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From Securities Regulation Daily, August 28, 2015

Facebook-type lock-up does not implicate short-swing profit concerns, SEC argues

By John M. Jascob, J.D., LL.M.

The SEC has advised a federal appellate court that the type of lock-up agreement entered into between Facebook, Inc. and its underwriters does not implicate short-swing profits concerns under Exchange Act Section 16. In an amicus brief filed at the request of the Second Circuit, the Commission advised that: (1) typical lock-up agreements with underwriters are not sufficient, by themselves, to establish a “group” for purposes of determining beneficial ownership; and (2) an underwriter is entitled to rely on the exemption under Rule 16a-7, even though the underwriter has obtained material non-public information, so long as the underwriter’s activities are conducted in connection with its participation in a bona fide public offering (Lowinger v. Morgan Stanley & Co., August 25, 2015).

Background. Facebook had enlisted the services of Morgan Stanley & Co., J.P. Morgan Securities, and Goldman Sachs & Co. (the underwriters) to underwrite its May 2012 initial public offering. Prior to the IPO, the underwriters entered into lock-up agreements with the selling shareholders, committing the selling shareholders not to sell Facebook shares for set periods of time after the IPO without Morgan Stanley’s consent.

On May 9, 2012, Facebook disclosed that increased use of mobile devices, which at the time did not display advertisements, could impact revenue. Facebook also allegedly informed “select investment bankers and their securities analysts” about the revised lower projected revenue, after which analysts for the underwriters then revised their revenue estimates downward in response, but allegedly told only a few “major clients” of the changes. Retail investors purchased Facebook stock while being unaware of these facts, driving up the price. The underwriters allegedly secured $100 million by selling short Facebook stock and then buying it back after the price fell.

Facebook shareholders then sued the underwriters, alleging that they had violated Exchange Act Section 16 by acting as a “group” with the selling shareholders within the meaning of Section 13(d) and that the underwriters had engaged in prohibited short-swing trading as beneficial owners. The Southern District of New York, however, rejected the shareholders’ contention that the lock-up agreements showed that the underwriters and the selling shareholders had formed a “group” for purposes of Section 13(d) and Section 16. The court also found that the shareholders did not adequately allege that the underwriters were beneficial owners of Facebook stock for purposes of short-swing liability.

Lock-up agreements. In its amicus brief, the Commission explained that, standing alone, typical lock-up agreements between shareholders and underwriters in connection with an underwritten public offering are not sufficient to establish a group for purposes of Section 13(d) or 16(b). As discussed on the Commission's website, the SEC noted that lock-up agreements are a common, indeed typical, fixture of the IPO process. In the Commission's view, these agreements do not raise Section 13(d) or Section 16(b) concerns because they have nothing to do with potential control, long-term ownership, or evading disclosure rules. Rather, such lock-up agreements facilitate the offering process by maintaining an orderly market and preventing a rush of pre-IPO shares from exerting downward pressure on the market price of the newly issued shares.

The Commission cautioned, however, that circumstances could exist such that a lock-up agreement may constitute supporting evidence of the establishment of a group. Atypical language in the lock-up agreement, or other facts and circumstances outside of the lock-up agreement, could demonstrate that the parties to an agreement share a common purpose sufficient to establish a group. Accordingly, whether a lock-up provision creates a Section 13(d) group depends on the specific facts and circumstances of any given case, the Commission stated.

Short-swing profit rule. The Commission next explained that Section 16(b)’s short-swing profit rule does not apply to sales and purchases made pursuant to a bona fide underwriting. An underwriter’s transactions are exempt from Section 16 liability as long as the underwriter acts as a conduit, rather than as an investor. By contrast, sham transactions, where an underwriter is simply a disguised investor or engages in transactions for a purpose other than to conduct an orderly underwriting, are not exempted.

In addition, an underwriter’s access to material non-public information does not affect eligibility for the exemption, the Commission stated. The Commission believes that, despite the potential for access to inside information, an underwriter’s sales and purchases do not lend themselves to the speculative abuse Section 16 was designed to prevent. Rather, such activities are designed to facilitate public offerings. Rule 16a-7 thus reflects that policy by broadly exempting an underwriter’s transactions in the secondary market that are intended to stabilize the market price, even though the underwriter is presumed to have access to inside information.

The Commission noted that the plaintiffs’ complaint did not appear to allege that the underwriting of the Facebook IPO was a sham or that the underwriters entered into it for a purpose other than the orderly distribution of Facebook stock. Rather, the complaint essentially alleged that the underwriters should be considered not to have been acting in good faith because they may have violated the antifraud provisions of the securities laws. If so, the Commission observed, the complaint disregards the fact that Congress has provided other remedies to certain problems stemming from the abuse of inside information, such as general antifraud statutes that proscribe insider trading.

The case is No. 14-3800-cv.

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