Low Down on Penny Stocks

I am not sure I have ever written an article about Penny Stocks. But it is no secret that I primarily speculate in small-cap biotechnology, some of which could be considered penny stocks depending on your definition of penny stocks. Investopedia states “the term penny stock has evolved with the market. In the past, penny stocks were stocks that traded for less than a dollar per share. The SEC, however, modified the definition to include all shares trading below $5.” They are still called penny stocks because they are perceived as very risky investments.

Penny stocks are typically growing companies with limited cash and resources. Most penny stocks are high-risk investments with low trading volumes and limited attention from investors. These companies trade mostly on the Over-the Counter Bulletin Board (OTC BB) and Pink Sheets and are susceptible to different forms of market manipulation that are more difficult to employ in stocks found on the larger exchanges such as Nasdaq and NYSE (Investopedia).


There is a growing international epidemic of penny stock fraud instigated by greedy promoters and unscrupulous company insiders. With the nearly global access of the Internet with email and online brokers, these con artist are now finding their victims everywhere around the world. A day does not go by that I do not receive a FAX or email touting the extraordinary gains of a Pink Sheets or OTC Bulletin Board equity that I have never heard of, promising gains of incredible proportions in a very short time. More recently, there have been more and more investors around the world who have been sucked in by these securities scams. The scammers know that U.S. regulators are unlikely to investigate and prosecute on behalf of an individual investor in a foreign country who has lost his life's savings by buying into the bilge that is being sold by these con artists.

Many times, these fraudulent schemes involve selling unregistered shares of obscure public companies with few assets, negligible revenues, and dubious operations. However, many foreign investors and domestic ones as well, do not know this and do not do their DD. They take the word of a crooked salesman, without checking the financial statements of these companies, many of which you would be hard pressed to find anyway. For many foreign individual investors, the U.S.-based broker has instant credibility. The scammer relies on the fact that many people in other countries and even here in the US cannot distinguish a legitimate brokerage firm from a fly-by-night operation.

As I mention in the first paragraph, most stock schemes commonly involve shares of companies that trade on the OTC Bulletin Board, and Pink Sheets. This arena is the perfect venue for securities schemes. Regulatory resources are overwhelmed, and often focused in other directions. Furthermore, the global nature of these schemes, and the ease in which companies can issue unregistered stock and sell it overseas, makes oversight difficult, if not impossible. This type of market manipulation is less prevalent and more difficult to employ with stocks registered on the Nasdaq and NYSE.

The penny stock frauds usually rely on the garden variety "pump and dump" scheme. This is when a promoters or shady stock brokers gain control of a company and then spreads false and misleading information by saturating the Internet with spam email, Faxes, or using cold callers to inform you how you cannot afford NOT to buy in to this sure thing! In this way they spark interest in the company, pump up prices, and create an environment in which they can sell stock. Once the promoters dump their shares at a hefty profit, stock prices slide back toward oblivion. This scam takes on several variations, but the basic framework seldom differs.

StockPatrol.com has outlined a list of warning signs to look out for. If you receive a sales pitch via email, FAX, or telephone, there are a number of warning signs that should set of bells and whistles, triggering concern. If you receive a pitch that claims that an obscure company is poised to capitalize in a "hot" sector, such as homeland defense, hurricane recovery or H1N1 Flu research, or companies that claim to have (non-existent) relationships with better known, successful businesses, you probably are the target of a scammer.

If the company being promoted does not file regular public financial reports with the SEC, there has been unusual, excessive trading in a stock, or there have been sudden dramatic price swings for the stock of a company with no track record, discernible business or demonstrated revenues, all of these would be warning signs.

Companies that routinely use Form S-8 to register shares for insiders, employees or consultants, allowing promoters to flood the market instantly with registered shares that have been issued to anonymous individuals and companies are likely non-legit. If the company has little operating history, but employs numerous consultants and awards them shares, it is probably just a shell operation for crooks.

If the company sells unregistered stock overseas under Regulation S, it is likely a scam Regulation S has produced a virtually unregulated situation for offshore sale of U.S. stocks or the company has offshore investors whose principals are undisclosed.

A common scheme is as follows: The business is incorporated in Nevada especially those with Canadian connections. Nevada law allows the individuals in control of a company to make significant decisions without first notifying or gaining approval from public shareholders. This leads many tiny companies to incorporate in Nevada, have offices in Canada, retain attorneys in Florida, California or New York, and often use transfer agents housed in Utah. Their goal is to create a jurisdictional nightmare that allows them to scam investors in the U.S., Canada and around the world.

So individual investors should be wary of penny stocks. The chances of huge profits are counteracted by even bigger chances of huge losses. The warning signs are there and obvious to anyone who looks for them. The bottom line remains, as always before you invest in any security, do your DD!