Reverse Stock Splits, Institutional Holdings, and Share Value

Abstract

We show that both the number of institutional investors and the percentage of shares that are held by institutional investors increase significantly after reverse splits with a presplit price lower than $5 and a target price higher than $5. This effect is larger than for other comparable reverse splits. These results suggest institutional holdings are affected by the prudent-person rule and reverse splits are used by firms to alleviate this constraint. We also show that an increase in institutional holdings that results from reverse splits is associated with an increase in share price.Despite its frequent occurrence, the reverse stock split has been the subject of relatively few studies. In this paper, we shed further light on the causes and consequences of the reverse stock split by analyzing its effects on institutional holdings and shareholder wealth using data from 1980 through 2010 for a large sample of reverse stock splits in the US markets.The level of institutional ownership in US companies has risen significantly in recent decades and corporate managers are paying increasingly greater attention to institutional preference to attract more institutional investments in their stocks. 1 Prior research shows that institutional investors are more likely to hold stocks of companies with higher share prices and larger market capitalizations (Faulkenstein, 1996;Gompers and Metrick, 2001), higher quality ratings (Del Guercio, 1996), better governance structures (McCahery, Sautner, and Starks, 2010; Chung and Zhang, 2011), stable payout policies (Grinstein and Michaely, 2005), better managerial performances (Parrino, Sias, and Starks, 2003), and higher pay-for-performance sensitivity (Hartzell and Starks, 2003). The present study offers new insight into institutional preference by analyzing the effect of the reverse stock split on institutional holdings.Anecdotal evidence suggests that companies use reverse splits as a means to expand and broaden their investor base by attracting more institutional investors and financial analysts. For example, Martin Brauns, chairman and chief executive officer (CEO) of Interwoven Inc., stated that, "We believe that the reverse stock split will position our stock in a price range more attractive to a broader range of institutional investors . . . Realigning our share base is one more step in our process of delivering long-term shareholder value." 2 More recently, Vikram Pandit, CEO of Citigroup, told shareholders that its recent announcement of a 1-for-10 reverse stock split willWe are grateful to an anonymous referee, Marc Lipson (Editor), and Laura Starks for their valuable comments and suggestions. We also thank Maria Kasch, Kenneth Kim, session participants at the FMA annual conference, and seminar participants at the State University of New York at Buffalo for useful comments and discussions. We are solely responsible

Earnings management around reverse stock splits

“…A closer examination of prior studies suggests that a significant percentage of reverse splits are carried out by firms that are potentially at risk of getting delisted from an exchange. Chung and Yang (2015) report that 49% of their sample firms stated "avoid delisting from exchange" as the reason behind the reverse split. Similarly, 63% (1018 out of 1612) of the sample examined by Kim et al (2008) had a pre-split price of below $1, firms likely to be facing the delisting threat.…”

“…In December 2020, when Heat Biologics Inc. announced a reverse split of their stock, Jeff Wolf, CEO of the company, stated: "Our sole purpose in conducting this reverse-split was to address market concerns related to the Nasdaq minimum bid price requirement". 2 In contrast, Chung and Yang (2015) propose that firms in L5H5 are likely to reverse split their stocks to attract institutional investors by bringing the stock price over $5. On the other hand, the above two motives seem unlikely for firms in H5H5 as the stock price already exceeds $5.…”

“…While it is generally believed that firms split their stocks to achieve an optimal trading price or to increase liquidity, recent studies have documented other motives. For instance, some firms reverse split stocks to attract institutional investors (Chung & Yang 2015), while others leverage it as a strategic move to avert delisting from an exchange (Frost et al., 2017; Yang 2006). Given the diverse motivations driving different firms to initiate reverse stock splits, analyzing them all in one group can hide the true picture.…”

Market Reactions on Corporate Actions in Growing and Nongrowing Energy Consuming Companies

“…In the case of a reverse split, the corporate action does not always signal the company's pessimism and lack of confidence on its prospects and future performances, but it can also signal the company's efforts to expand its investor base by attracting more institutional investors and financial analysts as one of the stages in a process of delivering the long-term shareholder value (Chung and Yang, 2015;Marwan, 2020). Therefore, investors that can understand the positive signal from a reverse split will be motivated to give a positive reaction.…”

“…In this case, a reverse split will put stock prices in a better range and improve the image of the company itself by removing the junk company label as stated by Radcliffe and Gillespie (1979) which arises due to the image of penny stock attached to it. Improvement of the image will make the relevant stock more marketable because it triggers more investor interest, especially institutional investors who initially tend to avoid these shares because the image of penny stock which according to Chung and Yang (2015) makes it considered more speculative and vulnerable to fraud schemes, as well as high risk of the loss of value of the entire investment. As a result, stock liquidity after the reverse split will increase.…”