Penny Stocks

"Could I have a minute of your time to tell you about one of the hottest investment opportunities available today?"

What are Penny Stocks?

The term "penny stock" is used to describe low-priced stocks, often selling for less than $1 per share. Of course, not all lowpriced stocks are the subject of fraud. Abuses generally occur when highly speculative stocks are sold by brokerage firms specializing in penny stocks and using manipulative marketing techniques.

How are Penny Stocks traded?

Most penny stocks are traded in the over the-counter (OTC) market, as opposed to the national securities exchanges such as the New York Stock Exchange, the American Stock Exchange, and the Midwest Stock Exchange. The number of shares traded (volume) and the price information on exchange-listed stocks and certain OTC stocks is continuously collected and reported to the public. But current price and volume information about most penny stocks is not made available to the public. Brokerage firms trading penny stocks usually provide information only about the trades they make themselves. As a result, the investor may not know that a better price is available elsewhere, or worse, that there is no other brokerage firm willing to buy or sell these stocks.

How can I obtain information about current Penny-Stock prices?

It can be difficult or impossible. One private company prints a daily list, known as the "pink sheets," of firms trading particular OTC stocks, including penny stocks. But these "pink sheets" are available only to brokerage firms. Although some newspapers do publish some penny-stock prices, prices are not listed for most penny stocks. Furthermore, even published prices are not necessarily the prices at which the stocks can be bought or sold.

What are the risks of Penny-Stock Investments?

While there are risks with any investment, certain risks are greater with penny stocks. Some of the risks are:

Risk of Manipulation
Because many penny stocks are traded by a single brokerage firm or by a small group of firms, it is easy for them to manipulate the stock price. After the brokerage firms acquire a large number of shares at a low price, they can manipulate the stock by creating an artificial demand to drive up the price. When manipulation occurs, the stock's price may not reflect the true value of the company, but rather the artificial demand created by aggressive marketing. The price may then collapse after the broker and other persons involved in the manipulation sell their shares.

Penny-Stock Broker: "Since my firm is a 'market maker' in this stock, we can get it for you without charging you a commission."

Risk of Being Overcharged
Brokerage firms selling penny stocks generally do not earn their profits through commissions. Instead, they make money by charging the investor an undisclosed "mark-up" above the price the firm has paid for the stock. Although excessive mark-ups are illegal, some firms nevertheless charge mark-ups of 100% or more.

Risk of Substantial, Immediate Loss
With penny stocks, the "spread" between the price at which the investor can buy the stock from the brokerage firm ("ask price") and the price at which the investor can sell the stock to the brokerage firm ("bid price") is often very large. At the time the stock is purchased, the investor may suffer a substantial "paper loss" on the investment. For example, if a stock has an ask price of 20 cents and a bid price of 10 cents, the investor would suffer an immediate paper loss of 50%. The bid price of the stock would have to double for the investor to break even.

Lack of Information About The Investment
Unlike most large, well established companies, many companies that issue penny stock do not make quarterly and annual reports available to the public. This lack of information about the company's operating history and financial health increases the risk to the investor. The market price of such stock can be based more on the aggressive marketing of the selling broker than on the real value of the company.

Penny-Stock Broker: "What did I tell you! Your stock is up 100% . . . SELL? Are you kidding ? This is no time to sell!"

Inability to Sell Stock and Receive Cash
Some penny-stock brokerage firms resist investors' attempts to sell their stocks for cash. The broker might become "unavailable" to an investor who wishes to sell, or the broker might refuse to accept the sell order unless the investor agrees to buy penny stock in another company which the brokerage firm is marketing.

Misleading Sales Practices

Penny-Stock Broker: "The last stock we marketed went from $.10 to $.45 in six months."

Impressive Track Records
Many penny-stock brokerage firms point to past performance as a reason to do business with them. Such claims can be misleading. Even if a firm accurately states the lowest and highest prices of a previously-recommended stock, those prices may have been artificially created as the result of market manipulation. A large spread between the bid and ask price can distort the track record. As explained earlier, in some cases a stock may need to double in price for the investor to break even.

Television Programs or Reports and Internet listings
The fact that a stock is mentioned or even recommended on television or on an Internet Website is no guarantee that the investment opportunity is legitimate. Moreover, some television programs or reports are actually advertisements paid for by penny-stock brokerage firms.

Insured by the Securities Investor Protection Corporation (SIPC)
Penny-stock brokerage firms will often point to their SIPC coverage as proof of their legitimacy. But the SIPC insures only that if the firm goes bankrupt, customer-owned securities which are held by the firm will not be lost. The SIPC does not insure against loss from fraud or changes in the value of an investment.

State and Federal Licensing or Registration
The fact that a brokerage firm and its brokers are licensed or registered is not a guarantee against fraudulent practices. State and federal enforcement actions against licensed or registered penny-stock firms have increased dramatically in recent years.

Penny-Stock Broker: "You're getting in on the ground floor of the next Xerox!"

Humble Beginnings
An often-made sales pitch implies that all successful companies began by issuing penny stocks. The truth is that not all successful companies began by issuing penny stocks, and it is extremely unlikely that any given penny-stock company will become another Xerox. And, according to the North American Securities Administrators Association Report on Fraud and Abuse in the Penny Stock Industry, September 1989, a widely-quoted industry figure is that at least 70 percent of penny-stock investors end up losing money, even without taking into account the risks of fraud and abuse.

Warning Signs of Penny-Stock Fraud

Cold Calls
Many penny stocks are sold through unsolicited telephone calls to persons who have had no prior involvement with the brokerage firm or salesperson. "Cold calling" nationwide to solicit as many persons as possible is an integral part of the business operation of penny-stock firms engaged in fraudulent activity.

Three-Call System
This system is commonly used to convince a potential customer to trust the broker. It generally works as follows:

Call 1: The broker uses a low-key approach to persuade potential investors that penny stocks are attractive and to find out how much they might be willing to invest. The broker promises to call back when he or she "has a stock to recommend." In reality, the broker has already chosen a stock to sell before placing the call;

Call 2: The broker calls about two weeks later to indicate that the firm has found a stock which it believes is about to "take off," and that the broker will soon attend a meeting or otherwise receive further information about the stock; and

Call 3: The broker calls back within 24 hours to say that he or she has received confirming information about the desirability of the stock and that the investor should buy it without delay.

Penny-Stock Broker: "I'm not pressuring you—all I'm saying is that tomorrow will be too late. Trust me. "

High-Pressure Sales Tactics
Whatever selling technique is used, it typically ends with advice to purchase the stock immediately because:

• The broker has "inside" information about the stock, and the investor should purchase it before the information becomes public;
• The investor has a unique opportunity, available for a short time only, to buy the stock at a special or below-market price;
• There have been a series of increases in the price of the stock, and the investor should purchase some of it immediately before the stock rises even further; or
• The broker has been informed that there is only a limited amount of stock available at the current price.

Unauthorized Purchases
No purchase or sale can legally be made in a customer's account without specific instructions from that customer. Some fraudulent penny stock brokers will make a purchase for the investor based solely on statements by the potential investor that he or she might be interested in making an investment. Although such a purchase is considered unauthorized and the investor is not legally required to complete the transaction, preventing such an occurrence is much easier than attempting to resolve a subsequent dispute over whether the purchase was or was not authorized.

How to protect yourself

Keep Personal Information To Yourself

Do not give out personal information such as your social security number, your financial condition, your past investment history, or your bank, credit union, or savings and loan references unless you feel confident about dealing with the salesperson and the firm. If you do give a caller such information, a claim may later be made that you did authorize a transaction; otherwise, why would you have given the caller such information?

Obtain Information

Ask the broker for written information about the recommended penny-stock company. Do not be afraid to request documents containing recent financial statements. If you make such a request, but the broker does not provide this information or tells you there is no time for you to read it, you should beware of investing.

Inquire About the Broker

Contact the Wisconsin Division of Securities to determine whether the firm and the broker are licensed to do business in Wisconsin and whether either has any history of disciplinary action.

Keep Records

Ask the broker to send you written copies of all predictions about the price of the stock and about the prospects for the company. Keep notes of what the broker tells you. Ask for an independent opinion from another broker, banker, or some other person knowledgeable about financial matters.

Penny-Stock Broker: "You're telling me you can't afford it? At this stage, I believe there is nothing but opportunity in this stock. Can you afford not to own it?"

Use Common Sense

If the investment is being marketed as a "sure thing," ask yourself why the broker is offering it to you. Remember, if an investment opportunity sounds too good to be true, it probably is.

Don't Let Yourself Be Rushed

If there is inadequate time for you to check out the investment carefully, do not invest. Other investment opportunities will come along, but money invested in a penny-stock fraud is probably gone forever.

If you have concerns or questions

If you believe that you have been victimized by penny-stock investment fraud or have questions concerning an offer being made to you, you should contact state or federal securities regulators.

If you were in Wisconsin when the offer or any other part of the transaction occurred, contact the:
Department of Financial Institutions
Division of Securities
1-800-47CHECK

Or send your written complaint or inquiry to:
Department of Financial Institutions
Division of Securities
PO Box 1768
Madison, Wisconsin 53701