Stock price reaction to the announcement of a reverse stock split, an investigation as a function of the rationale provided

ix LIST OF TABLES Table 1: t Test Statistics for Average ARE and CAR Values for Each 108 Day of Event Window Table 2: Summary of Results of Hypothesis Testing 148 Table A1a: Summary of

REVERSE STOCK SPLIT: AN INVESTIGATION AS A FUNCTION OF THE RATIONALE PROVIDED

by Mark R Williams

A Dissertation Presented in Partial Fulfillment of

the Requirements for the Degree Doctor of Philosophy

Capella University August 2006

3223886 2006

Copyright 2006 by Williams, Mark R.

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 All rights reserved.

by ProQuest Information and Learning Company

ii

Abstract

This study investigates reverse stock splits announced in the Wall Street Journal between

July 1, 2002 and June 30, 2005 The study focuses on whether management furnishes

investors with a rationale or rationales for implementing a reverse split Additionally, the

study investigates whether or not providing a rationale impacts the abnormal return

surrounding the announcement of a reverse split The study also examines whether the

type of rationale provided impacts the returns around the announcement date Various

factors impacting security returns in other research are also investigated as to whether

they impact price behavior differently around the announcement of the reverse split

Finally, the study takes a brief look at the longer-term performance after a stock split

Although companies are now providing rationales for using a reverse split, the results

suggest that investors still perceive the announcement of reverse splits negatively as

negative abnormal returns were generally detected during the window ending two days

after the announcement date Although differences in the price behavior were generally

not statistically different whether or not a rationale was provided, or regardless of the

type of rationale provided, or for other economic factors, abnormal returns associated

with the refinancing/merger rationale and for stocks with a post-split price of less than

$1.00 were significantly lower (at a 05 level of significance) which could influence

investors The data indicate that over half of the companies rebounded nicely and

reported positive returns six-months, one-year and two-years after the announcement

iii Unfortunately, the factors utilized in this study were not sufficient to enable one to

distinguish between the winners and losers at the time of the reverse split announcement

iv Dedication

Dedicated to my family—past, present, and future

There is insufficient space available to express my appreciation to all who have been an encouragement and sounding board during this project Nevertheless, special thanks go to Dr Zhenhu Jin, my Faculty Mentor and Committee Chair, for his insight, wisdom and encouragement throughout my doctoral studies He has truly been a blessing

in accomplishing this study and the entire doctoral program Special thanks also go to

Dr R D O’Connor for his counsel not only during the dissertation but also during the comprehensives Additionally, a special thanks goes to Dr Ray Bower for his patience and perseverance in guiding me through some of the statistical concepts included in this study Working with this group has been an incredible experience for which I am

grateful

I am also appreciative of the support and encouragement of my wife, Renita, and

my children, Christopher and Ashley, who have also made incredible sacrifices during this process Finally, I want to express my thanks to Jesus for apart from Him I can do nothing and through Him all things are possible (Phil 4:13)

vi

TABLE OF CONTENTS

Acknowledgements v

List of Tables ix

List of Figures xi

CHAPTER 1 INTRODUCTION 1

Background 1

Statement of the Problem 3

Research Questions 5

Listing of Research Hypotheses 6

Significance of the Study 7

Definitions, Limitations and Assumptions 8

Conclusion 15

CHAPTER 2 LITERATURE REVIEW 16

Introduction 16

Management’s Expression of Rationale for Using a Reverse Stock Split 20

Reverse Split Theories from Previous Research 21

SEC and Stock Exchange Notice Requirements 27

Using Reverse Stock Splits to Avoid Delisting 30

Shareholder Approval of Reverse Stock Splits 34

Empirical Evidence Regarding Abnormal Returns With Reverse Splits 35

Apparent Inconsistency Between Theorized Motivations and Stock Price Reactions 41

vii

Measurement of Security Price Performance 44

Explanation of Other Economic Factors Included in Study 51

Longer-Term Performance After Reverse Split 57

Conclusion 58

CHAPTER 3 METHODOLOGY 59

Introduction 59

Phase One of Study 59

Phase Two of Study 62

Research Hypotheses 70

Longer-Term Performance 76

Conclusion 77

CHAPTER 4 DATA COLLECTION AND ANALYSIS 78

Introduction 78

Phase One of Study 78

Phase Two of Study 82

Results of Hypothesis Testing 109

Brief Look at Longer Term Performance 138

Conclusion 141

CHAPTER 5 RESULTS, CONCLUSIONS AND RECOMMENDATIONS 143

Introduction 143

Overview of Study 143

Rationales for Declaring Reverse Split 145

viii

Brief Review of Hypothesis Results and Implications 147

Final Conclusions and Recommendations 158

REFERENCES 161

APPENDIX A TABLES 168

ix

LIST OF TABLES

Table 1: t Test Statistics for Average ARE and CAR Values for Each 108

Day of Event Window

Table 2: Summary of Results of Hypothesis Testing 148

Table A1a: Summary of Previous Reverse Split Studies 168

Table A2a: Reason(s) Provided by Companies for Reverse Splits—Phase One 170

Table A3: Frequency of Primary Rationales for Declaring a Reverse Split 175

Table A4a: Reverse Stock Splits Included in Final Sample 176

Table A5: Summary of Sample Descriptive Statistics (includes all cases) 178

Table A6: Summary of Descriptive Statistics for AREs and CARs 179

Table A7: ARE and CAR Means and Standard Deviations for No Rationale and 180

Rationale Groups

Table A8: Listing of Companies in Final Sample Expressing the Following 181

Primary Concerns for Effecting a Reverse Stock Split

Table A9: ARE and CAR Means for Various Primary Rationales for 182

Reverse Splits

Table A10: Listing of Companies in Final Sample with the Following Market 183

Sizes of Common Equity

Table A11: ARE and CAR Means and Standard Deviations for Various Market 184

Sizes of Common Equity

Table A12: Listing of Companies in Final Sample in the Following Post-Split 185

Stock Price Categories

Table A13: ARE and CAR Means and Standard Deviations for Various 186

Post-Split Stock Prices

Table A14: Listing of Companies in Final Sample Under Their Respective 187

Stock Exchange Listing

Table A16: Listing of Companies in Final Sample in Reverse Split Size Category 189

Table A17: ARE and CAR Means and Standard Deviations by Size of Reverse 190

Split Ratio Table A18: Listing of Companies in Final Sample by Average Two-Year 191

Growth Rate in Revenues

Table A19: ARE and CAR Means and Standard Deviations for Various Two- 192

Year Average Growth Rates in Revenues

Table A20: Listing of Companies in Final Sample by Two-Year Direction 193

in Revenues

Table A21: ARE and CAR Means and Standard Deviations for Various Two- 194

Year Revenue Direction Changes

Table A22: Listing of Companies in Final Sample by Direction Change in 195

Net Income for Year Preceding Announcement

Table A23: ARE and CAR Means and Standard Deviations for Various 196

Directional Changes in Net Income

Table A24: Listing of Companies in Final Sample by Categories of Book-to- 197

Market Ratios

Table A25: ARE and CAR Means and Standard Deviations for Different 198

Book-to-Market Ratio Categories

Table A26a: Longer-Term Stock Price Information 199

Table A27: Worst and Best Performers Six Months After Announcement Date 202

xi

LIST OF FIGURES

Figure 1: Phase one—number of reason(s) provided for reverse splits 81

Figure 2: Frequency distribution of pre-split stock prices 84

Figure 3: Frequency distribution of post-split stock prices 85

Figure 4: Frequency distribution of market values of common equity 87

Figure 5: Frequency distribution of book-to-market ratios 87

Figure 6: Average two-year growth rate in revenues 89

Figure 7: Average two-year growth rate in net income 92

Figure 8: Frequency distribution of the directional change in 93

net income

Figure 9: Frequency distribution of reverse split ratio factors 95

Figure 10: Frequency distribution of reverse splits by stock exchange listing 96

Figure 11: Frequency distribution of primary motivation for reverse 103

splits for companies included in final sample

Figure 12: Graphical comparison of average AREs and CARs 106

Figure 13: Comparison of average AREs of rationale vs 110

no rationale categories

Figure 14: Comparison of average CARs of rationale vs 111

no rationale categories

Figure 15: Comparison of average AREs by primary rationale 115

and overall Figure 16: Comparison of average CARs by primary rationale 116

and overall

Figure 17: Comparison of overall CAR means and CAR means for different 120

market sizes of common equity

xii

Figure 18: Graph of average CARs for various post-split 123

stock prices

Figure 19: Graph of average CARs for post-split prices of 124

greater than $1.00

Figure 20: Graph of average CARs by stock exchange listing 126

Figure 21: Graph of average CARs by size of reverse split factor 128

Figure 22: Graph of average CARs classified by average two- 131

year growth rate in revenues

Figure 23: Graph of average CARs classified by direction of 132

revenue change during the two years before the reverse split announcement

Figure 24: Graph of average CARs for different directional changes in 134

net income

Figure 25: Graph of average CARs for categories of book-to-market ratios 137

Figure 26: Graph comparing CARs of best 15 and worst 15 performers 140

six months after the reverse split announcement

Background Stock splits are interesting phenomena Conventional wisdom suggests that both forward and reverse stock splits should have no impact on the overall value of a company

as they normally represent a mere change in the number of shares of stock and the

corresponding par value per share resulting in no change in the assets, liabilities or

stockholder’s equity Nevertheless, Lakonishok and Lev (1987) indicate that stock splits have been a common practice since the beginning of the 1900s which suggests that managers find stock splits as useful tools to employ Considerable research has been conducted investigating why managers declare forward stock splits and the impact

thereof Studies of reverse stock splits, although much fewer in number, have also been completed to investigate the reasons for, and effects of, utilizing reverse stock splits

McNichols and Dravid (1990) find it puzzling that firms engage in forward stock splits Forward stock splits have been described as a cosmetic corporate event (Ikenberry, Rankine and Stice, 1996), as a finer slicing of a given cake (Lakonishok and Lev, 1987),

a minor financial maneuver (Futrelle, 1999) and as an arithmetic exercise (Baker and Gallagher, 1980) Copeland (1986) asserts that forward stock splits are nothing more than a paper transaction having no impact on a company’s future cash flows Hence, they should have no real economic impact

Nevertheless, Ikenberry, Rankine and Stice (1996) point out that "the market generally reacts favorably to split announcements" (p 357) Asquith, Healy and Palepu (1989) cite numerous studies that have shown positive stock price reactions upon

announcement of a forward stock split (see Bar-Yosef and Brown, 1977; Charest, 1978;

Foster and Vickery, 1978; Woolridge, 1983; and Grinblatt, Masulis and Titman, 1984)

Evidently, investors perceive the declaration of a forward split as “good” news generally

resulting in an increase in the overall value of the company Consequently, whether the

split is enacted to move the price of the stock to some optimal range or to signal positive

intimate information regarding future earnings or dividends, the declaration of a forward

stock split is viewed as a positive management initiative

Reverse stock splits have been described as the mirror image of forward splits

The prevailing wisdom is that reverse stock splits are a bad signal to investors Schack

(2003) suggests they are comparable to the last cigarette before the firing squad Tunick

(2002) contends reverse stock splits are last-ditch survival efforts and represent gimmicks

of management Gardner (2001) asserts that using a reverse stock split resembles

purposefully shooting yourself in the foot and has always been an ultra-rare Wall Street

maneuver However, Jain et al (2004) state that reverse stock splits have become

increasingly popular and argue that recent years have seen about as many reverse splits as

forward splits

Despite their recent increase in popularity, previous empirical studies have

generally shown that reverse splits reduce shareholder wealth (see Gillespie and Seitz,

1977b; Radcliffe and Gillespie, 1979; Woolridge and Chambers, 1983; Peterson and

Peterson, 1992; Han, 1995; and Desai and Jain, 1997 for example) If reverse stock splits

are generally perceived negatively and result in decreases in shareholder wealth, why

would managers, who are charged with increasing value to shareholders, ever utilize such

a technique and why would stockholders approve the measure? Interestingly, Gillespie

and Seitz (1977a) and Peterson and Peterson (1992) found that only about half of the

companies declaring a reverse stock split provided any specific reason for doing so

Not all reverse stock splits, however, have resulted in a negative effect on

shareholder wealth Peterson and Peterson (1992) found positive announcement returns

associated with “nondiscretionary” reverse splits Furthermore, Masse, Hanrahan and

Kushner (1997) also detected positive abnormal returns from reverse splits by Canadian

companies Jain et al (2004) conclude that the advantages associated with the use of

reverse splits appear to exceed the disadvantages Furthermore, since the bursting of the

tech bubble in the early 2000s, companies with high name recognition such as AT & T

Corp., 7-Eleven, and Palm, Inc., have declared a reverse split In analyzing reverse splits

from 2001, Simons (2002) found that the stock price of 39 of the 84 companies still being

traded increased in value (up an average of 66%) with 30 of them rising at least 20% after

the reverse split Norris (2003) argues that the declaration of reverse stock splits by

substantial companies could be a bullish sign Additionally, the success of

Microstrategy, Inc after their 2002 reverse stock split makes it difficult to conclude that,

ceteris paribis, reverse splits are necessarily a bad thing

Statement of the Problem Although empirical studies of reverse stock splits have generally detected

negative market reactions associated therewith, it is evident that negative reactions are

not universal Given that management is charged with the responsibility of increasing

value to shareholders, it would seem especially prudent to be transparent in explaining

the rationale for using a technique that generally results in a loss of shareholder wealth

Yet, as previously mentioned, only about half of the companies studied by Gillespie and

Seitz (1977a) and Peterson and Peterson (1992) did so

Previous research has resulted in the generation of a number of theories

attempting to explain why managers utilize reverse splits These theories are discussed in

detail in Chapter 2 One of the goals of this study is to determine if the proliferation of

reverse stock splits in the early 2000s and the high name recognition of companies

implementing reverse splits has impacted the number of companies providing a public

rationale for the reverse split and whether such reasons are consistent with the theories

generated

Additionally, does providing a public rationale for declaring a reverse stock split

have a different impact on a company’s stock price reaction to the reverse split than not

providing a public reason for engaging the reverse split? Furthermore, does the specific

type of rationale provided impact the stock price reaction?

The study also attempts to determine if other factors such as the company’s

market size, post-split price, exchange on which traded, growth rate in revenues and

earnings, book-to-market ratio and size of split ratio impact the reaction of a company’s

stock price to the announcement of a reverse split Finally, this study looks at the six

month, one- and two-year returns after the announcement of a reverse stock split to

investigate the longer-term market reaction to a reverse stock split

Research Questions This study is conducted in two phases The first phase consists of identifying all

the companies announcing a reverse stock split between July 1, 2002 and June 30, 2005

Phase one of the study also consists of investigating whether the companies that have

utilized a reverse stock split have publicly cited the reason(s) for doing so From this

phase, the four most commonly cited public rationales for declaring a reverse stock split

are identified Other financial data pertaining to the companies announcing a reverse

stock split are also gathered during this phase

The second phase of the study evaluates market reaction to the reverse stock split

announcement by looking for the existence of abnormal returns generated by each

company’s stock from two days before the announcement of the reverse stock split to two

days after the reverse split announcement The following research questions are

investigated during this phase:

1 Is the return for companies that publicly declare a rationale for a reverse split

better than for companies that do not?

2 Is there a difference in the returns associated with each of the four most

commonly cited rationales for declaring a reverse stock split?

3 Does the market size of the company impact the returns?

4 Does a higher post-split price result in better returns?

5 Does the stock exchange on which the stock is traded affect the post-split

performance?

6 Does the growth rate in revenues and earnings during the two year period

before the split impact the return?

7 Does a higher reverse split ratio result in better post-split performance?

8 Does the book-to-market ratio at the end of the year preceding the declaration

of the reverse split impact the market return for the company?

Listing of Research Hypotheses The following research hypotheses are derived from the research questions

noted above These hypotheses are described and discussed more fully in Chapter 3

Hypothesis 1

The price behavior surrounding the announcement of a reverse stock split is not

affected by whether or not a company provides a public rationale for declaring a reverse

stock split

Hypothesis 2

The price behavior surrounding the announcement of a reverse stock split is not

affected by the type of public rationale provided by the company

Hypothesis 3

The price behavior surrounding the announcement of a reverse stock split is

independent of the market size of the common equity before the reverse split

Hypothesis 4

Post-announcement stock price behavior is independent of the post-split price

range of the security

Hypothesis 5

Price behavior surrounding the announcement of a reverse stock split is

independent of the exchange upon which the security is traded

Hypothesis 6

Post-split price behavior is independent of the size of the reverse split ratio

Hypothesis 7

Price behavior surrounding the announcement of a reverse stock split is

independent of the two-year growth rate in revenues

Hypothesis 8

Price behavior surrounding the announcement of a reverse stock split is

independent of the directional change in net income for the year preceding the reverse

split announcement

Hypothesis 9

Price behavior surrounding the announcement of a reverse stock split is

independent of the company’s book-to-market ratio

Significance of the Study One of the expected contributions from this study is the determination of whether

more companies are now providing a public rationale when using reverse stock splits In

this post-Sarbanes-Oxley environment whereby transparency in financial disclosures is

desired, one would expect to find a higher percentage of companies providing a rationale

for declaring a reverse stock split than found by Gillespie and Seitz (1977a) and Peterson

and Peterson (1992) in their earlier studies

Both Gillespie (1974) and Pickford (1985) found better performance for larger,

well established companies after declaring a reverse stock split Pickford (1985) detected

a positive rebound and recovery for the larger companies included in her study This

study will provide an opportunity to see if the market reaction to larger companies

announcing a reverse stock split is still stronger than those of smaller firms or whether

company size affects the stock price behavior at all after announcing a reverse split

Peterson and Peterson (1992) found positive two-day abnormal returns associated

with nondiscretionary reverse stock splits They defined a nondiscretionary split as one

required to prevent delisting or to satisfy creditors This study expands on the types or

categories of reverse splits to evaluate whether the type of rationale provided by a

company for engaging a reverse split impacts the market return Do investors react to

certain types of splits more favorably than to others?

Using monthly stock price data, Gillespie (1974) analyzed the price impact of

factors such as post-split stock prices, split ratios and exchange listings of reverse stock

splits Gillespie (1974) rejected the notion that post-split price behavior is independent of

each of the factors noted This study evaluates whether conditions have changed

regarding whether these factors influence post-split stock price behavior Furthermore,

this study looks at daily price data as opposed to monthly price data attempting to capture

the immediate price impact associated with the reverse stock split announcements

Definitions, Limitations and Assumptions This section of the chapter provides definitions for some key terms, concepts and

measurements that are used in this study The operationalizing of these terms is

extremely important especially in light of the methodology issues discussed in Chapter 3

This section also highlights the limitations and key assumptions associated with this

study

Definition of Terms and Concepts

Abnormal return The abnormal or excess return for an individual security is the

difference between the actual return (defined later) for a company’s stock for a particular

day and the normal or expected return (defined later)

Actual return The actual return for an individual security is measured by the

change in the daily closing price for the common stock divided by the earlier day closing

price Any dividend paid by the company during the period reviewed is added to the

numerator of the above computation for that day

Announcement date The announcement date for the reverse split is determined

from the dividend news item reported daily in The Wall Street Journal

Book-to-market ratio The book-to-market ratio is the relationship between the

book value of the common stock and the market value of the common shares at the end of

the year prior to the announcement of the reverse split The book value per share is

computed by dividing the total common equity by the number of common shares

outstanding, each determined at the end of the year prior to the reverse split

announcement The common equity is computed by subtracting the liquidation

preference amounts or par value of any preferred stock issuances from total stockholders

equity The market price is the closing price of the common stock as of the end of the

year prior to the announcement of the reverse stock split For statistical analysis purposes

the companies are grouped into the following categories: < 0; 0 to 0.25; > 0.25 to 0.5; >

0.5 to 1.0; and > 1.0

Market return The market return is measured by the change in the closing value

for the Wilshire 5000 Total Market Index divided by the closing value for the earlier day

Net income growth rate The net income growth rate is the average of the growth

rates in net income for each of the two years preceding the announcement of the reverse

split For analysis purposes, the original intent was to divide the companies into loss and

income groups The loss group was to be further categorized into three classes as

follows: < -100%; -100% to < -30%; and -30% to < 0.00% The income group was to be

classified into these three categories: > 0.00% to < 20%; 20% to < 60%; and > 60%

However, wild fluctuations in net income resulted in the creation of a new metric to

evaluate the impact of net income on post-split stock price behavior The direction

change in net income for the year preceding the split announcement is determined and the

companies are divided into the following categories: larger loss; smaller loss; smaller or

larger income; loss to income and income to loss

Normal return The normal return for an individual security is the return expected

from the security without consideration of the event taking place Some type of model

must be used to measure this return which is discussed in detail in Chapters 2 and 3

Post-split share price The post-split share price is the opening price of the stock

after the effective date of the reverse stock split For analysis purposes the post-split

share prices are grouped into the following categories: < $1.00; U $1.00 to < $2.00; U

$2.00 to < $3.00; U $3.00 to < $4.00; U $4.00 to < $5.00; U $5.00 to < $10.00; and U

$10.00

Rationale for reverse split The public rationale provided by management for

implementing a reverse stock split is determined by analyzing the shareholder proxy

filings with the SEC (Form DEF 14A or its equivalent) and/or by reviewing public news

releases provided by the company

Revenue growth rate The revenue growth rate is the average of the growth rate

in total revenues for each of the two years preceding the announcement of the reverse

split For analysis, the companies are grouped in the following categories: < 20.0%; U

-20.0% to < 0.0%; no revenues, > 0.0% to +15.0%; > +15.0% to +50.0%; and > +50.0%

Size of company The size of the company is determined by the market value of

the common equity as of the year end preceding the announcement of the reverse stock

split The value is computed as the number of common shares outstanding multiplied by

the closing market price of the common stock at the preceding year end For analysis

purposes the companies are categorized as follows: W $10,000,000; > $10,000,000 to

$40,000,000; > $40,000,000 to $100,000,000; and > $100,000,000

Size of reverse split ratio At the time of the reverse split, the number of shares of

the company is consolidated into a smaller number of shares as determined by the reverse

split ratio For example, after a 1-to-4 reverse split is effective, the number of shares

outstanding would be 25% of the previous number of shares This also impacts the

presumed market price adjustment to the company’s stock In this example, theoretically

the market price of the stock when the reverse split is effective should be about four times

higher than before the split For analysis purposes, companies are grouped into the

following split ratio categories: < 1 : 5; 1 : 5 to < 1 : 10; 1 : 10 to < 1 : 20; and

U 1: 20

Limitations of Study

Cooper and Schindler (2003) contend that perfect research designs are few in

number and that most studies have certain limitations which can impact the conclusions

of the study The following limitations apply to this study

First, only domestic companies are included in the sample of companies

announcing a reverse stock split Consequently, if an investor had foreign companies

facing a reverse stock split included in their portfolio, the results of this study may not be

applicable to such foreign companies Meaningful results from this study could open the

door for future research applying similar procedures to foreign companies

Another limitation is that only reverse splits of common stocks are considered It

is likely that most reverse splits are associated with the common stock of a company;

however, it is possible for preferred shares to also be subject to a reverse stock split

Nevertheless, during the period of this study, no reverse splits of preferred stocks were

noted Once again, generalizability of the results of this study to preferred stock reverse

splits may be limited

Certain filtering procedures are used to screen companies included in the final

sample For example, companies with concurrent confounding events, such as a merger

or acquisition, are eliminated from the analysis phase of the study This is done in order

to evaluate the impact of only the reverse split announcement on the stock price behavior

Additionally, only companies with sufficient financial data available in the estimation

and event windows are included in the final sample Given the estimation window is

prior to the reverse split announcement and that the event window ends two days after the

announcement, it is not expected that this will be a major limiting factor However, if a

company has been liquidated and terminated after a reverse split, historical price

information may be unavailable introducing the possibility of survivor bias in the results

Key Assumptions

One of the key assumptions of this study is that the reasons provided by

management to investors for engaging the reverse stock split are accurate and truthful It

is possible for management to maintain ulterior motives for conducting the reverse stock

split that are not conveyed publicly If this is true, this represents another limitation of

the study However, it was assumed that company management is open and honest in

providing the reasons for their reverse stock split

A second major assumption underlying this study pertains to the validity of the

semi-strong form of the Efficient Markets Hypothesis (EMH) regarding the speed at

which stock prices respond to new public information Generally, event study research

has indicated that stock prices seem to adjust to new information within a day of the

event announcement (Fama, 1991; Russel and Torbey, 2002) Ferreira and Brooks

(2000) contend that prices generally respond to new information within a few stock

market transactions Fama (1991) contends that such results are so common that little

space is allocated to discussing the market efficiency of event studies

However, according to Findlay and Williams (2001), the semi-strong form of the

EMH also implies that a stock price always fairly reflects the new information It is

possible for stock prices to react quickly to new information but to not fully reflect the

true informational value provided by the new information Stout (2003) asserts that the

type of event being studied should be considered when evaluating the efficiency with

which markets incorporate new information She contends that events that are highly

publicized and easy to understand are more apt to be fairly reflected in the market price

adjustment Fama (1991) concludes that event studies provide the cleanest evidence

regarding market efficiency

Although a reverse stock split event may not be highly publicized, public

awareness of the event is possible through the reporting of the reverse split by The Wall

Street Journal The reverse stock split event itself is fairly easy to understand (although

the rationale and market reaction to the reverse split may not be fully understood,

prompting the necessity of this study) Consequently, it is plausible to assume that the

market price of the stock will react quickly to the reverse split announcement This

justifies the use of an event window consisting of the period from two days before to two

days after the announcement of the reverse split Long-term abnormal returns associated

with stock price behavior for periods one or two years after the reverse split would

provide challenges to the EMH Although this study briefly analyzes the longer term

performance of companies announcing a reverse stock split, the question as to whether

such evidence provides a challenge to the EMH is beyond the scope of this study

Conclusion Although reverse stock splits should seemingly have no impact on the wealth of

the shareholders, previous studies have found such effects This study attempts to

determine if the stock price behavior is significantly different if a public explanation for

the reverse split is provided by management versus when an explanation is not provided

Additionally, the study considers whether diverse publicly expressed rationales and other

economic factors impact the stock price behavior after announcing a reverse split A

review of prior studies identifying possible rationales for reverse splits and abnormal

returns associated therewith is discussed in the next chapter

The lack of attention given to reverse stock splits is not limited to academic research Pickford (1985) claims that financial management textbooks commonly define the term reverse split with no further details When further discussion is provided,

Pickford (1985) contends that it is likely to be negative Although a complete review of the information accounting and financial management textbooks provide regarding reverse stock splits is beyond the scope of this study, a few popular textbooks were reviewed Pyle and White (1966), Emery, Finnerty and Stowe (2004) and Warren, Reeve and Fess (2005) made no mention of reverse splits at all in their texts Kieso, Weygandt and Warfield (2005) did not discuss reverse splits in the text but provided a sidebar referencing an article discussing the increase in the number of reverse stock splits

in the early 2000s VanHorne and Wacowicz (2001) provide a brief description of what a

reverse stock split is and suggest that the number of unsuccessful reverse stock splits

should force a healthy company to think twice before declaring a reverse stock split

Perhaps the silence pertaining to reverse stock splits in academic textbooks stems

from the lack of attention given to reverse splits in the official accounting

pronouncements Section B of Chapter 7 in Accounting Research Bulletin 43 (ARB 43)

contains a discussion differentiating the treatment of a stock dividend and a stock split to

both the recipient and the issuer (American Institute of Certified Public Accountants,

1953) Interestingly, nothing is said about a reverse stock split in this pronouncement

The only mention of reverse stock splits in the official accounting pronouncements is

made in reference to the computation of earnings per share FAS 128: Earnings per

Share (which superseded APB Opinion 15: Earnings per Share) requires the calculation

of both basic and diluted earnings per share to be adjusted retroactively if the number of

shares decreases as a result of a reverse stock split (FASB, 1997)

Nevertheless, the accounting for a reverse stock split is derived from the guidance

provided in ARB 43 pertaining to forward stock splits Paragraph 15 of Chapter 7,

Section B, in ARB 43 provides that managerial intent plays a role in determining the

proper accounting When the motivation of declaring a forward split is to reduce the

market price of the stock, thus, obtaining improved marketability and a wider distribution

of the shares then only a memorandum entry is required on the books There is no

transfer from the retained earnings account to the capital stock accounts as there is with a

stock dividend Applying reverse logic to this guidance suggests that if management’s

intent was to increase the market price of the stock through the use of a reverse stock split

then no formal entries on the books would be required

However, companies have implemented reverse stock splits in a variety of ways

When the reverse stock split is accompanied by a proportionate increase in the par value

of the shares then the guidance of ARB 43 is applicable Pickford (1985) contends that

this is the most popular and simplest way of accounting for reverse splits Sometimes

companies will not change the par value of their stock when a reverse split is

implemented resulting in a transfer from the capital stock account to the paid in capital in

excess of par or retained earnings account This is necessary because the fewer number

of shares after the reverse split would have a lower total par value necessitating the

transfer in the equity accounts A change from par value to no par value stock or vice

versa also requires adjustments in the equity accounts on the corporation’s books (see

Owens, 1946 and Jome, 1948)

Reverse stock splits have also been referred to as stock split-downs (Owens,

1946), decapitalizations (Jome, 1948) and consolidations (Jain, et al., 2004) Jome

(1948) refers to the process of decapitalization as “the squeezing out of the water” (p

220) of overcapitalized or watered stock and suggests it is a painful process, a sad

occasion and a cause of wringing of hands by shareholders However, both Cherrington

(1948) and Dewing (1941) refer to the 1-for-4 reverse stock split declared by General

Motors Corporation in 1924 and the success they had in building the value of the shares

with the reverse split Dewing (1941) suggests that management has some measure of

control over the market price of their stock Hence he viewed both forward and reverse

stock splits as legitimate management tools Dewing (1941) wrote:

Consequently, if corporation managers are to restrict the market price of their

shares within even a wide range, they must employ some direct means to effect

an increase in the number of shares of their stock during times of prosperity and

to effect a decrease during periods of adversity (p 1242)

Although Dewing (1941) believed it was just as logical to implement a reverse

split when stock prices were deflated as it is to use a forward split when a company’s

stock price is high, he claimed it is against human inclination to do so Dewing (1941)

suggests that such an action by management constitutes an acknowledgement of the

previous era of overvaluation implying incompetent management Management would

prefer to blame deteriorating general conditions for the stock price decline rather than a

decline in the fundamental value of their company’s stock

Wert and Prather (1975) mention the 1938 1-for-10 reverse stock split conducted

by Cities Service Company claiming it is one of the most famous reverse splits to occur

Thus, clearly the controversy over the use of reverse stock splits has existed for a long

time Some companies have used them successfully and some have had disastrous results

after implementing a reverse split Is there a way to be able to predict the potential

success in using a reverse stock split and what role do management intentions in

declaring the reverse split play in evaluating the market reaction to the action?

The remainder of this chapter examines previous research of reverse stock splits

focusing especially on the areas of interest contemplated by this study The major topics

explored include what previous research has shown regarding the frequency with which

management has provided a public rationale for utilizing the reverse split tactic, theories

developed as to potential motivations for declaring reverse splits, a review of various

stock exchange requirements regarding the declaration of and disclosures required when

a reverse split is used by management An examination of earlier studies investigating

the existence of abnormal returns surrounding a reverse stock split will also be discussed

Additionally, support for the factors to be included in the current study’s analysis will be

documented and substantiated based on the earlier research

Management’s Expression of Rationale for Using a Reverse Stock Split

Only a few of the previous empirical studies of reverse stock splits have

investigated the actual motivations cited by management for declaring a reverse stock

split Furthermore, researchers attempting to discover a public reason provided by

management for using a reverse split were not always successful

Gillespie and Seitz (1977a) examined 24 reverse splits between 1970 and 1976 by

NYSE and AMEX companies They found that only 13 of the 24 companies provided a

public reason for implementing the reverse stock split Peterson and Peterson (1992)

suggest that management proxy statements may provide information regarding the motive

for using the reverse split tactic Their study included reverse splits occurring between

July 1962 and December 1989 by NYSE and AMEX companies and between November

1972 and December 1989 by Nasdaq firms Nevertheless, they found that 53.8% of the

reverse splits, with specific announcement dates and uncontaminated by other events,

failed to provide a reason for declaring the reverse split Given the negative perceptions

associated with the use of reverse stock splits, these findings are surprising It would

seem prudent for management to carefully explain the reasons for, and benefits

associated with, the reverse stock split

One of the major objectives of the Sarbanes-Oxley legislation passed in 2002 is

increased financial transparency for all publicly held companies for the protection of

investors Consequently, it is expected that the rationale and expected benefits associated

with the declaration of a reverse stock split will be provided by most of the companies

included in this study

Reverse Split Theories from Previous Research Although the previous studies of actual publicly cited motivations for declaring a

reverse stock split have not proved abundantly fruitful, a number of theories explaining

why companies declare reverse stock splits have been proposed in earlier research Many

of the potential motives for using a reverse split appear to be derived from research

associated with forward splits Pickford (1985) outlines the two direct impacts of

conducting a reverse split: an increase in the market price of the shares and a reduction in

the number of shares, and suggests that the proposed motivations for declaring a reverse

stock split may be classified accordingly

Motivations Associated with Increase in the Market Price of the Shares

One of the most commonly cited reasons for declaring a reverse stock split is to

move the price of the stock into some optimal price range (Wert and Prather, 1975;

Peterson and Peterson, 1992; Radcliffe and Gillespie, 1979; Vafeas, 2001) This

rationale corresponds with a frequent explanation for using forward stock splits

Copeland (1986) asserts “there is a strong belief, religiously attested to in the folklore of

Wall Street, that there is an ‘optimal trading range’ for security prices—one that enhances

the ‘marketability’ or ‘liquidity’ of a company’s stock by broadening its stockholder

base” (p 13)

This "optimal trading range" is somewhat elusive Dewing (1941) cites a study by

Fichtenbaum and Dolley showing a range between $25-$75 per share Copeland (1986)

asserts the range is generally believed to be between $20-$40 per share and Baker and

Powell (1993) suggest the range is between $20-$35 per share If an “optimal trading

range” does indeed exist and it lies between $20-$75 per share, it is doubtful that most

reverse splits enable a company’s stock to trade within this range Woolridge and

Chambers (1983) state that most reverse splits are implemented by small firms whose

stock is traded at extremely low price levels They contend that a general dissatisfaction

with the market price of their stock is an underlying factor for management in most

reverse stock split decisions

Hence a second commonly cited motivation for implementing a reverse stock split

is to prevent delisting from a stock exchange (Jain, et al., 2004; Peterson and Peterson,

1992) Han (1995) suggests that empirical evidence does not support the notion that

reverse splits occur to meet stock exchange requirements He cites evidence from

Peterson and Peterson (1982) indicating that 82% of the reverse splits they examined

were discretionary Nevertheless, the use of a reverse stock split to avoid delisting

appears to be a successful strategy Jain et al (2004) found that less than 15% of the

firms implementing a reverse split get delisted in the first year and that over 60% survive

three or more years It is expected that using a reverse split to meet stock exchange

requirements and avoid delisting will be a common reason cited in this study

It has been suggested that the higher share prices resulting from a reverse stock

split increases the probability of investors being able to use such securities as collateral

for loans (Dewing, 1941; Wert and Prather, 1975; Woolridge and Chambers, 1983) and in

margin transactions (Peterson and Peterson, 1992; Han, 1995) Han (1995) asserts that

such factors may improve the liquidity of the stock It is not expected that this will be a

major factor cited by companies for using a reverse stock split in this current study

Owens (1946) and Wert and Prather (1975) contend that management may expect

an improvement in the company’s credit rating after declaring a reverse stock split An

improved credit rating enables the company to borrow money at a lower cost and under

more favorable terms (Wert and Prather, 1975) Presumably an improved credit rating

would result from an improved company image after the reverse split This is another

possible motivation for using a reverse split which will be discussed next It is not

expected that many companies will cite an improved credit rating as their reason for

implementing a reverse stock split in the current study

Improving the company image was just mentioned as another possible motivation

for management to declare a reverse stock split A supposed by-product of an improved

image is the attraction of institutional investors to the company’s stock (Woolridge and

Chambers, 1983; Peterson and Peterson, 1992; Han, 1995; Vafeas, 2001; Jain, et al.,

2004) Peterson and Peterson (1992) argue that the increased stock price resulting from a

reverse stock split may enable a company to change its image from a “penny” stock

Woolridge and Chambers (1983) assert a higher stock price may increase the perceived

quality of the stock as an investment Han (1995) suggests this is important as

professional fund managers, especially pension fund managers, must be prepared to

justify the acquisitions to their portfolios Consequently, they will naturally gravitate

towards companies with a higher perceived quality

Empirical studies of increased institutional interest after a reverse split are mixed

Gillespie and Seitz (1977a) concluded that institutional ownership did not change

subsequent to a reverse split However, Jain et al (2004) found significant (at the 0.05

level) increased institutional ownership provided the post-split stock price was at least $5

per share If the stock price was below $5 per share, they detected decreasing

institutional ownership Regardless of the conflicting outcomes of the above studies, it is

expected that improving the company image to attract institutional investors will be a

very common explanation of management for utilizing a reverse split in the current study

Motivations Associated With the Reduction in the Number of Shares

Effecting a reverse stock split will automatically result in a decrease in the

number of shares a company has outstanding It is also common for the reverse split to

result in a reduction in the number of shareholders For example, the declaration of a

1-for-10 reverse stock split results in the elimination of any shareholder owning less than

10 shares when cash is paid in lieu of issuing fractional shares Using the framework

provided by Pickford (1985), some of the cited motivations for declaring a reverse stock

split can be associated with this outcome

The decrease in the number of shareholders after a reverse split enables the

company to reduce their shareholder servicing costs, such as registrar fees and

shareholder mailing expenses This has been cited as another possible motivation for

declaring a reverse stock split (West and Brouilette, 1970; Radcliffe and Gillespie, 1979;

Woolridge and Chambers, 1983; Peterson and Peterson, 1992; Vafeas, 2001) Radcliffe

and Gillespie (1979) argue that the immediate costs involved to implement the reverse

split would likely exceed the future benefits gained so this rationale for a reverse split has

little credibility However, Anonymous (1999) reports that the reverse split conducted by

NCR Corp after it split off from AT&T Corp involved a one-time cost of about $2

million initially, but the expectations were that amount would be saved each year in the

future after the reduction in the number of shareholders resulting from the 1-for-10

reverse stock split It is expected that this will be a frequently cited motivation for

declaring a reverse stock split in the current study

Cost savings for investors has also been cited as a potential motivation for

managers to utilize a reverse stock split (Woolridge and Chambers, 1983; Peterson and

Peterson, 1992; Jain, et al., 2004) Jain et al (2004) plotted average percentage quoted

and percentage effective spreads for 40 days before and after the reverse splits in their

sample They detected a substantial decrease in the spreads after the reverse split for both

NYSE/AMEX and Nasdaq reverse splits, indicating that transaction costs do decline

subsequent to a reverse split It is not anticipated that this will be a significant motivating

factor for the reverse stock splits in the current study