Reverse stock splits, motivations, effectiveness and stock price reactions

... 81 4.2.1 Stock Price Reactions – Announcement Date .81 4.2.2 Stock Price Reactions – Ex-date 82 4.2.3 Stock Price Reactions – Firm Characteristics 82 4.2.4 Stock Price Reactions. .. the health of the stock as related to reverse stock splits 1.4.1 Stock Price Reactions The first hypothesis tested relates to the stock price reactions associated with reverse stock splits Researchers... listing requirements in 2001 and its effects on reverse stock splits and delistings 3.1 Stock Price Reactions This section deals with the stock price reaction to a reverse stock split Event study

THE FLORIDA STATE UNIVERSITY COLLEGE OF BUSINESS

REVERSE STOCK SPLITS: MOTIVATIONS, EFFECTIVENESS AND

STOCK PRICE REACTIONS

By BARRY MARCHMAN

A Dissertation submitted to the Department of Finance

in partial fulfillment of the requirements for the degree of Doctor of Philosophy

Degree Awarded:

Summer Semester 2007

UMI Number: 3282643

3282643 2007

UMI Microform Copyright

All rights reserved This microform edition is protected against unauthorized copying under Title 17, United States Code.

ProQuest Information and Learning Company

300 North Zeeb Road P.O Box 1346 Ann Arbor, MI 48106-1346

by ProQuest Information and Learning Company

The members of the Committee approve the dissertation of Barry

Marchman defended June 5, 2005

Caryn L Beck-Dudley, Dean, College of Business

The Office of Graduate Studies has verified and approved the above named

committee members

For RC JAM and Evelyn

A work of this nature is never done in a vacuum I am grateful for all of the help and encouragement from family, friends, and colleagues My deepest debt of gratitude and most sincere appreciation goes to Gary Benesh Thank you for seeing me through

I am grateful to my committee members, Rick Morton, Yingmei Cheng, and Steve Celec for helping me finish I would also like to thank Don Nast and Bill Anthony for their constant encouragement and their belief in me I thank Bill Christiansen, James Ang, and David Peterson for all that they taught me Pam Peterson got me started on this study and I acknowledge her contribution I thank Scheri Martin for keeping me on track I am grateful to Caroline Jernigan and Daiho Uhm for SAS help and I am thankful to all my FSU officemates, classmates, and other colleagues for their support and friendship

I am grateful to my friends and colleagues at SBI, especially Amos Bradford and Charles Evans, for giving me the means to provide for my family during this process I thank Kenneth Gray and Colin Benjamin for their constant encouragement

I am grateful to my family I thank my parents, Mac and Tillie Marchman, for all

of their love, support, and encouragement through this process I owe a special debt of gratitude to Jack and Dianne Steen for making this all possible I am especially indebted to my biggest cheerleader and best friend without whom I could not have finished, Evelyn

I am ultimately thankful to God for all of these relationships and for His blessings

TABLE OF CONTENTS

LIST OF TABLES viii

LIST OF FIGURES x

ABSTRACT xi

CHAPTER 1: INTRODUCTION 1

1.1 Introduction and Motivation 1

1.2 What Is a Reverse Stock Split? 3

1.2.2 A Brief Overview of the Evidence on Forward and Reverse Stock Splits 4

1.2.2.1 Anecdotal 4

1.2.2.2 Forward Split Empirical Findings 6

1.2.2.3 Reverse Split Empirical Findings 7

1.3 Why Reverse Split? 7

1.3.1 Listing Requirements 8

1.3.2 Transaction Costs 10

1.3.3 Marginability 10

1.3.4 Signaling 11

1.4 Hypotheses 12

1.4.1 Stock Price Reactions 12

1.4.2 Financial Health 14

1.4.3 Listing Requirements 15

1.5 Outline of This Dissertation 16

CHAPTER 2: LITERATURE REVIEW 17

2.1 Why Does a Firm Split Its Stock? 17

2.1.1 Asymmetric Information (Signaling) 19

2.1.2 Signaling Combined with Transaction Costs 21

2.1.3 Trading Range 21

2.1.4 Institutional Reasons to Reverse Split 24

2.1.5 Margin Regulations 25

2.1.6 Reorganization 26

2.1.7 Liquidity 27

2.1.8 Risk 27

2.1.9 Investor Behavior in Relation to Stock Splits 28

2.1.9.1 Framing 29

2.1.9.2 Price Preference 30

2.1.9.3 Herding 31

2.1.10 Optimal Tick Size (Market Microstructure) 31

2.2 Conclusion 32

2.2.1 What We Know 32

2.2.2 What We Do Not Know 33

2.2.2.1 Managers’ Self-interest 34

2.2.2.2 Shareholders’ Best Interest 35

CHAPTER 3: METHODOLOGY AND RESULTS 36

3.1 Stock Price Reactions 36

3.1.2 Raw Returns Around the Announcement Day 38

3.1.3 Market Adjusted Returns Around the Announcement Day 40

3.1.4 Market Model Adjusted Returns Around the Announcement Day 41

3.1.5 Announcement Day Conclusions 42

3.1.6 Ex-date Raw Returns 42

3.1.7 Ex-date Market Adjusted Returns 44

3.1.8 Ex-date Market Model Adjusted Returns 44

3.1.9 The relation between ex-date returns and announcement date returns 45

3.1.10 Analysis of Subsamples Based on Firm Categories 46

3.1.10.1 Industry 46

3.1.10.2 Delisting threat and Motivations for Reverse Splits 49

3.1.10.3 Price 52

3.1.10.4 Size of the Firm 53

3.1.10.5 Consolidation 54

3.1.11 Long-run Returns Following Reverse Stock Split 55

3.1.12 Long Run Buy and Hold Returns 55

3.1.13 Long-run Abnormal Returns 59

3.1.14 Matched Firm Analysis 62

3.1.15 Analysis of Subsamples Based on Firm Categories 64

3.1.15.1 Industry 64

3.1.15.2 Delisting Threat and Motivations for Reverse Stock Splits 65

3.1.15.3 Price Considerations 66

3.1.15.4 Size of the Firm 66

3.1.15.5 Consolidation 67

3.1.15.6 Long-run Analysis Concluding Remarks 68

3.2 Market Movements and Reverse Stock Splits 68

3.2.1 Hypothesis 68

3.2.2 Testing 69

3.2.3 Results 70

3.3 Financial Distress and Future Performance 70

3.3.1 Hypothesis 70

3.3.2 Testing 71

3.3.3 Results 72

3.3.4 Concluding remarks 74

3.4: NASDAQ Regulatory Changes 74

3.4.1 NASDAQ Listing Rules – Before The Pilot Program 75

3.4.2 The Pilot Program 76

3.4.3 Hypotheses 77

3.4.4 Reverse splits and the Moratorium 78

3.4.5 Delistings and the Moratorium 79

CHAPTER 4: CONCLUSIONS 81

4.1 Overview 81

4.2 Results and Suggestions for Further Research 81

4.2.1 Stock Price Reactions – Announcement Date 81

4.2.2 Stock Price Reactions – Ex-date 82

4.2.3 Stock Price Reactions – Firm Characteristics 82

4.2.4 Stock Price Reactions – Long Run 83

4.2.5 Market Movements 83

4.2.6 Projecting Post Split Performance 84

4.2.7 NASDAQ Rule Change 84

4.3 Contribution 85

APPENDICES 87

BIBLIOGRAPHY 169

BIOGRAPHICAL SKETCH 176

LIST OF TABLES

Table 1 Forward and Reverse Stock Splits and Split Ratios 1962-2002 87

Table 2 Average Stock Price per Year and Yearly Stock Splits 1962-2002 88

Table 3 Changes in Margin Requirements 90

Table 4 Winners Versus Losers After Reverse Stock Split 90

Table 5 Summary of Stock Split Literature and Key Findings 91

Table 6 The Daily Raw Returns of Reverse Stock Splits Around the Announcement Date 96

Table 7 The Daily Market Adjusted Returns of Reverse Stock Splits Around the Announcement Date 96

Table 8 The Daily Market Model Adjusted Returns of Reverse Stock Splits Around the Announcement Date 98

Table 9 The Daily Raw Returns of Reverse Stock Splits Around the Ex-date 100

Table 10 The Daily Abnormal Returns of Reverse Stock Splits Around the Ex-date - Market Adjusted 102

Table 11 The Daily Market Model Adjusted Returns of Reverse Stock Splits Around the Ex-date 106

Table 12 Ex-date Returns vs Announcement Returns 110

Table 13 Number of Reverse Stock Splits by Industry 1962-2003 111

Table 14 Ex-date Returns by Industry 112

Table 15 Returns Based on Reason Given 114

Table 16 The Returns of Reverse Stock Splits by Price 115

Table 17 The Returns of Reverse stock splits and the Size of the Firm 116

Table 18 The Returns of Reverse stock splits and Consolidation 117

Table 19 Reverse Stock Split Delistings Within 250 Days of Ex-date (1962-2003) 118

Table 20 Average Buy and Hold Returns of Reverse stock splits from 1962 to 2003 119

Table 21 Average Market Adjusted Buy and Hold Abnormal Returns of Reverse stock splits from 1962 to 2003 121

Table 22 Matched Firm Statistics 123

Table 23 Average Abnormal Returns of Reverse stock splits from 1962 to 2003 Based on Matched Firm 124

Table 24 Long Term Returns By Industry 125

Table 25 Long Term Returns by Reason Given and Low-Priced Versus High Priced 130

Table 26 Long Term Returns By Size, Consolidation and Post Split Price 131

Table 27 Monthly Stock Splits Related to Market Movements 132

Table 28 Long Run Returns Regressed on Lagged Market Returns 133

Table 29 Regression Analysis of Financial Distress Variables – Definitions 134

Table 30 Correlation Matrix: The Returns of Reverse Stock Splits and Financial Distress Variables 135 Table 31 Regression Analysis of Financial Distress Variables – Single

Table 32 Multivariate Regression Reduced Model 138

Table 33 Nasdaq Requirements September 2001 139

Table 34 Low-priced Nasdaq Stocks and Reverse Stock Splits 1998 - 2005 140

Table 35 Delistings Around the NASDAQ 2001 Moratorium 142

LIST OF FIGURES

Figure 1 Reverse Stock Splits 1962-2002 144

Figure 2 Split Ratios of Stock Splits 145

Figure 3 Distribution of 250-Day Buy and Hold Returns 146

Figure 4 Buy and Hold Returns of Reverse Stock Splits 147

Figure 5 Market Adjusted Returns of Reverse Stock Splits 148

Figure 6 Matched Firm Abnormal Returns 149

An examination of financial ratios and variables reveals that firms with better sales performance and higher operating-income-to-assets have better ex-date returns

In the long run, firms with lower debt relative to their assets do better after the reverse stock split Operating income expressed as a percent of assets is also positively related to the 250-day BHARs

The NASDAQ minimum bid price rule change of 2001 is explored to determine if

it had an impact on reverse stock splits or delistings The evidence is mixed The number of firms delisted, expressed as a percentage of firms that would have been delisted under the old rules, decreased However, the percentage of reverse stock splits, expressed as a percentage of low priced firms, did not change

CHAPTER 1: INTRODUCTION 1.1 Introduction and Motivation

The wealth effects of reverse splits have been studied previously with little disagreement in the literature The consensus of Vafeas (2001), Desai and Jain (1997), Han (1995), Peterson and Peterson (1992), etc is that a reverse stock split is a negative informational event Given the harmony of the literature, what is the purpose of another study on reverse stock splits? There are three reasons that further study is warranted

First, more data are available As documented in Table 1 and Figure 1, reverse stock splits have been more frequent in the late 1990s and 2000s than in previous periods Since 1992 the number of reverse stock splits has almost doubled This is analogous to the number of smokers doubling after the Surgeon General has proven conclusively that smoking is bad for your health Research has shown that the market reacts negatively to reverse stock splits, yet the number of firms using this strategy has dramatically increased The research needs to be updated to determine if the reverse stock split is still followed by a negative market reaction Perhaps something has changed in the way the market perceives the reverse stock split or perhaps there are valid reasons for a firm to consolidate its shares

Second, the type of firm that is reverse splitting its stock has changed over the years In previous reverse split studies, most of the sample consisted of established firms that fell into financial difficulty In recent years, perhaps a consequence of the Internet bubble burst, a new type of reverse splitting firm has emerged.1 In the months preceding the bubble burst, the initial public offering (IPO) market was at its peak New technology-based and Internet-based firms were in high demand After the bubble burst, many of these technology and

1 This refers to the beginning of the bear market of 2000 and 2001, when the NASDAQ composite fell dramatically The beginning of this period of reversal is often referred to as the Internet Bubble burst

Internet start-up firms lost a large percentage of their market value and their stock price fell below the minimum bid price required for continued listing Some of these start-up firms chose to reverse split their stock in order to maintain compliance Previous studies have examined reverse splits using primarily well established companies Recent IPOs make up a large segment of this study.2

Third, a number of reverse splits with extraordinary post-reverse split performance have caught the attention of journalists who write for financial

publications such as Forbes magazine Journalists report that some reverse split

stocks have experienced price increases of more than 100% in the months following the reverse split.3 They have speculated that a reverse split may not be the negative signal, or negative news event, that it was once thought to be This study applies the rigors of academic research to the data to determine if these speculations are justified

Given the market rule changes, the changing composition of the sample, and perhaps a different dynamic in the market, results provided in this study may

be beneficial to both regulators and corporate managers The sheer number of reverse stock splits that have been announced during the past few years suggest that reverse stock splits are a strategic corporate decision that many managers now consider Additionally, the 2001 change in the NASDAQ continued listing requirements that allowed low-priced firms more time to bring their bid price back into compliance (above $1.00) provides a unique opportunity to study the impact of such an event.4

In this dissertation, reverse stock splits are investigated on three fronts First, the stock price reaction to the reverse stock split is examined The reaction

is examined in relation to certain firm characteristics and the reasons that a firm gives for reverse splitting Daily abnormal returns around the announcement of

2 Based on a regression analysis that revealed that that the number of days since market listing is inversely related to the date of the reverse stock spilt Coefficient –0.42 and p-value<0.0001

3 David Simmons, Forbes, January 25, 2002, for example

4 This opportunity is not available with NYSE and AMSE listing standard changes because so few stocks are affected

the reverse stock split are explored The ex-date returns and long-run abnormal returns are also investigated The methodology is similar to Vafeas (2001), Desai and Jain (1997), Han (1995), and Peterson and Peterson (1992)

Second, accounting variables taken from the financial distress literature are tested for their usefulness in forecasting post reverse split performance There is wide variation in firm performance after a reverse stock split and this analysis seeks to provide insight as to what firm specific variables are most related to post split performance

Third, reverse stock splits are examined in light of the changes in NASDAQ’s continued listing requirements that were introduced in September

2001 These changes granted additional time to low-priced firms to bring their bid price back into compliance (above $1.00) Even more time was granted if the company could maintain certain listing requirements besides minimum bid price

As a result this change, low-priced firms had less incentive to reverse split their stock This study seeks to discover whether this rule change was effective

1.2 What Is a Reverse Stock Split?

A forward stock split is the exchange of one share of stock for multiple shares For example, in a 2-for-1 split, each stockholder receives two shares for each share held, and in a 3-for-1 split, each stockholder receives three shares for each share When a firm splits its stock, the immediate value of the firm should not

be affected Theoretically, a holder of a $50 share that splits 2-for-1 is left with two shares worth $25 each

Companies may also reverse split stocks Unlike a forward split, which leaves the shareholder with more shares, the reverse split leaves the shareholder with fewer shares For example, a 1-for-2 reverse split requires the shareholder to trade two shares for one share of the new stock, and a 10-for-1 reverse split requires the shareholder to relinquish ten shares and receive one share in return

A reduction in the number of shares outstanding increases earnings per share and

stock price, but, like the forward stock split, it is a cosmetic change in ownership Whether a firm forward splits or reverse splits its shares, the market value of the total number of shares, which is the market capitalization, should remain the same

Firms split their stocks at varying ratios The most common forward split ratio is 2-for-1, and the most common reverse split ratio is 1-for-10, followed closely by 1-for-5 Table 1 presents the split ratios of both forward and reverse splits from 1962 to 2002

It is not shown in Table 1, but when the sample is divided into pre-2001 splits and 2001-2002 splits, the 1-for-10 split increased from approximately 19% to 25% of the total.5 This increase in large reverse splits (consolidation) may be due

to the fact that the market as a whole, especially NASDAQ, was in sharp decline and companies used the reverse split to stay in compliance with market listing requirements The forward split distribution has also changed in recent years In the pre-2001 sample, the 2-for-1 split is most frequent (45%), but in 2001 and

2002, the smaller 3-for-2 split has about the same frequency as the 2-for-1 split (40%) The average share price per year for the entire market is given in Table 2

It is interesting to note that the average remains in the same general range throughout the years The range does not seem to rise with inflation Table 2 also shows the percentage of firms that split and reverse split their stock each year The number shown is a percentage of firms listed in the CRSP database for that year

1.2.2 A Brief Overview of the Evidence on Forward and Reverse Stock Splits 6

1.2.2.1 Anecdotal

In the aftermath of the Internet Bubble, over 200 firms reverse split their stock Regardless of the reason given by the company, the popular press usually

5 The frequency of 1-for-10 splits was 20% for the entire sample

6 An extensive overview is presented in Chapter 2

portrays the reverse split as a negative news event for the particular firm This is consistent with the findings of academic researchers who, in general, observe negative abnormal returns following the reverse split The reverse split is usually understood in the press and in academic research as a signal that bad news is on the horizon There are some reports, however, that claim a reverse split may not

necessarily be a negative event for a company For example, Forbes magazine

reports on “reverse split losers” and “reverse split winners,” with double- and digit returns documented for the winners.7 A winner is defined as a firm that has positive returns after the stock split (the ex-date) and a loser is defined as a firm

triple-that has negative returns after the split There are no market or risk adjustments in these returns, and therefore they can be taken only as anecdotal This anecdotal evidence provided the catalyst for this study

In 2002, Forbes Magazine reported that there were 113 reverse stock splits

in 2001 and 84 of these stocks were still trading in January 2002.8 Six companies were acquired, four went out of business, and six split to facilitate transactions such as spin-offs or special dividends Contrary to the popular belief that reverse split stocks wind up trading on the pink sheets, the over the counter (OTC) bulletin board, or worse, about three quarters of 2001 reverse splits maintained a post-split price above $1 and remained listed.9 The fact that the reverse split stocks performed so well in the middle of a bear market is even more surprising According to the conclusions of previous researchers, most reverse splits should have negative abnormal returns This, coupled with the systematic decline in market prices, makes it interesting that such a large percentage of these firms had positive price increases Of the 84 still trading on January 2002, the winners (39) were up an average of 66% and the losers (45) were down an average of 84%

7 Forbes, January 25, 2002 David Simmons

8 CRSP data revealed that there were actually 127 reverse stock splits in 2001 and 95 in 2000 with

102 still trading on January 31, 2001

9 Popular belief means the consensus of previous researchers who show that reverse split stocks in

general are followed by negative abnormal returns and then suffer delisting or bankruptcy This is expanded and fully documented in the literature review in Chapter 2 The popular press also takes

a dim view of the future of firms that reverse split This, too, is expanded in Chapter 2

Even among the losers, 22 (about half) maintained the $1 listing requirement Internet-based firms, or “dot.coms,” made up about one fourth of the 2001 reverse splits Of the 23 dot.com companies, the winners (10) were up an average of 79% and the losers (13) were down an average of 63%.10 A more comprehensive record of winners and losers is given in Table 4.11

Industry seems to have played a role in how the media covered some of these firms Does industry play a role in post split firm performance? Is there any pre-split information like industry or financial ratios that is predictive of post-split performance? These questions are explored in this dissertation

1.2.2.2 Forward Split Empirical Findings

On average, firms that split their stock have been characterized by positive abnormal returns following the stock split This is curious because the stock split event adds no value to the firm; it is merely a cosmetic adjustment Even if the stock split is viewed as a positive signaling event, the market should respond to the good news on the stock split announcement day rather than on the ex-date If there were information leakage from the company about the upcoming split, then there should be some upward price drift leading up to the announcement day Researchers find that forward stock splits are associated with a small pre-announcement price drift, a positive reaction on announcement day, and short-term and long-term positive abnormal returns Researchers attribute the positive abnormal returns to either a sluggish response to the positive information (under-reaction) or asymmetric information It may be that managers signal their belief in strong performance in the future by splitting the stock, but the market is skeptical and reacts slowly, waiting for confirmation Other researchers contend that the forward split is the result of a price preference by managers, investors, and institutions

10 Forbes, January 25, 2002, referencing Thomson Financial/First

11 This table is referenced again in chapter 3

1.2.2.3 Reverse Split Empirical Findings

Researchers have generally found that when a firm reverse splits its stock, the stock will suffer negative abnormal returns in both the short and long terms A reverse split is often viewed as a last-ditch effort to artificially maintain the firm’s market listing or to delay inevitable bankruptcy The price of the stock is not the cause of bankruptcy, but bankruptcy follows many reverse stock splits This may

be due to the firm’s losing market value because of increased idiosyncratic risk The riskier the firm becomes, the lower its price becomes Researchers provided empirical evidence indicating that, in general, negative abnormal returns follow reverse splits As with forward stock splits, the market reaction to the reverse split

is only partial at the time of the announcement Perhaps investors are hoping for a turnaround, or perhaps the coverage by the press and stock analysts is so light on these thinly traded companies that it takes a while for the bad news to be disseminated into the market.12 Researchers have observed negative abnormal returns following reverse stock splits, but the anecdotal evidence suggests that this paradigm may need updating Perhaps market reaction to the reverse split is conditioned on other information that is available to investors.13 It is possible that the market response has become more sophisticated in that corporate information

is more readily available and more widely disbursed that in the past Readily available information may lead to more firm specific market responses

1.3 Why Reverse Split?

In theory, the total value of equity of the firm should be the same pre-split and post-split.14 If there are no restrictions on companies with regard to stock price and if the stock price does not affect investors’ transaction costs, the market

14 The market value of equity is shares outstanding times share price

should be indifferent when a firm splits its stock, either forward or backward The market, however, does not seem to view the split as a neutral-wealth event In fact, researchers show that the market treats the reverse stock split as a negative event with both short-term and long-term negative abnormal returns If reverse splits result in negative abnormal returns, why would a company choose to reverse split its stock?

There are numerous reasons cited by companies to reverse split their stock These reasons include (1) complying with listing requirements, (2) reducing the transaction costs of investors, (3) making the stock marginable, and (4) making the stock appear more reputable to investors by raising the share price of the stock

1.3.1 Listing Requirements

The primary listing requirement of interest in this study is the minimum bid price for continued listing The continued listing requirements are less stringent than the initial listing requirement Each market has slightly different requirements for initial and continued listing, yet some requirements are the same For example, the NYSE, the AMEX, and NASDAQ all have a $1 minimum bid price for continued listing.15 If a firm’s bid price drops below $1 for an extended period, the firm will be expelled from the market and no longer eligible for trade in that particular market For example, both NASDAQ and the NYSE begin the delisting process when a firm trades for less than $1 for 30 consecutive days However, the markets differ

on initial bid price, market capitalization, and other qualitative public interest criteria Firms not meeting the minimum bid price requirement may choose to

15 All current requirements for initial listing and continued listing are tabulated in Table 33

reverse split their stock.16 An interesting event to study is the changing of the rules How do regulatory decisions affect the firms that they govern?

Prior to 1997, NASDAQ had no minimum bid price, but in 1997 it saw the need to improve its image by divesting itself of low-priced stocks that were, as a group, highly speculative and prone to fraud In 1997, NASDAQ first instituted its minimum bid price of $1 per share for continued listing If a firm’s stock price fell below the minimum, the company then had 90 days to improve the price of the stock, either by reverse splitting or by taking actions to improve its market value

NASDAQ had a recent rule change involving grace periods granted to minimum bid price violators, but the NYSE and the AMEX had no such changes related to bid price or to any other criteria of interest to low-priced stocks In addition, the vast majority of the stocks in the later sample are NASDAQ stocks For example, in 2001 and 2002, there were no AMEX reverse splits and only five NYSE reverse splits per year In contrast, there were more than 100 reverse splits

on NASDAQ in each of these two years Given the limited sample size and the stability of bid price requirements in the NYSE and the AMEX, the focus of this dissertation regarding rule changes will be on NASDAQ stocks and the effects of these rule changes on reverse splits and low-priced stocks in general

On September 27, 2001, NASDAQ issued a moratorium on the enforcement of the $1 minimum bid price rule in response to the depressed stock prices in the overall market NASDAQ offered longer grace periods—180 rather than 90 days—for firms to bring their company into compliance If criteria other than bid price were in order but the bid price was too low, even longer grace periods were granted In January 2002, NASDAQ instituted a pilot program in which the moratorium was extended for two years Companies in both the National and Small Cap Markets now had extra time to address bid price deficiencies The program was slated to expire in December 2003 but was extended to December 2004 The pilot program was slightly different for the two

16 The AMSE section 970 says, “The Exchange may recommend to the management of a company, whose common stock sells at a low price per share for a substantial period of time, that it submit to its shareholders a proposal providing for a combination (’reverse split’) of such shares.”

NASDAQ markets The National market issuers had 180 days (formerly 90 days)

to bring their stock’s bid price back into compliance At the end of this time the firm could move to the Small Caps market if it wanted to stay listed Firms in the Small Caps market were given 180 days to comply (formerly 90 days) and were given an additional 180 days (formerly 0 days) if certain other market capitalization

criteria are met The Small Caps were then given an additional 90 days to comply

if they met certain non-price criteria at the end of the second 180-day period These criteria (continued listing requirements) are shown in Table 33 and are discussed in Chapter 3

1.3.2 Transaction Costs

Researchers have shown that the higher price range after a reverse stock split results in lower percentage bid-ask spreads, and thus the transaction costs are lowered The lower bid-ask spread is probably due to the increased liquidity of the stock at its post reverse split price However, a possible lost tax savings after

a reverse stock split can also be considered a “transaction cost.” Volatility decreases after a reverse stock split, and firms (and investors) are less able to take advantage of tax laws that allow them to expense a paper loss

1.3.3 Marginability

A stock is purchased on margin when the investor uses someone else’s money to fund a portion of his investment An investor may borrow up to 50% of the funds for an initial investment This requirement has fluctuated over the years from 10% to 50%, as shown in Table 3, but has remained fixed since 1974 Brokerage firms will monitor portfolios and “call” a margin if the equity that is less than fully funded drops in value The investor must either divest or “cover” the

margin by sending additional funds to the broker A stock must have a bid price of

$5 or more to be considered marginable.17

Increasing the price of a stock through a reverse split allows more investors

to use margin accounts to purchase the security The stock is more marketable because there are more potential buyers Institutional investors are also wary of low-priced stocks and generally avoid those that are unmarginable When firms reverse split their shares, the resulting price is often greater than $5 Why would a firm reverse split to a price that is not marginable (i.e., less than $5)? Because, a low bid price is not the only criterion that a firm is struggling to meet in order to remain listed on an exchange There are also minimum market valuations and minimum shares outstanding requirements If a firm does not have enough shares outstanding to reverse split to over $5, then marginability is not a likely motive for the reverse split

Closely associated with marginability is institutional interest For example, Judy Bruner, CFO of Palm, Inc., cites the loss of institutional investors as one reason for its 1-for-20 reverse split in October 2002.18

17 Margin requirement rules, Securities Exchange Act of 1934

18 Quoted to Tim Reason, Reverse Psychology Today, CFO, Magazine for Senior Financial

Executives, December 2002

19 Price increases are not necessarily indicative of positive abnormal returns, but this is interesting because, historically, decreasing prices follow reverse splits This issue is addressed formally and

due to the information conveyed by a reverse split, conditional upon information about the motivation for the split or the financial health of the splitting firm This study adds to the reverse split literature by showing how accounting variables or firm characteristics affect the signal of a reverse stock spilt

1.4 Hypotheses

Hypotheses are developed and tested in this dissertation to explore the stock price reactions to reverse stock splits The stock price reactions are examined in the context of the market environment, regulatory influences, the Internet Bubble burst, and the health of the stock as related to reverse stock splits

1.4.1 Stock Price Reactions

The first hypothesis tested relates to the stock price reactions associated with reverse stock splits Researchers have documented abnormal negative returns around the announcement date and negative abnormal returns around the ex-date The increase in reverse splits during the late 1990s and early 2000s is shown in Figure 1 This wealth of new data provides an enticing reason to revisit this topic Using the expanded data set (compared to previous studies), the abnormal returns surrounding the ex-date and the announcement date are examined

The primary hypothesis of this study, stated in the null, is:

There is no stock price reaction associated with the event of a

reverse stock split

The typical company performing a reverse stock split is generally smaller and less well known and trading in its stock may be quite thin It may be the case, then, that the effect on shareholders’ wealth is not confined to the event day, but

documented thoroughly in Chapter 3, in which abnormal returns following the reverse split are examined

rather is spread out over a longer period as more information about the company

is revealed Announcement day effects are examined in an 11-day window around the announcement Ex-date effects and long run effects are also examined The first wealth effect is examined specifically with the following two hypotheses:

There is no short-term stock price reaction associated with the

event of a reverse stock split

There is no long-term stock price reaction associated with the

event of a reverse stock split

One facet of this study deals with the regulatory environment and one of the question of interest is whether the reverse splits were motivated by the threat of delisting If there is a difference in the returns for firms that have been forced to reverse split their stock versus firms that have voluntarily reverse split, then it is possible that the exchange regulations may be having effects in the market The hypothesis, stated in the null, is then:

There is no difference in the stock price reaction on the stock of

firms which reverse split their stock for voluntary versus

The next hypothesis, stated in the null, is:

The frequency of reverse stock splits is not related to prior market

performance

A casual observation of the yearly reverse stock splits (Table 1) reveals no obvious pattern When prices drop in times of market decline, it seems that more firms would reverse split their stock This idea is tested Perhaps a relationship exists that is not apparent from casual observation

1.4.2 Financial Health

One of the motivations for the third hypothesis, is to determine if a distinction can be made between good firms that may have been caught in the downdraft of the 2000-2001 bull market versus firms that were destined for failure regardless Some firms had little chance of survival, while other firms were simply caught in the wake of the NASDAQ plummet The irrational exuberance (Alan Greenspan’s assessment) of the time preceding the plummet may have fueled the public’s hunger for IPOs of dot-com companies that were not quite strong enough

to go public.20 The public’s demand for more and more tech companies may have led to an environment in which sound business valuation and common sense were replaced by a gambler’s mentality IPOs in the high-tech industries, especially Internet-related firms, seemed extremely popular to investors This section of the dissertation borrows variables from the financial distress literature and seeks to determine if the same variables that predict financial distress can be used to forecast a firm’s performance after a reverse stock split If the distress variables for a firm do not indicate distress, then the bid price deficiency may be the result of getting caught up in a public panic to sell For example, if sales were still strong

20 Federal Reserve Board Chairman Alan Greenspan made these remarks in his speech at the Annual Dinner and Francis Boyer Lecture of The American Enterprise Institute for Public Policy Research in Washington, D.C., on December 5, 1996 The catchphrase later became the title of a

2000 book about the overpriced market Irrational Exuberance, by Robert J Shiller, won the 2000

Commonfund Prize for Best Contribution to Endowment Management Research Shiller is the Stanley B Resor Professor of Economics at Yale University

and a business had a full pipeline of orders for the next several quarters, then perhaps the market’s valuation of the equity was unjust If a firm in this situation reverse splits its stock, perhaps it sends a false signal to the market Did the market see through the false signal?

The next hypothesis, stated in the null, is:

The financial health of a stock does not help to predict firm’s

returns after a reverse stock split

1.4.3 Listing Requirements

The stock markets are interested in preserving the integrity and reputation

of their exchanges The markets have rules that specify the minimum bid price that

a firm must maintain to remain listed on the exchange The NYSE, the AMSE, and NASDAQ created these rules to enhance the reputation of the markets because low-priced stocks have been associated with price manipulation and stock scams

In 2000 and 2001, NASDAQ relaxed its minimum bid requirements and granted automatic extensions for firms that perhaps were caught in the downdraft

of the bear market The stated objective was to give the good firms adequate time

to recover Did the rule relaxation increase the probability that a low-priced stock would recover, or did the rule changes simply delay the inevitable bankruptcy or delisting? Were firms less likely to reverse split their shares in the aftermath of the rule changes? The next hypotheses, stated in the null, are:

The moratorium on the minimum bid price rules had no effect on

whether or not a NASDAQ firm reverse split its stock

The moratorium on minimum bid price rules did not result in fewer

delistings for NASDAQ firms whose stock had a bid price of less

than $1.00

1.5 Outline of This Dissertation

The remainder of this dissertation consists of a literature review followed by development and testing of the hypotheses Chapter 2, the reverse split literature review, is followed by Chapter 3, in which the hypotheses are motivated and tested Chapter 4 summarizes this research and its constraints while suggesting extensions for further research

CHAPTER 2: LITERATURE REVIEW 2.1 Why Does a Firm Split Its Stock?

Stock splits present an enigma to market observers A stock split produces

no material change in a firm, yet through the years the stock split has remained a popular fixture in the U.S financial markets For example, in 1930 almost 20% of the firms listed on the NYSE had split their shares in the prior decade (Conroy & Harris, 1999) In modern times, stock splits still endure, with 5-10% of NYSE firms announcing a split each year One of the results of the incessant stock split is that average stock prices in U.S financial markets have remained remarkably constant over time Over the last half-century, the average NYSE share price has remained

in the $30-$40 range regardless of rising inflation, consumer prices, or firm equity value (Conroy & Harris, 1999)

A stock split is, at one level, only a cosmetic change; the same-size pie is merely sliced into smaller pieces.21 The investor retains the same partial ownership of the company’s equity and the same voting power as before the split Yet, in spite of this seemingly cosmetic change, empirical researchers continue to demonstrate that stock splits have real effects in the financial markets In some ways, the effects of forward splits seem beneficial: equity value increases, trading volume increases, and the number of shareholders increases In other ways, the effects of forward splits seem less desirable: shareholder risks increase, and some transaction costs, such as bid-ask spreads, are higher after forward splits.22 The reverse splits mirror the forward splits Value decreases, volume decreases, the number of shareholders decreases, shareholder risks decrease, and transaction costs decrease

In an attempt to explain these varied benefits and consequences of stock splitting, the literature presents several reasons that a firm may reverse split its stock These reasons include asymmetric information, moving the stock’s price to

a more desirable trading range, exchange regulations, margin regulations, institutional limitations, reorganization, privatization, and liquidation Key findings

of major studies are presented in Table 5 Even though the literature presents several hypothetical reasons that a firm might split its stock, the truth is that no one knows the true motivations except the managers who actually make the decision

to split With this in mind, researchers conduct surveys Unfortunately, the managers who are surveyed are not always forthcoming in their explanations In a

1977 study of reverse splits, nearly half of the firms that reverse split their stock offered no public explanation at all for the split.23 Of the firms that made public announcements, the most common reason given was image improvement This was followed by exchange requirements, then appealing to a different type of investor, and finally, reduction in shareholder service costs (Gillespie & Seitz, 1977) In a similar survey on forward splits, 70% of managers who responded stated that moving the stock to a preferred price range or improving liquidity was the reason for the stock split Signaling was the primary motivation of only 14% of the responding managers (Baker & Powell, 1993)

Studies of reverse splits in the late 1970s and early 1980s find that there is

a small increase in volume and a decrease in the number of shareholders after the split, but the institutional interest remains unchanged The studies conclude that reverse splits are not justified because they are, in general, detrimental to shareholder wealth Moreover, reverse stock splits are not justified by the reasons cited by managerial surveys because there are no tangible benefits related to those reasons In addition, Radcliffe and Gillespie (1979) studied only firms that survived their test period, so it is likely that they understated the negative effects of the reverse splits on shareholder wealth (Woolridge & Chambers, 1983)

23 Gillespie and Seitz (1977) found that only 13 of 24 firms gave a public reason for the reverse split

Another negative effect of the reverse split is the decrease of the tax option value of stocks The investor has more possible tax alternatives when stock is more volatile High volatility allows investors to take advantage of U.S tax laws by offsetting capital gains with capital losses Reverse splits decrease volatility and therefore decrease the tax option value Forward splits, on the other hand, increase volatility (Lemoureux & Poon, 1987)

Although researchers have shown that reverse splits are detrimental to shareholder wealth, firms continue to engage in the practice of reverse splitting their stocks The stock split literature gives a variety of explanations for forward and reverse stock splits, and these are discussed in the following sections The first explanation considered is asymmetric information, or signaling

2.1.1 Asymmetric Information (Signaling)

The asymmetric information hypothesis is that managers will split the firm’s stock to send a signal to investors that conveys private or inside information about the firm For some reason, the firm is unable to disclose information such as trade secrets, a revolutionary breakthrough, or some other secret competitive advantage The managers cannot reveal their private information, but they feel that if their secrets were widely known, the company’s market value would improve A stock split is a way to signal investors that the managers believe that the company is undervalued and that there is a positive expectation about the future According to this theory, the main purpose of stock splits is to provide private information to the market The positive abnormal returns that follow stock splits are often attributed to this signaling effect A forward split is a sign of strength and confidence that the share price will continue to increase A reverse split, on the other hand, is a sign of weakness and could be viewed as the only remaining option to stay listed on an exchange or as a means of complying with creditor demands It is a negative signal to the market Succinctly, the signaling view is that management can influence market perceptions of their firm by changing its share price

Various researchers argue that forward stock splits are a favorable signal from management about future firm performance They argue that managers of undervalued firms will split the firm’s shares to signal positive private information about the company Even if the managers have no information to convey, the researchers suggest that managers are seeking to attract attention to the company

in hopes that investors and analysts will notice the company is undervalued The split is a costly signal to the market that a weaker competitor would not likely imitate It is a show of strength by the corporation and a disclosure by management indicating they think the firm is more valuable than the current market price dictates Reverse splits, however, have been shown to result in negative abnormal returns for the firm and are seen as a negative signal to the market (e.g., Brennan & Copeland, 1988; Brennan and Hughes, 1991; Conroy & Harris, 1999; Grinblatt, Masulis, & Titman, 1984; Ikenberry, Rankin, & Stice, 1996; Leland & Pyle, 1977; Ross, 1977) Some studies have concluded that even if managers are trying to signal the market, there is no evidence (or mixed evidence) supporting a change in information asymmetry after the split announcement However, even if the split itself is not a signal, the evidence does seem to support the notion that the size of the split factor signals information (Brennan & Copeland, 1988; Brennan & Hughes, 1991)

The studies discussed above conclude that forward stock splits convey positive information about a firm to the market, but more recently, researchers have extended this line of reasoning by examining whether the positive signal conveyed by the stock split announcement has an effect on companies in the same industry that did not have a stock split They find that, on average, the firms that did not split had significant positive abnormal returns following the split announcement of their intra-industry counterpart (Tawatnuntachai & D’Mello, 2002) This finding seems to strengthen the signaling theory

2.1.2 Signaling Combined with Transaction Costs

Theories that combine signaling with transaction costs offer further insight into stock splits The view is that for a signal to be credible, it must be costly One source of increased cost is the higher transaction costs of lower-priced shares after a forward split (Brennan & Copeland, 1988) Transaction costs are reduced for reverse split stocks (Han, 1995) The primary transaction cost is the bid-ask spread, which is proportionally higher per share after the forward split and proportionally lower per share after the reverse split

The empirical findings in the 1990s support the view that investors respond

to costly signals Investors respond to signaling even more favorably when the firm

is small Specifically, returns to forward split announcements are negatively correlated with firm size, and the post-split price is positively correlated with the size of the split factor The costly signaling explanation is that managers will not forward split unless they have exceptionally good information about the future of the firm (Ikenberry et al., 1996; McNichols & Dravid, 1990; Pilotte & Manuel, 1996)

When surveyed, most managers deny the signaling aspect of the split and will respond that their primary goal is to move the stock price to a more favorable trading range, where the liquidity is improved and the price is more attractive to investors (Baker & Gallagher, 1980; Baker & Powell, 1993) Trading range manipulation and liquidity are discussed next

2.1.3 Trading Range

What do executives say when asked why they split their stock? The answer seems to be consistent over time A survey reveals that from 1900 to 1930, 90% of managers of stock-splitting firms cited a wider distribution in shares as their primary motive (Dolley, 1933) Presumably, the lower price per share not only increases the number of shares outstanding, it also facilitates trading During the 1940s and 1950s, managers responding to a survey indicated that they wanted to

bring their share price down to the $15-$40 range (Dewing, 1953) Of the managers responding to a survey in the late 1980s (1987-1990), more than 70% cited a preferred price range as their primary motivation for splitting, and 14% cited signaling (Baker & Powell, 1993) Managers responding to a similar survey in the early 1990s reported that their main motivation for splitting is their belief that investors prefer stock prices in the $20-$35 range (Baker, Phillips, & Powell, 1995) Managers want to increase individual investor ownership because they feel that a broad base of ownership increases the value of the firm (Lakonishok & Lev, 1987)

Trading range motivation exists when the firm’s management believes that there is a desirable price range in which their stock is more liquid Firms will split the stocks when the price gets too high and out of range for investors who must purchase shares in round lots.24 Firms will reverse split stocks when the price gets too low Margin requirements and institutional perception make moving up to a higher trading range look like an attractive option for low-priced stocks In addition

to perceptions, it has also been shown that traders actually have lower transaction costs after a reverse split (Peterson & Peterson, 1992; West & Brouilette, 1970) Uninformed trades, proxied by non-institutional trades, increase after a forward split, and these trades are more expensive to the trader (Easley, O’Hara, & Saar, 2001) Easley et al interpreted their findings to be consistent with the trading range hypothesis since the number of small holdings increases—a stated goal of managers citing trading range as their motivation for splitting stock An alternate explanation of their findings is that forward splits move tick sizes relative to the stock price to a desired level (Angel, 1997; Anshuman & Kalay, 2002) The idea is that the proportionately larger tick size may provide market makers (brokers) with

an additional incentive to promote the stock to small investors.25 Brokerage firms

24 A round lot is 100 shares

25 This implies that stocks can be marketed or promoted at higher price levels and that irrational and naive investors can be taken advantage of by salespeople This goes against economic theory that says in aggregate investors are rational and all-knowing If promoters of consumer goods such as automobiles can benefit from promotional campaigns, why can’t promoters of equity

offerings? This is beyond the scope of this study but an interesting study for later

may encourage the split to preserve commission income (Brennan & Hughes, 1991) Supporting research demonstrates that there are indeed more small orders than large orders after a forward split, and the bulk of the orders are buys (Schultz, 2000) This is consistent with the trading range hypothesis and the view that forward splits act to promote stock trading among small individual investors It is also consistent with studies that show increasing numbers of shareholders after forward stock splits (Lamoureux & Poon, 1987; Maloney & Mulherin, 1992) In addition, it has been shown that forward stock splits are followed by increased trading activity by small investors (Angel, Brooks, & Mathew, 2004) This is a desirable outcome because when there is incomplete information in a market, a company may have lower capital costs as the number of unique shareholders increases (Merton, 1987) The demand for the stock is higher; thus, the price is higher and returns are lower

The trading range motivation for forward stock splits is well established in the literature, but trading range is a motive for reverse stock splits as well (Peterson & Peterson, 1992) Forward and reverse splits are both used to place a stock in a more attractive trading range For reverse splits, this generally results in lower transaction costs for the traders (Peterson & Peterson, 1992) Marketability

is another motive for reverse splits Low-priced securities can be seen as speculative or disreputable, but if a firm reverse splits its stock, the price is higher and the view is that the stock is more appealing or more available to the mass market These marketing issues are important because companies desire to have their stock purchased by institutional investors Institutional investors may have trouble justifying a portfolio with low-priced stocks A stock is viewed as more marketable if it is listed on a major market, and NASDAQ and the AMEX do not allow low-priced stocks to persevere In fact, a company is encouraged to reverse split if the stock trades at a low price for an extended period The NYSE does not have a minimum share price for continued listing, but it can delist companies in the case of unusually low share prices, typically less than $1 for more than 30 days

Low-priced securities are often seen as speculative or disreputable and cannot be bought with a margin account Thus, companies have incentive to raise the price via a reverse stock split so that the stock is available to a broader base of individual investors at a more favorable trading price (Spudeck & Moyer, 1985)

Research on why companies choose certain stock split ratios shows that the ratio is chosen to bring the equity price in line with the average market share price and, to a lesser extent, the industry-wide average share price (Lakonoshok & Lev, 1997) This supports the trading range theory Lakonoshok and Lev have also presented evidence that forward splits are confirmations of past activity rather than signals of future prospects Companies that forward split their stock are often companies that have recent abnormal growth in earnings and dividends The high growth does not persist after the forward split This is a strike against the signaling theory Some researchers have suggested that the signaling theory is valid for stock splits because the empirical properties of stock dividends seem to support it

If stock splits and stock dividends are the same corporate event, except on different scales, this is a valid argument Lakonoshok and Lev argued that empirical properties of stock splits and the empirical properties of stock dividends are fundamentally different, and therefore it is inappropriate to draw conclusions about splits based on the properties of dividends

2.1.4 Institutional Reasons to Reverse Split

Some firms desire to appease institutional investors because they want to attract institutional capital If a company has a low share price, institutional investors may be more prone to purchase a stock after a reverse stock split The fact that institutional investors shy away from low-priced stocks gives firms a motive to reverse split their stock The institutions are bound by covenants with their investors and often these covenants specify a minimum bid price.26 In

26 Vincent Sbarra, a senior partner with HBC Capital, says, “A lot of investment funds have

covenants that don't let them buy stocks under certain prices—usually $3 or $5.” Ulrico Font, senior analyst for Ned Davis Research, adds, “Everybody feels most comfortable with stocks priced

addition, institutions have to justify their investments and investors are more likely

to second-guess the fund managers when a fund includes low-priced stocks that underperform (Lakonishok, Shleifer, & Vishny, 1992)

2.1.5 Margin Regulations

“Buying on margin” occurs when an investor borrows money from the broker to buy a security The Securities Exchange Act of 1934 regulates margin accounts, but each brokerage firm has the power to place additional constraints on their customers Margin requirements dictate the minimum share price and percentage of investment that can be borrowed from the brokerage firm Currently,

a customer can borrow up to 50% of the price of a new investment for securities that trade for $5 or more Some brokerage firms keep a list of “unmarginable” securities The brokerage firm has decided, for whatever reason, that the firms on this list are too risky to be bought on margin Margin regulations can make a stock difficult to obtain for individual investors; thus, a company with low-priced shares may choose to increase the price through a reverse split This allows more access

to the security through margin accounts, resulting in a wider base of potential investors However, bid price is not the only consideration that the brokers or the Securities and Exchange Commission (SEC) use to disqualify a stock from being

“marginable”; therefore, a reverse split may not always be productive in this regard Factors such as trading volume, public interest (percentage of shares outstanding), volatility, and perceived risk (e.g., IPOs) may weigh into a broker’s decision to designate a stock unmarginable

Margin regulations have changed over the years In 1958, margin requirements were changed three times They were reduced from 70% to 50% in January, raised back to 70% in August, and raised again to 90% in October From

1960 to 1974, the margin requirements changed eight more times, fluctuating

between $5 and $50.” AT&T and Palm give similar reasons for reverse splitting (Tim Reason, CFO, Magazine for Senior Financial Executives, December 2002)

between 50% and 80% The last change, in 1974, set the margin requirement at 50%, and this rule has not been changed since then.27

Generally, to be marginable, a stock cannot be a penny stock In 1990, the SEC attempted to curb penny stock fraud and abuse by issuing the 1990 Securities Enforcement Remedies and Penny Stock Reform Act (PSRA) The centerpiece of this legislation is the severe restrictions placed on IPOs that are priced below $5 and not traded on major exchanges or a national automated quotation system The reasoning is that low-priced IPOs are low-quality IPOs The regulation succeeded in reducing the number of IPOs priced below $5, but it did not succeed in improving the overall quality of IPOs Studies find that delisting risk,

a proxy for IPO quality, did not decline significantly after the passage of the PSRA

As evidenced by the decline in abnormal returns earned by a portfolio of PSRA IPOs, the regulation had the unintended consequence of drawing speculative (i.e., more risky) IPOs in the higher price range (Beatty & Kadiyala, 2004)

post-2.1.6 Reorganization

In addition to the “marketing” considerations discussed previously, there could be a few other reasons that a firm chooses to reverse split its stock When a company declares bankruptcy, creditors could dictate the split as a part of the reorganization Reverse stock splits could also be used to reduce the number of shareholders so that the corporation can be privatized and avoid full disclosure requirements Reverse splits can squeeze out minority shareholders if the managers desire to take a public company private Some states will not allow investors to own fractional shares Therefore, the reverse split forces minority shareholders to sell In addition, reducing the number of shareholders reduces the cost of servicing those shareholders

27 This is from “Chronology of Significant Events,” California Department of Finance

2.1.7 Liquidity

Han (1995) showed that the liquidity of equity is improved after a reverse stock split He proxied liquidity with the bid-ask spread, trading volume, and the number of non-trading days He compared split firms with control firms and concluded that for the reverse split stocks, the spread is reduced, the volume is increased, and there are fewer days during which the stock is not traded In addition, he showed that bid-ask spread decreases and trading volume increases after the reverse split

Han (1995) says that reverse split improves the liquidity of a stock because the increased share price allows investors to buy the stock on margin Brokers do not allow their customers to buy low-priced shares on margin Therefore, a reverse split improves liquidity by allowing margin investors access to the stock

Another reason Han (1995) gave is that the increase in share price improves the market’s perception of the stock As discussed above, institutional investors are more likely to purchase shares that they can justify to their clients Low-priced stocks are not easily justified

The evidence for liquidity in forward splits is mixed, but one interesting study involving American Depository Rights (ADRs) found that when there is an ADR split announcement, both the underlying stock and the ADR will experience positive price gains (Muscarella & Vetsuypens, 1996) The stock price increases even when there is no stock split announcement in the firm’s home market The ADR split is accompanied by increased trading activity in the underlying stock This increased volume is cited as evidence of increased liquidity Muscarella and Vetsuypens did not test reverse split ADRs

2.1.8 Risk

Peterson and Peterson (1992) found that the total risk of returns of reverse split stocks declined after the reverse split Brennan and Copeland (1998a) documented decreasing risk shifts for forward splits However, Peterson and Peterson showed that systematic risk does not change after reverse splits In

contrast, Brennan and Copeland found that systematic risk decreased around forward splits

Peterson and Peterson (1992) found positive wealth effects for companies that were forced to reverse split Companies that were not forced to reverse split did not exhibit the same wealth effect Their research showed that firms were less risky after a reverse split because of decreased nonsystematic risk

2.1.9 Investor Behavior in Relation to Stock Splits

The idea of behavioral effects has been around since at least 1953, when

A S Dewing noted that even though arguments for forward and reverse splits are equally sound, managers are reluctant to reverse split He believed that a reverse split is an admission that the stock has been previously overpriced, and such an admission goes against human inclination since it may imply that the managers are either unethical or incompetent (Dewing, 1953)

Thirty-five years later, behaviorists offer a model that shows how analysts,

or the market as a whole, may underreact to new information such as a stock split announcement People tend to overweight their own beliefs and perceptions While new information may update or change these beliefs and perceptions, people tend to ascribe more weight to their prior beliefs than they do to the new information For example, people tend to be slow to change their minds about religious and political views that they “know” to be true—even in the face of overwhelming evidence to the contrary (Barberis, Schleifer, & Vishny, 1988; Daniel, Hirshleifer, & Subrahmanyam, 1988)

Are managers sensitive to underpricing or overpricing of their equity? Ikenberry, Lakonishok, and Vermaelen (1995, 2000) reported long-horizon return evidence in the United States and, more recently, in Canada These authors found that, at least for repurchases, managers seem just as sensitive to underpricing, as their counterparts seem sensitive to overpricing Ritter (1991) reported that managers appeared to be timing the market at a relative peak when initially issuing equity, since subsequent long-horizon abnormal returns were negative