Penny Stock Reform Act: What It Is, How It Works

What Is the Penny Stock Reform Act?

The Penny Stock Reform Act was enacted by the U.S. Congress in 1990 as part of securities legislation that sought to clamp down on fraud in non-exchange-listed stocks—called penny stocks. A company's stock is typically called a penny stock when its price trades below $5 per share.

Penny stocks usually traded via the over-the-counter (OTC) market, which is a broker-dealer network. The Penny Stock Reform Act added regulations for brokers and implemented a penny stock marketplace for stocks to be quoted.

Understanding the Penny Stock Reform Act

The Penny Stock Reform Act—which was part of the “Securities Enforcement Remedies and Penny Stock Reform Act of 1990”—was signed into law by President George H.W. Bush on Oct. 15, 1990. The legislation was designed to address the growing incidences of penny stock fraud in the 1970s and 1980s. The law attempted to impose more stringent regulations on brokers and dealers who recommended penny stocks to clients and also promoted establishing a structured electronic marketplace for quoting such securities.

Penny stocks are usually issued by small companies, which fall below the listing requirements needed to trade on national exchanges. For example, the New York Stock Exchange (NYSE) requires companies to have 1.1 million equity shares outstanding for a total value of $100 million at a minimum. Also, the company's stock must have a minimum listing price of $4 per share.

As a result, most penny stocks are traded over the counter (OTC) through the electronic OTC Bulletin Board (OTCBB) or through the privately owned OTC Markets Group.

Penny Stock Risks

Historically, there have been many risks and unique characteristics to penny stocks that have made them susceptible to fraud and abuse. The Penny Stock Reform Act sought to reduce these risks, but even today, some of the risks remain prevalent.

Lack of Financial Disclosure

Information about the companies that issue penny stocks is not readily available compared to more established companies. For example, penny stock companies are not required to report their financial statements like other publicly traded companies trading on the NYSE. As a result, information about a company may not be reliable.

Also, the lack of information means that investors don't have access to the company's financial history, including the financial performance of the company over the last several quarters. This lack of information and transparency can make investment decisions surrounding penny stocks quite difficult for investors and put them at risk for significant losses. Companies listed on the Pink Open Market (aka pink sheet markets) are not required to file any financial statements or report any disclosures, unless they are listed on the Qualified Foreign Exchange.

Listing Requirements 

The listing requirements to trade via over the counter versus a traditional exchange are quite different. Penny stocks, trading via OTC, don't have any minimum listing requirements, such as a minimum level of revenue or profit. If a company performs poorly or is in financial distress, the stock can be transferred to a smaller exchange.

Low Trading Volume 

When trading penny stocks, investors can have difficulty executing a buy and sell order when they want to, meaning there is little liquidity in the market. As a result, an investor who can't sell a penny stock at the prevailing price might have to accept a lower price or wait for a buyer to emerge. While the investor waits for a buyer, the stock price could fall—leading to a loss for the investor.

Penny Stock Manipulation

Penny stock transactions and abusive activities associated with them—such as “pump and dump” schemes and account “churning”—grew substantially in the U.S. from the mid-1980s onward. Advances in technology and telecommunications contributed to the dramatic rise in interstate “boiler room” operations where promoters used high-pressure sales tactics to convince unsuspecting investors to invest in dubious penny stocks.

Often such promoters of penny stocks would participate in pump and dump schemes, which included spreading false information about the company and coordinating the pump and dump. Because penny stocks, especially in OTC or pink sheet markets, have low share prices and limited liquidity or trading volume, large coordinated purchases could drive the price significantly higher, in percentage terms, in a short amount of time.

Once the share prices rose, other investors would jump in and buy shares to take advantage of the momentum in the stock price. The fraudsters would then sell or dump their shares after the price had elevated to a level where they made a sizable profit. The selling by the fraudsters led to a frenzy of selling by legitimate investors after realizing there was no fundamental reason for the stock price to rise. The victims were usually average investors that were stuck enduring the losses from the pump and dump scheme.

Penny Stock Reform Act Findings

In its report on the 1990 act, the House Committee on Energy and Commerce identified two main factors that had spurred the growth of penny stock fraud:

1. A lack of public information on these stocks, which facilitated price manipulation
2. The presence of a large number of promoters and others associated with penny stock issuers and broker-dealers who were repeat offenders under securities laws, convicted felons or had ties to organized crime.

The Penny Stock Reform Act used a two-pronged approach of more regulation and better disclosure to achieve the objective of reducing penny stock fraud. The legislation granted the Securities and Exchange Commission (SEC), which regulates the financial markets, administrative power over penny stock issuers, brokers, and dealers. The act also required penny stock dealers and brokers to disclose to potential customers general information about the penny stock market, and specific information about the penny stocks.

In addition, the OTC dealer network can place a designation of Caveat Emptor (literally, "buyer beware") on a penny stock as a means of informing investors that there may be reason to exercise additional care and due diligence for a particular issue. In fact, some brokerage houses are beginning to either restrict investments in Caveat Emptor issues, or are no longer allowing trading in penny stocks altogether