The ABCs of the OTC BB

Often I get e-mails about my opinion on small stocks. Of course, in many
cases, I’ve never heard of the company (nor really want to). Most of these
stocks are on the so-called Over-the-Counter Bulletin Board (OTC BB). My
advice: in many cases, stay away.

NASDAQ is a major exchange, which has rigorous listing requirements. A
company needs a minimum amount of assets, shareholders, float, market
capitalization, market makers, etc. The NASDAQ is divided into the
National Market System and the SmallCap Market, with the former having
higher listing requirements.

Now, below this is the OTC BB, as well as the Pink Sheets. The Pink Sheets
do not have an automated quote system (rather, trades were traditionally
printed on actual pink sheets). OTC BB stocks are posted on machines.

The OTC BB market has no listing requirements. In fact, companies usually
become part of this market from the “back door,” that is, a reverse merger.

Here’s how it works: Company X has public shareholders and trades lightly.
However, the company has no assets or liabilities. It is a shell. Then,
there is a private company, called Y, which wants to be public. So, it
will merge itself into X, but rename the company Y. Unlike an IPO, this
process does not result in any capital. But many of these companies will
then attempt to raise money in private offerings (such as to high-net worth
individuals), in expectation that NASDAQ listing requirements will be met.
But this is a rare event.

Why should investors be wary of the OTC BB? There are several reasons:

  1. Liquidity: Since many companies do not have big Wall Street firms
    backing them, there is light volume in the stocks. What’s more, there is
    little or no research coverage

  2. Regulations: The OTC BB is loosely regulated. As a result, the market
    is subject to manipulation. One popular technique is the “pump and dump.”
    Investors will drive the stock price up and create a frenzy and then cash

  3. Hype: To gain exposure, OTC BB companies have a tendency to engage in
    hype. You may see many — almost outlandish — press releases (saying things
    such as “We are the next Cisco”). Also, these companies usually pay Web
    sites to cover their stocks

  4. Leverage: Many OTC BB companies have low amounts of cash. Thus, it is
    difficult for them to adequately execute on their core business

  5. Trading Restrictions: Most of the major brokerage firms have trading
    restrictions on their brokers, barring them from recommending OTC BB
    stocks (because of the high risks and potential liability exposure)

Of course, there are legitimate companies on the OTC BB. Unfortunately, it
is not easy to tell. Typically, you can determine this by visiting the
company or knowing the individuals personally. This actually can present
tremendous opportunity. For example, this happened to me with a company
Vsource (VSRC)
, which has a great product for the business-to-business space. I was
able to get their new business plan several months ago when the stock was
below $2 per share. Now, the stock is trading at $15-3/4. But unless you
have this type of information, it is probably a good idea to focus on
NASDAQ for your portfolio.

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