Opinion

Alison Frankel

How Facebook IPO class action lawyers changed judge’s mind

By Alison Frankel
December 20, 2013

The first paragraph of Facebook’s motion to dismiss a securities class action that raised allegations about disclosures in its initial public offering was a no-brainer. Last February, U.S. District Judge Robert Sweet of Manhattan tossed four shareholder derivative suits based on the same underlying facts, concluding in a voluminous opinion that Facebook had “repeatedly made express and extensive warnings” about potential weaknesses in its revenue model as users shifted from desktop computers to mobile devices. So in May, when Facebook’s lawyers at Kirkland & Ellis and Willkie Farr & Gallagher moved to dismiss the parallel securities class action, which is also before Judge Sweet, they quoted the judge’s own words right back to him, not just in the first paragraph but seven more times in the dismissal brief.

To no avail, as it happened.

Sweet ruled earlier this week that Facebook IPO investors may proceed with their class action, holding that their consolidated complaint made out a sufficient case that the company failed to disclose material information about the impact of mobile usage on Facebook revenues and that the company materially misrepresented its knowledge of that impact. The judge noted twice – once in a footnote and once deep in the ruling in his discussion of materiality – that his new decision might seem to be at odds with his dismissal of the derivative suits. But after a long quote from the previous ruling that included his prior words about Facebook’s “express and extensive warnings,” Sweet called the language “dicta (that) does not change the analysis here.”

So how does a judge move from his finding that a company has told investors all they need to know in advance of its IPO to a holding that (based on untested shareholder allegations, to be sure) those same disclosures and representations are materially deficient? Sweet gave two explanations: The derivative claims were based on an alleged breach of duty, which has a higher evidentiary standard, and class counsel from Bernstein Litowitz Berger & Grossmann and Labaton Sucharow managed to tweak shareholders’ allegations to distinguish their arguments from those in the derivative suit.

In the class action ruling, Sweet looked separately at Facebook’s alleged disclosure failures and misrepresentations, though they’re really intertwined. At the heart of the shareholder claims is Facebook users’ increasing reliance on mobile devices and the impact of that change on the company’s advertising revenue. As you may recall, Facebook was concerned enough about losing ad revenue as users migrated to mobile devices to revise its projected quarterly revenue down during the IPO roadshow – a decision it communicated to selected analysts but not the investing public. Facebook argued in its motion to dismiss shareholder claims that it provided plenty of warnings about the loss of revenue, and that even the Securities and Exchange Commission does not require companies to disclose financial projections and internal valuations, so it committed no wrongs.

In the derivative litigation, Sweet agreed with Facebook. But in the securities case, shareholder lawyers asked him to look not just at the warnings Facebook did include in its offering documents but also at how those warnings lined up with what the company actually knew. As Sweet explained: “Plaintiffs contend that the company’s registration statements used language that only suggested there was a possibility that Facebook would have difficulty in the mobile market and that Facebook’s mobile user base was growing faster than its desktop user base when, in reality, these two trends were occurring and affecting Facebook’s advertising revenues,” he wrote. “Plaintiffs posit that the loss of revenues caused by the increasing mobile usage was a trend known by Facebook that the company had a duty to disclose.”

The judge said that Facebook’s “generalized and indefinite terms” didn’t amount to sufficient disclosure because Facebook knew for sure that mobile usage trends would be a problem. “The registration statement did not provide the extent increasing mobile users would affect the company’s overall revenues at a time (when) this trend was already affecting the company’s revenues as a result of the company’s product decisions,” he wrote. “Facebook should have disclosed more of this relationship to investors.”

Similarly, Sweet held the company’s warnings that it might lose revenue from users’ changeover to mobile devices to be actionable, even though he said in the derivative case that those warnings protected Facebook from shareholder claims. Under the class action plaintiffs’ theory, he wrote, Facebook already knew the lost revenues were not hypothetical but a fact. “The company’s purported risk warnings misleadingly represented that this revenue cut was merely possible when, in fact, it had already materialized,” Sweet said. “The warnings only warned what might occur if certain contingencies were met; the disclosures did not make clear that such contingencies had, in fact, already occurred.” (Sweet said it didn’t matter that Facebook ultimately reported revenues in line with its estimates.)

When the derivative decision came down last February, I noted that all IPO issuers should be relieved at Sweet’s strong language on the adequacy of Facebook’s warnings and at his finding that “courts throughout the country” agree that internal projections need not be disclosed. I was a bit premature. Under Sweet’s new reasoning, IPO defendants have to be careful that their representations to investors match what they actually know.

A Facebook representative said in a statement that the company continues to believe that the class action lacks merit and awaits “a full airing of the facts.”

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