Legal battles over Facebook Inc.’s initial public offering continue to dog the social media company and its bankers, which tried and failed to escape a consolidated securities class action over the IPO in December. But Davis Polk & Wardwell chipped away at the litigation on Friday, defeating an investor lawsuit alleging that Facebook’s underwriters improperly earned $100 million in so-called short-swing profits.
U.S. District Judge Robert Sweet in Manhattan ruled that the underwriters—Morgan Stanley & Co., JPMorgan Chase & Co. and Goldman Sachs & Co.—don’t need to disgorge profits earned by quickly buying and selling Facebook stock in the months after the May 2012 IPO.
The plaintiffs firm Abraham Fruchter & Twersky argued that the transactions ran afoul of Section 16(b) of the Securities and Exchange Act, which curbs insider trading by requiring large shareholders to disgorge profits from short-swing transactions (defined as the sale and subsequent purchase of stock within a six-month period). Sweet disagreed, writing that underwriters never had a large enough stake in Facebook to trigger disgorgement under Section 16(b).
On the day of Facebook’s IPO, the company’s stock was selling for $38 per share. The stock price jumped to $45 during early trading, but it eventually dropped dramatically amid reports that Facebook was struggling to turn increased mobile usage into advertising revenue. In the months that followed, the underwriters sold Facebook stock at a profit. These stock sales had the effect of helping to stabilize the company’s volatile stock price.
In the wake of the stock drop, the plaintiffs securities bar brought several lawsuits on behalf of Facebook investors, which were consolidated into multidistrict litigation before Judge Sweet. The suits primarily accuse Facebook and its underwriters of misleading small-time investors about the troubling mobile usage figures. Sweet threw out derivative claims over the IPO early last year, but he ruled in December that investors could pursue claims under Sections 11, 12, and 15 of the Securities Act of 1933.
In June 2013, Abraham Fruchter & Twersky tried its luck with a Section 16(b) case against the underwriters, arguing that the banks “earned a reported additional $100 million in short-swing profits by selling Facebook stock short at $38 per share and then buying back Facebook stock at lower prices in the open market following its price collapse.” The suit is the only Section 16(b) case in the Facebook IPO MDL.
The plaintiffs firm faced a couple of big obstacles. For one thing, it’s common practice for underwriters to cover short positions in order to stabilize a company’s stock price. For that reason, the Securities and Exchange Commission exempted underwriting activities from Section 16(b) disgorgement, so long as the underwriters are acting in good faith. In hopes of getting around the underwriter exemption, plaintiffs counsel segued back into the familiar arguments that the IPO was fundamentally unfair. “There is nothing normal about short sellers having superior access from corporate insiders to material information than the retail investors who were on the long side of the short trades,” the lawyers wrote.
In Friday’s ruling, Sweet didn’t reach the issue of whether the underwriters acted in bad faith. Instead, siding with the bank’s lawyers at Davis Polk, he tossed the case on the grounds that the underwriters didn’t have large enough stake in Facebook to qualify as the sort of insiders covered by Section 16(b). The provision only applies to directors, officers and “beneficial owners of more than 10 percent of any class of equity securities of a publicly traded corporation.” That 10 percent threshold wasn’t met, Sweet concluded, brushing aside an argument that the underwriters conspired with each other and with Facebook shareholders and should therefore be treated as a single group.
Jeffrey Abraham of Abraham Fruchter & Twersky declined to comment. Davis Polk partner James Rouhandeh, who represents the underwriters, also declined to comment.
Facebook, which was a nominal defendant in the Section 16(b) case, is represented in the MDL by Willkie Farr Gallagher and Kirkland & Ellis. Labaton Sucharow and Bernstein Litowitz Berger & Grossmann serve as co–lead plaintiffs counsel in the consolidated litigation.