Penny Stock Reform Act

What Is the Penny Stock Reform Act?

The Penny Stock Reform Act was enacted by the U.S. Congress in 1990 as part of securities legislation that looked to clasp down on fraud in non-exchange-listed stocks — called penny stocks. A company's stock is commonly called a penny stock when its price trades below $5 per share.

Penny stocks for the most part traded through the over-the-counter (OTC) market, which is a broker-dealer network. The Penny Stock Reform Act added regulations for brokers and executed a penny stock marketplace for stocks to be quoted.

Understanding the Penny Stock Reform Act

The Penny Stock Reform Act — which was part of the "Securities Enforcement Remedies and Penny Stock Reform Act of 1990" — was endorsed into law by President George H.W. Shrub on Oct. 15, 1990. The legislation was intended to address the developing frequencies of penny stock fraud during the 1970s and 1980s. The law endeavored to impose more severe regulations on brokers and dealers who prescribed penny stocks to clients and furthermore advanced laying out a structured electronic marketplace for citing such securities.

Penny stocks are generally issued by small companies, which fall below the listing requirements expected to trade on national exchanges. For instance, the New York Stock Exchange (NYSE) expects companies to have 1.1 million equity shares outstanding for a total value of $100 million at any rate. Likewise, the company's stock must have a base listing price of $4 per share.

Accordingly, most penny stocks are traded over the counter (OTC) through the electronic OTC Bulletin Board (OTCBB) or through the privately owned OTC Markets Group.

Penny Stock Risks

By and large, there have been many risks and unique characteristics to penny stocks that have made them helpless to fraud and abuse. The Penny Stock Reform Act looked to reduce these risks, however even today, a portion of the risks stay common.

Lack of Financial Disclosure

Data about the companies that issue penny stocks isn't promptly accessible compared to additional laid out companies. For instance, penny stock companies are not required to report their financial statements like other publicly traded companies trading on the NYSE. Subsequently, data about a company may not be solid.

Likewise, the lack of data means that investors don't approach the company's financial history, including the financial performance of the company over the last several quarters. This lack of data and transparency can go with investment choices encompassing penny stocks very hard for investors and put them at risk for huge losses. Companies listed on the Pink Open Market (also known as pink sheet markets) are not required to file any financial statements or report any disclosures, except if they are listed on the Qualified Foreign Exchange.

Listing Requirements

The listing requirements to trade by means of over the counter versus a traditional exchange are very unique. Penny stocks, trading by means of OTC, have no base listing requirements, like a base level of revenue or profit. In the event that a company performs inadequately or is in financial distress, the stock can be moved to a smaller exchange.

Low Trading Volume

While trading penny stocks, investors can experience issues executing a buy and sell order when they need to, significance there is little liquidity in the market. Subsequently, an investor who can't sell a penny stock at the common price could need to acknowledge a lower price or trust that a buyer will arise. While the investor waits for a buyer, the stock price could fall — prompting a loss for the investor.

Penny Stock Manipulation

Penny stock transactions and abusive activities associated with them —, for example, "pump and dump" schemes and account "agitating" — filled substantially in the U.S. from the mid-1980s ahead. Advances in technology and telecommunications contributed to the emotional rise in interstate "engine compartment" operations where advertisers utilized high-pressure sales tactics to persuade clueless investors to invest in questionable penny stocks.

Frequently such advertisers of penny stocks would participate in pump and dump schemes, which included spreading false data about the company and organizing the pump and dump. Since penny stocks, particularly in OTC or pink sheet markets, have low share prices and limited liquidity or trading volume, large planned purchases could drive the price fundamentally higher, in percentage terms, in a short amount of time.

When the share prices rose, other investors would hop in and buy shares to exploit the momentum in the stock price. The fraudsters would then sell or dump their shares after the price had raised to a level where they created a sizable gain. The selling by the fraudsters prompted a free for all of selling by genuine investors in the wake of acknowledging there was not a great explanation at the stock cost to rise. The casualties were typically average investors that were stuck enduring the losses from the pump and dump scheme.

Penny Stock Reform Act Findings

In its report on the 1990 act, the House Committee on Energy and Commerce recognized two primary factors that had prodded the growth of penny stock fraud:

1. A lack of public data on these stocks, which worked with price manipulation
2. The presence of a large number of promoters and others associated with penny stock issuers and broker-dealers who were repeat guilty parties under securities laws, sentenced criminals or had connections to organized crime.

The Penny Stock Reform Act utilized a two dimensional approach of more regulation and better disclosure to accomplish the objective of decreasing penny stock fraud. The legislation conceded the Securities and Exchange Commission (SEC), which manages the financial markets, administrative power over penny stock issuers, brokers, and dealers. The act additionally required penny stock dealers and brokers to reveal to potential customers general data about the penny stock market, and specific data about the penny stocks.

Furthermore, the OTC dealer network can place an assignment of Caveat Emptor (in a real sense, "buyer beware") on a penny stock for the purpose of illuminating investors that there might be motivation to exercise extra care and due diligence for a particular issue. In fact, some brokerage houses are beginning to either limit investments in Caveat Emptor issues, or are no more allowing trading in penny stocks altogether

Features

• The act additionally required penny stock dealers and brokers to reveal to customers data about the penny stock market.
• The Penny Stock Reform Act likewise advanced laying out a structured electronic marketplace for citing such securities.
• The legislation conceded the SEC administrative power over penny stock issuers, brokers, and dealers.
• The Penny Stock Reform Act was enacted by the U.S. Congress in 1990 to brace down on fraud with penny stocks.