Penny Stocks Are Scams: A Guide to Avoiding the Risks

Penny stocks are often touted as a way to make quick profits, but the reality is that they're frequently scams. Research has shown that nearly 80% of penny stocks are worthless, and investors lose billions of dollars each year to these schemes.

Investors often receive unsolicited emails and calls touting penny stocks, but most of these are just thinly veiled attempts to part you from your money. In fact, the Securities and Exchange Commission (SEC) has issued warnings about these types of solicitations, cautioning investors to be wary of any unsolicited investment advice.

The SEC has also found that many penny stocks are actually shell companies with no real assets or business operations. These companies are often created solely to pump and dump the stock, leaving investors with big losses.

Penny stocks are notorious for scams, and it's essential to know how to spot them. The "Pump and Dump" scheme is one of the most common, where promoters claim to have inside information to buy a stock quickly or sell before the price goes down.

These scammers often post messages online or make telemarketing calls to create a buying frenzy, which drives up the stock price. They then sell their shares and stop hyping the stock, causing the price to plummet and leaving investors with losses.

In the "Off-Shore Scam", unscrupulous microcap companies sell unregistered Reg. S stock to con artists posing as foreign investors at a deep discount.

Penny stocks are highly risky, with many trading on the over-the-counter (OTC) market that lacks centralization and regulation.

The OTC market is where scam stocks tend to live, and just being there can make you a mark for a con.

Typically, OTC stocks are microcap stocks with market capitalizations of under $300 million.

Penny stocks and microcap companies can be extremely hazardous investments. The OTC market, where these companies trade, is often referred to as a "bad neighborhood" because it's a breeding ground for scams.

Companies that list on the OTC market aren't required to file periodic or audited financial reports, making it impossible for investors to verify their claims. This lack of transparency is a major red flag.

The SEC has long warned investors about the high risks associated with microcap stocks, and the Financial Industry Regulatory Authority (FINRA) also issues warnings about buying and trading OTC securities. Despite these warnings, many investors still fall victim to these scams.

The shares that trade on the OTC market are often "illiquid", meaning they have low volumes and few buyers and sellers, making it difficult for investors to buy or sell shares at the prices they want. This lack of liquidity is a perfect setup for "pump-and-dump" schemes, where stock promoters lure investors into buying shares, only to sell them at a higher price, leaving investors with losses.

Here are some common characteristics of microcap stocks that make them so hazardous:

These characteristics make it easier for scammers to manipulate the stock price and deceive investors. It's essential to be aware of these risks and take steps to protect yourself when investing in penny stocks or microcap companies.

To invest wisely, it's essential to understand the requirements and exemptions that apply to companies offering securities to the public. Companies must either register with the SEC or meet an exemption to offer or sell securities.

If a company wants to raise less than $5 million in a 12-month period, it may be exempt from registering its securities under a rule known as Regulation A. This rule allows companies to file a printed copy of an "offering circular" with the SEC, which must include financial statements and other information.

Some smaller companies may offer and sell securities without registering the transaction under an exemption known as Regulation D. This exemption applies to companies that seek to raise less than $1 million dollars in a twelve-month period.

Regulation D also exempts companies seeking to raise up to $5 million, as long as the companies sell to 35 or fewer individuals or any number of "accredited investors" who must meet high net worth or income standards.

Companies claiming an exemption under Reg. D must still file what's known as a "Form D" within a few days after they first sell their securities. This brief notice includes the names and addresses of owners and stock promoters, but little other information about the company.

Unless they otherwise file reports with the SEC, companies that are exempt from registration under Reg. A, Reg. D, or another offering exemption, do not have to file reports with the SEC.

Here are some key details about the exemptions:

The U.S. government has taken steps to regulate penny stocks to prevent fraud. The Penny Stock Reform Act was passed in 1990.

Brokers are now required to follow strict rules when quoting OTC stocks. In September 2020, the SEC issued new rules that prevent brokers from quoting OTC stocks unless the company issuing shares releases up-to-date financial information.

Choosing the right online stock broker is crucial for a successful trading experience. Consider the broker's reputation and check feedback and reviews online to gauge customer satisfaction.

Conducting your own research is crucial when it comes to penny stocks. Due diligence means asking questions, seeking professional advice, and verifying information through neutral financial sources.

Penny stock scammers go the extra mile to convince you, often producing official-looking press releases that announce new product development or sales. These press releases are meant to satisfy your curiosity, but it's up to you to fact-check them.

Be cautious of companies that can't produce a balance sheet and income statement. Many penny stock companies don't file SEC-required reports, leaving you to make investment decisions based on rumors.

To avoid falling victim to scams, always ask relevant questions and seek expert advice. Don't rely solely on press releases or paid promoters, and never buy stock in response to a cold call.

Legitimate companies can be found in the OTC market, but they're not as straightforward as they seem. These companies are usually large, established foreign firms that list their U.S. shares over-the-counter instead of on major U.S. exchanges.

The Industrial & Commercial Bank of China Ltd. is one such example, being the biggest bank in the world and listed as IDCBY on the OTC market.

Foreign firms often prefer the OTC market because it's cheaper and more convenient than listing on the NYSE or Nasdaq. They can avoid the expense and burden of preparing two sets of reports for financial disclosures.

Companies like Nestlé, Tencent, and Nintendo are also listed on the OTC market, giving foreign firms easier access to U.S. equity investors.

Conducting your own research is crucial when it comes to making informed investment decisions. This means asking questions, seeking professional advice, and verifying information through neutral financial sources.

Penny stock scammers often produce official-looking press releases to convince you and satisfy your curiosity. However, it's essential to dig deeper and not rely solely on these releases.

Be sure to review a company's balance sheet and income statement, as these can be a good indicator of its financial health. If a company can't produce these statements, it may be a red flag.

Many penny stock companies don't file SEC-required reports because the bulletin board doesn't mandate it. This lack of reporting puts you in a position to make investment decisions based on rumors rather than facts.

To avoid falling prey to scams, it's essential to ask relevant questions and seek expert advice. Don't be afraid to ask for clarification or seek a second opinion.

Here are some questions to ask when researching a company:

By doing your due diligence and conducting thorough research, you can make more informed investment decisions and avoid falling victim to scams.

Companies that file reports with the SEC are required to do so electronically using the EDGAR system. This system is available on the SEC's Web site at www.sec.gov.

A company must file reports with the SEC if it has 500 or more investors and $10 million or more in assets, or if it lists its securities on one of several major stock markets, including the NASDAQ.

These stock markets include the American Stock Exchange, Boston Stock Exchange, Cincinnati Stock Exchange, Chicago Stock Exchange, New York Stock Exchange, Pacific Exchange, and Philadelphia Stock Exchange.

Currently, only about half of the 6,500 companies whose securities are quoted on the OTCBB file reports with the SEC. However, a new NASD rule requires all OTCBB companies to file updated financial reports with the SEC or with their banking or insurance regulators.

You can access many corporate filings, including annual and quarterly reports and registration statements, for free from the SEC's Web site using the EDGAR database.

To ensure a smooth trading experience, it's essential to investigate online brokers thoroughly. The U.S. Congress legislated the Penny Stock Reform Act in 1990 to prevent penny stocks fraud.

Before selecting a broker, consider their reputation. Check feedback and reviews online to gauge customer satisfaction. The SEC issued new rules in September 2020 to prevent brokers from quoting OTC stocks unless companies issuing shares release up-to-date financial information.

A good reputation is crucial when choosing an online broker. Research the broker's history, and look for any red flags that may indicate poor customer service or unscrupulous practices. The right online stock broker can be the difference between a frustrating trading experience and a profitable investment journey.