SEC must take action on penny stock listing

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The writer is the chief market policy officer at IEX

To function effectively, the stock market depends on trust. As part of this principle, investors trust that exchanges will establish, maintain and enforce reasonable listing standards.

But that confidence has been undermined in recent years as the number of cheap and highly speculative stocks that have remained listed has exploded. This trend hurts investors, shakes investor confidence and undermines the credibility of our markets. The Securities and Exchange Commission can and should take steps to reverse it.

The trend is clear. From the beginning of 2021 to the end of 2023, the number of public limited liability companies listed on a stock exchange increased from less than a dozen to well over 500. In part, this can be explained by the lagged effects of the “boom of the mini-IPO” that developed at the end of 2020 and until 2021.

It is generally accepted that a stock price below $1 is often an indicator of financial stress and correlates with higher volatility and greater risk of loss for investors. Such issuers often have ambiguous business models and uncertain revenues, and feature capital structures that allow insiders to convert their interests into common stock at a very favorable rate—an action that dilutes and substantially reduces the value of shares held by common investors.

In many cases, issuers are based offshore in countries with lower corporate governance protections than exist in the US. Trading in these stocks is often plagued by fraud and manipulation, fueled by anonymous activity on social media or other means.

These risks exist for all penny stocks, but by remaining listed, issuers can reach a wider group of investors because listing on a single market has the right to trade on each of the 16 registered exchanges. Unscrupulous promoters can and do point to the scholarship list to provide false comfort.

Recent experience has shown that the existing listing rules are not fulfilling their purpose of protecting ordinary investors in this area. First, they do not exclude companies that facilitate the insider’s ability to receive stock on terms that substantially dilute the interests of others. And when companies fail to meet share price and other minimums, they can easily remain listed for a year or more.

For example, under Nasdaq rules, companies receive notice of possible delisting if their stock price falls below $1 for 30 consecutive trading days, but if the stock breaks the threshold on just one of those days, the clock resets . Once the company fails this test, it is given a 180-day grace period to come into compliance, which is often extended by another 180 days. At the end of this process, the company can appeal a delisting decision, further extending a final calculation.

Finally, companies can often avoid delisting by completing a “reverse split,” which simply reduces the amount of available stock by some mathematical proportion. A reduction in available shares usually increases the price per share, but does not change the fundamentals and can actually hurt shareholders, as these actions are often viewed as negative market signals. The use of reverse splits has grown substantially as penny stocks have grown, reaching nearly 500 in 2023, a 72% increase from 2022.

To address the issue, trading firm Virtu Financial asked the SEC to take action. First, the petition calls for limits on the amount of public shareholder dilution that listed companies can afford. Second, it calls on the Commission to substantially reduce the time it takes for sub-dollar stocks to meet the price standard. Third, it calls for measures to limit the ability of companies to use reverse stock splits to evade compliance. Fourth, it requires exchanges to better monitor stock price manipulation.

Finally, the petition asks the SEC to improve corporate disclosures to better inform investors how much their shares could be diluted if originators and promoters fully exercise their rights to receive more shares. This would benefit shareholders of all penny stock companies.

These are strong measures that would greatly benefit retail investors and strengthen the overall integrity of the market. Listing standards only serve their purpose when they ensure that all investors are treated fairly and when the standards are effectively enforced and not easily circumvented. The recent glut of penny stocks is a real problem, but one that’s easy to fix. Hopefully the SEC will agree.

Tom Merritt, Deputy General Counsel at Virtu Financial, contributed to this article.