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Thomas McCarthy

CollegeStock...

A penny stock is a common stock that trades for less than $5 a share. While penny stocks generally are quoted over-the-counter, such as on the OTC Bulletin Board or in the Pink Sheets, they may also trade on securities exchanges, including foreign securities exchanges. In addition, penny stocks include the securities of certain private companies with no active trading market. Although a penny stock is said to be "thinly traded," share volumes traded daily can be in the hundreds of millions for a sub-penny stock. Legitimate information on penny stock companies can be difficult to find and a stock can be easily manipulated.^[1]

Definition

In the U.S. financial markets, the term penny stock commonly refers to any stock trading outside one of the major exchanges (NYSE, NASDAQ, or AMEX), and is often considered pejorative. However, the official SEC definition of a penny stock is a "low-priced, speculative security of a very small company, regardless of market capitalization or whether it trades on a securitized exchange (like NYSE or NASDAQ) or an "over the counter" listing service, such as the OTCBB or Pink Sheets." The terms penny stock, microcap stock, small caps, and nano caps are sometimes all used interchangeably, however per the SEC definition, penny stock status is determined by share price, not market capitalization or listing service.

High Risk/Reward Ratio

Many new investors are lured to the appeal of a penny stock due to the low price and potential for rapid growth which may be as high as several hundred percent in a few days. Similarly, severe loss can occur and many penny stocks lose all of their value in the long term. Accordingly, the SEC warns that penny stocks are high risk investments and new investors should be aware of the risks involved. These risks include limited liquidity, lack of financial reporting, and fraud.^[2]

Sudden changes in demand or supply of penny stock can lead to volatility in the stock price up or down. A lack of liquidity can also make it extremely difficult to sell a stock, particularly if there are no buyers that day. This can also make the stock extremely difficult to short. Lack of liquidity and volatility also makes penny stocks much more vulnerable to manipulation.

Secondly, unlike NASDAQ or the NYSE, there are only minimal requirements for a stock to be quoted on the OTCBB, namely that they make their filings with the SEC on time.^[3] In fact, companies that fail to meet minimum standards on one of the broader exchanges and are delisted often relist on the OTCBB or the Pink Sheets.

Furthermore, a stock trading on the Pink Sheets has little to no regulatory or listing requirements whatsoever, at least compared to major markets. There are no minimum accounting standards, change in notification of ownership of shares, and reported other material changes affecting the financial viability of a company, all of which are designed to protect shareholders.^[4]

The SEC notes most of the same about Internet message boards, where fraudsters claiming to be unbiased investors who've carefully done their due diligence may in fact be company insiders, and that a single person or a small team can create the appearance of a huge interest in a stock simply by creating a huge number of aliases, while banning the most vocal or perceptive critics of these offerings.

Pump and Dump Schemes

Penny stocks are often relentlessly promoted as part of illegal pump and dump schemes. The SEC explains how it works:^[5]

"A company's web site may feature a glowing press release about its financial health or some new product or innovation. Newsletters that purport to offer unbiased recommendations may suddenly tout the company as the latest "hot" stock. Messages in chat rooms and bulletin board postings may urge you to buy the stock quickly or to sell before the price goes down. Or you may even hear the company mentioned by a radio or TV analyst. Unwitting investors then purchase the stock in droves, creating high demand and pumping up the price. But when the fraudsters behind the scheme sell their shares at the peak and stop hyping the stock, the price plummets, and investors lose their money. Fraudsters frequently use this ploy with small, thinly traded companies because it's easier to manipulate a stock when there's little or no information available about the company."

There are all sorts of variations of the classic pump and dump, from short-and-distort to selling chop stocks — the last being a scam in which shares are acquired for pennies under Regulation S and then illegally sold to overseas or domestic retail investors.^[6] Other features of the typical penny stock scam include spam e-mails^[7] and junk faxes^[8] that tout ludicrous and fraudulent claims, crooked newsletter writers who promote a stock for a fee, message boards swarming with "buy now!!!" postings about a stock from anonymous, paid posters, fake or misleading press releases issued by the company, or boiler rooms full of cold-callers targeting naive, elderly, or foreign buyers all in attempt to drive up the share price while the insiders sell.

A more recent outbreak of penny stock fraud is far more brazen, and is based mostly overseas. Organized crime gangs in Eastern Europe and Asia will acquire a large number of shares of a moribund penny stock.

Then, using passwords and logins to electronic brokerages, such as E*Trade, stolen at public computer terminals in hotels and elsewhere, they will then use the hijacked customer accounts to buy up shares, while at the same time selling their own shares, draining the customer accounts and leaving their victims holding thousands of shares of worthless penny stocks.

While not all stocks listed on the OTCBB or the Pink Sheets are fraudulent, one Business Week article estimated that chop stocks alone "make up perhaps half the 85 million-share daily volume of the OTC Bulletin Board."^[9]