SEC Issues White Paper on Penny Stock Risks

The SEC recently announced several new settled enforcement proceedings against market participants, including issuers, attorneys and a transfer agent, related to penny stock fraud. On the same day, the SEC issued a new white paper detailing the risks associated with investing in penny stocks.

The prevention of micro-cap fraud is, and will always be, a primary focus of the SEC and other securities regulators. In fact, the SEC will go to great lengths to investigate and ultimately prosecute micro-cap fraud. Further information on this topic can be found HERE.


The SEC Division of Economic and Risk Analysis published a white paper on the risks and consequences of investing in stocks quoted in the micro-cap markets versus those listed on a national securities exchange. The paper reviewed 1.8 million trades by more than 200,000 investors and concludes that returns on investment in the micro-cap markets tend to be negative, with the returns and risk worsening for less transparent companies or those involved in improper promotional campaigns.

The white paper notes that the incidence of and amount of negative returns, as well as alleged market manipulation, increase with the fewer disclosure-related requirements associated with the company. The white paper, on the whole, is very negative towards OTC Markets securities.

The white paper does not provide a balanced distinction to the higher OTCQX tier of OTC Markets. In fact, “OTCQX” only appears twice in the entire white paper, both in a footnote that purports to list the OTCQX requirements, but fails to mention the quantitative requirements, including that the security not be a penny stock as defined by the federal securities laws. The shortened “QX” does appear 13 times in the white paper, providing some factual and statistical information such as market size and trading patterns, but again, ignores the significant distinction related to the penny stock definition. A review of the OTCQX tier of OTC Markets and its listing requirements can be found HERE.

It is axiomatic that the vast majority of new jobs are created by small and emerging companies and that these companies are critical to the economic well-being of the United States. The comprehensive definition of accredited investor can be found HERE; a corresponding study of private placements can be found HERE.

According to both Bloomberg and Forbes, eight out of ten new businesses fail within 18 months and that number jumps to 96% in the first ten years. However, despite that failure rate, it is indisputable that we need entrepreneurs to continue forming new businesses and access supportive capital to have a healthy economy.

Likewise, it is self-evident to all micro-cap market participants that those companies that fail to provide meaningful disclosure to the public are more likely to result in investment losses. Those companies are also more likely to engage in market manipulation and other securities law violations. However, the companies that do provide meaningful disclosure to the public, whether through SEC reporting or alternatively to the OTC Markets, and especially those companies that trade on the OTCQX, are the very small and emerging companies that are necessary and vital to a healthy domestic economy. They may be the eight out of ten or the 96%, but some will also be the two out of ten and 4%.

Also, the fact is that bank financing is not readily available for these companies, and that they have no choice but to try to access capital through the public. That public wants an exit strategy, and that exit strategy tends to be the public markets. Where the companies are small and immature in their business life cycle, the OTC Markets provide that secondary trading market. In discussing this aspect of the economies of these small public companies, they are more positively referred to by the SEC as “venture” companies and the trading market as a “venture exchange.” Additional information regarding this topic can be found HERE.

Many times when a company ceases to provide disclosure or information to the public and remains dark for a period of time, its business operations have failed, it has gone private, or it otherwise has been abandoned. These companies continue to trade, and sometimes with high volume with no public information. The SEC makes an effort to eliminate these companies through its Operation Shell-Expel, but unfortunately many remain and new ones are added all the time as the eight-out- of-ten cycle continues.

Although all penny stocks are undeniably the highest-risk investments, grouping all OTC Markets in the white paper, in the fashion that the SEC has done, seems fundamentally unbalanced.

SEC White Paper

The SEC white paper begins with an introduction on some high-level differences between an exchange-traded security and one on the OTC Markets. One of the primary distinctions is that the majority of ownership and trading of an exchange-listed security is by institutional investors, whereas the majority of ownership and trading on the OTC Markets is by individuals. The SEC points out that institutions tend to be more proactive in research and shareholder activism, creating a check on corporate governance. As an aside, these institutions are also more sophisticated and able to assert greater influence and power over a company than an individual small shareholder.

The SEC quickly highlights the negative literature on OTC Markets securities, including that they have poor liquidity, generate negative and volatile returns and are often subject to market manipulation, including by the dissemination of false and misleading information. Although OTC securities offer the opportunity to invest in early-stage companies that may grow to be larger successful ones, the number that do succeed is small.

One portion of the white paper states that despite the risks, OTC Markets continue to grow and investor demands for these stocks continues to rise. The SEC offers two hypotheses for this. The first is that OTC investors are simply gambling for the big return, just as they do with the lottery. The second is that OTC Markets investors simply make bad investment decisions. However, the report does admit that little is known about the characteristics of OTC investors and that this is likely the first comprehensive study attempting to determine those demographics.

The SEC reviewed 1.8 million trades by more than 200,000 investors and concludes that returns on investment in the micro-cap markets tend to be negative, with the returns and risk worsening for less transparent companies or those involved in improper promotional campaigns, and are also worse for elderly and retired investors and those with lower levels of income and education. The SEC white paper purports to be the first study of its kind that examines investor outcomes around stock promotions and level of disclosure.

The SEC white paper continues with a three-part discussion: (i) OTC Market structure and size; (ii) review of academic literature; and (iii) analysis of OTC investor demographics and outcomes.

OTC Market Structure and Size

The SEC white paper describes the basic makeup of OTC Markets, including its three tiers of OTC Pink, OTCQB and OTCQX. A review of the three tiers can be found HERE. The OTC Pink remains unchanged. The most current listing standards on the OTCQX, can be found HERE, and HERE for the OTCQB.

The SEC white paper also references the OTCBB, which technically still exists but has fewer than 400 listed securities and does not have a readily accessible quote page.

The SEC white paper has a lot of information on the market size and its growth over the years. Without overly elaborating on facts and figures, the OTC Markets grew by 47% from 2012 through 2015, with $238 billion of trading in 2015. There are approximately 10,000 securities quoted on OTC Markets, as compared to approximately 2,700 on NASDAQ, of which only approximately 675 are micro-cap companies.

The OTC Markets’ monthly newsletter provides a complete review and breakdown of the size of the OTC Markets. For the month of December 31, 2016, the following is the number of traded securities and volume:

Monthly Trade Summary – December 2016

Market Designations Number of Securities* Monthly $ Volume Monthly $ Volume per Security 2016 $ Volume*
OTCQX 461 $3,844,835,942 $8,340,208 $36,847,879,435
OTCQB 933 $3,249,939,872 $3,483,322 $13,638,584,206
Pink 8,234 $14,648,939,577 $1,779,079 $142,411,521,245
Total 9,628 $21,743,715,392 $2,258,383 $192,897,984,887

Literature Review

The SEC white paper continues with a summary of recent academic research and analysis, including on OTC Markets securities’ liquidity, returns, market manipulation, and transition to an exchange and investor participation.

Liquidity refers to the ability of shareholders to quickly buy and sell securities near the market price without substantial price impact. Where there is a lack of liquidity, it is difficult to sell. Also, low-volume stocks tend to have wider price fluctuations and bid- ask spreads, and are more expensive for dealers to hold in inventory. OTC Markets securities are less liquid than those listed on a national exchange such as the NYSE MKT or NASDAQ. Research also shows that there tends to be lower liquidity with less transparency and disclosure. None of this is surprising. Anyone familiar with the OTC Markets space has seen the anomaly of a company with no information, and likely no underlying business or management, trading on heavy volume.

The returns on OTC Markets securities are also very different from exchange-traded securities. Returns on OTC Markets are often negative, volatile and skewed (the lottery factor). Where the majority of trades have negative returns, there is the incidence of extremely high, lottery-like returns on some of the securities. This, again, is not surprising. OTC Markets-traded companies tend to be smaller companies and thus would naturally have a smaller market capitalization and smaller returns as well as the potential for larger upside.

Again, returns on companies that provide less transparency and public information tend to be lower. Interestingly, another hypothesis as to why returns are lower is the short- sale constraints on OTC Market securities. Many OTC Market securities are ineligible for margin (and thus short sales), and locating shares to borrow can be challenging. Those securities that are margin-eligible usually have a very high carry interest and per- share transaction cost for short sales. The argument is that short sales create equilibrium and thus help reflect a more accurate share price such that the stock will be less vulnerable to negative price adjustments. However, unfortunately, sophisticated traders can open offshore accounts that permit them to short-sell OTC Market securities, making those securities vulnerable to manipulation by investors.

OTC Markets securities are relatively often the target of market manipulation, including outright fraudulent disclosures and pump-and- dump schemes. Generally these schemes are conducted in the trading of those companies that are less transparent in disclosures. A market manipulation scheme can involve the dissemination of false information followed by taking advantage of the price changes that result. The scheme can be perpetrated by the company and its insiders, or by unaffiliated investors. Examples include spam and email campaigns, rumors and false information in Internet chat rooms or forums, and baseless “analyst reports.” Research shows that these schemes are effective – that is, the price increases while the stock is being touted and falls when the campaign is over.

Obviously not all increases in stock prices are a result of improper behavior. OTC Markets stocks react to legitimate news and growth as well. In fact, the majority of extreme increases in trading price and volume are the result of changes in company fundamentals and not market manipulation. Moreover, when done in a compliant manner, investor relations and stock promotion is perfectly legal and hence legitimate. It is when false or misleading information is being disseminated, or targeted marketing aimed at vulnerable investor groups is used, that it is problematic. The key is recognizing the difference, which generally involves transparency from companies that provide steady, consistent disclosure with credible information.

Many OTC investors are hoping to “bet” on the company that will grow and move to an exchange where it is likely that the stock price will increase substantially, as will liquidity. The SEC white paper gives dismal statistics on the rates of graduation. However, it does note that the rate of movement to an exchange is much higher for OTCQX or OTCQB (9%) than OTC Pink companies (less than 1%). The SEC white paper also suggests that companies that graduate to an exchange from the OTC Markets underperform those companies that go public onto an exchange in the first instance.

The last area that the SEC white paper discusses in this section is investor participation and, in particular, why that investor participation continues to grow year over year. The SEC white paper provides two hypotheses, the first being that investors are drawn by the opportunity for lottery-like payoffs and the second being that investors are “duped about the stock return probabilities.” Although this sounds harsh, the white paper is not actually referring to market manipulation, but rather suggests that all OTC investors, including the most sophisticated, make poor estimates on return probabilities. No reason for this is offered.

Studies show that although investors frequently lose small investments in OTC stocks, they also occasionally receive an extremely large return. As such, the SEC white paper suggests that these investors are really just gamblers.

Data Analysis and Investor Demographics

The Division of Economic and Risk Analysis studied a sampling of trades for specific securities and time periods, which included information on the issuer, trade and investor. The purpose of the review was to determine a relationship between investor returns on one hand and stock promotions, company transparency and investor demographics on the other hand. However, the information used for the analysis is admittedly biased in that such information was taken from the SEC enforcement files for the year 2014. Since one or more parties to the trades were the subject of enforcement proceedings, this information would not be indicative of the usual OTC company.

The SEC white paper comes to the conclusion that there is a positive correlation between losses and market manipulation and lack of transparency. As discussed above, this is not surprising and is actually quite logical. The white paper also found a positive correlation between losses and elderly, lower-income and poorly educated investors.

The Author

Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm

Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of, the small-cap and middle market’s top source for industry news, and the producer and host of, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including siting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.

Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.

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