Penny Stocks Rules
Penny Stock Rules And Broker Dealers
In last week’s blog regarding FINRA’s request to eliminate the OTC Bulletin Board quotation service (OTCBB) and to adopt rules relating to the quotation requirements for OTC equity services by inter-dealer quotation services, I touched upon the significance of penny stock rules related to the OTC marketplace. As further described herein, penny stocks are low-priced securities (under $5.00 per share) and are considered speculative and risky investments.
Penny stock rules focus on the activity of broker-dealers in effectuating trades in penny stocks. As a result of the risk associated with penny stock trading, Congress enacted the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (the “Penny Stock Act”) requiring the SEC to enact rules requiring brokers or dealers to provide disclosures to customers effecting trades in penny stocks. The rules prohibit broker-dealers from effecting transactions in penny stocks unless they comply with the requirements of Section 15(h) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and the rules promulgated thereunder and, in particular, Exchange Act rules 15g-1 through 15g-100 (the “penny stock rules”).
Section 17B of the Exchange Act, which was enacted as part of the Penny Stock Act, regulates automated quotation systems for penny stocks (such as OTC Markets) and provides, among other things, that the SEC shall facilitate the widespread dissemination of reliable and accurate last sale and quotation information with respect to penny stocks.
Definition of Penny Stock
A penny stock is defined in Exchange Act Rule 3a51-1. Like many SEC rules, the penny stock rule begins by including all equity securities and then carves out exemptions (for example, all offers and sales of securities must be registered unless an exemption applies). In particular, Rule 3a51-1 defines a penny stock as any equity security other than:
(a) A NMS (national market system) stock that is a reported security that is (i) registered on a national securities exchange that is grandfathered in because it has been in continuous operation since prior to April 20, 1992; or (ii) is quoted on either a national securities exchange or automated quotation system that that has certain quantitative initial listing standards and continued listing standards that are reasonably related to the initial listing standards. The initial listing standards must meet or exceed the following criteria: (a) the issuer must have $5 million of stockholders’ equity, market value of listed securities of $50 million for 90 consecutive days prior to applying, or net income of $750,000 (excluding extraordinary or non-recurring items) in the most recently completed fiscal year or in two or the last three most recently completed fiscal years; (b) the issuer must have an operating history of at least one year or a market value of listed securities of $50 million; (c) the issuer’s stock must have a minimum bid price of $4 per share; (d) there shall be at least 300 round lot holders of common stock; and (e) there must be at least 1,000,000 publicly held common shares with a market value of at least $5 million.
(b) Is issued by an investment company registered under the Investment Company Act of 1940, as amended;
(c) Is a put or call option issued by the Options Clearing Corporation;
(d) Has an inside bid quotation price of $5.00 (the Rule requires that the price be net of broker or dealer commissions, mark-up or mark-downs);
(e) Is registered, or approved for registration upon notice of issuance, on a national securities exchange that makes price and volume transaction reports available, subject to restrictions provided in the rule;
(f) Is a security futures product listed on a national securities exchange or an automated quotation system sponsored by a registered national securities association; or
(g) Whose issuer has: (i) net tangible assets (as calculated in accordance with the rule) in excess of $2 million, if the issuer has been in continuous operation for at least three years, or $5 million, if the issuer has been in continuous operation for less than three years; or (ii) average revenue (as calculated in accordance with the rule) of at least $6 million for the last three years.
Section 15(h) of the Exchange Act
Broker-dealers are required to comply with the penny stock rules, which rules center around disclosure of the risks and other market information associated with penny stock transactions and a determination of the suitability of the customer to engage in such high-risk transactions. Section 15(h) of the Exchange Act provides that no broker or dealer may effectuate the purchase or sale of any penny stock by a customer unless such broker or dealer (i) approves the customer for the specific penny stock transaction and receives from the customer a written agreement to the transaction; (ii) furnishes the customer a risk disclosure document describing the risks of investing in penny stocks; (iii) discloses to the customer the current market quotation, if any, for the penny stock, including the bid and ask price and the number of shares that apply to such bid and ask price; and (iv) discloses to the customer the amount of compensation the firm and its broker will receive for the trade. In addition, after executing the sale, a broker-dealer must send to its customer monthly account statements showing the market value of each penny stock held in the customer’s account.
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