What Ignited the Facebook-Analyst Fallout?

Banks underwriting Facebook— or any IPO for that matter — cannot publish proprietary research for 40 days following the IPO. They can, however, be privy to selective financial information regarding earnings guidance in order to begin building models with full-year forecasts.

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That detail is central to conflict-of-interest arguments about whetherMorgan Stanley— embattled lead bookrunner for Facebook’s recent debut — and other banks were allowed to make significant downward adjustments to financial estimates during the 9-day marketing period for Facebook’s deal. Of Facebook’s army of 33 underwriters, only 21 have in-house research analysts covering internet stocks.

Each of these banks was informed of adjusted financial disclosures, and each in return made downward revisions to internal estimates — not just at Morgan Stanley — according to sources familiar with the matter. One source said the banks were informed of the updates on May 9, the same day Facebook updated its S-1 filing more broadly to reflect heightened near-term weakness in monetizing a growing mobile user base.

Can banks then disclose this information to potential IPO investors? Yes, but typically do so orally due to strict regulations on written material and other official "reports".

So what spurred the disclosures?

First, there was a chink in the company’s advertising armor, according to one source. Facebook rolled out its sponsored story product in New York City in March with much fanfare, and was touting the product during a town-hall-esque analyst meeting in Menlo Park weeks later.

At that time, Facebook had high hopes for the product and expectations the product’s rollout could be reflected in revenues in the near-term. In early May, when the company got a better picture of the penetration of the sponsored story product — and also where second-quarter financials were heading overall — it needed to make material disclosures, according to sources.

The media coverage of the S-1 amendment — which said users were shifting to mobile faster than revenues would be able to — was wall-to-wall. But what specifics were the banks given?

Because the company gives them guidance in greater detail, it’s unclear what information made it to which clients and to what extent, since that communication was over the phone. Perhaps the better question is not whether such communication is legal, but whether it should be.

Since only the biggest investors on a deal are typically relayed the new analyst information orally, many investors wind up with a raw deal, remaining clueless about potentially significant research opinions at their own banks. However, that research is barred by regulators from being made public, so an information divide between big and small investors is all but inevitable.

Shareholders have sued Facebook and Morgan Stanley for not disclosing the analyst revisions in filings.

Reported by CNBC's Kayla Tausche and Jesse Bergman