the biggestmarketinworld: initial publicofferingsandsubsequent OTClistingsmakeit market begantopickupsteam. Sincethen,theexplosionof dwarfed theOTCmarket.But inthemid-1970s,OTC dealers tohandletransactions. brokers. Thetermreferstotheactualcountertopsused by exchange listingweretradedinformallyamong when smallfirmsthatdidn’tqualifyforan traces itsrootstotheearly1900s T Over-the-Counter Market? trading inasecurity. maintaining orderly who ischargedwith a solo“specialist” exchange arequotedby curities thattradeonalisted Brothers hasaboutthree.Se- merous marketmakers,Farmer securities theytrade.Microsofthasnu- ket makers”whomaintainbidsandoffersforthe through atleasttwo,butoftennumerous“mar- phia exchange.OTCsecuritiesaretraded American, Midwest,Boston,PacificorPhiladel- an organizedexchange—suchastheNewYork, loosely appliedtosecuritiesthataren’tlistedon Up untilabout30yearsago, volumeontheexchanges Over-the-counter trading he Basics:WhatIsthe “O ver-the-counter”, orOTC,isaterm different qualificationstandards: vrteCutr11,200 700 2,800 Over theCounter American StockExchange New YorkStockExchange over thecounterdon’tmeet currentNasdaqrequirements. ties andExchangeCommission) review. Nasdaq firmsmustsubmit regular reportsforSEC(Securi- National AssociationofSecurities Dealers(NASD)andall ings andmaintainingindependentdirectors. lishing annualandquarterlyreports,conductingmeet- also meetcertaingovernancerequirementsincluding: pub-

*As of12/03. The OTCmarketconsistsoffourbasicunits,eachwith But themajorityofcompanies whosesharesaretraded Trading inallNasdaqsecurities isoverseenbythe initial assetandcapitalizationrequirements.Theymust adqNtoa akt(N)3,500 Nasdaq NationalMarket(NNM) adqSala 700 Nasdaq SmallCap cial standardsgenerallyequaltoabouthalfthe tem, acompanymustmaintaincertainfinan- T ultnBad3,300 OTC BulletinBoard National MarketorNasdaqSmallCapsys- ikSet 3,700 Pink Sheets *As of12/03. Once includedineithertheNasdaq By John E. Deysher E. John By August 2004 Issues* Issues* No. of No. of 29 Strategies Stock Strategies

a company and other corporate malfeasance much may have no easier to commit on the Bulletin Board. The OTCBB assets, sales However, there are some larger, The OTCBB is an electronic quotation system that displays or earnings, conservatively financed companies that real-time quotes, last-sale prices, and volume information for but as long as have been around a long time and trade many OTC securities that are not listed on the Nasdaq stock they make actively on the Bulletin Board. These market or a national securities exchange. Although the NASD timely SEC include: Bresler & Reiner, Bulova, Mon- oversees the OTCBB, it is not part of the Nasdaq stock market. filings they’ll arch Cement, Erie Family Life and New In 1999, the SEC approved an NASD rule allowing the continue to Ulm Telecom. be listed. NASD to require that all OTCBB companies file updated  financial reports with the SEC or with their banking or insur- There are The Pink Sheets ance regulators. Beginning in June 2000, the rule applied to all also no gov- companies on the OTCBB. Since then, any companies that ernance stan- Finally, we come to the Pink Sheets, have refused to file timely reports with the SEC or their dards, inde- a dwelling place for companies that are banking or insurance regulators have been removed from the pendent audit not required to make SEC filings (usu- OTCBB. committees ally because they have less than 300 When an OTCBB company fails to file its reports on time, or indepen- shareholders) and are thus regulation- the NASD will add a fifth letter “E” to its four-letter stock dent directors free. symbol. The company then has 30 days to file with the SEC like those ap- There is often minimal disclosure, or 60 days to file with its banking or insurance regulator. If it’s plied to listed with some companies issuing nothing still delinquent after the grace period, the company will be and Nasdaq more than audited financial statements removed from the OTCBB. You’ll find a list of securities that companies. once a year. have been removed from the OTCBB at www.otcbb.com. All this Liquidity is often minimal, with makes fraud some issues trading only a few shares

These non-Nasdaq issues include small and large domestic and international Useful OTC On-Line Resources companies that can’t or don’t wish to comply with Nasdaq’s require- www.sec.gov ments. They trade on either the OTC Access to 10-Ks, 10-Qs, 8-Ks, proxies, etc., of all SEC-filing companies. Bulletin Board or in the Pink Sheets. www.nasdaq.com The Bulletin Board (OTCBB) Quotes, data and information on all Nasdaq-traded companies.

Founded in 1990, the Bulletin www.nasdaqnews.com Board is a network of electronically Market news, statistics, recent additions and deletions. linked market makers who trade shares of small companies. Unlike the totally www.nasdaqtrader.com unregulated Pink Sheets, the Bulletin Market news, Nasdaq indexes, broker-dealer information. Board is overseen by the SEC and the www.otcbb.com NASD. Bulletin Board companies must Quotes, data and information on Bulletin Board–traded companies. file audited financial statements with the SEC and comply with federal secu- www.pinksheets.com rities laws. Many companies end up Quotes, data and information on Pink Sheet–traded companies. here after being thrown off an exchange or Nasdaq for failing to meet financial www.otcquote.com or governance listing standards. Semi-current Level II quotes on Pink Sheet issues for a monthly fee. But caveat emptor:  Although Bulletin Board compa- www.walkersmanual.com nies are required to file annual Information on Bulletin Board, Pink Sheet and thinly traded issues. and quarterly reports, proxies and www.stockpatrol.com insider trades with the SEC, nei- Alerts investors to potential fraud in penny . ther the SEC nor NASD verifies the filings as factual.  There are no minimums either—

30 AAII Journal per month (or year). The Pinks are strewn with the shares of near worthless issuers, such as bank- The Pink Sheets rupt companies that are in reorganiza- Although the name derives from the color of tion or liquidation and have not made paper they were historically printed on, the “Pink timely SEC filings. There’s a lot of junk Sheets” today is an electronic quotation system here, as well as the increased risk of that displays quotes from broker-dealers for many fraud and malfeasance. over-the-counter (OTC) securities. Market makers But there are also some very good and other brokers who buy and sell OTC securities companies trading here and their num- can use the Pink Sheets to publish their bid and ask ber is growing. quotation prices. They are published by Pink Sheets LLC, One of the consequences of the a privately owned company. Pink Sheets LLC is not registered with the SEC Sarbanes-Oxley Act of 2002 and tougher in any way and it is not an NASD broker-dealer. corporate disclosure laws is the choice The Pink Sheets does not require companies whose securities are by many companies to deregister their quoted upon its systems to meet any listing requirements. With the excep- securities. Under the rules, any com- tion of a few foreign issuers, the companies quoted in the Pink Sheets tend pany that can show it has less than 300 to be closely held, extremely small and/or thinly traded. Most do not meet “owners of record” can deregister, the minimum listing requirements for trading on a national securities ex- meaning it is no longer a “public com- change, such as the New York or the Nasdaq stock market. pany,” is no longer required to make And many of these companies do not file periodic reports or audited SEC filings and is exempt from regula- financial statements with the SEC, making it very difficult for investors to tory oversight. Many small companies find reliable, unbiased information about them. estimate the cost of complying with Sarbanes-Oxley—in terms of higher in- surance, audit and legal fees—can easily exceed $1 million annually. Their shares can be significant. nies deregistered—up from 675 in 2002. now trade in the Pinks, but the savings Indeed, in 2003 about 718 compa- Many companies that deregister continue to make public earnings an- nouncements, file annual and quarterly Nasdaq Listing Requirements reports and hold annual shareholder meetings. When a company announces Nasdaq National Market companies must meet the following initial requirements: it is deregistering, the shares usually fall significantly, as investors run for the • At least $15 million of shareholders’ equity; exits, not wishing to continue to own • At least $1 million income from continuing operations before shares of a non-reporting company. income taxes in latest fiscal year or in two of the last three years; Over time, though, the share price re- • At least 1.1 million publicly held shares with a market value of $8 flects the operating fundamentals as it million or more; does for listed or Nasdaq securities. • A minimum bid price of $5; Some Pink Sheet issues with con- • At least three broker-dealers acting as market makers in the ; servative balance sheets, long and gen- and erally profitable operating histories and • At least 400 shareholders of record. limited analyst coverage include: Ash Grove Cement, Burnham Holdings, Nasdaq SmallCap issues must initially meet the following less stringent Central Steel & Wire, Goodheart-Wilcox requirements: and Lexcom.

• At least $5 million shareholder equity; or, at least $50 million of Tips on Investing market value; or, at least $750,000 of net income from continuing in the OTC Markets operations in latest fiscal year or two of the last three fiscal years; • At least 1 million publicly held shares with a market value of $5 1) Investigate before you invest. million or more; Since many OTC stocks have little • A minimum bid price of $4; if any analyst coverage, you will • At least three broker-dealers acting as market makers in the security; be doing much of the due dili- • At least 300 shareholders of record. gence research yourself. Many firms have Web pages, which is a

August 2004 31 Stock Strategies

From the SEC: Micro-Cap Fraud

Information is the investor’s best tool when it shows. Paid promoters are generally behind comes to wise investing. But accurate information the unsolicited “junk” faxes you may receive about “micro-cap stocks”—low-priced stocks issued that tout a micro-cap company. The federal by the smallest of companies—may be difficult to find. securities laws require the newsletters to dis- Many micro-cap stocks trade in the over-the- close who paid them, the amount, and the counter market and are quoted on OTC systems, such type of payment, but many fraudsters fail to as the OTC Bulletin Board (OTCBB) or the Pink do so and mislead investors into believing Sheets. they are receiving independent advice. But many micro-cap companies do not file finan-  “Boiler Rooms” and Cold Calling: Dis- cial reports with the SEC, so it’s hard for investors to honest brokers set up “boiler rooms” where a get the facts about the company’s management, prod- small army of high-pressure salespeople use ucts, services, and finances. And while many of the banks of telephones to make cold calls to as companies that don’t file reports with the SEC are many potential investors as possible. These legitimate businesses with real products or services, strangers hound investors to buy “house the lack of reliable, readily available information about stocks”—stocks that the firm buys or sells as these kinds of companies can open the door to fraud. a market maker or has in its inventory.  Questionable Press Releases: Fraudsters Spreading False Information often issue press releases that contain exag- gerations or lies about the micro-cap Micro-cap fraud depends on spreading false infor- company’s sales, acquisitions, revenue projec- mation. Here’s how this false information is often tions, or new products or services. These distributed: fraudulent press releases are then dissemi-  E-mail Spam: Fraudsters distribute junk nated through legitimate financial news por- E-mail or “spam” over the Internet to spread tals on the Internet. false information quickly and cheaply about a micro-cap company to thousands of potential The Schemes investors. Spam allows the unscrupulous to target many more potential investors than Micro-cap fraud schemes can take a variety of cold calling or mass mailing. forms. However, the two most common are the classic  Internet Fraud: Fraudsters often use aliases “” scheme, and the off-shore scam. on Internet bulletin boards and chat rooms to hide their identities and post messages urging Pump and Dump investors to buy stock in micro-cap compa- It’s common to see messages posted on the Internet nies based on supposedly “inside” informa- that urge readers to buy a stock quickly or to sell before tion about impending developments at the the price goes down, or a telemarketer will call using companies. the same sort of pitch. Often the promoters will claim  Paid Promoters: Some micro-cap compa- to have “inside” information about an impending de- nies pay stock promoters to recommend or velopment or to use an “infallible” combination of “tout” the micro-cap stock in supposedly in- economic and stock market data to pick stocks. In dependent and unbiased investment newslet- reality, they may be company insiders or paid promot- ters, research reports, or radio and television ers who stand to gain by selling their shares after the

good place to start. Order annual risks? Upside and downside? spread exists between the bid and reports and proxies, and review 2) If you are interested in a bank, offer. This may be especially true SEC filings. Do the same for the thrift or insurance company, check with inactive Bulletin Board and competitors. Crunch the numbers. the regulatory filings of federal Pink Sheet issues. Identify why you think this com- and state banking and insurance 4) If you are interested in inactive pany is a worthwhile investment. departments. issues (where greater price ineffi- What are the opportunities and 3) Use limit orders where a large ciencies may exist), obtain a copy

32 AAII Journal stock price is pumped up by the buying frenzy they cial Statements: Many micro-cap fraud create. schemes involve unusual transactions among Once these fraudsters sell their shares and stop individuals connected to the company. These hyping the stock, the price typically falls, and investors can be unusual loans or the exchange of ques- lose their money. tionable assets for company stock that may be discussed in the footnotes. The Off-Shore Scam  Unusual Auditing Issues: Be wary when a Under a rule known as “Regulation S,” companies company’s auditors have refused to certify the do not have to register stock they sell outside the company’s financial statements or if they’ve United States to foreign or “off-shore” investors. stated that the company may not have enough In the typical off-shore scam, an unscrupulous money to continue operating. Also question micro-cap company sells unregistered Reg S stock at a any change of accountants. deep discount to fraudsters posing as foreign inves-  Insiders Own Large Amounts of the Stock: tors. These fraudsters then sell the stock to U.S. inves- In many micro-cap fraud cases—especially tors at inflated prices, pocketing huge profits that they “pump and dump” schemes—the company’s share with the micro-cap company insiders. The flood officers and promoters own significant of unregistered stock into the U.S. eventually causes amounts of the stock. When one person or the price to plummet, leaving unsuspecting U.S. inves- group controls most of the stock, they can tors with enormous losses. more easily manipulate the stock’s price at your expense. You can ask your broker or the Red Flags company whether one person or group con- trols most of the company’s stock, but if the To avoid micro-cap fraud, the SEC recommends company is the subject of a scam, you may not that investors watch out for these “red flags”: get an honest answer.

 SEC Trading Suspensions: The SEC has Additional red flags: the power to suspend trading in any stock for up to 10 days when it believes that informa- High Pressure Sales Tactics: Beware of brokers tion about the company is inaccurate or unre- who pressure you to buy before you have a chance to liable. Think twice before investing in a com- think about and investigate the “opportunity.” Dis- pany that’s been the subject of an SEC trading honest brokers may try to tell you about a “once-in-a- suspension. You’ll find information about trad- lifetime” opportunity or one that’s based on “inside” ing suspensions on the SEC’s Web site at or “confidential” information. Don’t fall for brokers www.sec.gov. who promise spectacular profits or “guaranteed” re-  Assets Are Large But Revenues Are Small: turns. These are the hallmarks of fraud. Micro-cap companies sometimes assign high No Written Information: Don’t deal with bro- values on their financial statements to assets kers who refuse to provide you with written informa- that have nothing to do with their business. tion about the investments they’re promoting. Never Find out whether there’s a valid explanation tell a cold caller your social security number or num- for low revenues, especially when the com- bers for your banking and securities accounts. And be pany claims to have large assets. extra wary if someone you don’t know and trust rec-  Odd Items in the Footnotes to the Finan- ommends foreign investments.

of Walker’s Manual of Unlisted 500 thinly traded issues. 6) You should also check out the Stocks (732/431-6614). Editor 5) Stick with companies that use related article on these two pages Andrew Berger sifts through thou- reputable auditors, where stan- on how to avoid micro-cap fraud sands of companies and profiles dards are higher. in the OTC markets. 

John Deysher, CFA, is president and portfolio manager of the Pinnacle Value Fund, a diversified mutual fund specializing in the securities of small- and micro-cap companies. He is based in New York City and can be reached at [email protected].

August 2004 33