Facebook Sparks Disclosure Debate

Information provided to analysts prior to IPO involves ‘gray area’ in Reg FD.

Facebook Inc.’s initial public offering has triggered allegations the social network and banks led by Morgan Stanley selectively disclosed crucial information to investors. Securities law experts say it’s not clear the firms did anything wrong.

At issue is whether Facebook gave non-public, material information to analysts that was then shared with select investors in the form of lower earnings projections. The answer lies in the evidence uncovered and the interpretation of Regulation FD, a U.S. Securities Exchange and Commission rule that requires public disclosure of important information.

“This is a gray area,” Tamar Frankel, a professor at Boston University School of Law, said in a telephone interview. “There are a zillion rules, but there isn’t a rule that addresses precisely this.”

Facebook amended its IPO filing on May 9, about a week before the $16 billion sale, to say growth in advertising had failed to keep up with user gains. It then contacted more than 20 analysts, including those at underwriters Morgan Stanley, Goldman Sachs Group Inc. and JPMorgan Chase & Co., to guide them toward the lower end of its second-quarter sales estimate, according to a person with knowledge of the matter.

A day after that filing, the analysts called up some investor clients to communicate their revised estimates for sales and profit, said people with knowledge of the process.

Facebook’s stock has dropped 16 percent since the initial share sale, spurring shareholder suits from New York to California. They allege that Facebook and its underwriters misled investors by failing to disclose the figures to a wider audience. Information is material if it would probably affect a company’s share price, if known.


Burden of Proof

The Menlo Park, California-based company didn’t give the analysts any materially different information than the updated prospectus, said a person close to the company. It’s standard for a company to provide guidance to analysts ahead of an offering, that person said. Larry Yu, a spokesman for Facebook, declined to comment.

Any lawsuit will have to prove that the information Facebook and its bankers gave investors was material, or important, said Jeffrey Manns, professor of banking and securities law at George Washington University.

“It might have been better for Facebook had they made more specific disclosures and made them publicly, because rather than a story of public outrage and disgust, the expectations might have been a bit more tempered in a healthy way,” said Manns. “Facebook wouldn’t have this shadow of potential securities litigation hanging over their head.”

Morgan Stanley analysts cut their 2012 profit estimate for Facebook to 48 cents a share from 51 cents, said two of the people, who asked not to be identified because the process was private. They also cut their 2013 profit projection to 83 cents a share from 88 cents, they said. Investors received the new figures by phone as underwriters weren’t permitted to publish anything about Facebook during the marketing period, according to the people.

While the communication of the estimates may have been selective disclosure, investors may only have a case if they can prove the filing omitted crucial information, John Coffee, a Columbia University law professor, said in an e-mail.

“This is a good example of the shortfall of Regulation FD, which should embarrass the SEC,” he said.

While analysts cut their estimates, Facebook and its underwriters raised both the price range and the number of shares on offer. Facebook sold shares at $38 apiece in its IPO. The stock hovered close to that price in its trading debut as Morgan Stanley bought the stock to stabilize it, people familiar with the matter said at the time. The stock later fell as low as $30.94 on May 22.


Running for Exits


“If it turns out that the vast majority of investors who ran for the exits right off the bat, ran for the exits because they knew something, that’s clearly material,” said Dominic Auld, a lawyer at Labaton Sucharow, a New York-based law firm specializing in securities litigation on behalf of shareholders. He said he’s currently not representing anyone with a suit in connection with the IPO.

Morgan Stanley’s procedures in the offering are in compliance with all regulations, Pen Pendleton, a spokesman for the New York-based firm, said in a statement this week. The bank said it sent the revised prospectus to all institutional and retail clients and that the revised analyst estimates were taken into account in the initial share sale’s pricing. He declined to comment beyond the statement.

Investors have lost more than $2.5 billion since the offering last week, according to a complaint filed yesterday in Manhattan federal court. Among those named as defendants in the suit are Facebook, CEO Mark Zuckerberg, Chief Financial Officer David Ebersman, Morgan Stanley and other underwriters.

“The fact that underwriters took down their earnings estimates is material information,” said Sam Rudman, a partner at Robbins Geller Rudman & Dowd LLP, whose firm is handling the New York shareholder suit. “There isn’t any investor in Facebook that wouldn’t have wanted to know that.”

Facebook said in the May 9 filing that its revenue may be negatively affected by users accessing the site on mobile devices rather than personal computers since the company’s ability to make money off mobile users is “unproven.”

If the analysts’ revisions were based on the public disclosures, banks wouldn’t have needed to disclose them to all participants, said Boston University School of Law’s Frankel. If the revisions were based on inside information that other investors didn’t have, “that may create a problem.”
SEC spokesman John Nester declined to comment on Facebook’s disclosures.

“Until we unwind the facts and circumstances surrounding this situation, it is inappropriate to speculate about what potential violations may have occurred,” said a spokesperson for the Financial Industry Regulatory Authority, a financial industry watchdog.

The size and prominence of Facebook’s IPO may have made it more of a target for shareholder suits, regardless of the facts at hand, said Dennis Kelly, chairman of government investigations and white collar crime at Burns & Levinson. The size may also increase the threshold for disclosure, he said.

“Materiality is a moving target, it depends on a number of moving factors,” said Kelly. “It’s first a decision for a judge and ultimately a jury.”


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