SEC and FINRA Issue Risk Alert on Penny Stock Companies

I’m not your legal advisor.  And I’m definitely not your investment adviser.  But the first rule of penny stock companies should be: do not invest in penny stock companies.  I mean, does that seem like a smart thing to do?  Alas, some people will never obey that rule.  For them, on October 30th the SEC and FINRA have issued a risk alert, with five guiding rules.  Here they are, with my paraphrase of the agencies’ explanatory language below each:

1.      Research whether the company has been dormant—and brought back to life.

This sort of rebirth should be an automatic red flag.  You can search the SEC’s EDGAR database to see when the company may have last filed periodic reports.  Another resource is the Secretary of State’s office in the state where the company was formed or incorporated. The charter documents filed with the state may provide details of the company’s history.  See if the company recently reinstated business operations in its original state of incorporation, or re-incorporated in a new state.  If possible, contact company management to determine why it ceased operations to begin with, and why it decided to reinstate operations.  A company that does not answer the phone or return calls should be another warning sign.  Perhaps needless to say.

2.      Know where the stock trades.

Most stock pump-and-dump schemes involve stocks that do not trade on the NASDAQ or the NYSE.  Instead, these stocks tend to be quoted on an over-the-counter (OTC) quotation platform like the OTC Link Alternative Trading System (ATS) operated by OTC Markets Group, Inc. Companies that list their stocks on exchanges must meet minimum listing standards, but companies quoted on OTC Link generally do not.  Companies quoted on the OTC Link’s OTCQX and OTCQB marketplaces are subject to some initial and ongoing requirements.  But in this space, more disclosure tends to be better.  Watch out.

3.      Be wary of frequent changes to a company’s name or business focus.

Name changes and the potential for manipulation often go hand in hand.  You can learn about name changes and other corporate events on the OTC Markets website.  If the company files periodic reports, you can search changes in a company name or business focus in the SEC's EDGAR database.

4.      Check for mammoth reverse stock splits.

A reverse stock split reduces the number of shares outstanding and increases the price per share without changing the total economic value of the shares.  A company might perform a reverse stock split with a 1-for-5 or similar ratio (in an effort to meet minimum bid price requirements for continued listing on an exchange).  A dormant shell company, on the other hand, might carry out a 1-for-20,000 or even 1-for-50,000 reverse split.  This may be done to inflate the price of the stock.

5.      Know that “Q” is for caution.

A stock symbol with a fifth letter “Q” at the end denotes that the company has filed for bankruptcy.  Like other non-reporting shell companies, dormant, bankrupt companies can be candidates for manipulation.

I would add a sixth:

6.      Watch out for companies that spring to life to capitalize on news events.

Suffice it to say that businesses claiming to capitalize on Hurricane Katrina, the BP oil spill, or weed legalization are often hoping to capitalize on your investment.

If you can’t follow the very first rule at the top, consider these other six.