The opinion of the court was delivered by: MARILYN PATEL, Chief Judge, District
These consolidated securities class actions were brought on behalf of
individuals who purchased the publicly traded common stock of Terayon
Communications Systems, Inc. between November 15, 1999 and April 11,
2000. The parties came before the court on Defendants' Motion to
disqualify Lead Plaintiffs Cardinal Partners and Marshall Payne. Having
reviewed the motion and after hearing on the matter, the court has
concerns not only about the appropriateness of Cardinal Partners and
Marshall Payne as lead plaintiffs but also about the role of lead
counsel. For the reasons set forth below, the court issues the following
memorandum and order.
I. Cardinal's Investment in Terayon
Cardinal Investment Company ("Cardinal") is an investment company
located in Dallas Texas. Cardinal was founded and is operated by Edward
("Rusty") Rose, III. Marshall Payne is an employee of Cardinal, as are
James Traweek, Jr. and Kent McGaughy. Declaration of Christopher A. Patz
("Patz Decl.") Ex. 11.
In August of 1999 a publication called "Short Alert" identified Terayon
as a good candidate
for short selling. Id., Ex. 1 (Alpert Dep. At 20:14-21:9). A
"short sale" is a security trading practice "in which a party speculates
that a particular stock will go down in price and seeks to profit from
that drop." Lapidus v. Hecht, 232 F.3d 679, 680 (9th Cir.
2000)(quotations and citations omitted). The party places an order to
sell a security it does not own. The party borrows the security from a
broker and covers the short by subsequently purchasing the security and
returning the recently purchased security to the broker. If in the
interim period the security's price declined, the purchaser makes a
profit. If the price of the security increased in the interim, the
purchaser takes a loss.
After becoming aware of Terayon stock through the "Short Alert,"
Cardinal began shorting Terayon's stock in its clients' accounts. Patz
Decl. Ex. 3 (Cardinal Dep. At 108:13-110:8). The parties on whose behalf
Cardinal shorted the stock were: Cardinal Partners, Marshall Payne and at
least five other individuals and entities. During the third quarter of
1999, Rusty Rose also personally accumulated a large short position in
Terayon. By March 2000, Rose had a short position in approximately
125,000 shares of Terayon and Cardinal had another 400,000 shares on
behalf of its clients. Id. Exs. 11 &12 (Rose Dep. at
121:3-8)(Cardinal Dep. at 108:22-109:2). Marshall Payne's largest short
position was roughly 14,000 shares.
In the Spring of 2000 Cardinal also bet that the price of Terayon stock
would fall by buying "put options." "A put option is the right to sell a
security at a specified price; thus, the value of a put option increases
as the price of the underlying security falls." Magma Power Co. v.
Dow Chem. Co.. 136 F.3d 316, 321 n.2 (2d Cir. 1998).
Instead declining as Cardinal had bet, Terayon's stock price rose
dramatically. When Cardinal first purchased Terayon stock in August 1999
its highest price had been $41 5/8. In March 2000 Terayon's stock hit an
all time high price of $277 5/8. By March 2000, Cardinal and Rose were
short more than 500,000 shares equivalent to an $80 million loss
for Cardinal and a loss of $25 million for Rose personally.
Defendants assert that to counteract its losses Cardinal devised a
"game plan" to drive down the price of Terayon stock and that this "game
plan" was implemented during the class period. Cardinal had a thesis that
CableLabs would not accept Terayon's S-CDMA technology as a
in the industry. See e.g. Patz Dec. Ex. 1. (Alpert Dep.
at 120:12-21). Based on this thesis Cardinal claimed that statements
Terayon made to the contrary were fraudulent. Cardinal undertook a
campaign to inform the market and regulatory agencies about this alleged
fraud and about perceived weaknesses in Terayon's business strategy.
Cardinal's goal was to have the market lower the value of Terayon stock
which would "help [Cardinal's] investment pay off." Patz Dec. Ex. 1
(Alpert Dep. at 125:7-24).
On October 19, 1999, Cardinal sent a copy of its thesis to reporter
Brenda Moore at The Wall Street Journal. Id. Ex. 1
(Alpert Dep. at 127:1-8); Ex. 8; Ex. 3 (Cardinal Dep. at 135:18-136:10;
Ex. 15. Moore did write an article about Terayon which appeared in
The Wall Street Journal on December 29, 1999, however the
price of Terayon stock remained stable in the two week period after
the article appeared. In October 1999 Cardinal also began communicating
about Terayon to the Milberg Weiss firm, now designated as lead counsel
for plaintiffs in this case. Patz Dec. Ex. 12 (Traweek Dep. at
201:1-202:14). Traweek testified that from 1999 to April 2000 he
personally contacted the Milberg Weiss firm "on the order of ten
During January and February of 2000, Rose and his staff considered
"ways in which Cardinal Investment Company could communicate its views
about Terayon to the public." Id. Ex. 11 (Rose Dep. at
58:6-25). In this time period, Cardinal employee Kent McGaughy created a
document entitled "Game Plan" which document begins by posing the
question "What are the key levers we can pull?" Id. Ex. 20.
Whether McGaughy created this document of his own accord or at Rose's
suggestion is in dispute. Id. Ex. 11 (Rose Dep. at 58:6-25);
McGaughy Supp. RT at 31:5-11. Plaintiffs insinuate that McGaughy then did
nothing about the "Game Plan," but this assertion is belied by the
deposition testimony where it is clear that the substance of the "Game
Plan" was discussed with other Cardinal employees. Compare
Plaintiffs' Response to Motion at 8:14-17 ("three pages of hand written
notes . . . which were not even shown to anyone else hardly qualifies
as an elaborate game plan") with Patz Dec. Ex. 1 (Alpert Dep. at
117:6-118:16.)(discussions were had among Cardinal employees about the
"Game Plan"). Moreover, Cardinal employees in fact pursued the agenda
items listed on the plan.
One of the items on McGaughy's "Game Plan" called for Cardinal to
encourage CableLabs to make a statement about Terayon. Cardinal hoped
CableLabs would state unequivocally that Terayon's technology would not
be part of a DOCSIS standard, thus lowering Terayon's market value.
Id. Ex. 8 (McGaughy Dep. at 44:18-45:6). See also
Id. Ex. 11 (RoseDep. 104:14-23)(Rose communicated Cardinal's
thesis with the wish that "everyone would divest their holdings in
Terayon" and the wish that the "stock price of Terayon would go down.")
It is undisputed that Cardinal employees bombarded CableLabs with
calls. See e.g. Id. Ex. 5 (Fellows Dep.
181:20-182:10)(Alpert alone made 50 phone calls to Fellows). It is also
undisputed that starting in February 2000, Cardinal began a letter
writing campaign regarding Terayon to the Securities and Exchange
Commission ("SEC")*fn2, the National Association of Securities Dealers
("NASD") and the Assistant United States Attorney for the Southern
District of New York. Cardinal's opening letter to the SEC was 12 pages
long with 56 footnotes and claimed that "TERAYON HAS BLATANTLY LIED ABOUT
ITS INDUSTRY IN EVERY SEC DOCUMENT IT HAS FILED SINCE IT WENT PUBLIC IN
ORDER TO FALSELY INFLATE MARKET PERCEPTION ABOUT ITS TECHNOLOGY." Patz.
Dec. Ex. 36 at 2 (emphasis in the original). Cardinal wrote letters in a
similar vein to the SEC on February 23, March 8, March 15, March 20,
April 12 and April 25, 2000.
Starting in February 2000 Internet web site postings encouraged parties
to contact the Milberg Weiss firm about a proposed lawsuit against
Terayon. Despite the fact that these web postings in February 2000
claimed a lawsuit against Terayon was imminent, the stock drop which is
the issue of the current lawsuit did not occur until April 12, 2000.
See Patz Dec. Ex. 19 (postings of a_r_san of 2/09/00, 3:12 p.m.
("Will there be a class action suit? Messrs Lerach, Weiss will be looking
into it.") and 2/09/00, 5:42 p.m. ("I am in the process of faxing my TERN
stock transactions to [Milberg Weiss] to initiate the class action
lawsuit."). The court notes that 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.
In early April 2000 Cardinal Partners purchased April "puts" on Terayon
stock. Id. Ex. 3 (Cardinal Dep. At 13:2-22), Ex. 23, Ex. 60.
The "puts" expired on April 15, 2000. Thus Cardinal was betting that
something would cause a decline in Terayon stock between April 7 and
April 15. On April 11, 2000 Cardinal employee Kent McGaughy called into
Terayon's quarterly earnings conference call. McGaughy used a false name,
and posing as a bona fide securities analyst, accused Terayon of
fraud. Defendants assert that two other people participated in the
conference call at Cardinal's behest. These two, Jonathan Daws and Amir
Elgindy also used false names and raised issues of alleged fraud by
On April 12, 2000, Terayon's stock price fell. April 12, 2000 also
constituted one of the ten worst declines in NASDAQ history. Plaintiffs
filed their complaint in the Central District of California on April 13,
2000 clearly indicating that plaintiffs had been in contact with
counsel for some time prior to the April 12, 2000 stock decline. While
the complaint purports to have been signed on April 12, 2000, the
attached "Certification of Named Plaintiff'signed by named plaintiff in
that case, Shlomo Birnbaum, was dated April 11, 2000 one day
prior to Terayon's stock plunge. While neither Cardinal Partners or Payne
were named as plaintiffs in the Birnbaum complaint, much of the language
of the complaint very closely tracks the language of Cardinal's letters
to the SEC. Cardinal Partners and Payne signed their Certification of
Named Plaintiffs on April 14, 2000.
Milberg Weiss's relationship with Rose was not limited to the Terayon
case. As set out in the Fields v. Biomatrix case,
198 F.R.D. 451, 454 (D.N.J. 2000) the Milberg Weiss firm also represented Rose
in an almost identical short sale stock case. As in the case at
bar, defendants in Fields also asserted that Rose and
his associates had "systematically [made] false and misleading
allegations against Biomatrix on Internet message boards" and again as
here, the messages advised ...