Wednesday, June 07, 2006

Weak Signal, Dropped Call: The Vonage IPO Securities Litigation

Vonage Holdings Corp.’s May 24, 2006 IPO raised hundreds of millions of dollars of capital. It has also generated extensive negative press, as exemplified by the June 3, 2006 front-page article (subscription required) in the Wall Street Journal entitled “How Vonage’s IPO Stumbled.” To add injury to insult, the company, several of its directors and officers, and its offering underwriters have been sued in a purported securities class action lawsuit filed in United States District Court in New Jersey. The lawsuit was filed on June 2, 2006, only ten days after Vonage’s debut (which undoubtedly is the shortest interval between IPO and lawsuit since the Refco fiasco). The lawsuit (and indeed much of the adverse publicity) is focused on the somewhat unique Directed Share Program by which Vonage pre-sold 13.5 million of the offering shares to its own customers. The Complaint accuses the defendants of a number of errors or violations in connection with the Directed Share Program.

There are several interesting things about the Vonage IPO lawsuit. The first is that the lead law firm is not one of the usual plaintiff’s class action securities firms, but is the Motley Rice firm, best known for its prominence in asbestos and tobacco litigation. Perhaps the Milberg Weiss firm’s woes are encouraging opportunistic competition. Indeed, another law firm on the Complaint, Kahn Gauthier Swick, is also best known for its attorneys' prior involvement with tobacco litigation, and was the subject of a prior D & O Diary post for the firm’s activities in connection with options backdating investigations.

Another interesting thing about the Vonage IPO securities lawsuit is that even though the Complaint’s grievances center on the alleged malfunctioning of the Directed Share Program, the purported class on whose behalf the lawsuit supposedly is brought is not limited just to the Vonage Customers who participated in the Directed Share Program, but purports to include all investors who purchased shares in the offering. The implication seems to be that all IPO investors feel the pain from the alleged Customers’ Directed Share Program malfunction.

The third and most interesting thing about the Vonage IPO Securities lawsuit is its reliance on the defendants’ alleged violation of NASD Rule 2310, the so-called “suitability” rule. The rule requires anyone recommending a security to “have reasonable grounds for believing that the recommendation is suitable” for the customer based on the customer’s “other security holdings…financial situation and need.” The Company defendants are alleged to have violated Rule 2310 because they supposedly allowed (encouraged) its customers to purchase shares regardless of suitability. This alleged violation is stretched to the Offering Underwriters, because they allegedly were responsible for ensuring that Vonage complied with NASD Rule 2310.

While the seasoned tort lawyers who filed the Vonage securities lawsuit score points for creativity in their foray into the securities arena, their overall theory (at least to the extent it relies on NASD Rule 2310) strikes The D & O Diary as ultimately deficient on several grounds. Even if the defendants violated NASD Rule 2310, the aggrieved persons' remedies are under the NASD Rules themselves (presumably, some form of arbitration or even some kind of NASD disciplinary action), not an action for damages under the securities laws. There is no separate private right of action for damages under the securities laws for NASD Rules violations, and there is to the knowledge of The D & O Diary no authority to support the notion that NASD Rule 2310 has been incorporated as a substantive standard under the federal securities laws, violation of which gives rise to a claim for damages.

The ultimate deficiency with the plaintiffs' attempt to bootstrap an alleged violation of NASD Rule 2310 into a damages claim under the federal securities laws is that, even if there were a violation of NASD Rule 2310, the alleged violation is still missing the indispensable element to support a securities action. That is, what the securities laws protect against is misrepresentations or omissions. A violation of NASD Rule 2310, while arguably grievous, does not establish the existence of a misrepresentation or omission.

Setting aside the merits of the lawsuit, there are the merits of the IPO itself to be taken into account. The risk factors in Vonage’s Prospectus make for some interesting reading. Not only has the company consistently incurred losses since its inception (with an accumulated deficit through March 31, 2006 of $467.4 million), but its service prices “are lower than those of many competitors for comparable services,” and the Company anticipates that “prices will continue to decrease.” Most interestingly, the Company’s founder, Chairman and “Chief Strategist,” is Jeffrey A. Citron, whose prior association with Datek Online resulted in his paying $22.5 million in civil penalties, “among the largest fines ever collected by the SEC against individuals,” according to Vonage’s Prospectus.

So cue the whimsical Vonage jingle tune, and just recall what Vonage itself says in its ads about the kinds of things people do.

Marginal Note: An alert D & O Diary reader points out that in February 2006, Motley Rice opened an Atlanta office and started a securities litigation practice by luring four securities class action attorneys from the Chitwood Harley Harnes firm. Chitwood Harley Harnes promptly sued the four lawyers and their new firm.

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