Penny stocks or micro-cap 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, the “Exchange Act” or the “Federal Securities Act.” 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.
Penny stocks are purchased through your broker or broker-dealer like any other investments – regardless of whether the penny stock is listed on a public exchange. Even though penny stocks or micro-cap stocks are purchased through your broker-dealer, there is rampant fraud in the sale of penny stocks.
Penny stock fraud and micro-cap fraud is found principally in the unsuitable sale of these highly speculative investments and in pump and dump schemes. Pump and dump schemes involve the use of misleading opinions or statements to increase investor interest in a particular stock. As the stock prices rises, the penny stock or micro-cap fraudster beings to sell, or “dump,” his or her stock before causing the stock to crash. Pump and dump schemes are easier to accomplish using penny stocks and micro-cap stocks because smaller sales have a great effect than in small cap to large cap stocks.
Another common scheme associated with penny stocks and micro-cap stocks is called chop stocking. This is where a broker will purchase stocks for pennies on the dollar and sell to unsophisticated investors for a significant profit. Generally speaking, the stock at issue will have little to no value or liquidity and will be sold by fraud.
The attorneys at Gana Weinstein LLP have significant experience prosecuting penny stock and micro-cap stocks in FINRA arbitration. Our attorneys regularly analyze investor accounts to ferret out inappropriate penny stock and micro-cap stock schemes. Give us a call if you think you may be a victim of penny stock schemes.