The biggest problem with Facebook Inc.’s botched IPO isn’t that there was no first-day “pop.” Or that the shares went into free fall over the next few days. It’s what it might do to investor confidence.

Facebook’s initial public offering shows how broken the process has become, and we don’t say that just because technical glitches plagued it from the very start on May 18. There were flaws in building the order book, distributing information to potential investors, pricing the shares and setting the size of the float. It’s too soon to tell whether laws or rules were violated. But it’s not too soon to review some basic principles:

-- Follow the Law. This is obvious, but it bears repeating: Securities laws are clear about the do’s and don’ts of IPOs. Important information must be in the prospectus, and shouldn’t be revealed during roadshows. The Securities and Exchange Commission rightly considers the prospectus almost like a sacred document. It must be on file with the agency and updated regularly -- no excuses allowed.

The SEC’s Regulation Fair Disclosure, aka Reg FD, requires that company guidance be made available to all, not just to selected analysts who can then pass it on to major investors. It certainly shouldn’t be whispered to analysts working for the banks running the order book.

Reg FD

News reports allege that Morgan Stanley, the chief underwriter, did just that. (The company denies it.) But if its analysts independently scoured the prospectus, crunched the numbers and decided Facebook’s stock was overpriced, that’s not only legal, it’s encouraged by Reg FD. Facebook, did, in fact, file a revision to its prospectus on May 9 that said the company’s ad-sales growth wasn’t keeping up with its user-base expansion. That disclosure was public, if not exactly prominent. (It can be found on Page 57 of the company’s S-1.)

If, however, Facebook urged analysts to lower their revenue and earnings forecasts, and the information was relayed only to a select group of clients, that would raise legal issues. When an investment bank has material information not in the prospectus, and tips off analysts, knowing they will tell clients, that’s a misuse of information and could even be criminal insider trading.

-- Underwriter, Earn Your Fee. The job of the underwriter is to know the company and know the market for its shares. That means drumming up commitments from pension plans, mutual funds, hedge funds and other institutional investors, while also making sure the little guy has a chance to get some shares.

It means testing various prices and share allotments to see what the market will bear. It also requires some skepticism about your own hype, so you can hear what short-sellers are saying; their analysis can drive down the price.

A successful IPO should adhere to the Goldilocks ideal: not too hot, not too cold. A big first-day pop is a sign of poor underwriting, as is a post-IPO price plummet. Valuations are never perfect, but Morgan Stanley surely got this one wrong. A company’s value must be based on a demonstrated ability to generate sales and profits. It can’t be faith-based.

After first saying they would set the price between $28 and $35 a share, Morgan Stanley and Facebook executives decided the stock was worth $38 a share, which amounted to a $105 billion valuation. They also added 25 percent more shares to the float at the last minute, possibly flooding the market. It was the job of the underwriters to warn Facebook if demand for the shares couldn’t support such a large float.

Unconvinced Investors

When the share price dropped as soon as it began trading, it was evidence that investors didn’t believe Facebook is a $105 billion company. Morgan Stanley should have sussed that out beforehand.

-- Buyer Beware. Investors caught in the backwash of the Facebook IPO must share some of the blame, especially if they thought they could make a fast buck by flipping the shares. Many IPO investors are left with paper losses now that the shares are trading well below the $38 price. The lesson: Read the prospectus, financial statements and, yes, press clips about the company. When the price and size of an IPO are increased, but the company’s rate of revenue growth is slipping, that’s a bad sign.

A simple price-to-earnings calculation would also have raised a bright red flag. At $38 a share, Facebook has a P/E (a measure of how much profit a share buys) of almost 100 times projected earnings for the next 12 months. By comparison, Google Inc. trades at 13 times earnings.

-- Stock Exchange, Heal Thyself. Nasdaq, the exchange where Facebook’s stock is listed, wasn’t prepared for the high volume of trades. Technical problems prevented some investors from getting confirmations that their trades went through or were canceled. There was a five-minute delay, then a 25-minute delay as Nasdaq switched to a backup computer system. A technology upgrade seems in order. The exchange also may have been overtaken by a flood of orders from high-frequency traders. If so, it may be time for the SEC to control the trade-bots.

Friday was a good day for Facebook insiders, who managed to sell $16 billion worth of shares at a very high price. But the days that followed haven’t been good ones for the market’s reputation. Individual investors haven’t returned to the stock market since the 2008 financial crisis; the Facebook fiasco gives them another reason to keep their distance.

An IPO ought to leave investors confident that the system of share allocation is fair, the price is right, and the company is forthright. The Facebook IPO achieved none of these goals. The good news is that individual investors who were denied a piece of the IPO can now buy Facebook shares for about $32. For once, they were the smart money.

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Today’s highlights: the View editors on how Germany gained from the euro; Clive Crook on Europe at the brink; Jonathan Alter on political substance and slander; Ezra Klein on the fight over Bain; Caroline Baum on overregulating banks; Tobias Moskowitz on data-driven policy; Panagis Vourloumis on Greek shock therapy; Junheng Li on China’s economic misinformation.

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