The 10b-5 Daily

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. 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.

If the judge ain’t happy, ain’t nobody happy. Proving that axiom correct, Judge Vaughn Walker of the N.D. of Cal. issued a fairly amazing order last week in the Copper Mountain securities litigation, expressing displeasure with both plaintiffs and the 9th Circuit over the lead plaintiff/lead counsel selection process in that case.

The PSLRA provides that the “presumptively most adequate lead plaintiff” in a securities class action is the movant who “has the largest financial interest in the relief sought by the class” and “otherwise satisfies the requirements of Rule 23 of the Federal Rules of Civil Procedure.” To summarize the process, the judge’s task is to determine which plaintiff has the largest financial interest, evaluate whether that plaintiff meets the adequacy and typicality tests of Rule 23(a), and, if that plaintiff meets the requirements, declare that plaintiff the presumptive lead plaintiff (a presumption that may then be rebutted by other plaintiffs). The court must also approve the lead plaintiff’s choice of counsel.

Three years ago, Judge Walker determined that he would not name the lead plaintiff movant in the Copper Mountain case with the largest financial interest as lead plaintiff because that candidate, known as the CMI Group, failed to demonstrate that it was an adequate lead plaintiff. Judge Walker based his decision on the CMI Group’s failure to negotiate a “competitive” fee arrangement with proposed lead counsel and named a different movant as lead plaintiff. See In re Quintus Sec. Litig., 201 F.R.D. 475 (N.D. Cal. 2001) and In re Quintus Sec. Litig., 148 F. Supp. 2d 967 (N.D. Cal. 2001).

The CMI Group petitioned the Ninth Circuit for a writ of mandamus. In In re Cavanaugh, 306 F.3d 726 (9th Cir. 2002), the court overruled Judge Walker’s decision. The panel, in an opinion written by Judge Alex Kozinski, found that the lower court had failed to follow the statutory language of the PSLRA in appointing the lead plaintiff. In particular, the court found that “a straightforward application of the statutory scheme . . . provides no occasion for comparing plaintiffs with each other on any basis other than their financial stake in the case.” Moreover, the lead plaintiff process “is not a beauty contest” and information about fee arrangements “is relevant only to determine whether the presumptive lead plaintiff’s choice of counsel is so irrational, or so tainted by self-dealing or conflict of interest, as to cast genuine or serious doubt on that plaintiff’s willingness or ability to perform the functions of lead plaintiff.” Accordingly, the Ninth Circuit vacated the lower court’s order and instructed the lower court to proceed with the CMI Group as the presumptive lead plaintiff.

On remand, however, the CMI Group apparently decided to no longer seek lead plaintiff status (or, as Judge Walker puts it, “vanished – fled the scene – gone south – maybe vaporized”). In his order, Judge Walker compares the situation to a “heroic prince” turning into a “frog” and is incredulous over the course of events:

“By vindicating their ‘right’ to be the presumptive lead plaintiffs through the extraordinary remedy of mandamus (and establishing circuit precedent of no little value to their lawyers), the CMI group might seem to possess a tenacity and determination seldom seen on the battlegrounds of federal litigation. But what might seem apparently is not. Could there have been some motivation other than vindicating the interests of defrauded investors behind the mandamus proceedings? Could it be that the Ninth Circuit panel, perceiving the black letter of the PSLRA, was actually reading a fairy tale?”

Also not surprisingly, Judge Walker appears to believe that the CMI Group’s decision vindicates his earlier order. Noting that “Cavanaugh would seem to establish that the largest stakeholder’s selection of counsel must be approved unless that selection is either mad or crooked,” the court finds that the opinion converts the PSLRA into “a straightjacket against judicial measures to ensure that [securities class actions] genuinely benefit investors, not lawyers.” In the absence of the CMI Group, Judge Walker ends up simply reappointing the earlier lead plaintiff to the position. “The moral of the story,” the court concludes, “will be left to you, dear readers.”

The Recorder has an article (via law.com – free regist. req’d) on the case in today’s edition. Judge Walker’s order is not yet available online.

Addition: The opinion is now on Westlaw – In re Copper Mountain Sec. Litig., 2004 WL 369859 (N.D. Cal. Feb. 10, 2004).