Disclosure at heart of Facebook investors' lawsuit over IPO

Angry investors in Facebook Inc.'s controversial first public issue of stock launched a class-action lawsuit against the company and the underwriters of the $16-billion (U.S.) offering – using the same law firm that took on Enron.

The suit, filed in U.S. District Court in New York on Wednesday, is the latest and strongest investor response to the poor performance of Facebook's much-hyped initial public offering (IPO) since the stock made its debut to great fanfare last Friday. It alleges that Facebook and its underwriters made "false and misleading representations and omissions" to investors in advance of the company's May 18 stock market debut, specifically about the company's revenue and earnings outlook.

The class action relates to reports this week that during Facebook's so-called "road show" – a period ahead of the IPO in which the company and the underwriters pitch the shares to potential investors – research analysts at several of the issue's biggest underwriters, including lead banker Morgan Stanley , cut their revenue forecasts for the company. The cuts, considered highly unusual in the runup to a major IPO, appear to have been only disclosed to top clients of those investment banks, and not to all potential investors.

The controversy shines a new light on what has long been a grey area on Wall Street: who gets the best information, and when. Major reforms in the early 2000s attempted to level the playing field among investors and clamp down on the practice of "selective disclosure" of key information about a company's business to certain favoured analysts or shareholders.

But in the convoluted patchwork of U.S. regulations that address what an investment bank can and cannot do when disclosing information about share offerings, it's perfectly legal for a securities firm to disclose analyst research to only some classes of clients and not to others – so long as the research process is untainted by interference from the investment bankers involved in the underwriting. Investment banks are barred from disclosing research only to specific clients, but they can classify "tiers" of clients based on the amount of business they represent, and provide different amounts of research to different tiers.

Investors are asking the court to consider whether the company and the underwriters "negligently omitted and/or misrepresented material facts about Facebook and its business" to the investing public, and "whether federal securities laws were violated."

One key question is whether Facebook provided the underwriters with the information that led to the forecast cuts but didn't include the same information in its IPO filings, as the lawsuit suggests. Some media reports have alleged that Facebook may have instructed the underwriters to have their analysts lower their forecasts – which, if true, may have crossed regulatory lines.

Facebook's initial public offering of stock was priced at $38 a share, but the stock lost nearly 20 per cent in the first three days of trading, sparking growing outcry over how the company and its bankers handled the share issue. On Wednesday, the stock reversed a small portion of those losses, gaining $1 to $32 on the Nasdaq Stock Market.

The suit names Facebook, its top executives including founder and chief executive officer Mark Zuckerberg, and the major underwriters of the share issue, including Morgan Stanley, JPMorgan Chase & Co., Goldman Sachs, Merrill Lynch and Barclays Capital Inc. The lead lawyers for the plaintiffs are Robbins Geller Rudman & Dowd LLC, the same firm that helped Enron investors recover more than $7-billion from the scandal-riddled company, the biggest-ever recovery in a securities class action.

Morgan Stanley issued a statement via e-mail Tuesday denying any wrong-doing in its dissemination of information on Facebook in advance of the stock's public debut. "Morgan Stanley followed the same procedures for the Facebook offering that it follows for all IPOs," the statement said. "These procedures are in compliance with all applicable regulations."

The statement said that after Facebook issued a revised filing to the U.S. Securities and Exchange Commission on May 9, which contained new concerns about the pace of Facebook's per-user advertising growth, Morgan Stanley forwarded the filing to all its institutional and retail clients. Afterward, Morgan Stanley and "a significant number of research analysts in the [underwriting]syndicate" who were part of the road show lowered their earnings forecasts. "These revised views were taken into account in the pricing of the IPO," it said.

A Facebook spokesperson said the company plans to vigorously defend itself, but otherwise declined to comment.