Penny Stocks & Over-The-Counter Trading

According to the Securities and Exchange Commission (“SEC”), a “penny stock” generally refers to a security issued by a very small company that trades for less than $5 per share. Penny stocks are typically quoted over-the-counter (“OTC”) for trading purposes, meaning these stocks trade over a decentralized market, without a physical location, and where market participants trade with one another using various communication modes, including telephone, email, and proprietary electronic trading systems. OTC stock (in addition to other securities, including bonds and derivative products) trade on the following platforms:

• OTC Bulletin Board (“OTCBB”) which is a United States quotation medium operated by the Financial Industry Regulatory Authority (“FINRA”). Companies quoted on the OTCBB must fully report (i.e., remain current with all required SEC filings), but there are no market capitalization, minimum share price, corporate governance or other requirements to be quoted; and

• OTC Markets Group, Inc. - previously known as the “Pink Sheets”, OTC Markets Group is an American financial market providing pricing and liquidity information for roughly 10,000 OTC securities. OTC Markets Group designates securities into one of three markets to indicate the level of financial and corporate disclosure provided by the company using its quotation system, and includes the following markets:

  • OTCQX - a/k/a Trusted Tier - this market includes both multinational and domestic companies seeking access to U.S. investor capital; to be traded in this market, a company must undergo certain qualitative review, but is not required to be registered with the SEC;

  • OTCQB - a/k/a Transparent Tier - this market contains a one penny ($0.01) bid price requirement “intended to remove companies that are most likely to be the subject of dilutive stock fraud schemes and promotions.” Each company verifies via an annual OTCQB Certification, signed by the company CEO or CFO, that their company information is current, including information about a company’s reporting status, company profile, information on management and boards, major shareholders, law firms, transfer agents, and PR firms;

  • PINK - a/k/a Distressed Tier - this market is designated as The Pink Open Market and has very little in the way of financial standards or reporting requirements (some companies that trade on Pink do submit periodic disclosure filings – Pink Current Information – but are not required to do so). Pink Current Information companies can include shell companies or development stage companies with little or no operations, in addition to companies without audited financial statements.

In order for a stock to be listed on an exchange, a company must meet certain requirements. A number of companies trade OTC simply because their small size (as measured by market capitalization or “market cap”) renders these companies unable to meet listing requirements such as an exchange’s threshold requirement for number of publicly traded shares, or having shares trade above a certain minimum price. Other, larger OTC companies may have been delisted from a major securities exchange because they failed to meet listing standards (this would include companies that have filed for bankruptcy protection).

In certain instances, large and established companies choose not to list on a major exchange, electing instead to trade OTC. For example, some American Depository Receipts (“ADRs”), which are certificates that represent a specified number of shares in a foreign stock, may also trade as OTC equities instead of on a major exchange. This may include ADRs for large, established, and profitable multinational companies that have determined it is not in their best interest to devote the resources needed to meet U.S. listing requirements to trade on a major exchange.

As a general rule, investing in penny stocks is a risky proposition. The main risks associated with penny stocks, as opposed to more established securities (such as blue chip stocks), are as follows:

• Lack of Transparency – the cornerstone to any successful investment strategy is acquiring information, and enough solid information to allow an investor to make an informed, logical decision about whether to buy the stock of a particular company. When it comes to penny stocks, this information is much more difficult to find, particularly with respect to companies listed in the Pink Open Market that are not required to file with the SEC and may not submit any filings whatsoever;

• No Minimum Standards – Stocks trading OTC do not have to fulfill minimum standard requirements to remain trading. As a result, investors are left with little or no safety cushion that comes with requiring companies to fulfill certain minimum standards;

• Lack of History / Financial Footing – many penny stocks are companies considered to be nano-cap (market cap of less than $50 million) or micro-cap stocks (market cap of $50 - $300 million). Quite often, these companies are either newly formed entities with little track record, or worse still, approaching bankruptcy;

• Liquidity – generally, OTC stocks do not have the same liquidity as stocks trading on major exchange. As such, two problems often arise with illiquidity: one, it may be hard to find a buyer in order to sell out of a position, and two, because of the lack of liquidity, a seller may be required to significantly lower their asking price in order to attract a bidder (or buyer);

• Potential for Fraud and Manipulation – see below for further discussion.

Because of the many risks associated with investing in penny stocks, the SEC has issued guidance suggesting that investors should be prepared for the possibility that they may lose their whole investment (or an amount in excess of their initial investment if the stock was purchased on margin).

Perhaps the greatest risk associated with penny stocks concerns the potential that exists for unscrupulous individual(s) to engage in fraud, often manifested through pricing manipulation schemes, through the recommendation or promotion of penny stocks to unwitting investors. Both the SEC and FINRA have issued investor alerts and guidance in order to inform and educate investors of the potential for penny stock fraud.

Specifically, investors are cautioned to understand that penny stocks may be linked to dormant shell companies with little to no actual business operations. In such instances, a penny stock may be manipulated by a fraudster in a ‘pump and dump’ scheme designed to pump up the price of a thinly traded security for the benefit of the fraudster(s), while the investors are left holding the bag with worthless or near worthless shares of stock.

The SEC and FINRA have issued the following investor alert tips designed to help investors avoid potential penny stock scams involving dormant shell companies:

• Research whether the company has been dormant, only to be brought back to life – an investor can search the company name or trading symbol using the SEC’s EDGAR database;

• >Know where the stock trades – most pump-and-dump schemes involve stocks that do not trade on major exchanges, including the NYSE or NASDAQ;

• Be wary of frequent changes to a company’s name or business focus – such name changes or marked changes in business focus may suggest pricing manipulation;

• Check for mammoth reverse splits – investors are cautioned to tread carefully when it comes to a giant reverse split (e.g., 1-20,000 split in shares);

• Know that ‘Q’ is for caution – investors should be mindful that a stock symbol including a fifth letter ‘Q’ at the end denotes that the company has filed for bankruptcy.

At Law Office of Christopher J. Gray, P.C., our attorneys have successfully resolved many cases on behalf of investors who have sustained investment losses, including losses associated with fraud and manipulation. Investors who wish to discuss a possible claim may contact a securities arbitration attorney at Law Office of Christopher J. Gray, P.C. via the contact form on this website, by telephone at (866) 966-9598, or by e-mail at newcases@investorlawyers.net for a no-cost, confidential consultation.