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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

For the fiscal year ended December 31, 2002

OR

For the transition period from ____________ to ____________

Commission File Number 000-28843

TURNSTONE SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

2220 Central Expressway, Santa Clara, California 95050

(Address of principal executive offices) (Zip Code)

(408) 907-1400

(Registrant’s telephone number, including area code)

Securities Registered Pursuant to Section 12(b) of the Act:

None

Securities Registered Pursuant to Section 12(g) of the Act:

Common Stock, $0.001 par value

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x    No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes x    No ¨

As of June 28, 2002, the aggregate market value of the Registrant’s common stock held by non-affiliates of the Registrant (based on the closing price for the common stock on the Nasdaq National Market on such date) was approximately $142,130,899. This amount excludes shares held by the Registrant and its directors, executive officers, and holders of five percent or more of the Registrant’s outstanding common stock.

As of February 28, 2003, there were 65,957,107 shares of the Registrant’s common stock outstanding.

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TURNSTONE SYSTEMS, INC.

FORM 10-K

DECEMBER 31, 2002

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INFORMATION REGARDING FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements represent our expectations or beliefs and include, but are not limited to, the following:

Readers are urged to carefully review and consider the various disclosures we make which attempt to advise them of the factors which affect our business, including, without limitation, the disclosures made under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and under the caption “Business—Risk Factors Affecting Future Results” included herein. These important factors, which could cause actual results to differ materially from the forward-looking statements contained herein, include, without limitation:

We are under no duty to update any of the forward-looking statements after the date of this report to conform such statements to actual results or to changes in our expectations.

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PART I

Item 1.    Business

Company History and Recent Developments

We were incorporated in Delaware in January 1998. Our principal executive offices are located at 2220 Central Expressway, Santa Clara, California 95050, and our telephone number there is (408) 907-1400. All of our public filings with the Securities and Exchange Commission are accessible from our corporate website at www.turnstone.com. Information contained on the website is not a part of this annual report.

We are a provider of hardware and software products that enable local exchange carriers to rapidly deploy and efficiently maintain copper local loop services. We began shipping the Copper CrossConnect^® CX100, our first volume product, in the first quarter of 1999. In January 2000, we completed an initial public offering of our common stock, which began trading on the Nasdaq National Market under the symbol “TSTN”. By August 2000 we had shipped more than 10,000 CX100s.

Beginning in the fourth quarter of 2000 and continuing through 2001, however, substantially all of our competitive local exchange carrier customers were unable to obtain additional financing or generate sufficient cash flows to fund their operations. They either reduced or discontinued the build-out of their networks, including purchases of our products. Many of them ultimately ceased business operations or filed for bankruptcy protection. As a result, our sales were negatively impacted and we incurred significant operating losses. In response to reduced demand for our products, we restructured our operations by reducing overall company headcount and closing our New Zealand engineering facility. In addition, our future success became increasingly dependent upon penetrating the incumbent local exchange carrier market and developing new frame automation products for that market.

In 2002, we continued to focus on the incumbent carrier market and on research and development efforts related to new frame automation products. In the third quarter of 2002, BellSouth Corporation completed a field trial of and purchased one of our unbundled network element, or UNE, management systems. However, in the fourth quarter of 2002, BellSouth decided not to budget for additional network deployment of our UNE management solution in 2003. We also experienced weak demand for our existing products and a lack of visibility into future demand for our products under development.

On January 9, 2003, we announced that we were exploring various strategic alternatives, including possible merger and asset sale transactions, licensing arrangements, and dissolution of the company and distribution of assets to stockholders. We also announced that we had engaged Goldman Sachs & Co. as our financial advisor. While we explore our strategic alternatives, our operating activities will be focused primarily on in-process research and development related to our next generation copper automation products for incumbent local exchange carriers. While a limited supply of our existing products remain available for sale, we have generally ceased all direct sales efforts related to them, and do not expect to generate material revenues from them for the foreseeable future. In connection with these decisions, we further reduced our headcount by approximately 40%, or 29 employees, in January 2003.

Company Overview

We design, engineer, market and support hardware and software products that enable local exchange carriers to rapidly deploy and efficiently maintain copper local loop services. The “local loop” refers to the network of existing telephone lines that extend from telephone companies’ central offices out to end customers. Incumbent local exchange carriers originally built this network to deliver traditional voice services. Through deregulation under the U.S. Telecommunications Act of 1996 and similar legislation in some other countries, competitive local exchange carriers have gained access to, and are also allowed to deliver their services through, the incumbent carriers’ local loop infrastructure. In particular, with the advent and rapid growth of the Internet

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and the increasing demand for faster Internet access, both incumbent and competitive carriers have been offering high-speed digital subscriber line, or DSL, services over the local loop.

Efficient management of the local loop is challenging for incumbent local exchange carriers. This labor-intensive management process typically involves the incumbent carriers’ personnel manually completing or removing connections inside central offices, at subscribers’ sites and possibly at various points throughout the local loop, which often results in faulty connections. In addition, the ability to deliver certain types of local loop services, such as DSL, is dependent upon the length and quality of the copper line. In order to verify and properly prepare the copper line for service delivery, the length of the line must be correctly measured and various devices connected to, or faults occurring on, the line must be identified in advance. Finally, monitoring and maintenance of the delivered services can be labor intensive and costly. Local exchange carriers often must dispatch technicians to individual central offices to diagnose problems, reconnect lines, to correct equipment failures or to change subscriber services.

Our products enable incumbent and competitive local exchange carriers to more effectively deliver their services. Our CX loop management systems are deployed to assist with copper loop installation, qualification, service verification and maintenance. Our SX Smart Splitter^® platform combines signal splitting capabilities with test access to assist in the delivery of asynchronous DSL, or ADSL, services. Our MX Copper CrossConnect^® solution provides remote switching and service verification capabilities to facilitate the management of unbundled local loops. Our next generation frame automation solution, currently under development, is intended to provide fast, high capacity, automated copper line switching and connection verification capabilities. Finally, our CrossWorks^™ and ONYX automation software suites enable service providers to remotely control our network equipment and seamlessly integrate loop management functions into their back-office operations support systems, or OSS.

Products

Loop Management Family.    Our loop management product family consists of the CX40 and CX100 hardware platforms, optimized for remote terminal and central office environments, respectively, and a variety of expansion modules as well as CrossWorks^™ loop management application software. The base system, which depends on customer configuration, typically consists of: one CX series chassis; one P150 module that provides the management, testing and control functions of the chassis; and one or more modules that provide additional testing, test access, cross connecting, service verification and/or central office equipment management functions. The base system is typically installed and cabled in a central office, with additional modules added over time as subscriber count increases and as more DSL access multiplexer modules are added. All modules may be inserted or removed while the system is operational and are automatically recognized and inventoried by the system upon insertion. All modules, indicators and switches are accessible from the front of the system, consistent with current industry practices. The CX series platform supports dual 48-volt power feeds. In the event of a loss of power, the CX series platform maintains all connections with no loss of subscriber service. The CX100 chassis is available in the 19 inch configuration which supports 425 lines, and the 23 inch configuration, which supports 550 lines. The following modules are currently available for the CX series platforms:

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Smart Splitter^® Family.    Our Smart Splitter^® product family consists of the Smart Splitter^® SX500 and its expansion modules. The SX500 incorporates signal splitting and test access for the efficient provisioning of ADSL and voice services over the same line and in line sharing arrangements. The system consists of one SX500 chassis, one SP series module that provides management and control functions and one or more SL24 splitter modules that provide signal splitting functionality and test access for 24 lines per module. Additional modules may be added over time as subscriber count increases. All modules may be inserted or removed while the system is operational, and a continuous dial tone is assured even during these module changes. The SX500 supports dual 48-volt power feeds. The SX500 is available in the 19 inch configuration, which supports 456 lines, and the 23 inch version which supports 576 lines. The following modules are currently available in volume for the SX500:

Crossworks^™.    CrossWorks^™ is a suite of software products that enables service providers to automate physical management of a large volume of copper lines when using CX series systems. When the CX series systems and the SX500 systems are deployed together, CrossWorks^™ can be used to manage both systems. CrossWorks^™ employs a client-server architecture that offers flexible integration with existing operational support systems. Alternatively, a service provider can use CrossWorks^™ as a standalone client-server application. With either of these approaches, CrossWorks^™ is designed to interface with the service provider’s existing database through a standard application programming interface. These options are designed to provide the service provider with automated system capabilities while leveraging its existing operational support systems infrastructure.

UNE Management Family.    Our unbundled network element, or UNE, management product family consists of the MX500 Copper CrossConnect^® platform and ONYX UNE software. The MX500 platform is placed in central offices, serving as a demarcation point between incumbent local exchange carriers and alternate providers. It offers metallic switching capabilities that are used to handle the cut-over of unbundled copper loops from one service provider to another. An integrated testhead is used to provide remote service verification, corroborating the accuracy of the cut-over procedure during the allocated time window. ONYX UNE software is used to identify, coordinate, schedule and analyze all tasks involved in the cut-over process. The ONYX UNE software automatically schedules all work steps required for service transfer, and remotely controls the MX500 to insure that these transfers are performed accurately.

By using ONYX UNE software in conjunction with the MX500, a single network center technician can manage service transfers remotely. By eliminating the need for coordinated inside and outside central office dispatches, this improves the speed with which cut-overs are delivered and reduces the costs associated with wholesale service delivery. In addition, our UNE management solution improves the accuracy of service transfer, which helps service providers avoid labor costs and regulatory penalties that may be associated with missed delivery windows. Finally, by preserving dial tone throughout the entire transfer process, our solution helps to make the loop cut-over process seamless to end users.

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Customers

Revenues from significant customers as a percentage of our total revenues for the years ended December 31, 2002 and 2001 were as follows:

We have no long-term contracts with any of our customers, and they may reduce or discontinue their purchases at any time. Our sales declined materially in 2002. We anticipate that our revenues will continue to decline until we achieve substantial sales of our UNE management and frame automation solutions, if any.

Sales and Marketing

We sell and market our products through our direct sales force and through reseller arrangements.

Direct Sales.    As of February 1, 2003, our direct sales effort in North America was managed by three account executives and one systems engineer. We are primarily focused on North American incumbent local exchange carriers who may be interested in testing and purchasing our UNE management and frame automation product families. We have closed our international sales and marketing subsidiaries in Australia, Brazil, Hong Kong, Singapore and the United Kingdom.

Indirect Sales.    In June 2001, we entered into a worldwide, non-exclusive original equipment manufacturer agreement with Alcatel S.A. for our loop management and Smart Splitter product families. Under the terms of our agreement with Alcatel, Alcatel will market, sell and support our products in conjunction with its own suite of broadband access solutions. The Alcatel agreement expires in June 2004, may be renewed by agreement of both parties for an additional twelve-month period, and is terminable by either party on a yearly basis. The agreement contains no minimum purchase requirements, and products are shipped against individual purchase orders. As of February 1, 2003, sales of our products under the Alcatel agreement have been minimal.

Customer Service and Support

We believe a high level of continuing service and support is critical to our long-term success. We offer comprehensive hardware and software maintenance and support programs for our products. The majority of our service and support activities are related to training, troubleshooting and network management. These services are provided by telephone, email, web access and directly at customer locations using personnel from our customer support group. We also offer various training courses for our direct customers and resellers. Due to decreased demand for customer support services, we have substantially reduced the size of our customer support organization and our sales and marketing efforts related to our maintenance and support programs.

Research and Development

We are currently investing significant resources to develop next-generation frame automation and switching products and related operational support system interfaces and capabilities. We have assembled a team of highly skilled engineering professionals and operations specialists who are experienced in designing networking equipment and network management software. Our engineering personnel have expertise in a number of fields, including digital loop carrier design, voice and data switching technology, local loop equipment design and operations support systems. During 2002, we spent $15.0 million on research and development, exclusive of non- cash compensation expense. As of February 1, 2003, we had a total of 35 engineering and operations employees

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engaged in research and development. They are primarily focused on the development of our next-generation frame automation products.

Competition

The market for telecommunications equipment is highly competitive. A number of companies that have traditionally produced products for analog voice and circuit-based networks also sell products that compete with our loop management and Smart Splitter products.

These companies include: ADC Telecommunications, Inc.; Harris Corporation; Marconi; Nortel Networks; Sunrise Telecom; Spirent plc; Teradyne Corporation; and Tollgrade Communications. Our primary competitors in the copper switching and unbundled network management market include Avaya, Con-X Corporation, NHC Communications and Simpler Networks.

We also compete with DSL equipment providers including Alcatel, Lucent and Nokia, who have each announced plans to incorporate competitive features and functionality into their DSL access multiplexers. To the extent we expand the capabilities of our products to incorporate functionality traditionally contained in other equipment, we may also face increased competition from other vendors.

Remaining competitive in our markets will require a continued high level of investment in research and development, marketing, and customer service. The principal competitive factors in our market include:

Due to the rapidly evolving markets in which we compete, additional competitors with significant market presence and financial resources, including other large telecommunications equipment manufacturers, may enter our markets, thereby further intensifying competition. We may not have sufficient resources to continue to make the investments or achieve the technological advances necessary to compete successfully.

The markets for telecommunications products are characterized by rapid technological developments, frequent enhancements to existing products and new product introductions, frequent changes in end user requirements, evolving industry standards and governmental regulations. The emerging nature of these products and services and their rapid evolution requires us to continually improve the performance, features and reliability of our products, particularly in response to competitive product offerings. Current or future competitors may foresee the course of market developments more accurately than we do and may introduce products incorporating superior or alternative technologies that could render our products obsolete.

Manufacturing

Our manufacturing operation is entirely outsourced. We and Fine Pitch Technologies, Inc., a subsidiary of Solectron Corporation, are parties to a contract manufacturing agreement, under which we subcontract manufacturing of our products. Fine Pitch, located in San Jose, California, is an established contract

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manufacturer with ISO 9002 and Telecordia, formerly Bellcore, certifications. These certifications relate to the manufacturer’s compliance with industry standards for quality control procedures and telecommunications products. This subcontracting arrangement includes material procurement, board level assembly, final assembly, testing and shipment to our customers. We utilize automated design, manufacturing and test processes to minimize cycle times and improve product quality. We design and implement all of the tests that are required to meet internal and external quality standards, and routinely monitor product quality via on-site inspections.

Intellectual Property

We rely on a combination of copyright, patent, trademark, trade secret and other intellectual property laws, nondisclosure agreements and other protective measures to protect our intellectual property. We have filed 21 patent applications as of February 1, 2003, from which six patents have been issued. We have also registered Turnstone Systems, the Turnstone Systems logo, Copper CrossConnect CX100 and Smart Splitter SX500 as trademarks.

We attempt to protect our intellectual property rights by limiting access to the distribution of our software, documentation and other proprietary information. In addition, we enter into confidentiality agreements with our employees and certain customers, vendors and strategic partners. These steps may fail to prevent the misappropriation of our intellectual property, particularly in foreign countries where the laws may not protect our intellectual property as fully as in the United States. Other parties may independently develop competing technology. Attempts may be made to copy aspects of our products or to obtain and use information that we regard as proprietary. Our existing and future patent applications, if any, may not be approved, any issued patents may not protect our intellectual property, and any issued patents may be challenged by third parties. Any failure to adequately protect our intellectual property could result in our competitors offering similar products, potentially resulting in loss of a competitive advantage and decreased revenues.

Employees

As of February 1, 2003, we had a total of 48 full-time employees based in the United States. Of the total, 35 engineering and operations professionals were engaged in research and development, 5 were engaged in sales, marketing and customer support and 8 were engaged in administration and finance. None of our employees is subject to a collective bargaining agreement and we believe that our relations with our employees are good.

Risk Factors Affecting Future Results

In addition to other information in this Form 10-K, the following risk factors should be carefully considered in evaluating us and our business because such factors may have a significant impact on our business, operating results and financial condition. As a result of the risk factors set forth below and elsewhere in this Form 10-K, and the risks discussed in our other Securities and Exchange Commission filings, actual results could differ materially from those projected in any forward-looking statements.

Our exploration of strategic alternatives may be unsuccessful and may have an adverse effect on our operating results and stock price.

In January 2003, we engaged Goldman, Sachs & Co. as our financial advisor to explore various strategic alternatives to maximize our stockholder value, including possible merger and asset sale transactions, licensing arrangements, and dissolution of the company and distribution of assets to our stockholders. We are uncertain as to what strategic alternatives may be available to us or what impact any particular strategic alternative will have on our stock price if accomplished. Uncertainties and risks relating to our exploration of strategic alternatives include:

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Even if interested third parties are willing to explore strategic transactions with us, we may not be successful in executing and consummating any transactions because of the risks and uncertainties associated with our business.

We have a number of risks and uncertainties associated with our business that may prevent the consummation of a strategic transaction, including but not limited to:

These and other risks and uncertainties may prevent us and interested third parties from exploring and consummating mutually acceptable strategic alternatives.

We may elect to dissolve and distribute assets to our stockholders if our board of directors determines that such action is in the best interest of our stockholders.

As a result of our exploration of strategic alternatives, our board of directors may deem it advisable to dissolve the company and distribute assets to stockholders. Liquidation and dissolution may not create value to our stockholders or result in any remaining capital for distribution to our stockholders. The precise nature, amount and timing of any distribution to our stockholders would depend on and could be delayed by, among other things, sales of our non-cash assets, claim settlements with creditors and resolution of outstanding litigation matters. Our stockholders may also experience adverse tax consequences to the extent they receive any distributions from us.

We have lost money in the past, are currently experiencing losses and expect to record net losses for the foreseeable future, which could cause the market price of our common stock to decline further.

We have experienced losses in the past, are currently incurring net operating losses and expect to record net losses and generate negative cash flow for the foreseeable future. Our revenues have declined substantially since the third quarter of 2000 and are insufficient to offset operating expenses. As of December 31, 2002, we had an accumulated deficit of approximately $88.7 million. We expect to continue to incur significant research, product development and sales and marketing expenses as we continue to focus on developing our next generation copper automation products and penetrating the incumbent local exchange carrier market. As we expect to continue to generate negative cash flow, the amount of assets available to stockholders may be reduced, which could cause the market price of our common stock to decline further.

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If we fail to penetrate the incumbent local exchange carrier market, our business will be adversely affected.

If we cannot overcome the challenges inherent in penetrating the incumbent local exchange carrier market, we will not be able to sell our copper automation products. These challenges include our inexperience in selling to incumbent carriers, a long sales cycle, costs associated with customer evaluations of our products, cutbacks in carrier capital spending, competition from established suppliers and stringent customer service and support requirements. In addition, the incumbent carriers have repeatedly delayed or reduced their network maintenance and buildout plans and may decide not to make additional infrastructure investments. Furthermore, as a result of our January 2003 reduction in force, we have very limited marketing, sales and customer support resources to devote to penetrating the incumbent carriers. The incumbent carriers may also be reluctant to purchase products from a supplier that is seeking strategic alternatives or with whom they have not previously worked.

If incumbent local exchange carriers decide not to automate their existing local loop management systems and processes, we will not be successful in selling our UNE management and frame automation products to them.

If incumbent carriers decide not to upgrade their existing local loop switching and management systems, we will not be successful in selling our UNE management and frame automation products to them. We believe the local loop switching and management systems and processes currently implemented by the incumbent local exchange carriers are inefficient, labor-intensive and error prone. Our products are designed to automate these processes and allow incumbent carriers to more rapidly and effectively deploy and maintain copper local loop services. Incumbent carriers may consider a number of different factors when deciding whether or not to upgrade and automate their switching and management systems, including the cost of purchasing new systems and replacing existing infrastructure, the rate of return on their capital investments, issues arising from displaced union laborers, risks associated with the installation and deployment of a new generation of products and potential disruptions in copper local loop services.

Changes to regulations affecting, or the lack of demand from competitive carriers for, unbundled network elements may significantly reduce or eliminate the need for our unbundled network element management products.

Adjustments to the Federal Communications Commission (FCC) regulations regarding unbundled network elements, new FCC regulations or regulations set forth by other regulatory bodies or new congressional legislation may reduce or eliminate the demand for our unbundled network element management products. If the FCC or state public utility regulators should decide that incumbent carriers are no longer required to lease unbundled lines to competitive carriers, our unbundled network element management products would be made obsolete.

Demand for our unbundled network element management products may also be reduced or eliminated if competitive carriers fail to order unbundled lines in large volumes from incumbent carriers. Competitive carriers have experienced financial difficulties and have either reduced or delayed the buildout of their networks. In addition, some competitive carriers have chosen to utilize UNE-P, a form of resale, instead of deploying their own facilities, thus eliminating their need for the physical unbundled lines that create demand for our unbundled network element management products. If, as a result, such competitive carriers stop or delay or reduce their orders for physical unbundled lines, the incumbent carriers may have no incentive to purchase and install our unbundled network element management products.

Even if we succeed in obtaining product deployment approval from the incumbent local exchange carriers, they may not allocate capital to purchase and deploy our products.

If the incumbent carriers do not or cannot allocate enough capital spending for the purchase and deployment of our products, our business will suffer. As a result of the current downturn in the telecommunications market

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and reduced demand for their services, incumbent carriers have repeatedly lowered their capital spending budgets for the foreseeable future and delayed or canceled infrastructure investments. For example, BellSouth Corporation recently decided not to budget for additional network deployment of our UNE management solution in 2003. These carriers may decide not to or may simply lack the capital necessary to make the substantial investments required to deploy our products, regardless of the quality, performance and functionality of our products.

Our limited operating history, the limited visibility we are experiencing with our target customers and our recent decision to seek strategic alternatives make forecasting difficult, and if our operating results are below expectations, the price of our common stock could decline further.

As a result of our limited operating history, the limited visibility we are experiencing with our target customers and our recent decision to seek strategic alternatives, it is difficult to forecast accurately our revenues and operating expenses. Prior to the fourth quarter of 2001, we derived substantially all of our revenues from new and emerging competitive local exchange carriers. Substantially all of these competitive carriers have experienced financial difficulties and have discontinued their purchases of our products. Our target incumbent carrier customers have repeatedly announced cutbacks in capital spending, and we have limited visibility as to if or when they may purchase our products. Even if a target incumbent carrier customer decides to purchase our products, it may deploy our products more slowly than we or our investors or market analysts expect. Recently, we decided to seek strategic alternatives and reduce our headcount by approximately 40%, which may affect our ability to broadly market and sell our products. As a result of these various factors, our operating results have declined in the past and may fall below our expectations and the expectations of investors and market analysts in the future, and the price of our common stock could decline further.

If we fail to overcome the development risks associated with our next-generation copper automation products, we will not be able to introduce and recognize revenues from them in a timely manner.

We face a number of development risks associated with our next-generation copper automation products, which if not successfully overcome, could cause their introduction to be delayed indefinitely. We have in the past devoted, and expect to continue to devote, substantial research and development resources toward designing and building our next-generation products. Our product designs incorporate new and unproven technologies currently under development, and we cannot assure you that we will be successful in perfecting these new technologies. Furthermore, even if we are able to perfect these new technologies, incorporating them into our new products may be cost-prohibitive. In addition, we utilize third-party design firms and contract manufacturers to produce the components needed for our next-generation products. Several of these companies have recently experienced financial difficulties. If these companies were to go out of business, our development efforts could be delayed as we transition to new vendors. If we experience delay with the development of our next-generation products as a result of technology challenges, cost, vendor difficulties or otherwise, we will not be able to introduce and recognize revenues from such products.

Because our products are deployed in complex environments, they may have errors or defects that are found only after full deployment, which could result in liability claims against us.

Errors or other problems in our products could result in:

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Because our products are designed to provide critical services, if errors, defects or failures are discovered in our current products, or after new versions or future products are released, we may be exposed to significant legal claims. Any claims, with or without merit, could damage our reputation and our business, increase our expenses and impair our operating results. Although we maintain product liability insurance covering some damages arising from implementation and use of our products, our insurance may not fully cover claims brought against us. Liability claims could require us to spend significant time and money in litigation or to pay significant damages.

Our products are designed for large and complex networks and either have never been deployed or have only been deployed on a limited basis. Consequently, our customers may discover errors or defects in our hardware or software only after it has been fully deployed and operated as part of their infrastructure in connection with products from other vendors.

Our products incorporate numerous component parts designed and manufactured by third parties. We cannot assure you that these third-party parts are free of defects or errors. Given the complex nature of our products and our dependence on a large number of highly intricate third-party component parts, our products may contain defects or errors not detectable during our quality assurance and testing procedures. Any such defects or errors could delay or cost us market acceptance of our products or result in legal claims against us.

Intense competition in our industry could result in our losing customers or being unable to attract new customers.

The market for telecommunications equipment is highly competitive. Our primary competitors in the copper switching and unbundled network management market include Avaya, Con-X Corporation, NHC Communications and Simpler Networks. A number of companies produce products that compete with our loop management and Smart Splitter products, including ADC Telecommunications, Inc.; Harris Corporation; Marconi; Nortel Networks; Sunrise Telecom; Spirent plc; Teradyne Corporation; and Tollgrade Communications. We also compete with DSL equipment providers, including Alcatel, Lucent and Nokia, which have each announced plans to incorporate features and functionality provided by our loop management and Smart Splitter products into their DSL access multiplexers. Many of our current and potential competitors have significantly greater sales and marketing, technical, manufacturing, financial and other resources than we do. Due to the rapidly evolving market in which we compete, additional competitors with significant market presence and financial resources, including other large telecommunications equipment manufacturers, may enter the market, thereby further intensifying competition.

We could incur substantial costs and our management’s attention and resources could be diverted as a result of the outstanding securities class actions and shareholder derivative litigation against us.

We dispute, but cannot assure you that we will be successful in our defense of, the outstanding shareholder lawsuits against us. If we are unsuccessful, these lawsuits could have a material adverse effect on our business, financial condition and results of operations. Even if we are successful in defending against these claims, the litigation could result in substantial costs and divert management’s attention and resources, which could adversely affect our results of operations.

On March 28, 2001, the Louisiana School Employees’ Retirement System filed a putative class action lawsuit against us and certain of our current and former officers and directors in the United States District Court for the Northern District of California alleging claims under Sections 11, 12(a)(2) and 15 of the Securities Act of 1933. The case, which also names as defendants the underwriters of the Company’s September 21, 2000

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secondary offering of common stock, is encaptioned Louisiana School Employees’ Retirement System v. Turnstone Systems, Inc. et al. (formerly CV-01-1256 JL). The complaint alleges that the defendants issued false and misleading statements in our prospectus issued in connection with our secondary offering. At or about the same time, four other purported class action lawsuits were filed against us and certain of our current and former officers and directors in the United States District Court for the Northern District of California, encaptioned as follows: Huang v. Turnstone Systems, Inc., et al. (formerly C-01-1342-CW) (filing date 4/04/01); Riskin v. Turnstone Systems, Inc., et al. (formerly C-01-1355-CW) (filing date 4/05/01); Bojsza v. Turnstone Systems, Inc., et al. (formerly C-01-1411-CW) (filing date 4/10/01); and Greenberg, et al. v. Turnstone Systems, Inc. et al. (formerly C-01-1454-CW) (filing date 4/12/01). These latter complaints allege that the defendants made false or misleading statements during the class period of June 5, 2000 through January 2, 2001, in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and Rule 10b-5 promulgated thereunder.

All five cases were consolidated before Judge Saundra B. Armstrong in the United States District Court for the Northern District of California on October 26, 2001. The consolidated complaint is encaptioned In re Turnstone Systems, Inc. Securities Litigation, Case No. CV 01-1256 SBA. By order dated December 3, 2001, Judge Armstrong designated Radiant Advisors, LLC as lead plaintiff and the law firms of Bernstein Litowitz Berger & Grossman LLP and Bernstein Liebhard & Lifshitz, LLP as co-lead counsel for the consolidated actions. The lead plaintiff filed two separate consolidated amended complaints on March 19, 2002. On June 20, 2002, Judge Armstrong issued an order for plaintiff to show cause as to why the action should not be dismissed with prejudice for plaintiff’s failure to file one consolidated amended complaint. The lead plaintiff filed a certificate of counsel in response to the order on June 27, 2002. We filed a response on July 3, 2002. On August 30, 2002, Judge Armstrong struck the two separate amended complaints previously filed by the lead plaintiff and ordered that a single amended complaint be filed. The lead plaintiff filed a single amended complaint on September 13, 2002. We filed a motion to dismiss the amended complaint on October 8, 2002. On February 4, 2003, Judge Armstrong issued an order denying in part and granting in part, with leave to amend, our motion to dismiss.

On June 1, 2001, nominal plaintiff Bert Okino filed a shareholder derivative lawsuit in state court in California, County of Santa Clara, alleging claims against us, a nominal defendant in the action, and certain of our officers and directors. The lawsuit is encaptioned Okino v. Tinsley, et al., Case No. CV 798814. The complaint alleges that the individual defendants caused us harm by either making or permitting the corporation to make false and misleading statements between June 5, 2000 and January 2, 2001 and by permitting certain officers to profit from stock sales during that period. It asserts claims against the individual defendants for breach of fiduciary duty, waste of corporate assets, abuse of control and gross mismanagement.

We demurred to the complaint on July 9, 2001. On September 28, 2001, Judge Conrad L. Rushing issued an order sustaining the demurrer and granting plaintiff limited discovery. On December 19, 2001, subsequent to the completion of the court-ordered discovery, plaintiff filed a first amended derivative complaint alleging the same causes of action asserted in the initial complaint. We filed a demurrer to the first amended derivative complaint on January 10, 2002. On February 22, 2002, Judge Jack Komar issued an order sustaining the demurrer and granting plaintiff leave to amend its complaint. The plaintiff filed an amended complaint on March 19, 2002. We filed a demurrer to the second amended derivative complaint on April 22, 2002. On May 28, 2002, Judge Komar issued an order sustaining the demurrer and dismissing the complaint with prejudice. The plaintiff filed a notice of appeal on August 1, 2002.

On November 9, 2001, Arthur Mendoz