More Money, More Problems

Last week, a class action securities fraud lawsuit was also brought against Facebook in connection with the Facebook IPO, initiated by the law firm that obtained a $7 billion settlement with Enron.   The lawsuit was brought not only against Facebook, but also personally against Mark Zuckerberg and several others, including Facebook’s investment bank team and underwriters, such as Morgan Stanley.  The lawsuit alleges that Facebook and its chief investment team at Morgan Stanley failed to provide critical facts about the Facebook IPO with ordinary investors, but shared those sensitive facts with Morgan Stanley’s preferred investors.     

The class action lawsuit papers offer a good bit of detail about the nature of the omitted facts.   They are essentially as follows:

  • Facebook made representations to potential investors in its Prospectus and other IPO paperwork identifying certain events as “risks” that “could” lower Facebook’s revenues.  
  • These scenarios included more users accessing Facebook via mobile means (i.e., on their cell phones);  ad space purchasers not being given clear metrics or measurements about how much value they were getting out of purchasing Facebook ads; new laws or regulations that would make Facebook’s operations more difficult, and other events.  Facebook stated that these and other events could drive down their revenues and make the comapny less profitable over the long-term.
  • The main representation at issue in the class action involves the risk of more users using mobile devices to access Facebook. Apparently, Facebook disclosed in its SEC filings that it makes more money when users access Facebook on their computers rather than their cell phones and other mobile device, because there are more advertising opportunities available on the web-page version of Facebook. 
  • The class action alleges that at the same time Facebook was describing these events, including increase mobile use, as mere “possibilities,” they were happening or had substantially happened already.   The lawsuit alleges that Facebook was actually already undergoing a sharp decline in revenues, and had in fact told its underwriters to lower their revenue forecasts, because so many users were using Facebook via mobile decides.
  • Morgan Stanley, in the middle of the IPO roadshow, apparently became aware of the huge reduction in revenues due to the increase in mobile users of Facebook, and cut its revenue estimates.  According to the lawsuit papers, Morgan Stanley’s mid-stride cut in forecasts was highly unusual and a rare occurrence in the IPO world. 
  • Facebook ended up filing amended IPO paperwork with the SEC.
  • The lawsuit alleges that Morgan Stanley’s news about Facebook’s revenue problems were not shared broadly, and instead, shared with only preferred investors.
  • According to the lawsuit, ordinary investors who were not given any notice of the problems with Facebook’s revenue models simply bought the shares on May 18, 2012, when Facebook went public, resulting in a multi-billion dollar windfall to the Facebook team, its investment bankers, and underwriters.  The lawsuit asserts that Morgan Stanley’s “preferred” investors knew about the problems with Facebook’s revenue models, and could plan their investment strategy accordingly (in some cases, short-selling shares), while ordinary consumers were left in the dark, and thus, suffered monetary loss. 
  • The class action estimates the losses made by ordinary investors to be approximately $2.5 billion.

 If the facts alleged by the lawsuit are true, it could very well constitute securities fraud.  As has been the case with short-selling on prior occasions (including the subprime mortgage crisis), it would be the very essence of securities fraud for wealthy investment banks to turn a profit based on the ignorance of ordinary purchasers of Facebook stock about the fact that Facebook was having revenue problems pre-IPO. 

 Flurry of Investigations. Since then, there has been a blizzard of activity as a number of authorities have announced investigations of the Facebook IPO.  The Financial Industry Regulatory Authority has announced it intends to review the negative news Morgan Stanley shared with institutional investors in the days before the IPO.   The SEC also announced that it would be “exploring issues” surrounding the Facebook IPO, without providing specifics.  Congress has opened a congressional inquiry, and so has the State of Massachusetts.

 Next Steps in the Lawsuit.  As far as the lawsuit is concerned, once the defendants are all properly served with summonses, they will have about 30 days to respond, though they could ask for extensions of time to do so.  The New York federal court overseeing the matter will probably set an initial status conference which will establish the litigation dates and deadlines in the matter.  Once the discovery (fact-gathering)  process begins, Facebook users and investors may obtain a much clearer picture of the facts that were given to preferred investors, but not ordinary investors, and whether the omission is “material” enough to constitute securities fraud under the 1933 Securities Act.