Penny stocks are extremely cheap equity securities that trade in the over-the-counter financial markets and not on a major, regulated exchanges. Consequently, it is possible for penny stock fraud to occur more frequently than is likely on a major stock exchange. The Internet and social media are mechanisms that can be used to commit penny stock fraud by unethical market participants. Also, as these stocks trade in an unregulated environment, there is a greater chance that fraud could occur by the company itself.
The management teams of penny stock companies are not required to file formal documents with regulatory agencies in a region, such as the Securities and Exchange Commission in the U.S. As a result, it is more difficult for investors to obtain transparency on the financial health of an investment. Even when a penny stock company begins trading in the public markets for the first time, a proxy statement outlining the details of the offering is withheld. This lack of regulatory oversight makes penny stock fraud more possible if any market participant decides to push an investment based on false information.
Stock brokers or financial analysts can be the most reputable professionals in the industry. There is still a possibility of penny stock fraud that could occur among qualified members of the financial community. A scam known as "pump and dump" is when some financial professional touts the merits of an investment security. Once the investment community responds and buys shares of that stock, the financial professional goes on to sell shares and earn a profit on the investors.
Penny stocks trade over the counter because they do not meet the standards to list shares on a major exchange. A risk for investors is that the best possible price will not be obtained for an investment, either because of penny stock fraud or for inefficiencies in the markets. In the over-the-counter markets, the price to buy or sell a share of stock is negotiated with broker dealers over the telephone or computer, and this leaves room for human error or manipulation.
Investors in penny stocks anticipate profit growth through stock gains because there is so much room for a cheap stock to advance. Some experts, however, advise that these securities be avoided altogether because of the vulnerability to penny stock fraud. There are thousands upon thousands of securities that trade in regulated exchanges that have greater accountability and transparency.