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by Laura Anthony, Esq.

Penny Stock Rules And Broker Dealers

ABA Journal’s 10th Annual Blawg 100

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In last week’s blog regarding FINRA’s request to eliminate the OTC Bulletin Board quotation service (OTCBB) and to adopt rules relating to the quotation requirements for OTC equity services by inter-dealer quotation services, I touched upon the significance of penny stock rules related to the OTC marketplace.  As further described herein, penny stocks are low-priced securities (under $5.00 per share) and are considered speculative and risky investments.

Penny stock rules focus on the activity of broker-dealers in effectuating trades in penny stocks. As a result of the risk associated with penny stock trading, Congress enacted the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (the “Penny Stock Act”) requiring the SEC to enact rules requiring brokers or dealers to provide disclosures to customers effecting trades in penny stocks.   The rules prohibit broker-dealers from effecting transactions in penny stocks unless they comply with the requirements of Section 15(h) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and the rules promulgated thereunder and, in particular, Exchange Act rules 15g-1 through 15g-100 (the “penny stock rules”).

Section 17B of the Exchange Act, which was enacted as part of the Penny Stock Act, regulates automated quotation systems for penny stocks (such as OTC Markets) and provides, among other things, that the SEC shall facilitate the widespread dissemination of reliable and accurate last sale and quotation information with respect to penny stocks.

Definition of Penny Stock

A penny stock is defined in Exchange Act Rule 3a51-1.  Like many SEC rules, the penny stock rule begins by including all equity securities and then carves out exemptions (for example, all offers and sales of securities must be registered unless an exemption applies).  In particular, Rule 3a51-1 defines a penny stock as any equity security other than:

(a)    A NMS (national market system) stock that is a reported security that is (i) registered on a national securities exchange that is grandfathered in because it has been in continuous operation since prior to April 20, 1992; or (ii) is quoted on either a national securities exchange or automated quotation system that that has certain quantitative initial listing standards and continued listing standards that are reasonably related to the initial listing standards. The initial listing standards must meet or exceed the following criteria: (a) the issuer must have $5 million of stockholders’ equity, market value of listed securities of $50 million for 90 consecutive days prior to applying, or net income of $750,000 (excluding extraordinary or non-recurring items) in the most recently completed fiscal year or in two or the last three most recently completed fiscal years; (b) the issuer must have an operating history of at least one year or a market value of listed securities of $50 million; (c) the issuer’s stock must have a minimum bid price of $4 per share; (d) there shall be at least 300 round lot holders of common stock; and (e) there must be at least 1,000,000 publicly held common shares with a market value of at least $5 million.

(b)    Is issued by an investment company registered under the Investment Company Act of 1940, as amended;

(c)    Is a put or call option issued by the Options Clearing Corporation;

(d)    Has an inside bid quotation price of $5.00 (the Rule requires that the price be net of broker or dealer commissions, mark-up or mark-downs);

(e)    Is registered, or approved for registration upon notice of issuance, on a national securities exchange that makes price and volume transaction reports available, subject to restrictions provided in the rule;

(f)     Is a security futures product listed on a national securities exchange or an automated quotation system sponsored by a registered national securities association; or

(g)    Whose issuer has: (i) net tangible assets (as calculated in accordance with the rule) in excess of $2 million, if the issuer has been in continuous operation for at least three years, or $5 million, if the issuer has been in continuous operation for less than three years; or (ii) average revenue (as calculated in accordance with the rule) of at least $6 million for the last three years.

Section 15(h) of the Exchange Act

Broker-dealers are required to comply with the penny stock rules, which rules center around disclosure of the risks and other market information associated with penny stock transactions and a determination of the suitability of the customer to engage in such high-risk transactions.  Section 15(h) of the Exchange Act provides that no broker or dealer may effectuate the purchase or sale of any penny stock by a customer unless such broker or dealer (i) approves the customer for the specific penny stock transaction and receives from the customer a written agreement to the transaction; (ii) furnishes the customer a risk disclosure document describing the risks of investing in penny stocks; (iii) discloses to the customer the current market quotation, if any, for the penny stock, including the bid and ask price and the number of shares that apply to such bid and ask price; and (iv) discloses to the customer the amount of compensation the firm and its broker will receive for the trade. In addition, after executing the sale, a broker-dealer must send to its customer monthly account statements showing the market value of each penny stock held in the customer’s account.

Section 15(h) requires that the risk disclosure document include (i) a description of the nature and level of risk in the market for penny stocks in both public offerings and secondary trading; (ii) a description of the broker or dealer’s duties to the customer and of the rights and remedies available to the customer with respect to violations of such duties or other requirements under the federal securities laws; (iii) a brief, clear, narrative description of a dealer market, including “bid” and “ask” prices for penny stocks and the significance of the spread between the bid and ask prices; (iv) contains the toll-free telephone number for inquiries on disciplinary actions; (v) defines significant terms used in the disclosure document or in the conduct of trading in penny stocks; and (vi) contains such information, and is in such form as the SEC requires.

Section 15(h) also requires the SEC to adopt rules setting forth additional standards for the disclosure by brokers and dealers to customers concerning transactions in penny stocks.  As indicated above, those rules can be found in Exchange Act Rules 15g-1 through 15g-100.   

The Penny Stock Rules – Penny Stock Disclosure Requirements

Brokers and dealers that are subject to the penny stock rules (see exclusions below set forth in Rule 15g-1) are required to comply with the penny stock disclosure requirements set forth in Rules 15g-2 through 15g-9.

Exchange Act Rule 15g-2 requires the delivery of a Schedule 15G and, in particular, makes it “unlawful for a broker or dealer to effect a transaction in any penny stock for or with the account of a customer unless, prior to effecting such transaction, the broker or dealer has furnished to the customer a document containing the information set forth in Schedule 15G, Rule 15g-100, and has obtained from the customer a manually signed and dated written acknowledgement of receipt for the document.”

Rule 15g-3 requires the disclosure of quotations and other information relating to the penny stock market.  Rule 15g-3 makes it unlawful for a broker or dealer to effect a transaction in any penny stock for or with the account of a customer unless such broker or dealer provides the customer with (i) the inside bid and offer quotation; (ii) where there is no inside bid and offer, the dealer’s bid or offer; and (iii) the number of shares to which the bid and offer apply.

Rule 15g-4 requires the disclosure of compensation to the broker or dealers. Rule 15g-4 makes it unlawful for a broker or dealer to effect a transaction in any penny stock for or with the account of a customer unless such broker or dealer provides the customer with the aggregate amount of any compensation received by such broker or dealer in connection with such transaction. Similarly, Rule 15g-5 requires the disclosure of the compensation to the natural person associated with the broker dealer, related to the penny stock transaction.  Rule 15g-6 requires the broker-dealer to send to its customer monthly account statements showing the market value of each penny stock held in the customer’s account.

Rule 15g-9(a)(2) provides that, prior to effecting certain transactions in penny stocks, brokers and dealers must approve an investor’s account for transactions in penny stocks and receive a written agreement from the investor that provides the quantity of the particular stock to be purchased. In order to approve an investor’s account, the broker or dealer must obtain information regarding the investor’s financial situation, investment experience and investment objectives. Based on this information, the broker or dealer must determine whether transactions in penny stocks are suitable for the investor and whether the investor, or his or her adviser, has sufficient knowledge and experience to evaluate the associated risks. This determination must be delivered to the investor in writing and must be signed by the investor and returned to the broker or dealer prior to the broker or dealer effecting the trade.

In addition to the exemptions contained in Rule 15g-1 described below, no suitability determination need be made for established customers.  Established customers are those that have held an account and effected transactions with that broker or dealer for more than one year prior to the subject penny stock transaction, or have made at least three purchases of penny stocks on different days and involving different issuers.

               Schedule 15G

Schedule 15G is commonly referred to as the “penny stock disclosure document.” Rule 15g-100 contains the complete text of Schedule 15G.  Schedule 15G may be delivered electronically, including by a link to the schedule on the SEC website.  Schedule 15G sets forth information a customer must receive from the broker or dealer including the current market quotation, if any, for the penny stock, the bid and ask price and the number of shares that apply to such bid and ask price and discloses to the customer the amount of compensation the firm and its broker will receive for the trade.  Schedule 15G can be read in its entirety Here.

If sent by e-mail, no other information can be included other than instructions on how to provide the broker-dealer with a signed acknowledgment of receipt and a standard privacy or confidentiality message.

               Cooling-off Period

Rule 15g-2 also requires a two day “cooling-off” period after sending the Schedule 15G to the customer prior to effectuation of the penny stock transaction.  Similarly, Rule 15g-9 to require a broker or dealer to wait two business days after sending its suitability determination and the transaction agreement to an investor before effecting a transaction.

     Exclusions to Application of Penny Stock Rules to Broker-Dealers

Rule 15g-1 contains certain exclusions to the penny stock rule requirements and, in particular, exclusions for certain broker-dealers and certain transactions.  Broker-dealers whose total commissions in penny stocks comprise less than 5% of its total generated commissions and who do not act as market makers for penny stocks are exempted from compliance with certain of the penny stock rules, including the requirement to furnish a Schedule 15G and to make a suitability determination.  In addition, no Schedule 15G must be provided and no suitability determination must be made (i) for institutional accredited investors; (ii) for transactions involving private Regulation D offerings; (iii) where the customer is the issuer or an officer, director, or 5% or greater shareholder of the issuer; (iv) transactions that are not recommended by the broker or dealer; or (v) for transactions or persons for which the SEC grants an exemption.

Section 17B of the Exchange Act

Section 17B of the Exchange Act, which was enacted as part of the Penny Stock Act, establishes and regulates automated quotation systems for penny stocks (such as OTC Markets) and provides, among other things, that the SEC shall facilitate the widespread dissemination of reliable and accurate last sale and quotation information with respect to penny stocks.  The preamble to Section 17B finds that (i) “the market for penny stocks suffers from a lack of reliable and accurate quotation and last sale information available to investors and regulators” and (ii) “it is in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to improve significantly the information available to brokers, dealers, investors, and regulators with respect to quotations for and transactions in penny stocks.”

In that regard, Section 17B requires the SEC to “facilitate the widespread dissemination of reliable and accurate last sale and quotation information with respect to penny stocks.”  Ensuring compliance with Section 17B is a focus of the recent FINRA request to eliminate the OTC Bulletin Board quotation service (OTCBB) and to adopt rules relating to the quotation requirements for OTC equity services by inter-dealer quotation services, which was the subject of my blog last week.

Other Significances Related to Penny Stocks

Penny Stock issuers may not avail themselves of certain disclosure or offering rules and benefits afforded their non-penny stock counterparts.  Rule 405, promulgated under the Securities Act of 1933 (the “Securities Act”), contains a definition of “ineligible issuer” which definition includes penny stock issuers.  Certain disclosure and offering rules throughout the Securities Act exclude “ineligible issuers,” including penny stock issuers.

For example—and this is not meant to be an exhaustive summary—a penny stock issuer may not use a free writing prospectus in conjunction with the registered offering of securities.  A well-known seasoned issuer (WKSI) cannot be a penny stock issuer.  A penny stock issuer may not incorporate by reference into a Form S-1.  Rule 419 applies to all registered offerings of securities by blank check companies when the securities are penny stocks.

To be eligible to trade on the OTC Markets OTCQX trading platform, an issuer must meet one of the following penny stock exemptions under Rule 3a51-1 of the Exchange Act: (i) have a bid price of U.S. $5 or more; or (ii) have net tangible assets of U.S. $2 million if the company has been in continuous operation for at least three years, or U.S. $5,000,000 if the company has been in continuous operation for less than three years; or (iii) have average revenue of at least U.S. $6,000,000 for the last three years.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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