Journal of Scholarly Perspectives

Though the Enron and WorldCom cases were the focus of much attention, very little is known about the subset of securities class actions involving bankrupt companies. The context of bankruptcy should be interesting to scholars of securities litigation because it includes the cases where shareholders suffer the greatest harm. The resolution of securities class actions where a bankrupt company is the issuer may shed light on the way in which context affects how parties and courts assess the merit of lawsuits.

There are two competing views as to the relationship between bankruptcy and securities fraud. Companies approaching bankruptcy have greater incentives to commit fraud in order to save the company or the jobs of managers. There thus might be a causal relationship between bankruptcy and securities fraud. On the other hand, the context of bankruptcy could lead parties and judges to more readily assume that fraud was present in bankrupt companies. This perception could reflect hindsight bias, the tendency to overestimate the predictability of events, leading to the conclusion that management knew of the danger of bankruptcy but failed to disclose it.

This study assesses the relationship between bankruptcy and securities fraud by analyzing a data set of 1,466 consolidated class actions filed from 1996 to 2004, of which 234 (approximately 16%) cases involved a company that was in bankruptcy during the pendency of the class action (“bankruptcy cases”). The study tests two hypotheses: (1) bankruptcy cases are more likely to have actual merit than cases where the issuer is not bankrupt (“non-bankruptcy cases”); and (2) bankruptcy cases are more likely to be perceived as having merit than non-bankruptcy cases, even if they do not necessarily have more merit.