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TOPIC: An Analysis of Trading Activity around Reverse Mergers

An Analysis of Trading Activity around Reverse Mergers 11 years 1 month ago #1147

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[An Analysis of Trading Activity around Reverse Mergers]
The full study is located here:
www.fma.org/SLC/Papers/Shell_Companies_as_IPO_Alternatives.pdf


5. Conclusion

While shell companies are convenient vehicles for small private firms to go public via a reverse merger, they are also often mentioned in the popular press in conjunction with stock price manipulation. In 2004 SEC imposed stricter rules on these companies to speed up disclosure and curb potential abuses. Our paper looks at the trading activity around reverse mergers. Clearly, the merger is taken as significant news as the trading activity increases immediately following the merger announcement. This observation suggests that the SEC may have had good reason to speed up the required filings and provide timely information to the public. We find sporadic, but statistically significant positive returns surrounding the merger reflecting the increase in value of the shell companies that is also evidenced in the (statistically insignificant) positive CARs following merger announcements. Our results, however, do not show any evidence of persistent insider trading or price manipulation in these stocks. An interesting extension of this study would be to construct a portfolio of shells that are likely to merge and see whether one can make significant positive returns from this portfolio. Of course such a strategy would take illiquidity and relatively high transaction costs of these stocks into consideration as well as the small supply of shares that are publicly traded. This exercise is left for future research.

References

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Brau, J. C., B. Francis, and N. Kohers, 2003, “The Choice of IPO versus Takeover: Empirical Evidence”, Journal of Business, vol. 76 (4), 583-612.

Brenner, V. C. and W. K. Schroff, 2004, “Reverse Merger or IPO”, Strategic Finance, 85, 11, 46-52.

Brown, K. C., A. Ditmar, and H. Servaes, 2005, “Corporate Governance, Incentives, and Industry Consolidations”, Review of Financial Studies, v18, 1, 241-270.

Bushee, Brian J. and Christian Leuz, 2005, “Economic consequences of SEC disclosure regulations: Evidence from the OTC bulleting board”, Journal of Accounting and Economics 39 (2). [Forthcoming]

Chang, J., 1998, “The decline in value relevance of earnings and book values”, WorkingPaper, Northwestern University.

Corrado, C.J., 1989, “A nonparametric test for abnormal security-price performance in event studies”, Journal of Financial Economics 23, 385-395.

Dechow, P., Hutton, A., Sloan, R., 1996, “Causes and consequences of earnings manipulation: an analysis of firms subject to enforcement actions by the SEC”, Contemporary Accounting Research 13, 1-36.

Healy, P. and Palepu, K., 2001, “Information asymmetry, corporate disclosure, and the capital markets: A review of the empirical disclosure literature”, Journal of Accounting and Economics 31, 405-440.

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Kohers, N.,2004, “Acquisitions of private targets: the unique shareholder wealth implications”, Applied Financial Economics 14, 1151-1165.

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Poulsen, Annette B. and Stegemoller, Michael Andrew, “Moving from Private to Public Ownership: Selling out to Public Firms vs. Initial Public Offerings” (February 2005). ssrn.com/abstract=624524

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Table 1
Sample descriptive statistics - Initial data is collected by examining all US SEC 8-K filings made by blank check companies (or shells) from January 1st 1999 – December 31st 2001 and for 2004. Trading data - prices, volume, and shares outstanding - are collected from Quotemedia.com and from Datastream. The SIC codes are as assigned by the SEC, however the classification into shells and non-shells is made by examining firms’ financial statements as available on Edgar.

Table 2
Financial characteristics of the shell companies based on their Item 7 filings - The table is based on 83 Item 7 filings (75 from the 1999-2001 sample, and 8 from the 2004 sample).

Table 3
Trading activity around reverse mergers - The table presents the average number of stocks that trade at least once (i.e., stocks whose trading volume is greater than zero) before and after the reverse merger agreement is reached.

Table 4
Summary statistics for shell company stock prices and returns - The table presents general summary statistics for the 75 sample stocks based on daily closing prices and daily returns.

Table 5
Abnormal returns - Average abnormal returns (AR) and Cumulative Abnormal Returns (CAR) for 75 blank check companies around the agreement date prior to the 8-K filing 1999 to 2001 inclusive. Price data are collected from Quotemedia.com and from Datastream. Test statistics (t-stat) for daily ARs and CARs are estimated using the Corrado (1989) non-parametric rank test. Statistically significant t-stats at the 10% level and associated returns are in bold.

1 The term “blank check” is the result of shell companies making primary offerings with no specified goals as to how the proceeds would be used, essentially asking the investors for a “blank check”.
2 The London Stock Exhange’s global market for smaller, growing companies, opened in 1995.
3 “Moving the market: SEC may impose stricter rules on behavior of shell companies”, WSJ, April 14, 2004; “Regulators suspend trading in 26 stocks”, Reuters, June 8, 2004.
4 See SEC Release No. 33-8407, “Proposed Rule: Use of Form S-8 and Form 8-K by Shell Companies”.
5 “Companies Opting for Easy Way to Go Public Still Remain Rare”, The Wall Street Journal, 26 June 2003, Section B15F.
6 They also list the typical steps in a reverse merger - actively searching for a shell, possibly through a law or an accounting firm, followed by contacting the shareholders of the shell to determine their willingness to sell, and to determine the post-merger ownership structure of the “operational” company, due diligence, especially on liabilities of the shell company (perhaps by enlisting a reputable broker or law firm to lend credibility to the transaction), and finally steps to improve the liquidity and tradability of the stock - such that it reflects the true nature of the business and allows its use as currency for further deals.
7 “Reverse Mergers on the rise: Chinese companies, especially, use controversial route to get U.S. listing”, The Investment Dealers’ Digest, July 21, 2003, New York, pg 1.
8 “Investors left in limbo as Aim stocks suspended”, Daily Mail, London, April 4, 2006, page 59.
9 “NZ start-up eyes listing on Nasdaq”, Dominion Post, Wellington, New Zealand, April 4, 2006, page C2; “Reverse Mergers on the rise: Chinese companies, especially, use controversial route to get U.S. listing”, The Investment Dealers’ Digest, July 21, 2003, New York, pg 1.
10 “Elvis is Star Attraction In Small Firm’s Revival – Bulletin Board Stock Soars as Deal Will Make It Owner of Presley’s Rich Legacy”, The Wall Street Journal, 28 December, 2004, C3.
11 Effective August 23, 2004, this is reduced to 4 business days after the event. See SEC Release No. 33-8400, “Final Rule: Additional Form 8-K Disclosure Requirements and Acceleration of Filing Date”. The window period was modified in the March 2004 Final Rule to 71 calendar days. This coupled with the proposed 4 business days makes it approximately 75 days till investors see the financial statements, similar to the previously allowed 15 plus 60 days.
12 See Footnote 32, SEC Release No: 33-8407.
13 The Securities Industry Association, a U.S. organization, describes the U.S. capital markets as the most efficient in the world. www.sia.com/capital_hill/html/liquidity.html .
14 www.fool.com/EveningNews/1995/EveningNews951201.htm “Magellan Manager Playing Market Games?”
15 Wall Street Journal, 4/14/2004, Vol. 243, Issue 73, pC3, “SEC May Impose Stricter Rules on Behavior of Shell Companies”.
16 We chose this window to cover the required time allowed between the merger agreement and Item 2 filing (15 calendar days) and the required time for filing the Item 7 after the Item 2 filing (60 calendar days).
17 However, the merger can be perceived as bad news: if there is no disclosure regarding the private company, the investor does not know if the company is an asset or liability.
18 WORLD ASSOCIATES INC/NV/ (WAIV)’s price drops from $0.90 on 24 Oct, 2000 to $0.03125 on 25 Oct, 2000.
19 DECORIZE INC (DCZ)’s price increases from $$0.03 on 6 Jul, 2000 to $3.25 on 9 Jul, 2000.
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