The Facebook earnings-forecast scandal

By Felix Salmon
May 22, 2012

Yesterday, it was the greenshoe — the standard feature of IPOs which also happens to be an officially-mandated case of naked short-selling. Today, it’s another odd special case: the way in which analysts’ estimates of companies’ future earnings are deliberately not made public prior to the IPO — except to select investment-banking clients who are likely to put in large orders for IPO stock.

As Henry Blodget says, this whole episode stinks. It’s almost certainly not illegal. But if you look at the Finra rules about such things, it definitely violates the spirit of the law. For instance, the rules say that Morgan Stanley analysts weren’t allowed to show Facebook their research before it was published — but they don’t say that Facebook can’t quietly whisper in Morgan Stanley’s ear that its estimates might be a bit aggressive. Obviously, there’s no need for the analysts to give Facebook advance notice of their earnings downgrade if that earnings downgrade was a direct consequence of something Facebook told them.

Similarly, Morgan Stanley isn’t allowed to publish a research report or earnings estimates for Facebook within the 40 days following the IPO. But a few days before the IPO? I guess that’s OK — even if the way the estimates were “published” meant they were only available to good friends of the bank.

More generally, the rules ignore the key point here. Retail investors, and the market as a whole, knew when Facebook had its IPO that Morgan Stanley (and JP Morgan, and Goldman Sachs) had research teams with estimates for Facebook’s future earnings. They also knew that those estimates would be made public in 40 days’ time. And if they were sophisticated enough, they probably knew that select Morgan Stanley clients were given access to the analysts and their estimates.

What they didn’t know — what they couldn’t know, because nobody told them — was that those estimates had been cut, significantly, just days before the IPO.

It’s true that retail investors weren’t buying Facebook stock on the strength of the banks earnings estimates, since they didn’t (and still don’t) know what those earnings estimates are. But here’s a material nonpublic fact about Facebook, which retail investors and everybody else in the deal deserved to know: all three underwriters cut their estimates simultaneously, in response to some very minor changes in the revised IPO prospectus.

Here’s Blodget:

Speaking as a former analyst, it seems highly unlikely to me that the vague language in the final IPO amendment would prompt all three underwriter analysts to immediately cut estimates without some sort of nod and wink from someone who knew how Facebook’s second quarter was progressing.

Hot internet stocks like Facebook are all about momentum and growth. Investors expect companies like this to surprise on the upside, occasionally; they get extremely upset, by contrast, when they surprise on the downside. Especially when such surprises come in the immediate run-up to the biggest tech IPO in the history of the world.

Why is Groupon trading 40% below its IPO price? Because people were happy to buy into ramshackle governance and accounting conventions so long as all the lines were going sharply up and to the right. But when you’re trading at massive multiples, any hint of a slowdown in growth, or of failing to meet pretty aggressive targets, is a key sell signal. These companies aren’t supported by fundamentals: they’re only supported by a general atmosphere of aggressive growth expectations and zealous bullishness. When three banks all cut their earnings estimates for Facebook on the same day, that sure ain’t bullish.

This does not mean, of course, that Facebook stock is doomed for all eternity: it could pull an Amazon, and rise sharply out of its post-IPO slump. But this does mean that shareholders should not expect much in the way of transparency or full honesty from a company which is controlled by Mark Zuckerberg personally and which has deliberately created a dual-class share structure in order to to ensure that they can be completely ignored on all decisions. Facebook was whispering in the ears of the lead managers of its investment banks, on the understanding that the results of those whispers would remain available only to select clients until after the IPO was over. That’s not cool. And as a result the company definitely deserves the latest lurch downwards in its (still frothy) share price.


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The US is way behind Europe on this although both leave the retail investor at a material disadvantage.

In Europe pre-IPO research is published, but quite hard to get hold of. Impossible if you are a retail investor.
In the US you don’t necessarily have to be a whale to get access to the numbers but you have to be a client and have to speak with your sales contact.

As a result it is almost impossible to change your estimates at the 11th hour in Europe so the problem here – and let’s be clear – the problem is SELECTIVE DISSEMINATION – can’t happen in Europe.

However, any investor worth their 2&20 would have at the VERY LEAST made the three phone calls necessary to check whether the NEW IPO PROSPECTUS had caused the analysts to change their numbers.
That’s common sense.
Sure the switched on brokers would have called big clients with the heads-up but again – that is business as usual.

If FB was post-IPO and made a comment about the Q you can be damn sure there would be a note out about it the next day from every analyst – most would call the company for some colour.
The company would talk the analyst numbers down and BOOM: new estimates.

That is business as usual.

However, this is pre-IPO, so what does that change?
It makes access to the estimates harder to get.
But since they are ALREADY hard to get (even post-IPO) then I don’t really see a huge problem.

Felix already raised the whole issue of selective dissemination in the post “Sell-side research isn’t insider information” where you defended banks/analysts “monetizing their assets as best they can”…
So which is it Felix? Either selective dissemination is good or it’s bad. You can’t have it both ways.

Posted by TinyTim1 | Report as abusive

TinyTim, good question. And for the answer, look to the Chinese Wall between the investment bank and the traders. The analysts sit on the same side of the wall as the traders, and the opposite side of the wall from the investment bank. So while I’m OK with them talking to their traders, I’m not at all OK with all of this chumminess surrounding the investment bankers taking Facebook public.

Posted by FelixSalmon | Report as abusive

Selective dissemination in an IPO setting vs. normal market setting.

Even though it feels wrong even in the normal setting, there is a good argument to be made for allowing early dissemination to those who pay for it, one way or the other. Research isn’t created for free. Disclosures should be made when the information is released, though.

In the IPO setting, it seems different. There is in effect a relationship of sorts between the underwriter and the public, from the prospectus and the situation itself. If there is also inside (for lack of a better term) info floating around between the underwriters and a select few and that fact is not explicitly disclosed to the public, in the prospectus or otherwise, then IMO we’re sort of in ordinary fraudlent concealment territory.

OBTW: the green shoe seems to be a form of call-option for the underwriter, so the short doesn’t actually seem like it’s naked, but is covered by the option, up to the size of the option.

Posted by MrRFox | Report as abusive

I’m sure that “as a former analyst,” Blodget is very familiar with ways that the banks can manipulate the IPO price. There’s a reason he was banned from finance…

This seems like the sort of situation that we can let the market sort out. There will always be information asymmetries during IPOs, and I have a hard time pitying investors who lost money because they took Morgan Stanley’s numbers at face value.

Posted by MKCurious | Report as abusive

As much as it stinks, isn’t this simply one more logical reason why jack shouldn’t be exchanging real goods for magic beans? If all the other logical reasons to stand on the sideline have fallen on deaf ears…

Posted by thispaceforsale | Report as abusive

The FB IPO’s ridiculous valuation was predicated on the naivety of the retail investor and more importantly the informational asymmetry between the ‘smart money’ (institutions) and the ‘dumb money’ (retail). This IPO was based on exploitation of the retail investors.

If retail investors are involved then there ought to be no informational mismatches. All information must be made public.

Separately the practice of banks producing research only for ‘clients’ needs to end. All research needs to be made public. Their research needs to used as marketing for the bank in general and not as a perk for being a client. The Chinese Wall is a farce. It is time that this was re-looked at the information

Access to the analysts can be restricted to bank clients or the analysts can earn their keep by being providing live presentations to clients only. Much like how music stars earn most of their money by providing live concerts. Their music is freely available on the internet.

Posted by RS108 | Report as abusive

Felix, huh what?? the analysts most definitely don’t sit on the same side as the traders. As a matter of fact they’re not supposed to be talking about their research to traders unless chaperoned by legal and compliance, and if they breath a whiff of what the result of their analysis is likely to be, those traders can’t trade the stock any more.

Posted by niveditas | Report as abusive

I mean, seriously, do you have any clue what the regulations regarding research actually are?

Posted by niveditas | Report as abusive

I think the debate will quickly to move to whether or not Facebook and the underwriters disclosure in the S-1 regarding the mobile revenues was a material misstatement. If it turns out to be true that the company gave the analysts more information than was in the S-1 – enough to cause those analysts to change their models – it would seem to be material. Then we have securities fraud.

Posted by SteveDiamond | Report as abusive

SteveDiamond is correct that it’s securities fraud if material information was ommitted from the S1. Also, it is illegal for management to selectively disclose to analysts material non-public information. Any guidance someone from Facebook gave to the underwriters’ analysts on Q2 and FY2012 would have been material and should have been made public. Further, it is illegal to trade on material, non-public information, which you could argue is what the underwriters and others did through the greenshoe. One might also find that any trades by the clients who were told might be insider trading. Big fat festering pile this is.

Posted by nathan123 | Report as abusive