In 1990, the U.S. Congress passed the Penny Stock Reform Act to combat fraud associated with penny stocks. This legislation bestowed the Securities and Exchange Commission (SEC) with the authority to regulate penny stock issuers, brokers, and dealers. It also mandated that dealers and brokers provide customers with information about the penny stock market. Furthermore, the act aimed to encourage the creation of a structured electronic marketplace for trading these securities.
The Penny Stock Reform Act was passed in 1990 to combat fraudulent activities related to penny stocks, which are non-exchange-listed stocks that trade below $5 per share. Typically traded through the over-the-counter (OTC) market, a network of broker-dealers, these stocks were subject to regulations introduced by the act, which also established a dedicated marketplace for quoting penny stocks.
The Origins of Penny Stock Reform
On October 15, 1990, President George H.W. Bush signed the Penny Stock Reform Act as part of the broader "Securities Enforcement Remedies and Penny Stock Reform Act of 1990." This act was a response to the increasing instances of penny stock fraud during the 1970s and 1980s. Its purpose was to introduce stricter regulations for brokers and dealers who recommended penny stocks to clients, while also advocating for the creation of a structured electronic marketplace for quoting these securities.
Penny stocks are typically issued by small companies that do not meet the listing requirements of national exchanges. For instance, the New York Stock Exchange (NYSE) mandates that companies have at least 1.1 million outstanding equity shares with a total value of $100 million, along with a minimum listing price of $4 per share. As a result, most penny stocks are traded OTC through platforms such as the electronic OTC Bulletin Board or the privately owned OTC Markets Group.
Risks of Penny Stock
The nature of penny stocks has long exposed them to risks and vulnerabilities associated with fraud and abuse. The implementation of the Penny Stock Reform Act aimed to mitigate these risks, although certain challenges persist to this day.
Risks Associated with Penny Stocks:
- Lack of Financial Disclosure: Penny stock companies are not obligated to provide financial statements like publicly traded companies on major exchanges. This lack of financial disclosure makes it difficult for investors to access reliable information about the company's financial health and performance. Companies listed on the Pink Open Market may not file any financial statements or disclosures, further limiting transparency.
- Listing Requirements: Unlike traditional exchanges, penny stocks traded over the counter do not have minimum listing requirements such as revenue or profit levels. This means that financially distressed or poorly performing companies can still trade their stocks on smaller exchanges, potentially misleading investors about the true state of the company.
- Low Trading Volume: Penny stocks often have low trading volume, resulting in limited liquidity in the market. This poses challenges for investors when buying or selling penny stocks, as executing orders at desired prices may be difficult. Investors may have to settle for lower prices or wait for a buyer to emerge, which could lead to losses if the stock price drops during the waiting period.
Penny Stock Manipulations
Penny stocks in the U.S. saw a rise in abusive practices like "pump and dump" schemes and account "churning" from the mid-1980s. Promoters used aggressive tactics to convince unsuspecting investors to buy questionable penny stocks. They spread false information, artificially driving up the stock prices. Once the prices rose, fraudsters sold their shares for a significant profit, causing a selling frenzy among legitimate investors. Average investors were often the ones who suffered the losses.
Penny Stock Reform Act Results
The growth of penny stock fraud was attributed to two main factors: a lack of public information on these stocks, making price manipulation easier, and the involvement of individuals associated with criminal activities or repeat offenses in the securities industry. To address this issue, the Penny Stock Reform Act focused on increased regulation and better disclosure. It empowered SEC to oversee penny stock issuers, brokers, and dealers, while also requiring these entities to provide potential customers with comprehensive information about the penny stock market and specific stocks.
Additionally, the OTC dealer network can designate certain penny stocks as "Caveat Emptor," signaling the need for investors to exercise additional caution and due diligence. Some brokerage firms have even placed restrictions or ceased trading penny stocks altogether.
The Penny Stock Reform Act of 1990 was a response to the growing instances of penny stock fraud in the late 20th century. The act aimed to mitigate risks associated with penny stocks and encourage the creation of a structured electronic marketplace for trading these securities. While the act has helped to mitigate some of the risks associated with penny stocks, challenges persist, and investors should exercise caution when investing in these securities.