Facebook's failed U.S. private offering in 2010 led to major reforms, but its much maligned IPO is unlikely to have the same effect. In fact, the reforms prompted by Facebook's private offering could make the problems associated with its public offering more likely to be repeated.
Whether Facebook (FB) has a knack for making money, it certainly seems to have a knack for making law. Its bungled private placement last year was one impetus for major changes in rules governing private offerings. Many provisions of the JOBS Act, which became law last spring, can be traced to Facebook Fiasco No. 1.
Facebook's IPO, considered by many to be Facebook Fiasco No. 2, has triggered more calls for reform. The IPO has been deemed a failure because shares have traded well below the offering price and continue to decline, though selling shares at the highest possible price seems to have been exactly what Facebook's leadership intended. It has also been criticized because, permitted by current law, material information about the company was selectively disclosed to institutional shareholders.
Some politicians have called for reform, but it is hard to believe that they really mean it. Far from being reformed, the law that contributed to the way Facebook's IPO played out has become more firmly entrenched than before. Disappointing IPO performance and selective disclosure are now more likely, in part because of legal reform resulting from Facebook Fiasco No. 1. It looks like the regulatory yield of Facebook Fiasco No. 2 will end up somewhere south of the current yield on your money market fund.
Facebook Fiasco No. 1
Last year, I discussed the U.S. piece of a private offering by Facebook that foundered on the shoals of overly burdensome restrictions on public solicitations. The SEC failed to fix the problem, which had festered for years, so Congress simply erased the restrictions altogether. The JOBS Act orders the SEC to permit firms to engage in unlimited general solicitations and advertising when they are raising capital in an exempt private offering.
The problem with this approach is that the private offering exemption is only available for transactions "not involving any public offering" (see Section 4(2) of the Securities Act), which is inconsistent with allowing unlimited general solicitations and advertising. Congress created this contradiction but chose not to resolve it, deciding instead to pass the buck to the SEC to figure out how to allow public offerings for transactions that do not involve public offerings. (Links to public comments on the rulemaking are here, with Fund Democracy's here, here, and here.)
Congress also addressed another Facebook issue by raising the number of shareholders that would trigger public reporting and other public company requirements. The Facebook IPO was prompted partly by its shareholder count nearing the 500-shareholder trigger, at which point it would have had no choice but to become a public company. Congress raised the trigger to 2,000 shareholders and excluded more investors from being counted, which will allow companies to stay private longer. Congress also exempted trading platforms for private offerings from broker-dealer regulation, which may further expand private markets and make them even more attractive for raising capital. As will the JOBS Act's increasing of the offering limit for unregistered offerings under Regulation A to $50 million from $5 million.
(In contrast, the JOBS Act's new crowdfunding exemption is, in my view, so poorly drafted that it will not serve as a meaningful vehicle for raising capital.)
The upshot of these reforms will be that the private markets will continue to grow, causing a continuation in the decline of U.S. IPOs. This means that, like Facebook, companies are likely to be more mature if and when they go public and accordingly be far less likely to offer the traditional post-IPO price pop. These companies also will not have the same pressure to support their share price to facilitate follow-on offerings because they will not be under the same pressure to raise follow-on capital. Company insiders will choose to go public in order to sell their shares to the highest bidders, who The Winner's Curse teaches us are likely to pay too much.
Another consequence will be that an increased number of larger companies will escape public company regulation, including Regulation FD. Regulation FD prohibits the kind of selective disclosure that accompanied the Facebook IPO and ignited the investing public's ire. Regulation FD will not apply to this growing cadre of private companies. As discussed below, recent reforms have increased the likelihood of selective disclosure occurring in the public company arena, as well.
Facebook Fiasco No. 2
Bipartisan expressions of concern on Capitol Hill suggest that Facebook Fiasco No. 2 might produce a regulatory yield close to that of Facebook Fiasco No. 1. Rep. Darrell Issa, R-Calif., chairman of the House Committee on Oversight and Government Reform, wrote to the SEC that "it appears that the entire IPO regulatory framework, based on an outdated Securities Act of 1933, fails to provide a market-based solution to IPO pricing." Sen. Jack Reed, D-R.I., chairman of a key subcommittee of the Senate Banking Committee, tweeted: "#FacebookIPO raises questions that should be carefully examined. Regulators must act with urgency & hold those involved accountable."
The Facebook IPO has critics questioning a broad range of rules related to the selective sharing of nonpublic information by underwriters with their clients and underwriters' artificial support of the after-IPO price. More than anything else, these complaints highlight regulations that, while permitting intuitively unfair treatment of retail investors, reflect longstanding, mainstream practices. For example, providing access to material information only to favored clients of broker-dealers does not seem fair to retail investors, but this is common practice in IPOs and permitted by law. Regulation FD, which prohibits selective disclosure by public companies to address precisely this inequity, does not apply to IPOs.
Underwriters' practice of buying shares in the post-IPO market, which is also common and quite legal, serves to create a stable market. But it also can render the market price misleadingly inflated. What might otherwise be criminal market manipulation is not only legal, but also expected, applauded, and potentially lucrative. Morgan Stanley (MS) reportedly made $125 million just from propping up Facebook's share price on the IPO's first day.
The SEC is investigating the Facebook offering, but action is unlikely because selective disclosure and aftermarket pricing support are consistent with longstanding, fundamental elements of securities regulation. The securities laws tacitly approve the fundamental conflict that exists when underwriters can advise both issuers and investors in primary offerings.
Indeed, the JOBS Act further enshrined this conflict by giving greater freedom to analysts to market IPOs to retail customers and allowing a return to the kinds of abuses at the center of the analyst scandal early in the last decade (in which New York attorney general Eliot Spitzer exposed analysts who publicly touted stocks while privately trashing them as "POS"). The JOBS Act will permit more selective disclosure by analysts, while the Act's changes to private offerings discussed above will further narrow the coverage of Regulation FD's prohibition against selective disclosure because fewer companies will go public.
In short, Facebook Fiasco No. 2's regulatory yield is likely to be zero.
Facebook Litigation
In some cases, regulatory reform comes from private litigation, and Facebook Fiasco No. 2 has produced its share of lawsuits. For example, some investors and firms are suing Nasdaq OMX Group (NDAQ) to recover losses suffered because of trading glitches in the Facebook IPO. UBS (UBS) is asking for $356 million, with most of that loss appearing to result from a problem with trading systems that caused an order for 800,000 Facebook shares to be resubmitted about 50 times. Nasdaq's and UBS' technology problems, coupled with Knight Capital Group almost collapsing this month as a result of a $400 million technology glitch of its own, are enough to make one wonder when we'll see the headline: STUXNET/Flame/Gauss Shut Down Wall Street.
But these cases are not really about Facebook itself, which is facing its own raft of lawsuits. This story begins with one of the leading characters in the analyst scandals mentioned above--Henry Blodget--who has been at the forefront reporting on the Facebook IPO. Ex-Merrill Lynch analyst Blodget is best known for being permanently banned from the securities industry after publicly touting Internet stocks underwritten by Merrill in the late 1990s while trashing the same firms in private emails. He is now the CEO/editor-in-chief of Business Insider, an entertaining, edgy blog where, taking a page from Spitzer's book, he occasionally makes others' private trash very public.
Blodget has provided detailed accounts of a negative outlook that underwriters shared with favored institutional clients after May 9, just prior to the Facebook IPO on May 18. For example, he reported (Reuters may have been the first) that Facebook had cut its 2012 revenue forecast to $4.8 billion from $5.1 billion. In light of these details, and the contemporaneous increase in both the offering price and number of shares sold (by 25%), some institutional investors reduced and/or canceled their Facebook orders. That the increase in the number of available shares came from insiders' sales might also have gotten their attention.
The cancelations and increase in the number of shares offered allowed larger purchases by retail clients (constituting 26% of sales, compared with the more typical 15%), who were privy only to Facebook's SEC filings. In contrast with the details that Blodget says were shared with institutional clients, Facebook's updated prospectus featured a general warning:
Growth in use of Facebook through our mobile products, where our ability to monetize is unproven, as a substitute for use on personal computers may negatively affect our revenue and financial results.
Shareholders have sued Facebook and its officials and underwriters on the ground that this disclosure was misleading.
The defendants have responded that the prospectus "warned about the negative impact of the trend on the company's revenues and financial results." Plaintiffs will argue that the prospectus actually said this trend "may" negatively affect results while Facebook knew that the trend "would" negatively affect results. Plaintiffs will need to show that selectively disclosed information was not merely more detailed--which, by itself, would not be legally sufficient to make the plaintiffs' case--but materially different. In his SEC letter, chairman Issa seemed to go out his way to quote an article asserting that the change in revenue estimates was "'so material that it should absolutely have been disclosed in a revised [prospectus] before the IPO pricing."
The financial press has reported that it was the omitted details, and apparently not the amended disclosure, that scared some institutional investors away from the deal, which supports the argument that the registration statement disclosure was inadequate. The difference between annual revenues of $5.1 billion and $4.8 billion might not seem like much, until one considers that Facebook's IPO valuation was based partly on 88% revenue growth from 2010 to 2011. The revised revenue estimate would reflect a revenue increase of only 31% for 2012 and, according to one analyst, reduce Facebook's value by one third.
This is only one of many issues on which the outcome of this litigation will depend. For example, even if plaintiffs show that the prospectus was materially misleading, the defendants will nevertheless prevail if they can show the drop in price was not caused by the selective disclosure becoming public (known as "loss causation"). In many respects, the outcome of the litigation is likely to be very fact-dependent and therefore has limited potential to affect selective-disclosure practices.
A New Context for IPOs?
So the outcome of the Facebook litigation is unlikely to have a significant effect on securities regulation. Nor is any aspect of the Facebook IPO. Rather, Facebook Fiasco No. 2 might simply turn out to have been the most visible bellwether of basic changes in public offerings. Where Fiasco No. 1 served as a tipping point for the JOBS Act (just as Enron and Worldcom were the tipping points for the Sarbanes-Oxley Act of 2002, and the financial crisis was the tipping point for the Dodd-Frank Act of 2010), Fiasco No. 2 might simply be the tipping point in the public perception of IPOs.
Facebook Fiasco No. 2 involved the IPO of a huge technology firm that took place well past the firm's valuation/growth peak (in stark contrast with Google's 2004 IPO, for example). The delayed IPO was partly enabled by Facebook's ability to raise capital in the private markets and the ability of many of its shareholders to sell out easily pre-IPO, in each case relieving some of the pressure both to go public and to raise additional capital in follow-on offerings. Less pressure to go public and raise follow-on capital means less reason to sell shares at an IPO discount and more reason to do what Facebook did--seek the highest possible price for selling insiders.
Reforms motivated partly by Facebook Fiasco No. 1, as discussed above, will make private markets that much more--and IPOs concomitantly less--attractive to firms. It will also increase selective disclosure in both public and private markets. Ironically, the reforms prompted by Facebook Fiasco No. 1 make some of the problems associated with Facebook Fiasco No. 2 more likely to be repeated.
