The Financial Industry Regulatory Authority (FINRA) recently fined a Minneapolis broker-dealer $1 million for not properly supervising its large penny stock business. The action charges that brokers at the firm did not adequately inform customers of the inherent dangers of some of these penny stock transactions and also failed to advise customers on the suitability and risk that such stocks entail. The action against the broker-dealer also alleges that the market values for each penny stock were not listed in statements that were sent to customers.
Penny stocks are common shares of small public companies that typically trade at prices below five dollars a share. The SEC defines a penny stock as a security that trades below $5 per share and is not listed on a national exchange. The allure of these stocks is that the low price can lead to quick profits if the stock increases in value just a small amount because the investor will have the ability to purchase a large quantity of the stock because of its low price point.
However, these stocks come with some inherent risks. These stocks are thinly traded and can become the target of certain schemes used by promoters to manipulate the price of the stock. Often the promoters will purchase large quantities of the stock and then put out misleading or incorrect information to inflate the price of the shares before they sell out of their shares at a great profit. This is called a “pump and dump” scheme. This type of scheme can use mailing, newsletters, press releases, message boards or chat rooms, or social media to inflate the price of the stock.
FINRA has stated that these low priced stocks are an area of significant ongoing concern. The firm that FINRA fined did not keep proper records of transactions for securities that may temporarily not have met the definition of a penny stock and did not track penny-stock transactions in securities that did not make a market. The firm solicited transactions on 15 different penny stocks that earned the firm over $2.1 million. The firm actually created their own market for at least 17 penny stocks that the firm took advantage of to increase the profit on these stocks. They essentially created an artificial market for the stocks that they controlled, making commissions on the sale of each sale of these stocks.
Brokers should be very wary of recommending penny stocks to customers. These stocks often come with the allure of offering large commissions to the broker but that is usually at the expense of the best interests of the customer. A customer not having a large amount of money to invest does not necessarily mean that they should be investing in penny stocks or cheaper investments. Instead brokers and the firms that supervise them should look to properly recommend suitable investments to customers and research the investment recommendations they make extensively. While penny stocks can be appealing on a number of levels to both brokers and customers, they should generally be avoided unless there is an incredibly high risk tolerance by the customer.