Selective Disclosure in Facebook IPO?

New York, NY – Last week, a number of state and federal regulators announced that they plan to investigate the IPO of Facebook shares.  In addition, numerous lawsuits have been filed against underwriters Morgan Stanley, Goldman Sachs, JPMorgan Chase, Bank of America Corp. and Barclays PLC, as well as various Facebook executives by investors who claim that underwriters failed to properly disclose changes to analysts’ forecasts made by underwriting banks.  At the heart of all these investigations and lawsuits is the contention that Facebook’s analysts engaged in selective disclosure of material facts about the condition of the company to big institutional investors – while keeping this information secret from retail investors.

Facts Behind the Case

On May 9^th, three days into Facebook’s roadshow, the firm filed an updated prospectus with the SEC.  The revised prospectus contained new disclosure language that had not previously appeared in Facebook’s SEC filings. The language was on page 57 of the prospectus, in a section discussing the company’s recent financial and user trends:

“Based upon our experience in the second quarter of 2012 to date, the trend we saw in the first quarter of DAUs increasing more rapidly than the increase in number of ads delivered has continued. We believe this trend is driven in part by increased usage of Facebook on mobile devices where we have only recently begun showing an immaterial number of sponsored stories in News Feed, and in part due to certain pages having fewer ads per page as a result of product decisions.”

Whereas the new prospectus revealed that the number of Facebook’s users was continuing to grow faster than revenue, it did not disclose anything about second-quarter revenue weakness.

Immediately after the filing, a Facebook executive called the analysts at 21 Wall Street firms and told them to cut their estimates.  A number of analysts revised their forecasts lower.  Analysts at Facebook’s four largest underwriters, including Morgan Stanley, Bank of America Merrill Lynch, JPMorgan, and Goldman Sachs cut their revenue estimates for 2012 from approximately $5.1 billion before the call to approximately $4.8 billion after the call from the Facebook executive.  This suggests they received clear guidance from the company.

As a result of these revisions, the institutional sales forces at the underwriters were directed to call their biggest clients to tell them about the estimate cut and revenue slowdown.  According to a Reuters journalist, the Facebook analyst at Morgan Stanley, the lead underwriter of the IPO, Scott Devitt, communicated his revisions directly to major clients in at least one conference call.

People familiar with the revised Morgan Stanley projections said Devitt lowered his revenue forecast to $4.85 billion for 2012 from more than $5 billion earlier.  In addition, Devitt lowered his revenue estimate for the 2^nd Quarter of 2012 to $1.111 billion, down from about $1.175 billion previously.  One investor who was told of these revisions said that Devitt’s new second-quarter revenue forecast suggested that Facebook’s year-over-year revenue growth might slow from the first quarter of 2012.

Investors saw this news as extremely negative for the company – particularly as underwriters rarely if ever lower their estimates for a company they take public while the investor roadshow is taking place.

Unfortunately, most retail investors were never told of these revised forecasts.

When Estimates Are Not Estimates

To understand just how important these revisions were to sophisticated investors’ perception of the company, it is critical to know how sell-side analysts come up with these forecasts in the first place.

Traditionally, analysts involved in IPOs usually develop their company forecast models in collaboration with company management as these forecasts are used to market the company to the investing public.  These estimates are seen by institutional investors as having been reviewed by the company, and are therefore targets that management feels confident they will hit.  These estimates are not published anywhere.  Rather, these estimates are communicated verbally to institutional investors who are considering investing in the IPO.

Consequently, when Facebook’s management informed dozens of Wall Street analysts that they should cut their estimates of the company, they were in essence providing guidance on the firm’s upcoming financial performance.  This information was then disclosed to a limited set of the underwriters’ best customers, leaving other smaller investors in the dark.

In our view, the fact that some potential Facebook investors were told of the analysts’ estimate cuts and others were not seems to be a significant “selective disclosure” issue of facts which appear to be quite material.

The Letter Versus The Spirit of the Law

However, we are not saying that Morgan Stanley, or any of the other underwriters actually broke the law when they informed some investors of their analysts’ revisions on Facebook, while not providing this information to others.  U.S. regulations regarding IPOs are complex and differ considerably from other securities rules in key respects, including disclosure.

A spokesman for lead underwriter Morgan Stanley explained that, “Morgan Stanley followed the same procedures for the Facebook offering that it follows for all IPOs.  These procedures are in compliance with all applicable regulations.”  On the surface, this very well might be true.

One provision of securities law that some suggest may be at issue is Section 12 (a)(2) of the U.S. Securities Act of 1933.  The section states that any person who offers or sells a security by means of a prospectus or oral communication which includes an untrue statement of a material fact or fails to state an essential material fact could be held liable.  Thus, the question will be whether Facebook or its underwriters withheld material facts from investors when marketing the stock to them.

“Gun jumping” rules established by the SEC regulate the communications that can be made by underwriters about an issuer outside its prospectus.  Generally, information disseminated cannot be inconsistent with what is provided in the prospectus.  Unfortunately, there is an exception for oral communications – which would be the case in the Facebook situation.

Some market participants might conclude that Regulation Fair Disclosure (FD), which prohibits the selective disclosure of price-sensitive information, might come into play in the Facebook case.  However, this is not be likely to be applicable as selective disclosure is not generally applicable to initial public offerings.

However, despite all these very technical reasons why the letter of the law was not broken, it seems that the spirit of the law very well might have been.  After all, Facebook management told their underwriters, and other Wall Street analysts to revise their forecasts for the company lower.  Morgan Stanley, as lead underwriter, disclosed their analyst’s downwards revisions for Facebook to their best clients while the company roadshow was under way.  This information was important enough that many institutional investors chose not to invest in the stock at the IPO.  Unfortunately, this information regarding Facebook’s weaker financial conditions was not disclosed to retail investors – leaving many of them holding the bag.