Fraud on the Market: Analysis of the Efficiency of the Corporate Bond Market

Abstract

The efficiency of the corporate bond market is not well understood. Although many of the factors used to analyze stock market efficiency translate with some adjustments to corporate bond markets, the cause-effect factor is not intuitive and can be a source of significant confusion.

In this manuscript we analyze bond market efficiency in the context of a recent court decision. In recent litigation concerning allegations of securities fraud perpetrated by the American International Group (AIG), the federal district court for the Southern District of New York declined to certify a class of bondholders, citing lack of common questions of law or fact. The decision turned on an empirical analysis of whether certain AIG bonds traded in an open, developed and efficient market. If the market for these bonds had been found efficient, there would have been grounds to certify the bondholders as a class.

Ironically, the court found insufficient empirical evidence to hold that the $1.71 billion in AIG bonds, issued by the world’s largest insurance company, traded in efficient markets. Unfortunately, the AIG court missed salient differences between the stock and bond markets in reaching its conclusion. Our manuscript describes the analysis missed by the court and supports a contrary result.

Part I provides an overview of the law as it has developed regarding certification of class actions and the elements of a claim of fraud on the market as relevant to the lead plaintiffs’ claims of violations of the securities laws. Part II introduces the required empirical analysis and benchmarks to evaluate a claim of fraud on the market. Part III continues with a theoretical discussion of the distinctions missing in the AIG analysis between bonds and stocks relevant to determining whether the bond market should be afforded the fraud on the market presumption. Part IV builds on this with a discussion of our alternate empirical analyses. Concluding remarks follow.

The AIG decision has serious implications not only for the corporate bond market but also for public policy. Private securities fraud class actions are an important mechanism for deterring fraud and promoting confidence in the securities markets. When market efficiency is important for determining certification of a class of security holders, it is critical that courts carefully consider how different markets operate.