Penny Stock Reform Act - Explained
What is the Penny Stock Reform Act?
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What is the Penny Stock Reform Act?
The Penny Stock Reform Act of 1990 is a part of the U.S. financial assets legislation which aims to reduce the amount of fraud involved in non-exchange-listed stocks which generally trade under $5 in over-the-counter markets (OTC). These stocks are generally referred to as penny stocks, and this name is preferred due to the low amount of capital required to invest in them. Signed into law on October 15, 1990, by the then-president George H.W. Bush, this reform act was aimed at curbing the high rate of penny stocks related fraud in the 1970s through the 1980s. The Act was focused on brokers who provided penny stocks to clients, as it imposed stricter regulations on them. It also tried to make a great number of penny stocks available on the exchange market for transparency.
How Does the Penny Stock Reform Act Work?
The Reform Act was focused primarily on two different issues which were related to penny stocks. It sought to provide better disclosure and transparency, as well as impose stringent regulations on dealers in an attempt to curb the fraud rate related to this security. In order to do this, the Act first empowered the Security and Exchange Commission (SEC) with administrative authority over penny stock brokerage firms, issuers, and dealers. In the process of making sure that penny stocks were transparent, the Reform Act made it mandatory for penny stocks brokers and dealers to reveal the general and important details about a penny stock, and the full data and performance of the stock company to interested and potential clients. Penny Stocks are just like other company stocks, but they lack the requirements needed to be listed in a national exchange market. These stocks are typically issued by small companies with low asset and annual returns, with the hope of getting investors to purchase the shares so they can make some extra money to scale the business higher. However, with different annoying and capital sucking frauds like the famous pump and dump scheme or the account churning scheme which increased substantially in the 80s, the government found it essential to impose restrictions and regulations on this sector of the stocks market. Another fraud which was famously popular in the earlier years of technological innovations was the boiler room scheme, an operation which promoters used in pressurizing investors to invest in fraudulent penny stocks. It was named boiler room due to the irresistible sales tactics and tones which these promoters used to pressurize investors and traders into holding units of these penny stocks. In creating the Act, the House Committee on Energy and Commerce pointed out two externalities which influenced the growth of the penny stocks frauds. They highlighted them as such:
- A lack of publicly-available information on the stocks aided in price manipulation
- A substantial number of promoters of these penny stocks were convicted felons, offenders under the security laws, or had ties to financial organized crimes.
A great number of these promoters preferred going the way of the pump and dump scheme using chat forums to raise exposure and facilitate this scheme. Since penny stocks are not exchange-listed, they usually traded in OTC and pink sheet markets. This made it possible for large coordinated purchases to increase the price of these stocks percentage-wise in a short period since they were usually low valued shares and had limited liquidity. Unsuspecting investors are then provided with these inflated prices, which would only last a short amount of time without really disclosing this information to them. Thus, after investing, they tend to run returns in losses as the market is mostly illiquid, and the prices would have returned to normal before they can get their investments. For better understanding, a penny stock which initially cost $1.50 per unit can experience an inflation price of $2 per unit because the issuers or promoters have pumped over a thousand units to it. When this price is at $2, these promoters will then contact unsuspecting investors revealing the great increase in the value of this share in the past few days or weeks. These investors will then buy at $2 per unit, only for the promoters to remove their one thousand units making the price fall back to $1.50. Thus, the investor loses $0.50 per unit of stock when he wishes to withdraw his position.