New SEC Ruling Prohibits Retail Investors From Using OTC Gray Market

The SEC has recently taken action that could impact a specific segment of the stock market and potentially restrict retail investors from certain investment opportunities. 

Specifically, the SEC has prohibited broker-dealers from quoting “dark” or non-reporting companies, which are companies that do not provide timely financial statements and reports to the SEC. This means that brokerages like Schwab and TD Ameritrade are not allowed to supply quotes for their clients to trade these stocks.

The SEC had this to say 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protection in the OTC market by ensuring that broker-dealers, in their role as professional gatekeepers to this market, do not publish quotations for an issuer’s security when current issuer information is not publicly available, subject to certain exceptions.”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 has recently made changes to rule 15c2-11, which outlines the guidelines for how broker-dealers can quote stocks to their clients. These changes have further tightened the restrictions on quoting illiquid penny stocks and OTC stocks, which are known to carry higher levels of risk. Prior to these changes, these types of stocks were already subject to stricter quoting guidelines.

As a result of the changes made by the SEC to rule 15c2-11, retail investors will no longer be able to trade stocks of companies that do not report to the SEC through their everyday brokerage accounts. This is because brokerages will not supply quotes for these stocks and have also restricted their customers from trading them. 

The rationale behind this change is that companies that do not disclose financial or operational information are not transparent, and retail investors may not have enough information to make informed investment decisions. Brokerages have likely implemented these restrictions to reduce legal liabilities and customer service issues, as trading in these types of stocks generates relatively little revenue.

There has been some criticism of the SEC’s changes to rule 15c2-11 because it limits retail investors’ ability to invest in “dark” stocks, which are companies that do not report to the SEC. These types of stocks are often overlooked by other investors and may offer opportunities for individuals to find value where others are not looking or are unable to invest due to liquidity constraints. 

Dark stocks can be difficult to trade and understand, but some investors specialize in seeking out these types of opportunities. Before discussing the specific characteristics of dark stocks, how the SEC’s changes will impact them, and potential ways for retail investors to still trade them, it is helpful to understand the regulatory framework for quoting stocks.

SEC Rule 15c2-11 and how these changes affect dark stocks 

SEC rule 15c2-11 is a regulatory framework that outlines how and when broker-dealers can quote OTC stocks for their customers. Previously, brokers were required to comply with certain guidelines set by FINRA, the self-regulatory agency that oversees brokers, when quoting these types of stocks. However, the recent changes to rule 15c2-11 now prohibit broker-dealers from quoting dark stocks at all. 

This means that retail investors will not be able to view charts or other information about these stocks on their trading platforms, and most brokers will not allow their clients to trade them due to the additional regulatory burden and low revenue potential. Some brokers, such as TD Ameritrade, have announced that they will no longer provide trading services for dark stocks starting in September 2021. Investors who frequently trade dark stocks may need to consider alternative brokers that specialize in these types of securities.

What are Dark OTC Stocks and how do they work?

There are three primary tiers of stocks listed with the OTC Markets Group: OTCQX, OTCQB, and OTC Pink. In addition to these official tiers, there is also a “hidden” category of OTC stocks known as “gray” or “dark” stocks. These are stocks that are publicly traded but are not required to report current information to the SEC. 

As a result, they are not required to disclose financial statements like 10-Ks to their shareholders. Dark stocks are often considered to be more risky and may not be suitable for all investors. It is important for investors to carefully consider the potential risks and rewards before deciding to invest in these types of securities. 

Many dark stocks were previously public companies that chose to deregister from SEC reporting and delist their stocks from public exchanges. They may have done this because the costs and responsibilities of being a public company, such as exchange fees, increased legal risks, and the need to communicate with a large group of unknown shareholders, outweighed the benefits. 

As a result, these companies may no longer be required to disclose financial information to the public and may be considered riskier investments. It is important for investors to carefully consider the potential risks and rewards before deciding to invest in these types of securities.

When a company delists from a public exchange, some shareholders may not participate in the company’s going-private liquidation transactions and may still own their shares. In order to provide a market for these shares, “dark” stocks are created. These stocks allow investors to trade shares of companies that are no longer required to disclose financial information to the public. 

Some investors may see these stocks as an opportunity to find alpha, or outperformance, by researching and gaining insight into companies that are not well understood by the broader market. However, investing in dark stocks also carries additional risks, such as the lack of transparency and information about the company’s financial health. It is important for investors to carefully consider these risks before deciding to invest in these types of securities.

Investing in “dark” stocks can sometimes offer opportunities for investors due to the low volume of traders in these types of securities. This can allow investors to purchase shares at a discounted price when someone else needs to sell quickly and there is limited demand for the stock. Some investors who specialize in dark stocks may also be able to build relationships with company management and help shape the company’s business strategy. There are several online communities and blogs that focus on this type of investing, including the ever present GeoInvestors.

While some investors may view “dark” stocks as risky due to their lack of transparency and the difficulty in obtaining complete information about the company, these securities can also offer opportunities for those willing to take on additional risk. 

However, the recent changes to SEC rule 15c2-11 have led many US brokers to halt trading in these types of stocks for their customers, which could impact liquidity in these already highly illiquid securities. It is important for investors to carefully consider the risks and potential rewards of investing in these types of stocks before making a decision.

This change in SEC rules aims to address the issue of transparency in the OTC market, where many companies do not report timely financial statements and reports to the SEC. As a result, retail investors may not have enough information to make informed decisions about these stocks. 

The change prevents brokerages from quoting these “dark” stocks, and many brokers have also restricted their customers from trading them to reduce legal liabilities and customer service issues. This has caused liquidity in these already illiquid stocks to decrease further. While these stocks may offer significant alpha for investors who are able to research and understand them, the lack of transparency and increased risk makes them a potentially risky choice for most retail investors 

Dark securities, or securities that are traded off exchanges and not subject to the same regulatory requirements as those listed on exchanges, are often viewed negatively by investors due to their association with fraudulent activities such as pump and dump schemes. However, in reality, these types of securities are actually less likely to be used in such schemes compared to over-the-counter (OTC) stocks that are registered with the Securities and Exchange Commission (SEC). 

This may be because scammers seeking to appear legitimate are more likely to use registered shell companies rather than unregistered ones. Additionally, some people believe that dark securities benefit from the public markets without having to comply with the same requirements as other publicly traded companies.

Final thoughts

It can be disheartening when individual retail investors have a harder time participating in the financial markets. However, it is possible that some dark stocks, which are not subject to the same regulatory requirements as those listed on exchanges, will make an effort to become more transparent by registering with the Securities and Exchange Commission (SEC) and the OTC Markets Group. This process would involve following certain rules and requirements in order to increase transparency in the market and potentially make these stocks more appealing to investors.


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