Why are Microcaps Trading on the NASDAQ and NYSE Exchanges?

In the past three years, some important changes have occurred to how “penny stocks” or “microcaps” trade and are regulated. By the early 2000s, they’d moved from the obscurity of the National Quotation Bureau’s Pink Sheets to a new trading platform, Cromwell Coulson’s Pink Link. 

The accompanying website, initially called Pink Sheets, made quotations much easier for interested traders to access and, as time passed, also offered the kind of detailed information about many non-reporting issuers that had never been available in the past. The Pink Sheets also published quotes and SEC filings for the so-called “OTCBB” issuers that did report to the regulator. Pink Sheets’ efforts were so successful that little more than a decade later, the OTCBB, which had been operated by the Financial Industry Regulatory Authority, went out of business. 

As the second decade of the new century began, Pink Sheets had been renamed “OTC Markets Group,” and “Pink Link” was called “OTC Link.” Coulson’s business had grown and was by then a public company itself, trading in its own marketplace. Penny stocks were enormously popular with the increasingly large number of people who managed their investments on the Internet, and online brokerages like E*TRADE, TD Ameritrade, and Fidelity commanded a growing share of the securities markets. 

Penny stocks themselves were different. Back in the ‘90s, nearly all had been worth actual pennies, not fractions of pennies. But with the turn of the century came a decision by the SEC to require all OTCBB issuers to become current with their required periodic reports if they were not, or to register a class of stock if they’d never done so. Any that declined to do so would be delisted to the Pinks, which was considered an unthinkable fate by many. The delinquent filers and non-filers among the OTCBB were sorted into alphabetical groups and scheduled for successive compliance if they wished to remain on the Bulletin Board. 

Once the fear of the unfamiliar subsided, many new Pinks came to realize their altered status wasn’t so bad after all. They no longer had to think about the costs or the potential results of audits. They could release no more information than they wished to investors and the public. Professional promoters could be as creative as they liked. 

The penny market was seen by most as the Wild West of investing. Players won and lost on the scams, and cults were born in the ruins of some plungers’ dreams. One result was that when the dust cleared, most penny issuers traded in fractions of cents, often even in hundredths of cents. Few people in the game honestly expected their shares to appreciate to pennies and then dollars; they merely hoped the play would run hard before it crashed and burned.

Back in the ‘90s, most OTC issuers had low floats. Incredible as it may seem to those accustomed to today’s markets, most pennies of the time had fewer than 10 million shares of common stock. But as the turn of the new century came and went without “Y2K” technological problems bringing the world to an end, yet more enthusiastic players jumped into the market, many of them interested in buying big positions in really cheap stocks. They could buy tens of millions of shares of stock at, say, $0.0003, so why shouldn’t they? 

The outstanding shares of many issuers grew by leaps and bounds. Financiers offering to purchase market adjustable securities—preferred stock, warrants, or promissory notes that were convertible to common stock—increased in number as more and more people realized trafficking in them was nearly like printing money. CEOs in need of cash would go to the well, again and again, often dealing with three or more funders simultaneously. The eventual result was dilution that took the stocks in question to depths from which no promotion could rescue it. 

Once the management of CMKM Diamonds Inc. (fka CMKX) had succeeded in selling more than 700 billion shares into the market in 2003-2004, the shareholders of less extravagant issuers didn’t turn a hair at shares outstanding in the billions. But eventually, enough was enough. CMKX was a cult stock whose investors believed in it with religious fervor, but that was not the case with most other diluted pennies. A solution that worked for many was sequential reverse splits. Company leaders would dump as much stock as they felt they needed to keep the enterprise afloat, and when the market would bear no more, they’d set up a hefty reverse split. Some were (and still are) as large as 1:1,000. As soon as the split became effective, management would call its toxic funders and begin to dilute all over again. 

Many of these issuers would eventually become shells and be abandoned by their management. Not to worry: once they’d lain dormant for a year or so, they could be acquired by a shell vendor, “cleaned up,” and then resold to a private company looking to go public through what it hoped would be a quick and inexpensive reverse merger. And the cycle would begin again. 

Exchange-Listed Non-Investment Grade Stocks

While “investment grade” issuers may to some extent be in the eye of the beholder—after all, it’s every investor’s dream to spot a critical mispricing that results in enormous gains—exchange-listed stocks have long been considered of better quality than their OTC counterparts. 

Traditionally, they go public through Initial Public Offerings (IPOs) that involve the participation and guidance of investment banks with deep pockets and vast experience. They conduct extensive road shows through which they meet influential members of the national and sometimes international financial community. They attract the attention of the press and the public. They should, then, be “better,” should they not? Free of the problems that have plagued OTC issuers for decades: fully transparent, adequately funded and regularly trading above their exchange’s minimum requirement, with no signs of manipulation and toxic financing. 

That expectation, in which the average investor could once place confidence, is no longer a given. Two things seem to have happened over the past 10 years or so. First, the SEC took on the professional promoters who worked with company insiders to pump and dump OTC stocks, often while controlling the float. A case in point, though there are many others, is the enormously profitable and popular Awesome Penny Stocks group led by Canadians John Babikian and Eric Van Nguyen and backed by a variety of wealthy people with money to invest in profitable securities manipulations. Several crooked offshore brokerages joined in the fun. The SEC pulled the plug on all that in 2013 and continued the cleanup into the following years. Several of the group’s more prominent members went to prison; others got off lightly in exchange for testimony against their fellows. Babikian and Nguyen left North America and have never been arrested. 

Awesome Penny Stocks was as popular with penny players as it was with sleazy insiders and other malefactors. They were aware they’d have to content themselves with leftovers once the alpha beasts had fed, and they were happy with that. The APS plays were, with a few notable exceptions, well-run and predictable. Fans believed that if they played “correctly”—took profits early and then went back for a second, though smaller, helping—the stocks would offer consistent winnings. 

Once the SEC had cracked down on APS, it continued on to other professional promoters.  By the end of the decade, the survivors had moved into the shadows and been replaced, for the most part, by amateurs and semi-pros. 

The Commission also set its sights on the toxic funders, charging them and the business entities they operated as unregistered dealers under the Securities Exchange Act of 1934. So far, the actions it’s brought have been successful. Depriving needy issuers of their potential promoters and financiers was to cut off their lifeblood; many did not survive. The kind of stocks most market observers think of when they think of penny stocks were struggling. 

In late 2019, the Commission struck another blow when it introduced proposed amendments to Rule 15c2-11, which affects only OTC issuers and is administered by FINRA. In its final form, the rule was changed to eliminate, or at least greatly reduce, the number of public shells changing hands. 

This was a particularly important issue in the OTC market because the SEC had no way of forcing an abandoned public shell—known as a “zombie ticker”—to stop trading. Ultimately, it changed the rule so that these shell companies, along with all other OTC companies, would be required to make “current information” from some time within the past 16 months publicly available. In most cases, that meant the companies would make disclosure using OTC Markets’ Disclosure and News Service. 

The compliance date for the new rule was September 28, 2021. While the new rule didn’t materially affect the securities trading in the higher OTC Markets tiers, more than 3,000 shell companies were delisted to the Grey (or, as OTC Markets calls it, the Expert) Market. Grey/Expert stocks cannot have published quotations. At least for now, U.S. brokers will allow their clients to sell but not buy those securities.

FINRA Raises the Alarm

Even before the effects of the changes to Rule 15c2-11 had been felt, the OTC market was losing its appeal for many. Or perhaps it would be more accurate to say it had been bypassed by a significant group of new investors. They appeared in 2020, along with COVID-19, and became known as the “Meme Stock” players. Nearly all of them were newcomers to the financial markets, and they seemed not to feel it was important for them to learn how they worked, as earlier generations had done. 

They chose stocks for reasons not always clearly explained and expressed their approbation by using memes in their social media communications. As admirers of the movie Return to the Planet of the Apes, they called themselves “APES” and claimed to turn over difficult thinking to the “wrinkle brains.”

What is significant for the purposes of this discussion is that the stocks they selected were all exchange-listed securities. GameStop Corporation (GME) and AMC Entertainment (AMC) traded on the NYSE, some on the Nasdaq, and others popularized a bit later, were “bankruptcy plays” doomed to eventual liquidation, along with the cancellation of their common stock. But none of those objections made any difference to the APES. They were interested in one thing only: short squeezes. And squeeze many of their picks did, simply because there were so many APES, and nearly all of them were willing to follow the group’s plan and further inclined to believe in theories so outlandish nothing of the kind had been heard since the heyday of CMKX.

In the short term, their tactics worked. GME rose from $2.57 in April 2020 to reach an intraday high of $483 on January 28, 2021. Its climb was fueled by an insane theory suggesting that GME stock would someday become a kind of universal currency worth $500 billion a share. And owned only by APES, of course.

Rational market observers and participants had long put up with some penny stock shenanigans. Still, just as the regulators were beginning to get them under control, the action, to everyone’s surprise, moved to the exchanges. The meme stock phenomenon was discussed ad nauseam in the press, but no one knew how to deal with a very large number of smug APES. 

On November 17, 2022, FINRA stepped into the fray, warning its member firms of a “heightened threat of fraud” in small-cap IPOs. It explains that it, the NSYE, and the Nasdaq:

have observed initial public offerings (IPOs) for certain small capitalization (small-cap) issuers listed on U.S. stock exchanges that may be the subject of pump-and-dump-like schemes (sometimes referred to as “ramp-and-dump” schemes in other jurisdictions). FINRA has observed significant unusual price increases on the day of or shortly after the IPOs of certain small-cap issuers, most of which involve issuers with operations in other countries. FINRA has concerns regarding potential nominee accounts2 that invest in the small-cap IPOs and subsequently engage in apparent manipulative limit order and trading activity. Some of the investors harmed by ramp-and-dump schemes appear to be victims of social media scams.

[“Ramp and dump” is a term used in Hong Kong and other Asian financial centers.]

FINRA sees tactics used in the exchanges that are familiar from the days of Awesome Penny Stocks plays on the U.S. OTC market in the early 2010s: issuers with low market cap, the allocation of significant amounts of IPO shares to foreign broker-dealers, allocation of shares to a small number of IPO investors, extensive use of foreign omnibus accounts, price spikes and drops reminiscent of pump and dump operations, and the use of social media to draw in potential investors. FINRA ends its explanation and warning by asking underwriters to act as gatekeepers and report any suspicious transactions.

OTC Markets Group Expresses Its Concern

OTC Markets Group has discussed the subject of problematic exchange-listed IPOs and issuer activity twice in recent months. First, in 2022, it conducted a study of companies with market caps below $300 million at the time of their IPO. It concluded that these issuers may have believed choosing a “real” IPO would be the perfect way for them to go public, only to discover that doing so worsened, not bettered, their prospects.

The study evaluated…

the performance of all IPOs that went to the NASDAQ CM and NYSE AMEX markets in 2022. A total of 91 deals were reviewed. The average market cap of this group of companies was $213 million the day after the offering. 28 days post the offering, the average was $102 million, and the current average sits at $56 million. This analysis included traditional IPOs as well as IPOs by issuers that uplisted from OTC Markets with the key findings as of August 2023. 

Those findings were not encouraging for any small company considering listing on an exchange:

  • 92% of IPOs demonstrated a negative rate of return from their offer price, with the overall average total return of -64.8%
  • 34% of companies appeared on an exchange non-compliance list post-IPO
  • 51% of companies completed reverse splits either prior to their IPO or after their IPO
  • Five bankers accounted for over half (51%) of smaller IPOs in 2022, with five law firms advising over one-quarter (26%) of transactions
  • Two-thirds of these deals included banker warrants

We agree with OTC Markets: the companies studied paid too high a price for a listing process that was perhaps too complex and too expensive for them. We’ve seen many examples of OTC issuers that decide to “uplist” to an exchange, believing it will be a prestigious step forward for them, only to find themselves back on the OTC two or three years later, having lost money and investors in the process. 

In a second blog entry, this from the end of November, Cromwell Coulson says he’s seen the OTC Market transformed “from an opaque, paper-based system to a fully regulated market designed to meet the needs of global companies, community banks and early-stage venture companies. Frustratingly though, an outdated narrative still exists. One where the OTC market is portrayed as the Wild West or the Wolf of Wall Street and everything that is traded on an exchange is deemed ‘safe.'”  

That is fair enough. OTC Markets isn’t perfect, but over the past 25 years, it’s seen to the creation of electronic trade execution for the securities it deals in, which has brought OTC trading out of the Dark Ages. Though sometimes expensive, the services it offers issuers are intended to encourage them to become more transparent, providing more and more information to investors. As Coulson points out, OTCM has launched initiatives to persuade transfer agents to make regular disclosure of changes in their clients’ share structure and has further strongly encouraged issuers to make specific disclosures about convertible debt. Still, critics only want to talk about problems.

He also notes that he believes it’s appropriate that OTC Markets is not an SRO (self-regulatory organization) nor a commercial market operator. (As discussed above, it once was the operator of the OTCBB but has finally managed to dismantle it.) Why not take that further?

With SEC rules soon requiring every broker-dealer to be a FINRA member firm, it is worth considering if market-wide fraud and manipulation surveillance should be split off from exchange SRO’s and consolidated with FINRA. Expanding the mandate of FINRA’s Market Investigation Team would let a regulator without conflicts chase bad guys. Exchange SRO activities can focus on regulating trading on their systems and overseeing issuers’ compliance with listing and disclosure standards.

That is not a bad idea, but we think it’s unlikely to happen. Coulson is certainly correct when he says that while the exchanges “used to quickly delist companies that fail to publish financial reports or file for bankruptcy quickly, they now seek to retain these companies for as long as possible.”

The Nasdaq Modifies Its Delisting Process

Why delistings now take so long continues to confound, given that three years ago, the Nasdaq proposed a new rule that automatically became effective after some modification. It was submitted to the SEC, which is the Nasdaq’s regulator, as:

Order Approving a Proposed Rule Change to Modify the Delisting Process for Securities with a Bid Price at or Below $0.10 and for

Securities that Have Had One or More Reverse Stock Splits with a Cumulative Ratio of 250 Shares or More to One over the Prior Two-Year Period

The rule change was initially proposed on January 15, 2020. It was then adopted by the SEC on April 21, but implementation of some of its elements was delayed until September because of the COVID crisis. But… even now, is it regularly applied? 

Nasdaq delistings seem to take a very long time. Before the amended rule, the issuer would get a delisting notice if its bid price fell below $1.00 for a period of 30 consecutive business days. It then had 180 calendar days to regain compliance by maintaining a $1.00 bid price for a minimum of 10 consecutive business days. Nasdaq Capital Market companies could then request another 180-calendar-day extension. 

The new rule does not seem to be much better than the old one. If troubled companies know they can request a series of extensions, they will request those extensions. Nasdaq has warned that if the company has a “very low” bid price, it may not be granted the second extension in some circumstances. It is obvious from the way this material is presented that the exchange wants to avoid situations in which it will find itself dealing with issuers hanging on to their listings by going through successive reverse splits. 

To deal with that, the new rule provides that delisting will be expedited for “securities that have had one or more reverse stock splits with a cumulative ratio of one for 250 or more shares over the prior two-year period.” That makes excellent sense, as it prevents any issuer from doing enough splits to preserve its listing, but not enough to trigger a one-time limit. They now must think twice about resorting to an action so punitive to investors. What is not good is that the restricted period is only two years. Five would be better.

Are these new rules being applied now? We haven’t investigated, but delistings seem as slow as ever. Coulson remarks with disappointment that “over 700 still-listed companies are currently marked as non-compliant with Nasdaq or NYSE exchange listing standards.” Our senior national exchanges really ought to try harder.


To speak with a Securities Attorney, please contact Brenda Hamilton at 200 E Palmetto Rd, Suite 103, Boca Raton, Florida, (561) 416-8956, or by email at [email protected]. This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as and does not constitute legal advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.

Hamilton & Associates | Securities Attorneys
Brenda Hamilton, Securities Attorney
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Boca Raton, Florida 33432
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