Facebook Inc., the world's largest social-networking company,could be exposed to legal challenges surrounding its initial publicoffering similar to those faced by Morgan Stanley, according tolegal experts.

In the first regulatory claims to flow from the May 17 IPO,Massachusetts officials said on Dec. 17 that they fined MorganStanley $5 million for letting its investment bankers provideresearch analysts specific revenue information that was notdisclosed by Facebook to the general public. That broke adecade-old rule enacted after the dot-com crash to block bankersfrom influencing analysts, Massachusetts said.

The settlement includes for the first time details of theclosed-door conversations between Morgan Stanley and Facebook aheadof the IPO, including testimony from Michael Grimes, who led thedeal for the bank. According to the consent order, Grimes wrote ascript for Facebook's then-treasurer to read to analysts thatdetailed Facebook's lowered revenue estimates.

Grimes “did everything but make the phone calls himself,” theregulator said in a statement. Grimes was identified in thesettlement only as a “senior investment banker,” though it providedbiographical details that match his.

The revelation that Facebook gave specific estimates to bankanalysts and not to the public revives questions about whether thecompany was sufficiently forthcoming ahead of the IPO, said StephenDiamond, an associate professor at Santa Clara University School ofLaw.

“By providing that information to just a subset of potentialinvestors, in essence they have denied other investors access tomaterial information,” Diamond said. The Securities and ExchangeCommission “should have pushed much harder to find out whetherthere was quantifiable data available or not,” he added.

Facebook has not been accused by regulators of wrongdoing.Michael Buckley, a spokesman for the Menlo Park, California- basedcompany, declined to comment. The SEC had no immediate comment. NewYork-based Morgan Stanley did not admit or deny Galvin's claims insettling.

The settlement offers fresh insight into a widely anticipatedIPO that turned into a debacle for the company and Morgan Stanley.Facebook shares have tumbled 27 percent since they started tradingfor $38 on May 18, to $27.71 as of the close yesterday. The companycapitalized on its popularity among consumers by raising the priceand number of shares sold to retail investors, who weren't privy tothe private conversations or revenue estimates.

Class Action

William Galvin, the Secretary of the Commonwealth ofMassachusetts, said he didn't have the authority to determinewhether Facebook executives acted improperly.

“The broader issue is the fairness of the marketplace forinvestors,” Galvin said in an interview this week.

The details emerging from the consent order may also addammunition to dozens of class actions, which a judge ordered to beconsolidated earlier this month. The testimony disclosed byMassachusetts could be used by prosecutors attempting to make acase that Facebook and Morgan Stanley misled investors, said ErikGordon, a clinical assistant professor at the University ofMichigan's Stephen M. Ross School of Business.

“The real liability for Facebook and Morgan Stanley is yet tocome,” said Gordon.

If Facebook omitted material facts in its prospectus, known asan S-1, it could be found in violation of Section 11 or Section 12of the Securities Act of 1933, Diamond said.

While it told potential investors that mobile usage couldadversely affect revenue, the revelation that it gave a selectgroup of analysts specific numbers on how that trend would affectsales over the full year could be considered a material omission,he said.

A violation of Section 11 could result in a fine or injunctiverelief, or it could force the company to return proceeds of its IPOto shareholders, Diamond said.

“A material misstatement or omission in an S-1 is the scariestthing in the world,” Gordon said. “It's going to hinge on whetherthe disclosures made in the S-1 were sufficient to give reasonableinvestors as accurate a view as reasonably possible.”

One of the earliest signs that Facebook's growth wouldn't reachthe rosiest projections surfaced on May 7, the day the roadshowbegan, according to testimony cited in the settlement. Thatevening, Facebook Chief Financial Officer David Ebersman informedGrimes that Facebook's second-quarter revenue would likely be lowerthan previously estimated.

Ebersman had told analysts at an April 16 briefing at Facebook'sheadquarters that sales would be $1.1 billion to $1.2 billion.

Now, Ebersman was telling Grimes that he was less confidentabout those numbers because user growth on mobile devices wasoutpacing advertising gains. Ebersman also said it was unlikelythat Facebook would reach $5 billion in sales for the year, as he'dtold analysts.

Grimes relayed that information to a Morgan Stanley capitalmarkets banker, according to Massachusetts.

The next day, May 8, as the roadshow moved from New York toBoston and Baltimore, Facebook was predicting quarterly sales atthe low end of its $1.1 billion to $1.2 billion range and sales 3percent to 3.5 percent below the full-year estimate.

Grimes said in testimony that he advised Ebersman to updateanalysts on the numbers. To avoid the appearance of incompletedisclosure, he recommended updating the prospectus again to showinvestors the trend.

Treasurer Calls

At 8:10 p.m. that evening, Facebook's management held aconference call with Grimes, capital markets bankers and counselfrom Facebook and Morgan Stanley. Grimes testified that he was withthe treasurer on the call. Facebook, with input from MorganStanley, decided to update the filing.

On May 9, as the roadshow moved to Philadelphia, Ebersmaninformed Facebook's board by e-mail that the prospectus was beingrefiled. He also said the company was forecasting second- quarterrevenue of $1.14 billion, while analysts were predicting $1.18billion.

Grimes and Facebook's then-treasurer, Cipora Herman, stayed at aPhiladelphia hotel that evening to make calls to analysts. Inpreparation, they rehearsed the calls, with Grimes playing the roleof the analyst.

After the S-1 was filed, Herman would call an analyst everyfifteen minutes and read the script, which said that the socialnetwork's second-quarter sales would be at the lower end of the$1.1 billion to $1.2 billion range.

Grimes said that while the analyst calls were being made, he was“far down the hall” so he wouldn't hear anything.

“I took extra precaution to do that, and sat on the floor,” hetestified.

The first call was to Morgan Stanley, followed by JPMorgan Chase& Co., Goldman Sachs Group Inc., and Citigroup Inc. Sevenadditional calls were made by 8:30 p.m. Grimes and the treasurerthen joined the roadshow team in New York. On May 10 and May 15,the treasurer made calls to the remaining eight analysts.

Under the 2003 consent decree, Morgan Stanley had pledged tostop investment bankers from influencing analysts.

Galvin, citing the script and Grimes' involvement, faultedMorgan Stanley for dishonesty, ethics violations and failing tosupervise employees.

When asked later in testimony whether the treasurer had ascript, Grimes said he didn't remember. Yet, Facebook provided theMassachusetts securities division with a script that washandwritten by Grimes.

Low End

“You can decide what you want to do with your estimates,” hewrote. “Our long term conviction is unchanged, but in the near termwe see these trends continuing, hence our being at the low end ofthe” $1.1 billion to $1.2 billion range, the script said.

Facebook filed its sixth amended prospectus at 5:03 p.m., andwithin minutes the treasurer called bankers at Goldman Sachs andJPMorgan, with Grimes in the room.

No revenue projection numbers were provided in the May 9 filing,and the company only discussed the trend for the second quarter,not the rest of the year.

After the calls, all three analysts from the lead banks reducedtheir estimates to the lower end of the $1.1 billion to $1.2billion range. Morgan Stanley's analyst lowered his to $1.11billion from $1.18 billion.

The treasurer added to the script that the trends would remainover the next six to nine months, resulting in sales for the yearof 3 percent to 3.5 percent below the $5 billion target.

Morgan Stanley's analyst lowered his estimate by 3 percent to$4.85 billion from $5 billion.

Despite these lowered estimates, on May 15 the price range forthe IPO was increased and the next day the number of shares in theoffering was bolstered. On May 17, the pricing committee decided tooffer shares at $38 a piece, the high end of the increasedrange.

Herman, who held finance roles at Facebook for five years, leftthe company in October to take a job as CFO of the San Francisco49ers football team. Prior to joining Facebook, she was treasurerat Yahoo! Inc.

Bob Lange, a spokesman for the the San Francisco 49ers, declinedto make Herman available for comment.

Professor Diamond said the SEC could have been more vigilant asit scrutinized Facebook's IPO prospectus.

The SEC had asked Facebook for more disclosure about the impactof mobile users on revenue during a two-and-a-half-month volley ofmessages, which were published after the IPO on the agency'swebsite. While it succeeded in getting Facebook to reveal moredetails about its business, it did not ask the company to estimatehow mobile usage may affect its forecast for lower revenue in 2012,the messages show.

“The SEC bears some responsibility here, too,” Diamond said.“That's a question I think Congress ought to ask. Why didn't theSEC wake up and smell that something was going on here?”

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