When the topic is securities class action litigation, what is usually considered are lawsuits brought under the federal securities laws by shareholders. By way of illustration, when considering the extent of a company’s potential exposure to a future securities class action lawsuit, the starting point is usually the company’s market capitalization (that is, the number of its publicly traded shares multiplied by its current share price).
However, holders of publicly traded debt also have rights to pursue liability claims under the federal securities laws for material misrepresentations and omissions. According to a recent academic study, bondholder securities suits are more significant than may be recognized, and they could become increasingly important in the future. The extent of this potential liability exposure to bond holders could require a recalibration of the securities litigation risks of companies that have publicly traded debt.
In a February 19, 2015 post entitled “Bondholders and Securities Class Actions” on the Harvard Law School Forum on Corporate Governance and Financial Regulation (here), UCLA Law Professor James Park summarizes his longer scholarly paper of the same title. Based on his analysis of securities class action lawsuit settlements, Professor Park concludes that “bondholders are playing a greater role in securities class actions than previously recognized” and that this role “is likely to grow.”
Park examined 1660 securities lawsuits filed from 1996 through 2005. Park found that it was difficult to determine just from the initial filings whether or not bondholders were part of the class. In addition, he determined that looking only at cases where bondholders explicitly are named as plaintiffs underestimates the number of bondholder plaintiffs because some classes are defined in a way that might include bondholder plaintiffs. Park concluded that the most accurate way of measuring bondholder involvement in securities class actions was to search for bondholder recoveries by reviewing notices of settlement. In this way, Park identified many more cases where bondholders recovered than cases where bondholders were named as plaintiffs.
Of the 1660 securities cases in Park’s database, 1152 settled for some amount. Of those 1152 settled cases, 64 involved a bondholder recovery, a substantially higher number than cases where bondholders were specifically named as plaintiffs. In addition, the settlements of the later filed cases reflected a higher level of bondholder participation in the settlements than did the settlements of the earlier filed cases. Park found that for cases filed during the 1996-2000 period, three percent of cases involved bondholder recoveries. However, for cases filed during the period 2001 to 2005, nearly eight percent of the settlements involved bondholder recoveries. (The number of cases with settlements in the two periods was slightly different but fairly close; there were 542 settlements of cases filed during the period 1996 to 2000 and 610 settlements of cases filed during the period 2001-2005.)
In addition, Park also found that settlements involving bondholder recoveries were frequent in the largest securities class action lawsuit settlements. Four of the five largest securities class action lawsuit settlements involve bondholder recoveries, as did seven of the top ten and nineteen of the top thirty settlements. (In a footnote, Park says only that “it is unclear whether there is any causal relationship between bondholder recoveries and the size of securities class action settlements.”)
Many of the bondholder class actions raise allegations of distinct harm to bondholders. For the largest settlements, bondholder recoveries are primarily driven by credit downgrades, where a rating agency concludes that the issuer is at greater risk of defaulting on its debt. Fifteen of the nineteen largest bondholder settlements (79%) involved a credit downgrade. Bondholder class actions also often arise out of bond sales where risks were not adequately disclosed to bond purchasers. Both situations can involve transfers of wealth from bondholders to shareholders – as, for example, where a troubled company attempts to keep itself afloat (protecting shareholders) through an debt offering, or where a company pursues a risky strategy (which if successful would reward shareholders, through a higher share price) financed by a debt offering.
Park concludes that the growing involvement of bondholders in securities class action actions is likely to continue. Park found that in 1996, the first year in his securities suit filings database, less than 10 % of suits filed sought a recovery for non-shareholder plaintiffs. Over the next decade, however, it became routine for a securities class action lawsuit to allege claims on behalf of all investors of the company’s publicly traded securities. By 2005, close to half of securities class action lawsuits brought claims on behalf of such a broader class.
Professor Park’s paper also makes a number of interesting observations about the corporate governance implications of the bondholder involvement in securities class actions. Among other things, he notes that bondholder class actions highlight how fraud harms non-shareholder constituencies. A bondholder class action provides a remedy for reckless decisions that might well have benefitted shareholder, arguably providing a deterrent to this type of conduct.
Finally, Park suggests that certain aspects of these bondholder lawsuits arguably militate in favor of treating bondholder class actions differently than shareholder class actions. Among other things, the fraud-on-the-market hypothesis might have to be modified for bondholder claims, since bondholders rely not on the market price and the integrity of the market (since bond trade much less frequently than shares); rather, bondholders rely on credit ratings. Park argues that to the extent a fraud substantially distorts a credit rating, courts ought to presume that bondholders uniformly relied on the credit rating. Park also contend that in cases where bondholders rely on theory of harm distinct from that of shareholders, bondholders ought to be represented in a distinct sub-class with its own separate and independent counsel.
Park’s analysis is very interesting and provides a different perspective on the potential securities litigation exposure that companies with publicly trade debt may face. The reason the article’s perspective feels so different may be owing to the fact that there has been little prior research on the topic of the settlement of securities claims by bondholders. Indeed, Price himself states that his article is “the first to present extensive data on bondholder actions.”
At a minimum, it is clear that Park’s conclusions need to be taken into account when assessing the potential securities litigation exposure of companies that have publicly traded debt securities. For starters, Park’s analysis underscores the fact that companies whose only publicly traded securities are debt securities may face securities liability exposures to debt holders. In addition, Park’s analysis highlights the fact that when assessing the extent of the potential securities liability exposure for a company that has both publicly traded shares and publicly traded debt, the debt needs to be considered.
This latter point may have important implications when it comes to limits selection issues. (By “limits selection,” I mean the process of determining the appropriate D&O insurance limits of liability for any given publicly traded company.)
Typically, the starting point for thinking about limits selection is a company’s market capitalization – that is, the number of its shares that trade publicly multiplied by its share price. The company’s market cap is typically used as the starting point of the analysis because it is basis on which the potential settlement of a future class action lawsuit might be conjectured. Professor Park’s analysis suggests that market capitalization alone is not a sufficient starting point for thinking about the potential securities litigation exposure. His analysis suggests that the extent company’s publicly traded debt also needs to be taken into account.
This potential importance of taking publicly traded debt into account for purposes of limits selection is underscored by the fact that, as Park’s analysis shows, bondholder participation in class action settlements tends to be associated with the larger settlements. This suggests that in assessing worse and worst case scenarios – always an important part of limits selection analyses – the possibility and extent of bondholder participation in a possible future securities class action settlement needs to be taken into account. That is, in order to select limits likeliest to be able to respond to those worse and worst case scenarios, the possibility that bondholder claims as well as shareholder claims will have to be funded as part of a class action settlement will need to be taken into account.
Break in the Action: The D&O Diary is going to be out of the office on travel next week (the week of Feb. 23 to Feb. 27) and during that period the normal publication schedule will be disrupted. The normal publication schedule should resume in early March, when I will be back in the office.