Beware small investors: Facebook was just a warning

Facebook's IPO was all the rage Friday. Retail investors -- people like you, me and our neighbors -- flocked to the offering in hopes of returning to those glory days when a dramatic rise in stock price was a given.

But, alas, like so many recent IPOs, Facebook languished near its offering price on its first day and dropped on subsequent days of trading.

It could have been worse.

Disgruntled investors had ample opportunity to sell Friday afternoon once technical issues at Nasdaq were resolved. Those who chose to sell did so at a profit.

Investors in some other IPOs never have the chance to recoup what they put in. For example, PetroLogistics, a company that owns the world's largest propane processing plant, began trading below its offering price in early May. Nearly a month later, the stock still trades below what original investors paid.

So if profits aren't guaranteed, why the uproar over Facebook's IPO? Because an analyst at Morgan Stanley, the investment bank which set the offering price, released a report lowering the financial forecast for the company just before the offering. Angry stockholders allege the report was released only to a select circle of institutional investors, who then headed for the door. Consequently, most investors were left to shoulder the loss.

Why is Facebook being sued?

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If this feels unfair to you, you're not alone. After all, why should you have to lose out?

After the dot-com crash, WorldCom and Enron, Congress included provisions in the much maligned Sarbanes-Oxley legislation to address potential conflicts of interest. Among other things, the bill led to a so-called "Chinese Wall" separating communication between investment bank research analysts and underwriters.

However last month a bipartisan bill, innocuously named the JOBS Act, rolled back these and other investor protections for companies with less than $1 billion in revenue, deemed emerging growth companies. Once again, research analysts can communicate directly with management and if desired share favorable (or unfavorable) reports.

Under these new rules it is only a matter of time before an enterprising young analyst crosses the line and writes an ethically questionable report.

Prior to Sarbanes-Oxley, researchers at Cornell and Dartmouth universities found that analysts affiliated with the underwriting bank issued buy ratings to prop up dropping stocks, only to watch the stocks drop further after the buy rating was issued. This was in direct contrast to reports written by unaffiliated analysts, where stocks rose following a buy rating. The differences in performance were staggering.

For markets to function effectively, investors need to trust the information reported by companies, and research analysts need to be able to act independently. Investors should remember that any stock can lose value no matter how much hype surrounds the company, and that research analysts have many bosses -- not just the small investors on the streets.

Congress must create a level playing field such that every investor has a fair shake, not just those who have special access. Facebook was just a warning. The real risk lies in the countless other IPOs less likely to receive so much scrutiny and spotlight.