SEC Charges Four Long Island Men With Perpetrating $2 Million “Free-Riding Scheme”

Case History

On October 31, 2023, the SEC charged Defendants Eduardo Hernandez (“Hernandez”), Christopher Flagg (“Flagg”), Daquan Lloyd (“Lloyd”), and Corey Ortiz (“Ortiz”) with fraud for perpetrating a multi-year “free-riding” scheme. The scheme generated approximately $2.08 million in illicit profits between November 2018 and January 2022 (the “Relevant Period”) at the expense of broker-dealer A (“Broker A”).

In this case, the free-riding scheme is about the fraudulent practice that Defendants used to misappropriate the “instant deposit credit” that certain broker-dealers extended to the holders of trading accounts.

Facts Of SEC Charges Against Four Long Island Men

1. Defendants Established Loser Accounts With Broker A

During the Relevant Period, Broker A offered a subscription service called Broker A Gold (“Gold”) to those holding a trading account with the Broker and having a portfolio value of up to $10,000.

Accordingly, the account holders who had subscribed to the “Gold” service were given an instant deposit credit of $5,000, provided these account holders:

linked a bank account in their name to their Broker A account; and
initiated funds transfer equivalent to the instant deposit credit of $5,000 from the linked bank account to their Broker A account

Once the account holders initiated the funds transfer from their linked bank accounts to the Broker A accounts, it triggered the transfer of instant deposit credit into the Broker A trading accounts.

Such instant deposit credit from Broker A allowed the account holders to trade while the cash transfer from their linked bank account was pending as it took up to five business days to complete.

Hernandez and Flagg (the “Principals”) opened trading accounts at Broker A through Lloyd and Ortiz (the “Recruiters”). These Recruiters had further solicited individuals who either agreed to open new trading accounts at Broker A or provide access to existing trading accounts at Broker A (collectively the “Recruits”) for a nominal sum.

The most important part of the free-riding scheme executed by the Principals was opening numerous trading accounts at Broker A through the Recruiters. This is because as Recruits initiated funds transfers from their linked bank accounts for opening trading accounts at Broker A, Broker A gave instant deposit credit of $5,000. The account holders at Broker A received instant deposit credit of $5,000 before cash was transferred from their linked bank accounts to their trading accounts at Broker A as it took 5 business days to complete the transfer.

Further, the Principals had warned the Recruits to keep no funds in their linked bank accounts to prevent Broker A from receiving money from those accounts. Thus, the Principals misrepresented to Broker A that there were sufficient funds in the Recruits’ linked bank accounts to repay any instant deposit credit extended to them.

Also, the Principals directed Recruits to provide them with their Broker A account login information so that the Principals could access their Broker A accounts to engage in a matched trading scheme and generate illicit gains.

The Principals paid a nominal fee to the Recruits to influence them to open more trading accounts with Broker A, link their bank accounts, and provide Principals with login credentials to engage in the matched trading scheme.

The Principals ensured they traded continuously until the instant deposit credit was fully exhausted. Typically, the Principals exhausted the instant deposit credit the same day to prevent Broker A from knowing that bank accounts linked to Broker A’s trading accounts had insufficient funds to fund such trades.

The trading accounts Principals opened at Broker A through the Recruiters and the Recruits were called Loser Accounts. This is because these accounts were unfunded and loss-bearing. Once the Principals exhausted the instant deposit credit limit using the matched trading strategy, the Broker A trading accounts became useless as the account holders had no intention of funding their accounts.

When Broker A became aware of the insufficient funds for trading, he froze the investor accounts and eventually closed these accounts entirely.

2. Defendants Established Winner Accounts At Other Broker-Dealers

The Principals also used brokerage accounts in their own names, in the names of the Recruiters, and in the names of the Nominees to execute their free-riding scheme. These brokerage accounts were held with broker-dealers other than Broker A adn were collectively called as Winner Accounts.

Nominees were individuals who were inexperienced in trading but desired to make money via trading. The Principals asked the Recruiters to hire Nominees by convincing them that the Principasl were successful traders who could make profits for the Nominees by trading in the Nominees’ brokerage accounts.

Thus, the Nominees set up brokerage accounts in their names and gave the login credentials to the Principals so that they could directly carry put trades in the Nominees’ brokerage accounts.

Note that the Principals used the Winner Accounts to (a) hide their identity and escape detection by Broker A and (b) carry out trades and transfer profits from the Nominees’ brokerage accounts to their own accounts.

3. Defendants Engaged In Matched Trading to Take Benefit of Instant Deposit Credit

The Principals began trading in the Broker A Loser Accounts within days after the Recruits’ accounts were opened and almost immediately after the instant deposit credit was available in the Loser Accounts.

Once the Principals began trading, they traded continuously until they exhausted the instant deposit credit. In most instances, the Principals began and ended trading on the same day in order to use the full instant deposit credit. Further, they didn’t want Broker A to know that there were insufficient funds in the linked bank accounts to fund the Broker A brokerage accounts.

Additionally, to maximize their illicit gains from the free-riding scheme, the Principals typically traded in the stock options.

Let’s understand how Principals generated illicit gains using the stock options to carry out matched trading transactions.

Matched Trading Transaction: How Did It Work?

The Principals used highly illiquid put option contracts to maximize their earnings from the matched trading.

What Are Illiquid Options?

Illiquid options are options contracts that have very low trading activity or lack of market participants willing to buy or sell them. This lack of liquidity can make it difficult for traders to enter or exit positions at desired prices.

Illiquid options typically have wider bid-ask spreads, meaning there is a significant difference between the price at which sellers are willing to sell and buyers are willing to buy.

To understand the complex trading mechanism that the Principals used to generate illicit profits, we first need to understand what are option contracts, particularly put options.

What Is An Option Contract?

An option is a derivative instrument that gives the option holder the right but not an obligation to buy or sell a specific amount of the underlying asset at a particular price (called the “Strike Price”) and within a specific period. The buyer of the option exercises his right to buy or sell the underlying asset when he earns a positive payoff by exercising his right.

Further, an investor buying an option contract needs to pay an option premium to purchase an option contract.

There are two types of option contracts: Call Option and Put Option.

Call Option

A call option is the right to buy the underlying asset at a particular strike price within a specific period.

A call option is called:

“In the Money” when its strike price is less than the spot price as it generates a positive payoff
“At the Money” when its strike price is equal to the spot price as it generates no payoff
“Out of Money” when its strike price is more than the spot price as it generates a negative payoff

The buyer of a call option gains when the call option generates a positive payoff for the buyer. Whereas, the writer (or the seller) of the call option gains to the extent of option premium when the call option buyer fails to exercise his right.

Put Option

A put option is the right to sell the underlying asset at a particular strike price at a specific future date. Such an option generates a positive payoff for the buyer when the strike price is more than the spot price, i.e., the current market price of the underlying asset.

A put option is called:

“In the Money” when its strike price is more than the spot price as it generates a positive payoff
“At the Money” when its strike price is equal to the spot price as it generates no payoff
“Out of Money” when its strike price is less than the spot price as it generates a negative payoff

The buyer of a put option gains when the put option generates a positive payoff for the buyer. The writer (or the seller) of the put option gains to the extent of option premium when the put option buyer fails to exercise his right.

Now that you know how option contracts work, let’s understand how the Principals used the matched trading strategy for highly illiquid put option contracts to generate illicit gains.

Mechanics Of Matched Trading

The Principals first selected highly illiquid put options that were deep “Out of Money”. Deep “Out of Money” options trade at low prices as they are thinly traded.
Then, the Principals ensured that the underlying assets of these put options were stocks of companies announced as merger or takeover targets. Consequently, the stocks of these companies traded in a very narrow range between the period when the merger or acquisition was announced and the deal was closed.
Next, the Principals sold these put options at highly inflated prices from the Winner Accounts they controlled to the Loser Accounts set up by the Recruits. This appeared to be an arms-length transaction, however, the Principals controlled both sides of the trade. The Principals executed these transactions by adopting the following procedure:
The Principals posted limit orders on an exchange through Winner Accounts offering to sell several contracts in a particular series of put options. A limit order is an order that allows traders to set the minimum price at which they will sell (or the maximum price for which they will buy) the options contracts.
As mentioned earlier, the put options that the Principals selected were thinly traded options and were typically “Out of Money” option contracts. Deep out of the money options typically trade at very low prices because they have minimal chance of ever becoming “In the Money” or obtaining any meaningful value.
Further, the underlying securities of the put options were stocks of companies announced as merger or takeover targets. As a result, those stocks typically traded in a very narrow range between the time the deal was announced and the deal was closed.
Thus, the Principals used Winner Accounts to set the limit order at prices that were way higher than the normal market prices but within the allowed price range imposed by exchange for such option contracts. Due to options’ inflated prices, low volume, and least chance of their underlying stocks’ spot price falling enough to make these put options “In the Money”, no rational market participants would want to buy these put option contracts.
When Principals posted limit orders on an exchange through Winner Accounts offering to sell several put options contracts, at the same time, the Principals used Loser Accounts to place orders to buy the exact same put option series at or slightly higher than the limit price of the Winner Account’s offering to sell several contracts in a particular series of put options.
Since no market participant was willing to sell option contracts at lower prices and buy option contracts for such a high price, the exchange automatically matched the trades that the Principals placed through the Winner and Loser Accounts in a transaction. This way, the exchange filled the sell order from the Winner Account with the buy order from the Loser Account. Furthermore, the Winner Accounts received a credit for the trade.
Finally, to close these open positions, the Loser Accounts would place the order to sell the put option contracts at or near the market price. Likewise, the Winner Accounts would place the order to buy these same put option contracts at or near the market price. Since no other rational market participants would take such positions, the exchange again matched and executed the trades of the Winner Accounts and Loser Accounts.
The Principals thus profited from such a strategy in the Winner Accounts and incurred losses to the extent of the ill-gotten gains in the Loser Accounts.

Example Of A Matching Trade Executed By The Principals

October 7, 2020 Hernandez SINA Trading

Hernandez trading via a brokerage account in his name with a broker-dealer other than Broker A (“Winner 1”) offered to sell SINA Corp. (“SINA”) put option contracts with a strike price of $30.

SINA stock’s current trading price at this time was $42.70. Additionally, New Wave Holdings Ltd., the previous week, on September 28, 2020, announced its proposal to acquire SINA at $43.30 per share.

As can be observed, SINA’s put options were of no value since the strike price of these contracts was lower than the current market price of SINA’s stock. They were deeply out of money and illiquid.

Despite the put options being out of money, Hernandez placed the order at the exchange to sell SINA put options from the Winner 1 account at $4.50 per contract. This option premium was way higher than the value of these options.

A Broker A Gold account (“Loser 1”) that initiated a fund transfer of $5000 from its linked bank account and received the instant deposit credit of the same amount that very day, bought these same put options at the price offered.

A few minutes after the trade was executed, Hernandez bought back the put options via his Winner 1 account to close his position from the Loser 1 account at $0.25 per contract. This made him warm $850 in profits in the Winner 1 account and losses in the Loser 1 account to the same extent.

What Is The Free-Riding Scheme?

An investor must have sufficient funds in his cash accounts to buy and sell securities. A cash account is a type of brokerage account in which the investor transfers the complete amount for securities he purchases.

The investor buying and selling securities via cash accounts is prohibited to borrow funds from his broker-dealer to pay for his buy or sell transactions.

However, if an investor buys or sells securities without having sufficient funds in his cash account, he engages in a scheme called free-riding. Free-riding is a practice that is not allowed as per Regulation T of the Federal Reserve Board and may require the investor’s broker to freeze the investor’s cash account for 90 days.

In the SEC v. Eduardo Hernandez case, the Defendants were involved in free-riding by taking advantage of the instant deposit credit facility extended by Broker A.

Defendants converted the instant deposit credit into cash using a matched trading strategy for put options. This involved the execution of a matched trading in illiquid, out-of-money put options between unfunded, loss-bearing Loser Accounts with Broker A and profitable Winner Accounts with broker-dealers other than Broker A.

Since Defendants controlled both sides of the matched trade, they earned profits in Winner Accounts and incurred losses of the same amount in the Broker A Loser Accounts.

Charges By The Court

As per the complaint filed by the SEC on October 31, 2023, Hernandez and Flagg were charged with violating the antifraud provisions of Section 10(b) of the Securities Exchange Act of 1934 and Rules 10b-5(a) and (c) thereunder. They were also charged with further violating these provisions by acting through another person in violation of the Exchange Act Section 20(b).

The SEC complaint also charged Ortiz and Llyod with helping and encouraging Hernandez’s and Flagg’s violations as mentioned above.

Relief Sought By The SEC

The SEC seeks conduct-based injunction and permanent injunctive relief and orders the Defendants to pay disgorgement, prejudgment interest, and civil money penalties.

Important Takeaways for the Investors

Considering SEC v. Eduardo Hernandez case, the investors are prohibited from buying and selling securities without transferring the complete amount for the securities they purchase. This is illegal as it is against the provisions set out in Regulation T of the Federal Reserve Board.

Furthermore, the investors cannot deceit Brokers by opening numerous brokerage accounts through Recruiters and Recruits with the intent to fraudulently obtain instant deposit credit. Also, they are not allowed to open brokerage accounts with one broker to conduct losing trades and open broker accounts with other brokers to conduct winning trades essential to execute matched trading strategy.

In case, any investor engages in any of the above-mentioned acts, they are liable to pay civil penalties, disgorgement, and prejudgment interest.

Gayatri GuptaApril 9, 2024

Nasdaq Compliance

The Nasdaq Stock Market features three tiers of listed companies, namely: (1) The Nasdaq Global Select Market, (2) The Nasdaq Global Market, and (3) The Nasdaq Capital Market. These tiers are characterized by progressively stringent listing requirements, with the Nasdaq Global Select Market setting the highest standards for initial listings and the Nasdaq Capital Market serving as the entry-level tier, particularly suitable for most small-cap issuers.

To list securities on Nasdaq, a company must fulfill minimum listing requirements, encompassing defined criteria related to financial performance, liquidity, and corporate governance. Nasdaq retains extensive discretion in the listing process and reserves the right to reject an application, even if the technical prerequisites are satisfied, if it deems such denial essential to safeguard the interests of investors and the public.

After securing a listing on Nasdaq, a company is obligated to adhere to ongoing listing standards. To initiate the listing process, a company seeking inclusion on Nasdaq must diligently complete and submit a comprehensive listing application to Nasdaq. This application should include specific documents and information as outlined by Nasdaq's requirements.

Typically, the application process spans a duration of four to six weeks. Once the application is submitted, a Nasdaq analyst is designated as the primary liaison with the company. Within two to three weeks of submission, the company can expect to receive an initial comment letter. The comment and review process persists until a decision is reached on the approval or denial of the application. Similar to filing with the SEC, a meticulously prepared Nasdaq application tends to attract fewer comments and facilitates a more streamlined process. Generally, the company's securities counsel assumes a leading role, serving as the primary contact for preparing the application and engaging in communication with Nasdaq.

Similarly to the SEC review process, Nasdaq conducts a thorough examination of publicly accessible information pertaining to a company. This encompasses, but is not limited to, SEC filings, the company's website, management communications and speeches, as well as press releases. The iterative nature of the review process typically doesn't necessitate a formal protocol, and communication is commonly facilitated through email correspondence and phone calls.

Listing Criteria For Nasdaq
For a company to list its securities on Nasdaq, it must satisfy the following criteria:

Specific Initial Requirements:
- Quantitative Standards: Meeting defined thresholds for both quantitative and qualitative factors.
- Qualitative Standards: Fulfilling certain qualitative benchmarks.
Continuing Requirements:
- Quantitative Criteria: Adhering to ongoing quantitative benchmarks.
- Qualitative Criteria: Maintaining specified qualitative standards.

The initial quantitative thresholds are typically set at a higher level than those required for continued listing. This distinction aims to ensure that companies achieve a sufficient level of maturity before being listed. Additionally, Nasdaq imposes rigorous corporate governance standards that listed companies must adhere to throughout their tenure on the exchange.

Before formally submitting a comprehensive listing application, a company has the option to pursue a preliminary listing eligibility review. In this stage, the Listing Qualifications Staff conducts a thorough examination of the company's public filings to assess its compliance with numerical listing requirements. Additionally, the team evaluates the company's adherence to corporate governance requirements outlined in the Marketplace Rules ("Rules"). This preliminary review provides valuable insights into the company's eligibility for listing on Nasdaq before committing to the full application process.

Upon completion of the preliminary review, the Listing Qualifications Staff will make an assessment regarding whether the company meets the numerical listing criteria. Additionally, any corporate governance or regulatory concerns raised during this phase will be considered to determine their impact on the listing approval. It's important to note that while the preliminary review provides insights, final approval necessitates the submission of a formal listing application. This application undergoes a thorough examination by the NASDAQ Listing Qualifications Staff. Furthermore, the final approval process involves satisfactory compliance with specific qualitative reviews. This includes an examination of the regulatory history of the company's officers, directors, and significant shareholders. Meeting these criteria is integral to obtaining the final approval for listing on Nasdaq.

Financial And Liquidity Requirements

    Requirements

    Equity Standard
    Market Value of Listed Standard
    Net Income Standard

    Listing Rules

    5505(a)
and
5505(b)(1)
    5505(a)
and
5505(b)(2)
    5505(a)
and
5505(b)(3)
    
    Stockholders Equity

    	$5 million
    	$4 million
    	$4 million
    
    The market value of publicly held shares

    $15 million
    $15 million
    $
      5 million
    
    Operating History

    	Two years
    N/A
    N/A
    
    The market value of listed securities

    N/A
    $50 million
    N/A
    
    Net income from continuing operations (in the latest fiscal
a year or in two of the last three
fiscal years)

    N/A
    N/A
    $750,000
    
    Publicly held shares

    	1 million
    	1 million
    	1 million
    
    Bid Price

    	$4
    	$4
    	$4)
    
    Closing Price

    	$3
    	$2
    	$43
    
    Corporate Governance

    Yes
    Yes
    Yes
    
    Total Shareholders

    300
    300
    300

Corporate Governance Requirements

Across all three tiers of the Nasdaq Stock Market, corporate governance requirements remain largely consistent. The categories encompassing corporate governance standards include:

Distribution of Annual or Interim Reports
Independent Directors
Audit Committee
Compensation Committee
Nomination of Directors
Code of Conduct
Annual Meetings
Solicitation of Proxies
Quorum
Conflict of Interest
Shareholder Approval
Voting Rights

These governance elements play a crucial role in ensuring transparency, accountability, and ethical conduct within listed companies, irrespective of the specific tier within the Nasdaq Stock Market.

Companies seeking listing on Nasdaq must adhere to specific corporate governance standards, including the following:

Compensation Committee with Independent Directors:
- The company is required to establish a compensation committee comprised of independent directors.
- The committee must consist of at least two members.
- Rule 5605(d)(2)(A) introduces an additional independence test for compensation committee members.
Responsibility for Executive Compensation:
- The compensation committee is tasked with determining or recommending to the entire board the compensation of the chief executive officer (CEO) and all other executive officers.

These standards are designed to ensure a level of independence and scrutiny in the decision-making processes related to executive compensation within the company.

The Application And Documents

The Nasdaq application package encompasses several key components:

Symbol Reservation Form:
- Used to request the reservation of a specific trading symbol for the company.
Listing Application:
- Requires supplemental documents and details about the company's financials, operations, and other pertinent information.
Listing Agreement:
- A formal agreement outlining the terms and conditions of the listing on Nasdaq.
Corporate Governance Certification:
- A certification affirming the company's commitment to meeting Nasdaq's corporate governance standards.
Initial Application Fee:
- Payable via check or wire transfer, this fee is a prerequisite for initiating the listing process.
Logo Submission Form:
- Used for submitting the company's logo for use in Nasdaq's materials.

These application forms are completed through the Nasdaq website listing center, utilizing the online platform to facilitate the submission of supplemental and supporting documents. It is advisable to thoroughly review all required paperwork in advance, ensuring that the necessary information is readily available before initiating the application process.

Symbol Reservation Form

The symbol reservation form is a concise, one-page electronic form where applicants input information for Nasdaq's consideration. Nasdaq symbols, limited to 1-5 characters, adhere to guidelines established by the Intermarket Symbols Reservation Authority (ISRA). The ISRA system is designed to organize symbols efficiently, prevent duplication, and reduce programming and operational complexities. The ISRA operates within the framework of the NMS Symbology Plan, a plan utilized by Nasdaq.

Key details about the symbol reservation process:

Symbol Choices:
- The form allows applicants to propose three symbol choices in order of preference.
- While Nasdaq generally honors the first choice if available, it retains the authority to assign, rescind, or reassign a trading symbol at its discretion.
ISRA and Nasdaq Authority:
- The ISRA and Nasdaq have overarching authority in managing the assignment of symbols.
Additional Information:
- The form captures essential details about the issuer and the planned public offering.
- Information may include the name of the attorney, lead underwriter (if applicable), CEO and CFO names, yearly revenues, company website, and the sector in which the company operates.

Completion of this symbol reservation form initiates the process of securing a trading symbol on Nasdaq, and it's essential to provide accurate and comprehensive information to facilitate this stage of the listing application.

The Application

The Nasdaq listing application process is comprehensive and varies based on the circumstances surrounding the listing sought. There are twelve distinct listing applications catering to different situations, including changes of control, switches from other exchanges or markets, spin-offs, and initial public offerings (IPOs). Each application, spanning approximately seven pages, collects detailed information about the company, covering areas such as address, contact and billing details, securities attorney and auditor information, transfer agent particulars, and the company's officers and directors. Specific information on the company's securities, including type, par value, and cusip number, is also required.

Furthermore, the application mandates disclosure of legal proceedings involving the company, its officers or directors, or significant shareholders over the past ten years. This encompasses inquiries, investigations, lawsuits, litigation, arbitrations, and other legal and administrative proceedings. Documents supporting the backup and final disposition of these matters must be provided.

Regarding private offerings within the prior six months, including bridge financings, shelf registrations, and Regulation S offerings, the company is required to disclose such activities. Additionally, the application delves into the company's background, posing questions to ensure compliance with seasoning rules.

While Nasdaq retains the right to request relevant supporting documents, specific documents are mandatory based on the application type. For an uplisting from an existing U.S. market, the application must include letters from three market makers confirming their commitment to making a market in the subject securities. Other required documents include a listing agreement, a logo submission form, a corporate governance certification form, regulatory correspondence over the past 12 months, and shareholder confirmation documents. Nasdaq often seeks confirmation from the company's transfer agent regarding the eligibility of the security for the direct registration program (DRS).

During the review of an up listing application, Nasdaq may request additional information, such as a Broadridge share range analysis and NOBO list, a certified shareholder list, details about mitigating any going concerns or opinions, income statement and/or balance sheet projections for the next 12 months, and confirmation of Sarbanes Oxley Section 302 and 906 certifications by the company, among other inquiries related to compliance and financial matters.

The Listing Agreement

The Listing Agreement is a concise document, spanning two pages, serving as a formal affirmation of the company's commitment to adhere to all rules and regulations set forth by the Nasdaq Stock Market. It includes provisions for indemnifying and holding Nasdaq harmless from liability. Notable points in the agreement include:

Compliance Assurance:
- The company explicitly agrees to comply with all rules and regulations stipulated by the Nasdaq Stock Market.
Indemnification Clause:
- The company indemnifies Nasdaq, meaning it undertakes to compensate or reimburse Nasdaq for any losses or damages incurred. This includes harm resulting from third-party trademark infringement claims related to the company's symbol and logo, as well as Nasdaq's use of the same.
Disclaimer of Warranty and Liability:
- The agreement contains a disclaimer of warranty and liability against Nasdaq for trading issues, with the exception of those resulting from gross negligence or willful misconduct.

This agreement establishes a clear framework for the relationship between the listed company and Nasdaq, emphasizing the company's commitment to regulatory compliance while providing indemnification for certain specified matters and delineating the scope of Nasdaq's liability.

Corporate Governance Certification Form

The corporate governance certification form certifies compliance with the governance requirements related to an audit committee, director nomination process, compensation committee, board composition, executive sessions, quorum, and codes of conduct. Where an exemption applies, the form requires specification of the exemption terms. The document specifies the different rules and exceptions in a check-the-box format.

Logo Submission Form

The logo submission form contains the guidelines for the logo and affirms Nasdaq’s rights to use the same. Nasdaq uses company logos in its marketing materials, on the MarketSite Video Wall and Tower, and websites.

Fees

Entry fees are based upon the aggregate number of shares to be listed at the time of initial listing, regardless of class, with a maximum cap of $75,000. Fees are assessed on the entry date in The Nasdaq Capital Market, except for $5,000, representing a non-refundable application fee. This fee must be submitted with the company’s application.

Nasdaq does not charge application or entry fees for any securities transferred from a national securities exchange.

Benefits Of Trading On An Exchange

There are many benefits to trading on an exchange instead of the OTC Markets. The most significant benefits to a business are the ability to attract analyst coverage and institutional investors and the corresponding increase in liquidity that comes with both. Stocks that trade on Nasdaq tend to have a lower bid/offer spread — again encouraging trading volume and liquidity. Exchange-traded securities are exempt from the penny stock definition, allowing more market maker and broker-dealer participation. As further explained below, a broker-dealer cannot recommend a penny stock transaction to its retail clients. Therefore, no analysts, financial advisors, or institutional investors make recommendations for purchases of penny stocks.

As an aside, this is one of the reasons that OTC Markets created the OTCQX market tier, which does not list penny stocks. It is also why the small-cap industry is pushing for a supported valid venture exchange (for further reading.

In today’s world, depositing stock and/or trade-in non-exchange traded securities is increasingly difficult. Despite the congressional efforts and SEC rulemaking in support of small-cap capital formation (for example, the JOBS Act, including the emerging growth company regulations, new Regulation A+ and Title III Crowdfunding and the new FAST Act), through enforcement and investigative proceedings, both the SEC and FINRA continue to apply pressure on broker-dealers, clearing firms and transfer agents to reduce the secondary trading and free flow of penny stocks. For more information on difficulties in depositing stocks.

Further On Penny Stocks

NASDAQ and NYSE MKT traded securities are exempted from the definition of a “penny stock” due to the initial and ongoing listing standards. Penny stock rules focus on broker-dealers’ activity in effectuating trades in penny stocks. The Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (the “Penny Stock Act”) prohibits broker-dealers from effecting transactions in penny stocks unless they comply with the requirements of Section 15(h) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The rules promulgated thereunder, particularly Exchange Act rules 15g-1 through 15g-100 (the “penny stock rules”).

Section 15(h) of the Exchange Act provides that no broker or dealer may effectuate a customer’s purchase or sale of any penny stock unless such broker or dealer.

Approves the customer for the specific penny stock transaction and receives a written agreement to the transaction from the customer.
Furnishes the customer a risk disclosure document describing the risks of investing in penny stocks.
Discloses to the customer the current market quotation, if any, for the penny stock, including the bid and ask prices and the number of shares that apply to such bid and ask prices.
Discloses to the customer the amount of compensation the firm and its broker will receive for the trade.

In addition, after executing the sale, a broker-dealer must send its customer monthly account statements showing the market value of each penny stock held in the customer’s account.

Moreover, brokers and dealers subject to the penny stock rules are subject to additional disclosure requirements outlined in Rules 15g-2 through 15g-9. For my information on penny stocks and the rules affecting broker-dealer activity.

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