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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549





Form 10-Q







|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------

For the quarterly period ended June 30, 2009

OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------

For the transition period from  to

Commission File Number: 0-27422





ArthroCare Corporation

(Exact name of registrant as specified in its charter)







|                         |  |                                     
|------------------------ |  | ------------------------------------
|Delaware                 |  | 94-3180312                          
|(State of incorporation) |  | (I.R.S. Employer Identification No.)

7500 Rialto Blvd., Building Two, Suite 100, Austin, Texas 78735

(Address of principal executive offices)

(512) 391-3900

(Registrants telephone number, including area code)





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   ̈    No  x

Indicate by check mark whether the registrant has submitted 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   ̈    No   ̈

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 definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b.2 of the Exchange Act (check one):



|                        |  |   |  |                           |  |  
|----------------------- |  | - |  | ------------------------- |  | -
|Large accelerated filer |  | x |  | Accelerated filer         |  |  ̈
|                        |  |   | 
|Non-accelerated filer   |  |  ̈ |  | Smaller reporting company |  |  ̈

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

As of October 31, 2009, the number of outstanding shares of the Registrants Common Stock was 26,805,565.









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ARTHROCARE CORPORATION

Form 10-Q Quarterly Report

For the quarter ended June 30, 2009

TABLE OF CONTENTS



|                                                                                               |  |   
|---------------------------------------------------------------------------------------------- |  | --
|PART I. FINANCIAL INFORMATION                                                                  |  | 2 
|ITEM 1. FINANCIAL STATEMENTS                                                                   |  | 2 
|CONDENSED CONSOLIDATED BALANCE SHEETS                                                          |  | 2 
|CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS                                                |  | 3 
|CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS                                                |  | 4 
|ITEM 2. 
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |  | 17
|ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                             |  | 25
|ITEM 4. CONTROLS AND PROCEDURES                                                                |  | 27
|PART II. OTHER INFORMATION                                                                     |  | 32
|ITEM 1. LEGAL PROCEEDINGS                                                                      |  | 32
|ITEM 1A. RISK FACTORS                                                                          |  | 32
|ITEM 2. UNREGISTERED SALES OF SECURITIES AND USE OF PROCEEDS                                   |  | 32
|ITEM 3. DEFAULTS UPON SENIOR SECURITIES                                                        |  | 32
|ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS                                  |  | 32
|ITEM 5. OTHER INFORMATION                                                                      |  | 32
|ITEM 6. EXHIBITS                                                                               |  | 32
|SIGNATURES                                                                                     |  | 33
|EXHIBIT INDEX                                                                                  |  | 34
|Exhibit 31.1                                                                                   |  |   
|Exhibit 31.2                                                                                   |  |   
|Exhibit 32.1                                                                                   |  |   
|Exhibit 32.2                                                                                   |  |   
|Exhibit 99.1                                                                                   |  |   



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EXPLANATORY NOTE

We are filing this quarterly report on Form 10-Q for the second quarter of 2009. We experienced substantial delays in filing these reports
with the Securities and Exchange Commission (SEC) as a result of issues identified during a review of accounting issues and internal controls and insurance billing and healthcare compliance issues, conducted under the direction of our
Audit Committee (the Review) which was completed in August 2009. The 2008 Form 10-K contains: (i) our consolidated financial statements and related notes for the year ended December 31, 2008; (ii) a restatement of our
previously issued consolidated financial statements and related notes as of December 31, 2007 and for the years ended December 31, 2007 and December 31, 2006; (iii) selected financial data restated for 2004 through 2007; and
(iv) quarterly financial statements for the eight quarters in 2007 and 2008. For additional information regarding the Review, the background of the restatement, related adjustments and cumulative impact, you should refer to the 2008 Form 10-K.



1



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##### Table of Contents

PART I. FINANCIAL INFORMATION



|ITEM 1. | FINANCIAL STATEMENTS
|------- | --------------------

ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited)

(in thousands, except par value data)



|                                                                                                                                                         |  |              |          |   |                  |   |          |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | -------- | - | ---------------- | - | -------- | -
|                                                                                                                                                         |  | June 30,2009 |          |   | December 31,2008 |  
|ASSETS                                                                                                                                                   |  |              |          |   |                  |   |          |  
|Current assets:                                                                                                                                          |  |              |          |   |                  |   |          |  
|Cash and cash equivalents                                                                                                                                |  | $            | 37,634   |   |                  | $ | 33,506   |  
|Restricted cash equivalents and investments                                                                                                              |  |              | 4,489    |   |                  |   | 4,474    |  
|Accounts receivable, net of allowances of $4,423 and $4,001 at June 30, 2009 & December 31, 2008,
respectively                                           |  |              | 35,965   |   |                  |   | 41,797   |  
|Inventories, net                                                                                                                                         |  |              | 49,024   |   |                  |   | 56,437   |  
|Deferred tax assets                                                                                                                                      |  |              | 29,292   |   |                  |   | 29,265   |  
|Prepaid expenses and other current assets                                                                                                                |  |              | 6,532    |   |                  |   | 8,654    |  
|                                                                                                                                                         |  |              |          |   |                  |   |          |  
|Total current assets                                                                                                                                     |  |              | 162,936  |   |                  |   | 174,133  |  
|                                                                                                                                                         |  |             
|Property and equipment, net                                                                                                                              |  |              | 48,627   |   |                  |   | 48,933   |  
|Intangible assets, net                                                                                                                                   |  |              | 21,152   |   |                  |   | 24,085   |  
|Goodwill                                                                                                                                                 |  |              | 119,781  |   |                  |   | 118,054  |  
|Deferred tax assets                                                                                                                                      |  |              | 16,651   |   |                  |   | 16,651   |  
|Other assets                                                                                                                                             |  |              | 6,423    |   |                  |   | 5,420    |  
|                                                                                                                                                         |  |              |          |   |                  |   |          |  
|Total assets                                                                                                                                             |  | $            | 375,570  |   |                  | $ | 387,276  |  
|                                                                                                                                                         |  |              |          |   |                  |   |          |  
|                                                                                                                                                         |  |             
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                     |  |              |          |   |                  |   |          |  
|Current liabilities:                                                                                                                                     |  |              |          |   |                  |   |          |  
|Accounts payable                                                                                                                                         |  | $            | 15,651   |   |                  | $ | 17,607   |  
|Accrued liabilities                                                                                                                                      |  |              | 63,015   |   |                  |   | 60,200   |  
|Deferred tax liabilities                                                                                                                                 |  |              | 140      |   |                  |   | 129      |  
|Current portion of notes payable                                                                                                                         |  |              | 45,000   |   |                  |   | 55,000   |  
|                                                                                                                                                         |  |              |          |   |                  |   |          |  
|Total current liabilities                                                                                                                                |  |              | 123,806  |   |                  |   | 132,936  |  
|                                                                                                                                                         |  |             
|Deferred tax liabilities                                                                                                                                 |  |              | 375      |   |                  |   | 327      |  
|Deferred revenue                                                                                                                                         |  |              | 3,841    |   |                  |   | 3,210    |  
|Other non-current liabilities                                                                                                                            |  |              | 6,478    |   |                  |   | 6,521    |  
|                                                                                                                                                         |  |              |          |   |                  |   |          |  
|Total liabilities                                                                                                                                        |  |              | 134,500  |   |                  |   | 142,994  |  
|                                                                                                                                                         |  |             
|Commitments and contingencies (Notes 8 and 9)                                                                                                            |  |              |          |   |                  |   |          |  
|                                                                                                                                                         |  |             
|Stockholders equity:                                                                                                                                    |  |              |          |   |                  |   |          |  
|Preferred stock, par value $0.001; Authorized: 5,000 shares; Issued and outstanding: none                                                                |  |              |         |   |                  |   |         |  
|Common stock, par value $0.001; Authorized: 75,000 shares; Issued and outstanding: 26,841 shares at June 30, 2009 and 26,755
shares at December 31, 2008 |  |              | 27       |   |                  |   | 27       |  
|Treasury stock: 4,041 shares at June 30, 2009 and 4,101 shares at December 31, 2008                                                                      |  |              | (109,324 | ) |                  |   | (110,945 | )
|Additional paid-in capital                                                                                                                               |  |              | 376,481  |   |                  |   | 374,089  |  
|Accumulated other comprehensive loss                                                                                                                     |  |              | (602     | ) |                  |   | (3,800   | )
|Accumulated deficit                                                                                                                                      |  |              | (25,512  | ) |                  |   | (15,089  | )
|                                                                                                                                                         |  |              |          |   |                  |   |          |  
|Total stockholders equity                                                                                                                               |  |              | 241,070  |   |                  |   | 244,282  |  
|                                                                                                                                                         |  |              |          |   |                  |   |          |  
|Total liabilities and stockholders equity                                                                                                               |  | $            | 375,570  |   |                  | $ | 387,276  |  
|                                                                                                                                                         |  |              |          |   |                  |   |          |  

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



2



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ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

(in thousands, except per-share data)



|                                            |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|------------------------------------------- |  | -------------------------- | ------ | - | ------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                            |  | Three Months EndedJune 30, |        |   | Six Months EndedJune 30, |  
|                                            |  | 2009                       |        |   | 2008                     |   |        | 2009 |  |   | 2008    |  
|                                            |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|Revenues:                                   |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|Product sales                               |  | $                          | 77,513 |   |                          | $ | 80,623 |      |  | $ | 153,081 |   |  | $ | 155,748 |  
|Royalties, fees and other                   |  |                            | 3,297  |   |                          |   | 5,053  |      |  |   | 6,519   |   |  |   | 7,481   |  
|                                            |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|Total revenues                              |  |                            | 80,810 |   |                          |   | 85,676 |      |  |   | 159,600 |   |  |   | 163,229 |  
|                                            |  |                            |        |  
|Cost of product sales                       |  |                            | 22,073 |   |                          |   | 22,892 |      |  |   | 43,869  |   |  |   | 46,479  |  
|                                            |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|                                            |  |                            |        |  
|Gross profit                                |  |                            | 58,737 |   |                          |   | 62,784 |      |  |   | 115,731 |   |  |   | 116,750 |  
|                                            |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|                                            |  |                            |        |  
|Operating expenses:                         |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|Research and development                    |  |                            | 9,508  |   |                          |   | 7,374  |      |  |   | 17,870  |   |  |   | 15,625  |  
|Sales and marketing                         |  |                            | 30,471 |   |                          |   | 33,595 |      |  |   | 60,137  |   |  |   | 66,156  |  
|General and administrative                  |  |                            | 12,172 |   |                          |   | 22,394 |      |  |   | 24,120  |   |  |   | 30,015  |  
|Amortization of intangible assets           |  |                            | 1,588  |   |                          |   | 1,652  |      |  |   | 3,174   |   |  |   | 3,254   |  
|Reimbursement services                      |  |                            | 98     |   |                          |   | 478    |      |  |   | 266     |   |  |   | 858     |  
|Investigation and restatement-related costs |  |                            | 7,306  |   |                          |   | 678    |      |  |   | 16,030  |   |  |   | 678     |  
|                                            |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|Total operating expenses                    |  |                            | 61,143 |   |                          |   | 66,171 |      |  |   | 121,597 |   |  |   | 116,586 |  
|                                            |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|                                            |  |                            |        |  
|Income (loss) from operations               |  |                            | (2,406 | ) |                          |   | (3,387 | )    |  |   | (5,866  | ) |  |   | 164     |  
|Interest income                             |  |                            | 76     |   |                          |   | 165    |      |  |   | 151     |   |  |   | 381     |  
|Interest expense and bank fees              |  |                            | (1,010 | ) |                          |   | (1,083 | )    |  |   | (2,280  | ) |  |   | (2,205  | )
|Foreign exchange gain (loss), net           |  |                            | (989   | ) |                          |   | (594   | )    |  |   | (1,135  | ) |  |   | 160     |  
|Other income (expense), net                 |  |                            | (6     | ) |                          |   | 48     |      |  |   | (3      | ) |  |   | 63      |  
|                                            |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|Interest and other expense, net             |  |                            | (1,929 | ) |                          |   | (1,464 | )    |  |   | (3,267  | ) |  |   | (1,601  | )
|                                            |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|                                            |  |                            |        |  
|Loss before income taxes                    |  |                            | (4,335 | ) |                          |   | (4,851 | )    |  |   | (9,133  | ) |  |   | (1,437  | )
|                                            |  |                            |        |  
|Income tax provision (benefit)              |  |                            | (1,646 | ) |                          |   | (1,682 | )    |  |   | 63      |   |  |   | (499    | )
|                                            |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|                                            |  |                            |        |  
|Net loss                                    |  | $                          | (2,689 | ) |                          | $ | (3,169 | )    |  | $ | (9,196  | ) |  | $ | (938    | )
|                                            |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|                                            |  |                            |        |  
|Weighted-average shares outstanding:        |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|Basic                                       |  |                            | 26,810 |   |                          |   | 26,607 |      |  |   | 26,798  |   |  |   | 26,562  |  
|Diluted                                     |  |                            | 26,810 |   |                          |   | 26,607 |      |  |   | 26,798  |   |  |   | 26,562  |  
|                                            |  |                            |        |  
|Loss per common share:                      |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|Basic                                       |  | $                          | (0.10  | ) |                          | $ | (0.12  | )    |  | $ | (0.34   | ) |  | $ | (0.04   | )
|                                            |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  
|Diluted                                     |  | $                          | (0.10  | ) |                          | $ | (0.12  | )    |  | $ | (0.34   | ) |  | $ | (0.04   | )
|                                            |  |                            |        |   |                          |   |        |      |  |   |         |   |  |   |         |  

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



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ARTHROCARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)



|                                                                                                                      |  |                          |         |   |      |   |         |  
|--------------------------------------------------------------------------------------------------------------------- |  | ------------------------ | ------- | - | ---- | - | ------- | -
|                                                                                                                      |  | Six Months EndedJune 30, |        
|                                                                                                                      |  | 2009                     |         |   | 2008 |  
|                                                                                                                      |  |                         
|Cash flows from operating activities:                                                                                 |  |                          |         |   |      |   |         |  
|Net loss                                                                                                              |  | $                        | (9,196  | ) |      | $ | (938    | )
|Adjustments to reconcile net loss to net cash provided by operating activities:                                       |  |                          |         |   |      |   |         |  
|Depreciation and amortization                                                                                         |  |                          | 11,804  |   |      |   | 11,056  |  
|Provision for doubtful accounts receivable and product returns                                                        |  |                          | 1,890   |   |      |   | 2,775   |  
|Provision for inventory and warranty reserves                                                                         |  |                          | 1,948   |   |      |   | 1,110   |  
|Non-cash stock compensation expense                                                                                   |  |                          | 2,392   |   |      |   | 5,374   |  
|Deferred taxes                                                                                                        |  |                          | 110     |   |      |   | 165     |  
|Income tax benefits relating to employee stock options                                                                |  |                          |        |   |      |   | (1,280  | )
|Other                                                                                                                 |  |                          | 355     |   |      |   | (563    | )
|Changes in operating assets and liabilities, net of assets acquired and liabilities assumed in business
combinations: |  |                          |         |   |      |   |         |  
|Accounts receivable                                                                                                   |  |                          | 4,635   |   |      |   | (7,037  | )
|Inventories                                                                                                           |  |                          | 5,579   |   |      |   | 2,897   |  
|Prepaid expenses and other current assets                                                                             |  |                          | 1,247   |   |      |   | (4,164  | )
|Accounts payable                                                                                                      |  |                          | (1,870  | ) |      |   | 205     |  
|Accrued liabilities                                                                                                   |  |                          | 3,312   |   |      |   | 20,064  |  
|Deferred revenue                                                                                                      |  |                          | 631     |   |      |   | 52      |  
|                                                                                                                      |  |                          |         |   |      |   |         |  
|                                                                                                                      |  |                         
|Net cash provided by operating activities                                                                             |  |                          | 22,837  |   |      |   | 29,716  |  
|                                                                                                                      |  |                          |         |   |      |   |         |  
|                                                                                                                      |  |                         
|Cash flows from investing activities:                                                                                 |  |                          |         |   |      |   |         |  
|Purchases of property and equipment                                                                                   |  |                          | (8,352  | ) |      |   | (13,527 | )
|Earnout payment for purchase of ATI, net                                                                              |  |                          |        |   |      |   | (483    | )
|Payments for business combinations and purchases of intangible assets                                                 |  |                          | (472    | ) |      |   | (1,375  | )
|Disbursement of loan receivable                                                                                       |  |                          | (180    | ) |      |   | (1,105  | )
|Maturities and other changes in restricted cash equivalents and investments                                           |  |                          | (10     | ) |      |   | 524     |  
|                                                                                                                      |  |                          |         |   |      |   |         |  
|Net cash used in investing activities                                                                                 |  |                          | (9,014  | ) |      |   | (15,966 | )
|                                                                                                                      |  |                          |         |   |      |   |         |  
|                                                                                                                      |  |                         
|Cash flows from financing activities:                                                                                 |  |                          |         |   |      |   |         |  
|Payments for purchases of treasury stock                                                                              |  |                          |        |   |      |   | (11,778 | )
|Repayments on revolving Credit Agreement                                                                              |  |                          | (10,000 | ) |      |   | (5,000  | )
|Proceeds from issuance of common stock, net of issuance costs                                                         |  |                          |        |   |      |   | 171     |  
|Proceeds from exercise of options to purchase common stock, net of issuance costs                                     |  |                          |        |   |      |   | 1,150   |  
|Income tax benefit relating to employee stock options                                                                 |  |                          |        |   |      |   | 1,280   |  
|                                                                                                                      |  |                          |         |   |      |   |         |  
|Net cash used in financing activities                                                                                 |  |                          | (10,000 | ) |      |   | (14,177 | )
|                                                                                                                      |  |                          |         |   |      |   |         |  
|                                                                                                                      |  |                         
|Effect of exchange rate changes on cash and cash equivalents                                                          |  |                          | 305     |   |      |   | 245     |  
|                                                                                                                      |  |                          |         |   |      |   |         |  
|                                                                                                                      |  |                         
|Net increase (decrease) in cash and cash equivalents                                                                  |  |                          | 4,128   |   |      |   | (182    | )
|Cash and cash equivalents, beginning of the period                                                                    |  |                          | 33,506  |   |      |   | 38,249  |  
|                                                                                                                      |  |                          |         |   |      |   |         |  
|Cash and cash equivalents, end of the period                                                                          |  | $                        | 37,634  |   |      | $ | 38,067  |  
|                                                                                                                      |  |                          |         |   |      |   |         |  



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



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ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

NOTE 1  BASIS OF PRESENTATION

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of ArthroCare Corporation (ArthroCare or the Company) and its subsidiaries (collectively, the
Company) have been prepared in accordance with the instructions to Form 10-Q and therefore do not include all information and footnotes necessary for a fair presentation of financial position, results of operations and cash flows in
conformity with U.S. generally accepted accounting principles (GAAP), however, such information reflects all adjustments (consisting of normal recurring adjustments), which are, in the opinion of management, necessary for a fair
statement of the results for the interim periods.

The condensed consolidated financial statements should be read in
conjunction with the consolidated financial statements and notes thereto together with managements discussion and analysis of financial condition and results of operations contained in the 2008 Form 10-K. In the opinion of management, the
accompanying condensed consolidated financial statements reflect all adjustments of a normal recurring nature considered necessary to fairly state the financial position of the Company at June 30, 2009 and December 31, 2008, the results of
its operations for the three and six month periods ended June 30, 2009 and 2008 and its cash flows for the six month periods ended June 30, 2009 and 2008.

In addition, some of the Companys statements in this quarterly report on Form 10-Q may be considered forward-looking and involve risks and uncertainties that could significantly impact expected
results. The results of operations for the three and six month periods ended June 30, 2009 are not necessarily indicative of results for the full year.

Use of Estimates

The unaudited condensed consolidated financial
statements have been prepared in conformity with GAAP, using managements best estimates and judgments where appropriate. These estimates and judgments affect the reported amounts of assets and liabilities and disclosure of the contingent
assets and liabilities at the date of the financial statements. These estimates and judgments will also affect the reported amounts for certain revenues and expenses during the reporting period. Actual results could differ materially from these
estimates and judgments.

Recently Issued Accounting Pronouncements

New accounting pronouncements or changes in existing accounting pronouncements may have a significant effect on the results of operations,
the financial condition, or the net worth of the Companys business operations.

In April 2008, the Financial Accounting
Standards Board (FASB) issued new requirements regarding the determination of the useful lives of intangible assets. These new requirements apply to intangible assets acquired after January 1, 2009. The adoption of these new rules did not have
a material impact on the consolidated financial statements.

In November 2008, the FASB issued guidance on accounting for an
asset acquired in a business combination or in an asset acquisition that an entity does not intend to actively use. The Company adopted this guidance on January 1, 2009, and there was no impact upon adoption.

On January 1, 2009 the Company adopted the revised FASB guidance regarding business combinations. In April 2009, the FASB issued an
amendment to the revised business combination guidance regarding the accounting for assets acquired and liabilities assumed in a business combination that arise from contingencies. There was no impact upon adoption and the effect of this guidance
will depend on the nature and significance of business combinations occurring after the effective date.



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ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)



The FASB guidance on fair value measurement and disclosures became effective
January 1, 2008. However, in February 2008, the FASB delayed the effective date regarding fair value measurement and disclosures of nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in
the financial statements, to January 1, 2009. The adoption of these provisions related to nonfinancial assets and nonfinancial liabilities on January 1, 2009 did not have a material impact on the consolidated financial statements.

In April 2009, the FASB issued guidance on determining fair value when the volume and level of activity for an asset or
liability has significantly decreased, and in identifying transactions that are not orderly. The guidance was effective on a prospective basis for interim and annual periods ending after June 15, 2009. The Company adopted this guidance for the
quarter ended June 30, 2009, and there was no material impact on the consolidated financial statements.

In April 2009,
the FASB issued guidance on the recognition and presentation of other-than-temporary impairments on investments in debt securities. This guidance was effective on a prospective basis for interim and annual periods after June 15, 2009. The
Company adopted this guidance for the quarter ended June 30, 2009, and there was no material impact on the consolidated financial statements.

In April 2009, the FASB issued additional requirements to disclose the fair value of financial instruments which are not recorded at fair value in the financial statements in both their interim and annual
financial statements. The new requirements were effective for the interim and annual periods ending after June 15, 2009 on a prospective basis. The Company adopted these requirements in the quarter ended June 30, 2009.

In May 2009, the FASB issued guidelines on accounting for subsequent events effective for interim and annual periods ending after
June 15, 2009 and the Company adopted them in the quarter ended June 30, 2009. There was no impact on the consolidated financial statements from the adoption of these guidelines. The Company has evaluated subsequent events through the
filing date.

In July 2009, the FASB issued the FASB Accounting Standard Codification (the Codification). The Codification
became the single source of authoritative nongovernmental U.S. GAAP, superceding existing FASB, American Institute of Certified Public Accountants (AICPA), Emerging Issues Task Force (EITF) and related literature. The Codification eliminates the
previous U.S. GAAP hierarchy and establishes one level of authoritative GAAP. All other literature is considered non-authoritative. The Codification was effective for interim and annual periods ending after September 15, 2009. This change in
codification had no impact on the consolidated financial statements.

In August 2009, the FASB issued guidance on the
measurement of fair value. The Company adopted this guidance in the quarter ended September 30, 2009 and there was no material impact on the consolidated financial statements.

In October 2009, the FASB issued amended revenue recognition guidance for arrangements with multiple deliverables. The new guidance
eliminates the residual method of revenue recognition and allows the use of managements best estimate of selling price for individual elements of an arrangement when vendor specific objective evidence (VSOE) or third-party evidence (TPE) is
unavailable. For the Company, this guidance is effective for all new materially modified arrangements entered into on or after January 1, 2011 with earlier application permitted as of the beginning of a fiscal year. Full retrospective
application of the new guidance is optional. The Company is currently assessing its implementation of this new guidance, but does not expect a material impact of the consolidated financial statements.

Fair Value Measurements

The major category of financial assets and liabilities of the Company that are measured at fair value on a recurring basis are short-term investments. In the second quarter of 2009, there was no required
fair value measurements for assets and liabilities measured at fair value on a non-recurring basis.



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)



Fair value is defined in the accounting guidance as the price that would be received
from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value for applicable assets and liabilities, we consider the principal or most
advantageous market in which we would transact and consider assumptions the market participants would use when pricing the asset or liability, such as inherent risk, transfer restriction, and risk of nonperformance.

NOTE 2  COMPREHENSIVE LOSS

The Companys comprehensive income (loss) is included as a component of stockholders equity and is composed of net loss and foreign currency translation adjustments. The following table presents the calculation of comprehensive
loss for the six month periods ended June 30, 2009 and 2008, respectively, (in thousands):



|                                         |  |                          |        |   |      |   |      |  
|---------------------------------------- |  | ------------------------ | ------ | - | ---- | - | ---- | -
|                                         |  | Six Months EndedJune 30, |       
|                                         |  | 2009                     |        |   | 2008 |  
|Comprehensive loss:                      |  |                          |        |   |      |   |      |  
|Net loss                                 |  | $                        | (9,196 | ) |      | $ | (938 | )
|Foreign currency translation adjustments |  |                          | 3,198  |   |      |   | 516  |  
|                                         |  |                          |        |   |      |   |      |  
|Comprehensive loss                       |  | $                        | (5,998 | ) |      | $ | (422 | )
|                                         |  |                          |        |   |      |   |      |  

NOTE 3  COMPUTATION OF LOSS PER SHARE

Basic loss per common share is computed using the weighted average number of shares of common stock outstanding. Diluted loss per common
share is computed using the weighted average number of shares of common stock outstanding and potential shares of common stock when they are dilutive. In periods when a net loss is reported, potential shares from stock awards are not included in the
calculation because they would have an anti-dilutive effect, meaning the loss per share would be reduced. Therefore, in periods when a loss is reported, the calculation of basic and diluted net loss per share results in the same value.



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)



The following is a reconciliation of the numerator, net loss, and the denominator,
number of shares, used in the calculation of basic and diluted loss per share (in thousands, except per-share data):



|                                                                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|----------------------------------------------------------------------------- |  | -------------------------- | ------ | - | ------------------------ | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                              |  | Three Months EndedJune 30, |        |   | Six Months EndedJune 30, |  
|                                                                              |  | 2009                       |        |   | 2008                     |   |        | 2009 |  |   | 2008   |  
|Net loss                                                                      |  | $                          | (2,689 | ) |                          | $ | (3,169 | )    |  | $ | (9,196 | ) |  | $ | (938   | )
|                                                                              |  |                            |        |  
|Basic:                                                                        |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Weighted-average common shares outstanding                                    |  |                            | 26,810 |   |                          |   | 26,607 |      |  |   | 26,798 |   |  |   | 26,562 |  
|                                                                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Basic loss per share                                                          |  | $                          | (0.10  | ) |                          | $ | (0.12  | )    |  | $ | (0.34  | ) |  | $ | (0.04  | )
|                                                                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|                                                                              |  |                            |        |  
|Diluted:                                                                      |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Weighted-average shares outstanding used in basic calculation                 |  |                            | 26,810 |   |                          |   | 26,607 |      |  |   | 26,798 |   |  |   | 26,562 |  
|Dilutive effect of options                                                    |  |                            |       |   |                          |   |       |      |  |   |       |   |  |   |       |  
|Dilutive effect of unvested restricted stock                                  |  |                            |       |   |                          |   |       |      |  |   |       |   |  |   |       |  
|                                                                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Weighted-average common stock and common stock equivalents                    |  |                            | 26,810 |   |                          |   | 26,607 |      |  |   | 26,798 |   |  |   | 26,562 |  
|                                                                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Diluted loss per share                                                        |  | $                          | (0.10  | ) |                          | $ | (0.12  | )    |  | $ | (0.34  | ) |  | $ | (0.04  | )
|                                                                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|                                                                              |  |                            |        |  
|Stock awards excluded from calculation as their effect would be anti-dilutive |  |                            | 1,980  |   |                          |   | 3,322  |      |  |   | 1,980  |   |  |   | 3,322  |  

NOTE 4  INVENTORIES

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



|                             |  |              |        |   |                  |   |        |  
|---------------------------- |  | ------------ | ------ | - | ---------------- | - | ------ | -
|                             |  | June 30,2009 |        |   | December 31,2008 |  
|Raw materials                |  | $            | 9,051  |   |                  | $ | 12,243 |  
|Work-in-process              |  |              | 10,088 |   |                  |   | 9,886  |  
|Finished goods               |  |              | 37,967 |   |                  |   | 42,077 |  
|                             |  |              |        |   |                  |   |        |  
|                             |  |              | 57,106 |   |                  |   | 64,206 |  
|Inventory valuation reserves |  |              | (8,082 | ) |                  |   | (7,769 | )
|                             |  |              |        |   |                  |   |        |  
|Inventories, net             |  | $            | 49,024 |   |                  | $ | 56,437 |  
|                             |  |              |        |   |                  |   |        |  

NOTE 5  PROPERTY AND EQUIPMENT

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



|                                               |  |              |         |   |                  |   |         |  
|---------------------------------------------- |  | ------------ | ------- | - | ---------------- | - | ------- | -
|                                               |  | June 30,2009 |         |   | December 31,2008 |  
|Controller placements                          |  | $            | 39,604  |   |                  | $ | 39,904  |  
|Computer equipment and software                |  |              | 27,822  |   |                  |   | 27,353  |  
|Machinery and equipment                        |  |              | 18,834  |   |                  |   | 17,259  |  
|Furniture, fixtures and leasehold improvements |  |              | 11,794  |   |                  |   | 11,549  |  
|Building and improvements                      |  |              | 6,345   |   |                  |   | 6,339   |  
|Construction in process                        |  |              | 1,564   |   |                  |   | 955     |  
|Land                                           |  |              | 745     |   |                  |   | 745     |  
|                                               |  |              |         |   |                  |   |         |  
|                                               |  |              | 106,708 |   |                  |   | 104,104 |  
|Less: accumulated depreciation                 |  |              | (58,081 | ) |                  |   | (55,171 | )
|                                               |  |              |         |   |                  |   |         |  
|Total property and equipment, net              |  | $            | 48,627  |   |                  | $ | 48,933  |  
|                                               |  |              |         |   |                  |   |         |  



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)



NOTE 6  INTANGIBLE ASSETS

Intangible assets consist of the following (in thousands):



|                                                     |  |              |         |   |                  |   |         |  
|---------------------------------------------------- |  | ------------ | ------- | - | ---------------- | - | ------- | -
|                                                     |  | June 30,2009 |         |   | December 31,2008 |  
|                                                     |  |             
|Intellectual property rights                         |  | $            | 26,901  |   |                  | $ | 26,901  |  
|Patents                                              |  |              | 11,700  |   |                  |   | 11,700  |  
|Trade name/trademarks                                |  |              | 4,828   |   |                  |   | 4,828   |  
|Distribution/customer relationships                  |  |              | 6,272   |   |                  |   | 6,049   |  
|Licensing, employment and non-competition agreements |  |              | 1,096   |   |                  |   | 1,084   |  
|                                                     |  |              |         |   |                  |   |         |  
|                                                     |  |              | 50,797  |   |                  |   | 50,562  |  
|Less: accumulated amortization                       |  |              | (29,645 | ) |                  |   | (26,477 | )
|                                                     |  |              |         |   |                  |   |         |  
|Total intangible assets, net                         |  | $            | 21,152  |   |                  | $ | 24,085  |  
|                                                     |  |              |         |   |                  |   |         |  

NOTE 7  ACCRUED LIABILITIES

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



|                                   |  |              |        |                  |   |       
|---------------------------------- |  | ------------ | ------ | ---------------- | - | ------
|                                   |  | June 30,2009 |        | December 31,2008
|                                   |  |             
|Legal fees and arbitration accrual |  | $            | 24,343 |                  | $ | 24,250
|Insurance dispute reserve          |  |              | 16,300 |                  |   | 16,195
|Compensation                       |  |              | 11,380 |                  |   | 7,920 
|Royalties and discounts            |  |              | 1,941  |                  |   | 1,575 
|Agent commissions                  |  |              | 1,684  |                  |   | 2,550 
|Acquisition costs                  |  |              | 1,635  |                  |   | 1,635 
|Marketing costs                    |  |              | 1,184  |                  |   | 1,660 
|Professional fees                  |  |              | 2,076  |                  |   | 1,874 
|Other                              |  |              | 2,472  |                  |   | 2,541 
|                                   |  |              |        |                  |   |       
|                                   |  | $            | 63,015 |                  | $ | 60,200
|                                   |  |              |        |                  |   |       

On May 26, 2009, the Company entered into a Settlement Agreement and Release (the
Settlement Agreement) with State Farm Mutual Automobile Insurance Company, State Farm Fire & Casualty Insurance Company and their affiliates (collectively, State Farm) regarding prior claims for reimbursement made to
State Farm related to cases in which letters of protection were held by DiscoCare. Pursuant to the Settlement Agreement, State Farm and ArthroCare each released the other and the others subsidiaries and affiliates generally from any claims,
demands, losses and liabilities occurring prior to the date of the Settlement Agreement, other than third party claims. In consideration of the mutual releases, and without admitting any liability or wrongdoing, the Company agreed to pay State Farm
an aggregate of $2.5 million which has reduced the Companys accrued liabilities when paid in the second and third quarters of 2009. In addition, the Company agreed that it will not seek payment from State Farm on any pending SpineWand claims
for which the SpineWand surgical device was provided in exchange for a letter of protection.

NOTE 8  COMMITMENTS

Operating Leases

The Company leases facilities and certain equipment under operating leases. The Company recognizes rent expense on a straight-line basis over the lease term. Rent expense was $1.5 million and $1.4 million
for the quarter ended June 30, 2009 and 2008, respectively. Rent expense for the six months ended June 30, 2009 and 2008 was $3.0 million in each period. There have been no significant changes to the Companys future lease commitments
during the six months ended June 30, 2009.



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)



Purchase Commitments

The Company is a party to a variety of agreements pursuant to which it may be obligated to purchase products from other parties. Typically,
these obligations arise in the context of contracts entered into by the Company in the normal course of business. During the six months ended June 30, 2009, there were no material changes from the Companys contractual obligations
presented in its 2008 Annual Report on Form 10-K.

Contingent Payments

Certain of the Companys agreements for purchase business combinations and intangible asset purchases include provisions to provide
additional consideration if contractually specified conditions related to the acquired business or assets are achieved. At June 30, 2009, liabilities have been recorded for conditions which have been or are expected to be met based on current
information available.

NOTE 9  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 the Companys 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 they are probable and reasonably estimable. Except as otherwise specifically
noted, the Company currently cannot determine the ultimate resolution of the matters described below. For matters where the likelihood or extent of a loss is not probable or cannot be reasonably estimated, the Company has not recognized in its
consolidated financial statements the potential liability that may result from these matters. If one or more of these matters is determined against the Company, it could have a material adverse effect on the Companys earnings, liquidity and
financial condition.

SEC Investigation

The Fort Worth Regional Office of the SECs Division of Enforcement is conducting a formal investigation into accounting matters related
to the restatement of financial results described in Note 2, Restatement of Previously Issued Consolidated Financial Statements in the notes to the consolidated financial statements of our Annual Report on Form 10-K for the year ended
December 31, 2008. The Company is cooperating with the SEC investigation. At this stage of the investigations, the Company cannot predict the ultimate outcome and is unable to estimate any potential liability that the Company may incur.

DOJ Investigation

The U.S. Department of Justice (DOJ) is investigating certain of the Companys activities including past sales, accounting, and billing procedures in relation to, primarily, the operation
of the Companys Spine business unit. The DOJ is also reviewing the Companys relationship with its DiscoCare, Inc. (DiscoCare) subsidiary. Specifically, the Company has also been informed by the Office of the U.S. Attorney for
the Southern District of Florida that the Company and its DiscoCare subsidiary are targets of a grand jury investigation being conducted by that Office. The Company has also been informed that the Office of the U.S. Attorney for the Western District
of North Carolina is conducting a separate grand jury investigation of the Company that is related to the investigation being conducted in the Southern District of Florida. The Company is cooperating with these investigations. At this stage of the
investigation, the Company cannot predict the ultimate outcome and is unable to estimate any potential liability that the Company may incur.

Private Securities Class Action and Shareholder Derivative Lawsuits

Federal Court Actions

On April 4, 2008, a putative securities class action was filed in Federal court in
the Southern District of Florida against the Company and certain of its 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 the Companys internal controls, business, and financial results. On October 28, 2008, the court granted
the Companys motion to transfer this case to the U.S. District Court, Western District of Texas (McIlvaine v. ArthroCare, et al).



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)



On July 25, 2008, a putative securities class action was filed in Federal court in
the Western District of Texas against the Company, and certain of its current and 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 the Companys internal controls, business, and financial results. (Strong v. ArthroCare, et
al).

On August 7, 2008, a derivative action was filed in Federal court in the Southern District of Florida against
the Company and its then-current directors alleging breach of fiduciary duty based on the Companys 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. On October 14, 2008, the court granted the Companys motion to transfer this case to the U.S. District Court, Western District of Texas (Weil v. Baker, et al).

On March 4, 2009, a derivative action was filed in Federal court in the Western District of Texas against the Companys current
directors, a former director, certain of its current and former executive officers and other employees and PricewaterhouseCoopers LLP alleging (i) disgorgement under Section 304 of the Sarbanes-Oxley Act; (ii) violations of
Section 10(b) of the Exchange Act and Rule 10b-5; (iii) breach of fiduciary duty; (iv) abuse of control; (v) gross mismanagement of the Company; (vi) waste of corporate assets; (vii) insider trading; and
(viii) unjust enrichment. (King v. Baker, et al).

On April 29, 2009, a derivative action was filed in Federal
court in the Western District of Texas against the Companys current directors and a former director alleging breach of fiduciary duty based on its 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. (Barron v. Baker, et al).

On October 28, 2008 and thereafter, the two putative securities class actions and the 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. On December 10, 2008, Lead Plaintiffs and Lead Plaintiffs counsel were appointed in the putative consolidated securities class
action. The Lead Plaintiff has been ordered to file an Amended Consolidated Class Action Complaint within thirty (30) days of the Companys filing of the 2008 Form 10-K. The federal court stayed derivative actions pending the
resolution of all motions to dismiss the Amended Consolidated Class Action Complaint and any further amended consolidated class action complaints.

At this stage of the above-described Federal Court actions, the Company cannot predict the ultimate outcome and the Company is unable to estimate any potential liability it may incur.

State Court Actions

On September 23, 2008, a derivative action was filed in Texas State District Court against the Company, and its then current directors and certain of its current and former officers. (Wieser v. Baker). In this action, one of the
Companys 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 October 20, 2008, a derivative action was filed in Texas State District Court against the Company, its then directors and certain of its current and former executive officers. (Bocklet v.
Baker). In this action, one of the Companys shareholders alleged derivative claims on behalf of the Company that its directors and officers breached their fiduciary duties to shareholders by failing to maintain adequate financial controls
over revenue recognition, allowing improper financial reporting, disseminating false financial statements, and engaging in insider trading.



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)



On October 27, 2008, a derivative action was filed in Texas State District Court
against the Company, its then directors and certain of its current and former executive officers. (Guthrie v. Baker). In this action, one of the Companys shareholders alleged derivative claims on behalf of the Company that its directors
and officers breached their fiduciary duties to shareholders by failing to maintain adequate financial controls over revenue recognition, allowing improper financial reporting, disseminating false financial statements, and engaging in insider
trading.

On March 18, 2009, these three 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. On the Companys motion, the case was stayed until October 1, 2009. The Company renewed its motion to stay, which was
granted through December 1, 2009, with leave to file a further motion to stay the case.

At this stage of the
above-described State Court actions, the Company cannot predict the ultimate outcome and the Company is unable to estimate any potential liability that it may incur.

Patent Matters

On November 14, 2007, the Company brought a
lawsuit against Gyrus Medical Inc., Gyrus ENT L.L.C. and Gyrus ACMI Inc., Case No. 1:07-CV-00729-SLR in the U.S. District Court for the District of Delaware, in which the Company sought monetary damages and equitable relief for claims of patent
infringement relating to U.S. Patent No. 5,697,882 (the 882 Patent). In the lawsuit, the Company alleged that the use of Gyruss PlasmaCision and PlasmaKinetic products and systems infringes
the 882 Patent. Gyrus sought invalidation of our 882 Patent based on alleged inequitable conduct and alleged prior art. On October 8, 2009, the parties reached a settlement of this matter. In accordance with the settlement,
Gyrus will make a one-time payment to the Company of $2.5 million and the Company will receive certain licenses subject to running royalties ranging from 4 percent to 6.5 percent and payable quarterly from October 2009 through January 2012, when the
882 patent expires. The parties will also release each other from any claims of patent infringement and dismiss the litigation upon Gyruss $2.5 million payment, which will be made concurrently with any payment to Gyrus in connection with
the resolution of the Gyrus arbitration matter described below.

On May 5, 2008, Gyrus Medical Ltd. and Gyrus Group PLC
commenced an arbitration proceeding against the Company. In its arbitration notice, Gyrus alleged that, under the Settlement Agreement dated June 28, 1999 among the Company, Gyrus Medical Ltd., and Ethicon, Inc. and certain Ethicon affiliates
(collectively, Ethicon), the Company made material changes to certain of its arthroscopy products  the Super TurboVac 90, the UltraVac, the Super MultiVac 50, the TurboVac 90XL and the MultiVac XL  and that those
products infringed two Gyrus patents. Shortly thereafter, on June 12, 2008, Ethicon and DePuy Mitek, Inc. joined the arbitration (Gyrus, Ethicon and DePuy Mitek collectively, the Claimants). The Company filed a counterclaim in the
arbitration for breach of the Settlement Agreement, alleging that Ethicon had not paid certain royalties when due under the Settlement Agreement.

On June 10, 2009, the arbitration panel issued its interim decision and award. The panel ruled in favor of the Claimants on all issues, including the patent infringement and breach of contract
claims, and against the Company on its breach of contract counterclaim. The panel issued a final award on August 20, 2009 and awarded the Claimants (i) $11.8 million for royalties on the patents due from April 2001 through February 2009,
including pre-judgment interest of 10 percent through September 15, 2009 which continues to accrue thereafter until paid; (ii) a 6.5 percent royalty for all sales of the infringing products starting from March 1, 2009; and
(iii) $4.6 million in attorneys fees and costs, including the costs of the arbitration.

On July 15, 2009, the
Company filed a Petition to vacate or modify the Arbitration Award and to stay enforcement of the arbitration award. This petition was filed in the U.S. District Court for the Northern District of California.



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)



NOTE 10  DEBT

On January 13, 2006, the Company entered into a 5-year revolving Credit Agreement (the Credit Agreement) with a syndicate of
bankers (collectively, the Lenders). Borrowings under the Credit Agreement bear interest at a rate equal to the lenders prime rate (3.25 percent at December 31, 2008) plus a percentage ranging from 0.75 percent to 2.0
percent or, at the Companys option, at LIBOR plus a percentage ranging from 2.0 percent to 3.25 percent, based on its operating leverage ratio. Borrowings are secured by essentially all assets of the U.S. companies. At June 30,
2009 the Company had $45.0 million in outstanding balances under the Credit Agreement and a weighted average interest rate applicable to the borrowings under the Credit Agreement of 6.8 percent.

The Credit Agreement contained customary representations and warranties, as well as affirmative, negative and financial covenants, which
limited, among other things, the Companys ability to incur indebtedness and liens, enter into business combination transactions and cause its subsidiaries to declare and pay dividends to the Company or its subsidiaries.

On July 21, 2008, the Company announced that it would restate its previously reported financial statements. In a letter dated
July 29, 2008, Bank of America, N.A., as Administrative Agent under the Credit Agreement consented to an extension of the deadline for delivery of its June 30, 2008 financial statements to September 15, 2008. On
September 15, 2008 the Company received a letter from the Administrative Agent consenting to a further extension of the deadline to December 1, 2008 for delivery of the Companys financial statements for the periods ending
June 30, 2008 and September 30, 2008.

On November 26, 2008, the Company entered into a Second Amendment and
Consent with respect to the Credit Agreement. Pursuant to the Second Amendment and Consent, the Administrative Agent and the Lenders consented to the extension of the delivery deadline for the Companys June 30, 2008 and
September 30, 2008 financial statements from December 1, 2008 to the earliest of (a) the end of business on March 2, 2009, (b) the date on which the Company receives notice from Nasdaq Stock Market LLC (Nasdaq)
that its common stock will be delisted from the Nasdaq Global Select Market, (c) the date that the Companys common stock is delisted from the Nasdaq Global Select Market and (d) the date on which the Company receives notice from
Nasdaq that its requested extension of time for delivery of its June 30, 2008 and September 30, 2008 financial statements has been denied. In addition, pursuant to the Second Amendment and Consent, the commitment fees, letter of credit
fees and interest rates that the Company will pay and any given leverage ratio was increased. Finally, the Second Amendment and Consent contained other changes relating to the determination of the interest rate applicable to loans that are
determined with reference to the LIBOR.

On January 14, 2009, the Company received a letter from the Nasdaq Listing
Qualifications Panel (the Panel) stating that the Panel has determined to delist and suspend trading of its common stock on Nasdaq effective at the open of trading on January 16, 2009. The Panels delisting notice
constituted an event of default under the Credit Agreement. On January 16, 2009 the Company received a waiver from the Lenders and the Administrative Agent relating to the event of default resulting from the delisting of its stock. Under
the terms of the waiver, the Company paid $10 million of the principal amount (plus accrued and unpaid interest) outstanding under the Credit Agreement. The other terms of the waiver are substantially identical to the Second Amendment and
Consent of November 26, 2008.

On February 23, 2009, the Company received a letter from the Administrative Agent
asserting that certain Events of Default (as defined in the Credit Agreement) exist under the Credit Agreement, including Events of Default resulting from:



| |  |  | failure to maintain a Consolidated EBITDA (as defined in the Credit Agreement) of $50 million or greater for each of the 12-month periods ended
March 31, 2008, June 30, 2008 and September 30, 2008;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the Companys failure to deliver certain documentation that was required to be delivered to the Agent in connection with the Lenders consent
to the Company making a construction loan of up to $3 million to an unrelated third party commencing in the second quarter of 2008;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)



| |  |  | the breach of a representation in the Credit Agreement resulting from the occurrence of an Internal Control Event (which, as defined in the Credit
Agreement, means a material weakness in, or fraud that involves management or other employees who have a significant role in, the Companys internal control over financial reporting, in each case as described in the securities laws) associated
with deficiencies in the Companys internal control over financial reporting; and
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the breach of several covenants and representations contained in the Credit Agreement and the occurrence of a Material Adverse Effect (as defined in
the Credit Agreement), which the Company believes were alleged to exist as the result of certain improper practices in the insurance billing and healthcare compliance practices.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The letter also notified the Company that the Lenders are not required to honor and do not intend to honor further extensions of credit
under the Credit Agreement. Additionally, the Administrative Agent and Lenders stated that while they were not presently exercising any of their rights, powers, or remedies available to them with respect to the alleged Events of Default (which
include the right to accelerate the maturity of the remaining $45 million of indebtedness outstanding under the Credit Agreement), all such rights, powers and remedies were expressly reserved. As a result of the February letter, the Company
wrote-off the remaining unamortized debt issuance costs of $0.3 million in the first quarter of 2009. On March 20, 2009, the Company received a letter from the Administrative Agent notifying the Company that it would be required to pay interest
on the principal amount of all outstanding obligations at the Default Rate, as defined in the Credit Agreement.

On
April 1, 2009, the Company received a letter from the Administrative Agent notifying the Company that as a result of the existence of certain Events of Default under the Credit Agreement, the Administrative Agent, at the request of the Lenders,
terminated the commitments of the Lenders to make additional loans and the Administrative Agent to make credit extensions including letters of credit under the Credit Agreement, effective as of close of business on March 31, 2009.

See Note 15, Subsequent Events.

NOTE 11  STOCKHOLDERS EQUITY

In 2007, the Board of Directors
authorized the purchase of up to $75.0 million in shares of the Companys common stock. In February 2008, the Board of Directors authorized the purchase of an additional $75.0 million in shares of the Companys stock. The Company did not
purchase any additional shares. In September 2009, the Board of Directors cancelled the additional repurchase authorization.

NOTE
12  LOAN RECEIVABLE

The Company loaned $2.5 million to its primary sterilization subcontractor with
proceeds used to construct the subcontractors Costa Rican sterilization facility. The loan, which is recorded in other assets in the accompanying condensed consolidated balance sheet, bears interest at a rate of 7.0 percent and calls for
repayment during the period of 2010 through 2015. The loan is secured by all of the subcontractors assets in Costa Rica.

NOTE
13  FAIR VALUE MEASUREMENTS

At June 30, 2009, restricted short-term investments were fair valued at
$0.1 million based on quoted prices from active markets. The Companys short term investments consist primarily of corporate bonds. The carrying amount reported in the condensed consolidated balance sheet as of June 30, 2009 for loan
receivable and notes payable is $2.7 million and $45.0 million, respectively. Using a discounted cash flow technique that incorporates market interest rates with adjustments for duration and risk profile, the Company has determined that the fair
value of its loan receivable and notes payable approximate their carrying value at June 30, 2009.



14



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)



NOTE 14  SEGMENT INFORMATION

ArthroCare has organized its marketing and sales efforts based on three operating segments which are aggregated into one reportable
segmentthe development, manufacture and marketing of disposable devices for less invasive surgical procedures. Each of the Companys business units has similar economic characteristics, technology, manufacturing processes, customers,
distribution and marketing strategies, regulatory environments, and shared infrastructures. These business units are Sports Medicine, ENT, and Spine.

Product sales by business unit for the periods shown were as follows (in thousands):



|                    |  |                            |        |                          |   |        |  |      |         |  |   |        
|------------------- |  | -------------------------- | ------ | ------------------------ | - | ------ |  | ---- | ------- |  | - | -------
|                    |  | Three Months EndedJune 30, |        | Six Months EndedJune 30,
|                    |  | 2009                       |        | 2008                     |   | 2009   |  | 2008
|                    |  |                            |        |                         
|Sports Medicine     |  | $                          | 49,845 |                          | $ | 52,521 |  | $    | 100,019 |  | $ | 102,134
|ENT                 |  |                            | 22,645 |                          |   | 21,510 |  |      | 42,884  |  |   | 41,473 
|Spine               |  |                            | 5,023  |                          |   | 6,592  |  |      | 10,178  |  |   | 12,141 
|                    |  |                            |        |                          |   |        |  |      |         |  |   |        
|Total Product Sales |  | $                          | 77,513 |                          | $ | 80,623 |  | $    | 153,081 |  | $ | 155,748
|                    |  |                            |        |                          |   |        |  |      |         |  |   |        

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):



|                      |  |                            |        |                          |   |        |  |      |         |  |   |        
|--------------------- |  | -------------------------- | ------ | ------------------------ | - | ------ |  | ---- | ------- |  | - | -------
|                      |  | Three Months EndedJune 30, |        | Six Months EndedJune 30,
|                      |  | 2009                       |        | 2008                     |   | 2009   |  | 2008
|                      |  |                            |        |                         
|United States         |  | $                          | 55,035 |                          | $ | 54,649 |  | $    | 108,814 |  | $ | 108,675
|Non-United States (1) |  |                            | 22,478 |                          |   | 25,974 |  |      | 44,267  |  |   | 47,073 
|                      |  |                            |        |                          |   |        |  |      |         |  |   |        
|Total Product Sales   |  | $                          | 77,513 |                          | $ | 80,623 |  | $    | 153,081 |  | $ | 155,748
|                      |  |                            |        |                          |   |        |  |      |         |  |   |        



|(1) | No additional locations are individually significant.
|--- | -----------------------------------------------------

Long-lived assets by geography were as follows (in thousands):



|                        |  |              |        |                  |   |       
|----------------------- |  | ------------ | ------ | ---------------- | - | ------
|                        |  | June 30,2009 |        | December 31,2008
|                        |  |             
|United States           |  | $            | 32,903 |                  | $ | 34,706
|Costa Rica              |  |              | 13,066 |                  |   | 11,830
|Other                   |  |              | 6,647  |                  |   | 6,254 
|                        |  |              |        |                  |   |       
|Total long-lived assets |  | $            | 52,616 |                  | $ | 52,790
|                        |  |              |        |                  |   |       



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##### Table of Contents

ARTHROCARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)



NOTE 15  SUBSEQUENT EVENTS

Credit Agreement

On August 14, 2009, the Company signed a Third Amendment to the Credit Agreement and Forbearance Agreement (the Forbearance Agreement) with respect to the Credit Agreement. The
Forbearance Agreement became effective upon the Company meeting certain conditions, including (but not limited to): the Company being current in payments on all interest on loans and letter of credit fees; a payment of $7.5 million of the
outstanding principal indebtedness; a forbearance fee equal to 0.75 percent of the outstanding Commitments after taking account of the $7.5 million reduction to principal described above with the fee to be paid (i) 0.50 percent on the effective
date of the Forbearance Agreement and (ii) 0.25 percent due on October 1, 2009 unless all indebtedness under the Credit Agreement shall have been fully repaid before October 1, 2009, in which case the 0.25 percent amount shall be
waived; the delivery of a collateral questionnaire to the Administrative Agent and consenting Lenders; and the payment of all fees and expenses incurred by the Administrative Agent.

On September 1, 2009, the Company repaid all outstanding indebtedness under the Credit Agreement, all rights and obligations under the
Credit Agreement have been terminated and all security interests and other encumbrances have been released, other than the Companys obligations with respect to a letter of credit in favor of an affiliate of one of the Lenders in the amount of
750,000, which was cash collateralized in the approximate amount of $1.4 million.

Securities Purchase Agreement

On September 1, 2009, the Company issued and sold to OEP AC Holdings, LLC (OEP) 75,000 shares of the
Companys Series A 3.0 Percent 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.

The Company used approximately $39 million
of the proceeds to repay all outstanding indebtedness under the Credit Agreement and to cash collateralize the letter of credit. After the repayment of the Credit Agreement and the payment of fees and expenses related thereto and to the
issuance of the Preferred Stock to OEP, the Company had approximately $35 million of net proceeds, which the Company intends to use together with cash from operations to fund its general business requirements.

The Series A Preferred Stock is subordinate and ranks junior in right of payment 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. The holders of the Series A Preferred Stock may convert Series A Preferred Stock at any time, in whole or in part, into shares
of Common Stock, 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, 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 (a) the number of additional shares
of Series A Preferred Stock the holder would have otherwise been paid during the Dividend Duration Period, multiplied by (b) the Conversion Rate.

Holders of the Series A Preferred Stock will not be permitted to transfer or dispose of its interest in the Series A Preferred Stock other than to certain of its affiliates and will not convert any Series
A Preferred Stock into shares of the Companys Common Stock for one year from the date of issuance, absent certain reorganization events occurring prior to that date.

At any time after September 1, 2014, or in connection with a change in control, holders may require the Company to redeem any or all
outstanding shares of Series A Preferred Stock at the Liquidation Preference of such redeemed Series A Preferred Stock including any applicable make-whole adjustment.



16



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##### Table of Contents

|ITEM 2. | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|------- | -------------------------------------------------------------------------------------

The following discussion should be read in conjunction with the condensed consolidated financial statements and notes thereto appearing
elsewhere in this Form 10-Q. Readers should also review carefully 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. Unless otherwise noted, all financial information provided in this report gives effect to our restatement. Statements in this Managements Discussion and
Analysis of Financial Condition and Results of Operations and elsewhere in this quarterly report on Form 10-Q which express that we believe, anticipate, expect or plan to as well as other statements
which are not historical fact, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and are subject to the safe harbors created under the Securities Act of 1933 and the Securities Exchange Act of
1934. Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties, and assumptions that are difficult to predict. As such, actual events or results may differ materially as a result of the
risks and uncertainties described herein and elsewhere including, but not limited to, those factors discussed in Risk Factors set forth in Part I of our 2008 Form 10-K. In this quarterly report on Form 10-Q, the terms the
Company, we, us and our refer to ArthroCare Corporation and its subsidiaries.

Restatement

We restated our previously issued consolidated financial statements and related notes as of
December 31, 2007 and for the years ended December 31, 2007 and December 31, 2006 as well as our quarterly condensed consolidated financial statements for each of the quarters in 2007 and the first quarter of 2008, as discussed in
Note 2, Restatement of Previously Issued Consolidated Financial Statements, to the Consolidated Financial Statements in our 2008 Form 10-K.

Overview

During the quarter ended June 30, 2009, continuing
through the date of this report, our results of operations, financial position and cash flows were adversely affected by the effect that the Review and the restatement had on our management and employees, the significant costs of the Review and
restatement, and our failure to maintain compliance with covenants in our revolving Credit Agreement. Certain of the facts and circumstances that necessitated the Review and restatement have led to legal and administrative proceedings against us,
which continue to adversely affect, and to contribute to uncertainty with respect to, our results of operations, financial position and cash flows. For additional information regarding these legal and administrative proceedings, please see
Part IIItem 1Legal Proceedings, and Note 9 in this Form 10-Q and Note 2, Restatement of Previously Issued Consolidated Financial Statements, in the notes to the Consolidated Financial Statements in our 2008 Form
10-K.

Our restatement was announced in July 2008. The restatement process has included a thorough and comprehensive review of
our accounting policies and practices to evaluate compliance with GAAP; implementing revised accounting policies, and enhancing or developing new systems to track, value and account for our transactions. In connection with the Review and
restatement, we identified errors in our accounting and material weaknesses in our internal control over financial reporting. For a description of material weaknesses identified by management as a result of the Audit Committees Review and
managements plan to remediate those material weaknesses, see Part I  Item 4  Controls and Procedures.

Summary of Second Quarter and Year-to-Date Results

In February
2009, the Audit Committee Review identified certain facts relating to particular insurance reimbursement issues in the Companys DiscoCare and DRS subsidiaries and healthcare compliance issues associated with our Spine, Sports Medicine, and ENT
business units. We announced the resignation of our President and Chief Executive Officer; and, the Securities and Exchange Commission issued a formal order of investigation and we were informed that the Company was a target of an investigation
being conducted by the U.S. Attorneys offices in the Southern District of Florida and in North Carolina. These events resulted in a number of distractions to our management team that impacted our operating performance during the first and
second quarters of 2009.



17



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##### Table of Contents

Total revenue for the quarter ended June 30, 2009 was $80.8 million, a decrease of 5.7
percent compared to the quarter ended June 30, 2008 as a result of foreign exchange translation of our international product sales and royalty revenue. For the quarter ended June 30, 2009, we had a loss from operations of $2.4 million
compared to a loss from operations of $3.4 million for the same period in 2008. Investigation and restatement-related expenses totaled $7.3 million for the second quarter of 2009 and were the primary cause for the loss from operations in the
quarter. The net loss for the quarter ended June 30, 2009 was $2.7 million compared to a net loss for the second quarter of 2008 of $3.2 million.

Total revenue for the six months ended June 30, 2009 was $159.6 million, a decrease of 2.2 percent compared to the six months ended June 30, 2008 primarily as a result of foreign exchange
translation of our international product sales and royalty revenue. For the six months ended June 30, 2009, we had loss from operations of $5.9 million compared to operating income of $0.2 million for the same period in 2008. Investigation and
restatement-related expenses totaled $16.0 million for the six months ended June 30, 2009 and were the primary cause for the loss from operations. The net loss for the six months ended June 30, 2009 was $9.2 million compared to a loss for
the six months ended June 30, 2008 of $0.9 million.



18



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##### Table of Contents

Results of Operations

Results of operations for the three and six months ended June 30, 2009 and 2008 (in thousands, except percentages and per-share data)
were as follows:



|                                             |  |                            |        |   |                          |       |   |         |   |        |                |  |       |         |  |   |                |   |  |         |   |  |                |         |   |  |       |  
|-------------------------------------------- |  | -------------------------- | ------ | - | ------------------------ | ----- | - | ------- | - | ------ | -------------- |  | ----- | ------- |  | - | -------------- | - |  | ------- | - |  | -------------- | ------- | - |  | ----- | -
|                                             |  | Three Months EndedJune 30, |        |   | Six Months EndedJune 30, |      
|                                             |  | 2009                       |        |   | 2008                     |       |   | 2009    |   |        | 2008           | 
|                                             |  | Dollars                    |        |   | % TotalRevenue           |       |   | Dollars |   |        | % TotalRevenue |  |       | Dollars |  |   | % TotalRevenue |   |  | Dollars |   |  | % TotalRevenue |        
|Revenues:                                    |  |                            |        |   |                          |       |   |         |   |        |                |  |       |         |  |   |                |   |  |         |   |  |                |         |   |  |       |  
|Product sales                                |  | $                          | 77,513 |   |                          | 95.9  | % |         | $ | 80,623 |                |  | 94.1  | %       |  | $ | 153,081        |   |  | 95.9    | % |  | $              | 155,748 |   |  | 95.4  | %
|Royalties, fees and other                    |  |                            | 3,297  |   |                          | 4.1   | % |         |   | 5,053  |                |  | 5.9   | %       |  |   | 6,519          |   |  | 4.1     | % |  |                | 7,481   |   |  | 4.6   | %
|                                             |  |                            |        |   |                          |       |   |         |   |        |                |  |       |         |  |   |                |   |  |         |   |  |                |         |   |  |       |  
|Total revenues                               |  |                            | 80,810 |   |                          | 100.0 | % |         |   | 85,676 |                |  | 100.0 | %       |  |   | 159,600        |   |  | 100.0   | % |  |                | 163,229 |   |  | 100.0 | %
|                                             |  |                            |        |   |                          |       |   |        
|Cost of product sales                        |  |                            | 22,073 |   |                          | 27.3  | % |         |   | 22,892 |                |  | 26.7  | %       |  |   | 43,869         |   |  | 27.5    | % |  |                | 46,479  |   |  | 28.5  | %
|                                             |  |                            |        |   |                          |       |   |         |   |        |                |  |       |         |  |   |                |   |  |         |   |  |                |         |   |  |       |  
|                                             |  |                            |        |   |                          |       |   |        
|Gross profit                                 |  |                            | 58,737 |   |                          | 72.7  | % |         |   | 62,784 |                |  | 73.3  | %       |  |   | 115,731        |   |  | 72.5    | % |  |                | 116,750 |   |  | 71.5  | %
|                                             |  |                            |        |   |                          |       |   |         |   |        |                |  |       |         |  |   |                |   |  |         |   |  |                |         |   |  |       |  
|                                             |  |                            |        |   |                          |       |   |        
|Operating expenses:                          |  |                            |        |   |                          |       |   |         |   |        |                |  |       |         |  |   |                |   |  |         |   |  |                |         |   |  |       |  
|Research and development                     |  |                            | 9,508  |   |                          | 11.8  | % |         |   | 7,374  |                |  | 8.6   | %       |  |   | 17,870         |   |  | 11.2    | % |  |                | 15,625  |   |  | 9.6   | %
|Sales and marketing                          |  |                            | 30,471 |   |                          | 37.7  | % |         |   | 33,595 |                |  | 39.2  | %       |  |   | 60,137         |   |  | 37.7    | % |  |                | 66,156  |   |  | 40.5  | %
|General and administrative                   |  |                            | 12,172 |   |                          | 15.1  | % |         |   | 22,394 |                |  | 26.1  | %       |  |   | 24,120         |   |  | 15.1    | % |  |                | 30,015  |   |  | 18.4  | %
|Amortization of intangible assets            |  |                            | 1,588  |   |                          | 2.0   | % |         |   | 1,652  |                |  | 1.9   | %       |  |   | 3,174          |   |  | 2.0     | % |  |                | 3,254   |   |  | 2.0   | %
|Reimbursement services                       |  |                            | 98     |   |                          | 0.1   | % |         |   | 478    |                |  | 0.6   | %       |  |   | 266            |   |  | 0.2     | % |  |                | 858     |   |  | 0.5   | %
|Investigation and restatement- related costs |  |                            | 7,306  |   |                          | 9.0   | % |         |   | 678    |                |  | 0.8   | %       |  |   | 16,030         |   |  | 10.0    | % |  |                | 678     |   |  | 0.4   | %
|                                             |  |                            |        |   |                          |       |   |         |   |        |                |  |       |         |  |   |                |   |  |         |   |  |                |         |   |  |       |  
|Total operating expenses                     |  |                            | 61,143 |   |                          | 75.7  | % |         |   | 66,171 |                |  | 77.2  | %       |  |   | 121,597        |   |  | 76.2    | % |  |                | 116,586 |   |  | 71.4  | %
|                                             |  |                            |        |   |                          |       |   |         |   |        |                |  |       |         |  |   |                |   |  |         |   |  |                |         |   |  |       |  
|                                             |  |                            |        |   |                          |       |   |        
|Income (loss) from operations                |  |                            | (2,406 | ) |                          |       |   |         |   | (3,387 | )              |  |       |         |  |   | (5,866         | ) |  |         |   |  |                | 164     |   |  |       |  
|                                             |  |                            |        |   |                          |       |   |        
|Interest and other expense, net              |  |                            | (1,929 | ) |                          |       |   |         |   | (1,464 | )              |  |       |         |  |   | (3,267         | ) |  |         |   |  |                | (1,601  | ) |  |       |  
|                                             |  |                            |        |   |                          |       |   |         |   |        |                |  |       |         |  |   |                |   |  |         |   |  |                |         |   |  |       |  
|                                             |  |                            |        |   |                          |       |   |        
|Loss before income taxes                     |  |                            | (4,335 | ) |                          |       |   |         |   | (4,851 | )              |  |       |         |  |   | (9,133         | ) |  |         |   |  |                | (1,437  | ) |  |       |  
|                                             |  |                            |        |   |                          |       |   |        
|Income tax provision (benefit)               |  |                            | (1,646 | ) |                          |       |   |         |   | (1,682 | )              |  |       |         |  |   | 63             |   |  |         |   |  |                | (499    | ) |  |       |  
|                                             |  |                            |        |   |                          |       |   |         |   |        |                |  |       |         |  |   |                |   |  |         |   |  |                |         |   |  |       |  
|                                             |  |                            |        |   |                          |       |   |        
|Net loss                                     |  | $                          | (2,689 | ) |                          |       |   |         | $ | (3,169 | )              |  |       |         |  | $ | (9,196         | ) |  |         |   |  | $              | (938    | ) |  |       |  
|                                             |  |                            |        |   |                          |       |   |         |   |        |                |  |       |         |  |   |                |   |  |         |   |  |                |         |   |  |       |  
|                                             |  |                            |        |   |                          |       |   |        
|Weighted-average shares outstanding:         |  |                            |        |   |                          |       |   |         |   |        |                |  |       |         |  |   |                |   |  |         |   |  |                |         |   |  |       |  
|Basic                                        |  |                            | 26,810 |   |                          |       |   |         |   | 26,607 |                |  |       |         |  |   | 26,798         |   |  |         |   |  |                | 26,562  |   |  |       |  
|Diluted                                      |  |                            | 26,810 |   |                          |       |   |         |   | 26,607 |                |  |       |         |  |   | 26,798         |   |  |         |   |  |                | 26,562  |   |  |       |  
|                                             |  |                            |        |   |                          |       |   |        
|Loss per common share:                       |  |                            |        |   |                          |       |   |         |   |        |                |  |       |         |  |   |                |   |  |         |   |  |                |         |   |  |       |  
|Basic                                        |  | $                          | (0.10  | ) |                          |       |   |         | $ | (0.12  | )              |  |       |         |  | $ | (0.34          | ) |  |         |   |  | $              | (0.04   | ) |  |       |  
|                                             |  |                            |        |   |                          |       |   |         |   |        |                |  |       |         |  |   |                |   |  |         |   |  |                |         |   |  |       |  
|Diluted                                      |  | $                          | (0.10  | ) |                          |       |   |         | $ | (0.12  | )              |  |       |         |  | $ | (0.34          | ) |  |         |   |  | $              | (0.04   | ) |  |       |  
|                                             |  |                            |        |   |                          |       |   |         |   |        |                |  |       |         |  |   |                |   |  |         |   |  |                |         |   |  |       |  



19



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##### Table of Contents

Product Sales

Product sales by business unit and geographic market for the periods shown were as follows (in thousands, except percentages):



|                    |  |                                 |        |   |                                 |   |        |                   |  |   |                   |   |  |          |   |  |               |        |   |                   |   |        |                   |  |   |        |   |  |       |  
|------------------- |  | ------------------------------- | ------ | - | ------------------------------- | - | ------ | ----------------- |  | - | ----------------- | - |  | -------- | - |  | ------------- | ------ | - | ----------------- | - | ------ | ----------------- |  | - | ------ | - |  | ----- | -
|                    |  | Three Months EndedJune 30,
2009 |        |   | Three Months EndedJune 30,
2008 |  
|                    |  | Americas                        |        |   | International                   |   |        | TotalProductSales |  |   | % NetProductSales |   |  | Americas |   |  | International |        |   | TotalProductSales |   |        | % NetProductSales | 
|Sports Medicine     |  | $                               | 35,429 |   |                                 | $ | 14,416 |                   |  | $ | 49,845            |   |  | 64.3     | % |  | $             | 35,529 |   |                   | $ | 16,992 |                   |  | $ | 52,521 |   |  | 65.1  | %
|ENT                 |  |                                 | 19,466 |   |                                 |   | 3,179  |                   |  |   | 22,645            |   |  | 29.2     | % |  |               | 18,089 |   |                   |   | 3,421  |                   |  |   | 21,510 |   |  | 26.7  | %
|Spine               |  |                                 | 2,630  |   |                                 |   | 2,393  |                   |  |   | 5,023             |   |  | 6.5      | % |  |               | 3,446  |   |                   |   | 3,146  |                   |  |   | 6,592  |   |  | 8.2   | %
|                    |  |                                 |        |   |                                 |   |        |                   |  |   |                   |   |  |          |   |  |               |        |   |                   |   |        |                   |  |   |        |   |  |       |  
|Total Product Sales |  | $                               | 57,525 |   |                                 | $ | 19,988 |                   |  | $ | 77,513            |   |  | 100.0    | % |  | $             | 57,064 |   |                   | $ | 23,559 |                   |  | $ | 80,623 |   |  | 100.0 | %
|                    |  |                                 |        |   |                                 |   |        |                   |  |   |                   |   |  |          |   |  |               |        |   |                   |   |        |                   |  |   |        |   |  |       |  
|% Net Product Sales |  |                                 | 74.2   | % |                                 |   | 25.8   | %                 |  |   | 100.0             | % |  |          |   |  |               | 70.8   | % |                   |   | 29.2   | %                 |  |   | 100.0  | % |  |       |  



|                    |  |                               |         |   |                               |   |        |                   |  |   |                   |   |  |          |   |  |               |         |   |                   |   |        |                   |  |   |         |   |  |       |  
|------------------- |  | ----------------------------- | ------- | - | ----------------------------- | - | ------ | ----------------- |  | - | ----------------- | - |  | -------- | - |  | ------------- | ------- | - | ----------------- | - | ------ | ----------------- |  | - | ------- | - |  | ----- | -
|                    |  | Six Months EndedJune 30, 2009 |         |   | Six Months EndedJune 30, 2008 |  
|                    |  | Americas                      |         |   | International                 |   |        | TotalProductSales |  |   | % NetProductSales |   |  | Americas |   |  | International |         |   | TotalProductSales |   |        | % NetProductSales | 
|Sports Medicine     |  | $                             | 71,258  |   |                               | $ | 28,761 |                   |  | $ | 100,019           |   |  | 65.3     | % |  | $             | 71,823  |   |                   | $ | 30,311 |                   |  | $ | 102,134 |   |  | 65.6  | %
|ENT                 |  |                               | 36,773  |   |                               |   | 6,111  |                   |  |   | 42,884            |   |  | 28.0     | % |  |               | 35,131  |   |                   |   | 6,342  |                   |  |   | 41,473  |   |  | 26.6  | %
|Spine               |  |                               | 5,758   |   |                               |   | 4,420  |                   |  |   | 10,178            |   |  | 6.7      | % |  |               | 6,601   |   |                   |   | 5,540  |                   |  |   | 12,141  |   |  | 7.8   | %
|                    |  |                               |         |   |                               |   |        |                   |  |   |                   |   |  |          |   |  |               |         |   |                   |   |        |                   |  |   |         |   |  |       |  
|Total Product Sales |  | $                             | 113,789 |   |                               | $ | 39,292 |                   |  | $ | 153,081           |   |  | 100.0    | % |  | $             | 113,555 |   |                   | $ | 42,193 |                   |  | $ | 155,748 |   |  | 100.0 | %
|                    |  |                               |         |   |                               |   |        |                   |  |   |                   |   |  |          |   |  |               |         |   |                   |   |        |                   |  |   |         |   |  |       |  
|% Net Product Sales |  |                               | 74.3    | % |                               |   | 25.7   | %                 |  |   | 100.0             | % |  |          |   |  |               | 72.9    | % |                   |   | 27.1   | %                 |  |   | 100.0   | % |  |       |  

Our Sports Medicine product sales declined 5.1 percent during the quarter ended
June 30, 2009 compared to the same period in 2008. Sports Medicine product sales declined 2.1 percent for the six months ended June 30, 2009 compared to the same period in 2008. The decreases for both the quarter and six month period ended
June 30, 2009 were primarily due to foreign exchange translation impacts on the U.S. dollar reported value of International product sales combined with a decline in the growth rate of Americas procedures resulting from weakening economic
and employment conditions in the U.S. Additionally, our first quarter 2009 sales were negatively affected by Opus product issues that reduced our available product supply beginning in the second half of 2008.

Product sales in our ENT business unit increased 5.3 percent during the quarter ended June 30, 2009 compared to the same period of
2008. ENT product sales increased 3.4 percent for the six months ended June 30, 2009 compared to the same period of 2008. For both the quarter and the six month periods ended June 30, 2009, our increased product sales reflected the growth
of our Coblation products in the tonsillectomy and adenoidectomy market.

Our Spine business unit product sales decreased 23.8
percent during the quarter ended June 30, 2009 compared with the same period of 2008. Product sales in our Spine business unit decreased 16.2 percent for the six months ended June 30, 2009 compared to the same period of 2008. Our Spine
business unit performance was negatively affected by management changes that occurred in February 2009. In the first six months of 2009, we began an effort to refocus our Spine business unit and continue to reassess the strategy for the Spine
business unit.

International product sales decreased $3.6 million or 15.2 percent in the second quarter of 2009 compared to
the second quarter of 2008. International product sales declined $2.9 million, or 6.9 percent in the first six months of 2009 compared with the same period in 2008. The translation effect of changes in foreign currency rates reduced the U.S. dollar
of reported International product sales by $2.7 million for the quarter and $5.7 million for the six month period ended June 30, 2009 in each case compared to the same period of 2008. The effect of currency translation was offset by
approximately $2.2 million of product sales in new international markets in the first half of 2009.



20



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##### Table of Contents

Royalties, Fees and Other Revenues

Royalties, fees and other revenues consisted primarily of revenue from the licensing of our products and technology. Royalties, fees and
other revenues were $3.3 million for the quarter ended June 30, 2009, compared to $5.1 million for the quarter ended June 30, 2008. Royalties, fees, and other revenue were $6.5 million in the six month period ended June 30, 2009
compared with $7.5 million in the six months ended June 30, 2008. The decrease for both periods in 2009 compared to 2008 primarily related to a one-time royalty settlement we received in the second quarter of 2008 for $1.9 million.

Cost of Product Sales



|                            |  |                            |        |                   |                          |   |         |      |                   |  |      |         |  |                   |        |  |         |   |                   |   |        |  |      |  
|--------------------------- |  | -------------------------- | ------ | ----------------- | ------------------------ | - | ------- | ---- | ----------------- |  | ---- | ------- |  | ----------------- | ------ |  | ------- | - | ----------------- | - | ------ |  | ---- | -
|                            |  | Three Months EndedJune 30, |        |                   | Six Months EndedJune 30, |  
|                            |  | 2009                       |        |                   | 2008                     |   |         | 2009 |                   |  | 2008 |        
|                            |  | Dollars                    |        | % NetProductSales |                          |   | Dollars |      | % NetProductSales |  |      | Dollars |  | % NetProductSales |        |  | Dollars |   | % NetProductSales |  
|Product cost                |  | $                          | 17,470 |                   | 22.5                     | % |         | $    | 19,191            |  | 23.8 | %       |  | $                 | 35,836 |  | 23.4    | % |                   | $ | 38,617 |  | 24.8 | %
|Controller amortization     |  |                            | 2,227  |                   | 2.9                      | % |         |      | 2,332             |  | 2.9  | %       |  |                   | 4,394  |  | 2.9     | % |                   |   | 4,609  |  | 2.9  | %
|Other                       |  |                            | 2,376  |                   | 3.1                      | % |         |      | 1,369             |  | 1.7  | %       |  |                   | 3,639  |  | 2.4     | % |                   |   | 3,253  |  | 2.1  | %
|                            |  |                            |        |                   |                          |   |         |      |                   |  |      |         |  |                   |        |  |         |   |                   |   |        |  |      |  
|Total Cost of Product Sales |  | $                          | 22,073 |                   | 28.5                     | % |         | $    | 22,892            |  | 28.4 | %       |  | $                 | 43,869 |  | 28.7    | % |                   | $ | 46,479 |  | 29.8 | %
|                            |  |                            |        |                   |                          |   |         |      |                   |  |      |         |  |                   |        |  |         |   |                   |   |        |  |      |  

Product margin as a percentage of product sales remained essentially constant at 71.5
percent in the second quarter of 2009 compared to the second quarter of 2008. Product margin as a percentage of product sales increased to 71.3 percent for the six months ended June 30, 2009 compared to 70.2 percent in the same period in 2008.
This increase for the six month period ended June 30, 2009 compared to the same period in 2008 resulted from favorable product mix and production cost efficiencies, partially offset by higher product scrap and royalty costs.

Operating Expenses



|                                             |  |                            |        |                |                          |   |         |      |                |  |      |         |  |                |         |  |         |   |                |   |         |  |      |  
|-------------------------------------------- |  | -------------------------- | ------ | -------------- | ------------------------ | - | ------- | ---- | -------------- |  | ---- | ------- |  | -------------- | ------- |  | ------- | - | -------------- | - | ------- |  | ---- | -
|                                             |  | Three Months EndedJune 30, |        |                | Six Months EndedJune 30, |  
|                                             |  | 2009                       |        |                | 2008                     |   |         | 2009 |                |  | 2008 |        
|                                             |  | Dollars                    |        | % TotalRevenue |                          |   | Dollars |      | % TotalRevenue |  |      | Dollars |  | % TotalRevenue |         |  | Dollars |   | % TotalRevenue |  
|Research and development                     |  | $                          | 9,508  |                | 11.8                     | % |         | $    | 7,374          |  | 8.6  | %       |  | $              | 17,870  |  | 11.2    | % |                | $ | 15,625  |  | 9.6  | %
|Sales and marketing                          |  |                            | 30,471 |                | 37.7                     | % |         |      | 33,595         |  | 39.2 | %       |  |                | 60,137  |  | 37.7    | % |                |   | 66,156  |  | 40.5 | %
|General and administrative                   |  |                            | 12,172 |                | 15.1                     | % |         |      | 22,394         |  | 26.1 | %       |  |                | 24,120  |  | 15.1    | % |                |   | 30,015  |  | 18.4 | %
|Amortization of intangible assets            |  |                            | 1,588  |                | 2.0                      | % |         |      | 1,652          |  | 1.9  | %       |  |                | 3,174   |  | 2.0     | % |                |   | 3,254   |  | 2.0  | %
|Reimbursement services                       |  |                            | 98     |                | 0.1                      | % |         |      | 478            |  | 0.6  | %       |  |                | 266     |  | 0.2     | % |                |   | 858     |  | 0.5  | %
|Investigation and restatement- related costs |  |                            | 7,306  |                | 9.0                      | % |         |      | 678            |  | 0.8  | %       |  |                | 16,030  |  | 10.0    | % |                |   | 678     |  | 0.4  | %
|                                             |  |                            |        |                |                          |   |         |      |                |  |      |         |  |                |         |  |         |   |                |   |         |  |      |  
|Total operating expenses                     |  | $                          | 61,143 |                | 75.7                     | % |         | $    | 66,171         |  | 77.2 | %       |  | $              | 121,597 |  | 76.2    | % |                | $ | 116,586 |  | 71.4 | %
|                                             |  |                            |        |                |                          |   |         |      |                |  |      |         |  |                |         |  |         |   |                |   |         |  |      |  



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##### Table of Contents

Operating expenses were $61.1 million for the quarter ended June 30, 2009, compared to
$66.2 million for the quarter ended June 30, 2008, a decrease of $5.1 million. General and administrative expenses decreased $10.2 million in the second quarter of 2009 compared to the second quarter of 2008. In the second quarter of 2008, we
accrued $13.3 million of Gyrus arbitration award costs, partially offset by higher legal defense costs in the second quarter of 2009. Sales and marketing expense decreased $3.1 million, primarily related to the translation effect of changes in
foreign currency rates on our International operating expenses, a decrease in ENT marketing expense, lower Spine sales and marketing personnel, and lower stock-based compensation expense. We had an increase of $6.6 million in investigation and
restatement-related costs due to the Audit Committee Review and a $2.1 million increase in research and development expenses, due to increased headcount to support product development activities.

Total operating expenses for the six months ended June 30, 2009 were $121.6 million compared to $116.6 million for the same period in
2008. This is primarily due to increased investigation and restatement expenses of $15.4 million in the first six months of 2009. In the six months ended June 30, 2008, we accrued $13.3 million of Gyrus arbitration award costs, partially offset
by higher legal defense costs in the same period of 2009. Sales and marketing expense decreased $6.0 million for the six month period ended June 30, 2009, primarily related to the translation effect of changes in foreign currency rates on our
International operating expenses, a decrease in ENT marketing expense, lower Spine sales and marketing personnel, and lower stock-based compensation expense. We also had an increase of $2.2 million in research and development expenses for the sixth
month period ended June 30, 2009 compared to the same period of 2008, due to increased headcount to support product development activities.

Interest and Other Expense, Net



|                                  |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|--------------------------------- |  | -------------------------- | ------ | - | ------------------------ | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                  |  | Three Months EndedJune 30, |        |   | Six Months EndedJune 30, |  
|                                  |  | 2009                       |        |   | 2008                     |   |        | 2009 |  |   | 2008   |  
|Interest income                   |  | $                          | 76     |   |                          | $ | 165    |      |  | $ | 151    |   |  | $ | 381    |  
|Interest expense and bank fees    |  |                            | (1,010 | ) |                          |   | (1,083 | )    |  |   | (2,280 | ) |  |   | (2,205 | )
|Foreign exchange gain (loss), net |  |                            | (989   | ) |                          |   | (594   | )    |  |   | (1,135 | ) |  |   | 160    |  
|Other income (loss), net          |  |                            | (6     | ) |                          |   | 48     |      |  |   | (3     | ) |  |   | 63     |  
|                                  |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Interest and other expense, net   |  | $                          | (1,929 | ) |                          | $ | (1,464 | )    |  | $ | (3,267 | ) |  | $ | (1,601 | )
|                                  |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  

Interest income and interest expense remained relatively constant for the quarter and
six months ended June 30, 2009 compared to the same period in 2008. The change in foreign exchange gain (loss) during the periods primarily relates to the remeasurement impact of changing exchange rates during the period on assets and
liabilities of our foreign subsidiaries.

Income Tax Provision (Benefit)

The provision for income tax for the six months ended June 30, 2009 was $0.1 million. In January 2009, the U.S. Treasury issued temporary
cost-sharing regulations. The Company has analyzed these regulations and has decided to adjust its inter-company payments for all open years. As a result of these adjustments to its inter-company payments, the Company utilized approximately $1.9
million of the FIN 48 reserve and recorded an additional income tax expense of approximately $3.6 million in the first quarter of 2009. For the six months ended June 30, 2009, the net $3.6 million income tax expense from the above changes in tax
regulations and accrual reversal has been offset by the tax effect of our loss before taxes.

Liquidity and Capital
Resources

As of June 30, 2009, we had $39.1 million in working capital, compared to $41.2 million at
December 31, 2008. Our principal sources of liquidity consisted of $42.1 million in cash, cash equivalents, restricted cash equivalents and investments at June 30, 2009. Cash equivalents were highly liquid with original maturities of
ninety days or less. Our short-term investments consisted primarily of corporate bonds.



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##### Table of Contents

Cash provided by operating activities for the six months ended June 30, 2009 was $22.8
million and differed from our net loss of $9.2 million as a result of non-cash depreciation and amortization expense of $11.8 million and a decrease in accounts receivable and inventories. Cash provided by operating activities for the six months
ended June 30, 2008 was $29.7 million. Cash from operations differed from our net loss of $0.9 million as a result of non-cash expense, recognized or accrued, most notably depreciation and amortization expense of $11.1 million, $13.3 million
accrual for the Gyrus arbitration award, and stock-based compensation expense of $5.4 million. In addition, cash from operations increased due to an increase in accrued liabilities, partially offset by an increase in accounts receivable.

Cash used in investing activities for the six months ended June 30, 2009 was $9.0 million, due primarily to purchases of property
and equipment. Cash used in investing activities for the six months ended June 30, 2008 was $16.0 million, due primarily to $13.5 million of purchases of property and equipment, partially offset by a $0.5 million reduction in restricted cash.

Cash used in financing activities for the six months ended June 30, 2009 was $10.0 million, due to cash used to repay
borrowings under the revolving Credit Agreement. Cash used in financing activities for the six months ended June 30, 2008 was $14.2 million, due primarily to cash used for the repurchase of stock on the open market and repayment of a portion of
the amount borrowed under our revolving Credit Agreement.

Historically, our liquidity needs have been to finance the costs of
operations, to acquire complementary businesses or assets and to make repurchases of our common stock. Our operating cash flow has historically been affected by the overall profitability of the sales of our products, our ability to invoice and
collect from clients in a timely manner, and our ability to efficiently implement our acquisition strategy and manage costs. We have historically relied on our cash flow from operations, cash on hand and borrowings under our Credit Agreement
for liquidity.

On July 21, 2008, we announced that we would restate our previously reported financial statements. In
a letter dated July 29, 2008, Bank of America, N.A., as Administrative Agent under the Credit Agreement consented to an extension of the deadline for delivery of our June 30, 2008 financial statements to September 15, 2008. On
September 15, 2008 we received a letter from the Administrative Agent consenting to a further extension of the deadline to December 1, 2008 for delivery of our financial statements for the periods ending June 30, 2008 and
September 30, 2008.

On November 26, 2008, we entered into a Second Amendment and Consent with respect to the Credit
Agreement. Pursuant to the Second Amendment and Consent, the Administrative Agent and the Lenders consented to the extension of the delivery deadline for our June 30, 2008 and September 30, 2008 financial statements from
December 1, 2008 to the earliest of (a) the end of business on March 2, 2009, (b) the date on which we receive notice from Nasdaq Stock Market LLC (Nasdaq) that our common stock will be delisted from the Nasdaq Global
Select Market, (c) the date that our common stock is delisted from the Nasdaq Global Select Market and (d) the date on which we receive notice from Nasdaq that its requested extension of time for delivery of its June 30, 2008 and
September 30, 2008 financial statements has been denied. In addition, pursuant to the Second Amendment and Consent, the commitment fees, letter of credit fees and interest rates that we will pay and any given leverage ratio was increased.
Finally, the Second Amendment and Consent contained other changes relating to the determination of the interest rate applicable to loans that are determined with reference to the LIBOR.

On January 14, 2009, we received a letter from the Nasdaq Listing Qualifications Panel (the Panel) stating that the Panel
had determined to delist and suspend trading of our common stock on Nasdaq effective at the open of trading on January 16, 2009. The Panels delisting notice constituted an event of default under the Credit Agreement. On
January 16, 2009, we received a waiver from the Lenders and the Administrative Agent relating to the event of default resulting from the delisting of our stock. Under the terms of the waiver, we repaid $10 million of the principal amount
(plus accrued and unpaid interest) outstanding under the Credit Agreement. The other terms of the waiver are substantially identical to the Second Amendment and Consent of November 26, 2008.

On February 23, 2009, we received a letter from the Administrative Agent asserting that certain Events of Default (as defined in the
Credit Agreement) exist under the Credit Agreement, including Events of Default resulting from:



| |  |  | failure to maintain a Consolidated EBITDA (as defined in the Credit Agreement) of $50 million or greater for each of the 12-month periods ended
March 31, 2008, June 30, 2008 and September 30, 2008;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

| |  |  | our failure to deliver certain documentation that was required to be delivered to the Agent in connection with the Lenders consent to us making a
construction loan of up to $3 million to an unrelated third party commencing in the second quarter of 2008;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the breach of a representation in the Credit Agreement resulting from the occurrence of an Internal Control Event (which, as defined in the Credit
Agreement, means a material weakness in, or fraud that involves management or other employees who have a significant role in, our internal control over financial reporting, in each case as described in the securities laws) associated with
deficiencies in our internal control over financial reporting; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the breach of several covenants and representations contained in the Credit Agreement and the occurrence of a Material Adverse Effect (as defined in
the Credit Agreement), which we believe were alleged to exist as the result of certain improper practices in the insurance billing and healthcare compliance practices.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The letter also notified us that the Lenders were no longer required to honor and did not intend to honor further extensions of credit under
the Credit Agreement. Additionally, the Administrative Agent and Lenders stated that while they were not presently exercising any of their rights, powers, or remedies available to them with respect to the alleged Events of Default (which
include the right to accelerate the maturity of the remaining $45 million of indebtedness outstanding under the Credit Agreement), all such rights, powers and remedies were expressly reserved.

On April 1, 2009, we received a letter from the Administrative Agent notifying us that as a result of the existence of certain Events
of Default under the Credit Agreement, the Administrative Agent, at the request of the Lenders, terminated the commitments of the Lenders to make additional loans and the Administrative Agent to make credit extensions including letters of credit
under the Credit Agreement, effective as of close of business on March 31, 2009.

On August 14, 2009, we signed a
Third Amendment to the Credit Agreement and Forbearance Agreement (the Forbearance Agreement) with respect to the Credit Agreement. The Forbearance Agreement became effective upon us meeting certain conditions, including (but not
limited to): being current in payments on all interest on loans and letter of credit fees; a payment of $7.5 million of the outstanding principal indebtedness; a forbearance fee equal to 0.75 percent of the outstanding Commitments after taking
account of the $7.5 million reduction to principal described above with the fee to be paid (i) 0.50 percent on the effective date of the Forbearance Agreement and (ii) 0.25 percent due on October 1, 2009 unless all indebtedness under
the Credit Agreement shall have been fully repaid before October 1, 2009, in which case the 0.25 percent amount shall be waived; the delivery of a collateral questionnaire to the Administrative Agent and consenting Lenders; and the payment of
all fees and expenses incurred by the Administrative Agent.

On September 1, 2009, we sold 75,000 shares of Series A
Preferred Stock to OEP AC Holdings LLC, an affiliate of One Equity Partners, for gross proceeds of $75.0 million. We used approximately $39 million of the proceeds to repay all outstanding indebtedness under the Credit Agreement and to cash
collateralize the letter of credit. In connection with the repayment of all outstanding indebtedness under the Credit Agreement, all rights and obligations under the Credit Agreement have been terminated and all security interests and other
encumbrances have been released, other than our obligations with respect to a letter of credit issued in favor of an affiliate of one of the Lenders in the amount of 750,000, which is cash collateralized in the approximate amount of $1.4
million.

After the repayment of the Credit Agreement and the payment of fees and expenses related thereto and to the issuance
of the Preferred Stock to OEP, we had approximately $35 million of net proceeds, which we intend to use together with cash from operations to fund our general business requirements.



24



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##### Table of Contents

During the six months ended June 30, 2009 and continuing through the date of this
report, our liquidity and cash flow has been materially and adversely affected by the significant cash required to pay the costs associated with the Review and the resulting events of default that have followed which restrict our normal access to
credit markets. We are unable to predict the outcome of ongoing litigation and investigations to which we are a party and these matters could have a material adverse effect on our liquidity and cash flow. We expect that our cash flows from
operations together with cash on hand will be sufficient to satisfy our short-term and, excluding the uncertainty related to the ongoing litigation and investigations to which we are a party, long-term normal operating liquidity requirements.

Critical Accounting Policies and Estimates

There have been no material updates to our critical accounting policies and estimates set forth in Part IIItem
7MD&ACritical Accounting Policies and Estimates of our annual report on Form 10-K for the year ended December 31, 2008.

Recently Issued Accounting Pronouncements

See Note 1 of Notes
to Condensed Consolidated Financial Statements included in Part IItem 1Financial Statements for a description of recently issued accounting pronouncements, including the expected dates of adoption and estimated
effects on our results of operations, financial position, and cash flows.

Disclosures about Contractual Obligations and
Commercial Commitments

We have various contractual obligations, which are recorded as liabilities in our condensed
consolidated financial statements. Other items, such as certain purchase commitments with suppliers and minimum lease payments under operating leases, are not recognized as liabilities in our condensed consolidated financial statements but are
required to be disclosed. During the quarter and six months ended June 30, 2009, there were no material changes from our contractual obligations presented in our 2008 Annual Report on Form 10-K.



|ITEM 3. | 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. Although payments under the operating leases for our facilities are tied to market indices, we are not exposed to material interest rate risk associated with operating leases. As of
September 1, 2009, we repaid all indebtedness owed under our Credit Agreement and terminated the Credit Agreement. As a result, we are no longer exposed to the risks associated with fluctuating interest rates for borrowings under the Credit
Agreement. Prior to repayment, borrowings under our Credit Agreement incurred interest based on then-current market interest rates. We have not historically used derivative financial instruments to manage these market risks.

Our interest income is dependent on changes in the general level of U.S. dollar interest rates. Our cash and cash equivalents consist of
money market funds and various deposit accounts. Short-term investments consist primarily of corporate bonds with readily determinable fair values based on quoted prices from active markets. Our investments are classified as
available-for-sale and accordingly are reported at fair value, with unrealized gains and losses reported as a component of stockholders equity. Unrealized losses are charged against income when a decline in the fair market value of
an individual security is determined to be other than temporary. Realized gains and losses on investments are included in interest income and are determined on the specific identification method. Due to the nature of our investments, we have
concluded that we do not have material interest risk exposure. For the quarters ended June 30, 2009 and 2008, we had no significant realized gains or losses. As of June 30, 2009, we had $0.1 million invested in available-for-sale
marketable securities. An immediate 10 percent increase or decrease in interest rates would not have a material adverse impact on our future operating results or cash flows.



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The table below presents principal amounts and related weighted average interest rates as of
June 30, 2009 for our cash, cash equivalents, restricted cash equivalents and investments as well as our balances outstanding under the Credit Agreement (in thousands):



|                                                                                                     |  |   |        |  
|---------------------------------------------------------------------------------------------------- |  | - | ------ | -
|Cash, cash equivalents, restricted cash equivalents, and investments                                 |  | $ | 42,123 |  
|Average interest rate earned on cash, cash equivalents, restricted cash equivalents, and investments |  |   | 0.2    | %
|Current portion of notes payable                                                                     |  | $ | 45,000 |  
|Average interest rate paid on notes payable                                                          |  |   | 6.8    | %

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 June 30, 2009 are denominated primarily in U.S. Dollars; however, we also maintain significant
balances in Euros, British Pounds, Swedish Krona, Australian Dollars and Costa Rican Colones. A ten-percent change in the June 30, 2009 exchange rates for these currencies would have an impact on pre-tax income of approximately $0.8
million.

We have not used derivative financial instruments to hedge against foreign currency risk. Our objective to minimize
foreign currency gains and losses has been managed by maintaining only enough cash necessary for immediate working capital requirements in accounts denominated in currencies other than the U.S. Dollar and holding the majority of our cash and
cash equivalents in U.S. Dollar accounts.



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|ITEM 4. | CONTROLS AND PROCEDURES
|------- | -----------------------

Evaluation of Disclosure Controls and Procedures

As required by Rule 13a-15 under the Securities
Exchange Act of 1934, management has evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report.
Disclosure controls and procedures refer to controls and other procedures designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the
time periods specified in the rules and forms of the SEC. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or
submit under the Exchange Act is accumulated and communicated to management, including our CEO and CFO, as appropriate, to allow timely decisions regarding our required disclosure. In designing and evaluating our disclosure controls and procedures,
management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management was required to apply its judgment in evaluating and
implementing possible controls and procedures.

Pursuant to this evaluation, our CEO and CFO concluded that, as of
June 30, 2009, the end of the period covered by this report, our disclosure controls and procedures were not effective at the reasonable assurance level. We have not filed periodic reports on a timely basis, as required by the rules of the SEC,
since May 2008. The restatement of our consolidated financial statements for the years ended December 31, 2007 and 2006 and for the quarter ended March 31, 2008, as discussed in Note 2 , Restatement of Previously Issued
Consolidated Financial Statements in the notes to the consolidated financial statements of the 2008 Form 10-K, resulted in an inability to timely file our Annual Report on Form 10-K for the year ended December 31, 2008 and our Quarterly
Reports on Form 10-Q for the quarters ended June 30, 2008, September 30, 2008, March 31, 2009, June 30, 2009 and September 30, 2009. In addition, as described below, management identified material weaknesses
in our internal control over financial reporting.

We have made progress in improving our disclosure controls and procedures.
We have taken, and are taking, the actions described more fully below under Remediation Activities to remediate the material weaknesses in our internal control over financial reporting. We also strive to enhance our processes to enable
us to provide complete and accurate public disclosure on a timely basis. However, management believes that our disclosure controls and procedures will not be effective at the reasonable assurance level until we are able to file required reports with
the SEC on a timely basis.

To address the material weaknesses described in this Item 4, management performed additional
analyses and other post-closing procedures designed to provide reasonable assurance that our consolidated financial statements were prepared in accordance with GAAP. As a result of these procedures and other factors, including internal procedures
that identified revisions to previously issued financial statements and the performance of additional procedures by management designed to establish the reliability of financial reporting, management believes that the consolidated financial
statements included in this report fairly present, in all material respects, our financial position, results of operations and cash flows as of the dates and for the periods presented, in conformity with GAAP.

Management identified the following control deficiencies that constitute material weaknesses that continue to exist as of the filing date of
this report.



|1. | Control environment. We did not maintain an effective control environment, which is the foundation upon which all other components of internal controls are
based. Specifically:
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We did not maintain a consistent and proper tone and control consciousness that consistently emphasized the importance of consistent application of
accounting policies and procedures and strict adherence to GAAP. Specifically, we did not maintain sufficient safeguards to provide reasonable assurance that controls could not be circumvented by management override or to prevent or detect possible
misconduct by certain former
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | members of senior management with respect to certain revenue transactions. Information related to certain revenue transactions was not communicated to accounting personnel to appropriately
consider the financial reporting implications of such transactions.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We did not maintain effective procedures for communicating to all relevant personnel our accounting policies, the importance of consistent application
of our accounting policies, and essential data required to properly apply GAAP to our transactions. Specifically, we did not have appropriate procedures to provide reasonable assurance that non-routine terms in business arrangements with financial
reporting implications were communicated completely, accurately or in a timely manner to the accounting personnel. As a result, accounting personnel did not have the necessary information to determine the financial reporting consequences of certain
transactions.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We did not maintain a sufficient complement of personnel with an appropriate level of accounting knowledge, experience and training in the application
of GAAP commensurate with our financial reporting requirements.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We did not maintain effective monitoring activities to provide reasonable assurance that breakdowns in the operation of controls within our individual
business units were detected and corrected on a timely basis. As a result, we did not detect deficiencies in compliance with our accounting policies on a timely basis.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

This material weakness led to erroneous judgments regarding the application of GAAP, which resulted in errors and possible irregularities in
the preparation of our financial statements. This material weakness also contributed to the existence of the material weaknesses described in items 2 through 4 below.



|2. | Period-end financial reporting process. We did not maintain effective controls over the period-end financial reporting process, including controls with respect
to the review, supervision, and monitoring of accounting operations. Specifically:
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We did not maintain effective controls to provide reasonable assurance that account reconciliations were properly performed and that reconciliations
and journal entries were consistently reviewed for completeness and accuracy.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We did not maintain effective controls to provide reasonable assurance that foreign currency transactions and balances were valued accurately in our
consolidated financial statements.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We did not maintain effective controls related to our accounting for stockholders equity to provide reasonable assurance that our treasury stock
transactions and stock-based compensation expense were accurately recorded.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We did not maintain effective controls to provide reasonable assurance that expenses were recognized in the proper reporting period, which affected the
accuracy and valuation of certain intangible assets and also the completeness, accuracy and timely recording of prepaid expenses, accrued liabilities and the associated operating expenses. The Audit Committee Review identified at least one instance
in which an accrual appeared to be reversed and the recording of certain expenses appeared to be delayed in order to achieve a particular EPS target.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|3. | Revenue recognition.We did not maintain effective controls related to our accounting for revenue to provide reasonable assurance that
(a) our accounting policy for revenue recognition was appropriately applied to the individual facts and circumstances of our various distributor, sales agent or customer agreements; (b) revenue was recognized in the proper reporting period
in accordance with the terms of our sales contracts and our practice for replacing product that was lost or damaged during shipment; (c) appropriate collectibility assessments were performed prior to recognizing revenue; (d) our policies
for returns and exchanges were consistently followed; (e) sufficient policies and procedures were developed and implemented for our reimbursement assistance service subsidiaries, DiscoCare and DRS, and revenue recognition accounting rules were
properly applied by these subsidiaries; (f) revenue was recorded on a net basis with respect to all rebates or other payments due to customers; and (g) amounts received from third-party sales agents were recognized as a reduction of
commission expense rather than revenue. The Audit Committee Review identified facts indicating that (a) a substantial number of sales
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | transactions were quarter-end transactions structured to recognize revenue in a particular quarter in order to meet revenue forecasts; and (b) certain conduct occurred in our reimbursement
assistance service subsidiaries, DiscoCare and DRS, including coding and billing inaccuracies and encouraging and/or recommending the use of certain codes and terms/phrases to describe the technology underlying our products.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|4. | Acquisition accounting.We did not maintain effective controls related to our accounting for business acquisitions to provide reasonable assurance that
(a) business combination accounting identified and considered all pertinent facts related to pre-acquisition business arrangements between the parties to determine appropriate acquisition date accounting for the settlement of a pre-existing
business arrangement; and (b) the rationale for an acquisition transaction was adequately considered, documented and communicated to properly assess the fair value of the net assets acquired.
|-- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

These material weaknesses resulted in material errors in and the restatement of our annual and interim financial statements for 2006, 2007
and the first quarter of 2008, and resulted in adjustments, including audit adjustments, to our annual and interim financial statements for the second, third and fourth quarters of 2008 and the first and second quarters of 2009. Additionally, these
material weaknesses could result in a material misstatement to the annual or interim financial statements that would not be prevented or detected on a timely basis.

CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING

Management has
evaluated, with the participation of our CEO and CFO, whether any changes in our internal control over financial reporting that occurred during the period from April 1, 2008 through the date of this filing (including the quarter ended
June 30, 2009) have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Based on this evaluation, Management concluded it has identified the material weaknesses discussed above and
implemented material enhancements during the period from April 1, 2008 through the date of this filing to remediate our material weaknesses in internal control over financial reporting as discussed below.

REMEDIATION ACTIVITIES

Overview

Management has implemented, and continues to design and implement, certain remediation
measures to address the above-described material weaknesses and enhance our system of internal control over financial reporting. These measures include (a) enhancing our communication process by initiating a specific and targeted communication
plan involving the executive leadership and the board of directors; (b) taking certain personnel actions; (c) implementing standard contracts throughout our agent and distributor network and a review of non-standard contracts;
(d) adopting a revised revenue recognition policy; (e) enhancing our financial reporting policies, procedures and processes involving the review and approval of account reconciliations, journal entries and corresponding supporting
documentation; (f) designing and implementing training programs; and (g) increasing the emphasis of the accounting and internal audit groups on the review of key accounting controls and processes, including documentation requirements.

Management believes the remediation measures described below will remediate the identified control deficiencies and
strengthen our internal control over financial reporting. As management continues to evaluate and work to enhance our internal control over financial reporting, it may be determined that additional measures must be taken to address control
deficiencies or it may be determined that we need to modify or otherwise adjust the remediation measures described below.

Description of Remediation Actions

The remediation efforts outlined below are intended both to address
the identified material weaknesses and to enhance our overall financial control environment.

Leadership Tone.
In light of the Review, we commenced in late 2008 significant efforts to communicate and establish an effective culture and the leadership tone necessary to support our desired control environment.



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| |  |  | Effective December 18, 2008, we accepted the resignations of our then CFO, our then Senior Vice President of Strategic Business Units and our then
Senior Vice President of the Spine unit. On February 18, 2009, we accepted the resignation of our then President and CEO.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Effective February 18, 2009, our board of directors appointed David Fitzgerald as our Acting President and CEO, and effective April 2, 2009,
our board of directors appointed Todd Newton as our Senior Vice President and CFO. Effective October 21, 2009, our board of directors appointed Mr. Fitzgerald as our President and CEO.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Effective December 19, 2008, we enhanced our legal department and function by establishing the position of Senior Vice President and General
Counsel by promoting the current VP of Legal Affairs to this position and hired additional legal staff to work at the direction of the General Counsel.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | To reinforce our desired control environment and to align responsibility and accountability for individual conduct, the CEO and CFO have implemented a
process requiring all vice presidents, significant department heads and regional sales managers to sign, in advance of the filing of our periodic quarterly and annual reports, a representation letter with respect to the application of accounting
policies, procedures and internal controls.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We enhanced our third-party operated ethics hotline, which is available to employees and any external parties, to support multiple languages besides
English. Quarterly communications from the CEO or Compliance Officer to all employees highlight our expectations for ethical conduct and legal compliance as well as the availability of the ethics hotline as a mechanism to raise questions and address
potential concerns.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We conducted a review and update of our key employee policies and procedures, including our Code of Conduct. Annually, all employees are expected to
certify that they have read, understand and will abide by the Code and other key policies and procedures.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Communication and Application of Accounting Policies. Management continues to evaluate and enhance controls to develop a more formalized process for monitoring, updating and disseminating non-routine contractual agreements to
facilitate a complete and timely review by accounting personnel. Remedial efforts to date include:



| |  |  | We have developed standard contract templates for all stocking distributors and sales agents. All new contracts are reviewed by finance and legal
personnel for conformity. Proposed deviations from the standard contract template are subject to reviews and approval according to our delegation of authority policy, which requires financial and legal officer approval. Existing distributor and
agent contracts are being updated accordingly.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We have implemented additional controls, including the implementation of a global contractual agreement database related to existence, completeness,
approval and retention of global contractual agreements amongst the various departments. We have also established a contract administrator position and function that reports to the General Counsel and is responsible for gathering and maintaining a
database of all contracts and amendments thereto as well as checking that all required approvals have been obtained.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We require all sales, marketing, finance, accounting, customer service, order entry, credit and collections personnel to attend periodic
revenue-recognition training. The training programs are designed to provide our personnel with an appropriate level of knowledge, experience and training in the application of GAAP commensurate with their responsibilities and our financial reporting
requirements. As part of developing this training program, current management established a process to identify specific information that (a) is material to the application of our revenue recognition policies and (b) must be communicated
from the sales staff to the accounting function. As of the date of this report, essentially all of the employees in the functions identified above have been trained. Refresher training will occur annually. Personnel in these functions will annually
certify that they understand the policy, have abided by the policy and intend to continue to do so.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We revised our delegation of authority policies. The revised policies include enhancements with respect to the communication and approval channels in
the areas of certain commercial terms, sourcing, capital investments and treasury activities, including requirements relating to communication, authorization and support criteria for specified types of modifications to standard contracts or other
arrangements.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | We revised, or are in the process of revising, our policies and procedures related to mergers and acquisitions, accruals, account reconciliations, and
accounting reviews. The revision of these policies and procedures has and will continue to require additional training.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Monitoring. We continue to enhance our accounting and finance processes to enhance our ability to assess the accuracy of the consolidated financial statements and whether business practices
are consistent with our stated accounting policies and procedures. Additionally, we continue to review and assess the sufficiency of our accounting and internal audit resources. Remedial efforts include:



| |  |  | We have hired additional qualified accounting staff in addition to hiring a new CFO. The new members of the accounting staff have sufficient experience
for their roles and responsibilities based on prior experience in the accounting function of public companies.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The accounting department is also implementing additional preventive and detective control procedures including: (a) a quarterly cut-off test
designed to detect improper revenue recognition; (b) a process to review distributor purchasing history and period end inventory levels in order to analytically verify the adequacy and accuracy of our sell-through estimation process and detect
improper revenue recognition; and (c) lag time analyses for returns and exchanges to analyze the reasonableness of our accounting estimates for returns and exchanges and detect the improper recognition of net revenue.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In early 2009, we enhanced our global account reconciliation process governing account reconciliation content, format, review and approval procedures.
The account reconciliation process is expected to be maintained prospectively as a tool to evaluate the consistent application of GAAP throughout our worldwide operations.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We have increased our staffing in the internal audit function and have hired a new head of internal audit. The internal audit department expects to
implement enhanced risk assessment methodology which more actively recruits the input of business unit and functional leadership. Hiring of additional internal audit staff may be necessary.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

These remediation activities are designed to address our material weaknesses.

The material weaknesses identified by management and discussed above are not fully remediated as of the date of the filing of this quarterly
report. We have performed additional substantive procedures in an effort to provide reasonable assurance that the underlying transactions reflected in our financial statements are supported and that the financial statements are fairly presented as
of the date of this report.

The Audit Committee will oversee managements development of an implementation plan and
timetable for the above-referenced remedial measures, to the extent not already complete, and will monitor their implementation. In addition, under the direction of the Audit Committee, management will continue to review and make necessary changes
to the overall design of the internal controls environment, as well as policies and procedures to enhance the overall effectiveness of our internal control over financial reporting.



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PART II. OTHER INFORMATION



|ITEM 1. | LEGAL PROCEEDINGS
|------- | -----------------

We
discuss our material legal proceedings in Note 9, Litigation and Contingencies, in the notes to the consolidated financial statements. In addition to the matters specifically described in Note 9, Litigation and Contingencies,
we are involved in other legal and regulatory proceedings that arise in the ordinary course of business that do not have a material impact on our business. Litigation claims and proceedings of all types are subject to many factors that generally
cannot be predicted accurately. We record reserves for claims and lawsuits when they are probable and reasonably estimable. Except as otherwise specifically noted, we currently cannot determine the ultimate resolution of the matters described in
Note 9, Litigation and Contingencies. For matters where the likelihood or extent of a loss is not probable or cannot be reasonably estimated, we have not recognized in our consolidated financial statements the potential liability that
may result from these matters. If one or more of these matters is determined against us, it could have a material adverse effect on our earnings, liquidity and financial condition.



|ITEM 1A. | RISK FACTORS
|-------- | ------------

There have
been no material updates to the risk factors set forth in Part IIItem 1ARisk Factors of our annual report on Form 10-K for the year ended December 31, 2008.



|ITEM 2. | UNREGISTERED SALES OF SECURITIES AND USE OF PROCEEDS
|------- | ----------------------------------------------------

None.



|ITEM 3. | DEFAULTS UPON SENIOR SECURITIES
|------- | -------------------------------

None.



|ITEM 4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
|------- | -----------------------------------------------------

None.



|ITEM 5. | OTHER INFORMATION
|------- | -----------------

None.



|ITEM 6. | EXHIBITS
|------- | --------



|               |  |                                                                                                        
|-------------- |  | -------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                            
|31.1           |  | Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|               | 
|31.2           |  | Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|               | 
|32.1           |  | Certification of the Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
|               | 
|32.2           |  | Certification of the Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
|               | 
|99.1           |  | Forward-Looking Statements                                                                             



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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf
by the undersigned thereunto duly authorized.



|                        |  |                                                  
|----------------------- |  | -------------------------------------------------
|                        |  | ARTHROCARE CORPORATION                           
|                        |  | a Delaware corporation                           
|                        | 
|Date: November 19, 2009 |  | /S/    DAVID FITZGERALD                          
|                        |  | David Fitzgerald                                 
|                        |  | President and Chief Executive Officer            
|                        | 
|Date: November 19, 2009 |  | /S/    TODD
NEWTON                               
|                        |  | Todd Newton                                      
|                        |  | Senior Vice President and Chief Financial Officer



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EXHIBIT INDEX



|           |  |                                                                                                                                                       
|---------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------
|EXHIBITNO. |  | DOCUMENT DESCRIPTION                                                                                                                                  
|31.1       |  | Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.             
|           | 
|31.2       |  | Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.             
|           | 
|32.1       |  | Certification of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
|           | 
|32.2       |  | Certification of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 
|           | 
|99.1       |  | Forward-Looking Statements                                                                                                                            



34