The Facebook I.P.O.'s potential legal exposure

Facebook's initial public offering was one of the highest profile stock offerings ever. Now, it may develop into the most litigated.

At least three shareholder lawsuits have so far been brought against Facebook and the three leading underwriters of the I.P.O., Morgan Stanley, JPMorgan Chase and Goldman Sachs, alleging that Facebook failed to disclose material information about its growth prospects.

The Securities and Exchange Commission and the Financial Industry Regulatory Authority, or Finra, are also looking at the company and its lead underwriter, Morgan Stanley, along with the Nasdaq market over how it handled the initial flow of orders on the first day of trading.

The question now is how all of these suits and investigations are likely to play out.

The shareholder lawsuits are largely based on a Reuters article that raised questions over whether Facebook gave guidance to analysts for its underwriting banks — who in turn may have alerted only selected clients.

Facebook disclosed in an amendment to its prospectus on May 9 the issue about how much advertising revenue it can generate from mobile device users. In the typically vague language used in these documents, it stated "we do not currently directly generate any meaningful revenue from the use of Facebook mobile products, and our ability to do so successfully is unproven."

The shareholder lawsuits claim that Facebook made a material misstatement concerning Facebook's revenue in the I.P.O. prospectus concerning its slowing growth by failing to disclose the conversations with analysts.

And investors will have the benefit of stronger protection in their securities suits than those who buy and sell shares on the open market. Under Section 11 of the Securities Act of 1933, those who obtain their shares in the I.P.O., or who can trace shares to the distribution, can sue for any material misstatement or omission in the company's registration statement, which incorporates all the information in the prospectus.

Unlike a securities fraud claim under Rule 10b-5, however, there is no need to prove any intent to mislead, only that a material error was made.

The damages in this type of case are the difference between the purchase price and the stock price at the time of the filing of the case, or the loss the investor incurred if the shares were sold. This means the difference between $38 a share and roughly where Facebook is trading as of the filing of the lawsuits, about $32 per share.

In addition, under Section 12(a)(2) of the Securities Act of 1933, investors who bought directly from the underwriters will have rescission rights, which allow them to simply give back their shares and receive the $38 offering price.

As a result, we're talking about a potential for billions of dollars in damages.

The Securities and Exchange Commission can also bring an enforcement action based on misdisclosure under Section 17(a) of the Securities Act of 1933, which requires only proof of negligence related to the issuance of securities. The S.E.C. typically lets these types of claims play out in the shareholder litigation, but the attention is so sharp on this I.P.O, that it may feel greater than normal pressure to pursue this case.

The success of all these claims is likely to come down to whether there was information provided that needed to be disclosed to all shareholders and whether Facebook should have given more specifics about its advertising growth so all investors could judge for themselves the company's prospects.

A company is required to disclose all "material" information to investors, and questions about monetizing one of its fastest growing areas certainly seems to be something investors would consider important. In other words, would investors have found the information important in the decision to purchase shares?

Facebook is likely to push back and say that its growth prospects are so uncertain that this information could not have been material. Besides, Facebook will no doubt claim that it sufficiently warned about this in the revised language in the prospectus. It all comes down to how certain the uncertainty was and whether the analysts' conversations were simply more speculative talk about a speculative company.

But if it is proven that Facebook felt the need to talk down its stock, this will weigh heavily towards a finding of materiality. And the revised earnings estimate apparently scared off some institutional investors, which strengthens the materiality determination.

Beyond the shareholder litigation and the possible misstatement of material facts, another possible issue for the S.E.C. is likely to explore is whether analysts at Morgan Stanley, JPMorgan and Goldman Sachs acted improperly.

There is a "firewall" that investment banks have to maintain between the underwriting function and their analysts. With certain exceptions, investment bankers cannot discuss research reports with analysts. If information was passed along to the analysts improperly, then underwriters like Morgan Stanley may have violated rules first put in place 10 years ago to limit conflicts of interest.

The S.E.C. may also look at whether there was selective disclosure of the Facebook earnings projections by the underwriters, giving some of their clients a benefit in deciding how much to invest. While a brokerage firm is not required to disclose everything to its customers, disclosing to only some clients might violate a broker's obligation not to engage in deceptive practices. Again, the commission is likely to feel real pressure to look at these claims and bring charges if this indeed happened. This conduct may also constitute a violation of the 2003 global settlement of analyst conflict claims reached that allows the New York court supervising that settlement to impose sanctions.

At a minimum, even if there was no violation of any S.E.C. rules, clients of the underwriters who did not receive a heads up about the reduced revenue projections for Facebook will not be happy that they were not protected to the same extent as other clients. The reputational hit may ultimately prove to be more costly than any legal claims.

Nasdaq's handling of the flood of customer orders on the first day of trading will also be reviewed by regulators. Because of problems executing orders and processing trade cancellations, a number of individual investors were unable to see how many shares they had purchased, and whether they had been able to reverse orders.

Finra will look closely at how Nasdaq handled customer orders. There is also a shareholder suit brought today against the Nasdaq over its handling of Facebook's trading, but without knowing more about what Nasdaq did and did not do, it is hard to know if they breached any commitment to a customer.

Major penalties are unlikely to come out of any of the Nasdaq cases, but there is the possibility of some reform as this is only one in a series of blunders by Nasdaq on trading.

All in all, the Facebook I.P.O, is looking to be a long, drawn-out affair as the recriminations will now turn into investigations and litigation. Importantly none of these claims need to be tied to the actual decline in Facebook's share price, which seems more a result of over-pricing on the fundamentals, but that has been enough to draw significant scrutiny.

It really didn't have to be this way had the underwriters and Facebook not pushed the offering price of the stock up so far. In the end, they brought this on themselves.

(Published by NY Times - May 23, 2012)