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The Financial Regulators – SEC, FINRA, and Penny Stocks

11 May The Financial Regulators – SEC, FINRA, and Penny Stocks

The Financial Regulators - SEC, FINRA, and Penny Stocks


There are three principal national financial regulators:  the Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), and the U.S. Commodity Futures Trading Commission (CTFC).  The SEC is a federal agency; FINRA is private.  It is subject to SEC regulation itself.  The CTFC regulates the derivative markets, and so is irrelevant to any discussion of penny stocks.  The SEC and FINRA cover some of the same territory, but have different roles and responsibilities.


The SEC describes its mission succinctly:  it is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”  From the 18th to the early 20th century our capital markets were entirely unregulated, their history characterized by extravagant boom and bust cycles.  Some shakeouts were bad indeed, but none affected the economy as profoundly as the Crash of 1929.  Franklin Delano Roosevelt inherited the Great Depression, so-called, ironically, because officials didn't want to alarm people by calling it a “panic,” the word used for earlier crashes. 

In an effort to restore confidence, Roosevelt worked with Congress to establish rules and regulations.  The year he took office, the Securities Act of 1933 was passed and signed into law.  There followed the Securities Exchange Act of 1934, which among other things created the SEC.  The first SEC Chairman was Joseph P. Kennedy, a savvy trader whose fortune had not been significantly damaged by the events of the previous four years.  He bought Securities and Exchange Commission, SEC, Building in Washington DCundervalued stocks in the depths of the Depression, and emerged from it wealthier than ever.

The acts were based on two simple principles:  that companies offering securities to the public must disclose the truth about their businesses, the securities they're selling, and the risks to which buyers are exposed; and that market professionals must treat investors fairly, putting the public's interests first.  In the aftermath of the 2008 meltdown, many would argue that the second has not been adhered to as rigorously as it should be.

The SEC is still governed by the 1933 and 1934 Acts.  The complexity of the markets has of course greatly increased, as has the complexity of the financial instruments traded, so these documents have been amended and expanded many times in the succeeding decades.  But they still dictate what most public companies must disclose, and how they must disclose it; they also provide for registration of stock, and contain specific anti-fraud statutes.

The SEC and penny stocks

As they were framed, the new regulations did not envisage that all issuers should be considered equal.  In order to make entry into the marketplace easier for small companies, they were not required to register with the SEC if they had minimal assets and fewer than a certain number of shareholders.  That is where penny stocks enter the picture.

Information—or misinformation—contained in SEC filings is the point of departure for most investigations undertaken by the agency's enforcement division.  Some penny stocks do report to the SEC, but Pinks, the vast majority of OTC issues, do not.  Some novice traders believe that means Pinks cannot be regulated or sanctioned, but that is not the case.  Companies and individuals—management, affiliates, promoters, attorneys, transfer agents—can be sued by the SEC for securities fraud, market manipulation, money laundering, conspiracy, and a host of other offenses.  Since the SEC has no prosecutorial powers, if it wants to see the perps criminally charged, it needs to persuade the Department of Justice to step in with arrests and indictments.

When bringing enforcement actions, the agency tends to interest itself in broad themes rather than look around for potential miscreants.  Over the last couple of years, it has taken aggressive action against illegal insider trading, fraudulent issuance of unregistered stock, and illicit and manipulative promotional activities.  The insider trading cases have mostly to do with exchange-listed stocks, but the last two offenses are almost exclusively associated with penny stocks.  Since Pinks are unregistered, they can only sell stock in private placements if they qualify for an exemption from registration such as such as those provided by Regulation D or Regulation S.  Reg D and Reg S stock is subject to a one-year hold in the case of non-reporting companies; only in certain exceptional circumstances can it be sold earlier.  It often is sold earlier, though; sometimes almost immediately.  This is done with the collusion of sleazy lawyers and the holders of the new restricted stock issued by the company.  The lawyer writes an opinion letter stating that the stock—for some invented reason—should be considered free trading, and in the blink of an eye, it is.  If the SEC catches wind of it, it will crack down.

Heavily promoted pennies, and the touts that pump them, are another favorite target.  Major cases are few and far between, but when brought they usually result in heavy monetary penalties, and sometimes in criminal prosecutions.  The company may or may not be sued along with the touts, but nearly always the pump and dump scheme will have destroyed it long before the SEC files a complaint. 


Another weapon in the SEC's arsenal is the trading suspension.  If it is deemed to be in the public interest, the agency can suspend a stock for ten trading days.  While its brief is to protect investors, in the case of suspensions those protected are potential, not actual, shareholders.  Suspensions are announced without notice, and usually to the surprise of everyone, just before the opening bell. 

There are essentially two reasons for action to be taken:  the company is an SEC reporter that is delinquent in its required filings, or fraud is suspected.  The suspected fraud can take the form of “misleading” press releases or other company statements, inadequate information (or no information at all) about the company's capital structure, management, and business operations.  The purpose of suspending delinquent filers is to make sure these companies—sometimes not companies at all, but merely tickers left to trade when the doors closed for good—cannot be hijacked by scammers and used to run a pump and dump scheme.  Those companies' registration will be revoked, and they will never trade again.  Suspensions for cause are more interesting, and usually involve egregious violations of securities laws.

Either way, a suspension is a death sentence.  The stock automatically loses compliance with SEC Rule 15c2-11, which means that once trading resumes, it will resume on what's known as the Grey Market.  No market makers may quote it, nor may they perform other normal MM activities.  Their only function is to facilitate matched trades.  Typically, on the day the stock reopens, it will lose 60% to 80% of its value.  Thereafter, price may recover a little, but liquidity will dry up.


FINRA's principal job is to regulate its own members, who are securities firms and the people who work for them.  It does, however, have a fraud division that often takes a look at questionable penny stocks.  Since FINRA is able to track trading better than the SEC, it often picks up on unusual activity, especially the huge increases in actual and dollar volume that accompany major promotions.  It may call the company to ask whether it has any involvement in the promo, or whether insiders have been selling.  Naturally the company offers a categorical denial.  Outsiders have no way of knowing whether FINRA finds those denials plausible.

Recently there's been a new and interesting development.  Eco-Trade Corporation (BOPT) was the subject of a Stock Market Authority promotion.  Once the promo had been underway for a few days, FINRA halted trading unexpectedly, in the middle of the session, by invoking Rule 6440.  Rule 6440 provides that this may be done “if FINRA determines that an extraordinary event has occurred or is ongoing that has had a material effect on the market for the OTC Equity Security... or has the potential to cause major disruption to the marketplace or significant uncertainty in the settlement and clearance process.” 

For observers, the most extraordinary event was that it happened at all.  More than two weeks later—unlike the SEC, FINRA can extend its ten day halts successively, if it wants—BOPT is still not trading, and no explanation for the action has been provided.  It is unclear whether FINRA reacted to a genuinely anomalous situation, or whether it's experimenting with a new way to deal with out of control promotions. 

What this means for penny stock players


The lesson to be learned from all this is that the SEC, and sometimes FINRA, can and will move against penny companies with vigor.  Lawsuits resulting in civil or criminal actions after years of investigation do not pose a threat to short-term traders looking for a quick profit. 

Suspensions and halts, however, are different animals.  They happen without even a moment's notice, and once they do, anyone holding the stock is likely to suffer serious losses.

Penny stocks are almost never investment quality.  The possibility of fraud is always present.  Experienced traders know to take profits early and often; the tantalizing ten-bagger is far more elusive than the bag players end up holding when caught in a suspension or halt.

SEC, FINRA, and Penny Stocks

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