Know The Risks of OTC Stocks
isky OTC stock" is a phrase that has reached cliché status. Yet many investors, and even some lawyers representing them in securities arbitration, have a limited understanding of the characteristics of an OTC stock. Let's discuss the important points.
"OTC" means "Over the Counter." Dating back to the early 1900s, that literally was the way such stocks were bought and sold. Due to lack of financial strength (or risk), OTC stocks did not qualify for being listed on an organized exchange, such as the New York Stock Exchange. By comparison to the stock exchanges, OTC volume (the amount of shares traded) was light.
Today, however, the OTC marketplace is the largest in the world, with 11,200 stocks listed compared to 2,800 listed on the New York Stock Exchange (as of 12/03). Similarly, the financial strength of the OTC stocks now varies greatly, from excellent to insolvent, depending upon where the stock trades. There are four OTC markets:
1. Nasdaq National Market (NNM), with 3,500 stocks;
2. Nasdaq Small Cap, with 700 stocks;
3. OTC Bulletin Board, with 3,300 stocks; and
4. Pink Sheets, with 3,700 stocks.
Let's overview the characteristics of each OTC market.
Both the Nasdaq National Market and the Nasdaq Small Cap require companies to maintain minimum financial standards, including minimum shareholder equity, minimum income from operations, minimum "float" (shares held in the market), minimum bid price and a minimum number of market makers. Additionally, Nasdaq listed companies must meet certain governance standards, including publishing quarterly and annual reports, conducting annual meetings and maintaining independent directors. Finally, Nasdaq listed companies must submit regular reports to the Securities and Exchange Commission (SEC) for its review. Overall, these are important protections for investors.
On the other hand, the majority of OTC marketplace stocks do not afford investors such protections. These are the companies - often called "penny stocks" - that trade on the OTC Bulletin Board and the Pink Sheets. The OTC Bulletin Board was founded in 1990 and is a network of electronically linked market makers trading shares of small companies. The OTC Bulletin Board does have one regulatory requirement, imposed since 1999, which requires companies traded there to file audited financial statements with the SEC or with their banking or insurance regulators. Nonetheless, no securities regulator reviews or verifies these financial statements for accuracy. Similarly, there are no minimum financial standards and there are no governance standards.
The Pink Sheets are one step further removed, in terms of their lack of investor protections. Companies trading on the Pink Sheets are regulation free. Hence, often one finds non-existent or minimal financial disclosure. Furthermore, liquidity of a Pink Sheet company's stock often is non-existent or minimal too, which causes great spreads between the bid and the ask prices of such stocks. In conclusion, this market tends to be the dwelling place for companies down and out.
Investors can take some precautions should they wish to invest in companies listed on the OTC Bulletin Board and the Pink Sheets. First, investigate, by attempting to locate any available (and preferably audited) financial disclosures. Second, consult Walker's Manual of Unlisted Stocks, which profiles 500 thinly traded stocks. Third, use limit orders (not market orders) to buy and sell stocks, in order to reduce the negative pricing effects of the bid and ask spreads.
Or, "Just Say No" to investing in OTC Bulletin Board and Pink Sheet stocks, because there, the phrase, "Risky OTC stock" always is accurate!
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James J. Eccleston is a securities attorney, representing customers as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston, and can be reached at 312-621-4400.
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