Stock Splits as a Manipulation Tool: Evidence from Mergers and Acquisitions

Article excerpt

We document that acquiring firms are more likely than nonacquiring firms to split their stocks before making acquisition announcements, especially when acquisitions are financed by stock and when the deals are large. Our findings support the hypothesis that some acquiring firms use stock splits to manipulate their equity values prior to acquisition announcements. Using earnings quality as a proxy for firms' intention to manipulate, we find that acquirers with low earnings quality (i.e., acquirers that are more likely to use stock splits to manipulate their stock values) have lower long-run stock returns compared with their benchmarks, especially when the deals are financed with stock. In contrast, acquirers with high earnings quality do not show that pattern. Our evidence complements and extends the findings in the literature that some acquirers manipulate their stock prices before stock-swap acquisitions. This study suggests that target shareholders should use information such as earnings quality and stock splits to discriminate among acquirers and ensure that exchanges are conducted on fair terms.

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After recent accounting scandals in once high-flying firms like Enron and WorldCom, management behavior has been under close scrutiny by regulators, financial media, and researchers. Jensen (2005) argues that the dramatic increase in corporate scandals around the turn of the century can be explained by agency costs of overvalued equity: when a firm's equity is substantially overvalued, managers are forced to take value-destroying actions (some perhaps fraudulent) to satisfy the market's unrealistic growth expectations. One action that firms often take is to acquire other companies using their overvalued equity.

Recent studies show that some firms engage in certain activities that inflate their equity values or prevent their overvalued prices from falling before acquisitions. For example, Erickson and Wang (1999) and Louis (2004) find that acquiring firms on average overstate their earnings in the quarter preceding a stock-swap acquisition announcement. Efendi, Srivastava, and Swanson (2007) find that the likelihood of an earnings restatement is significantly higher for firms that make one or more sizable acquisitions. Anecdotal evidence also indicates that some firms manipulate their stock prices before large acquisitions financed by stock. For example, the Wall Street Journal (November 24, 2004, C1; November 26, 2004, C1) reported that shortly before American International Group (AIG) finalized its acquisition of insurer American General Corporation in August 2001, AIG Chairman Greenberg called the office of Dick Grasso, then head of the NYSE, to ask him to help bolster AIG's stock price. This later prompted inquiries by the NYSE, the Securities and Exchange Commission (SEC), and federal prosecutors as to whether Greenberg manipulated the huge insurance company's share price to save money on the large acquisition deal.

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This paper examines whether some firms use stock splits as another tool to manipulate their stock price before an acquisition. Acquiring firms have two incentives to use stock splits to manipulate their stock prices. First, prior research has documented that the market usually reacts positively to the announcement of a stock split (Grinblatt, Masulis, and Titman, 1984; Conroy and Harris, 1999; Kadiyala and Vetsuypens, 2002). Therefore, managers of acquiring firms may believe that their stock prices will increase following stock splits. Second, the previous literature has documented that stock splits increase the marketability of a firm's stock (Lamoureux and Poon, 1987; Maloney and Mulherin, 1992; Schultz, 2000; Dhar, Goetzmann, Shepherd, and Zhu, 2005). (1) In the context of mergers and acquisitions (M&As), if acquiring firms are concerned that their share prices are overvalued and poised to decline and if they still need time to complete the acquisitions, they may use stock splits to defer market corrections. …