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Penny Stocks

Penny stocks are equity securities that present significant investment risks for investors. A “penny stock” is defined by the Securities and Exchange Commission (SEC) as a security issued by a small or micro-cap company having less than $100 million in market capitalization. Penny stocks also typically trade at less than $5 per share. Penny stocks are generally quoted on over-the-counter exchanges such as on the OTC Bulletin Board. In addition, penny stocks can also include private companies with no active trading market.

The risks of penny stocks stem from several contributing factors. First, penny stocks may trade infrequently. Thus, it is often difficult to liquidate a penny stock holding once acquired and when the investor wants to. Second, it is often difficult to find accurate quotes for penny stocks. Due to these risks, penny stocks often fluctuate wildly day-to-day and investors may lose their whole investment. If an investor combines penny stock investing with margin borrowing the investor can magnify their already volatile holdings.

If the foregoing risks of penny stocks were not enough, penny stocks are often used and manipulated for fraudulent purposes. One scheme employed for fraudulent purposes is the “pump and dump” scheme. In a pump and dump scheme, the schemer creates unfounded and false hype for a penny stock the pumper already owns. As the pumper’s victims purchase the stock due to the schemer’s false hype the price of the penny stock is artificially increased. The scheming penny stock pumper then sells their shares for a profit. The schemers sales of the penny stock causes downward pressure on the security and the penny stock quickly loses value causing the investors to suffer huge losses.

In order to protect investors, broker-dealers are required to comply with the requirements of Section 15(h) of the Securities Exchange Act of 1934. These SEC rules provide that a brokerage firm must: (1) approve the customer for the specific penny stock transaction and receive from the customer a written agreement authorizing the penny stock transaction; (2) provide the customer with a written disclosure describing the risks of investing in penny stocks; (3) disclose to the customer the current market quotation for the penny stock; and (4) disclose to the customer the amount of compensation the firm receives. In addition, the brokerage firm must provide the penny stock investor monthly account statements showing the market value of each penny stock held in the account.

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