IMPORTANT – Please read this Disclaimer in its entirety before continuing to read our research opinion. The information set forth in this report does not constitute a recommendation to buy or sell any security. This report represents the opinion of the author as of the date of this report. This report contains certain “forward-looking statements,” which may be identified by the use of such words as “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential,” “outlook,” “forecast,” “plan” and other similar terms. All are subject to various factors, any or all of which could cause actual events to differ materially from projected events. This report is based upon information reasonably available to the author and obtained from sources the author believes to be reliable; however, such information and sources cannot be guaranteed as to their accuracy or completeness. The author makes no representation as to the accuracy or completeness of the information set forth in this report and undertakes no duty to update its contents. The author encourages all readers to do their own due diligence.
You should assume that as of the publication date of his reports and research, Aurelius and possibly any companies affiliated with him and their members, partners, employees, consultants, clients and/or investors (the “Aurelius Affiliates”) have a short position in the stock (and/or options, swaps, and other derivatives related to the stock) and bonds of MiMedx. They therefore stand to realize significant gains in the event that the prices of either equity or debt securities of Mimedx decline. Aurelius and the Aurelius Affiliates intend to continue transactions in the securities of Mimedx for an indefinite period after his first report on a subject company at any time hereafter regardless of initial position and the views stated in Aurelius’ research. Aurelius will not update any report or information on this website to reflect such positions or changes in such positions.
Please note that Aurelius, the author of this report, and the “Aurelius Affiliates” are not in any way associated with Aurelius Capital Management, LP, a private investment firm based in New York, and any affiliates of or funds managed by the latter company.
Dear Mr. Brock,
We are writing to express our concerns about the risks of serious and pervasive fraud at Mimedx Group, Inc. and your firm’s audit thoroughly testing these risks in light of facts and allegations that have emerged.
As you are likely aware, multiple whistleblowers have made detailed allegations of accounting fraud and wrongdoing at MiMedx. Short sellers, including ourselves, have published research reports questioning the integrity of the company’s financial reporting and disclosures. MiMedx is subject to an SEC investigation and has admitted that at that at least one former employee has now pled “the fifth amendment rather than answer questions related to dinners provided to doctors”. In recent months, MiMedx has embarked on an aggressive retaliatory campaign that appears to be singularly intended to intimidate and silence those who present facts that contradict management’s narrative.
Last September, we published a research report that highlighted disturbing similarities between our observations of MiMedx and certain characteristics displayed by ArthroCare, a medical device company that engaged in accounting fraud through undisclosed transactions involving distributors, sales agents, and doctors. Soon afterwards, MiMedx filed a lawsuit and has repeatedly claimed to be the victim of a purported “illegal, unscrupulous and massive short sell attack”. It is particularly notable that after allegations of fraud first emerged at ArthroCare, the CEO also accused short sellers of making false claims he said were “the most salacious kind of garbage you can possibly find.” Yet the fraud was exposed and the CEO eventually went to prison.
We believe your audit engagement of MiMedx presents an important opportunity to protect the reputation of Ernst & Young. ArthroCare’s auditors could have put an end to the fraud but failed. The PCAOB instituted disciplinary proceedings against the PriceWaterhouse partner in charge of ArthroCare’s 2005-2009 audits, leading to a three-year disbarment for that individual. The PCAOB specifically cited the audit partner’s failure to examine short seller allegations beyond accepting statements from management:
“[Audit Partner] learned no later than early December 2007 that allegations of potential wrongdoing were being made against ArthroCare by short sellers…. After speaking during the 2007 audit with PwC’s local Regional Risk Management Partner about the “short-attack on ArthroCare,”…. [Audit Partner] accepted management’s representations regarding the short seller allegations, ultimately concluding that they did not appear to have merit. Neither [Audit Partner] nor his team performed any additional procedures to specifically respond to the short seller allegations”
We are concerned by public statements made by MiMedx soon after your August 2017 appointment as the company’s new auditor implying that you had endorsed MiMedx’s accounting practices before even conducting an audit or issuing an audit opinion. Examples include:
- “Our Big 4 auditors are with us! We are answering the SEC’s subpoena – thank you! (October 25, 2017)
- “Believe our auditors” (November 2, 2017 MiMedx repeated this phrase four times in a written public response to a short seller’s allegations concerning improper revenue recognition).
- “These exceptional results have been reviewed by our new auditors, who are one of the ‘Big Four’ Auditing firms.” (October 26, 2017)
- “there is no malfeasance, there is no revenue recognition issues, et cetera, et cetera, I mean here we’ve gone through a year-end audit, we’ve gone through two quarterly audits” (CEO Parker Petit during a call with an investor)
We believe these assertions are likely false because it seems virtually impossible for your engagement team to have completed the necessary audit procedures into such detailed allegations so quickly after being retained (and well before audits typically begin). Also, contrary to Mr. Petit’s claims, we note that the company’s 10-Q filings with the SEC specifically state the financials are not audited. Yet MiMedx’s representations concerning your firm may have enticed investors into purchasing shares of the company, especially since they were bundled into management statements intended to placate fears about the SEC’s investigation and discredit whistleblowers. It is our opinion that MiMedx is using your brand as a means to convey legitimacy to itself, especially since EY named Mr. Petit “Entrepreneur Of The Year” in 2015. We therefore believe it is imperative that Ernst & Young publicly clarify if MiMedx’s statements about it are accurate.
MiMedx has repeatedly made false statements to investors. In press releases and conference calls, the company and CEO Parker Petit have pointed to the findings from an investigation purportedly led by “independent outside counsel” as proof that there is “no malfeasance” at MiMedx. But we learned that this investigation was actually led by Troutman Sanders, MiMedx’s own securities counsel. SEC filings show that Troutman has represented MiMedx in securities matters since at least 2013 and has previously represented other companies that were controlled by Mr. Petit, Healthdyne and Matria. Therefore, Troutman clearly fails to meet both legal and common-sense definitions of independence. Yet instead of correcting this clear misrepresentation after we first publicized it, Mr. Petit has continued to falsely characterize Troutman as being independent. If MiMedx has made similar representations to you, we reference AS 2805.04, which states that:
“if a representation made by management is contradicted by other audit evidence, the auditor should investigate the circumstances and consider the reliability of the representation made. Based on the circumstances, the auditor should consider whether his or her reliance on management’s representations relating to other aspects of the financial statements is appropriate and justified.”
At absolute minimum, it is our opinion that this falsehood may impair your ability to rely on the investigation as credible audit evidence. A whitepaper authored by Ernst & Young recognizes that “issues are present when using the company’s regular outside counsel with strong ties to management” to conduct special investigations. Furthermore, although Mr. Petit has told investors that “believe me, this board is a group of individuals that are very independent of this management group”, we discovered that the Chairman of MiMex’s Audit Committee, J. Terry Dewberry has “very close” personal ties to Mr. Petit. Mr. Dewberry is Mr. Petit’s Fraternity Little Brother at Georgia Tech’s Pi Kappa Phi and Petit was quoted in an interview stating that Mr. Dewberry has “been a member of the executive team for all our businesses over the years”. The fraternity publication explains that Mr. Dewberry even assisted in the creation and award of a bronze bust of Mr. Petit in 2014.
We have conducted exhaustive forensic research into MiMedx and observe significant irregularities involving MiMedx and its distributor and sales agent networks. We believe these issues merit your full attention under AS 2401 (Consideration of Fraud in a Financial Statement Audit), AS 2405 (Illegal Acts by Clients) and AS 2410 (Related Parties).
AvKARE was MiMedx’s primary distributor to the VA, having consignment agreements allowing it to store product at VA Hospitals. MiMedx recognizes revenues as soon as product is shipped to stocking distributors, as opposed to when the product is implanted. At least three whistleblowers have alleged that MiMedx abused this accounting policy by using AvKare’s consignment agreements to hit sales targets by filling shelves before the end of quarters with excess product that neither AvKARE nor the VA had requested. While a significant amount of supporting detail exists in court documents filed by the whistleblowers, items we believe are particularly salient include:
- Evidence indicates that AvKARE was merely an intermediary and that MiMedx retained responsibility for the inventory. In a deposition under oath, MiMedx’s current Senior Vice President of Global Sales Mike Carlton stated that Avkare “didn’t do anything”, “it was really our direct guys that sold the product”. This statement corroborates the whistleblower allegations that MiMedx sales representatives were responsible for “ensuring the resale of AvKARE tissues to the end-customer (in this case, the federal government), monitoring and tracking the AvKARE tissues, and accounting for any lost AvKARE tissues”. Former representatives we have spoke to also have said they were heavily involved in the stocking and resale of AvKARE inventory.
- MiMedx shared a fax number with AvKARE (a practice observed in historical frauds such as ArthroCare).
- A court-filed transcript of a recording of a current MiMedx sales manager states that product was “stuffed in our VAs” to the point where “grafts are spilling out of every cabinet available to us”.
- According to other whistleblower allegations, some of the excess inventory was intercepted by MiMedx employees and then hidden in their home or car. One former MiMedx sales representative we spoke to in a different region than the whistleblowers corroborated this allegation:
“Products being kept at employees’ homes? Yes. Yeah. Absolutely. Yeah. Lots of cases. Yeah. I’ve heard stories, I’ve heard lots of crazy stuff, things buried or just thrown away. Really just stuff that turns your stomach”
After we publicized this, MiMedx stated that “over the past year, MiMedx has uncovered a few such instances and have terminated employees for this unacceptable conduct”.
- MiMedx’s contract with AvKARE included product return rights. According to whistleblower allegations, there was a separate understanding that:
“If MiMedx sales representatives could not locate AvKARE tissues that MiMedx shipped directly to VAs and obtain a purchase order for the re-sale of AvKARE tissues to the federal government, MiMedx was required to credit AvKARE for the lost tissue. Hence, AvKARE’s obligation to pay was implicitly excused until the resale of the AvKARE tissues to the end customer.”
This is consistent with a court-filed transcript of a recording in which a current MiMedx sales manager states that MiMedx would credit AvKare for missing VA tissue. The existence of such credits was reiterated in an email which expressed concern over “what will happen to the quarter” if MiMedx provided credit to AvKARE for missing product.
We fail to understand how MiMedx’s sales to AvKARE meet the criteria for revenue recognition in accordance with SEC Staff Accounting Bulletin No. 104 (“SAB 104”). Especially because this arrangement appears to meet characteristics described in the SEC’s interpretative response of SAB 104 that would specifically preclude revenue recognition. The interpretative response (emphasis ours) states in pertinent part that:
“Other situations may exist where title to delivered products passes to a buyer, but the substance of the transaction is that of a consignment or a financing….the presence of one or more of the following characteristics in a transaction precludes revenue recognition even if title to the product has passed to the buyer:
The buyer has the right to return the product and:
(a) the buyer does not pay the seller at the time of sale, and the buyer is not obligated to pay the seller at a specified date or dates.
(b) the buyer does not pay the seller at the time of sale but rather is obligated to pay at a specified date or dates, and the buyer’s obligation to pay is contractually or implicitly excused until the buyer resells the product or subsequently consumes or uses the product
(c) the buyer’s obligation to the seller would be changed (e.g., the seller would forgive the obligation or grant a refund) in the event of theft or physical destruction or damage of the product
(d) the buyer acquiring the product for resale does not have economic substance apart from that provided by the seller
(e) the seller has significant obligations for future performance to directly bring about resale of the product by the buyer.
If title to the goods has passed but the substance of the arrangement is not a sale, the consigned inventory should be reported separately from other inventory in the consignor’s financial statements as “inventory consigned to others” or another appropriate caption.”
MiMedx’s Commercial Distributor & Agent Network
ArthroCare’s fraud relied on a distributor managed by a former company sales manager. ArthroCare then used this “captive” distributor to recognize revenue on shipments of excess product at the end of quarters to meet Wall Street analysts forecasts, rather than the distributor’s actual orders. Furthermore, “evidence at trial further showed that ArthroCare’s distributors agreed to accept shipment of millions of dollars of products in exchange for special conditions, including substantial, upfront cash commissions…allowing ArthroCare to falsely inflate revenue by tens of millions of dollars”. This background is precisely why we believe the irregularities and undisclosed entanglements that exist between MiMedx and multiple distributors and agents are so problematic:
- Two MiMedx distributors, CPM Medical and SLR Medical, are identified in Florida court documents filed by one of MiMedx’s whistleblowers as having special undisclosed agreements along with an unidentified third having a “house account”. MiMedx allegedly uses these agreements to engage in channel stuffing and manipulate its financials. An investigative news company, the Capitol Forum, also reported of an alleged MiMedx scheme to load product onto a truck and be “driven around the corner like it was going to a wholesaler”.
- The court documents cite specific order amounts with totals implying that CPM was over a 5% customer for MiMedx during 2015. For example, the whistleblower states that CPM made roughly $2.5 million of purchases immediately before the end of Q1 2015, an order that would have been directly responsible for MiMedx’s ability to meet its guidance of $40.8 million during that quarter. ThePCAOB stated that ArthroCare’s audit partner “failed to properly evaluate numerous indicators that should have alerted him to the possibility that ArthroCare was improperly recognizing revenue”. One of these indicators was a “pattern of quarter-end spikes” in distributor sales.
- The owner of CPM Medical, Mark Brooks, “was personal friends with the MiMedx Vice President of Sales, Mike Carlton”, according the whistleblower’s court filing. An investigator from another investor visited CPM’s headquarters and asked for Mr. Brooks but was instead referred to a man named Bill Cochrane. Cochrane is MiMedx’s former National Sales Director. Asked about his role, Mr. Cochrane said he is “a consultant to distributors” before producing a card for a business named “AZ Biomedical”. Mr. Cochrane estimated that the business has over 100 employees and holds inventory that includes MiMedx product as well as spine & orthopedic hardware.
- Although MiMedx has told investors that “the relationship between CPM and MiMedx ended in 2015, with our last shipment in July of 2015”, CPM (dba “AmbioMed”) filed a 2018 tissue bank registration to “store” and “distribute” MiMedx product. A web of at least 53 different LLCs are registered to CPM’s Richardson, Texas address, including a now inactive tissue bank, Trident Spine, that was storing MiMedx product at the address of a self-storage center unit in Florida. Another tissue bank, Palm Springs Partners dba Maxim Surgical, reports storing and distributing unspecified amounts of MiMedx product as of 2018 at CPM’s address. We question if CPM either had so much excess product that it has taken multiple years to sell it all or if CPM (or affiliates) have continued to stock and distribute for MiMedx.
- MiMedx has an undisclosed OEM agreement with CPM to sell product under the “AmbioChoice” trademark, a label that Mr. Cochrane says he has substantial involvement with. MiMedx denied that such an agreement exists in court documents filed as part of its lawsuit against short sellers, but the most recent tissue bank registrations for MiMedx, CPM, and Palm Springs Partners each report storing and distributing AmbioChoice inventory. Tissue banks registered to residential homes in Texas also report stocking and distributing AmbioChoice. We also obtained a publicly posted photo of AmbioChoice believed to have been captured in 2017. If MiMedx’s relationship with CPM has ended, where is AmbioChoice coming from?
- CPM Medical was recently acquired by a publicly traded entity named Fuse Medical, which both CPM and SLR had previously supplied. Fuse filed a 2018 registration as a tissue bank storing products that include AmbioChoice. Fuse is also a physician owned distributor and its SEC filings name over 40 podiatrists across the country who received membership interests in Fuse. Mr. Cochrane also stated he was involved in Fuse’s operations even prior to the acquisition of CPM.
- SLR Medical is currently owned by a now-former MiMedx Sales Director, Jerry Morrison. SLR was treated as a “house account” that received highly favorable financing terms in exchange for making end of quarter purchases at MiMedx’s request, according to whistleblower allegations. Some excess product was also allegedly stored in the home of a former MiMedx employee that went to work for SLR.
- After we questioned if SLR is an undisclosed related party in our initial research report, MiMedx claimed that:
One of the principles of SLR is a former MiMedx employee. After the CPM contract ended, he left the company to join his fiancé (now wife) who previously managed the distributorship. SLR then became the MiMedx distributor in the Texas territory and replaced CPM. There was no contract or sales between SLR and MiMedx while the principle of SLR was an employee
But this assertion is directly contradicted by records from an FDA inspection of SLR Medical in January 2015, when Mr. Morrison appears to have still been employed by MiMedx. As a result, we continue to view SLR Medical as an undisclosed related party:
1) The FDA documents name Mr. Morrison as “responsible for all operations” and “the sole owner of the firm” since its founding in 2010
2) Although MiMedx claims Mr. Morrison’s wife controlled SLR prior to Mr. Morrison’s arrival, the FDA records name her as merely an office manager that had been with the firm only two years.
3) The records state that SLR was storing and distributing “amniotic membrane allograft” (presumably MiMedx). Furthermore, “Mr. Morrison stated the firm directly picks up the HCT/Ps [human tissue] and then immediately distributes via [redacted] or a courier service.
MiMedx has attempted to dismiss these irregularities by claiming that its sales to distributors represent less than 5% of sales, creating the impression that these sales relationships are minimal in size. But we find this misleading because we learned that SLR Medical, for example, does most of its business as a sales agent for MiMedx (receiving commissions) rather than just as a distributor. MiMedx classifies sales through agents as “direct” sales and has refused to specifically disclose what portion of its overall sales come through agents. We therefore believe the true size of these third party sales relationships is both highly material and substantially bigger than MiMedx has represented.
We find this problematic because ArthroCare’s primary distributor simultaneously functioned as an agent, receiving large fee payments from the company that were recorded as operating expenses. These fee payments, in turn, helped the distributor finance its inventory purchases from the company because a substantial portion was treated as a reduction in the receivable owed (which had the added benefit of reducing ArthroCares days sales outstanding calculation). In addition, according to the SEC, “ArthroCare also inflated revenue by mischaracterizing volume-based commission payments to distributors as fees for services. This enabled ArthroCare to record the gross amount of the sale as revenue and expense the commission, rather than recording the net revenue of the sale, as required by GAAP.” The PCAOB also stated that the auditors failed to recognize “ArthroCare’s contradictory treatment of [the distributor] as a reseller for revenue recognition purposes but as an agent for purposes of service fee accounting”.
We believe that MiMedx’s relationship with AvKARE, CPM, SLR, and their affiliates should be reviewed under PCOAB standards which provide that in the case of “significant transactions that are outside the normal course of business for the entity [under audit], or that otherwise appear to be unusual given the auditor’s understanding of the entity and its environment”. In addition to distributor sales, we believe this review should encompass the accounting for any and all sales agent commission and consulting fees paid to these entities and their affiliates. Especially because MiMedx displays anomalously high SG&A expenses which range above 70% of sales as compared to approximately 30% for many small cap medical companies. We also note that the PCAOB states that the auditor “should gain an understanding of the business rationale for such transactions and whether that rationale (or the lack thereof) suggests that the transactions may have been entered into to engage in fraudulent financial reporting. Considerations [among other things] include whether “parties that do not have the substance or the financial strength to support the transaction without assistance from the entity under audit”.
We possess additional documentation that we believe is material to your audit, including certain whistleblower documents involving tissue tagging irregularities. This information can only be supplied to you on a confidential basis to protect individuals from the company’s aggressive attempts to intimidate and harass those with knowledge of wrongdoing. The PCAOB has stated that “When an auditor is confronted with multiple indicators of problematic revenue recognition … he or she must get to the bottom of the relevant issues, including digging into management’s representations.” We stand ready to assist you in this effort and sincerely appreciate your attention to this extremely important matter.