Are Internet telephony companies a good investment? Perhaps not–or perhaps just not yet.

Atlanta-based law firm Motley Rice has filed a class action against Vonage, on behalf of shareholders who bought stock in the Internet telephony provider prior to its intial public offering on 24 May, and have already lost a great deal on their investment. Filed on Friday 2 June in the US District Court for the District of New Jersey, the suit alleges that investors were mislead by the company, its officers, and certain underwriters of the IPO, when they were offered shares in the company.

According to Motley Rice, the complaint alleges that Vonage had spent “hundreds of millions of dollars” to market VoIP and related services to customers in the United States, Canada, and the United Kingdom. As alleged in the complaint, the rationale for the IPO was to provide an “exit strategy” for investors who were losing money.

Selling share to customers prior to an IPO is not a problem in itself (from a legal point of view). But the circumstances in which those shares were sold may be a problem.

According to the complaint, Vonage and its underwriters violated United States securities laws by pre-selling at least 13.5% of the company’s shares to customers. This action is in itself unusual, but probably would not have attracted any attention had Vonage’s value remained stable. Vonage’s IPO on the New York Stock Exchange raised about US$531 million. Vonage’s stock debuted at $17, but lost 30% of its value in the first seven days of trading. Since the value of the stock has dropped, some of Vonage’s shareholders have threatened not to pay for the shares they were allocated.

The problem, as identified by the complaint, is that Vonage and some of its underwriters may have violated NASD Conduct Rule 2310, which requires that sales recommended to non-institutional customers must be suitable for those customers:

2310. Recommendations to Customers (Suitability)

(a) In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.

(b) Prior to the execution of a transaction recommended to a non-institutional customer, other than transactions with customers where investments are limited to money market mutual funds, a member shall make reasonable efforts to obtain information concerning:

(1) the customer’s financial status;
(2) the customer’s tax status;
(3) the customer’s investment objectives; and
(4) such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer.

(This Conduct Rule is administered by NASD, which is the primary private-sector regulator of U.S. securities markets. )

In short, the complaint alleges that customers were encouraged to purchase Vonage stock, with no attention paid to whether this investment was suitable for those investors. The complaint alleges that Vonage and its underwriters believed that institutional investors (investment banks, mutual fund managers, etc) would be unwilling to purchase the volume of Vonage shares necessary to make the IPO successful, and so decided to sell shares to its retail customers. As commented by Motley Rice,

The complaint alleges that Vonage’s officers decided to offer shares to customers because they knew institutional investors who normally buy IPOs would be reluctant to buy Vonage stock. Vonage has consistently lost money and has never been profitable.

The underwriters have been alleged to be liable not only for permitting these sales, but from allowing the situation to continue when it was clear that the shares were not suitable for non-institutional investors. Both Vonage and the underwriters are said to be motivated by the large amount of money to be raised by the IPO, and the fees for raising that money.

Although not mentioned in Motley Rice’s summary of the complaint, it is likely that the class also alleges that Vonage and the underwriters violated section 10(b) of the Securities Act of 1934. This provision applies to unsuitable recommendations of securities. The test, which hasbeen settled by case law, includes proving that: the investment was unsuitable for the buyer; the seller was aware that it was unsuitable, but nonetheless recommended the purchase and made material misrepresentations in doing so; and the buyer relied on these misrepresentations and suffered loss as a result.

The class action suit seeks damages on behalf of all persons to purchased or otherwise acquired Vonage stock and has suffered financial loss as a result.