Quick Answer
Penny stocks are equity securities under $5 per share that trade OTC without an exemption. Before publishing quotes, a firm must review current issuer information; before executing a trade, separate SEC rules require quotation disclosure (bid/ask and size) and compensation disclosure (for both the firm and the salesperson). Every OTC quotation must also identify the responsible dealer.
The final topic in this unit covers the special disclosure rules that apply to low-priced OTC securities. Because penny stocks carry elevated risks of fraud and manipulation, the SEC requires additional protections before a firm can trade them for customers.
What Are Penny Stocks?
- Equity securities priced below $5 per share
- Do not trade on a national exchange
- Do not meet certain exemptions (e.g., established Exchange Act reporting, adequate net tangible assets)
- Considered speculative and high-risk
Think of it this way: Not every cheap stock is a penny stock. A $3 stock listed on the NYSE is not a penny stock because it trades on a national exchange. Penny stock rules target low-priced OTC securities that lack the transparency and oversight of exchange-listed companies.
Exam Tip: Gotchas
- Penny stock rules apply to equity securities below $5 that trade OTC and do not meet exemptions. A stock priced below $5 on a national exchange is not a penny stock.
What Must a Firm Review Before Publishing Quotes?
- Before a broker-dealer can publish quotations for an OTC security, the firm must review specified current information about the issuer
- Required information includes: financial statements, business description, and other material details
- Ensures a minimum level of issuer information is publicly available before quotes are circulated
Exemptions exist for:
- Securities with current Exchange Act reporting
- Securities with an established quotation history
- Unsolicited customer orders
Exam Tip: Gotchas
- The current-information requirement must be satisfied before a firm can even publish quotes, not just before trading. The information review happens at the quotation stage, before any customer transaction takes place.
What Must Be Disclosed Before Executing a Penny Stock Trade?
Two separate SEC rules apply before a penny stock transaction executes:
| Rule | Requires |
|---|---|
| Quotation disclosure | The current bid and ask quotations and the number of shares to which they apply |
| Compensation disclosure | The broker-dealer's compensation and, separately, the associated person's (salesperson's) compensation in connection with the transaction |
Both disclosures must also appear on the customer's confirmation.
Exam Tip: Gotchas
- Quotation disclosure and compensation disclosure are two separate rules, not one combined requirement. A firm can satisfy the quotation-disclosure rule and still violate the compensation-disclosure rule, or vice versa. Read the exam question carefully to see which one it is asking about.
- The compensation disclosure must cover both the firm's and the salesperson's compensation. Disclosing only the firm's share is not sufficient.
What Is the Identification-of-Quotations Requirement?
- Quotations in OTC securities must identify the broker-dealer responsible for the quotation
- Prevents anonymous or misleading quotation practices
- Ensures accountability for published prices
Think of it this way: The penny stock rules follow a logical sequence. First, a firm must verify issuer information before it can even quote the stock (the current-information requirement). Then, before executing a trade, two separate rules require it to disclose pricing (quotation disclosure) and compensation (compensation disclosure) to the customer. And every quotation must identify which dealer is behind it (the quotation-identification requirement). Each step adds a layer of transparency to protect investors in a market prone to manipulation.
What Should You Check on Exam Day?
- Confirm a penny stock is priced below $5, trades OTC, and does not meet an exemption before applying these rules; an under-$5 exchange-listed stock is not a penny stock.
- Remember the current-information review happens before quoting, not just before trading.
- Treat quotation disclosure and compensation disclosure as separate rules, each independently required before execution.
- Check that compensation disclosure names both the firm's and the salesperson's compensation.