Facebook I.P.O. Raises Regulatory Concerns

By EVELYN M. RUSLI and MICHAEL J. DE LA MERCED
Keith Bedford/ReutersFacebook stock, which slid again Tuesday, is now more than 18 percent below its offering price.
9:38 p.m. | Updated
Just days before Facebook went public, some big investors grew nervous about the company’s prospects.
After publicly warning about challenges in mobile advertising, Facebook executives held conference calls to update their banks’ analysts on the business. Analysts at Morgan Stanley and other firms soon started advising clients to dial back their expectations. One prospective buyer was told that second-quarter revenue could be 5 percent lower than the bank’s earlier estimates.

This is the classic impact of investors being driven by their emotions. While we all acknowledge that our emotions are a driving force in all of our money decisions, this acknowledgement should force all of us to pause and step back when we are making money decisions. So many of us work on our gut reaction to things, which can be a fantastic source of feedback to ourselves, but we also need to pay attention to the other saying of “ check your gut”. So yes, listen to your gut but also be very aware that your instinct may be driven by desire, not logic. We often see what we want to see.

In the end, Facebook and the Morgan Stanley bankers decided they had enough demand and interest for Facebook to justify an offering price of $38 a share.

They didn’t.

When Facebook went public on Friday, its shares barely budged — and they have been falling ever since. On Tuesday, the stock closed at $31, more than 18 percent below its offering price.
The I.P.O. of Facebook was supposed to be Morgan Stanley’s crowning achievement, but it is turning out to be a big embarrassment, raising broader questions from regulators about the I.P.O. process.

Once again, the securities sector is giving the public reason to not trust it. It also causes the public to wonder about the regulators and their ability to really oversee what these firms are doing. The IPO is out and it’s only now that regulators are questioning the process. Where were they when there were rumblings in the market about the offering price?

Over the last year, Morgan helped usher in a new generation of technology companies, leading the offerings of LinkedIn, Groupon, Pandora and more than a dozen other start-ups. Facebook was poised to be the biggest and most ambitious. When the dust settles, Morgan Stanley could make more than $100 million in fees on the I.P.O.
But rival bankers and big investors have complained that Morgan Stanley botched the debut. They contend that the bank set the price too high and sold too many shares to the public. Facebook’s management team is also shouldering some blame. David Ebersman, the company’s chief financial officer, spent more than a year orchestrating the stock offering, drafting the prospectus and meeting with investors long before the company picked its bankers.

Facebook’s fate as a public company is hardly sealed. Many newly public companies stumble out of the gate and later become top performers with appealing stocks, a group that includes Amazon.com.

But regulators are concerned that banks may have shared information only with certain clients, rather than broadly with investors. On Tuesday, William Galvin, the secretary of state in Massachusetts, subpoenaed Morgan Stanley over discussions with investors about Facebook’s offering. The Financial Industry Regulatory Authority, Wall Street’s self-regulator, is also looking into the matter. The chairwoman of the Securities and Exchange Commission, Mary L. Schapiro, said Tuesday that the agency would examine issues related to Facebook’s I.P.O., but she did not elaborate.

Certainly, this isn’t a surprise. Regulators and insiders knew that Morgan Stanley was sharing information with select clients. The rumours had been on the street for a long time. Why did they not act at that time. It seems a little late for the hand-wringing now.

The steps a company takes to go public are highly choreographed and regulated by securities law. A company cannot comment or disclose new information about its business or prospects unless it does so publicly by amending its prospectus. Otherwise, it risks running afoul of regulators. The company could also be vulnerable to securities lawsuits, as investors would have to prove only that it made “material misstatements” ahead of an offering, rather than a high threshold of securities fraud.

“Morgan Stanley followed the same procedures for the Facebook offering that it follows for all I.P.O.’s,” a bank spokesman said in a statement. “These procedures are in compliance with all applicable regulations.”

A Facebook spokeswoman declined to comment.

In the weeks leading up to Facebook’s I.P.O., Morgan Stanley took a frontal approach to the pricing process. When the firm considered raising the offering price as high as $38 a share and increasing its size, other bankers pushed back. They worried that the company’s growth prospects did not support such lofty valuations.
Some bankers were also troubled by the huge demand from individual investors, a relatively capricious group. While Facebook allocated most of its shares to big, institutional investors like mutual funds and hedge funds, it also gave a larger-than-usual block, close to 25 percent, to ordinary investors.

But then, how much real sympathy should we extend to individual investors. Why does anybody think they’re smarter or wiser than all those big brains on Wall Street? I’m always intrigued by these individuals who follow the developments of these offerings, hear the push-back from bankers about the pricing and then think they know better and go ahead and buy anyway? Seems to either be an incredible arrogance or a severe case of wishful thinking. People have gotten burned in the market before- and yet many don’t learn their lessons. So perhaps the consequences they suffer are simply their just desserts?

Around the same time, red flags emerged about the company’s growth prospects. On May 9, Facebook revealed in a regulatory filing some potential challenges to its growth. In particular, the company highlighted that users were increasingly using Facebook on mobile devices, but the company was not making much money on mobile ads.
Even after some analysts revised their expectations downward, underwriters were inundated with orders. Demand from American investors alone exceed the number of shares by 20 times.

On Thursday, top bankers and Mr. Ebersman held discussions on a final price. The bankers were looking to orchestrate a “pop” of 10 percent, but not more than 20 percent. The underwriters, who at one point discussed a price as high as $40, settled on $38 a share. Mr. Ebersman signed off.

“The demand was astronomical,” said a banker involved in the process who spoke on the condition of anonymity. “We were all trying to thread a needle.”

On the day of the debut, last Friday, the mood at Facebook’s campus in California and at Nasdaq’s market site in Midtown Manhattan was jubilant. Nasdaq’s chief executive, Robert Greifeld, had flown to Menlo Park, Calif., to stand by Mark Zuckerberg as he rang the bell. In New York, Nasdaq and Facebook officials had Champagne on hand to commemorate the moment.

The celebration didn’t last.

Institutional investors began calling underwriters for guidance on where Facebook shares would open. Early market whispers had pegged the price at $50 a share. By 10:45 a.m., that fell to $45. Then $43. Then $42.
Investors were already uneasy, with many having received far more shares than expected. To some, that portended growing troubles with the offering — and made many consider selling their entire investments.

A few minutes before 11 a.m., Nasdaq advised of a five-minute delay, typical for an I.P.O. When Facebook still hadn’t started trading at 11:05 a.m., investors grew even more nervous. After switching software, Nasdaq was able to open Facebook manually at $42.05 at 11:30 a.m.
But Facebook shares quickly began to tumble. One investor, after being briefed on Facebook’s revised forecast, unloaded all of its holdings in the first hour of trading, according to Scott Sweet, founder of the IPO Boutique, who advises mutual funds, hedge funds and individuals. The investor sold hundreds of thousands of shares at about $42.

“They knew the jig was up,” Mr. Sweet said.

stock brokerage firms, which had been besieged by customers seeking a piece of Facebook, were overwhelmed as well. Customers of Just2Trade, a discount broker with hundreds of orders lined up by 11:30 a.m., received an unusual message notifying that its orders were still open.
As investor calls began flooding the broker’s offices, Just2Trade tried to contact Nasdaq and Wall Street brokers. The exchange didn’t respond; the Wall Street firms said they had no clarity from Nasdaq.
“I have never experienced this before,” said Fuad Ahmed, Just2Trade’s chief executive. “You are driving a car with a broken windshield. You have no idea what was happening.”

At Morgan Stanley, the situation grew tense. The din of shouting and barked orders echoed across the trading floor, with several of the top bankers on the deal gathering to monitor the erratic trading. As the stabilization agent, the firm was tasked with keeping Facebook shares from falling below their offer price of $38 a share. But the market problems only made Morgan Stanley’s job more difficult.
Shares of Facebook ended the day at roughly the same place they started. Now as controversy swirls around Facebook and its bankers, the uncertainty could cloud the stock, as well as the broader I.P.O. market.
“There is a stigma around a broken deal, and Facebook is a broken deal,” said Connor Browne, a managing director for Thornburg Investment Management.

Will anybody learn from this? Likely not. Like the gambler whose losses don’t convince him that maybe the house always wins, many of these investors will chalk this up to bad luck and wade in again the next time they dream of the next big thing. For many of those investors who were skeptical about the investing world, this will only serve to reinforce their lack of trust in the sector.

Reporting was contributed by Nathaniel Popper, Jeffrey Cane, Nick Bilton and Susanne Craig.

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