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Avoid Fraud

Low-Priced Stocks Can Spell Big Problems

Low-Priced Stocks istockimage

Are you considering investing in low-priced securities? You might have heard that they’re a good way to make a profit without spending much. But how much do you know about these securities?

Low-priced securities are often known as “microcap stocks” or “penny stocks.” Generally, microcap stocks are stocks issued by companies with market capitalization of less than $250 to $300 million. Penny stocks are typically stocks issued by very small companies that trade at less than $5 per share. While the two categories overlap, not all penny stocks are microcap stocks, and not all microcap stocks are penny stocks. 

Low-priced securities may trade either in the over-the-counter (OTC) market or on an exchange. Securities—including low-priced securities—that trade in the OTC market aren’t required to meet the listing standards imposed by exchanges, such as a minimum share price, total market value or number of shareholders. Listing standards do apply to low-priced securities that trade on an exchange—often known as small capitalization or “small cap” stocks—but this doesn’t guarantee that they’re safe investments. 

Some exchange-listed small-cap securities might have fallen below the exchange’s minimum share price or other standards but remain listed if, for example, the issuer engages in a corporate action such as a reverse stock split that increases the per-share price of the security. They might also remain listed simply due to the time involved in the delisting process. 

Even if it’s listed on an exchange, a security with a very low share price can still carry additional risks and should be treated accordingly. Low-priced securities can be legitimate investments, but they can also be targets of market manipulation schemes. 

A Risky Proposition

Low-priced securities often are considered speculative investments, which you should only make with money that you can afford to lose. They tend to be volatile, and they trade in low volumes, which means they’re subject to price fluctuations from even relatively small trades. The low trading volume of these securities also can make them hard to sell due to a potential lack of buyers. 

A major risk for OTC low-priced securities is the limited amount of publicly available information. Many of these securities are issued by small or emerging companies, which can make it difficult to find comprehensive information about the company’s finances or business model. Without this information, it can be hard to judge whether a company might be a reasonable investment. 

In addition, some OTC low-priced securities aren’t registered with the Securities and Exchange Commission (SEC). Companies that don’t register their securities have fewer federal filing and disclosure requirements, meaning that there may be even less public information available for—and therefore even greater risk with—these investments. 

Potential for Fraud

Unfortunately, low-priced securities also can be more susceptible to fraud. These securities can be targets for pump and dump and similar schemes in which fraudsters artificially inflate the price of a security and then quickly sell their shares, leaving investors facing losses.

When it comes to OTC securities, scammers might take advantage of some of the lesser listing and disclosure standards to misrepresent key facts about the company. They might exaggerate—or even invent—its products or capabilities, perhaps capitalizing on current events or market trends to appeal to investors. The potential combination of minimal information and low trading volume can also make it easier for bad actors to manipulate an OTC stock’s price to their advantage. 

In these instances, price inflation often depends on the spread of false information promoting the stock to lure in new investors, such as through social media or mass email campaigns. More sophisticated scammers might even issue fraudulent press releases or reports about the stock or the company and engage in trading to support their manipulative schemes. When there’s little other information available about the company, these fakes become harder to catch.

Low-priced securities listed on an exchange are subject to SEC reporting disclosures; however, investors shouldn’t assume that these stocks are immune from potential fraud. In fact, bad actors might exploit the sense of safety that comes from exchange-listed stocks and target these securities for manipulation schemes, particularly stocks that that have low trading volume and trade at a lower price ($5 or less).

Recent stock manipulations involving listed securities have been driven by misdirected text messaging scams and fraudulent investment clubs on social media. These scams often don’t involve public press releases or stock promotion activity; instead, investors are convinced directly by scammers to purchase shares of a particular stock. Be wary of investing in any stock recommended by someone you’ve met online, and treat stocks with a small market cap, foreign issuers or significant price spikes and drops with particular caution.

If you’re considering investing in low-priced securities, look out for these red flags that can signify fraud:

  • claims of guaranteed returns or that the investment is “no risk”;
  • overly optimistic performance projections for a new or untested company, especially in a sector with stiff competition, or unsupported claims regarding partnerships or joint ventures;
  • aggressive social media, email or press release campaigns, particularly of information that can’t be reliably confirmed; 
  • unsolicited social media messages, emails, texts or phone calls promoting specific stocks; 
  • a lack of current publicly available financial information in SEC filings; and
  • frequent changes of company name, ticker symbol or business model, or abrupt expansion of an existing business model, often to benefit from the latest trend.

Proceed with Caution

In addition to checking for signs of fraud or manipulation, ask questions. Make sure you understand the company’s business and the terms of your investment. Rather than relying on unsolicited marketing or promotional materials or on commentary from stock-focused social threads, look for or request written information from the company, including a prospectus, financial reports and business documentation—and read these materials carefully. Some companies have been known to state outright in disclosure documents that they have no operations or revenue sources even as social media posts paint a rosier picture.

Find out whether the company issuing the securities you’re considering is registered with the SEC and if it files reports. To do this, check the SEC’s EDGAR database or contact your state securities regulator to see if the securities are registered. If you’ve been given a recommendation for an exchange-listed stock that’s just below $1, consider whether the issuer has received a delisting notice from the exchange and whether the recommendation is part of an attempt to keep the stock above $1.

You can also check the OTC Markets website to see which market the stock trades in and what the reporting standards are for those companies. OTC securities with limited information are the riskiest. OTC Markets Group also uses different designations and compliance flags to provide additional information to investors about a company’s profile and risk factors. 

If you’re working with a registered financial professional, they should be able to help you get all this information.

If you receive an unsolicited pitch to buy or sell a penny stock, use FINRA’s BrokerCheck to find out whether the person or firm is registered and if they have any complaints against them. 

Remember: Low-priced securities might sound like a steal. But too often, FINRA has seen retail investors lose money to frauds in this space. Even a web search for the name of the company or person and the word “scam” or “fraud” can be helpful. If you suspect a penny stock scam, contact FINRA.

Updated on 7/30/24