There is an adage that stocks need to be sold by having their stories widely told. This is especially important for smaller companies looking to promote themselves to customers and build their visibility with the investment community.
Social networks and online media sites have created new ways for public companies to interact and connect with potential investors. Digital marketing has made it easier for investor relations professionals to reach millions of investors with the click of a mouse, but it can also be abused by anonymous market manipulators for fraudulent promotional campaigns.
When visibility campaigns lose touch with facts, and cross the line into fiction, investors are deceived and market pricing mechanisms break down. The specter of fraud created by manipulative promotional campaigns touches all small and micro-cap issuers making it more difficult for them to raise capital and reach investors.
OTC Markets recognizes the damage created by manipulative promotion and has been a leader in using transparency to improve investor information and mitigate promotion risk. Since 2007, we have used our market designations to indicate which issuers are making adequate current disclosure available to the public and our Caveat Emptor flag to indicate public interest concerns. Promotion has always been a significant factor in our Caveat Emptor flag decision making process.
It is our belief that a baseline of easily accessible information is the best way for market participants to analyze, value and trade securities. When public companies provide timely disclosure and clear financial reporting, the markets’ price setting is most efficient.
Our market tiers and Caveat Emptor designations have become widely accepted in the industry with many brokers using them as a basis for restricting trading. These policies resulted in .7% and .083% of 2016 OTC dollar volume occurring in Pink No Information and Caveat Emptor securities, respectively.
We are now working to update our policies and procedures to further expose the relatively small number of bad actors manipulating public markets. This post provides context around the scope of promotion, the practical concerns for investors and issuers, as well as some potential solutions. We would also like to engage our community to provide feedback on this very important issue.
The first point to recognize is that stock promotion directly impacts a very small percentage of OTC trading. Based on 2016 promotion data from theOTC.today*, the 2016 dollar volume trading for promoted securities (466 securities) was only 2.04% of total dollar volume in the OTC market. More importantly, the dollar volume for these promoted securities (~$3.9 billion) pales against the dollar volume of promoted exchange-listed securities which totaled ~$7.5 billion. The point is not to disparage the listed markets but to highlight that the perception of promotion in OTC securities often out-weighs the reality.
Another key data point is that the majority of OTC promotion occurs in the securities of SEC Reporting companies which have current information available. In 2016, the securities of SEC Reporting companies (285 securities) represented 72% of promoted security dollar volume. The reputational legitimacy given by retail investors to SEC Reporting companies and constant messaging by regulators that market manipulation is primarily concentrated in securities without financial information publicly available** is often exploited within the promotional community.
The concept of promotion is extremely broad and inherently includes plenty of gray area between legal issuer investor relations and misleading or manipulative promotion; however, the risk increases when anonymous third party promoters or promotional websites are involved. It is one of the reasons we asked the SEC to bring more transparency to the people and money behind paid promotional campaigns.***
The negative effects of a highly visible campaign by anonymous third party promoters are defined and concrete: eventual share price declines and shareholder relations problems for the issuer. Both scenarios are more likely when discounted (toxic) share financing and dilution are part of the equation.
A common form of discounted financing is convertible debt, which converts to equity at below the market price. This discount can be significant and creates a sizable profit margin for the convertible debt investors. It also places significant downward pressure on the stock which may necessitate additional share issuance/financing. The result for investors and issuers is a rapid, massive dilution (increase of shares outstanding) of the stock.
Anonymous third-party promotion
Anonymous third-party promotion may be used in the above scenario to drive up or stabilize a stock’s price while the converted shares are liquidated. The gray area appears again when trying to discern the source of the promotion. Is the issuer involved? Is the issuer aware? Is the financing firm involved? Are investors in a recent private offering involved in an illegal distribution of shares? Could those investors be considered underwriters?
Regardless of the source, the data offers insight into the frequency and severity of this scenario. In 2016, ~60% of promoted securities experienced dilution with 33% of promoted securities experiencing both dilution and a decrease in Market Capitalization. For the 10 most actively promoted securities, which incidentally comprised 45% of the promoted dollar volume, the 2016 mean increase in shares outstanding was 42%.
While investors may find it exciting to trade highly volatile promoted securities, the data is clear; when you analyze the changes to share price post-promotion median share price dropped 64%.****
Investors Must be Diligent
In the current environment, investors must be diligent in their research and understand how financing terms and dilution may impact their investment. OTCMarkets.com provides investors with access to disclosure information, shares outstanding, split information for SEC and ARS reporting companies. The burden is squarely on investors as these issues and their association with promotion have not been prioritized by the SEC. In 2016, only 9 (1.93%) out of the 466 promoted OTC securities were suspended by the SEC.
Issuers must be aware of their financing options and the terms of those agreements. They must also perform due diligence on their offering investors and be very careful of firms that use anonymous or newly formed entities to hold their shares.
OTC Markets is considering ways to mitigate the risk posed by promotion for issuers and market participants.
Our first step is to see how we can use technology and data to identify and limit the effectiveness of promotional campaigns. We are developing a promotional monitoring program which will aggregate promotional information and assign an ‘Active Promotion’ status to the applicable securities. This way brokers can identify potentially problematic customers selling these securities and warn all investors of the clear risks of investing in promoted securities. A second step is improving our market standards so companies take greater responsibility for quickly warning investors about any fraudulent or misleading promotion in their securities from anonymous third parties. We will be publishing a revised OTC Markets Promotion Policy. The policy will outline best practices and requirements for OTC issuers, including promotion disclosure requirements and guidance on what is expected of issuers when their security is actively promoted.
We are also working with broker-dealer compliance departments to build better risk metrics in our Compliance products and studying how we can improve our Service Provider data analytics to highlight the relationships between the providers and third-party promotions.
On the regulatory front, we are advocating for more efficient public financing options for small/micro-cap companies such as making Reg. A offerings available to SEC Reporting companies and amending Reg A to permit ‘At the Market’ offerings. Expanding public market financing options will make the market more competitive and hopefully decrease the leverage toxic financing firms have with small/micro-cap issuers. Read our Petition for Rulemaking to Amend Regulation A.
All of these concepts are still in the planning stages, so please help us improve the OTC market by emailing us at firstname.lastname@example.org with your feedback.
*theOTC.today data is collected from promotional newsletters. Other forms of promotion (e.g. tweets, message boards) are not included in this data set.
**“Microcap (or “penny”) stocks are particularly vulnerable to market manipulation given the lack of public information regarding the companies’ underlying business and management, as well as the lack of verifiable financial information.” FINRA 2017 Regulatory and Examinations Priority Letter
***Petition for Commission Action to Protect the Investing Public from Unlawful and Deceptive Securities Promotions https://www.sec.gov/rules/petitions/petn4-519.pdf
****Median % price decrease value compared last date of promotion pricing and pricing as of December 31, 2016. Only 2016 promotional campaigns which ended on or before September 30, 2016 were evaluated.