Double whammy in stock
Short sellers trash, then sue, Santa Clara tech firm
San Francisco Chronicle
By Reynolds Holding
November 9, 2003
There was something curious about the securities fraud case against Terayon Communications Co.
Shareholders sued the Santa Clara firm on April 13, 2000, one day after Terayon stock plummeted more than 25 percent. But the 58-page complaint was much too detailed for a last-minute lawsuit. It was certified for filing a full day before the stock's precipitous fall.
And the shareholders leading the San Francisco class-action included a fund run by Dallas investor Edward "Rusty" Rose III.
The political world knows Rose as George Bush's pal: A guest at Camp David, a prolific campaign-fund raiser and, with the president, a former managing partner of the Texas Rangers baseball team.
But in corporate boardrooms, he was "the Mortician," a tight-lipped, whip-smart financier who earned millions finding over-hyped companies, betting their stock would fall and then driving share prices down.
With Terayon, he was playing both sides of the fence.
As the company recently discovered, Rose and his associates sought profit by bad-mouthing Terayon until its stock dropped. They then sought damages through a shareholder class-action filed because, in essence, the stock had dropped.
At a time of jarring angst among investors made poorer by Enron, Tyco and other 401k-draining scandals, securities-fraud class actions often represent a last, best hope for legal retribution. They are designed to help innocent shareholders get their money back, and Rose's strategy, though not illegal, could seriously undermine that effort, say experts in securities law.
"It's just so blatant," says Professor Lynn Stout of UCLA law school. "They're trying to use the legal process for their own benefit and not for the benefit of fellow shareholders."
Thomas Bilek, an attorney for Rose's firm, sharply disagrees.
"They are honestly looking to do the right thing here," he says, "and see that shareholders get protected."
Attorneys for the shareholder class stress that investors who bet against stocks have been allowed in the past to lead suits on behalf of stockholders, but courts have never addressed the issues raised in this case -- a case that the San Francisco federal judge who presides over it has already called "utterly amazing."
"It disturbs me," declared Judge Marilyn Hall Patel during a hearing in September, "that the people who are going to drive the litigation are in fact the people who are betting on the stock going down."
Like many high-tech companies that roared to paper riches in the 1990s, Terayon's problems began when hype outpaced reality.
The company, founded in 1993 by Israeli brothers Zaki and Shlomo Rakib, designed and sold modems for transmitting data over cable TV lines. By 1999, it was elbowing for advantage in broadband, the high-stakes business of providing flash-quick Internet connections. The company's technology seemed better than the competition, but it had not yet received certification from CableLabs, the industry group that established uniform specifications for cable equipment.
Without CableLabs' blessing, Terayon's prospects were bleak, comparable to the fortunes of Betamax video tape in a VHS world. Survival depended on persuading the public that certification was virtually certain, a difficult task while CableLabs refused to commit.
So the company trod the line between exuding optimism and telling lies, and with its stock holding at about $35 a share in August 1999, investors seemed willing to listen.
But Rusty Rose and his colleagues had heard enough.
Rose, a Dallas native and graduate of Harvard Business School, founded Cardinal Investment Co. in 1974 and quickly gained notoriety as a short seller.
A short seller essentially borrows stock from a broker, sells it, then reimburses the broker with identical stock bought, say, a month later. If the stock has dropped in value over that month, the short seller profits. If not, he loses.
Short sellers typically grease the skids for a stock by knocking the company to journalists, financial analysts and government regulators. Although short sellers often get accused of disseminating false information, they sometimes elicit praise for publicizing wrongdoing and keeping the market honest.
The trick for them is to find an overvalued stock ready to fall, an arcane skill at which Rose grew so adept that he became a major dealmaker and member of Texas' elite. In 1989, when baseball officials needed a business heavyweight to join George W. Bush's bid for the Texas Rangers, they chose Rose.
Even after Bush left the Rangers in 1993, he and Rose remained friends, much to their mutual benefit. According to campaign-finance records, Rose contributed more than $40,000 to Bush's gubernatorial campaigns and raised more than $100,000 for his presidential run. When Bush's daughter Barbara needed a summer job, Rose's daughter Lela, a New York fashion designer, gave her one. When Barbara and her twin sister, Jenna, needed clothes for their father's inauguration, Lela designed their outfits.
Bush has hosted Rose at Camp David and, in 2002, appointed Rose's wife to the National Council on the Arts, which advises the chairman of the National Endowment for the Arts.
In August 1999, though, Rose and his firm were circling Terayon.
NASDAQ, the stock market on which the company traded, would rocket to its peak a mere six months later. Every technology stock, including Terayon, seemed an easy ticket to wealth.
But the financial newsletter Short Alert warned subscribers on Aug. 3 that limited prospects for the cable-modem industry meant Terayon was overvalued -- and ripe for selling short. After further investigation, Cardinal Investment took the advice, initially shorting 5,000 shares through Cardinal Partners, a fund that Cardinal ran.
Over the following month, Cardinal increased its bet against Terayon stock while growing more confidant that "the company was less than perceived," testified Cardinal partner James Traweek in a deposition. Confounding Cardinal's expectations, the stock continued to rise, reaching more than $40 a share on September 7.
The next day, CableLabs announced that Terayon's technology was "very likely (but not certain)" to gain certification if it met certain conditions. Cardinal suspected this lukewarm endorsement might disappoint shareholders and send the stock lower. But after Terayon expressed delight with the news, the share price rose to $43 -- and Cardinal swung into action.
On October 19, for example, Cardinal sent Wall Street Journal reporter Brenda Moore an eight-page memo outlining the "thesis" of Terayon's demise. The memo, later filed in court, included the names and telephone numbers of sources and a glossary of technology terms.
"We look forward to helping you in any and every way possible except going on the record," the cover letter said. "Furthermore we consider all our correspondences with you confidential."
On Dec. 29, the Journal ran an article under the headline, "Has Terayon Inflated the Prospects for Its Cable-Modem Technology?"
Apparently, the market didn't think so. On Dec. 30, Terayon shares reached almost $62, then doubled in price three weeks later.
It was shortly thereafter that the "Game Plan" was born.
On a January 2000 day in Dallas, with Cardinal and its clients facing tens of millions of dollars in potential losses and Rose demanding action, firm analyst Kent McGaughy scratched the words "GAME PLAN" at the top of a legal pad.
"What are the key levers we can pull?" McGaughy wrote before listing CableLabs, the Securities and Exchange Commission, federal prosecutors, financial journalists and others capable of flooding the market with negative information about Terayon.
"Dirt on Zaki, Schlomo, Ray," continued McGaughy, apparently referring to Terayon's top three officers at the time. "Get Rusty (Rose) to brainstorm."
In a deposition last June, McGaughy made light of his notes, saying he was "not exactly sure" what they meant, that he had been "brainstorming, trying to organize my thoughts." But court records show that over the first three months of 2000, as if someone were ticking down the items one by one, the game plan -- ambitious even for short sellers -- played out:
- Rose and his colleagues made scores of phone calls to CableLabs, suggesting that Terayon had lied about receiving certification, a CableLabs official testified. The organization received so many calls from Cardinal and others that on Feb. 2, it wrote a confidential letter demanding that Terayon "cease and desist" from "making misleading statements." After talking to Terayon, CableLabs acknowledged in a second letter that the statements had been "more a matter of interpretation" than "misleading."
- On Feb. 9, the day before Terayon says it received the cease-and- desist letter, a Cardinal partner began touting the missive on a Yahoo! message board. Terayon "has been lying all along," the partner wrote under the alias FredScott9. "These guys are going to be punished for their actions . . . by the SEC."
- On Feb. 11, Cardinal sent the first of at least 10 letters to the SEC and the National Association of Securities Dealers accusing Terayon of "blatantly" lying "in every SEC document it has filed since it went public." The SEC asked Terayon about its public statements but did not pursue the matter further, according to the company's lawyers.
- On Feb. 15, Cardinal e-mailed its "thesis" on Terayon to Fortune magazine reporter Bethany McLean, later credited with breaking the Enron story.
Thus began a lengthy correspondence about the cease-and-desist letter and Terayon's alleged "outright lies." On March 6, Fortune reported that the company may have overstated its chances for receiving CableLabs approval, and a Cardinal partner highlighted the article during a conference call with financial analysts.
- In March, Rose sent federal prosecutor Bonnie Jonas Cardinal's letters to the SEC and a copy of the Fortune article, asking her to "keep my name and the name of our firm confidential." Rose had gotten Jonas' name from his daughter, Lela, who had met her at a bar in New York, Rose testified.
On March 9, Terayon's stock peaked at almost $278 a share. The "Game Plan" wasn't working.
Cardinal's financial risk appeared untenable. According to deposition testimony, the firm had sold short 400,000 Terayon shares, exposing it to losses of about $80 million. Rose alone was on the hook for $25 million. Cardinal was forced to hedge its bets by purchasing 6,000 shares of Terayon stock at almost $269 a share, a $1.6 million investment that might soften the blow if the share price continued to rise.
"It was," testified former Cardinal partner Robert Alpert, "a stressful period."
The final showdown with Terayon came late in the afternoon of April 11, during a conference call the company held to tell financial analysts what its quarterly earning would be
Among the cries of "great quarter" and other fawning comments rose the harshly critical voices of Joe Blow and other short sellers using phony names. One grilled Terayon about the Feb. 2 cease-and-desist letter from CableLabs, accusing executives of dumping stock while keeping the letter secret, a charge that Terayon denied. Cardinal's McGaughy, using the alias Paul Williams, accused Terayon of maintaining an overly cozy relationship with CableLabs.
That same day, Shlomo Birnbaum, the owner of 10 Terayon shares, signed a sworn statement authorizing the filing of a legal complaint that repeated almost verbatim the accusations contained in Cardinal's letters to the SEC. The complaint tied the negative news from the conference call to "an immediate decline in the price of Terayon stock," an event that would not occur until the following day.
On April 12, 2000, Terayon stock did drop, from almost $163 a share to under $120. It is unclear whether the decline occurred because of the conference call - or because the overall stock market plummeted that day, with the NASDAQ Composite Index suffering the second-largest point loss in its history.
In any event, Terayon investors sued the company on April 13 for securities fraud. Cardinal joined them the next day as a lead plaintiff, claiming that Terayon had duped it into paying too much for the 6,000 shares it had purchased as a hedge. In its sworn statement accompanying the complaint,
Cardinal never mentioned the hundreds of thousands of shares that it and its affiliates had sold short.
More than a year later, it appeared that Terayon might win vindication: CableLabs announced on August 31, 2001, that the next version of modem specifications would include Terayon's technology.
But in an order dated March 29, 2002, Judge Patel refused to dismiss the class-action complaint. She accepted the shareholders' preliminary showing that at least several of Terayon's statements about getting CableLabs' certification were misleading at the time they were made.
It would take another year for Terayon to discover what Cardinal had been up to, but on Aug. 4, 2003, the company asked Judge Patel to disqualify the firm as a lead party representing the interests of other shareholders.
Terayon's lawyers told Patel that as a short seller "who tried to drive down the price of Terayon stock," Cardinal had "conflicts of interest with the other members of the plaintiff class, who bought Terayon stock hoping that its price would increase."
In response, Cardinal accused Terayon and its executives of trying "to distract the court from their own culpability for securities fraud."
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."
Patel has yet to issue a ruling, but Bilek says Cardinal is just "trying to prevent this massive fraud" and isn't looking for trouble.
"Cardinal is more than willing to step down at any time," he said, "if the judge feels like it is not doing a good job."
A short seller essentially borrows stock from a broker, sells it, then reimburses the broker with identical stock bought at a later time. Here's a simple example of how it works.
You research a company and think the share price will drop so you decide to short 100 shares trading at $100 a share.
You borrow those shares from your broker for a month. You sell the shares for $10,000.
The share price can go down, or it can go up. No matter. You owe your broker 100 shares.
The share price falls to $50. You place an order with your broker for 100 shares, paying $5,000. You own these shares and use them to repay your broker for the borrowed shares.
That leaves you with a profit of $5,000 excluding commissions. What if the share price soars to $150? You still must return the shares you borrowed. However, buying 100 shares at $150 means that when you return the borrowed shares to your broker you have lost $5,000 plus commissions.
Thus if the stock drops in value over the month, the short seller profits.
If not, he loses.
That is why institutional short sellers typically try to drive down the value of a stock by knocking the company to journalists, financial analysts and government regulators.
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