What Is a Reverse Stock Split?
Definition of a Reverse Stock Split and Why Reverse Stock Splits Are Used
Common questions from new investors during both the aftermath of the dot-com bubble in 2001-2003 and the Great Recession of 2007-2009 often centered around a reverse stock split. Questions included:
- What is a reverse stock split?
- Why would a company choose to undergo a reverse stock split?
- Is there any benefit or drawbacks to this action?
To help understand reverse stock splits you must first understand the basics; the justification, mechanics, and potential benefits of a company restructuring its common stock through this particular move that only seems to get noticed when the economic skies are dark and the outlook terrifying.
Understanding Reverse Stock Splits
Many companies attempt to list their common stock and preferred stock on one of the major stock exchanges, such as the NYSE, so they can offer greater liquidity to shareholders. In order to earn and maintain exchange listing, the corporation must meet several criteria, including a minimum number of round lot holders (shareholders owning more than 100 shares), an absolute number of shareholders, a specific net income threshold, a total number of public shares outstanding, and a minimum stock price.
These requirements are designed to ensure that the common stocks classified as exchange-traded securities are only made up of reputable, respected, financially viable enterprises that represent a major engine of economic productivity in the United States. That doesn't mean they'll be good investments - historically, some have gone bankrupt, leaving their investors with painful losses - only that the business is large enough to meet the standard of the exchange.
In times of market or economic turmoil, including during a major recession, individual businesses or entire sectors may suffer a catastrophic decline in the per share stock price. As previously mentioned, the aftermath of the internet bubble is the perfect example because many stocks fell by 90 percent or more. More recently, the 2009 collapse saw some previously admired firms fall into total disrepute, the stock price a mere fraction of its former self. If the market price falls far enough, the company risks being delisted from the exchange; a severe hardship for existing stockholders.
At the New York Stock Exchange, this is triggered after a company's shares trade at below $1 per share for 30 consecutive days.
Reverse Stock Splits Can Help Investors Maintain Liquidity and the Company to Avoid the Embarrassment of Delistment
In order to avoid the embarrassment and practical disadvantages of being delisted, the Board of Directors of a corporation may declare a reverse stock split for the sole purpose of increasing the nominally quoted market value of its shares. The move has no real economic consequences and, in theory, is neither good nor bad for stockholders in and of itself.
Here’s an illustration to demonstrate the logic. Assume you own 1,000 shares of Bubble Gum Industries, Inc., each trading at $15 per share. The business hits an unprecedented rough patch. The firm loses key customers, suffers a labor dispute with workers, and experiences an increase in raw commodity costs, eroding profits. The result is a dramatic shrinkage in the stock price, falling like a stone all the way down to $0.80 per share. This is bad. Long-term, you believe the business will still be fine but it's hard to remain an optimist, especially when your shares are quoted in terms of pocket change.
Short-term prospects don’t look good. Management knows it has to do something to avoid delisting, so it asks the aforementioned directors to declare a 10-for-1 reverse stock split. The Board agrees and the total number of shares outstanding is reduced by 90 percent. You wake up one day, log into your brokerage account, and now see that instead of owning 1,000 shares at $0.80 each, you own 100 shares at $8.00 each. Economically, you are in the exact same position as you were prior to the reverse stock split, but the company has now bought itself time.
One of the most famous illustrations of a reverse stock split in recent years is AIG, the former blue-chip insurance conglomerate that was so mismanaged, it obliterated the wealth of the equity owners. In September of 2007, the stock was trading at $67.65 per share. As of August 2016, the stock closed at $58.94 per share. Those two numbers don't sound far off, do they? Reality is far more devastating. In July of 2009, AIG shares underwent a 20-for-1 reverse stock split. Adjusting for that stock split, the $67.65 stock bought in September of 2007 is now worth $2.95 per share.
Before dividends, you've lost more than 95.6% of your investment after almost nine years of patiently following a buy and hold strategy.