Vonage Class Action: What's the Damage?

Vonage Holdings Corp. (NYSE: VG) could be forced to indemnify its IPO underwriters for as much as $70 million, as many of its customers are suspected to have reneged on commitments to buy stock.

So say lawyers who last week filed an investor class action suit against Vonage in New Jersey district court. (See Vonage Gets a Haircut.)

News emerged last week that many Vonage customers who bought stock reserved for them in a customer stock program may have defaulted on paying for the shares.

Vonage reserved roughly 13.5 percent of its IPO shares for its customers, and gave them three days to settle up after they agreed to purchase them. But within that three-day window, Vonage's stock slipped 26 percent to $12.50.

Vonage said last week it would indemnify its underwriters for IPO shortfalls caused by Vonage customers defaulting on payment. (See Vonage Falls Hard & Fast in Public Debut.)

But how much could that potentially cost Vonage in a worst-case scenario?

If a Vonage customer commits to buy a certain amount of stock at the $17 opening price and then reneges, the underwriter is most likely to sell the stock into the market to recoup some of the loss, explains David Menlow, president of IPO Financial Network. The problem is, the market price is now down around $12, Menlow says. "So Vonage would cover that $5 gap, less an underwriting fee."

According to the Vonage S-1, that underwriting fee is roughly $1.25 per share. If Vonage had to pay the underwriters $3.75 ($5 minus $1.25) for every share of the some 4.2 million that were reserved for customers, it would give up roughly $15.75 million of its IPO proceeds to pay the underwriters.

The 4.2 million shares Vonage set aside for customers represents about $71.5 million of the $531 million IPO (14 percent), according to numbers from American Technology Research .

Vonage sold a total 31.25 million shares -- about 20 percent of the company -- in the IPO, raising badly needed capital.

The firm believes somewhere between 5,000 and 10,000 Vonage customers bought stock under the purchase program.

Attorneys in the class action suit take a very cynical view of Vonage's motivations for creating the customer stock purchase program. The suit suggests Vonage and its underwriters attempted to build customer excitement over the stock as a replacement for institutional excitement, which was lacking.

"Unbeknownst to the public investors who purchased shares in the Vonage IPO, in racing to create a public market for shares of the Company before its core technology and services became virtually worthless, and before insiders lost their half billion dollar investment, defendants had improperly stuffed customer accounts full of IPO shares," reads the complaint, which was filed in a New Jersey district court last Friday.

Motley Rice, the South Carolina-based law firm that brought the suit, believes that "hundreds or thousands" of Vonage customer-investors might be eligible to join the class action. A Motley Rice spokeswoman was unclear on how many Vonage customers had joined the suit so far.

Vonage's IPO price was set at $17 a share but lost about 30 percent of its value in just a week of trading. As a result, Motley Rice says, roughly $170 million of investor capital has been lost. (See Vonage Targets $500M From IPO.)

The firm and its lead plaintiff, somebody named Roy Bradley Lang III, are suing Vonage for "making false and materially misleading statements in the registration statement and prospectus." (See Vonage S-1 Nuggets.)

Motley Rice attorneys also hope to prove that Vonage shirked its responsibility under securities law to make sure individual customers were "suitable" to buy stock. This, Motley Rice asserts, could have been established by a review of the customers' income statements and credit ratings.

American Technology Research analyst Albert Lin is skeptical of the idea that Vonage created the customer stock purchase program only to inflate the stock price.

"It has been our impression that well before the deal's road show was underway (to institutions), that up to 15 percent of the shares would be sold to customers and retail owners to keep in the spirit of being the 'anti-establishment' company that Vonage holds itself out to be in the telecommunications industry," Lin writes in a brief.

A Vonage spokeswoman said her company had not received a copy of the suit and therefore could not comment.

The IPO was underwritten by six financial institutions, including Deutsche Bank AG , UBS AG , and Thomas Weisel Partners .

— Mark Sullivan, Reporter, Light Reading