of action to burn away tissue. This treatment leads to greater depth of energy penetration into tissue at higher temperatures, which can cause thermal damage to sensitive tissue structures surrounding the targeted area. Conversely, bipolar devices such as ours include both an active and return electrode at the tip of the device, eliminating the need for a grounding pad. With a bipolar device, focused energy is applied at the surgical site, where the plasma provides precise debridement of targeted tissue, with minimal damage to the surrounding tissue. Studies have shown depth of penetration at 100-200 microns, which is less than or equal to a mechanical shaver device.
The use of Coblation allows surgeons to operate with a high level of ablation performance, with precision and accuracy to minimize collateral tissue damage. Our Coblation-based systems consist of a controller unit with accessories and an assortment of sterile, single-use disposable devices that are engineered to address specific types of procedures. A single multi-purpose surgical system using Coblation technology can replace the multiple surgical tools traditionally used in soft-tissue surgery procedures.

4

We have applied Coblation technology to soft-tissue surgery throughout the body and commercialize products today, primarily in the areas of arthroscopic sports medicine, ENT, spine and wound debridement applications. We also license our technology to other companies in a variety of fields.
Sports Medicine
Our Sports Medicine product area focuses on the development, production and marketing of advanced energy-based systems and innovative fixation technologies used in the treatment of soft tissue injuries, mostly in shoulders, knees and hips. According to the Truven Health MarketScan® Database in 2012, more than 1.7 million surgical procedures were performed to address instabilities, impingement, and/or tendon tears of the shoulder; an additional 2.5 million arthroscopic procedures were performed to address cartilage, meniscus, ligament and/or tendon injuries in the knee; and over 60,000 arthroscopic hip procedures were performed in the U.S. Sports Medicine is currently our largest product area and product sales accounted for 64.6 percent, 64.0 percent and 64.3 percent of our total revenue in 2013, 2012 and 2011, respectively. Included in Sports Medicine product sales are disposable surgical devices and implants based on our technologies that we contract manufacture for other companies. Contract manufacturing represented 9.6 percent, 10.1 percent and 10.3 percent of our Sports Medicine sales in 2013, 2012, and 2011, respectively.
We attribute our success in Sports Medicine to several factors, including:
•
a greater emphasis on physical fitness across all demographics and an aging population accustomed to an active lifestyle, which results in an increasing incidence of acute and degenerative joint and soft tissue injuries;
•
increased patient demand for less invasive surgical procedures allowing for faster recovery and return to activity;
•
an increase in the proportion of surgical procedures performed arthroscopically; and
•
an increase in the number of physicians trained in arthroscopic surgical techniques.
Sports activities often affect joints that are susceptible to damage from blows, falls or sudden changes in direction, as well as from natural degeneration associated with repeated use and aging. Arthroscopic surgeries are most commonly performed on the knees and shoulders but are also used in the treatment of injuries affecting other joints, such as elbows, wrists, ankles and hips. Prior to the widespread availability of arthroscopic surgery, joint injuries were treated through surgery involving large incisions, and through cutting or dislocating muscles to reach targeted tissues. These open procedures often required a hospital stay and prolonged rehabilitation and recovery. In contrast, arthroscopic surgery is performed through several small incisions, or portals, resulting in lower overall costs, reduced surgical trauma, pain and scarring, and fewer complications. Arthroscopic surgery is often times performed on an outpatient basis with no overnight stay. We believe that the products that we develop, manufacture, market and sell through our Sports Medicine business further advance arthroscopic surgery. Our technologies allow surgeons to precisely remove targeted soft-tissue while minimizing collateral tissue damage; facilitate efficient, effective repair of specific anatomical structures; and help restore function and patient activity.
Our Sports Medicine Products
The ArthroCare Sports Medicine product portfolio includes two proprietary platforms—Coblation and Soft-Tissue Fixation. The products in each platform can be used separately or together in a wide array of clinical applications in the field of Sports Medicine.
Coblation.    ArthroCare's market-leading Coblation platform has been a principal product line in Sports Medicine and was first introduced for sports medicine applications in 1996. To date, Coblation has been used clinically for over 16 years, and has been studied in over 90 peer-reviewed articles. This product line features a series of specialized disposable, energy-based surgical wands, called "Coblation Wands", designed for single patient use to treat a number of orthopedic conditions, including injuries of the shoulder, knee, hip, foot, ankle, elbow, and wrist. Coblation Wands are used with a controller, a software-based generator that provides energy in a precise manner to ablate, resect and sculpt soft tissue and to seal bleeding vessels arthroscopically. ArthroCare's Coblation portfolio also includes the Ambient® family of Wands, which allow surgeons to intra-operatively monitor the temperature of the circulating fluid in the joint and is the only such product on the market that offers real-time temperature feedback, giving the surgeon unparalleled performance and confidence when treating their patients. ArthroCare has the largest portfolio of wands on the market to provide our surgeon partners and their patients with a variety of treatment options in sports medicine.
Soft-Tissue Fixation.    The acquisitions of Atlantech and Opus Medical in 2002 and 2004, respectively, provided the foundation for ArthroCare's Soft-Tissue Fixation products. Today the Soft-Tissue Fixation product portfolio includes a broad line of specialized implants and instruments, including knotless and traditional anchors for rotator cuff and labrum repairs in the shoulder and hip, screws for ligament reconstruction in the knee, a variety of arthroscopic suture passers, and a full offering of

5

associated reusable hand-held instruments, procedural kits, and accessories. ArthroCare's Soft Tissue Fixation technologies are designed to enable surgeons to more efficiently and effectively complete repairs arthroscopically that previously may have only been possible using open surgical techniques. In January 2013, we acquired Eleven Blade Solutions Inc. which added an all-suture soft anchor technology to our soft-tissue fixation portfolio that can be used in a variety of Sports Medicine procedures.
ENT
Overview
In ENT, we focus on the development, production and marketing of surgical products used in the treatment of conditions typically performed by ENT surgeons. Our ENT product sales accounted for 28.0 percent, 28.7 percent, and 28.2 percent of our total revenue during 2013, 2012 and 2011, respectively. One of the most common ENT procedures which utilizes our products is the removal of tonsils and adenoids, and according to Millennium Research Group, Inc. there were more than 800,000 tonsillectomies performed in the U.S. in 2012. Today, we estimate that approximately 30 percent of all U.S. tonsil and adenoid procedures are performed using our products. Other commonly performed ENT procedures include endoscopic sinus surgery, balloon dilation, turbinate reduction and other procedures to treat sleep disorders. These procedures are performed by ENT surgeons in hospitals and ambulatory surgery centers. Historically, monopolar electrocautery devices were the standard surgical tool used for the removal, or ablation, of soft tissue and cauterization during ENT procedures. We have developed a variety of products for use by ENT surgeons for general head and neck surgery, sinus surgery and procedures, airway sculpting, and turbinate reductions in addition to tonsil and adenoid removal.
Our ENT Products
Coblation.    We market three categories of disposable devices, or wands, to address the ENT market—suction wands, channeling wands and excision wands, each of which use Coblation technology and provide significant benefits over monopolar electrocautery devices. During a tonsillectomy, suction wands simultaneously ablate and remove tissue providing the surgeon enhanced visibility and shorter anesthesia time for patients. Channeling wands provide controlled ablation and thermal coagulation during turbinate reduction procedures to relieve nasal obstructions and stiffen the soft palate for the treatment of snoring. Excision wands provide precise dissection of soft tissue with minimal damage to surrounding tissue.
Sinus Surgery. In 2013, we purchased ENTrigue Surgical, Inc. (ENTrigue Surgical), a medical device company focused on the development and manufacturing of surgical instruments and implants used in sinus surgery. Some of the products include the ENTact® Septal Stapler for easily and rapidly reattaching nasal mucosal flaps which are created during a septoplasty procedure to straighten a patient’s septum; SerpENT® Articulating Instruments which are cutting and grasping tools that give surgeons the ability to change the angles of the devices in real-time to obtain optimal approaches to sinus anatomy in need of intervention; and the Ventera® Sinus Dilation System which utilizes the same intranasal articulating technology as the SerpENT® to dilate sinus openings using a surgical balloon.
Nasal Dressings.    In 2005, we completed the purchase of substantially all of the assets of Applied Therapeutics, Inc., or ATI, a maker of sinus surgery treatment products, that are complementary to our ENT devices. These carboxymethyl-cellulose based packing and tamponade products comprise our Rapid Rhino® product line. This line includes the dissolvable Stammberger Sinus Dressing and Sinu Knit, which are used after endoscopic sinus surgery to control minor bleeding, facilitate epithelial healing and preserve the spatial integrity of the sinus area and our epistaxis balloon tamponade products, which are used primarily in the hospital emergency room environment to control severe nosebleeds.
Other
We develop, produce and market surgical products used in other procedures. Other product sales accounted for 2.3 percent, 2.5 percent and 2.7 percent of our total revenue during 2013, 2012 and 2011, respectively.
SpineWand® Product Line.    The SpineWand devices use Coblation technology to treat soft tissue (intervertebral disc and vertebrae) conditions in the spine. Disc decompression, a common soft tissue minimally-invasive treatment for herniated discs, involves the removal of disc material either through a narrow tube, or cannula, or through a small surgical incision. Our Plasma Disc Decompression, or PDD SpineWands are used for the treatment of contained herniated discs. The PDD SpineWands remove portions of these herniated discs to relieve pressure on major spinal nerves in either large or small disc spaces, and allow the removal of soft tissue in the spine through a much smaller incision. The Cavity SpineWand® is used to reduce the size of malignant lesions within the vertebrae in patients suffering from spinal compression fractures resulting from benign or malignant tumors.
WoundWand® Debridement Device.    The WoundWand was Conformité Européenne, or CE, marked in 2010 making it available for distribution in Europe. The WoundWand is intended for wound debridement in acute and chronic wounds and wound cleansing by removal of necrotic tissue in a precise and controlled manner.

6

Our Customers and Competition
Our primary customers across all of our product areas are surgeons and other specialized medical professionals who utilize our products to treat their patients. Our primary competitors include Medtronic, Inc., Smith & Nephew, Stryker Corporation, Johnson & Johnson (through their Mitek and Acclarent subsidiaries), Olympus (through their subsidiary Gyrus) and Arthrex, Inc. These competitors tend to be large, well-financed companies with diverse product lines.
In the Sports Medicine market, we also compete directly with competitors to whom we have licensed our technology.
For additional discussion of the risks and considerations concerning our competition, see "Part I—Item 1A—Risk Factors."
Our Distribution Network
Distribution in the Americas
We sell our Sports Medicine products in North America through a network of employee sales representatives and independent sales agents. We sell our ENT products in the U.S. exclusively through employee sales representatives. As of December 31, 2013, for these two core business areas our Americas sales organization approximated 190 people, including sales management. In South America, we sell our products through independent distributors who retain the risk of inventory obsolescence and collection from their customers. Sales in the Americas accounted for 67.2 percent, 68.4 percent and 69.0 percent of our consolidated product sales during 2013, 2012 and 2011, respectively. We continually evaluate performance of our distribution network in order to maximize our ability to cover and increase our customer base and improve the efficiency of our product sales efforts. For the year ended December 31, 2013, approximately 62 percent of Americas product sales in dollars were from employee sales representatives and the remainder was from independent sales agents or distributors.
Distribution in International
International sales accounted for 32.8 percent, 31.6 percent and 31.0 percent of our consolidated product sales during 2013, 2012 and 2011, respectively. In several countries in Western Europe and in Australia and Singapore, we have wholly-owned subsidiaries that sell our products directly to end users of our products. In other markets, we sell our products to independent distributors who import and sell our products in their country of domicile, with the independent distributors retaining the risk of inventory obsolescence and collection from their customers. We may expand the number of markets where we sell our products directly to end users in the future.
For the year ended December 31, 2013, approximately 74.5 percent of International sales were derived from direct markets where we sell our products to end users and the remainder of our International sales were to independent distributors.
Geographic Information
Product sales and long-lived assets attributable to significant geographic areas are presented in Note 17, "Segment Information" in the notes to the consolidated financial statements.
Research and Development
We conduct our research and development activities in the U.S. at facilities in Irvine, California and Austin, Texas. Research and development expenses as reported includes experimental research, new product development, process enhancements, process engineering, quality engineering, regulatory affairs and clinical studies and were in aggregate 9.0 percent, 8.7 percent and 8.2 percent of our total revenues during 2013, 2012 and 2011, respectively. Our efforts are focused on:
•
designing new surgical devices that incorporate additional functionalities;
•
developing new applications of our Coblation and other innovative technologies;
•
developing complementary technologies and products for introduction into our product portfolio in order to provide more value to our customers and participate to a greater extent in certain surgical procedures; and
•
modifying and enhancing the performance of our existing technologies and products, including our processes to manufacture these products.
We may continue to explore and develop the plasma physics underlying our Coblation technology and evaluate the use of our technology in new fields of treatment. We are engaged with a number of doctors, scientists and research institutions to further understand the technology and expand its applications base and technical capability.

7

To facilitate our research and development efforts, we routinely receive feedback from physicians who use our products and consult with product area specific Scientific Advisory Boards, which are comprised of experienced physicians, surgeons and scientists who advise us on our products, current and prospective, and other areas relating to our medical devices. These medical professionals are valued contributors and advisors to our research and development process and their feedback allows us to achieve significant strides in our product development.
Manufacturing and Supply
Our products are primarily manufactured at our facility located in San Jose, Costa Rica. We believe our existing operations will provide adequate capacity for our manufacturing needs into 2015. On July 22, 2013, we entered into agreements with Zona Franca Coyol, S.A. (“CFZ”) under which we acquired property in Alajuela, Costa Rica for $4.9 million from CFZ and CFZ is now in the process of designing and constructing a new manufacturing facility for the Company on the acquired property. It is expected that the new facility will be operational during 2015.
We have established manufacturing process and quality assurance systems in conformance with the International Organization for Standardization's ISO 13485:2003 standard, the U.S. Food and Drug Administration's, or FDA, Quality System Regulation, 21 CFR Part 820 and we are certified under the Canadian Medical Devices Conformity Assessment System. Our facilities are in conformance with domestic and international regulatory requirements that apply to medical device manufacturers and subject to audits by FDA, Technischer Überwachungs-Verein, or TUV, a Notified Body per the Medical Device Directive for the European Union, and other regulatory agencies representing countries in which our products are registered to be sold.
Our products are manufactured from several components, most of which are supplied to us from third parties. Many of the components we use in the manufacture of our products are available from more than one qualified supplier. For some components, however, there are relatively few alternative sources of supply and the establishment of additional or replacement suppliers may not be accomplished quickly. In some cases, we rely upon a single supplier for a component. In such cases, a disruption from our single supply source could materially affect and disrupt our ability to manufacture and distribute certain of our products, as we experienced in the latter half of 2011 with our Rapid Rhino products.
Patents and Proprietary Rights
We own 170 issued U.S. patents and 211 issued international patents. In addition, we have 157 U.S. and international pending patent applications. We believe our issued patents are directed at, among other things, the core technology used in our soft-tissue surgery systems, including both multi-electrode and single electrode configurations of our disposable devices, as well as the use of Coblation technology in many different surgical procedures. In addition, our issued patents are directed at many of the core features of our acquired technologies from Opus, Atlantech, ATI, Eleven Blade Solutions and ENTrigue Surgical. Our earliest Coblation-related patents expired in January of 2012. The majority of our royalty income is associated with licenses that include core Coblation patent rights which extend through the end of 2015. A portion of license royalty revenue is associated with license grants from patents rights that extend beyond 2017.
In addition to patents, we hold intellectual property that we believe has significant value and provides us with competitive advantages in the form of copyrights, know-how, trademarks and customer relationships.
See "Part I—Item 1A—Risk Factors" and Intangible Asset information outlined in Note 7, "Goodwill and Intangible Assets" in the notes to the consolidated financial statements for additional information.
Government Regulation
U.S.
Our products are considered medical devices and are subject to extensive regulation in the U.S. We must comply with FDA regulations to market our products or obtain pre-market clearance or approval by the FDA for each of our products and indications before they can be commercialized.
FDA regulations are wide-ranging and govern, among other things: product design and development; product testing; product labeling; product storage; premarket clearance or approval; advertising and promotion; and product sales and distribution. Non-compliance with applicable regulatory requirements can result in enforcement action, which may include: warning letters; fines, injunctions and civil penalties against us; recall or seizure of our products; operating restrictions, partial suspension or total shutdown of our production; refusing our requests for premarket clearance or approval of new products; withdrawing product approvals already granted; and criminal prosecution.
Unless an exemption applies, generally, before we can introduce a new medical device or a new use for a medical device into the U.S. market, we must obtain FDA clearance of a premarket notification 510(k) or obtain premarket approval, or PMA.

8

If we can establish that our device is "substantially equivalent" to a pre-amendment or previously cleared device for which the FDA has not called for premarket approvals, we may seek clearance from the FDA to market the device by submitting a 510(k). The 510(k) requires the support of appropriate data, including, in some cases, clinical data establishing the claim of substantial equivalence to the satisfaction of the FDA. Where a product is not deemed as substantially equivalent to a pre-amendment or previously cleared device, a more rigorous premarket approval process, or a PMA process, is required. This PMA process requires us to independently demonstrate that the new medical device is safe and effective by collecting data regarding design, materials, bench and animal testing, and human clinical data for the medical device. Only if the FDA determines there is reasonable assurance that the medical device is safe and effective, will the FDA authorize the device's commercial release. The premarket approval process is much more detailed, time-consuming and expensive than the 510(k) process.
We have received 510(k) clearance to the extent we believe it is required for applicable products for a variety of indications. We subject our products not requiring clearance to our manufacturing and quality guidelines and standards to the same extent as if clearance were required.
Our products and the facilities manufacturing our products are subject to continued review and periodic inspections by the FDA. Each U.S. device-manufacturing establishment must be registered with the FDA. Domestic manufacturing establishments are subject to biannual inspections by the FDA, and must comply with the FDA's quality system regulations. Further, we must report adverse events involving our devices to the FDA under regulations issued by the FDA. Failure to maintain compliance with the regulatory requirements of the FDA may result in administrative or judicial actions, such as fines, warning letters, holds on clinical studies, product recalls or seizures, product detention or refusal to permit the import or export of products, refusal to approve pending applications or supplements, restrictions on marketing or manufacturing, injunctions, or civil or criminal penalties.
Federal healthcare laws apply when we or our customers submit claims for items or services that are reimbursed under Medicare, Medicaid or other federally funded healthcare programs. The principal federal laws include: (1) the False Claims Act which prohibits the submission of false or otherwise improper claims for payment to a federally funded healthcare program; (2) the Anti-Kickback Statute which prohibits offers to pay or receive remuneration of any kind for the purpose of inducing or rewarding referrals of items or services reimbursable by a Federal healthcare program; (3) the Stark law which prohibits physicians from referring Medicare or Medicaid patients to a provider that bills these programs for the provision of certain designated health services if the physician (or a member of the physician's immediate family) has a financial relationship with that provider; and (4) healthcare fraud statutes that prohibit false statements and improper claims with any third party payor. Often similar state laws also apply to claims submitted under state Medicaid or state funded healthcare programs. Some states, such as California, Massachusetts and Vermont, mandate implementation of corporate compliance programs to ensure compliance with these laws. In addition, the U.S. Foreign Corrupt Practices Act can be used to prosecute companies in the U.S. for arrangements with physicians, or other parties outside the U.S. if the physician or party is a government official of another country and the arrangement violates the law of that country.
The laws applicable to us are subject to change and to evolving interpretations. To help build more consistent business practices, we have implemented a corporate-wide compliance program that intends to conform business practices throughout our business areas to applicable laws and regulations.
For additional discussion of the risks and considerations surrounding our business in the context of our regulatory environment, see "Part I—Item 1A—Risk Factors."
International
International sales of our products are also subject to extensive regulation. The regulatory review process varies from country to country. The member countries of the European Union, or EU, have adopted the European Medical Device Directives, which create a single set of medical device regulations for all EU member countries. These regulations require companies that wish to manufacture and distribute medical devices in EU member countries to obtain the CE mark for their products. We have authorization to apply the CE mark to substantially all of our products. Additionally, we have obtained regulatory clearance to market our key products throughout other countries. In addition, the U.S. Foreign Corrupt Practices Act can be used to prosecute companies in the U.S. for arrangements entered into directly or through its affiliates with physicians, or other parties outside the U.S. if the physician or party is a government official of another country and the arrangement violates the law of that country. Other international laws such as the U.K. Anti-Bribery Act provide further restrictions on interactions with physicians and other potential customers.
General Considerations
The demand for our products is highly dependent on the policies of third-party payors such as Medicare, Medicaid, and private insurance and managed care organizations that reimburse our customers when they use our products. If coverage or payment policies of these third-party payors are revised in light of increased efforts to control healthcare spending or otherwise,

9

the amount we may charge or the demand for our products may decrease. Government programs, including Medicare and Medicaid, private healthcare insurance and managed-care plans have attempted and continue to attempt to control costs by limiting the amount of reimbursement they will pay for particular procedures or treatments. This practice has increased price sensitivity among certain customers for our products. Additionally, some third-party payors require approval of coverage for new or innovative devices or therapies before they will reimburse healthcare providers who use the medical devices or therapies. Even though a new medical device may have been approved for commercial distribution, we may find limited demand for the device until reimbursement approval has been obtained from governmental and private third-party payors. In the U.S., we believe that healthcare reform legislation proposals will most likely remain focused on reducing the cost of healthcare and that efforts by private payors to contain costs through managed care and other methods will continue in the future as efforts to reform the healthcare system continue. We believe we can effectively respond to reasonable changes resulting from the worldwide trend toward cost containment due to our manufacturing efficiencies and cost controls. However, it is difficult for us to predict the potential impact of cost containment trends on future operating results due to uncertainty that remains regarding future legislation.
Impact of Business Outside of the U.S.
Our operations in countries outside the U.S. are accompanied by certain financial and other risks. Relationships with customers and effective terms of sale vary by country, sometimes with longer payment terms on receivables than are typical in the U.S. Currency exchange rate fluctuations can affect the U.S. dollar value of net sales from, and profitability of, our operations outside the U.S. See "Part II—Item 7A—Quantitative and Qualitative Disclosures About Market Risk" and Note 17, "Segment Information" in the notes to the consolidated financial statements.
Product Liability Risk and Insurance Coverage
The development, manufacture and sale of medical products entail significant risk of product liability claims. Historically our product liability insurance coverage limits have been adequate to protect us from significant liabilities being imposed on us in connection with product liability claims. However, we cannot be assured that our current product liability insurance coverage limits will continue to be adequate, and we may require increased product liability coverage as products are successfully commercialized in additional applications. Product liability insurance is expensive and in the future may not be available to us on acceptable terms, if at all. A successful product liability claim or series of claims brought against us in excess of our insurance coverage could have a material adverse effect on our business, financial condition, results of operations and our ability to attract and retain customers for our products. We also have directors and officers, comprehensive general liability, cargo, business property and interruption, worker compensation, employed lawyers, employment practices, crime, and special contingency insurance coverage.
Employees
We have approximately 1,840 employees. In North America, we have approximately 480 employees, of which 24 are engaged in supply and logistics activities, 157 in research and development, process engineering, clinical affairs, regulatory affairs and quality assurance activities, 217 in sales, customer service and marketing activities, and 82 in administration, finance and corporate support functions. In Europe and Asia Pacific, we have approximately 243 employees responsible for our international markets. In Costa Rica, we have approximately 1,115 employees engaged in manufacturing and plant management. We have no employees covered by collective bargaining agreements, and we believe we maintain good relations with our employees.
Where You Can Find Additional Information
We maintain an internet website at www.arthrocare.com. On our website, we make available, free of charge, the following filings as soon as reasonably practicable after they are electronically filed with or furnished to the SEC: our annual reports on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, or the Exchange Act. You may also read and copy any materials that we file with the SEC at the SEC's Conventional Reading Room at 100 F Street, NE, Washington, DC 20549. You may obtain information on the operation of the Conventional Reading Room by calling the SEC at 1-800-SEC-0330. Our reports, proxy statements and other documents filed electronically with the SEC are available at the website maintained by the SEC at www.sec.gov.
Forward Looking Statements
This Annual Report may include "forward-looking" statements. Forward-looking statements broadly involve our current expectations or forecasts of future results. Our forward-looking statements generally relate to our growth and growth strategies, financial results, product development, regulatory approvals, competitive strengths, intellectual property rights, litigation and tax matters, mergers and acquisitions, market acceptance of our products, accounting estimates, financing activities, ongoing

10

contractual obligations and sales efforts. Such statements can be identified by the use of terminology such as "anticipate," "believe," "could," "estimate," "expect," "forecast," "intend," "may," "plan," "possible," "project," "should," "will" and similar words or expressions.
For more information about the nature of forward-looking statements and risks that could affect our future results and the disclosure provided in this Annual Report, please see "Part I—Item 1A—Risk Factors" and Exhibit 99.1—Forward-Looking Statements, which is incorporated herein by reference.
ITEM 1A.    RISK FACTORS
This section identifies specific risks that should be considered carefully in evaluating our business. Any of these risks could adversely affect our business, results of operations or financial condition. Although we believe that these risks represent the material risks relevant to us, our business and our industry, new material risks may emerge that we are currently unable to predict. As a result, this description of the risks that affect our business and our industry is not exhaustive. The risks discussed below could cause our actual results to differ materially from our historical results or the results contemplated by the forward-looking statements as described above.
Our entry into the Merger Agreement may have adverse impacts.
On February 3, 2014, we announced entry into an Agreement and Plan of Merger (the "Merger Agreement"). Consummation of the Merger Agreement is subject to customary closing conditions, including approval by our stockholders, the absence of any material adverse effect on our business and receiving antitrust approvals (including under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended). It is not certain that these conditions will be met or waived, that the necessary approvals will be obtained, or that we will be able to successfully consummate the merger as provided for under the Merger Agreement, or at all. We face risks and uncertainties due both to the pendency of the Merger as well as the potential failure to consummate the Merger, including:
•
We will remain liable for significant transaction costs, including legal, financial advisory, accounting, and other costs relating to the Merger even if it is not consummated;
•
If the Merger Agreement is terminated before we complete the Merger, under some circumstances, we may have to pay a termination fee of $54.9 million;
•
The pending Merger could have an adverse impact on our relationships with employees, customers and suppliers, and prospective customers or other third parties may delay or decline entering into agreements with us as a result of the announcement of the proposed Merger; and
•
The attention of our management and employees may be diverted from day-to-day operations.
    
The occurrence of any of these events individually or in combination could have a material adverse effect on our share price, business and cash flows, results of operations and financial position.
Our costs have increased due to the restatement of our previous financial statements announced in 2008 and completed in 2009, the Audit Committee's review of certain accounting, financial reporting and insurance billing and healthcare compliance practices and our response to and the settlement of the DOJ investigation by entry into a deferred prosecution agreement (“DPA”).  Failure to comply with the DPA  could result in severe civil or criminal penalties, which could materially adversely affect our business, financial condition, results of operations, and liquidity.
As of December 31, 2013, we settled or reached settlement on all known proceedings against the Company arising from the restatement or the Review including the investigation by the Department of Justice, or the DOJ investigation. See Note 10, "Litigation and Contingencies," in the notes to the 2013 consolidated financial statements. We have incurred substantial costs and expenses related to the Audit Committee's review of certain accounting, financial and reporting and insurance billing and healthcare compliance practices, and resulting investigations, proceedings, and indemnity obligations to former officers and to certain other employees and former employees. These matters may continue to divert our management's time and attention periodically and cause us to continue to incur substantial costs and expenses which will be funded without the benefit of further insurance coverage.
The Department of Justice ("DOJ") was investigating allegations of securities and related fraud committed under a previous management team.   On December 31, 2013, the Company entered into a Deferred Prosecution Agreement (“DPA”) with the DOJ. The DPA will resolve the ongoing investigation by the DOJ regarding allegations of securities and related fraud committed under a previous management team.   The DPA is for a 24-month period and requires the Company to maintain an effective compliance program and to make certain reports to the government.  Subject to its successful completion, the DOJ agrees that the DPA will expire and that the DOJ will seek dismissal of the criminal information. Compliance with the DPA

11

may increase the Company’s costs and failure to comply could result in criminal penalties and potential debarment from participation in Federal Healthcare programs.
We are subject to substantial government regulation that could have a material adverse effect on our business. Our failure to comply with extensive and evolving government regulations and laws could result in enforcement actions and subject us to civil or criminal penalties and materially adversely affect our business, results of operations and financial condition.
Our medical device products and operations are subject to extensive regulation by numerous governmental authorities both in the U.S. and abroad. See "Business—Government Regulation" for further details on such regulation. Government regulations and foreign requirements specific to medical devices are wide ranging and govern, among other things: design, development and manufacturing; testing, labeling and storage; clinical trials; product safety; marketing, sales and distribution; pre-market clearance and approval; record keeping procedures; advertising and promotions; recalls and field corrective actions; post-market surveillance, including reporting of deaths or serious injuries and malfunctions that, if they were to recur, could lead to death or serious injury; and product import and export.
During the past several years, the U.S. health care industry has been subject to an increase in governmental regulation at both the federal and state levels. We are subject to numerous federal and state regulations. As part of our internal compliance program, we review our sales and marketing materials, contracts and programs with counsel, and require employees and marketing representatives to participate in regular training. We also have adopted and train our personnel on the Code of Ethics on Interactions with Health Care Professionals promulgated by the Advanced Medical Technology Association or AdvaMed, a leading trade association representing medical device manufacturers. We believe our Code of Business Conduct and Ethics (the "Code of Ethics") qualifies as a "code of ethics" within the meaning of Section 406 of the Sarbanes-Oxley Act of 2002 and under the current Federal Sentencing Guidelines and the U.S. Department of Health and Human Services Office of Inspector General's Compliance Program Guidance for Pharmaceutical Manufacturers (68 FR 23731 (May 5, 2003)) applicable to medical device companies. The Code of Ethics applies to all of our directors, officers, employees and agents and serves as an essential element of our Corporate Compliance Program. However, we can give no assurances that our compliance program will ensure that the Company is in compliance with existing or future applicable laws and regulations. If our compliance program fails to meet its objectives, or if we otherwise fail to comply with existing or future applicable laws and regulations, we could suffer civil or criminal penalties. We devote significant operational and managerial resources to comply with these laws and regulations. Different interpretations and enforcement policies of these laws and regulations could subject our current practices to allegations of impropriety or illegality or could require us to make significant changes to our products and operations. In addition, we cannot predict the impact of future legislation and regulatory changes on our business or assure you that we will be able to obtain or maintain the regulatory approvals required to operate our business.
Both federal and state government agencies conduct civil and criminal enforcement efforts against health care companies, as well as their executives and managers. These efforts generally relate to a wide variety of matters, including referral and billing practices, and implicate a variety of state and federal laws, including state insurance fraud provisions, common law fraud theories, as well as both state and federal fraud-and-abuse, anti-kickback, false claims statutes, and the Foreign Corrupt Practices Act and similar international anti-bribery laws and regulations with which we must comply. Although we no longer directly bill any payor, some of our prior activities could become the subject of additional governmental investigations or inquiries. In addition, even though we no longer directly bill any payor, we are still subject to health care fraud and abuse laws and regulations, and enforcement thereof by both the federal government and the states in which we conduct our business.
In addition, amendments to the False Claims Act have made it easier for private parties to bring "qui tam" whistleblower lawsuits against companies. Numerous states have adopted similar state whistleblower and false claims provisions. The federal False Claims Act provides incentives for private plaintiffs to initiate lawsuits that lead to the government recovering money of which it was defrauded by providing that a private plaintiff may receive up to 30% of the proceeds from a successful litigation. If we, as a defendant in a qui tam lawsuit, are found to have violated the False Claims Act, we could be subject to treble damages, civil monetary penalties for each false claim submitted and exclusion from the Medicare and Medicaid programs. In addition, we could be subject to criminal penalties under a variety of federal statutes to the extent that we knowingly violate legal requirements under federal health programs or otherwise present false or fraudulent claims or documentation to the government.
The risk of our being found in violation of these laws is increased by the fact that many of them have not been fully interpreted by the regulatory authorities or the courts, and their provisions are open to a variety of interpretations. Moreover, recent health care reform legislation has strengthened these laws. For example, the Patient Protection and Affordable Care Act (PPACA) which was signed into law in March 2010, among other things, amends the intent requirement of the federal anti-kickback and criminal health care fraud statutes; a person or entity no longer needs to have actual knowledge of this statute or specific intent to violate it. The PPACA legislation, among other things, imposed a new excise tax on medical device makers effective January 1, 2013 which resulted in a reduction in our results of operations and our cash flows. Other elements of this legislation such as comparative effectiveness research, an independent payment advisory board, payment system reforms

12

including shared savings pilots and other provisions could significantly change the way healthcare is developed and delivered, and may materially impact many aspects of our business. We expect there will continue to be federal and state laws and/or regulations, proposed and implemented, that could impact our operations and business. The extent to which future legislation or regulations if any relating to health care fraud abuse laws and/or enforcement may be enacted or what effect such legislation or regulation would have on our business remains uncertain. If our operations are found to be in violation of any of the laws described above or any other governmental regulations that apply to us, we may be subject to penalties, including civil and criminal penalties, damages, fines, exclusion from governmental health care programs, and the curtailment or restructuring of our operations, any of which could adversely affect our ability to operate our business and our financial results.
The FDA, DOJ and other governmental authorities have broad enforcement powers, and if our operations are found to be in violation of any of the laws described above or any other governmental regulatory requirements, or if a governmental authority interprets the legality of one of our practices differently than we do, it could result in governmental agencies or a court taking action, which would adversely affect our business through any of the following: issuing public warning letters to us; imposing fines and penalties on us; obtaining an injunction preventing us from manufacturing or selling our products; bringing civil or criminal charges against us; delaying the introduction of our products into the market; delaying pending requests for clearance or approval of new uses or modifications to our existing products; recalling, detaining or seizing our products; or withdrawing or denying approvals or clearances for our products. For example, we and certain of our third-party suppliers are required to comply with the FDA's Quality System Regulation, ("QSR") which covers the methods and documentation of the design, testing, production, control, quality assurance, labeling, packaging, sterilization, storage and shipping of our products. We and our suppliers are also subject to the regulations of foreign jurisdictions regarding the manufacturing process if we market our products in these jurisdictions. The FDA enforces the QSR through periodic and unannounced inspections of manufacturing facilities. If our facilities or those of our suppliers fail to take satisfactory corrective action in response to an adverse QSR inspection, the FDA could take enforcement action, including any of the aforementioned actions.
Our intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, business, financial condition, results of operations and future growth prospects.
Our ability to compete effectively depends in part on developing and maintaining the proprietary aspects of our Coblation technology and our acquired technologies. We believe that our issued patents are directed at the core technology used in our soft-tissue surgery systems, as well as the use of Coblation technology in specific surgical procedures. In addition, we believe that our issued patents are directed at many of the core features of our acquired technologies (Opus, Atlantech, Applied Therapeutics, Inc., Eleven Blade and ENTrigue Surgical). Our earliest Coblation-related patent expired in January of 2012. The majority of our royalty income is associated with licenses that include core Coblation patent rights which extend through the end of 2015. A portion of license royalty revenue is associated with license grants from patents rights that extend beyond 2017. However, one licensee asserted in early 2012 that their license obligations expired in January 2012. Subsequently, this dispute was resolved and the licensee will continue to pay royalties into 2015. However, other licensees may in the future similarly attempt to assert that their license obligations end at an earlier date than we believe which may lead us to incur significant legal and dispute resolution costs to defend our right to royalties under our existing licenses.
There is no assurance that the patents we have obtained, or any patents we may obtain as a result of our pending U.S. or international patent applications, will provide adequate protection to insure any competitive advantages for our products. We also cannot assure investors that those patents will not be successfully challenged, invalidated or circumvented prior to their expiration. In addition, we cannot provide assurance that competitors, many of which have substantial resources and have made substantial investments in competing technologies, have not already applied for or obtained, or will not seek to apply for and obtain, patents that will prevent, limit or interfere with our ability to make, use and sell our products either in the U.S. or in international markets. In Sports Medicine, many of our competitors have licensed our technology for limited fields of use. Patent applications are maintained in secrecy for a period after filing. We may not be aware of all of the patents and patent applications potentially adverse to our interests.
A number of medical device and other companies, universities and research institutions have filed patent applications or have issued patents relating to i) monopolar and/or bipolar electrosurgical methods and apparatus, ii) soft tissue fixation methods and apparatus, and iii) sinus treatment methods and apparatus. We have received, and we may receive in the future, notifications of potential conflicts of existing patents, pending patent applications and challenges to the validity of existing patents. In addition, we have become aware of, and may become aware of in the future, patent applications and issued patents that relate to our products and/or the surgical applications and issued patents and, in some cases, have obtained internal and/or external opinions of counsel regarding the relevance of certain issued patents to our products. We do not believe that our products currently infringe any valid and enforceable claims of any issued patents that we have reviewed. However, if third-party patents or patent applications contain claims infringed by our technology and such claims are ultimately determined to be valid, we may not be able to obtain licenses to those patents at a reasonable cost, if at all, or be able to develop or obtain

13

alternative technology. Our inability to do either would have a material adverse effect on our business, financial condition, results of operations and future growth prospects. We cannot assure investors that we will not have to defend ourselves in court against allegations of infringement of third-party patents, or that such defense would be successful.
In addition to patents, we rely on trade secrets and proprietary know-how, which we seek to protect, in part, through confidentiality and proprietary information agreements. We require our employees and technical consultants to execute confidentiality agreements upon the commencement of an employment or consulting relationship with us. These agreements generally provide that all confidential information, developed or made known to the individual during the course of the individual's relationship with us, is to be kept confidential and not disclosed to third parties. These agreements also generally provide that inventions conceived by the individual in the course of rendering services to us shall be our exclusive property. We cannot assure investors that employees and consultants will not breach such agreements, that we would have adequate remedies for any breach or that our trade secrets will not otherwise become known to or be independently developed by competitors.
We may in the future be subject to intellectual property claims, which are costly to defend, could require us to pay damages and could limit our ability to use certain technologies in the future.
A number of medical device and other companies, universities and research institutions have filed patent applications or have issued patents relating to i) monopolar and/or bipolar electrosurgical methods and apparatus, ii) soft tissue fixation methods and apparatus and iii) sinus treatment methods and apparatus. We have received, and we may receive in the future, notifications of potential conflicts of existing patents, pending patent applications and challenges to the validity of existing patents. In addition, we have become aware of, and may become aware of in the future, patent applications and issued patents that relate to our products and/or the surgical applications and issued patents and, in some cases, have obtained internal and/or external opinions of counsel regarding the relevance of certain issued patents to our products. We do not believe that our products currently infringe any valid and enforceable claims of the issued patents that we have reviewed. However, if third-party patents or patent applications contain claims infringed by our technology and such claims are ultimately determined to be valid, we may not be able to obtain licenses to those patents at a reasonable cost, if at all, or be able to develop or obtain alternative technology. Our inability to do either would have a material adverse effect on our business, financial condition, results of operations and future growth prospects. We cannot assure investors that we will not have to defend ourselves in court against allegations of infringement of third-party patents, or that such defense would be successful.
We cannot assure you that we will not become subject to patent infringement claims or other litigation, including interference proceedings declared by the U.S. Patent and Trademark Office, (USPTO) or similar proceedings in foreign jurisdictions to determine the priority of inventions. The defense and prosecution of intellectual property lawsuits, USPTO reexamination and interference proceedings and related legal and administrative proceedings, generally are costly and time-consuming. If other parties violate our proprietary rights, further litigation may be necessary to enforce our patents, to protect trade secrets or know-how we own or to determine the enforceability, scope and validity of the proprietary rights of others. Any litigation or reexamination or interference proceedings will be costly and cause significant diversion of effort by our technical and management personnel.
An adverse determination in existing claims, additional litigation or reexamination or interference proceedings to which we may become a party could subject us to significant liabilities to third parties, require disputed rights to be licensed from third parties or require us to cease using certain technology. Furthermore, we cannot assure you that we could obtain necessary licenses on satisfactory terms, if at all. Adverse determinations in judicial or administrative proceedings or failure to obtain necessary licenses could prevent us from manufacturing and selling our products, which would have a material adverse effect on our business, financial condition, results of operations, and future growth prospects.
We may not be able to successfully introduce to the market new products in a timely manner, which could cause us to lose business to competitors.
We compete in a market characterized by rapidly changing technology. We may not be able to keep pace with technology or to develop viable new products. Our future financial performance will depend in part on our ability to develop and manufacture new products in a cost-effective manner, to introduce these products to the market on a timely basis, and to achieve market acceptance of these products. Factors which may result in delays of new product introductions or cancellation of our plans to manufacture and market new products include capital constraints, research and development delays, and delays in acquiring regulatory approvals. Our new products and new product introductions may fail to achieve expected levels of market acceptance. Factors impacting the level of market acceptance include our ability to successfully implement new technologies, the timeliness of our product introductions, our product pricing strategies, our available financial and technological resources for product promotion and development, our ability to show clinical benefit from our products, and the availability of coverage and reimbursement for our products as discussed in the risk factor titled "Changes in coverage and reimbursement for procedures using our products could affect use of our devices and our future revenue" below.

14

The markets for our products are intensely competitive, which may result in our competitors developing technologies and products that are more effective than ours or that make our technologies and products obsolete. Many of our competitors have significantly greater resources and market power than we do.
Our primary competitors across all of our operating units consist of Medtronic, Inc., Smith & Nephew, Stryker Corporation, Johnson & Johnson (through their Mitek and Acclarent subsidiaries), Olympus (through their Gyrus subsidiary), and Arthrex, Inc. These competitors tend to be large, well-financed companies with diverse product lines who may have significantly greater financial, manufacturing, marketing, distribution and technical resources than we do. Some of these companies offer broad product lines that they may offer as a single package and frequently offer significant price discounts as a competitive tactic. Furthermore, some of our competitors utilize purchasing contracts that link discounts on the purchase of one product to purchases of other products in their broad product lines. Many of the hospitals in the U.S. have purchasing contracts with our competitors. Accordingly, customers may be dissuaded from purchasing our products instead of our competitors' products to the extent the purchase would cause them to lose discounts on our competitors' products. In addition, we are aware of several small companies that may directly or indirectly compete with our products.
If we were to be unable to continue to compete for any of the above reasons, it could have a material adverse effect on our business, financial condition, results of operations and future growth prospects.
Failure to obtain FDA clearance or approval for our products could materially adversely affect our business, results of operations, financial condition, and future growth prospects.
The U.S. is the largest single market in which we sell our products. In the U.S., before we can market a new medical device, or a new use of, or claim for, or significant modification to an existing product, we must first receive either premarket clearance under Section 510(k) of the U.S. Federal Food, Drug, and Cosmetic Act, or FDCA, or approval of a Premarket Approval (PMA) submission from the FDA, unless an exemption applies. In the 510(k) clearance process, the FDA must determine that a proposed device is "substantially equivalent" to a device legally on the market, known as a "predicate" device, with respect to intended use, technology and safety and effectiveness, in order to clear the proposed device for marketing. Clinical data is sometimes required to support substantial equivalence. However, as was the case in our submission for 510(k) clearance of Coblator IQ ENT Plasma Wands, the FDA has a high degree of latitude when determining the amount of data it requires as part of determination and evaluation of submissions and may determine that a proposed device submitted for 510(k) clearance is not substantially equivalent, or NSE, to a predicate device.
An FDA NSE determination means that the device is automatically reclassified into Class III and we cannot market the device unless it is either approved through the PMA process or reclassified into Class I or Class II based on a new 510(k) submission with supporting data. A new submission may require clinical data. In addition, under new changes instituted by the Food and Drug Administration Safety and Innovation Act of 2012, or FDASIA, FDA may now change the classification of a medical device by administrative order, following a device classification panel meeting and public comment on the proposed reclassification. The PMA approval pathway requires an applicant to demonstrate the safety and effectiveness of the device based, in part, on data obtained in clinical trials. Both of these processes can be expensive and lengthy and entail significant user fees, unless exempt. The FDA's 510(k) clearance process usually takes from three to twelve months, but it can last longer. The process of obtaining PMA approval is much more costly and uncertain than the 510(k) clearance process. It generally takes from one to three years, or even longer, from the time the PMA application is submitted to the FDA until an approval is obtained. There is no assurance that we will be able to obtain FDA clearance or approval for any of our new products on a timely basis, or at all. Failure to obtain FDA clearance or approval for our new products could materially adversely affect our business, results of operations, financial condition, and future growth prospects.
After a device receives 510(k) premarket notification clearance from the FDA, any modification that could significantly affect its safety or effectiveness, or that would constitute a major change in the intended use of the device, technology, materials, packaging, and certain manufacturing processes may require a new 510(k) clearance or PMA. The FDA requires every manufacturer to make the determination regarding the need for a new 510(k) clearance or PMA approval in the first instance, but the FDA may review any manufacturer's decision and may retroactively require the manufacturer to submit a premarket notification requesting 510(k) clearance or an application for PMA approval. The FDA also can require the manufacturer to cease marketing and/or recall the modified device until 510(k) clearance or approval is obtained. It is expected that the FDA will introduce new changes to existing policy and practices regarding the assessment of whether a new 510(k) is required for changes or modifications to existing devices. For example, in response to industry and healthcare provider concerns regarding the predictability, consistency and rigor of the 510(k) regulatory pathway, the FDA initiated an evaluation of the 510(k) program, and in January 2011, announced several proposed actions intended to reform the review process governing the clearance of medical devices. Most recently, on July 9, 2012, FDASIA was signed into law, which, among other requirements, obligates the FDA to prepare a report for Congress on the FDA's approach for determining when a new 510(k) will be required for modifications or changes to a previously cleared device. After submitting this report, the FDA is expected to issue revised guidance to assist device manufacturers in making this determination. Until then, manufacturers may continue

15

to adhere to the FDA's 1997 guidance on this topic when making a determination as to whether or not a new 510(k) is required for a change or modification to a device, but the practical impact of the FDA's continuing scrutiny of these issues remains unclear. We have modified some of our marketed devices, and have determined that in certain instances new 510(k) clearances or PMA approvals are not required. No assurance can be made that the FDA would agree with any of our decisions not to seek 510(k) clearance or PMA approval. If the FDA requires us to cease marketing and/or recall the modified device until we obtain a new 510(k) clearance or PMA approval, our business, financial condition, results of operations and future growth prospects could be materially adversely affected.
We may be subject to fines, penalties or injunctions if we are determined to be promoting the use of our products for unapproved or "off-label" uses, which would adversely affect our financial condition.
Our promotional materials and training methods must comply with FDA regulations and other applicable laws and regulations, including the prohibition of the promotion of a medical device for a use that has not been cleared or approved by the FDA. Use of a device outside its cleared or approved indications is known as "off-label" use. Physicians may use our products off-label, as the FDA does not restrict or regulate a physician's choice of treatment within the practice of medicine. However, if the FDA determines that our promotional materials or training constitutes the promotion of an off-label use, it could subject us to certain sanctions ranging from a request that we modify our training or promotional materials to further regulatory or enforcement actions, including the issuance of an untitled letter, a warning letter, injunction, seizure, civil fine and/or criminal penalties against us or our officers or employees. It is also possible that other federal, state or foreign enforcement authorities might take action if they consider our promotional or training materials to constitute promotion of an unapproved use, which could result in significant fines or penalties under other statutory authorities, such as laws prohibiting false claims for reimbursement. In that event, our reputation could be damaged and adoption of the products would be impaired. Although our policy is to refrain from statements that could be considered off-label promotion of our products, the FDA or another regulatory agency could disagree and conclude that we have engaged in off-label promotion. In addition, the off-label use of our products may increase the risk of injury to patients, and, in turn, the risk of product liability claims. Product liability claims are expensive to defend and could divert our management's attention and result in substantial damage awards against us.
Our products may in the future be subject to product recalls that could harm our reputation, business operations and financial results, and if our products cause or contribute to a death or serious injury, we will be subject to medical device reporting regulations, which can result in voluntary corrective actions or FDA enforcement actions.
The FDA and similar foreign governmental authorities have the authority to require the recall of commercialized products in the event of material deficiencies or defects in design or manufacture or in the event that a product poses an unacceptable risk to health. Manufacturers may, under their own initiative, recall a product if any material deficiency in a device is found. A government mandated or voluntary recall by us or one of our distributors could occur as a result of an unacceptable risk to health, component failures, manufacturing errors, design or labeling defects or other deficiencies and issues. Recalls of any of our products would divert managerial and financial resources and have an adverse effect on our financial condition and results of operations. Any of these sanctions could impair our ability to produce our products in a cost-effective and timely manner in order to meet customer' demand. We may also be required to bear other costs or take other actions that may have a negative impact on our future sales and our ability to generate profits.
Further, under the FDA medical device reporting regulations we are required to report to the FDA any incident in which our product may have caused or contributed to a death or serious injury or in which our product malfunctioned and, if the malfunction were to recur, would likely cause or contribute to death or serious injury. Any adverse event involving our products could result in future voluntary corrective actions, such as recalls or customer notifications, or agency action, such as inspection, mandatory recall or other enforcement action. Any corrective action, whether voluntary or involuntary, as well as defending ourselves in a lawsuit, will require the dedication of our time and capital, distract management from operating our business, and may harm our reputation and financial results.
Changes in coverage and reimbursement for procedures using our products could affect use of our devices and our future revenue.
The demand and pricing for our products is highly dependent on the policies of third-party payors such as Medicare, Medicaid, private insurance, and managed care organizations that reimburse our customers when they use our products. Failure by physicians, hospitals and other users of our products to obtain sufficient coverage and reimbursement from healthcare payors for procedures in which our products are used, or adverse changes in environmental and private third-party payors' policies toward coverage and reimbursement for such procedures would have a material adverse effect on our business, financial condition, results of operations and future growth prospects.

16

In the U.S., third-party payors continue to implement initiatives that restrict the use of certain technologies to those that meet certain clinical evidentiary requirements. We are aware of several third-party payors in the U.S., including governmental payors such as Medicare and Medicaid and private health insurance companies, who consider Coblation technology used in certain procedures to treat certain clinical conditions to be experimental or investigational. These payors have developed policies that deny coverage and therefore make no reimbursement for such procedures using our devices. Procedures using our devices that are not covered by some payors include such procedures as plasma disc decompression, or Coblation nucleoplasty, as well as Coblation or radiofrequency volumetric tissue reduction for (1) removing soft tissue during arthroscopic surgery, (2) hypertrophied nasal turbinates for the treatment of chronic nasal obstruction or obstructive sleep apnea and (3) soft palate and tongue for the treatment of obstructive sleep apnea. However, some payors in the U.S. provide coverage and reimbursement for Coblation tonsillectomy for certain clinical indications. In addition, some payors are moving toward a managed care system and control their health care costs by limiting authorizations for surgical procedures, including elective procedures using our devices. Failure to obtain favorable payor policies could have a material adverse effect on our business and operations.
In addition to uncertainties surrounding coverage policies, third-party payors from time to time update reimbursement amounts and also revise the methodologies used to determine reimbursement amounts. This includes annual updates to payments to ambulatory surgical centers and physicians for procedures using our products. Because the cost of our products generally is recovered by the healthcare provider as part of the payment for performing a procedure and not separately reimbursed, these updates could directly impact the demand for our products. An example of payment updates is the Medicare program updates to physician payments, which is done on an annual basis using a prescribed statutory formula. In the past, when the application of the formula resulted in lower payment, Congress has passed interim legislation to prevent the reductions. Most recently, the American Taxpayer Relief Act (ATRA), signed into law in January 2013, froze the 2012 payment rates under the Medicare Physician Fee Schedule through 2013. If Congress fails to intervene to prevent the negative update factor in future years, the resulting decrease in payment may adversely affect our revenues and results of operations. In addition, ATRA, among other things, delayed for another two months the budget cuts mandated by these sequestration provisions of the Budget Control Act of 2011. The ATRA also reduced Medicare payments to several providers, including hospitals, imaging centers and cancer treatment centers, and increased the statute of limitations period for the government to recover overpayments to providers from three to five years.
Market acceptance of our products in international markets would be dependent, in part, upon the availability of coverage and reimbursement within prevailing health care payment systems which vary significantly by country and may include both government sponsored health care and private insurance. We cannot assure investors that any reimbursement approvals will be obtained in a timely manner, if at all, or assess the impact on our business of any future changes, if any, that are made to coverage and reimbursement policies by government action in key international markets.
Product liability claims could adversely impact our financial condition and impair our reputation.
Our business exposes us to potential product liability risks which are inherent in the design, manufacture and marketing of medical devices. In addition, many of our products are designed to be implanted in the human body for long periods of time. Component failures, manufacturing flaws, design defects or inadequate disclosure of product related risks or product related information with respect to these or other products we manufacture or sell could result in an unsafe condition or injury to a patient. The occurrence of such a problem could result in product liability claims or a recall of one or more of our products, which could ultimately result in the removal from the body of such products and claims regarding associated costs and damages, which could materially adversely impact our business, financial condition, results of operations, our ability to attract and retain customers for our products, and future growth prospects.
We cannot assure you that our current product liability insurance coverage limits are adequate to protect us from any liabilities we might incur in connection with the development, manufacture and sale of our products. In addition, we may require increased product liability coverage as products are successfully commercialized in additional applications. Product liability insurance is expensive and in the future may not be available to us on acceptable terms, if at all. A successful product liability claim or series of claims brought against us in excess of our insurance coverage could have a material adverse effect on our business, financial condition, results of operations, our ability to attract and retain customers for our products, and future growth prospects.
We are dependent on key suppliers, and supply disruptions could materially adversely affect our business, financial condition, results of operations and future growth prospects.
Some of the raw materials and components within our products are purchased from single vendors. If the supply of materials from a single source supplier were interrupted, replacement or alternative sources might not be readily obtainable. An inability to continue to source materials or components from any of these suppliers, which could be due to regulatory actions or requirements affecting the supplier, adverse financial or other strategic developments experienced by a supplier, labor disputes

17

or shortages, unexpected demands or quality issues, could adversely affect our ability to satisfy demand for our products. A new or supplemental filing with applicable regulatory authorities may require us to obtain clearance prior to our marketing a product containing new material. This clearance process may take a substantial period of time and we cannot assure investors that we would be able to obtain the necessary regulatory approval for a new material to be used in our products on a timely basis, if at all. This could create supply disruptions that would materially adversely affect our business, financial condition, results of operations and future growth prospects.
The Dodd-Frank Wall Street Reform and Consumer Protection Act imposes new disclosure requirements regarding the use of "conflict" minerals mined from the Democratic Republic of Congo and adjoining countries in products, whether or not these products are manufactured by third parties. These new requirements are intended to affect the sourcing and availability of minerals used in the manufacture of any products that use the defined minerals, including medical devices. In addition to adding administrative costs associated with complying with the disclosure requirements, it is reasonably possible that the cost of our materials could increase as a result of the legislation for any conflict minerals used in our products regardless if where the minerals are sourced. Our supply chain is complex and we may be unable to verify the origins for all metals used by suppliers or their sub-suppliers for components included in our products. We may also encounter activism from our customers and stockholders if we are unable to certify that our products are conflict free.
In addition, we primarily use a subcontractor located in Costa Rica to sterilize our disposable devices. We have the ability to use alternative sterilization service providers for most of our products. If our Costa Rica sterilization service were to be disrupted for any reason, we would be required to use alternative sources with potentially longer processing and logistics cycles, which could lead to a disruption in our ability to supply products for a period of time.
We are dependent on warehouses in the U.S. and Belgium owned and operated by Deutsche Post DHL, Inc. Our ability to supply products to our customers in a timely manner and at acceptable commercial terms could be disrupted by factors such as fire, earthquake or any other natural disaster, work stoppages, disputes or difficulties between Deutsche Post DHL, Inc. and its employees, malfunctions in Deutsche Post DHL, Inc.'s information systems or disruptions in Deutsche Post DHL, Inc.'s shipping channels.
Many of our business processes depend upon our information technology systems and the proper interaction with or interfacing with systems of third parties or with systems supplied by third parties. If those systems fail or are interrupted, or if our ability to connect to or interact with one or more networks is interrupted, our processes may not function properly or at all. In addition, our servers are vulnerable to computer viruses, unauthorized tampering and other disruptions. These occurrences could harm our ability to ship products, and our financial results would likely be adversely affected.
Our business is susceptible to risks associated with international operations.
International operations are generally subject to a number of risks, including: protectionist laws, business practices, licenses, tariffs and other trade barriers that favor local competition; multiple, conflicting and changing governmental laws and regulations, such as tax laws regulating intercompany transactions; difficulties in managing foreign operations, including staffing, seasonality of operations, dependence on local vendors, and collecting accounts receivable; loss of proprietary information due to piracy, misappropriation or weaker laws regarding intellectual property protection; foreign currency uncertainties; and political and economic instability.
To be able to market and sell our products in other countries, we must obtain regulatory approvals and comply with the regulations of those countries. These regulations, including the requirements for approvals and the time required for regulatory review, vary from country to country and we cannot be certain that we will receive regulatory approvals in any foreign country in which we plan to market our products. If we fail to obtain or maintain regulatory approval in any foreign country in which we plan to market our products, our ability to generate revenue could be harmed.
We derived 32.8 percent, 31.6 percent and 31.0 percent of our total product sales for the year ended December 31, 2013, 2012 and 2011, respectively, from customers located outside of the Americas and we expect international revenue to remain a significant percentage of total revenue. Historically, a majority of our international revenues and costs have been denominated in foreign currencies and we expect future international revenues and costs will be mostly denominated in foreign currencies.
Disruptions or other adverse developments at our Costa Rica facility could materially adversely affect our business.
Our products are manufactured at our facility in an industrial park in San Jose, Costa Rica. We do not maintain redundant manufacturing facilities of sufficient scale to meet our current business needs in the event of a major disruption to our Costa Rica facility. If our Costa Rica facility is not able to produce sufficient quantities of our products with adequate quality, or if our Costa Rica operations are disrupted for any reason, then we may be forced to locate alternative manufacturing facilities, including facilities operated by third parties. Disruptions may include, but are not limited to: changes in the legal and regulatory environment in Costa Rica; slowdowns or work stoppages within the Costa Rican customs authorities; acts of God (including

18

but not limited to potential disruptive effects from an active volcano near the facility or earthquakes, hurricanes and other natural disasters); and other issues associated with significant operations that are remote from our headquarters and operations centers. Additionally, continued growth in product sales could outpace the ability of our Costa Rican operation to supply ordered products on a timely basis or cause us to take actions within our supply and manufacturing operations which increase costs, complexity and timing. Locating alternative facilities would be time-consuming, would disrupt our production and cause shipment delays and could result in damage to our reputation and profitability. Additionally, we cannot assure you that alternative manufacturing facilities would offer the same cost structure as our Costa Rica facility.
One Equity Partners, a private equity firm, may have influence on our major corporate decisions.
As previously reported, on September 1, 2009, an affiliate of One Equity Partners, or OEP, a private equity firm, acquired our Series A Preferred Stock. See "Part II—Item 7—Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources" in our 2009 Form 10-K for a description of this transaction. As a result of this transaction, OEP became the largest beneficial owner of our stock. In connection with this transaction, we expanded the Board of Directors to eight members and granted OEP the right to nominate two directors. Effective September 1, 2009, Messrs. Gregory Belinfanti and Christian Ahrens, both partners of OEP, were appointed to our Board of Directors. On February 11, 2014, the Series A Preferred Stock was converted to Common Stock and OEP's ownership interest is approximately 15.2 percent of our voting stock.
Consequently, OEP may have the ability to influence our Board of Directors and matters requiring stockholder approval, subject to the restrictions placed on OEP by the Securities Purchase Agreement, including without limitation OEP's agreement to vote for any director nominated by the Board. OEP is free to dispose of its holding, which could result in a decrease of the market price of our Common Stock, particularly if such dispositions are made in the open market and are substantial.
Circumstances associated with our integration of acquisitions may adversely affect our operating results.
An element of our growth strategy in the future may be the pursuit of acquisitions of other businesses that expand or complement our existing products and distribution channels. Integrating businesses, however, involves a number of special risks, including: the possibility that management attention may be diverted from regular business concerns by the need to integrate operations; unforeseen costs, difficulties and liabilities in integrating our and the acquired company's employees, operations and systems; accounting, regulatory, or compliance issues that could arise in connection with, or as a result of, the acquisition of the acquired company; challenges in retaining our customers or the customers of the acquired company following the acquisition; the difficulty of incorporating acquired technology and rights into our products and services; and impairment charges if our acquisitions are not successful due to these risks.
In addition, we may finance future acquisitions by issuing equity securities, which may dilute the holdings of our current stockholders. If we are unable to successfully complete and integrate strategic acquisitions in a timely manner, our business, financial condition or operating results may be adversely affected.
Unidentified or other control deficiencies relating to our internal control over financial reporting could result in errors in our reported results and could have a material adverse effect on our operations, investor confidence in our business and the trading prices of our securities.
Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting can also be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements will not be prevented or detected on a timely basis by internal control over financial reporting.
ITEM 1B.    UNRESOLVED STAFF COMMENTS
None.

19

ITEM 2.    PROPERTIES
We lease facilities in Austin, Texas, which are used for general and administrative purposes, research and development activities, training, and may in the future be used for product or prototype manufacturing. Our leases in Austin, Texas generally will expire in 2022. We also have a lease for space in an Austin, Texas office building that was previously used as our corporate headquarters. In addition to these leases, beginning in 2013 we leased a facility in Austin, Texas that is used in the manufacturing of our Rapid Rhino product line. We lease a facility in Irvine, California, which is used for product and prototype development and this lease expires in March 2016. Internationally, we lease various facilities in support of local sales and marketing activities. We have access to a facility in Opglabbeek, Belgium that is used for controller servicing, returns processing, and product repackaging. In Costa Rica, we own a building located in a tax-advantaged business park which is used as our principal manufacturing location for our products. In Q3 2013, we entered into agreements with Zona Franca Coyol, S.A. (“CFZ”) under which we acquired property in Alajuela, Costa Rica from CFZ and CFZ has been contracted to design and construct a new manufacturing facility for the Company on the acquired property.
We believe these facilities, in addition to multiple less significant facilities leased in various countries around the world for sales and marketing purposes are adequate to conduct our current business.
ITEM 3.    LEGAL PROCEEDINGS
In addition to the matters specifically described below, we are involved in other legal and regulatory proceedings that arise in the ordinary course of business that do not have a material impact on our business. Litigation claims and proceedings of all types are subject to many factors that generally cannot be predicted accurately.
We record reserves for claims and lawsuits when they are probable and reasonably estimable. Except as otherwise specifically noted, we currently cannot determine the ultimate resolution of the matters described below. For matters where the likelihood or extent of a loss is not probable or cannot be reasonably estimated, we have not recognized in our consolidated financial statements the potential liability that may result from these matters. Further, for such matters where a loss is believed to be reasonably possible, but not probable, no accrual has been made and an estimate of the reasonably possible loss cannot be made at this time. If one or more of these matters is determined against the Company, it could have a material adverse effect on our earnings, liquidity and financial condition.
We continue to gather additional facts and information related to insurance billing and healthcare compliance issues and marketing and promotional practices in connection with these legal and administrative proceedings with the assistance of legal counsel.
DOJ Investigation
On December 31, 2013, the Company entered into a Deferred Prosecution Agreement ("DPA") with the DOJ. The DPA will resolve the ongoing investigation by the DOJ regarding allegations of securities and related fraud committed under a previous management team.
In conjunction with the DPA, the DOJ concurrently filed a criminal information concerning a single-count of conspiracy to commit wire and securities fraud. The DPA is for a 24 month period and, subject to its successful completion, the DOJ agrees that the DPA will expire and that the DOJ will seek dismissal of the criminal information. Pursuant to the DPA, ArthroCare paid, subsequent to December 31, 2013, a $30 million fine to the DOJ and agreed to maintain a compliance program meeting certain criteria specified in the DPA. ArthroCare also must report annually on the status of the Compliance Program to the DOJ.
As discussions were on-going throughout the year, a charge of $20.2 million was recorded in the second quarter of 2013 as investigation and restatement related expenses which increased the balance of the Company’s insurance dispute and settlement reserve to $30 million.
False Claims Act Investigation
In the first quarter of 2012, the Company received a Civil Investigative Demand ("CID") from the DOJ, requesting information related to the marketing of its radio-frequency ablation devices, which could implicate the False Claims Act, 31 U.S.C. § 3729. On January 17, 2014, a representative of the DOJ confirmed to the Company that the CID related to a qui tam case, in which the DOJ elected not to intervene, had been dismissed by the United States District Court in the Eastern District of New York. The case, United States of America ex rel. Michael Scherl v. ArthroCare Corporation et al., 2:11-cv-00668-LDW-AKT (E.D.N.Y. Feb 10, 2011), had previously been filed under seal and alleged violations of the False Claims Act. Based on the confirmation from the DOJ, the Company believes that the CID matter is closed.


20

Legal Proceedings Related to the Merger
Between February 4, 2014 and February 12, 2014, five putative class action lawsuits were filed in the Court of Chancery of the State of Delaware by alleged stockholders of ArthroCare Corporation (“ArthroCare” or the “Company”) against the Company and the individual directors of the Company, as well as Smith & Nephew, Inc., Rosebud Acquisition Corporation and Smith & Nephew PLC (collectively, “Smith Nephew”), and in one case, against One Equity Partners LLC, OEP AC Holdings, LLC, (together, with One Equity Partners LLC, “OEP”) and JPMorgan Chase & Co. (“JPM”).  These lawsuits are captioned: King v. ArthroCare Corporation et al. C.A. No. 9313, Rybacki v. ArthroCare Corporation et al. C.A. No. 9336, State-Boston Retirement System v. Fitzgerald et al., C.A. No. 9346, Dixon v. ArthroCare Corporation et al., C.A. No. 9347 and Machcinski v. ArthroCare Corporation et al., C.A. No. 9344. 
These lawsuits generally allege that the members of ArthroCare’s Board of Directors breached their fiduciary duties in negotiating and approving the merger agreement with Smith Nephew, that the merger consideration undervalues the Company, that ArthroCare’s stockholders will not receive adequate or fair value for their ArthroCare common stock in the merger and that the terms of the merger agreement impose improper deal protection terms that preclude competing offers.  The King lawsuit further alleges that the Board of Directors have failed to provide ArthroCare stockholders with complete and accurate information about the proposed merger.  The State-Boston Retirement System lawsuit further alleges that JPM and OEP had conflicts of interest in the transaction, resulting from OEP’s investment in ArthroCare and JPM’s economic interest in the buy-side financial advisor fees and the buy-side financing fees and economics, and that JPM’s involvement as Smith Nephew’s advisor and deal financing source violated the terms of the securities purchase agreement that OEP entered into with ArthroCare at the time that OEP invested in the Company.  The lawsuits further allege that the Company and/or Smith Nephew, and in the State-Boston Retirement System case, OEP and JPM, aided and abetted the purported breaches of fiduciary duty.  The State-Boston Retirement System case further alleges that OEP breached the securities purchase agreement entered into between OEP and the Company, and that JPM and Smith Nephew tortuously interfered with the securities purchase agreement.
The lawsuits seek, among other things, to enjoin the merger, or in the event that an injunction is not entered and the merger closes, rescission of the Merger and unspecified money damages, costs and attorneys’ and experts’ fees.  We believe these lawsuits are meritless and intend to defend against them vigorously.
ITEM 4.    MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5.    MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
The following table sets forth, for the periods indicated, the quarterly high and low sales prices of our Common stock as listed on the NASDAQ Composite Index.
 
 
Year Ending December 31, 2013
 
 
Quarter 1
 
Quarter 2
 
Quarter 3
 
Quarter 4
High
 
$
36.99

 
$
36.58

 
$
37.49

 
$
40.48

Low
 
34.06

 
32.28

 
31.56

 
33.50


 
 
Year Ending December 31, 2012
 
 
Quarter 1
 
Quarter 2
 
Quarter 3
 
Quarter 4
High
 
$
32.63

 
$
29.49

 
$
32.81

 
$
34.68

Low
 
23.54

 
24.13

 
27.21

 
29.33

As of January 31, 2014, there were 161 holders of record of 28,567,064 shares of outstanding common stock. We have not paid any cash dividends since our inception and do not anticipate paying cash dividends on our common stock or preferred stock in the foreseeable future. There were no purchases of equity securities made by the Company during the year-ended December 31, 2013.

21

On February 11, 2014, the Series A Preferred Stock was converted to 5,805,921 shares of the Company's common stock in accordance with the terms of the automatic conversion feature.
We describe our equity compensation plans in our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Exchange Act in connection with our annual meeting of stockholders scheduled to be held on or before June 22, 2014, which is hereby incorporated herein by reference. See further discussion regarding our equity compensation plan and the common stock that may be issued upon the exercise of options, warrants and rights under our existing equity compensation plan in Part III - Item 12 - Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
PERFORMANCE GRAPH
 This performance graph shall not be deemed "filed" for purposes of Section 18 of the Exchange Act, or incorporated by reference into any filing of ArthroCare under the Securities Act or the Exchange Act, except as shall be expressly set forth by specific reference in such filing.
The following graph shows a comparison of total stockholder return for holders of our common stock for the five years ended December 31, 2013 compared with the Nasdaq Stock Exchange, U.S. Index and the Nasdaq Health Services Index. This graph is presented pursuant to SEC rules. The information below is based on $100 invested on December 31, 2008, including reinvestment of dividends with fiscal years ending December 31. The stock prices of medical device companies like ours are subject to a number of factors, such as those discussed in "Part I—Item 1A—Risk Factors," above.


___________________________________________________________
*
$100 invested on 12/31/08 in stock or index, including reinvestment of dividends. Fiscal year ending December 31.

 
 
2008
 
2009
 
2010
 
2011
 
2012
 
2013
ArthroCare Corporation
 
100.00

 
496.86

 
651.15

 
664.15

 
725.16

 
843.61

NASDAQ Composite
 
100.00

 
144.88

 
170.58

 
171.30

 
199.99

 
283.39

NASDAQ Health Services
 
100.00

 
118.31

 
122.82

 
111.62

 
117.99

 
163.12


22

ITEM 6.    SELECTED CONSOLIDATED FINANCIAL DATA
The following selected financial data (in thousands, except per share data) should be read in conjunction with "Part II—Item 7—Management's Discussion and Analysis of Financial Condition and Results of Operations" and the consolidated financial statements and notes thereto included in this Annual Report on Form 10-K. The statements of comprehensive income data for the years ended December 31, 2013, 2012 and 2011 and the balance sheet data as of December 31, 2013 and 2012 have been derived from audited consolidated financial statements included elsewhere in this report. The historical results are not necessarily indicative of the results of operations to be expected in the future.
 
 
Year Ended December 31,
 
 
2013
 
2012
 
2011
 
2010
 
2009
Statements of Comprehensive Income:
 
 
 
 
 
 
 
 
 
 
Product sales(1)
 
$
358,564

 
$
350,671

 
$
338,319

 
$
338,757

 
$
308,493

Royalties, fees and other
 
19,425

 
17,783

 
16,566

 
16,622

 
15,624

Total revenues
 
377,989

 
368,454

 
354,885

 
355,379

 
324,117

Gross profit
 
261,725

 
260,503

 
251,571

 
244,628

 
233,177

Operating expenses(2)
 
229,760

 
196,369

 
267,038

 
190,358

 
233,124

Net income (loss) from continuing operations
 
26,056

 
46,378

 
(2,813
)
 
37,518

 
(5,296
)
Net income (loss)
 
26,056

 
46,378

 
(902
)
 
37,084

 
(5,777
)
Net income (loss) applicable to common stockholders(3)
 
22,321

 
42,803

 
(4,318
)
 
33,820

 
(33,822
)
Net earnings (loss) per share from continuing operations applicable to common stockholders
 
 
 
 
 
 
 
 
 
 
Basic
 
$
0.65

 
$
1.28

 
$
(0.23
)
 
$
1.04

 
$
(1.24
)
Diluted
 
$
0.64

 
$
1.25

 
$
(0.23
)
 
$
1.03

 
$
(1.24
)
Net earnings (loss) per share applicable to common stockholders
 
 
 
 
 
 
 
 
 
 
Basic
 
$
0.65

 
$
1.28

 
$
(0.16
)
 
$
1.03

 
$
(1.26
)
Diluted
 
$
0.64

 
$
1.25

 
$
(0.16
)
 
$
1.02

 
$
(1.26
)
 
 
December 31,
 
 
2013
 
2012
 
2011
 
2010
 
2009
Balance Sheet Data:
 
 
 
 
 
 
 
 
 
 
Cash, cash equivalents, restricted cash equivalents and investments
 
$
214,853

 
$
218,787

 
$
219,605

 
$
132,536

 
$
57,386

Working capital(4)
 
247,380

 
287,730

 
222,742

 
191,939

 
106,267

Total assets
 
594,141

 
519,787

 
533,001

 
439,195

 
391,128

Long-term liabilities
 
21,554

 
20,554

 
18,951

 
13,979

 
5,147

Series A 3% Redeemable Convertible Preferred Stock
 
84,494

 
80,759

 
77,184

 
73,768

 
70,504

Total stockholders' equity
 
403,095

 
364,007

 
306,738

 
295,728

 
250,395

_______________________________________________
(1)
Product sales in 2010 include $6.6 million of previously deferred product sales and $2.1 million increased contract manufacturing sales when compared to 2011.
(2)
Operating expenses include $37.0 million, $10.8 million, $80.8 million, $5.9 million and $34.9 million of investigation and restatement cost for the years ended December 31, 2013, 2012, 2011, 2010 and 2009, respectively. Investigation and restatement cost in 2011 includes a $74 million accrual related to the settlement of the private securities class actions and in 2013 includes a $20.2 million accrual related to the financial component of the settlement of the DOJ investigation. Operating expenses in 2011 also include exit costs of $8.3 million related to the relocation of our Sunnyvale, California office to Austin, Texas as well as $3.8 million of costs related to this event that did not qualify to be classified as exit costs.
(3)
The 2009 net loss applicable to common stock holders included a charge of $28.0 million related to the accretion of the beneficial conversion feature, preferred stock discount and accrued dividends on the Series A Preferred Stock compared to $3.7 million, $3.6 million, $3.4 million and $3.3 million in 2013, 2012, 2011 and 2010, respectively.
(4)
Working capital in 2011 is net of $74 million accrued liability related to the settlement of the private securities class actions. See Note 10 in the consolidated financial statements.

23

ITEM 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 The following discussion should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this report. Readers should also review carefully "Part I—Item 1A—Risk Factors" and Exhibit 99.1—"Forward-Looking Statements," which provides information about the forward-looking statements in this report and a discussion of the factors that might cause our actual results to differ, perhaps materially, from these forward-looking statements.
Overview
We are a medical device company that develops, manufactures and markets surgical products, many of which are based on our minimally invasive patented Coblation® technology. Our products are used across several medical specialties, improving many existing soft-tissue surgical procedures and enabling new minimally invasive surgical procedures. Our business consists of one operating and reportable segment for the development, manufacturing and marketing of disposable devices and implants for select surgical procedures. The product development, manufacturing and other supporting functions, such as regulatory affairs and distribution, are common across our Company. We organize and manage our sales and marketing functions according to geography and the surgical procedure that typically employs our products. Most of the Company's products are used in Sports Medicine or ENT procedures.
Key Financial Items, Trends and Uncertainties Affecting Our Business
Our management reviews and analyzes several metrics and ratios in order to manage our business and assess the quality of and potential variability of our operating performance. The most important of these financial metrics and ratios include:
Product Sales Growth
Our principal source of revenue has come from and is expected to continue to come from sales of our products, which primarily include disposable surgical devices and implants. Depending on geography, product sales are made through our employed sales representatives, independent sales agents or distributors. Product sales increased $7.9 million or 2.3 percent for the year ended December 31, 2013 as compared to the year ended December 31, 2012, increased $12.4 million or 3.7 percent for the year ended December 31, 2012 as compared to the year ended December 31, 2011 and decreased $0.4 million or 0.1 percent for the year ended December 31, 2011 as compared to the year ended December 31, 2010.
In 2013, 2012 and 2011, International sales comprised 32.8 percent, 31.6 percent and 31.0 percent of our consolidated product sales. Changes in the U.S. dollar exchange rate of foreign currencies in which we operate reduced the U.S dollar value of product sales by $0.6 million in 2013, reduced the value of product sales by $3.8 million in 2012 and increased the value of product sales by $5.9 million in 2011. In constant currency, product sales increased 2.4 percent, increased 4.8 percent and decreased 1.9 percent for the years ended 2013, 2012 and 2011. We believe percentage sales growth in constant currency is an important metric for evaluating trends in our business because to measure percentage sales growth in constant currency, we remove the impact of changes in foreign currency exchange rates. Percentage sales growth in constant currency is calculated by translating current year sales at prior year average foreign currency exchange rates. Constant currency is a non-GAAP measure and should not be considered as a substitute for measures prepared in accordance with GAAP.
We contract manufacture disposable surgical devices and implants based on our technologies for other medical devices companies. Product sales from contract manufacturing for the years ended December 31, 2013, 2012 and 2011 were $23.5 million, $23.8 million, and $23.5 million, respectively.
We also generate revenue from royalties from licensing our products and technology to other companies, and earn other revenues from shipping and handling costs billed to customers. Royalties combined with shipping and handling costs are reported as Royalties, fees and other in our Consolidated Statement of Comprehensive Income.
Gross Product Margin
Gross product margin as a percentage of product sales in 2013, 2012, and 2011 was 67.6 percent, 69.2 percent and 69.5 percent, respectively. Cost of product sales consists of all product manufacturing costs (including material costs, labor costs, manufacturing overhead, warranty and other direct product costs), adjustments to the carrying value of inventory for excess or obsolete items, certain stock based compensation costs associated with manufacturing and operations personnel, costs of product shipped to our customers and beginning on January 2, 2013, excise tax imposed on our U.S. product sales resulting from the Patient Protection and Affordable Care Act which was signed into law in March 2010 (the "Medical Device Tax"). Cost of product sales also includes the amortization of controller units and instruments that have been placed at customer

24

locations to enable the use of our disposable surgical products. We maintain ownership of all placed controllers and instruments and the costs are amortized into cost of product sales over their estimated useful life. Our manufactured products are mostly produced at our Costa Rica facility. Raw materials used to produce our products are generally not subject to substantial commodity price volatility. Most of our product manufacturing costs are incurred in U.S. dollars.
The comparability of gross product margin between periods will be impacted by several items, including the Medical Device tax that was newly implemented in 2013; the mix between proprietary and contract manufactured product sales; the stability of the average sales price we realize on proprietary products; changes in foreign exchange rates used to translate foreign currency denominated sales into U.S. dollars; changes in the estimated percentage of engineering activities related to manufacturing process design or improvement; and changes in our product emphasis which could result in excess and obsolescence charges being included in the cost of product sales in a particular period.
Operating Margin
Operating margin is our income from operations as a percentage of total revenues. Our key operating expenses include expenses incurred in connection with research and development, sales and marketing, and general and administrative activities, as well as the amortization of intangible assets. We also incur investigation and restatement-related costs in connection with the DOJ investigation concerning us as discussed in Note 10 to our consolidated financial statements and indemnification costs associated with certain of our former officers as discussed in Note 9 to our consolidated financial statements. Operating margin for 2013, 2012 and 2011 was 8.5 percent, 17.4 percent and (4.4) percent, respectively.
Under the short-term incentive plan for 2013 approved by our Board of Directors, Adjusted Operating Margin is a key metric for purposes of evaluating management's performance. Adjusted Operating Margin is Operating Margin adjusted for investigation and restatement related costs. Investigation and restatement related costs were 9.8 percent, 2.9 percent and 22.8 percent of total revenue for 2013, 2012 and 2011, respectively, and Adjusted Operating Margin was 18.3 percent, 20.3 percent and 18.4 percent, respectively, for these same periods. Adjusted Operating Margin is a non-GAAP measure of profitability and it should not be considered as a substitute for measures prepared in accordance with GAAP.
We completed the relocation of our Sunnyvale, California operations to Austin, Texas in December of 2011 which resulted in an accrual for contract termination. In the second quarter of 2012, we entered into two subleases for our former Austin, Texas location which decreased the amount accrued for contract termination by $1.1 million. In the fourth quarter of 2013, we accrued an additional $0.7 million for contract termination as a result of the termination of one of the sublease agreements. In 2011 we incurred $8.3 million in exit costs and we reported an additional $3.8 million of aggregate costs related to the relocation of our Sunnyvale, California activities to Austin, Texas that did not meet the definition of exit costs. This included costs of product sales of $0.4 million, research and development costs of $1.4 million; sales and marketing costs of $0.5 million; and, general and administrative costs of $1.5 million. These expenses include accelerated amortization of leasehold improvements related to facilities that ceased to be used upon completion of the relocation; personnel recruiting and training expense; and, duplicate rent and employee cost, offset by forfeited stock compensation.
Net Earnings
For most periods, our net earnings will be affected by the same trends that impact our revenues, gross product margin and operating margin. In addition, net earnings will also be affected by non-operating other income and expenses, such as foreign currency gains and losses, and by income taxes. We expect that we will report foreign currency gains or losses each period due primarily to changes in the value of the euro, British pound and Australian dollar versus the U.S. dollar.
In periods when we report income before taxes, our effective income tax rate is typically less than the U.S. statutory rate as a substantial portion of our operations are outside the U.S. in jurisdictions with lower tax rates, including Costa Rica, where we manufacture the majority of our products and have a tax holiday that extends through December 31, 2023. The Company will have a 50% income tax exemption from January 1, 2024 through January 28, 2028. In years of loss, our effective tax rate has exceeded the U.S. statutory rate due to the apportionment of income or loss between jurisdictions in which we operate. In the third quarter of 2013, we settled with the Internal Revenue Service ("IRS") its examination of our federal income tax returns for the 2006-2011 tax years and recorded a net income tax benefit of $10.5 million. In the second quarter of 2013, we reversed $3.7 million of deferred tax assets related to amounts accrued previously as insurance dispute and settlement reserves once we determined that the insurance dispute and settlement reserves would be used to settle the DOJ investigation and we would obtain no income tax deduction when this liability was paid. We expect to be able to fully utilize our deferred tax assets, which amounted to $38.2 million as of December 31, 2013.

25

Results of Operations
Overview of our Results of Operations
Results of operations for the three years ended December 31, 2013, 2012 and 2011 (in thousands, except percentages and per-share data) were as follows:
 
 
Year Ended December 31,
 
 
2013
 
2012
 
2011
 
 
Dollars
 
% Total
Revenue
 
Dollars
 
% Total
Revenue
 
Dollars
 
% Total
Revenue
Revenues:
 
 
 
 
 
 
 
 
 
 
 
 
Product sales
 
$
358,564

 
94.9
%
 
$
350,671

 
95.2
 %
 
$
338,319

 
95.3
 %
Royalties, fees and other
 
19,425

 
5.1
%
 
17,783

 
4.8
 %
 
16,566

 
4.7
 %
Total revenues
 
377,989

 
100.0
%
 
368,454

 
100.0
 %
 
354,885

 
100.0
 %
Cost of product sales
 
116,264

 
30.8
%
 
107,951

 
29.3
 %
 
103,314

 
29.1
 %
Gross profit
 
261,725

 
69.2
%
 
260,503

 
70.7
 %
 
251,571

 
70.9
 %
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
Research and development
 
33,965

 
9.0
%
 
32,146

 
8.7
 %
 
28,932

 
8.2
 %
Sales and marketing
 
122,595

 
32.4
%
 
116,127

 
31.5
 %
 
108,621

 
30.6
 %
General and administrative
 
33,463

 
8.9
%
 
33,212

 
9.0
 %
 
35,069

 
9.9
 %
Amortization of intangible assets
 
1,996

 
0.5
%
 
4,857

 
1.3
 %
 
5,291

 
1.5
 %
Exit costs
 
695

 
0.2
%
 
(778
)
 
(0.2
)%
 
8,300

 
2.3
 %
Investigation and restatement- related costs
 
37,046

 
9.8
%
 
10,805

 
2.9
 %
 
80,825

 
22.8
 %
Total operating expenses
 
229,760

 
60.8
%
 
196,369

 
53.3
 %
 
267,038

 
75.2
 %
Income (loss) from operations
 
31,965

 
8.5
%
 
64,134

 
17.4
 %
 
(15,467
)
 
(4.4
)%
Other income, net
 
2,648

 
 

 
678

 
 

 
14

 
 

Interest expense and bank fees
 
(1,974
)
 
 

 
(848
)
 
 

 
(622
)
 
 

Foreign exchange gain (loss), net
 
(1,524
)
 
 

 
(257
)
 
 

 
(723
)
 
 

Total other expense
 
(850
)
 
 

 
(427
)
 
 

 
(1,331
)
 
 

Income (loss) from continuing operations before income taxes
 
31,115

 
 

 
63,707

 
 

 
(16,798
)
 
 

Income tax provision (benefit)
 
5,059

 
 

 
17,329

 
 

 
(13,985
)
 
 

Net income (loss) from continuing operations
 
26,056

 
 

 
46,378

 
 

 
(2,813
)
 
 

Loss from discontinued operations, net of taxes
 
—

 
 

 
—

 
 

 
1,911

 
 

Net income (loss)
 
26,056

 
 

 
46,378

 
 

 
(902
)
 
 

Accrued dividend and accretion charges on Series A 3% Redeemable Convertible Preferred Stock
 
(3,735
)
 
 

 
(3,575
)
 
 

 
(3,416
)
 
 

Net income (loss) applicable to common stockholders
 
22,321

 
 

 
42,803

 
 

 
(4,318
)
 
 

Other comprehensive income
 
 
 
 
 
 
 
 
 
 
 
 
Foreign currency adjustments
 
(179
)
 
 

 
685

 
 

 
369

 
 

Total comprehensive income
 
$
25,877

 
 

 
$
47,063

 
 

 
$
(533
)
 
 

Weighted-average shares outstanding:
 
 
 
 
 
 
 
 
 
 
 
 
Basic
 
28,311

 
 

 
27,752

 
 

 
27,382

 
 

Diluted
 
28,988

 
 

 
28,407

 
 

 
27,382

 
 

Earnings (loss) per share from continuing operations applicable to common stockholders:
 
 
 
 
 
 
 
 
 
 
 
 
Basic
 
$
0.65

 
 

 
$
1.28

 
 

 
$
(0.23
)
 
 

Diluted
 
$
0.64

 
 

 
$
1.25

 
 

 
$
(0.23
)
 
 

Earnings (loss) per share applicable to common stockholders:
 
 
 
 
 
 
 
 
 
 
 
 
Basic
 
$
0.65

 
 

 
$
1.28

 
 

 
$
(0.16
)
 
 

Diluted
 
$
0.64

 
 

 
$
1.25

 
 

 
$
(0.16
)
 
 


26

2013 Comparison with 2012
Product Sales
Product sales by each of our product groups and geographic markets for the years ended December 31, 2013 and 2012 are as follows (in thousands, except percentages):
 
 
Year Ended December 31, 2013
 
Year Ended December 31, 2012
 
 
Americas
 
International
 
Total
Product
Sales
 
% Net
Product
Sales
 
Americas
 
International
 
Product
Sales
 
% Net
Product
Sales
Sports Medicine
 
$
158,063

 
$
85,963

 
$
244,026

 
68.1
%
 
$
155,164

 
$
80,631

 
$
235,795

 
67.3
%
ENT
 
81,436

 
24,406

 
105,842

 
29.5
%
 
82,880

 
22,835

 
105,715

 
30.1
%
Other
 
1,497

 
7,199

 
8,696

 
2.4
%
 
1,831

 
7,330

 
9,161

 
2.6
%
Total Product Sales
 
$
240,996

 
$
117,568

 
$
358,564

 
100.0
%
 
$
239,875

 
$
110,796

 
$
350,671

 
100.0
%
% Net Product Sales
 
67.2
%
 
32.8
%
 
100.0
%
 
 

 
68.4
%
 
31.6
%
 
100.0
%
 
 

Worldwide Sports Medicine sales increased $8.2 million, or 3.5 percent in 2013 compared to 2012. In constant currency, Sports Medicine product sales increased 3.7 percent in 2013 compared to 2012.
Americas Sports Medicine product sales, which includes both proprietary product sales and contract manufacturing product sales increased $2.9 million or 1.9 percent in 2013 compared to 2012. Americas Sports Medicine proprietary product sales increased $3.2 million or 2.5 percent in 2013 primarily as Coblation product sales volume trended upward throughout 2013. During 2013, Americas Sports Medicine proprietary product sales increased 4.7 percent, 4.5 percent and 3.4 percent during the fourth, third and second quarter, respectively, of 2013 when compared to the same quarters in 2012. In the first quarter of 2013, proprietary product sales decreased 2.5 percent. For the year, higher Coblation product sales volumes were partially offset by lower sales of Fixation products and a decline in average selling price of approximately 2.3 percent. The decline in average selling price also includes the effect of changes in the mix of products being sold. Contract manufactured product sales decreased $0.3 million, or 1.4 percent, in 2013.
International Sports Medicine product sales increased $5.3 million or 6.6 percent in 2013 compared to 2012 as a result of increased product sales primarily in European markets. In constant currency, International Sports Medicine product sales increased $5.8 million, or 7.3 percent. In the fourth quarter of 2013, we initiated a restructuring of our China distribution channel that reduced Sports Medicine product sales by approximately $0.7 million compared to the same period in 2012 and we expect this restructuring may also affect the trend of International Sports Medicine product sales in the first half of 2014.
Worldwide ENT product sales increased $0.1 million, or 0.1 percent, in 2013 compared to 2012. Changes in foreign exchange rates did not have a material effect on the comparability of reported ENT product sales between the periods.
Americas ENT sales decreased $1.4 million, or 1.7 percent, in 2013 compared to 2012 despite trending upward throughout the year. Americas ENT product sales increased 3.3 percent, increased 1.3 percent, decreased 1.6 percent and decreased 9.3 percent during the fourth, third, second and first quarters, respectively, of 2013 when compared to the same quarters in 2012. The decreased sales for the year ended December 31, 2013 are due to the decline in tonsillectomy product sales volume in 2013 as compared to the prior year. This was partially offset by the sale of ENTrigue products sold subsequent to the acquisition of ENTrigue on July 1, 2013. In addition, Americas product sales in the first quarter of 2012 included approximately $0.7 million related to fulfilled Rapid Rhino back orders from the end of 2011. Excluding the effect of the back order on 2012 product sales, Americas ENT product sales decreased $0.7 million or 0.9 percent for the year ended December 31, 2013.
International ENT product sales increased $1.6 million, or 6.9 percent, in 2013 compared to 2012. The increase in International ENT product sales was related to increased product sales in most markets. Product sales in distributor and direct markets increased 6.4 percent and 7.2 percent, respectively, for the year ended December 31, 2013 as compared to prior year. Direct market sales comprised approximately 52.7 percent of the total International ENT product sales during the year-ended December 31, 2013. In the fourth quarter of 2013, we initiated a restructuring of our China distribution channel that reduced ENT product sales by approximately $0.7 million compared to the same period in 2012 and we expect this restructuring may also affect the trend of International product sales in the first half of 2014. Product sales in the first quarter of 2012 included approximately $0.3 million related to fulfilled Rapid Rhino back orders from the end of 2011. Excluding the effect of the back

27

order on 2012 product sales, International ENT product sales increased $1.9 million or 8.3% for the year ended December 31, 2013. In constant currency, International ENT product sales increased $1.7 million, or 7.6 percent.
Worldwide Other product sales decreased $0.5 million in 2013, when compared to 2012. Other product sales represent less than 3.0 percent of total product sales in the year ended December 31, 2013.
Royalties, Fees and Other Revenues
Royalties, fees, and other revenues was 5.1 percent and 4.8 percent of total revenues for 2013 and 2012 respectively.
Cost of Product Sales
Cost of product sales for the years ended December 31, 2013 and 2012 were as follows (in thousands, except percentages):
 
 
Year Ended December 31,
 
 
2013
 
2012
 
 
Dollars
 
% Net
Product
Sales
 
Dollars
 
% Net
Product
Sales
Product cost
 
$
99,023

 
27.6
%
 
$
92,490

 
26.4
%
Controller amortization
 
6,440

 
1.8
%
 
8,425

 
2.4
%
Other
 
10,801

 
3.0
%
 
7,036

 
2.0
%
Total Cost of Product Sales
 
$
116,264

 
32.4
%
 
$
107,951

 
30.8
%
Gross product margin as a percentage of product sales was 67.6 percent in 2013 compared to 69.2 percent in 2012. Excluding the impact on gross product margin due to the new Medical Device Tax which came into effect in the first quarter of 2013 and the decline in average selling prices for proprietary Sports Medicine products in the Americas, gross product margin in 2013 would have been 68.6 percent. The additional reduction in gross product margin is due to higher labor and overhead costs in Costa Rica partially offset by lower controller amortization and lower charges for inventory obsolescence.
Operating Expenses
Operating expenses for the periods shown were as follows (in thousands, except percentages):
 
 
Year Ended December 31,
 
 
2013
 
2012
 
 
Dollars
 
% Total
Revenue
 
Dollars
 
% Total
Revenue
Research and development
 
33,965

 
9.0
%
 
32,146

 
8.7
 %
Sales and marketing
 
122,595

 
32.4
%
 
116,127

 
31.5
 %
General and administrative
 
33,463

 
8.9
%
 
33,212

 
9.0
 %
Amortization of intangible assets
 
1,996

 
0.5
%
 
4,857

 
1.3
 %
Exit costs
 
695

 
0.2
%
 
(778
)
 
(0.2
)%
Investigation and restatement related costs
 
37,046

 
9.8
%
 
10,805

 
2.9
 %
Total operating expenses
 
229,760

 
60.8
%
 
196,369

 
53.3
 %
Research and development expense increased $1.8 million during 2013 compared to 2012 due to increased Sports Medicine new product development initiatives which increased the number of engineering personnel involved in research and development activities when compared to 2012.
 Sales and marketing expense increased to 32.4 percent of total revenue in 2013 compared to 31.5 percent of total revenue in 2012 as a result of efforts to expand our sales and distribution coverage and training in the United States in advance of anticipated new product introductions expected in 2014. Sales and marketing expense also increased as a result of organizational costs incurred in advance of efforts that began in the fourth quarter of 2013 to restructure our China distribution channel. Sales and marketing expense in 2013 also increased $1.0 million due to severance costs.

28

 General and administrative expense increased $0.3 million in 2013 when compared to 2012. The increase in general and administrative expenses is primarily due to $0.8 million of one-time transaction-support costs resulting from the ENTrigue acquisition that closed on July 1, 2013 partially offset by lower depreciation expense.
 Exit costs are associated with the relocation of our Sunnyvale, California facilities to Austin, Texas which started in April 2011. All activities associated with the Sunnyvale campus closure and relocation was completed in 2011. In the second quarter of 2012, we entered into two sublease agreements for our former Austin, Texas location which decreased the amount accrued for contract termination by $1.1 million. During the fourth quarter of 2013, as a result of the termination of the contract with one of the subtenants of our former Austin, Texas location, an additional $0.7 million was accrued for contract termination.
 Investigation and restatement expenses primarily relate to legal fees and settlement costs associated with the DOJ investigation concerning us, as discussed in Note 10 to our consolidated financial statements, and indemnification costs associated with certain of our former officers discussed in Note 9 to our consolidated financial statements. As a result of preliminary discussions with the DOJ, we increased the amount accrued for the insurance dispute and settlement reserve to $30 million in the second quarter of 2013 to reflect our best estimate of the likely settlement amount at that time. This resulted in a charge of $20.2 million that was recorded during the second quarter of 2013 as investigation and restatement related expenses. As further described in Note 10 of our consolidated financial statements, on December 31, 2013, the Company entered into a Deferred Prosecution Agreement (“DPA”) with the DOJ which resolved the ongoing investigation by the DOJ. Pursuant to the DPA, we agreed to pay a $30 million fine to the DOJ which is consistent with our preliminary estimate. The increase in investigation and restatement related expenses is also a result of additional legal costs related to our indemnification agreements with certain former officers and we expect indemnification expenses to continue until the matters concerning the former officers are concluded.
Interest and Other Expense, Net
Interest and other expense for the periods shown were as follows (in thousands):

 
 
Year Ended
December 31,
 
 
2013
 
2012
Other income, net
 
$
2,648

 
$
678

Interest expense and bank fees
 
(1,974
)
 
(848
)
Foreign exchange loss, net
 
(1,524
)
 
(257
)
Total other expense, net
 
$
(850
)
 
$
(427
)
Total other expense, net increased $0.4 million in 2013 when compared to 2012 as a result of interest accretion related to the earn-out liability from the Entrigue acquisition and foreign exchange losses offset by increased interest and other income. Interest and other income in 2013 include a gain of $1.7 million received in the first quarter of 2013 from the extinguishment of our membership interests in a mutual insurance company.
Income Tax Provision (Benefit)
Our effective tax rate in 2013 was 16.3 percent compared to 27.2 percent in 2012. In 2013, the tax rate differed from the federal rate of 35% primarily due to lower statutory rates in foreign jurisdictions and a settlement with the IRS concerning its examination of our federal income tax returns for the 2006-2011 tax years which resulted in a net income tax benefit of $10.5 million.
We also recorded a charge of $20.2 million in the second quarter of 2013 as investigation and restatement related expenses which increased the balance of the Company's insurance dispute and settlement reserve to $30 million. We reversed $3.7 million of deferred tax assets in the second quarter related to amounts accrued previously as insurance dispute and settlement reserves once we determined that the insurance dispute and settlement reserves would be used to settle the DOJ investigation, and we would obtain no income tax deduction when this liability was paid. In addition, on January 2, 2013 the American Taxpayer Relief Act of 2012 (ATRA) was signed into law which extended the federal research and development tax credit from January 1, 2012 through December 31, 2013. As a result of the ATRA, income tax expense was reduced in 2013 by $0.8 million for  research and development tax credits related to 2012.


29

2012 Comparison with 2011
Product Sales
Product sales by each of our product groups and geographic markets for the years ended December 31, 2012 and 2011 are as follows (in thousands, except percentages):
 
 
Year Ended December 31, 2012
 
Year Ended December 31, 2011
 
 
Americas
 
International
 
Total
Product
Sales
 
% Net
Product
Sales
 
Americas
 
International
 
Product
Sales
 
% Net
Product
Sales
Sports Medicine
 
$
155,164

 
$
80,631

 
$
235,795

 
67.3
%
 
$
149,010

 
$
79,337

 
$
228,347

 
67.5
%
ENT
 
82,880

 
22,835

 
105,715

 
30.1
%
 
81,810

 
18,429

 
100,239

 
29.6
%
Other
 
1,831

 
7,330

 
9,161

 
2.6
%
 
2,785

 
6,948

 
9,733

 
2.9
%
Total Product Sales
 
$
239,875

 
$
110,796

 
$
350,671

 
100.0
%
 
$
233,605

 
$
104,714

 
$
338,319

 
100.0
%
% Net Product Sales
 
68.4
%
 
31.6
%
 
100.0
%
 
 

 
69.0
%
 
31.0
%
 
100.0
%
 
 


Worldwide Sports Medicine product sales increased $7.4 million, or 3.3 percent, in 2012 compared to 2011. In constant currency, Sports Medicine sales increased 4.5 percent in 2012 as compared to 2011.
Americas product sales increased $6.2 million in 2012 as compared to 2011. Americas Sports Medicine proprietary product sales increased $5.9 million or 4.6 percent in 2012 primarily as a result of new Coblation and fixation products and distribution changes made in late 2011 and early 2012 which converted former stocking distributor territories in the U.S. to sales agency territories. Contract manufactured product sales increased $0.3 million, or 1.4 percent, in 2012.
International Sports Medicine product sales increased $1.3 million, or 1.6 percent in 2012 compared to 2011. Product sales growth in Asia Pacific was partially offset by lower reported product sales in European markets due to the effect of the stronger U.S. dollar and lower southern European distributor sales. In constant currency, International Sports Medicine product sales increased $4.2 million, or 5.3 percent.
Worldwide ENT product sales increased $5.5 million, or 5.5 percent in 2012 when compared to 2011. In constant currency, ENT product sales increased 6.0 percent in 2012 compared to 2011.
Americas ENT sales increased $1.1 million, or 1.3 percent, in 2012 compared to 2011. ENT product sales in 2011 were lower as a result of product supply issues affecting the Rapid Rhino product line that resulted in backorders in late 2011. In 2012, Rapid Rhino backorders from late 2011 were filled and product sales of Rapid Rhino stabilized in the latter half of 2012. Partially offsetting the higher 2012 Rapid Rhino product sales was lower Coblation product sales, particularly of our tonsil and adenoid products.
International ENT product sales increased $4.4 million, or 23.9 percent, in 2012 compared to 2011. The increase in International ENT product sales was primarily related to an increase in Asia Pacific product sales, most notably in Australia and China. In constant currency, International ENT product sales increased $4.9 million, or 26.7 percent.
Worldwide Other product sales decreased $0.6 million in 2012, when compared to 2011 as lower Spine sales in the Americas was partially offset by higher Spine sales in International Markets. In 2012, Other product sales were less than 3 percent of total product sales.
Royalties, Fees and Other Revenues
Royalties, fees, and other revenues consist mainly of revenue from the licensing of our products and technology along with shipping and handling costs billed to customers and was 4.8 percent and 4.7 percent of total revenues for 2012 and 2011, respectively.





30

Cost of Product Sales
Cost of product sales for the years ended December 31, 2012 and 2011 were as follows (in thousands, except percentages):
 
 
Year Ended December 31,
 
 
2012
 
2011
 
 
Dollars
 
% Net
Product
Sales
 
Dollars
 
% Net
Product
Sales
Product cost
 
$
92,490

 
26.4
%
 
$
86,843

 
25.6
%
Controller amortization
 
8,425

 
2.4
%
 
8,830

 
2.6
%
Other
 
7,036

 
2.0
%
 
7,641

 
2.3
%
Total Cost of Product Sales
 
$
107,951

 
30.8
%
 
$
103,314

 
30.5
%
Gross product margin as a percentage of product sales was 69.2 percent in 2012 compared to 69.5 percent in 2011. The decrease in gross product margin for 2012 was due to lower reported International product sales due to the weakening of the Euro, British pound and Australian dollar against the U.S. dollar, partially offset by lower controller amortization and other costs.
Operating Expenses
Operating expenses for the periods shown were as follows (in thousands, except percentages):
 
 
Year Ended December 31,
 
 
2012
 
2011
 
 
Dollars
 
% Total
Revenue
 
Dollars
 
% Total
Revenue
Research and development
 
32,146

 
8.7
 %
 
28,932

 
8.2
%
Sales and marketing
 
116,127

 
31.5
 %
 
108,621

 
30.6
%
General and administrative
 
33,212

 
9.0
 %
 
35,069

 
9.9
%
Amortization of intangible assets
 
4,857

 
1.3
 %
 
5,291

 
1.5
%
Exit costs
 
(778
)
 
(0.2
)%
 
8,300

 
2.3
%
Investigation and restatement related costs
 
10,805

 
2.9
 %
 
80,825

 
22.8
%
Total operating expenses
 
196,369

 
53.3
 %
 
267,038

 
75.2
%
 Research and development expense increased $3.2 million during 2012 compared to 2011. The increase in research and development expense in 2012 was due to higher Sports Medicine product development cost and a higher proportion of engineering personnel involved in research and development activities when compared to 2011. In 2011, research and development expense included $1.4 million of accelerated depreciation and other costs resulting from the relocation of our Sunnyvale, California offices to Austin, Texas that did not qualify as exit costs.
Sales and marketing expense increased to 31.5 percent of total revenue in 2012 as compared to 30.6 percent of total revenue in 2011. The increase was primarily the result of expanding our International sales infrastructure. In 2012, we began new direct market sales activities in the Netherlands, Belgium and Finland and we also increased our sales and marketing activities in the Asia Pacific region.
General and administrative expense decreased $1.9 million in 2012 when compared to 2011. General and administrative costs in 2011 included approximately $1.5 million related to accelerated depreciation and other cost resulting from the relocation of our Sunnyvale, California activities that did not qualify to be classified as exit costs.
Exit costs were associated with the relocation of our Sunnyvale, California facilities to Austin, Texas which started in April, 2011. All activities associated with the Sunnyvale campus closure and relocation were completed as of December 31, 2012.
Investigation and restatement expenses in 2011 included $74 million related to the settlement of the private securities class actions against us. In 2012, legal costs associated with the DOJ investigation concerning us, as discussed in Note 10 to our consolidated financial statements, and indemnification costs associated with certain of our former officers increased due to an increase in activities related to those matters. We expect to continue to incur additional legal costs related to our

31

indemnification agreements with certain former officers and in connection with the matters described in Note 10 of our consolidated financial statements.
Interest and Other Expense, Net
Interest and other expense for the periods shown were as follows (in thousands, except percentages):
 
 
Year Ended
December 31,
 
 
2012
 
2011
Interest and other income, net
 
$
678

 
$
14

Bank fees
 
(848
)
 
(622
)
Foreign exchange gain (loss), net
 
(257
)
 
(723
)
Total other income (expense)
 
$
(427
)
 
$
(1,331
)
Other expense decreased $0.9 million in 2012 when compared to 2011 as a result of lower foreign exchange losses and higher other income related to gains on the sale of previously impaired assets.
Discontinued Operations
In the fourth quarter of 2010, we determined that our non-Coblation spine products (our Parallax and Contour product lines) met the criteria under generally accepted accounting principles to be reported as discontinued operations. We completed the sale on June 30, 2011 for cash proceeds of $5.5 million and recorded a pre-tax gain of $2.2 million or $1.3 million after tax.
Income Tax Provision (Benefit)
Our effective tax rate in 2012 was 27.2 percent compared to 83.3 percent in 2011. In 2012, the tax rate differed from the federal rate of 35% due primarily to lower statutory tax rates in foreign jurisdictions. In 2011, we incurred a pre-tax loss in the U.S. of $44 million due to the settlement of the private securities class action which was partially offset by pre-tax income of $27 million in jurisdictions outside the U.S. where the corporate tax rates are lower than in the U.S., such as Costa Rica where we currently have a tax holiday.
In 2011, our results of operations reflected an income tax benefit from the federal research and development tax credit for the years ended December 31, 2011 and 2010. The results of operations for the year ended December 31, 2012 did not reflect an income tax benefit related to the tax credit as the credit expired on December 31, 2011.
Liquidity and Capital Resources
Our operating cash flow has historically been affected by the overall profitability of the sales of our products, our ability to collect from customers in a timely manner, and our ability to efficiently implement our acquisition strategy and manage costs. We expect that our cash flows from operations together with cash on hand will be sufficient to satisfy our short-term or long-term normal operating liquidity requirements.
Cash Flows and Working Capital for the Year Ended December 31, 2013 compared to the year ended December 31, 2012
As of December 31, 2013 we had $247.4 million in working capital compared to $287.7 million at December 31, 2012. Our cash and cash equivalents balance was $214.9 million at December 31, 2013 and $218.8 million at December 31, 2012, the majority of which are held in U.S bank accounts.
Cash provided by operating activities for the year ended December 31, 2013 was $72.4 million and differed from net income primarily as a result of depreciation and amortization expense, stock based compensation expense, deferred taxes and increases in various payables and accrued liabilities offset by increased accounts receivable.
Cash used by investing activities for the year ended December 31, 2013 was $85.1 million and consisted of $31.6 million in property and equipment purchases, $45.0 million in payments for business combinations as a result of the acquisition of ENTrigue Surgical and $8.5 million related to acquisitions of intangible assets. Cash used by investing activities was $11.8 million for the year ended December 31, 2012 and consisted of $10.5 million in purchases of property and equipment and $1.3 million paid to acquire an orthopedic sales and marketing entity in Finland.
Cash provided by financing activities for the year ended December 31, 2013 and 2012 was $8.6 million and $4.4 million, respectively, and consisted primarily of proceeds from exercises of stock options and purchases under the employee stock purchase plan.

32

Cash Flows and Working Capital for the Year Ended December 31, 2012 compared to the year ended December 31, 2011
As of December 31, 2012 we had $287.7 million in working capital compared to $222.7 million at December 31, 2011. Our cash and cash equivalents balance was $218.8 million at December 31, 2012 and $219.6 million at December 31, 2011, the majority of which are held in U.S bank accounts. In the first quarter of 2012, we paid $74 million to settle the private securities class actions as discussed in Note 10 of our consolidated financial statements.
Cash provided by operating activities for the year ended December 31, 2012 was $6.3 million and differed from net income primarily as a result of settling the private securities class action in the first quarter of 2012, which we accrued in the fourth quarter of 2011, depreciation and amortization expense and stock based compensation expense, offset by increased inventories. Adjusting for the funding of the $74 million settlement of the private securities class actions, cash provided by operating activities for 2012 would have been $80.3 million compared to $84.6 million in 2011.
Cash used by investing activities for the year ended December 31, 2012 was $11.8 million and consisted of $10.5 million in property and equipment purchases and $1.3 million paid to acquire an orthopedic sales and marketing entity in Finland. Cash used by investing activities was $5.7 million for the year ended December 31, 2011 and consisted of $13.5 million in purchases of property and equipment offset by the sales of our non-Coblation spine assets for $5.5 million, and proceeds from the repayment of a loan for $2.3 million.
Cash provided by financing activities for the year ended December 31, 2012 and 2011 was $4.4 million and $7.8 million, respectively, and consisted primarily of proceeds from exercises of stock options and purchases under the employee stock purchase plan.
Contractual Obligations and Commercial Commitments
The following table aggregates all material contractual obligations and commercial commitments that affected our financial condition and liquidity as of December 31, 2013 (in thousands):
 
 
Payments Due by Period
(in thousands)
Contractual Obligations
 
Total(1)
 
Less than
1 Year
 
1 - 3
Years
 
3 - 5
Years
 
More than
5 Years
Operating lease obligations
 
$
33,158

 
$
6,398

 
$
9,775

 
$
6,684

 
$
10,301

Sub-lease income
 
264

 
79

 
164

 
21

 
 

Other(2)
 
105

 
105

 
—

 
—

 
—

Total
 
$
32,999

 
$
6,424

 
$
9,611

 
$
6,663

 
$
10,301

________________________________________________
(1)
The Company has entered into indemnification agreements with several former executives and employees, under which it is advancing legal costs associated with the ongoing litigation and investigations discussed in Note 10 "Litigation and Contingencies" in the notes to the consolidated financial statements. While we expect to advance payments pursuant to these agreements in future periods; we are unable to estimate the amount or timing of these payments.
(2)
Represents minimum obligations to DHL for warehousing services in Belgium.

Off-Balance Sheet Arrangements
There are no off-balance sheet arrangements other than the operating leases noted above.
Critical Accounting Policies and Estimates
The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the U.S., or GAAP, requires our management to make judgments, assumptions and estimates that affect the amounts of revenue, expenses, income, assets and liabilities, reported in our consolidated financial statements and accompanying notes. Understanding our accounting policies and the extent to which our management uses judgment, assumptions and estimates in applying these policies is integral to understanding our financial statements. We describe our most significant accounting policies in Note 2, "Summary of Significant Accounting Policies" in the notes to the consolidated financial statements. We have identified the following accounting policies as those that require significant judgments,

33

assumptions and estimates and that have a significant impact on our financial condition and results of operations. These policies are considered critical because they may result in fluctuations in our reported results from period to period due to the significant judgments, estimates and assumptions about highly complex and inherently uncertain matters and because the use of different judgments, assumptions or estimates could have a material impact on our financial condition or results of operations. We evaluate our critical accounting estimates and judgments required by our policies on an ongoing basis and update them as appropriate based on changing conditions.
Revenue Recognition
We recognize revenues from product sales when there is persuasive evidence of an arrangement providing for the sale of a product, delivery of the product has occurred, the sale price of the product is fixed or determinable and collectability is reasonably assured. Other revenues include shipping and handling costs billed to customers. Shipping and handling costs incurred are presented as a part of cost of product sales.
For product sales made by our direct sales professionals or independent agents, our criteria for revenue recognition are usually complete when our product is delivered to end customers, such as surgical centers or hospitals. These sales occur either in fulfillment of a purchase order submitted by the customer or through trunk sales. For purchase orders, we ship product to and invoice the end customer directly. For trunk sales, product is hand-delivered at the end customer's premises from trunk stock maintained by the direct sales representative or independent agent and a bill-only order is received notifying us of the product's delivery at which time we invoice the end customer.
Sales to distributors occur either as stocking and replenishment orders or as drop shipments to end customers. In the majority of cases involving sales to distributors, our requirements for revenue recognition are met when we deliver product to a particular distributor.
Our customers generally have the right to return or exchange products purchased from us for up to 60 days from the date of product shipment. At each period end, we determine the extent to which our revenues need to be reduced to account for returns and exchanges and we record a reserve against revenue recognized during that period for product returns and exchanges that our management estimates are likely to occur after the end of that period. We base these estimates on our historical experience with our customers.
Our revenue recognition is also impacted by management's estimate of our customers' ability to pay us pursuant to the terms of our customer agreements. If after we have recognized revenue, collectability of an account receivable becomes doubtful, we will establish an allowance for doubtful accounts with respect to the previously recognized revenue that remains uncollected. Where our management forms a judgment that a particular customer has not established a sufficient credit history but decides to deliver products to the customer, we will defer recognizing revenues on product sales to that customer until collectability is reasonably assured, which typically coincides with the collection of cash. Once the customer establishes a reliable payment history we generally return to normal revenue recognition based on our criteria. We regularly review the creditworthiness of our customers considering such factors as historical collection experience, a customer's current credit standing, the age of accounts receivable balances, and general economic conditions that may affect a customer's ability to pay (both individually and in the aggregate).
Although the terms of our agreements with many of our customers provide that risk of loss passes to the customer upon shipment, we have historically accepted the risk of loss until product delivery. Accordingly, we only recognize revenues on a product sale if, in management's judgment, it has been delivered during the relevant reporting period. The application of this policy requires our management to make estimates as to the timing of deliveries. We base these estimates on our historical experience with product shipments to particular markets that we serve. We periodically compare these estimates to actual results based on delivery confirmations to determine whether a change of estimate is required.
Royalties are recognized as earned, based on our estimates using current and historical trends reported to us by our licensees and adjusted for market factors, and are classified as royalties, fees and other revenues in the accompanying statements of comprehensive income.
Inventory Allowance
We value our inventory based on cost. We adjust the value of our inventory to the extent our management determines that our cost cannot be recovered due to obsolescence or other factors. In order to make these determinations, our management uses estimates of future demand and sales prices for each product to determine appropriate inventory reserves and to make corresponding reductions in inventory values to reflect the lower of cost or market value.



34

Long-lived Assets
Our goodwill balance is not amortized to expense; instead it is tested for impairment at least annually on October 31. In the fourth quarter of 2011, we adopted the FASB's new guidance on performing the annual goodwill impairment test. If events or indicators of impairment occur between annual impairment analyses, we perform an impairment analysis of goodwill at that date.
The process of evaluating the potential impairment of goodwill is subjective and requires significant judgment at many points during the analysis, including the identification of our reporting units, qualitative indicators of changes to a reporting unit's fair value, and determination of the reporting unit's fair value. Changes in judgment on these assumptions and estimates could result in further goodwill impairment charges. We believe that the assumptions and estimates utilized are appropriate based on the information available to management.
On October 31, 2013, we performed our required annual goodwill impairment test. We determined that we have one reporting unit and thus all of our operations, assets, and liabilities were allocated to the one reporting unit. Our closing stock price on October 31, 2013, was $37.44 and we had approximately 28.4 million shares of common stock outstanding representing an imputed market capitalization of $1.1 billion. Our book value on October 31, 2013 was $393 million, thus the fair value of our reporting unit exceeds the carrying amount of the reporting unit and no further testing was required.
Intangible assets with finite lives and property, plant and equipment are amortized or depreciated over their estimated useful life on a straight line basis. We monitor conditions related to these assets to determine whether events and circumstances warrant a revision to the remaining amortization or depreciation period. We test these assets for potential impairment whenever our management concludes events or changes in circumstances indicate that the carrying amount may not be recoverable. The original estimate of an asset's useful life and the impact of an event or circumstance on either an asset's useful life or carrying value involve significant judgment regarding estimates of the future cash flows associated with each asset.
Legal and Other Contingencies
The outcomes of legal proceedings and claims brought against us and other loss contingencies are subject to significant uncertainty. We accrue a charge against income when our management determines that it is probable that an asset has been impaired or a liability has been incurred and the amount of loss can be reasonably estimated. In addition, we accrue for the authoritative judgments or assertions made against us by government agencies at the time of their rendering regardless of our intent to appeal. In determining the appropriate accounting for loss contingencies, we consider the likelihood of loss or impairment of an asset or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss. We regularly evaluate current information available to us to determine whether an accrual should be established or adjusted. Estimating the probability that a loss will occur and estimating the amount of a loss or a range of loss involves significant judgment.
Income Taxes
We account for income taxes under the liability method, whereby deferred tax asset or liability account balances are determined based on the difference between the financial statement and the tax bases of assets and liabilities using current tax laws and rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets when we expect the amount of tax benefit to be realized is less than the carrying value of the deferred tax asset.
We make an evaluation at the end of each reporting period as to whether or not some or all of the undistributed earnings of our foreign subsidiaries are permanently reinvested. While we have concluded in the past that undistributed earnings will be permanently reinvested and we do not expect changes to this evaluation, facts and circumstances may change in the future. Changes in facts and circumstances may include a change in the estimated capital needs of our foreign subsidiaries, or a change in our corporate liquidity requirements. Such changes could result in our management determining that some or all of such undistributed earnings are no longer permanently reinvested. In that event, we would be required to recognize income tax liabilities on our foreign undistributed earnings that are not permanently reinvested.
Accounting for income taxes involves uncertainty and judgment on how to interpret and apply tax laws and regulations within our annual tax filings. Such uncertainties from time to time may result in a tax position that may be challenged and overturned by a tax authority in the future which could result in additional tax liability, interest charges and possibly penalties. An income tax benefit from an uncertain tax position is recognized only if it is more likely than not that the tax position will be sustained upon examination by the relevant taxing authorities, based on the technical merits of the position. This can be a subjective and judgmental determination. The liability for uncertain tax positions, including related interest and penalties, is recorded as other non-current liabilities. Interest on unpaid taxes and penalties when incurred are classified as a component of income tax expense.

35

Stock-Based Compensation
We account for stock-based compensation by measuring and recognizing as compensation expense the fair value of all share-based payment awards made to employees, including employee stock options, stock settled stock appreciation rights (SARs) and restricted stock awards. We use the Black-Scholes option pricing model to estimate the fair value of employee stock options and SARs that only have service or performance conditions. We use the Monte Carlo pricing model to estimate the fair value of options and restricted stock awards that have market based conditions. The inputs to both pricing models require a number of management estimates such as volatility, risk free interest rate and expected term. Management estimates the expected volatility of our stock and employee exercise behavior based on historical data as well as expectations of future developments over the term of the stock compensation award. The risk free interest rate is based on the U.S. traded treasury bond with a maturity date closest to the expected life of the stock compensation award. As stock-based compensation expense is based on the number of stock compensation awards expected to vest, we must make estimates regarding whether or not the performance and service conditions will be achieved. These estimates are made at the time of grant and revised, if necessary, in subsequent periods which might result in a significant change in stock-based compensation expense in future periods.
Recently Issued Accounting Pronouncements
New accounting pronouncements or changes in existing accounting pronouncements may have a significant effect on our results of operations, our financial condition, or our business operations.
Accounting Standards Update (ASU) 2013-11, “Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists” was issued in July 2013 and addresses when an unrecognized tax benefit shall be recorded as a reduction to a deferred tax asset or presented as a gross liability. ASU 2013-11 is effective for the Company beginning in 2014. Management is still evaluating the impact of this ASU but anticipates that any change in balance sheet classification will be immaterial.
ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to certain market risks as part of our ongoing business operations, primarily risks from changing interest rates and foreign currency exchange rates that may impact, adversely or otherwise, our financial condition, results of operations, or cash flows.
Our interest income is dependent on changes in the general level of U.S. interest rates. Our cash and cash equivalents consist of money market funds and various deposit accounts.
The table below presents principal amounts and related weighted average interest rates as of December 31, 2013 for our cash and cash equivalents (in thousands, except percentages):

Cash and cash equivalents
$
214,853

Average interest rate earned on cash and cash equivalents
Less than 1%

Foreign Currency Risk
A significant portion of our international sales and operating expenses are denominated in currencies other than the U.S. dollar. To the extent that the exchange rates for these currencies fluctuate against the U.S. dollar, we will experience variations in our results of operations.
Our cash and cash equivalents at December 31, 2013 are denominated primarily in U.S. dollars; however, we also maintain balances in various other currencies in support of local subsidiary operations. The most significant of these are Euros, British pounds, Swedish kroner, Swiss francs, Australian dollars, and Costa Rican colones. A 10 percent change in the December 31, 2013 exchange rates for these currencies would have an impact on pre-tax income of approximately $0.9 million.
We have not used derivative financial instruments to hedge foreign currency exchange risk and do not anticipate doing so in the future.

36

ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
The following financial statements of the Company and the Report of Independent Registered Public Accounting Firm are included in this Report on the pages indicated.
All other schedules are omitted because they are not applicable.


Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders of ArthroCare Corporation:
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of ArthroCare Corporation and its subsidiaries at December 31, 2013 and 2012, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2013 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control—Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management's Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedule, and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ PricewaterhouseCoopers LLP
Austin, Texas

February 13, 2014


ARTHROCARE CORPORATION
CONSOLIDATED BALANCE SHEETS
(in thousands, except par value data)
 
 
December 31,
 
 
2013
 
2012
ASSETS
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
214,853

 
$
218,787

Accounts receivable, net of allowances of $1,255 and $1,565 at 2013 and 2012, respectively
 
52,810

 
48,881

Inventories, net
 
46,288

 
48,417

Deferred tax assets
 
12,371

 
20,090

Prepaid expenses and other current assets
 
6,056

 
6,022

Total current assets
 
332,378

 
342,197

Property and equipment, net
 
51,244

 
30,461

Intangible assets, net
 
14,581

 
1,859

Goodwill
 
165,953

 
119,893

Deferred tax assets
 
25,842

 
23,206

Other assets
 
4,143

 
2,171

Total assets
 
$
594,141

 
$
519,787

LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY
 
 
 
 
Current liabilities:
 
 
 
 
Accounts payable
 
$
18,325

 
$
12,189

Accrued liabilities
 
64,948

 
41,674

Deferred tax liabilities
 
3

 
33

Deferred revenue
 
350

 
285

Income tax payable
 
1,372

 
286

Total current liabilities
 
84,998

 
54,467

Deferred tax liabilities
 
249

 
354

Other non-current liabilities
 
21,305

 
20,200

Total liabilities
 
106,552

 
75,021

Commitments and contingencies (Notes 9 and 10)
 

 

Series A 3% Redeemable Convertible Preferred Stock, par value $0.001; Authorized: 100 shares; Issued and outstanding: 75 shares at December 31, 2013 and 2012, respectively. Redemption value: $87,089
 
84,494

 
80,759

Stockholders' equity:
 
 
 
 
Preferred stock, par value $0.001; Authorized: 4,900 shares; Issued and outstanding: none
 
—

 
—

Common stock, par value, $0.001: Authorized: 75,000 shares; Issued: 32,385 and 31,949; Outstanding: 28,466 and 27,977 shares at December 31, 2013 and 2012, respectively
 
28

 
28

Treasury stock: 3,919 and 3,942 shares at December 31, 2013 and 2012, respectively
 
(105,798
)
 
(106,425
)
Additional paid-in capital
 
429,979

 
413,660

Accumulated other comprehensive income
 
5,121

 
5,300

Retained earnings
 
73,765

 
51,444

Total stockholders' equity
 
403,095

 
364,007

Total liabilities, redeemable convertible preferred stock and stockholders' equity
 
$
594,141

 
$
519,787

   

The accompanying notes are an integral part of these consolidated financial statements.
39

ARTHROCARE CORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands, except per-share data)
 
 
Years Ended December 31,
 
 
2013
 
2012
 
2011
Revenues:
 
 
 
 
 
 
Product sales
 
$
358,564

 
$
350,671

 
$
338,319

Royalties, fees and other
 
19,425

 
17,783

 
16,566

Total revenues
 
377,989

 
368,454

 
354,885

Cost of product sales
 
116,264

 
107,951

 
103,314

Gross profit
 
261,725

 
260,503

 
251,571

Operating expenses:
 
 
 
 
 
 
Research and development
 
33,965

 
32,146

 
28,932

Sales and marketing
 
122,595

 
116,127

 
108,621

General and administrative
 
33,463

 
33,212

 
35,069

Amortization of intangible assets
 
1,996

 
4,857

 
5,291

Exit costs
 
695

 
(778
)
 
8,300

Investigation and restatement-related costs
 
37,046

 
10,805

 
80,825

Total operating expenses
 
229,760

 
196,369

 
267,038

Income (loss) from operations
 
31,965

 
64,134

 
(15,467
)
Other income, net
 
2,648

 
678

 
14

Interest expense and bank fees
 
(1,974
)
 
(848
)
 
(622
)
Foreign exchange loss, net
 
(1,524
)
 
(257
)
 
(723
)
Total other expense
 
(850
)
 
(427
)
 
(1,331
)
Income (loss) from continuing operations before income taxes
 
31,115

 
63,707

 
(16,798
)
Income tax provision (benefit)
 
5,059

 
17,329

 
(13,985
)
Net income (loss) from continuing operations
 
26,056

 
46,378

 
(2,813
)
Income from discontinued operations, net of taxes
 
—

 
—

 
1,911

Net income (loss)
 
26,056

 
46,378

 
(902
)
Accrued dividend and accretion charges on Series A 3% Redeemable Convertible Preferred Stock
 
(3,735
)
 
(3,575
)
 
(3,416
)
Net income (loss) attributable to common stockholders
 
22,321

 
42,803

 
(4,318
)
Other comprehensive income
 
 
 
 
 
 
Foreign currency adjustments
 
(179
)
 
685

 
369

Total comprehensive income (loss)
 
$
25,877

 
$
47,063

 
$
(533
)
Weighted-average shares outstanding:
 
 
 
 
 
 
Basic
 
28,311

 
27,752

 
27,382

Diluted
 
28,988

 
28,407

 
27,382

Earnings (loss) per share from continuing operations attributable to common stockholders:
 
 
 
 
 
 
Basic
 
$
0.65

 
$
1.28

 
$
(0.23
)
Diluted
 
$
0.64

 
$
1.25

 
$
(0.23
)
Earnings (loss) per share attributable to common stockholders:
 
 
 
 
 
 
Basic
 
$
0.65

 
$
1.28

 
$
(0.16
)
Diluted
 
$
0.64

 
$
1.25

 
$
(0.16
)

The accompanying notes are an integral part of these consolidated financial statements.
40

ARTHROCARE CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(in thousands)
 
 
Common
Stock
Shares
 
Common
Stock
Amount
 
Treasury
Stock
 
Additional
Paid-In
Capital
 
Accumulated
Other
Comprehensive
Income
 
Retained
Earnings

 
Total
Stockholders'
Equity
Balance, December 31, 2010
 
27,112

 
$
27

 
$
(107,899
)
 
$
386,395

 
$
4,246

 
$
12,959

 
$
295,728

Issuance of common stock through:
 
 

 
 

 
 

 
 

 
—

 
 

 
 

Exercise of options and restricted stock
 
412

 
1

 
—

 
7,422

 
—

 
—

 
7,423

Employee stock purchase plan
 
9

 
—

 
—

 
264

 
—

 
—

 
264

Contribution to employee benefit plan
 
29

 
—

 
773

 
140

 
—

 
—

 
913

Stock compensation
 
—

 
—

 
—

 
6,226

 
—

 
—

 
6,226

Income tax effect of exercise of stock options
 
—

 
—

 
—

 
133

 
—

 
—

 
133

Accrued dividends and accretion charges on Series A 3% Redeemable Convertible Preferred Stock
 
—

 
—

 
—

 
—

 
—

 
(3,416
)
 
(3,416
)
Currency translation adjustment
 
—

 
—

 
—

 
—

 
369

 
—

 
369

Net loss
 
—

 
—

 
—

 
—

 
—

 
(902
)
 
(902
)
Balance, December 31, 2011
 
27,562

 
28

 
(107,126
)
 
400,580

 
4,615

 
8,641

 
306,738

Issuance of common stock through:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Exercise of options and restricted stock
 
380

 
—

 
—

 
4,104

 
—

 
—

 
4,104

Employee stock purchase plan
 
9

 
—

 
—

 
272

 
—

 
—

 
272

Contribution to employee benefit plan
 
26

 
—

 
701

 
88

 
—

 
—

 
789

Stock compensation
 
—

 
—

 
—

 
8,616

 
—

 
—

 
8,616

Accrued dividends and accretion charges on Series A 3% Redeemable Convertible Preferred Stock
 
—

 
—

 
—

 
—

 
—

 
(3,575
)
 
(3,575
)
Currency translation adjustment
 
—

 
—

 
—

 
—

 
685

 
—

 
685

Net income
 
—

 
—

 
—

 
—

 
—

 
46,378

 
46,378

Balance, December 31, 2012
 
27,977

 
28

 
(106,425
)
 
413,660

 
5,300

 
51,444

 
364,007

Issuance of common stock through:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Exercise of options and restricted stock
 
460

 
—

 
—

 
8,000

 
—

 
—

 
8,000

Employee stock purchase plan
 
6

 
—

 
—

 
219

 
—

 
—

 
219

Contribution to employee benefit plan
 
23

 
—

 
627

 
219

 
—

 
—

 
846

Stock compensation
 
—

 
—

 
—

 
7,511

 
—

 
—

 
7,511

Income tax effect of exercise of stock options
 
—

 
—

 
—

 
370

 
—

 
—

 
370

Accrued dividends and accretion charges on Series A 3% Redeemable Convertible Preferred Stock
 
—

 
—

 
—

 
—

 
—

 
(3,735
)
 
(3,735
)
Currency translation adjustment
 
—

 
—

 
—

 
—

 
(179
)
 
—

 
(179
)
Net Income
 
—

 
—

 
—

 
—

 
—

 
26,056

 
26,056

Balance, December 31, 2013
 
28,466

 
$
28

 
$
(105,798
)
 
$
429,979

 
$
5,121

 
$
73,765

 
$
403,095


The accompanying notes are an integral part of these consolidated financial statements.
41

ARTHROCARE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
 
 
Year Ended December 31,
 
 
2013
 
2012
 
2011
Cash flows from operating activities:
 
 
 
 
 
 
Net income (loss)
 
$
26,056

 
$
46,378

 
$
(902
)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
 
 
 
 
 
 
Depreciation and amortization
 
14,540

 
20,424

 
24,600

Provision for doubtful accounts receivable and product returns
 
(192
)
 
153

 
208

Provision for inventory and warranty reserves
 
1,713

 
2,507

 
2,718

Non-cash stock compensation expense
 
7,638

 
8,616

 
6,226

Deferred taxes
 
10,419

 
15,504

 
(18,289
)
Income tax benefits relating to employee stock options
 
(410
)
 
—

 
(134
)
Unrealized foreign exchange (gain) loss
 
869

 
(2,999
)
 
(482
)
(Gain) Loss on assets sold/disposed
 
421

 
300

 
(2,177
)
Other
 
846

 
789

 
745

Changes in operating assets and liabilities
 
 
 
 
 
 
Accounts receivable
 
(3,657
)
 
2,720

 
(2,793
)
Inventories
 
2,071

 
(13,313
)
 
(3,485
)
Prepaid expenses and other current assets
 
(2,364
)
 
1,732

 
(24
)
Accounts payable
 
4,771

 
(3,208
)
 
1,409

Accrued and other liabilities
 
8,573

 
(71,550
)
 
76,115

Deferred revenue
 
65

 
(457
)
 
742

Income taxes payable
 
1,086

 
(1,310
)
 
120

Net cash provided by operating activities
 
72,445

 
6,286

 
84,597

Cash flows from investing activities:
 
 
 
 
 
 
Purchases of property and equipment
 
(31,578
)
 
(10,504
)
 
(13,481
)
Payments for business combinations, net of cash acquired
 
(44,983
)
 
(1,252
)
 
—

Payments for intangible asset acquisition
 
(8,500
)
 
—

 
—

Proceeds from sale of assets held for sale
 
—

 
—

 
5,500

Proceeds from loan receivable
 
—

 
—

 
2,275

Other
 
—

 
—

 
17

Net cash used in investing activities
 
(85,061
)
 
(11,756
)
 
(5,689
)
Cash flows from financing activities:
 
 
 
 
 
 
Proceeds from issuance of common stock, net of issuance costs
 
219

 
272

 
264

Proceeds from exercise of options to purchase common stock
 
8,000

 
4,104

 
7,422

Income tax benefit relating to employee stock options
 
410

 
—

 
134

Net cash provided by financing activities
 
8,629

 
4,376

 
7,820

Effect of exchange rate changes on cash and cash equivalents
 
53

 
276

 
341

Net (decrease) increase in cash and cash equivalents
 
(3,934
)
 
(818
)
 
87,069

Cash and cash equivalents, beginning of the period
 
218,787

 
219,605

 
132,536

Cash and cash equivalents, end of the period
 
$
214,853

 
$
218,787

 
$
219,605


The accompanying notes are an integral part of these consolidated financial statements.
42

ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1—FORMATION AND BUSINESS OF THE COMPANY
ArthroCare Corporation ("ArthroCare" or the "Company") is a medical device company incorporated on April 29, 1993, that develops, manufactures and markets surgical products, many of which are based on the Company's minimally invasive patented Coblation technology. The Company's products are used across several medical specialties, improving many existing soft-tissue surgical procedures and enabling new minimally invasive surgical procedures. The Company's business consists of two core product areas: Sports Medicine and ENT. The Company's product areas are each structured to support the sale and marketing of our products in two geographic distribution channels: Americas (North and South America) and International (all other geographies).
NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation.    The consolidated financial statements include the accounts of the Company and all of its wholly owned subsidiaries. All intercompany transactions and accounts have been eliminated.
Use of Estimates.    The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities in the consolidated financial statements and the reported amount of revenue and expenses during the reporting period. Actual results could differ from those estimates.
Cash and Cash Equivalents.    The Company considers all highly liquid investments purchased with original maturities of ninety days or less to be cash equivalents. Cash and cash equivalents include money market funds and various deposit accounts.
Inventories and Inventory Allowances.    The Company's inventories are stated at standard cost, which include material, labor and overhead costs and approximates actual cost determined on a first-in, first-out basis. The Company adjusts the value of its inventory to the extent management determines that the cost cannot be recovered due to obsolescence or other factors. In order to make these determinations, management uses estimates of future demand and sales prices for each product to determine appropriate inventory reserves and to make corresponding reductions in the carrying value of inventory to reflect the lower of cost or market value.
Property and Equipment.    Property and equipment is stated at cost and is depreciated on a straight-line basis over the asset's estimated useful life. The Company places the majority of its manufactured controller units with customers in order to facilitate the sale of disposable devices. Controller units placed with customers are capitalized at cost and amortized to cost of product sales over a 4-year period. Leasehold improvements are depreciated over the shorter of 10 years or the lease term. Furniture, fixtures, machinery and equipment are depreciated over a 5 year period, while computer equipment and software are depreciated over 3 to 5 years. Buildings are depreciated over a 30 year life. Maintenance and repair costs are charged to operations as incurred. Upon retirement or sale, the cost of disposed assets and their accumulated depreciation are removed from the balance sheet and any gain or loss is recognized in current operations. The Company tests its property, plant and equipment for potential impairment whenever management concludes events or changes in circumstances indicate that the carrying amount may not be recoverable. The original estimate of an asset's useful life and the impact of an event or circumstance on either an asset's useful life or carrying value involve significant judgment.
Revenue Recognition.    The Company's principal sources of revenue are from sales of its products. These revenues are recognized when there is persuasive evidence of an arrangement providing for the sale of a product, delivery of the product has occurred, the sale price of the product is fixed or determinable and collectability is reasonably assured. Revenues include shipping and handling costs billed to customers. Shipping and handling costs are presented as a part of cost of product sales, when related to revenue producing activities.
For product sales made by direct sales professionals or independent agents to customers, the Company's criteria for revenue recognition are generally complete when the product is delivered to end customers, such as surgical centers and hospitals. These sales occur either through a purchase order submitted by the customer or through trunk sales. For purchase orders, the Company ships product to and invoices the end customer directly. For trunk sales, product is hand-delivered at the end customer's premises from trunk stock maintained by the direct sales representative or independent agent and a bill-only order is received notifying the Company of the product's delivery at which time the end customer is invoiced.
Sales to distributors occur either as stocking and replenishment orders or as drop shipments to end customers. The requirements for revenue recognition are met when the product is delivered to the distributor.

ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Customers generally have the right to return or exchange products purchased from the Company for up to 60 days from the date of product shipment. At each period end, the Company determines the extent to which its revenues need to be reduced to account for expected returns and exchanges and a reserve is recorded against revenue recognized. These estimates are based on historical experience with customers and on direct customer feedback.
Revenue recognition is also impacted by management's estimate of customers' ability to pay pursuant to the terms of customer agreements. If after the Company has recognized revenue, collectability of an account receivable becomes doubtful, an allowance for doubtful accounts will be established with respect to the previously recognized revenue that remains uncollected. When management forms a judgment that a particular customer has not established a sufficient credit history but decides to deliver products to the customer, revenue recognition will be deferred. Once the customer establishes a reliable payment history the Company generally returns to normal revenue recognition based on the Company's criteria. The creditworthiness of customers is periodically reviewed considering such factors as historical collection experience, a customer's current credit standing, the age of accounts receivable balances, and general economic conditions that may affect a customer's ability to pay.
The terms of the agreements with most of the Company's customers provide that title and risk of loss passes to the customer upon shipment, however, the Company has historically accepted the risk of loss until product delivery. Accordingly, revenue is recognized on a product sale if in management's judgment it has been delivered during the relevant reporting period. The application of this policy requires management to make estimates as to the timing of deliveries. These estimates are based on historical experience with product shipments to particular markets that are served. These estimates are periodically compared to actual results based on delivery confirmations to determine whether a change of estimate is required.
Royalties are recognized as earned, based on the Company's estimates using current and historical trends reported to us by its licensees and adjusted for market factors, and are classified as royalties, fees and other revenues in the accompanying statements of comprehensive income.
Discontinued Operation.    In the fourth quarter of 2010, management determined that the Company's non-Coblation spine products met the criteria under generally accepted accounting principles to be reported as discontinued operations. The Company's non-Coblation spine products consist of its Parallax and Contour product lines. As a result of this determination, the reported impact from these discontinued product lines on current and previously reported net income in all periods is separately reported as "Income from discontinued operations, net of taxes" in the consolidated statements of comprehensive income.
Business Combinations.    Assets acquired and liabilities assumed as part of a business acquisition are generally recorded at their fair value at the date of acquisition. The excess of purchase price over the fair value of assets acquired and liabilities assumed is recorded as goodwill. Determining fair value of identifiable assets, particularly intangibles, and liabilities acquired also requires management to make estimates, which are based on all available information and in some cases assumptions with respect to the timing and amount of future revenues and expenses associated with an asset. Accounting for business acquisitions requires management to make judgments as to whether a purchase transaction is a multiple element contract, meaning that it includes other transaction components such as a settlement of a preexisting relationship. This judgment and determination affects the amount of consideration paid that is allocable to assets and liabilities acquired in the business purchase transaction.
Goodwill.    The Company performs its annual goodwill impairment test on October 31 each year. If events or indicators of impairment occur between annual impairment analyses, the Company performs an impairment analysis of goodwill at that date.
The process of evaluating the potential impairment of goodwill is subjective and requires significant judgment at many points during the analysis, including the identification of the Company's reporting units, identification and allocation of the assets and liabilities to each of its reporting units and determination of fair value. If required, estimating the fair value of a reporting unit for the purposes of the annual or periodic impairment analyses, the Company makes estimates and significant judgments about the future cash flows of that reporting unit. The cash flow forecasts are based on assumptions that represent the highest and best use for the Company's reporting unit. Changes in judgment on these assumptions and estimates could result in further goodwill impairment charges. The Company believes that the assumptions and estimates utilized are appropriate based on the information available to management.
On October 31, 2013, the Company performed its required annual goodwill impairment test and as part of this, management determined that the Company has one reporting unit and thus all of its operations, assets, and liabilities were allocated to the one reporting unit. On October 31, 2013, the closing stock of the Company's common stock price was $37.44

ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

and the Company had approximately 28.4 million shares of common stock outstanding representing a market capitalization of $1.1 billion. The book value of the Company on October 31, 2013 was $393 million, thus the fair value of the Company's reporting unit exceeds the carrying amount of the reporting unit and no further testing of goodwill impairment was required.
Intangible assets with finite lives are amortized over their estimated useful life. The Company monitors conditions related to these assets to determine whether events and circumstances warrant a revision to the remaining amortization period. The Company tests its intangible assets with finite lives for potential impairment whenever management concludes events or changes in circumstances indicate that the carrying amount may not be recoverable. The original estimate of an asset's useful life and the impact of an event or circumstance on either an asset's useful life or carrying value involve significant judgment.
Series A 3% Redeemable Convertible Preferred Stock.    The Company's Series A Preferred Stock is classified as mezzanine equity and is shown net of issuance costs. The difference in carrying value and redemption value resulting from offering costs and return of capital to the investor is accreted over the redemption period using the effective interest method. As the preferred stock is convertible at the option of the holder, the Company elected to immediately amortize the entire amount of the beneficial conversion feature as a dividend on the date of issuance. As the Company had an accumulated deficit, the election to immediately amortize the beneficial conversion feature had no impact on the accompanying consolidated balance sheets. Additional dividends are accrued at the stated rate each period so that the mezzanine equity carrying value will equal its redemption value at the date the equity is redeemable and are recorded on the declaration date at fair market value. Dividends on the preferred stock shares, including declared dividends, accrued cumulative dividends, deemed dividends on the accretion of issuance costs and amortization of the beneficial conversion feature, reduce the net income available to common stockholders and are presented as a separate amount on the accompanying consolidated statements of comprehensive income.
Earnings Per Share.    The Company calculates earnings per share ("EPS") using the two class method for all periods ending after September 1, 2009, the date of issuance of the Series A Preferred Stock. Under the two-class method, distributed and undistributed earnings are allocated to common stockholders based on their participation rights in those earnings.
Treasury Stock.    Treasury stock is accounted for under the cost method and is included as a component of stockholders' equity. When treasury stock is sold, the treasury stock balance is relieved using the weighted average cost.
Research and Development.    Research and development costs are charged to operations as incurred.
Advertising Expense.    Advertising expenses are charged to operations as sales and marketing expenses as incurred. Advertising expense was $0.7 million, $0.9 million and $0.6 million in 2013, 2012 and 2011, respectively.
Stock Based Compensation. The Company accounts for stock-based compensation by measuring and recognizing as compensation expense the fair value of all share-based payment awards made to employees, including employee stock options, stock settled stock appreciation rights (SARs) and restricted stock awards. The Company uses the Black-Scholes option pricing model to estimate the fair value of employee stock options and SARs that only have service or performance conditions. The Company uses the Monte Carlo pricing model to estimate the fair value of options and restricted stock awards that have market based conditions. The inputs to both pricing models require a number of management estimates such as volatility, risk free interest rate and expected term. Management estimates the expected volatility the Company's stock and employee exercise behavior based on historical data as well as expectations of future developments over the term of the stock compensation award. The risk free interest rate is based on the U.S. traded treasury bond with a maturity rate closest to the expected life of the stock compensation award. As stock-based compensation expense is based on the number of stock compensation award expected to vest, the Company must make estimates regarding whether or not the performance and service conditions will be achieved. These estimates are made at the time of grant and revised, if necessary, in subsequent periods which might result in a significant change in stock-based compensation expense in future periods.
The Company presents excess tax benefits from the exercise of stock options, if any, as financing cash flows rather than operating cash flows.
Legal and Other Contingencies.    The outcomes of legal proceedings and claims brought against the Company and other loss contingencies are subject to significant uncertainty. The Company accrues a charge against income when management determines that it is probable that an asset has been impaired or a liability has been incurred and the amount of loss can be reasonably estimated. In determining the appropriate accounting for loss contingencies, the Company will consider the likelihood of loss or impairment of an asset or the incurrence of a liability, as well as management's ability to reasonably estimate the amount of loss. Current information available to the Company is regularly evaluated to determine whether an

ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

accrual should be established or adjusted. Estimating the probability that a loss will occur and estimating the amount of a loss or a range of loss involves significant judgment.
Foreign Currency Translation.    Assets and liabilities of foreign subsidiaries that operate primarily in a currency other than the U.S. dollar are translated into U.S. dollars using the current exchange rate in effect at the balance sheet date, and revenues and expenses are translated using the average exchange rate in effect during the period. The gains and losses from foreign currency translation of these subsidiaries' financial statements are recorded directly as a separate component of stockholders' equity and represent essentially all of the balance under the caption "accumulated other comprehensive income."
For the Company's foreign subsidiaries that operate primarily in the U.S. dollar, all foreign currency denominated monetary assets and liabilities are remeasured into U.S. dollars at exchange rates in effect at the balance sheet date, and non-monetary assets and related elements of expense are remeasured using historical rates of exchange. Income and expense elements are remeasured into U.S. dollars using average exchange rates in effect during the period. Remeasurement gains and losses are recorded each period in the consolidated statements of comprehensive income.
Concentration of Risks and Uncertainties.    A majority of the Company's cash and cash equivalents are maintained at financial institutions in the U.S. Deposits at these institutions may exceed federally insured limits on such deposits. The Company has not experienced any losses on deposits of cash and cash equivalents.
Sales to both international and domestic customers are generally made on open credit terms. Management performs ongoing credit evaluations of the Company's customers and maintains an allowance for potential credit losses when needed. No individual customer represented more than 10 percent of product sales during the years ended December 31, 2013, 2012 and 2011 or the accounts receivable balance as of December 31, 2013 and 2012.
Income Taxes.    The Company accounts for income taxes under the liability method, whereby deferred tax asset or liability account balances are determined based on the difference between the financial statement and the tax bases of assets and liabilities using current tax laws and rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets when the amount of expected tax benefit to be realized is less than the carrying value of the deferred tax asset.
We make an evaluation at the end of each reporting period as to whether or not some or all of the undistributed earnings of our foreign subsidiaries are permanently reinvested. While we have concluded in the past that undistributed earnings will be permanently reinvested and we do not expect changes to this evaluation, facts and circumstances may change in the future. Changes in facts and circumstances may include a change in the estimated capital needs of our foreign subsidiaries, or a change in our corporate liquidity requirements. Such changes could result in our management determining that some or all of such undistributed earnings are no longer permanently reinvested. In that event, we would be required to recognize income tax liabilities on our foreign undistributed earnings that are not permanently reinvested.
Accounting for income taxes involves uncertainty and judgment on how to interpret and apply tax laws and regulations within the Company's annual tax filings. Such uncertainties from time to time may result in a tax position that may be challenged and overturned by a tax authority in the future which could result in additional tax liability, interest charges and possibly penalties. An income tax benefit from an uncertain tax position is recognized only if it is more likely than not that the tax position will be sustained upon examination by the relevant taxing authorities, based on the technical merits of the position. The liability for unrecognized tax benefits, including related interest and penalties, is recorded as other non-current liabilities. Interest and penalties are classified as a component of income tax expense.
Investigation and Restatement Related Costs.    Investigation and restatement related costs are legal expenses, indemnification and settlement costs incurred as a result of the SEC and DOJ investigations described in Note 10 "Litigation and Contingencies" and costs associated with the review and restatement of previously reported financial statements contained in the 2008 Form 10-K filed on November 18, 2009.

ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Recent Accounting Pronouncements
New accounting pronouncements or changes in existing accounting pronouncements may have a significant effect on our results of operations, our financial condition, our net worth or our business operations.
During 2012, the Company adopted FASB ASU 2011-5 ("Comprehensive Income (Topic 220): Presentation of Comprehensive Income ") which provided new requirements for the presentation of comprehensive income. The adoption of this standard did not have a material impact on our consolidated financial statements.
Accounting Standards Update (ASU) 2013-11, “Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists” was issued in July 2013 and addresses when an unrecognized tax benefit shall be recorded as a reduction to a deferred tax asset or presented as a gross liability. ASU 2013-11 is effective for the Company beginning in 2014. Management is still evaluating the impact of this ASU but anticipates that any change in balance sheet classification will be immaterial.
NOTE 3—DISCONTINUED OPERATIONS
In the fourth quarter of 2010, the Company determined that its non-Coblation spine products met the criteria under GAAP to be reported as discontinued operations. The Company's non-Coblation spine products consisted of its Parallax and Contour product lines. As a result of this determination, the impact from these product lines on the Company's reported net income in all periods is separately reported as "Income from discontinued operations" in our consolidated statements of comprehensive income.
On June 30, 2011 the Company sold the discontinued operations for $5.5 million in cash and recorded a gain on the sale of assets of approximately $2.2 million ($1.3 million after tax), which is included in income from discontinued operations in the accompanying consolidated statements of comprehensive income for 2011.
Revenues, gain on the sale of assets, income and income taxes related to discontinued operations for the year ended December 31, 2011 were as follows (in thousands):
 
 
Year Ended
December 31,
 
 
2011
Revenue
 
$
2,271

Gain on sale of assets
 
2,177

Income from discontinued operations before income taxes
 
3,084

Income tax provision
 
1,173

Income from discontinued operations
 
1,911

NOTE 4—COMPUTATION OF EARNINGS (LOSS) PER SHARE
The Company's Series A Preferred Stock has participation rights in dividends issued to common stockholders. As a result, the Company calculates earnings per share using the two class method. The following is a reconciliation of net income (loss) applicable to common stockholders and the number of shares used in the calculation of basic and diluted earnings (loss) per share applicable to common stockholders (in thousands, except per-share data):

ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 4—COMPUTATION OF EARNINGS (LOSS) PER SHARE (Continued)

 
 
Year Ended December 31,
 
 
2013
 
2012
 
2011
Income (loss) from continuing operations allocated to common stockholders (net of $3,781 and $7,370 attributable to Series A Preferred Stock for 2013 and 2012, respectively)
 
$
18,540

 
$
35,433

 
$
(6,229
)
Income from discontinued operations
 
—

 
—

 
1,911

Net income (loss) allocated to common stockholders (net of $3,781 and $7,370 of undistributed earnings to Series A Preferred Stock for 2013 and 2012, respectively)
 
$
18,540

 
$
35,433

 
$
(4,318
)
Basic:
 
 
 
 
 
 
Weighted-average common shares outstanding
 
28,311

 
27,752

 
27,382

Earnings (loss) from continuing operations per share allocated to common stockholders
 
$
0.65

 
$
1.28

 
$
(0.23
)
Earnings from discontinued operations per share allocated to common stockholders
 
—

 
—

 
0.07

Earnings (loss) per share allocated to common stockholders
 
$
0.65

 
$
1.28

 
$
(0.16
)
Diluted:
 
 
 
 
 
 
Weighted-average shares outstanding used in basic calculation
 
28,311

 
27,752

 
27,382

Dilutive effect of options
 
275

 
241

 
—

Dilutive effect of unvested restricted stock
 
402

 
414

 
—

Weighted-average common stock and common stock equivalents
 
28,988

 
28,407

 
27,382

Earnings (loss) from continuing operations per share allocated to common stockholders
 
$
0.64

 
$
1.25

 
$
(0.23
)
Loss from discontinued operations per share allocated to common stockholders
 
—

 
—

 
0.07

Earnings (loss) per share allocated to common stockholders
 
$
0.64

 
$
1.25

 
$
(0.16
)
Stock issuable upon conversion of the Series A Preferred Stock
 
5,806

 
5,806

 
5,806

Stock awards excluded from calculation as their effect would be anti-dilutive
 
479

 
787

 
2,531

Awards approved under the Company's Long Term Incentive Program (see Note 12) are excluded from diluted shares until both the market conditions and performance conditions have been met.
NOTE 5—INVENTORY
The following summarizes the Company's inventories (in thousands):
 
 
December 31,
 
 
2013
 
2012
Raw materials
 
$
12,815

 
$
10,760

Work-in-process
 
12,281

 
11,984

Finished goods
 
26,265

 
30,338

 
 
51,361

 
53,082

Inventory valuation reserves
 
(5,073
)
 
(4,665
)
Inventories, net
 
$
46,288

 
$
48,417




48
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 6—PROPERTY AND EQUIPMENT
The following summarizes the Company's property and equipment (in thousands):
 
 
December 31,
 
 
2013
 
2012
Controller placements
 
$
45,094

 
$
40,995

Computer equipment and software
 
27,439

 
26,485

Machinery and equipment
 
26,036

 
20,867

Furniture, fixtures and leasehold improvements
 
8,738

 
5,531

Building and improvements
 
7,614

 
7,280

Land
 
5,738

 
745

Construction in process
 
13,515

 
1,169

 
 
134,174

 
103,072

Less: accumulated depreciation
 
(82,930
)
 
(72,611
)
Total property and equipment, net
 
$
51,244

 
$
30,461

Depreciation expense related to the Company's property and equipment was $12.5 million, $15.6 million and $19.3 million for the years ended December 31, 2013, 2012 and 2011, respectively. Accumulated depreciation for controllers was $25.7 million at December 31, 2013.
NOTE 7—GOODWILL AND INTANGIBLE ASSETS
Goodwill
The changes in the carrying amount of goodwill are as follows (in thousands):
 
 
December 31,
 
 
2013
 
2012
Goodwill as of January 1, 2013 and 2012 net of accumulated impairment losses of $18,945
 
$
119,893

 
$
119,159

Business combination
 
45,950

 
405

Translation adjustments
 
110

 
329

Goodwill as of December 31, 2013 and 2012 net of accumulated impairment losses of $18,945
 
$
165,953

 
$
119,893












49
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 7—GOODWILL AND INTANGIBLE ASSETS (Continued)

Intangible assets with finite lives
Intangible assets consist of the following (in thousands, except weighted average useful life):
 
 
December 31,
 
Weighted-
Average
Useful Life
 
 
2013
 
2012
 
Intellectual property rights
 
$
5,199

 
$
5,199

 
8.0 years
Patents
 
12,452

 
1,266

 
18.0 years
Distribution/customer relationships
 
4,029

 
3,597

 
6.4 years
Trade name/trademarks
 
810

 
399

 
8.4 years
Collaboration agreements
 
1,500

 
—

 
2.0 years
Non-competition agreements
 
1,231

 
313

 
4.0 years
 
 
25,221

 
10,774

 
12.2 years
Less: accumulated amortization
 
(10,640
)
 
(8,915
)
 
 
Total intangible assets, net
 
$
14,581

 
$
1,859

 
 
In the fourth quarter of 2012, the Company wrote off $31.8 million of fully amortized intangible assets.
Estimated future amortization expense is as follows (in thousands):
2014
 
$
2,023

2015
 
1,733

2016
 
949

2017
 
927

2018
 
867

Thereafter
 
8,082

 
 
$
14,581

NOTE 8—ACCRUED LIABILITIES
The following summarizes the Company's accrued liabilities (in thousands):
 
 
December 31,
 
 
2013
 
2012
Compensation
 
$
19,367

 
$
17,031

Insurance dispute and settlement reserve
 
30,000

 
9,729

Legal expenses
 
2,226

 
3,730

Other
 
13,355

 
11,184

 
 
$
64,948

 
$
41,674


On December 31, 2013, the Company entered into a Deferred Prosecution Agreement (“DPA”) with the DOJ (see further discussion in Note 10). A charge of $20.2 million was recorded in the second quarter of 2013 as investigation and restatement related expenses which increased the balance of the Company’s insurance dispute and settlement reserve to $30 million. The $30 million fine was paid in January 2014.
NOTE 9—COMMITMENTS
On December 31, 2012, the Company entered into a stock purchase agreement to acquire Eleven Blade Solutions, Inc. (Eleven Blade). The closing of the transaction was conditioned upon Eleven Blade obtaining United States Food and Drug

50
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 9—COMMITMENTS (Continued)

Administration clearance for certain suture-based anchor products, which was received in January 2013, and the Company subsequently paid $7 million in cash and closed the acquisition. In addition, the agreement provides that the Company will pay the sellers a one-time earn-out payment based on the net sales of Q-Fix® products during the three-year period following the full commercialization of these products in the United States. Finally the purchase agreement provides the sellers a right to receive royalties based on the net sales of Q-Fix® products for a term of 10 years.
On July 1, 2013, the Company acquired ENTrigue Surgical, Inc. ("ENTrigue"), a privately-held Delaware corporation specializing in ENT sinus surgical products. The Agreement provides that the Company will make annual cash payments to the former stockholders of ENTrigue shortly after each of the next five anniversaries of the acquisition date based on the annual net sales of the acquired products. The annual payment shall equal annual net sales growth times the applicable sales growth multiple for the year. The sales growth multiple is 0.6 for years 1-3; 1.1 for year 4; and 1.25 for year 5. For purposes of calculating this multiple, the annual growth of net sales each year is determined by subtracting the highest amount of net sales in any previous year from the net sales in the current year. The range of undiscounted future payments that could be required is currently estimated to be between $2.4 million and $32.2 million. The estimated fair value of the contingent consideration arrangement used for determining total purchase price is $14.5 million, which was estimated by applying the income approach using a Monte Carlo simulation model.

The fair value of the liability is based on valuation inputs that are not observable in the market (considered as a level 3 fair value in the hierarchy to classify fair value under generally accepted accounting principles) including volatility of 21%, a risk free rate between 0.16% to 1.76% and a discount rate between 11.5% to 13%, each of which fluctuates within those ranges over the term of the earn out. The Company updated the fair value of the earn out as of December 31, 2013 using the Monte Carlo simulation model noting that the change in fair value from $14.5 million on the date of acquisition to $15.2 million as of December 31, 2013 was due to the accretion of interest expense.

On July 22, 2013, ArthroCare Costa Rica S.R.L. (“ACR”), an indirect wholly-owned subsidiary of ArthroCare, entered into agreements with Zona Franca Coyol, S.A. (“CFZ”) under which ACR acquired property in Alajuela, Costa Rica for $4.9 million from CFZ and CFZ has been contracted to design and construct a new manufacturing facility for the Company on the acquired property currently expected to cost approximately $19.9 million.
The Company recognizes rent expense on a straight-line basis over the lease term. Rent expense for 2013, 2012 and 2011 was $6.0 million, $6.0 million and $5.4 million, respectively.
The Company advances legal fees as required pursuant to indemnification agreements that were entered into with certain former executives and employees while they were employed with the Company. The company advanced and expensed $12.5 million, $7.7 million and $6.3 million for the years ended December 31, 2013, 2012 and 2011, respectively, under these indemnification agreements. We expect to continue to advance payments pursuant to these agreements in future periods; however, management is unable to estimate the amount or timing of future payments under such agreements.
The Company leases certain facilities and equipment under operating leases. At December 31, 2013, total and future minimum commitments were as follows (in thousands):
 
 
Minimum
Lease
Payments
 
Other
 
Sub-lease
Income
 
Minimum
Commitments
2014
 
$
6,398

 
$
105

 
$
79

 
$
6,424

2015
 
5,188

 
—

 
81

 
5,107

2016
 
4,587

 
—

 
83

 
4,504

2017
 
3,609

 
—

 
21

 
3,588

2018
 
3,075

 
—

 
—

 
3,075

Thereafter
 
10,301

 
—

 
—

 
10,301

 
 
$
33,158

 
$
105

 
$
264

 
$
32,999


51
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 9—COMMITMENTS (Continued)

Warranties
The Company guarantees its disposable medical devices for materials, function and workmanship for a single usage. The Company's warranty obligation is affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. The Company periodically evaluates and adjusts the warranty reserve to the extent actual warranty expense varies from the original estimates.
NOTE 10—LITIGATION AND CONTINGENCIES
In addition to the matters specifically described below, the Company is involved in other legal and regulatory proceedings that arise in the ordinary course of business that do not have a material impact on its business. Litigation claims and proceedings of all types are subject to many factors that generally cannot be predicted accurately.
The Company records reserves for claims and lawsuits when the likelihood of a loss is probable and reasonably estimable. Except as otherwise specifically noted, the Company currently cannot determine the ultimate resolution of or the amount of monetary damages sought as relief in the matters described below. For matters where the likelihood or extent of a loss is not probable or cannot be reasonably estimated, the Company has not recognized any potential liability that may result from these matters in its consolidated financial statements. The resolution of these matters could have a material adverse effect on our earnings, liquidity and financial condition.
The Company continues to gather additional facts and information related to insurance billing and healthcare compliance issues and marketing and promotional practices in connection with these legal and administrative proceedings with the assistance of legal counsel.
DOJ Investigation
On December 31, 2013, the Company entered into a Deferred Prosecution Agreement (“DPA”) with the DOJ. The DPA will resolve the ongoing investigation by the DOJ regarding allegations of securities and related fraud committed under a previous management team.
In conjunction with the DPA, the DOJ concurrently filed a criminal information concerning a single-count of conspiracy to commit wire and securities fraud. The DPA is for a 24 month period and, subject to its successful completion, the DOJ agrees that the DPA will expire and that the DOJ will seek dismissal of the criminal information. Pursuant to the DPA, ArthroCare paid a $30 million fine, subsequent to December 31, 2013, to the DOJ and agreed to maintain a compliance program meeting certain criteria specified in the DPA. ArthroCare also must report annually on the status of the Compliance Program to the DOJ.
A charge of $20.2 million was recorded in the second quarter of 2013 as investigation and restatement related expenses which increased the balance of the Company’s insurance dispute and settlement reserve to $30 million. The $30 million fine was paid in January 2014.
False Claims Act Investigation
In the first quarter of 2012, the Company received a Civil Investigative Demand ("CID") from the DOJ, requesting information related to the marketing of its radio-frequency ablation devices, which could implicate the False Claims Act, 31 U.S.C. § 3729. On January 17, 2014, a representative of the DOJ confirmed to the Company that the CID related to a qui tam case, in which the DOJ elected not to intervene, had been dismissed by the United States District Court in the Eastern District of New York. The case, United States of America ex rel. Michael Scherl v. ArthroCare Corporation et al., 2:11-cv-00668-LDW-AKT (E.D.N.Y. Feb 10, 2011), had previously been filed under seal and alleged violations of the False Claims Act. Based on the confirmation from the DOJ, the Company believes that the CID matter is closed.
Shareholder Derivative Actions
In 2008 and 2009 three derivative actions were filed in Federal court against the Company and its then-current directors alleging breach of fiduciary duty based on alleged improper revenue recognition, improper reporting of such revenue in SEC filings and press releases, failure to maintain adequate internal controls, and failure to supervise management. These federal derivative actions were consolidated with the two securities class actions described below and designated In Re ArthroCare Corporation Securities Litigation, Case No. 1:8-cv-574-SS (consolidated) in the U.S. District Court, Western District of Texas.
In 2008 and 2009, three derivative actions were filed in Texas State District Court against the Company, its then current directors, and certain of its current and former officers. In these actions, certain of the Companies shareholders alleged derivative claims on behalf of the Company that its directors and officers breached their fiduciary duties to shareholders by allowing improper financial reporting, failing to maintain adequate financial controls over revenue recognition, disseminating

52
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 10—LITIGATION AND CONTINGENCIES (Continued)

false financial statements, abuse of control, gross mismanagement, waste of corporate assets, and engaging in insider trading. On March 18, 2009, these three state shareholder derivative actions were consolidated and designated: In Re ArthroCare Corporation Derivative Litigation, Case No. D-1-GN-8-3484 (consolidated), Travis County District Court.
Settlement of Federal and State Derivative Actions
On December 8, 2011, the U.S. District Court for the Western District of Texas granted final approval to the settlement of the Federal Court and State Court derivative actions that were pending against ArthroCare's directors and officers. Under the terms of the settlement, the Company's director and officer insurers collectively paid us $8.0 million on behalf of the individuals named as defendants in the Federal Court and State Court derivative actions to settle the State and Federal Derivative actions. The lawyers for the plaintiffs were awarded legal fees and costs from the Federal Court in an amount of $2.25 million. Under a related settlement, the directors' and officers' insurers paid the Company an additional $2.0 million for a broad mutual release by us and the insurers of any further rights or obligations under the directors' and officers' liability insurance policies. The settlement also contained certain mutually acceptable governance changes and the release by the individual officers and directors and former officers and directors who were parties to the derivative actions, of our directors' and officers' liability insurance carriers from any further rights or obligations under the applicable directors' and officers' liability insurance policies. On December 15, 2011, a dismissal with prejudice of the State derivative action was entered pursuant to the Settlement.
Private Securities Class Action
In 2008, two putative securities class actions were filed in Federal court against us and certain of our former executive officers, alleging violations of Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 promulgated thereunder. Plaintiffs allege that the defendants violated federal securities laws by issuing false and misleading financial statements and making material misrepresentations regarding our internal controls, business, and financial results. On October 28, 2008 and thereafter, the two putative securities class actions and the federal shareholder derivative actions were consolidated and designated: In Re ArthroCare Corporation Securities Litigation, Case No. 1:8-cv-574-SS (consolidated) in the U.S. District Court, Western District of Texas.
The Company reached an agreement to settle the private securities class action suits consolidated into the action titled In Re ArthroCare Corporation Securities Litigation, Case No. 1:8-cv-574-SS (consolidated) in the U.S. District Court, Western District of Texas.
The settlement resolves all claims arising from the purchase or sale of ArthroCare securities of a class of all purchasers of ArthroCare common stock and call options, and sellers of put options on ArthroCare common stock between December 11, 2007 and February 18, 2009, inclusive (the Class), except those members of the Class who opt out, for a payment of $74 million to a settlement fund to be created for the settlement. Counsel for the plaintiff applied for and received an award of attorneys' fees and reimbursement of expenses from the settlement fund. On February 10, 2012, the Court entered an order of preliminary approval of the settlement and ordered that Notice be sent to all class members. Pursuant to the preliminary approval order, the Company paid the $74 million in settlement funds into the applicable settlement escrow account on February 23, 2012. The settlement was approved by the United States District Court for the Western District of Texas and entered as a final judgment on June 4, 2012.
Legal Proceedings Related to the Merger
Between February 4, 2014 and February 12, 2014, five putative class action lawsuits were filed in the Court of Chancery of the State of Delaware by alleged stockholders of ArthroCare Corporation (“ArthroCare” or the “Company”) against the Company and the individual directors of the Company, as well as Smith & Nephew, Inc., Rosebud Acquisition Corporation and Smith & Nephew PLC (collectively, “Smith Nephew”), and in one case, against One Equity Partners LLC, OEP AC Holdings, LLC, (together, with One Equity Partners LLC, “OEP”) and JPMorgan Chase & Co. (“JPM”).  These lawsuits are captioned: King v. ArthroCare Corporation et al. C.A. No. 9313, Rybacki v. ArthroCare Corporation et al. C.A. No. 9336, State-Boston Retirement System v. Fitzgerald et al., C.A. No. 9346, Dixon v. ArthroCare Corporation et al., C.A. No. 9347 and Machcinski v. ArthroCare Corporation et al., C.A. No. 9344. 
These lawsuits generally allege that the members of ArthroCare’s Board of Directors breached their fiduciary duties in negotiating and approving the merger agreement with Smith Nephew, that the merger consideration undervalues the Company, that ArthroCare’s stockholders will not receive adequate or fair value for their ArthroCare common stock in the merger and that

53
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 10—LITIGATION AND CONTINGENCIES (Continued)

the terms of the merger agreement impose improper deal protection terms that preclude competing offers.  The King lawsuit further alleges that the Board of Directors have failed to provide ArthroCare stockholders with complete and accurate information about the proposed merger.  The State-Boston Retirement System lawsuit further alleges that JPM and OEP had conflicts of interest in the transaction, resulting from OEP’s investment in ArthroCare and JPM’s economic interest in the buy-side financial advisor fees and the buy-side financing fees and economics, and that JPM’s involvement as Smith Nephew’s advisor and deal financing source violated the terms of the securities purchase agreement that OEP entered into with ArthroCare at the time that OEP invested in the Company.  The lawsuits further allege that the Company and/or Smith Nephew, and in the State-Boston Retirement System case, OEP and JPM, aided and abetted the purported breaches of fiduciary duty.  The State-Boston Retirement System case further alleges that OEP breached the securities purchase agreement entered into between OEP and the Company, and that JPM and Smith Nephew tortuously interfered with the securities purchase agreement.
The lawsuits seek, among other things, to enjoin the merger, or in the event that an injunction is not entered and the merger closes, rescission of the Merger and unspecified money damages, costs and attorneys’ and experts’ fees.  The Company believes these lawsuits are meritless and intends to defend against them vigorously.


54
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 11—SERIES A 3.00% REDEEMABLE CONVERTIBLE PREFERRED STOCK
On September 1, 2009, the Company issued and sold 75,000 shares of the Company's Series A 3 percent Redeemable Convertible Preferred Stock, par value $0.001 per share (the "Series A Preferred Stock"), for an aggregate purchase price of $75.0 million (the "Equity Financing") pursuant to the Securities Purchase Agreement dated August 14, 2009, by and between the Company and OEP AC Holdings, LLC ("OEP").
Cumulative dividends on the Series A Preferred Stock are payable-in-kind on a quarterly basis at the rate per annum of 3 percent of the liquidation preference of $1,000 per share (the "Liquidation Preference") until October 1, 2014, (the "Dividend Duration Period"). As of December 31, 2013, 2012 and 2011, dividends of $10.4 million, $7.9 million and $5.5 million were accrued, respectively. Gross proceeds from the sale of the Series A Preferred Stock were reduced by direct issuance cost of $5.6 million, including the amount used to pay the expenses of the investor, and will be accreted over a five year period using the effective interest rate method. Total accretion charges for the periods ended December 31, 2013, 2012 and 2011 were $1.2 million, $1.1 million and $1.0 million and were recorded as a dividend.
The closing value of the Company's common stock on the date of issuance was $17.45 (the "Closing Price") resulting in an intrinsic value of $4.65 per Conversion Share calculated as the Closing Price of $17.45 less the Conversion Price of $12.92 less approximately $0.7 million in proceeds which were used to pay expenses of the investor. This resulted in a beneficial conversion feature of $27.0 million on the sale of the Series A Preferred Stock based on the intrinsic value of each Conversion Share multiplied by the number of Conversion Shares. The beneficial conversion feature was immediately charged against net loss applicable to common stockholders as the Series A Preferred stock can be converted into common stock at the option of the holder.
The holders of the Series A Preferred Stock may convert their shares at any time, in whole or in part, at a rate of 66.667 shares of the Company's Common Stock per $1,000 of Liquidation Preference of the Series A Preferred Stock, subject to customary anti-dilution adjustments (the "Conversion Rate"), representing an initial conversion price of $15.00 per share of Common Stock. If a conversion occurs prior to the expiration of the Dividend Duration Period, the number of shares of Common Stock received shall be increased for a make-whole adjustment equal to the number of additional shares of Series A Preferred Stock the holder would have otherwise been paid during the Dividend Duration Period, multiplied by the Conversion Rate (the "Make-Whole Adjustment"). As of December 31, 2013, none of the shares of Series A Preferred Stock have been converted into Common Stock.
The Company may, at any time, cause an automatic conversion of all outstanding shares of Series A Preferred Stock upon no less than 10 days prior notice if all of the following events occur: the closing sales price of the Common Stock equals or exceeds $35.00 per share (subject to adjustment in the event of a stock split, stock dividend, combination or other similar recapitalization) for the prior 20 consecutive trading days; the Company is current on its reporting requirements with the SEC; the Company has an effective resale registration statement and related prospectus that permits the Common Stock issued upon such automatic conversion to be immediately resold thereunder; and the current DOJ investigations of the Company initiated by the U.S. Attorney's offices in Florida and North Carolina have been terminated, settled or adjudicated.
On February 11, 2014, the Series A Preferred Stock was converted to 5,805,921 shares of the Company's Common Stock in accordance with the terms of the automatic conversion feature.
NOTE 12—STOCKHOLDERS EQUITY
Employee Stock Purchase Plan
The Company has an Employee Stock Purchase Plan, or ESPP, which allows regular full-time U.S. employees (subject to certain exceptions) to contribute up to 10 percent of base compensation to the semi-annual purchase of shares of the Company's common stock at 95 percent of the fair market value at certain plan-defined dates. The Company reserved a total of 450,000 shares of common stock for issuance under the ESPP of which 27,393 shares remained available for future purchases as of December 31, 2013.
Stock Option Plans
In August 1999, the Company adopted the Non-statutory Option Plan ("1999 Plan") which expired in 2009. Awards that were granted under the 1999 Plan will continue to operate in accordance with the terms of the 1999 Plan until the awards are either exercised or canceled.

55
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 12—STOCKHOLDERS EQUITY (Continued)

In May 2003, the Company adopted the 2003 Incentive Stock Plan ("2003 Plan") under which the Board of Directors is authorized to grant incentive and non-statutory stock option awards, stock settled stock appreciation rights (SARs) and restricted stock awards to employees, directors and consultants. The 2003 Plan has been subsequently amended and currently a total of 5,900,000 shares have been authorized for issuance. As of December 31, 2013, the Company had 1,309,426 shares remaining available for future grant under the 2003 Plan.
Options and SARs granted under the 1999 Plan and the 2003 Plan generally become exercisable over a 48-month period and restricted stock awards generally become exercisable over a three to five year period. Since 2005, all options, SARs and awards granted under each of the Company's plans have a contractual life of seven years. Prior to that, options granted had a contractual life of ten years from the grant date. The Company has historically issued new shares upon exercises of stock options, SARs and vesting of restricted stock. Directors of the Company are eligible to receive deferred restricted stock awards ("DRSA") that vest over a five year period. Delivery of the DRSA occurs upon the director's retirement, resignation or other departure from membership of the Board of Directors.
On January 6, 2012, the Company's Board of Directors (the "Board") approved a Long Term Incentive Program (the "LTIP"), which provides for shares of the Company's Common Stock (the "Performance Shares") to certain senior executives of the Company, under the Company's Amended and Restated 2003 Incentive Stock Plan.
The Board also approved the participants, goals and award levels for the first performance period under the LTIP. Under the 2012-2014 Performance Period, in aggregate the participants may earn up to a maximum of 600,000 shares of Common Stock pursuant to Performance Shares. The final number of shares to be earned under the LTIP will be determined based upon the Company's actual achievement compared to revenue, operating income and free cash flow goals, during the performance period, provided that the Company's stock price is equal to or greater than $35 on December 31, 2014. The number of earned shares, if any, will be determined on the date that the Company files its Form 10-K for the year ended December 31, 2014 (the "Determination Date") and 50 percent of the earned Performance Shares vests on the thirtieth day following the Determination Date and 25 percent of the earned shares vests on each of the next two anniversaries of the Determination Date. During the year ended December 31, 2013 no expense was recorded related to the LTIP awards and the intrinsic value is $0.
The weighted average fair value of each stock option and SARs granted to employees during the years ended December 31, 2013, 2012 and 2011 was estimated at $9.90, $12.71 and $15.70, respectively. The weighted average fair value of restricted stock awards granted in December 31, 2013, 2012 and 2011 was $35.53, $26.30 and $33.35, respectively.
The fair value of each stock option and SAR was estimated on the grant date using the Black Scholes option pricing model with the following weighted average assumptions for the years ended December 31, 2013, 2012 and 2011:
 
 
2013
 
2012
 
2011
Expected term (in years)
 
4.6

 
4.4

 
4.3

Expected volatility
 
32
%
 
60
%
 
58
%
Risk-free interest rate
 
0.7
%
 
0.7
%
 
1.7
%
Expected dividends
 
—

 
—

 
—

The fair value of each LTIP award granted on January 6, 2012 was estimated at $17.07 using the Monte Carlo pricing model with the following assumptions:
 
 
2012
Grant date stock price
 
$
31.30

Expected term (in years)
 
3

Expected volatility
 
33.5
%
Risk-free interest rate
 
0.4
%
Expected dividends
 
—


56
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 12—STOCKHOLDERS EQUITY (Continued)

Activity for all stock based compensation plans for the year ended December 31, 2013 is as follows:
 
 
Stock Options/SARs
Outstanding
 
Restricted Stock Awards
Outstanding
 
 
Number of
Shares
 
Weighted-
Average Exercise
Price
 
Number of
Shares
 
Weighted-
Average Grant
Date Fair Value
Balance as of December 31, 2012
 
1,962,008

 
$
28.99

 
471,562

 
$
28.77

Granted
 
343,558

 
$
35.78

 
201,973

 
$
35.53

Exercised/vested
 
(357,034
)
 
$
24.01

 
(110,987
)
 
$
28.93

Canceled/forfeited
 
(374,168
)
 
$
37.89

 
(64,120
)
 
$
30.82

Balance as of December 31, 2013
 
1,574,364

 
$
29.48

 
498,428

 
$
31.21

Exercisable/Deferred at December 31, 2013
 
1,154,415

 
$
28.18

 
72,473

 
$
29.92

The weighted average remaining contractual term for stock options and SARs outstanding and exercisable at December 31, 2013, is 3.6 and 2.8 years, respectively. The aggregate intrinsic value for stock options and SARs outstanding and exercisable at December 31, 2013, is $17.2 million and $14.2 million, respectively. The total intrinsic value of options and SARs exercised during the years ended December 31, 2013, 2012, and 2011, was $4.0 million, $3.8 million, and $4.0 million, respectively. As of December 31, 2013 there was $4.1 million of unrecognized compensation expense related options and SARs granted under the Company's stock plans. That unrecognized cost is expected to be recognized over a weighted average period of 2.6 years.
As of December 31, 2013, there was $8.9 million of unrecognized compensation expense related to restricted stock awards granted under the Company's stock plans. That unrecognized cost is expected to be recognized over a weighted average period of 2.7 years. The total fair value of shares vested during the years ended December 31, 2013, 2012 and 2011, was $3.2 million, $3.6 million, and $1.8 million, respectively.
Valuation and Expense Information
The following table summarizes the reporting of total stock based compensation expense resulting from employee stock options, including SARs, and restricted stock awards for the years ended December 31, 2013, 2012 and 2011 (in thousands):
 
 
Year Ended December 31,
 
 
2013
 
2012
 
2011
Cost of product sales
 
$
502

 
$
586

 
$
1,524

Research and development
 
1,263

 
1,490

 
850

Sales and marketing
 
2,591

 
3,057

 
1,828

General and administrative
 
3,282

 
3,483

 
2,024

Stock based compensation expense before income taxes
 
7,638

 
8,616

 
6,226

Income tax benefit
 
2,753

 
2,570

 
1,690

Total stock-based compensation expense, net of income taxes
 
$
4,885

 
$
6,046

 
$
4,536

Stock-based compensation expense recognized has been reduced for estimated forfeitures at a rate of 6.4 percent based on the Company's historical experience. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.
NOTE 13—EXIT COSTS
The Company entered into a new lease agreement on April 4, 2011, for facilities located in Austin, Texas in order to relocate the activities conducted at its Sunnyvale, California facility. The Company incurred $8.3 million of exit costs including $4.6 million of employee related costs and $3.7 million of contract termination and other costs in conjunction with this relocation and has reported these costs as incurred in "exit costs" in its consolidated statements of comprehensive income. The

57
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 13—EXIT COSTS (Continued)


Company completed the relocation of its Sunnyvale, California activities and the final employee related costs were paid by the second quarter of 2012.
The following summarizes the accrued and paid exit costs during the years ended December 31, 2013, 2012, and 2011 (in thousands):
 
 
 
 
 
 
 
Accrued
Exit Cost
Balance at
January 1,
2011
Cost
Incurred
Payments
Accrued
Exit Cost
Balance at
December 31,
2011
Cost
Incurred
Payments
Accrued
Exit Cost
Balance at
December 31,
2012
Cost
Incurred
Payments
Accrued
Exit Cost
Balance at
December 31,
2013
Employee-related
$
—

$
4,559

$
3,142

$
1,417

$
32

$
1,449

$
—

$
—

$
—

$
—

Contract termination and other
—

3,741

1,370

2,371

(810
)
652

909

695

161

1,443

Total
$
—

$
8,300

$
4,512

$
3,788

$
(778
)
$
2,101

$
909

$
695

$
161

$
1,443

In 2011, the Company reported in aggregate $3.8 million of costs related to the relocation of our Sunnyvale, California activities to Austin, Texas that did not meet the definition of exit costs. This included costs of product sales of $0.4 million, research and development costs of $1.4 million; sales and marketing costs of $0.5 million; and, general and administrative costs of $1.5 million. These expenses include accelerated amortization of leasehold improvements related to facilities that ceased to be used upon completion of the relocation; personnel recruiting and training expense; and, duplicative rent and employee cost, offset by forfeited stock compensation.
In the second quarter of 2012, the Company entered into two sublease agreements for its former Austin, Texas location which decreased the amount accrued for contract termination by $1.1 million. During the fourth quarter of 2013, as a result of the termination of a contract with one of the subtenants, an additional $0.7 million expense was accrued for contract termination.
NOTE 14—INCOME TAXES
The components of income (loss) before income taxes were as follows (in thousands):
 
 
Year Ended December 31,
 
 
2013
 
2012
 
2011
Domestic
 
$
4,691

 
$
37,095

 
$
(43,518
)
Foreign
 
26,424

 
26,612

 
26,720

Total
 
$
31,115

 
$
63,707

 
$
(16,798
)
The amounts above for 2011 exclude income (loss) from discontinued operations before income taxes of $3.1 million.

58
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 14—INCOME TAXES (Continued)

The income tax provision (benefit) consisted of the following (in thousands):
 
 
Year Ended December 31,
 
 
2013
 
2012
 
2011
Current:
 
 
 
 
 
 
Federal
 
$
(8,132
)
 
$
382

 
$
2,938

State
 
673

 
686

 
848

Foreign
 
2,099

 
757

 
518

Total current
 
(5,360
)
 
1,825

 
4,304

Deferred:
 
 
 
 
 
 
Federal
 
10,434

 
15,168

 
(15,516
)
State
 
5

 
1,337

 
(2,167
)
Foreign
 
(20
)
 
(1,001
)
 
(606
)
Total deferred
 
10,419

 
15,504

 
(18,289
)
Total income tax provision (benefit)
 
$
5,059

 
$
17,329

 
$
(13,985
)
The amounts above for 2011 exclude the income tax provision (benefit) from discontinued operations of $1.2 million.
The income tax provision (benefit) differed from a provision computed at the U.S. statutory tax rate as follows (in thousands):
 
 
Year Ended December 31,
 
 
2013
 
2012
 
2011
Tax at federal statutory rate
 
$
10,892

 
$
22,298

 
$
(5,879
)
State income taxes
 
644

 
692

 
(1,304
)
Differences in foreign tax rates
 
(8,232
)
 
(9,545
)
 
(7,759
)
Stock-based compensation
 
103

 
585

 
442

Research and development credits
 
(2,045
)
 
(136
)
 
(1,608
)
Nondeductible expenses
 
852

 
166

 
288

Accruals for intercompany payments
 
1,884

 
1,947

 
1,889

Change in tax rates
 
122

 
1,078

 
—

Non-deductible DOJ settlement
 
10,998

 
—

 
—

Settlement of IRS examination
 
(10,542
)
 
—

 
—

Other
 
383

 
244

 
(54
)
Total income tax provision (benefit)
 
$
5,059

 
$
17,329

 
$
(13,985
)
The Company's tax expense for the periods 2011 through 2013 was significantly reduced due to a tax holiday for its Costa Rican manufacturing operations. Under its original holiday agreement, the Company was not subject to Costa Rican income tax until January 2016.  As of December 31, 2013, this agreement has been extended and will expire on December 31, 2023. The Company will have a 50 percent income tax exemption from January 1, 2024 until January 28, 2028. After January 28, 2028, the Company will be subject to the normal Costa Rican corporate income taxes, which are currently 30 percent. Without the Costa Rican tax holiday, the increase in income tax expense would have been $3.3 million for 2013, $3.4 million for 2012 and $3.0 million for 2011 representing a reduction to earnings (loss) per share in each year of $0.10, $0.10, and $0.11, respectively.
The Company recognized an income tax benefit from the federal research and development tax credit for the years ended December 31, 2013 and 2011. For the year ended December 31, 2012, the Company did not reflect an income tax benefit related to the tax credit as the credit expired on December 31, 2011. However, the tax credit was extended by the signing of the American Taxpayer Relief Act of 2012 ("ATRA") on January 2, 2013. Since the ATRA was enacted during 2013, the income tax benefit related to the federal 2012 research and development tax credit was recognized in the year ended December 31, 2013.

59
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 14—INCOME TAXES (Continued)

 
 
December 31,
 
 
2013
 
2012
Federal loss carryover
 
$
50,059

 
$
40,894

State loss carryover
 
7,362

 
33,116

Federal research and development credit carryover
 
8,261

 
7,999

State research and development credit carryover
 
12,561

 
12,346

Foreign loss carryover
 
251

 
1,391

U.S. Alternative Minimum Tax carryover
 
1,549

 
948

The Company's federal net operating loss carryforwards will expire between 2020 and 2032. The Company's federal research and development credit carryforwards will expire during the period 2021 through 2033. The Company's state loss carryforward will expire between 2018 and 2032. The Company's foreign net operating loss carryforwards, alternative minimum tax credits, and state research and development credits are not subject to expiration, with the exception of unused Texas state research and development credits totaling $0.5 million which will expire in 2033.
Under U.S. tax law, certain changes in the Company's ownership could result in an annual limitation on the amount of net operating loss carryforwards and income tax credits that could be utilized to offset future tax liabilities. At December 31, 2013, approximately $37.0 million of the Company's net operating loss carryforwards are subject to an annual utilization limit of approximately $6.5 million pursuant to IRC Section 382.
The Company's deferred tax assets and liabilities consist of the following (in thousands):
 
 
December 31,
 
 
2013
 
2012
Deferred tax assets:
 
 

 
 

Net operating loss carryovers, net of reserves
 
$
13,561

 
$
13,063

  R&D and other tax credits, net of reserves
 
13,197

 
13,221

Allowances and reserves
 
6,546

 
5,911

  Deferred revenue
 
2,261

 
4,522

Alternative Minimum Tax credit
 
1,549

 
948

  Stock-based compensation
 
9,197

 
6,938

Other
 
278

 
861

Gross deferred tax assets
 
46,589

 
45,464

Valuation allowance
 
—

 
—

Subtotal
 
46,589

 
45,464

Deferred tax liabilities:
 
 
 
 
Property and equipment
 
(2,849
)
 
(2,232
)
Non-goodwill intangibles
 
(4,510
)
 
(323
)
Other
 
(1,269
)
 
—

Gross deferred tax liabilities
 
(8,628
)
 
(2,555
)
Net deferred tax assets
 
$
37,961

 
$
42,909

Income tax benefits resulting from employee stock compensation of $0.4 million , $0.0 million, and $0.1 million, were credited to additional paid-in capital for the years ended December 31, 2013, 2012 and 2011, respectively. The Company expects to record an additional $0.4 million credit to additional paid-in capital upon utilization of tax loss carryforwards generated in 2012.
Deferred U.S. income taxes and foreign withholding taxes are not provided on the undistributed cumulative earnings of foreign subsidiaries because those earnings are considered to be permanently reinvested in those operations. The permanently

60
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 14—INCOME TAXES (Continued)

reinvested undistributed earnings were approximately $132.7 million, $105.7 million, and $73.3 million as of December 31, 2013, 2012, and 2011, respectively. For the same period, the tax impact resulting from a distribution of these earnings would be approximately $48.7 million, $38.7 million, and $27.0 million, respectively.
The Company's change in gross unrecognized tax benefits during 2013, 2012 and 2011 were as follows (in thousands):
 
 
2013
 
2012
 
2011
Balance at January 1
 
$
20,449

 
$
18,601

 
$
16,478

Additions for tax positions of current period
 
2,355

 
1,848

 
2,232

Additions for tax positions of prior years
 
—

 
—

 
—

Decreases for tax positions of prior years
 
(14,924
)
 
—

 
(109
)
Balance at December 31
 
$
7,880

 
$
20,449

 
$
18,601

The gross balance of unrecognized tax benefits of $7.9 million excluded $0.9 million of offsetting state tax benefits. The Company recorded interest and penalties on the reserve for uncertain tax positions of $0.0 million, $0.2 million, and $0.2 million for the years ended December 31, 2013, 2012 and 2011, respectively. The Company's accounting policy is to include interest and penalties related to unrecognized tax benefits as a component of income tax expense. At December 31, 2013, 2012, and 2011, the amount of net unrecognized tax benefits that, if recognized, would affect the effective tax rate is $6.9 million, $19.3 million, and $17.4 million, respectively. At December 31, 2013 long-term liabilities included $1.9 million of net unrecognized tax benefits related to reserves and $5.0 million was recorded against the deferred tax asset for the net operating loss carryovers and credits.
In 2010, the Company was notified by the IRS of its intention to examine the 2006 federal income tax return related to certain transfer pricing tax positions. This examination was subsequently extended to include the 2007 - 2011 federal income tax returns. In the third quarter of 2013, the Company received a final settlement letter from the IRS which resulted in additional taxes payable of $2.4 million for the cumulative 2006 - 2011 tax years. As a result of this settlement, the Company reversed reserves for uncertain tax positions related to these years. The net effect of the final settlement was a net income tax benefit of $10.5 million for the year ended December 31, 2013.
The Company is subject to audit by the IRS and California Franchise Tax Board for the years 1994 through 2012 as a result of its net operating loss and credit carryover positions, and by the Texas State Comptroller for the years 2008 through 2012. As the Company has operations in most other U.S. states, other state tax authorities may conduct audits related to prior year activities; however, the years open to assessment vary with each state. The Company also files income tax returns for non-U.S. jurisdictions; the most significant of which are the UK, Sweden, Germany and Australia. The years open to adjustment for the UK and Germany are 2008 through 2012. The years open to adjustment for Sweden and Australia are 2009 through 2012.
NOTE 15— ACQUISITIONS
On December 31, 2012, the Company entered into a stock purchase agreement to acquire Eleven Blade Solutions, Inc. (Eleven Blade) which was accounted for as an asset acquisition. As a result of this transaction, the Company recorded $10.8 million of intangible assets in the form of intellectual property rights, non-compete agreements with the former employees, owners and consultants of Eleven Blade and the associated deferred tax liabilities. The Company also agreed to pay the previous owners of Eleven Blade future cash consideration on certain product sales over the next five years. The amount of contingent future consideration payable to the previous owners of Eleven Blade is capped at $25 million and is not estimable at this time.

On July 1, 2013, the Company acquired ENTrigue Surgical, Inc. ("ENTrigue"), a privately-held Delaware corporation specializing in ENT sinus surgical products. The Company paid approximately $45 million in cash to the former stockholders of ENTrigue, less an amount placed in escrow to secure the indemnification obligations of the former stockholders of ENTrigue.

The Agreement also provides that the Company will make annual cash payments to the former stockholders of ENTrigue shortly after each of the next five anniversaries of the acquisition date based on the annual net sales of the acquired products. The annual payment shall equal annual net sales growth times the applicable sales growth multiple for the year. The sales

61
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 15— ACQUISITIONS (Continued)

growth multiple is 0.6 for years 1-3; 1.1 for year 4; and 1.25 for year 5. For purposes of calculating this multiple, the annual growth of net sales each year is determined by subtracting the highest amount of net sales in any previous year from the net sales in the current year. The range of undiscounted future payments that could be required is currently estimated to be between $2.4 million and $32.2 million. The estimated fair value of the contingent consideration arrangement used for determining total purchase price is $14.5 million, which was estimated by applying the income approach using a Monte Carlo simulation model. That measure is based on valuation inputs that are not observable in the market.

The purchase price was allocated to the assets acquired and liabilities assumed based on estimates of fair values at the date of acquisition and is summarized below (in thousands):

Current assets
$
1,183

Property, plant and equipment
340

Intangible assets
2,386

Goodwill
45,950

Deferred tax assets
10,348

     Total assets acquired
60,207

Liabilities
664

     Total purchase price
59,543

Cash payments at acquisition date
45,000

Fair value of contingent consideration liability
14,543

     Total purchase price
$
59,543


The fair value of the assets and liabilities acquired, including goodwill, is preliminary and therefore may be subject to adjustments. The goodwill of $46.0 million arising from the acquisition is not expected to be deductible for income tax purposes. Subsequent to July 1, 2013, the revenues and expenses of ENTrigue have been included in the Company's consolidated statements of comprehensive income. The Company incurred transaction related expenses of approximately $0.8 million for the year ended December 31, 2013 which have been recorded as general and administrative expenses.

The fair value and weighted-average useful life of the identifiable intangible assets acquired are summarized below (in thousands):

 
 
 
 
Weighted-Average Useful Life
 
 
 
 
 
Trade names
 
$
410

 
9 years
Developed technology
 
940

 
12 years
Customer relationships
 
390

 
10 years
Distribution agreements
 
280

 
3 years
Non-compete agreements
 
366

 
5 years
 
 
$
2,386

 
 
On June 20, 2012, the Company acquired an orthopedic sales and marketing entity in Finland for $1.3 million. The acquisition did not materially affect the Company's financial position at December 31, 2013 and did not materially affect the results of its operations for the year ended December 31, 2013.

62
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 16—EMPLOYEE BENEFIT PLAN
The Company maintains a Retirement Savings and Investment Plan ("401(k) Plan"), which covers all U.S.-based employees. Eligible employees may defer salary (before tax) up to a federally specified maximum. Management, at its discretion, may make matching contributions in stock on behalf of the participants in the 401(k) Plan. The Company matched up to $2,500 in Company stock annually in 2013, 2012 and 2011. The Company's 401(k) Plan expenses were approximately $0.8 million, $0.8 million and $0.9 million for the years ended December 31, 2013, 2012 and 2011, respectively.
NOTE 17—SEGMENT INFORMATION
Our business consists of one operating and reporting segment for the development, manufacturing and marketing of disposable devices and implants for select surgical procedures. The development, manufacturing and other supporting functions, such as regulatory affairs and distribution, are common across our Company. We organize and manage our sales and marketing functions according to both the surgical procedure that typically employs our products and geography. Most of the Company's products are used in Sports Medicine or ENT procedures.
Product sales by product area for the periods shown were as follows (in thousands):
 
 
Year Ended December 31, 2013
 
Year Ended December 31, 2012
 
Year Ended December 31, 2011
 
 
Americas
 
International
 
Total
Product
Sales
 
Americas
 
International
 
Total
Product
Sales
 
Americas
 
International
 
Total
Product
Sales
Sports Medicine
 
$
158,063

 
$
85,963

 
$
244,026

 
$
155,164

 
$
80,631

 
$
235,795

 
$
149,010

 
$
79,337

 
$
228,347

ENT
 
81,436

 
24,406

 
105,842

 
82,880

 
22,835

 
105,715

 
81,810

 
18,429

 
100,239

Other
 
1,497

 
7,199

 
8,696

 
1,831

 
7,330

 
9,161

 
2,785

 
6,948

 
9,733

Total Product Sales
 
$
240,996

 
$
117,568

 
$
358,564

 
$
239,875

 
$
110,796

 
$
350,671

 
$
233,605

 
$
104,714

 
$
338,319

Internationally, the Company markets and supports its products primarily through its subsidiaries and various distributors. Revenues attributed to geographic areas are based on the country or regional area where the Company's customer is domiciled. Product sales by geography for the periods shown were as follows (in thousands):
 
 
Year Ended December 31,
 
 
2013
 
2012
 
2011
United States
 
$
231,880

 
$
228,883

 
$
221,988

Non-United States(1)
 
126,684

 
121,788

 
116,331

Total product sales
 
$
358,564

 
$
350,671

 
$
338,319

___________________________________________
(1)
No additional locations are individually significant.
Long-lived assets by geography at the balance sheet dates shown were as follows (in thousands):
 
 
December 31,
 
 
2013
 
2012
United States
 
$
172,360

 
$
109,950

Non-United States
 
63,560

 
44,434

Total long-lived assets
 
$
235,920

 
$
154,384


63
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 18—QUARTERLY FINANCIAL INFORMATION (unaudited)

The following tables present certain unaudited condensed consolidated quarterly financial information for each quarter in the years ended December 31, 2013 and 2012. In the Company's opinion, this unaudited quarterly information has been prepared on the same basis as the consolidated financial statements and includes all adjustments necessary to state fairly the information for the periods presented (in thousands, except per share data).
 
 
Year Ended December 31, 2013
 
 
First Quarter
 
Second Quarter
 
Third Quarter
 
Fourth Quarter
Revenues:
 
 
 
 
 
 
 
 
Product sales
 
$
87,478

 
$
87,470

 
$
87,060

 
$
96,556

Royalties, fees and other
 
4,870

 
4,600

 
4,803

 
5,152

Total revenues
 
92,348

 
92,070

 
91,863

 
101,708

Cost of product sales
 
28,328

 
28,724

 
28,876

 
30,336

Gross profit
 
64,020

 
63,346

 
62,987

 
71,372

Operating expenses:
 
 
 
 
 
 
 
 
Research and development
 
8,445

 
8,659

 
8,433

 
8,428

Sales and marketing
 
30,332

 
30,218

 
29,322

 
32,723

General and administrative
 
7,458

 
8,683

 
8,785

 
8,537

Amortization of intangible assets
 
423

 
505

 
534

 
534

Exit costs
 
—

 
—

 
—

 
695

Investigation and restatement-related costs
 
3,893

 
26,335

 
3,164

 
3,654

Total operating expenses
 
50,551

 
74,400

 
50,238

 
54,571

Income (loss) from operations
 
13,469

 
(11,054
)
 
12,749

 
16,801

Interest and other income (expense), net
 
522

 
(392
)
 
(28
)
 
(952
)
Income (loss) from operations before income taxes
 
13,991

 
(11,446
)
 
12,721

 
15,849

Income tax provision (benefit)
 
2,806

 
(4,667
)
 
2,449

 
4,471

Net income (loss) from operations
 
11,185

 
(6,779
)
 
10,272

 
11,378

Accrued dividend and accretion charges on Series A 3% Redeemable Convertible Preferred Stock
 
(919
)
 
(929
)
 
(940
)
 
(947
)
Net income (loss) attributable to common stockholders
 
10,266

 
(7,708
)
 
9,332

 
10,431

Other comprehensive income
 
 
 
 
 
 
 
 
Foreign currency translation adjustments
 
(1,099
)
 
(344
)
 
1,131

 
133

Total comprehensive income (loss)
 
$
10,086

 
$
(7,123
)
 
$
11,403

 
$
11,511

Weighted-average shares outstanding:
 
 
 
 
 
 
 
 
Basic
 
28,055

 
28,081

 
28,374

 
28,480

Diluted
 
28,785

 
28,722

 
28,968

 
29,160

Earnings (loss) per share applicable to common stockholders:
 
 
 
 
 
 
 
 
Basic
 
$
0.31

 
$
(0.27
)
 
$
0.27

 
$
0.30

Diluted
 
$
0.30

 
$
(0.27
)
 
$
0.27

 
$
0.30

 



64
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 18—QUARTERLY FINANCIAL INFORMATION (unaudited) (Continued)

 
 
Year Ended December 31, 2012
 
 
First Quarter
 
Second Quarter
 
Third Quarter
 
Fourth Quarter
Revenues:
 
 
 
 
 
 
 
 
Product sales
 
$
88,375

 
$
87,471

 
$
82,602

 
$
92,223

Royalties, fees and other
 
4,497

 
4,235

 
4,338

 
4,713

Total revenues
 
92,872

 
91,706

 
86,940

 
96,936

Cost of product sales
 
26,651

 
27,355

 
26,204

 
27,741

Gross profit
 
66,221

 
64,351

 
60,736

 
69,195

Operating expenses:
 
 
 
 
 
 
 
 
Research and development
 
7,594

 
7,899

 
8,184

 
8,469

Sales and marketing
 
30,200

 
28,842

 
27,175

 
29,910

General and administrative
 
8,488

 
8,154

 
8,191

 
8,379

Amortization of intangible assets
 
1,321

 
1,316

 
1,363

 
857

Exit costs
 
160

 
(938
)
 
—

 
—

Investigation and restatement-related costs
 
1,093

 
1,131

 
2,139

 
6,442

Total operating expenses
 
48,856

 
46,404

 
47,052

 
54,057

Income from operations
 
17,365

 
17,947

 
13,684

 
15,138

Interest and other income (expense), net
 
386

 
(1,147
)
 
183

 
151

Income from operations before income taxes
 
17,751

 
16,800

 
13,867

 
15,289

Income tax provision
 
4,793

 
4,536

 
3,882

 
4,118

Net income from operations
 
12,958

 
12,264

 
9,985

 
11,171

Accrued dividend and accretion charges on Series A 3% Redeemable Convertible Preferred Stock
 
(879
)
 
(887
)
 
(900
)
 
(909
)
Net income attributable to common stockholders
 
$
12,079

 
$
11,377

 
$
9,085

 
$
10,262

Other comprehensive income
 
 
 
 
 
 
 
 
Foreign currency translation adjustments
 
392

 
(778
)
 
951

 
120

Total comprehensive income
 
$
13,350

 
$
11,486

 
$
10,936

 
$
11,291

Weighted-average shares outstanding:
 
 
 
 
 
 
 
 
Basic
 
27,614

 
27,639

 
27,714

 
27,912

Diluted
 
27,987

 
27,934

 
28,087

 
28,341

Earnings per share applicable to common stockholders:
 
 
 
 
 
 
 
 
Basic
 
$
0.36

 
$
0.34

 
$
0.27

 
$
0.30

Diluted
 
$
0.36

 
$
0.34

 
$
0.27

 
$
0.30








65
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 19—SUPPLEMENTAL CASH FLOW INFORMATION
Information below is in thousands:
 
 
Year Ended December 31,
 
 
2013
 
2012
 
2011
Cash paid for interest
 
$
—

 
$
—

 
$
—

Cash paid for income taxes
 
5,137

 
1,692

 
4,369

Non cash Series A Preferred Stock accrued dividends and accretion charges
 
3,735

 
3,575

 
3,416

Unpaid purchases of property and equipment
 
1,192

 
—

 
—

NOTE 20—RELATED PARTY TRANSACTION
The Company recognized product sales to Wright Medical Group, Inc. ("Wright") of approximately $0.1 million and $2.2 million during the years ended December 31, 2012 and 2011, respectively, at which time a former senior manager of the Company had a family relationship with a member of the Wright board of directors. During the year ending December 31, 2013, there were no related party transactions.
NOTE 21—SUBSEQUENT EVENTS
On February 3, 2014, the Company announced the entry into an Agreement and Plan of Merger (the "Merger Agreement") with Smith & Nephew, Inc. ("Parent"), Rosebud Acquisition Corporation, a wholly owned subsidiary of Parent ("Merger Subsidiary") and Smith & Nephew plc ("Parent Holdco"), pursuant to which the Company agreed to be acquired by Parent and become a wholly-owned subsidiary of Parent (the "Merger"). At the effective time of the Merger, each issued and outstanding share of common stock of the Company (other than common shares held by the Company or its subsidiaries, Parent or its subsidiaries, Merger Subsidiary or a stockholder who properly demands appraisal of such common shares under Delaware Law) will be converted into a right to receive $48.25 per share in cash.
 
At the effective time of the Merger, each equity award with respect to shares of common stock of the Company that is outstanding immediately prior to the Merger will be canceled in consideration of a cash payment to the holder of the award (subject to reduction for withholding taxes). In the case of a stock option or stock appreciation award, the holder will receive an amount equal to $48.25 less the applicable exercise price per share, multiplied by the number of shares covered by the award. In the case of a restricted stock award, the holder will receive an amount equal to $48.25 multiplied by the number of shares covered by the award. In the case of a performance award, the holder will receive an amount equal to $48.25 multiplied by the number of shares covered by the award that are earned based on performance through the last business day of the completed fiscal quarter that immediately precedes the effective time of the Merger (but in no event less than one-third of the target number of shares covered by the award). Each of the Company and Parent made customary representations, warranties and covenants in the Merger Agreement, including, among others, covenants by the Company to conduct its business in the ordinary course during the interim period between the execution of the Merger Agreement and the consummation of the Merger.
 
The completion of the Merger is subject to customary conditions, including approval by the Company’s stockholders, the absence of any material adverse effect on the Company’s business and receiving antitrust approvals (including under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended). The Company has also agreed, subject to certain exceptions, not to enter into discussions concerning, or provide confidential information in connection with, any alternative transaction. In addition, each of the parties have agreed to use their reasonable best efforts to cause the Merger to be consummated. Subject to certain exceptions, the Merger Agreement also requires the Company to call and hold a stockholders’ meeting and for the Company’s Board of Directors (the "Board") to recommend that the Company’s stockholders adopt the Merger Agreement. Prior to adoption of the Merger Agreement by the Company’s stockholders, the Board may in certain circumstances change its recommendation that the Company’s stockholders adopt the Merger Agreement, subject to complying with certain notice and other specified conditions set forth in the Merger Agreement, including giving Parent the opportunity to propose changes to the Merger Agreement.
 
The Merger Agreement may be terminated under certain circumstances by the Company, prior to the adoption of the Merger Agreement by the Company’s stockholders, including in the event that the Company receives an unsolicited alternative

66
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
NOTE 21—SUBSEQUENT EVENT (Continued)


acquisition proposal that the Company concludes, after following certain procedures, is a Superior Proposal (as defined in the Merger Agreement).  If the Company receives a Superior Proposal, Parent must be given the opportunity to match the Superior Proposal. In addition, Parent may terminate the Merger Agreement under certain circumstances, including if the Board changes its recommendation that stockholders adopt the Merger Agreement, if after a request from Parent the Board fails to reaffirm its recommendation of the Merger following an alternative acquisition proposal or if there is a material breach of the Company’s obligations relating to non-solicitation of an alternative acquisition proposal or the procedures to be followed following receipt of an unsolicited alternative acquisition proposal. Upon termination of the Merger Agreement under certain circumstances, the Company may be required to pay Parent a termination fee equal to $54.9 million.

On February 11, 2014, the Series A Preferred Stock was converted to 5,805,921 shares of the Company's Common Stock in accordance with the terms of its automatic conversion feature.
    
ITEM 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.    CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
As required by Rule 13a-15 under the Exchange Act, management has evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Disclosure controls and procedures refer to controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our CEO and CFO, as appropriate, to allow timely decisions regarding our required disclosure. In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management was required to apply its judgment in evaluating and implementing possible controls and procedures.
Pursuant to this evaluation, our CEO and CFO concluded that, as of December 31, 2013, the end of the period covered by this report, our disclosure controls and procedures were effective at the reasonable assurance level.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
During the quarter ended December 31, 2013, there have been no changes in our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management, under the supervision of the CEO and CFO, is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting, as defined in Rules 13a-15(f) under the Exchange Act, refers to a process designed by, or under the supervision of, our CEO and CFO, and effected by our Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP and includes those policies and procedures that:
•
pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets;
•
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP and that our receipts and expenditures are being made only in accordance with authorizations of our management and Board of Directors; and

67

•
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements.
Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2013, using the framework set forth in the report of the Treadway Commission's Committee of Sponsoring Organizations (COSO), "Internal Control—Integrated Framework (1992)." As a result of that assessment, management has concluded that our internal control over financial reporting was effective as of December 31, 2013.
PricewaterhouseCoopers LLP, the independent registered public accounting firm that audited the consolidated financial statements included in this Report on Form 10-K for the year ended December 31, 2013, issued an attestation report on the effectiveness of our internal control over financial reporting as of December 31, 2013 which report is set forth in Part II, Item 8 of this annual report.
INHERENT LIMITATIONS ON EFFECTIVENESS OF CONTROLS
Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting can also be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements will not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process, and it is possible to design into the process safeguards to reduce, though not eliminate, the risk.
ITEM 9B.    OTHER INFORMATION
None.

68

PART III
ITEM 10.    DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
All information required by this item is included in our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Exchange Act in connection with our annual meeting of stockholders scheduled to be held on or before June 22, 2014 and is incorporated herein by reference.
ITEM 11.    EXECUTIVE COMPENSATION
All information required by this item is included in our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Exchange Act of 1934 in connection with our annual meeting of stockholders scheduled to be held on or before June 22, 2014 and is incorporated herein by reference.
ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Except as set forth below regarding securities authorized for issuance under equity compensation plans, the information required by this item is included in our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Exchange Act in connection with our annual meeting of stockholders scheduled to be held on or before June 22, 2014 and is incorporated herein by reference.
EQUITY COMPENSATION PLAN INFORMATION
The following table provides information as of December 31, 2013 regarding the common stock that may be issued upon the exercise of options, warrants and rights under our existing equity compensation plans.
Plan category
 
Number of securities to
be issued upon exercise
of outstanding options,
warrants and rights
 
Weighted average
exercise price of
outstanding options,
warrants and rights
 
Number of securities
remaining available for
future issuance under
equity compensation plans
(excluding securities
reflected in the first
column)
Equity compensation plans approved by security holders(1)
 
2,666,654

 
28.63

 
1,309,427

Equity compensation plans not approved by security holders(2)
 
31,842

 
41.34

 
—

Total
 
2,698,496

 
28.78

 
1,309,427

________________________________________
(1)
Includes 27,393 shares remaining available for future issuance under the Company's Employee Stock Purchase Plan.
(2)
Consists of shares issuable under our Amended and Restated Non-statutory Option Plan, which does not require the approval of, and has not been approved by, our stockholders.
ITEM 13.    CERTAIN RELATIONSHIPS, RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Under its charter, the Audit Committee is responsible for reviewing and approving all related party transactions, regardless of the dollar amount involved, that, if entered into, would be required to be disclosed under the rules and regulations of the SEC. No member of the Audit Committee having an interest in a related party transaction may participate in any decision regarding that transaction.
All additional information required by this item is included in our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Exchange Act in connection with our annual meeting of stockholders scheduled to be held on or before June 22, 2014 and is incorporated herein by reference.
DIRECTOR INDEPENDENCE
Our Board of Directors, with the assistance of the Nominating and Corporate Governance Committee, has reviewed the independence of all current Board members under the NASDAQ listing standards and our Corporate Governance Guidelines. The Board of Directors has determined that all current Board members, other than David Fitzgerald, meet the general


requirements to be independent directors under the NASDAQ listing standards and our Corporate Governance Guidelines. Based on its review, the Board of Directors has also determined that Terrence E. Geremski, James G. Foster and Fabiana Lacerca-Allen meet the specific independence requirements to serve on the Audit Committee under the Nasdaq listing standards and the Securities Exchange Act.
ITEM 14.    PRINCIPAL ACCOUNTANT FEES AND SERVICES
All information required by this item is included in our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Exchange Act, in connection with our annual meeting of stockholders scheduled to be held on or before June 22, 2014 and is incorporated herein by reference.

70

PART IV
ITEM 15.    EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a)
(2).     Financial statement schedule
The following report and schedule are included in this Part IV, and are found in this report:
•
Valuation and Qualifying Accounts for the years ended December 31, 2013, 2012 and 2011.
All other schedules are omitted, as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes.
(a)
(3).     Exhibits
2.1
 
Agreement and Plan of Merger, dated as of September 3, 2004, by and among ArthroCare Corporation, Opus Medical, Inc., OC Merger Sub Corporation, OC Acquisition Sub LLC, and James W. Hart and Steven L. Gex, as the Shareholders' Agents (Incorporated herein by reference to Exhibit 2.1 to the registrant's Current Report on Form 8-K filed on November 18, 2004).
  
 
 
2.2
 
Amendment No. 1, dated as of October 6, 2004, to the Agreement and Plan of Merger, dated as of September 3, 2004, by and among ArthroCare Corporation, Opus Medical, Inc., OC Merger Sub Corporation, OC Acquisition Sub LLC, and James W. Hart and Steven L. Gex, as the Shareholders' Agents (Incorporated herein by reference to Exhibit 2.2 to the registrant's Current Report on Form 8-K filed on November 18, 2004).
  
 
 
2.3
 
Asset Purchase Agreement, dated as of August 16, 2005, by and among ArthroCare Corporation, a Delaware corporation, ArthroCare (Deutschland) GmbH, a corporation organized under the laws of Germany and a wholly-owned subsidiary of ArthroCare, ArthroCare UK, Ltd., a corporation registered in England & Wales and a wholly-owned subsidiary of ArthroCare, Applied Therapeutics, Inc., a Florida corporation, Applied Therapeutics, Ltd., a corporation registered in England & Wales, Applied Therapeutics GmbH, a corporation organized under the laws of Germany and BHK Holding, a corporation organized under the laws of the Cayman Islands. (Incorporated herein by reference to Exhibit 2.1 to the Company's Current Report on Form 8-K filed on August 22, 2005).
  
 
 
3.1
 
Restated Certificate of Incorporation of the Company. (Incorporated herein by reference to Exhibit 3.1 filed previously with the Company's Annual Report on Form 10-Q for the period ended June 29, 2002).
  
 
 
3.2
 
Amended and Restated Bylaws of the Company. (Incorporated herein by reference to Exhibit 3.1 filed previously with the Company's Current Report on Form 8-K filed on August 17, 2009).
 
 
 
3.3**
 
Certificate of Amendment of Certificate of Designations of Series A 3.00% Convertible Preferred Stock of ArthroCare Corporation, filed in the Office of the Secretary of State of the State of Delaware on December 12, 2013.
  
 
 
4.1
 
Specimen Common Stock Certificate. (Incorporated herein by reference to Exhibit 4.1 filed previously with the Company's Registration Statement on Form 8-A (Registration No. 000-27422)).
  
 
 
4.2
 
Certificate of Designations of Series A 3.00 percent Convertible Preferred Stock (Par Value $0.001) (Incorporated herein by reference to Exhibit 99.2 filed previously with the Company's Current Report on Form 8-K filed on August 17, 2009).
  
 
 
10.1*
 
Form of Indemnification Agreement between the registrant and each of its directors and officers. (Incorporated herein by reference to Exhibit 10.1 filed previously with the Company's Registration Statement on Form S-1 (Registration No. 33-80453)).
  
 
 
10.2*
 
Incentive Stock Plan and form of Stock Option Agreement there under. (Incorporated herein by reference to Exhibit 10.2 filed previously with the Company's Registration Statement on Form S-1 (Registration No. 33-80453)).


  
 
 
10.3*
 
Director Option Plan and form of Director Stock Option Agreement there under. (Incorporated herein by reference to Exhibit 10.3 filed previously with the Company's Registration Statement on Form S-1 (Registration No. 33-80453)).
  
 
 
10.4*
 
Employee Stock Purchase Plan and forms of agreements there under. (Incorporated herein by reference to Exhibit 10.4 filed previously with the Company's Registration Statement on Form S-1 (Registration No. 33-80453)).
 
 
 
10.5
 
Form of Exclusive Distribution Agreement. (Incorporated herein by reference to Exhibit 10.5 filed previously with the Company's Registration Statement on Form S-1 (Registration No. 33-80453)).
  
 
 
10.6†
 
Litigation Settlement Agreement, between the Company and ETHICON Inc. dated June 24, 1999 (Incorporated herein by reference to Exhibit 10.33 previously filed with the Company's Quarterly Report on Form 10-Q for the period ended July 3, 1999).
  
 
 
10.7†
 
License Agreement between ArthroCare Corporation and Stryker Corporation, dated June 28, 2000. (Incorporated herein by reference to Exhibit 10.36 filed previously with this the Company's Quarterly Report on Form 10-Q for the period ended July 1, 2000).
  
 
 
10.8*
 
Amendment to the 1995 Director Option Plan (Incorporated herein by reference to Exhibit 4.4 to the Company's Statement on Form S-8 filed on August 8, 2000).
  
 
 
10.9*
 
Amended and Restated 2003 Incentive Stock Plan (Incorporated herein by reference to the Company's Proxy Statement on Schedule 14A filed with the Securities and Exchange Commission on March 23, 2010).
  
 
 
10.10*
 
Second Amendment to the 1995 Director Option Plan (Incorporated herein by reference to Exhibit 4.3 to the Company's Registration Statement on Form S-8 filed with the Securities and Exchange Commission on June 24, 2003).
  
 
 
10.11
 
Form of Option Agreement under the Amended and Restated 2003 Incentive Plan (Incorporated herein by reference to Exhibit 10.48 to the Company's Current Report on Form 8-K filed on February 22, 2005).
  
 
 
10.12
 
Form of Restricted Stock Bonus Agreement under the Amended and Restated Director Option Plan (Incorporated herein by reference to Exhibit 10.49 to the Company's Current Report on Form 8-K filed on February 22, 2005).
  
 
 
10.13†
 
Settlement and License Agreement between the Company, ArthroCare Corporation Cayman Islands, a corporation organized under the laws of the Cayman Islands and a wholly-owned subsidiary of the Company and Smith & Nephew, Inc., dated September 2, 2005 (Incorporated herein by reference to Exhibit 10.52 to the Company's Quarterly Report on Form 10-Q filed November 3, 2005).
  
 
 
10.14†
 
Supply and Distribution Agreement between the Company, ArthroCare Corporation Cayman Islands, a corporation organized under the laws of the Cayman Islands and a wholly-owned subsidiary of the Company and Smith & Nephew, Inc., dated September 2, 2005 (Incorporated herein by reference to Exhibit 10.53 to the Company's Quarterly Report on Form 10-Q filed November 3, 2005).
  
 
 
10.15
 
Lease Agreement between Lantana Office Properties I, L.P. and the Company (Incorporated herein by reference to Exhibit 10.57 to the Company's Quarterly Report on 10-Q filed on August 4, 2006).
  
 
 
10.16†
 
Settlement and License Agreement between the Company, ArthroCare Corporation Cayman Islands and MarcTec, LLC effective January 3, 2007 (Incorporated herein by reference to Exhibit 10.60 to the Company's Annual Report on Form 10-K filed February 27, 2007).
  
 
 

72

10.17*
 
Form of "Amended VP Continuity Agreement" between ArthroCare Corporation and its Vice Presidents (Incorporated herein by reference to Exhibit 10.61 to the Company's Current Report on Form 8-K filed on April 5, 2007).
 
 
 
10.18*
 
Form of "Amended Senior VP Continuity Agreement" between ArthroCare Corporation and its Senior Vice Presidents (Incorporated herein by reference to Exhibit 10.62 to the Company's Current Report on Form 8-K filed on April 5, 2007).
  
 
 
10.19
 
Amendment dated September 20, 2007 to Supply and Distribution Agreement between the Company ArthroCare Corporation Cayman Islands and Smith & Nephew, Inc. (Incorporated herein by reference to Exhibit 10.31 to the Company's Annual Report on Form 10-K filed on November 18, 2009).
  
 
 
10.20†
 
Pricing and Delivery Amendment dated June 16, 2008 to Supply and Distribution Agreement between the Company, ArthroCare Corporation Cayman Islands and Smith & Nephew, Inc. (Incorporated herein by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 2008 filed on November 18, 2009)
  
 
 
10.21†
 
Amendment dated June 16, 2008 for Development and Supply of S&N Branded Probes and Controllers to Supply and Distribution Agreement between the Company, ArthroCare Corporation Cayman Islands and Smith & Nephew, Inc. (Incorporated herein by reference to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 2008 filed on November 18, 2009)
  
 
 
10.22
 
General Release and Separation Agreement between John Raffle and the Company, dated February 21, 2009 (Incorporated herein by reference to Exhibit 10.71 to the Company's Current Report on Form 8-K filed on February 26, 2009).
  
 
 
10.23*
 
Employment Agreement between ArthroCare Corporation and David Fitzgerald, effective March 30, 2009 (Incorporated herein by reference to Exhibit 10.74 to the Company's Current Report on Form 8-K filed on April 3, 2009).
  
 
 
10.24*
 
Employment Agreement between ArthroCare Corporation and Todd Newton, effective April 2, 2009 (Incorporated herein by reference to Exhibit 10.75 to the Company's Current Report on Form 8-K filed on April 3, 2009).
  
 
 
10.25*
 
Indemnification Agreement dated April 2, 2009 between ArthroCare Corporation and Todd Newton (Incorporated herein by reference to Exhibit 10.77 to the Company's Current Report on Form 8-K filed on April 3, 2009).
  
 
 
10.26†
 
Securities Purchase Agreement, dated as of August 14, 2009, by and between ArthroCare Corporation and OEP AC Holdings, LLC. (Incorporated herein by reference to Exhibit 10.50 to the Company's Annual Report on 10-K filed on November 18, 2009).
  
 
 
10.27†
 
Disclosure Letter to Securities Purchase Agreement, dated as of August 14, 2009, by and between ArthroCare Corporation and OEP AC Holdings, LLC. (Incorporated herein by reference to Exhibit 10.51 to the Company's Annual Report on 10-K filed on November 18, 2009).
  
 
 
10.28
 
Registration Rights Agreement, dated as of August 14, 2009, by and between ArthroCare Corporation and OEP AC Holdings, LLC. (Incorporated herein by reference to Exhibit 10.52 to the Company's Annual Report on 10-K filed on November 18, 2009).
  
 
 
10.29
 
Letter Agreement dated September 1, 2009 between ArthroCare Corporation and OEP AC Holdings, LLC with regard to director seats for OEP representatives. (Incorporated herein by reference to Exhibit 10.53 to the Company's Annual Report on 10-K filed on November 18, 2009).
  
 
 
10.30*
 
2010 Executive Officer Bonus Plan dated January 7, 2010 (Incorporated herein by reference to Exhibit 10.1 to the Company's Current Report on 8-K filed on January 11, 2010).
 
 
 

73

10.31
 
Correction to Certificate of Designations of Series A 3.00% Convertible Preferred Stock (Incorporated herein by reference to Exhibit 99.2 to the Company's current report on 8-K filed on August 3, 2010.)
  
 
 
10.32*
 
2011 Executive Officer Bonus Plan dated March 23, 2011 (Incorporated herein by reference to Exhibit 10.1 to the Company's Current Report on 8-K filed on March 24, 2011).
  
 
 
10.33
 
Office building lease for 7000 West at Lantana, Buildings 1 & 2 located at 7000 West William Cannon Drive, Austin, Texas (Incorporated herein by reference to Exhibit 10.43 to the Company's Quarterly Report on form 10-Q filed on May 2, 2011).
  
 
 
10.34*
 
2012 ArthroCare long Term Incentive Plan effective January 6, 2012, (Incorporated herein by reference to Exhibit 10.1 to the Company's Current Report on 8-K filed on January 11, 2012).
  
 
 
10.35*
 
2012 Grant Agreement for Performance Shares for Senior Executives under the ArthroCare Corporation Long Term Incentive Program and ArthroCare Amended and Restated 2003 Incentive Stock Plan (Incorporated herein by reference to Exhibit 10.2 to the Company's Current Report on 8-K filed on January 11, 2012).
  
 
 
10.36*
 
Second Amendment to Employment Agreement between ArthroCare Corporation and Todd Newton, entered into January 20, 2012 (Incorporated herein by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed on January 20, 2012).
  
 
 
10.37*
 
2012 Executive Officer Bonus Plan dated March 1, 2012 (Incorporated herein by reference to Exhibit 10.1 to the Company's Current Report on 8-K filed on March 2, 2012).
  
 
 
10.38†
 
Amendment to the June 28, 2000 License Agreement and Settlement Agreement with Stryker Corporation (Incorporated herein by reference to Exhibit 10.1 to the Company's Form 10-Q filed on October 31, 2012).
 
 
 
10.39*
 
Agreement and Plan of Merger, by and among ArthroCare Corporation, Durante Merger Sub, Inc., ENTrigue Surgical, Inc., and Shareholder Representative Services, LLC as the Representative, dated as of July 1, 2013 (incorporated by reference to Exhibit 2.1 to the Company's Current Report on Form 8-K filed on July 2, 2013 (Commission File No. 0-027422)).

 
 
 
10.40*
 
Deferred Prosecution Agreement (“DPA”), by and among Arthrocare Corporation and the United States District Court in the Western District of Texas (the Court), dated December 31, 2013 (incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K filed on January 7, 2014).
  
 
 
21.1**
 
Subsidiaries of the Company.
  
 
 
23.1**
 
Consent of PricewaterhouseCoopers LLP, an Independent Registered Public Accounting Firm
  
 
 
31.1**
 
Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
  
 
 
31.2**
 
Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
  
 
 
32.1**
 
Certification of the Chief Executive Officer pursuant to Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
  
 
 
32.2**
 
Certification of the Chief Financial Officer pursuant to Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
 
99.1**
 
Forward-Looking Statements.

74

  
 
 
101
 
Interactive Data Files
___________________________________________________________
†
Confidential treatment has been granted as to portions of this exhibit.
*
Management contract or compensatory plan or arrangement.
**
Filed herewith.

75

Financial Statement Schedule
The following financial statement schedule is filed as a part of this report under Schedule II immediately preceding the signature page: Schedule II—Valuation and Qualifying Accounts for the three fiscal years ended December 31, 2013, 2012 and 2011. All other schedules called for by Form 10-K are omitted because they are not applicable or the required information is shown in the consolidated financial statements, or notes thereto, included herein.
Schedule II
ARTHROCARE CORPORATION
VALUATION AND QUALIFYING ACCOUNTS
(in thousands)
 
 
Balance at
Beginning
of Period
 
Additional
Charges to
Costs and
Expenses
 
Deductions
 
Balance at
End of
Period
Year Ended December 31, 2013
 
 
 
 
 
 
 
 
Deducted from asset accounts:
 
 
 
 
 
 
 
 
Allowance for doubtful accounts
 
$
1,285

 
$
(21
)
 
$
(177
)
 
$
1,087

Product returns
 
280

 
(171
)
 
59

 
168

Inventory reserves
 
4,665

 
980

 
(572
)
 
5,073

Warranty reserves
 
718

 
1,043

 
(1,191
)
 
570

Year Ended December 31, 2012
 
 
 
 
 
 
 
 
Deducted from asset accounts:
 
 
 
 
 
 
 
 
Allowance for doubtful accounts
 
$
1,868

 
$
26

 
$
(609
)
 
$
1,285

Product returns
 
383

 
(230
)
 
127

 
280

Inventory reserves
 
4,544

 
509

 
(388
)
 
4,665

Warranty reserves
 
643

 
1,111

 
(1,036
)
 
718

Year Ended December 31, 2011
 
 
 
 
 
 
 
 
Deducted from asset accounts:
 
 
 
 
 
 
 
 
Allowance for doubtful accounts
 
$
2,173

 
$
(37
)
 
$
(268
)
 
$
1,868

Product returns
 
272

 
245

 
(134
)
 
383

Inventory reserves
 
10,070

 
(3,879
)
 
(1,647
)
 
4,544

Warranty reserves
 
529

 
1,162

 
(1,048
)
 
643


76

SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized:

ARTHROCARE CORPORATION
a Delaware Corporation
By:
 
/s/ DAVID FITZGERALD
 
 
David Fitzgerald
 President and Chief Executive Officer
Date: February 13, 2014
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated:

77

Signature
 
Title
 
Date
 
 
 
 
 
/s/ DAVID FITZGERALD
 
President, Chief Executive Officer and Director (Principal Executive Officer)
 
February 13, 2014
David Fitzgerald
 
 
 
 
 
 
 
/s/ TODD NEWTON
 
Executive Vice President, Chief Financial Officer and Chief Operating Officer
 
February 13, 2014
Todd Newton
 
 
 
 
 
 
 
/s/ JAMES G. FOSTER
 
Director
 
February 13, 2014
James G. Foster
 
 
 
 
 
 
 
/s/ PETER L. WILSON
 
Director
 
February 13, 2014
Peter L. Wilson
 
 
 
 
 
 
 
/s/ TORD B. LENDAU
 
Director
 
February 13, 2014
Tord B. Lendau
 
 
 
 
 
 
 
/s/ BARBARA D. BOYAN
 
Director
 
February 13, 2014
Barbara D. Boyan
 
 
 
 
 
 
 
/s/ TERRENCE E. GEREMSKI
 
Director
 
February 13, 2014
Terrence E. Geremski
 
 
 
 
 
 
 
/s/ GREGORY A. BELINFANTI
 
Director
 
February 13, 2014
Gregory A. Belinfanti
 
 
 
 
 
 
 
/s/ FABIANA LACERCA-ALLEN
 
Director
 
February 13, 2014
Fabiana Lacerca-Allen
 
 
 
 
 
 
 
/s/ CHRISTIAN P. AHRENS
 
Director
 
February 13, 2014
Christian P. Ahrens
 
 
 
 

78

ARTHROCARE CORPORATION
INDEX TO EXHIBITS*

Exhibit Number
 
Exhibit Name
 
 
 
3.3

 
Certificate of Amendment of Certificate of Designations of Series A 3.00% Convertible Preferred Stock of ArthroCare Corporation, filed in the Office of the Secretary of State of the State of Delaware on December 12, 2013.
 
 
 
21.1

 
Subsidiaries of the Registrant.
 
 
 
23.1

 
Consent of PricewaterhouseCoopers LLP, an Independent Registered Public Accounting Firm.
 
 
 
31.1

 
Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
 
31.2

 
Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
 
32.1

 
Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
 
32.2

 
Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
 
 
 
 
 
 
 
99.1

 
Forward-Looking Statements.
 
 
 
101

 
Interactive Data Files
_______________________________________________
*
Only exhibits actually filed are listed. Exhibits incorporated by reference are set forth in the exhibit listing included in Item 15 of the Report on Form 10-K.