Penny Stocks: How To Investigate Them and Avoid the Traps

Information is the investor’s best tool when it comes to investing wisely. But accurate information about “microcap stocks” — low-priced stocks issued by the smallest of companies, often called “penny stocks” — may be difficult to find. Many microcap companies do not file financial reports with the SEC, so it’s hard for investors to get the facts about the company’s management, products, services, and finances. When reliable information is scarce, wrongdoers can easily spread false information about microcap companies, making profits while creating losses for unsuspecting investors.

This Financial Guide gives you the basics about microcap or “penny” stocks, discusses how to find information on them, and points out what “red flags” to watch out for.


The term “microcap stock” applies to companies with low or “micro” capitalizations — meaning the total value of the company’s stock. Microcap companies typically have limited assets. For example, in recent cases where the SEC suspended trading in microcap stocks, the average company had only $6 million in net tangible assets – and nearly half had less than $1.25 million. Microcap stocks tend to be low priced and trade in low volumes.


Many microcap stocks trade in the “over-the-counter” (OTC) market and are quoted on OTC systems, such as the OTC Bulletin Board (OTCBB) or the “Pink Sheets.”

Caution: Although the NASD oversees the OTCBB, the OTCBB is not part of the NASDAQ. Wrongdoers often claim that an OTCBB company is a NASDAQ company to mislead investors.


Microcap stocks differ from other stocks in a number of ways:

Lack of Public Information. The biggest difference between a microcap stock and other stocks is the amount of reliable, publicly available information about the company. Larger public companies file reports with the SEC that any investor can get for free from the SEC’s website. Professional stock analysts regularly research and write about larger public companies, and it’s easy to find larger companies’ stock prices. In contrast, information about microcap companies can be extremely difficult to find, making them more vulnerable to investment fraud schemes.

Note: The SEC has proposed new rules that will increase the amount of information brokers must gather about microcap companies before quoting prices for their stocks in the OTC market.

No Minimum Listing Standards. Companies that trade their stocks on major exchanges and in the NASDAQ must meet minimum listing standards. For example, they must have certain minimums when it comes to net assets, and minimum numbers of shareholders. In contrast, companies on the OTCBB or the Pink Sheets do not have to meet any minimum standards.

Risk. While all investments involve risk, microcap stocks are among the most risky. Many microcap companies are new, with no track record. Some of these companies have no assets or operations. Others have products and services that are still in development or have yet to be tested in the market.


In general, the federal securities laws require all but the smallest of public companies to file reports with the SEC. A company can become “public” in one of two ways – by issuing securities in an offering or transaction that’s registered with the SEC or by registering the company and its outstanding securities with the SEC. Both types of registration trigger ongoing reporting obligations, meaning the company must file periodic reports that disclose important information to investors about its business, financial condition, and management.

This information is a treasure trove for investors: it tells you whether a company is making money or losing money and why.

Tip: You’ll find this information in the company’s quarterly reports on Form 10-Q, annual reports (with audited financial statements) on Form 10-K, and periodic reports of significant events on Form 8-K.

A company must file reports with the SEC if:

Currently, only about half of the 6,500 companies whose securities are quoted on the OTCBB file reports with the SEC.

Note: In January 1999, the SEC approved a new NASD rule allowing the NASD to require that all OTCBB companies file updated financial reports with the SEC or with their banking or insurance regulators. The new rule now applies to all companies on the OTCBB. Companies refusing to file with the SEC or their banking or insurance regulators cannot remain on the OTCBB.

With few exceptions, companies that file reports with the SEC must do so electronically using the SEC’s EDGAR system. EDGAR stands for electronic data gathering and retrieval. The EDGAR database is available on the SEC’s Web site at You’ll find many corporate filings in the EDGAR database, including annual and quarterly reports and registration statements. Any investor can access and download this information for free from the SEC’s Web site.

Caution: As with any information, SEC filings should be read with a questioning and critical mind.


Smaller companies – those with less than $10 million in assets – generally do not have to file reports with the SEC. But some smaller companies, including microcap companies, may choose voluntarily to register their securities with the SEC. As described above, companies that register with the SEC must also file quarterly, annual, and other reports.


Any company that wants to offer or sell securities to the public must either register with the SEC or meet an exemption. Here are two of the most common exemptions that many microcap companies use:

Tip: You may be able to find out more about Reg. D companies by contacting your state securities regulator.

Unless they otherwise file reports with the SEC, companies that are exempt from registration under Reg. A, Reg. D, or another offering exemption, do not have to file reports with the SEC.


Many of the microcap companies that don’t file reports with the SEC are legitimate businesses with real products or services. But the lack of reliable, readily available information about some microcap companies can open the door to fraud. It’s easier to manipulate a stock when there’s little or no information available about the company.

Microcap fraud depends on spreading false information. Here’s how some perpetrators carry out their scams:

Tip: Never buy stock in response to a cold call.


Microcap fraud schemes can take a variety of forms. Here’s a description of the two most common:

The Classic “Pump and Dump” Scheme. It’s common to see messages posted on the Internet that urge readers to buy a stock quickly or to sell before the price goes down, or a telemarketer will call using the same sort of pitch. Often the promoters will claim to have “inside” information about an impending development or to use an “infallible” combination of economic and stock market data to pick stocks. In reality, they may be company insiders or paid promoters who stand to gain by selling their shares after the stock price is pumped up by the buying frenzy they create. Once these con artists sell their shares and stop hyping the stock, the price typically falls, and investors lose their money.

The Off-Shore Scam. Under a rule known as “Regulation S,” companies do not have to register stock they sell outside the United States to foreign or “off-shore” investors. In the typical off-shore scam, an unscrupulous microcap company sells unregistered Reg. S stock at a deep discount to con artists posing as foreign investors. These con artists then sell the stock to U.S. investors at inflated prices, pocketing huge profits, which they share with the microcap company insiders. The flood of unregistered stock into the U.S. eventually causes the price to plummet, leaving unsuspecting U.S. investors with enormous losses.

Note: The SEC recently strengthened Reg. S to make this type of fraud harder to conduct.


If you’re working with a broker or an investment adviser, you can ask your investment professional if the company files reports with the SEC and to get you written information about the company and its business, finances, and management. Be sure to carefully read the prospectus and the company’s latest financial reports.

You can also get information on your own from these sources:

Caution: If you’ve been asked to invest in a company but you can’t find any record that the company has registered its securities with the SEC or your state, or that it’s exempt from registration, call or write your state’s securities regulator or the SEC immediately with all the details. You may have come face to face with a scam.


To invest wisely and avoid investment scams, research each investment opportunity thoroughly and ask questions. These simple steps can make the difference between profits and losses:

  1. Find out whether the company has registered its securities with the SEC or your state’s securities regulators.
  2. Make sure you understand the company’s business and its products or services.
  3. Read the most recent reports the company has filed with its regulators and pay attention to the company’s financial statements, particularly if they are not audited or not certified by an accountant. If the company does not file reports with the SEC, be sure to ask your broker for what’s called the “Rule 15c2-11 file” on the company. That file will contain important information about the company.
  4. Check out the people running the company with your state securities regulator, and find out if they’ve ever made money for investors before. Also ask whether the people running the company have had run-ins with the regulators or other investors.
  5. Make sure the broker and his or her firm are registered with the SEC and licensed to do business in your state. And ask your state securities regulator whether the broker and the firm have ever been disciplined or have complaints against them.

Also, watch out for these “red flags”:

Caution: Don’t deal with brokers who refuse to provide you with written information about the investments they’re promoting.

Caution: Never tell a cold caller your social security number or numbers for your banking and securities accounts.

Caution: Be extra wary if someone you don’t know and trust recommends foreign investments.