SEC and Penny Stock Rules

Penny stocks are closely regulated by the SECstocks and shares image by Andrew Brown from Fotolia.com

Penny stocks, also called micro cap equity, refer to shares of small companies that generally trade for less than $5. Penny stocks are usually sold in the over-the-counter market via the OTC Bulletin Board or in the Pink Sheets. Because they represent stocks of small companies whose fortunes can be uncertain, the Securities and Exchange Commission (SEC) closely regulates trade in penny stocks.

Risk Disclosure Documents

The SEC requires brokers to make sure their customers read and understand the risk disclosure document before they can sell them penny stocks. The risk disclosure document describes all relevant risks involved in buying such stocks, including the possibility that a client may lose all or part of the investment. The broker must make sure that the client has read and fully understood the document. To do that, the broker obtains a dated and signed receipt of the risk disclosure document from the customer.

Customers have to fully understand the risks involved in investing in penny stocks. The primary risk is of the issuer's default, which is always possible because the issuer is a small company. To be certain that the customer recognizes the risks, the broker must formally approve the customer and recognize him as a well informed investor. The broker must also receive from the customer a written agreement for the transaction. As with the risk disclosure agreement, the customer is required to send the broker a signed and dated suitability statement.

Brokers are obliged to send monthly account statements of the market value of each penny stock the customer holds in her account. It is necessary, because sometimes penny stocks can be illiquid, which means it can be difficult to find a seller or buyer for them and thus establish the penny stock's market value.

Online trading simplifies the process by allowing the broker to acquire digital signatures from the customer for the risk disclosure document and the customer's agreement for the transaction instead of going through all the physical paperwork.