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States Attorneys General Square Off Against Facebook

Should investors view this as a political Keystone Cops episode, or is there real cause for concern?

Recently, a group of states Attorneys Generals (AG’s) announced that they would be conducting their own investigations against Facebook for possible violations of anti-trust and consumer protection statutes. The efforts of the states AG’s will coordinate and complement the anti-trust inquiries currently underway by the Justice Department.

Although the market seemed to respond to the announcement of the consolidated legal effort with indifference or outright dismissal, the joint state effort could substantially heighten the liability exposure of not only Facebook, but also, the other tech giants as well.

There are a number of reasons why the new wave of investigations will subject Facebook to enhanced risks the company has avoided – or fortuitously dodged — to date.

The $5 billion fine the FTC levied against Facebook recently shouldn’t be used as a basis for minimizing the exposure of the company. There were a number of unique factors in the FTC proceedings that circumscribed or limited the Commissions ability to assess a more punitive fine. First, there was the unavoidable bureaucratic turf war between the FTC and the Justice Department concerning jurisdiction over unfair competition cases.

Secondly, the FTC settlement was limited to determining a fine appropriate for Facebook’s breach of a previous consent decree regarding user privacy, and was subject to statutory limitations by which the AG’s actions will not be bound.

Lastly, there was a component of the FTC’s settlement that was unavoidably political: there was a split between the Democrat and Republican members of the Committee. Democrats believed the $5 billion fine was de minimis for a $527.4 billion company; Republicans believed the amount of the fine was sufficient to send a message concerning privacy abuses. Additionally, the amount of the fine, to some degree, was an attempt by FTC chairman Joseph Simons, to present to the public a consensus decision between all members of the Committee.

The AG’s efforts against Facebook will not be similarly constrained by such political considerations.

Indeed, the states’ joint investigations is a bipartisan effort. It is significant to note that only 20 states were involved in the Microsoft anti-trust case; attorneys general from 50 states will be subjecting Facebook to intense scrutiny, with subpoena powers at their disposal. It is truly a rare political event, when Democrats and Republicans both agree on a course of action to be pursued against a corporation that enjoys a dominant market position in its industry. This factor, in and of itself, should worry not only Facebook and other tech companies, but investors as well.

Many investors and financial journalists who use the Microsoft case as the template to support their belief in Facebook’s limited anti-trust liability, seem to take comfort in the outcome of that case decided more than three decades ago. While there are those who claim that any Justice Department anti-trust action against Facebook is destined ultimately to result in a Microsoft-like settlement, that preserved

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the company, an anti-trust case against Facebook is likely to be qualitatively and legally distinguishable from facts surrounding the Microsoft action.

Although Microsoft itself remained intact, there were changes made to its business model that facilitated new start-up companies. For Microsoft, these modifications to its business model or business operations did not substantially impair its fundamental operations that drove its revenue. The risks to Facebook are that any revisions to its operations in any settlement agreement with the states, that impairs or circumscribes, its unfettered ability to sell users data, could potentially be significant and deleterious to its earnings growth, which is at present, entirely dependent on advertising revenue. Facebook is a giant advertising platform which exposes it to anti-trust risks with which Microsoft never had to contend.

Additionally, the states could seek remedies against Facebook based on an entirely different legal cause of action based on their unfair and deceptive trade practices statutes which would examine the propriety of failing to disclose to consumers the extent of data the company was harvesting and the number of third parties, particularly app developers, to whom it was transferring that information and the likely risk of a concomitant data security breach.

New York state’s attorney general, Letitia James, announced another separate and distinct multi-state probe to determine whether Facebook’s misappropriation of its users’ private data harmed consumers and the tech advertising market. This is an entirely different legal theory, with its own distinct remedies, that could subject Facebook to additional fines or constraints to its existing business model.

Over the past two years a consensus has been building among legislators, regulators and privacy advocates, that the deceptive practice of data harvesting, needs to be circumscribed. Europe is leading the way in terms of data privacy protections afforded users. The U.S. is playing catch-up ball, but undoubtedly will eventually mirror Europe’s privacy provisions, in whole or in part.

Investors and financial journalists, who view the latest legal actions against Facebook as a $5 billion FTC fine redux, might want to reassess the new risks these joint investigations present to the company.

This article appeared originally in GuruFocus, a value investing site

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