Back to: ECONOMICS, FINANCE, & ACCOUNTING
“Penny Stock Reform Act” Definition
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.
A Little More on What is a “Penny Stock Reform Act”
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.
References For Penny Stock Reform Act
Academic Research on Penny Stock Reform Act
The Securities Enforcement Remedies and Penny Stock Reform Act of 1990: By Keeping Up with the Joneses, the SEC’s Enforcement Arsenal Is Modernized, Morris, M. S. (1993). Admin. LJ Am. U., 7, 151. Morris, M. S. (1993). Admin. LJ Am. U., 7, 151. This paper discusses the main points of the SERPS Reform Act (Securities Enforcement Remedies & Penny Stock) 1990, including its historical context, changes in this Act, monetary penalties in admin proceedings and civil actions, disgorgement , desist and cease orders, permanent and temporary cease and desist orders, suspensions of directors and officers, and effective dates. The author also highlights the authority of the SEC (Securities & Exchange Commission) to impose or seek monetary penalties. Finally, the author explains the tools of the SEC for enforcement prior to the ability of the Commission to impose or seek monetary penalties.
The Penny Stock Reform Act of 1990: A Costly Solution to a Serious Problem, Lampe, C. E. (1990). Geo. Mason UL Rev., 13, 779. This paper analyzes the benefits and costs attached to different sections of the Act. First, the author elaborates the penny stock market background and the latest development in market manipulation and cold calling, which are 2 important categories of penny stock fraud. Then, the author reviews the legislative history of the SLERA (Securities Law Enforcement & Remedies Act). He defines a penny stock for the PSRA purposes (Penny Stock Reform Act). He considers the benefits and costs of the sanctioned person exclusion from taking part in penny stock distributions, the progress of an Automated Quotation System (AQS) for penny stocks and the disclosure requirements for penny stocks dealers and brokers.
SEC enforcement activities: a survey and critical perspective, Bremser, W. G., Licata, M. P., & Rollins, T. P. (1991). Critical Perspectives on Accounting, 2(2), 185-199. This study reviews and makes an analysis of the Accounting and Auditing Enforcement Releases (AAERs) and briefly describes the auditors, registrant, violations types made and sanctions the SEC (Securities & Exchange Commission) requires. The findings are that the firms, among large registrants, receiving sanctions are fairly larger having a higher opinion qualifications proportion as compared to industry counterparts. On the other hand, the auditors received the Commission’s sanctions just for a short time. The most common penalties for the auditors are peer review, practice suspensions, injunctions or censures and CPE hours. Finally, the authors also discuss future enforcement powers by the SEC.
The Securities Enforcement and Penny Stock Reform Act of 1990: The Cost of Flexibility, Cook, J. M. (1992). Admin. LJ Am. U, 6, 359. This paper discusses the cost of flexibility in the context of the SERPS Reforms Act 1990 (Securities Enforcement Remedies & Penny Stock), which is considered as an outstanding agency of law enforcement. Although the securities law enforcement by the SEC (Securities & Exchange Commission) is effective and aggressive, it is mostly stated as ‘gentle & genteel’. The SEC is inclined to impose equitable broad remedies to enjoy future violations and ensure the provision of restitution to the injured. It is comprehensive, precise and effective with no obstruction. The aggressive rule of the securities sector can be regarded as interference. However, the Commission avoids making any kind of interference by being aware of its own limits.
Penny stock markups and markdowns, Goldstein, J. I., & Cox, L. D. (1990). Nw. UL Rev., 85, 676. According to the NASAA (North American Securities Administrators Association), the American public invests almost ten billion USD yearly in penny stocks that are equity securities traded in the United States with low price. However, a fairly large portion of such investments does not ever reach the real capital market. Disreputable broker-dealers utilize several penny stocks in manipulative and fraudulent schemes, such as making a sale to nominee accounts for supporting the stock price artificially, enabling insiders to make a sale at inflated prices, false representations of a firm the stock of which is touted by another firm and churning the accounts of customers.
Impact of the Penny Stock Reform Act of 1990 on the initial public offering market, Beatty, R., & Kadiyala, P. (2003). The Journal of Law and Economics, 46(2), 517-541. The Penny Stock Reform Act (PSRA) was enacted in 1990 to resolve fraudulent security problems by imposing severe restrictions on IPOs (Initial Public Offerings) priced below 5 USD. There was a cosmetic impact of minimizing the number of IPOs prices in the market under 5 USD but having no substantive effect on issuer quality. The delisting risk did not decrease considerably in the post-Act period. Rather the abnormal returns, non-penny stocks portfolio earned considerably declined in that period. The authors provide evidence that attributes the decrease in abnormal returns to the speculative issuers’ migration into the non-penny range.
An Historical Perspective to the Corporate Bar Provisions of the Securities Enforcement Remedies and Penny Stock Reform Act of 1990, McDonald, J. T. (1992). Wash. & Lee L. Rev., 49, 987. A limited government’s Madisonian System primarily demands to keep a proper balance between the 2 opposing rules of private freedom and public power. The latter principle is self-government that gives the majority of society a right to control the minority. It is done for the public good. The former principle is that there are, nonetheless, specific areas where the minority should have freedoms from the majority control. The persistent reconciliation of both these principles creates the Madisonian dilemma, i.e. for the appropriate functioning of the government, the society freedom to govern, or the individual’s freedom not to be governed, both cases should not be absolutely dominant.
Patterns of SEC Enforcement Under the 1990 Remedies Act: Civil Money Penalties, Laby, A. B., & Callcott, W. H. (1994). Alb. L. Rev., 58, 5. 4 years before the publication of this paper, Congress passed the SERPS (Securities Enforcement Remedies & Penny Stock) Reform Act in 1990. Most probably, the largest single change brought by the Remedies Act in the enforcement of SEC (Securities & Exchange Commission) was giving it authority for seeking penalties of civil money against any provision violations. Now, it may seek civil money pen. This Act granted authority to the SEC for seeking admin cease-and-desist orders permanently against anyone who violates the federal securities law and for seeking admin cease-and-desist orders temporarily against the securities sector. It was also authorized to seek an order in the FDC (Federal District Court) banning a person to serve a director or officer of a public firm.
Evaluating the mission: A critical review of the history and evolution of the SEC enforcement program, Atkins, P. S., & Bondi, B. J. (2008). Fordham J. Corp. & Fin. L., 13, 367. This paper explores the shifting focus of the enforcement program by the Securities & Exchange Commission (SEC) from its origin until today. The research assesses the application of principles by its enforcement decisions. Further, it analyzes the usage and development of the statutory enforcement powers of the SEC with respect to fairness and due process. Lastly, the authors call for the SEC to make an appointment of an independent advisory committee in order to evaluate and review the procedures and policies of the enforcement program in the context of changes in the statutory authority of the SEC during the period of past 3 decades.
Loose Change: The Campaign for Penny Stock Reform, Lash III, W. H. (1991). UMKC L. Rev., 60, 1. This paper considers the origins and issues of the penny stock market and the efforts by the regulators for resolving these issues. Penny Stock is basically related to selling a share for less than $1, though it may increase to $10 per share after the IPOs (Initial Public Offerings). The author discusses the history of this market, the main stock operators as well as their fraudulent schemes. He brings under consideration the previous efforts of the state, international and federal regulators to control the abuses attached to penny stocks. Then, he analyzes the PSRA 1990 (Penny Stock Reform Act). Finally, the author provides his suggestions and describes some techniques to fight against the penny stock frauds.
SEC Enforcement: A Look at the Current Program and Some Thoughts About the 1990s, McLucas, W. R., DeTore, S. M., & Colachis, A. (1991). The Business Lawyer, 797-848. Senior members of the Division of Enforcement of the SEC (Securities & Exchange Commission) staff examine continuing and new priorities and trends in the enforcement program of the Commission, specifically, in the light of extra sanctions and remedies provided by the SERPS Reforms Act 1990 (Securities Enforcement Remedies & Penny Stock). Particular discussion topics are insider trading, public companies’ financial fraud and false disclosure, penny stock fraud and market manipulation, security professionals violations, security offering cases and corporate control changes violations. Finally, the authors analyze the criminalization problem of FSL enforcement (Federal Securities Law) and in enforcement proceedings, naming attorneys.