Securities class actions are often criticized as wasteful strike suits that target temporary fluctuations in the stock prices of otherwise healthy companies. The securities class actions brought by investors of Enron and WorldCom, companies that fell into bankruptcy in the wake of fraud, resulted in the recovery of billions of dollars in permanent shareholder losses and provide a powerful counterexample to this critique. An issuer’s bankruptcy may affect how judges and parties perceive securities class actions and their merits, yet little is known about the subset of cases where the company is bankrupt.
This is the first extensive empirical study of securities class actions and bankrupt companies. It examines 1,466 securities class actions filed from 1996 to 2004, of which 234 (16 percent) involved companies that were in bankruptcy proceedings while the class action was pending. The study tests two hypotheses. First, securities class actions involving bankrupt companies (“bankruptcy cases”) are more likely to have actual merit than securities class actions involving companies not in bankruptcy (“nonbankruptcy cases”). Second, bankruptcy cases are more likely to be perceived as having merit than nonbankruptcy cases, regardless of their actual merit.
The study finds stronger support for the second hypothesis than for the first, suggesting that judges and parties use bankruptcy as a heuristic for merit. Even when controlling for various indicia of merit, bankruptcy cases are more likely to be successful in terms of dismissal rates, significant settlements, and third-party settlements than nonbankruptcy cases. These results are evidence that judges use heuristics not only to dismiss cases but also to avoid dismissing cases.
Securities class actions cannot be adequately understood without examining the subset of cases with a bankrupt issuer. The perception that securities class actions merely harass healthy companies should be revised in light of the significant number of bankruptcy cases in which shareholders have a greater need for a securities fraud remedy.