Penny stocks, also known as micro-cap stocks, nano-cap stocks, small cap stocks, or OTC stocks, are common shares of small public companies
that initially trade at low prices per share. It is also a term for
inexpensive stocks that subsequently become highly lucrative holdings.
According to the U.S. Securities and Exchange Commission
(SEC) the term "penny stock" generally refers to a security issued by a
very small company that trades at less than $5 per share initially.
Penny stocks generally are quoted over-the-counter, hence the name "OTC stocks". Over-the-counter exchanges that list penny stocks include, the OTC Bulletin Board (which is a facility of FINRA) or OTC Link LLC (which is owned by OTC Markets Group, Inc., formerly known as Pink OTC Markets Inc.). Penny stocks can also trade on securities exchanges, including foreign securities exchanges. Penny stocks can include the securities of certain private companies with no active trading market.
Prosecutors and the Federal Bureau of Investigation say that fraud is widespread in the penny stock market. Even though the penny stock companies are small, the scams that involve them can be for tens of millions of dollars.
In the case of many penny stocks, low market price inevitably leads to low market capitalization. Such stocks can be highly volatile and subject to manipulation by stock promoters and pump and dump
schemes. Such stocks present a high risk for investors, who are often
lured by the hope of large and quick profits. Penny stocks in the US are
often traded over-the-counter on the OTC Bulletin Board, or Pink Sheets.
Another problem with the penny stock market is that it has little liquidity, so holders of shares in penny stock companies often find it difficult for them to cash out of positions.
In the United States, the SEC and the Financial Industry Regulatory Authority (FINRA) have specific rules to define and regulate the sale of penny stocks.
Concerns for investors
Many penny stocks, particularly those that trade for fractions of a cent, are thinly traded. They can become the target of stock promoters and manipulators.These manipulators first purchase large quantities of stock, then
artificially inflate the share price through false and misleading
positive statements. This is referred to as a "pump and dump" scheme. The pump and dump is a form of microcap stock fraud.
In more sophisticated versions of the fraud, individuals or organizations buy millions of shares, then use newsletter websites, chat rooms, stock message boards, fake press releases, or e-mail blasts to drive up interest in the stock.Very often, the perpetrator will claim to have "inside" information
about impending news to persuade the unwitting investor to quickly buy
the shares. When buying pressure pushes the share price up, the rise in
price entices more people to believe the hype and to buy shares as well.
Eventually the manipulators doing the "pumping" end up "dumping," when
they sell their holdings.
The expanding use of the Internet and personal communication devices has made penny stock scams easier to perpetrate.
Regulation
In the United States, regulators have defined a penny stock as a
security that meets a number of specific standards. The criteria include
price, market capitalization, and minimum shareholder equity. Securities traded on a national stock exchange, regardless of price, are exempt from regulatory designation as a penny stock, since it is thought that exchange-traded securities are less vulnerable to manipulation. Therefore, Citigroup (NYSE:C) and other NYSE-listed
securities which traded below $1.00 during the market downturn of
2008–09, while properly regarded as "low-priced" securities, were not
technically "penny stocks".
Although penny stock trading in the United States is now primarily controlled through rules and regulations enforced by the SEC and FINRA, the genesis of this control is found in State securities law. The State of Georgia was the first state to codify a comprehensive penny stock securities law. Secretary of State Max Cleland, whose office enforced State securities laws, was a principal proponent of the legislation. Representative Chesley V. Morton, the only stockbroker in the Georgia General Assembly
at the time, was principal sponsor of the bill in the House of
Representatives. Georgia's penny stock law was subsequently challenged
in court. However, the law was eventually upheld in U.S. District Court, and the statute
became the template for laws enacted in other states. Shortly
thereafter, both FINRA and the SEC enacted comprehensive revisions of
their penny stock regulations.
These regulations proved effective in either closing or greatly
restricting broker/dealers, such as Blinder, Robinson & Company,
which specialized in the penny stocks sector. Meyer Blinder was jailed
for securities fraud in 1992, after the collapse of his firm.
However, sanctions under these specific regulations lack an effective
means to address pump and dump schemes perpetrated by unregistered
groups and individuals.
