THE IMPACT OF THE PENNY STOCK REFORM ACT

The Securities Enforcement Remedies and Penny Stock Reform Act of 1990 is one of the two principal causes for the reverse merger boom and the predominance of shell company transactions.

Under this law, a penny stock is defined as a security trading under five dollars if the company does not meet certain asset or revenue requirements. In the economic boom of the 1980s, there was a significant need for capital creation to finance the huge number of startup companies. There was a large number of small underwritings by small and medium-sized securities firms, with prices mostly under five dollars a share, as reflected in the startup nature of the businesses which were financed. Of course, there are bad actors in any industry, and there were abuses.

The effect of the Penny Stock Reform Act was to severely limit trading in penny stocks. Since trading was limited in penny stocks, it became much more difficult for broker-dealers to raise money in underwritings. The result of this regulatory change was to eliminate the possibility of a small company IPO, for example with revenues under $10 million a year, to go public through an IPO.

Another factor causing the demise of the small capitalization IPO was increasing regulation by the NASD, (the predecessor to FINRA). Increasing regulation of the brokerage community drove up costs. The regulatory costs of a $500,000 dollar offering, with commissions and other compensation, allow compensation of about $70,000. The regulatory costs of such an offering  is nearly the same as an offering for $10 million, with over $1 million compensation. Therefore, it was not profitable to carry out an IPO of the development stage company.

You might say, however, wouldn’t small companies be willing to pay more in commissions to reflect the relatively proportionally higher costs of an IPO for small company? This is not possible, because the NASD, and now FINRA, limits the amount of compensation that may be paid to an underwriter. These price controls, as all price controls, have generated  distortions in the market and led to regulatory problems even greater than they sought to solve. This is a perfect example of what is known as “the law of unintended consequences.”