Introducing pink sheets: the OTC market

Pink sheets are an over-the-counter (OTC) market that connects broker-dealers electronically. There is no trading floor, and the quotations are also all done electronically. Since there is no central trading floor or stock exchange like the NYSE, the pink sheet-listed companies do not have the same criteria to fulfill as the companies listed on national stock exchanges. Pink sheets got their name because the original pink sheets were actually printed and distributed on pink pieces of paper.

In this article we'll describe what pink sheet securities are, along with their risks and potential benefits. 

Pink sheet-listed companies have no requirement to be listed. All a company needs to do to get listed on the pink sheets is submit a form, entitled Form 211, with the OTC Compliance Unit. Usually this is done on behalf of a company by a market maker. The form must have current financial information. The more willing a company is to show its books, the easier it is for a broker-dealer to quote a price for that company. Some companies will make it easier and others will not; they are under no obligation to do so, and because of this, transparency is not comparable to financials for exchange-listed companies.

Pink sheet-listed companies are usually very small, tightly held and may also be thinly traded. The most difficult part about the pink sheet-listed companies is many of them do not even file annual or periodic reports with the Securities & Exchange Commission (SEC). This can make it very difficult – if not nearly impossible – for an average investor to get any real information regarding these companies.

(To learn more, check out SEC Filings: Forms You Need to Know.)

You may have seen the term "OTCBB" on a stock quote, which stands for Over-the-Counter Bulletin Board. The OTCBB is a quotation service that also lists over-the-counter securities. The pink sheets are a privately held company, while the Nasdaq owns and operates the OTCBB.

The other difference between the pink sheets and OTCBB is that there are stricter standards for OTCBB. OTCBB issuers have to register with the SEC. For the purpose of this article, we will only discuss the pink sheets quotation system.

(To find out more about the OTCBB, read Spot Hotshot Penny Stocks.)

Advantages

The biggest advantage of trading pink sheets is that they are very inexpensive per share – some cost even less than $1. Because of this, even penny moves can mean a great return for an investor because of the higher volatility levels.

Another advantage is finding a once-strong company that has subsequently been beaten down. If a company was once listed on a major exchange like the NYSE, but has been delisted because it no longer meets certain requirements, an investor could buy shares of that company with the hope it could make a comeback. Usually, a company is delisted because of a major financial event that makes the company's future bleak.

Being early to a party may not be hip, but being early on a rising stock certainly is. When it comes to pink sheets-listed companies, you can invest in a small company that may not be nationally known. Investing in this company can be quite profitable if it continues to grow; it may even end up on a major exchange in the future.

Another advantage of pink sheets firms is the introduction of a new classification or tier system for differentiating stocks. These tiers make it easier to steer clear of the higher-risk companies listed on the pink sheets market.

(To read about other stock-classification systems, see GICS vs. ICB: Competing Systems for Classifying Stocks.)

Disadvantages

One should not forget that there are many disadvantages for investors to consider as well. First and foremost is limited information. Pink sheet-listed companies do not need to report any information to investors. This can make it difficult to know what you're buying and how the company is doing over time.

Thinly traded companies are another disadvantage. Sure, you can buy 1,000 shares of the next Microsoft, but what if you made a nice profit and want to sell? When a stock is thinly traded, the chances of getting out without driving the price down are slim. No matter what the market, if you can't find a buyer, you won't get out of your position, and this is an even more difficult situation when it comes to pink sheets-listed companies. Bid-ask spreads are very high, and high bid-ask spreads can make it difficult to initiate a position in the stock.

(To read more, see The Basics of the Bid-Ask Spread.)

Investors also have to be aware that these companies are not usually covered by analysts. If you read or watch financial media, they rarely (if ever) cover a company that is not listed on a major exchange. This requires a lot more due diligence on the part of the investor to locate information. Of course, that information may or may not be worthwhile in the end.

The pink sheets system now has market tiers in order to list the companies by their "hazard" or risk level. The tiers allow the investor to quickly get an idea of what kind of company he or she is buying.

Trusted Tier

The first tier contains both international and U.S. companies that the pink sheets OTC market has deemed trustworthy and more investor friendly.

• International Premier QX. These companies are based overseas and are listed on an international exchange, but they still meet the financial requirements of the NYSE Worldwide Listing Standards. These companies establish an independent audit as well as providing immediate certification by the CEO of any non-compliance with corporate governance. These companies, while listed in another country on another exchange, still provide the NYSE with a written and updated notification of their corporate-governance practices.
• Premiere QX. These are companies listed in the U.S. only that meet the Nasdaq's Capital Market continued listing standards. These companies may or may not report to the SEC, yet they still follow all of the guidelines listed by the Nasdaq.

Transparent Tier

This tier is lower than the Trusted tier and is made up of the following:

• Pink Quote OTCBB. These companies are listed in both the pink sheets system and the OTCBB. The bulk of all OTC stocks will be dually-listed. The OTCBB requires these companies to report to the SEC frequently.
• OTCBB Only. This is obvious, as these are companies only listed on the OTCBB market.
• Current Information. These are companies that are providing information with either the SEC or the OTC Disclosure and News Service. This information is no more than six months old. In order for companies to stay at this tier and not be moved down, they need to have filed a quarterly or annual report within 75 days after the last quarter has ended. The pink sheet OTC market will verify that the information has been posted.

Distressed Tier

This tier is not for the faint of heart. Companies falling in this tier will all be listed under

• Limited Information. These are companies that fit one of the following criteria:
  
  • They have information that is available to the general public, but is older than six months and does not usually conform to the pink sheets OTC-market guidelines.
  • These companies could have also filed with the SEC but have not updated their information.
  • You will also see companies here if they have filed information with the OTC Disclosure and News Service. They must have, at a minimum, a balance sheet, income statement and shares outstanding within the last six months.
  • Companies that have gone bankrupt will also appear on this list. These newly bankrupt companies are required to file information with the OTC Disclosure and News Service promptly.

Dark/Defunct Tier

There are two types of companies that will fall into this memorably named tier:

• No Information. You will see this category listed with a stop sign as a symbol. These are companies that are defunct or have not filed any information with either the SEC or the OTC Disclosure and News Service within the last six months. These companies are the ones that you need to be very cautious about.
• Gray Market. The symbol for the gray market is an exclamation point. Companies in this category do not have a market maker. These companies are listed on neither the OTCBB nor the pink sheets. This category has no market transparency. Trades in this category are made by a broker-dealer and reported to their self-regulatory organization (SRO). The SRO will distribute the trade information, which is how prices can be tracked.

Toxic Tier

This tier advertises its extreme risk level by having a skull-and-crossbones symbol. There is only one category in this group:

• Caveat Emptor. Here, the title says it all: "buyer beware." The Caveat Emptor tier is described on the pink sheets website as consisting of "stocks that are the subject of unsolicited spam, questionable promotion, regulatory suspensions, disruptive corporate actions (including reverse mergers), or other public-interest concerns." These are companies that are either scams or not actual businesses.

(To read about how pink sheet investing can go wrong, see Wham Bam Micro-Cap Scam.)

If you are interested in investing in pink sheet stocks you will need to find a broker. If you already have a brokerage account, chances are the broker will allow you to trade pink sheet stocks, although some brokerage firms only allow seasoned clients trading privileges in the pink sheet market.

They will also ask you to sign an additional form that says you understand the risks associated with trading pink sheets stocks. A lot of investors like to use a different broker with better rates – some will charge a flat fee and others will charge a different fee to trade pink sheet stocks.

You should not forget that there are many companies listed that are not interested in giving out information, and investing in them can mean losing all of the money you invested. The biggest appeal of pink sheet companies is their low price, and they are attractive to those investors that really want to get in on the ground floor of an up-and-coming company. Understanding the risks and the potential for losing your entire investment will allow you to make better decisions regarding these most speculative stocks.

Pink sheets have come a long way, and with the help of the expanding OTC markets, more information and some standards have been set to help investors find out about the companies listed on the pink sheets. The introduction of a new tier system will only make those other legitimate companies listed in the pink sheet market better equipped to attract investors. Pay very careful attention to the tier system that the pink sheet market has set up, and consult an investment professional to help steer you in the right direction before taking the plunge on pink sheet stocks.