Facebook Attracting Lawsuits Over IPO

If you read my piece last week about the Facebook initial public offering of stock, and you’ve read the news this week about the social network and others associated with the IPO getting slapped with class-action lawsuits and investigations, you know why I’m not a stockbroker. What happened? The stock dropped, and many smaller investors lost money – because they did not receive the guidance from Facebook that large institutional investors did, according to the charges.

What happened with Facebook’s IPO was unprecedented, not because of the size of the offering (though it was certainly the largest ever offered), but because of some questionable matters concerning who knew what, and when, and what they did as a result. Henry Blodget gives an excellent rundown of the events. It’s particularly helpful for those of us who aren’t familiar with the conventional industry practices surrounding IPOs, and therefore might not realize just how far Facebook’s IPO deviated from that standard.

So what happened, exactly? Facebook held what is known as the IPO roadshow to drum up interest in the stock. In the middle of that roadshow, the analysts at Facebook’s IPO underwriters cut their estimates for how the company would perform in its second quarter. This event is so unusual that at least a couple of long-time observers wrote that they had literally never heard of it happening before. Why did they cut their estimates? According to the lawsuits, someone at Facebook verbally told them to. But the worst part of it was that these cuts in estimates did NOT get shared with everyone.

Apparently, Facebook expected a weak second quarter. But why? We got a hint as early as May 9, when Facebook made a change to its S-1 filing with the SEC. In the revision, Facebook noted that many more users are accessing its website through mobile devices. This in turn reduced what the social network could charge for ads, which hits the company right in the long-term bottom line.

Here’s the money quote from the filing: “We believe this increased usage of Facebook on mobile devices has contributed to the recent trend of our daily active users (DAUs) increasing more rapidly than the increase in the number of ads delivered. If users increasingly access Facebook mobile products as a substitute for access through personal computers, and if we are unable to successfully implement monetization strategies for our mobile users, or if we incur excessive expenses in this effort, our financial performance and ability to grow revenue would be negatively affected.”

Now any investor who knows about this might take warning from it. The lawsuits allege that Facebook specifically told their underwriter investors to reduce their estimates for Facebook’s second quarter – and didn’t tell anyone else. Blodget explained that “The information about the estimate cut was then verbally conveyed to sophisticated institutional investors who were considering buying Facebook stock, but not to smaller investors.” This adds a whole new perspective to the increases in the amount of Facebook stock that large investors decided to sell when the social network raised the target price of its IPO.

Once this news reached the institutional investors, according to the “scuttlebutt”  Blodget dug up, Facebook faced two tiers of prices for its IPO. The institutional investors, who knew of the cut in earnings estimates for Facebook’s second quarter, were willing to buy the company’s stock at $32 per share. Retail investors, who probably didn’t know about the earnings cut, would be content to buy the stock at $40 per share. “Knowing that a big percentage of the IPO stock could be sold to retail investors instead of institutional investors,” Blodget observed, “Facebook and Morgan Stanley decided to price the IPO at $38.”

There were some glitches on the first day of the offering – and instead of increasing in value, the stock dropped. Though not precipitous, the drop was certainly embarrassing for such a highly-anticipated IPO. The price has continued to drop all this week, and while it recovered some value, it has recently been trading around $31 per share – right about the price at which the institutional investors were comfortable buying it.

Facebook, Morgan Stanley, Facebook CEO Mark Zuckerberg, and other large institutions involved with the IPO face lawsuits on multiple fronts. ABC mentions two, one filed in the U.S. District Court of New York and another filed in San Mateo County Superior Court in California. Both suits seek class action status on behalf of the Facebook investors who bought stock on May 18 and lost money. One of the law firms involved even put out a press release about the filing.

David Rosenfeld, a partner with firm who filed the lawsuit in New York, notes that “This is not a fraud case. This is a case of strict liability…If there’s a materially false statement or an omission in the filings, then the signatories, the board and the underwriters, are on the hook for investors that suffered as a result.”

There seems to be more than enough blame to go around. Reuters reported that Nasdaq OMX Group Inc also became the target of a lawsuit. The plaintiff, a Facebook investor, believes that the exchange operator was negligent in its handling of orders for Facebook shares.

It’s gotten to the point that government regulators are taking an interest. PC Magazine reported that Massachusetts’ Securities Division “has put out a subpoena to Morgan Stanley in connection with [an] analyst’s discussion with certain institutional investors about the revenue prospects for Facebook.”

Massachusetts regulators are hardly alone in their concern over the matter. Reuters noted that both the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have expressed interest in reviewing issues around Facebook’s IPO. It’s no wonder if you look at the larger numbers. Facebook stock is down 8.9 percent from its IPO, closing recently at $31 on volume of 101 million shares. Given that the stock opened at $38 per share, the company has lost more than $19 BILLION in market capitalization in less than a week!

Worse, there are a number of voices in the industry that think Facebook stock will fall still further. Thomson Reuters Starmine believe the stock’s true value is more on the order of $9.59 a share, based on a growth rate just under 11 percent. That price discounts Facebook’s IPO price by 72 percent. If that sounds low, well, consider that the social network’s current stock price implies a forward price-to-earnings ratio of 60, which is ridiculously high in a market where Google’s forward P/E is 13.3 on a similar rate of growth.

In short, Facebook’s IPO was poorly handled on all sides, probably due to plain old greed. The next status updates on this saga will be posted from the courtroom.

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