Reverse Merger Arbitrage Works!

Wow.. I just completed a deal that gave me a 2,567% ROI in 212 days. That's an annualized ROI of 4,419%!! And it's perfectly legal! Anyone can do it!

I sound like a bad infomercial. I better explain.

Thanks to Gualberto over at The Art Of Money blog, I learned about a stock investing technique called reverse merger arbitrage. He's explains the concept here. How it works is you buy shares in a shell company - a company that has no operations and is basically created just to be sold. The shell company has a stock symbol and is typically traded on the "pink sheets", the over the counter market (as opposed to on the NASDAQ or NYSE). These stocks are typically trading at pennies per share.

Why do this? Because the whole reason for this company's existence is to be sold to another company. The buying company wants to become a publicly traded company and issue stock. However, it is very expensive to put together an IPO - you need to pay a company to issue the stock, you need to get regulatory approval to be listed, you need to go through audits, etc. Rather than deal with all this, it is cheaper and easier to simply merge with another company that is already listed as a public company. Hence, the buying company buys out the shell company. Often, at the completion of the sale, they will change the ticker symbol and do a reverse split on the stock to raise the price from pennies to dollars.

Normally, a split or a reverse split does not change your investment amount. If you have 100 shares at $1 per share, after a 1 for 50 reverse split, you'll have 2 shares at $50 per share. In both cases, you have a total of $100 worth of stock.

But many times, the reverse split will include special treatment for small shareholders. For example, if you have less than 100 shares, they might say your shares will not be affected by the reverse split. This is probably done to preserve "round lots" and prevent the company from having to pay out any cash to shareholders. For example, without the special provision, if I had 99 shares before the 1 for 50 reverse split, I would end up with 1 share plus cash in the amount of 49/50ths of one share (or $49 in this example). But if the company has specified that holders of less than 100 shares are not affected, then, after the split, I am left with 99 shares still. But, and this is where the magic happens, because the reverse split affected everyone else, the stock price is now at $50. So I have 99 shares of stock at $50/share where before I had 99 shares at $1/share!

Hard to believe, but it's true. This happens. It's legal. It works. The drawback, of course, is that there is an upper limit on how much profit you can make - typically only 99 shares worth. But even so, that's one heck of an impressive return. But if you have several accounts, you can do this in each account.

Here's what I did. Back in December, Gualberto posted about a potential arbitrage opportunity with QRUS. That was going to be a 1 for 10 reverse merger with shareholders of less than 100 shares being unaffected. I bought 99 shares of QRUS at $0.30/share. Time passed and no news came. Nothing happened. It turns out, that deal fell through and the merger never happened. However, I held on to the stock, figuring another merger would come along soon. Sure enough, in July, Gualberto posted about a new merger involving QRUS. This time, the split was going to be 1 for 50, meaning I could make an even bigger profit!

Again, time passed and there was no news. (You'll find it's somewhat difficult to get news, or any information at all, on companies trading on the pink sheets.) One day, I received an information packet in the mail explaining the split. I took this as a good sign that the merger was going to take place, since I didn't get one of these for the failed merger. (Why incur the expense of printing and mailing the things if it's not going to go through?) Unfortunately, the only date listed for when the split would happen was "at least 20 days after" the information packet was first distributed. So I've been watching the stock daily and checking Gualberto's blog daily for news. One of his readers posted a press release saying the split was to happen on 8/2 and that the new ticker symbol would be DFXN. Sweet!

The next concern was that my broker, Schwab, would handle the reverse split correctly. Well, August 2 came and went and nothing happened. My account showed that my shares of QRUS were replaced by a number, no symbol. I called and was told that the stock was undergoing a reverse split and that Schwab was waiting for the new shares to arrive from the company. I explained to the broker about the special treatment for those holding less than 100 shares. He had never heard of such a thing. I was transferred the Schwab's Reorganization Department and they had never heard of such a thing either. So time went by and I was a little anxious about whether or not Schwab would handle the split correctly. Both the broker and the Reorg Department said I would received 1 share plus cash. This was not what I wanted. But I was hopeful things would work out since they said they were waiting for instructions from the company. Presumably, the company would know the special conditions of their split and would instruct Schwab to handle things accordingly.

Today, a week after the split, I logged in to my Schwab account and saw 99 shares of DFXN. The last trade price was $11. I got a real time quote and saw the bid was $8 and the ask was $11. I put in a sell order for $10.50 and waited. Nothing happened for about 30 minutes. The stock was somewhat volatile, trading between $8 and $14 over the last week and I didn't want to get too greedy and end up holding on to a $2 stock, so I changed my order to sell at the bid price of $8. The shares were immediately sold.

So, to recap, I bought at $0.30 a share and sold at $8.00 a share. Put another way, I turned $29.70 into $792 (not counting some trading commissions).Pretty darn impressive! And this was done in my Roth IRA account, so the profit is tax free!

I don't know how Gualberto finds out about these opportunities, but I check his blog daily for news of upcoming mergers. Next time, I'm doing this in 5 different accounts to really jack up my profits.


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