Penny Stock Disclosure Requirements
The final topic in this unit covers the extra regulatory requirements that apply when broker-dealers trade penny stocks; securities generally priced under $5 per share.
Why Extra Rules for Penny Stocks?
Penny stocks carry elevated risks:
- Low liquidity and wide spreads
- Limited public information about issuers
- Vulnerability to manipulation (pump-and-dump schemes)
- Disproportionate impact of transaction costs on returns
Because of these risks, the Securities and Exchange Commission (SEC) imposes additional disclosure requirements on broker-dealers who trade penny stocks, beyond what is required for exchange-listed or Nasdaq securities.
SEC Rule 15g-3 - Penny Stock Quotation Disclosure
When a broker-dealer effects a transaction in a penny stock (generally under $5 per share), it must provide the customer with:
- The inside bid and ask quotation for the penny stock
- The number of shares to which those quotations apply
This disclosure must be provided before the transaction is effected and applies to both new and existing customer relationships.
SEC Rule 15g-4 - Compensation Disclosure
- Broker-dealers must disclose to the customer the aggregate amount of compensation received by the firm and the associated person in connection with the penny stock transaction
- Must be disclosed before the transaction
Think of it this way: The customer must know how much the firm and rep are making on the trade before they agree to it.
Exam Tip: Gotchas
- The compensation disclosure covers both the firm's and the associated person's compensation. The exam may test whether you know both must be disclosed, not just one.
Financial Industry Regulatory Authority (FINRA) Rule 2114 - Recommendations in OTC Equity Securities
- Imposes additional suitability obligations when recommending over-the-counter (OTC) equity securities
- The member must have a reasonable basis for believing the recommendation is suitable based on the customer's investment profile
- Applies to all OTC equity recommendations, with heightened scrutiny for penny stocks
Exam Tip: Gotchas
- These suitability obligations are in addition to, not instead of, normal suitability requirements. A penny stock recommendation must satisfy both the standard suitability rules and the additional OTC equity requirements.
What Triggers These Extra Requirements?
| Requirement | Trigger | Timing |
|---|---|---|
| Inside bid/ask disclosure (15g-3) | Transaction in a penny stock | Before the trade |
| Compensation disclosure (15g-4) | Transaction in a penny stock | Before the trade |
| Suitability review (FINRA 2114) | Recommendation of an OTC equity security | Before the recommendation |
Exam Tip: Gotchas
- Penny stock disclosure rules apply to OTC penny stocks only. They do not apply to stocks listed on Nasdaq or a national exchange, even if the stock price is below $5.
- Both disclosures (quotation and compensation) must be made before the transaction is effected.