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 paper we analyze bond market efficiency in the context of a recent court decision concerning allegations of securities fraud perpetrated by the American International Group (“AIG”).  The decision turned on an empirical analysis of whether certain AIG bonds traded in open, developed, and efficient markets.  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 open, developed, and efficient markets.  If the market for these bonds had been found efficient, there would have been grounds to certify the bondholders as a class.  Unfortunately, the AIG court missed salient differences between the stock and bond markets in reaching its conclusion.  Our paper describes the analysis missed by the court and supports a contrary result.  The AIG decision has serious implications not only for the corporate bond market but also for public policy.  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.