Road shows, analysts and jumping the gun: the Facebook IPO

May 25, 2012

By Helen Parry, additional reporting by Julie Dimauro

LONDON/NEW YORK, May 25 (Thomson Reuters Accelus) – Facebook’s chaotic initial public offering has sparked much speculation and legal action based on the idea that securities laws and regulations over disclosure may have been breached, which would leave Facebook and others involved in the offering process liable to potential regulatory enforcement or civil liability for losses caused to investors.

An analyst at lead underwriter Morgan Stanley cut his revenue forecasts for Facebook in the days before the offering, information that may not have reached many investors before the stock was listed, Reuters has reported.JPMorgan Chase and Goldman Sachs, which were also underwriters on the deal, each revised their own estimates during Facebook’s IPO road show as well, according to sources familiar with the situation. Morgan Stanley selectively disclosed the change in Facebook estimates, Reuters reported,

The U.S. regulations regarding IPOs are complex and differ from other securities rules in key respects including disclosure. But besides setting off a legal snarl of lawsuits, the IPO’s problems also pointed to potentially significant corporate governance lapses. Both the firm and the underwriters should have been ensuring consistency in the IPO process.

“These events signal problems with the effectiveness of internal governance, controls and the role of the chief compliance officer at Facebook and their financial advisor, Morgan Stanley,” said John Alan James, executive director of the Center for Global Governance, Reporting and Regulation at Pace University’s Lubin School of Business in New York.

The Securities Act and liability

One of the key provisions that may be at issue is Section 12 (a)(2) of the U.S. Securities Act of 1933. The section holds liable 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.

The remarks reported to be made by analysts who reduced earnings forecasts, citing a shift by Facebook users to smartphones where the company’s revenues were small, could constitute a possible ground of liability under this provision. This would require establishing that disclosures in the prospectuses were rendered misleading as a result of such information — which was reportedly selectively communicated to some major investors — being omitted in the documentation that was available to all investors.

Mandatory disclosure requirements under the Securities Act

Section 10 and Schedule A of the Securities Act of 1933 mandate the information that must be included in offering documentation. Although there are requirements for financial reports, such as a balance sheet and a profit and loss statement, the act does not mandate the disclosure of revenue or earnings forecasts.

Regulation Fair Disclosure

Regulation Fair Disclosure (FD) prohibits the selective disclosure of price-sensitive information. It would, however, not be likely to be applicable in the Facebook case, as it is not generally applicable to initial public offerings.

However, the U.S. Securities and Exchange Commission (SEC) has noted in connection with this regulation that the disclosure regime and the civil-liability provisions of the Securities Act reduced substantially any meaningful opportunity for an issuer to make selective disclosure of material information in connection with a registered offering.

It said it was satisfied that the Securities Act already accomplished at least some of the policy imperative of Regulation FD within the context of a registered offering. As a result, with limited exceptions, Regulation FD did not apply to disclosures made in connection with securities offering registered under the Securities Act.

U.S. lawmakers, however, have also protested that the selective disclosure of the analyses to only some investors violated transparency principles.

“Effective capital markets require transparency and accountability, not one set of rules for insiders and another for the rest of us,” said U.S. Sen. Sherrod Brown, an Ohio Democrat and Senate Banking subcommittee chairman.

Jumping the gun

The so-called pre-offering “quiet period” starts when the issuer reaches an understanding with the managing underwriter and continues until the the dealer must deliver a prospectus or the securities are sold. Under earlier standards, communication by means other than the prospectus, such as road shows and other marketing communications had been severely restricted. Breaching the quiet period was referred to as “jumping the gun.”

However, rules concerning the quiet period were relaxed in 2005 in the SEC release “Securities Offering Reform” to take account, among other things, of new methods of communication such as computers, sophisticated financial software, electronic mail, teleconferencing and webcasting

Under the new regime, all issuers and offering participants were permitted to use “free-writing prospectuses.” These were defined as any written sales or purchase offer of securities in a registered offering that is made after the registration statement and outside of a prospectus.

Electronic road shows

One such means other than a prospectus is the road show. Such events for IPOs concerning equity or convertible equity securities that are not done for a live audience are considered to be electronic road shows. They will be considered written communication and fall into the category of free-writing prospectuses. They must be filed with the SEC unless they are made available to all potential investors.

In-person, live, road shows are considered to be oral communications.

All road shows that are offers are, however, subject to Securities Act Section 12(a)(2) liability. Road show presentations should, therefore, not contain information that conflicts with or goes materially beyond information in the preliminary prospectus or contain materially misleading statements or omissions.

Road shows and section 11 liability

Section 11 of the Securities Act imposes liability when a registration statement, at the time it becomes effective, contains a material misstatement or omission. However, a free-writing prospectus is not considered to be part of the registration statement and is generally not subject to liability under Section 11, even if it is required to be filed.

However, oral communications made in connection with a registered offering after the registration statement is filed are not to be subject to any filing or public disclosure requirements. The SEC took the view that subjecting oral communications to a public disclosure requirement could adversely affect the capital-formation process.

Analysts and road shows

Also in 2005, the SEC approved an amendment to rules of the Financial Industry Regulatory Authority that prohibits research analysts from participating in road shows related to investment-banking services. The amended FINRA rule 2711 prohibits research analysts from participating in such road shows or engaging in any communication with a current or prospective customer in the presence of investment banking department personnel or company management about an investment banking services transaction.

However, the rule allows research analysts to “educate” investors or internal staff in a “fair, balanced, and not misleading way” about an offering, as long as representatives of the issuer or investment banking department are not present.

If, however, Morgan Stanley analysts’ remarks were not communicated in the prohibited manner, then it is unlikely that there would be any liability under the amended rule.

Compliance issues

While the many law suits that are being prepared in the wake of the Facebook IPO may face hurdles due to the complex and technical nature of IPO law and regulation, the avalanche of bad publicity has created serious reputational damage to Facebook and the market professionals involved.

This underlines the crucial importance of ensuring that there are no significant discrepancies in the content of IPO-related communications of any kind, written or oral, as such discrepancies can lead to liability if the result is that the universally available public documents contain misleading information and retail investors lose out.

What the compliance officers at Morgan Stanley knew about the IPO communications that the firm’s analysts were making to investors is an important, and so far unanswered question, James said.

“ I wonder if they were told of the factors leading to the share-pricing changes – and the lack of disclosure about the changes to all but a few investors — discovered by the executives at Morgan Stanley,” he said.

“ If the chief compliance officer lacked these communications, it would indicate that that something was wrong with the corporate-governance communication channels here. If the chief compliance officer knew about them, he or she would have been obligated to let the board know of them.”

It is the responsibility of the company, he said, to make sure that the firm has the right policies and procedures to reveal such potential problems, and to give the compliance officer the authority to take concerns to top executives and to the board.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. <a href=” ions/regulatory-intelligence/compliance- complete/” target=_new”>Compliance Complete</a> provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)

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