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Saturday, October 22, 2005

Penny Stocks

This paper will explore the history of Penny Stocks, the OTCBB and how the development of the North American markets has affected the development of the Over The Counter market. The second part will explore the evolution of the OTC and the effect it has had on the economy. The third paper will explore potential abuses of the market and how to avoid them. The final paper will be an oratory on the benefits of the market and potential ways it can be improved.

Normally, when we ask a question such as why something is, we are searching for the historical or the linear answer. I am asking this question to determine if we need the OTC markets and why, if at all, investors should participate in it. Let us explore the history of the OTC market and through this exploration begin to see how the OTC has evolved.

The United States has a long history of stock and stock exchanges. The American propensity for economic growth was the fuel behind the industrial revolution and on into the modern age. The first stock sold in North America was sold in 1515 with the sale of shares by the crown of Spain for land acquisition ventures in the new world. This tradition continued through the Jamestown and Plymouth colonies. The Hudsons Bay Company was the largest company in the world at one point and was created specifically to take advantage of the lucrative North American market. For over 2 hundred years, the English Crown would not allow coin or gold and silver exchanges with the American Colonies. Their grip on trading with the Americans helped to proliferate the use of bills and letters of credit between buyers and sellers. The existence of the colonies as "business" enterprises also helped develop the American willingness to use other peoples money to grow an enterprise. English investors were more than willing to purchase these letters and bills. After all, the American colonies created more wealth for the English industrialists than any war had ever produced.

These share exchanges happened from one banker to another and from one shareholder to another through private transactions. John Law, father of modern share distribution and the government backed security, caused the first modern financial panic in October of 1720 when shares of his Louisiana Company collapsed because of lack of earnings. John Law found that through the issuances of certificates backed by the government or the large companies and ventures, investors were more ready to part with their money. These certificates, called specie, were essentially stock and were sold by Law's bank to other bankers and investors.

This financial panic was the first of its kind in recorded history. People were not accustomed to the utilization of value and had no tools with how to appraise correct value. Investors were so certain that John Laws investment scheme would bear fruit that they began to purchase assets that they felt they would need in their new status as wealthy aristocrats. They spent their current savings to purchase lavish homes and land from which they could retire. The debt rate in France went up almost 212% in the 6 months that John Law was awaiting his returns. Thus when the specie that John Law distributed failed to bear fruits, the investors went into an asset sales panic to cover their debts. The losses taken by the investing public ruined so many bankers and banks that the suicide rate doubled in 1 week. Banks and bankers closed shop and left the cities where they had sold the Louisiana shares. Individual investors went to prison for failure to pay debts. The financial panic was so devastating in its impact that poets and writers would immortalize it.

Some in clandestine companies combine;
Erect new stocks to trade beyond the line;
With air and empty names beguile the town,
And raise new credits first, then cry 'em down;
Divide the empty nothing into shares,
And set the crowd together by the ears. {Defoe}


This panic gave us a new word, "speculation", meaning to buy specie. The specie in question are shares in ventures "penny stocks" without proven return rates. At the time all specie were issued as a way to capitalize a new or start up venture. Thus speculators were those individuals who purchased shares. This practice was the first step in the modern venture capitalist movement. Venture capitalists became synonymous with the loan sharks of today. Their practices included the strangulation of ventures until the venture capitalists had their return on investment.

Speculation has been the cause of many financial crises'. The Panic of 1819 was caused by poor overseas markets and increased speculation in the over the counter shares of the export companies and shippers. The Panic of 1837 was brought on by speculation in over the counter shares of western land developers and the poor performance of those developments. The Panic of 1857 was caused by speculation both in Europe and the US markets in over the counter shares of railroads. The speculation in large railroads was not the problem, it was over speculation that smaller railroads would become large ones. The collapse of these smaller companies shares caused a depression that was not overcome until after the Civil War. There were many other panics such as Black Friday in 1869 based on a manipulation scheme to try and corner the gold market. In 1873 a crisis occurred when credit was over extended causing banks to call debt and was not caused by speculation in the over the counter market. Credit became the cause of the 1893 and 1907 crises.

Speculation problems inherent in the system prior to 1933 were caused by dishonest stock brokers who sold shares of low grade penny stocks to large groups of investors. The investors then panicked as they realized how worthless their securities were. The losses coupled with the current economic climate exacerbated problems, and encouraged bank runs on banks which had authorized the issuance of similar low grade securities. The banks failed to meet withdrwal demands, there were no cash reserves and banks were forced to shutter. Bank runs occurred frequently during this time. Banks served depositors similarly then as they do today, offering checking, savings and investment accounts. As banks closed, depositors lost all their savings

The closures created such an enormous outcry in the US. The government in 1908 set up a commission to investigate the need for a federal banking system. In 1913 this commissions findings were put into the Federal Banking Act of 1913. This act established the Federal Reserve as a lender of last resort to protect banks from these runs. This would allow the bank to continue to provide their customers with cash even when they were running low. This "insurance" allowed many bank brokers to continue their practice of speculating in penny stocks without fear of a run. They could now calculate the losses and factor them into other operations. Thus windfalls could be gained and risk managed.

The Crash of 1929 and subsequent depression was caused by over speculation in radio issues. This over speculation was partly due to the continued practice of investing client funds into low grade securities. This collapse was so complete and the nature of the economy so intertwined with the world markets that the government knew it had to act for the security of the nation. In 1933, the US government acted to bolster its control over the markets by enacting the Securities acts of 1933 and again in 1934. These acts became the first to curb rampant speculation and enact safeguards to prevent the sale of securities immediately after an investment. It also established criteria for investors to meet that help inform investors about their risk. Since the enactment of the Securities acts, the markets have had their ups and downs. The latest crisis in 2000 and 2001 was caused by speculation in technology stocks very similar to the shipping crisis of 1819, the railroad crisis of 1857 and the speculation in radio companies of the 1929 crash.

The banks and traders were utilizing non-standard methods to transfer and trade these more or less private shares in a more public manner. Many of the biggest brokerage firms and trading houses were located in the financial district in Lower Manhattan. Other cities around the country such as Chicago, Philadelphia, Boston, St. Louis and San Francisco had smaller versions of Lower Manhattan. These trades were transacted face to face and through the mail and overland transportation.

Transactions occurred in taverns and bars where the brokers would get together to share information and buy and sell issues. The New York Stock Exchange was formed by a group of prominent bankers and brokers who began trading local taverns in the early 1790's. It later evolved into the curb exchange where brokers would trade on the steps outside its Wall Street office at 40 Wall St. This practice was abandoned in 1836 when the NYSE forbade its traders from trading in the streets. When this happened the over the counter market in bank stocks received a boost since these issues were traded actively on the curb exchange and could no longer be traded in the NYSE. Thus the trading of these shares had to continue with the banks and brokers over the counter. The NYSE made their proclamation in part to prevent the trading of these penny stocks by their members. Some have speculated that this act caused the panic of 1837. These shares had been regularly traded and many brokers and investors relied on the daily trading to fairly value the shares. When investors could no longer count on these daily price changes they could not make active decisions on when to buy and sell. Thus, when the economic crisis built, these investors from the United States panicked and tried to sell their shares all at once. This selling caused a run on the banks to redeem their certificates. This run made so many banks close that when the word reached Europe, there were runs on the banks there as well.

The existence of the over the counter market was not the cause of these economic crises'. It was however a medium for the abuses that took place. The problem with the over the counter was lack of regulation and standardization of transactions and disclosures. In addition, lack of timely information created a greater propensity for panic when bad information came out.

In 1901 a great event occurred in the world of investing. Noted investment advisor and statistician John Babson, who later contracted Tuberculosis. Why was this such a great event, it certainly wasn't a great event to Mr. Babson? Well, Mr. Babson spent the next few years in bed. With all that time to think, Mr. Babson came up with a strategy to reinvent himself and provide sustenance for his family. By utilizing his contacts in the investment industry, Mr. Babson was able to build a network of investment firms who contributed buy sell and volume data to Mr. Babson. Babson then compiled this data and applied the first technical statistics to the markets to determine value and increase accurate pricing. This system was the foundation for his company the Business Statistics Organization and later called the Babson Report. This report was the catalyst for information utilized by Arthur Elliot in his 1904 venture to publish the quotations of buy and sell transactions in a weekly and monthly sheet known as the National Quotation Bureau. Arthur Elliot was a publisher who knew he could capitalize on this data in a newsletter format. By utilizing Mr. Babson's reputation he could gain readership fast and provide data that people can trust and rely on.

In 1904, the National Quotation Bureau began operation and helped to standardize the transfer and transactions in these shares. The Bureau's responsibility was to facilitate trading between market makers and dealers in paper certificates across the nation. The National Quotations board has continued to provide quote and trade data. In 1962, the automated electronic quotation system began operation through a joint venture with the National Quotation Bureau and solved many of the time delay and quotation differential problems present in the market. In 1971, the National Association of Securities Dealers Automated Quotation System began operations. The NASDAQ quoted all over the counter issues at its beginning. The quotations were later upgraded to include 3 levels. The first was for larger more established companies and is called the National Market. The second tier is called the Small Cap market. The last level was the remainder of the over the counter issues that could not qualify for the upper levels and was managed in a joint venture by the NASD and the National Quotations Bureau. This level was often called the NASDAQ OTC, OTCBB, or penny stocks. Erroneously, this market was not a NASDAQ market but rather a National Quotations market piggybacked on the NASDAQ quotation system.

The NASDAQ began the first formalized regulation of the over the counter market. The additions that NASDAQ made had an immediate impact on the quality of the issues it presented. In addition, the NASDAQ made capital readily available to those new start up companies in technology and medical areas. Since its inception, the NASDAQ has become one of the largest exchanges in the world responsible for over 1/3 of the trades in the US markets each year.

Since 1994, the NASD has been ridding itself of the burden present in the OTC bulletin boards. These companies represent the greatest area of abuse in the market and subsequently the NASD decided to rid itself of the regulatory burden of this market. The over the counter has essentially reverted back to the pre 1962 day's. The addition of trading software for the OTC bulletin boards allow real time trading and allows brokers to receive data in real time identical to the NASDAQ markets. This new trading data has enhanced the ability of traders and investors to gather trade data but has done nothing to increase the quality of companies on the OTCBB.

Prior to 1999, over the counter non-reporting issues were quoted along with the fully reporting issues. This was a difficult system because the investor was left to determine which of the over the counter issues were reporting their financials and which were not. In 1998 the Securities Exchange Commission in cooperation with the National Association of Securities Dealers enacted new regulations requiring all companies listed on the over the counter to be fully reporting or face de-listing to the pink sheets. This forced many of the over the counter issues that have never reported to disclose practices and transactions that are critical to investors being able to make informed decisions. The companies who are not reporting are relegated to the Pink Sheets. The Pink Sheets are managed by a private non government entity and subsequently has much less volume than the OTC supported by the NASDAQ trading system.

New share exchange systems are being tested currently such as Internet Exchanges. These exchanges hoped to capitalize on the individual investor growth of the 1990's. The bursting of the bubble in 2001 ended that. There is a much smaller audience for this type of trading now. The over the counter volume has slowly declined over the last several months as well. Volume is at a low point for a 15-year period. The loss in portfolio value has caused many investors to reevaluate their portfolio's and to rebuild rather than risk capital positions. Part of this is due to the quality of the companies located on the exchange and part of it is due to the lack of broker involvement following the 1999 SEC change.

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