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Judge: Facebook Must Face Fraud Suit in 2012 IPO

A federal judge has ruled that Facebook must face two class action lawsuits claiming the company concealed slowing ad growth in its initial public offering (IPO) in 2012, and helped its underwriters make a $2.4 billion profit by shorting 63 million shares on inside information.

Judge Robert Sweet for the U.S. District Court for the Southern District of New York ruled that plaintiffs for California government pension funds and other institutional investors may have a basis to allege that social networking company Facebook, that went public with a peak market capitalization of over $104 billion, may have knowingly over-emphasized the growth of advertising in its mobile business just before the IPO.

The Court also approved consolidations of 41 class action lawsuits against Facebook; founder Mark Zuckerberg and other officers; the NASDAQ exchange; and underwriters.

The litigation involves Facebook’s filing of an S-1 registration statement with the Securities ad Exchange Commission on May 12, 2012 that valued the company at $77 billion to $96 billion.

The prospectus given to potential investors at the time highlighted the company’s phenomenal growth in “users.” But is alleged to have failed to explain the fact that there was a huge difference between the revenue generated from serving ads to laptop and desktop computer users on one hand, versus smartphone users on the other.

Facebook is alleged to have made “disclosure of certain forward looking projections to analysts employed by its underwriters,” led by Morgan Stanley, such that in the beginning of the second quarter of 2012, “growth in the number of Facebook’s daily active users continued to outpace growth in the number of ads delivered.”

On Friday, May 18, 2012, Facebook released its IPO at a peak market capitalization of over $104 billion, or $38 a share. Having set a new record high for a technology IPO, Media pundits called Facebook a “cultural touchstone.”

Demand for the offering was so strong, Morgan Stanley and its underwriting banks sold 484 million shares of Facebook at $38 each. At the same time, they bought 421 million shares of Facebook from the company and its investor, at $37.582 each. The underwriters made a fee of 1.1 percent on the 421 million shares they bought from Facebook at $37.582 and sold at $38.

The underwriters also sold about 63 million shares of Facebook they didn’t own in what is called a “short.” The underwriters had the option right from Facebook for at least to a 120-day period to buy up 15 percent more stock from a company at $37.582 to fill potential higher demand in the offering.

But the next day, on a Saturday when very few financial analysts were around, Facebook filed a “May 19 2012 Amendment to the S-l Registration Statement, which disclosed the negative data given to the underwriters before the offering.

Facebook stock price fell by more than 50 percent, to under $18 in the next three months. It is believed that Morgan Stanley and the other underwriters made up to a $2.4 billion profit on the short.

Facebook’s stock eventually turned around and has tripled in price in the last three years since the IPO.

But Judge Sweet seemed to indicate that shareholders have the right to a trial to determine if Facebook should have publicly revealed its internal projections on how increased mobile usage might have reduced future revenue, rather than quietly warning its underwriters, which then cut their earnings forecasts.

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