SAN FRANCISCO (MarketWatch) — The controversy over Facebook Inc.’s initial public offering touches on language used in regulatory filings called “risk factors.”

Essentially, it’s where a company going public warns about pretty much everything that could go wrong in its business.

Facebook FB, +1.93% always has been clear about one “risk factor”: Its ability to make money in the mobile market is, as the company said repeatedly in regulatory filings, “unproven.”

But in an amended IPO prospectus on May 9, nine days before its debut, Facebook included a change in language that some analysts say wasn't such a big deal — but that some business-law experts now argue was significant, in light of allegations that the company and its underwriters misled investors. The change was made after the company already had kicked off its investor road show leading up to the public offering.

In the amended filing, the company noted “an increased usage of Facebook on mobile devices” that it believed “has contributed to the recent trend of our daily active users increasing more rapidly than the increase in the number of ads delivered.”

The disclosure prompted some analysts to revise their financial estimates. One of them was Susquehanna analyst Herman Leung, who put out a note trimming his revenue targets for Facebook. “Simply put,” Leung wrote, “this means lower ad coverage for higher usage on the platform.”

Michael Pachter, a Wedbush analyst, said that with the disclosure, Facebook “merely clarified the obvious.” He maintained his bullish outperform rating on the stock.

“It was patently obvious that mobile cannot monetize as well as desktop, so the update was not surprising at all,” Pachter told MarketWatch via emailed comments. “I thought they did it because of something they said in their road-show video, and assumed that their lawyers required them to make it clear that mobile-ad revenues would not grow as rapidly as desktop.”

The effect of the disclosures, in what has become one of the most controversial stock debuts in recent memory, is a matter of debate.

Facebook’s much-anticipated IPO has been considered a disappointment, with the shares closing only slightly higher on their first day, and slipping more than 16% below the IPO price as of Friday afternoon.

Who knew what when

Some legal experts said that making the disclosure so close to the IPO date raises serious questions.

For one thing, the meaning of that disclosure may not be readily obvious to a specific group — such as retail investors, who were swept up in the hype surrounding the IPO, but weren't privy to the higher-level advice and analysis available to large investors.

Most retail investors probably didn’t even read the amended filing, according to Thomas Bowers, a business-law professor at the Kelley School of Business at Indiana University, who noted that IPO filings are typically long and boring. “They start reading it and they fall asleep,” he said.

But Bowers argued that, given the importance of the disclosure, Facebook should have delayed the IPO to give investors more time to digest the new information.

Prof. Stephen Diamond of Santa Clara University also questioned the timing of the disclosure. “There’s all this hype built up for months,” he said, “and then eight to nine days before the actual offering they drop in three sentences, and we’re supposed to expect ordinary investors to figure out what it means?”

Diamond added that the meaning of the change was significant in terms of how Facebook’s business prospects in the mobile market could be viewed. “The change was from, ‘This is a possibility and if it happens, it will be bad for us,’ to ‘This is happening,’” he said.

Hulbert: Facebook should be $13.80

That information, which had not been mentioned as of the previous amendment on May 3, should have been made public earlier, according to Diamond.

“The question is: Did they know on May 3 that this problem existed and they only disclosed on May 9?” Diamond said. “To convince me that they didn’t know this on May 3 and they all of a sudden knew about this on May 9 is beyond belief.”

To be sure, analysts long have highlighted the mobile market as a potential weakness for Facebook, whose revenues are still derived mainly from display ads shown on the social network’s pages.

Mobile ads are viewed as the next major battleground for Internet companies. This is underscored by Facebook rival Google Inc.’s GOOG, +0.32% aggressive push with its Android mobile operating-system software, widely used in smartphones and tablets, and its recent acquisition of Motorola Mobility.

Kelley School’s Bowers also said investors could claim that, given the May 9 filing’s emphasis on the number of active monthly users on Facebook, “the emphasis given to this negative information is inadequate.”

They could also argue, he elaborated, that “the positive information about ad revenue previously given and the emphasis in color graphics inside the front cover of the number of users is misleading, in light of the additional information regarding how some of those 901 million monthly active users are accessing, and will likely in the future access Facebook.”

Degree of disclosure

The issue of the disclosure has been highlighted by media reports that some of the IPO underwriters, including Morgan Stanley, cut their revenue forecasts for the company before the IPO, based on worries about Facebook’s mobile business, but made this known only to some clients.

Facebook declined to comment for this story. In a statement, a Morgan Stanley representative had said it had forwarded Facebook’s May 9 amendment to all of its institutional and retail investors.

Facebook and favoritism on Street

“The amendment was widely publicized in the press at the time,” the statement went on.

Morgan Stanley also said that, because of the new information from Facebook, “a significant number of research analysts in the syndicate who were participating in investor education reduced their earnings views to reflect their estimate of the impact of the new information.”

Whether Facebook or Morgan Stanley, as the lead IPO underwriter, should have publicly disclosed the analysts’ revised estimates is unclear, experts say.

“One of the things at issue is whether or not the analysts got additional color or additional information beyond that little disclosure that led them to lower their estimates,” said Robert Daines, a professor at Stanford Law School.

But it isn’t clear if Facebook or its underwriters are required to disclose the interpretation of new information the company’s disclosed. “There’s some gray area here,” he added.

Facebook could contend that the company’s May 9 amended filing had enough information to let investors know what was going on. “The information was out in the marketplace,” Bowers suggested.



Prof. Stephen Diamond of Santa Clara University also said that there is “no specific requirement that they disclose what other people are saying about their stock. … There is no rule which says analysts’ oral conversations with their clients must be placed in a prospectus. That does not exist. What does exist is the general principle that all material information must be disclosed.”

One thing’s that is clear, Diamond added, is that Facebook faces an “existential problem” with its business model. “It was a gathering storm… They knew what mobile was doing. It was eating away at its business model.”

