Short Sellers Drive Down Stock Price, Then Sue Based On Loss In Hedge Position

The San Franciso Chronicle has a fascinating article on the Terayon Communication Systems, Inc. (Nasdaq: TERN) securities class action pending in the N.D. of Cal. Terayon is a Santa Clara-based maker of cable modem equipment. The case, originally filed in April 2000, is based on allegedly misleading statements made by the company in connection with its ability to obtain certification for its technology.
The lead plaintiff (or one of them) in the case is Cardinal Investment Co. According to the article, court records reveal that Cardinal was a massive short seller of Terayon stock (hundreds of thousands of shares) and in early 2000 began 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 rumours, letters to the SEC, and contacts with financial reporters. At the same time, Cardinal apparently hedged its short position by purchasing 6000 shares of Terayon stock.
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 “repeated almost verbatim the accusations contained in Cardinal’s letters to the SEC.” It was not until the next day, however, that the price of Terayon’s stock dropped significantly. The highly detailed complaint was filed on April 13. Cardinal also brought a suit and later successfully moved to act as a lead plaintiff in the case based on the losses in its hedge position.
The motion to dismiss in the case was denied by District Judge Patel in early 2002. Discovery, however, has apparently revealed Cardinal’s role in the company’s downfall. Terayon has asked Judge Patel to remove Cardinal as a lead plaintiff.
Quote of note: “On Sept. 8, during a hearing on Terayon’s request, Patel sounded receptive to the company’s arguments, noting that Cardinal’s partners ‘were doing just about everything they could to make sure the (stock) price went down.’ But her sharpest comments concerned the puzzling events that led to Cardinal’s lawsuit. ‘I think it’s utterly amazing,’ she told the opposing attorneys, ‘that we have this lengthy complaint, and with all of these excruciating details, and the stock just drops the day before.’ It ‘raises some very serious questions.'”

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