Penny-Stock Compensation Disclosure
Quick Answer
The SEC's penny-stock compensation-disclosure rule makes it unlawful for a broker-dealer to effect a penny-stock transaction without disclosing the aggregate compensation the firm will receive. The disclosure has two parts: oral or written before the trade, and written at or before the confirmation. Records are preserved under broker-dealer recordkeeping rules for three years. Registered investment-company securities are generally exempt.
The Series 6 universe (mutual funds, variable contracts, municipal fund securities) is largely outside the penny-stock regime. Yet the Function 4.1 outline lists the penny-stock compensation-disclosure rule, because a Series 6 rep may occasionally interact with penny-stock transactions through a dual-registered account or a cross-line referral and must recognize the disclosure trigger when it appears.
What does the penny-stock compensation-disclosure rule require?
The penny-stock compensation-disclosure rule makes it unlawful for a broker or dealer to effect a penny-stock transaction with or for a customer unless the broker-dealer (BD) discloses to the customer the aggregate amount of compensation the BD will receive in connection with the transaction.
- The rule is part of the SEC's broader penny-stock rules package, which also covers:
- A separate risk-disclosure document the customer must receive
- Quotation disclosures for penny stocks
- Associated-person compensation disclosure
- Monthly account statements showing penny-stock positions
Purpose: the penny-stock market is thin, easily manipulated, and frequently the vehicle for pump-and-dump schemes. The penny-stock rules package is designed to ensure customers know, before they trade, exactly how the firm profits from the transaction. The compensation-disclosure rule is the transparency leg of that package.
When must the penny-stock compensation disclosure be given to the customer?
The compensation-disclosure rule has a two-part disclosure structure. Both parts are required. Satisfying one does not satisfy the other.
| Part | When | How |
|---|---|---|
| Part 1: Pre-trade disclosure | Prior to effecting the transaction | Orally or in writing |
| Part 2: Confirmation-stage disclosure | At or prior to the time the written confirmation is delivered to the customer | In writing |
Why both are required:
- Oral pre-trade disclosure gives the customer real-time information to decide whether to proceed
- Written confirmation-stage disclosure creates a permanent record the customer can review and the firm can preserve
Exam Tip: Gotchas
- The compensation-disclosure rule has a TWO-PART structure. Oral-or-written pre-trade AND written at or before confirmation. A firm that discloses only at confirmation has violated the pre-trade leg. A firm that discloses only orally pre-trade has violated the written confirmation-stage leg.
- The pre-trade disclosure may be oral OR written; the confirmation-stage disclosure must be written. Do not flip this. Oral-only satisfies the pre-trade leg but not the confirmation leg. Written-only at confirmation satisfies the confirmation leg but not the pre-trade leg.
What "Compensation" Means
The disclosure must state the aggregate amount of compensation the BD will receive. What counts as compensation depends on how the firm handled the trade.
| Trade type | What "compensation" means |
|---|---|
| Agency trade | The amount of remuneration received or to be received from the customer (the commission) |
| Riskless principal trade | The difference between the price to the customer and the contemporaneous offsetting purchase or sale price |
| Other principal trade | The difference between the price to the customer and the prevailing market price |
Riskless principal means the firm bought (or sold) the security specifically to fill the customer's order, with the offsetting side already lined up. The "compensation" in that case is the markup between what the firm paid and what the customer pays.
Other principal means a standard principal trade out of the firm's inventory. The compensation is the markup measured against the prevailing market price.
Think of it this way: the customer sees either a commission (agency) or a markup (principal). In both cases, the rule forces the firm to spell out the dollar amount so the customer can judge whether the cost of the trade is reasonable before it happens.
Exam Tip: Gotchas
- Compensation is calculated differently for agency vs. principal trades. Agency = commission. Riskless principal = price-to-customer minus contemporaneous offsetting price. Other principal = price-to-customer minus prevailing market price. The disclosure must reflect the correct category.
- The purpose is to ensure the customer understands how much the firm profits from the transaction. In the thin, easily-manipulated penny-stock market, outsized markups are a primary abuse. The rule is a transparency requirement, not a markup cap.
How long must a firm preserve the penny-stock compensation-disclosure record?
The broker-dealer must make and preserve a record of each penny-stock compensation disclosure as part of its books and records.
- Retention period: governed by the SEC's broker-dealer recordkeeping rules
- Retention tier: generally 3 years, first 2 years easily accessible
- Parallels the general retention tier that applies to order tickets, trade confirmations, and communications
Why this matters: a firm that makes the disclosure but does not preserve the record is still in violation. The broker-dealer recordkeeping rules are the retention anchor, and the compensation-disclosure record sits in the same tier as other transaction documentation.
Exam Tip: Gotchas
- The record of the compensation disclosure is retained under broker-dealer recordkeeping rules. That is 3 years, first 2 years easily accessible, the same tier as order tickets, trade confirmations, and communications. Do not conflate with the 6-year tier for customer account records.
- Creating the disclosure but failing to preserve the record is still a violation. Both obligations (make it, keep it) are independent; satisfying one does not satisfy the other.
What is the definition of a penny stock?
Before the compensation disclosure is triggered, the security must be a "penny stock" as defined under the SEC's penny-stock rules.
General rule: a penny stock is an equity security priced below $5 per share that is not listed on a national securities exchange.
Primary exclusions (a security is NOT a penny stock if it meets any one of these):
- Traded on a national securities exchange (New York Stock Exchange (NYSE), Nasdaq) - exchange listing alone exempts
- Bid price of $5.00 or more
- Issuer has net tangible assets of:
- $2 million (if the issuer has been in continuous operation for at least 3 years), OR
- $5 million (if the issuer has been in operation for less than 3 years)
- Issuer has average revenue of at least $6 million over the last 3 years
Investment-company exclusion: registered investment-company securities (mutual funds, closed-end funds, ETFs) are not penny stocks. Fund shares are typically excluded from the penny-stock regime because they are priced on NAV mechanics or are exchange-listed, or both.
Series 6 implication: a Series 6 rep's typical product set (investment companies, variable contracts, municipal fund securities) falls outside the penny-stock universe. But the Function 4.1 outline names the compensation-disclosure rule, so the rep must know the rule's existence, triggers, and mechanics for fact patterns that cross into dual-registered or referral territory.
Exam Tip: Gotchas
- Exchange listing alone exempts a security from penny-stock treatment, even if its price drops below $5. Conversely, an Over-the-Counter (OTC)-traded security under $5 without meeting a financial exclusion IS a penny stock regardless of the issuer's size. The listing-status plus price combination drives the classification.
- Registered investment-company securities are generally NOT penny stocks. The Series 6 universe (mutual funds, variable annuities, 529 plans, closed-end funds, ETFs) is largely outside the rule's scope. The rule appears in the Function 4.1 outline because a Series 6 rep may occasionally interact with penny-stock transactions and must recognize the compensation-disclosure trigger.
- Net tangible assets thresholds are $2 million (3+ years in operation) or $5 million (less than 3 years). Average revenue exclusion is $6 million over 3 years. These are the three financial escape hatches from penny-stock status beyond the $5 price floor and the exchange-listing exemption.