The Basics: What Is the Over-the-Counter Market?

    by John Deysher

    "Over-the-counter," or OTC, is a term loosely applied to securities that aren't listed on an organized exchange—such as the New York, American, Midwest, Boston, Pacific or Philadelphia exchange. OTC securities are traded through at least two, but often numerous "market makers" who maintain bids and offers for the securities they trade. Securities that trade on a listed exchange are quoted by a solo "specialist" who is charged with maintaining orderly trading in a security.

    Over-the-counter trading traces its roots to the early 1900s when small firms that didn't qualify for an exchange listing were traded informally among brokers. The term refers to the actual countertops used by dealers to handle transactions. Up until about 30 years ago, volume on the exchanges dwarfed the OTC market. But in the mid-1970s, the OTC market began to pick up steam. Since then, the explosion of initial public offerings and subsequent OTC listings make it the biggest market in the world.

    The OTC market consists of four basic units, each with different qualification standards:

    • NASDAQ National Market (NNM)
    • NASDAQ SmallCap
    • OTC Bulletin Board
    • Pink Sheets
    Once included in either the NASDAQ National Market or NASDAQ SmallCap system, a company must maintain certain financial standards generally equal to about half the initial asset and capitalization requirements. They must also meet certain governance requirements including: publishing annual and quarterly reports, conducting annual meetings and maintaining independent directors.

    Trading in all NASDAQ securities is overseen by the National Association of Securities Dealers (NASD) and all NASDAQ firms must submit regular reports for SEC (Securities and Exchange Commission) review.

    But the majority of companies whose shares are traded over the counter don't meet current NASDAQ requirements. These non-NASDAQ issues include small and large domestic and international companies that can't or don't wish to comply with NASDAQ's listing requirements. They trade on either the OTC Bulletin Board or in the Pink Sheets.

    The Bulletin Board (OTCBB)

    Founded in 1990, the Bulletin Board is a network of electronically linked market makers who trade shares of small companies. Unlike the totally unregulated Pink Sheets, the Bulletin Board is overseen by the SEC and the NASD. Bulletin Board companies must file audited financial statements with the SEC and comply with federal securities laws. Many companies end up here after being thrown off an exchange or NASDAQ for failing to meet financial or governance listing standards.

    But caveat emptor:

    • Although Bulletin Board companies are required to file annual and quarterly reports, proxies and insider trades with the SEC, neither the SEC nor FINRA (formerly the NASD) verifies the filings as factual.

    • There are no minimums either—a company may have no assets, sales or earnings, but as long as they make timely SEC filings they'll continue to be listed.

    • There are also no governance standards, independent audit committees or independent directors like those applied to listed and NASDAQ companies.
    All this makes fraud and other corporate malfeasance much easier to commit on the Bulletin Board.

    However, there are some larger, conservatively financed companies that have been around a long time and trade actively on the Bulletin Board. These include: Bresler & Reiner, Bulova, Monarch Cement, Erie Family Life and New Ulm Telecom.

    The Pink Sheets

    Finally, we come to the Pink Sheets, a dwelling place for companies that are not required to make SEC filings (usually because they have less than 300 shareholders) and are thus regulation-free.

    There is often minimal disclosure, with some companies issuing nothing more than audited financial statements once a year.

    Liquidity is often minimal, with some issues trading only a few shares per month (or year).

    The Pinks are strewn with the shares of near worthless issuers, such as bankrupt companies that are in reorganization or liquidation and have not made timely SEC filings. There's a lot of junk here, as well as the increased risk of fraud and malfeasance.

    But there are also some very good companies trading here and their number is growing.

    One of the consequences of the Sarbanes-Oxley Act of 2002 and tougher corporate disclosure laws is the choice by many companies to deregister their securities. Under the rules, any company that can show it has less than 300 "owners of record" can deregister, meaning it is no longer a "public company," is no longer required to make SEC filings and is exempt from regulatory oversight. Many small companies estimate the cost of complying with Sarbanes-Oxley—in terms of higher insurance, audit and legal fees—can easily exceed $1 million annually. Their shares now trade in the Pinks, but the savings can be significant.

    Many companies that deregister continue to make public earnings announcements, file annual and quarterly reports and hold annual shareholder meetings. When a company announces it is deregistering, the shares usually fall significantly, as investors run for the exits, not wishing to continue to own shares of a non-reporting company. Over time, though, the share price reflects the operating fundamentals as it does for listed or NASDAQ securities.

    Tips on Investing in the OTC Markets

    • Investigate before you invest. Since many OTC stocks have little if any analyst coverage, you will be doing much of the due diligence research yourself. Many firms have Web pages, which is a good place to start. Order annual reports and proxies, and review SEC filings. Do the same for the competitors. Crunch the numbers. Identify why you think this company is a worthwhile investment. What are the opportunities and risks? Upside and downside?

    • If you are interested in a bank, thrift or insurance company, check the regulatory filings of federal and state banking and insurance departments.

    • Use limit orders where a large spread exists between the bid and offer. This may be especially true with inactive Bulletin Board and Pink Sheet issues.

    • If you are interested in inactive issues (where greater price inefficiencies may exist), obtain a copy of Walker's Manual of Unlisted Stocks (732/431-6614). Editor Andrew Berger sifts through thousands of companies and profiles 500 thinly traded issues.

    • Stick with companies that use reputable auditors, where standards are higher.
    Access to 10-Ks, 10-Qs, 8-Ks, proxies, etc., of all SEC-filing companies.
    Quotes, data and information on all NASDAQ-traded companies.
    Market news, statistics, recent additions and deletions.
    Market news, NASDAQ indexes, broker-dealer information.
    Quotes, data and information on Bulletin Board-traded companies.
    Quotes, data and information on Pink Sheet-traded companies.
    Semi-current Level II quotes on Pink Sheet issues for a monthly fee.
    Information on Bulletin Board, Pink Sheet and thinly traded issues.
    Alerts investors to potential fraud in penny stocks.

    John Deysher, CFA, is president and portfolio manager of the Pinnacle Value Fund, a diversified mutual fund specializing in the securities of small- and micro-cap companies. He is based in New York City and can be reached at

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