Reverse stock splits, motivations, effectiveness and stock price reactions

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

UMI Microform 3282643
Copyright 2007 by ProQuest Information and Learning Company.
All rights reserved. This microform edition is protected against
unauthorized copying under Title 17, United States Code.

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The members of the Committee approve the dissertation of Barry
Marchman defended June 5, 2005

Gary Benesh
Professor Directing Dissertation

Rick Morton
Outside Committee Member

Stephen Celec
Committee Member

Yingmei Cheng
Committee Member

Approved:

Caryn L Beck-Dudley, Dean, College of Business

The Office of Graduate Studies has verified and approved the above named
committee members.
ii


For RC JAM and Evelyn

iii

ACKNOWLEDGEMENTS
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.

iv


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

v


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

vi


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

vii


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 Exdate - 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 (19622003).....................................................................................................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
Independent Variable............................................................................137
viii


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

ix


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

x


ABSTRACT

Stock price reactions to reverse stock splits are examined in relation to various

firm characteristics and market movements. It is found that the market reacts stronger
on the ex-date than on the announcement date. The market reaction varies by industry
and by reason given for the reverse stock split. Firms that split for regulatory reasons
perform worse than firms that split for other reasons. In the long run, there is little
evidence of a negative abnormal buy and hold abnormal return (BHAR) after a reverse
stock split, but there is some evidence BHARs varying by industry.
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.

xi


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.

1


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.

2


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

3


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 Splits6
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.
An extensive overview is presented in Chapter 2.

6

4


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 tripledigit 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
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
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.
8

5


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 preannouncement price drift, a positive reaction on announcement day, and shortterm and long-term positive abnormal returns. Researchers attribute the positive
abnormal returns to either a sluggish response to the positive information (underreaction) 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
11

Forbes, January 25, 2002, referencing Thomson Financial/First.
This table is referenced again in chapter 3.

6


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
12

Daniel, Hirshleifer, and Subrahmanyam (1988) model how analysts might overweight their own
priors when valuing firms and thus underweight new information such as split announcements.
13
Stocks that reverse split are sometimes delisted shortly thereafter. For example, PlanetRx.com
did an 8-for-1 reverse split on December 14, 2000, and was delisted two weeks later. Eglobe did a
47-for-10 split on November 13, 2000, and was delisted nine days later. Why did these companies
incur the expense of the reverse split?
14
The market value of equity is shares outstanding times share price.

7


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.

8


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.”

9

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

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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

1.3.4 Signaling
Empirical studies on reverse stock splits are in agreement that, on average,
reverse splits reduce the value of the splitting firm; abnormal negative returns tend
to follow the reverse split. This observation suggests that reverse splitting conveys
negative information about the firm. However, as mentioned earlier, some
companies have recently experienced positive share price increases in the months
after a reverse split. This observation suggests that the reverse split event is not
always negative and that the market reaction to a reverse split may instead be
driven by other factors.19 Perhaps the returns associated with a reverse split are

17

Margin requirement rules, Securities Exchange Act of 1934.
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
18

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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.

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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
regulatory reasons.
Closely related to the wealth effects is the enormous loss in the value of
NASDAQ composite stock index during 2000 and 2001. This loss of equity value
in technology stocks has been referred to as the Internet Bubble burst. Laying
aside the arguments concerning whether or not there was an Internet Bubble, the
systematic loss of equity value during this period is given as the motivation for
exchange rule changes and other regulatory changes. Did the systematic loss of
equity value contribute to a firm’s decision to reverse split its stock? Firms that
may never have considered reverse splitting their stocks may have been caught in
the systematic downdraft of equity prices and therefore felt obligated to prop up
their otherwise healthy company’s stock price. They may have felt that the price
was too low due to exchange requirements, trading range goals, liquidity
concerns, or other market considerations.

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