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February 23, 2004.


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 Page 2 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 standard Page 3 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 times." Id.

  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. Page 4

  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. Page 5

  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 Terayon.

  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 ...

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