Groupon Faces SEC Probe, Investor Lawsuit as Stock Hits New Low

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Brendan McDermid / Reuters

Groupon Chief Executive Andrew Mason (2nd L) and Groupon's largest shareholder and Chairman, Eric Lefkofsky, (L) have been named in a lawsuit charging that the discount website perpetrated a "fraudulent scheme" on shareholders.

Groupon’s headaches are growing more serious. Just days after an accounting snafu forced the discount website to reveal a greater-than-reported fourth-quarter loss, the company was slapped with a shareholder lawsuit accusing its top executives of a “fraudulent scheme” that “deceived the investing public” about the company’s prospects and business. As if that wasn’t enough, Groupon’s stock hit an all-time low Wednesday and it faces a probe by the Securities and Exchange Commission.

Filed on behalf of Groupon shareholder Fan Zhang, the lawsuit is just the latest of Groupon’s troubles, which date back to well before the company went public. Last Friday, Groupon disclosed that its auditor Ernst & Young found “material weakness in its internal controls” — financial-speak for lax accounting practices. It turns out that Groupon was not setting aside adequate reserves to account for customer returns, which have been increasing as it sells more expensive deals. In response, the SEC has launched a preliminary probe into Groupon’s book-keeping.

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Groupon’s restatement — following repeated accounting gaffes — has renewed questions about whether its financial results can be trusted. The key question is whether the “material weakness in internal controls” that Ernst & Young found existed when Groupon went public, on November 4, 2012, says Reed Kathrein, a San Fransisco-based partner at Hagens Berman Sobol Shapiro.

“If at the time of the IPO there were weaknesses in the internal controls, there is a good argument to be made that the registration and prospectus were false and misleading,” says Kathrein, who specializes in securities fraud and has been examining the Groupon case. “If you don’t have internal controls you can’t rely on the financial statements.”

In an odd wrinkle of securities law, Groupon would not have been required to disclose such an internal control weakness, but if its prospectus contained false or misleading statements, the company, its executives and its underwriters could be liable for damages.

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Groupon’s top executives including CEO Andrew Mason and company chairman Eric Lefkofsky, as well as its Wall Street IPO underwriters including Goldman Sachs, are accused of misleading the public about Groupon’s business to make it more attractive to investors. The IPO produced billion-dollar windfalls for Mason, Lefkofsky and other early funders, and millions in fees for the Wall Street banks that took it public.

A Groupon spokesperson did not immediately respond to a request for comment on the litigation.

Groupon, the lawsuit charges, “issued materially false and misleading statements regarding the Company’s business practices and financial results. Specifically, defendants failed to disclose negative trends in Groupon’s business and made false statements as to Groupon’s financial results. As a result of these false statements, defendants were able to successfully accomplish Groupon’s IPO at $20.00 per share, and subsequently Groupon’s stock traded at artificially inflated prices during the Class Period, reaching a high of $26.19 per share on November 18, 2011.”

Groupon stock hit an all-time low on Wednesday, closing at $14.54.

“Defendants’ fraudulent scheme…was a success,” the lawsuit adds, as it “deceived the investing public regarding Groupon’s prospects and business…artificially inflated the price of Groupon common stock, and…caused plaintiff and other members of the Class to purchase Groupon common stock at inflated prices.” The lawsuit seeks class action status in the U.S. District Court for the Northern District of Illinois and will likely be consolidated into one case.

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The SEC’s probe is not the first time Groupon has caught the attention of regulators. Last summer, before the company’s $700 million IPO, the SEC objected to a funky financial metric that failed to include marketing expenses, a huge part of the company’s costs. (Groupon’s business model relies on sending out vast numbers of emails in order to lure customers to participate in its discount offers.) The SEC also objected to the way Groupon disclosed revenue, forcing it to adopt a new formulation that cut its reported revenue in half.

Two of Groupon’s most prominent leaders have also run afoul of regulators. CEO Mason was forced to include a profanity-laden memo touting the company in the IPO documents after the memo was leaked to the press. In retrospect, one portion of Mason’s now-infamous screed — in which he aimed to rally his troops during the IPO quiet period — seems particularly poignant.

And company chairman Lefkofsky ruffled regulators after he publicly predicted Groupon would be “wildly profitable,” during the company’s pre-IPO quiet period. Lefkofsky is an Adjunct Professor of Entrepreneurship at University of Chicago Booth School of Business.

During a speech at the Northbrook Chamber of Commerce outside Chicago on Tuesday night, Lefkofsky described the experience of running Groupon. “Our main focus is trying to figure out how this model evolves and not consistently falling on our face in the public,” he said, according to Northbrook Patch. “It’s like giving a 7-year-old a Ferrari; you’re going to get a certain amount of chaos.”

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