September 16, 2021

New SEC Rule Effectively Bans Retail Investors from the OTC Gray Market

New SEC Rule Effectively Bans Retail Investors from the OTC Gray Market
New SEC Rule Effectively Bans Retail Investors from the OTC Gray Market

The SEC just disrupted a niche corner of the stock market and their involvement could potentially lock retail investors out of areas of significant opportunity. 

To put it shortly, the SEC is not allowing broker-dealers to quote non-reporting or “dark” companies. In other words, if a company doesn’t report timely financial statements and reports to the SEC, brokerages like Schwab or TD Ameritrade aren’t allowed to supply quotes to their clients to trade them. 

Here’s a direct quote from the SEC’s press release on the matter: 

“The amended rule enhances disclosure and investor protection in the OTC market by ensuring that broker-dealers, in their role as professional gatekeepers to this market, do not publish quotations for an issuer’s security when current issuer information is not publicly available, subject to certain exceptions.” 

The SEC implemented this by changing rule 15c2-11, which is the set of rules on how broker-dealers can quote stocks to their clients.

Even before the rule change, the guidelines for quoting illiquid penny stocks and OTC stocks have always been stricter due to the increased risk. But the SEC just made the quoting restrictions even stricter. 

The outcome of this rule change is that if a company doesn’t report to the SEC, you won’t be able to trade them with an everyday retail brokerage account.

Not only will the brokerages not supply you quotes to know where the price is, but almost every US broker responded to this change by restricting customers from trading the stocks, probably to reduce any legal liabilities they open themselves up to, as well as reduce customer service headaches for a part of their business that supplies very little revenue. 

On the surface, this makes a lot of sense. A company that doesn’t report information about their financials or operations is opaque and the argument is that retail investors don’t have enough information to trade them. 

However, the space of “dark” stocks is one of the few areas left where an individual investor can find significant alpha by sifting through these unwanted, unknown, and illiquid companies to find value where others refuse to look, or can’t invest because of liquidity constraints. 

So this action doesn’t come without criticism from the community of investors who invest in these stocks for a living. 

Before we move onto the finer details of defining what dark stocks are, what will change with them, and also potential ways retail investors can still trade them, we’re going to explain how quoting works from a regulatory perspective. 

SEC Rule 15c2-11 Explained: The New Changes That Affect Dark Stocks

SEC rule 15c2-11 is the rule that sets guidelines for broker-dealers on how and when they can quote OTC stocks for customers.

Historically, brokers had to check in with FINRA, which is the self-regulatory agency that regulates brokers. So the regulatory hurdle on brokerage firms was already much higher for quoting these stocks, but now brokerage firms can’t quote these types of stocks period. 

That means you can’t pull up a chart of a dark stock in your trading platform. And for the vast majority of you reading, your broker probably won’t even let you trade them because it’s simply too much of a regulatory hassle for a very low-revenue part of their business. 

Several brokers like TD Ameritrade have made public statements to their clients informing them that they don’t intend to provide trading services for dark stocks starting in September 2021. If these are your bread and butter, it’s probably smart to start making arrangements with a more niche broker. 

What are Dark OTC Stocks? Also Known as Non-Reporting Companies or Gray Market Stocks

There are several tiers of OTC stocks.

There are three official tiers of stocks listed with the OTC Markets Group: OTCQX, OTCQB, and OTC Pink. But there’s an additional ‘hidden’ tier of OTC stocks: ‘gray’ or ‘dark’ stocks.

These are stocks that don’t report current information with the SEC, but still have a publicly traded stock. They’ve gone ‘dark’ because they’re no longer reporting financial statements like 10-Ks to their shareholders.

Most of the time these “dark” stocks were at one point public, and voluntarily deregistered from SEC reporting and delisted their stock from a public exchange.

They delist because the benefits of being a public company were outweighed by the drawbacks like exchange fees, increased legal risk, and having to answer to a swath of unknown shareholders. 

But, for example, in a delisting process, some shareholders don’t participate in the company’s going-private liquidation transactions and are still rightful owners of their shares. So there needs to be a market where investors can trade these shares, and a ‘dark’ stock is the result. 

These dark stocks provide a significant source of alpha to many investors because of the potential information asymmetry you can attain by deeply researching a company that very few investors understand.

Furthermore, there’s so few traders dealing in these stocks that you can sometimes get a great price when an investor needs to sell quickly and there’s nobody around to buy from them except you. 

Many investors who specialize in dark stocks succeed through establishing relationships with company management and even assisting the companies with business strategy. There’s several popular blogs and online communities in this space, one such community is GeoInvestors. 

Contrary to what you might think, these companies aren’t all bad. While most of them aren’t worth taking a second look, there are many diamonds in the rough in this corner of the market that the most sophisticated fund managers don’t pay any attention to. 

But being dark and not reporting current financial information to the SEC, investors can’t get a full picture of the stock they’re trying to purchase. 

As a result of this new rule, most US brokers have halted all trading of these stocks for their customers, and as you could probably predict, the liquidity in these already highly illiquid stocks just took a nosedive.

Now, this SEC rule didn’t force the brokers to halt trading, they took this action voluntarily, likely because of the potential legal liabilities associated with allowing customers to sell securities they can’t get quotes for. 

You see, the OTC market exploded in popularity in 2020. With COVID lockdowns creating millions of new traders around the world, many retail investors got interested in the OTC market with the allure of buying stocks that go up 1,000% in a day, as you might see on those free online OTC screeners.

With the OTC market having so many shady characters, many of the stocks retail traders got involved in were total scams or pump and dumps so a lot of people called for the SEC to take action. 

However, among the small community of investors who traffic in these dark securities, the overwhelming sentiment is that dark securities are inappropriate targets because they’re used  in schemes far less often than OTC stocks that are registered with the SEC.

The reason for this is probably that scammers looking for shell companies to start a pump and dump scheme are likely going to buy a registered shell to look legitimate. 

Additionally, you could argue that dark companies are getting a free ride from the public markets by accessing investors and having a source of liquidity for their own shares without having to do any of the work other public companies have to. 

Bottom Line

From the outside looking in, it’s always sad to see the market becoming less accessible to the individual retail investor.

However, a silver lining to this is that perhaps some of these dark stocks will go through the trouble to get into compliance with the SEC and OTC Markets Group, creating more market transparency.