Shifting Capital Markets; Bank of America’s Merrill Lynch Exits the Penny Stock Business
Posted by Securities Attorney Laura Anthony | October 23, 2018 Tags:

There is a strange dichotomy building in the capital markets and what some are calling a clearing firm crisis. At the same time that the world of penny stocks and low-priced securities is on shaky ground with regulators and market participants, the U.S. is trying to regenerate the IPO marketplace, and a whole world of cryptocurrency investments and global trading continues to flourish. However, the IPO market cannot flourish for small companies if stockholders cannot clear their securities and sell into a secondary market. Recently, penny stocks have experienced a one-two punch that leaves me, and many of my colleagues, wondering how the marketplace will respond and evolve. Furthermore, as the inevitable birth of securities tokens and an actual licensed operational securities token exchange looms on the near-term horizon, it is clear we are at the precipice of experiencing fundamental changes in the capital markets.

Background on Penny Stocks

Penny stocks and low-priced securities have always been considered speculative and risky investments, with the potential for large swings in value, thus enticing investors with an appetite for risk. As a result of the risk associated with penny stock trading, Congress enacted the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (the “Penny Stock Act”) requiring the SEC to enact rules requiring brokers or dealers to provide disclosures to customers affecting trades in penny stocks.  The rules prohibit broker-dealers from effecting transactions in penny stocks unless they comply with certain stringent rules, including providing a Schedule 15G risk disclosure document. Since enactment of the Penny Stock Act, broker-dealers do not recommend or solicit transactions in penny stocks, but have, at least until recently, effectuated client-requested transactions. For more information on the penny stock rules, see HERE.

A penny stock is defined in Exchange Act Rule 3a51-1.  Like many SEC rules, the penny stock rule begins by including all equity securities and then carves out exemptions (for example, all offers and sales of securities must be registered unless an exemption applies).  In particular, Rule 3a51-1 defines a penny stock as any equity security other than:

(a)    A NMS (national market system) stock that is a reported security that is (i) registered on a national securities exchange that is grandfathered in because it has been in continuous operation since prior to April 20, 1992; or (ii) is quoted on either a national securities exchange or automated quotation system that that has certain quantitative initial listing standards and continued listing standards that are reasonably related to the initial listing standards. The listing standards must meet or exceed the following criteria: (a) the issuer must have $5 million of stockholders’ equity, market value of listed securities of $50 million for 90 consecutive days prior to applying, or net income of $750,000 (excluding extraordinary or non-recurring items) in the most recently completed fiscal year or in two or the last three most recently completed fiscal years; (b) the issuer must have an operating history of at least one year or a market value of listed securities of $50 million; (c) the issuer’s stock must have a minimum bid price of $4 per share; (d) there shall be at least 300 round lot holders of common stock; and (e) there must be at least 1,000,000 publicly held common shares with a market value of at least $5 million;

(b)    Is issued by an investment company registered under the Investment Company Act of 1940, as amended;

(c)    Is a put or call option issued by the Options Clearing Corporation;

(d)    Has an inside bid quotation price of $5.00 (the Rule requires that the price be net of broker or dealer commissions, mark-up or mark-downs);

(e)    Is registered, or approved for registration upon notice of issuance, on a national securities exchange that makes price and volume transaction reports available, subject to restrictions provided in the rule;

(f)     Is a security futures product listed on a national securities exchange or an automated quotation system sponsored by a registered national securities association; or

(g)    Whose issuer has: (i) net tangible assets (as calculated in accordance with the rule) in excess of $2 million, if the issuer has been in continuous operation for at least three years, or $5 million, if the issuer has been in continuous operation for less than three years; or (ii) average revenue (as calculated in accordance with the rule) of at least $6 million for the last three years.

In reading the definition of a penny stock, it mainly includes those that do not trade on a national exchange or rather those that do trade on the OTC Markets. Both the Nasdaq and NYSE American have initial listing standards that generally fit within the exclusion from the definition of a penny stock; however, the continued listing requirements would allow a company to fail to meet the net tangible assets and revenue tests or otherwise fail to fall within one of the Rule 3a51-1 exclusions. Nasdaq actually publishes a daily list of those companies that it believes are considered a penny stock and subject to the Penny Stock Act.

Which leaves OTC Markets. The SEC has been unfavorable to OTC Markets in the past, which is somewhat understandable as it has undeniably been a forum for fraud, but it is also undeniably a venture and growth market for solid companies seeking to access capital markets. OTC Markets and its management group have been working hard to gain favor with the SEC and initiate regulatory changes that would help reduce micro-cap fraud.

The SEC has always publicly fought a battle against micro-cap fraud and back in December 2016, it published an antagonistic white paper detailing the risks associated with investing in OTC Markets securities. I blogged about the white paper at the time (see HERE), including my issues with its framework, lack of understanding of the multiple tiers of trading on OTC Markets (OTC Pink, OTCQB and OTCQX) and data sources (i.e., SEC enforcement actions). Furthermore, the SEC was the impetus behind FINRA’s withdrawal of its request to delete the OTCBB and later proposal to expand its operations. See HERE, though as of today, this proposal remains just that: a proposal. Despite some temporary negative publicity, the white paper did not appear to impact the OTC Markets’ business.

Both before and after the white paper, the OTC Markets has continued to make self-regulating changes to its marketplace, including adding various “flags” such as the “shell risk” and “stock promotion” flags. The “shell risk” designation indicates that a company displays characteristics common to shell companies. This designation is made at OTC Markets’ sole and absolute discretion based on an analysis of the company’s annual financial data and may differ from a company’s self-reported shell classifications in their own public filings. For more on the OTC Markets stock promotion policy, see HERE.

Moreover, OTC Markets has added quantitative and qualitative listing requirements for both the OTCQB and OTCQX, such as a minimum number of shareholders and public float (see HERE), IPO listing standards (see HERE) and change of control re-application procedures (see HERE). Effective January 1, 2019 OTC Markets is also requiring all OTCQB and OTCQX companies to provide verified share data directly to OTC Markets through a transfer agent that participates in its Transfer Agent Verified Shares Program (blog coming).

In March of this year, OTC Markets made a presentation to the SEC’s Investor Advisory Committee (“IAC”) as part of a panel on “Discussion of Regulatory Approaches to Combat Retail Investor Fraud.” During the meeting, Mr. Coulson discussed the most serious market risks and presented a list of 14 OTC Markets regulatory recommendations to improve disclosure and combat these market risks. The recommendations include items that could increase the liquidity and facilitate capital formation, but also include recommendations to improve regulatory responsiveness and reduce fraud. For more on Coulson’s presentation and a complete list of the 14 regulatory recommendations, see HERE.

Also, on September 26, 2018, OTC Markets took part in the SEC’s Roundtable on Regulatory Approaches to Combating Retail Investor Fraud hosted by the SEC Division of Trading and Markets, at which Cromwell Coulson and OTC Markets General Counsel Dan Zinn both sat on panels focused on combating fraud and stock manipulation.

Despite these self-regulating and lobbying efforts, recent developments have leveled an attack on the marketplace.

Recent Developments

Bank of America’s Merrill Lynch bans penny stocks

Bank of America’s Merrill Lynch brokerage division has shut down business in penny stocks. The big wire house has told its customers, including its 17,442 financing advisors, that it will no longer allow any transactions involving the purchase of securities that are priced below $5.00 per share and that trade on the OTC Markets. This change went into effect in July of this year, but many clients were not informed until they tried to execute a purchase order. Effective September 30, the company has also added increased compliance controls for all securities that are under $5.00 per share with a market capitalization under $300 million, regardless of where they trade. Although at first the firm indicated it would likewise prevent sales of such securities, it has since loosened that policy to allow for the orderly sell-off and/or transfer to other firms of these low-priced securities. Bank of America is the first major wirehouse to completely restrict transactions in penny stocks.

Clients and financial advisors have been trying to figure out the best way to sell off or transfer their holdings to other firms.  The increased compliance controls cause a delay in execution of sell orders, and not all sales will be allowed. For example, the wirehouse will not allow any sales of a security designated with a skull and crossbones on the OTC Markets website. As discussed below, moving the securities to another brokerage or clearing house has its own hurdles as others restrict deposits as well.

The move is surprising even though CEO Brian Moynihan is publicly conservative. I certainly can understand greater compliance controls and increased scrutiny over suspicious activity, but am surprised to see the bank shut down an entire asset class. The company is likewise averse to cryptocurrencies, having halted clients from using credit cards to purchase bitcoin and other cryptos back in February of this year.

Cor Clearing Exits the Penny Stock Business

In a settled enforcement proceeding with the SEC published on September 28, 2018, Cor Clearing, LLC (“COR”) has agreed to exit the penny stock business, agreeing not to effectuate any sales in any equity security that does not trade on a national securities exchange and trades at a price of less than $5 per share subject to certain limited exceptions. In other words, COR has ceased trading in OTC Markets securities below $5.00 per share. The limited exceptions in which COR may execute a sell order include:

(a) COR obtains and retains a trade confirmation evidencing that the securities were purchased on the open market as opposed to having been deposited at COR another broker-dealer;

(b) The securities are exemption from the Securities Act registration requirements under Section 3(a)(2) (i.e., a security issued or guaranteed by a governmental body) or Section 3(a)(5) (i.e., a security issued by a savings and loan, farmer’s coop or charitable organization), or the securities are defined as government securities under Section 3(a)(42) of the Exchange Act;

(c) The security is an unsponsored American Depository Receipt (ADR); or

(d) The aggregate value of the sale of the securities of any particular company is less than $10,000 and the customer has not availed itself of this exception within the last three months in any account in the name of the customer or in which it has a beneficial interest.

The SEC investigation involved the failure by COR to file suspicious activity reports (SAR’s) related to the trading in customer accounts. For more on a broker’s responsibility to file SARs, see HERE  and HERE This order has had and will continue to have, at least for the short term, a significant impact on the trading in OTC Markets securities. COR was one of the largest clearing firms in the penny stock marketplace, where few others play. In fact, only a small handful of clearing firms actively, or did actively, participate in the penny stock marketplace on a regular basis.  In 2016, the year that triggered the SEC enforcement investigation, COR ranked second among all broker-dealers in the total dollar value of sub-$1 penny stocks that it cleared. Alpine ranked first, and they have their own issue as discussed below.  Additionally, the vast majority of COR’s clearing activity in penny stocks was on behalf of introducing broker-dealers, which are now scrambling for a new clearing arrangement or likewise exiting the penny stock business.

Within days of the SEC’s Order, it was announced that COR has entered into a contract to be sold to Axos Financial. The acquisition is expected to close in early 2019. Although Axos expects to have a presence in low-priced securities, it will be subject to the SEC order related to COR’s activities.  It will be interesting to see how the business evolves. Up to now, Axos has operated more of a traditional bank (BofI Federal Bank) with customer deposits and the majority of income generated from loan activity, including mortgages.

Alpine Securities

In June 2017, the SEC filed a complaint in the United States District of New York against Alpine Securities Corporation, claiming a violation of the same activity in the COR matter, and in particular the failure to file suspicious activity reports (SARs) for penny stock transactions. The SEC is seeking $20,000,000 in fines and penalties, including injunctive relief.  Unlike COR, Alpine decided to fight the SEC action and proceed with litigation. However, in April 2018, the SEC won a partial summary judgment against Alpine on all but one of their claims, and Alpine appealed. Litigation continues with Alpine’s survival at stake – literally – if the SEC wins, it is likely Alpine will no longer be able to continue in business.

In April, around the time the SEC won its partial summary judgment, Alpine lost its X-clearing arrangement with Merrill Lynch. Trades in securities are deemed “X-Clearing” when they are settled outside of the DTCC FAST system. DTC’s subsidiary, the National Securities Clearing Corp (NSCC), charges large “illiquid fees” for the clearing of securities that are low-priced and not traded on a national exchange (for more on the settlement and clearing process and the role of the NSCC, see HERE and HERE). To manage these charges, small clearinghouses such as Alpine can enter into arrangements with larger clearinghouses that can clear the securities for them outside of the DTC system. As a result of losing its x-clearing arrangement, Alpine no longer processes transactions for securities priced below $0.10.

In an effort to assist Alpine Securities with its twofold predicaments, a special purpose vehicle has been set up to raise funds privately, which funds will be used to invest in SCA Clearing, LLC, the holding company for Alpine Securities. The purpose of the investment will be to increase Alpine’s net capital so that it can reduce its NSCC illiquid charges. Although I have no direct knowledge of the status of the private offering, I find it difficult to imagine that investors will invest in light of the risk imposed by the SEC litigation.

Inevitable Securities Token Exchange

I’ve written a lot on blockchain, cryptocurrencies and my belief that a change in capital markets is inevitable. I believe that the sale of digital assets as a security is here to stay and that several of the companies that claim to be seeking proper registration and licensing to operate a secondary marketplace for the trading of these digital assets, will succeed. FINRA is actively working with broker-dealers and licensed ATSs to figure out the operations, compliance and regulatory aspects of an operational exchange (see HERE). Furthermore, the SEC has proven that it will take enforcement action against those that operate without such appropriate licenses (see HERE).

However, the vast majority of the companies that are issuing crypto and securities tokens are very early-stage with valuations that, even if inflated today, will adjust to reasonable levels. That is, the vast majority of crypto and securities tokens, are and will be, just another form of a penny stock.  As quickly as clearing firms exit the penny stock marketplace, a new platform is building to provide an alternative. The race is on for the first entrant with T-Zero, Coinbase, Templum, SharesPost and others all vying for the prize.

I don’t know which clearing firms will be involved in the trading and clearing of securities tokens on individual ATSs, but I believe it will be new players that are working with individual ATSs as I write this. Also, it could be that the trading on a particular ATS will be siloed such that the trading of a security token on one ATS will be independent from the trading of that same token on another ATS. A clearing firm could be tied to a particular ATS, which in turn is run by a single broker-dealer, creating multiple individual marketplaces. That is how it works on crypto-exchanges today, which is why, for example, bitcoin can be a slightly different price or rise and fall in different patterns on different exchanges.


During an industry life cycle, it is normal to see the rise and fall of key participants; Lehman Brothers and others have once been too big to fail and plenty of smaller players have closed their doors along the way. Likely, this is a similar scenario for clearing firms and new players will see the opportunity and enter the penny stock marketplace. OTC Markets is invariably working hard to help its customers, and their stockholders, have the ability to gain liquidity. However, with the rise of alternative markets, it will be interesting to see the changes that take place over the next few years.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of, the OTC Market’s top source for industry news, and the producer and host of, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.

This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.

© Legal & Compliance, LLC 2018

Copy of Logo

« »