Reverse Splits and Shareholder Wealth

Reverse Splits and Shareholder WealthAuthor(s): J. Randall Woolridge and Donald R. ChambersSource: Financial Management, Vol. 12, No. 3 (Autumn, 1983), pp. 5-15Published by: Wiley on behalf of the Financial Management Association InternationalStable URL: http://www.jstor.org/stable/3665511 .

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Reverse Splits and Shareholder Wealth

J. Randall Woolridge and Donald R. Chambers

The authors are Assistant Professors of Finance in the College of Business Administration at The Pennsylvania State University.

1. Introduction Reverse splits, unlike their direct counterparts, have

received little attention in the academic literature. In

perfect capital markets, neither reverse nor direct splits influence shareholder wealth. In practice, however, market imperfections such as transactions costs and information asymmetries can be cited in defending splits as management tools. In their seminal article, Fama, Fisher, Jensen, and Roll [2] analyze the impact of direct splits on stockholder returns. Their conclusion, which has been corroborated in subsequent studies, is that direct splits, per se, have no effect on shareholder wealth.

Over the past decade more than 20 reverse splits per year have been declared by NYSE, AMEX, and listed OTC firms. Most reverse splits have been declared by relatively small firms whose stock was trading at ab-

normally low price levels. Two recent empirical studies (Gillespie and Seitz [4] and Radcliffe and Gillespie [7]) have concluded that reverse splits, in general, are detrimental to shareholder wealth. However, these results may be questioned on methodological and data

grounds. In this paper the impact of reverse splits on shareholder wealth is investigated using a more refined methodology and better data.

The following section reviews the previous reverse splits studies. In Section III, two hypotheses regarding reverse splits and stock prices are identified - a trading imperfections and an information asymmetries hypothesis - and the pricing implications of each on the proposal, approval, and effective dates are discussed. The data, methodology and empirical results are detailed in Sections IV and V. Hypotheses con-

cerning other factors that may influence investors' re- actions to reverse splits are analyzed in Section VI. The final section summarizes the study and provides implications for both investors and financial managers.

II. Previous Empirical Studies A reverse split involves a substitution of one new

share for a certain number of outstanding shares. The

par value of the new shares is usually increased by the size of the split factor.' Reverse splits are proposed by a firm's board of directors and then must be approved by a vote of shareholders before they can be effected.

'In some cases, firms eliminate par value when reverse splitting their stocks.



FINANCIAL MANAGEMENT/AUTUMN 1983

The factor(s) that motivate firms to reverse split their stock is (are) not well understood but general dissatisfaction with the price at which shares are trading in the marketplace is an underlying factor for most reverse splits. West and Brouilette 18] offer some reasons for reverse splits. The absolute level of share

prices may influence investors' perceptions concerning the size, importance, or quality of a company. If this argument is valid, a firm may elect to reverse split its stock to enhance its "image" among investors. In addition, higher share prices (as a result of a reverse split) are normally more acceptable to brokers as col- lateral for loans, can lead to lower trading commis- sions and transfer taxes for investors, and can lower stockholder servicing expenses for the firm.

Gillespie and Seitz 131 investigated the motivation behind 24 reverse splits declared between 1970 and 1976 by NYSE and AMEX firms. They found that only 13 of the 24 firms gave any public reason for a reverse split. Of those 13, image improvement was the most common reason given, followed by (2) compli- ance with stock exchange requirements, (3) appeal to a different type of investor, and (4) reduction of stockholder service costs. They also tested to determine if firms receive benefits from reverse splits in the form of increased trading volume, more shareholders, and increased institutional interest. They discovered that while trading volume did increase somewhat, the number of shareholders declined and institutional interest did not change. They conclude that "reverse splits are not justified in terms of any tangible benefits related to the stated motivations."

West and Brouilette [8], Gillespie and Seitz [4], and Radcliffe and Gillespie [7] have analyzed the relationship between reverse splits and share prices. These studies are briefly reviewed below.

West and Brouilette (hereafter W-B) analyzed ex- split day share prices for over 30 reverse splits declared by NYSE and AMEX firms over the 1958-67 decade. They compared actual and predicted opening ex-split day prices, where the predicted opening price is defined as the day prior close adjusted for the reverse split. Looking at the distribution of the mean differ- ences between actual and predicted prices, they discovered the median value was zero, but the mean was - 2.8%. Whereas these results may imply that for the average firm the stock price did not rise by the full amount of the split factor, upon further examination they discovered a positive relationship between recent operating performance (years of positive earnings) and the degree of ex-split day price adjustments.

Gillespie and Seitz (hereafter G-S) and Radcliffe and Gillespie (hereafter R-G) both investigated stock returns around reverse splits. Since their data, methodology, and results are all quite similar, their studies are reviewed together. G-S and R-G analyzed monthly market model residuals around ex-split dates for NYSE and AMEX reverse splits declared over the 1960-1976 period and compared these results with the monthly market model residuals for direct stock splits (as discovered by Fama, Fisher, Jensen, and Roll 121 (hereafter FFJR)). For the 12 months preceding to one month before the effective dates (- 12 to - 1) of the two types of splits, the cumulative market model residuals move in similar fashion but in opposite direc- tions; the direct split residuals are positive and the reverse split residuals are negative. For months - 1 to + 12, the cumulative residuals for direct splits remain relatively constant while the cumulative residuals for reverse splits continue to move in a negative direction, with a large negative return in the split month. Both studies also looked at the impact of dividend policy and of post-split price range to see if these factors influenced shareholders' returns, but no significant patterns could be detected. They concluded that while the negative returns around reverse splits are a function of deteriorating firm conditions, it is likely that the large negative returns in the split month indicate that reverse splits themselves are detrimental to shareholder wealth. Presumably, this results from the information conveyed to the market through the split.

III. Reverse Splits and Share Prices The impact of reverse splits on shareholder returns

concerns investors and financial managers alike. In a perfect markets environment with perfectly divisible financial assets, homogeneous investor expectations, and no transactions costs, reverse splits have no effect whatsoever on shareholder wealth. Stock prices are not influenced by a firm proposing or announcing a reverse

split, and the expected price adjustment on the ex-split day is the day prior closing price adjusted for the reverse split. However, in less than perfect markets, trading and information imperfections may cause stock price to react to reverse splits on the day the board proposes the reverse split, and/or on the day it is announced that shareholders have approved or rejected the reverse split, and/or on the day the reverse split becomes effective. The potential pricing effects of these imperfections (and the form they take) on these three dates are contained in Exhibit 1.

The potential pricing effects on the proposal and

6



WOOLRIDGE, CHAMBERS/REVERSE SPLITS AND SHAREHOLDER WEALTH

Exhibit 1. Potential Pricing Effects of Reverse Splits on the Proposal, Approval, and Effective Dates

DATE

Proposal/Approval Effective

1. Lower trading costs and taxes and enhanced margin eligibility

Positive 2. Reduced stockholder servicing expenses.

3. Enhanced image. 1. Inability to increase share 1. Transactions costs.

Negative prices by traditional means. 2. Indivisibilities.

approval dates are identical. Approval day stock

prices, however, will only be affected to the extent that uncertainty is resolved concerning the outcome of the shareholders' vote on the reverse split. Trading considerations of reverse splits may have a positive impact on the proposal/approval date stock prices. Investors may derive benefits from lower trading costs and taxes and enhanced margin eligibility. In addition, firms should

expect reduced stockholder servicing expenses due to the reduction in shares outstanding.

Information conveyed to shareholders by a firm proposing or approving a reverse split may be positive or negative. As previously stated, reverse splits have gen- erally been declared by small firms whose stock was selling at very low levels. As such, they have received much adverse publicity in the financial press.2 By reverse splitting their shares, managers may be admitting to investors that they do not anticipate that share prices will increase in the near future to a higher, preferred level in the absence of a reverse split.

A positive informational effect may result from image enhancement. Gillespie and Seitz [3] discovered image improvement to be the most common motivation for reverse splits. If higher stock prices do enhance a firm's image or provide other benefits to a firm, then stock prices would be affected positively on the proposal and/or approval dates.

The expected opening price on the effective date is equal to the closing price from the day prior adjusted for the reverse split. If the effective day stock price tended to be greater (less) than the expected price, investors would buy (short sell) the stock on the day prior and reverse the transaction the following day. In this manner arbitragers would eliminate any abnormal price behavior around the effective date. However, indivisibilities and transactions costs may have a nega-

2See Merjos [6] and West and Brouilette [8].

tive impact on effective date stock returns. Stock prices may not increase by the full amount of the split since trading only occurs at intervals on organized exchanges. Transactions costs may also cause the effective date price increase to be less than expected because arbitragers will only eliminate abnormal price behavior to the point where the price increase equals the expected adjustment minus trading costs. This effect is buffered somewhat for reverse splits (compared with direct splits) because they tend to increase the number of investors holding shares in odd lots.

It should be noted that the alternative price effects on the proposal/approval and effective dates are not

necessarily mutually exclusive. On each date, it is possible that both the effects of information and trading factors are reflected in security prices. However, in the tests that follow, conclusions can only be drawn

concerning the predominate effect on the different dates.

IV. Data and Methodology To gain a better understanding of the impact of re-

verse splits on shareholder wealth, this study employs improved data and a more refined methodology than used in previous studies. Specifically: 1) daily and not monthly returns are analyzed around reverse splits using a mean adjusted return measure. The advantage of employing daily as opposed to monthly returns is to isolate the effects of reverse splits. In a shorter time period price movements are more discernible and less subject to information influences other than the reverse split; 2) in contrast to previous studies, returns are analyzed not just around the effective date but also around the proposal and approval dates; 3) observations have been screened to insure that other firm- specific news was not announced around the date un- der examination. The objective of this screen is to minimize the impact of other information on stock

DIRECTIONAL IMPACT

ON STOCK PRICE

7




prices; and 4) an analysis is performed to ascertain if split size, ex-split price ranges, dividend policy, and previous earnings are related to shareholder wealth around reverse splits.

A. Data All reverse splits declared by AMEX and NYSE

firms over the 1962 to 1981 period are initially considered for inclusion in the sample.3 Several sample screens are then used. First, daily returns must be available on the Center for Research in Security Prices (CRSP) Daily Return File for at least 90 days before and 30 days after around each reverse split. Secondly, for a reverse split to be included in the proposal/approval/effective date samples, it had to be published in the Wall Street Journal (WSJ) (as indicated in the Wall Street Journal Index). In addition, to minimize the impact of other information on stock prices, an observation is deleted from the proposal/approval/effective date samples if other firm-specific information was published in the WSJ within two days of the date in question (as indicated by the Wall Street Journal Index).

B. Methodology To ascertain the impact of reverse splits on share-

holder returns, the Mean Adjusted Returns Approach (MARA) is employed. Using monthly returns Brown and Warner Il1 have shown mean adjusted and com- parison period approaches to be at least as powerful as market adjusted approaches in detecting significant price movements for nonclustered events. Masulis [5] notes that this conclusion is even stronger when using daily returns due to the very low and often insignificant relationship of the market model when applied on a daily basis.

The MARA can be specified as follows. Given that the return generating process is stochastic in nature, a security's return (r,) over time can be specified as:

rit it + ?i, (1)

The expected return (ti) of a security is a function of a market determined pricing process (in the spirit of the capital asset pricing model) and of a security's return characteristics. The stochastic error term (E,), which has an expected value of zero and is uncorrelated over time, reflects security specific influences.

If returns are stationary over time, the impact (if any) of new information security prices may be discov-

3The source of the reverse splits is the Standard and Poor's Stock Guide.

ered through an examination of E,'s. Portfolios of securities are formed in event time around reverse splits and the cross-sectional properties of the e,'s are investigated. Aggregation in event time serves to minimize the effect of unrelated factors on the ?i,s.

To apply the MARA, the /i, for each security must be estimated. In this study, the g?,'s for the 61 days around and including day 0 (the proposal, approval or effective date) are examined. For each of these 61 days, /il is estimated using the daily returns from the 60 previous trading days.4 Therefore, 2l, for day t may be expressed as:5

- 6 1 Y

' -

60 t= -60 i (2)

The estimated unexpected return (Z,) for firm i and day t may be written as:

(3)

For each day around and including day 0, a cross- sectional t-test can be performed to determine if the mean estimated unexpected return (Z,) is significantly different from zero.6

V. Empirical Results Exhibit 2 contains the summary statistics for daily

returns around the proposal, approval, and effective day samples. The mean daily abnormal return measure (Z(), and the cross-sectional t statistic for Z, (t) are given in each case. For descriptive purposes, also in-

4ln the tests which follow, several different periods were used to esti- mate /.it and the results proved to be quite insensitive to the period chosen.

5Because the Ei's for the proposal, approval, and effective dates may be expected to differ from zero, these dates (both days - I and 0) were omitted in estimating git's.

6The cross-sectional t-test for each day may be specified as follows:

t = N*\/, N-l (Zi - t)

where

_ I N

Z, = I Zi,. Applying a cross-sectional t test requires that Zt be N i= i

independent and identically distributed. Since the reverse splits are, not clustered, independence should hold. However, assuming that Zt is identically distributed can be troubling. To determine if this is a problem here, cross-sectional t's were also computed using a standardized Z,. The results were very similar.

8

Zt, = (r,, - /,i,).




Exhibit 2. Summary Statistics for Daily Returns Around Proposal, Approval, and Effective Days

Proposal Day Approval Day Effective Day N = 32 N = 39 N = 54

PDRt CPDR Zt PDRt CPDR Zt PDR, CPDR Zt Day (%) (%) (%) t Day (%) (%) (%) t Day (%) (%) (%) t

-30 -0.84 -0.84 - 1.11 - 1.36 -30 0.20 0.20 -0.07 -0.07 -30 0.68 0.68 0.42 0.51 -20 0.11 3.46 -0.17 -0.16 -20 -1.37 -0.68 -1.64 -2.14* -20 0.05 0.58 -0.16 -0.19 -10 0.23 4.82 -0.06 -0.11 -10 -0.48 - 1.99 -0.68 -0.44 -10 -0.00 -1.70 -0.19 -0.25 -9 0.36 5.18 -0.07 0.07 -9 0.78 - 1.21 -0.57 0.72 -9 0.45 - 1.25 0.29 0.36 -8 0.39 5.58 0.10 0.11 -8 -0.42 - 1.63 -0.61 -0.70 -8 0.54 -0.71 0.38 0.35 -7 -1.27 4.31 -1.56 -1.98* -7 0.97 -0.65 0.78 0.97 -7 -1.37 -2.08 -1.51 -1.73* -6 0.43 4.74 0.14 0.18 -6 -1.38 -2.04 -1.58 -1.59 -6 -1.54 -3.62 -1.67 -1.68* -5 -0.33 4.41 -0.60 -0.68 -5 0.27- 1.77 0.11 0.17 -5 0.15 -3.47 0.04 0.06 -4 1.93 6.34 1.67 1.29 -4 0.40- 1.37 0.24 0.27 -4 -0.74 -4.21 -0.82 -1.12 -3 -0.40 5.94 -0.68 -0.75 -3 -0.58 - 1.95 -0.75 -0.85 -3 -0.60 -4.81 -0.68 -0.83 -2 1.28 7.22 1.02 0.67 -2 0.29 - 1.66 0.13 0.13 -2 -0.11 -4.92 -0.17 -0.24 -1 -2.09 5.13 -2.38 -1.65* - 1 -1.78 -3.44 -1.95 - 1.88* -1 -0.58 -5.50 -0.65 -0.88

0 -2.70 2.43 -2.99 -2.16* 0 -1.55 -5.00 -1.74 - 1.41 0 -2.09 -7.59 -2.13 -2.64** 1 -2.51 -0.08 -2.82 -3.13** 1 -0.46 -5.46 -0.62 -0.79 1 -1.77 -9.36 -1.79 -2.06* 2 0.59 0.51 0.32 0.34 2 -1.16 -6.62 -1.32- 1.48 2 -1.36 -10.73 -1.35 -1.74* 3 -2.46 -1.95 -2.71 -2.81** 3 -1.14 -7.76 -1.26 -1.51 3 -1.61 -12.34 -1.59 -2.53** 4 1.94 -0.01 1.75 1.13 4 -1.59 -9.34 -1.68 - 1.37 4 -1.79 -14.13 -1.74 -1.96* 5 0.06 0.05 -0.16 -0.20 5 -0.98 -10.32 -1.05 - 1.12 5 -1.96 -16.09 -1.85 -3.55** 6 -0.45 -0.40 -0.66 -0.84 6 -0.69 -11.02 -0.74 -0.88 6 -0.63 -16.72 -0.51 -0.64 7 0.51 0.11 0.31 0.38 7 -0.52 -11.54 -0.55 -0.69 7 -0.42 -17.14 -0.29 -0.53 8 0.38 0.49 0.19 0.19 8 0.03 - 11.51 0.02 0.03 8 0.90 - 16.23 1.03 1.94* 9 0.70 1.19 0.50 0.50 9 0.30 -11.21 0.31 0.37 9 0.12 -16.11 0.23 0.35

10 2.03 3.22 1.80 2.14* 10 -0.73 -11.95 -0.73 -0.86 10 0.85 -15.26 0.97 1.33 20 0.28 - 1.61 0.19 0.20 20 -0.25 - 16.30 0.39 0.39 20 -0.53 - 16.35 -0.36 -0.95 30 0.22 -3.66 0.15 0.18 30 1.09 - 15.43 1.25 1.86 30 -0.16 - 16.68 0.01 0.01

*Significant at the .05 level. **Significant at the .01 level.

cluded in the summary statistics are the mean portfolio daily return (PDR,) and the cumulative portfolio daily return (CPDR).

A. Proposal Day Over the sample period the news of 32 reverse split

proposals which met sample screen criteria was published in the WSJ. Day 0 in Exhibit I is the day in which these proposals appeared in the WSJ. Since most

proposals actually were made on day - 1, stock prices may initially react to reverse split proposals at this time. From days - 30 to - 2, returns are predominant- ly positive with a CPDR of 7.22%. However, for days - 1 to + 1, the PDR,'s are less than -2.0% each day with a CPDR of - 7.29%. The Zt's for the three days, which are also less than -2.0%, are all significantly less than zero. The CPDR declines another 3.74% from day + 2 to + 30, but this trend reflects to some extent approval and effective day effects.

Overall, these results demonstrate that reverse split proposals convey negative information to investors and result in a significant reduction in shareholder

wealth. Furthermore, judging by the daily returns for the six weeks prior to the proposals, they are not imme-

diately preceded by adverse stock price movements and are not anticipated by the market.

B. Approval Day In this study the approval day is defined as the day in

which the WSJ reports that shareholders have approved the reserve split proposal. The effective date of the reverse split is also reported at this time. Over the sample period no instances were found where shareholders rejected the board's proposal. However, in almost half of the cases, the news of the reverse split proposal had not been published in the WSJ and thus the approval announcement effectively conveyed to some of the market the firm's decision to reverse split the stock. This issue is addressed further in the following section.

Thirty-nine reverse split approval announcements were published in the WSJ and met other sample screen criteria. The summary statistics for the daily returns around the approval day are given in Exhibit 2. As in

9




the proposal day case, most announcements were made on day - 1 and reported in the WSJ on day 0. The PDR,'s and the Zt's for day - 1 and the following seven days are all negative and the CPDR declines by 9.89% over that period. However, the absolute sizes of the individual daily returns are not large and the only cross-sectional t statistic which nears an acceptable level of significance is for day - 1. The negative returns for the seven days after day 0 may be attributable to the impact of the effective or ex-split day, as is discussed below. Nonetheless, these results seem to indicate that additional negative information is conveyed to investors on the approval day. However, this effect is small relative to the impact of the reverse split proposal.7

C. Effective Day Summary statistics for daily returns around the ef-

fective or ex-split day for the 54 reverse splits which met sample screen criteria are contained in Exhibit 2. Eight of the 54 splits were not preceded by either a proposal or an approval announcement.

The PDRt and Zt for the effective date (day 0) are -2.09% and -2. 12%, respectively. The cross-sectional t-statistic for Zt is - 2.64 which is significant at the .01 level. Given the relatively low pre-split prices of these securities (all pre-split prices were less than $10), much of the effective day return may be attributable to indivisibilities and transactions costs. In addition this return may reflect the reverse split information for the small number of firms in which neither the proposal nor approval news had been published. None- theless, the large number of negative returns surrounding the effective date indicates that some other factor(s) is (are) influencing security prices. For the pre-effective day negative returns, this would appear to be the impact of the approval day. The average number of trading days between the approval and effective dates is 12. However, this distribution is highly skewed with a maximum of 126 days and a minimum of -2.8 The post-effective day negative returns are difficult to explain. In an efficient and perfect market,

7The negative CPDR prior to the approval day is due primarily to the impact of the proposal day. In this sample the average number of trading days between the proposal day and the announcement day is 33, with a minimum of 11 and a maximum of 74.

8There are a large number of observations where only 0 to 2 days pass between the approval and effective dates. The minimum is negative because in three cases the news of the stockholders' approval did not appear in the WSJ until after the effective date. The average number of trading days between the proposal and effective dates is 46, with a maximum of 137 and a minimum of 12. Consequently, the pre-ex-split returns are not affected to a great extent by the reverse split proposal.

the excess returns subsequent to the effective date should not be significantly different from zero. The inability to short sell some securities in the sample may explain the absence of arbitragers in exploiting and eliminating these negative returns.

In summary, the findings for the proposal/approval dates indicate that the negative aspects or the information effect of reverse splits dominate the potentially positive effects (see Exhibit 1) and result in a significant reduction in shareholder wealth. On the effective date the effect of trading considerations (transactions costs and indivisibilities) also appears to reduce shareholders' wealth. In addition, stock prices for the imme- diate period beyond the effective date drift downward which is not explained by our hypotheses.

VI. Reverse Splits and Shareholder Wealth: Related Hypotheses A. Previous News

As discussed above, in some instances the approval. announcement and/or effective date served as the first news of the reverse split since not all proposals and/or approvals were published in the financial press. Thus, negative returns on the approval and/or effective days for these firms may be attributable to the lack of wide- spread market knowledge of the split.

To address this issue, the approval and effective day samples are classified as to whether or not a previous announcement (a proposal and/or approval) had appeared in the WSJ. These results are contained in Ex- hibit 3. For the approval day, the prior news sample (n = 23)^has a CPDR of - 0.43% for days - 1 and 0 and the Z,'s for both days are not significant. However, for the no prior news sample (n= 16), the days' - I and 0 CPDR is -7.56% and the Zt for day 0 ( - 5.20%) is significant at the .05 level. These results strongly indicate that the negative returns around the approval date in Exhibit 2 are caused by the portion of the sample whose proposals did not appear in the WSJ. In addition, these findings suggest that the negative information that reverse splits apparently convey to the market is not impounded into the stock price until the approval announcement date for firms whose proposals did not appear in the WSJ. This observation indicates that the market may lack complete information on smaller firms whose activities are not closely followed by the financial press.

These results are corroborated to some extent by the effective day results. As previously noted, indivisibilities and transactions costs may cause effective day returns to be negative. The prior news sample (n = 46)

10




Exhibit 3. Previous News and Daily Returns Around the Approval and Effective Days

Approval Day Effective Day n = 23 n = 46

Day PDRt (%) CPDR (%) Zt (%) t Day PDRt (%) CPDR (%) Zt (%) t

A. Previous Proposal and/or Approval Announcement - 30 1.44 1.44 1.09 0.96 - 30 1.05 1.05 0.80 0.83 - 10 -0.41 -3.75 -0.62 -0.51 - 10 0.18 -0.76 0.00 0.00 -5 -0.03 -3.82 -0.20 -0.20 -5 -0.06 - 1.99 -0.18 -0.22 -1 -1.28 -5.54 -1.44 -1.18 -1 -0.89 -4.31 -0.96 -1.15

0 0.85 -4.69 0.68 0.59 0 -1.40 -5.71 -1.44 -1.84* +1 -1.86 -6.55 -2.00 -2.21* +1 -1.67 -7.38 - 1.70 - 1.96* +5 -2.94 -15.32 -2.91 -2.85** +5 -2.03 -14.75 -1.91 -3.13**

+ 10 0.89 - 14.33 0.99 0.96 + 10 0.80 -14.15 0.93 1.06 +30 1.62 - 16.55 1.85 2.02* +30 -0.74 - 17.12 -0.57 - 1.02

B. No Previous Proposal and/or Approval Announcement Approval Day Effective Day

n= 16 n= 8

-30 - 1.60 - 1.60 - 1.77 - 1.10 -30 0.55 0.55 0.35 0.29 - 10 -0.59 0.60 -0.77 -0.22 - 10 0.94 0.27 0.79 0.22 -5 0.71 1.24 0.57 0.81 -5 -0.67 -6.62 -0.76 - 1.25 - 1 -2.57 -0.36 -2.75 -1.47 -1 2.04 -5.32 1.97 1.18

0 -4.99 - 5.35 - 5.20 - 2.26* 0 -6.03 - 11.34 -6.08 - 2.64* +1 1.63 -3.72 1.45 1.16 +1 -2.27 - 13.57 -2.21 -0.65 +5 2.10 -2.44 1.87 1.18 +5 - 1.94 - 19.52 - 1.83 - 1.60

+ 10 -3.17 -7.97 -3.31 -2.73** + 10 1.11 - 16.02 1.21 1.12 +30 0.25 -13.46 0.30 0.32 +30 1.61 -9.34 1.61 0.74

*Significant at .05 level. **Significant at .01 level.

has an effective date Zt of - 1.44% which is significant at the .05 level (t = - 1.84). The effective day Z, for the no prior news sample (n=8) is also negative (-6.08%) and significant (-2.64) and, absolutely, more than four times the size of the prior news sample Z. Although the sample size is limited and no formal statistical tests are performed, this result certainly seems to indicate that the reverse split information is influencing the effective date return for the no prior news sample.

B. Earnings Performance The results presented heretofore indicate that re-

verse splits convey negative information to investors and reduce shareholders' wealth. This negative information is hypothesized to be that investors interpret reverse splits as admissions from managers that share prices are not likely to increase in the near future based on overall performances. If recent earnings performance has been relatively good, however, investors may feel that a reverse split is not a desperation maneuver to increase stock price. If this is the case, then the stock of firms which have performed relatively well prior to a split would not be expected to suffer as much from

reverse splits as the stock of relatively poor performing firms. To test this proposition, pre-split earnings/price ratios are calculated for each firm and the mean value is used to classify the proposal, approval, and effective date samples into high and low relative earnings/price categories.9 The summary statistics are presented in Exhibit 4.

Although no formal tests are performed in compar- ing the stock price performance of high versus low relative E/P firms around reverse splits, several observations are readily apparent. Around the proposal day, stock prices decline for both samples but low relative E/P firms perform much worse (a CPDR of - 10.99% for days - 1 to + 1) than high relative E/P firms (a CPDR of - 4.84%). 1 These results seem to show that reverse split proposals convey negative information to investors even for relatively well performing firms. The overall returns of high relative E/P firms are much higher (a CPDR of 3.78%) than the returns of low relative E/P firms (a CPDR of - 15.18%) for the 12

9The earnings/price ratio is defined as the four quarters of earnings prior to the split divided by the pre-split stock price. 10The lack of statistical significance of the Z,'s may be attributed to the relatively small sample size.

11




Exhibit 4. Earnings Performance and Reverse Splits Summary Statistics for Daily Returns Around Proposal, Approval, and Effective Rates

Proposal Dayt Approval Dayt Effective Days HIGH RELATIVE E/P

N = 18 N = 16 N = 21

PDRt Zt PDRt Zt PDRt Zt Day (%) CPDR (%) t Day (%) CPDR (%) t Day (%) CPDR (%) t

-30 -0.78 -0.78 -1.00 -1.30 -20 0.93 3.39 0.74 0.54 -10 -0.65 4.10 -0.85 -1.34 -5 -0.47 5.01 -0.64 -0.52 -4 3.18 8.19 3.04 1.47 -3 -0.24 7.95 -0.43 -0.29 - 2 1.57 9.52 1.38 0.59 -1 -0.33 9.19 -0.56 -0.24

0 -2.42 6.77 -2.64 -1.22 1 -2.09 4.69 -2.32 -3.19** 2 0.83 5.51 0.58 0.62 3 -2.90 2.61 -3.13 -2.11 4 2.93 5.54 2.76 1.14 5 -1.78 3.76 -1.99 -2.81**

10 1.77 7.83 1.55 1.21 20 -0.22 2.84 -0.37 -0.26 30 0.63 3.78 0.49 0.40

N = 13

-30 -0.94 -0.94 -1.27 -0.71 -20 -1.22 3.73 -1.62 -0.88 - 10 1.65 6.12 1.19 1.13 -5 -0.11 3.61 -0.53 -0.40 -4 -0.08 3.53 -0.52 -0.50 -3 -0.67 2.86 -1.08 -2.07* -2 0.82 3.68 0.44 0.25 - 1 -4.74 -1.06 -5.13 -5.33**

0 -3.11 -4.17 -3.51 -2.24* 1 -3.14 -7.31 -3.56 -1.76 2 0.23 -7.09 -0.08 -0.04 3 -1.75 -8.84 -2.03 -1.86* 4 0.37 -8.48 0.14 0.09 5 2.99 -5.48 2.77 1.89*

10 2.45 -3.75 2.20 2.19* 20 1.17 -8.22 1.18 1.08 30 -0.43 -15.18 -0.39 -0.35

-30 1.34 -20 -0.58 -10 1.99 -5 0.21 -4 1.83 -3 -0.49 -2 -0.18 -1 -0.10

0 0.31 1 0.41 2 0.00 3 - 1.78 4 -0.21 5 -0.77

10 -0.50 20 0.58 30 0.78

1.34 1.08 0.72 0.28 -0.81 -0.76 1.57 1.84 0.54 1.65 0.06 0.06 3.48 1.67 1.00 2.99 -0.67 -0.44 3.17 0.01 -0.00 3.06 -0.30 -0.19 3.37 0.09 0.08 3.78 0.22 0.22 3.78 -0.19 -0.29 2.00 -1.94 -2.15* 1.79 -0.33 -0.30 1.02 -0.91 -0.83

-0.04 -0.60 -0.66 -2.30 0.67 0.88 -1.09 0.81 0.91

LOW RELATIVE E/P N = 21

-30 0.02 0.02 -0.31 -0.26 -20 -1.71 -1.43 -2.07 -1.82* -10 -2.13 -5.17 -2.38 -2.33 -5 -0.33 -5.91 0.16 0.17 -4 -0.79 -6.69 -0.95 -1.04 - 3 -0.68 -7.37 -0.86 -0.72 -2 0.73 -6.64 0.58 0.54 - 1 -2.24 -8.88 -2.39 -2.09*

0 -3.19 -12.07 -3.36 -1.61 1 -1.26 -13.33 -1.39 -1.12 2 -2.20 - 15.53 -2.33 - 1.47 3 -0.66 -16.19 -0.74 -0.53 4 -2.39 -18.59 -2.47 -1.17 5 -1.21 -19.79 -1.22 -0.78

10 -0.96 -21.47 -0.89 -0.62 20 -0.01 -28.00 0.18 0.10 30 0.82 -27.63 1.10 1.19

-30 1.04 -20 -0.51 -10 0.40 -5 -1.23 -4 -0.44 -3 -0.11 -2 1.75 -1 -1.66 -0 0.00

1 - 1.24 2 - 1.21 3 - 1.54 4 -0.28 5 -0.58

10 -0.73 20 -0.43 30 -0.49

1.04 0.75 0.49 -0.77 -0.74 -0.48 0.58 0.19 0.23

-0.50 -1.39 -1.36 -0.94 -0.55 -0.48 -1.04 -0.21 -0.17 0.71 1.65 1.62

-0.95 - 1.78 -2.43* -0.94 -0.10 -0.10 -2.18 -1.34 -1.09 -3.40 -1.27 -1.30 -4.93 - 1.56 -2.44* -5.21 -0.28 -0.46 -5.79 -0.58 -1.17 -6.81 -0.68 -1.14 -4.40 -0.34 -0.72 -4.42 -0.48 -0.93

N = 31

-30 0.36 -20 0.48 - 10 -0.22 -5 0.63 -4 -1.23 -3 -0.67 -2 -1.16 -1 0.28

0 -3.83 1 -2.86 2 -1.85 3 -1.94 4 -2.77 5 -2.92

10 1.79 20 -0.40 30 -0.59

0.36 0.13 0.13 -0.04 0.30 0.29 -2.41 -0.38 -0.31 -4.91 0.56 0.59 -6.15 -1.28 -1.25 -6.82 -0.73 -0.62 -7.98 -1.20 -1.21 -7.71 0.24 0.21 11.54 -3.83 -3.40** 14.40 -2.81 -2.29* 16.25 -1.78 -1.47 18.18 -1.86 -1.82* 20.95 -2.66 -1.79* 23.87 -2.74 -3.32** 21.38 1.98 1.65* 24.05 -0.18 -0.31 26.92 -0.29 -0.36

*Significant at the .05 level. **Significant at the .01 level. tmissing earnings data for 1 firm. tmissing earnings data for 2 firms.

weeks surrounding reverse split proposals. Regard- less, it should be noted that investor returns for both high and low relative E/P firms are not abnormally poor until day - 1.

The findings around the approval day for the shareholder returns of high and low relative E/P firms are also contained in Exhibit 4. Before considering whether or not a split proposal appeared in the WSJ, it appears that the stock prices of high relative E/P firms (a

CPDR of .21% for days - 1 to + 1) are not affected and that the stock prices of low relative E/P firms drop significantly (a CPDR of -6.69% for days - 1 to + 1) when reverse split approvals are announced. In Exhibit 5, the approval and effective day samples are classified first, as in Exhibit 3, on whether or not a previous announcement (a proposal and/or approval) had appeared in the WSJ and then on earnings performance (relative E/P). The Zt's for the approval days (- 1 and

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Exhibit 5. Previous News, Earnings Performance, and Daily Returns Around Approval and Effective Dates

Approval Day Effective Day A. Previous Proposal and/or Approval Announcement

High Relative E/P

n= 13 n = 20 Day PDRt (%) CPDR (%)t Zt t Day PDRt (%) CPDR (%)t Zt t

-5 -0.11 0.72 -0.22 -0.20 -5 -1.17 -0.97 -1.35 -1.38 -1 -1.44 -0.65 - 1.59 -0.83 -1 -0.95 -0.77 - 1.09 -1.17

0 1.85 1.20 1.67 1.30 0 -0.05 -0.81 -0.18 -0.19 1 -0.09 1.11 -0.25 -0.26 1 -1.33 -2.14 -1.46 -1.24 5 - 1.68 -2.74 - 1.76 - 1.83* 5 -0.45 -4.72 -0.49 - 1.02

Low Relative E/P n = 8 n = 24

-5 0.09 -11.75 -0.18 -0.09 -5 1.10 -3.02 1.05 0.83 - 1 - 1.00 - 14.10 - 1.19 -2.78* - 1 -0.84 -7.99 -0.84 -0.61

0 -1.01 -15.10 -1.17 -0.52 0 -2.90 - 10.89 -2.86 -2.31* 1 -5.39 -20.49 -5.48 -4.62** 1 -2.06 - 12.95 - 1.96 - 1.50 5 -5.14 -37.90 -4.94 -2.23* 5 -3.52 -25.07 -3.27 -3.16**

B. No Previous Proposal and/or Announcement High Relative E/P

n =3 n =

-5 1.63 11.81 1.29 0.84 -5 -0.00 -6.11 -0.07 - 1 0.12 22.98 -0.41 -0.07 - I -3.13 -9.13 -3.14

0 -2.78 20.21 -3.30 -1.12 0 -2.96 - 12.09 -2.96 1 1.95 21.15 1.46 0.78 1 4.55 7.54 4.65 5 3.72 23.71 1.21 0.62 5 0.00 8.09 0.40

Low Relative E/P n =13 n= 7

-5 0.48 -1.41 0.40 0.48 -5 -0.80 -7.53 -0.90 - 1.26 -1 -3.30 -6.49 -3.39 -1.71 -1 3.07 -5.36 2.99 1.77

0 -5.59 - 12.08 -5.72 -2.02* 0 -7.43 - 12.79 -7.51 -3.41** 1 0.45 -11.62 0.36 0.28 1 -2.60 - 15.39 -2.59 -0.65 5 1.66 -9.33 1.50 0.80 5 -2.27 -22.08 -2.16 - 1.66

*Significant at .05 level **Significant at .01 level tReflects CPDR from day -30

0), when a proposal had been published, sum to .08% (and neither is significantly different from zero) for the high relative E/P subsample and sum to - 2.37% (with day - l's return significant) for the low relative E/P subsamples. In addition, the CPDR for the low relative E/P subsample is much lower (-20.49% as of day + 1) than the CPDR for the high relative E/P subsample (1.11% as of day + 1). When a proposal did not appear in the WSJ, the Z,'s for the approval days sum to - 3.71% (but are insignificant due to the small sample size) for the high relative E/P subsample and sum to -9.11% (with day 0 significant) for the low relative E/P group).

Overall, several observations are worth noting concerning the approval day results:

1) as shown in Exhibits 4 and 5, recent earnings performance (in terms of relative E/P) seems to influence stock returns around reverse split approval announcements;

2) the findings presented in Exhibits 3 and 5 seem to show that approval day returns are worse for firms whose reverse split proposals did not appear in the WSJ. This may indicate that the market does not have complete information for some firms which are not closely followed by the financial press; and

3) observations 1) and 2) seem to be related since high (low) relative E/P firms are more (less) likely to have their proposals published in the WSJ.

Although the no previous news sample is quite

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small, these three observations can also be made con-

cerning the effective day returns. As shown in Exhibit 4, the effective day PDR, and Z, for high relative E/P firms are larger (.00 and 0. 10, respectively) than the effective day PDR, and Z, for the low relative E/P firms (-3.83%/ and -3.83%, respectively). In addition, the latter Z, is significant beyond the .01 level. Further- more, the post-effective day price decline, which was discussed earlier, is much less for the high relative E/P firms (a CPDR of -4.76% for days + 1 to + 7) than the low relative E/P firms (a CPDR of - 13.97% for days + 1 to + 7). As noted above, only 8 cases were found where a firm's reverse split proposal and approval had not appeared in the WSJ. In seven of these cases, the firms' E/P ratios were below the sample mean. As given in Exhibit 5, the effective day Z, for this subsample is -7.51% (t = -3.41) which is, absolutely, almost 3 times as large as the Z, for the previous news - low relative E/P subsample (-2.86%).

D. Other Factors Dividend policy, pre- and post-split price levels,

and split size were also analyzed to ascertain their

impact on stock returns around reverse splits. FFJR [2] conclude that direct stock splits have no

effect on common stock returns once changes in dividend policy are properly considered. This proposition was tested for reverse splits by stratifying the proposal, approval, and effective day samples according to whether or not firms increased dividends by the full amount of the reverse split. It should be noted that 90% of the firms in the sample did not pay dividends before or after their reverse split which severely reduced the

sample size. Possibly due to this sample size limita- tion, the tests of this dividend policy proposition were inconclusive and are not reported.

The split factors in this study ranged from 2.0 to 20.0 with a mean of 5.33. The pre- (post-) split prices ranged from .25 (1.00) to 9.125 (27.625) with a mean of 2.58 (10.25). A main problem in analyzing the impact of these factors on shareholder returns is the effect of earnings. Firms with relatively high earnings performance (high earnings/price ratios) tended to have higher pre-split stock prices and lower split factors. To minimize the influence of earnings the observations in the three samples were ranked from lowest to highest in terms of the earnings/price variable and these rankings were used as the basis for forming five security portfolios. These portfolios were then strati- fied based on the medians of the pre- and post-split

prices and the split factor. Although the results are not reported and formal statistical tests were not performed, the results seem to indicate that these factors do not affect shareholder returns beyond the impact of the relative earnings performance.

VII. Summary and Conclusions In this paper the impact of reverse splits on share-

holder wealth is investigated. Compared with previous studies in this area, the study employs better data and a more refined methodology.

The major conclusions are: (1) that stock prices of reverse splitting firms decline significantly on the proposal, approval, and effective dates; (2) that stock price reductions on the proposal, approval and effective dates are attributed to an information effect and declines on the effective date may also be caused by trading considerations; (3) that reverse splits are unan- ticipated by the market and are not preceded by adverse stock price movement (within the previous six weeks); (4) that stock prices continue to decline for a brief period after the effective day; (5) that relative earnings performance influences shareholder returns on the proposal, approval, and effective dates, with better (poorer) performing firms yielding smaller (larger) absolute negative returns on all three dates; and (6) that in cases where the proposal and/or approval news was not published in the WSJ, this information does not become incorporated as quickly into the security price. This final conclusion may indicate that the market may not have complete information for some smaller, lesser known firms.

These conclusions have implications for investors and financial managers. For investors, it would be wise to sell (or short-sell, if possible) the securities of firms that propose reverse splits. Based on these findings it seems possible that stock prices may decline after a reverse split has been proposed, especially after the effective date. Financial managers, on the other hand, would be advised to evaluate carefully the per- ceived benefits of reverse splits because these results indicate that they lead to a significant initial decline in shareholder wealth even for firms that have performed relatively well. As West and Brouilette 181 state, . . . the basically sound firm that declares one may find itself involved in unnecessary guilt by association."

References 1. S. J. Brown and J. B. Warner, "Measuring Security Price

Performance," Journal of Financial Economics (Septem- ber, 1980), pp. 205-258.

14




2. E. F. Fama, L. Fisher, M. Jensen, and R. Roll, "The Ad- justment of Stock Prices to New Information," Internation- al Economic Review (February, 1969), pp. 1-21.

3. W. Gillespie and N. Seitz, "Reasons for and Results of Reverse Stock Splits," paper presented at Regional AIDS

Meeting, 1977. 4. W. Gillespie and N. Seitz, "Price Trends Following Re-

verse Stock Splits," paper presented at Regional AIDS Meeting, 1977.

5. R. W. Masulis, "The Effects of Capital Structure Change on

Security Prices: A Study of Exchange Offers," Journal of Financial Economics (June, 1980), pp. 105-139.

6. A. Merjos, "Reverse Stock Splits," Barron's (May 28, 1962), p. 9.

7. R. C. Radcliffe and W. Gillespie, "The Price Impact of Reverse Splits," Financial Analysts Journal (January/Feb- ruary, 1979), pp. 63-67.

8. R. R. West and A. B. Brouilette, "Reverse Stock Splits . .. Harbinger of Bad Times or Valid Management Technique," Financial Executive (January, 1970), pp. 12-17.

CALL FOR PAPERS AND PARTICIPANTS

1984 ANNUAL MEETINGS OF THE WESTERN FINANCE ASSOCIATION June 20-23, 1984

Vancouver, British Columbia, Canada

Members and friends of the Western Finance Association are invited to submit papers to be considered for presentation at the 1984 Annual Meetings. Papers on any topic related to financial economics will be considered.

Submission of Papers

Send four copies of the paper to the program chairman no later than November 25, 1983. While we prefer a

completed paper, in its absence we will consider a lengthy and detailed abstract. After the papers are reviewed, the authors will be notified in January, 1984, of the program committee's decision. Please attach a

separate sheet indicating the author's name(s), affiliation(s), the title of the paper and whether you would be willing to serve as a discussant or as a session chairman. All completed papers received will be considered for publication in the December issue of the Journal of Financial and Quantitative Analysis.

Other Participants

Individuals willing to serve as session chairmen or as discussants should write directly to the program chairman indicating their fields of interest.

Trefftzs Award This announcement is also a call for student papers to be considered for the Annual Trefftzs Award. These

papers should also be sent to the program chairman, with a cover letter indicating that they are student papers and should be considered for the Trefftzs Award.

All papers and communications pertaining to participation in the program should be sent by November 25, 1983, to

Professor Seha M. Tinic

Program Chairman, WFA Amos Tuck School of Business Administration Dartmouth College Hanover, NH 03755

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Documents

Reverse Splits and Shareholder Wealth