Rules and Regulations on Penny Stocks in the United States

John Smith

If an equity security is not listed on a national market and trades for less than $5 per share, the SEC considers it a penny stock.

The Pink Sheets and OTC Bulletin Board are two sites where penny stocks are typically traded over-the-counter. These investments are seen as extremely risky.

In an effort to safeguard investors from possible fraudulent or scamming practices, the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) implement stringent regulations pertaining to the advertising and sale of penny stocks.

SEC Regulations

In 1990, the SEC enforced Rule 15g-9, which mandated that broker-dealers engaging in penny stock trading furnish clients with risk disclosure materials. The dangers of buying cheap shares must be laid out in these publications. They consist of:

  • Lack of publicly available information: Companies trading as penny stocks are not required to register or file periodic reports with the SEC. Therefore, reliable, non-biased information on penny stock companies is scarce. Investors may not have access to audited financial statements, details on company management, or other data to make informed decisions.
  • Price volatility: The share prices of penny stocks are often highly unstable with drastic price spikes up and down over short periods. The stocks can be easily manipulated by fraudsters spreading misinformation, paid stock promoters, or over-zealous investors themselves. Lack of liquidity also contributes to volatility.
  • Potential for fraud: Microcap stock fraud happens frequently with penny stocks. Common fraudulent activities include pump-and-dump schemes, misleading public statements on a company’s financials or operations, and false reporting of ownership stakes. Naïve investors get tricked into buying shares.

Along with these written disclosures on risks, FINRA rules state that broker-dealers must receive a signed and dated acknowledgment from each penny stock customer that they understand the risks prior to executing any trades.

Restrictions on Solicitation and Advertising

The SEC enacted Rule 15g-2 to reduce pump-and-dump scams. This rule states that broker-dealers cannot solicit trades in penny stocks without proper verification of the customer’s knowledge and experience in high-risk equity trading.

The account application gathers background information such as employment position, income level, net worth, investment history, and more.

The rule also applies to any advertising materials related to penny stocks. These materials cannot make false or misleading statements nor fail to disclose the risks.

Compliance Requirements for Broker-Dealers

As per Rule 15g-3, broker-dealers who deal in penny stocks are required to enhance their compliance processes, maintain comprehensive records of all transactions, and put in place extra measures for oversight. Things needed are:

  • Securities approval: Firms must pre-approve transactions by a registered principal before executing any buy or sell orders in penny stocks for customers. Doing so ensures proper due diligence.
  • Account statements: Brokerages need to send out monthly account statements displaying market values and profits/losses so customers can accurately track positions in volatile penny stocks.
  • Supervisory procedures: Stringent standards around supervision of trading activity must be established and followed. Higher-level managers are held responsible for ensuring broker-dealer staff adhere to regulations.

By forcing extensive transparency and accountability measures, regulators aim to prevent penny stock brokers from taking advantage of less knowledgeable traders.

Legal Consequences for Non-Compliance

The SEC and FINRA take severe disciplinary action against firms who do not comply with penny stock requirements.

Violators of the rules or those who fail to oversee trading activities can face fines of several hundred thousand dollars. Criminal charges are also sought in circumstances of severe fraud.

Any broker found to have intentionally misled a client for financial benefit will have their license revoked by the appropriate regulatory body.

A ban on their practice means they can no longer make a living for these agents. The results show how serious the watchdogs are about protecting penny stock investors.

Closing Thoughts

U.S. regulators put clear regulations on penny stock trading in place to prevent brokers from engaging in scams and to protect regular investors from unnecessary risk through stringent reporting requirements enforced by FINRA and the SEC.

These speculative over-the-counter assets should nevertheless be purchased by interested parties with the utmost care. When investing in penny stocks, it’s smart to do your own research and compare broker claims with the company’s official filings with regulators.

It is wise for investors to conduct thorough research before risking their capital on unproven microcap businesses, as the old saying goes.

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John Smith is a veteran stock trader with over 10 years of experience in the financial markets. He is a widely followed market commentator known for his astute analysis and accurate predictions. John has authored multiple bestselling books explaining complex market concepts in simple terms for novice investors looking to grow their wealth through strategic trading and long-term investments.
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