March 1, 2004

This Is No Fairy Tale

Close on the heels of the Copper Mountain decision (the "fairy tale" case) comes another remarkable lead plaintiff/lead counsel order. In the Terayon securities class action, Judge Marilyn Hall Patel of the N.D. of Cal. has both disqualified two of the lead plaintiffs and found it "probable" that lead counsel must also be removed.

Terayon Communication Systems, Inc. is a Santa Clara-based maker of cable modem equipment. The securities class action against the company, initially filed in April 2000, is based on allegedly misleading statements concerning the company's ability to obtain certification for its technology.

Judge Patel originally appointed Cardinal Investment Co. and Marshall Payne (an employee of Cardinal) as two of the lead plaintiffs in the case. It came out in discovery, however, that Cardinal and Payne were significant short sellers of Terayon stock (hundreds of thousands of shares) and in early 2000 had begun a campaign to flood the market with negative information about the company. The campaign included phone calls to the certification entity, starting Internet chat room rumors, letters to the SEC, and contacts with financial reporters.

Moreover, Cardinal was apparently working closely with plaintiffs' counsel (later lead counsel for the class) during this period. Starting in February 2000, Internet website postings encouraged parties to contact plaintiffs' counsel about a proposed lawsuit against Terayon. According to Judge Patel, "the class period in the original complaint, i.e. the first day on which plaintiffs claim they were damaged, was February 9, 2000 the same day these Internet postings appeared. Defendants assert that these web postings were part of plaintiffs’ alleged scheme to drive the price of the stock down."

On April 11, 2000, the same day as a Terayon earnings conference call during which the company's executives were sharply criticized by short sellers using phony names, an investor plaintiff signed a sworn statement authorizing the filing of a complaint that closely tracked the language of Cardinal’s letters to the SEC. It was not until the next day, however, that the price of Terayon's stock dropped significantly. The complaint was filed on April 13.

Following the revelation of these facts, defendants moved to have Cardinal and Payne removed as lead plaintiffs. (See this earlier post in The 10b-5 Daily about press coverage of the hearing held last September.) Judge Patel has agreed and more.

The court found "[w]hile some short sales may not, in and of themselves render a lead plaintiff’s claims atypical, a pattern of affirmatively engaging in campaigns devised to lower the price of the stock in question certainly contains within it the seeds of discord between lead plaintiffs and the remaining plaintiffs." Accordingly, the court removed Cardinal and Payne as lead plaintiffs (and also noted that they "appear to have participated, if not perpetrated, a fraud of their own on the market" and could be subject to claims by their fellow shareholders).

As for lead counsel, the court expressed concern over lead counsel's pre-suit involvement with Cardinal and its apparent efforts "to mislead the court as to the scope and nature of lead plaintiffs’ holdings in Terayon stock" as part of the lead plaintiff selection process. Based on this course of events, the court wondered "whether counsel for plaintiffs actively participated in or provided advice to plaintiffs regarding their scheme to cause a fall in Terayon’s stock price" and invited a motion on whether lead counsel had waived privilege. In any event, the court found "it is probable that there is a conflict not only between lead plaintiffs and the class but also between lead counsel and the remainder of the class." Lead counsel was asked to provide a written response to a number of questions and defendants were given leave to take further discovery on the issue.

Judge Patel's order, dated February 23, can be found here. The San Francisco Chronicle has an article on the decision.

Posted by Lyle Roberts at March 1, 2004 10:04 PM | TrackBack
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