10-K 1 a2212001z10-k.htm 10-K

Table of Contents

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, 2012

Commission File Number: 0-27422

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 o    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 o    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 o

         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 o

         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 o   Non-accelerated filer o
(Do not check if a
smaller reporting company)
  Smaller reporting company o

         Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o    No ý

         As of June 30, 2012, the aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was approximately $811,641,600 (based upon the closing sales price of such stock as reported by NASDAQ on such date).

         As of February 1, 2013, the number of outstanding shares of the Registrant's Common Stock was 28,044,142.

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 May 22, 2013 are incorporated by reference into Part III of this Annual Report.

   


ARTHROCARE CORPORATION
FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS

PART I

  3

ITEM 1. BUSINESS

  3

ITEM 1A. RISK FACTORS

  13

ITEM 1B. UNRESOLVED STAFF COMMENTS

  24

ITEM 2. PROPERTIES

  25

ITEM 3. LEGAL PROCEEDINGS

  25

ITEM 4. MINE SAFETY DISCLOSURES

  27

PART II

  27

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

  27

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

  29

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

  30

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

  45

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

  47

CONSOLIDATED BALANCE SHEETS

  49

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

  50

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

  51

CONSOLIDATED STATEMENTS OF CASH FLOWS

  52

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

  53

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

  81

ITEM 9A. CONTROLS AND PROCEDURES

  81

ITEM 9B. OTHER INFORMATION

  82

PART III

  83

ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

  83

ITEM 11. EXECUTIVE COMPENSATION

  83

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

  83

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

  83

ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES

  84

PART IV

  84

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES

  84

Schedule II

  89

VALUATION AND QUALIFYING ACCOUNTS

  89

SIGNATURES

  90

INDEX TO EXHIBITS*

  92

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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

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 senior citizens suffering from herniated discs 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

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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, which uses bipolar radiofrequency energy to generate a precisely focused plasma field to remove and shape soft tissues such as cartilage and tendons. This use of bipolar energy is the primary factor that distinguishes our Coblation technology from traditional monopolar and bipolar radiofrequency surgical tools. Monopolar devices drive electrical energy into the treatment site and requires electrical energy to travel through the patient's body and exit via a grounding pad usually placed underneath the patient. Conversely, traditional bipolar devices include both an active electrode and a return at the tip of the device so a separate grounding pad is not required. To effect treatment by a bipolar device, electrical energy is applied at the surgical site, where it is concentrated at the targeted tissue and exits via the return electrode. These traditional monopolar and bipolar electrosurgical or laser surgery tools use the heat from the electrical current to burn away targeted tissue, often causing thermal damage to tissue surrounding the targeted surgical area.

        Our bipolar Coblation devices also include both an active and return electrode at the tip but, in contrast to other bipolar devices, apply electrical energy in a conductive medium at the surgical site. The electrical energy along with electrically conductive fluid, which is found in normal saline solutions, form a highly ionized vapor layer, or plasma field, around the active electrode of the Coblation device. This plasma field enables our Coblation-based products to operate at lower operating temperatures than traditional devices, minimizing tissue necrosis and damage when compared to traditional bipolar or monopolar instruments.

        The use of Coblation allows surgeons to operate with a high level of 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.

        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 Coblation technology to other companies in a variety of fields of use and may explore the use of Coblation technology in other applications.

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, more than 1.7 million surgical procedures are performed each year to address instabilities, impingement, and/or tendon tears of the shoulder while an additional 2.4 million arthroscopic procedures are performed to address cartilage, meniscus, ligament and/or tendon injuries in the knee. Additionally, hip arthroscopy, which now accounts for over 80,000 procedures in the U.S. annually, is widely regarded as one of the fastest growing sub-segments of sports medicine. Sports Medicine is currently our largest product area and product sales accounted for 64.0 percent, 64.3 percent and 65.3 percent of our total revenue in 2012, 2011 and 2010, 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 10.1 percent, 10.3 percent and 11.0 percent of our Sports Medicine sales in 2012, 2011, and 2010.

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        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 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. This line features a series of specialized disposable, energy-based surgical wands, called ArthroWands®, designed for single patient use to treat a number of orthopedic conditions, including injuries of the shoulder, knee, hip, foot, ankle, elbow, and wrist. ArthroWands 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 includes the Ambient® family of ArthroWands, the only wands on the market today that allow surgeons to interoperatively monitor the temperature of the circulating fluid in the joint.

        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, screws for ligament reconstruction in the knee, a variety of arthroscopic suture passers, and a full offering of 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. On December 31, 2012, we entered into a contract to acquire Eleven Blade Solutions Inc. that will add an all-suture soft anchor technology to our soft-tissue fixation portfolio that can be used in a variety of Sports Medicine procedures.

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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 28.7 percent, 28.2 percent, and 26.5 percent of our total revenue during 2012, 2011 and 2010, respectively. One of the most common ENT procedures which utilize our products is the removal of tonsils and adenoids, and according to the Truven Health MarketScan® Database there are more than 700,000 tonsillectomies performed in the U.S. each year. Other commonly performed ENT procedures include endoscopic sinus surgery, turbinate reduction and procedures to treat sleep disorders. These procedures are performed by ENT surgeons in hospitals and ambulatory surgery centers. Historically, monopolar electrocautery devices, or bovies, 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, neck and oral surgical procedures, including sinus surgery, the treatment of snoring, reduction of nasal turbinates, and tonsil and adenoid removal. Today, we estimate that approximately 30 percent of all US tonsil and adenoid procedures are performed using our products.

    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 bovies and similar devices. During a tonsillectomy, suction wands simultaneously ablate and remove tissue providing the surgeon enhanced visibility and shorter anesthesia time. 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.

        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. ATI's carboxymethyl-cellulose based packing and tamponade products are used in situations of significant nosebleed, or epistaxis, treatments which are treated in an emergency room setting or surgicenter. Our Rapid Rhino® product 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. Our Rapid Rhino product line also includes 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 2.5 percent, 2.7 percent and 3.5 percent of our total revenue during 2012, 2011 and 2010, 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.

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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.

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, 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, 2012, for these two core business areas our Americas sales organization approximated 260 people, including sales management. In South America, we sell our products through independent distributors. Sales in the Americas accounted for 68.4 percent, 69.0 percent and 72.0 percent of our consolidated product sales during 2012, 2011 and 2010, respectively. We continually evaluate the regional and territorial performance 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, 2012, approximately 54 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 31.6 percent, 31.0 percent and 28.0 percent of our consolidated product sales during 2012, 2011 and 2010, respectively. In several countries in Western Europe and in Australia and Singapore, we have subsidiaries that sell our products direct to end users of our products. In other markets, we sell our products to independent distributors who import and sell our products in the country to end users or other sub-distributors who retain the risk of inventory obsolescence and collection from their customers. We may expand the number of markets where we sell our products direct to end users in the future.

        For the year ended December 31, 2012, approximately 80.1 percent of international sales were derived from direct markets where we manage the relationship with our end customers and the remainder of our International sales are to independent distributors and agents.

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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. on two campuses 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 8.7 percent, 8.2 percent and 10.1 percent of our total revenues during 2012, 2011 and 2010, respectively. Our efforts are focused on:

    modifying and enhancing the performance of our existing technologies and products, including our processes to manufacture these products;

    designing new surgical devices that incorporate additional functionalities;

    developing new applications of our Coblation and other innovative technologies and

    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.

        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.

        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 at least through 2013.

        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

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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 171 issued U.S. patents and 197 issued international patents. In addition, we have 110 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, Parallax and ATI. 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. 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.

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        We have received 510(k) clearance to the extent we believe it is required for applicable products for a variety of indications.

        We strive to ensure that our products not requiring clearance meet 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 federal False Claims Act imposes civil liability on individuals or entities that submit false or fraudulent claims for payment to the government. Violations of the False Claims Act may result in 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 False Claims Act also allows a private individual to bring a qui tam suit on behalf of the government against a health care provider for violations of the False Claims Act. A qui tam suit may be brought by, with only a few exceptions, any private citizen who has material information of a false claim that has not yet been previously disclosed. Even if disclosed, the original source of the information leading to the public disclosure may still pursue such a suit. Although a corporate insider is often the plaintiff in such actions, an increasing number of outsiders are pursuing such suits.

        In a qui tam suit, the private plaintiff is responsible for initiating a lawsuit that may eventually lead to the government recovering what it paid as a result of allegedly false claims. After the private plaintiff has initiated the lawsuit, the government must decide whether to intervene in the lawsuit and become the primary prosecutor. In the event the government declines to join the lawsuit, the private plaintiff may choose to pursue the case alone, in which case the private plaintiff's counsel will have primary control over the prosecution (although the government must be kept apprised of the progress of the lawsuit and will still receive at least 70% of any recovered amounts). Qui tam complaints are

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filed under seal and generally remain under seal during the pendency of an investigation of the allegations. During that time, certain documents filed by the private plaintiff may not be accessible or certain documents and/or information may only be provided subject to an order of the presiding court that disallows publicly disclosing the existence of or any details relating to the proceeding until the case is unsealed.

        In return for bringing the suit on the government's behalf, the statute provides that the private plaintiff is to receive up to 30% of the recovered amount from the litigation proceeds if the litigation is successful. The number of qui tam suits brought against health care providers has increased dramatically. In addition, many states have enacted laws modeled after the False Claims Act that allow those states to recover money which was fraudulently obtained by a health care provider from the state (e.g., Medicaid funds provided by the state).

        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 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, 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

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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 1,700 employees. In North America, we have approximately 450 employees, of which 19 were engaged in supply and logistics activities, 153 in research and development, process engineering, clinical affairs, regulatory affairs and quality assurance activities, 199 in sales, customer service and marketing activities, and 80 in administration, finance and corporate support functions. In Europe and Asia Pacific, we had approximately 225 employees responsible for our international markets. In Costa Rica, we had approximately 1,025 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 Public Reference Room at 100 F Street, NE, Washington, DC 20549. You may obtain information on the operation of the Public Reference 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.

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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 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.

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 the DOJ and other investigations, legal and administrative proceedings have increased our costs and could result in fines, injunctions, orders, and penalties which could materially adversely affect our business, financial condition, results of operations, and liquidity.

        As of December 31, 2012, we have settled or reached settlement on all known proceedings against the Company arising from the restatement or the Review with the exception of the ongoing investigation by the Department of Justice, or the DOJ investigation. See Note 10, "Litigation and Contingencies," in the notes to the 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 DOJ investigation could also lead to fines, injunctions or orders with respect to future activities. We could incur substantial additional costs to defend and resolve the investigation or proceedings arising out of or related to the investigation. Two of our former officers have been indicted by the DOJ and we could incur substantial additional costs advancing legal defense costs to these former officers as required by indemnity obligations with these former officers. In addition, we could be exposed to enforcement or other actions upon completion of the DOJ investigation. At this point, we are unable to predict the scope or result of the investigation or whether any other federal or state agencies will commence any further investigation or legal action. Any such investigations may result in us being subject to criminal and civil penalties and other remedial measures, which could have an adverse impact on our business, results of operations, financial condition and liquidity. We had entered

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into a statute of limitations tolling agreement with the DOJ effective until February 1, 2013. On January 30, 2013, we and the DOJ mutually agreed to extend the tolling of the statute of limitations to March 1, 2013.

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

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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, imposes a new excise tax on medical device makers effective January 1, 2013 which will result 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 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

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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 and Applied Therapeutics, Inc.) 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 monopolar and/or bipolar electrosurgical 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.

        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

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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 monopolar and/or bipolar electrosurgical 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,

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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.

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, 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.

Until we resolve our contingencies, we may not have access to a cost effective credit facility and we will be required to fund our working capital needs and planned expenditures with cash on hand. Our ability to generate cash in the future depends on many factors including those factors described in this Annual Report.

        In the absence of a credit facility as a possible source of liquidity, our ability to meet our working capital needs and to fund capital expenditures will depend on our ability to generate cash from operations and effectively manage our cash balances. Our ability to continue to generate cash from operations is subject to general economic, financial, competitive and other factors that may be beyond our control. We are unable to predict the outcome of the ongoing DOJ investigation with which we are cooperating and this matter could have a material adverse effect on our liquidity and cash flows. See Note 10, "Litigation and Contingencies," in the notes to the consolidated financial statements for further discussion on this matter and other legal proceedings.

        As a result, from time to time, we may be required to seek financing from alternative sources. We cannot assure you that such alternative funding will be available to us on terms and conditions acceptable to us, or at all.

        In addition, we maintain deposit accounts with numerous financial institutions around the world in amounts that exceed applicable governmental deposit insurance levels. While we actively monitor our deposit relationships, the unanticipated failure of a financial institution in which we maintain deposits could cause us to suffer losses that could materially harm our results of operations and financial condition.

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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 501(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. FDA guidance documents, including a draft guidance issued on July 27, 2011 that has yet to become final, define when to submit premarket notifications for new or modified devices. These guidance documents also define modifications for which a new 510(k) is not required. 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.

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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.

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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.

        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, delays 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.

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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 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 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.

        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

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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 31.6 percent, 31.0 percent and 28.0 percent of our total product sales for the year ended December 31, 2012, 2011 and 2010, 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 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.

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

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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.

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. At this time, assuming conversion of the Series A Preferred Stock to our Common Stock, including make-whole amounts as defined in the Certificate of Designation for the Series A Preferred Stock but excluding outstanding options and warrants held by other parties, OEP would represent an ownership interest of approximately 17.2 percent of our voting 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.

        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 and to comply with the terms of the standstill. Since September 1, 2010, OEP is free to convert the Series A Preferred Stock into our Common Stock and, subject to the registration requirements of the federal securities laws, dispose of such stock, 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.

ITEM 1B.    UNRESOLVED STAFF COMMENTS

        None.

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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 and has now been sub-leased. 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.

        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 the likelihood of a loss is probable and reasonably estimable. Except as otherwise specifically noted, we 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, we have not recognized any potential liability that may result from these matters in our consolidated financial statements. The resolution of these matters 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

        The Department of Justice ("DOJ") is investigating certain of our activities including past sales, accounting, and billing procedures primarily in relation to the operation of our Spine product sales. The DOJ is also reviewing our relationship with our DiscoCare subsidiary. We are cooperating with this investigation. In connection with such cooperation, and pursuant to a request from the DOJ, we entered into a statute of limitations tolling agreement with the DOJ effective until February 1, 2013. On January 30, 2013, also as part of its continuing cooperation, we entered into a second statute of limitations tolling agreement with DOJ effective until March 1, 2013. At this stage of the investigation, we cannot predict the ultimate outcome and are unable to estimate any potential liability we may incur.

False Claims Act Investigation

        We received a Civil Investigative Demand 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. We are cooperating fully with the investigation, although no assurances can be given regarding the duration of the investigation or whether proceedings will be instituted against us. Management intends to represent our interests vigorously in this matter. At this stage of the investigation, however,

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management cannot predict the ultimate outcome of the investigation or any potential liability we may incur.

Shareholder Derivative Actions

        In 2008 and 2009 three derivative actions were filed in Federal court against us and our then-current directors alleging breach of fiduciary duty based on our 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. 1:08-cv-00574-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 us, our then current directors, and certain of our current and former officers. In these actions, certain of our shareholders alleged derivative claims on behalf of us that our directors and officers breached their fiduciary duties to shareholders by allowing improper financial reporting, failing to maintain adequate financial controls over revenue recognition, disseminating 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-08-3484 (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, our 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 us 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. 1:08-cv-00574-SS (consolidated) in the U.S. District Court, Western District of Texas.

        We reached an agreement to settle the consolidated private securities class action suits which resolves all claims arising from the purchase or sale of ArthroCare securities of a class of all purchasers

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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, we 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.

ITEM 4.    MINE SAFTEY 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, 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  

 

 
  Year Ending December 31, 2011  
 
  Quarter 1   Quarter 2   Quarter 3   Quarter 4  

High

  $ 35.27   $ 35.33   $ 34.77   $ 31.84  

Low

    27.82     32.31     27.98     25.56  

        As of February 1, 2012, there were 173 holders of record of 28,044,142 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.

        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").

        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: 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 investigation of the Company by the DOJ has been terminated, settled or finally adjudicated.

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        No conversion of Series A Preferred Stock will be permitted to the extent that any holder of Series A Preferred Stock would individually hold in excess of 19.99 percent of the Company's voting power after the proposed conversion, or to the extent that the holders of Series A Preferred Stock would hold in excess of 17.8 percent of the Company's voting power in the aggregate, in each case solely attributable to their holdings of Series A Preferred Stock and any Common Stock received upon conversion thereof (such limitations collectively, the "Conversion Cap"). Shares of Series A Preferred Stock not convertible as a result of the Conversion Cap shall remain outstanding and shall become convertible to the extent the Conversion Cap no longer applies.

        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 May 22, 2013, which is hereby incorporated herein by reference.


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, 2012 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, 2007, 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.


COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among ArthroCare Corporation, the NASDAQ Composite Index, and the NASDAQ Health
Services Index

GRAPHIC


*
$100 invested on 12/31/07 in stock or index, including reinvestment of dividends. Fiscal year ending December 31.

 
  12/07   12/08   12/09   12/10   12/11   12/12  

ArthroCare Corporation

    100.00     9.93     49.32     64.64     65.93     71.99  

NASDAQ Composite

    100.00     59.03     82.25     97.32     98.63     110.78  

NASDAQ Health Services

    100.00     75.94     86.81     88.01     72.95     83.15  

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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, 2012, 2011 and 2010 and the balance sheet data as of December 31, 2012 and 2011 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,  
 
  2012   2011   2010   2009   2008  

Statements of Comprehensive Income:

                               

Product sales(1)

  $ 350,671   $ 338,319   $ 338,757   $ 308,493   $ 295,118  

Royalties, fees and other

    17,783     16,566     16,622     15,624     12,165  

Total revenues

    368,454     354,885     355,379     324,117     307,283  

Gross profit

    260,503     251,571     244,628     233,177     214,638  

Operating expenses(2)

    196,369     267,038     190,358     233,124     238,509  

Net income (loss) from continuing operations

    46,378     (2,813 )   37,518     (5,296 )   (24,582 )

Net income (loss)

    46,378     (902 )   37,084     (5,777 )   (35,025 )

Net income (loss) applicable to common stockholders(3)

    42,803     (4,318 )   33,820     (33,822 )   (35,025 )

Net earnings (loss) per share from continuing operations applicable to common stockholders

                               

Basic

  $ 1.28   $ (0.23 ) $ 1.04   $ (1.24 ) $ (0.92 )

Diluted

  $ 1.25   $ (0.23 ) $ 1.03   $ (1.24 ) $ (0.92 )

Net earnings (loss) per share applicable to common stockholders

                               

Basic

  $ 1.28   $ (0.16 ) $ 1.03   $ (1.26 ) $ (1.32 )

Diluted

  $ 1.25   $ (0.16 ) $ 1.02   $ (1.26 ) $ (1.32 )

 

 
  December 31,  
 
  2012   2011   2010   2009   2008  

Balance Sheet Data:

                               

Cash, cash equivalents, restricted cash equivalents and investments

  $ 218,787   $ 219,605   $ 132,536   $ 57,386   $ 37,980  

Working capital(4)

    287,730     222,742     191,939     106,267     43,406  

Total assets

    519,787     533,001     439,195     391,128     389,485  

Long-term liabilities

    20,554     18,951     13,979     5,147     10,058  

Series A 3% Redeemable Convertible Preferred Stock

    80,759     77,184     73,768     70,504      

Total stockholders' equity

    364,007     306,738     295,728     250,395     246,491  

(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 $10.8 million, $80.8 million, $5.9 million, $34.9 million, and $17.0 million of investigation and restatement cost for the years ended December 31, 2012, 2011, 2010, 2009 and 2008 respectively. 2011 Investigation and restatement cost include a $74 million accrual related to the settlement of the private securities class actions. 2011 Operating expenses also include exit costs of $8.3 million related to the relocation of our Sunnyvale, California office

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    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 $3.6 million, $3.4 million and $3.3 million in 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 consoidated financial statements

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 disposable surgical devices and implants. Product sales are made through our employed sales representatives, independent sales agents and distributors. Reported product sales in 2010 included the recognition of $6.6 million of product sales that had been previously deferred pending the outcome of certain contract matters. Excluding the impact of the deferred revenue recognized in 2010, product sales growth for 2012, 2011 and 2010 was 3.7 percent, 1.8 percent and 7.7 percent, respectively.

        In 2012, 2011 and 2010, International sales comprised 31.6 percent, 31.0 percent and 28.0 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 $3.8 million in 2012, increased product sales by $5.9 million in 2011 and increased product sales $0.2 million in 2010. In constant currency, product sales increased 4.8 percent, decreased 1.9 percent and increased 9.7 percent for the years ended 2012, 2011 and 2010. Management believes percentage sales growth in constant currency is

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an important metric for evaluating our operations because the impact of changing foreign currency exchange rates may not provide an accurate baseline for analyzing trends in our business. 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 which is included in product sales. Product sales from contract manufacturing for the years ended December 31, 2012, 2011 and 2010 were $23.8 million, $23.5 million and $25.6 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.

Gross Product Margin

        Gross product margin as a percentage of product sales in 2012, 2011, and 2010 was 69.2 percent, 69.5 percent and 67.3 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 and costs of product shipped to our customers. Cost of product sales also includes the amortization of controller units and instruments that have been placed at customer 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 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. The Patient Protection and Affordable Care Act which was signed into law in March 2010 imposes a new excise tax on our U.S. product sales from January 1, 2013, which will lower our gross product margin beginning in 2013.

Operating Margin

        Operating margin is our income from operations as a percentage of total revenues. The key operating expenses incurred in connection with our ongoing business activities are 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. Operating margin for 2012, 2011 and 2010 was 17.4 percent, negative 4.4 percent and 15.3 percent, respectively.

        Under the short-term incentive plan for 2012 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 2.9 percent, 22.8 percent and 1.7 percent of total

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revenue for 2012, 2011 and 2010 respectively, and Adjusted Operating Margin was 20.3 percent, 18.4 percent and 16.9 percent 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. In the second quarter of 2012, the Company entered into a sublease for its former Austin, Texas location which decreased the amount accrued for contract termination by $1.1 million. 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

        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 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.

        Our effective income tax rate is 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 have a tax holiday that extends through December 2015. 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. We expect to be able to fully utilize our deferred tax assets, which amounted to $43.3 million as of December 31, 2012.

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Results of Operations

Overview of our Results of Operations

        Results of operations for the three years ended December 31, 2012, 2011 and 2010 (in thousands, except percentages and per-share data) were as follows:

 
  Year Ended December 31,  
 
  2012   2011   2010  
 
  Dollars   % Total
Revenue
  Dollars   % Total
Revenue
  Dollars   % Total
Revenue
 

Revenues:

                                     

Product sales

  $ 350,671     95.2 % $ 338,319     95.3 % $ 338,757     95.3 %

Royalties, fees and other

    17,783     4.8 %   16,566     4.7 %   16,622     4.7 %
                           

Total revenues

    368,454     100.0 %   354,885     100.0 %   355,379     100.0 %

Cost of product sales

   
107,951
   
29.3

%
 
103,314
   
29.1

%
 
110,751
   
31.2

%
                           

Gross profit

    260,503     70.7 %   251,571     70.9 %   244,628     68.8 %
                           

Operating expenses:

                                     

Research and development

    32,146     8.7 %   28,932     8.2 %   35,846     10.1 %

Sales and marketing

    116,127     31.5 %   108,621     30.6 %   107,852     30.3 %

General and administrative

    33,212     9.0 %   35,069     9.9 %   35,534     10.0 %

Amortization of intangible assets

    4,857     1.3 %   5,291     1.5 %   5,237     1.5 %

Exit costs

    (778 )   -0.2 %   8,300     2.3 %       0.0 %

Investigation and restatement- related costs

    10,805     2.9 %   80,825     22.8 %   5,889     1.7 %
                           

Total operating expenses

    196,369     53.3 %   267,038     75.2 %   190,358     53.6 %
                           

Income (loss) from operations

    64,134     17.4 %   (15,467 )   -4.4 %   54,270     15.3 %

Other income, net

   
678
         
14
         
216
       

Bank fees

    (848 )         (622 )         (769 )      

Foreign exchange gain (loss), net

    (257 )         (723 )         (3,311 )      
                                 

Total other expense

    (427 )         (1,331 )         (3,864 )      
                                 

Income (loss) from continuing operations before income taxes

    63,707           (16,798 )         50,406        

Income tax provision (benefit)

   
17,329
         
(13,985

)
       
12,888
       
                                 

Net income (loss) from continuing operations

    46,378           (2,813 )         37,518        

Loss from discontinued operations, net of taxes

   
         
1,911
         
(434

)
     
                                 

Net income (loss)

    46,378           (902 )         37,084        

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

   
(3,575

)
       
(3,416

)
       
(3,264

)
     
                                 

Net income (loss) applicable to common stockholders

    42,803           (4,318 )         33,820        
                                 

Other comprehensive income

                                     

Foreign currency adjustments

    685           369           2,601        
                                 

Total comprehensive income

  $ 47,063         $ (533 )       $ 39,685        
                                 

Weighted-average shares outstanding:

                                     

Basic

    27,752           27,382           27,006        

Diluted

    28,454           27,382           27,348        

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

                                     

Basic

  $ 1.28         $ (0.23 )       $ 1.04        
                                 

Diluted

  $ 1.25         $ (0.23 )       $ 1.03        
                                 

Earnings (loss) per share applicable to common stockholders:

                                     

Basic

  $ 1.28         $ (0.16 )       $ 1.03        
                                 

Diluted

  $ 1.25         $ (0.16 )       $ 1.02        
                                 

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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 sales increased $7.4 million, or 3.3 percent in 2012 compared to 2011. In constant currency, Sports Medicine product sales increased 4.5 percent in 2012 compared to 2011.

        Americas Sports Medicine product sales increased $6.2 million in 2012 compared to 2011. Americas Sports Medicine proprietary product sales increased $5.9 million or 4.6 percent in 2012 primarily as a result of recently launched 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 a 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 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 increase 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.

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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 cost in 2012 is 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 includes $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 could be classified as exit costs.

        Sales and marketing expense increased to 31.5 percent of total revenue in 2012 compared to 30.6 percent of total revenue in 2011. The increase was primarily a 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 costs resulting from the relocation of our Sunnyvale, California activities that did not qualify to be classified as exit costs.

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Table of Contents

        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 2011.

        Investigation and restatement expenses in 2011 included $74 million related to the settlement of the private securities class actions pending 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 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):

 
  Year Ended
December 31,
 
 
  2012   2011  

Interest and other income, net

  $ 678   $ 14  

Bank fees

    (848 )   (622 )

Foreign exchange loss, net

    (257 )   (723 )
           

Total other 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 US 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.

        The Company's result of operations reflect 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 do 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 ("Act") on January 2, 2013.

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Table of Contents

2011 Comparison with 2010

Product Sales

        Product sales consist principally of sales of disposable surgical devices and implants. Product sales by each of our product groups and geographic markets for the years ended December 31, 2011 and 2010 are as follows (in thousands, except percentages):

 
  Year Ended December 31, 2011   Year Ended December 31, 2010  
 
  Americas   International   Total
Product
Sales
  % Net
Product
Sales
  Americas   International   Product
Sales
  % Net
Product
Sales
 

Sports Medicine

  $ 149,010   $ 79,337   $ 228,347     67.5 % $ 160,859   $ 71,120   $ 231,979     68.5 %

ENT

    81,810     18,429     100,239     29.6 %   79,019     15,270     94,289     27.8 %

Other

    2,785     6,948     9,733     2.9 %   4,122     8,367     12,489     3.7 %
                                   

Total Product Sales

  $ 233,605   $ 104,714   $ 338,319     100.0 % $ 244,000   $ 94,757   $ 338,757     100.0 %
                                   

% Net Product Sales

    69.0 %   31.0 %   100.0 %         72.0 %   28.0 %   100.0 %      

        Worldwide Sports Medicine product sales decreased $3.6 million, or 1.6 percent, in 2011 compared to 2010. Americas product sales decreased $5.2 million or 3.4 percent, net of the $6.6 million of product sales recognized in the first quarter of 2010 that had been previously deferred pending the outcome of certain contract matters. Contract manufactured product sales, which is reported as part of the Americas, decreased by $2.1 million in 2011. Proprietary Sports Medicine product sales in the Americas decreased by $3.1 million in 2011 when compared to 2010, as sales to stocking distributors were $3.4 million lower in 2011 than in 2010. In 2011, we initiated changes in our Americas Sports Medicine sales organization which included converting certain of our stocking distributors to sales agents. As a result of this initiative, product sales in the affected territories were lower as stocking distributors sold off their inventories on hand. International Sports Medicine product sales increased $8.2 million, or 11.6 percent in 2011 versus 2010 as a result of a combination of the translation effect of a weaker U.S. dollar, higher sales volumes and higher average selling prices.

        Worldwide ENT product sales increased $6.0 million, or 6.3 percent in 2011 when compared to 2010. ENT product sales in the Americas increased 3.5 percent for the 2011 year after increasing at a rate of 7.8 percent in the first six-months of 2011. The decline in the rate of product sales growth in the second half of 2011 was due to raw material supply issues that persisted during the third and fourth quarters of 2011 that disrupted our Rapid Rhino product sales. At the end of 2011, we had unfilled customer orders for our Rapid Rhino products amounting to approximately $1.5 million. International ENT product sales increased 20.7 percent in 2011 when compared to 2010 primarily due to higher sales volumes, most notably in the Asia Pacific region, and the translation effect of a weaker U.S. dollar.

        Other product sales, primarily spine products, decreased $2.8 million in 2011 when compared with the same periods in 2010 and are approximately 3 percent of total product sales.

        Across all product areas, International product sales increased $10.0 million, or 10.5 percent, in 2011 compared to 2010. Changes in foreign currency rates increased the U.S. dollar reported value of International's local currency product sales by $5.7 million. In our direct markets, product sales increased $6.9 million in 2011, while sales to distributors increased $3.8 million. In 2011, direct markets represented approximately 71 percent of International product sales, respectively, compared to 72 percent in 2010.

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. Such revenues remained consistent in 2011 compared to 2010.

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Cost of Product Sales

        Cost of product sales for the years ended December 31, 2011 and 2010 were as follows (in thousands, except percentages):

 
  Year Ended December 31,  
 
  2011   2010  
 
  Dollars   % Net
Product
Sales
  Dollars   % Net
Product
Sales
 

Product cost

  $ 86,843     25.6 % $ 91,931     27.1 %

Controller amortization

    8,830     2.6 %   10,019     3.0 %

Other

    7,641     2.3 %   8,801     2.6 %
                   

Total Cost of Product Sales

  $ 103,314     30.5 % $ 110,751     32.7 %
                   

        Gross product margin as a percentage of product sales was 69.5 percent in 2011 compared to 67.3 percent in 2010. Product cost was lower in 2011 as inventory obsolescence charges were $5.3 million lower in 2011 when compared to 2010. We also incurred costs of $0.4 million related to accelerated depreciation and other costs resulting from the relocation of our Sunnyvale, California activities that did not qualify to be classified as exit costs.

Operating Expenses

        Operating expenses for the periods shown were as follows (in thousands, except percentages):

 
  Year Ended December 31,  
 
  2011   2010  
 
  Dollars   % Total
Revenue
  Dollars   % Total
Revenue
 

Research and development

  $ 28,932     8.2 % $ 35,846     10.1 %

Sales and marketing

    108,621     30.6 %   107,852     30.3 %

General and administrative

    35,069     9.9 %   35,534     10.0 %

Amortization of intangible assets

    5,291     1.5 %   5,237     1.5 %

Exit costs

    8,300     2.3 %       0.0 %

Investigation and restatement related costs

    80,825     22.8 %   5,889     1.7 %
                   

Total operating expenses

  $ 267,038     75.2 % $ 190,358     53.6 %
                   

        Research and development expense decreased $6.9 million during 2011 compared to 2010. Research and development expense decreased $6.6 million as a result of a higher proportion of engineering and other personnel costs that were estimated as being associated with manufacturing activities in the current periods, which increased the allocation of engineering costs to inventory and cost of goods. We do not expect this trend to continue in 2012. Research and development expense was $2.2 million lower as a result of a reduction in personnel expenses primarily due to the campus consolidation and the forfeiture of certain stock awards. The decrease in research and development costs in 2011 was partially offset by $1.4 million of accelerated depreciation and other costs resulting from the relocation of our Sunnyvale, California activities that did not qualify to be classified as exit costs.

        Sales and marketing expense as a percentage of total revenue was relatively consistent between periods.

        General and administrative expense decreased $0.5 million in 2011 when compared to 2010. General and administrative costs in 2010 included approximately $1.8 million in higher severance and bonus costs while in 2011 general and administrative costs included approximately $1.5 million related

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Table of Contents

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 year-end.

        Investigation and restatement expenses increased to $80.8 million in 2011 which includes $74 million for the proposed settlement of the private securities class actions against us. Indemnification costs of our former officers increased $3.2 million and legal defense cost related to the various contingent matters increased $5.4 million in 2011 when compared 2010. Investigation and restatement expenses were offset by $7.8 million in proceeds from the settlement of the derivative actions net of court awarded plaintiff attorneys fees.

Interest and Other Expense, Net

        Interest and other expense for the periods shown were as follows (in thousands, except percentages):

 
  Year Ended
December 31,
 
 
  2011   2010  

Interest and other income, net

  $ 14   $ 216  

Bank fees

    (622 )   (769 )

Foreign exchange gain (loss), net

    (723 )   (3,311 )
           

Total other income (expense)

  $ (1,331 ) $ (3,864 )
           

        Other expense decreased $2.5 million in 2011 when compared to 2010 as a result of a reduction in foreign exchange loss in 2011. The change in foreign exchange loss in the period was due primarily to fluctuations in the material foreign currencies in which we operate. During 2011 the U.S. dollar weakened against the euro, British pound, and Australian dollar which increased the local currency amount of U.S. dollar payables of certain international subsidiaries, resulting in the reporting of foreign exchange losses.

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 2011 was 83.3 percent compared to 25.6 percent in 2010. In 2011, we incurred a pre-tax loss in the US 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.

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. Until we resolve the DOJ investigation

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(see Note 10 in our consolidated financial statements) we may not have cost effective access to credit facilities and will be required to fund our needs through cash flows from operations and cash on hand. 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, excluding the uncertainty related to the ongoing DOJ investigation to which we are a party.

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, 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.

Cash Flows and Working Capital for the Year Ended December 31, 2011 compared to the year ended December 31, 2010

        As of December 31, 2011 we had $222.7 million in working capital, compared to $191.9 million at December 31, 2010. Our cash and cash equivalent holdings increased to $219.6 million at December 31, 2011 from $132.5 million at December 31, 2010, respectively and our U.S. cash and cash equivalent holdings at December 31, 2011 were $207.8 million. Our working capital is net of accrued liability of $74 million related to the proposed settlement of the private securities class actions as discussed in Note 10 of our consolidated financial statements.

        Cash provided by operating activities for 2011 was $84.6 million and differed from our net loss of $0.9 million due to $13.4 million of non-cash expenses, primarily depreciation and amortization and stock based compensation expense and the fact that the proposed settlement of the private securities class action, while accrued at the end of 2011, has not been paid. Cash provided by operating activities included cash provided by discontinued operations of $1.3 million, and is not expected to have a material impact on our future cash flows.

        Cash used in investing activities for 2011 was $5.7 million. Purchases of property and equipment was approximately $13.5 million offset by $5.5 million received for the sale of the assets related to our discontinued operations and $2.3 million received from collection of a loan receivable. Cash used in investing activities for 2010 was $12.2 million, consisting primarily of purchases of property and equipment.

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        Cash provided by financing activities for 2011 and 2010 was $7.9 million and $3.6 million, respectively, and consisted primarily of proceeds from the exercise of stock options.

Contractual Obligations and Commercial Commitments

        On December 31, 2012, we 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 Administration clearance for certain suture-based anchor products, which was received in January 2013, and we subsequently paid $7 million in cash and closed the acquisition. In addition, the agreement provides that we 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.

        The following table aggregates all material contractual obligations and commercial commitments that affected our financial condition and liquidity as of December 31, 2012 (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

  $ 36,807   $ 6,015   $ 10,240   $ 7,409   $ 13,143  

Sub-lease income

  $ 2,433   $ 483   $ 1,174   $ 776        

Other(2)

    154     102     52          
                       

Total

  $ 34,528   $ 5,634   $ 9,118   $ 6,633   $ 13,143  
                       

(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 contributions to foundations that promote and support education and research initiatives as well as minimum obligations to DHL for warehousing services in Belgium.

        The Company has not included liabilities for uncertain tax positions in the above table of contractual obligations and commercial commitments because the Company is unable to estimate the anticipated timing of payment.

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, assumptions and estimates and that have a significant impact on our

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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. In the case of certain distributors we had agreed to pricing reductions based on the distributors' ultimate reselling price and in those cases we recognized revenue on a "sell-through" basis only after the distributor had sold our products to an end user. In order to determine the amount of sell-through revenue that should be recognized during a given reporting period, we relied on reports from the distributors that provided us with information about sales to end customers during the reporting period as well as the amount and types of our products in the distributor's inventory at the end of a reporting period. Our management was required to exercise a significant level of judgment to determine the accuracy and reliability of the reported information. We used a first-in-first-out accounting method to account for products sold by these distributors where we applied the sell-through method. These distributors have subsequently been converted to sales agents and revenues are now recognized when products are delivered to the end customer.

        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. We had an agreement with one former customer that provided for an extended right of exchange. Our management concluded that the duration of the exchange agreement with this former customer was inconsistent with our revenue recognition criteria and as a result revenue related to product sales to this customer was deferred until the related right of exchange period expired during the first quarter of 2010.

        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

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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.

    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, 2012, 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, 2012, was $30.08 and we had approximately 27.8 million shares of common stock outstanding representing an imputed market capitalization of $836 million. Our book value on October 31, 2012 was $350 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

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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 may have concluded in the past that undistributed earnings will be permanently reinvested, 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 the assumption that our foreign undistributed earnings will be distributed to the U.S.

        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.

    Series A 3.00% Convertible Preferred Stock

        Our Series A Preferred Stock is classified as mezzanine equity and is shown on our balance sheet net of issuance costs. The difference between the carrying value of the Series A Preferred Stock and its

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redemption value is accreted over 5 years using the effective interest method. As the Series A Preferred Stock is convertible at the option of the holder, we immediately amortized the entire amount of the beneficial conversion feature, as determined on the date of issuance, as a dividend. Additional dividends are accrued at the stated rate each period so that the mezzanine equity carrying value will equal its redemption value on the fifth anniversary of the issuance when any remaining unconverted Series A Preferred Stock could be redeemable at the option of the holder. Dividends declared on the Series A Preferred Stock shares, the accretion of issuance costs and amortization of the beneficial conversion feature reduce the amount of net earnings that are available to common stockholders and are presented together as a separate amount on the consolidated statements of comprehensive income.

    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 rate 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, our net worth or our business operations.

        During 2012, the Company adopted FASB ASU 2011-05 ("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 results of operations or financial condition.

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, 2012 for our cash and cash equivalents (in thousands, except percentages):

Cash and cash equivalents

  $218,787

Average interest rate earned on cash and cash equivalents

  Less than 1%

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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 and financial condition.

        Our cash and cash equivalents at December 31, 2012 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, 2012 exchange rates for these currencies would have an impact on pre-tax income of approximately $1.4 million.

        We have not used derivative financial instruments to hedge foreign currency exchange risk and do not anticipate doing so in the future.

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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.

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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, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2012 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, 2012, based on criteria established in Internal Control—Integrated Framework 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 14, 2013

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ARTHROCARE CORPORATION

CONSOLIDATED BALANCE SHEETS

(in thousands, except par value data)

 
  December 31,  
 
  2012   2011  

ASSETS

             

Current assets:

             

Cash and cash equivalents

  $ 218,787   $ 219,605  

Accounts receivable, net of allowances of $1,565 and $2,251 at 2012 and 2011, respectively

    48,881     51,350  

Inventories, net

    48,417     35,761  

Deferred tax assets

    20,090     40,622  

Prepaid expenses and other current assets

    6,022     5,532  
           

Total current assets

    342,197     352,870  

Property and equipment, net

   
30,461
   
35,769
 

Intangible assets, net

    1,859     5,457  

Goodwill

    119,893     119,159  

Deferred tax assets

    23,206     18,159  

Other assets

    2,171     1,587  
           

Total assets

  $ 519,787   $ 533,001  
           

LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY

             

Current liabilities:

             

Accounts payable

  $ 12,189   $ 15,258  

Accrued liabilities

    41,674     112,586  

Deferred tax liabilities

    33      

Deferred revenue

    285     742  

Income tax payable

    286     1,542  
           

Total current liabilities

    54,467     130,128  

Deferred tax liabilities

   
354
   
29
 

Other non-current liabilities

    20,200     18,922  
           

Total liabilities

    75,021     149,079  

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, 2012 and 2011, respectively. Redemption value: $87,089

   
80,759
   
77,184
 

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: 31,949 and 31,523; Outstanding: 27,977 and 27,562 shares at December 31, 2012 and 2011, respectively

    28     28  

Treasury stock: 3,942 and 3,968 shares at December 31, 2012 and 2011, respectively

    (106,425 )   (107,126 )

Additional paid-in capital

    413,660     400,580  

Accumulated other comprehensive income

    5,300     4,615  

Retained earnings

    51,444     8,641  
           

Total stockholders' equity

    364,007     306,738  
           

Total liabilities, redeemable convertible preferred stock and stockholders' equity

  $ 519,787   $ 533,001  
           

   

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

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ARTHROCARE CORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands, except per-share data)

 
  Years Ended December 31,  
 
  2012   2011   2010  

Revenues:

                   

Product sales

  $ 350,671   $ 338,319   $ 338,757  

Royalties, fees and other

    17,783     16,566     16,622  
               

Total revenues

    368,454     354,885     355,379  

Cost of product sales

    107,951     103,314     110,751  
               

Gross profit

    260,503     251,571     244,628  
               

Operating expenses:

                   

Research and development

    32,146     28,932     35,846  

Sales and marketing

    116,127     108,621     107,852  

General and administrative

    33,212     35,069     35,534  

Amortization of intangible assets

    4,857     5,291     5,237  

Exit costs

    (778 )   8,300      

Investigation and restatement-related costs

    10,805     80,825     5,889  
               

Total operating expenses

    196,369     267,038     190,358  
               

Income (loss) from operations

    64,134     (15,467 )   54,270  

Other income, net

    678     14     216  

Bank fees

    (848 )   (622 )   (769 )

Foreign exchange loss, net

    (257 )   (723 )   (3,311 )
               

Total other expense

    (427 )   (1,331 )   (3,864 )
               

Income (loss) from continuing operations before income taxes

    63,707     (16,798 )   50,406  

Income tax provision (benefit)

    17,329     (13,985 )   12,888  
               

Net income (loss) from continuing operations

    46,378     (2,813 )   37,518  

Income (loss) from discontinued operations, net of taxes

        1,911     (434 )
               

Net income (loss)

    46,378     (902 )   37,084  
               

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

    (3,575 )   (3,416 )   (3,264 )
               

Net income (loss) attributable to common stockholders

    42,803     (4,318 )   33,820  
               

Other comprehensive income

                   

Foreign currency adjustments

    685     369     2,601  
               

Total comprehensive income (loss)

  $ 47,063   $ (533 ) $ 39,685  
               

Weighted-average shares outstanding:

                   

Basic

    27,752     27,382     27,006  

Diluted

    28,407     27,382     27,348  

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

                   

Basic

  $ 1.28   $ (0.23 ) $ 1.04  
               

Diluted

  $ 1.25   $ (0.23 ) $ 1.03  
               

Earnings (loss) per share attributable to common stockholders:

                   

Basic

  $ 1.28   $ (0.16 ) $ 1.03  
               

Diluted

  $ 1.25   $ (0.16 ) $ 1.02  
               

   

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

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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
(Accumulated
Deficit)
  Total
Stockholders'
Equity
 

Balance, December 31, 2009

    26,886   $ 27   $ (108,724 ) $ 379,921   $ 1,645   $ (22,474 ) $ 250,395  

Issuance of common stock through:

                                         

Exercise of options and restricted stock

    190             1,868             1,868  

Employee stock purchase plan

    5             128             128  

Contribution to employee benefit plan

    31         825     80             905  

Stock compensation

                8,001             8,001  

Income tax effect of exercise of stock options

                (1,990 )           (1,990 )

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

                (1,613 )       (1,651 )   (3,264 )

Currency translation adjustment

                    2,601         2,601  

Net income

                        37,084     37,084  
                               

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  
                               

   

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

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CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 
  Year Ended December 31,  
 
  2012   2011   2010  

Cash flows from operating activities:

                   

Net income (loss)

  $ 46,378   $ (902 ) $ 37,084  

Adjustments to reconcile net income (loss) to net cash provided by by operating activities:

                   

Depreciation and amortization

    20,424     24,600     24,130  

Provision for doubtful accounts receivable and product returns

    153     208     (336 )

Provision for inventory and warranty reserves

    2,507     2,718     8,149  

Non-cash stock compensation expense

    8,616     6,226     8,001  

Deferred taxes

    15,504     (18,289 )   2,885  

Income tax benefits relating to employee stock options

        (134 )   (1,608 )

Unrealized foreign exchange (gain) loss

    (2,999 )   (482 )   4,594  

(Gain) Loss on assets sold/disposed

    300     (2,177 )    

Other

    789     745     1,027  

Changes in operating assets and liabilities

                   

Accounts receivable

    2,720     (2,793 )   (2,057 )

Inventories

    (13,313 )   (3,485 )   5,990  

Prepaid expenses and other current assets

    1,732     (24 )   2,615  

Accounts payable

    (3,208 )   1,409     (698 )

Accrued and other liabilities

    (71,550 )   76,115     (2,001 )

Deferred revenue

    (457 )   742     (4,508 )

Income taxes payable

    (1,310 )   120     (631 )
               

Net cash provided by operating activities

    6,286     84,597     82,636  
               

Cash flows from investing activities:

                   

Purchases of property and equipment

    (10,504 )   (13,481 )   (12,231 )

Payments for business combinations, including earnouts, and purchases of intangible assets

    (1,252 )       (149 )

Proceeds from sale of assets held for sale

        5,500      

Proceeds from loan receivable

        2,275     168  

Other

        17     38  
               

Net cash used in investing activities

    (11,756 )   (5,689 )   (12,174 )
               

Cash flows from financing activities:

                   

Proceeds from issuance of common stock, net of issuance costs

    272     264     128  

Proceeds from exercise of options to purchase common stock

    4,104     7,422     1,868  

Income tax benefit relating to employee stock options

        134     1,608  
               

Net cash provided by financing activities

    4,376     7,820     3,604  
               

Effect of exchange rate changes on cash and cash equivalents

    276     341     1,084  
               

Net increase (decrease) in cash and cash equivalents

    (818 )   87,069     75,150  

Cash and cash equivalents, beginning of the period

    219,605     132,536     57,386  
               

Cash and cash equivalents, end of the period

  $ 218,787   $ 219,605   $ 132,536  
               

   

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

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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. In the event of a sudden significant decrease in demand for the Company's products, or a higher incidence of inventory obsolescence, the Company could be required to increase its inventory reserve, which would increase cost of product sales and decrease gross profit.

        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 four-year period. Leasehold improvements are amortized over the shorter of ten years or the lease term. Furniture, fixtures, machinery and equipment are amortized over a five year period, while computer equipment and software are amortized over three to five years. Buildings are depreciated over a thirty 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

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

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 through direct sales professionals, independent sales agents and independent distributors. 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, 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. In the majority of cases involving sales to distributors, the requirements for revenue recognition are met when the product is delivered to a particular distributor. In the case of certain distributors the Company agreed to pricing concessions based on the distributors' ultimate reselling price and in these cases revenue was recognized on a "sell-through" basis only after the distributor sold the products to an end user. In order to determine the amount of sell-through revenue that should be recognized during a given reporting period, the Company relied on reports from the distributors that provided information about sales to end customers during the reporting period as well as the amount and types of products in the distributor's inventory at the end of a reporting period. The Company's management was required to make estimates and exercise a significant level of judgment to determine the accuracy and reliability of the reported information. A first-in-first-out accounting method was used to account for products sold by these distributors where the sell-through method had been applied. These distributors were converted to sales agents and revenues are now recognized when products are delivered to the end customer.

        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. The Company had an agreement with one former customer that provided for an extended right of exchange. Management determined that for this former customer, it was not possible to reasonably estimate future return levels and as a result, revenue related to product sales to this customer was deferred until the related right of exchange period expired in the first quarter of 2010.

        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,

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ARTHROCARE CORPORATION

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

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.

        Although the terms of the agreements with many of the Company's customers provide that title and risk of loss passes to the customer upon shipment, 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 (loss) in all periods is separately reported as "Loss from discontinued operations, net of taxes" in the consolidated statements of comprehensive income. Assets identifiable with these discontinued product lines are reported in the Consolidated Balance Sheet as "Assets held for sale".

        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's goodwill balance is not amortized to expense; instead it is tested for impairment at least annually. The Company performs its annual goodwill impairment test on October 31. If events or indicators of impairment occur between annual impairment analyses, the Company performs an impairment analysis of goodwill at that date.

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ARTHROCARE CORPORATION

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

        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, 2012, the Company performed its required annual goodwill impairment test. The Company determined that it has one reporting unit and thus all of its operations, assets, and liabilities were allocated to the one reporting unit. The closing stock price on October 31, 2012, was $30.08 and the Company had approximately 27.8 million shares of common stock outstanding representing an imputed market capitalization of $836 million. The book value of the Company on October 31, 2012 was $350 million, thus the fair value of the Company's reporting unit exceeds the carrying amount of the reporting unit and no further testing 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.

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ARTHROCARE CORPORATION

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

        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 $0.9 million, $0.6 million and $1.1 million in 2012, 2011 and 2010, respectively.

        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 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

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

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, 2012, 2011 and 2010 or the accounts receivable balance as of December 31, 2012 and 2011.

        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.

        An evaluation is made at the end of each reporting period as to whether or not some or all of the undistributed earnings of foreign subsidiaries are permanently reinvested. While the Company may have concluded in the past that earnings of its foreign subsidiaries are permanently reinvested, facts and circumstances may change in the future based on the estimated capital needs of foreign subsidiaries, or a change in corporate liquidity requirements. Such changes could result in management determining that some or all of such undistributed earnings are no longer permanently reinvested. In that event, the Company would be required to recognize income tax liabilities on the assumption that foreign undistributed earnings will be distributed to the U.S.

        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.

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ARTHROCARE CORPORATION

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

        Investigation and Restatement Related Costs.    Investigation and restatement related costs are expenses 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. These costs include legal expenses, including indemnification costs and forensic accountant fees and incremental external audit costs.

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 2011-05 ("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 results of operations or financial condition.

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 (loss) 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 (loss) and income taxes related to discontinued operations for the year ended December 31, 2011 and 2010 were as follows (in thousands):

 
  Year Ended
December 31,
 
 
  2011   2010  

Revenue

  $ 2,271   $ 5,851  

Gain on sale of assets

    2,177      

Income (loss) from discontinued operations before income taxes

    3,084     (616 )

Income tax provision (benefit)

    1,173     (182 )

Income (loss) from discontinued operations

    1,911     (434 )

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ARTHROCARE CORPORATION

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

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):

 
  Year Ended December 31,  
 
  2012   2011   2010  

Income (loss) from continuing operations allocated to common stockholders (net of $7,370 and $6,061 attributable to Series A Preferred Stock for 2012 and 2010)

  $ 35,433   $ (6,229 ) $ 28,193  

Income (loss) from discontinued operations (net of $77 attributable to Series A Preferred Stock for 2010)

        1,911     (357 )
               

Net income (loss) allocated to common stockholders (net of $7,370 and $5,984 of undistributed earnings to Series A Preferred Stock for 2012 and 2010)

  $ 35,433   $ (4,318 ) $ 27,836  

Basic:

                   

Weighted-average common shares outstanding

    27,752     27,382     27,006  

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

  $ 1.28   $ (0.23 ) $ 1.04  
               

Earnings (loss) from discontinued operations per share allocated to common stockholders

        0.07     (0.01 )
               

Earnings (loss) per share allocated to common stockholders

  $ 1.28   $ (0.16 ) $ 1.03  
               

Diluted:

                   

Weighted-average shares outstanding used in basic calculation

    27,752     27,382     27,006  

Dilutive effect of options

    241         266  

Dilutive effect of unvested restricted stock

    414         76  
               

Weighted-average common stock and common stock equivalents

    28,407     27,382     27,348  

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

  $ 1.25   $ (0.23 ) $ 1.03  
               

Loss from discontinued operations per share allocated to common stockholders

        0.07     (0.01 )
               

Earnings (loss) per share allocated to common stockholders

  $ 1.25   $ (0.16 ) $ 1.02  
               

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

    787     2,531     1,977  

        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.

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 5—INVENTORY

        The following summarizes the Company's inventories (in thousands):

 
  December 31,  
 
  2012   2011  

Raw materials

  $ 10,760   $ 9,146  

Work-in-process

    11,984     10,293  

Finished goods

    30,338     20,852  
           

    53,082     40,291  

Inventory valuation reserves

    (4,665 )   (4,530 )
           

Inventories, net

  $ 48,417   $ 35,761  
           

        In the current year the Company reclassified obsolete inventory from inventory reserves to raw materials, work-in-process and finished goods. The amount of obsolete inventory reclassified at December 31, 2011 resulted in a $4.3 million reduction to the inventory valuation reserve, a $0.1 million reduction to raw materials and $4.2 million reduction to finished goods.

NOTE 6—PROPERTY AND EQUIPMENT

        The following summarizes the Company's property and equipment (in thousands):

 
  December 31,  
 
  2012   2011  

Controller placements

  $ 40,995   $ 42,672  

Computer equipment and software

    26,485     27,456  

Machinery and equipment

    20,867     21,142  

Furniture, fixtures and leasehold improvements

    5,531     5,296  

Building and improvements

    7,280     7,213  

Land

    745     745  

Construction in process

    1,169     595  
           

    103,072     105,119  

Less: accumulated depreciation

    (72,611 )   (69,350 )
           

Total property and equipment, net

  $ 30,461   $ 35,769  
           

        Depreciation expense related to the Company's property and equipment was $15.6 million, $19.3 million and $18.1 million for the years ended December 31, 2012, 2011 and 2010, respectively. Accumulated depreciation for controllers was $21.2 million at December 31, 2012.

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 7—GOODWILL AND INTANGIBLE ASSETS

Goodwill

        The changes in the carrying amount of goodwill are as follows (in thousands):

 
  December 31,  
 
  2012   2011  

Goodwill as of January 1, 2012 and 2011 net of accumulated impairment losses of $18,945

  $ 119,159   $ 119,020  

Business combination

   
405
   
 

Translation adjustments

    329     139  
           

Goodwill as of December 31, 2012 and 2011 net of accumulated impairment losses of $18,945

  $ 119,893   $ 119,159  
           

Intangible assets with finite lives

        Intangible assets consist of the following (in thousands, except weighted average useful life):

 
  December 31,    
 
  Weighted-
Average
Useful Life
 
  2012   2011

Intellectual property rights

  $ 5,199   $ 21,399   8.0 years

Patents

    1,266     9,766   8.2 years

Distribution/customer relationships

    3,597     5,817   6.2 years

Trade name/trademarks

    399     4,199   8.0 years

Non-competition agreements

    313     391   4.4 years
             

    10,774     41,572   7.7 years

Less: accumulated amortization

    (8,915 )   (36,115 )  
             

Total intangible assets, net

  $ 1,859   $ 5,457    
             

        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):

2013

  $ 798  

2014

    234  

2015

    205  

2016

    198  

2017

    176  

Thereafter

    248  
       

  $ 1,859  
       

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 8—ACCRUED LIABILITIES

        The following summarizes the Company's accrued liabilities (in thousands):

 
  December 31,  
 
  2012   2011  

Compensation

  $ 17,031   $ 16,751  

Proposed settlement of private securities class actions

        74,000  

Insurance dispute reserve

    9,729     9,627  

Idemnification expenses

    2,799     1,378  

Other

    12,115     10,830  
           

  $ 41,674   $ 112,586  
           

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 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.

        The Company recognizes rent expense on a straight-line basis over the lease term. Rent expense for 2012, 2011 and 2010 was $6.0 million, $5.4 million and $4.8 million, respectively.

        The Company provides contributions to foundations that promote and support education and research initiatives.

        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 expensed $7.7 million, $6.3 million and $3.0 million for the years ended December 31, 2012, 2011 and 2010, respectively, advanced 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.

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 9—COMMITMENTS (Continued)

        The Company leases certain facilities and equipment under operating leases. At December 31, 2012, total and net future minimum commitments were as follows (in thousands):

 
  Minimum
Lease
Payments
  Other   Sub-lease
Income
  Net
Minimum
Commitments
 

2013

  $ 6,015   $ 102   $ 483   $ 5,634  

2014

    5,707     52     577     5,182  

2015

    4,533         597     3,936  

2016

    4,098         618     3,480  

2017

    3,311         158     3,153  

Thereafter

    13,143             13,143  
                   

  $ 36,807   $ 154   $ 2,433   $ 34,528  
                   

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

        The Department of Justice ("DOJ") is investigating certain of the Company's activities including past sales, accounting, and billing procedures primarily in relation to the operation of its Spine product sales. The DOJ is also reviewing the Companies relationship with its DiscoCare subsidiary. The Company is cooperating with this investigation. In connection with such cooperation, and pursuant to a

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 10—LITIGATION AND CONTINGENCIES (Continued)

request from the DOJ, the Company entered into a statute of limitations tolling agreement with the DOJ effective until February 1, 2013. On January 30, 2013, also as part of its continuing cooperation, the Company entered into a second statute of limitations tolling agreement with DOJ effective until March 1, 2013. The outcome of this investigation could lead to fines, injunctions or orders against future activities being assessed against the Company. At this stage of the investigation, the Company cannot predict the ultimate outcome and are unable to estimate any potential liability it may incur.

False Claims Act Investigation

        The Company received a Civil Investigative Demand 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. The Company is cooperating fully with the investigation, although no assurances can be given regarding the duration of the investigation or whether proceedings will be instituted against the Company. Management intends to represent the Company's interests vigorously in this matter. At this stage of the investigation, however, management cannot predict the ultimate outcome of the investigation or any potential liability the Company may incur.

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. 1:08-cv-00574-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 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-08-3484 (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

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 10—LITIGATION AND CONTINGENCIES (Continued)

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. 1:08-cv-00574-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. 1:08-cv-00574-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.

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, 2012, 2011 and 2010, dividends of $7.9 million, $5.5 million and $3.1 million were accrued, respectively.

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 11—SERIES A 3.00% REDEEMABLE CONVERTIBLE PREFERRED STOCK (Continued)

        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, 2012, 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.

        No conversion of Series A Preferred Stock will be permitted to the extent that any holder of Series A Preferred Stock would individually hold in excess of 19.99 percent of the Company's voting power after the proposed conversion, or to the extent that the holders of Series A Preferred Stock would hold in excess of 17.8 percent of the Company's voting power in the aggregate, in each case solely attributable to their holdings of Series A Preferred Stock and any Common Stock received upon conversion thereof (such limitations collectively, the "Conversion Cap"). Shares of Series A Preferred Stock not convertible as a result of the Conversion Cap shall remain outstanding and shall become convertible to the extent the Conversion Cap no longer applies.

        At any time after September 1, 2014, or in connection with a change in control of the Company, holders of the Series A Preferred Stock may require the Company to redeem any or all outstanding shares of Series A Preferred Stock at the Liquidation Preference amount plus any applicable Make-Whole Adjustment. The Series A Preferred Stock has a maximum redemption value of $87.1 million.

        The Series A Preferred Stock will rank subordinate and junior in right of payments to all indebtedness of the Company. Holders of the Series A Preferred Stock will vote with the Common Stock on an as-converted basis, including any applicable Make-Whole Adjustment. However, no holder of the Series A Preferred Stock shall be permitted to vote more than an equivalent of 19.99 percent of the Company's outstanding voting securities solely attributable to its ownership of the Series A Preferred Stock and any Common Stock received upon conversion thereof. Holders of a majority of the Series A Preferred Stock then outstanding, voting as a separate class, must approve any amendment to the Company's articles of incorporation or bylaws that would adversely affect the rights of the holders of the Series A Preferred Stock.

        The Series A Preferred Stock can be converted into a maximum of 5,805,921 shares of the Company's common stock (the "Conversion Shares") representing a conversion price after the

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 11—SERIES A 3.00% REDEEMABLE CONVERTIBLE PREFERRED STOCK (Continued)

Make-Whole Adjustment of $12.92 (the "Conversion Price"). 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.

        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, 2012, 2011 and 2010 were $1.1 million, $1.0 million and $1.0 million and were recorded as a dividend.

        Pursuant to the Registration Rights Agreement between us and the holders of our Series A Preferred Stock, the Company was required to file a registration statement on Form S-1 prior to September 1, 2010, to register the resale of the Common Stock underlying the Series A Preferred Stock. The Company filed a registration statement on Form S-1 on May 13, 2010, a notice of effectiveness on August 8, 2010, and a Post Effective Amendment on December 6, 2010, to convert the registration statement on Form S-1 to a registration statement on Form S-3. Accordingly, as of December 31, 2012, the Company was in compliance with its registration statement obligations contained in the Registration Rights Agreement.

NOTE 12—STOCKHOLDERS EQUITY

Employee Stock Purchase Plan

        The Company has an Employee Stock Purchase Plan, or ESPP. Under the ESPP, regular full-time U.S. employees (subject to certain exceptions) may 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 33,730 shares remained available for future purchases as of December 31, 2012.

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.

        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, 2012, the Company had 1,556,323 shares remaining available for future grant under the 2003 Plan.

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 12—STOCKHOLDERS EQUITY (Continued)

        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.

        The weighted average fair value of each stock option and SARs granted to employees during the years ended December 31, 2012, 2011 and 2010 was estimated at $12.71, $15.70 and $12.76, respectively. The weighted average fair value of restricted stock awards granted in December 31, 2012, 2011 and 2010 was $26.30, $33.35 and $28.24, 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, 2012, 2011 and 2010:

 
  2012   2011   2010  

Expected term (in years)

    4.4     4.3     4.4  

Expected volatility

    60 %   58 %   56 %

Risk-free interest rate

    0.7 %   1.7 %   1.7 %

Expected dividends

             

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 12—STOCKHOLDERS EQUITY (Continued)

        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)

    3.0  

Expected volatility

    33.5 %

Risk-free interest rate

    0.4 %

Expected dividends

     

        Activity for all stock based compensation plans for the year ended December 31, 2012 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, 2011

    2,131,219   $ 27.89     400,493   $ 32.86  

Granted

    262,734   $ 26.43     220,686   $ 26.30  

Exercised/vested

    (285,103 ) $ 16.91     (127,145 ) $ 37.52  

Canceled/forfeited

    (146,842 ) $ 31.89     (22,382 ) $ 27.89  
                       

Balance as of December 31, 2012

    1,962,008   $ 28.99     471,652   $ 28.77  
                       

Exercisable/Deferred at December 31, 2012

    1,465,524   $ 29.53     39,112   $ 30.41  
                       

        The weighted average remaining contractual term for stock options and SARs outstanding and exercisable at December 31, 2012, is 3.5 and 2.9 years, respectively. The aggregate intrinsic value for stock options and SARs outstanding and exercisable at December 31, 2012, is $14.0 million and $10.4 million, respectively. The total intrinsic value of options and SARs exercised during the years ended December 31, 2012, 2011, and 2010, was $3.8 million, $4.0 million, and $1.2 million, respectively. As of December 31, 2012 there was $5.5 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 3.5 years.

        As of December 31, 2012, there was $8.0 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 2.9 years. The total fair value of shares vested during the years ended December 31, 2012, 2011, and 2010, was $3.6 million, $1.8 million, and $2.5 million, respectively.

        During the year ended December 31, 2012 we granted a maximum of 600,000 awards under the LTIP plan with a weighted average fair value of $17.07. During the year ended December 31, 2012 no expense was recorded related to the LTIP awards and intrinsic value is $0.

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ARTHROCARE CORPORATION

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 12—STOCKHOLDERS EQUITY (Continued)

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, 2012, 2011 and 2010 (in thousands):

 
  Year Ended December 31,  
 
  2012   2011   2010  

Cost of product sales

  $ 586   $ 1,524   $ 1,401  

Research and development

    1,490     850     849  

Sales and marketing

    3,057     1,828     2,282  

General and administrative

    3,483     2,024     3,469  
               

Stock based compensation expense before income taxes

    8,616     6,226     8,001  

Income tax benefit

    2,570     1,690     2,360  
               

Total stock-based compensation expense, net of income taxes

  $ 6,046   $ 4,536   $ 5,641  
               

        Stock-based compensation expense recognized has been reduced for estimated forfeitures at a rate of 5.9 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 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, 2011 and 2012 (in thousands):

 
  (Dollars 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
 

Employee-related

  $   $ 4,559   $ 3,142   $ 1,417   $ 32   $ 1,449   $  

Contract termination and other

        3,741     1,370     2,371     (810 )   652     909  
                               

  $   $ 8,300   $ 4,512   $ 3,788   $ (778 ) $ 2,101   $ 909  
                               

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ARTHROCARE CORPORATION

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 13—EXIT COSTS (Continued)

        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 a sublease for its former Austin, Texas location which decreased the amount accrued for contract termination by $1.1 million.

NOTE 14—INCOME TAXES

        The components of income (loss) before income taxes were as follows (in thousands):

 
  Year Ended December 31,  
 
  2012   2011   2010  

Domestic

  $ 37,095   $ (43,518 ) $ 29,433  

Foreign

    26,612     26,720     20,973  
               

Total

  $ 63,707   $ (16,798 ) $ 50,406  
               

        The amounts identified above exclude income (loss) from discontinued operations before income taxes of $0, $3.1 million and ($0.6 million) for 2012, 2011 and 2010, respectively.

        The income tax provision (benefit) consisted of the following (in thousands):

 
  Year Ended December 31,  
 
  2012   2011   2010  

Current:

                   

Federal

  $ 382   $ 2,938   $ 7,801  

State

    686     848     1,221  

Foreign

    757     518     981  
               

Total current

    1,825     4,304     10,003  

Deferred:

                   

Federal

    15,168     (15,516 )   3,088  

State

    1,337     (2,167 )   (8 )

Foreign

    (1,001 )   (606 )   (195 )
               

Total deferred

    15,504     (18,289 )   2,885  
               

Total income tax provision (benefit)

  $ 17,329   $ (13,985 ) $ 12,888  
               

        The amounts in the table above exclude the income tax provision (benefit) from discontinued operations. These amounts are $0, $1.2 million, and ($0.2 million) for 2012, 2011 and 2010, respectively.

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ARTHROCARE CORPORATION

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 14—INCOME TAXES (Continued)

        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,  
 
  2012   2011   2010  

Tax at federal statutory rate

  $ 22,298   $ (5,879 ) $ 17,642  

State income taxes

    692     (1,304 )   890  

Differences in foreign tax rates

    (9,545 )   (7,759 )   (6,555 )

Stock-based compensation

    585     442     693  

Research and development credits

    (136 )   (1,608 )   (1,276 )

Nondeductible expenses

    166     288     324  

Accruals for intercompany payments

    1,947     1,889     1,814  

Change in estimate for state tax rate

    1,078          

Other

    244     (54 )   (644 )
               

Total income tax provision (benefit)

  $ 17,329   $ (13,985 ) $ 12,888  
               

        The Company's tax expense for the periods 2010 through 2012 was significantly reduced due to a tax holiday for its Costa Rica manufacturing operations. Under its holiday, the Company will not be subject to Costa Rican income tax until January 2016. At that time, unless the tax holiday is extended as a result of future investment, the Company will be subject to the normal Costa Rican corporate taxes, which are currently 30 percent. Without the Costa Rican tax holiday, the increase in income tax expense and the reduction to earnings per share would have been $3.4 million/$0.10 for 2012, $3.0 million/$0.11 for 2011 and $2.7 million/$0.10 for 2010.

        The Company's results of operations reflect 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 do 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 ("Act") on January 2, 2013. Since the Act was enacted during 2013, the income tax benefit related to the federal 2012 research and development tax credit will be reflected in the results of operations for the quarter ended March 31, 2013.

 
  December 31,  
 
  2012   2011  

Federal loss carryover

  $ 40,894   $ 8,945  

State loss carryover

    33,116      

Federal research and development credit carryover

    7,999     8,697  

State research and development credit carryover

    12,346     11,991  

Foreign loss carryover

    1,391     777  

U.S. Alternative Minimum Tax Carryover

    948     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 2031. The Company's state loss carryforward will expire between 2018 and 2032. The

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ARTHROCARE CORPORATION

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 14—INCOME TAXES (Continued)

Company's foreign net operating loss carryforwards, alternative minimum tax credits, and state research and development credits are not subject to expiration.

        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, 2012, approximately $8.9 million of the Company's net operating loss carryforwards are subject to an annual utilization limit of approximately $0.9 million pursuant to IRC Section 382.

        The Company's deferred tax assets and liabilities consist of the following (in thousands):

 
  December 31,  
 
  2012   2011  

Deferred tax assets:

             

Net operating loss carryovers, net of reserves

  $ 13,063   $ 3,348  

R&D and other tax credits, net of reserves

    13,221     12,667  

Allowances and reserves

    5,911     35,150  

Deferred revenue

    4,522     4,500  

Alternative Minimum Tax credit

    948     948  

Stock-based compensation

    6,938     6,607  

Other

    861     820  
           

Gross deferred tax assets

    45,464     64,040  

Valuation allowance

         
           

Subtotal

    45,464     64,040  
           

Deferred tax liabilities:

             

Property and Equipment

    (2,232 )   (4,023 )

Non-goodwill intangibles

    (323 )   (1,265 )
           

Gross deferred tax liabilities

    (2,555 )   (5,288 )
           

Net deferred tax assets

  $ 42,909   $ 58,752  
           

        Income tax benefits resulting from employee stock compensation of $0 million, $0.1 million, and $1.2 million, were credited to additional paid-in capital for the years ended December 31, 2012, 2011 and 2010, 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.

        In 2010, the Company made an adjustment to reduce additional paid-in capital related to past employee stock compensation by $3.2 million to reflect the impact of the amendment and filing of prior year returns for 2006 through 2009.

        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 reinvested undistributed earnings were approximately $66.6 million, $39.0 million, and $17.6 million as of December 31, 2012, 2011, and 2010, respectively. For the same period, the tax impact resulting from a distribution of these earnings would be approximately $24.4 million, $14.3 million, and $6.5 million, respectively. The Company's accounting

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ARTHROCARE CORPORATION

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 14—INCOME TAXES (Continued)

policy is to include interest and penalties related to unrecognized tax benefits as a component of income tax expense.

        The Company's change in gross unrecognized tax benefits during 2012, 2011 and 2010 were as follows (in thousands):

 
  2012   2011   2010  

Balance at January 1

  $ 18,601   $ 16,478   $ 7,078  

Additions for tax positions of current period

    1,848     2,232     2,252  

Additions for tax positions of prior years

            7,384  

Decreases for tax positions of prior years

        (109 )   (236 )
               

Balance at December 31

  $ 20,449   $ 18,601   $ 16,478  
               

        The gross balance of unrecognized tax benefits of $20.4 million excluded $1.5 million of offsetting state tax benefits. The Company recorded interest and penalties on the reserve for uncertain tax positions of $0.2 million, $0.2 million, and $0 million for the years ended December 31, 2012, 2011 and 2010, respectively. At December 31, 2012, 2011, and 2010, the amount of net unrecognized tax benefits that, if recognized, would affect the effective tax rate is $19.3 million, $17.4 million, and $15.2 million, respectively. At December 31, 2012 long-term liabilities included $14.8 million of net unrecognized benefits, $2.8 million of the net unrecognized benefit was recorded against the deferred tax asset for the R&D credit carryovers, and $1.7 was recorded against the deferred tax asset for the net operating loss carryovers.

        In 2010, the Company amended or filed its U.S. income tax returns for its 2006, 2007, 2008 and 2009 tax years. The Company's tax filings were based on its historical intercompany cost sharing and transfer pricing policies whereas the tax liability accrued in prior years was based on certain possible modifications to these policies. The excess income tax payable over the amount reported in the Company's income tax returns of approximately $7.4 million was recorded as an addition for tax positions of prior years during 2010 as reflected in the above table.

        In 2010, the Company was notified by the IRS of its intention to examine the 2006 federal income tax return and this examination was extended to include the 2007, 2008, 2009, and 2010 federal tax returns. The Company has received Notices of Proposed Adjustments from the IRS primarily related to transfer pricing. The Company is preparing for mediation concerning the proposed adjustments from the IRS and intends to vigorously defend its position.

        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 2007 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 2007 through 2012. The years open to adjustment for Sweden and Australia are 2009 through 2012.

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ARTHROCARE CORPORATION

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 15—BUSINESS COMBINATION

        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, 2012 and did not materially affect the results of its operations for the year ended December 31, 2012.

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 2012, 2011 and 2010. The Company's 401(k) Plan expenses were approximately $0.8 million, $0.9 million and $0.9 million for the years ended December 31, 2012, 2011 and 2010, 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, 2012   Year Ended December 31, 2011   Year Ended December 31, 2010  
 
  Americas   International   Total
Product
Sales
  Americas   International   Total
Product
Sales
  Americas   International   Total
Product
Sales
 

Sports Medicine

  $ 155,164   $ 80,631   $ 235,795   $ 149,010   $ 79,337   $ 228,347   $ 160,859   $ 71,120   $ 231,979  

ENT

    82,880     22,835     105,715     81,810     18,429     100,239     79,019     15,270     94,289  

Other

    1,831     7,330     9,161     2,785     6,948     9,733     4,122     8,367     12,489  
                                       

Total Product Sales

  $ 239,875   $ 110,796   $ 350,671   $ 233,605   $ 104,714   $ 338,319   $ 244,000   $ 94,757   $ 338,757  
                                       

        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,  
 
  2012   2011   2010  

United States

  $ 228,883   $ 221,988   $ 226,383  

Non-United States(1)

    121,788     116,331     112,374  
               

Total product sales

  $ 350,671   $ 338,319   $ 338,757  
               

(1)
No additional locations are individually significant.

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ARTHROCARE CORPORATION

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 17—SEGMENT INFORMATION (Continued)

        Long-lived assets by geography at the balance sheet dates shown were as follows (in thousands):

 
  December 31,  
 
  2012   2011  

United States

  $ 109,950   $ 117,527  

Non-United States

    44,434     44,445  
           

Total long-lived assets

  $ 154,384   $ 161,972  
           

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, 2012 and 2011. In the Company's opinion, this unaudited quarterly information has been prepared on the same basis as the consolidated

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ARTHROCARE CORPORATION

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 18—QUARTERLY FINANCIAL INFORMATION (unaudited) (Continued)

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, 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