Table of Contents

 

 

 

**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 March 31, 2010**

** **

**OR**

** **
| **o** | **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 inits 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, includingarea code)

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.  Yes x  No o

 

Indicate by check mark whether the registrant hassubmitted and posted on its corporate Web site, if any, every Interactive DataFile required to be submitted and posted pursuant to Rule 405 ofRegulation S-T (§232.405 of this chapter) during the preceding 12 months (orfor such shorter period that the registrant was required to submit and postsuch files). Yes o  No o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reportingcompany.  See definitions of “large accelerated filer,” “acceleratedfiler” and “smaller reporting company” in Rule 12b.2 of the Exchange Act

 

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

 

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

 

As of April 29, 2010, the number of outstandingshares of the Registrant’s Common Stock was 26,956,266.

 

 

 

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**ARTHROCARE CORPORATION**

 

**Form 10-Q Quarterly Report**

**For the quarter ended March 31, 2010**

** **

**TABLE OF CONTENTS**

 
| **PART 1.  FINANCIAL INFORMATION**                                                            | **1**  |
|---------------------------------------------------------------------------------------------------------|--------|
| **ITEM 1.  FINANCIAL STATEMENTS**                                                                       | **1**  |
| **CONDENSED  CONSOLIDATED BALANCE SHEETS**                                                              | **1**  |
| **CONDENSED  CONSOLIDATED STATEMENTS OF OPERATIONS**                                                    | **2**  |
| **CONDENSED  CONSOLIDATED STATEMENTS OF CASH FLOWS**                                                    | **3**  |
| **NOTES  TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**                                               | **4**  |
| **ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF  FINANCIAL CONDITION AND RESULTS OF OPERATIONS** | **12** |
| **ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT  MARKET RISK**                                 | **18** |
| **ITEM  4. CONTROLS AND PROCEDURES**                                                                    | **19** |
| **PART II.  OTHER INFORMATION**                                                                    | **23** |
| **ITEM  1. LEGAL PROCEEDINGS**                                                                          | **23** |
| **ITEM  1A. RISK FACTORS**                                                                              | **23** |
| **ITEM 2. UNREGISTERED SALES OF SECURITIES AND USE OF  PROCEEDS**                                       | **36** |
| **ITEM 3. DEFAULTS UPON SENIOR SECURITIES**                                                             | **36** |
| **ITEM  4.  RESERVED**                                                                             |   |
| **ITEM  5.  OTHER INFORMATION**                                                                    | **36** |
| **ITEM 6. EXHIBITS**                                                                                    | **36** |
| **SIGNATURES**                                                                                          | **37** |
| **EXHIBIT INDEX**                                                                                       | **38** |
| **Exhibit 31.1**                                                                                   |   |
| **Exhibit 31.2**                                                                                   |   |
| **Exhibit 32.1**                                                                                   |   |
| **Exhibit 32.2**                                                                                   |   |
| **Exhibit 99.1**                                                                                   |   |

 

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**PART I. ****FINANCIALINFORMATION**

 

**ITEM 1. FINANCIAL STATEMENTS**

 

**ARTHROCARE CORPORATION**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(unaudited)**

**(in thousands, except par value data)**

** **
| ** **                                                                                                                                                                                                           | ** ** | **March 31,  2010** | ** **     | **December 31,********2009** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|----------------|------------------------------|------------|
|                                                                                                                                                                                                                 | ** ** | ** **               | ** **     | ** **                   | ** ** |
| **ASSETS**                                                                                                                                                                                                           |       |                     | ** **     | ** **                   | ** ** |
| Current assets:                                                                                                                                                                                                      |       |                     |           |                         |       |
| Cash and cash  equivalents                                                                                                                                                                                           |       | $                        | 65,252         |                         | $          | 57,386 |   |
| Accounts receivable,  net of allowances of $3,716 and $4,069 at March 31, 2010 and  December 31, 2009, respectively                                                                                        |       | 43,631                   |           | 45,789                       |       |
| Inventories, net                                                                                                                                                                                                     |       | 47,153                   |           | 48,628                       |       |
| Deferred tax assets                                                                                                                                                                                                  |       | 10,040                   |           | 12,983                       |       |
| Prepaid expenses and  other current assets                                                                                                                                                                           |       | 4,535                    |           | 6,563                        |       |
| Total current assets                                                                                                                                                                                                 |       | 170,611                  |           | 171,349                      |       |
|                                                                                                                                                                                                                 |       |                     |           |                         |       |
| Property and equipment,  net                                                                                                                                                                                         |       | 46,572                   |           | 47,386                       |       |
| Intangible assets, net                                                                                                                                                                                               |       | 16,405                   |           | 17,975                       |       |
| Goodwill                                                                                                                                                                                                             |       | 118,748                  |           | 119,076                      |       |
| Deferred tax assets                                                                                                                                                                                                  |       | 30,526                   |           | 30,526                       |       |
| Other assets                                                                                                                                                                                                         |       | 4,723                    |           | 4,816                        |       |
| Total assets                                                                                                                                                                                                         |       | $                        |  387,585  |                         | $          |  391,128 |   |
|                                                                                                                                                                                                                 |       |                     |           |                         |       |
| **LIABILITIES,  REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY**                                                                                                                               |       |                     |           |                         |       |
| Current liabilities:                                                                                                                                                                                                 |       |                     |           |                         |       |
| Accounts payable                                                                                                                                                                                                     |       | $                        |  15,562   |                         | $          |  14,299 |   |
| Accrued liabilities                                                                                                                                                                                                  |       | 33,457                   |           | 46,077                       |       |
| Deferred tax  liabilities                                                                                                                                                                                            |       | 17                       |           | 3                            |       |
| Deferred revenue                                                                                                                                                                                                     |       | —                   |           | 4,508                        |       |
| Income tax payable                                                                                                                                                                                                   |       | —                   |           | 195                          |       |
| Total current  liabilities                                                                                                                                                                                           |       | 49,036                   |           | 65,082                       |       |
|                                                                                                                                                                                                                 |       |                     |           |                         |       |
| Deferred tax  liabilities                                                                                                                                                                                            |       | 294                      |           | 303                          |       |
| Other non-current  liabilities                                                                                                                                                                                       |       | 4,822                    |           | 4,844                        |       |
| Total liabilities                                                                                                                                                                                                    |       | 54,152                   |           | 70,229                       |       |
|                                                                                                                                                                                                                 |       |                     |           |                         |       |
| Commitments and  contingencies (Notes 6 and 7)                                                                                                                                                                       |       |                     |           |                         |       |
|                                                                                                                                                                                                                 |       |                     |           |                         |       |
| Series A 3%  Redeemable Convertible Preferred Stock, par value $0.001; Authorized: 100  shares; Issued and outstanding: 75 shares at March 31, 2010 and  December 31, 2009; Redemption value: $87,089 |       | 71,306                   |           | 70,504                       |       |
|                                                                                                                                                                                                                 |       |                     |           |                         |       |
| Stockholders’ equity:                                                                                                                                                                                           |       |                     |           |                         |       |
| Preferred stock, par  value $0.001; Authorized: 4,900 shares; Issued and outstanding: none                                                                                                                           |       | —                   |           | —                       |       |
| Common stock, par value  $0.001; Authorized: 75,000 shares; Issued and outstanding: 26,959 shares at  March 31, 2010 and 26,886 shares at December 31, 2009                                                |       | 27                       |           | 27                           |       |
| Treasury stock: 4,012  shares at March 31, 2010 and 4,019 shares at December 31, 2009                                                                                                                      |       | (108,534                 | )              | (108,724                     | )          |
| Additional paid-in  capital                                                                                                                                                                                          |       | 380,734                  |           | 379,921                      |       |
| Accumulated other  comprehensive income                                                                                                                                                                              |       | 3,547                    |           | 1,645                        |       |
| Accumulated deficit                                                                                                                                                                                                  |       | (13,647                  | )              | (22,474                      | )          |
| Total stockholders’  equity                                                                                                                                                                                     |       | 262,127                  |           | 250,395                      |       |
| Total liabilities,  Redeemable Convertible Preferred Stock and stockholders’ equity                                                                                                                             |       | $                        |   387,585 |                         | $          |  391,128 |   |

 

Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.

 

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**ARTHROCARE CORPORATION**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

**(unaudited)**

* ***(in thousands, except per-share data)**

** **
| ** **                                                                              | ** ** | **Three Months Ended********March 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                              | ** ** | **2010**                                     | ** ** | **2009** | ** ** |
| ** **                                                                              | ** ** | ** **                                   | ** ** |   | ** ** |
| **Revenues:**                                                                           | ** ** | ** **                                   | ** ** |   | ** ** |
| Product sales                                                                           |       | $                                            | 86,617     |   | $ | 75,568 |   |
| Royalties, fees and  other                                                              |       | 3,994                                        |       | 3,222 |   |
| Total revenues                                                                          |       | 90,611                                       |       | 78,790 |   |
|                                                                                    |       |                                         |       |   |   |
| **Cost  of product sales**                                                              |       | 26,933                                       |       | 21,796 |   |
|                                                                                    |       |                                         |       |   |   |
| **Gross  profit**                                                                       |       | 63,678                                       |       | 56,994 |   |
| **Operating  expenses:**                                                                |       |                                         |       |   |   |
| Research and  development                                                               |       | 9,150                                        |       | 8,362 |   |
| Sales and marketing                                                                     |       | 27,820                                       |       | 29,666 |   |
| General and  administrative                                                             |       | 8,982                                        |       | 11,948 |   |
| Amortization of  intangible assets                                                      |       | 1,567                                        |       | 1,586 |   |
| Investigation and  restatement related costs                                            |       | 1,043                                        |       | 8,724 |   |
| Reimbursement services                                                                  |       | 21                                           |       | 168 |   |
| Total operating  expenses                                                               |       | 48,583                                       |       | 60,454 |   |
| ** **                                                                              |       |                                         |       |   |   |
| **Income  (loss) from operations**                                                      |       | 15,095                                       |       | (3,460 | ) |
| Interest and other  expense, net                                                        |       | (101                                         | )          | (1,192 | ) |
| Foreign exchange loss,  net                                                             |       | (2,960                                       | )          | (146 | ) |
| Interest and other  expense, net                                                        |       | (3,061                                       | )          | (1,338 | ) |
|                                                                                    |       |                                         |       |   |   |
| **Income  (loss) before income taxes**                                                  |       | 12,034                                       |       | (4,798 | ) |
|                                                                                    |       |                                         |       |   |   |
| Income tax provision                                                                    |       | 3,207                                        |       | 1,709 |   |
|                                                                                    |       |                                         |       |   |   |
| **Net  income (loss)**                                                                  |       | 8,827                                        |       | (6,507 | ) |
|                                                                                    |       |                                         |       |   |   |
| Accrued dividend and  accretion charges on Series A 3% Convertible Preferred Stock |       | (802                                         | )          | — |   |
|                                                                                    |       |                                         |       |   |   |
| **Net  income (loss) available to common stockholders**                                 |       | $                                            | 8,025      |   | $ | (6,507 | ) |
|                                                                                    |       |                                         |       |   |   |
| **Weighted-average  shares outstanding:**                                               |       |                                         |       |   |   |
| Basic                                                                                   |       | 26,922                                       |       | 26,746 |   |
| Diluted                                                                                 |       | 27,221                                       |       | 26,746 |   |
|                                                                                    |       |                                         |       |   |   |
| **Earnings  (loss) per common share:**                                                  |       |                                         |       |   |   |
| Basic                                                                                   |       | $                                            | 0.25       |   | $ | (0.24 | ) |
| Diluted                                                                                 |       | $                                            | 0.24       |   | $ | (0.24 | ) |

 

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

 

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**ARTHROCARECORPORATION**

**CONDENSED CONSOLIDATED STATEMENTS OF CASHFLOWS**

**(unaudited)**

**(in thousands)**

** **
| ** **                                                                                                              | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                              | ** ** | **2010**                               | ** ** | **2009** | ** ** |
| ** **                                                                                                              | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Cash flows from  operating activities:                                                                                  |       |                                   |       |   |   |
| Net income (loss)                                                                                                       |       | $                                      | 8,827      |   | $ | (6,507 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities:                               |       |                                   |       |   |   |
| Depreciation and  amortization                                                                                          |       | 5,901                                  |       | 5,923 |   |
| Provision for doubtful  accounts receivable and product returns                                                         |       | (114                                   | )          | 1,283 |   |
| Inventory and warranty  provision                                                                                       |       | 2,633                                  |       | 1,524 |   |
| Non-cash stock  compensation expense                                                                                    |       | 1,297                                  |       | 1,029 |   |
| Deferred taxes                                                                                                          |       | 3,206                                  |       | — |   |
| Other                                                                                                                   |       | (1,859                                 | )          | 495 |   |
| Changes in operating  assets and liabilities, net of assets acquired and liabilities assumed in  business combinations: |       |                                   |       |   |   |
| Accounts receivable                                                                                                     |       | 5,831                                  |       | 1,905 |   |
| Inventories                                                                                                             |       | (624                                   | )          | 2,123 |   |
| Prepaid expenses and  other current assets                                                                              |       | 2,149                                  |       | 1,696 |   |
| Accounts payable                                                                                                        |       | 1,424                                  |       | (2,229 | ) |
| Taxes payable                                                                                                           |       | (538                                   | )          | — |   |
| Accrued liabilities                                                                                                     |       | (12,382                                | )          | 806 |   |
| Deferred revenue                                                                                                        |       | (4,508                                 | )          | 537 |   |
| Net cash provided by  operating activities                                                                              |       | 11,243                                 |       | 8,585 |   |
|                                                                                                                    |       |                                   |       |   |   |
| Cash flows from  investing activities:                                                                                  |       |                                   |       |   |   |
| Purchases of property  and equipment                                                                                    |       | (3,601                                 | )          | (3,801 | ) |
| Payments for business  combinations and purchases of intangible assets                                                  |       | —                                 |       | (390 | ) |
| Other                                                                                                                   |       | 17                                     |       | (213 | ) |
| Net cash used in  investing activities                                                                                  |       | (3,584                                 | )          | (4,404 | ) |
|                                                                                                                    |       |                                   |       |   |   |
| Cash flows from  financing activities:                                                                                  |       |                                   |       |   |   |
| Repayments on revolving  credit agreement                                                                               |       | —                                 |       | (10,000 | ) |
| Proceeds from exercise  of options to purchase common stock, net of issuance costs                                      |       | 298                                    |       | — |   |
| Net cash provided by  (used) in financing activities                                                                    |       | 298                                    |       | (10,000 | ) |
|                                                                                                                    |       |                                   |       |   |   |
| Effect of exchange rate  changes on cash and cash equivalents                                                           |       | (91                                    | )          | (119 | ) |
|                                                                                                                    |       |                                   |       |   |   |
| Net increase (decrease)  in cash and cash equivalents                                                                   |       | 7,866                                  |       | (5,938 | ) |
| Cash and cash equivalents,  beginning of period                                                                         |       | 57,386                                 |       | 33,506 |   |
| Cash and cash  equivalents, end of period                                                                               |       | $                                      | 65,252     |   | $ | 27,568 |   |

 

The accompanyingnotes are an integral part of these condensed consolidated financialstatements.

 

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**ARTHROCARE********CORPORATION**

**NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1 — BASIS OF PRESENTATION**

 

***Basis of Presentation***

 

Theaccompanying unaudited condensed consolidated financial statements ofArthroCare Corporation (“ArthroCare” or the “Company”) and its subsidiaries(collectively with ArthroCare, the “Company”) have been prepared in accordancewith the instructions to Form 10-Q and therefore do not include allinformation and footnotes necessary for a fair presentation of financialposition, results of operations and cash flows in conformity with U.S.generally accepted accounting principles (“GAAP”).  However, such information reflects alladjustments (consisting of normal recurring adjustments), which are, in theopinion of management, necessary for a fair statement of the results for theinterim periods.

 

Thecondensed consolidated financial statements should be read in conjunction withthe consolidated financial statements and notes thereto together withmanagement’s discussion and analysis of financial condition and results ofoperations contained in the Company’s 2009 Annual Report on Form 10-Kfiled on March 15, 2010 (“2009 Form 10-K”).  In the opinion of management, theaccompanying condensed consolidated financial statements reflect alladjustments of a normal recurring nature considered necessary to fairly statethe financial position of the Company at March 31, 2010 and December 31,2009, the results of its operations and cash flows for the three month periodsended March 31, 2010 and 2009.

 

Inaddition, some of the Company’s statements in this quarterly report on Form 10-Qmay be considered forward-looking and involve risks and uncertainties thatcould significantly impact expected results. The results of operations for thethree month periods ended March 31, 2010 and 2009 are not necessarilyindicative of results for the full year.

 

***Use of Estimates***

 

The unauditedcondensed consolidated financial statements have been prepared in conformitywith GAAP, using management’s best estimates and judgments whereappropriate.  These estimates andjudgments affect the reported amounts of assets and liabilities and disclosureof the contingent assets and liabilities at the date of the financialstatements.  The estimates and judgmentswill also affect the reported amounts for certain revenues and expenses duringthe reporting period.  Actual resultscould differ materially from these estimates and judgments.

 

***PriorPeriod Classifications***

 

Certain priorperiod balances have been reclassified in the Condensed Consolidated Statementof Cash Flows to conform to the current year presentation.

 

***FirstQuarter 2010 Accounting Corrections***

 

Our results for thequarter ended March 31, 2010 include reductions of stock compensation expenseto correct forfeiture calculation errors in prior periods. The impact of theerror was an overstatement of operating expenses of $0.4 million in the yearended December 31, 2008 and $0.7 million in the year ended December 31, 2009.To correct this error, we recorded reductions of $0.8 million to general andadministrative expense and $0.3 million to sales and marketing expense in thecondensed consolidated statement of operations for the quarter ended March 31,2010. We have determined that the impact of this uncorrected error isimmaterial to all prior periods, and we expect these out-of-period adjustmentsto be immaterial to our results for the year ending December 31, 2010.

 

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**ARTHROCARE********CORPORATION**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS — (continued)**

 

***Recently Issued Accounting Pronouncements***

 

InOctober 2009, the FASB issued amended revenue recognition guidance forarrangements with multiple deliverables. For the Company, this guidance iseffective for all new or materially modified arrangements entered into on orafter January 1, 2011 with earlier application permitted as of thebeginning of a fiscal year. The Company is currently assessing itsimplementation of this new guidance, but does not expect it to have a materialimpact on the consolidated financial statements.

 

**NOTE 2 —COMPREHENSIVE INCOME (LOSS)**

 

The followingtable presents comprehensive income (loss) (in thousands):

 
| ** **                                | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------|------------|------------------------|------------|
| ** **                                | ** ** | **March 31,**     | ** ** |
| ** **                                | ** ** | **2010**               | ** ** | **2009** | ** ** |
| ** **                                | ** ** | ** **             | ** ** | ** ** | ** ** |
| Comprehensive income  (loss):             | ** ** | ** **             | ** ** | ** ** | ** ** |
| Net income (loss)                         |       | $                      | 8,827      |   | $ | (6,507 | ) |
| Foreign currency  translation adjustments |       | 1,902                  |       | (442 | ) |
| Comprehensive income  (loss)              |       | $                      | 10,729     |   | $ | (6,949 | ) |

 

**NOTE 3 — COMPUTATION OF EARNINGS (LOSS) PER SHARE**

 

The Company’s Series A 3% Redeemable Convertible Preferred Stock(the “Series A Preferred Stock”) has participation rights in dividendsissued to common stockholders.  As aresult, the Company calculates earnings per share using the two class methodfor periods ending after September 1, 2009.  The following is a reconciliation of netincome (loss) applicable to common stockholders and the number of shares usedin the calculation of basic and diluted earnings (loss) per share applicable tocommon stockholders (in thousands, except per-share data):

 

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**ARTHROCARE********CORPORATION**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS — (continued)**

 
| ** **                                                                                    | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                    | ** ** | **March 31,**     | ** ** |
| ** **                                                                                    | ** ** | **2010**               | ** ** | **2009** | ** ** |
| ** **                                                                                    | ** ** | ** **             | ** ** | ** ** | ** ** |
| Net income (loss)  available to common stockholders                                           |       | $                      | 8,025      |   | $ | (6,507 | ) |
| Series A preferred  Stock interest in undistributed earnings                             |       | 1,422                  |       | — |   |
| Net income (loss) used  in computation of earnings per share available to common stockholders |       | 6,603                  |       | (6,507 | ) |
|                                                                                          | ** ** | ** **             | ** ** | ** ** | ** ** |
| Basic:                                                                                        | ** ** | ** **             | ** ** | ** ** | ** ** |
| Weighted-average common  shares outstanding                                                   |       | 26,922                 |       | 26,746 |   |
| Basic earnings (loss)  per share available to common stockholders                             |       | $                      | 0.25       |   | $ | (0.24 | ) |
|                                                                                          | ** ** | ** **             | ** ** | ** ** | ** ** |
| Diluted:                                                                                      | ** ** | ** **             | ** ** | ** ** | ** ** |
| Weighted-average common  shares outstanding                                                   |       | 26,922                 |       | 26,746 |   |
| Dilutive effect of  options                                                                   |       | 244                    |       | — |   |
| Dilutive effect of  unvested restricted stock                                                 |       | 55                     |       | — |   |
| Weighted-average common  stock and common stock equivalents                                   |       | 27,221                 |       | 26,746 |   |
| Diluted earnings (loss)  per share available to common stockholders                           |       | $                      | 0.24       |   | $ | (0.24 | ) |
|                                                                                          | ** ** | ** **             | ** ** | ** ** | ** ** |
| Stock awards excluded  from calculation as their effect would be anti-dilutive                |       | 2,120                  |       | 1,997 |   |
| Common stock issuable  upon conversion of the Series A Preferred Stock                        |       | 5,806                  |       | — |   |

 

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**ARTHROCARE********CORPORATION**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS — (continued)**

 

**NOTE 4 —****INVENTORIES**

 

The following summarizes the Company’s inventories (inthousands):

 
| ** **                    | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                    | ** ** | **2010**           | ** ** | **2009**              | ** ** |
| ** **                    | ** ** | ** **         | ** ** | ** **            | ** ** |
| Raw materials                 |       | $                  | 9,199      |                  | $          | 8,937 |   |
| Work-in-process               |       | 8,512              |       | 6,990                 |       |
| Finished goods                |       | 37,050             |       | 39,081                |       |
|                          |       | 54,761             |       | 55,008                |       |
| Inventory valuation  reserves |       | (7,608             | )          | (6,380                | )          |
| Inventories, net              |       | $                  | 47,153     |                  | $          | 48,628 |   |

 

**NOTE 5 — ACCRUED LIABILITIES**

 

The following summarizes the Company’s accruedliabilities (in thousands):

 
| ** **                          | ** ** | **March 31,********2010** | ** ** | **December 31,********2009** | ** ** |
|-------------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|
| ** **                          | ** ** | ** **                     | ** ** | ** **                        | ** ** |
| Accrued liabilities:                |       |                           |       |                              |       |
| Insurance dispute  reserve          |       | $                              | 12,319     |                              | $          | 15,268 |   |
| Compensation                        |       | 9,376                          |       | 15,007                            |       |
| Agent commissions                   |       | 2,203                          |       | 2,106                             |       |
| Royalties and discounts             |       | 2,162                          |       | 2,943                             |       |
| Legal fees and  arbitration accrual |       | 1,711                          |       | 2,862                             |       |
| Professional fees                   |       | 750                            |       | 2,748                             |       |
| Other                               |       | 4,936                          |       | 5,143                             |       |
| ** **                          |       | $                              | 33,457     |                              | $          | 46,077 |   |

 

The Company entered into settlement and releaseagreements in February and March 2010 with certain private insurersrelated to cases in which letters of protection were held by its DiscoCaresubsidiary.  The Company agreed to paythese insurers an aggregate of $3.2 million, which reduced the Company’saccrued insurance dispute reserve when paid in the first quarter of 2010.

 

**NOTE 6 — COMMITMENTS**

 

*Operating Leases*

 

The Company leasescertain facilities and equipment under operating leases.  The Company recognizes rent expense on astraight-line basis over the lease term. Rent expense was $1.6 million and $1.4 million for the quarters ended March 31,2010 and 2009, respectively.  During thequarter ended March 31, 2010, there were no material changes from theCompany’s lease obligations presented in its 2009 Form 10-K.

 

*Purchase Commitments*

 

TheCompany is a party to a variety of agreements pursuant to which it may beobligated to purchase products from other parties.  Typically, these obligations arise in thecontext of contracts entered into by the Company in the normal course ofbusiness.  During the quarter ended March 31,2010, there were no material changes from the Company’s contractual obligationspresented in its 2009 Form 10-K.

 

7

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**ARTHROCARE********CORPORATION**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS — (continued)**

 

*ContingentPayments*

 

Certainof the Company’s agreements for purchase business combinations and intangibleasset purchases include provisions to provide additional consideration ifcontractually specified conditions related to the acquired business or assetsare achieved.

 

*IndemnificationAgreements*

 

TheCompany advances legal fees as required pursuant to indemnification agreementsthat were entered with certain former executives and employees while they wereemployed with the Company.  During thequarters ended March 31, 2010, the Company advanced $1.1 million underthese indemnity agreements.  We expect tocontinue to advance payments pursuant to these agreements in future periods;however, management is unable to estimate the amount or timing of futurepayments under such agreements.

 

**NOTE 7 —LITIGATION AND CONTINGENCIES**

 

In addition to the matters specifically described below, the Company isinvolved in other legal and regulatory proceedings that arise in the ordinarycourse of business that do not have a material impact on the Company’sbusiness. Litigation claims and proceedings of all types are subject to manyfactors that generally cannot be predicted accurately.

 

The Company records reserves for claims and lawsuits when they areprobable and reasonably estimable. Except as otherwise specifically noted, theCompany currently cannot determine the ultimate resolution of the mattersdescribed below. For matters where the likelihood or extent of a loss is notprobable or cannot be reasonably estimated, the Company has not recognized inits consolidated financial statements the potential liability that may resultfrom these matters. If one or more of these matters is determined against theCompany, it could have a material adverse effect on the Company’s earnings,liquidity and financial condition.

 

We continue to gather additional facts and information related toinsurance billing and healthcare compliance issues and marketing andpromotional practices in connection with these legal and administrativeproceedings with the assistance of legal counsel.

 

**SEC Investigation**

 

The Fort Worth Regional Office of the Securities and ExchangeCommission’s (“SEC”) Division of Enforcement is conducting a formalinvestigation into accounting matters related to the restatement of financialresults as announced by the Company on July 21, 2008 and completed on November 18,2009. The Company is cooperating with the SEC investigation. At this stage ofthe investigation, the Company cannot predict the ultimate outcome and isunable to estimate any potential liability the Company may incur.

 

**DOJ Investigation**

 

The DOJ is investigating certain of the Company’s activities includingpast sales, accounting, and billing procedures primarily in relation to theoperation of the Company’s Spine business unit. The DOJ is also reviewing theCompany’s relationship with its DiscoCare subsidiary. The Company iscooperating with this investigation. At this stage of the investigation, theCompany cannot predict the ultimate outcome and is unable to estimate anypotential liability the Company may incur.

 

**Private Securities Class Action and ShareholderDerivative Lawsuits**

 

***Federal Court Actions***

 

On April 4, 2008, a putative securities class action was filed inFederal court in the Southern District of Florida against the Company andcertain of its former executive officers, alleging violations ofSections 10(b) and 20(a) of the Exchange Act and Rule 10b-5promulgated thereunder. Plaintiffs allege that the defendants violated federalsecurities

 

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**ARTHROCARE********CORPORATION**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS — (continued)**

 

lawsby issuing false and misleading financial statements and making materialmisrepresentations regarding the Company’s internal controls, business, andfinancial results. On October 28, 2008, the court granted the Company’smotion to transfer this case to the U.S. District Court, Western District ofTexas (*McIlvaine v. ArthroCare, et al*).

 

On July 25, 2008, a putative securities class action was filed inFederal court in the Western District of Texas against the Company, and certainof its current and former executive officers, alleging violations ofSections 10(b) and 20(a) of the Exchange Act and Rule 10b-5promulgated thereunder. Plaintiffs allege that the defendants violated federalsecurities laws by issuing false and misleading financial statements and makingmaterial 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 courtin the Southern District of Florida against the Company and its then-currentdirectors alleging breach of fiduciary duty based on the Company’s alleged improperrevenue recognition, improper reporting of such revenue in SEC filings andpress releases, failure to maintain adequate internal controls, and failure tosupervise management. On October 14, 2008, the court granted the Company’smotion to transfer this case to the U.S. District Court, Western District ofTexas (*Weil v. Baker, et al*).

 

On March 4, 2009, a derivative action was filed in Federal courtin the Western District of Texas against the Company’s current directors, aformer director, certain of its current and former executive officers and otheremployees and PricewaterhouseCoopers LLP alleging (i) disgorgementunder Section 304 of the Sarbanes-Oxley Act; (ii) violations of Section 10(b) ofthe Exchange Act and Rule 10b-5; (iii) breach of fiduciary duty; (iv) abuseof control; (v) gross mismanagement of the Company; (vi) waste ofcorporate assets; (vii) insider trading; and (viii) unjustenrichment. (*King v. Baker, et al*).

 

On April 29, 2009, a derivative action was filed in Federal courtin the Western District of Texas against the Company’s current directors and aformer director alleging breach of fiduciary duty based on the Company’simproper revenue recognition, improper reporting of such revenue in SEC filingsand press releases, failure to maintain adequate internal controls, and failureto supervise management. (*Barron v. Baker,et al*).

 

On October 28, 2008, and thereafter, the two putative securitiesclass actions and the shareholder derivative actions were consolidated anddesignated: *In Re ArthroCare CorporationSecurities 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 theputative consolidated securities class action. The Lead Plaintiff filed anAmended Consolidated Class Action Complaint on December 18, 2009,seeking unspecified monetary damages and interest.  ArthroCare filed a Motion to Dismiss theAmended Consolidated Class Action Complaint on February 16, 2010. Thefederal court stayed the derivative actions pending the resolution of allmotions to dismiss the Amended Consolidated Class Action Complaint and anyfurther amended consolidated class action complaints.

 

At this stage of the above-described Federal Court actions, the Companycannot predict the ultimate outcome and is unable to estimate any potentialliability the Company may incur.

 

***State Court Actions***

 

On September 23, 2008, a derivative action was filed in TexasState District Court against the Company, and its then current directors andcertain of its current and former officers. (*Wieserv. Baker*). In this action, one of the Company’s shareholders allegedderivative claims on behalf of the Company that its directors and officers breachedtheir fiduciary duties to shareholders by allowing improper financialreporting, failing to maintain adequate financial controls over revenuerecognition, disseminating false financial statements, abuse of control, grossmismanagement, waste of corporate assets, and engaging in insider trading.

 

On October 20, 2008, a derivative action was filed in Texas StateDistrict Court against the Company, its then directors and certain of itscurrent and former executive officers. (*Bockletv. Baker*). In this action, one of the Company’s shareholders allegedderivative claims on behalf of the Company that its directors and officersbreached their fiduciary duties to shareholders by failing to maintain adequatefinancial controls over revenue recognition, allowing improper financialreporting, disseminating false financial statements, and engaging in insidertrading.

 

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**ARTHROCARE********CORPORATION**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS — (continued)**

 

On October 27, 2008, a derivative action was filed in Texas StateDistrict Court against the Company, its then directors and certain of itscurrent and former executive officers. (*Guthriev. Baker*). In this action, one of the Company’s shareholders allegedderivative claims on behalf of the Company that its directors and officersbreached their fiduciary duties to shareholders by failing to maintain adequatefinancial controls over revenue recognition, allowing improper financialreporting, disseminating false financial statements, and engaging in insidertrading.

 

On March 18, 2009, these three shareholder derivative actions wereconsolidated and designated: *In Re ArthroCareCorporation Derivative Litigation*, Case No. D-1-GN-08-3484(consolidated), Travis County District Court. On the Company’s motion, thestate shareholder derivative actions were stayed pending resolution of allmotions to dismiss the federal Amended Consolidated Class Action Complaintand class certification, if any, of a class in the federal Amended ConsolidatedClass Action Complaint.

 

At this stage of the above described State Court actions, the Companycannot predict the ultimate outcome and is unable to estimate any potentialliability the Company may incur.

 

**NOTE 8 —SEGMENT INFORMATION**

 

The Company hasorganized its marketing and sales efforts based on three operating segmentswhich are aggregated into one reportable segment—the development, manufactureand marketing of disposable devices for less invasive surgical procedures.  Each of the Company’s business units hassimilar economic characteristics, technology, manufacturing processes,customers, distribution and marketing strategies, regulatory environments, andshared infrastructures. These business units are Sports Medicine, Ear Nose andThroat (“ENT”), and Spine.

 

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

 
| ** **          | ** ** | **Three Months Ended** | ** ** |
|---------------------|------------|------------------------|------------|
| ** **          | ** ** | **March 31,**     | ** ** |
| ** **          | ** ** | **2010**               | ** ** | **2009** | ** ** |
| ** **          | ** ** | ** **             | ** ** | ** ** | ** ** |
| Sports Medicine     |       | $                      | 60,449     |   | $ | 50,174 |   |
| ENT                 |       | 21,745                 |       | 20,239 |   |
| Spine               |       | 4,423                  |       | 5,155 |   |
| Total Product Sales |       | $                      | 86,617     |   | $ | 75,568 |   |

 

Internationally,the Company markets and supports its products primarily through itssubsidiaries and various distributors. Revenues attributed to geographic areas are based on the country orregional area where the Company’s customer is domiciled.  Product sales by geography for the periodsshown were as follows (in thousands):

 
| ** **            | ** ** | **Three Months Ended** | ** ** |
|-----------------------|------------|------------------------|------------|
| ** **            | ** ** | **March 31,**     | ** ** |
| ** **            | ** ** | **2010**               | ** ** | **2009** | ** ** |
| ** **            | ** ** | ** **             | ** ** | ** ** | ** ** |
| United States         |       | $                      | 61,584     |   | $ | 53,779 |   |
| Non-United States (1) |       | 25,033                 |       | 21,789 |   |
| Total  Product Sales  |       | $                      | 86,617     |   | $ | 75,568 |   |

 

----

(1) No additional locations are individuallysignificant.

 

Long-lived assetsby geography at the Balance Sheet dates shown were as follows (in thousands):

 

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**ARTHROCARE********CORPORATION**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS — (continued)**

 
| ** **               | ** ** | **March 31,  2010** | ** ** | **December 31,  2009** | ** ** |
|--------------------------|------------|---------------------|------------|------------------------|------------|
| ** **               | ** ** | ** **          | ** ** | ** **             | ** ** |
| United States            |       | $                   | 30,883     |                   | $          | 31,791 |   |
| Costa Rica               |       | 13,605              |       | 13,693                 |       |
| Other                    |       | 6,807               |       | 6,719                  |       |
| Total long-lived  assets |       | $                   | 51,295     |                   | $          | 52,203 |   |

 

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**ITEM2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS**

 

*The following discussion should be read in conjunction withthe condensed consolidated financial statements and notes thereto appearingelsewhere in this Form 10-Q. Readers should also review carefully Exhibit 99.1,“Forward-Looking Statements,” which provides information about theforward-looking statements in this report and a discussion of the factors thatmight cause our actual results to differ, perhaps materially, from theseforward-looking statements.  Statementsin this Management’s Discussion and Analysis of Financial Condition and Resultsof Operations and elsewhere in this quarterly report on Form 10-Q whichexpress that we “believe,” “anticipate,” “expect” or “plan to” as well as otherstatements which are not historical fact, are forward-looking statements withinthe meaning of the Private Securities Litigation Reform Act of 1995 and aresubject to the safe harbors created under the Securities Act of 1933, asamended, and the Securities Exchange Act of 1934, as amended.**** Readers are cautioned that theseforward-looking statements are only predictions and are subject to risks,uncertainties, and assumptions that are difficult to predict.** **Assuch, actual events or results may differ materially as a result of the risksand uncertainties described herein and elsewhere including, but not limited to,those factors discussed in Part II — Item 1A — “Risk Factors”. In thisquarterly report on Form 10-Q, the terms the “Company”, “we”, “us” and “our”refer to ArthroCare Corporation and its subsidiaries.*

 

***Overview***

 

We are a medical device company that develops, manufactures and marketssurgical products, many of which are based on our minimally invasive patentedCoblation technology. Our products are used across several medical specialties,improving many existing soft-tissue surgical procedures and enabling newminimally invasive surgical procedures. Our business is divided into threebusiness units: Sports Medicine, ENT, and Spine. Each business unit markets andsells their products in two principal geographic markets: Americas (North andSouth America) and International (all other geographies).

 

As previously reported, during 2009 and 2008, we experiencedsubstantial delays in filing our periodic reports as a result of issuesidentified during a review of certain accounting and financial reportingmatters as well as certain insurance billing and healthcare compliancepractices conducted under the direction of our Audit Committee (the “Review”),which began in July 2008. The Review was completed in August 2009 andthe results were reported to the Audit Committee and to the Board. In July 2008,we also commenced a separate comprehensive review of our accounting policiesand procedures, financial reporting, internal controls and corporategovernance. We completed this comprehensive review in November 2009, andas a result of our comprehensive review and the Review we made extensiveorganizational and operational changes, and improved our internalcontrols.  During the year ended December 31,2009, our results of operations, financial position and cash flows wereadversely affected by the effect that the Review and the restatement had on ourmanagement and employees, the significant costs of the Review and restatement,and through the third quarter of 2009, our failure to maintain compliance withcovenants in our previous five year revolving Credit Agreement (the “CreditAgreement”) that was entered into on January 13, 2006 with a syndicate ofbanks (collectively, the “Lenders”). In connection with the Review andrestatement we identified errors in our accounting and material weaknesses inour internal control over financial reporting. As described in “Part I—Item 4—Controlsand Procedures,” we are still in the process of remediating certain of theseidentified material weaknesses.

 

***First Quarter 2010 AccountingCorrections***

 

Our results for the quarterended March 31, 2010 include reductions of stock compensation expense tocorrect forfeiture calculation errors in prior periods. The impact of the errorwas an overstatement of operating expenses of $0.4 million in the year endedDecember 31, 2008 and $0.7 million in the year ended December 31, 2009. Tocorrect this error, we recorded reductions of $0.8 million to general andadministrative expense and $0.3 million to sales and marketing expense in thecondensed consolidated statement of operations for the quarter ended March 31,2010. We have determined that the impact of this uncorrected error isimmaterial to all prior periods, and we expect these out-of-period adjustmentsto be immaterial to our results for the year ending December 31, 2010.

 

***Key Financial Items, Trends andUncertainties Affecting Our Business***

 

Our management reviews and analyzes several metrics and ratios in orderto manage our business and assess the quality of and potential variability ofour operating performance. The most important of these financial metrics andratios include:

 

*Product Sales Growth*

 

Our principal source of revenue is from sales of our products, whichprimarily include disposable surgical devices and implants. Product sales aremade through our direct sales employees, independent sales agents andindependent distributors. Reported product sales increased 14.6 percent in thequarter ended March 31, 2010, compared to the same time period in 2009. Wealso generate revenue from royalties and fees from licensing of our productsand technology to other companies and earn other revenues from shipping andhandling costs billed to customers.

 

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Our investment in our sales and distribution organization has had apositive effect on product sales, as has the execution of our strategic plan tobuild market share through the introduction of new products designed to addresssurgical procedures that have traditionally been difficult to perform. Weanticipate that disposable device sales and implants will remain the keycomponent of our product sales for the foreseeable future.

 

*Gross Product Margin*

 

Gross product margin as a percentage of product sales in the quarterended March 31, 2010 was 68.9 percent compared to 71.2 percent for thesame period in 2009. Cost of product sales consists of all product manufacturingcosts (including material costs, labor costs, manufacturing overhead, warrantyand other direct product costs), adjustments to the carrying value of inventoryfor excess or obsolete items, and certain stock-based compensation costsassociated with manufacturing and operations personnel. Cost of product salesalso includes amortization of controller units that are placed at customerlocations to enable the use of our disposable surgical products. We maintainownership of all placed controllers and the cost of controller units arecapitalized and amortized into cost of product sales over the useful life ofthe controller unit. Most of our manufactured products are produced at ourCosta Rica facility which has experienced stable operations. Raw materials usedto produce our products are generally not subject to substantial commodityprice volatility.

 

*Operating Margin*

 

Operating margin is our income (loss) from operations as a percentageof total revenues. Our key operating expenses include expenses incurred inconnection with research and development, sales and marketing, general andadministrative and amortization of intangible assets. During the quarter ended March 31,2009, our operating expenses were significantly higher than in the quarterended March 31, 2010 due to expenses incurred in connection with theReview and the restatement of our financial statements.  Operating margin in the quarter ended March 31,2010 was 16.7 percent compared to negative 4.4 percent for the same period in2009.

 

*Net Earnings*

 

Net earnings represent the net income or loss in the period. Netearnings will be affected by the same trends that impact our revenues, grossmargin and operating margin. In addition, net earnings will also be affected byother income and expenses, such as interest expense, and by income taxes.  Interest expense and bank fees were lower inthe quarter ended March 31, 2010 as we repaid all outstanding bankborrowings on September 1, 2009. We expect that we will report foreigncurrency gains or losses each period due primarily to changes in the value ofthe euro, British pound and Australian dollar versus the U.S. dollar.

 

Our effective income tax rate is less than the U.S. statutory rate as asubstantial portion of our operations are outside the U.S. in jurisdictionswith lower tax rates, including Costa Rica, where we have a tax holiday. Inyears of loss, our effective tax rate may exceed the U.S. statutory ratedepending on the apportionment of income or loss between jurisdictions in whichwe operate. We expect to be able to fully utilize our deferred tax assets.

 

**Results of Operations**

 

Results of operations for the three months ended March 31, 2010and 2009 (inthousands, except percentages and per-share data) were as follows:

 

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| ** **                                                                              | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                              | ** ** | **March 31,**          | ** ** |
| ** **                                                                              | ** ** | **2010**               | ** ** | **2009** | ** ** |
| ** **                                                                              | ** ** | **Dollars**            | ** ** | **% Total  Revenue** | ** ** | **Dollars** | ** ** | **% Total  Revenue** | ** ** |
|                                                                                    | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Revenues:**                                                                           |       |                   |       |   |   |   |   |   |   |
| Product sales                                                                           |       | $                      | 86,617     |   | 95.6 | % | $ | 75,568 |   | 95.9 | % |
| Royalties, fees  and other                                                              |       | 3,994                  |       | 4.4 | % | 3,222 |   | 4.1 | % |
| Total revenues                                                                          |       | 90,611                 |       | 100.0 | % | 78,790 |   | 100.0 | % |
|                                                                                    |       |                   |       |   |   |   |   |   |   |
| **Cost  of product sales**                                                              |       | 26,933                 |       | 29.7 | % | 21,796 |   | 27.7 | % |
| ** **                                                                              |       |                   |       |   |   |   |   |   |   |
| **Gross  profit**                                                                       |       | 63,678                 |       | 70.3 | % | 56,994 |   | 72.3 | % |
| ** **                                                                              |       |                   |       |   |   |   |   |   |   |
| **Operating  expenses:**                                                                |       |                   |       |   |   |   |   |   |   |
| Research and development                                                                |       | 9,150                  |       | 10.1 | % | 8,362 |   | 10.6 | % |
| Sales and marketing                                                                     |       | 27,820                 |       | 30.7 | % | 29,666 |   | 37.6 | % |
| General and administrative                                                              |       | 8,982                  |       | 9.9 | % | 11,948 |   | 15.2 | % |
| Amortization of intangible assets                                                       |       | 1,567                  |       | 1.7 | % | 1,586 |   | 2.0 | % |
| Investigation and restatement-related costs                                             |       | 1,043                  |       | 1.2 | % | 8,724 |   | 11.1 | % |
| Reimbursement services                                                                  |       | 21                     |       | 0.0 | % | 168 |   | 0.2 | % |
| Total operating  expenses                                                               |       | 48,583                 |       | 53.6 | % | 60,454 |   | 76.7 | % |
| ** **                                                                              |       |                   |       |   |   |   |   |   |   |
| **Income  (loss) from operations**                                                      |       | 15,095                 |       |   |   | (3,460 | ) |   |   |
| Interest and  other expense, net                                                        |       | (3,061                 | )          |   |   | (1,338 | ) |   |   |
| ** **                                                                              |       |                   |       |   |   |   |   |   |   |
| **Income  (loss) before income taxes**                                                  |       | 12,034                 |       |   |   | (4,798 | ) |   |   |
|                                                                                    |       |                   |       |   |   |   |   |   |   |
| Income tax  provision                                                                   |       | 3,207                  |       |   |   | 1,709 |   |   |   |
|                                                                                    |       |                   |       |   |   |   |   |   |   |
| **Net  income (loss)**                                                                  |       | 8,827                  |       |   |   | (6,507 | ) |   |   |
| ** **                                                                              |       |                   |       |   |   |   |   |   |   |
| **Accrued  dividends and accretion charges on Series A 3% Convertible Preferred Stock** |       | (802                   | )          |   |   | — |   |   |   |
| ** **                                                                              |       |                   |       |   |   |   |   |   |   |
| **Net  income (loss) available to common stockholders**                                 |       | $                      | 8,025      |   |   |   | $ | (6,507 | ) |   |   |
|                                                                                    |       |                   |       |   |   |   |   |   |   |
| **Weighted-average shares outstanding:**                                                |       |                   |       |   |   |   |   |   |   |
| Basic                                                                                   |       | 26,922                 |       |   |   | 26,746 |   |   |   |
| Diluted                                                                                 |       | 27,221                 |       |   |   | 26,746 |   |   |   |
|                                                                                    |       |                   |       |   |   |   |   |   |   |
| **Earnings (loss) per common share:**                                                   |       |                   |       |   |   |   |   |   |   |
| Basic                                                                                   |       | $                      | 0.25       |   |   |   | $ | (0.24 | ) |   |   |
| Diluted                                                                                 |       | $                      | 0.24       |   |   |   | $ | (0.24 | ) |   |   |

 

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***ProductSales***

 

Productsales by business unit and geographic market for the periods shown were asfollows (in thousands, except percentages):

 
| ** **           | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** |
|----------------------|------------|------------------------|------------|------------------------|------------|
| ** **           | ** ** | **March 31, 2010**     | ** ** | **March 31, 2009**     | ** ** |
| ** **           | ** ** | **Americas**           | ** ** | **International**      | ** ** | **Total  Product  Sales** | ** ** | **% Net  Product  Sales** | ** ** | **Americas** | ** ** | **International** | ** ** | **Total  Product  Sales** | ** ** | **% Net  Product  Sales** | ** ** |
| ** **           | ** ** | ** **             | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Sports Medicine      |       | $                      | 44,391     |                   | $          | 16,058 |   | $ | 60,449 |   | 69.8 | % | $ | 35,829 |   | $ | 14,345 |   | $ | 50,174 |   | 66.4 | % |
| ENT                  |       | 18,415                 |       | 3,330                  |       | 21,745 |   | 25.1 | % | 17,307 |   | 2,932 |   | 20,239 |   | 26.8 | % |
| Spine                |       | 2,281                  |       | 2,142                  |       | 4,423 |   | 5.1 | % | 3,128 |   | 2,027 |   | 5,155 |   | 6.8 | % |
| Total Product  Sales |       | $                      | 65,087     |                   | $          | 21,530 |   | $ | 86,617 |   | 100.0 | % | $ | 56,264 |   | $ | 19,304 |   | $ | 75,568 |   | 100.0 | % |
|                 |       |                   |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| % Net Product  Sales |       | 75.1                   | %          | 24.9                   | %          | 100.0 | % |   |   | 74.5 | % | 25.5 | % | 100.0 | % |   |   |

 

Our reportedSports Medicine product sales increased 20.5 percent during the quarter ended March 31,2010 compared to the same period in 2009. Sports Medicine product sales for the Americas included the recognitionof $6.6 million of product sales from prior periods that were deferredpending resolution of certain contract issues with customers which wereresolved in the quarter ended March 31, 2010.  Americas’ product sales also increased $3.0million, or 8.4 percent, due to higher contract manufacturing volume pursuantto a supply and distribution agreement with Smith & Nephew.International Sports Medicine sales increased 11.9 percent.

 

Product sales inour ENT business unit increased 7.4 percent during the quarter ended March 31,2010 compared to the same period of 2009 as a result of increased Coblationsales and improved average sales price due to a price increase that went intoeffect in late 2009. The increase in Coblation sales is attributed to greatermarket share in tonsillectomy and adenoidectomy procedures.

 

Our Spine business unit product sales decreased $0.7 million or 14.2percent during the quarter ended March 31, 2010 compared with the sameperiod of 2009.  Product sales volumeswere significantly lower in the Americas for all products, while InternationalCoblation product sales increased approximately 5.6 percent.

 

Intotal, International product sales increased $2.2 million or 11.5 percentduring the quarter ended March 31, 2010 compared with the same period of2009. Product sales in the first quarter of 2010 increased by $3.1 million inthe Company’s direct International markets while sales to distributors, asignificant portion of which were in U.S. dollars, decreased by $0.9 millionwhen compared to the first quarter of 2009. Product sales were also affected by changes in foreign exchange ratesused to translate foreign currency sales from international markets to the Company’sU.S. dollar reporting currency.  Changesin exchange rates increased the U.S. dollar reported value by approximately$1.8 million.

 

***Royalties, Fees and OtherRevenues***

 

Royalties, fees, and other revenues consist mainly of revenue from thelicensing of our products and technology, plus shipping and handling costsbilled to customers. Royalties, fees, and other revenues increased to$4.0 million or 24.0 percent during the quarter ended March 31, 2010compared with the same period of 2009 primarily as a result of increasedroyalties from third parties that use our radio frequency, or RF, technologypursuant to a license.

 

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***Cost of Product Sales***

 
| ** **                   | ** ** | **Three Months Ended** | ** ** |
|------------------------------|------------|------------------------|------------|
| ** **                   | ** ** | **March 31,**          | ** ** |
| ** **                   | ** ** | **2010**               | ** ** | **2009** | ** ** |
| ** **                   | ** ** | **Dollars**            | ** ** | **% Net  Product  Sales** | ** ** | **Dollars** | ** ** | **% Net  Product  Sales** | ** ** |
| ** **                   | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Product cost                 |       | $                      | 22,263     |   | 25.7 | % | $ | 18,366 |   | 24.3 | % |
| Controller  amortization     |       | 2,359                  |       | 2.7 | % | 2,167 |   | 2.8 | % |
| Other                        |       | 2,311                  |       | 2.7 | % | 1,263 |   | 1.7 | % |
| Total cost of  product sales |       | $                      | 26,933     |   | 31.1 | % | $ | 21,796 |   | 28.8 | % |

 

Product margin as a percentage of productsales was 68.9 percent during the quarter ended March 31, 2010 and 71.2percent in the same period in 2009.  Inthe first quarter of 2010, there was $1.0 million in higher inventoryobsolescence charges as well as $0.9 million in additional royalty costscompared to the same period in 2009.  Thedeferred revenue recognized in the first quarter of 2010 increased net productmargin by $4.2 million.  Additionally,product margin for the first quarter of 2010 was impacted by higher contractmanufactured product sales on which we realize lower margins but incur no salesand marketing expense.

 

***OperatingExpenses***

 
| ** **                                  | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------|------------|------------------------|------------|
| ** **                                  | ** ** | **March 31,**          | ** ** |
| ** **                                  | ** ** | **2010**               | ** ** | **2009** | ** ** |
| ** **                                  | ** ** | **Dollars**            | ** ** | **% Total  Revenue** | ** ** | **Dollars** | ** ** | **% Total  Revenue** | ** ** |
|                                        |       |                   |       |   |   |   |   |   |   |
| Research and development                    |       | $                      | 9,150      |   | 10.1 | % | $ | 8,362 |   | 10.6 | % |
| Sales and marketing                         |       | 27,820                 |       | 30.7 | % | 29,666 |   | 37.6 | % |
| General and administrative                  |       | 8,982                  |       | 9.9 | % | 11,948 |   | 15.2 | % |
| Amortization of intangible assets           |       | 1,567                  |       | 1.7 | % | 1,586 |   | 2.0 | % |
| Investigation and restatement-related costs |       | 1,043                  |       | 1.2 | % | 8,724 |   | 11.1 | % |
| Reimbursement services                      |       | 21                     |       | 0.0 | % | 168 |   | 0.2 | % |
| Total operating  expenses                   |       | $                      | 48,583     |   | 53.6 | % | $ | 60,454 |   | 76.7 | % |

 

*Research and development expense* increased $0.8 million during the quarter ended March 31,2010, compared to the same period in 2009 primarily as a result of an increasein research, development and quality personnel headcount.

 

*Sales and marketing expense* decreased $1.8million, to 30.7 percent of total revenues during the quarter ended March 31,2010, compared to 37.6 percent of total revenues for the same period in2009.  Previously deferred revenue thatwas recognized in the first quarter of 2010, contract manufacturing product revenues,and royalty revenues did not incur commission expense which lowered sales andmarketing expense as a percentage of total revenues in the quarter.  Additionally, Spine sales and marketingexpense in the Americas decreased $1.7 million as we restructured our Spinedistribution channel from primarily a direct sales organization to agents.

 

*General and administrative expense* decreased $3.0million, to 9.9 percent of total revenues during the quarter ended March 31,2010, compared to 15.2 percent of total revenues for the same period in2009, primarily as a result of a decrease in legal defense costs involvingcertain patent matters that were settled in December 2009, offset by anincrease in accounting and compliance personnel costs.

 

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*Investigation and restatement**expenses* decreased to $1.0 million or 1.2 percent of totalrevenues during the quarter ended March 31, 2010 primarily as a result ofcompleting the Review and restatement process in November of 2009.  We expect to continue to incur during 2010legal defense costs in connection with the DOJ and SEC and shareholder andderivative class action matters related to the Review and restatement whichwill be classified as investigation and restatement expense.

 

***Interest and Other Expense, Net***

 
| ** **                       | ** ** | **Three Months Ended** | ** ** |
|----------------------------------|------------|------------------------|------------|
| ** **                       | ** ** | **March 31,**          | ** ** |
| ** **                       | ** ** | **2010**               | ** ** | **2009** | ** ** |
| ** **                       | ** ** | ** **             | ** ** | ** ** | ** ** |
| Interest and  other expense, net |       | $                      | (101       | ) | $ | (1,192 | ) |
| Foreign exchange  loss, net      |       | (2,960                 | )          | (146 | ) |
| Interest and  other expense, net |       | $                      | (3,061     | ) | $ | (1,338 | ) |

 

Interest and other expense, netincreased $1.7 million for the quarter ended March 31, 2010 compared tothe quarter ended March 31, 2009. During the fourth quarter ended December 31, 2009 the companyidentified an error related to the translation of foreign currencies into U.S.dollars for certain subsidiaries.  Theimpact of this error was recorded in the quarter ended December 31, 2009as management determined that the impact of the error was immaterial to theperiods ending March 31, 2009, June 30, 2009 and September 30,2009.  Had management recorded the impactof the error in the period ending March 31, 2009 the foreign exchange losswould have increased $1.0 million. Interest expense decreased in the quarter ended March 31, 2010 as aresult of paying off our outstanding Credit Agreement in September 2009.

 

***Income TaxProvision (Benefit)***

 

Oureffective tax rate for the quarter ended March 31, 2010 and 2009 was 26.6percent and negative 35.6 percent, respectively.  In January 2009, the U.S. Treasuryissued temporary cost-sharing regulations and we decided to adjust ourintercompany payments for all open tax years. Accordingly we recorded additional income tax expense of approximately$3.6 million in the quarter ended March 31, 2009.

 

**Liquidityand Capital Resources**

 

Asof March 31, 2010 we had $121.6 million in working capital, compared to$106.3 million at December 31, 2009. Cash and cash equivalents increased from $57.4 million at December 31,2009 to $65.3 million at March 31, 2010. Since the repayment and termination of our Credit Agreement on September 1,2009, cash and cash equivalents are our principal source of liquidity.  We expect that our cash flows from operationstogether with cash on hand will be sufficient to satisfy our short-term and,excluding the uncertainty related to the ongoing litigation and investigationsto which we are a party, long-term normal operating liquidity requirements.

 

Cashprovided by operating activities for the three months ended March 31, 2010was $11.2 million and differed from our net income of $8.8 million due tonon-cash expenses partially offset by reductions to accrued liabilities as wemade settlement payments to certain private insurers of $3.2 million,performance compensation payments related to the 2009 year, and paidinvestigation and restatement related costs accrued at the end of 2009.

 

Cashused in investing activities for the three months ended March 31, 2010 and2009 was $3.6 million and $4.4 million.

 

Cashprovided by financing activities for the three months ended March 31, 2010was $0.3 million while cash used by financing activities for the quarter ended March 31,2009 was $10.0 million, due to principal repayments on our revolving creditagreement.

 

**Critical Accounting Policies and Estimates**

 

Therehave been no material updates to our critical accounting policies and estimatesset forth in “Part II—Item 7—Management Discussion and Analysis ofFinancial Condition and Results of Operations — Critical Accounting Policiesand Estimates” in our 2009 Form 10-K.

 

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**Recently Issued Accounting Pronouncements**

 

See Note 1 of Notes to Condensed Consolidated Financial Statementsincluded in “Part I—Item 1—Financial Statements” for a description ofrecently issued accounting pronouncements, including the expected dates ofadoption and estimated effects on our results of operations, financialposition, and cash flows.

 

**Disclosuresabout Contractual Obligations and Commercial Commitments**

 

Wehave various contractual obligations, which are recorded as liabilities in ourcondensed consolidated financial statements. Other items, such as certain purchase commitments with suppliers andminimum lease payments under operating leases, are not recognized asliabilities in our condensed consolidated financial statements but are requiredto be disclosed.  During the quarterended March 31, 2010, there were no material changes from our contractualobligations presented in our 2009 Form 10-K.

 

**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

We are exposed to certain market risks as part of ourongoing business operations, primarily risks from changing interest rates andforeign currency exchange rates that may impact, adversely or otherwise, ourfinancial condition, results of operations, or cash flows. Although paymentsunder the operating leases for our facilities are tied to market indices, weare not exposed to material interest rate risk associated with operatingleases.  We have not historically usedderivative financial instruments to manage these market risks.

 

Our interest income is dependent on changes in thegeneral level of U.S. dollar interest rates. Our cash and cash equivalentsconsist of money market funds and various deposit accounts.  Due to the nature and value of our investments,we have concluded that we do not have material interest rate riskexposure.  An immediate 10 percentincrease or decrease in interest rates would not have a material adverse impacton our future operating results or cash flows.

 

The table belowpresents principal amounts and related weighted average interest rates as of March 31,2010 for our cash and cash equivalents as well as the balance of our loanreceivable (in thousands):

 
| Cash,  cash equivalents, restricted cash equivalents and investments |   | $              | 65,252 |   |
|----------------------------------------------------------------------|--------|----------------|--------|--------|
| Average  interest rate earned on cash and cash equivalents           |   | less than 0.01 | %      |
| Loan  receivable                                                     |   | $              | 2,762  |   |
| Average  interest rate on loan receivable                            |   | 7.0            | %      |

 

***Foreign Currency Risk***

 

A significantportion of our international sales and operating expenses are denominated incurrencies other than the U.S. dollar.  To the extent that the exchangerates for these currencies fluctuate against the U.S. dollar, we willexperience variations in our results of operations and financial condition.

 

Our cash and cashequivalents at March 31, 2010 are denominated primarily in U.S. dollars;however, we also maintain significant balances in euros, British pounds,Swedish kroner, Swiss Francs, Australian dollars and Costa Rican colones. A 10 percent change in the March 31, 2010 exchange rates for these currencieswould have an impact on pre-tax income of approximately $1.2 million.

 

Wehave not used derivative financial instruments to hedge against foreigncurrency exchange risk. Our objective to minimize foreign currency gains andlosses has been managed by maintaining only enough cash necessary for immediateworking capital requirements in accounts denominated in currencies other thanthe U.S. dollar and holding the majority of our cash and cash equivalents inU.S. dollar accounts.

 

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**ITEM 4. CONTROLS AND PROCEDURES**

 

**Evaluationof Disclosure Controls and Procedures**

 

Asrequired by Rule 13a-15 under the Securities Exchange Act of 1934, asamended, management has evaluated, with the participation of our ChiefExecutive Officer and Chief Financial Officer, the effectiveness of ourdisclosure controls and procedures as of the end of the period covered by thisreport.  Disclosure controls andprocedures refer to controls and other procedures designed to ensure thatinformation required to be disclosed in the reports we file or submit under theExchange Act is recorded, processed, summarized and reported within the time periodsspecified in the rules and forms of the SEC. Disclosure controls andprocedures include, without limitation, controls and procedures designed toensure that information required to be disclosed by us in the reports that wefile or submit under the Exchange Act is accumulated and communicated tomanagement, including our CEO and CFO, as appropriate, to allow timelydecisions regarding our required disclosure. In designing and evaluating our disclosure controls and procedures,management recognizes that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable assurance of achieving thedesired control objectives, and management was required to apply its judgmentin evaluating and implementing possible controls and procedures.

 

Pursuantto this evaluation, our CEO and CFO concluded that, as of March 31, 2010,the end of the period covered by this report, our disclosure controls andprocedures were not effective at the reasonable assurance level as a result ofthe material weaknesses that management has identified in our internal controlover financial reporting.

 

Wehave taken steps and are taking the actions described more fully below under “RemediationActivities” to remediate the material weaknesses in our internal control overfinancial reporting.  We also strive toenhance our processes to enable us to provide complete and accurate publicdisclosure on a timely basis.  Aspreviously reported, the restatement of our consolidated financial statementsfor the years ended December 31, 2007 and 2006 and for the quarter ended March 31,2008, resulted in an inability to timely file our periodic reports from May 2008through November 2009.   Managementwill not consider our disclosure controls and procedures to be effective at thereasonable assurance level until we are able to consistently file requiredreports with the SEC on a timely basis.

 

Toaddress the material weaknesses described in this Item 4, management performedadditional analyses and other post-closing procedures designed to providereasonable assurance that our consolidated financial statements were preparedin accordance with GAAP.  As a result ofthese procedures, management believes that the consolidated financial statementsincluded in this report fairly present, in all material respects, our financialposition, results of operations and cash flows as of the dates and for theperiods presented, in conformity with GAAP.

 

Managementidentified the following control deficiencies that constitute material weaknessesthat are not fully remediated as of the filing date of this report.

 

1.               We did not maintain aneffective control environment with the sufficient complement of personnel,procedures for gathering and disseminating information pertinent to our financialreporting (information and communication) or activities that effectivelymonitor the performance of controls. Specifically:

 

·                  *Controlenvironment*.  We did notmaintain the sufficient complement of personnel with the appropriate level ofaccounting knowledge, experience, and training in the application ofGAAP commensurate with our financial reporting requirements.

 

·                  *Informationand communication.*   We did notmaintain effective procedures for communicating to all relevant personnel ouraccounting policies, the importance of consistent application of our accountingpolicies, and essential data required to properly apply GAAP to ourtransactions. Specifically, we did not have appropriate procedures to providereasonable assurance that non-routine terms in business arrangements withfinancial reporting implications are communicated completely, accurately or ina timely manner to our accounting personnel. As a result, accounting personneldid not have the necessary information to determine the financial reportingconsequences of certain transactions.

 

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·                  *Monitoringof controls.*   We did notmaintain effective monitoring activities to provide reasonable assurance thatbreakdowns in the operation of controls would be timely detected and corrected.As a result, we did not detect deficiencies in compliance with our accountingpolicies on a timely basis.

 

These material weaknesses led to erroneous judgments regarding theapplication of GAAP and resulted in errors in the preparation of our financialstatements. These material weaknesses also contributed to the continuedexistence of the material weaknesses described in items 2 through 4 below.

 

2.*                                      **Period-endfinancial reporting process.*  We did not maintain effective controls overthe period-end financial reporting process, including controls with respect tothe preparation, review, supervision, and monitoring of accounting operations.Specifically:

 

·                  We did not maintaineffective controls to provide reasonable assurance that account reconciliationswere properly performed and that reconciliations and journal entries wereconsistently reviewed for completeness and accuracy.

 

·                  We did not maintain effectivecontrols to provide reasonable assurance that foreign currency transactions andbalances were valued accurately in our consolidated financial statements.

 

·                  We did not maintaineffective controls related to our accounting for stockholders’ equity to providereasonable assurance that stock-based compensation expense was accuratelyrecorded.

 

·                  We did not maintaineffective controls to provide reasonable assurance that expenses wererecognized in the proper reporting period, which affected the accuracy andvaluation of certain intangible assets and also the completeness, accuracy andtimely recording of prepaid expenses, accrued liabilities and the associatedoperating expenses.

 

3.*                                      **Revenuerecognition.*  We did notmaintain effective controls related to our accounting for revenue to providereasonable assurance that (a) our accounting policy for revenuerecognition was appropriately applied to the individual facts and circumstancesof our various distributor, sales agent or customer agreements; (b) revenuewas recognized in the proper reporting period in accordance with the terms ofour sales contracts and our practice for replacing product that was lost ordamaged during shipment; (c) appropriate collectibility assessments wereperformed prior to recognizing revenue; (d) our policies for returns andexchanges were consistently followed; and (e) revenue was recorded on anet basis with respect to all rebates or other payments due to customers.

 

4.                                       *Acquisitionaccounting. *We did notmaintain effective controls related to our accounting for business acquisitionsto provide reasonable assurance that (a) business combination accountingidentified and considered all pertinent facts related to pre-acquisitionbusiness arrangements between the parties to determine appropriate acquisitiondate accounting for the settlement of a pre-existing business arrangement; and (b) therationale for an acquisition transaction was adequately considered, documentedand communicated to properly assess the fair value of the net assets acquired.

 

Thesematerial weaknesses resulted in material errors in and the restatement of ourannual and interim financial statements for 2006, 2007 and the first quarter of2008, and resulted in adjustments and revisions to our annual and interim financialstatements for the second, third and fourth quarters of 2008, and fourthquarter of 2009.  Additionally, thesematerial weaknesses could result in a material misstatement to the annual orinterim financial statements that would not be prevented or detected on atimely basis.

 

**CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING**

 

Managementhas evaluated, with the participation of our CEO and CFO, whether any changesin our internal control over financial reporting that occurred during thequarter ended March 31, 2010 have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.Based on this evaluation, management has concluded that there are no materialchanges in internal controls over financial reporting which occurred during thequarter ended March 31, 2010; however, we have made progress towardimplementing 

 

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enhancementsduring the period from January 1, 2010 through the date of this filing toremediate our material weaknesses in the internal controls over financialreporting as discussed above.

 

**REMEDIATION ACTIVITIES**

 

**Overview**

 

Management continues to implement, certain remediation measures toaddress the above-described material weaknesses and enhance our system ofinternal control over financial reporting. These measures include (a) enhancingour communication process by initiating a specific and targeted communicationplan involving the executive leadership and the board of directors; (b) takingcertain personnel actions; (c) implementing standard contracts throughoutour agent and distributor network and a review of non-standard contracts; (d) adoptingand communicating a revised revenue recognition policy; (e) enhancing ourfinancial reporting policies, procedures and processes involving accountreconciliations, journal entries and corresponding supporting documentation; (f) designingand implementing training programs; and (g) changing monitoring practicesconcerning the review of key accounting controls and processes. However, someof the enhancements we have implemented have not been in place for a sufficientperiod of time to demonstrate that their design and implementation wereeffective.

 

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

 

**Remediation Actions for Existing Material Weaknesses**

 

Management expects the ongoing remediation efforts outlined below toaddress the identified material weaknesses and to enhance our overall financialcontrol environment. During the quarter ended March 31, 2010, there wereno material changes to the remediation plan which was previously disclosed inthe 2009 Form 10-K.

 

***Control Environment.***  We continue to enhance and change ourstaffing and training requirements to maintain the sufficient complement ofpersonnel; as such, accounting staff changes have occurred, such asre-assignment of roles and responsibilities or the hiring of additionalaccounting personnel.  The new members ofthe accounting staff have sufficient experience for their roles andresponsibilities based on prior public company experience.

 

***Information and Communication.***  Management continues to evaluate and enhancecontrols to develop a more formalized process for monitoring, updating anddisseminating non-routine transactions to facilitate a complete and timelyreview by accounting personnel. Remediation efforts to date include:

 

·                  We have implemented acontrol where by standard contract templates are used for all stockingdistributors and sales agents. New contracts are reviewed by finance and legalpersonnel for conformity. Proposed deviations from the standard contracttemplate are subject to reviews and approval according to our delegation ofauthority policy, which requires financial and legal officer approval.  This control has been implemented; however,the effectiveness assessment of this control is ongoing.

 

·                  We have implemented a globalcontractual agreement database related to existence, completeness, approval andretention of global contractual agreements amongst the various departments. Wehave also established and filled a contract administrator position that reportsto the General Counsel and is responsible for gathering and maintaining thedatabase for all contracts and amendments thereto as well as checking that allrequired approvals have been obtained. This remediation effort is ongoing.

 

·                  We require specificemployees to certify annually that they have read and understand our RevenueRecognition policy and require sales, marketing, finance, accounting, customerservice, order entry, credit and collections personnel to attend periodicrevenue-recognition training. The policy and training programs are designed toprovide our personnel with an appropriate level of knowledge, experience andtraining in the application of GAAP to commensurate with their responsibilitiesand our financial

 

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reporting requirements. As part of developing this training program,current management established a process to identify specific information that (a) ismaterial to the application of our revenue recognition policies and (b) mustbe communicated from the sales staff to the accounting function. Thisremediation effort is ongoing.

 

·                  We communicated our reviseddelegation of authority policies. The delegation of authority policies includesthe communication and approval channels in the areas of certain commercialterms, sourcing, capital investments and treasury activities, includingrequirements relating to communication, authorization and support criteria forspecified types of modifications to standard contracts or other arrangements.Management has made certain changes to business practices to facilitate theadherence to the revised delegation of authority policies.  The effectiveness assessment of these changesis ongoing.

 

·                  We have revised and arerevising our policies and procedures related to mergers and acquisitions,accruals, account reconciliations, and accounting reviews. Further enhancementsare required to validate that documentation is maintained to support accountreconciliations, reviews and corresponding journal entries. The furtherrevision or development of these policies and procedures and the requiredtraining is ongoing.

 

***Monitoring.***  We continue to enhance our ability to assessthe accuracy of the consolidated financial statements and whether businesspractices are consistent with our stated accounting policies and procedures.Additionally, we continue to review and assess the sufficiency of ouraccounting and internal audit resources. Remedial efforts have included:

 

·                  The accounting departmentimplemented additional preventive and detective controls to monitor revenuerecognition including: (a) a process to review distributor purchasinghistory and period end inventory levels in order to analytically verify theadequacy and accuracy of our sell-through estimation process and detectimproper revenue recognition and (b) lag time analyses for returns andexchanges to analyze the reasonableness of our accounting estimates for returnsand exchanges and detect potential improper recognition of net revenue.  These procedures have been implemented;however, the effectiveness assessment is still ongoing.

 

·                  We have made enhancements toour account reconciliation process governing account reconciliation content,supporting evidence, format, review and approval procedures. The accountreconciliation process assists us in monitoring the consistent application ofGAAP throughout our worldwide operations. This effort is ongoing.

 

·                  We have implemented a riskbased internal audit methodology which is based on ongoing risk assessments,input of business unit and functional leadership, and provides the checks andbalances that controls are designed appropriately and operating effectively.Hiring of additional internal audit staff is in process.

 

The material weaknesses identified by management and discussed aboveare not fully remediated as of the date of the filing of this quarterly report.The Audit Committee continues to oversee management’s implementation plan forthe above-referenced remedial measures and continues to monitor theirimplementation. In addition, under the direction of the Audit Committee,management will continue to review and make necessary changes to the overalldesign of the internal controls environment, as well as policies and proceduresto enhance the overall effectiveness of our internal control over financialreporting.

 

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**PART II.OTHER INFORMATION**

 

**ITEM 1.  LEGAL PROCEEDINGS**

 

We discuss ourmaterial legal proceedings in Note 7, “Litigation and Contingencies,” in thenotes to the condensed consolidated financial statements.  In addition to the matters specificallydescribed in Note 7 we are involved in other legal and regulatory proceedingsthat arise in the ordinary course of business that do not have a materialimpact on our business.  Litigationclaims and proceedings of all types are subject to many factors that generallycannot be predicted accurately. We record reserves for claims and lawsuits whenthey are probable and reasonably estimable. Except as otherwise specifically noted, we currently cannot determinethe ultimate resolution of the matters described in Note 7.  For matters where the likelihood or extent ofa loss is not probable or cannot be reasonably estimated, we have not recognizedin our condensed consolidated financial statements the potential liability thatmay result from these matters.  If one ormore of these matters is determined against us, it could have a materialadverse effect on our earnings, liquidity and financial condition.

 

**ITEM 1A.  RISK FACTORS**

 

This section identifies specific risks that should be consideredcarefully in evaluating our business. Any of these risks could adversely affectour business, results of operations or financial condition. Although we believethat these risks represent the material risks relevant to us, our business andour industry, new material risks may emerge that we are currently unable topredict. As a result, this description of the risks that affect our businessand our industry is not exhaustive. The risks discussed below could cause ouractual results to differ materially from our historical results or the resultscontemplated by the forward-looking statements contained in Exhibit 99.1Forward-Looking Statements.

 

***Material weaknesses and othercontrol deficiencies relating to our internal control over financial reportingcould result in errors in our reported results and could have a materialadverse effect on our operations, investor confidence in our business and thetrading prices of our securities.***

 

Internal control over financial reporting cannot provide absoluteassurance of achieving financial reporting objectives because of its inherentlimitations. Internal control over financial reporting is a process thatinvolves human diligence and compliance and is subject to lapses in judgmentand breakdowns resulting from human failures. Internal control over financialreporting can also be circumvented by collusion or improper managementoverride. Because of such limitations, there is a risk that materialmisstatements will not be prevented or detected on a timely basis by internalcontrol over financial reporting. However, these inherent limitations are knownfeatures of the financial reporting process, and it is possible to design intothe process safeguards to reduce, though not eliminate, the risk.

 

Management’s assessment of our internal control over financialreporting as of December 31, 2009 concluded that our internal control overfinancial reporting was not effective and that material weaknesses existed.Until these material weaknesses and other control deficiencies are remediated,they could lead to errors in our reported financial results and could have amaterial adverse effect on our operations, investor confidence in our businessand the trading prices of our securities.

 

As described in “Part I—Item 4—Controls and Procedures,” weare currently in the process of remediating our identified material weaknesses.Management’s continuing evaluation and work to enhance our internal controlover financial reporting will require the dedication of additional resourcesand management time and expense. If we fail to establish and maintain adequateinternal control over financial reporting, including any failure to implementremediation measures and enhancements for internal controls, or if weexperience difficulties in their implementation, our business, financialcondition and operating results could be harmed.

 

Any material weakness or unsuccessful remediation could affect investorconfidence in the accuracy and completeness of our financial statements. As aresult, our ability to obtain any additional financing, or additional financingon favorable terms, could be materially and adversely affected, which in turncould materially and adversely affect our business, our strategic alternatives,our financial condition and the market value of our securities. In addition,perceptions of us among customers, lenders, investors, securities analysts andothers could also be adversely affected. Current material weaknesses or any weaknessesor deficiencies identified in the future could also hurt confidence in ourbusiness and the accuracy and completeness of our financial statements, andadversely affect our ability to do business with these groups.

 

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We can give no assurances that the measures we have taken to date, orany future measures we may take, will remediate the material weaknessesidentified or that any additional material weaknesses will not arise in thefuture due to our failure to implement and maintain adequate internal controlover financial reporting. In addition, even if we are successful instrengthening our controls and procedures, those controls and procedures maynot be adequate to prevent or identify irregularities or ensure the fair andaccurate presentation of our financial statements included in our periodicreports filed with the SEC.

 

***A failure to remain current in ourfilings may have material impacts on our business and liquidity.***

 

If we are not able to remain current in our filings with the SEC, wewill face several adverse consequences and restrictions. We will not be able tohave a registration statement under the Securities Act of 1933, as amended (the“Securities Act”), covering a public offering of securities, declared effectiveby the SEC, or make offerings pursuant to existing registration statements; wewill not be able to make an offering to any purchasers not qualifying as “accreditedinvestors” under certain “private placement” rules of the SEC underRegulation D; we will not be eligible to use a “short form” registrationstatement on Form S-3 for a period of at least 12 months after thetime we become current in our periodic and current reports under the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”); we will not be able todeliver the requisite annual report and proxy statement to our stockholders tohold our annual stockholders meeting; our employees cannot be granted stockoptions, nor will they be able to exercise stock options registered on Form S-8,because Form S-8 would not be available to us; and our Common Stock may bedelisted from the NASDAQ Stock Market. These restrictions may impair ourability to raise funds in the public markets, should we desire to do so, and toattract and retain employees.

 

***The Review (as defined below) andresulting restatement, SEC and DOJ investigations and other investigations,legal and administrative proceedings have increased our costs and could resultin fines, injunctions, orders, and penalties which could materially adverselyaffect our business, financial condition, results of operations, and liquidity.***

 

As previously reported, during 2009 and 2008, we experiencedsubstantial delays in filing our periodic reports as a result of issuesidentified during a review of certain accounting and financial reportingmatters as well as certain insurance billing and healthcare compliancepractices conducted under the direction of our Audit Committee (the “Review”),which began in July 2008. The Review was completed in August 2009 andthe results were reported to the Audit Committee and to the Board. In July 2008,we also commenced a separate comprehensive review of our accounting policiesand procedures, financial reporting, internal controls and corporategovernance. We completed this comprehensive review in November 2009, andas a result of our comprehensive review and the Review we made extensiveorganizational and operational changes, and improved our internal controls. Asa result of errors and possible irregularities identified by the Review andmanagement’s review and analysis of certain accounting matters, we restated ourfinancial statements for: the years ended December 31, 2007, 2006, 2005,and 2004; the quarter ended March 31, 2008 and each of the quarters forthe years ended December 31, 2007 and 2006 in our Form 10-K for theyear ended December 31, 2008 filed on November 18, 2009, or the 2008 Form 10-K.

 

We are involved in ongoing material legal proceedings and the actionscurrently pending result primarily from matters relating to our restatement andReview as well as from intellectual property related litigation and claims. SeeNote 7, “Litigation and Contingencies,” in the notes to the condensedconsolidated financial statements.  Theseproceedings and other legal actions may harm our business or liquidity in thefuture.

 

We have incurred substantial cost and expenses for legal and accountingservices due to the Review and resulting SEC and DOJ investigations. Thesematters will likely continue to divert our management’s time and attention andcause us to continue to incur substantial costs and expenses. Suchinvestigations can also lead to fines or injunctions or orders with respect tofuture activities. We could incur substantial additional costs to defend andresolve litigation, investigations or proceedings arising out of or related tothese matters. In addition, we could be exposed to enforcement or other actionswith respect to these matters by the SEC’s Division of Enforcement, the DOJ orother federal or state agencies. At this point, we are unable to predict theduration, scope or result of these investigations or whether any of these agencieswill commence any legal action. Any such investigations may result in us beingsubject to criminal and civil penalties and other remedial measures, whichcould have an adverse impact on our business, results of operations, financialcondition and liquidity.

 

In connection with our pending legal proceedings, including any furtherlitigation that is pursued or other relief sought by persons asserting claimsfor damages allegedly resulting from or based on the restatement or related

 

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events,we will incur defense costs that may exceed our insurance coverage. We may alsoincur costs if the insurers of our directors and our liability insurers denycoverage for the costs and expenses related to any litigation.

 

Many of our pending legal proceedings are in the early stages and wecannot predict their outcomes. However, irrespective of the outcomes, we mayincur substantial costs, including defense and indemnity costs, and thesematters may divert the attention of our technical and management personnel,which could materially harm our business. Moreover, if we do not prevail in anysuch actions, we could be required to pay substantial damages or settlementcosts. Adverse outcomes or other developments during the course of litigationor other proceedings may harm our business, financial condition, results ofoperations or liquidity as well as investors’ perception of our business, anyof which could harm our stock price.

 

***Our failure to comply with extensivegovernment regulations could subject us to penalties and materially adverselyaffect our business, results of operations and financial condition.***

 

Our medical device products and operations are subject to extensiveregulation by the Food and Drug Administration, or FDA, and various otherfederal, state and foreign governmental authorities. Government regulations andforeign requirements specific to medical devices are wide ranging and govern,among other things: design, development and manufacturing; testing, labelingand storage; clinical trials; product safety; marketing, sales anddistribution; pre-market clearance and approval; record keeping procedures;advertising and promotions; recalls and field corrective actions; post-marketsurveillance, including reporting of deaths or serious injuries andmalfunctions that, if they were to recur, could lead to death or seriousinjury; and product import and export.

 

The FDA and other governmental authorities have broad enforcementpowers, and our failure to comply with these regulatory requirements couldresult in governmental agencies or a court taking action, including any of thefollowing, which would adversely affect our business: issuing public warningletters to us; imposing fines and penalties on us; obtaining an injunctionpreventing us from manufacturing or selling our products; bringing civil orcriminal charges against us; delaying the introduction of our products into themarket; delaying pending requests for clearance or approval of new uses ormodifications to our existing products; recalling, detaining or seizing ourproducts; or withdrawing or denying approvals or clearances for our products.

 

***If we fail to comply with complexand rapidly evolving laws and regulations, we could suffer civil and criminalpenalties, be required to pay substantial damages and make significant changesto our products and operations.***

 

During the past several years, the U.S. health care industry has beensubject to an increase in governmental regulation at both the federal and statelevels. We are subject to numerous federal and state regulations. As part ofour internal compliance program, we review our sales and marketing materials,contracts and programs with counsel, and require employees and marketingrepresentatives to participate in regular training. We also have adopted andtrain our personnel on the code of conduct for Interactions with Health CareProfessionals promulgated by the Advanced Medical Technology Association, orAdvaMed, a leading trade association representing medical device manufacturers.Most recently, we amended our Code of Business Conduct and Ethics, the “Code ofEthics,” in August 2009. Originally adopted in 2004 to qualify as a “codeof ethics” within the meaning of Section 406 of the Sarbanes-Oxley Act of2002, the Code of Ethics was amended to qualify as well as a “code of conduct”under the current Federal Sentencing Guidelines and “Compliance ProgramGuidance for Pharmaceutical Manufacturers” 68 FR 23731 (May 5, 2003)applicable to medical device companies as published by the Office of InspectorGeneral for the Department of Human Services. The Code of Ethics applies to allof our directors, officers, employees and agents. It also serves as anessential element of our Corporate Compliance Program, as announced in August 2009.However, we can give no assurances that our compliance program will ensure thatthe Company is in compliance with existing or future applicable laws andregulations. If our compliance program fails to meet its objectives, or if weotherwise fail to comply with existing or future applicable laws andregulations, we could suffer civil or criminal penalties. We devote significantoperational and managerial resources to comply with these laws and regulations.Different interpretations and enforcement policies of these laws andregulations could subject our current practices to allegations of improprietyor illegality or could require us to make significant changes to our productsand operations. In addition, we cannot predict the impact of future legislationand regulatory changes on our business or assure you that we will be able toobtain or maintain the regulatory approvals required to operate our business.

 

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***Our accounting policies and methodsrequire management to make judgments and estimates about matters that areinherently uncertain, which may result in our actual results differingsignificantly from those generated by our judgments and estimates.***

 

Our accounting policies and methods require management to exercisejudgment in applying many of these accounting policies and methods so thatthese policies and methods comply with generally accepted accounting principlesin the U.S., or GAAP, and reflect management’s judgment of the most appropriatemanner to report our financial condition and results of operations. SeeNote 3, “Summary of Significant Accounting Policies” in the notes to theconsolidated financial statements for a description of our significantaccounting policies in our 2009 Form 10-K.

 

The accounting policies we have identified as critical to thepresentation of our financial condition and results of operations are describedin “Part II — Item 7 - Management’s Discussion and Analysis of FinancialCondition and Results of Operations — Critical Accounting Policies andEstimates” in our 2009 Form 10-K. We believe these policies are critical because they require managementto make particularly subjective or complex judgments about matters that areinherently uncertain at the end of a period and because of the likelihood thatmaterially different amounts would be reported under different conditions orusing different assumptions. Due to the complexity of these critical accountingpolicies, our accounting methods relating to these policies involve substantialuse of estimates. Estimates are inherently imperfect predictors of actualresults because they are based on assumptions, including assumptions aboutfuture events. Our estimates may not include assumptions that reflect verypositive or very negative market conditions and, accordingly, our actualresults could differ significantly from those generated by our estimates. As aresult, the estimates that we use to prepare our financial statements, as wellas our estimates of our future results of operations, may be significantlyinaccurate.

 

***We may be the subject of federal andstate government civil and criminal enforcement efforts against health carecompanies, which could result in civil and/or criminal penalties which couldhave a material negative impact on our operations and financial condition.***

 

In addition to uncertainties surrounding coverage policies, bothfederal and state government agencies have heightened civil and criminalenforcement efforts against health care companies, as well as their executivesand managers. These efforts generally relate to a wide variety of matters,including referral and billing practices, and implicate a variety of state andfederal laws, including state insurance fraud provisions, common law fraudtheories, as well as both state and federal fraud-and-abuse, anti-kickback, andfalse claims statutes. Although we no longer directly bill any payor, some ofour prior activities could become the subject of additional governmentalinvestigations or inquiries. If we do not comply with the laws and regulationsrelevant to our business, we could be subject to civil and/or criminalpenalties which could have a material negative impact on our operations andfinancial condition.

 

***We are, and may in the future be,subject to intellectual property claims, which are costly to defend, couldrequire us to pay damages and could limit our ability to use certaintechnologies in the future.***

 

The medical device industry has been characterized by extensivelitigation regarding patents and other intellectual property rights, andcompanies in the medical device industry have employed intellectual propertylitigation to gain a competitive advantage.

 

We cannot assure you that we will not become subject to additionalpatent infringement claims or other litigation, including interference proceedingsdeclared by the U.S. Patent and Trademark Office, or USPTO, to determine thepriority of inventions. The defense and prosecution of intellectual propertylawsuits generally, USPTO reexamination and interference proceedings andrelated legal and administrative proceedings, are costly and time-consuming. Ifother parties violate our proprietary rights, further litigation may benecessary to enforce our patents, to protect trade secrets or know-how we ownor to determine the enforceability, scope and validity of the proprietaryrights of others. Any litigation or reexamination or interference proceedingswill be costly and cause significant diversion of effort by our technical andmanagement personnel.

 

An adverse determination in existing litigation, additional litigationor reexamination or interference proceedings to which we may become a partycould subject us to significant liabilities to third parties, require disputedrights to be licensed from third parties or require us to cease using certain technology.Furthermore, we cannot assure you that we could obtain necessary licenses onsatisfactory terms, if at all. Adverse determinations in judicial oradministrative proceedings or failure to obtain necessary licenses couldprevent us from manufacturing and selling our 

 

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products,which would have a material adverse effect on our business, financial condition,results of operations, and future growth prospects.

 

***Our intellectual property rights arevaluable, and any inability to protect them could reduce the value of ourproducts, business, financial condition, results of operations and futuregrowth prospects.***

 

Our ability to compete effectively depends in part on developing andmaintaining the proprietary aspects of our Coblation technology and ouracquired technologies. We believe that our issued patents are directed at thecore technology used in our soft-tissue surgery systems, including bothmulti-electrode and single electrode configurations of our disposable devices,as well as the use of Coblation technology in specific surgical procedures. Inaddition, we believe that our issued patents are directed at many of the corefeatures of our acquired technologies from Opus, Parallax, Atlantech and ATI.Our earliest Coblation patents begin to expire in 2012. The majority of ourroyalty income is associated with licenses that include core Coblation patentrights which extend through the end of 2014.

 

There is no assurance that the patents we have obtained, or any patentswe may obtain as a result of our pending U.S. or international patentapplications, will provide any competitive advantages for our products. We alsocannot assure investors that those patents will not be successfully challenged,invalidated or circumvented prior to their expiration. In addition, we cannotprovide assurance that competitors, many of which have substantial resourcesand have made substantial investments in competing technologies, have notalready applied for or obtained, or will not seek to apply for and obtain,patents that will prevent, limit or interfere with our ability to make, use andsell our products either in the U.S. or in international markets. In SportsMedicine, many of our competitors have licensed our technology for limitedfields of use. Patent applications are maintained in secrecy for a period afterfiling. We may not be aware of all of the patents and patent applicationspotentially adverse to our interests.

 

A number of medical device and other companies, universities andresearch institutions have filed patent applications or have issued patentsrelating to monopolar and/or bipolar electrosurgical methods and apparatus. Wehave received, and we may receive in the future, notifications of potentialconflicts of existing patents, pending patent applications and challenges tothe validity of existing patents. In addition, we have become aware of, and maybecome aware of in the future, patent applications and issued patents thatrelate to our products and/or the surgical applications and issued patents and,in some cases, have obtained internal and/or external opinions of counselregarding the relevance of certain issued patents to our products. We do notbelieve that our products currently infringe any valid and enforceable claimsof the issued patents that we have reviewed. However, if third-party patents orpatent applications contain claims infringed by our technology and such claimsare ultimately determined to be valid, we may not be able to obtain licenses tothose patents at a reasonable cost, if at all, or be able to develop or obtainalternative technology. Our inability to do either would have a material adverseeffect on our business, financial condition, results of operations and futuregrowth prospects. We cannot assure investors that we will not have to defendourselves in court against allegations of infringement of third-party patents,or that such defense would be successful.

 

In addition to patents, we rely on trade secrets and proprietaryknow-how, which we seek to protect, in part, through confidentiality andproprietary information agreements. We require our key employees andconsultants to execute confidentiality agreements upon the commencement of anemployment or consulting relationship with us. These agreements generallyprovide that all confidential information, developed or made known to theindividual during the course of the individual’s relationship with us, is to bekept confidential and not disclosed to third parties. These agreements alsogenerally provide that inventions conceived by the individual in the course ofrendering services to us shall be our exclusive property. We cannot assure investorsthat employees will not breach such agreements, that we would have adequateremedies for any breach or that our trade secrets will not otherwise becomeknown to or be independently developed by competitors.

 

***We will require a significant amountof cash to fund our working capital needs and planned expenditures. Our abilityto generate cash depends on many factors beyond our control.***

 

In the absence of a credit facility as a possible source of liquidity,our ability to meet our working capital needs and to fund capital expenditureswill depend on our ability to generate cash from operations and effectivelymanage our cash balances. This is subject to general economic, financial,competitive and other factors that may be beyond our control. We are unable topredict the outcome of ongoing litigation and investigations to which we are aparty and these matters could have a material adverse effect on our liquidityand cash flows. See Note 7, “Litigation and Contingencies,” in the notes to thecondensed consolidated financial statements for further discussion on legal

 

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proceedings.We expect that our cash flows from operations together with cash on hand willbe sufficient to satisfy our short-term and, excluding the uncertainty relatedto the ongoing litigation and investigations to which we are a party, long-termnormal operating liquidity requirements; however, we cannot assure you that ourbusiness will generate sufficient cash flow from operations in an amountsufficient to enable us to fund our other liquidity needs.

 

As a result, from time to time, we may be required to seek financingfrom alternative sources. In light of the current capital and credit marketdisruption and volatility, we cannot assure you that such alternative fundingwill be available to us on terms and conditions acceptable to us, or at all.

 

In addition, we maintain deposit accounts with numerous financialinstitutions around the world in amounts that exceed applicable governmentaldeposit insurance levels. As a result of the same considerations that led tothe termination of our Credit Agreement, we were required to transition ourcash management services in the U.S. to another financial institution, whichmay result in significant business disruption if not effectively transitioned.While we actively monitor our deposit relationships, the unanticipated failureof a financial institution in which we maintain deposits could cause us tosuffer losses that could materially harm our results of operations andfinancial condition.

 

***We may not be able to keep pace withtechnological change or successfully develop new products with wide marketacceptance, which could cause us to lose business to competitors.***

 

We compete in a market characterized by rapidly changing technology. Wemay not be able to keep pace with technology or to develop viable new products.Our future financial performance will depend in part on our ability to developand manufacture new products in a cost-effective manner, to introduce theseproducts to the market on a timely basis, and to achieve market acceptance ofthese products. Factors which may result in delays of new product introductionsor cancellation of our plans to manufacture and market new products includecapital constraints, research and development delays, and delays in acquiringregulatory approvals. Our new products and new product introductions may failto achieve expected levels of market acceptance. Factors impacting the level ofmarket acceptance include our ability to successfully implement newtechnologies, the timeliness of our product introductions, our product pricingstrategies, our available financial and technological resources for productpromotion and development, our ability to show clinical benefit from ourproducts, and the availability of reimbursement for our products as discussedin the risk factor titled “Changes in coverage and reimbursement for proceduresusing our products could affect physicians” below.

 

***The markets for our products areintensely competitive, which may result in our competitors developingtechnologies and products that are more effective than ours or that make ourtechnologies and products obsolete. Many of our competitors have significantlygreater resources and market power than we do.***

 

The markets for our current products in our core businesses areintensely competitive. These markets include arthroscopy, spinal surgery and ENTsurgery. We cannot assure you that other companies will not succeed indeveloping technologies and products that are more effective than ours, or thatwould render our technologies or products obsolete or uncompetitive in thesemarkets.

 

Our primary competitors across all of our operating units consist ofMedtronic, Inc., Smith & Nephew, Stryker Corporation, Johnson &Johnson, Cardinal Health/Allegiance, Olympus (also known as Gyrus), Arthrex, Inc.and Cook Medical. These competitors tend to be large, well-financed companieswith diverse product lines who may have significantly greater financial,manufacturing, marketing, distribution and technical resources than we do. Someof these companies offer broad product lines that they may offer as a singlepackage and frequently offer significant price discounts as a competitivetactic. Furthermore, some of our competitors utilize purchasing contracts thatlink discounts on the purchase of one product to purchases of other products intheir broad product lines. Many of the hospitals in the U.S. have purchasingcontracts with our competitors. Accordingly, customers may be dissuaded frompurchasing our products instead of our competitors’ products to the extent thepurchase would cause them to lose discounts on our competitors’ products. Inaddition, we are aware of several small companies offering alternativetreatments for back pain and other ailments or indications that may indirectlycompete with our products.

 

If we were to be unable to continue to compete for any of the abovereasons, it could have a material adverse effect on our business, financialcondition, results of operations and future growth prospects.

 

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***Modifications to our currentlyFDA-cleared products may require new regulatory clearance or approvals orrequire us to recall or cease marketing our current products until clearancesor approvals are obtained.***

 

After a device receives 510(k) premarket notification clearancefrom the FDA, any modification that could significantly affect its safety oreffectiveness, or that would constitute a major change in the intended use ofthe device, technology, materials, packaging, and certain manufacturingprocesses may require a new 510(k) clearance or Premarket Approval, orPMA. The FDA requires every manufacturer to make the determination regardingthe need for a new 510(k) clearance or PMA approval in the first instance,but the FDA may review any manufacturer’s decision and may retroactivelyrequire the manufacturer to submit a premarket notification requesting 510(k) clearanceor an application for PMA approval. The FDA also can require the manufacturerto cease marketing and/or recall the modified device until 510(k) clearanceor approval is obtained. FDA guidance documents define when to submit premarketnotifications for new or modified devices. These guidance documents also definemodifications for which a new 510(k) is not required. We have modifiedsome of our marketed devices, and have determined that in certain instances new510(k) clearances or PMA approvals are not required. No assurance can begiven that the FDA would agree with any of our decisions not to seek 510(k) clearanceor PMA approval. If the FDA requires us to cease marketing and/or recall themodified device until we obtain a new 510(k) clearance or PMA approval,our business, financial condition, results of operations and future growthprospects could be materially adversely affected.

 

***Failure to obtain FDA clearance orapproval for our products could materially adversely affect our business,results of operations, financial condition, and future growth prospects.***

 

In the U.S., before we can market a new medical device, or a new useof, or claim for, or significant modification to, an existing product, we mustfirst receive either premarket clearance under Section 510(k) of theU.S. Federal Food, Drug, and Cosmetic Act, or FDCA, or approval of a PMA submissionfrom the FDA, unless an exemption applies. In the 510(k) clearanceprocess, the FDA must determine that a proposed device is “substantiallyequivalent” to a device legally on the market, known as a “predicate” device,with respect to intended use, technology and safety and effectiveness, in orderto clear the proposed device for marketing. Clinical data is sometimes requiredto support substantial equivalence. The PMA approval pathway requires anapplicant to demonstrate the safety and effectiveness of the device based, inpart, on data obtained in clinical trials. Both of these processes can beexpensive and lengthy and entail significant user fees, unless exempt. The FDA’s510(k) clearance process usually takes from three to twelve months, but itcan last longer. The process of obtaining PMA approval is much more costly anduncertain than the 510(k) clearance process. It generally takes from oneto three years, or even longer, from the time the PMA application is submittedto the FDA until an approval is obtained. There is no assurance that we will beable to obtain FDA clearance or approval for any of our new products on atimely basis, or at all. Failure to obtain FDA clearance or approval for ournew products could materially adversely affect our business, results ofoperations, financial condition, and future growth prospects.

 

***We may be subject to fines,penalties or injunctions if we are determined to be promoting the use of ourproducts for unapproved or “off-label” uses, which would adversely affect ourfinancial condition.***

 

Our promotional materials and training methods must comply with FDA andother applicable laws and regulations, including the prohibition of thepromotion of a medical device for a use that has not been cleared or approved byFDA. Use of a device outside its cleared or approved indications is known as “off-label”use. Physicians may use our products off-label, as the FDA does not restrict orregulate a physician’s choice of treatment within the practice of medicine.However, if the FDA determines that our promotional materials or trainingconstitutes promotion of an off-label use, it could request that we modify ourtraining or promotional materials or subject us to regulatory or enforcementactions, including the issuance of an untitled letter, a warning letter,injunction, seizure, civil fine and criminal penalties. It is also possiblethat other federal, state or foreign enforcement authorities might take actionif they consider our promotional or training materials to constitute promotionof an unapproved use, which could result in significant fines or penaltiesunder other statutory authorities, such as laws prohibiting false claims forreimbursement. In that event, our reputation could be damaged and adoption ofthe products would be impaired. Although our policy is to refrain fromstatements that could be considered off-label promotion of our products, theFDA or another regulatory agency could disagree and conclude that we haveengaged in off-label promotion. In addition, the off-label use of our productsmay increase the risk of injury to patients, and, in turn, the risk of productliability claims. Product liability claims are expensive to defend and coulddivert our management’s attention and result in substantial damage awardsagainst us.

 

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***Our products may in the future besubject to product recalls that could harm our reputation, business operationsand financial results, and if our products cause or contribute to a death orserious injury, we will be subject to medical device reporting regulations,which can result in voluntary corrective actions or FDA enforcement actions.***

 

The FDA and similar foreign governmental authorities have the authorityto require the recall of commercialized products in the event of materialdeficiencies or defects in design or manufacture or in the event that a productposes an unacceptable risk to health. Manufacturers may, under their owninitiative, recall a product if any material deficiency in a device is found. Agovernment-mandated or voluntary recall by us or one of our distributors couldoccur as a result of an unacceptable risk to health, component failures,manufacturing errors, design or labeling defects or other deficiencies andissues. Recalls of any of our products would divert managerial and financialresources and have an adverse effect on our financial condition and results ofoperations. Any of these sanctions could impair our ability to produce ourproducts in a cost-effective and timely manner in order to meet our customers’demands. We may also be required to bear other costs or take other actions thatmay have a negative impact on our future sales and our ability to generateprofits.

 

Further, under the FDA medical device reporting regulations, or MDR, weare required to report to the FDA any incident in which our product may havecaused or contributed to a death or serious injury or in which our productmalfunctioned and, if the malfunction were to recur, would likely cause orcontribute to death or serious injury. Any adverse event involving our productscould result in future voluntary corrective actions, such as recalls or customernotifications, or agency action, such as inspection, mandatory recall or otherenforcement action. Any corrective action, whether voluntary or involuntary, aswell as defending ourselves in a lawsuit, will require the dedication of ourtime and capital, distract management from operating our business, and may harmour reputation and financial results.

 

***If we or our third-party suppliersfail to comply with FDA’s Quality System Regulations, our manufacturingoperations could be interrupted and our sales and our ability to generateprofits could suffer.***

 

We and certain of our third-party suppliers are required to comply withthe FDA’s Quality System Regulation, or QSR, which covers the methods anddocumentation of the design, testing, production, control, quality assurance,labeling, packaging, sterilization, storage and shipping of our products. Weand our suppliers are also subject to the regulations of foreign jurisdictionsregarding the manufacturing process if we market our products in these jurisdictions.The FDA enforces the QSR through periodic and unannounced inspections ofmanufacturing facilities. If our facilities or those of our suppliers fail totake satisfactory corrective action in response to an adverse QSR inspection,the FDA could take enforcement action, including any of the followingsanctions: untitled letters; warning letters, fines, injunctions, consentdecrees and civil penalties; customer notifications or repair, replacement,refunds, recall, detention or seizure of our products; operating restrictionsor partial suspension or total shutdown of production; refusing or delaying ourrequests for 510(k) clearance or premarket approval of new products ormodified products; withdrawing 510(k) clearances on PMA approvals thathave already been granted; refusal to grant export approval for our products;or criminal prosecution.

 

Any of these sanctions could impair our ability to produce our productsin a cost-effective and timely manner in order to meet our customers’ demands.We may also be required to bear other costs or take other actions that may havea negative impact on our future sales and our ability to generate profits.

 

***Failure to market our products thatuse Coblation technology could adversely affect our financial condition, resultsof operations and future growth prospects.***

 

We commercially introduced our Coblation technology product lines in December 1995.Our Coblation technology product lines accounted for more than two-thirds ofour product sales in 2009 and we are highly dependent on these sales. We cannotassure you that we will be able to continue to manufacture arthroscopy productsbased on our Coblation technology in commercial quantities at acceptable costs,or that we will be able to continue to market such products successfully.

 

To achieve increasing disposable device sales over time, we believe wemust continue to penetrate the market in other orthopedic procedures, expandphysicians’ education with respect to Coblation technology, and continueworking on new product development efforts.

 

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Moreover, our ability to market our products depends on clinicalreports and recommendations by influential surgeons supporting our Coblationtechnology in certain key procedures. We believe that surgeons will not use ourproducts unless they determine, based on experience, clinical data and otherfactors, that our products are an attractive alternative to conventional meansof tissue ablation. We believe that if recommendations and endorsements byinfluential surgeons cease or long-term data do not support our current claimsof efficacy, our business, financial condition, results of operations andfuture growth prospects could be materially adversely affected.

 

***Changes in coverage andreimbursement for procedures using our products could affect use of our devicesand our future revenue.***

 

The demand for our products is highly dependent on the policies ofthird-party payors such as Medicare, Medicaid, private insurance, and managedcare organizations that reimburse our customers when they use our products.Failure by physicians, hospitals and other users of our products to obtainsufficient coverage and reimbursement from healthcare payors for procedures inwhich our products are used, or adverse changes in environmental and privatethird-party payors’ policies toward coverage and reimbursement for suchprocedures would have a material adverse effect on our business, financialcondition, results of operations and future growth prospects.

 

In the U.S., third-party payors continue to implement initiatives thatrestrict the use of certain technologies to those that meet certain clinicalevidentiary requirements. We are aware of several third-party payors in theU.S., including governmental payors such as Medicare and Medicaid and privatehealth insurance companies, who consider Coblation technology used in certainprocedures to treat certain clinical conditions to be experimental orinvestigational. These payors have developed policies that deny coverage andtherefore make no reimbursement for such procedures using our devices.Procedures using our devices that are not covered by some payors include such proceduresas plasma disc decompression, or Coblation nucleoplasty, as well as Coblationor radiofrequency volumetric tissue reduction for (1) removing soft tissueduring arthroscopic surgery, (2) hypertrophied nasal turbinates for thetreatment of chronic nasal obstruction or obstructive sleep apnea and (3) softpalate and tongue for the treatment of obstructive sleep apnea. However, somepayors in the U.S. provide coverage and reimbursement for Coblationtonsillectomy for certain clinical indications and percutaneous vertebroplastyfor patients that meet specified criteria. In addition, some payors are movingtoward a managed care system and control their health care costs by limitingauthorizations for surgical procedures, including elective procedures using ourdevices. Failure to obtain favorable payor policies could have a materialadverse effect on our business and operations.

 

In addition to uncertainties surrounding coverage policies, third-partypayors from time to time update reimbursement amounts and also revise themethodologies used to determine reimbursement amounts. This includes annualupdates to payments to ambulatory surgical centers and physicians forprocedures using our products. Because reimbursement for our products generallyis included as part of the payments for procedures, these updates directlyimpact the amounts recognized for the costs of our products. An example ofpayment updates is the Medicare program updates to physician payments, which isdone on an annual basis using a prescribed formula that results in loweredpayments for physician services. In the past, Congress has passed legislationto prevent certain reductions in Medicare payments to physicians. UnlessCongress does so for 2010, the prescribed formula would result in a21.5 percent reduction in aggregate Medicare payments to physicians.Legislative proposals have been introduced to revise the statutory formula andprevent the rate reduction. We are unable to predict, however, whether thelegislation would be passed or what future changes will be made to computeMedicare payments or reimbursement amounts used by other third-party healthcare payors.

 

Further, as part of the Obama Administration’s efforts to passextensive federal healthcare reforms, there have already been several newlegislative initiatives which could have a negative impact on the demand forour products and our business. It is unclear at this time how these initiativeswould influence policies on coverage and reimbursement. Nor can we predictwhether the proposed reform measures, if adopted, or any federal legislationenacted in the future will have any impact on our revenues, profit margins,profitability, operating cash flows and results of operations.

 

If we obtain the necessary international regulatory approvals, marketacceptance of our products in international markets would be dependent, inpart, upon the availability of coverage and reimbursement within prevailinghealth care payment systems. Reimbursement and health care payment systems ininternational markets vary significantly by country and include bothgovernment-sponsored health care and private insurance. We intend to seekinternational reimbursement approvals, although we cannot assure investors thatany such approvals will be obtained in a timely manner, if at all. We are alsounable to predict at this time the impact on our business of any futurechanges, if any, that are made to coverage and reimbursement policies bygovernment action in key international markets.

 

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***Product liability claims couldadversely impact our financial condition and impair our reputation.***

 

Our business exposes us to potential product liability risks which areinherent in the design, manufacture and marketing of medical devices. Inaddition, many of our products are designed to be implanted in the human bodyfor long periods of time. Component failures, manufacturing flaws, designdefects or inadequate disclosure of product-related risks or product-relatedinformation with respect to these or other products we manufacture or sellcould result in an unsafe condition or injury to a patient. The occurrence ofsuch a problem could result in product liability claims or a recall of one ormore of our products, which could ultimately result in the removal from thebody of such products and claims regarding associated costs and damages, whichcould materially adversely impact our business, financial condition, results ofoperations, our ability to attract and retain customers for our products, andfuture growth prospects.

 

We cannot assure you that our current product liability insurancecoverage limits are adequate to protect us from any liabilities we might incurin connection with the development, manufacture and sale of our products. Inaddition, we may require increased product liability coverage as products aresuccessfully commercialized in additional applications. Product liabilityinsurance is expensive and in the future may not be available to us onacceptable terms, if at all. A successful product liability claim or series ofclaims brought against us in excess of our insurance coverage could have amaterial adverse effect on our business, financial condition, results ofoperations, our ability to attract and retain customers for our products, andfuture growth prospects.

 

***We are dependent on key suppliers,and supply disruptions could materially adversely affect our business,financial condition, results of operations and future growth prospects.***

 

Some of the key components of our products are purchased from singlevendors. If the supply of materials from a single source supplier wereinterrupted, replacement or alternative sources might not be readily obtainabledue to the regulatory and other requirements applicable to our manufacturingoperations or the availability of certain product drawings and/orspecifications. A new or supplemental filing with applicable regulatory authoritiesmay require us to obtain clearance prior to our marketing a product containingnew material. This clearance process may take a substantial period of time andwe cannot assure investors that we would be able to obtain the necessaryregulatory approval for a new material to be used in our products on a timelybasis, if at all. This could create supply disruptions that would materiallyadversely affect our business, financial condition, results of operations andfuture growth prospects.

 

In addition, we primarily use a subcontractor located in Costa Rica tosterilize our disposable devices. We have the ability to use alternativesterilization service providers for most of our products. If our Costa Ricasterilization service were to be disrupted for any reason, we would be requiredto use alternative sources with longer processing and logistics cycles, whichcould lead to a disruption in our ability to supply products for a period oftime.

 

We are dependent on warehouses in the U.S. and Belgium owned andoperated by DHL Worldwide Express, Inc. If our ability to use thesewarehouses is disrupted, we may be unable to supply products to our customerson a timely basis, which could materially adversely affect our business.

 

The complex nature of the underlying support technologies utilized toexchange critical product information with third party transportation andlogistics providers, such as “Electronic Data Interchange,” has, at times,caused disruptions in our ability to deliver products to customers on a timelybasis. Failure of these supporting systems could impair our business for theduration of the failure.

 

***Our business is susceptible to risksassociated with international operations.***

 

International operations are generally subject to a number of risks,including: protectionist laws, business practices, licenses, tariffs and othertrade barriers that favor local competition; multiple, conflicting and changinggovernmental laws and regulations, such as tax laws regulating intercompanytransactions; difficulties in managing foreign operations, including staffing,seasonality of operations, dependence on local vendors, and collecting accountsreceivable; loss of proprietary information due to piracy, misappropriation orweaker laws regarding intellectual property protection; foreign currencyexchange rate fluctuations; and political and economic instability.

 

We derived 24.9 percent and 25.5 percent of our total product sales forthe quarter ended March 31, 2010 and 2009, respectively, from customerslocated outside of the Americas. We expect international revenue to remain asignificant percentage of total revenue and we believe that we must continue toexpand our international sales activities

 

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tobe successful. Historically, a majority of our international revenues and costshave been denominated in foreign currencies and we expect future international revenuesand costs will be denominated in foreign currencies. Our international salesgrowth will be limited if we are unable to establish appropriate foreignoperations, expand international sales channel management and supportorganizations, hire additional personnel, develop relationships withinternational sales representatives, and establish relationships withadditional distributors. In that case, our business, operating results andfinancial condition could be materially adversely affected. Even if we are ableto successfully expand international operations, we cannot be certain that wewill be able to maintain or increase international market demand for ourproducts.

 

***We require foreign regulatoryapprovals to market and sell our products in other countries. Failure to obtainand maintain these regulatory approvals would harm our ability to generaterevenue.***

 

To be able to market and sell our products in other countries, we mustobtain regulatory approvals and comply with the regulations of those countries.These regulations, including the requirements for approvals and the timerequired for regulatory review, vary from country to country. Obtaining andmaintaining foreign regulatory approvals is expensive, and we cannot be certainthat we will receive regulatory approvals in any foreign country in which weplan to market our products. If we fail to obtain or maintain regulatoryapproval in any foreign country in which we plan to market our products, ourability to generate revenue will be harmed.

 

***Disruptions or other adversedevelopments at our Costa Rica facility could materially adversely affect ourbusiness.***

 

Our high-volume disposable devices and controllers are manufactured atour Company-owned facility in an industrial park in San Jose, Costa Rica. Ifour Costa Rica facility is not able to produce sufficient quantities of ourcontrollers and products with adequate quality, or if our Costa Rica operationsare disrupted for any reason, then we may be forced to locate alternativemanufacturing facilities, including facilities operated by third parties.Disruptions may include, but are not limited to: changes in the legal andregulatory environment in Costa Rica; slowdowns or work stoppages withinthe Costa Rican customs authorities; acts of God (including but not limited topotential disruptive effects from an active volcano near the facility); andother issues associated with significant operations that are remote from ourheadquarters and operations centers. Additionally, continued growth in product salescould outpace the ability of our Costa Rican operation to supply orderedproducts on a timely basis or cause us to take actions within our supply andmanufacturing operations which increase costs, complexity and timing. Locatingalternative facilities would be time-consuming, would disrupt our productionand cause shipment delays and could result in damage to our reputation andprofitability. Additionally, we cannot assure you that alternativemanufacturing facilities would offer the same cost structure as our Costa Ricafacility.

 

***Future changes in technology ormarket conditions could result in adjustments to our recorded asset balance forintangible assets, including goodwill, resulting in additional charges thatcould significantly impact our operating results.***

 

Our balance sheet includes significant intangible assets, includinggoodwill and other acquired intangible assets. The determination of relatedestimated useful lives and whether these assets are impaired involvessignificant judgments. Our ability to accurately predict future cash flowsrelated to these intangible assets may be adversely affected by unforeseen anduncontrollable events. In the highly competitive medical device industry, newtechnologies could impair the value of our intangible assets if they createmarket conditions that adversely affect the competitiveness of our products. Wetest our goodwill for impairment in the fourth quarter of each year, but wealso test goodwill and other intangible assets for impairment at any time whenthere is a change in circumstances that indicates that the carrying value ofthese assets may be impaired. Any future determination that these assets arecarried at greater than their fair value could result in substantial non-cashimpairment charges, which could significantly impact our reported operatingresults.

 

***If we fail to effectively manage ourgrowth, then our business, financial condition and operating results could beadversely affected.***

 

Our business has grown in size and complexity over the past few yearsas a result of internal growth. This growth and increase in complexity haveplaced significant demands on financial and managerial controls, reportingsystems and procedures. In addition, we continue to explore ways to extend ourtarget markets. We will need to continue to improve our financial andmanagerial controls, reporting systems and procedures as we continue to grow 

 

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andexpand our business. To meet such demands, we intend to continue to invest innew technology, make other capital expenditures, develop management andoperating systems, and, where appropriate, hire, train, supervise and manageemployees with expertise to handle these particular demands. If we fail toefficiently manage operations in a way that accommodates continued internalgrowth, our business, financial condition and operating results could beadversely affected.

 

***Delaware law and provisions in ourcharter could make the acquisition of our company by another company moredifficult, which could adversely affect our stock price.***

 

Certain provisions of our certificate of incorporation and bylaws mayhave the effect of making it more difficult for a third party to acquire, or ofdiscouraging a third party from attempting to acquire, control of our company.This could limit the price that certain investors might be willing to pay inthe future for shares of our Common Stock. Certain provisions of ourcertificate of incorporation and bylaws allow us to issue preferred stockwithout any vote or further action by the stockholders, to eliminate the rightof stockholders to act by written consent without a meeting, to specify advancenotice and other procedures for director nominations by stockholders andsubmission of other proposals for consideration at stockholder meetings, and toeliminate cumulative voting in the election of directors. Certain provisions ofDelaware law applicable to us could also delay or make more difficult a merger,tender offer or proxy contest involving us, including Section 203, whichprohibits a Delaware corporation from engaging in any business combination withany interested stockholder for a period of three years unless certainconditions are met. The procedures required for director nominations andstockholder proposals and Delaware law could have the effect of delaying,deferring or preventing a change in control of the company, including withoutlimitation, discouraging a proxy contest or making more difficult theacquisition of a substantial block of our Common Stock. These provisions ofDelaware law, our certificate of incorporation, and our bylaws may have theeffect of delaying or preventing changes in control or management of theCompany, which could have an adverse effect on the market price of our stock.

 

***One Equity Partners, a privateequity firm, may have influence on our major corporate decisions.***

 

As previously reported, on September 1, 2009, an affiliate of OneEquity Partners, or OEP, a private equity firm, acquired our Series APreferred Stock. See “Part II — Item 7 - Management’s Discussion andAnalysis of Financial Condition and Results of Operations —Liquidity andCapital Resources” in our 2009 Form 10-K for a description of thistransaction. As a result of this transaction, OEP became the largest beneficialowner of our stock. At this time, assuming conversion of the Series APreferred Stock to our Common Stock, including make-whole amounts as defined inthe Certificate of Designation for the Series A Preferred Stock butexcluding outstanding options and warrants held by other parties, OEP wouldrepresent an ownership interest of approximately 17.7 percent of ourvoting stock. In connection with this transaction, we expanded the Board ofDirectors to eight members and granted OEP the right to nominate two directors.Effective September 1, 2009, Messrs. Gregory Belinfanti and ChristianAhrens, both Partners of OEP, were appointed to our Board of Directors.

 

Consequently, OEP may have the ability to influence our Board ofDirectors and matters requiring stockholder approval, subject to therestrictions placed on OEP by the Securities Purchase Agreement, includingwithout limitation OEP’s agreement to vote for any director nominated by theBoard and to comply with the terms of the standstill.

 

From and after the first anniversary of the investment, OEP, is free toconvert the Series A Preferred Stock into our Common Stock and, subject tothe registration requirements of the federal securities laws, dispose of suchstock, which could result in a decrease of the market price of our CommonStock, particularly if such dispositions are made in the open market and aresubstantial.

 

***We may not be able to comply withthe redemption rights, registration rights, and other rights of our holders of Series APreferred Stock and our obligations under the Registration Rights Agreementwith our holders of Series A Preferred Stock.***

 

After September 1, 2014, or in connection with a change incontrol, the holders of our Series A Preferred Stock may require us toredeem any or all outstanding shares of Series A Preferred Stock at theliquidation preference of such redeemed Series A Preferred Stock includingany applicable make-whole adjustment. We may not have sufficient liquidity tocomply with the redemption right of our holders of Series A PreferredStock at that time if such right is exercised. Alternatively, if we are able tocomply with the redemption right of the holders of our Series A

 

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PreferredStock, we may have insufficient remaining liquidity to conduct our business,which would materially adversely affect our business, liquidity, and financialcondition.

 

In addition, pursuant to the Registration Rights Agreement between usand the holders of our Series A Preferred Stock, if a registrationstatement is not timely filed or does not become effective in accordance withthe requirements of the Registration Rights Agreement, a Registration Default,then we shall pay the holders of the Series A Preferred Stock2.00 percent per annum of the original liquidation preference of the Series APreferred Stock, accruing from the date of the Registration Default until theRegistration Default is cured.

 

***We are dependent upon keymanagement, technical personnel and advisors, and loss of our key personnel andadvisors could have a material adverse effect on our business and results ofoperations.***

 

The loss of the services of one or more key employees or consultantscould have a material adverse effect on us. Our success also depends on ourability to attract and retain additional highly qualified management andtechnical personnel. We face intense competition for qualified personnel, anyof whom often receive competing employment offers. We cannot assure you that wewill continue to be able to attract and retain such personnel. The processrelated to the restatement of our financial results has impacted the amounts,timing and forms of employee compensation. These impacts could materiallyimpact our ability to attract and retain essential managerial and technicalpersonnel. Loss of key personnel would materially impact our ability to meetour financial and operational objectives and could have a material adverseeffect on our business and our results of operations.

 

***Circumstances associated with ourintegration of acquisitions may adversely affect our operating results.***

 

An element of our growth strategy has been and in the future may be thepursuit of acquisitions of other businesses that expand or complement ourexisting products and distribution channels. Integrating businesses, however,involves a number of special risks, including: the possibility that managementattention may be diverted from regular business concerns by the need tointegrate operations; unforeseen costs, difficulties and liabilities inintegrating our and the acquired company’s employees, operations and systems;accounting, regulatory, or compliance issues that could arise in connectionwith, or as a result of, the acquisition of the acquired company; challenges inretaining our customers or the customers of the acquired company following theacquisition; the difficulty of incorporating acquired technology and rightsinto our products and services; and impairment charges if our acquisitions arenot successful due to these risks.

 

In addition, we may incur debt to finance future acquisitions and mayissue securities in connection with future acquisitions, which may dilute theholdings of our current and future stockholders. If we are unable tosuccessfully complete and integrate strategic acquisitions in a timely manner,our business, financial condition or operating results may be adverselyaffected.

 

***Our operating results may fluctuate.***

 

In our experience, our results of operations may fluctuatesignificantly from period to period. Adverse fluctuations due to these factorsmay adversely affect our level of revenues and profitability, results ofoperations, financial condition, and future growth prospects in the short andlong term: the introduction of new product lines and increased penetration inexisting applications; achievement of research and development milestones; theamount and timing of expenditures and the receipt and recognition of licensefees; and timing of the receipt of orders and product shipments, absence of abacklog of orders, and the rate of product returns.

 

***Factors may make the market price ofour stock highly volatile.***

 

The market price of our Common Stock could fluctuate substantially inthe future. Investors may be unable to resell our Common Stock at or abovetheir purchase price. This volatility may subject our stock price to materialfluctuations due to the factors discussed in this “Risk Factors” section, andother factors including market reaction to acquisitions and trends in sales,marketing, and research and development; rumors or dissemination of falseinformation; changes in coverage or earnings estimates by analysts; our abilityto meet analysts’ or market expectations; and sales of Common Stock by existingstockholders.

 

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As previously reported, as of September 1, 2009, OEP owns all ofour outstanding Series A Preferred Stock. From and after the firstanniversary of its investment, or September 1, 2010, OEP may convert the Series APreferred Stock into our Common Stock and, subject to the registrationrequirements of the federal securities laws, dispose of such stock, which couldresult in a decrease of the market price of our Common Stock, particularly ifsuch dispositions are made in the open market and are substantial.

 

**ITEM 2.  UNREGISTERED SALES OF SECURITIES AND USE OFPROCEEDS**

 

None.

 

**ITEM 3.  DEFAULTS UPON SENIOR SECURITIES**

 

None.

 

**ITEM4.  RESERVED**

 

**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**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, as amended, theregistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|                    | **ARTHROCARE CORPORATION**                        |
|-------------------------|---------------------------------------------------|
|                    | *a Delaware corporation*                          |
|                    |                                              |
| Date:  May 5, 2010 | /s/  David Fitzgerald                             |
|                    | David Fitzgerald                                  |
|                    | President and Chief Executive Officer             |
|                    |                                              |
| Date:  May 5, 2010 | /s/  Todd Newton                                  |
|                    | Todd  Newton                                      |
|                    | Senior Vice President and Chief Financial Officer |

 

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**EXHIBIT INDEX**

 
| **EXHIBIT  NO.** | ** ** | **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                                                                                                                                        |

 

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