FINRA handed out one of its largest fines ever last year to a firm claiming that it ignored its Anti-Money Laundering obligations when accommodating client activity in low priced stocks. That $8 million fine was not levied against a broker-dealer operating a boiler room operation in penny stocks, rather it was levied against Wall Street’s oldest and largest private bank that was founded in 1818. For them, penny stocks were not a significant business, but they turned into a significant risk.
Some broker-dealers have historically set limitations on low-priced or penny stock activity in an attempt to limit operational, suitability and regulatory risk. However, the restrictions on activity in low-priced stocks sometimes becomes relaxed to accommodate established clients or as the market rallies, as it has during the last five years. There are 10,000 stocks traded on the Over-The-Counter Bulletin Board or OTC Markets Group. While some broker-dealers focus on helping small cap companies raise capital on these exchanges, other firms may accommodate their clients who want to trade in low-priced stocks.
Whatever your firm’s reason might be for trading in low priced stocks, understanding the risks that accompany this activity will help protect your firm.
Financial Risks to Firms Whose Clients Trade in Low Priced Stocks:
- These stocks often have reverse splits so be careful of physical certificates. Reverse splits have the potential to leave a firm short when physical certificates are delivered to the broker-dealer to cover a sale. For example: A low priced stock went through a 1000-for-1 reverse split. Unfortunately, the firm sold the shares assuming the certificate was valid. In this case, the firm sold post-split shares based on a pre-split quantity and got caught short due to the re-org. The client will often plead ignorance, the shares delivered do not cover the sale, and the firm is left at risk. The order is marked incorrectly as a long sale, the short must be covered, and if the funds received from the sale have been paid out, or are not sufficient to cover the cost of the buy-in, the account is potentially left with a deficit. Unfortunately, the firm is often left with a loss.
- The operational risk of getting caught in a re-organization. Transfer Agents of low priced stocks are often the least equipped to handle meaningful re-organization activity. When re-organizations result in firms getting caught short, Transfer Agents are frequently part of the problem—enough so that the SEC’s Division of Enforcement created a Microcap Fraud Task Force.
- Clients sometimes pursue classic low-priced stock frauds. The schemes usually involve false press releases, large stock purchases, and hidden ownership. Transfer Agents are in a position to prevent unregistered securities from being distributed in violation of the Securities Act—this is particularly important because typically with low priced stocks there is little, if any, meaningful disclosure or independent research regarding such companies. A couple of examples of low-priced stock frauds:
- The Pump and Dump – talking up the stock to get the price to double or triple while selling into that demand created by false and misleading statements
- The Dump & Dilute – outright stock promotions where the company keeps issuing shares
- Unsupervised activity in penny stocks can leave your firm open to AML Risk: Even when just an accommodation for your clients, activity in low priced stocks should be monitored and firms should know the beneficial owners, know how large penny stock positions were acquired, and know that the shares are properly registered.
To Limit These Risks Firms Should:
- Review policies and procedures and supervisory controls regarding low-priced stock sales and trades
- Review low-priced stock commission payouts to Financial Advisors
- Review low-priced stock disclosure policies and supervisory controls
- Have a robust due diligence process for clients engaging in low-priced stock transactions or acting as stock promoters/public relations
- Have a thorough process to manage the receipt, transfer and payouts related to low-priced stock transactions and pay special attention to physical certificates
- Engage the firm’s anti-money laundering team to ensure that the surveillance and reporting processes are consistent with regulatory expectations
For more information about understanding the risk to your firm that goes along with facilitating your clients’ activity in low-priced stocks, please contact Oyster Consulting and one of our associates will be happy to help. Oyster Consulting can help limit your firm’s exposure to these risks by assessing operational risks and developing policies and procedures around low-priced stock sales and trades. Oyster Consulting can also provide a comprehensive risk assessment of your compliance program.