Unfriendly fire for IPO regulations

The Facebook class action may change the way brokers communicate with their clients

It was a mere three business days after the launch of Facebook’s much-anticipated public offering before the company, its officers and underwriters landed in court. Disappointed ­investors, sitting on stock worth far less than they had paid for it, ­commenced a class action.

The gravamen of the complaint is that in its offering documents Facebook stated that its revenue and the number of ads delivered to users may be hit by increasing usage of mobile apps to access the site when, in fact, the company was aware that its revenue was already being significantly impacted by these issues.

It is also alleged that, because of these revenue concerns, during its roadshow with institutional investors, Facebook told certain underwriters to lower their revenue forecasts for 2012 and that these revised forecasts were disclosed by underwriters to preferred investors, but hidden from retail investors and omitted altogether from the registration statement and prospectus. As a result, institutional investors bought, sold and profited while retail ­investors bought, held and lost.

The claim is that, in choosing to provide disclosure to a select few, Facebook and its underwriters violated federal securities laws and, in particular, Regulation Fair Disclosure, which prohibits private discussions with analysts about whether anticipated earnings will be higher or lower than forecast. Moreover, investors complained that Facebook and its underwriters violated securities laws by failing to announce that forecasts had been revised. Had this been disclosed, the plaintiffs would never have purchased the stock.

Although the defendants have yet to answer the complaint, legal experts have begun debating how the courts will decide the case. They make the point that Regulation Fair Disclosure does not apply to selective disclosures made in respect of a ­company about to go public. And, ­although underwriters’ analysts may not distribute written or electronic projections until 40 days after the IPO, they are allowed to communicate their projections to their investor clients orally before the IPO.

As for disclosing those pre-IPO projections in the prospectus, there is generally no legal requirement to do so because, by definition, they are only a best guess. If a forecast is wrong, public disclosure misleads rather than guides investors.

It is still not clear whether Facebook will be able to post ads on ­mobile devices, to what extent and when. In such uncharted territory Facebook repeatedly warned investors of the potential revenue drop without projecting numbers.

Nevertheless, while a broker is not required to disclose everything to all clients, disclosure to a chosen few may violate their duty to avoid ­engaging in deceptive practices.

After the clamour of the lawsuits and investigations subsides, it may well be found that no rules were broken, yet the perception of favouritism will persist. This may lead to rules banning analysts from communicating with investors for a designated period before and after IPOs.