Blue Chips or Red Flags: The Exchange Myth

For years, the equity markets have perpetuated the narrative that if a company is listed on a National Securities Exchange, it has achieved “Blue Chip” status. The belief was that the listing process required to meet exchange standards would weed out speculative or financially strapped companies. However, if the markets in recent years have taught us anything, it is that the narrative of Exchange Listed = Investment Grade is not always reality and that sometimes companies try to buy their reputation rather than earn it.

Another misperception that permeates the capital markets is the idea that OTC Markets is the “penny stock” market.  While there are penny stocks that trade on the lower tiers of the market, the reality is that the highest tier, the OTCQX Market, prohibits penny stocks.  In fact, over 93% of total OTC dollar volume in 2023 was in companies that are not “penny stocks.”

By contrast, if one were to look closer at the exchanges, one would be amazed at the number of securities that would not even qualify for the OTCQX Best Market.  In fact, most companies that leave exchanges, do not qualify for the OTCQB Venture Market.

The OTCQX Market’s initial and continuing standards require a company not be a penny stock under SEC Rule 3a51-1.  The rule defines a penny stock as any security that trades under $5, unless it meets either a net tangible asset test ($2M or $5M depending on years in operation) or a revenue test (average of $6M for the last 3 years).  However, if a company is listed on an exchange, it is exempt by default.  As such, securities that should be considered penny stocks based on their stock price and financials are not, simply because they are listed on an exchange.

The recent Wall Street Journal article, Hundreds of Stocks Have Fallen Below $1. They’re Still Listed on Nasdaq, by Alexander Osipovich, highlights the size and scope of this issue. 

As noted in the article: “557 stocks listed on U.S. exchanges were trading below $1 a share, up from fewer than a dozen in early 2021, according to Dow Jones Market Data.  The majority of these stocks—464 of them—are listed on the Nasdaq Stock Market, whose rules require companies to maintain a minimum share price of $1 or risk being delisted.”

The Exchange Penny Stock Problem

The current Exchange landscape looks quite different than the image portrayed.  While still home to mega-cap companies, more and more of the IPOs and listed companies on exchanges are small and micro-caps. 

There are now over 2,700 securities on U.S. exchanges that are sub $500 million in market cap.

Of this group, 22%, totaling 588 securities, were on an exchange non-compliance list as of January 2024.  While exchange rules dictate that stocks that trade under $1.00 need to be delisted, a massive number of small cap companies and low-priced securities now remain Exchange Listed far longer than the 180-day grace period.  Exchanges no longer automatically delist companies that file for bankruptcy or are late in their SEC filings.

The narrative that anything on an exchange is deemed safe can create false sense of security among investors, that they do not need to read the financials or look under the hood.  When we look at the data, it tells a clear story that both the number and makeup of securities remaining on exchanges has shifted dramatically over the last several years.

As quoted in the WSJ article, “Exchanges are supposed to be gatekeepers and list only bona fide companies that have investor interest,” said Rick Fleming, a former SEC investor advocate. “If a bunch of companies aren’t really meeting those standards, it undermines the seal of approval that the exchanges are supposed to be imparting.”

Promotional Activity Jumping to Exchanges

Trading volumes among low priced securities, as well as those under promotion has also increased significantly in a post-COVID world.  Analysis of promoted securities from 2023 shows that exchanges host close to double the number securities flagged for promotion versus the OTC market.

Dollar volume of promoted small cap exchange listed securities is 46 times higher than what you see in the OTC markets.

Promotion Data for January 1, 2023 to December 31, 2023:

As transparency, market surveillance and the integrity of OTC markets have improved, promotional activity has shifted to the exchanges.  As the chart below shows, the number of instances of promotion is increasing year over year in exchange listed securities.  The dollar volume associated with these promotions remains at significantly higher levels than what we find in the OTC space.

Year over Year Growth in Promoted Exchange Listed Small Cap Securities:

Much of this shift is based on the compliance processes that OTC Markets built to actively track and flag promotions.  We require issuers to make public disclosure in instances where promotional activity is identified, to address any misleading information that may be in the market.  Our promotion risk flag, which we make available on our website, alerts investors to instances of promotion.  Promotion data is also added into our compliance products.

Flagging promotional activity and providing additional disclosure helps investors understand the potential risks associated with these types of securities.  It also lessens the burden for companies that are doing the right thing. 

Where there is Promotion, there can be Fraud

With increased instances of promotion and hundreds of companies out of compliance with continuing listing standards, it should be no surprise there has also been a rise in enforcement cases involving manipulative activities and fraudulent securities distributions in exchange listed microcap securities and penny stocks.  We have previously covered an SEC enforcement case against an investment advisor and their fund for alleged manipulative short-selling as part of private financing activities in multiple exchange-listed issuers.

In December of 2022, an SEC action was announced “against eight individuals in a $100 million securities fraud scheme in which they used the social media platforms Twitter and Discord to manipulate exchange-traded stocks.”

The mix of speculative securities with the brand reputation of the exchanges makes it more attractive and profitable for those looking to manipulate markets and defraud investors.  This is compounded by the fact that many brokers and investment banks’ compliance departments have not built robust policies to address these risks for the listed market. 

In September of 2023, the SEC brought charges against entities “engaged in the business of purchasing convertible notes from microcap issuers, converting those notes into shares of stock at a large discount from the market price, and selling the newly issued shares into the market at a significant profit.”  In the court filings the SEC alleged, “In late 2020 and early 2021, Defendants transitioned from trading primarily penny stocks and began targeting microcap issuers with stock trading on the Nasdaq stock market (“Nasdaq”).”  

Most recently, the SEC brought charges against Future FinTech’s CEO, Shanchun Huang, for “allegedly [using] an account in Hong Kong to place trades in Future FinTech stock beginning in January 2020, at a time when Future FinTech was at risk of being delisted from NASDAQ because its stock price had fallen below NASDAQ’s minimum bid price requirement of $1.00 per share. Huang allegedly bought more than 530,000 shares of Future FinTech over a two-month period and repeatedly traded at a volume so large that his trades constituted a high percentage of the daily volume of Future FinTech stock transactions.”

Forward-looking compliance officers know that when there are SEC enforcement activities in securities, regulatory reviews will follow into broker-dealer sales practices, KYC, and AML programs.  As a result, we see more broker-dealers with a strong culture of compliance working to close gaps and create robust, automated procedures that look at the equity market as a whole.  By applying the data sets, financial standards, and risk flags that have modernized the OTC markets, broker-dealers can remove complexity and strengthen their processes.

With our deep experience in data-driven market standards, strong distribution channels and recent acquisition of Edgar Online providing troves of new data sets, OTC Markets is well positioned to support these efforts and more.

For example, our Small Cap Listed dataset looks at a series of factors to create risk profiles for the universe of exchange listed companies with market caps below $500 million. Elements such as active and historical stock promotion, hot sector, shell and former shell status play a crucial role.  We also include Penny Stock Status using SEC defined exemptions, excluding the exchange-listed exemption, to highlight this metric.  Shares outstanding and split history also factor into the algorithm. 

It’s essential for broker-dealers, compliance teams and investors to look at the companies themselves and not assume that being on an exchange is a signal of quality.  With less delineation between exchange-listed and OTC traded than ever before, it’s vital for firms to create one set of data-driven policies for small-cap securities, regardless of where they trade.

Going forward, we believe data-driven markets are the only way to improve capital formation, price risk, and support compliance with securities laws.  It is with broad data sets streaming into systems and automated processes, that we will create better informed and more efficient markets.  Public companies need to maximize information available on screens and structured data in machines to support diverse public market investors and allow broker-dealers to lawfully trade their stocks.