In the USA, a penny stock is a common stock that trades for less than five dollars a share and is traded over the counter (OTC) through quotation services such as the OTC Bulletin Board or the Pink Sheets. Although penny stocks are 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.[1]
In the UK markets, penny shares as they are more commonly called, generally refer to a stock and shares in small cap companies, defined as being companies with a market capitalization of less than £100 million and/or a share price of less than £1 with a bid/offer spread greater than 10%. In the UK Penny Shares are covered by a standard regulatory risk warning issued by the Financial Services Authority(FSA).
High-risk investments
Many new investors are lured to the appeal of a penny stock due to the low price and perceived potential for rapid growth, which can appear to be occurring if the stock is being promoted. However, 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 (recognizable with a .PK suffix) 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.[3]
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.
Potential fraud
Low-priced shares and micro-cap stocks are often relentlessly promoted as part of illegal pump and dump schemes. The SEC[4] explains how it works:
"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."
Another fraudulent scheme is the sale of chop stocks in which shares acquired below market under Regulation S are illegally sold to overseas or domestic retail investors.[5]
Other features penny stock scams include spam e-mails[6] and junk faxes[7] that tout ludicrous and fraudulent claims, crooked newsletter writers who promote a stock for a fee,[8] message boards swarming with "buy now!!!" postings about a stock from anonymous, paid posters,[9] fake or misleading press releases issued by the company,[10] or boiler rooms full of cold-callers targeting naive, elderly, or foreign buyers[11] all in attempt to drive up the share price while the insiders sell.[12]
A more recent outbreak of penny stock fraud is far more brazen, and is based mostly overseas.[13] 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 Pink Sheets or the OTCBB 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."[5]
Internet spam
Many Internet users have been exposed to e-mail spam promoting penny stocks. According to a study conducted at Oxford,[14] 15% of all spam was related to penny stock fraud. According to the study, "People who responded to the 'pump and dump' scam lost 8% of their investment in two days. Conversely, the spammers who buy low-priced stock before sending the e-mails, typically see a return of between 4.9% and 6% when they sell."
References
External links
