Pennaluna Prospector™
Penny stocks refused for deposit
- why it's happening now, how to cope

Tom Wobker
Apr 13, 2012

Summary

• New fed war on fraud and money laundering hits the innocent too.
• Penny stocks now more often refused for deposit
• SEC mounts combined attack with FINRA, DTCC
• Average investor normally OK - but new paperwork, delay, costs
• Management, insiders, promoters undergo special scrutiny
• How to avoid some of the new headaches

A new government offensive against microcap fraud and money laundering is aimed at crooks and evildoers. But the attack is also creating problems for innocent people who own low priced shares.

As brokers and clearing firms run for cover under a barrage of new microcap compliance dictates, the collateral damage inflicted by the federal assault ranges from inconvenience to major trouble.

The list of bystanders who can be hit by errant regulatory shrapnel includes:

• Consultants and service providers who take stock for services
• Private placement investors (mainly if they keep poor records or are insiders)
• Employees who get stock for pay, incentives or bonuses
• Officers, directors, large shareholders
• IR pros, newsletter and website writers
• Folks who hold physical stock certificates (subject to closer inspection now)

The crackdown started, or at least coalesced, last year with formation of the SEC's Microcap Fraud Working Group. (More on that in a moment.)

More scrutiny

Since then, investors who want to deposit low priced small cap stock into their accounts -- as distinct from simply buying or selling it -- have routinely faced increased questioning. There is more paperwork, scrutiny, delays for more compliance approvals, and sometimes expense.

While the hurdles to be cleared are higher than before, penny stock deposited by John Q. Public shareholder is still generally accepted. But more than in the past, it also stands a real chance of rejection.

While the new offensive may present added inconvenience for the average investor, it promises much larger problems for company executives, directors, and other insiders since their transactions now face far more stringent examination.

And stock promoters, investor relations consultants, and some newsletter and website writers -- because of their promotional work -- may find their shares won't be accepted under any circumstances.

Safe havens?

Let's be clear. This isn't panic time for every investor who decides to buy, sell or own microcap stock.

At our shop and others, most ordinary investors aren't running into major roadblocks.

For instance, well-documented restricted stock from most private placements hasn't been greatly impacted.

Transactions may take extra time and work and minimum price requirements sometimes complicate things (see below). However, at this point we generally see few major problems for investors who deposit cheap stock like the following:

• U.S. restricted stock in reasonable quantity owned by non-insider investors who can document acquisition
• Canadian free trading stock
• Canadian warrants
• Canadian restricted stock with documentation as to acquisition
• U.S. restricted or free-trading stock of companies for which the broker submitted the FINRA Form 211 (this is the process to get a stock quoted on the OTCBB and/or OTC Markets Group, formerly Pink Sheets)

But smooth sailing is not absolutely guaranteed -- and certainly not for officers, directors, insiders, promoters and others close to the issuing company, whose transactions now face detailed examination.

The "new normal" is fluid

The "new normal" for microcaps traded on the OTCBB and OTC Markets is changing and evolving even as you read this.

With the industry racing to comply, rules spawned by the crackdown are new and quite fluid. They vary among brokers and over time, often shaped by a firm's unique - perhaps unhappy - experience in this area.

Our suggestion: always ask your broker first about the rules currently in place before trying to deposit stock.

Following are the broad outlines of small cap stock deposit requirements across the industry as we see them presently.

There may be some outliers that don't fit this general pattern -- firms slow to adapt or trying to rig a workaround -- but government power will almost inevitably bring them into line.

More paperwork

One key change is that expanded stock purchase documentation is now generally required from owners before stock will be accepted for deposit.

Often they must complete written questionnaires about the stock... their purchase or other acquisition of it... and their relationship to the issuing company.

The size and quality of their account may be considered. Legal opinions may more often be required. New compliance review or other fees may be charged.

The issuing company is also examined. There's a sharpened focus on history, disclosure, management background, and stock trading patterns.

Upfront filters

Some securities firms now use a price test as a first filter. This helps them decide whether to take on the costs of compliance review and the legal and regulatory risks that can shadow low priced stock.

One big clearing outfit automatically rejects any stock priced under a dime. Another sets the bar at 75 cents.

Or the bright line test can be minimum market capitalization. At one firm, for example, that's now $25 million.

The type, quantity and quality of the issuing company's public disclosure of financial information is important too -- for instance, a firm might refuse any stock branded by OTC Markets with a Stop Sign, Gray Market or Caveat Emptor indicator.

Sometimes the test(s) are quirkier, leaning towards arbitrary, and including any or all of these and other elements.

Pre-approvals for transfers

Pre-approval reviews for incoming accounts are also common.

More clearing firms do advance checks of new accounts transferring in from other brokers (transfer of assets). They give thumbs up or down only after eyeing the stocks.

In most situations, if the stock... the owner... the issuer... the acquisition method... or anything else doesn't pass muster, the deposit is refused.

Physical or electronic - no difference

Difficulty depositing physical certificates isn't new. That got stickier some time ago with Wall Street's move toward "dematerialization," but doesn't seem tied to this new regulatory offensive. (We wrote an article about vanishing paper certs last year. It's here in pdf format.)

In contrast, the new changes generally apply no matter how you give the shares to your broker - whether in physical form or by electronic transfer.

Unlike dematerialization -- a move to improve efficiency -- this new regulatory drive springs from the Patriot Act; the Bank Secrecy Act; anti-money laundering regulations; fraud prevention initiatives; and other government mandates.

FINRA Regulatory Notice 09-05 figures in this too. It concerns unregistered resales of restricted shares and lists red flags for brokers. You can read it here.

SEC Microcap Fraud Working Group

The sparkplug that fires this new regulatory engine is the recently formed SEC Microcap Fraud Working Group, assembled during the past year or so.

The SEC says the powerful new task force is composed of elements drawn from many parts of the agency:

"staff from the SEC's headquarters in Washington D.C., each of its 11 regional offices, and from the Office of Market Intelligence, Division of Corporation Finance, Division of Risk, Strategy, and Financial Innovation, Office of General Counsel, Division of Trading and Markets, and the Division of Investment Management."

The SEC also explains -- in words worth a careful reading -- that the group:

"... is pursuing a strategic approach to combating microcap fraud by focusing on recidivists and insiders, and on the attorneys, auditors, broker-dealers, transfer agents and other gatekeepers that facilitate a large volume of the fraud in this sector."

The precise legal parameters of the new "strategic approach" remain to be defined. Who are the "other gatekeepers?" What exactly does "facilitate" mean?

Regulators apply pressure

The U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) are leading the charge and leaning on clearing firms to enlist in the new offensive.

And risk management and compliance staffs at clearing outfits are doing so... sometimes zealously.

Depository Trust & Clearing Corporation (DTCC) has also joined the crusade. The clearing, settlement and custody giant electronically touches nearly every security in the country. It has power to "chill" and thus restrict transfer of stock almost at will. You can read DTCC's embrace of the program on page 19 of its pdf newsletter here.

Of course brokers too are swept up in this offensive -- like drafted grunts choppered into a jungle firefight on orders from the brass, scrambling to stay alive.

SEC round table

You can get some feel for the power of the new government push by watching a round table discussion held by the SEC last October. The webcast is on the SEC website here.

Chaired by SEC head Mary Schapiro, participants came from government, regulatory agencies, clearing and settlement companies, law firms and private industry.

As the SEC explained, the meeting covered "...key regulatory issues, including anti-money laundering monitoring, compliance challenges, and potential changes to the microcap regulatory framework."

Since the discussion lasted over three-hours, you may find it more convenient to skim the transcript instead. It's here.

Ultimate result

It's hard to find anybody who is in favor of stock fraud... or money laundering, for that matter. But there seem to be two quite different views on the likely outcome of this new regulatory push.

Utopians expect the end result to be a sanitized small cap market largely free of fraud... populated by better-capitalized and more transparent small companies that offer investors a better marketplace.

Cynics believe the new initiative will inflict more damage on small firms already crippled by costly regulations, injure innocent investors and entrepreneurs, and hurt good companies along with bad... producing a we-had-to-destroy-the-village in-order-to-save-it outcome.

Time will tell. But for the immediate future, you can bet that depositing cheap stock will be more complicated than it ever has been.

Deposit tips

Small cap U.S. and Canadian mining and resource stocks and other microcaps are part of our business, so we're keeping a close eye on developments.

Based on what we see right now, here are points to keep in mind about depositing microcap stock. We assume the stock passes any price or market cap test.

These factors can make deposit easier

• Talk to your broker first. This is key. Compliance rules are changing faster than Idaho weather, so you should find out what rules apply currently at your brokerage firm.
• You have an established account. The longer you've been with a firm, the more likely your request will be viewed favorably. If you opened an account yesterday and want to deposit a big pile of five-cent stock today, you may face problems.
• Your portfolio also has some high-value shares or significant cash. Clearing firms aren't crazy about accounts that hold only microcaps.
• Your documentation is thorough, showing how you acquired the stock and your exact relationship with the company - are you an insider or just average Joe investor? (Especially important: copies of private placement memorandums and subscription agreements; service and/or consulting contracts; employment or incentive agreements.)
• The company's public financial disclosure is of good quality and quantity.

These factors can make it tougher

• You're a company insider -- officer, director, 10% shareholder or otherwise exercise control.
• You're a stock promoter, IR consultant, financial newsletter or website writer.
• The company has a history of name changes, industry changes or securities problems.
• Company management or large shareholders have a record of prior securities violations or serious legal infractions.
• Stock ownership is concentrated in few hands.
• The company's public financial disclosure is of poor quality or quantity.
• Your stock came from a debt to equity conversion. (Extra tough.)

A last word

Our best advice, once again: before you try to deposit cheap stock into your account or transfer a portfolio of cheap stock to a new firm, be sure to contact your broker or new firm in advance.

This will simplify your life in the evolving new normal, save you time and spare you some headaches and disappointment -- and, we hope, help you make a lot of money in the volatile small cap market.

Thanks for reading. We'll see you next time.

"In politics stupidity is not a handicap."
-Napolean Bonaparte (1769-1821)

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Editor Tom Wobker holds degrees in journalism and law from the University of Kansas.

Founded in 1926, Pennaluna trades stocks on all U.S. and Canadian exchanges, Nasdaq, OTCBB and Pink Sheets.

Phone 800-535-5329 or visit www.pennaluna.com.

For online trading see www.penntrade.com.

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Disclosure: Pennaluna & Company is a FINRA broker-dealer and market maker. As such, it frequently buys or sells stocks for its own account, or in order to make a market. Consequently, Pennaluna may at any time buy or sell or make a market in any stock mentioned herein, and associated persons may also buy, sell or hold such stock at any time. The firm and/or associated persons may also engage in private placements or other investment banking activities with any company mentioned. Some securities mentioned may be small-cap stocks and subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information; some may be foreign securities and subject in addition to currency, political and other risks. Mention of a security does not imply an endorsement. Comments and opinions are solely those of the writer. This publication is not investment advice; is not a research report and provides insufficient information upon which to base investment decisions; is intended solely to provide readers with information; is not a solicitation for the purchase or sale of any security; and is not intended to be nor should it be used as tax advice, which should be sought from a professional familiar with your individual financial situation. Mention of a company or stock does not in any manner constitute a recommendation, unless specifically so stated. Information is believed accurate but accuracy is not guaranteed. Any websites mentioned other than www.pennaluna.com and www.penntrade.com are not under the control of the firm and it can take no responsibility for information found on such sites.

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