How The SEC Places Rules On Penny Stocks

By Prableen Bajpai | Updated August 27, 2014 AAA

There are rules for every game, even investments. As the speculative nature of investments increases, the market regulators get more cautious about the possibility of foul play and have stringent rules in place to safeguard the investor’s interest. Penny stocks are one such category that the Securities and Exchange Commission (SEC) is wary about. They are a class of stocks which involve very high risk and work on the principle of “all-or-nothing,” i.e. investors can lose all their invested money (and even more, if bought on margin), or alternately, there they may hit the jackpot. The latter does not happen very often, though.

Penny stocks, also known as “nano-cap” and “micro-cap” stocks, are issued by very small companies and trade at less than $5 per share. These shares are generally quoted over-the-counter (OTC). Since they fall short of the requisite criteria needed to be listed on a stock exchange (e.g. regarding the number of shares and the number of holders), they can instead be found on the OTC Bulletin Board (OTCBB) or the pink sheets.

Why Risky?

These stocks tend to lure many beginning investors, and even experienced investors with a very high risk appetite. Penny stocks tend to be very volatile, and in some cases have reported gains in a matter of few days or even hours. However, the vast majority just fade away or trade infrequently, making it difficult to sell them.

To give an example: Let’s assume that the fictitious Mr. James invested $10,000 in penny stocks of a company DomDom at $0.80 per share. In a matter of ten days' time, the shares go up to $2.00 per share (an increase of 250%!). Mr. James is elated to think that his $10,000 has turned into $25,000, which constitutes a profit of $15,000 in just 10 days. Unfortunately, Mr. James is ignorant about the fact that he may not be able to find buyers for the shares of DomDom for days (or ever). So yes, there is a theoretical profit, will the big question is whether it will be converted into realized gains.

The riskiness of penny stocks is severalfold:

  • The companies that issue such stocks are relatively unknown and there is little information available from reliable sources about them.
  • These stocks are mostly traded OTC, as they fail to fulfill the eligibility requirements for being listed on a stock exchange. This makes them less liable to scrutiny and thus their actual financial position, history, annual reports, etc are not fully analyzed.
  • There is very little or no historical data available about these companies.
  • These stocks suffer from the lack of liquidity (it’s difficult to find buyers for such stocks). Further to this, these stocks are also susceptible to manipulations such as “pump and dump,” which means that the prices are artificially escalated to look “attractive” and are then sold. The person who buys them is stuck with them, as the stock is actually not worth the “created” price and there aren’t any buyers. (see How To Indentify A Micro-Cap Scam)

Rules in Place

Due to the above reasons as well as a history of many scams, penny stocks are considered  highly speculative investments. In order to protect the investor’s interest, the SEC and the Financial Industry Regulatory Authority (FINRA) have specific rules to regulate the sale of penny stocks. All broker-dealers need to comply with the requirements of Section 15(h) of the Securities Exchange Act of 1934 and the accompanying rules in order to be eligible to effect any transactions in penny stocks.

(1) Sales Practice Requirements §240.15g-9   

Before effecting any transaction, a broker-dealer must approve the investor's transaction (of specific penny stocks); meanwhile, the customer must give a written agreement to the broker-dealer for the same transaction. This measure has been taken to prevent manipulative, fraudulent practices in such investments. “Approving” the customer basically means checking his suitability for such investments. Approval should be given only after the broker-dealer has assessed the customer's investment experience and objectives along with his or her financial position. 

(2) Disclosure Document §240.15g-2

A broker-dealer must provide a standardized disclosure document to the customer. The documents explains the risk factor associated with investing in penny stocks, concepts related to the penny-stock market, customer rights, broker-dealers' duties towards the customers, remedies in case of fraud and other important information which can be handy for an investor. The investor would be well-advised to go through this document so as to take informed decisions. 

(3) Bid-Offer Quotations Disclosure §240.15g-3 

It is mandatory for a broker-dealer to disclose and later confirm the current quotation prices and related information to the customer before effecting a transaction. If a broker-dealer doesn’t follow the same, it is considered unlawful. This helps the investor to keep a track of the price movement in the market place.

 (4) Compensation Disclosure §240.15g-4   

This rule makes the investor aware of the money being earned by the broker-dealer from a certain transaction. This can help the customer to judge if the broker-dealer has a selfish motive in trying to push a certain transaction.

(5) Monthly Accounts Statements §240.15g-6   

A broker-dealer must send to its clients a monthly account statement which discloses details such as: the number and identity of each penny stock in the customer’s account; the dates of transaction; purchase price; and the estimated market value of the security (based on recent bids and purchase prices). Such statements must also explain the limited market for the securities and the nature of an estimated price in such a limited market. In cases where there have been no transactions effected in the customer’s account for a period of six months, the broker-dealer shall not be required to provide monthly statements. However, broker-dealers should send written statements on a quarterly basis.

The Bottom Line

It would be wrong to conclude that all penny stocks are bad. Some of these are quality companies who are working hard to grow and expand. However, out of many such nano-cap and micro-cap companies, only a handful pass muster to be listed on recognized stock exchanges while others crumble. Investors need to understand that a cheaper stock doesn’t mean more scope for growth or appreciation and such stocks may never be able to cross the threshold. If you are still pulled towards them, make sure that you understand the rules and riskiness of penny stocks.

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