HOW REVERSE STOCK SPLITS ARE IMPLEMENTED
A reverse stock split results in a reduction in the number of a company’s outstanding shares with a proportionate increase in its earnings per share. The market value of the total number of shares outstanding remains the same and shareholders’ rights are intact. Through a reverse stock split, the company, however, manages to edge out fractional shareholders as they get paid cash in lieu of their shareholding.
Companies resort to a reverse stock split to pre-empt delisting of their securities by the stock exchange. It is resorted to by companies to shore up the price of their stocks and create an illusion that the stock is valuable. According to the SEC, a company’s board of directors may declare a reverse stock split without shareholder approval. It is state corporate law and a company’s articles of incorporation and by-laws which govern reverse stock splits though the SEC is the final authority on exchange-listed entities. SEC has made it mandatory for companies to notify its shareholders of a reverse stock split on Forms 8-K, 10-Q and 10-K.
A recent example of a reverse stock split is Flagstar Bancorp Inc (NYSE: FBC). The company filed the amended and restated Articles of Incorporation with the state of Michigan on May 27, 2010. This amendment filed in form 8-K effected the reverse stock split of the outstanding common stock of the company in the ratio of one for every ten held.
Earlier, stockholders granted the discretionary power to the board of directors of the company to effect the reverse stock split at the company’s annual general meeting on May 27. Immediately after the annual meeting, the board of directors met to give effect to the reverse stock split scheme. As a result, the number of company’s outstanding stock stands reduced to 153 million from 1.53 billion. The company will also make payment to fractional shareholders on the adjusted closing share price as on May 26, 2010. Trading in the split stock commenced from May 28, 2010.
Shareholders need to remember that stock splits result in an adjustment of the stock price depending on the ratio of the split. It is in a way like a bonus issue, where the share price gets adjusted on the cut-off day and the buyer of a ex-bonus share pays at the adjusted rate because he is foregoing his right to the bonus share.
A stock split serves the limited purpose of improving liquidity in a stock. A reverse stock split reduces the number of shares traded in the market and enables the company to eliminate marginal shareholders by paying them cash in exchange of fractional entitlements. For shareholders, there is no material change as the market capitalization of the company remains unchanged.