This article was downloaded by: [Dalhousie University] On: 28 September 2012, At: 13:53 Publisher: Routledge Informa Ltd Registered in England and Wales Registered Number: 1072954 Registered office: Mortimer House, 37-41 Mortimer Street, London W1T 3JH, UK Applied Financial Economics Publication details, including instructions for authors and subscription information: http://www.tandfonline.com/loi/rafe20 Shell companies as IPO alternatives: an analysis of trading activity around reverse mergers Murat Aydogdu a , Chander Shekhar b & Violet Torbey c a Department of Finance, Bryant University, Smithfield, RI 02197, USA b Department of Finance, University of Melbourne, Carlton, VIC 3010, Australia c Government Superannuation Office, Queensland Treasury, Brisbane, QLD 4000, Australia Version of record first published: 07 Nov 2007. To cite this article: Murat Aydogdu, Chander Shekhar & Violet Torbey (2007): Shell companies as IPO alternatives: an analysis of trading activity around reverse mergers, Applied Financial Economics, 17:16, 1335-1347 To link to this article: http://dx.doi.org/10.1080/09603100600993752 PLEASE SCROLL DOWN FOR ARTICLE Full terms and conditions of use: http://www.tandfonline.com/page/terms-and-conditions This article may be used for research, teaching, and private study purposes. Any substantial or systematic reproduction, redistribution, reselling, loan, sub-licensing, systematic supply, or distribution in any form to anyone is expressly forbidden. The publisher does not give any warranty express or implied or make any representation that the contents will be complete or accurate or up to date. The accuracy of any instructions, formulae, and drug doses should be independently verified with primary sources. The publisher shall not be liable for any loss, actions, claims, proceedings, demand, or costs or damages whatsoever or howsoever caused arising directly or indirectly in connection with or arising out of the use of this material.
Transcript
This article was downloaded by: [Dalhousie University]On: 28 September 2012, At: 13:53Publisher: RoutledgeInforma Ltd Registered in England and Wales Registered Number: 1072954 Registered office: Mortimer House,37-41 Mortimer Street, London W1T 3JH, UK
Applied Financial EconomicsPublication details, including instructions for authors and subscription information:http://www.tandfonline.com/loi/rafe20
Shell companies as IPO alternatives: an analysis oftrading activity around reverse mergersMurat Aydogdu a , Chander Shekhar b & Violet Torbey ca Department of Finance, Bryant University, Smithfield, RI 02197, USAb Department of Finance, University of Melbourne, Carlton, VIC 3010, Australiac Government Superannuation Office, Queensland Treasury, Brisbane, QLD 4000, Australia
Version of record first published: 07 Nov 2007.
To cite this article: Murat Aydogdu, Chander Shekhar & Violet Torbey (2007): Shell companies as IPO alternatives: an analysisof trading activity around reverse mergers, Applied Financial Economics, 17:16, 1335-1347
To link to this article: http://dx.doi.org/10.1080/09603100600993752
PLEASE SCROLL DOWN FOR ARTICLE
Full terms and conditions of use: http://www.tandfonline.com/page/terms-and-conditions
This article may be used for research, teaching, and private study purposes. Any substantial or systematicreproduction, redistribution, reselling, loan, sub-licensing, systematic supply, or distribution in any form toanyone is expressly forbidden.
The publisher does not give any warranty express or implied or make any representation that the contentswill be complete or accurate or up to date. The accuracy of any instructions, formulae, and drug doses shouldbe independently verified with primary sources. The publisher shall not be liable for any loss, actions, claims,proceedings, demand, or costs or damages whatsoever or howsoever caused arising directly or indirectly inconnection with or arising out of the use of this material.
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. Recently the Securities
and Exchange Commission (SEC) has imposed stricter rules on these
companies to speed up disclosure of financial information and curb
potential abuses. Our article 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. However, our results do not show any evidence
of persistent insider trading or price manipulation in these stocks.
I. Introduction
The Securities and Exchange Commission (SEC) has
recently imposed stricter rules on the shell company
acquisitions process. Shell companies, sometimes also
known as ‘blank checks’1 are among the most thinly
traded of all stocks. They usually have no assets or
operations but are registered with the SEC. Therefore
they have reporting requirements. Some of these
companies are established with the goal of merging
with an unidentified company or companies,
whereas others become shell companies after selling
their operations and assets possibly following a
bankruptcy. These companies provide an alternative
route to an initial public offering (IPO) for a private
company that wishes to go public. Shell companies
typically trade on the NASD Bulletin Board (BB) or
on the Pink Sheets.To date there is a paucity of research on these
‘penny stocks’. But we believe they are an important
subject to study given the fact that they are often
mentioned in the popular press in conjunction with
stock price manipulation. According to recent press
articles, shell company abuse is a constant problem
*Corresponding author. E-mail: [email protected] The term ‘blank check’ is the result of shell companies making primary offerings with no specified goals as to how theproceeds would be used, essentially asking the investors for a ‘blank check’.
Applied Financial Economics ISSN 0960–3107 print/ISSN 1466–4305 online � 2007 Taylor & Francis 1335http://www.tandf.co.uk/journalsDOI: 10.1080/09603100600993752
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for the SEC2 and it has proposed the imposition of
stricter rules on these companies. In April 2004, the
SEC proposed rule amendments relating to Form S-8
and 8-K filings by shell companies, with the aim of
protecting investors by deterring fraud.3 Form S-8
has been used by shells to raise capital with the form,
although it is meant to be used in relation to
employee benefit plans. Since most shells have no
employees, the form has been used to circumvent
required registration and prospectus requirements
in order to improperly sell securities to the public.
The aim of the April 2004 proposal was to prohibit
the use of Form S-8 by shell companies. Form 8-K,
which is used to report significant corporate events,
has been used by shells to report an acquisition of or
merger with a private company (Item 2), within 15
calendar days after the completed transaction and to
provide financial statements (Item 7) after a delayed
period of 71 calendar days following the transaction.
The proposal became effective on 23 August 2004 and
reduced both the Item 2 and Item 7 filing period to
just four business days.A private company that wishes to go public
can merge with a shell company. ‘Reverse mergers’
can be fast and cost-effective, as several steps in an
IPO – legal and accounting fees, underwriting
expenses and prospectus filing requirements – are
either unnecessary or are significantly more onerous.
For instance, an IPO requires securities registration
statements (including audited financial statements) to
be filed with the SEC and relevant state securities
offices. A reverse merger does not require a registra-
tion statement and filings need not disclose business
details or shareholdings of a private company’s
officers. As noted by Hennessey (2003), ‘A reverse
merger is therefore not only simpler, but also for a
modest fee a company can get listed quickly’.4
The benefits of lower costs and shorter time delaysfeature prominently in detailed descriptions of actual
reverse mergers. Although there is no formal
record of reverse mergers (neither the AmericanStock Exchange nor Nasdaq keeps track of reverse
mergers), participants in such transactions highlight
such benefits. Brenner and Schroff (2004) note thatit can sometimes be accomplished in ‘. . . 45 days
instead of the year or more frequently needed for anIPO’. They also indicate that a reverse merger may
cost as little as $75 000 to $100 000, whereas an IPO’scost may exceed $400 000 or more and the filing fees
are also significantly less.5 Other commentators seem
to agree – Tim Halter, who advises companies onreverse mergers, suggests that merging with a pink
sheets or over-the-counter (OTC) listed companycosts about $300 000 and takes 30–60 days, whereas
cost of an IPO can run into seven digits.6
Nevertheless, reverse mergers seem to have become
more common – between June 2000 and September
2002, as the IPO market slowed down, Done Dealsreported 84 reverse mergers.
The owners of the shell company, however, only
seek to increase the value of their investment and
merging with an existing (and hopefully profitable)
private company accomplishes this quickly. Recently
the stock of Sports Entertainment Enterprises Inc.,
rocketed form 10 cents to as high as $11 on the
news of a proposed reverse merger by Robert F. X.
Sillerman, who in turn, made a deal to take control of
Elvis Presley’s estate. Although Sports Entertainment
has had no active operations since 2002,
Mr Sillerman proposed to buy upto 96% of Sports
Entertainment’s stock to engineer the merger. Only
4% of the company’s stock is actually publicly
traded, but Mr Sillerman is purchasing the stock
from the founders of Sports Entertainment and will
change the company’s name once the deal is
completed.7
Prior to 23 August 2004 SEC disclosure regulationrelating to significant events required that a firm
2 ‘Moving the market: SEC may impose stricter rules on behaviour of shell companies’, WSJ, 14 April 2004; ‘Regulatorssuspend trading in 26 stocks’, Reuters, 8 June 2004.3 See SEC Release No. 33-8407, ‘Proposed Rule: Use of Form S-8 and Form 8-K by Shell Companies’.4 ‘Companies Opting for Easy Way to Go Public Still Remain Rare’, The Wall Street Journal, 26 June 2002, Section B15F.5 They also list the typical steps in a reverse merger – actively searching for a shell, possibly through a law or an accountingfirm, 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 (perhapsby enlisting a reputable broker or law firm to lend credibility to the transaction) and finally steps to improve the liquidity andtradability of the stock – such that it reflects the true nature of the business and allows its use as currency for further deals.6 ‘Reverse Mergers on the rise: Chinese companies, especially, use controversial route to get US listing’, The InvestmentDealers’ Digest, 21 July 2003, New York, p. 1.7 ‘Elvis is Star Attraction In Small Firm’s Revival – Bulletin Board Stock Soars as Deal Will Make It Owner of Presley’s RichLegacy’, The Wall Street Journal, 28 December 2004, C3.
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report an event within 15 days of it occurring by filingan 8-K Item 2.8 Two such events are a change incontrol of the company and the company’s acquisi-tion or disposition of a significant amount of assets.Although the 8-K Item 2 for an acquisition had to befiled within 15 days of the acquisition, the actualacquisition date need not be reported in the filing.The actual date may be included or may be gleanedfrom any attachments with the filing. It is possiblethat some firms do not file in the required time frame.
After the actual acquisition, the firm had to file an8-K Item 7 which provided the financial statements.The Item 7 had to be filed within 60 days of theItem 2. Ideally the Item 7 should be filed immediatelybut firms got an extension for another 60 days,making it up to 75 days after the acquisition that thefinancial details were made public. With the latter,the Item 7 audited financial statements were due atthe time of filing Item 2.9 During the period, therewere restrictions imposed on the company, forexample, firms were not allowed to issue securities.For instance, consider the following excerpts from8-K filed by HouseHold Direct Com Inc. (SIC code9995, BYIT.OB) with the SEC (emphasis added)
‘‘On 9 March 2000, HouseHold Direct.com, Inc.,a Delaware corporation (‘‘HouseHold’’ or‘‘Company’’) executed an Agreement and Planof Merger with Cross Check Corp., a ColoradoCorporation . . .whereby HouseHold Directacquired all the issued and outstanding sharesof the Registrant for the purpose of completing amerger of HouseHold and Cross. On March 20,
2000 HouseHold and Cross completed a merger
with HouseHold being the surviving entity’’, andregarding financial statements
‘‘HouseHold is currently in the process ofcompleting their first audit . . . (statements) aretherefore not available for the initial reportherein. The Company intends to file its audited
financials for fiscal years 1998 and 1999 in an
amended 8-K within sixty (60) days of the date
hereof’’
Effectively, the trading public did not have materialfinancial information about the firm until the Item 7was filed and was at an informational disadvantage.Under pre-August 23rd regulation, reporting require-ments may have aided shells in ‘pump-and-dump’
schemes as investors lack the necessary details tomake informed decisions and insiders may be able tomanipulate trading. Once a private company agreesto a merger, unscrupulous promoters may ‘talk-up’the new company, create a demand for the stock anddump their stock at artificially high prices, leaving themanagement with a sullied reputation, angry share-holders and quite possibly, additional regulatoryscrutiny.
In this article we contribute to the literature inseveral ways. This is, we believe, the first empiricalanalysis of shell companies. Our study provides someinsight into the characteristics of private companiesthat choose the reverse merger route to go public by‘back-door listing’. We document the tradingactivity surrounding reverse mergers, look forevidence of market-wide stock price manipulationand do not find any. The merger announcementseems to be taken as positive news as reflected in theincrease in stock prices and sporadic but statisticallysignificant positive returns. But overall our results areinconclusive as to whether reverse mergers are valueincreasing events for all shell companies.
The rest of the article proceeds as follows. SectionII reviews literature related to the questions we try toanswer in this study. Section III details our datacollection and related issues. In Section IV, we discussour methodology and then the results of our analysis.Section V concludes.
II. Literature Review
Information asymmetry
Efficient capital markets exist when security pricesreflect available information. Corporate disclosureis a critical component of an efficient capitalmarket. The US market is considered among themost efficient in the world. Firms can communicatewith investors through financial reports, pressreleases, company websites or indirectly throughanalysts and rating agencies. Larger firms tend tobe well-followed whereas very small firms are notlikely to be followed by any analysts and investorsrely on corporate disclosures to make investmentdecisions. Many institutions are prohibited by theircharters from investing in penny stocks. There is awealth of literature on information asymmetry and
8Effective 23 August 2004, this is reduced to four 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 theMarch 2004 Final Rule to 71 calendar days. This coupled with the proposed four business days makes it �75 days tillinvestors see the financial statements, similar to the previously allowed 15 plus 60 days.9 See footnote 32, SEC Release No: 33-8407.
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agency problems. Managers know more about thefuture investment opportunities than investors(Jensen and Meckling, 1976; Myers and Majluf,1984). Since firm size is negatively related to thelevel of information asymmetry, in the smallest oftraded companies, information asymmetry is likelyto be greatest. Therefore, corporate disclosures areof paramount importance for the investor whorelies on managers to provide timely information.With very small companies like shells, the oppor-tunities for managers to conceal important infor-mation from investors are much greater.
Seyhun (1986, 1997) has uncovered ample insidertrading evidence of managers who sell stock in theirown company while hyping it up to the public. Hefound evidence by looking at insider trading records.Insider reporting is one form of disclosure requiredby the SEC for listed firms. Stock price manipulationcan occur in very large public companies – even ahigh profile well followed fund like Fidelity, thelargest in the world, was found to be dumping shareswhile at the same time talking bullishly about them tothe media.10 Prior to 1999, firms listed on the OTCBB were not required to report insider trading and itis still not required for firms listed on the Pink Sheets.Recent media articles show the use of the internet inpump and dump schemes. Certainly it can occur inthe very smallest of companies with little or noanalyst scrutiny.
Disclosure regulation
Most countries regulate corporate reporting anddisclosure. In the US, the SEC sets disclosure rulesfor companies that want access to the capitalmarkets. The aim of minimum corporate disclosurerequirements is to reduce the information gapbetween insiders and outsiders. Despite the desiredbenefits of such regulation, Healy and Palepu (2001)consider the economic rationale behind regulatingdisclosure and its effectiveness in reducing informa-tion asymmetry and agency problems and find thatthe paucity of empirical research to date leaves theseissues unresolved. Accounting research providesmixed evidence on whether financial reports providenew and relevant information to investors (Chang,1998; Kothari, 2001). SEC disclosure regulationexists to prevent security price manipulation. Onthe other hand, incentives for managers to provideforward-looking information might be reduced iflitigation is a likely outcome. When the SEC pursuescompanies for violation of accounting standards, the
stock prices of those companies are penalized(Dechow et al., 1996; Beneish, 1999).
Bushee and Leuz (2005) document changes inliquidity following the introduction of disclosurerequirements for the OTC BB. In a rare piece ofresearch on BB stocks, they are able to test for changesaround the 1999 imposition of disclosure regulation.They find that the costs of SEC disclosure regulationoutweigh the benefits. Prior to 1999, not all firms listedon the OTC BB were required to file reports inaccordance with the Securities Exchange Act of 1934.The new regulationmeant that a firm had to comply orbe delisted and move to the Pink Sheets where firmsare not subject to disclosure requirements. Firms thatdecided to comply with the regulation received thebenefit of significant increases in liquidity at the cost ofnegative announcement returns.
Bushee and Leuz (2005) further report thatthree-quarters of the OTC firms chose not tocomply and moved to the Pink Sheets. Althoughthe main reason for noncompliance is likely to be thecost, it is possible that some of these firms wish toavoid regulation. Little is known about the possiblemanipulation of stock prices by firms that list onthese markets. Also, little is known about whetherthese companies systematically flout the regulation bynot submitting the appropriate reports.
SEC’s monitoring of disclosure has increased inrecent years. Also, with the rising use of internet,communication between companies and investors hasincreased. The SEC’s proposed disclosure require-ments for shell companies aim to speed up financialdisclosure which would curb possible stock pricemanipulations.11
Alternatives to IPO
In addition to the choice between staying private orgoing public via an IPO, private firms can considermerging with or selling-out to an existing public firm.To date, only limited literature has examined thefactors that affect this choice. Specifically, Brau et al.(2003) report that macro factors such as industryconcentration, hi-tech industry affiliation and bondrate, among others, may influence companies toundertake an IPO as opposed to selling out. In acomplementary study, Poulsen and Stegemoller(2005) study the influence of micro (company specific)factors as profitability, growth opportunitiesand liquidity constraints on choice between a sell-out and IPO, and find that, for instance, insiderownership may veer companies towards sell-outs.
10 http://www.fool.com/EveningNews/1995/EveningNews951201.htm ‘Magellan Manager Playing Market Games?’11Wall Street Journal, 4/14/2004, Vol. 243, Issue 73, pC3, ‘SEC May Impose Stricter Rules on Behavior of Shell Companies’.
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Both studies contribute to the growing understanding
of the corporate decision making process as compa-
nies evaluate alternatives to access public capital
markets.A recent study by Brown et al. (2005) analyses
a third alternative whereby several small private
firms conduct a roll-up (i.e. merge into a bigger
company) and simultaneously conduct an IPO.
Their results indicate that future performance of
these roll-ups depends on the continued involvement
of the original private companies’ owners and
managers. On average more than nine firms are
involved in a roll-up and as Brown et al. (2005)
indicate, roll-ups rapidly declined in popularity in the
late 1990s.The three mechanisms studied – sell-outs, IPOs or
roll-ups – are simply alternative ways for private
companies to access capital markets for continued
growth and expansion, for owners to liquidate their
ownership, or both. The chosen mechanism may
depend on the economic conditions, capital market
constraints and the owners’ preferences. In this
context, we study companies that choose ‘back-
door’ listing (as described earlier), a mechanism that
seems suitable in the absence of other, more
commonly used, alternatives.
III. Data
In order to carry out our analysis, we first identify
shell companies. For this purpose, we start out with
all 8K filings from 1999 through 2001 by firms with
SIC codes of 6770 or 9995. Next, we identify the
Item 2 filings among all of these 8K filings. Since not
all the firms with these SIC codes are necessarily
shells, we then proceed to screen out the companies
that are not true shell companies. Once a shell is
identified, we record three important dates relevant to
each event: agreement date, Item 2 filing date and
Item 7 filing date. We carry out our data analysis on
this sample. As the SEC proposed changes in 2004,
we also look at 2004 filings and note some observa-
tions about company disclosure behaviour in light of
these changes.
The second step in the data collection is to obtain
trading data for the shells. This is challenging given
the scarcity of data regarding these companies. This
lack of data leads to a sample that is smaller than
we would have with listed or NASD stocks. The
following paragraphs detail the data set construction
process.
Identifying the shell companies filing Item 2and Item 7 8-Ks
SIC codes 6770 and 9995 represent blank checkcompanies: SIC code 6770 is defined as Blank Checksand SIC code 9995 is defined as Non-OperatingEstablishments. Using Edgar, we obtained a list ofcompanies with SIC codes 6770 and 9995 that filed an8-K from 1 January 1999 to 31 December 2001 andfor 2004. This resulted in 3405 filings. Over 60% ofall 8-Ks filed were by companies with SIC code 6770.We looked through each filing to determine if it wasan Item 2 or Item 7, ignoring other types of 8-Kfilings. Sometimes firms filed multiple Item 7s yetonly one had the required financial statements. Thisresulted in a total of 705 filings: 585 Item 2s and 120Item 7s. Panel A of Table 1 details the results of theinitial sample collection process. For each firm, wecollected its name, CIK, state of incorporation, stateof business, filing date and agreement date. TheItem 2 is required to be filed within 15 business daysof the agreement being finalized. Until the Item 2filing, the public may be unaware of the agreementand managers may trade on this information. Theagreement date is usually stated in the Item 2 filing.In only a handful of cases was it missing.
We also checked each case to identify the filingdate of the required financial information. If financialstatements were not included, we noted if anymention was made of when they would be filed.Usually the 8-K mentioned the financial statementswould be filed within 60 days yet most firms failed tofile the Item 7 within 60 days of the Item 2 and evenfailed to file the Item 7 at all. Table 1 shows that forthe 585 Item 2 filings, only 100 filed the Item 7 in thesame 8-K filing, 15 filed within the permitted 60 days,5 filed late and 465 never filed. Perhaps manycompanies do not file Item 7 because they do file a10Q-SB that has the financial statements. For someof our sample, it seems that form 10QSB is filedseveral months later (as part of regular filings, not forthe merger per se) and are, of course, consolidated.Also we cannot use the information from form10QSB as it may include several acquisitions andeven if it does not, it is not representative of theprivate firm’s financial state when it was bought.
A casual comparison of the frequency of financialinformation disclosure before and after the new SECrulings of 2004 does not show much of a change infirms’ filing behaviour. As indicated in Panel A ofTable 1, of the 494 firms which filed Item 2 between1999 and 2001, only 97, or 20%, filed an Item 7within the required timeframe. During 2004, whenSEC rule changes were proposed and enacted, thefrequency of disclosure via Item 7 did not improve
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and remained at about 20% (18 of 91). Additionally,5 shells (about 1%) making acquisitions between1999 and 2001 firms filed Item 7 late, however, thereare no late filings from acquirers in 2004.
Identifying true blank check companies
Not all firms that use SIC codes of 6770 and 9995 areactually blank checks. For instance, companies arerequired to file Form 12 after an acquisition to notifythe SEC of their new SIC code. Many fail to file asthey acquire operations in a business with a moredescriptive SIC code, yet they continue to use 6770
or 9995. We searched SEC filings to identify trueblank check firms, i.e. firms with no operations.
We searched balance sheets and income statementsin 10Q filings. Sometimes this was not sufficient.For example, if small revenues existed, it wasimpossible to tell whether the revenues were theresult of poor operations for a going concern orinvestment income for a shell company withoutinvestigating further. Searching a variety of SECfilings was sometimes required. Item 2 of the 10Qstatement provided useful information. This section isentitled ‘Management’s Discussion of FinancialCondition and Results of Operations’. Usually thediscussion in this section provided sufficient detail to
SIC code Shell Non-shell All Item 2s6770 199 124 3239995 187 75 262
Total 386 199 585
Year Shell Non-shell All item 2s1999 79 30 1092000 135 69 2042001 118 63 1812004 54 37 91
Total 386 199 585
Trade data searchYear Tickers Some data Sufficient data1999 61 38 202000 80 55 272001 53 45 282004 26 16 8
Total 220 154 83
Notes: Initial data is collected by examining all US SEC 8-K filings made by blank check companies (or shells) from 1 January1999 to 31 December 2001 and for 2004. Trading data – prices, volume and shares outstanding – are collected fromQuotemedia.com and from Datastream. The SIC codes are as assigned by the SEC, however, the classification into shells andnonshells is made by examining firms’ financial statements as available on Edgar.
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determine if a company was a shell. Occasionally itwas necessary to look at other 8-Ks filed before orafter the 8-K in question. In a string of acquisitions, ifa company is a shell for the first, then for subsequentacquisitions the company is technically no longer ashell. From this search, we confirmed that of the 5858-K Item 2 filings, only 386 were made by true shellcompanies and 199 filings were from nonshellcompanies. Panel B of Table 1 details the break-upof the sample in true blank checks (shells) andnonblank checks. Of these 386 shells, only 83 (22%)filed Item 7s; 71 at the same time as Item 2, 9 withinthe required frame and 3 late.
Bushee and Leuz (2005) suggest that in theirsample, some small companies moved to the PinkSheets (from OTCBB) both to avoid (the new)regulation and to avail of lower disclosure standards.By dropping to Pink Sheets, these firms were alsono longer subject to the associated enforcement.Companies may also take advantage of less strictcorporate laws, by choosing to incorporate inNevada. In our sample of 386 shells, 148 (38%) areNevada companies. Further, 83 companies (22%) areincorporated in Delaware, 45 (12%) in Colorado,28 (7%) in Florida and the remainder in other states.
Collecting price and volume data
Our data sources in order of preference are:Bloomberg, Datastream (these two sources haveclosing price, trading volume and sharesoutstanding figures on a daily basis, withBloomberg having somewhat more precise pricedata), Quotemedia web site (www.quotemedia.com)and yahoo finance pages (finance.yahoo.com). Whenlooking for trade data, we first identify a tickersymbol (or a history of tickers) for a company byperforming searches on the company name using websearch engines, the Quotemedia web site, the OTC BBweb site (www.otcbb.com) and the pink sheetsweb site (www.pinksheets.com). If we identify
a ticker, then we look for trading data surroundingthe reverse merger event.
Of the 386 shell company Item 2 filings in all theperiods we look at, we are able to find tickers for 239events. Seventeen firms file two Item 2s while one filesthree in this period. We look at only the first filing foreach company to avoid possible problems, whichleaves us with 220 unique tickers. We are able tofind some (i.e. one day or more) trading data for 154of these companies. Our analysis spans the 61-tradingday window from 20 days before the event to 40 daysafter the event, roughly a 3-calendar monthwindow.12 When we refer to this window in relativeterms, Day 0 is the event day, days �20 through �1precede the event and days þ1 through þ40 followthe event. For a stock to be in the sample, we requiredata for the 61-trading day window surrounding theannouncement date. This leaves us with 83 events.Out of these 83 events, only 8 are from the post-regulation change period of 2004. Since this is toosmall a sample, we do not analyse the trading activityfor this period. Of the 75 events that form the samplefor the trading activity analysis, we are able to finddata from Bloomberg or Datastream (that has sharesoutstanding information) for only 23 events.
Target characteristics
Although the primary focus of our study is the pricemovement in shell company stocks aroundreverse mergers, we can glean some detail about thetargets – private firms that are taking this route to gopublic – from the information provided in the SECfilings. We examine the 83 Item 7s filed by shellcompanies and collect data about the target assets,revenues, profitability and cash reserves. Thisinformation is provided in Table 2.
As the data indicate, even Item 7s were incompletein that the financial information was not provided forall targets. The target firms are very small, with mean(median) assets of only $2 211 167 ($397 915).
Table 2. Financial characteristics of the shell companies based on their Item 7 filings
Target N Mean ($) Median ($) Maximum ($) Minimum ($) SD ($)
The table is based on 83 Item 7 filings (75 from the 1999 to 2001 sample and 8 from the 2004 sample).
12We 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).
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This is in stark contrast to sample firms in Poulsenand Stegemoller (2005) whose median assets size is$35 million! Further comparisons underscore thedifferences – our sample target firms have medianrevenues of $186 780, whereas in Poulsen et al. (2005)it is $47.7 million, median net income is $�25,335 vs.$1.6 million. Private firms in our sample are, onaverage, unprofitable, which would perhaps make itsignificantly more difficult to undertake a normalIPO. Sample firms in both Poulsen and Stegemoller(2005) and Brau et al. (2003) choose to either float viaan IPO or sell-out to a publicly listed firm andalthough private firms in our sample are getting‘listed’, it would seem that a backdoor listing is theonly alternative available to them.
IV. Methodology and Results
Our purpose with trading activity analysis is touncover any unusual trading behaviour surroundingreverse mergers. From the perspective of a publicshareholder, a reverse merger is most likely to begood news: instead of owning shares in a companythat does ‘nothing’, the investor will own shares in acompany that does ‘something’ after the merger.13
Questions of specific interest are: (1) Is the reversemerger perceived as significant news that causes a bigchange in price on event date? and (2) Do cumulativeabnormal returns (CARs) suggest a price responsethat starts before the event (suggesting asymmetricinformation) or that continues days after theevent (suggesting inefficient market response)?We analyse returns and CARs to answer thesequestions.
When a material event occurs (for instance areverse merger) the shell company has to report thisevent to the SEC. Prior to the August 2004regulation, this report was required within 15
calendar days. The involved companies first agreeto the merger (on agreement date) and then the shellreports this to the SEC through an Item 2 filing.Since the shell can announce the merger to the public,for instance via a press release, the public may learnof the merger ahead of the filing and the markets willrespond to the event at this time. It is only in theabsence of any information release that the publicfirst learns about the reverse merger officially on theItem 2 filing date. Thus, probably a better candidatefor event day is the agreement date. In our sample,the median (mean) difference between the agreementdate and the Item 2 filing date is 11 trading days(15.89 days) where this difference ranges between1 day and 89 days. We report the results for the casewhere agreement day is treated as the event day andnote differences only if inferences based on Item 2filing day as the event day are different.
Trading around reverse mergers
Shell company stocks are some of the most inactivestocks traded over the counter. In our sample basedon the 61-day event window for the 75 stocks (4575daily observations in total) there is no trading at allfor 1570 stock-days. In other words, for 34.32% ofour daily observations there is no trading. But thereverse merger seems to increase trading activity forthe shells. Since many shells don’t trade at all, wecount the number of stocks that do trade (i.e. tradingvolume greater than zero) relative to the agreementdate. If all stocks trade at least once in a day, thiscount would equal 75; if no stocks trade it would bezero. Also, for the 23 stocks for which we have thenumber of shares outstanding, we compute the dailyturnover (volume traded divided by shares outstand-ing) and present these results in Table 3.
Clearly the reverse merger event causes an increasein trading activity. While during the 20 dayspreceding the merger agreement about 42 stocks
Table 3. Trading activity around reverse mergers
Number of daysStocks that trade atleast once in a day (N¼ 75)
Daily turnover(N¼ 23)
Before agreement date 20 41.75 0.004474After agreement date 41 52.93 0.006984
The table presents the average number of stocks that trade at least once (i.e. stocks whose trading volume isgreater than zero) before and after the reverse merger agreement is reached.
13However, the merger can be perceived as bad news: if there is no disclosure regarding the private company, the investor doesnot know if the company is an asset or liability.
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trade at least once in a day, this count goes up to 53
immediately following the agreement. Similarly, the
average daily turnover goes from 0.45% to 0.70%.
The differences in means for these two measures are
statistically significant as the p-values associated with
both the nonparametric Wilcoxon test statistic and
the two-sample t-test statistic are <1%. Figure 1
visually confirms this increase in trading activity.
Based on the observation that the reverse mergers do
cause increased trading activity, we proceed to the
analysis of stock prices surrounding the merger
agreement to seek evidence of information based
trading or market inefficiencies.Along with the inactivity in trading, another
property of the shell company stocks is the volatility
in prices. In our sample of 4575 daily observations,
returns range from 6.5314 to 10 733.33%.15 As a
byproduct of trading inactivity, 2040 of the daily
returns (44.59% of the sample) are zero. Based on
individual univariate tests, for most of the sample
stocks (70 of the 75) the mean and median
return is not statistically different from zero.
The univariate statistics for 75 stocks are reported
in Table 4.Based on these observations, we take the expected
daily return on any of our sample stocks to be zero;
thus the abnormal return is equal to the actual return.
The data underlines the volatility of the returns for
the sample stocks; for instance the mean SD for the
75 daily returns series is 68.93% and the SD for
individual stock returns series range from a minimum
of 0% (i.e. no price variation throughout the event
window) to 1374.30%!
Price movements around reverse merger events
We analyse returns using a nonparametrictesting method proposed by Corrado (1989).
The methodology is based on ranks of variables
and does not require normality of returns. Given the
properties of the returns, we believe this procedureyields more reliable results than the standard t-tests.
The methodology is based on constructing a statistic
30354045505560657075
−20
−15
−10 −5 0 5 10 15 20 25 30 35 40
Trading daysN
um
ber
of
sto
cks
Fig. 1. Stocks that trade
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 pricesand daily returns.
14WORLD ASSOCIATES INC/NV/(WAIV)’s price drops from $0.90 on 24 October 2000 to $0.03125 on 25 October 2000.15DECORIZE INC (DCZ)’s price increases from $$0.03 on 6 July 2000 to $3.25 on 9 July 2000.
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that is analogous to the standard t-statistic. Using
daily returns, first, we compute ranks:
Kjt ¼ rankðrjtÞ where rjt is the return for stock j
on day t, t ¼ �20 to þ40
By definition Kjt ranges from 1 to 61
for each stock.
Then we compute the test statistic for each day:
Tt ¼ð1=N Þ
PNi¼1 ðKit � 31Þ
SðK Þ
The number 31 reflects the average rank (61 returns
We perform these tests on average returns (ARs) and
on cumulative abnormal returns (CARs) where we
cumulate returns for each stock from day �20
through dayþ40.Note that the test statistic can be constructed for
any day (�20 throughþ40) in the sample, not just the
event day (Day 0). The value of this test statistic will
indicate whether the average return is statistically
significantly greater than the average returns on other
days. The test statistic has a standard normal
distribution and we use þ2 and �2 as critical values
to assess statistical significance. A value above 2 or
below �2 denotes the average return (or CAR)
computed for the relative day is significantly different
from zero.To give some intuitive support to understand the
results, we also report average ranks. Essentially, this
test looks at whether the average rank on a particular
day is statistically significantly different from 31,
which is the average rank in a 61-day time series data.
For instance, if we analyse a positive-surprise event,
the returns on the event day will tend to be large and
positive, thus the associated ranks (and the average
rank) will be high and the computed test statistic will
end up being positive and large. If the average rank is
significantly above (below) 31, the test statistic
associated with the returns or CARs will have a
large positive (negative) value.In order to test for abnormal price movements
around merger agreements, we analyse daily and
cumulative abnormal returns on and around the
event dates using the methodology noted before.
Table 5 provides these returns and corresponding test
statistics and rank estimates for the 60-day eventperiod surrounding the agreement dates.
We begin by examining the daily average returns(ARs) and CARs as plotted in Fig. 2, which showsseveral positive spikes at 10 and 1 day before theagreement date and at 3 and 6 days after the eventand are statistically significant at days �1, þ3 andþ6. Figure 2 also clearly shows an upward movementin the CARs. The 3-month average CAR is 520%!The figure also reveals that this large return ispossibly due to the few large daily returns in thedata sample. Overall, this suggests that the reversemerger is taken as a positive signal in the market.
We further plot the test statistics in Fig. 3 andaverage ranks in Fig. 4. As already noted, dailyreturns are positive and significant on days �1, þ3and þ6 (suggesting positive price responses) andsignificantly negative on day þ8. The test statisticsfor CARs are never statistically significant whichemphasizes that the large average CAR may be due toseveral large positive returns rather than a sample-wide phenomenon. Having said that, the CAR teststatistics are uniformly negative prior to the agree-ment day and uniformly positive following theagreement (from day þ3 on) suggesting a consistent,albeit statistically insignificant, upward price move-ment. The fact that the statistics are positive aroundthe agreement day but not the day itself might be dueto either illiquidity of the stocks or inefficiency incommunicating with the public in the over-thecounter market. Positive returns on day 1 maysuggest trading due to information leakage, but thisdoes not preclude price manipulation by parties whomay be privy to the impending agreement. Pricemanipulation is a plausible explanation as thesecompanies are thinly traded, are not followed oranalysed by professional analysts and generally sufferfrom scarcity of information in the public domain.
Finally, in Fig. 4 we plot the average ranks for bothARs and CARs. The average ranks for CARs areabove 31 starting on day þ3 and below that valuebefore that date, in line with the test statistics.The average ranks fluctuate for returns (which ismanifested in the test statistics). The overall implica-tion of these results is that the reverse mergers aretaken as positive signals, although with some noisethat may be due to illiquidity or difficulty incommunicating information in the over the countermarket. The fact that there is a price runup the dayprior to the agreement day may suggest informationbased trading. It may also be a result of agreementdays being recorded with delay. A statisticallysignificant CAR on this date would support the firstexplanation but our results do not lend supportto that argument.
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Table 5. Abnormal returns
Panel A: returns Panel B: CARs
Day Average t-stat Average rank Average t-stat Average rank
Notes: AR and 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 areestimated using the Corrado (1989) nonparametric rank test. Statistically significant t-stats at the 10% level and associatedreturns are in bold.
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−20%
0%
20%
40%
60%
80%
100%
120%
140%
160%
180%
−20
−15
−10 −5 0 5 10 15 20 25 30 35 40
Days relative to agreement date
Ret
urn
s
−20%
80%
180%
280%
380%
480%
580%
CA
RS
Avg return Avg CAR
Fig. 2. Returns and CARs
−4
−2
0
2
4
−20
−15
−10 −5 0 5 10 15 20 25 30 35 40
Days relative to agreement date
t_st
ats
Ret_t_stat CAR_t_stat
Fig. 3. Test statistics
0
10
20
30
40
50
−20
−15
−10 −5 0 5 10 15 20 25 30 35 40
Days relative to agreement date
t_st
ats
Ret_Avg_rank CAR_Avg_rank
Fig. 4. Average ranks
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V. 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 article 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 follow-
ing 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.
Acknowledgements
We would like to thank Guarav Jain and Peter
DiMartino for their research assistance. We also
thank attendees at The Australian Finance and
Banking Conference, Sydney, 2004.
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