Bondholders and Securities Class Actions

The following post comes to us from James Park, Professor of Law at the UCLA School of Law. Recent work from the Program on Corporate Governance about securities litigation includes: Rethinking Basic by Lucian Bebchuk and Allen Ferrell (discussed on the Forum here) and Negative-Expected-Value Suits by Lucian Bebchuk and Alon Klement.

Prior studies of corporate and securities law litigation have focused almost entirely on cases filed by shareholder plaintiffs. Bondholders are thought to play little role in holding corporations accountable for poor governance that leads to fraud. My article, Bondholders and Securities Class Actions, challenges that conventional view in light of new evidence that bond investors are increasingly recovering losses through securities class actions.

Drawing upon a data set of 1660 securities class actions filed from 1996 through 2005, I find that bondholder involvement in securities class actions is increasing. Bondholder recoveries were rare for the first five years covered by the data set, averaging about 3% of settlements from 1996 through 2000. The rate of bondholder recoveries increased to an average of 8% of settlements from 2001 through 2005. Bondholder recoveries have not only become more frequent, they are disproportionately represented in the largest settlements of securities class actions. For the period covered by the data set, bondholders recovered in 4 of the 5 largest settlements and 19 of the 30 largest settlements.

Bondholders do not simply repeat the arguments made by shareholders. Many securities class actions raise allegations of distinct harm to bondholders. Companies often commit securities fraud in the hope they will increase shareholder wealth by taking on additional risk that is not disclosed. Bondholders do not benefit from such a course of action and can be harmed when such risk is hidden. In such cases, securities fraud essentially distributes wealth from bondholders to shareholders. A significant number of bondholder class actions are associated with a downgrade of the company’s credit rating, an event signaling a substantial increase in the credit risk of a company. For example, complaints in the Adelphia, Delphi, and Williams Companies class actions all alleged that the fraud hid debt from the markets and credit rating agencies. Indeed, half of all cases ending with a bondholder settlement involved a credit downgrade. Bondholder class actions also often arise out of bond sales where risks were not adequately disclosed to bond purchasers. The HealthSouth complaint alleged that fraudulent bond offerings were used to raise fresh capital to keep HealthSouth afloat. The complaint in General Motors alleged that the company saved $520 million in interest costs by fraudulently issuing bonds.

The growing involvement of bondholders in securities class actions is likely to continue. In the first year of the data set, 1996, less than 10% of securities class actions sought recovery for non-shareholder plaintiffs. Over the next decade, plaintiffs began certifying broader classes that included bondholders. It has now become routine for a securities class action to allege claims on behalf of all investors of the issuer’s publicly traded securities. By 2005, close to half of securities class actions brought claims on behalf of such a broader class.

The increase in bondholder recoveries illustrates how the nature of securities fraud can change over time. There is a tendency in the literature to assume that securities class actions have a fixed essence. The reality is far more complex. In some periods, cries of securities fraud appear to be opportunistic attempts to recover losses from temporary stock price fluctuations. In more recent times, frauds have been associated with serious declines in the fortune of public companies. Securities class actions are evolving as the nature of securities fraud changes. For example, in earlier years, suits alleging fraudulent securities offerings primarily targeted emerging companies selling stock in an initial public offering (IPO). Now, the most significant recoveries arising out of securities offerings involve bond sales by seasoned public companies.

Bondholder class actions also have implications for corporate governance. Corporate law has traditionally focused on the rights of shareholders, who are protected by fiduciary duties, and not bondholders, whose rights are defined by contract. With bondholder class actions, an investor who purchases a bond at a price that does not reflect the true risk of a corporation’s insolvency can recover damages. A recovery by bondholders typically shifts funds from shareholders to bondholders, providing a remedy for reckless decisions meant to benefit shareholders. Bondholder class actions highlight how fraud harms non-shareholder constituencies, while respecting the traditional corporate law distinction between shareholders and bondholders.

Given the unique position of bondholder plaintiffs, in some circumstances, courts should treat bondholder class actions differently from shareholder class actions. The fraud-on-the-market presumption, which facilitates certification of a class by assuming that all investors uniformly rely upon the integrity of the market price for a security, should be modified for bondholders. Investors rely more on credit rating agencies than markets in assessing the risk of corporate bonds. To the extent that a fraud substantially distorts a credit rating, courts ought to presume that bondholders uniformly relied on such credit rating. In addition, to the extent that bondholder class actions raise distinct theories of harm, bondholders should be represented in a separate sub-class from shareholders by independent counsel. Such representation could enhance the ability of bondholders to assert their interests in securities class actions.

The full paper is available for download here.

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