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The writer is chief market policy officer at IEX
To function effectively, the stock market depends on trust. As one part of that principle, investors trust that exchanges will set, maintain and enforce reasonable listing standards.
But this trust has been undermined over the past few years, as the number of low-price, highly speculative stocks that have remained listed on exchanges 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 action to reverse it.
The trend is clear. From early 2021 to the end of 2023, the number of penny stock companies listed on an exchange increased from less than a dozen to well over 500. In part, this may be explained by the lagging effects of the “mini-IPO boom” that developed in late 2020 and through 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 losses 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 highly favourable rate — an action that substantially dilutes and reduces the value of shares held by ordinary investors.
In many cases, the issuers are based offshore in countries with lower corporate governance protections than exist in the US. Trading in these stocks is often affected by fraud and manipulation, spurred by anonymous activity on social media outlets or through other means.
These risks exist for all penny stocks, but by remaining listed, issuers can reach a wider pool of investors because listing on one market carries the right to trade on each of the 16 registered exchanges. Unscrupulous promoters can and do point to the exchange listing to offer false comfort.
Recent experience has shown that existing listing rules fall short of their purpose in protecting ordinary investors in this area. For one thing, they do not exclude companies that facilitate insiders’ ability to receive shares 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 longer.
For example, under Nasdaq rules, companies receive a notice of possible delisting if their stock price falls below $1 for 30 consecutive trading days, but if the stock creeps above the threshold on just one of those days, the clock resets. Once the company fails that test, it is given a grace period of 180 days to come into compliance, which is often extended for another 180 days. At the end of this process, the company can appeal a delisting decision, further extending a final reckoning.
Finally, companies can often avoid delisting by completing a “reverse split”, which simply reduces the amount of available stock by some mathematical proportion. Reducing the available shares typically raises the per share price, but it doesn’t change the fundamentals and may actually hurt shareholders because these actions are often viewed as negative market signals. The use of reverse splits has grown substantially, in pace with the rise in penny stock listings, reaching nearly 500 in 2023, an increase of 72 per cent from 2022.
To address the problem, trading firm Virtu Financial has petitioned the SEC to take action. First, the petition calls for limits on how much dilution of public shareholders listed companies can allow. Second, it asks the commission to substantially reduce the time allowed for sub-dollar stocks to meet the price standard. Third, it calls for action to limit companies’ ability to use reverse stock splits to evade compliance. Fourth, it calls on exchanges to better monitor for share price manipulation.
Finally, the petition asks the SEC to enhance corporate disclosures to better inform investors how much their shares could be diluted if insiders and promoters fully exercise their rights to receive more stock. This would benefit shareholders in all penny stock companies.
These are strong measures that would do much to benefit retail investors and strengthen overall market integrity. Listing standards serve their purpose only when they ensure all investors are treated fairly, and when the standards are effectively enforced and not easily evaded. The recent glut of listed penny stocks is a real problem, but one that is easily fixable. Hopefully, the SEC will agree.
Tom Merritt, deputy general counsel at Virtu Financial, contributed to this article.